Final Installment Agreement Regulations

The IRS has issued final regulations relating to the payment of tax liabilities through installment agreements. The regulations reflect changes to the law made by the Taxpayer Bill of Rights II (P.L. 104-168), the Internal Revenue Service Restructuring and Reform Act of 1998 (P.L. 105-206) and the American Jobs Creation Act of 2004 (P.L. 108-357). The final regulations generally adopt proposed regulations issued in March 2007 (NPRM REG-100841-97), with revisions to two provisions made in response to comments received by the IRS. The regulations are effective November 25, 2009.
The final regulations adopt without change procedures set forth in the proposed regulations regarding submission and consideration by the IRS of proposed installment agreements, and acceptance, form and terms of installment agreements. The regulations provide that a proposed installment agreement must be submitted according to the procedures prescribed by the IRS, and becomes pending when it is accepted for processing. An installment agreement request is not accepted until the IRS notifies the taxpayer or the taxpayer's representative of the acceptance.
The final regulations clarify that partial payment agreements do not reduce the amount of taxes, interest or penalties owed. They also clarify that the IRS may enter into agreements that end before the expiration of the period of limitations on collection. Thus, a partial payment installment agreement ending before the expiration of the collection period of limitations would allow the IRS to collect the balance of the tax liability after the agreement expired. However, the preamble to the final regulations notes that the IRS does not currently enter into partial payment installment agreements that expire before the end of the collection statute and has no plans to do so routinely in the future. The final regulations also require the IRS to review partial payment agreements every two years to determine whether the financial condition of the taxpayer has significantly changed. Further, the regulations provide that, while an installment agreement is in effect, the IRS may require the taxpayer to provide updated financial information at any time.
In addition, the final regulations provide that the IRS may not notify a taxpayer of the rejection of an installment agreement until an independent review of the proposed rejection is completed. The final regulations also allow taxpayers to appeal a rejection of an installment agreement to the IRS Office of Appeals within 30 days of being notified of the rejection.
The IRS may modify or terminate an installment agreement if it determines that the taxpayer's financial condition has significantly changed or if the taxpayer fails to meet certain requirements. The proposed regulations provided that the IRS may modify or terminate an installment agreement if the taxpayer fails to provide a financial condition update requested by the Service. The final regulations clarify that the IRS may terminate an installment agreement only if the taxpayer provides materially inaccurate or incomplete information in connection with a requested financial update. Further, the final regulations modify the rule provided in the proposed regulations to explicitly allow taxpayers to request a modification or termination of an existing installment agreement. Additionally, the final regulations clarify that a taxpayer must comply with the terms of an existing installment agreement while a request for modification is being considered, and that a proposed modification will not result in a suspension of the statute of limitations on collection.
The final regulations generally prohibit the IRS from taking any collection activity while a proposed installment agreement is pending, while an installment agreement is in effect, or during the 30-day period following the rejection of a proposed installment agreement or the termination of an installment agreement. Further, the final regulations provide that the statute of limitations on collection under Code Sec. 6502 is suspended while a proposed installment agreement is pending, plus 30 days following a rejection of a proposed installment agreement, and during any appeal. The final regulations also provide that each taxpayer with an installment agreement must also be provided with an annual statement showing the balance due at the beginning of the year, the payments made during the year, and the remaining balance due at the end of the year.
T.D. 9473, filed with the Federal Register on, November 24, 2009.
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
SUMMARY: This document contains final regulations relating to the payment of tax liabilities in installments. The regulations reflect changes to the law made by the Taxpayer Bill of Rights II, the Internal Revenue Service Restructuring and Reform Act of 1998, and the American Jobs Creation Act of 2004. The regulations will affect taxpayers submitting installment agreements to the IRS.
DATES: Effective Date: These regulations are effective on [ INSERT DATE OF PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER].
Applicability Date: For the date of applicability, see §301.6159(k). FOR FURTHER INFORMATION CONTACT: Walter Ryan, (202) 622-3620 (not a tollfree number).
SUPPLEMENTARY INFORMATION:
Background
This document contains amendments to the Procedure and Administration Regulations (26 CFR part 301) under section 6159 of the Internal Revenue Code (Code). Section 6159 allows the IRS to enter into agreements for the payment of any unpaid tax in installments. Taxpayers may request administrative review of IRS decisions to terminate installment agreements pursuant to section 6159(e), added to the Code by section 202 of the Taxpayer Bill of Rights II, Public Law 104-168 (110 Stat. 1452, 1457 (1996)). Taxpayers may appeal rejections of proposed installment agreements under section 7122(e), added to the Code by section 3462 of Internal Revenue Service Restructuring and Reform Act of 1998 (RRA 98), Public Law 105-206 (112 Stat. 685, 764 (1998)). Section 6159(c), added to the Code by section 3467 of RRA 1998, requires the IRS to accept a proposed installment agreement for income taxes under certain circumstances. Section 3506 of RRA 1998 requires the IRS to send each taxpayer with an installment agreement an annual statement showing the balance due at the beginning of the year, the payments made during the year, and the remaining balance due at the end of the year.
Section 843 of the American Jobs Creation Act of 2004 (AJCA), Public Law 108-357 (118 Stat. 1418, 1600 (2004)), amended section 6159(a) to allow the IRS to enter into installment agreements that provide for partial (as well as full) payment of a tax liability, but excludes partial payment installment agreements from the scope of installment agreements that must be accepted by the I RS. Section 843 of the AJCA also added new section 6159(d), requiring the IRS to review partial payment installment agreements every two years. The primary purpose of the review is to determine whether the financial condition of the taxpayer has significantly changed so as to warrant an increase in the value of the payments being made. See H. Rep. No. 108-755, 108th Cong., 2d Sess., 2005 U.S.C.C.A.N. 1341 (October 7, 2004).
On March 5, 2007, a notice of proposed rulemaking (REG-100841-97; 72 FR 9712) was published in the Federal Register. The proposed regulations reflected the changes made to section 6159 by the Taxpayer Bill of Rights II, the RRA 98, and the AJCA. The proposed regulations reflected current IRS administrative practice. The IRS received one set of written comments with numerous recommendations. No public hearing was requested or held. After consideration of the comments, the proposed regulations are adopted as revised by this Treasury decision.
Summary of Comments and Explanation of Revisions
The final regulations adopt certain recommendations contained in the comments by clarifying two provisions of the proposed regulations. As explained in this preamble, §301.6159-1(e)(3) was amended to clarify that the taxpayer may submit a request to modify or terminate the installment agreement. Section 301.6159-1(e)(3) further clarifies that such a request will not suspend the statute of limitations on collection and the taxpayer must comply with the existing installment agreement while the request is being considered. As also explained in this preamble, §301.6159-1(e)(1)(i) clarifies that the IRS may terminate an installment agreement if the taxpayer provides materially incomplete or inaccurate information in response to an IRS request for a financial update.
The following is a section-by-section analysis of the comments.
Section 301.6159-1(b): Procedures for submission and consideration of proposed installment agreements.
Section 301.6159-1(b) of the proposed regulations provided that an installment agreement request must be submitted according to procedures prescribed by the IRS. It did not require the IRS to accept or reject the request within a specific time frame. The commenter proposed to limit the IRS's time to consider an installment agreement to 90 days; if the IRS fails to act in that time, the agreement would be granted automatically. The commenter reasoned that the limited time frame would benefit the IRS because more installments agreements would be automatically allowed, thereby increasing revenues, and would benefit the taxpayer by allowing payments to begin quickly and efficiently. The recommendation was not adopted for two reasons. First, the IRS already grants installment agreements quickly and automatically in the vast majority of cases. If the taxpayer owes less than $25,000 and offers to pay the liabilities in full within 5 years, the agreement can be granted automatically under the IRS's “streamlined” installment agreement procedures. See Internal Revenue Manual 5.14.5.2 at http://www.irs.gov/irm/part5/irm_05-014-005.html. The IRS granted over 2.62 million installment agreements in fiscal year 2008, of which over 2.51 million were granted through the IRS's streamlined procedures. In cases that do not meet the streamlined criteria, the IRS has determined that a more detailed review of the taxpayer's financial situation is warranted. Second, the IRS generally responds to nonstreamlined installment agreement requests in a timely manner. During the filing season, however, inventory fluctuations may cause delays. The automatic allowance of installment agreements in such cases would not be appropriate.
Proposed § 301.6159-1(b)(2) provided that an installment agreement request becomes pending when it is accepted for processing. The commenter recommended that the IRS send an automatically-generated response acknowledging the date of acceptance for processing to the taxpayer and the taxpayer's representative. This recommendation was not adopted. The vast majority of installment agreements are streamlined agreements, which the IRS accepts very quickly. The IRS will, however, consider adopting an administrative procedure for the minority of cases where it anticipates a time lag between acceptance for processing and the acceptance or rejection of the installment agreement.
Proposed §301.6159-1(b)(2) also provided that if an installment agreement request does not contain sufficient information to permit the IRS to evaluate whether the request should be accepted, the IRS will request the needed information. The commenter recommended that all requests for additional information should be reasonably necessary. The proposed regulations already address this recommendation by directing that requests be for “needed” information.
Proposed §301.6159-1(b)(3) allowed a taxpayer to submit a good faith revision of a rejected installment agreement request within 30 days of rejection. The commenter recommended that the time for taxpayers to submit a good faith revision should be extended to 60 days because taxpayers often have difficulty obtaining the necessary documents within 30 days. This recommendation was not adopted. The recommendation would apply to a small number of installment agreement requests that are not accepted under the IRS's streamlined procedures. In these cases, the IRS requests the information necessary for a financial analysis before rejecting the installment agreement request. See Internal Revenue Manual 5.15.1.6 at http://www.irs.gov/irm/part5/irm_05-015-001.html. Allowing 60 days following the rejection would encourage untimely responses and delay case resolution.
Section 301.6159-1(c): Acceptance, form, and terms of installment agreements.
Section 301.6159-1(c)(1) of the proposed regulations provided that an installment agreement request has not been accepted until the IRS notifies the taxpayer or the taxpayer's representative of the acceptance. Section 6159(a) requires that an installment agreement be in writing, and proposed §301.6159-1(c)(2) provided that the writing may take the form of a document signed by the taxpayer and the IRS or the written confirmation of an agreement entered into by the taxpayer and the IRS that is mailed or personally delivered to the taxpayer. The commenter recommended that the IRS's notification of the acceptance or rejection of a proposed installment agreement also be directed to the taxpayer's representative and include the terms of the agreement and payment submission information. These recommendations were not adopted in the regulations because they are more appropriately addressed in the IRS's procedures. The IRS currently does, however, provide written notification to the taxpayer and the taxpayer's representative of the acceptance or rejection of an installment agreement and the suggested information.
The commenter was concerned that the IRS intended to change its streamlined procedures and recommended that the procedures be retained. The commenter was also concerned that proposed §301.6159-1(c)(3)(iii)(A) may represent a departure from the IRS's current policy that limits the acceptance of extensions of the collection statute of limitations in connection with installment agreements to the narrow subset of partial payment installment agreements in which the liability will not be paid in full under the agreement before the collection statute expires. As stated in the preamble to the notice of proposed rulemaking, the regulations were intended to reflect existing practices. The regulations will have no effect on the IRS's streamlined procedures or its policy with regard to waivers of the collection statute.
The commenter stated that the proposed regulations did not explain the inclusion of §301.6159-1(c)(3)(ii), which provided that an installment agreement may, by its terms, end upon the expiration of the period of limitations on collection, or at some prior date. As explained in the preamble to the proposed regulations, this provision clarifies that the IRS may enter into partial payment installment agreements that end upon the running of the collection statute, or that end prior to that time so that the IRS may collect the balance of the tax liability against any property belonging to the taxpayer before the collection period expires. The IRS does not currently enter into partial payment installment agreements that expire before the end of the collection statute and has no plans to do so routinely in the future.
Proposed §301.6159-1(c)(3)(v) provided that while an installment agreement is in effect, the IRS may request a financial condition update from the taxpayer at any time. The commenter recommended that the IRS be permitted to request only one financial condition update per year. This recommendation was not adopted. The IRS very rarely requests updates more than once a year. In certain rare circumstances, more frequent updates may be appropriate, such as when the IRS has reason to believe that the taxpayer's financial condition has improved.
Section 301.6159-1(d): Rejection of a proposed installment agreement.
Section 301.6159-1(d)(2) of the proposed regulations provided that the IRS may not notify a taxpayer or the taxpayer's representative of the rejection of an installment agreement until an independent review of proposed rejection is completed. The commenter was concerned that the proposed regulations did not provide any guidance as to how the independent administrative review will be assured. The commenter recommended that the review be undertaken by an IRS office located in a different territory. The recommendation was not adopted. Managers in the IRS offices in San Jose, California, and Jacksonville, Florida, supervise employees throughout the United States who review rejected installment agreements. An independent review is assured by assigning these cases to an employee who has no prior involvement in the case and who reports to a supervisor in either of these two offices.
The commenter recommended that the determination that the taxpayer did not submit a good faith revision be subject to independent administrative review. This recommendation was not adopted because it would delay case resolution and would, in effect, treat requests that were not made in good faith as valid requests. The commenter also recommended that the rejection of revisions that were made in good faith receive independent review. The proposed regulation already provided for this review. Proposed §301.6159-1(b) stated that if the IRS determines that the taxpayer made a good faith revision within 30 days of the rejection, the provisions of §301.6159-1 apply to the revised proposal.
Proposed §301.6159-1(d)(3) provided that a taxpayer may appeal the rejection of an installment agreement request within 30 days of the rejection. The commenter recommended that the 30-day period be tolled while a revised proposal of a rejected request is being evaluated so that the taxpayer would not have to file an appeal while the revision is under consideration. This recommendation was not adopted. The IRS's procedures are designed to allow a quick resolution of the taxpayer's request; tolling the appeal period would add an unneeded layer of complexity to the process and delay case resolution. The commenter also recommended that the IRS provide more definitive guidance as to what qualifies as a good faith revision. This recommendation was not adopted because this guidance is more appropriately left to the IRS procedures.
Section 301.6159-1(e): Modification or termination of installment agreements by the Internal Revenue Service.
Proposed §301.6159-1(e)(2)(i) provided that the IRS may modify or terminate an installment agreement if the IRS determines that the financial condition of the taxpayer has significantly changed. Proposed §301.6159-1(c)(3)(vi) provided that the IRS and the taxpayer may agree to modify or terminate an installment agreement or may agree to a new installment agreement that supersedes the existing agreement. The commenter recommended that the regulations explicitly allow taxpayers to request a modification or termination of an existing installment agreement, as was stated in existing §301.6159-1(c)(3). This clarification was adopted in §301.6159-1(e)(3).
The commenter recommended that the regulations require the taxpayer to comply with the terms of an installment agreement while a request for modification is being considered and that a proposed modification will not result in a suspension of the statute of limitations on collection. These clarifications were also adopted in §301.6159-1(e)(3).
The commenter recommended that a taxpayer's request to modify an existing installment agreement should be exempt from user fees under regulations §§300.1 and 300.2. This recommendation was not adopted because user fees are outside the scope of this regulation project.
Proposed §301.6159-1(e)(2)(ii)(C) provided that the IRS may modify or terminate an installment agreement if the taxpayer fails to provide a financial condition update requested by the IRS. The commenter recommended that the regulations provide explicitly whether the IRS may terminate an installment agreement if the taxpayer provided materially inaccurate or incomplete information. This recommendation was adopted. Section 301.6159-1(e)(1)(i) was revised to clarify that the IRS may terminate an installment agreement if the taxpayer provided materially inaccurate or incomplete information in connection with a requested financial update.
Proposed §301.6159-1(e)(3) provided that the IRS will generally notify the taxpayer in writing at least 30 days prior to terminating an installment agreement and describe the reason for the termination, after which the taxpayer may provide information showing that the IRS's reason is incorrect. Proposed §301.6159-1(e)(4) provided for the administrative appeal of the modification or termination of an installment agreement to the Office of Appeals if the request is properly made within 30 days after the termination or modification is to take effect. The commenter recommended that the regulations clarify that an appeal should be made to the Office of Appeals within 30 days after the modification or termination will take effect, regardless of whether the taxpayer submits additional information under §301.6159-1(e)(3), has filled out Form 9423, “Collection Appeal Request,” or has requested a meeting with a Collection Manager. This recommendation was not adopted in the regulations because it is more appropriately addressed in IRS forms and procedures.
Proposed §301.6159-1(e)(4) provided, in part, that the taxpayer may administratively appeal the modification or termination of an installment agreement to the Office of Appeals. The commenter recommended that the taxpayer be allowed to appeal the IRS's determination not to modify an installment agreement. This recommendation was not adopted. The IRS routinely grants taxpayer modification requests that result in agreements within the streamlined criteria. See Internal Revenue Manual 5.19.1.5.4.24 at http://www.irs.gov/irm/part5/irm_05-019-001.html. Taxpayers do not have a statutory right to appeal rejected modification requests, and the IRS has not determined there is a need for additional administrative review of the denial of a modification request.
Section 301.6159-1(f): Effect of installment agreement or pending installment agreement on collection activity.
Section 301.6159-1(f)(1) of the proposed regulations stated that the IRS may not levy during the time an installment agreement is pending. Proposed §301.6159-1(f)(2) stated that levy is not prohibited if an installment agreement request was made solely to delay collection. The commenter recommended that the solely to delay collection standard in the proposed regulations be replaced with language that references the “frivolous submission” standard in section 6702(b) of the Code. This recommendation was not adopted. Under existing IRS procedures, an installment agreement is returned as made solely to delay collection when there is no economic reality to the request, the request fails to address changes previously requested by the IRS in response to a prior request, the request ignores direction provided by revenue officers, the request is made by a taxpayer that has defaulted prior installment agreements, or the request is made at a time that causes it to be classified as a request made to delay enforcement action. See Internal Revenue Manual 5.14.3.2 at http://www.irs.gov/irm/part5/irm_05-014-003.html. Section 6702(b) imposes a $5,000 penalty for installment agreement requests that reflect a desire to delay or impede the administration of the Federal tax laws, and the IRS has not yet developed procedures defining the kinds of installment agreements that constitute frivolous submissions. The standard in section 6702(b) therefore may not be an appropriate standard for identifying those installment agreements that fail to qualify for the prohibition against levy.
In the alternative, the commenter recommended that the regulations state that a taxpayer may appeal the IRS's levy action when the IRS determines that an installment agreement request was made solely to delay collection, and that damages may be appropriate under section 7433 of the Code. These recommendations were not adopted. Taxpayers' rights to appeal proposed levies and seek damages are provided for in the regulations under sections 6330 and 7433 of the Code, respectively.
Section 301.6159-1(g): Suspension of the statute of limitations on collection.
Section 301.6159-1(g) of the proposed regulations provided that the statute of limitations on collection under section 6502 of the Code is suspended for the period that a proposed installment agreement is pending, plus 30 days following a rejection, and during any appeal. The commenter recommended that the regulations clearly define when an installment agreement is pending. This recommendation is already addressed by proposed §301.6159-1(b)(2), which provides a detailed explanation of when an installment agreement is pending.
Section 301.6159-1(h): Annual statement.
Section 301.6159-1(h) of the proposed regulations requires the IRS to provide taxpayers with an annual statement setting forth the balance owed at the beginning of the year, the payments made during the year, and the remaining balance at the end of the year. The commenter recommends that the annual statement be as clear as possible and that the IRS provide the taxpayer with a single annual statement describing all tax liabilities covered by the agreement. Currently, the IRS sends an annual statement for each separate liability covered by an installment agreement. No change was made to the final regulations because this recommendation is more appropriately addressed when the IRS updates the forms used for the annual statements.
Section 301.6159-1(i): Biennial review of partial payment installment agreements.
Section 301.6159-1(i) of the proposed regulations required the IRS to perform a review of the taxpayer's financial condition at least once every two years in cases of partial payment installment agreements. The proposed regulations also stated that the purpose of the review was to determine whether an increase in payments is warranted. The commenter recommended that §301.6159-1(i) be rephrased to provide that the biennial review of a taxpayer's financial condition may result in a decrease, as well as an increase, in the amount of payments being made. This recommendation was not adopted. While taxpayers may request a decrease in the amount of payments due under an installment agreement, the IRS does not have the information to unilaterally make that determination. The automatic biennial review done by the IRS does not, in every case, result in a request for updated financial information. As explained above, taxpayers may request that their payments be lowered if their financial condition has worsened.
Section 301.6159-1(k): Effective/applicability date.
Section 301.6159-1(k) of the proposed regulations provided that the effective date of the final regulations would be the date the final regulations are published in the Federal Register. The commenter was concerned about how previously proposed or accepted installment agreements will be affected by the regulations and recommended that the effective date of paragraphs (b), (c), and (d) apply prospectively. This recommendation was not adopted. As explained earlier and in the preamble to the proposed regulations, the regulations substantially reflect existing practices. The regulations will therefore have no effect on previously proposed or accepted installment agreements.
Special Analyses
It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, the proposed regulations preceding these regulations were submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.
Drafting Information
The principal author of these regulations is Walter Ryan, Office of Associate Chief Counsel (Procedure and Administration).
List of Subjects in 26 CFR Part 301
Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income taxes, Penalties, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR part 301 is amended as follows:
PART 301—PROCEDURE AND ADMINISTRATION
Paragraph 1. The authority citation for part 301 continues to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 301.6159-0 is added to read as follows:
§301.6159-0 Table of contents.
This section lists the major captions that appear in the regulations under §301.6159-1.
§301.6159-1 Agreements for the payment of tax liabilities in installments.
(a) Authority.
(b) Procedures for submission and consideration of proposed installment agreements.
(c) Acceptance, form, and terms of installment agreements.
(d) Rejection of a proposed installment agreement.
(e) Modification or termination of installment agreements by the Internal Revenue Service.
(f) Effect of installment agreement or pending installment agreement on collection activity.
(g) Suspension of the statute of limitations on collection.
(h) Annual statement.
(i) Biennial review of partial payment installment agreements.
(j) Cross reference.
(k) Effective/applicability date.
Par. 3. Section 301.6159-1 is revised to read as follows:
§301.6159-1 Agreements for payment of tax liabilities in installments.
(a) Authority. The Commissioner may enter into a written agreement with a taxpayer that allows the taxpayer to make scheduled periodic payments of any tax liability if the Commissioner determines that such agreement will facilitate full or partial collection of the tax liability.
(b) Procedures for submission and consideration of proposed installment agreements—(1) In general. A proposed installment agreement must be submitted according to the procedures, and in the form and manner, prescribed by the Commissioner.
(2) When a proposed installment agreement becomes pending. A proposed installment agreement becomes pending when it is accepted for processing. The Internal Revenue Service (IRS) may not accept a proposed installment agreement for processing following reference of a case involving the liability that is the subject of the proposed installment agreement to the Department of Justice for prosecution or defense. The proposed installment agreement remains pending until the IRS accepts the proposal, the IRS notifies the taxpayer that the proposal has been rejected, or the proposal is withdrawn by the taxpayer. If a proposed installment agreement that has been accepted for processing does not contain sufficient information to permit the IRS to evaluate whether the proposal should be accepted, the IRS will request the taxpayer to provide the needed additional information. If the taxpayer does not submit the additional information that the IRS has requested within a reasonable time period after such a request, the IRS may reject the proposed installment agreement.
(3) Revised proposals of installment agreements submitted following rejection. If, following the rejection of a proposed installment agreement, the IRS determines that the taxpayer made a good faith revision of the proposal and submitted the revision within 30 days of the date of rejection, the provisions of this section shall apply to that revised proposal. If, however, the IRS determines that a revision was not made in good faith, the provisions of this section do not apply to the revision and the appeal period in paragraph (d)(3) of this section continues to run from the date of the original rejection.
(c) Acceptance, form, and terms of installment agreements—(1) Acceptance of an installment agreement—(i) In general. A proposed installment agreement has not been accepted until the IRS notifies the taxpayer or the taxpayer's representative of the acceptance. Except as provided in paragraph (c)(1)(iii) of this section, the Commissioner has the discretion to accept or reject any proposed installment agreement.
(ii) Acceptance does not reduce liabilities. The acceptance of an installment agreement by the IRS does not reduce the amount of taxes, interest, or penalties owed. (However, penalties may continue to accrue at a reduced rate pursuant to section 6651(h).)
(iii) Guaranteed installment agreements. In the case of a liability of an individual for income tax, the Commissioner shall accept a proposed installment agreement if, as of the date the individual proposes the installment agreement—
(A) The aggregate amount of the liability (not including interest, penalties, additions to tax, and additional amounts) does not exceed $10,000;
(B) The taxpayer (and, if the liability relates to a joint return, the taxpayer's spouse) has not, during any of the preceding five taxable years—
( 1) Failed to file any income tax return;
( 2) Failed to pay any required income tax; or
( 3) Entered into an installment agreement for the payment of any income tax;
(C) The Commissioner determines that the taxpayer is financially unable to pay the liability in full when due (and the taxpayer submits any information the Commissioner requires to make that determination);
(D) The installment agreement requires full payment of the liability within three years; and
(E) The taxpayer agrees to comply with the provisions of the Internal Revenue Code for the period the agreement is in effect.
(2) Form of installment agreements. An installment agreement must be in writing. A written installment agreement may take the form of a document signed by the taxpayer and the Commissioner or a written confirmation of an agreement entered into by the taxpayer and the Commissioner that is mailed or personally delivered to the taxpayer.
(3) Terms of installment agreements. (i) Except as otherwise provided in this section, an installment agreement is effective from the date the IRS notifies the taxpayer or the taxpayer's representative of its acceptance until the date the agreement ends by its terms or until it is superseded by a new installment agreement.
(ii) By its terms, an installment agreement may end upon the expiration of the period of limitations on collection in section 6502 and §301.6502-1, or at some prior date.
(iii) As a condition to entering into an installment agreement with a taxpayer, the Commissioner may require that—
(A) The taxpayer agree to a reasonable extension of the period of limitations on collection; and
(B) The agreement contain terms that protect the interests of the Government.
(iv) Except as otherwise provided in an installment agreement, all payments made under the installment agreement will be applied in the best interests of the Government.
(v) While an installment agreement is in effect, the Commissioner may request, and the taxpayer must provide, a financial condition update at any time.
(vi) At any time after entering into an installment agreement, the Commissioner and the taxpayer may agree to modify or terminate an installment agreement or may agree to a new installment agreement that supersedes the existing agreement.
(d) Rejection of a proposed installment agreement—(1) When a proposed installment agreement becomes rejected. A proposed installment agreement has not been rejected until the IRS notifies the taxpayer or the taxpayer's representative of the rejection, the reason(s) for rejection, and the right to an appeal.
(2) Independent administrative review. The IRS may not notify a taxpayer or taxpayer's representative of the rejection of an installment agreement until an independent administrative review of the proposed rejection is completed.
(3) Appeal of rejection of a proposed installment agreement. The taxpayer may administratively appeal a rejection of a proposed installment agreement to the IRS Office of Appeals (Appeals) if, within the 30-day period commencing the day after the taxpayer is notified of the rejection, the taxpayer requests an appeal in the manner provided by the Commissioner.
(e) Modification or termination of installment agreements by the Internal Revenue Service—(1) Inadequate information or jeopardy. The Commissioner may terminate an installment agreement if the Commissioner determines that—
(i) Information which was provided to the IRS by the taxpayer or the taxpayer's representative in connection with either the granting of the installment agreement or a request for a financial update was inaccurate or incomplete in any material respect; or
(ii) Collection of any liability to which the installment agreement applies is in jeopardy.
(2) Change in financial condition, failure to timely pay an installment or another Federal tax liability, or failure to provide requested financial information. The Commissioner may modify or terminate an installment agreement if—
(i) The Commissioner determines that the financial condition of a taxpayer that is party to the agreement has significantly changed; or
(ii) A taxpayer that is party to the installment agreement fails to—
(A) Timely pay an installment in accordance with the terms of the installment agreement;
(B) Pay any other Federal tax liability when the liability becomes due; or
(C) Provide a financial condition update requested by the Commissioner.
(3) Request by taxpayer. Upon request by a taxpayer that is a party to the installment agreement, the Commissioner may terminate or modify the terms of an installment agreement if the Commissioner determines that the financial condition of the taxpayer has significantly changed. The taxpayer's request will not suspend the statute of limitations under section 6502 for collection of any liability. While the Commissioner is considering the request, the taxpayer shall comply with the terms of the existing installment agreement.
(4) Notice. Unless the Commissioner determines that collection of the tax is in jeopardy, the Commissioner will notify the taxpayer in writing at least 30 days prior to modifying or terminating an installment agreement pursuant to paragraph (e)(1) or (2) of this section. The notice provided pursuant to this section must briefly describe the reason for the intended modification or termination. Upon receiving notice, the taxpayer may provide information showing that the reason for the proposed modification or termination is incorrect.
(5) Appeal of modification or termination of an installment agreement. The taxpayer may administratively appeal the modification or termination of an installment agreement to Appeals if, following issuance of the notice required by paragraph (e)(4) of this section and prior to the expiration of the 30-day period commencing the day after the modification or termination is to take effect, the taxpayer requests an appeal in the manner provided by the Commissioner.
(f) Effect of installment agreement or pending installment agreement on collection activity—(1) In general. No levy may be made to collect a tax liability that is the subject of an installment agreement during the period that a proposed installment agreement is pending with the IRS, for 30 days immediately following the rejection of a proposed installment agreement, during the period that an installment agreement is in effect, and for 30 days immediately following the termination of an installment agreement. If, prior to the expiration of the 30-day period following the rejection or termination of an installment agreement, the taxpayer appeals the rejection or termination decision, no levy may be made while the rejection or termination is being considered by Appeals. This section will not prohibit levy to collect the liability of any person other than the person or persons named in the installment agreement.
(2) Exceptions. Paragraph (f)(1) of this section shall not prohibit levy if the taxpayer files a written notice with the IRS that waives the restriction on levy imposed by this section, the IRS determines that the proposed installment agreement was submitted solely to delay collection, or the IRS determines that collection of the tax to which the installment agreement or proposed installment agreement relates is in jeopardy.
(3) Other actions by the IRS while levy is prohibited—(i) In general. The IRS may take actions other than levy to protect the interests of the Government with regard to the liability identified in an installment agreement or proposed installment agreement. Those actions include, for example—
(A) Crediting an overpayment against the liability pursuant to section 6402;
(B) Filing or refiling notices of Federal tax lien; and
(C) Taking action to collect from any person who is not named in the installment agreement or proposed installment agreement but who is liable for the tax to which the installment agreement relates.
(ii) Proceedings in court. Except as otherwise provided in this paragraph (f)(3)(ii), the IRS will not refer a case to the Department of Justice for the commencement of a proceeding in court, against a person named in an installment agreement or proposed installment agreement, if levy to collect the liability is prohibited by paragraph (f)(1) of this section. Without regard to whether a person is named in an installment agreement or proposed installment agreement, however, the IRS may authorize the Department of Justice to file a counterclaim or third-party complaint in a refund action or to join that person in any other proceeding in which liability for the tax that is the subject of the installment agreement or proposed installment agreement may be established or disputed, including a suit against the United States under 28 U.S.C. 2410. In addition, the United States may file a claim in any bankruptcy proceeding or insolvency action brought by or against such person. If a person named in an installment agreement is joined in a proceeding, the United States obtains a judgment against that person, and the case is referred back to the IRS for collection, collection will continue to occur pursuant to the terms of the installment agreement. Notwithstanding the installment agreement, any claim or suit permitted will be for the full amount of the liabilities owed.
(g) Suspension of the statute of limitations on collection. The statute of limitations under section 6502 for collection of any liability shall be suspended during the period that a proposed installment agreement relating to that liability is pending with the IRS, for 30 days immediately following the rejection of a proposed installment agreement, and for 30 days immediately following the termination of an installment agreement. If, within the 30 days following the rejection or termination of an installment agreement, the taxpayer files an appeal with Appeals, the statute of limitations for collection shall be suspended while the rejection or termination is being considered by Appeals. The statute of limitations for collection shall continue to run if an exception under paragraph (f)(2) of this section applies and levy is not prohibited with respect to the taxpayer.
(h) Annual statement. The Commissioner shall provide each taxpayer who is party to an installment agreement under this section with an annual statement setting forth the initial balance owed at the beginning of the year, the payments made during the year, and the remaining balance as of the end of the year.
(i) Biennial review of partial payment installment agreements. The Commissioner shall perform a review of the taxpayer's financial condition in the case of a partial payment installment agreement at least once every two years. The purpose of this review is to determine whether the taxpayer's financial condition has significantly changed so as to warrant an increase in the value of the payments being made or termination of the agreement.
(j) Cross reference. Pursuant to section 6601(b)(1), the last day prescribed for payment is determined without regard to any installment agreement, including for purposes of computing penalties and interest provided by the Internal Revenue Code. For special rules regarding the computation of the failure to pay penalty while certain installment agreements are in effect, see section 6651(h) and §301.6651-1(a)(4).
(k) Effective/applicability date. This section is applicable on [ INSERT DATE OF PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER].
Par. 4. Section 301.6331-4, paragraph (d) is revised and paragraph (e) is added to read as follows:
§301.6331-4 Restrictions on levy while installment agreements are pending or in effect.
* * * * *
(d) Cross-reference. For provisions relating to the making of levies while an installment agreement is pending or in effect, see §301.6159-1.
(e) Effective /applicability date. Paragraphs (a), (b), and (c) are applicable beginning December 18, 2002. Paragraph (d) is applicable beginning [ INSERT DATE OF PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER].
Steven T. Miller
Deputy Commissioner of Services and Enforcement.
Approved: November 11, 2009
Michael F. Mundaca
Acting Assistant Secretary of the Treasury (Tax Policy).

reasonable cause case

Wayne Robert Risley and Nanette Risley v. Commissioner., U.S. Tax Court, T.C. Summary Opinion 2009-172, (Nov. 23, 2009)
Docket No. 10857-05S. Filed November 23, 2009.
A married couple who participated in a fraudulent tax shelter was not entitled to the claimed business expense deductions or disabled access credits for any of the tax years at issue. The IRS was not equitably estopped from assessing deficiencies against them. The couple failed to prove that the IRS made any representations to them regarding the tax shelter. In fact, the IRS had no contact with the couple before the returns claiming the dubious expenses and credits were filed. Since the couple invested in the tax shelter separate and apart from any advice from the IRS, equitable estoppel did not apply. In addition, the promoter’s statements regarding the validity of the tax shelter were not imputed to the IRS even though the promoter advertised that it employed enrolled agents and former IRS employees. The IRS was not estopped from challenging the tax shelter merely because an enrolled agent or former IRS employee was affiliated with it. Moreover, the couple was not entitled to deduct their investment in the tax shelter as a theft loss under Code Sec. 165 because they failed to establish that they discovered the "theft" during any of the tax years at issue. Finally, the accuracy-related penalty for negligence was imposed because the couple failed to show that they had reasonable cause or acted in good-faith. The couple could not rely on the tax shelter’s alleged preparation of their returns to show reasonable reliance of a tax professional. Not only did the couple prepare their own returns for two of the tax years at issue, but the tax shelter informed the couple that it was not providing them with legal or tax advice. Moreover, any reliance on the tax shelter promoter would be per se unreasonable.
PURSUANT TO INTERNAL REVENUE CODE SECTION 7463(b), THIS OPINION MAY NOT BE TREATED AS PRECEDENT FOR ANY OTHER CASE.
Robert L. Risley, for petitioners; Kevin W. Coy and Kelly R. Morrison-Lee, for respondent.
LARO, Judge: Petitioners petitioned the Court to redetermine respondent's determination of deficiencies in and accuracy-related penalties related to their joint 2001, 2002, and 2003 Federal income tax returns (2001 return, 2002 return, and 2003 return, respectively; collectively, subject returns). Petitioners filed their petition pursuant to the provisions of section 7463. 1
This case is now before the Court on respondent's motion for summary judgment. We hold that respondent is entitled to summary judgment and shall enter a decision accordingly. Pursuant to section 7463(b), the decision to be entered is not reviewable by any other court, and this opinion shall not be treated as precedent for any other case.
Background
I. Preliminaries
Petitioners are husband and wife. They resided in California when their petition was filed. They filed the subject returns jointly.
II. Tax Shelter
Petitioners participated in a fraudulent tax shelter (tax shelter) promoted and sold by the National Audit Defense Network (NADN). The NADN advertised itself as a conglomerate of former Internal Revenue Service agents, enrolled agents, certified public accountants, and tax attorneys who could help U.S. taxpayers pay no Federal income tax. The NADN informed petitioners that they could qualify for significant tax benefits by forming a Web site and then paying the NADN to modify the Website to comply with the Americans with Disabilities Act of 1990 (ADA), Pub. L. 101-336, sec. 302(a), 104 Stat. 355, codified at 42 U.S.C. sec. 12182(a) (2006). The ADA generally provides that any person who owns, leases, or operates a place of public accommodation shall not discriminate against disabled individuals in the full and equal enjoyment of goods, services, facilities, privileges, advantages, and accommodations of the place of public accommodation.
The NADN informed petitioners that they had to pay the NADN $2,495 and issue to the NADN a $7,980 promissory note as to each year in which they wanted to participate in the tax shelter. Payments on a note were to be made from the revenue generated by the Web site or, if no revenue was generated, 8 years after the note's making. The NADN informed petitioners that they could claim a $5,000 tax credit pursuant to section 44 and deduct at least $5,475 of business expenses pursuant to section 162 for each year that they participated in the tax shelter. The NADN advised petitioners that it was not providing them (nor was it engaged in the rendering of) any legal, accounting, or other professional service and that they should retain a “competent professional” if they wanted any legal advice or other expert assistance with respect to the tax shelter.
Petitioners paid the NADN $2,495 in each subject year to participate in the tax shelter. Petitioners also signed at least one $7,980 promissory note payable to the NADN or to an affiliate thereof.
III. Subject Returns
A. 2001 Return
Petitioners prepared their 2001 return themselves. Petitioners attached a 2001 Schedule C, Profit or Loss From Business (Sole Proprietorship), to their 2001 return reporting that petitioner Wayne R. Risley (Mr. Risley) operated an “Electronic Shipping and Information Service” business during 2001. The only item of income or expense reported on the 2001 Schedule C was a $5,475 expense identified as “Excess expenditures for modifications made for disabled access to business”. Petitioners also attached a 2001 Form 8826, Disabled Access Credit, to their 2001 return. The 2001 Form 8826 reported that petitioners paid $10,475 in total eligible access expenditures during 2001 and were claiming a $5,000 disabled access credit for 2001. Petitioners claimed the $5,000 credit on their 2001 return.
B. 2002 Return
Petitioners prepared their 2002 return themselves. Petitioners attached a 2002 Schedule C to their 2002 return reporting that Mr. Risley operated an “Apple Electronic Shopping & Information” business during 2002. The only item of income or expense reported on the 2002 Schedule C was a $5,475 expense identified as “Excess expenditures for modifications made for [sic]”. Petitioners also attached a 2002 Form 8826 to their 2002 return. The 2002 Form 8826 reported that petitioners paid $10,475 in total eligible access expenditures during 2002, that petitioners had a current year disabled access credit of $5,000, and that petitioners were claiming $611 of the $5,000 as an allowable disabled access credit for 2002. Petitioners claimed the $611 credit on their 2002 return.
C. 2003 Return
Petitioners' 2003 return was prepared by H&R Block. Petitioners' 2003 return did not report any income or deductions as to the tax shelter. Petitioners attached a 2003 Form 8826 to their 2003 return. The 2003 Form 8826 reported that petitioners paid $5,000 in total eligible access expenditures during 2003 and that petitioners were claiming a $2,375 disabled access credit for 2003. Petitioners claimed the $2,375 credit on their 2003 return.
IV. Notice of Deficiency
Respondent issued petitioners a notice of deficiency as to the subject returns. Respondent determined in the notice of deficiency that petitioners were not entitled to any of the deductions or credits claimed as to the tax shelter. For the respective years, respondent determined deficiencies of $6,513, $2,776, and $2,712. 2 Respondent also determined accuracy-related penalties under section 6662(a) and (b) of $1,303, $555, and $542, respectively, for negligence or disregard of rules and regulations.
Discussion
I. Standard for Summary Judgment
Summary judgment may be granted with respect to any part of the legal issues in controversy if the record before the Court shows no genuine issue as to any material fact and that a decision may be rendered as a matter of law. See Rule 121(a) and (b); Craig v. Commissioner, 119 T.C. 252, 259-260 (2002). Respondent bears the burden of proving the absence of any genuine issue of material fact, and all facts are viewed in the light most favorable to petitioners. See Craig v. Commissioner, supra at 260. Petitioners, however, must do more than merely allege or deny facts; they must set forth “specific facts showing that there is a genuine issue for trial.” See Rule 121(d); Celotex Corp. v. Catrett, 477 U.S. 317, 324 (1986). Petitioners have failed to raise any genuine issue of material fact under that standard, and this case is ripe for summary judgment.
II. Deficiencies
Petitioners make no claim that sections 44 and 162 actually allow them to deduct or credit the items that they reported as to the tax shelter. Cf. Good v. Commissioner, T.C. Memo. 2008-245 (holding on the merits that the taxpayers were not entitled to the section 162 expenses and disabled business credits reported as to the tax shelter). Petitioners' primary argument in challenging respondent's determination of the deficiencies is that respondent is equitably estopped from assessing against them any amount relating to the tax shelter. We disagree. Equitable estoppel is a judicial doctrine that precludes a party from denying his or her acts or representations which induced another to act to his or her detriment. See Hofstetter v. Commissioner, 98 T.C. 695, 700 (1992). The following requirements must be satisfied where, as here, equitable estoppel is asserted against the Commissioner: (1) A false representation by the Commissioner or his wrongful, misleading silence; (2) an error in a statement of fact and not in an opinion or statement of law; (3) ignorance of the true facts; (4) a taxpayer's reasonable reliance on the Commissioner's acts or statements; and (5) adverse effects of the Commissioner's acts or statement. See Norfolk S. Corp. v. Commissioner, 104 T.C. 13, 59-60 (1995), affd. 140 F.3d 240 (4th Cir. 1998). Petitioners' failure to establish any one of these five requirements means that their claim of equitable estopped must fail as well.
Petitioners have failed to establish on the part of respondent either a false representation or a wrongful, misleading silence as to the tax shelter. 3 To that end, we are unable to find as to the tax shelter that respondent made any representation (let alone any misrepresentation) to petitioners or otherwise wrongfully concealed from petitioners any material fact. Instead, the record establishes (and we so find) that respondent had no contact with petitioners as to the tax shelter before his audit of the subject returns and that petitioners invested in the tax shelter separate and apart from any action taken by respondent.
Petitioners argue that the statements of the the NADN's workforce are imputed to respondent to the extent that those workers were registered with the Internal Revenue Service as enrolled agents or tax preparers. Petitioners also argue that the tax shelter is imputed to respondent because the NADN advertised that it employed those workers as well as former Internal Revenue Service employees. We disagree on both counts. The record does not establish, nor do petitioners claim, that any of the NADN's workers also were working for the Internal Revenue Service at the same time. Moreover, the mere fact that a former employee of the Internal Revenue Service, or an individual registered with the Internal Revenue Service as an enrolled agent or a tax preparer, may have been affiliated with the NADN (and/or the tax shelter) does not estop respondent from challenging the legitimacy of the tax shelter. See Auto. Club of Mich. v. Commissioner, 353 U.S. 180, 183-184 (1957) (holding that the Commissioner is usually not estopped from correcting retroactively a mistake of law); see also Martin's Auto Trimming, Inc. v. Riddell, 283 F.2d 503, 506 (9th Cir. 1960); Schwalbach v. Commissioner, 111 T.C. 215, 228 n.4 (1998); Fortugno v. Commissioner, 41 T.C. 316, 323-324 (1963), affd. 353 F.2d 429 (3d Cir. 1965). Nor do we believe, as petitioners argued, that respondent was sufficiently aware of the impropriety of the tax shelter through petitioners' filing of their 2001 return so that he is estopped from challenging any of the amounts that petitioners later claimed as to the tax shelters for 2002 and 2003.
Petitioners also argue that the Government should bear the loss of any Federal income taxes owed by them as to the tax shelter because respondent failed to inform petitioners that the tax shelter was a “fraud” and is in a better position than they to recover the $7,485 that they paid to the NADN. We disagree. While petitioners consider it inequitable that they have to pay taxes as to the tax shelter when they have paid $7,485 to the NADN for what they now consider to be a worthless investment, we know of no reason the Government should act as an insurer of that investment. Nor do we agree with petitioners that they are entitled for the subject years to deduct the $7,485 as a theft loss under section 165. While section 165 lets an individual deduct a theft loss in the year during which the individual discovers the loss, see sec. 165(a), (c)(3), (e), the record does not establish that petitioners discovered any such theft loss during the subject years.
We hold that respondent is not estopped from disallowing the claimed amounts. Accordingly, we sustain respondent's determination of the deficiencies.
III. Accuracy-Related Penalties
Respondent determined that petitioners are liable for accuracy-related penalties under section 6662(a) and (b)(1). Section 6662(a) and (b)(1) imposes a penalty equal to 20 percent of the portion of an underpayment of tax attributable to a taxpayer's negligence or disregard of rules or regulations. Negligence connotes a lack of due care or failure to do what a reasonable and prudent person would do under the circumstances. See Allen v. Commissioner, 92 T.C. 1, 12 (1989), affd. 925 F.2d 348 (9th Cir. 1991). An accuracy-related penalty is not applicable to any portion of an underpayment to the extent that the taxpayer had reasonable cause for that portion and acted in good faith with respect thereto. See sec. 6664(c)(1).
Respondent bears the burden of production with respect to the applicability of the accuracy-related penalties. See sec. 7491(c). That burden requires that respondent produce sufficient evidence that it is appropriate to impose the accuracy-related penalties. See Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Once respondent meets this burden, the burden of proof falls upon petitioners. See id. at 447. Petitioners may carry their burden by proving that they were not negligent; i.e., that they made a reasonable attempt to comply with the provisions of the Internal Revenue Code and were not careless, reckless, or in intentional disregard of rules or regulations. See sec. 6662(c). Alternatively, petitioners may establish that their underpayment was attributable to reasonable cause and their acting in good faith. See sec. 6664(c)(1).
We conclude that respondent has met his burden of production and that petitioners have failed to carry their burden of proof. The record establishes that petitioners claimed significant amounts of tax benefits to which they neither were entitled nor had a reasonable claim. The record does not establish that petitioners made a reasonable attempt to comply with the provisions of the Internal Revenue Code, that petitioners' underpayment was attributable to reasonable cause, or that petitioners acted in good faith as to the underpayment. Petitioners claim that the subject returns were prepared and reviewed by the NADN and that they reasonably relied on the NADN to prepare those returns correctly. We reject that claim as factually and legally incorrect. As a point of fact, petitioners prepared their 2001 and 2002 returns themselves; H&R Block prepared their 2003 return; and the NADN informed petitioners that it was not providing them with any legal or other professional service and that they should retain a competent professional if they wanted any legal advice or other expert assistance with respect to the tax shelter. As a point of law, any such claimed reliance upon the NADN (if it in fact had occurred) would not be reasonable in the setting of this case given that the NADN was the tax shelter's promoter. See Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43, 98-99 (2000), affd. 299 F.3d 221 (3d Cir. 2002).
We hold that petitioners are liable for the accuracy-related penalties respondent determined. Accordingly, we sustain respondent's determination as to those penalties.
IV. Conclusion
We have considered all of petitioners' contentions and have concluded that those contentions not discussed herein are without merit. To reflect the foregoing,
An appropriate order and decision will be entered for respondent.

Footnotes


1
Section references are to the applicable versions of the Internal Revenue Code. Rule references are to the Tax Court Rules of Practice and Procedure.
2
These deficiencies total $11,664, and petitioners' cash expenditures as to the tax shelter total $7,485 ($2,495 × 3). Petitioners reportedly realized an economic gain of $4,179 from the tax shelter ($11,664—$7,485 = $4,179).
3
Given this failure, we need not and do not address any of the other four requirements of equitable estoppel.

§301.6501(c)-1 for 6011 listed transactions

Proposed Amendments of Regulations, NPRM REG-160871-04, published in the Federal Register on, October 7, 2009.


Amendments of Reg. §301.6501(c)-1, relating to the exception to the general three-year period of limitations on assessment under Code Sec. 6501(c)(10) for listed transactions that a taxpayer failed to disclose as required under Code Sec. 6011, are proposed.



AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

SUMMARY: This document contains proposed regulations relating to the exception to the general three-year period of limitations on assessment under section 6501(c)(10) of the Internal Revenue Code (Code) for listed transactions that a taxpayer failed to disclose as required under section 6011. These regulations will affect taxpayers who fail to disclose listed transactions in accordance with section 6011.

DATES: Written or electronic comments and requests for a public hearing must be received by [ INSERT DATE THAT IS 90 DAYS AFTER DATE OF PUBLICATION IN THE FEDERAL REGISTER].

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-160871-04), room 5203, Internal Revenue Service, P. O. Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-160871-04), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, DC, or sent electronically via the Federal eRulemaking Portal at http://www.regulations.gov (IRS REG-160871-04).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Audra M. Dineen at (202) 622-4910; concerning submissions of comments and requests for a public hearing, Oluwafunmilayo Taylor of the Publications and Regulations Branch at (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act
The collection of information contained in this notice of proposed rulemaking has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)) under control number 1545-1940. The collection of information in these proposed regulations is in §301.6501(c)-1(g)(5). This information is required to provide the IRS, under penalties of perjury, with the information necessary to properly determine the taxpayer's applicable period of limitations. The collection of information in these proposed regulations is the same as the collection of information in Revenue Procedure 2005-26 (2005-1 CB 965), which was previously reviewed and approved by the Office of Management and Budget under control number 1545-1940. The collection of information in §301.6501(c)-1(g)(6) is the same as the collection of information required under section 6112. See § 601.601(d)(2)(ii)(b).

An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Office of Management and Budget.

Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. § 6103.

Background
This document contains proposed amendments to the Procedure and Administration Regulations (26 CFR Part 301) under section 6501(c) relating to exceptions to the period of limitations on assessment. Section 6501(a) provides that, except as otherwise provided, if a return is filed, tax with respect to that return must be assessed within 3 years from the later of the date the return was filed or the original due date of the return. Section 6501(c) contains several exceptions to the general threeyear period of limitations on assessment.

Section 6501(c)(10) was added to the Code by section 814 of the American Jobs Creation Act of 2004, Public Law 108-357 (118 Stat. 1418, 1581 (2004)) (AJCA), enacted on October 22, 2004. Section 6501(c)(10) provides that, if a taxpayer fails to disclose a listed transaction as required under section 6011, the time to assess tax against the taxpayer with respect to that transaction will end no earlier than one year after the earlier of (1) the date on which the taxpayer furnishes the information required under section 6011, or (2) the date that a material advisor furnishes to the Secretary, upon written request, the information required under section 6112 with respect to the taxpayer related to the listed transaction. Accordingly, if neither the taxpayer nor a material advisor furnishes the requisite information, the period of limitations on assessment will remain open, and thus, the tax with respect to the listed transaction may be assessed at any time. Section 6501(c)(10) is effective for taxable years with respect to which the period of limitations on assessment did not expire prior to October 22, 2004.

As noted, section 6501(c)(10) applies when a taxpayer does not properly disclose a listed transaction (as defined in section 6707A(c)(2)) as required under section 6011. Taxpayers are required under section 6011 and the regulations under section 6011 (collectively referred to as the “section 6011 disclosure rules”) to disclose certain information regarding each reportable transaction in which the taxpayer participated. See Treas. Reg. §§1.6011-4; 20.6011-4; 25.6011-4; 31.6011-4; 53.6011-4; 54.6011-4; and 56.6011-4. Among the transactions that are reportable are “listed transactions.” See Treas. Reg. §1.6011-4(b)(2). Under the section 6011 disclosure rules, a listed transaction is a transaction that is the same as, or substantially similar to, a transaction that the IRS has determined to be a tax avoidance transaction and identified by notice, regulation, or other form of published guidance. Treas. Reg. §1.6011-4(b)(2). Section 6707A(c)(2) incorporates the same definition of listed transaction. For a list of transactions the IRS has identified as listed transactions, see Notice 2009-59, 2009-31 IRB 1. See §601.601(d)(2).

If the section 6011 disclosure rules require a taxpayer to disclose a listed transaction, the taxpayer must complete and file a disclosure statement in accordance with the section 6011 disclosure rules. The section 6011 disclosure rules currently require that Form 8886, “Reportable Transaction Disclosure Statement” (or successor form), be used as the disclosure statement and be completed in accordance with the instructions to the form. The Form 8886 (or successor form) generally must be attached to the taxpayer's original or amended tax return for each taxable year for which a taxpayer participates in a listed transaction. Treas. Reg. §1.6011-4(e)(1). If a listed transaction results in a loss that is carried back to a prior year, Form 8886 (or successor form) must be attached to the taxpayer's application for tentative refund or amended tax return for that prior year. The taxpayer also must send a copy of Form 8886 (or successor form) to the IRS Office of Tax Shelter Analysis (OTSA), generally at the same time that a disclosure statement pertaining to a particular listed transaction is first filed. Under the current rules, when a transaction is identified as a listed transaction after the date on which the taxpayer files a tax return (including an amended return) for a taxable year reflecting the taxpayer's participation in the listed transaction and before the end of the period of limitations for assessment of tax for any taxable year in which the taxpayer participated in the listed transaction, then the taxpayer must file Form 8886 (or successor form) with OTSA within 90 calendar days after the date the transaction became a listed transaction.

If a taxpayer does not disclose its participation in a listed transaction in accordance with all of the requirements of the section 6011 disclosure rules and section 6501(c)(10) applies, then the time to assess tax related to the listed transaction will expire no earlier than the earlier of (1) one year after the date on which the information described in section 6501(c)(10)(A) is provided, or (2) one year after the date on which the information described in section 6501(c)(10)(B) is provided.

The IRS and Treasury Department issued Rev. Proc. 2005-26 (2005-1 CB 965) on April 25, 2005, to provide interim guidance on section 6501(c)(10). The revenue procedure prescribes how taxpayers and material advisors should disclose listed transactions that were not properly disclosed under section 6011 in order to start the one-year period under section 6501(c)(10). Taxpayers may continue to rely on Rev. Proc. 2005-26 until temporary or final regulations are issued under section 6501(c)(10). See §601.601(d)(2). In that revenue procedure, the IRS and Treasury Department also requested comments concerning the procedures set forth in the revenue procedure, especially their application to partners and partnerships. One comment was received but it did not address the limitations period.

Explanation of Provisions
These proposed regulations provide rules reflecting the enactment of section 6501(c)(10) by the AJCA. They explain how to determine whether section 6501(c)(10) applies and, if so, the applicable period of limitations on assessment. As a preliminary matter, the effective date of section 6501(c)(10) limits its application to taxable years with respect to which the period of limitations on assessment was open on or after October 22, 2004 (the date the AJCA was enacted). Thus, for taxable years for which a return was due prior to October 22, 2004, an analysis under section 6501 must be conducted to determine if the period of limitations on assessment was open under the general three-year period or an exception other than section 6501(c)(10).

1. Application of Section 6501(c)(10).
The general rule for applying section 6501(c)(10) is set forth in §301.6501(c)-1(g)(1) of these proposed regulations. The first step in analyzing whether section 6501(c)(10) applies is to determine whether the taxpayer failed to comply with any disclosure obligation under the section 6011 disclosure rules with respect to a listed transaction (as defined in section 6707A(c)(2)) for any taxable year. The IRS and Treasury Department have issued several regulations under section 6011, some of which apply only to certain types of taxpayers. The disclosure requirements also vary among the regulations. Therefore, particular attention must be paid to the effective dates of the various section 6011 disclosure rules in order to determine whether there was a disclosure obligation.

If there was no obligation to disclose the listed transaction, or if the taxpayer complied with its disclosure obligations, then section 6501(c)(10) does not apply. If there was a disclosure obligation and a failure to disclose as required, then section 6501(c)(10) applies. Section 6501(c)(10) applies to all open years for which the taxpayer failed to disclose its participation in the transaction as required under the section 6011 disclosure rules, even if the disclosures required under section 6011 were not due in, or with a return for, the year of participation but were due in a later year when the transaction was subsequently identified as a listed transaction. If section 6501(c)(10) applies because a taxpayer failed to disclose a listed transaction and the transaction is later removed from the category of listed transactions, section 6501(c)(10) will continue to apply with respect to the tax years for which disclosure was required. If section 6501(c)(10) applies, then the period of limitations with respect to the listed transaction will remain open until at least the earlier of (1) one year after the date on which the taxpayer provides a disclosure to satisfy section 6501(c)(10)(A) (as provided in §301.6501(c)-1(g)(5) described elsewhere in this preamble), or (2) one year after the date on which a material advisor provides the IRS with information concerning the taxpayer's participation in the transaction sufficient to satisfy section 6501(c)(10)(B) (as provided in §301.6501(c)-1(g)(6) described elsewhere in this preamble). If either paragraph (g)(5) or (g)(6) is satisfied, the period of limitations on assessment will end under the circumstances described in §301.6501(c)-1(g)(2) of these proposed regulations.

Section 301.6501(c)-1(g)(2) of these proposed regulations also provides guidance on how section 6501(c)(10) interacts with the otherwise applicable period of limitations provided in the Internal Revenue Code. The proposed regulations confirm that section 6501(c)(10) does not operate to extend a limitations period that expired before the effective date of section 6501(c)(10) or before the date on which the failure to disclose occurs. In addition, a taxpayer or material advisor cannot shorten any other applicable period of limitations on assessment by following the procedures to begin the one-year period provided under section 6501(c)(10), including, but not limited to, a limitations period that has been extended by agreement under section 6501(c)(4), or the limitations period described in section 6501(c)(1) relating to a false or fraudulent return.

The terms “listed transaction,” “material advisor,” and “taxable year(s) to which the failure to disclose relates” are defined in §301.6501(c)-1(g)(3) of these proposed regulations by cross-reference to section 6707A and the relevant regulations under sections 6011 and 6111.

Under section 6501(c)(10), the term “listed transaction” is defined by reference to section 6707A(c)(2), which defines a listed transaction as “a reportable transaction that is the same as, or substantially similar to, a transaction specifically identified by the Secretary as a tax avoidance transaction for purposes of section 6011.” Although section 6707A was enacted by section 811 of the AJCA and is effective for returns and statements due after October 22, 2004, and which were not filed before that date, its definition of “listed transactions” incorporates transactions identified as listed transactions in the section 6011 disclosure rules before section 6707A was enacted. Accordingly, any transactions that were listed transactions as of October 22, 2004, under the section 6011 disclosure rules are listed transactions under section 6707A and, thus, for purposes of section 6501(c)(10). Therefore, section 6501(c)(10) applies to transactions that were identified as listed transactions prior to October 22, 2004.

The term “taxable year(s) to which the failure to disclose relates” identifies the years to which section 6501(c)(10) applies. Clarification is necessary because a taxpayer may participate in a listed transaction over multiple years, because a transaction may be identified as a listed transaction after the taxpayer enters into the transaction, and because the section 6011 disclosure rules may require disclosure in a year in which the taxpayer did not participate in the listed transaction. The term “taxable year(s) to which the failure to disclose relates” means each taxable year that the taxpayer participated (as defined by the regulations under section 6011) in a transaction that was identified as a listed transaction and for which there was no proper disclosure when required under the section 6011 disclosure rules. For these purposes, it does not matter whether the transaction was identified as a listed transaction before or after the taxpayer filed a tax return for any taxable year in which the taxpayer participated in the transaction. On occasion, the section 6011 disclosure rule may require that a disclosure be filed in a taxable year or with a tax return for a taxable year other than the taxable year in which the taxpayer participated in the listed transaction. In those circumstances, the taxable year(s) to which the failure to disclose relates is not the taxable year in which the disclosure is required to be filed, but each taxable year that the taxpayer participated in the listed transaction.

Section 301.6501(c)-1(g)(4) of these proposed regulations provides the rule for application of section 6501(c)(10) in the case of taxpayers who are partners in partnerships, shareholders in S corporations, or beneficiaries of trusts. If these taxpayers were required to disclose their participation in a listed transaction under the section 6011 disclosure rules, and failed to disclose, then the period of limitations on assessment with respect to each partner, shareholder, or beneficiary that failed to disclose will remain open under section 6501(c)(10) even if the partnership, S corporation, or trust disclosed in accordance with the section 6011 disclosure rules and even if another partner, shareholder, or beneficiary disclosed in accordance with the section 6011 disclosure rules. This rule is as adopted because the period of limitations on assessment is specific to each taxpayer. Consistent with the above rule, a failure to disclose by an entity will not cause section 6501(c)(10) to apply to all of the taxpayers who are partners, shareholders or beneficiaries of the entity.

2. One-Year Period Under Section 6501(c)(10).
Guidance on the events that will start the one-year period under section 6501(c)(10) is provided in §301.6501(c)-1(g)(5) and (6) of these proposed regulations.

a. Disclosures by taxpayers of required information.
Under section 6501(c)(10)(A), if there is a failure to disclose information related to a listed transaction as required under the section 6011 disclosure rules, the time to assess tax will end no earlier than one year after the date “the Secretary is furnished the information so required.” Section 301.6501(c)-1(g)(5)(i)(A)-(C) of these proposed regulations sets forth the general procedures for how to furnish the information to the IRS. These procedures are similar to the ones required under the section 6011 disclosure rules because failure to comply with those rules triggers the application of section 6501(c)(10). Because the rules set forth in §301.6501(c)-1(g)(5)(i) generally concern annual returns, §301.6501(c)-1(g)(5)(ii) provides that the IRS may issue published guidance that prescribes alternative procedures to address particular listed transactions, if necessary, in the case of returns other than annual returns.

Section 301.6501(c)-1(g)(5)(i)(A) of these proposed regulations provides that to begin the one-year period under section 6501(c)(10)(A) taxpayers must complete Form 8886 (or successor form) in accordance with the instructions to the form and these proposed regulations and submit the completed form with a cover letter (as described in §301.6501(c)-1(g)(5)(i)(B)) to OTSA. Under the procedures set forth in Revenue Procedure 2005-26, taxpayers were required to submit the completed form and cover letter both to OTSA and the Internal Revenue Service Center where the taxpayer filed its original return in all cases and, if applicable, to an IRS examiner or Appeals officer. These proposed regulations simplify the procedures taxpayers need to follow by only requiring them to submit the information to one IRS office instead of two, unless the taxpayer also needs to submit a copy to an IRS examiner or Appeals officer, as discussed later in this Preamble.

Taxpayers must complete the most current version of the form available at the time the taxpayer attempts to satisfy section 6501(c)(10). In other words, if the Form 8886 (or successor form) changes between the date that the taxpayer was required to disclose the listed transaction under the section 6011 disclosure rules and the date that the taxpayer discloses the listed transaction for purposes of section 6501(c)(10), then the taxpayer must follow the rules in effect on the date of the section 6501(c)(10) disclosure.

The taxpayer also must indicate on the form that the disclosure is for purposes of section 6501(c)(10) and the tax return(s) and taxable year(s) for which the taxpayer is making a section 6501(c)(10) disclosure. The section 6501(c)(10) disclosure will only be effective for the tax return(s) and taxable year(s) that the taxpayer specifies he or she is attempting to disclose for purposes of section 6501(c)(10). Thus, for example, if a taxpayer failed to disclose the taxpayer's participation in a listed transaction in three taxable years but the taxpayer's section 6501(c)(10) disclosure only specifies one taxable year, then the period of limitations on assessment for the other two taxable years will remain open under section 6501(c)(10). If the Form 8886 (or successor form) contains a line for that purpose, then taxpayers may use that line, so long as the line is completed in accordance with the instructions to the form. If no line is provided on the form, then the taxpayer must include on the top of Page 1 of the Form 8886, and each copy of the form, the following statement: “ Section 6501(c)(10) Disclosure” followed by the tax return(s) and taxable year(s) for which the taxpayer is making a section 6501(c)(10) disclosure. This information is necessary to place the IRS on notice that the taxpayer is attempting to remedy its failure to properly disclose the listed transaction and, thus, the one-year period will start to run with respect to the tax years identified. Because the IRS may have as little as one year to determine whether to conduct an examination and, if it does conduct an examination, to determine whether any additional tax is due with respect to the listed transaction, it is important that the IRS receives proper notice that the one-year period has started.

Taxpayers must submit a separate Form 8886 (or successor form) and cover letter (discussed elsewhere in this Preamble) for each listed transaction that the taxpayer did not properly disclose under the section 6011 disclosure rules. If the taxpayer participated in one listed transaction over multiple years, then the taxpayer may submit one Form 8886 (or successor form), so long as the taxpayer indicates on the Form 8886 all of the tax returns and taxable years for which the taxpayer is making a section 6501(c)(10) disclosure. If a taxpayer participated in more than one listed transaction, then the taxpayer must submit separate Forms 8886 (or successor form) for each listed transaction, unless the listed transactions are the same or substantially similar, in which case all the listed transactions may be reported on one Form 8886.

Section 301.6501(c)-1(g)(5)(i)(B) of these proposed regulations provides the requirements for the cover letter. The cover letter must identify the tax return(s) and taxable year(s) for which the taxpayer is making a section 6501(c)(10) disclosure. In addition, the cover letter must include the statement provided in §301.6501(c)-1(g)(5)(i)(B) signed under penalties of perjury by the taxpayer and, if applicable, by the paid preparer preparing the Form 8886. The cover letter is necessary because the Form 8886 does not currently contain a penalties-of-perjury statement or place for signature.

A special rule for taxpayers under examination or Appeals consideration by the IRS is provided in §301.6501(c)-1(g)(5)(i)(C) of these proposed regulations. If the taxpayer wants to make a section 6501(c)(10) disclosure for a taxable year or a listed transaction under examination or Appeals consideration, then, in addition to the otherwise applicable filing obligations set forth in §301.6501(c)-1(g)(5)(i)(A), the taxpayer must submit a copy of the submission made under paragraph (g)(5)(i)(A) to the IRS examiner or Appeals officer examining or considering the taxable year to which the section 6501(c)(10) disclosure relates. This rule is adopted to ensure that the IRS personnel who are considering the taxpayer's tax year(s) at issue are made aware as soon as possible that the one-year period under section 6501(c)(10) may have started to run, so that whatever action is necessary can be taken within the one-year period.

Section 301.6501(c)-1(g)(5)(i)(D) provides guidance concerning the date on which the taxpayer is considered to have furnished the information to the IRS to satisfy section 6501(c)(10)(A) and start the running of the one-year period. The one-year period under section 6501(c)(10)(A) will begin on the date that the taxpayer satisfies all the requirements set forth in §301.6501(c)-1(g)(5)(i)(A) through (C). If the required procedures are not completed on the same date, the one-year period will begin on the date that the last procedure is satisfied. For example, if a taxpayer mails a completed Form 8886 to OTSA but not to the IRS examiner or Appeals officer who is examining or considering the taxable year to which the section 6501(c)(10) disclosure relates, the one-year period under section 6501(c)(10)(A) will not begin until both events occur.

Information provided under §301.6501(c)-1(g)(5) is deemed furnished on the date the IRS receives the information. Section 7502 does not apply to the mailing of the information detailed in §301.6501(c)-1(g)(5), because the information is not required to be filed within a prescribed period or on or before a prescribed date. Taxpayers can determine the date the IRS receives the information by using a delivery service that provides a way to track delivery, such as U.S. registered or certified mail, express or priority mail, or delivery confirmation from the U.S. post office or a private delivery service that provides tracking. Moreover, documentation from the post office or private delivery service showing the date the information was delivered to the IRS, together with evidence that the envelope was properly addressed to the office to which the information was required to be sent, generally will be sufficient proof that the IRS received the information, unless the IRS can establish that it did not in fact receive the information. Separate delivery confirmation documentation should be obtained to establish receipt by OTSA and the appropriate IRS revenue agent or Appeals officer, if applicable.

b. Disclosures by material advisors.
Under section 6501(c)(10)(B), if a taxpayer fails to disclose information related to a listed transaction as required under the section 6011 disclosure rules, the time to assess tax will end no earlier than one year after the date “a material advisor meets the requirements of section 6112 with respect to a request by the Secretary under section 6112(b) relating to such transaction with respect to such taxpayer.” Section 6112 requires material advisors to maintain lists of advisees and other information with respect to reportable transactions, including listed transactions, and to furnish that information to the IRS upon request. The term “material advisor” is defined in §301.6111-3(b). The IRS and Treasury Department finalized regulations under section 6112 in TD 9352 (72 FR 43154) published on August 3, 2007. Section 6112 and §301.6112-1 provide guidance relating to the preparation, content, maintenance, retention, and furnishing of lists by material advisors.

Section 6501(c)(10)(B) provides that a material advisor must satisfy the requirements of section 6112 to begin the one-year period. Information provided in response to another method of inquiry, such as an Information Document Request in a section 6700 investigation, will not begin the one-year period. In addition, §301.6501(c)-1(g)(6)(i) provides that the material advisor must furnish the information described in §301.6112-1(e) with respect to the taxpayer that failed to properly disclose the listed transaction. Thus, if the material advisor furnishes the information described in §301.6112-1(e) for some, or even most, of its clients but not for a particular taxpayer that failed to properly disclose the listed transaction, then the assessment period for that taxpayer will remain open under section 6501(c)(10).

Section 301.6501(c)-1(g)(6)(ii) of these proposed regulations clarifies that the one-year period will begin once the material advisor furnishes the information in response to an IRS request under section 6112, regardless of whether the material advisor provides the information within 20 business days of the IRS's request as required by section 6708. If the material advisor furnishes the required information over the course of multiple days, the requirements of paragraph (g)(6) of this section will be deemed satisfied and the one-year period will begin on the date that the IRS is furnished the information that, together with prior information, satisfies the requirements of section 6112 and §301.6112-1 with respect to the taxpayer. The information is deemed furnished for purposes of section 6501(c)(10) on the date the material advisor is treated as satisfying the requirements of section 6112 under the rules applicable to that section.

3. Taxes that can be Assessed under Section 6501(c)(10).
Section 6501(c)(10) allows the IRS to assess any tax with respect to a listed transaction for the taxable year(s) to which the failure to disclose relates. Section 301.6501(c)-1(g)(7) of these proposed regulations provides that taxes with respect to the listed transaction include, but are not limited to, (1) adjustments made to the tax consequences claimed on the return, (2) adjustments to any item to the extent the item is affected by the listed transaction even if it is unrelated to the listed transaction, and (3) interest and penalties that are related to the listed transaction or the adjustments made to the tax consequences (see I.R.C. §§6601(e)(1) and 6665(a)(2)). An example of an item affected by the listed transaction but not related to the listed transaction is the threshold for the medical expense deduction under section 213 that varies if there is a change in an individual's adjusted gross income. Examples of a penalty related to the adjustments made to the tax consequences are the accuracy-related penalties under sections 6662 and 6662A. An example of a penalty related to the listed transaction is the penalty under section 6707A for failure to file the disclosure statement reporting the taxpayer's participation in the listed transaction.

4. Examples.
Section 301.6501(c)-1(g)(8) of these proposed regulations contains examples of the application of section 6501(c)(10) to various types of taxpayers participating in listed transactions. Additional examples illustrate the application of the one-year period under section 6501(c)(10), the coordination of section 6501(c)(10) with other limitations periods provided by the Internal Revenue Code, and tax that can be assessed with respect to a listed transaction.

Proposed Effective/Applicability Date
When adopted as final regulations, these rules will apply to taxable years with respect to which the period of limitations on assessment did not expire before the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register. However, taxpayers may rely on these proposed regulations for taxable years with respect to which the period of limitations on assessment expired before the publication of the Treasury decision. Otherwise, Rev. Proc. 2005-26 continues to apply for taxable years to which these regulations do not apply and for which the period of limitations on assessment did not expire before April 8, 2005 - the effective date of Rev. Proc. 2005-26.

Effect on Other Documents
Upon the publication of final regulations under section 6501(c)(10) in the Federal Register, Rev. Proc. 2005-26 (2005-1 CB 965) will be superseded for taxable years with respect to which the period of limitations on assessment did not expire before the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register.

Special Analyses
It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations.

It is hereby certified that these regulations will not have a significant economic impact on a substantial number of small entities pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6). Section 6501(c)(10) applies when taxpayers fail to comply with the reporting requirements set forth in section 6011. The Treasury Department and the IRS do not know the exact number and types of taxpayers that fail to comply with those requirements. However, although the Treasury Department and the IRS are aware that many tax avoidance transactions involve pass-through entities, when passthrough entities are utilized, the entities are not ultimately liable for the tax; rather, the taxpayers subject to section 6501(c)(10) will be the individuals and corporations owning, directly or indirectly, the interests in the pass-though entities. Therefore, the Treasury Department and the IRS have determined that these proposed regulations will not affect a substantial number of small entities.

In addition, the Treasury Department and the IRS have determined that any impact on small entities resulting from these proposed regulations will not be significant. Most of the information required under these proposed regulations is already required by other regulations or forms, namely §1.6011-4, §301.6112-1, and Form 8886, “Reportable Transaction Disclosure Statement.” The only new information required to be submitted to the IRS is a cover letter, which must contain a reference to the tax returns and taxable year(s) at issue and a statement signed under penalty of perjury. The cover letter should take minimal time and expense to prepare. Therefore, the additional requirement of the cover letter should not significantly increase the burden on taxpayers. Based on these facts, the Treasury Department and the IRS have determined that these proposed regulations will not have a significant economic impact on a substantial number of small entities. Pursuant to section 7805(f) of the Internal Revenue Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Comments and Requests for a Public Hearing
Before these proposed regulations are adopted as final regulations, consideration will be given to any written (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The IRS and Treasury Department request comments on the substance of the proposed regulations, as well as on the clarity of the proposed rules and how they can be made easier to understand. All comments submitted by the public will be made available for public inspection and copying. A public hearing will be scheduled if requested in writing by any person that timely submits written comments. If a public hearing is scheduled, notice of the date, time, and place for the public hearing will be published in the Federal Register.

Drafting Information
The principal author of these regulations is Audra M. Dineen of the Office of the Associate Chief Counsel (Procedure and Administration).

List of Subjects in 26 CFR Part 301
Employment taxes, Estate taxes, Excise taxes, Gift taxes, Income taxes, Penalties, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations
Accordingly, 26 CFR Part 301 is proposed to be amended as follows:

PART 301 - - PROCEDURE AND ADMINISTRATION
Paragraph 1. The authority citation for part 301 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 301.6501(c)-1 is amended by adding paragraph (g) to read as follows:

§301.6501(c)-1 Exceptions to general period of limitations on assessment and collection.
* * * * *

(g) Listed transactions—(1) In general. If a taxpayer is required to disclose a listed transaction under section 6011 and the regulations under section 6011 and does not do so in the time and manner required, then the time to assess any tax attributable to that listed transaction for the taxable year(s) to which the failure to disclose relates (as defined in paragraph (g)(3)(iii) of this section) will not expire before the earlier of one year after the date on which the taxpayer makes the disclosure described in paragraph (g)(5) of this section or one year after the date on which a material advisor makes a disclosure described in paragraph (g)(6) of this section.

(2) Limitations period if paragraph (g)(5) or (g)(6) is satisfied. If one of the disclosure provisions described in paragraphs (g)(5) or (g)(6) of this section is satisfied, then the tax attributable to the listed transaction may be assessed at any time before the expiration of the limitations period that would have otherwise applied under this section (determined without regard to paragraph (g)(1) of this section) or the period ending one year after the date that one of the disclosure provisions described in paragraphs (g)(5) or (g)(6) of this section was satisfied, whichever is later. If both disclosure provisions are satisfied, the one-year period will begin on the earlier of the dates on which the provisions were satisfied. Paragraph (g)(1) of this section does not apply to any period of limitations on assessment that expired before the date on which the failure to disclose the listed transaction under section 6011 occurred.

(3) Definitions—(i) Listed transaction. The term listed transaction means a transaction described in section 6707A(c)(2) of the Code and §1.6011-4(b)(2) of this chapter.

(ii) Material advisor. The term material advisor means a person described in section 6111(b)(1) of the Code and §301.6111-3(b) of this chapter.

(iii) Taxable year(s) to which the failure to disclose relates. The taxable year(s) to which the failure to disclose relates are each taxable year that the taxpayer participated (as defined under section 6011 and the regulations under section 6011) in a transaction that was identified as a listed transaction and the taxpayer failed to disclose the listed transaction as required under section 6011. If the taxable year in which the taxpayer participated in the listed transaction is different from the taxable year in which the taxpayer is required to disclose the listed transaction under section 6011, the taxable year(s) to which the failure to disclose relates are each taxable year that the taxpayer participated in the transaction.

(4) Application of paragraph with respect to pass-through entities. In the case of taxpayers who are partners in partnerships, shareholders in S corporations, or beneficiaries of trusts and are required to disclose a listed transaction under section 6011 and the regulations under section 6011, paragraph (g)(1) of this section will apply to a particular partner, shareholder, or beneficiary if that particular taxpayer does not disclose within the time and in the form and manner provided by section 6011 and §1.6011-4(d) and (e), regardless of whether the partnership, S corporation, or trust or another partner, shareholder, or beneficiary discloses in accordance with section 6011 and the regulations under section 6011. Similarly, because paragraph (g)(1) of this section applies on a taxpayer-by-taxpayer basis, the failure of a partnership, S corporation, or trust that has a disclosure obligation under section 6011 and does not disclose within the time or in the form and manner provided by §1.6011-4(d) and (e) will not cause paragraph (g)(1) of this section to apply automatically to all the partners, shareholders or beneficiaries of the entity. Instead, the application of paragraph (g)(1) of this section will be determined based on whether the particular taxpayer satisfied their disclosure obligation under section 6011 and the regulations under section 6011.

(5) Taxpayer's disclosure of a listed transaction that taxpayer did not properly disclose under section 6011—(i) In general—(A) Method of disclosure. The taxpayer must complete the most current version of Form 8886, “Reportable Transaction Disclosure Statement” (or successor form), available on the date the taxpayer attempts to satisfy this paragraph in accordance with §1.6011-4(d) (in effect on that date) and the instructions to that form. The taxpayer must indicate on the Form 8886 that the form is being submitted for purposes of section 6501(c)(10) and the tax return(s) and taxable year(s) for which the taxpayer is making a section 6501(c)(10) disclosure. The section 6501(c)(10) disclosure will only be effective for the tax return(s) and taxable year(s) that the taxpayer specifies he or she is attempting to disclose for purposes of section 6501(c)(10). If the Form 8886 contains a line for this purpose then the taxpayer must complete the line in accordance with the instructions to that form. Otherwise, the taxpayer must include on the top of Page 1 of the Form 8886, and each copy of the form, the following statement: “ Section 6501(c)(10) Disclosure” followed by the tax return(s) and taxable year(s) for which the taxpayer is making a section 6501(c)(10) disclosure. For example, if the taxpayer did not properly disclose its participation in a listed transaction the tax consequences of which were reflected on the taxpayer's Form 1040 for the 2005 taxable year, the taxpayer must include the following statement: “ Section 6501(c)(10) Disclosure; 2005 Form 1040” on the form. The taxpayer must submit the properly completed Form 8886 and a cover letter, which must be completed in accordance with the requirements set forth in paragraph (g)(5)(i)(B) of this section, to the Office of Tax Shelter Analysis (OTSA). The taxpayer is permitted, but not required, to file an amended return with the Form 8886 and cover letter. Separate Forms 8886 and separate cover letters must be submitted for each listed transaction the taxpayer did not properly disclose under section 6011. If the taxpayer participated in one listed transaction over multiple years, the taxpayer may submit one Form 8886 (or successor form) and cover letter and indicate on that form all of the tax returns and taxable years for which the taxpayer is making a section 6501(c)(10) disclosure. If a taxpayer participated in more than one listed transaction, then the taxpayer must submit separate Forms 8886 (or successor form) for each listed transaction, unless the listed transactions are the same or substantially similar, in which case all the listed transactions may be reported on one Form 8886.

(B) Cover letter. A cover letter to which a Form 8886 is to be attached must identify the tax return(s) and taxable year(s) for which the taxpayer is making a section 6501(c)(10) disclosure and include the following statement signed under penalties of perjury by the taxpayer and if the Form 8886 is prepared by a paid preparer, the Form 8886 must be signed under penalties of perjury by the paid preparer as well:

Under penalties of perjury, I declare that I have examined this reportable transaction disclosure statement and, to the best of my knowledge and belief, this reportable transaction disclosure statement is true, correct, and complete. Declaration of preparer (other than taxpayer) is based on all information of which the preparer has any knowledge.

(C) Taxpayer under examination or Appeals consideration. A taxpayer making a disclosure under paragraph (g)(5) of this section with respect to a taxable year under examination or Appeals consideration by the IRS must satisfy the requirements of paragraphs (g)(5)(i)(A) and (B) of this section and also submit a copy of the submission to the IRS examiner or Appeals officer examining or considering the taxable year(s) to which the disclosure under paragraph (g) of this section relates.

(D) Date the one-year period will begin to run if paragraph (g)(5) satisfied. Unless an earlier expiration is provided for in paragraph (g)(6) of this section, the time to assess tax under paragraph (g) of this section will not expire before one year after the date on which the Secretary is furnished the information from the taxpayer that satisfies all the requirements of paragraphs (g)(5)(i)(A) and (B) of this section and, if applicable, paragraph (g)(5)(i)(C) of this section. If the taxpayer does not satisfy all of the requirements on the same date, the one-year period will begin on the date that the IRS is furnished the information that, together with prior disclosures of information, satisfies the requirements of paragraph (g)(5) of this section. For purposes of paragraph (g)(5) of this section, the information is deemed furnished on the date the IRS receives the information.

(ii) Exception for returns other than annual returns. The IRS may prescribe alternative procedures to satisfy the requirements of this paragraph (g)(5) in a revenue procedure, notice, or other guidance published in the Internal Revenue Bulletin for circumstances involving returns other than annual returns.

(6) Material advisor's disclosure of a listed transaction not properly disclosed by a taxpayer under section 6011—(i) Method of disclosure. In response to a written request of the IRS under section 6112, a material advisor with respect to a listed transaction must furnish to the IRS the information described in section 6112 and §301.6112-1(b) in the form and manner prescribed by section 6112 and §301.6112-1(e). If the information the material advisor furnishes identifies the taxpayer as a person who engaged in the listed transaction, regardless of whether the material advisor provides the information before or after the taxpayer's failure to disclose the listed transaction under section 6011, then the requirements of this paragraph (g)(6) will be satisfied for that taxpayer. The requirements of this paragraph (g)(6) will be considered satisfied even if the material advisor furnishes the information required under section 6112 to the IRS after the date prescribed in section 6708 or published guidance relating to section 6708.

(ii) Date the one-year period will begin if paragraph (g)(6) is satisfied. Unless an earlier expiration is provided for in paragraph (g)(5) of this section, the time to assess tax under paragraph (g) of this section will expire one year after the date on which the material advisor satisfies the requirements of paragraph (g)(6)(i) of this section with respect to the taxpayer. For purposes of paragraph (g)(6) of this section, information is deemed to be furnished on the date that, in response to a request under section 6112, the IRS receives the information from a material advisor that satisfies the requirements of paragraph (g)(6)(i) of this section with respect to the taxpayer.

(7) Tax assessable under this section. If the period of limitations on assessment for a taxable year remains open under this section, the Secretary has authority to assess any tax with respect to the listed transaction in that year. This includes, but is not limited to, adjustments made to the tax consequences claimed on the return plus interest, additions to tax, additional amounts, and penalties that are related to the listed transaction or adjustments made to the tax consequences. This also includes any item to the extent the item is affected by the listed transaction even if it is unrelated to the listed transaction. An example of an item affected by, but unrelated to, a listed transaction is the threshold for the medical expense deduction under section 213 that varies if there is a change in an individual's adjusted gross income. An example of a penalty related to the listed transaction is the penalty under section 6707A for failure to file the disclosure statement reporting the taxpayer's participation in the listed transaction. Examples of penalties related to the adjustments made to the tax consequences are the accuracy-related penalties under sections 6662 and 6662A.

(8) Examples. The rules of paragraph (g) of this section are illustrated by the following examples:

Example 1. No requirement to disclose under section 6011. P, an individual, is a partner in a partnership that entered into a transaction in 2001 that was the same as or substantially similar to the transaction identified as a listed transaction in Notice 2000-44 (2000-2 CB 255). P claimed a loss from the transaction on his Form 1040 for the tax year 2001. P filed the Form 1040 prior to June 14, 2002. P did not disclose his participation in the listed transaction because P was not required to disclose the transaction under the applicable section 6011 regulations (TD 8961). Although the transaction was a listed transaction and P did not disclose the transaction, P had no obligation to include on any return or statement any information with respect to a listed transaction within the meaning of section 6501(c)(10) because TD 8961 only applied to corporations, not individuals. Accordingly, section 6501(c)(10) does not apply.

Example 2. Taxable year to which the failure to disclose relates when transaction is identified as a listed transaction after taxpayer files a tax return for that year. (i) In January 2009, A, a calendar year taxpayer, enters into a transaction that at the time is not a listed transaction. A reports the tax consequences from the transaction on its individual income tax return for 2009 timely filed on April 15, 2010. The time for the IRS to assess tax against A under the general three-year period of limitations for A's 2009 taxable year would expire on April 15, 2013. A only participated in the transaction in 2009. On March 1, 2012, the IRS identifies the transaction as a listed transaction. A does not file the Form 8886 with OTSA by May 30, 2012.

(ii) The period of limitations on assessment for A's 2009 taxable year was open on the date the transaction was identified as a listed transaction. Under the applicable section 6011 regulations (TD 9350, 2007-38 IRB 607), A must disclose its participation in the transaction by filing a completed Form 8886 with OTSA on or before May 30, 2012, which is 90 days after the date the transaction became a listed transaction. A did not disclose the transaction as required. A's failure to disclose relates to taxable year 2009 even though the obligation to disclose did not arise until 2012. Section 6501(c)(10) operates to keep the period of limitations on assessment open for the 2009 taxable year with respect to the listed transaction until at least one year after the date A satisfies the requirements of paragraph (g)(5) of this section or a material advisor satisfies the requirements of paragraph (g)(6) of this section with respect to A.

Example 3. Requirements of paragraph (g)(6) satisfied. Same facts as Example 2, except that on April 5, 2013, the IRS hand delivers to Advisor J, who is a material advisor, a section 6112 request related to the listed transaction. Advisor J furnishes the required list with all the information required by section 6112 and §301.6112-1, including all the information required with respect to A, to the IRS on May 13, 2013. The submission satisfies the requirements of paragraph (g)(6) even though Advisor J furnishes the information outside of the 20-business-day period provided in section 6708. Accordingly, under section 6501(c)(10), the period of limitations with respect to A's taxable year 2009 will end on May 13, 2014, one year after the IRS received the required information, unless the period of limitations remains open under another exception. Any tax for the 2009 taxable year not attributable to the listed transaction must be assessed by April 15, 2013.

Example 4. Requirements of paragraph (g)(5) also satisfied. Same facts as Examples 2 and 3, except that on May 23, 2013, A files a properly completed Form 8886 and signed cover letter with OTSA both identifying that the section 6501(c)(10) disclosure relates to A's Form 1040 for 2009. A satisfied the requirements of paragraph (g)(5) of this section as of May 23, 2013. Because the requirements of paragraph (g)(6) were satisfied first as described in Example 3, under section 6501(c)(10) the period of limitations will end on May 13, 2014 (one year after the requirements of paragraph (g)(6) were satisfied) instead of May 23, 2014 (one year after the requirements of paragraph (g)(5) were satisfied). Any tax for the 2009 taxable year not attributable to the listed transaction must be assessed by April 15, 2013.

Example 5. Period to assess tax remains open under another exception. Same facts as Examples 2, 3, and 4, except that on April 1, 2013, A signed Form 872, consenting to extend, without restriction, its period of limitations on assessment for taxable year 2009 under section 6501(c)(4) until July 15, 2014. In that case, although under section 6501(c)(10) the period of limitations would otherwise expire on May 13, 2014, the IRS may assess tax with respect to the listed transaction at any time up to and including July 15, 2014, pursuant to section 6501(c)(4). Section 6501(c)(10) can operate to extend the assessment period but cannot shorten any other applicable assessment period.

Example 6. Requirements of (g)(5) not satisfied. In 2009, X, a corporation, enters into a listed transaction. On March 15, 2010, X timely files its 2009 Form 1120, reporting the tax consequences from the transaction. X does not disclose the transaction as required under section 6011 when it files its 2009 return. The failure to disclose relates to taxable year 2009. On February 12, 2014, X completes and files a Form 8886 with respect to the listed transaction with OTSA but does not submit a cover letter, as required. The requirements of paragraph (g)(5) of this section have not been satisfied. Therefore, the time to assess tax against X with respect to the transaction for taxable year 2009 remains open under section 6501(c)(10).

Example 7. Taxable year to which the failure to disclose relates when transaction is identified as a listed transaction after first year of participation. (i) On December 30, 2003, Y, a corporation, enters into a transaction that at the time is not a reportable transaction. On March 15, 2004, Y timely files its 2003 Form 1120, reporting the tax consequences from the transaction. On April 1, 2004, the IRS issues Notice 2004-31 that identifies the transaction as a listed transaction. Y also reports tax consequences from the transaction on its 2004 Form 1120, which it timely filed on March 15, 2005. Y did not attach a completed Form 8886 to its 2004 Form 1120 and did not send a copy of the form to OTSA. The general three-year period of limitations on assessment for Y's 2003 and 2004 taxable years would expire on March 15, 2007, and March 17, 2008, respectively.

(ii) The period of limitations on assessment for Y's 2003 taxable year was open on the date the transaction was identified as a listed transaction. Under the applicable section 6011 regulations (TD 9108), Y should have disclosed its participation in the transaction with its next filed return, which was its 2004 Form 1120, but Y did not disclose its participation. Y's failure to disclose with the 2004 Form 1120 relates to taxable years 2003 and 2004. Section 6501(c)(10) operates to keep the period of limitations on assessment open for the 2003 and 2004 taxable years with respect to the listed transaction until at least one year after the date Y satisfies the requirements of paragraph (g)(5) of this section or a material advisor satisfies the requirements of paragraph (g)(6) of this section with respect to Y.

Example 8. Section 6501(c)(10) applies to keep one partner's period of limitations on assessment open. T and S are partners in a partnership, TS, that enters into a listed transaction in 2010. T and S each receive a Schedule K-1 from TS on April 11, 2011. On April 15, 2011, TS, T and S each file their 2010 returns. Under the applicable section 6011 regulations, TS, T, and S each are required to disclose the transaction. TS attaches a completed Form 8886 to its 2010 Form 1065 and sends a copy of Form 8886 to OTSA. Neither T nor S files a disclosure statement with their respective returns nor sends a copy to OTSA on April 15, 2011. On May 17, 2011, T timely files a completed Form 8886 with OTSA pursuant to §1.6011-4(e)(1). T's disclosure is timely because T received the Schedule K-1 within 10 calendar days before the due date of the return and, thus, T had 60 calendar days to file Form 8886 with OTSA. TS and T properly disclosed the transaction in accordance with the applicable regulations under section 6011, but S did not. S's failure to disclose relates to taxable year 2010. The time to assess tax with respect to the transaction against S for 2010 remains open under section 6501(c)(10) even though TS and T disclosed the transaction.

Example 9. Section 6501(c)(10) satisfied before expiration of three-year period of limitations under section 6501(a). Same facts as Example 8, except that on August 27, 2012, S satisfies the requirements of paragraph (g)(5) of this section. No material advisor satisfied the requirements of paragraph (g)(6) of this section with respect to S on a date earlier than August 27, 2012. Under section 6501(c)(10), the period of time in which the IRS may assess tax against S with respect to the listed transaction would expire no earlier than August 27, 2013, one year after the date S satisfied the requirements of paragraph (g)(5). As the general three-year period of limitations on assessment under section 6501(a) does not expire until April 15, 2014, the IRS will have until that date to assess any tax with respect to the listed transaction.

Example 10. No section 6112 request. B, a calendar year taxpayer, entered into a listed transaction in 2010. B did not comply with the applicable disclosure requirements under section 6011 for taxable year 2010; therefore, section 6501(c)(10) applies to keep the period of limitations on assessment open with respect to the tax related to the transaction until at least one year after B satisfies the requirements of paragraph (g)(5) of this section or a material advisor satisfies the requirements of paragraph (g)(6) of this section with respect to B. In June 2011, the IRS conducts a section 6700 investigation of Advisor K, who is a material advisor to B with respect to the listed transaction. During the course of the investigation, the IRS obtains the name, address, and TIN of all of Advisor K's clients who engaged in the transaction, including B. The information provided does not satisfy the requirements of paragraph (g)(6) with respect to B because the information was not provided pursuant to a section 6112 request. Therefore, the time to assess tax against B with respect to the transaction for taxable year 2010 remains open under section 6501(c)(10).

Example 11. Section 6112 request but the requirements of paragraph (g)(6) are not satisfied with respect to B. Same facts as Example 10, except that on January 2, 2014, the IRS sends by certified mail a section 6112 request to Advisor L, who is another material advisor to B with respect to the listed transaction. Advisor L furnishes some of the information required under section 6112 and §301.6112-1 to the IRS for inspection on January 13, 2014. The list includes information with respect to many clients of Advisor L, but it does not include any information with respect to B. The submission does not satisfy the requirements of paragraph (g)(6) of this section with respect to B. Therefore, the time to assess tax against B with respect to the transaction for taxable year 2010 remains open under section 6501(c)(10).

Example 12. Section 6112 submission made before taxpayer failed to disclose a listed transaction. Advisor M, who is a material advisor, advises C, an individual, in 2010 with respect to a transaction that is not a reportable transaction at that time. C files its return claiming the tax consequences of the transaction on April 15, 2011. The time for the IRS to assess tax against C under the general three-year period of limitations for C's 2010 taxable year would expire on April 15, 2014. The IRS identifies the transaction as a listed transaction on November 1, 2013. On December 5, 2013, the IRS hand delivers to Advisor M a section 6112 request related to the transaction. Advisor M furnishes the information to the IRS on December 30, 2013. The information contains all the required information with respect to Advisor M's clients, including C. C does not disclose the transaction on or before January 30, 2014, as required under section 6011 and the regulations under section 6011. Advisor M's submission under section 6112 satisfies the requirements of paragraph (g)(6) of this section even though it occurred prior to C's failure to disclose the listed transaction. Thus, under section 6501(c)(10), the period of limitations to assess tax against C with respect to the listed transaction will end on December 30, 2014 (one year after the requirements of paragraph (g)(6) of this section were satisfied), unless the period of limitations remains open under another exception.

Example 13. Transaction removed from the category of listed transactions after taxpayer failed to disclose. D, a calendar year taxpayer, entered into a listed transaction in 2011. D did not comply with the applicable disclosure requirements under section 6011 for taxable year 2011; therefore, section 6501(c)(10) applies to keep the period of limitations on assessment open with respect to the tax related to the transaction until at least one year after D satisfies the requirements of paragraph (g)(5) of this section or a material advisor satisfies the requirements of paragraph (g)(6) of this section with respect to D. In 2016, the IRS removes the transaction from the category of listed transactions because of a change in law. Section 6501(c)(10) continues to apply to keep the period of limitations on assessment open for D's taxable year 2011.

Example 14. Taxes assessed with respect to the listed transaction. (i) F, an individual, enters into a listed transaction in 2009. F files its 2009 Form 1040 on April 15, 2010, but does not disclose his participation in the listed transaction in accordance with section 6011 and the regulations under section 6011. F's failure to disclose relates to taxable year 2009. Thus, section 6501(c)(10) applies to keep the period of limitations on assessment open with respect to the tax related to the listed transaction for taxable year 2009 until at least one year after the date F satisfies the requirements of paragraph (g)(5) of this section or a material advisor satisfies the requirements of paragraph (g)(6) of this section with respect to F.

(ii) On July 1, 2014, the IRS completes an examination of F's 2009 taxable year and disallows the tax consequences claimed as a result of the listed transaction. The disallowance of a loss increased F's adjusted gross income. Due to the increase of F's adjusted gross income, certain credits, such as the child tax credit, and exemption deductions were disallowed or reduced because of limitations based on adjusted gross income. In addition, F now is liable for the alternative minimum tax. The examination also uncovered that F claimed two deductions on Schedule C to which F was not entitled. Under section 6501(c)(10), the IRS can timely issue a statutory notice of deficiency (and assess in due course) against F for the deficiency resulting from (1) disallowing the loss, (2) disallowing the credits and exemptions to which F was not entitled based on F's increased adjusted gross income, and (3) being liable for the alternative minimum tax. In addition, the IRS can assess any interest and applicable penalties related to those adjustments, such as the accuracy-related penalty under sections 6662 and 6662A and the penalty under section 6707A for F's failure to disclose the transaction as required under section 6011 and the regulations under section 6011. The IRS cannot, however, pursuant to section 6501(c)(10), assess the increase in tax that would result from disallowing the two deductions on F's Schedule C because those deductions are not related to, or affected by, the adjustments concerning the listed transaction.

(9) Effective/applicability date. The rules of this paragraph (g) apply to taxable years with respect to which the period of limitations on assessment did not expire before the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register. However, taxpayers may rely on the rules of this paragraph (g) for taxable years with respect to which the period of limitations on assessment expired before the date of publication of the Treasury decision. If an individual does not choose to rely on the rules of this paragraph (g), Rev. Proc. 2005-26 (2005-1 CB 965) will continue to apply to taxable years with respect to which the period of limitations on assessment expired on or after April 8, 2005, and before the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.

/s/ Linda E. Stiff

Deputy Commissioner for Services and Enforcement

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First time home buyer credit - extention

2009ARD 225-9
Internal Revenue Service: First-Time Homebuyers Credit: Questions and answers: Homes purchased in 2009
First-Time Homebuyer Credit Questions and Answers: Homes Purchased in 2009
New legislation signed on Nov. 6, 2009, extends and expands the first-time homebuyer credit allowed by previous Acts. The new law:
• extends deadlines for purchasing and closing on a home
• authorizes the credit for long-time homeowners buying a replacement principal residence
• raises the income limitations for homeowners claiming the credit
Q. I plan to build a home and occupy it in 2009 or early 2010. Can I claim the first-time homebuyer credit now and use the funds toward the down payment or other ongoing construction costs?
A. No. To qualify for the first time home buyer credit, the residence must be purchased. By statute, a residence which is constructed by the taxpayer is treated as purchased on the date the taxpayer first occupies the residence. (05/06/09)
Q. I bought my home in 2009 (early) and filed my 2008 tax return claiming the $7,500 first-time homebuyer credit that has to be repaid. Now the expanded law provides for an $8,000 credit that doesn't have to be repaid. What do I need to do to get the $8,000 credit that doesn't have to be paid back?
A. You can file an amended return.
Q. If I purchase a home in June 2009, and have already filed my 2008 tax return, can I amend my 2008 return or will I have to claim it on my 2009 return?
A. You can either file an amended return to claim it on your 2008 return or claim it on your 2009 return.
Q. I am in the process of buying a home. Can I claim the first-time homebuyer credit now? That would allow me to use the refund for a down payment.
A. No. You may not claim the credit in anticipation of a purchase that has yet to happen. Until you have finalized the purchase of your home, which for most purchasers occurs at the time of the closing, you do not qualify for the credit. IRS news release 2009-27 , First-Time Homebuyers Have Several Options to Maximize New Tax Credit, contains details for filing options if the home is purchased after April 15, 2009.
Q: When must I pay back the credit for the home I purchased in 2009?
A: Generally, there is no requirement to pay back the credit for a principal residence purchased in 2009 or early 2010. The obligation to repay the credit arises only if the home ceases to be your principal residence within 36 months from the date of purchase. The full amount of the credit received becomes due on the return for the year the home ceased being your principal residence.
Q. If I claim the first-time homebuyer credit for a purchase in 2009 or early 2010 and stop using the property as my principal residence before the 36 month period expires after I purchase, how is the credit repaid and how long would I have to repay it?
A. If, within 36 months of the date of purchase, the property is no longer used as your principal residence, you are required to repay the credit. Repayment of the full amount of the credit is due at the time the income tax return for the year the home ceased to be your principal residence is due. The full amount of the credit is reflected as additional tax on that year's tax return. Form 5405 and its instructions will be revised for tax year 2009 to include information about repayment of the credit.
Q: I'm already a homeowner. If I buy a replacement home after Nov. 6, 2009, to use as my principal residence, do I have to sell my home to qualify for the homebuyer tax credit?
A: If you meet all of the requirements for the credit, the law does not require you to sell or otherwise dispose of your current principal residence to qualify for a credit of up to $6,500 when you buy a replacement home to use as your principal residence. The requirements are that you must buy, or enter into a binding contract to buy, the replacement principal residence after Nov. 6, 2009, and on or before April 30, 2010, and close on the home by June 30, 2010. Additionally, you must have lived in the same principal residence for any five-consecutive-year period during the eight-year period that ended on the date the replacement home is purchased. For example, if you bought a home on Nov. 30, 2009, the eight-year period would run from Dec. 1, 2001, through Nov. 30, 2009. (11/17/09)
Related Items:
• First-Time Homebuyer Credit Questions and Answers: Basic Information
• First-Time Homebuyer Credit Questions and Answers: Homes Purchased in 2008
• First-Time Homebuyer Credit: Scenarios
• First-Time Homebuyer Credit


2009ARD 225-8
Internal Revenue Service: First-Time Homebuyers Credit: Questions and answers: Basic information
First-Time Homebuyer Credit Questions and Answers: Basic Information
Updated Nov. 6, 2009, to note new legislation. The new legislation extends and expands the first-time homebuyer credit allowed by previous Acts. The new law:
• extends deadlines for purchasing and closing on a home
• authorizes the credit for long-time homeowners buying a replacement principal residence
• raises the income limitations for homeowners claiming the credit
Q. What is the credit?
A. The first-time homebuyer credit is a new tax credit included in the Housing and Economic Recovery Act of 2008. For homes purchased in 2008, the credit operates like an interest-free loan because it must be repaid over a 15-year period. The credit was expanded in 2009 for homes purchased in 2009, increasing the amount of the credit and eliminating the requirement to repay the credit, unless the home ceases to be your principal residence within the 36-month period beginning on the purchase date. It was further expanded in late 2009 to extend deadlines and to allow long-time homeowners buying replacement homes and people with higher incomes to qualify for the credit.
Q. How much is the credit?
A. The credit is 10 percent of the purchase price of the home, with a maximum available credit of $7,500 ($8,000 if you purchased your home in 2009 or early 2010) for either a single taxpayer or a married couple filing a joint return, but only half of that amount for married persons filing separate returns. The full credit is available for homes costing $75,000 or more ($80,000 in 2009 or early 2010). Long-time homeowners who buy a replacement home after Nov. 6, 2009, or in early 2010 may qualify for a credit of up to $6,500, or $3,250 for a married person filing a separate return.
Q. Which home purchases qualify for the first-time homebuyer credit?
A. Any home purchased as your principal residence and located in the United States qualifies. You must buy the home after April 8, 2008, and before May. 1, 2010 (with closing to take place before July 1), to qualify for the credit. For a home that you construct, the purchase date is considered to be the first date you occupy the home. Normally, taxpayers (including spouse, if married) who owned a principal residence at any time during the three years prior to the date of purchase are not eligible for the credit. This means that you can qualify for the credit if you (and your spouse, if married) have not owned a home in the three years prior to a purchase. However, a long-time homeowner can also get the credit for a qualifying replacement home purchased after Nov. 6, 2009. To qualify, you must have owned and used the same home as your principal residence for at least five consecutive years of the eight-year period ending on the date you by your new principal residence.
If you make an eligible purchase in 2008, you claim the first-time homebuyer credit on your 2008 tax return. For an eligible purchase in 2009, you can choose to claim the credit on either your 2008 or 2009 income tax return. For an eligible purchase in 2010, you can choose to claim the credit on either your 2009 or 2010 return.
Q. If a taxpayer purchases a mobile home (manufactured home) with land and qualifies for the credit, is the amount of the credit based on the combined cost of the home and land?
A. Yes. The first-time homebuyer credit is ten percent of the purchase price of a principal residence. The total purchase price (mobile home and land) is used to determine the amount of the first-time homebuyer credit.
Q. Is a taxpayer who purchases a mobile home and places the home on leased land eligible for the first-time homebuyer credit?
A. Yes. A mobile home may qualify as a principal residence and it is not necessary that the taxpayer own the land to qualify for the first-time homebuyer credit.
Q. Can a taxpayer who purchases a travel trailer qualify for the credit?
A. A travel trailer that is affixed to land may qualify as a principal residence.
Q. Can an individual who has lived in an RV qualify for the credit?
A. For purposes of the first-time homebuyer credit, an RV with a built-in motor is personal property that is not affixed to land and does not qualify as a principal residence. Accordingly, someone who has owned and lived in an RV within the past three years may still qualify as a first-time homebuyer.
Q. Can I apply for the credit if I bought a vacation home or rental property?
A. No. Vacation homes and rental property do not qualify for this credit.
Q. Who is considered to be a first-time homebuyer?
A. Taxpayers who have not owned another principal residence at any time during the three years prior to the date of purchase are considered first-time homebuyers. For example, if you bought a home on July 1, 2008, you cannot take the credit for that home if you owned, or had an ownership interest in, another principal residence at any time from July 2, 2005, through July 1, 2008. In addition, Long-time homeowners who buy a replacement home after Nov. 6, 2009 or in early 2010 can also qualify. Under this rule, you must have owned and used the same home as your principal residence for at least five consecutive years of the eight-year period ending on the date you by your new principal residence. For an eligible taxpayer who, for example, bought a home on Nov. 30, 2009, the eight-year period would run from Dec. 1, 2001, through Nov. 30, 2009.
Q. Can a dependent on someone else's tax return claim the first time homebuyer credit if they otherwise qualify?
A. Different rules apply depending upon whether a dependent buys a home after Nov. 6, 2009, or on or before that date. Dependents are not eligible to claim the credit on any purchase after Nov. 6, 2009. However, a dependent who buys a home on or before Nov. 6, 2009 may qualify for the credit.
Q. Can a minor buy a home and claim the credit?
A. Usually, no. However, different rules apply to purchases after Nov. 6, 2009 and those on or before that date.
Minors are generally barred from claiming the credit on home purchases after Nov. 6, 2009. To qualify for the credit, a purchaser must be at least 18 years of age on the date of purchase. For a married couple, only one spouse must meet this age requirement. A dependent is not eligible for the credit, regardless of age.
For purchases on or before Nov. 6, 2009, the tax law does not bar a minor from buying a home and claiming the credit. However, taxpayers who do not otherwise qualify for the credit do not become eligible for the credit simply by using a minor child's name. In addition, under state law, children under the age of 18 generally are not bound by any contract they sign and cannot be required to comply with the terms of the contract. Thus, it is extremely unlikely that a seller of a home, or a lender if financing is required, would enter into a bona fide sale of a home to a child. Merely using the child's name to purchase a home does not qualify the child for the credit if, in substance, the child is not a bona fide purchaser of a home.
Q. When do I have to buy a new home to get the credit?
A. The credit is available for eligible home purchases after April 8, 2008. You must enter into a binding contract to buy the home before May 1, 2010 and close before July 1, 2010, in order to obtain the credit. For a home you construct, the purchase date is considered to be the date you first occupy the home.
Q. How do I apply for the credit?
A. The credit is claimed on IRS Form 5405 , First-Time Homebuyer Credit, and filed with your 2008, 2009 or 2010 federal income tax return.
Q. Are there income limits?
A. Yes. The credit is reduced or eliminated for higher-income taxpayers. The credit is phased out based on your modified adjusted gross income (MAGI). Different income limits apply to purchases on or before Nov. 6, 2009 and those after that date.
For purchases on or before Nov. 6, 2009, for a married couple filing a joint return, the phase-out range is $150,000 to $170,000. For other taxpayers, the phase-out range is $75,000 to $95,000. This means that the full credit is available for married couples filing a joint return whose MAGI is $150,000 or less and for other taxpayers whose MAGI is $75,000 or less.
For purchases after Nov. 6, 2009, for a married couple filing a joint return, the phase-out range is $225,000 to $245,000. For other taxpayers, the phase-out range is $125,000 to $145,000. This means that the full credit is available for married couples filing a joint return whose MAGI is $225,000 or less and for other taxpayers whose MAGI is $125,000 or less.
Q. Can a taxpayer claim the first-time homebuyer credit after entering into a contract for the purchase of a residence but before closing on the purchase?
A. No. Taxpayers cannot claim the credit before there is a completed sale and purchase of the residence. The sale and purchase are generally completed at the time of closing on the purchase. (New 7/2/09)
Q. Can a taxpayer claim the first-time homebuyer credit if the purchase is pursuant to a seller financing arrangement (for example, a contract for deed, installment land sale contract, or long-term land contract), and the seller retains legal title to secure the taxpayer's payment obligations?
A. If the taxpayer obtains the “benefits and burdens” of ownership of a residence in a seller financing arrangement, then the taxpayer can claim the credit even though the seller retains legal title. Factors that indicate that a taxpayer has the benefits and burdens of ownership include: 1. the right of possession, 2. the right to obtain legal title upon full payment of the purchase price, 3. the right to construct improvements, 4. the obligation to pay property taxes, 5. the risk of loss, 6. the responsibility to insure the property and 7. the duty to maintain the property. (New 7/2/09)
Q. I purchased a home that qualifies for the first-time homebuyer credit. I will be renting two of the bedrooms and reporting the rental income on Schedule E. Will I still qualify for the credit if I use the home as my principal residence?
A. Yes, if you meet all first-time homebuyer eligibility requirements. See Form 5405 , First-Time Homebuyer Credit, for more details.
Q. I purchased a duplex home with two separate dwelling units. I will live in one dwelling and will rent out the other dwelling unit and report the rental income on Schedule E. May I qualify for the first-time homebuyer credit, and what amount do I use for the purchase price to determine the amount of the credit?
A. Yes, you may qualify for the credit for the dwelling unit that you use as your principal residence. To determine the amount of your credit, you must allocate the purchase price of the duplex between the two separate dwelling units. You may not use the entire purchase price of the duplex to determine the amount of your credit.
Q. If two unmarried people buy a house together, how do they determine how much each may take of the credit?
A. IRS Notice 2009-12 provides guidance for allocating the first-time homebuyer credit between taxpayers who are not married.
Q. I am a single co-owner of a home. How do I get this credit?
A. Depending on the year of purchase, you will claim the credit on your 2008, 2009 or 2010 federal income tax return.
Q. I don't owe taxes and/or my income is exempt from tax and I do not have a filing requirement. Do I qualify for the credit?
A. The credit is fully refundable and, if you qualify as a first-time homebuyer, having tax-exempt income will not preclude eligibility. Although there are maximum income limits for qualifying first-time homebuyers, there are no minimum income criteria. Thus, someone with no taxable income who qualifies as a first-time homebuyer may file for the sole purpose of claiming the credit for a refund.
Q. Does the first-time homebuyer credit apply to homes located in the U.S. Territories?
A. No.
Q. Would I be considered a first time homebuyer if I owned a principal residence outside of the United States within the previous three years?
A. Yes. A taxpayer who owned a principal residence outside of the United States within the last three years is not disqualified from taking the credit for a purchase within the United States.
Q. If qualified, are homebuyers required to claim the first-time homebuyer credit?
A. No.
Q. Who cannot take the credit?
A. If any of the following describe you, you cannot take the credit, even if you buy a new home:
• Your income exceeds the phase-out range.
• You buy your home from a close relative. This includes your spouse, parent, grandparent, child or grandchild.
• You do not use the home as your principal residence.
• You are a nonresident alien.
Q. Does previously inheriting a home and living in it automatically disqualify me as a first-time homebuyer if I buy a different home on or before Nov. 6, 2009?
A. Yes, an ownership interest in a prior principal residence would bar you from being considered a first-time homebuyer. As long as you owned and used the prior home as your principal residence, you are not a first-time homebuyer. There is no exception for taxpayers who did not buy their prior residences. (05/06/09)
Q. If I claim the first-time homebuyer credit in 2009 and stop using the property as my main home before the 36 month period expires after I purchase, how is the credit repaid and how long would I have to repay it?
A. If, within 36 months of the date of purchase, the property is no longer used as your principal residence, you are required to repay the credit. Repayment of the full amount of the credit is due at the time the income tax return for the year the home ceased to be your principal residence is due. The full amount of the credit is reflected as additional tax on that year's tax return. Form 5405 and its instructions will be revised for tax year 2009 to include information about repayment of the credit. (05/06/09)
Q . If a person does not actually make the payments on a home that's their principal residence, but the deed and mortgage documents are in their name, can they be considered a first-time homebuyer?
A. Yes. If a taxpayer purchases a home to be used as a principal residence from an unrelated person and has not owned a home within the previous 36 months, the taxpayer is eligible for the first-time homebuyer credit regardless of who makes the mortgage payment. (05/06/09)
Q. Do taxpayers affected by Hurricane Katrina or other disasters qualify as first-time homebuyers if their principal residence (i.e. main home) became uninhabitable more than three years ago and they have not formally disposed of the uninhabitable home or purchased or built a new home in the interim?
A. Yes. They may be eligible for the first-time homebuyer credit when they purchase a new principal residence. (11/19/09)
Related Items:
• First-Time Homebuyer Credit Questions and Answers: Homes Purchased in 2008
• First-Time Homebuyer Credit Questions and Answers: Homes Purchased in 2009
• First-Time Homebuyer Credit: Scenarios
• First-Time Homebuyer Credit

Substantiating mileage - Cohan Rule

USTC Cases, United States of America, Plaintiff v. Charles B. Norlem, et al., Defendants., U.S. District Court, D. Minnesota, 2009-2 U.S.T.C. ¶50,748, (Oct. 14, 2009)
U.S. District Court, Dist. Minn.; CIV. 07-4799 (JRT/FLN), October 14, 2009.

The individual could possibly use the standard mileage rate approach instead of the actual expense method because he potentially met the substantiation requirements of Code Sec. 274. Furthermore, the Cohan rule could be used to estimate his business expenses for four months at issue for which he could not produce credit card statements. The amount of deductible expenses could be estimated based on the amount of substantiated deductible expenses that the IRS allowed in 25 previous months.
DATED: October 14, 2009 at Minneapolis, Minnesota.
REPORT AND RECOMMENDATION
NOEL, United States Magistrate Judge: THIS MATTER came before the undersigned United States Magistrate Judge on July 24, 2009 on the United States' Motion for Summary Judgment [#40]. The matter was referred to the undersigned for Report and Recommendation pursuant to 28 U.S.C. §636 and Local Rule 72.1. For the reasons which follow, this Court recommends the United States' Motion [#40] be DENIED.
III. LEGAL ANALYSIS
A. There is a genuine issue of material fact as to whether Norlem can claim his automobile expenses using the standard mileage rate method.
The IRS contends that Norlem should not be able to claim his automobile expenses using the standard mileage rate because such expenses are subject to strict substantiation and Norlem has failed to meet that burden. Under 26 U.S.C. §274, no deduction for travel expenses will be allowed “unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating the taxpayer's own statement (A) the amount of such expense or other item, (B) the time and place of the travel …, [and] (C) the business purpose of the expense or other item …” Treasury Regulation §1,274-5T(c) addresses the rules of substantiation in greater detail:
[A] taxpayer must substantiate each element of an expenditure or use …by adequate records or by sufficient evidence corroborating his own statement …. Written evidence has considerably more probative value than oral evidence alone. In addition, the probative value of written evidence is greater the closer in time it relates to the expenditure or use. A contemporaneous log is not required, but a record of the elements of an expenditure … made at or near the time of the expenditure or use, supported by sufficient documentary evidence, has a high degree of credibility not present with respect to a statement prepared subsequent thereto when generally there is a lack of accurate recall. Thus, the corroborative evidence required to support a statement not made at or near the time of the expenditure or use must have a high degree of probative value to elevate such statement and evidence to the level of credibility reflected made at or near the time of the expenditure or use supported by sufficient documentary evidence.
26 C.F.R. §1.274-5T(c)(1).
The IRS disallowed the automobile expenses using the standard mileage rate method because the IRS contends that Norlem's mileage logs were reconstructed fourteen to sixteen years after the purported travel occurred. (Am. Czapko Decl. ¶ 46.) In addition, the IRS contends that Norlem failed to provide invoices, receipts, or credit card statements indicating that he incurred any of the claimed mileage expenses. The IRS claims that the mileage logs are inaccurate because the logs indicate that Norlem drove the daily route every weekday for three years with few holidays, no sick days and hardly any vacation days. (Am. Czapko Decl. ¶ 49.) The IRS claims the logs are inaccurate because the mileage log conflicts with Norlem's credit card statements in at least four instances in which the log states Norlem was driving his car to pick up transcripts; however the credit card statements indicate Norlem was paying for lodging in other states at those times. (Am. Czapko Decl. ¶ 50.)
The Court has examined Norlem's mileage logs, and the logs set forth the information required by §274: (1) the amount of miles driven; (2) the time and place where the car was driven; and (3) the business purpose (to pick up medical tapes to be transcribed). (Declaration of Charles B. Norlem Ex. 4.) Norlem does not deny that the mileage logs were reconstructed (Norlem Decl. ¶ 11.) and the regulations do not require that a log be contemporaneous. 26 C.F.R. §1.274-5T(c)(1). In response to the IRS contention that the logs are inaccurate because there are few vacation and sick days and the logs are inconsistent with Norlem's credit card statements, Norlem states in his Declaration that when he was out of town other employees drove his vehicle to pick up transcription tapes. (Norlem Decl. ¶ 12.) He states his credit card statements which reflect charges for car rentals in other states support his contention that he left his car in Minnesota for employees to drive when he was out of town. (Norlem Decl. Ex. 1.) Indeed, his American Express statement for December 1994 reflects charges for renting a car from Avis. 1 Id. Norlem has set forth specific facts demonstrating there is a genuine issue for trial concerning whether he is allowed to claim automobile expenses using the standard mileage rate method rather than the actual expense method.
B. There is a genuine issue of material fact as to whether Norlem should be able to deduct business expenses charged to his American Express card in the four months for which Norlem cannot produce credit card statements.
The IRS disallowed business expenses totaling $2,433.69 because the IRS claimed that Norlem failed to provide any substantiation. (Am. Czapko Decl. ¶ 37.) The Court presumes these claimed expenses were charged to Norlem's American Express card in the four months for which Norlem cannot produce credit card statements. 2
Norlem requests that the Cohan Rule be used to estimate his business expenses for these four months for which he cannot produce American Express statements. The Cohan Rule provides that the court may make an estimation of business expense deductions when a taxpayer is unable to produce evidence substantiating the exact amount of a claimed deduction. Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930). The Cohan Rule has been superseded by statute with respect to some business expense deductions including those for travel, meals and entertainment, and automobile expenses. 26 U.S.C. §274; Treas. Reg. §1.274-5(a). The IRS contends that for the Cohan Rule to apply, there must be a basis on which the court can make an approximation. Vanicek v. Commissioner, 85 T.C. 731, 742-43, 1985 WL 15409 (1985).
In this case there is certainly a basis on which the Court can make a approximation for the amount of business expenses charged to the credit card for the four months at issue. Norlem was able to produce American Express credit card statements for 25 other months in the years 1993, 1994 and 1995. (Norlem Decl. Ex. 2.) The IRS allowed business expenses to be claimed for some of the charges made in those 25 months. There is a record of expenses allowed (Norlem Decl. Ex. 2) and a record of the credit card bills for those 25 months (Norlem Decl. Ex. 3.) The Court could estimate the amount of deductible expenses for the four months at issue based on the amount of deductible expenses allowed in the other 25 months for which there are credit card statements. There is a genuine issue of material fact as to whether Norlem should be entitled to take business expense deductions for the four months at issue.
IV. RECOMMENDATION
Based upon all the files, records and proceedings herein, IT IS HEREBY RECOMMENDED that United States' Motion for Summary Judgment [#40] be DENIED.

Footnotes


1
In Czapko's Amended Declaration, she states that the mileage log conflicts with the American Express statements in at least four instances: March 27, 1995 (credit card statements indicate Norlem was paying for lodging in Iowa and mileage log indicates he was driving his normal route in Minnesota); June 13-14, 1995 (credit card statements indicate Norlem was in Iowa and mileage log indicates he was driving his normal route in Minnesota); September 18, 1995. Norlem's credit card records however show that he rented a car from Avis on March 20, 1995 (a charge totaling $242.72). (Norlem Decl. Ex. 2.) His credit card records also show he rented a car from Hertz on September 14, 1995 (a charge of $400.42). (Norlem Decl. Ex. 2.) These records support Norlem's contention that when he went out of town he left his car in Minnesota and allowed employees to use it to pick up transcription tapes.
2
A Quickbooks summary of all payments made out of the All-Star Transcription bank account indicate that the following payments were made to American Express in the months for which Norlem cannot now locate the credit card statements:
check #1711, dated 06/28/1994 in the amount of $624.19;
check #1756, dated 08/02/1994 in the amount of $371.52;
check #1799 dated 08/29/1994 in the amount of $723.90;
check #2048 dated 02/08/1995 in the amount of $732.48
TOTAL: $2452.09

Fraudulent return preparation

Cases, United States of America, Plaintiff v. Thomas A. Turner, Defendant., U.S. District Court, W.D. Kentucky, 2009-2 U.S.T.C. ¶50,743, (Oct. 28, 2009)
U.S. District Court, West. Dist. Ky., Louisville Div.; 1:08-CR-00024, October 28, 2009.

Tax crimes: Evidence: Admissibility: Expert witness’ testimony: Tax return preparer: False and fraudulent returns: False representation: Undue prejudice.–
Expert witness testimony was allowed in the case of an individual charged with preparing false tax returns in violation of Code Sec. 7206(2), and rulings were issued regarding the admissibility of other evidence. An IRS agent qualified as an expert witness and his testimony was helpful to the jury. Evidence that the individual did not timely file his personal tax returns for a few tax years because of a disagreement with the IRS over an audit of his own return did not prove motive for his activities as return preparer and could unduly prejudice the jury; therefore, such evidence was not admissible. However, evidence that the individual falsely represented that he was a former IRS employee, professed personal animosity towards the IRS and that certain customers invested money in the individual’s cabinet-making business was admissible.

MEMORANDUM OPINION & ORDER

Russell, Chief Judge, U.S. District Court: This matter comes before the Court upon Defendant's Motion to Preclude Government's Expert Witness, or for a Daubert Hearing (DN 45), and Defendant's Motion in Limine (DN 46). Plaintiff has responded (DN 47 & DN 48). Defendant replied with respect to the Motion in Limine (DN 52). This matter is now ripe for adjudication. For the reasons that follow, Defendant's Motion to Preclude is DENIED and Defendant's Motion in Limine is DENIED IN PART and GRANTED IN PART.
Defendant Thomas A. Turner has been charged with preparing false tax returns in violation of 26 U.S.C. § 7206(2). Turner was a tax return preparer based in Columbia, Kentucky. From 2003 through 2006, he prepared tax returns for individuals residing in Columbia, Russell Springs, Jamestown, and surrounding areas. The Government alleges that Turner regularly engaged in a common scheme of fraud and deceit when completing returns for his taxpayer customers. For example, Turner allegedly falsely represented that the taxpayers used one or more of their family cars 100% of the time in their side jobs. Turner also allegedly told many of his customers that he was formerly employed by the IRS, implying that he understood tax laws and regulations in such a way to get the best refunds for his customers.
1. Testimony of Robert L. Hayden
The Government intends to call IRS Revenue Agent Robert L. Hayden to testify that certain depreciation deductions caused by Turner on returns he prepared for various taxpayers were improper and in violation of applicable provisions of IRS code and regulations. Turner objects to Hayden's testimony because “(1) it does not meet the Daubert standards, (2) it should not be used to evaluate whether other witnesses are telling the truth, and (3) it should not be used to give the jury instructions about the law.”
The admissibility of expert testimony is governed by Federal Rule of Evidence 702. Rule 702 provides as follows:
If scientific, technical or other specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact in issue, a witness qualified as an expert by knowledge, skill, experience, training, or education, may testify thereto in the form of an opinion or otherwise, if (1) the testimony is based upon sufficient facts or data, (2) the testimony is the product of reliable principles and methods, and (3) the witness has applied the principles and methods reliably to the facts of the case.
In 2000, Rule 702 was amended in response to the Supreme Court's decisions in Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579 (1993), and Kumho Tire Co. v. Carmichael, 526 U.S. 137 (1999). In Daubert, the Court held trial judges must act as gatekeepers to exclude unreliable expert testimony, 509 U.S. at 592, and it clarified in Kumho that this gatekeeper function applies to all expert testimony, scientific and nonscientific, 526 U.S. at 149.
Turner first argues that Hayden's testimony is not necessary to assist the jury's understanding of whether he improperly prepared tax returns. The Court disagrees, and finds that the testimony will assist the jury. See United States v. Mahoney, 949 F.2d 1397, 1406 (6th Cir. 1991). Turner is charged with a pattern of fraudulent depreciation deductions included on numerous tax returns he prepared for clients of his tax preparation business. Average jurors do not have specialized knowledge in the field of tax deductions, therefore Hayden's testimony would help them determine whether Turner violated 26 U.S.C. § 7206(2).
Second, Turner argues that witness testimony on which Hayden will base his opinion is not reliable because the witnesses, Turner's former customers, swore that their tax forms were correct when they submitted them. The Court finds this argument unpersuasive because Hayden will only offer his opinion as to the tax consequences of testimony elicited from relevant witnesses and documents admitted into evidence. The jurors will still determine the weight, if any, to be given to the evidence relied upon by Hayden.
Finally, Turner challenges Hayden's qualifications as an expert. The Court finds that these concerns can best be addressed through cross-examination and jury instructions. The jury may decide what weight to give Hayden's testimony, but his educational background and experience at the IRS qualify him to testify as an expert witness on the rules that apply to the depreciation deductions at issue in this matter.
With regard to Turner's objection that Hayden's testimony will be used to evaluate the truthfulness of other Government witnesses, the Court finds that Hayden will be used as a summary witness, and will not opine as to the truthfulness of other witnesses' testimony. Indeed it would be improper for him to do so. Instead, Hayden will discuss the tax consequences related to the testimony elicited from the witnesses. See Mahoney, 949 F.2d at 1406. The jury will still determine whether witnesses are telling the truth and what weight to give their testimony.
Turner's final objection to Hayden's testimony is that Hayden will impermissibly instruct the jury on the applicable law. The Sixth Circuit, however, has held that an IRS expert's opinion as to the tax consequences of certain transactions is admissible. Mahoney, 949 F.2d at 1406. Hayden may not state his opinion as to whether Turner intended to prepare false tax returns, but he may testify whether tax liability would arise under certain assumed circumstances. See United States v. Sabino, 274 F.3d 1053, 1067 (6th Cir. 2001), amended on other grounds by 307 F.3d 446 (6th Cir. 2002); United States v. Monus, 128 F.3d 376, 386 (6th Cir. 1997).
Finally, the Court declines to conduct a Daubert hearing on this issue. Nelson v. Tenn. Gas Pipeline Co., 243 F.3d 244, 249 (6 th Cir. 2001) (“[T]he district court is not required to hold an actual hearing to comply with Daubert.”). Turner's objections go mostly to the weight of Hayden's testimony.
2. Evidence Related to Turner's Personal Tax Returns
Turner filed his personal federal income tax returns for the years 1998 though 2005 on June 20, 2006. The Government wishes to introduce into evidence Turner's statement as to why he did not file the tax returns earlier, as well as his actual returns from 2003, 2004, and 2005. Turner argues that this evidence is irrelevant, confusing, and unduly prejudicial.
Turner allegedly told the IRS that he intentionally did not file his personal tax returns from 1998 through 2005 because of a disagreement with the IRS over an audit of his 1989 tax return. The Government argues that this evidence goes to the motive for the perpetration of the scheme charged in the Superceding Indictment- that he wanted to “screw the IRS”- and is thus admissible under Federal Rule of Evidence 404(b). The Court finds that this evidence has little probative value, which is substantially outweighed by the danger of unfair prejudice to Turner. See Fed. R. Evid. 403. According to Turner, the law did not require filing those returns and the IRS has never questioned their accuracy or completeness. Creating an issue over why the returns were filed late would be confusing for the jurors, and may unduly prejudice them against Turner. Furthermore, the Government still has testimony from several of the taxpayers to show Turner's alleged motive. Therefore Turner's statement, and the fact that he did not file his returns until 2006, is inadmissible at trial.
The Government also seeks to admit Turner's 2003, 2004, and 2005 returns to demonstrate his personal knowledge and use of depreciation deductions for his own businesses in a manner similar to the pattern of depreciation deductions charged in the Superceding Indictment. The Government argues that this evidence shows Turner's personal knowledge of factors bearing upon the use of such deductions, identity of the wrongdoer, and absence of mistake. The Government also states that information in Turner's 2005 tax return rebuts statements made by Turner in his interview that Rhonda Shelton owned and operated the tax preparation business. The Court finds this evidence admissible pursuant to Rule 404(b). The Court also finds this evidence has probative value that is not outweighed by unfair prejudice to Turner.
3. Evidence of Turner's Alleged False Representations that he Worked for the IRS
The Government states that Turner represented to his customers that he used to work for the IRS. For example, he allegedly told one customer that when he worked for the IRS he “screwed people and now he wants to get people their money back.” The Government argues that this evidence is admissible because it is inextricable intertwined with Turner's customer dealings in his tax preparation business. He allegedly made these false statements in order to attract clients to his business and convince them he knew how to use tax regulations and rules to benefit them.
Background evidence may be admissible when it “consists of those other acts that are inextricably intertwined with the charged offense or those acts, the telling of which is necessary to complete the story of the charged offense.” United States v. Hardy, 228 F.3d 745, 748 (6th Cir. 2000). “Proper background evidence has a causal, temporal or spatial connection with the charged offense,” such as when it “is a prelude to the charged offense, is directly probative of the charged offense, arises from the same events as the charged offense, forms an integral part of a witness's testimony, or completes the story of the charged offense.” Id.
The false representations made by Turner are relevant as to why individuals may have chosen Turner to prepare their tax returns, and to explain their confidence in Turner as a former IRS employee. This background information is necessary to explain the story of Turner allegedly preparing false tax returns for these customers. Therefore, the evidence of false representations made by Turner is admissible.
Turner also objects to the admission of the alleged statement that “he hated the IRS and that the IRS wouldn't get a dime from him.” Turner argues that the statement could only relate to his personal tax returns and not returns he prepared for others. There are two inferences, however, that can be made from the statement. Considered in the context of the other statements it could also relate to how he prepared returns for others. The Court finds the testimony admissible.
4. Evidence of Investments Made by Customers in Turner's Cabinet Making Business
Turner admits that he sought small investments from some of his customers in a cabinet making business that ultimately failed. He argues that even though his actions were proper, the jury may believe he is a dishonest person. The Government states that in several instances evidence regarding these investments are inextricably intertwined with information in customer's tax returns. For example, the Government states that money invested in Turner's cabinet making business was referenced on some of his customers's Schedule C forms as money they earned from a side business. The Court agrees that the investment evidence is an integral part of these witnesses' stories, and therefore admissible for this limited purpose.
CONCLUSION
For the foregoing reasons, IT IS HEREBY ORDERED that Defendant's Motion to Preclude Government's Expert Witness, or for a Daubert Hearing (DN 45) is DENIED and Defendant's Motion in Limine (DN 46) is DENIED IN PART and GRANTED IN PART. IRS Revenue Agent Robert L. Hayden's expert/summary testimony is admissible; Turner's 2003, 2004, and 2005 returns are admissible for limited purposes; evidence that Turner represented to his taxpayer customers that he used to work for the IRS is admissible; and evidence that certain customers invested money in Turner's cabinet making business is admissible for limited purposes. Turner's statement that he intentionally did not file his personal tax returns from 1998 through 2005 because of a disagreement with the IRS over an audit of his 1989 tax return, and the fact that he did not file these returns until 2006, is inadmissible at trial.
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title United States of America, Plaintiff v. Thomas A. Turner, Defendant.
search-title Case: USTC Cases, United States of America, Plaintiff v. Thomas A. Turner, Defendant., U.S. District Court, W.D. Kentucky, 2009-2 U.S.T.C. ¶50,743, (Oct. 28, 2009)
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wk-da number WKUS_TAL_533
CCH Paragraph No. [¶50,743]
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sort-date: 2009-10-28
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G2I-TRANSFORMATION-DATE: 2009-11-17
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I2A-TRANSFORMATION-DATE: 2009-11-17
wkcase-law:metadata parties plaintiff:United States of America, Plaintiff
defendant:Thomas A. Turner, Defendant.
case-abbrev-name United States of America, Plaintiff v. Thomas A. Turner, Defendant.
court U.S. District Court, W.D. Kentucky [http://wk-us.com/meta/courts/#US-KY-FJ-WD]
document-date , precision: day
2009-10-28
document-number 1:08-CR-00024 [docket]
document-number 2009-2 U.S.T.C. ¶50,743 [primary-citation]

wkext-meta:metadata ust02 WKUS_TAL_533

Great discussion of "substance over form"

This is a very well written decision. It is a heads-up for return preparers to understand that "substance" does prevail over the "form" of a transaction

USTC Cases, Enbridge Energy Company Inc., Enbridge Midcoast Energy LP, formerly known as Enbridge Miscoast Energy Inc., formerly known as Midcoast Energy Resources Inc., Plaintiffs-Appellants v. United States of America, Defendant-Appellee., U.S. Court of Appeals, Fifth Circuit, 2009-2 U.S.T.C. ¶50,737, (Nov. 10, 2009), U.S. Court of Appeals, 5th Circuit; 08-20261, November 10, 2009.

A transaction in which a corporation’s sole shareholder sold his stock to an intermediary followed by a buyer’s purchase of the corporation’s assets with a step-up in basis was an abusive tax shelter transaction. Therefore, the IRS properly assessed taxes based on substance, rather than form, and disregarded the conduit transaction. The intermediary was a shell created solely to facilitate the tax-avoidance transaction; it had no assets, did not engage in any business activity, and served no bona fide purpose. The financing obtained by the intermediary to purchase the stock was secured by the buyer’s funds that had been deposited in an escrow account. The buyer failed to prove tax-independent business considerations for using a conduit entity rather than a direct asset purchase.
I. BACKGROUND
The material facts of this case are undisputed, and the district court ably and accurately recited them in its memorandum opinion and order. See Enbridge Energy Co. v. United States, 553 F.Supp.2d 716 (S.D. Tex. 2008). We highlight the most salient facts here.
Midcoast and Bishop were in the business of owning and operating natural gas pipelines. Dennis Langley was Bishop's sole shareholder, and thus controlled Bishop's assets, which consisted primarily of natural gas pipelines. Beginning in 1999, Langley decided to sell Bishop. Specifically, Langley sought to sell his stock in Bishop because a direct stock-sale would be substantially more beneficial to him from a tax perspective than a sale of only the entity's assets. Langley arranged with Chase Securities, Inc. to solicit potential buyers of the Bishop stock.
Midcoast was an interested buyer, but preferred to purchase Bishop's assets rather than Langley's stock. Midcoast's preference for purchasing the Bishop's assets stemmed from a desire to avoid the tax liability that would result from purchasing Langley's stock. Midcoast nonetheless submitted a series of non-binding, conditional bids for the purchase of the stock, none of which led to a final sale agreement. In September 1999, after conducting further due diligence, Midcoast reduced its bid price for the stock to $163 million, a price below what Langley had sought for the stock. As Midcoast's general counsel has averred, this bid “resulted in a significant gap between the price Midcoast was willing to pay and the price Langley indicated he was willing to accept.”
At approximately this same time, Midcoast consulted with an outside tax advisor, PricewaterhouseCoopers, LLP (“PWC”), concerning the transaction. PWC first suggested the idea of using a “midco transaction,” in which Langley would sell his Bishop stock to a third party, and the third party would in turn sell the Bishop assets to Midcoast. This arrangement, PWC advised, would provide tax benefits for both Midcoast and Langley. PWC suggested that Midcoast use Fortrend International LLC (“Fortrend”), an investment bank, to facilitate the transaction. Thomas J. Palmisano, then a senior manager with PWC, testified that his firm contacted Fortrend to facilitate the Midco transaction specifically so that “Midcoast [would] receive a stepped-up basis in the [Bishop] assets. And by doing so, it would give [Midcoast] an ability to increase the amount of consideration for the assets.” Recognizing the benefits of the Fortrend-facilitated midco transaction, Midcoast agreed because, as Midcoast's CFO testified, “this was the only thing that we felt could close” the gap between Langley's requested price and Midcoast's offer.
Fortrend began negotiating with Langley to acquire his Bishop stock, with Midcoast and PWC participating in the negotiations and often dealing directly with Langley. Fortrend created an entity, K-Pipe, specifically for the transaction. K-Pipe had no assets of its own, nor had it conducted any prior business. On September 30, 1999, K-Pipe submitted a letter of intent to Langley containing its offer to purchase the Bishop stock. The following day, October 1, 1999, Midcoast submitted a letter of intent to K-Pipe containing its offer to purchase the Bishop assets. Approximately one week later, following the letters of intent, K-Pipe purchased all of Langley's Bishop stock; the next day, K-Pipe sold all of Bishop's assets to Midcoast, save for a royalty interest (described as the Butcher Interest) held by Bishop that K-Pipe sold to a partnership consisting of K-Pipe and Midcoast. K-Pipe financed its purchase of Langley's stock with a loan obtained from Rabobank Nederland, a Dutch bank known for financing midco transactions, which was entirely secured by funds totaling $191.1 million that Midcoast deposited in escrow with Rabobank. KPipe transferred approximately $122.5 million to Langley in consideration for the stock; Midcoast transferred $122.6 million to K-Pipe in consideration for the assets, and an additional $79 million directly to Bishop's creditors. The difference in price between the stock purchase price and the asset sale price was $6.4 million, representing K-Pipe's (and therefore Fortrend's) commission.
K-Pipe retained title interest to the Bishop stock, equity in the Butcher Interest, and certain causes of action against third parties (as well as the difference between the purchase price of the stock and sale price of the assets). K-Pipe continued in existence through at least 2002, though its annual tax filings show that it conducted virtually no business. Subsequent to the stockasset sale, in November 2000, Midcoast paid K-Pipe $244,750 for K-Pipe's equity in the Butcher Interest by exercising an effectively mandatory purchase option it retained from the original transaction. Midcoast subsequently terminated the Butcher Interest and deducted an alleged loss on its 2001 corporate tax return of approximately $5.7 million.
Midcoast claimed an adjusted basis in the former Bishop assets in tax year 1999 equal to the $192 million it paid for them. In subsequent years, Midcoast began claiming deductions based on the depreciation of those assets. The IRS instituted an audit and partially disallowed those deductions, finding that Midcoast should have paid taxes as though it purchased the stock of Bishop. Accordingly, the IRS disregarded the form of the conduit transaction and treated it as though Midcoast directly purchased the stock of Bishop. The IRS permitted Midcoast to claim a carryover basis of $35 million in the assets (the basis that Bishop could have claimed) and make deductions based on that amount. The IRS also assessed a 20% penalty due to the substantial underpayment of taxes. Midcoast paid approximately $5.4 million to the IRS under protest. Thereafter, Midcoast sought a refund of that payment. When the IRS denied the refund, Midcoast brought the instant suit to obtain the refund.
On the parties' cross-motions for summary judgment, the district court granted summary judgment to the United States, concluding that Midcoast failed to meet its burden to prove that the IRS erroneously disregarded the form of the conduit transaction. The district court also held that the IRS was permitted to assess the 20% penalty. Midcoast timely appealed.
II. STANDARD OF REVIEW
“The general characterization of a transaction for tax purposes is a question of law subject to review.” Frank Lyon Co v. United States, 435 U.S. 561, 581 n.16 (1978). We review the district court's grant of summary judgment de novo. Turner v. Baylor Richardson Med. Ctr., 476 F.3d 337, 343 (5th Cir. 2007). A party is entitled to summary judgment only if “the pleadings, the discovery and disclosure materials on file, and any affidavits show that there is no genuine issue as to any material fact and that the movant is entitled to judgment as a matter of law.” Fed. R. Civ. P. 56(c). On a motion for summary judgment, the court must view the facts in the light most favorable to the non-moving party and draw all reasonable inferences in its favor. See Hockman v. Westward Commc'ns, LLC, 407 F.3d 317, 325 (5th Cir. 2004). In reviewing the evidence, the court must “refrain from making credibility determinations or weighing the evidence.” Turner, 476 F.3d at 343.
III. DISCUSSION
A. Substance Over Form
The Supreme Court held in Commissioner v. Court Holding Co., 324 U.S. 331 (1945), that the IRS may assess taxes based on the substance, rather than the form, of a conduit transaction. The Court explained:
The incidence of taxation depends upon the substance of a transaction. The tax consequences which arise from gains from a sale of property are not finally to be determined solely by the means employed to transfer legal title. Rather, the transaction must be viewed as a whole, and each step, from the commencement of the negotiations to the consummation of the sale, is relevant. A sale by one person cannot be transformed for tax purposes into a sale by another by using the latter as a conduit through which to pass title. To permit the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress.
Id. at 334. The Court reaffirmed this holding in United States v. Cumberland Public Service Co., 338 U.S. 451 (1950), and observed that in applying the substance-over-form principle, the court “can consider motives, intent, and conduct in addition to what appears in written instruments used by parties to control rights as among themselves.” See id. at 455 n.3. The Supreme Court has also cautioned, however, against disregarding legitimate transactions, stating that “where … there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax avoidance features that have meaningless labels attached, the Government should honor the allocation of rights and duties effectuated by the parties.” Frank Lyon, 435 U.S. at 583-84.
We have applied the substance-over-form doctrine on numerous occasions, beginning with our decision in Davant v. Commissioner, 366 F.2d 874 (5th Cir. 1966), to conclude that the sale of a corporation's assets through an intermediary to avoid capital gains taxation could be treated as a direct sale, thus triggering a higher rate of taxation. Davant involved taxpayers who sold their stock in a corporation and attempted to claim a lower capital gains rate for the sale. To accomplish this, the taxpayers sold their stock to an intermediary who would “make a reasonable profit” for his role, 1 and then the intermediary would sell the corporation's assets to a buyer (in this case, another corporation owned by the taxpayers) and liquidate the target corporation. See id. at 878. The taxpayer argued that the transaction was a bona fide sale of his stock in the corporation, while the IRS argued that the transaction should have been treated as a corporate reorganization and taxed at a higher ordinary income rate. See id. at 879. We agreed with the IRS's determination, stating that the “courts have never been shackled to mere paper subterfuges. It is hard to imagine a transaction more devoid of substance than the purported ‘sale’ to [the intermediary].” Id. at 880. This court specifically noted that the intermediary “served no function other than to divert our attention to avoid tax. Stated another way, his presence served no legitimate nontax-avoidance business purpose.” Id. at 881. There was thus no merit in the taxpayers' argument that a stock sale could not be treated as a sale of assets: “[W]e see that the treatment of stocks as assets, or assets as stock, has always been utilized by the courts in harmonizing the statutory language with the single rational plane of taxation envisioned by Congress.” Id. at 887.
Similarly, in Blueberry Land Co. v. Commissioner, 361 F.2d 93 (5th Cir. 1966), the taxpayers sought to sell their corporations' assets. After finding a buyer, the taxpayers and the buyer began negotiating the sale and reached an agreement, but the deal fell apart because of the perceived adverse tax consequences. Id. at 94-96. At that time, an intermediary agreed to establish a holding company that would buy the taxpayers' stock, sell the assets to the buyer, and liquidate the corporations. Id. at 96-97. The intermediary established the holding company and accomplished the transaction, retaining a modest fee for his services. See id. The IRS sought to treat the transaction as a sham, and we agreed, specifically relying on the fact that the transaction had been negotiated by the taxpayer with the eventual buyer — and that the intermediary “served no real or useful economic purpose apart from tax savings.” Id. at 102. “Nothing here said is intended to prevent or in any way discourage a real and bona fide sale of stock by stockholders of one corporation to a second corporation, and liquidation of the first by the acquiring corporation…. But missing here is that all-important element — the transaction must be real and bona fide.” Id.
We also agreed with the IRS's substance-over-form determination in Reef Corp. v Commissioner, 368 F.2d 125 (5th Cir. 1966). The taxpayer in that case was a corporation owed by two groups of shareholders. One group sought to buy the other's interest in the corporation. The initial plan for accomplishing this goal was rejected by the sellers because of the adverse tax consequences, so the parties developed a new plan for using a new corporate entity and an intermediary to engage in a stock/asset swap in order to obtain a more favorable tax basis for the purchased assets. Id. at 128-29. We explained:
[The intermediary] was a mere conduit in a preconceived and prearranged unified plan to redeem the stock of the [sellers]. His activity was but a step in the plan. He carried out a sales contract already entered into between the corporations. He assumed no risk, incurred no personal liability, paid no expenses and obtained only bare legal title to the stock. There was an insufficient shifting of economic interests to [the intermediary]. It is settled that under such circumstances substance must be given effect over form for federal tax purposes.
Id. at 130.
However, we have not always agreed with the IRS's application of the substance over form doctrine. In Compaq Computer Corp. v Commissioner, 277 F.3d 778 (5th Cir. 2001), the taxpayer (Compaq) purchased shares of a foreign corporation using an intermediary. The evidence established that the intermediary approached Compaq about buying the stock and that the intermediary “[w]ithout involving Compaq … chose both the sizes and prices of the trades and the identity of the company that would sell the [shares] to Compaq.” Id. at 779-80. The IRS argued that the transaction should be disregarded, which would prevent Compaq from claiming favorable tax treatment on its capital losses and dividends. We disagreed, concluding that the transaction was motivated by a business purpose unrelated to obtaining tax benefits and “economic substance.” Id. at 781-82. Specifically, we noted that the transactions “had both a reasonable possibility of profit attended by a real risk of loss and an adequate non-tax business purpose. The transaction was not a mere formality or artifice but occurred in a real market subject to real risks.” Id. at 788.
B. Application to the Instant Case
The uncontroverted evidence supports the district court's conclusion that this was a sham conduit transaction, and that Midcoast is not entitled to claim a stepped-up basis for the assets it purchased. Langley sought to sell his stock in Bishop, knowing that a direct asset sale would have negative tax consequences for him. As Midcoast concedes, Bishop's assets had appreciated considerably and the corporation would have to pay significant taxes on those gains, and Langley in turn would have to pay taxes on distributions he took as a shareholder from Bishop. Midcoast was one of many interested buyers and submitted a bid of $157 million for the stock, which it subsequently increased to $184.2 million, but then — upon further reflection — lowered to $163 million. Langley found this offer unacceptable.
When Langley rejected Midcoast's reduced offer, Midcoast asked its tax advisor, PWC, for suggestions about improving its bid. PWC suggested that the parties use a third-party intermediary for the transaction and suggested Fortrend, a corporation that has done a number of conduit transactions. PWC then brought Fortrend into the fold. The evidence shows that this was done to “bridge the gap” in the transaction — referring to the agreed dispute over the sale price. Midcoast understood that Fortrend would buy Langley's stock and then sell the Bishop assets to Midcoast.
Fortrend, rather than buying the stock and selling the assets itself, formed a special vehicle solely for this purpose: K-Pipe. K-Pipe existed for no other purpose than to accomplish this transaction, and did no substantive business before or after it finished the transaction here. Although K-Pipe obtained financing for its purchase of Langley's stock, that financing was wholly secured by Midcoast's funds equal to the loan deposited in escrow accounts. Thus, while technically a loan, it was effectively no different than purchasing the stock with Midcoast's funds. That financing was obtained through a foreign bank known to finance these types of midco transactions. K-Pipe did not exist prior to the transaction's occurrence; it was created solely to buy the stock and sell the Bishop assets. The evidence shows that Langley and Midcoast were discussing the purchase prior to K-Pipe's involvement, that they met together — along with PWC — to discuss the deal, and that the sell/buy transactions occurred within 24 hours. This evidence supports only the inference that K-Pipe was merely an intermediary without a bona fide role in the transaction.
Indeed, Midcoast concedes that “Midcoast wanted to acquire the Bishop pipeline assets. But the only way Midcoast could acquire the Bishop assets at a price Midcoast was willing to pay was if a third party (K-Pipe) acquired Bishop's stock from Langley and then sold the assets to Midcoast.” Midcoast articulates only three purported business reasons why it used a conduit transaction rather than a direct asset purchase. First, Midcoast states that KPipe sought to earn a “profit.” But this does not answer the question of why any party was willing to pay K-Pipe to be an intermediary. Moreover, as our case law shows, the mere payment of a fee or profit by the intermediary does not prevent finding that the transaction was a sham. Second, Midcoast states that it used the midco transaction form because it “wanted to acquire and operate the Bishop pipeline assets at a price it was willing and could afford to pay.” This is not a tax-independent business consideration; the money Midcoast saved by lessening its tax burden allowed it to pay more for the assets.
Midcoast further contends that this transaction limited its exposure to litigation because, had it purchased the Bishop stock, it would have been liable for claims against Bishop. By purchasing only the assets, Midcoast contends, it could avoid liability on known and unknown claims that might be asserted against the Bishop corporate entity. But this in no way explains why an intermediary was necessary: The parties could have achieved the same result had Midcoast bought the assets directly from Langley and Bishop without using an intermediary. See Polius v. Clark Equip. Co., 802 F.2d 75, 77 (3d Cir. 1986) (“Liability continues [in the context of a stock sale] because the corporate body itself survives. A different rule applies when one corporation purchases the assets of another. Under the well-settled rule of corporate law, where one company sells or transfers all of its assets to another, the second entity does not become liable for the debts and liabilities, including torts, of the transferor.”).
Accordingly, the uncontroverted facts support the district court's determination that the IRS was entitled to disregard the form of the transaction and treat it as a direct sale of stock. Given that the transaction was designed solely for the purpose of avoiding taxes, and Midcoast has offered no adequate non-tax reasons for using a conduit entity, the district court did not err in finding the IRS appropriately disregarded the form of the transaction.
C. Penalty Determination
In addition to challenging the IRS's treatment of the conduit transaction, Midcoast's suit also challenges the imposition of a 20% underpayment penalty. We review the district court's decision on the penalty issue for abuse of discretion. See Pan Amer. Life Ins. Co. v. United States, 174 F.3d 694, 696 (5th Cir. 1999).
Midcoast makes two arguments against the district court's ruling that the IRS was permitted to assess the 20% penalty. First, Midcoast argues that because it did not underpay, then no penalty could be assessed. This argument necessarily fails in light of our decision above that Midcoast understated its income tax liability for this transaction. Alternatively, Midcoast argues that, even if the IRS is entitled to disregard the form of the conduit transaction, the IRS could not assess the penalty because Midcoast had “substantial authority” to support its actions.
The Internal Revenue Code generally provides for a 20% penalty for the “substantial understatement of income tax.” 26 U.S.C. § 6662(a)&(b). However, a taxpayer is not subject to the penalty if the understatement is attributable to “the tax treatment of any item by the taxpayer if there is or was substantial authority for such treatment.” Id. § 6662(d)(2)(B)(i). Even if there is substantial authority supporting the taxpayer's tax treatment, though, a taxpayer cannot avoid the penalty in the case of tax shelters. Id. § 6662(d)(2)(C). The Code defines a tax shelter as, inter alia, an entity or plan or arrangement “if a significant purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of Federal income tax.” Id.
The district court ruled that there was no substantial authority for Midcoast's tax treatment of the transaction and that, in any event, the conduit transaction constituted a “tax shelter,” making the substantial authority exception inapplicable. This was not abuse of discretion. First, all of the available authority indicated that this transaction — motivated solely by the avoidance of taxes — would be disregarded and that Midcoast would not be entitled to claim a stepped-up basis for the Bishop assets. This authority took the form of both Supreme Court and Fifth Circuit precedent. Second, the uncontroverted evidence shows that the arrangement at issue in this case had the sole purpose of avoiding federal income tax. Thus, it falls squarely within the Code's definition of a “tax shelter.” It is clear that tax avoidance was, at a minimum, a “significant purpose” of the arrangement as required by the statute. Accordingly, we affirm the district court's ruling that the IRS was permitted to assess a penalty against Midcoast pursuant to § 6662.
IV. CONCLUSION
For the foregoing reasons, we AFFIRM the judgment of the district court.

Footnotes


*
Pursuant to 5TH CIR. R. 47.5, the court has determined that this opinion should not be published and is not precedent except under the limited circumstances set forth in 5TH CIR. R. 47.5.4.
1
The intermediary received $15,583.30 for his role in the transaction. The entire sale was for approximately $1 million in consideration. See Davant, 366 F.2d at 878.

Detailed analysis of NOL carryback rules in the ''Worker, Homeownership, and Business Assistance Act of 2009''




Practitioners and businesses alike have hailed the NOL changes in the ''Worker, Homeownership, and Business Assistance Act of 2009'' (the Act), signed into law on Nov. 6 as P.L. 111-92 . These changes extend the 5-year carryback of NOLs to apply to 2009 NOLs, and expand the 5-year carryback's availability to include most businesses (not just eligible small businesses, or ESBs). But the rules are tricky, including a new 50% limit on the NOL that can be carried back to the 5th preceding tax year, and a complex transition rule. This Practice Alert carries a detailed analysis of the new NOL carryback rules in the Act, including numerous examples illustrating the rules' practical impact, and strategies for businesses large and small.

Five-Year Carryback of NOLs Extended to Include 2009 NOLs and to Apply to Most Businesses
A net operating loss (NOL) is the excess of business deductions (computed with certain modifications) over gross income in a particular tax year. The loss can be deducted, through an NOL carryback or carryover, in another tax year in which gross income exceeds business deductions. In general, NOLs may be carried back two years and forward 20 years. The NOL is first carried back to the earliest tax year for which it's allowable as a carryback or a carryover, and is then carried to the next earliest tax year. A taxpayer may elect to forego the entire carryback period for an NOL and instead carry it forward. Life insurance companies may carry back losses for three years.

If a corporation has a corporate equity reduction transaction (a CERT, i.e., a major stock acquisition or an excess distribution) and an “excess interest loss” (i.e., interest allocable to the CERT) for a “loss limitation year,” the loss is an NOL. It's subject to the regular NOL carryback and carryover rules, except that it can't be carried back to a tax year before the year in which the CERT occurred. The “loss limitation year” is generally the tax year in which the CERT occurred (the “CERT year”) and each of the next two tax years.

For purposes of the alternative minimum tax (AMT), a taxpayer's NOL deduction cannot reduce the taxpayer's alternative minimum taxable income (AMTI) by more than 90% of the AMTI.

For NOLs arising in tax years ending after Dec. 31, 2007, ESBs can elect to increase the NOL carryback period for an applicable 2008 NOL (the “applicable NOL”) from 2 years to 3, 4, or 5 years. An ESB is a corporation or partnership that meets the gross receipts test of Code Sec. 448(c) ) (applied by substituting $15 million for $5 million) for the tax year in which the loss arose, or a sole proprietorship that would meet that test if the proprietorship were a corporation. This means an ESB is any trade or business (including one conducted in or through a corporation, partnership, or sole proprietorship) whose average annual gross receipts (for the three-tax-year period (or shorter period of existence)) ending with the tax year in which the loss arose are $15 million or less.

An applicable 2008 NOL is the taxpayer's NOL for any tax year ending in 2008, or, at the taxpayer's election, any tax year beginning in 2008. Any such election is irrevocable. Additionally, any carryback election may be made only with respect to one tax year. If an ESB makes an election to increase the carryback period for an applicable 2008 NOL, then Code Sec. 172(b)(1)(E)(ii) (which defines “loss limitation year”) is applied by using the whole number that is one less than the number of years the taxpayer elected as the carryback for the NOL instead of “two.”

New law. The Act provides an election for most taxpayers (not just small businesses) to increase the carryback period for an applicable NOL to 3, 4, or 5 years from 2 years. ( Code Sec. 172(b)(1)(H)(i)(I) , as amended by Act Sec. 13(a))

RIA observation: Thus, a business may elect to carry an applicable NOL back to the 3rd, 4th, or 5th preceding tax year instead of just to the 2nd preceding tax year. If an election is made to carry an NOL back for 5 years, any part of the NOL that does not offset taxable income in that 5th preceding tax year (subject to the 50% limit, see below) will be carried over to the 4th preceding tax year, etc. If the election is made to carry the NOL back only 4 years, then any part of the NOL that does not offset taxable income in that 4th preceding tax year will be carried over to the 3rd preceding tax year, etc.
RIA observation: The Act doesn't change the allowable carryforward period for NOLs.
Applicable NOL defined. An applicable NOL means the taxpayer's NOL for any tax year ending after Dec. 31, 2007, and beginning before Jan. 1, 2010. ( Code Sec. 172(b)(1)(H)(ii) , as amended by Act Sec. 13(a))

RIA observation: This means that an applicable NOL for a tax year that is a 2008 or 2009 calendar year or a fiscal year that begins in 2007, 2008, or 2009 can be carried back to the 3rd, 4th, or 5th preceding tax year, subject to the only one election rule (see below).
One election rule. Generally, an election may be made for only one tax year. ( Code Sec. 172(b)(1)(H)(iii)(I) , as amended by Act Sec. 13(a)) However, an ESB that made or makes an election under the Code as in effect before Nov. 6, 2009 (the enactment date) may make an election for 2 tax years instead of just 1. ( Code Sec. 172(b)(1)(H)(v)(I) , as amended by Act Sec. 13(a))

RIA observation: This means that if an ESB elects to carry a 2008 NOL back to the 3rd, 4th or 5th preceding tax year under the provisions of pre-Act law, it can also elect, under the Act, to carry an NOL for a second tax year back to the 3rd, 4th, or 5th preceding tax year as well. If the election is made for a 2008 calendar year, it can also be made for the 2009 calendar year. If it was made for a fiscal year beginning in 2007 and ending in 2008, it can also be made for (1) a fiscal year beginning in 2008 and ending in 2009, or (2) a fiscal year beginning in 2009 and ending in 2010 (but not for both); see definition of applicable NOL, below.
RIA illustration 1: Taxpayer, a C corporation, an ESB, and a fiscal year taxpayer with a tax year beginning on Nov. 1 and ending Oct. 31, had an NOL of $400,000 for its tax year ending Oct. 31, 2008. Under pre-Act law, it elected to carry this NOL back to its 5th preceding tax year that ended Oct. 31, 2003. Taxpayer expects to have NOLs for both its 2009 and 2010 fiscal years. It may elect to carry either of those NOLs back to its 5th preceding tax year but cannot elect to carry both of them back since it already elected to carry its NOL for fiscal year 2008 back to the 5th preceding tax year.
RIA recommendation: A taxpayer with more than one NOL that is eligible to be carried back for 3, 4, or 5 years should determine where the greatest tax savings will result. Remember that the year that is not elected can be carried back only two years. The size of the NOL in each year will usually be the determining factor. The larger the NOL, the more likely it will be that the taxpayer will want to carry it back as far as possible especially if the taxpayer needs to use taxable income from more than two years to completely use up the NOL.
RIA illustration 2: A calendar year C corporation that is not an ESB, has an NOL of $4 million for its 2008 tax year, and expects to have an NOL of $7 million for its 2009 tax year. It had taxable income of $2 million in 2003, $3 million in 2004, $4 million in 2005, $2 million in 2006 and $1 million in 2007. If it elects to carry its 2008 NOL back for more than 2 years, it will be able to offset its entire 2008 loss of $4 million but it will be only able to offset $1 million of its 2009 $7 million NOL by carrying it back to 2007. If it doesn't make the election for its 2008 tax year, it can offset $3 million of the 2008 NOL by carrying it back to 2006 and 2007 under the general rule. Then it will be able to offset $5.5 million of its 2009 NOL by carrying it back to 2004 (i.e., $1.5 million (50% of its 2004 taxable income of $3 million, see limit on carrying NOLs back to 5th preceding tax year, below), and all of its taxable income of $4 million in 2005. Thus, be electing to carry the 2009 NOL back to the 5th preceding tax year, it will be able to offset a total of $8.5 million of its combined NOLs for 2008 and 2009 instead of just $5 million that it would have been able to offset if it elected to carry back the 2008 NOL for 3 or more tax years.
Limit on amount of NOL that can be carried back to 5th preceding tax year. The amount of the NOL that can be carried back to the 5th tax year before the loss year may not be more than 50% of the taxpayer's taxable income for that 5th preceding tax year determined without taking into account any NOL for the loss year or for any tax year after the loss year. ( Code Sec. 172(b)(1)(H)(iv)(I) , as amended by Act Sec. 13(a)) The amount of the NOL otherwise carried to tax years after the 5th preceding tax year is adjusted to take into account that the NOL could offset only 50% of the taxable income for that 5th preceding tax year. ( Code Sec. 172(b)(1)(H)(iv)(II) , as amended by Act Sec. 3(a))

The 50% limitation does not apply to the applicable 2008 NOL of an ESB with respect to which an election is made under pre-Act law even if the election is made after Nov. 6, 2009, the date of enactment of the Act. ( Code Sec. 172(b)(1)(H)(iv)(III) , as amended by Act Sec. 13(a))

RIA illustration 3: ACE Corp., which is not an ESB, has an NOL of $5 million for its tax year ending Aug. 31, 2009. In its tax year ending Aug. 31, 2004, it had taxable income of $6 million. If Ace elects to carry its NOL back to its 2004 tax year, it will be able to apply only $3 million of that NOL against its taxable income for 2004. In determining the amount of the NOL that can be carried forward by Ace to years ending after Aug. 31, 2004, the NOL is reduced by only the $3 million that was used to offset taxable income for 2004. The balance of $2 million can be carried over to 2005, 2006, etc., until completely used up.
RIA observation: In deciding whether to elect to carry an NOL back 3, 4, or 5 tax years, taxpayers should determine which election will result in the largest tax refund. Thus, if the NOL is more than or at least equal to the taxpayer's combined income for the 3rd, 4th, and 5th years before the year in which it arose, then the loss should be carried back to the fifth year so that it can be used in all three years. On the other hand, if the NOL is less than the combined income for those three years, the taxpayer should try to carry it back to the year(s) in which income was taxed at the highest rate so as to get the highest refund, e.g., a year in which an individual is taxed at a 35% rate or a year in which a C corporation is taxed at a 38% “bubble” rate. In some cases, it may be better to not make the election because the largest tax savings will come from carrying the NOL back to the second year before the year in which the NOL arose. Generally, if the taxpayer can get at least some tax savings from a carryback to a year before the first year before the year in which the NOL arose, the taxpayer would not want to carry the NOL back to that year because the income for that first year could be applied against an NOL the taxpayer might have in its succeeding tax year. Unless the NOL rules are amended again, a taxpayer will have only one opportunity to carry an applicable NOL back to the 2nd, 3rd, 4th, or 5th years before the year in which the NOL arose.
RIA illustration 4: Taxpayer, a C corporation and a calendar year taxpayer that is not an ESB, expects to have an NOL of $20 million for its 2009 tax year. It had taxable income of $10 million in 2004, $5 million in 2005, $10 million in 2006, and $2.5 million in both 2007 and 2008. Taxpayer paid federal income taxes of $3.4 million on its 2004 income, $1.7 million on its 2005 income, $3.4 million on its 2006 income, and $850,000 on its income for both 2007 and 2008. If Taxpayer elects to carry its 2009 NOL back 5 years, the NOL will offset 50% of its income for 2004 ($5 million), and all of its income for 2005 and 2006 ($5 million + $5 million + $10 million = $20 million), and it will be entitled to a refund of $6,800,000 (the sum of 50% of the taxes it paid for 2004 ($1.7 million), and all of the taxes it paid for 2005 and 2006. If Taxpayer carries the NOL back only 4 years, it will completely offset its income for 2005, 2006, 2007, and 2008 ($5 million +$10 million + $2.5 million + $2.5 million = $20 million). This will also result in a refund of $6,800,000 (the sum of the taxes it paid for those four tax years) but it will mean that the income for 2008 will not be available to offset any NOL Taxpayer may possibly have in 2010 when Taxpayer will only be able to carry its NOL back for 2 years. Accordingly, Taxpayer should elect to carry its NOL back for 5 years so its taxable income for 2008 will be available to generate a refund if it has an NOL in 2010.
RIA illustration 5: Assume the same facts as in Illustration (4) except that in 2005, Taxpayer had taxable income of $15 million on which it paid federal income taxes of $5,150,000, and in 2006, it had taxable income of $18 million, on which it paid federal income taxes of $6,290,000. If Taxpayer elects to carry the NOL of $20 million back 5 years years, it will offset 50% of its income of 2004 ($5 million), and all of its income for 2006 ($15 million). This will result in a total refund of income taxes for those years of $6,850,000 (income taxes of $1.7 million for 2004, and $5,150,000 for 2005). However, if Taxpayer carries the NOL back only four years to 2005, it will be entitled to a refund of $6,990,000 ($5,150,000 for 2005 and $1,840,000 for 2006 when the top $3 million of its total income of $18 million was taxed at a bubble rate of 38%). Thus, by electing to carry back its NOL for only 4 years, Taxpayer's refund will be $140,000 higher than it would have been if it carried the refund back 5 years ($6,9990,000 − $6,850,000).
RIA illustration 6: Taxpayer, a C corporation and a calendar year corporation that is not an ESB, expects to have an NOL of $5 million for its 2009 tax year. It had taxable income of $6 million in 2004, $8 million in 2005, $10 million in 2006, $20 million in 2007, and $10 million in 2008. If it elects to carry back its NOL for either 5, 4, or 3 years it will get a refund of $1.7 million dollars because all the income it will offset in any of those tax years will be taxed at a rate of 34% (the rate that applies to a C corporation's taxable income over $335,000 and not over $10 million). On the other hand, if it does not make the election, it will get a refund of $1,850,000, the tax on a C corporation's taxable income over $15 million but not over $20 million). Thus, by not making the election, taxpayer will get a refund that is $150,000 higher than it would be if it did make the election ($1,850,000 − $1,700,000).
RIA observation: By not making the election in Illustration (6), Taxpayer is risking losing part of its taxable income for 2007 to offset an NOL for 2010 or a later year if the election to carry back an NOL for more than 2 years is extended to cover years beginning after 2009.
How to make the extended carryback election. The extended carryback election under the Act must be made in such manner as IRS determines, and must be made by the due date (including extensions) for filing the taxpayer's last tax return for a tax year beginning in 2009. ( Code Sec. 172(b)(1)(H)(iii)(II) , as amended by Act Sec. 13(a))

RIA observation: Thus, the election can be made for a tax year beginning before 2009 as long as it is made by the due date (including extensions) for filing the taxpayer's last tax return for a year beginning in 2009.
RIA observation: The taxpayer must affirmatively elect the increased carryback. Absent any election, the regular NOL carryback period rules apply.
RIA recommendation: The taxpayer should use the tentative (or “quick”) carryback procedures to expedite the recovery of the refund. Under these procedures, taxpayers can recover a refund attributable to an NOL carryback before IRS processes the return filed for the year the NOL arises. By using them, the taxpayer won't have to wait until IRS processes the return for the NOL year to get the refund. Presumably, as was the case for ESBs with respect an applicable 2008 NOL, a taxpayer will be able to make the election on the applicable claim form (Form 1045 for individuals and Form 1139 for corporations).
Irrevocability of election. Once made, the extended carryback election is irrevocable. ( Code Sec. 172(b)(1)(H)(iii)(II) , as amended by Act Sec. 13(a))

Determining “loss limitation year” if extended carryback period is elected. As was the case for ESBs, if a business makes an election to increase the carryback period for an applicable NOL, then Code Sec. 172(b)(1)(E)(ii) (which defines “loss limitation year” with respect to a CERT) is applied by using the whole number that is one less than the number of years the taxpayer elected as the carryback for the NOL instead of “2.” ( Code Sec. 172(b)(1)(H)(i)(II) , as amended by Act Sec. 13(a))

Suspension of 90% Limitation on NOL for AMT purposes
For tax years ending after 2002, the Act suspends the 90% limitation on the use of any alternative tax NOL deduction attributable to the carryback of an applicable NOL for which the extended carryback period is elected. ( Code Sec. 56(d)(1)(A)(ii)(I) , as amended by Act Sec. 13(b))

Increase in Carryback Period for Life Insurance Companies
For losses from operations arising in tax years ending after Dec. 31, 2007, the Act allows life insurance companies to elect to carry back an applicable loss from operations for 4 or 5 years and not just 3 years as is provided under pre-Act law. ( Code Sec. 810(b)(4)(A) , as amended by Act Sec. 13(c)) An applicable loss from operations is the life insurance company's loss from operations for any tax year ending after 2007 and beginning before 2010. ( Code Sec. 810(b)(4)(B) , as amended by Act Sec. 13(c)) The amount of the loss that can be carried back to the 5th preceding tax year is limited to 50% of the taxable income for such preceding tax year. ( Code Sec. 810(b)(4)(D) , as amended by Act Sec. 13(c))

Transition Rules for NOLs
Under transition rules, a taxpayer may revoke any election to waive the carryback period under either Code Sec. 172(b)(3) or Code Sec. 810(b)(3) with respect to an applicable NOL or an applicable loss from operations for a tax year ending before Nov. 6, 2009, by the extended due date for filing the tax return for the taxpayer's last tax year beginning in 2009. Similarly, any application for a tentative carryback adjustment under Code Sec. 6411(a) with respect to such loss is treated as timely filed if filed by the extended due date for filing the tax return for the taxpayer's last tax year beginning in 2009. (Act Sec. 13(e)(4))

RIA observation: Normally, an election to waive the carryback period under Code Sec. 172(b)(3) or Code Sec. 810(b)(3) so that the loss will be carried forward cannot be revoked. The transition rules afford an opportunity to undo the waiver with respect to an applicable NOL or an applicable loss from operations for a tax year ending before Nov. 6, 2009. They provide ample time to do this as the taxpayer has until the extended due date of its last tax year beginning in 2009 to make the election. By then, the taxpayer should be in a good position to determine whether to go ahead with the revocation and take advantage of the longer carryback period under the new law.
Businesses Ineligible to Elect Extended Carryback Period
The right to elect an extended carryback period under the Act does not apply to any taxpayer if:

... the Federal government acquired an equity interest in that taxpayer under the Emergency Economic Stabilization Act of 2008. (Act Sec. 13(f)(1)(A))
... the Federal government acquired before Nov. 6, 2009, any warrant (or other right) to acquire any equity interest with respect to the taxpayer under the Emergency Economic Stabilization Act of 2008. (Act Sec. 13(f)(1)(B))
... the taxpayer receives after Nov. 6, 2009, funds from the Federal government in exchange for an interest described above under a program established under title I of Division A of the Emergency Economic Stabilization Act of 2008 (unless such taxpayer is a financial institution as defined in Section 3 of such Emergency Economic Stabilization Act, and the funds are received under a program established by the Secretary of the Treasury for the stated purpose of increasing the availability of credit to small businesses using funding made available under that Act). (Act Sec. 13(f)(1)(C))
The right to elect an extended carryback period also does not apply to any taxpayer that at any time in 2008 or 2009 was or is a member

F-Bar

Report of Foreign Bank and Financial Accounts (FBAR)— TD F 90.22-1
The Currency and Foreign Transactions Reporting Act, otherwise known as the Bank Secrecy Act, was enacted in 1970 to address the fact that financial institutions in certain tax havens were being used by U.S. taxpayers to hide income, evade taxes and facilitate other illegal activities.1 The Bank Secrecy Act authorized the Department of Treasury to establish recordkeeping and filing requirements, and to promulgate regulations. Under 31 CFR §103.24(a), "each person subject to the jurisdiction of the United States (except a foreign subsidiary of a U.S. person) having a financial interest in, or signature or other authority over, a bank, securities or other financial account in a foreign country shall report such relationship to the Commissioner of the IRS for each year in which such relationship exists, and shall provide such information as shall be specified in a reporting form … ."

The FBAR is designed to provide information for use in criminal, tax or regulatory investigations or proceedings, and to create leads that "facilitate the identification and tracking of illicit funds or unreported income, as well as providing additional prosecutorial tools to combat money laundering and other crimes."3 The information derived from the FBAR is entered into the Detroit Computing Center’s Currency and Banking Retrieval System database ("the Database") administered by the Financial Crimes Enforcement Network ("FinCEN") and the IRS.4
The Database can be accessed by various government agencies to assist in law enforcement efforts, including those "officers and employees of any constituent unit of the Department of Treasury who have a need for the records in the performance of their duties"; "any other department or agency of the United States upon the request of the head of such department or agency for use in a criminal, tax, or regulatory investigation or proceeding"; and "appropriate state, local, and foreign law enforcement and regulatory personnel in the performance of their official duties."5

An FBAR must be filed by any U.S. person having a financial interest in, or signatory or other authority over, financial accounts maintained with financial institutions in foreign countries if the aggregate balances of such foreign accounts exceed $10,000 at any time during the year. This directive has spawned much debate and more scholarly articles and "tax alerts" than one can imagine. It is not the purpose of this article to debate the finer points of who should file an FBAR; that discussion will last long past this writer’s deadline. Instead, we simply summarize the definitions.
A "U.S. person" includes any citizen or resident of the United States, or person in or doing business in the United States.6 For purposes of the FBAR, a "person" includes individuals and all business entities, trusts and estates. Prior to October 2008, the FBAR instructions identified a more narrow group of persons subject to FBAR filing requirements and the INTERNAL REVENUE MANUAL instructed examiners to follow those instructions when determining whether a person had an FBAR filing obligation.7
In October 2008, the IRS revised the FBAR instructions, expanding the definition of U.S. person to match 31 USC §5314 by adding "person in or doing business in the United States." This revision caused significant confusion among tax practitioners and other parties affected by the FBAR requirements. On June 5, 2009, the IRS issued Announcement 2009-51, which suspended the reporting obligation for any "person in or doing business in the United States," and returned to the prior definition.8
A "resident" of the United States is a "permanent resident," a term that is not defined in the FBAR instructions. The INTERNAL REVENUE MANUAL offers some assistance in this regard, noting that an individual can establish nonresidency by showing that he or she (i) does not hold a green card, (ii) does not meet the substantial presence test of Code Sec. 7701(b)(3), or (iii) has not made the first-year residency election under Code Sec. 7701(b)(4).9
A person has a "financial interest" in an account if the person is the owner of record or holds title to the account, regardless of how the account is titled or whether the account is maintained for that person’s own benefit. This includes persons acting as an agent, nominee or in some other capacity for a third party. A person who holds an account indirectly through ownership in a corporation (more than 50 percent of the shares by value or vote), a partnership (more-than-50-percent interest in the profits or capital), or a trust (present beneficial interest in more than 50 percent of the assets or receiving more than 50 percent of the current income) also holds a financial interest.
There has been significant discussion, and there remain unanswered questions, regarding the definitions of "financial interest" and "financial accounts," particularly with respect to interests in commingled funds.10 On August 7, 2009, in recognition of these concerns, the IRS issued Notice 2009-62 offering administrative relief for persons with a financial interest in a foreign financial account in which the assets are held in a commingled fund. For such persons, the deadline to file an FBAR for 2008 and earlier calendar years with respect to commingled funds is extended to June 30, 2010.
The following are examples provided by the IRS in its Workbook on Report of Foreign Bank and Financial Accounts:11
Example 1. John, a U.S. citizen who resides in Mexico, granted his brother Paul, a U.S. citizen, a Power of Attorney to access his Mexican bank accounts. Paul is the owner of record. John has a financial interest in the account. Paul is acting only as an attorney on behalf of John. Paul also has a financial interest in the account, since he is the owner of record. Both John and Paul must file an FBAR.
Example 2. Given the information in the above example, if Paul is a Mexican citizen, must he file the FBAR? No, Paul is not considered to be a U.S. person. Financial interest in an account also includes a corporation in which a U.S. person directly or indirectly owns more than 50 percent of the total value of the shares of stock.
Example 3. A Florida corporation that owns 100 percent of a foreign company that has foreign financial accounts has to file an FBAR because the corporation is a U.S. person and the owner of record or holder of legal title is a corporation that directly owns more than 50 percent of the total value of the shares of stock.
Example 4. A U.S. person who owns 75 percent of the Florida corporation in the previous example has to file an FBAR because he indirectly owns more than 50 percent of the total value of shares of stock of the foreign corporation.
A U.S. person has "signatory authority" if the person can control the disposition of the funds in the account by delivering a document containing his or her signature to the financial institution with which the account is maintained. "Other authority" expands to any exercise of power of the account by direct communication. For example, if Joe can direct a third party, who has signatory authority on the account, to withdraw funds for Joe’s benefit (or for the benefit of anyone else), Joe has "other authority" over the account.
"Financial accounts" include traditional bank accounts such as savings accounts, checking accounts, and time deposits, as well as securities accounts, such as mutual funds, brokerage accounts and securities derivatives accounts. Also included are commingled funds where the account holder owns an equity interest in the fund. The debate over whether hedge funds and private equity funds are included in the definition of "financial accounts" rages on. Due to those taxpayers and practitioners erring on the side of caution, the FBAR filings dramatically increased with the filings by thousands of U.S. persons who, within the scope of their employment, maintain signatory or other authority over a hedge fund. Anecdotally, one particular hedge fund filed more than 15,000 FBARs prior to June 30, 2009.12 As noted, on August 7, 2009, the IRS issued Notice 2009-62, extending the FBAR filing date to June 30, 2010, for U.S. persons having signatory authority over, but no financial interest in, a foreign financial account, and for U.S. persons with financial interest in, or signatory authority over, foreign commingled funds. The IRS’s ultimate decision on this issue remains to be seen, and additional notices certainly may be issued once again changing the landscape in this area. Finally, at least one court has held that an account similar to a capital account in a foreign corporation constitutes a "financial account" where the U.S. person was able to direct the disbursement of funds by a Swiss financial company charged with maintaining the books and records related to the capital account.13
So when is a financial account "foreign"? A financial account is "foreign" if the account’s geographic location is outside the following jurisdictions:
• United States
• Northern Mariana Islands
• District of Columbia
• American Samoa
• Guam
• Puerto Rico
• U.S. Virgin Islands
• Trust Territories of the Pacific Islands
An account opened with Bank of America’s branch overseas constitutes a foreign account, but an account with the New York branch of an international bank does not. U.S. persons with accounts at U.S. military banking facilities or financial institutions designated to serve the U.S. government overseas are not subject to FBAR filing requirements.
Certain individuals are exempt from FBAR filing requirements as long as they have no personal financial interest in the account at issue. These include "officers or employees of a bank under the supervision of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Office of Thrift Supervision, or the Federal Deposit Insurance Corporation," and "officers or employees of a domestic corporation whose equity securities are listed on national securities exchanges, or which has assets exceeding $10 million and 500 or more shareholders of record."14 The corporate officers and employees must receive written notice from the chief financial officer of the corporation that the corporation has filed a current FBAR that includes the account at issue.
What Information Is Required?
Having now established "who," we turn to the question of "what" information must be provided on the FBAR. The TD F 90.22-1 is generally self-explanatory and providing the basics should not present a problem: name, address, Social Security number, date of birth, name on account, financial institution and its location, account number, etc.
The request that causes some concern is for the "maximum value of the account" during the calendar year. Let’s begin with the instructions, which define the maximum value of an account as "the largest amount of currency or non-monetary assets that appear on any quarterly or more frequent account statement issued for the applicable year." In cases where periodic account statements are not issued, the instructions appear to penalize the filer by requiring the largest amount of currency and nonmonetary assets in the account on any given day during the year. The instructions raise a myriad of questions. For example, if an account contains stock and currency, can you choose between using periodic statements and valuing at year end? And if you withdraw foreign currency, do you use the exchange rate at year end, at the time of the withdrawal, or based on the date of a periodic statement? The answers to these questions are sure to be debated during FBAR penalty discussions.
Of course, if you don’t have periodic statements, the obvious question is how to determine the largest value at any time during the year. Many practitioners are simply using the information available—such as year end statements—and expressly noting the source of the maximum account value on the face of the FBAR.
For accounts holding foreign currency, filers are directed to use the official exchange rate at the end of the year. For currency with multiple exchange rates, use the rate for converting to U.S. dollars at year end. Stocks, other securities and nonmonetary assets should be valued at year end, unless withdrawn from the account during the year in which case the filer should use the fair market value at the time of the withdrawals.
When and Where the FBAR Is Filed
The FBAR must be received by the IRS by June 30 of the year following the calendar year in which the U.S. person is subject to the FBAR filing requirements. Because the FBAR is not a form required by the Internal Revenue Code, the mailbox rule ("timely mailing is timely filing") of Code Sec. 7502(a)(1) does not apply. An FBAR is not filed with the taxpayer’s income tax return. Instead, the FBAR must be filed by mailing it to the Department of Treasury, P.O. Box 32621, Detroit, MI 48232-0621; hand delivering it to any IRS office; or delivering to a tax attaché at a U.S. embassy. To verify filing, filers may call the Detroit Computing Center Hotline at (800) 800-2877.
Record Keeping Requirements
FBAR filers are required to maintain certain records for five years from the due date of the FBAR.15 These records include the name in which each account is held or maintained; the number or other designation of the account; the name and address of the foreign financial institution with which the account is maintained; the type of account; and the maximum value of each account during the reporting period.16 Filers can request verification and/or a copy of an FBAR filed 60 days after the date of filing by making a written request (and paying a nominal fee) to the IRS Detroit Computing Center, P.O. Box 32063, Detroit, MI 48232, Attn: Verification.
The five-year retention period does not include any period in which the taxpayer is under indictment or subject to an information filed with respect to filing a false federal income tax return, or failing to file a federal income tax return, ending with the final disposition of the criminal proceeding.17
Enforcement and Delegation
The IRS was initially authorized to investigate possible civil FBAR violations, while enforcement was delegated to FinCen.18 On April 10, 2003, in a Memorandum of Understanding, FinCen delegated its authority to enforce the provisions of 31 USC §5314 and 31 CFR §§103.24 and 103.32 to the IRS.19 The IRS is now authorized to do the following:20
• Investigate possible civil violations of these provisions
• Assess and collect civil FBAR penalties
• Employ the summons power of Subpart F of part 103
• Issue administrative rulings under Subpart G of part 103
• Take any other action reasonably necessary for the enforcement of these and related provisions, including pursuit of injunctions
In addition, the IRS Criminal Investigation Division (CID) has had the authority to examine for criminal FBAR violations since 1992, with expanded authority to investigate money laundering offenses under "18 U.S.C. §§1956 and 1957 where the underlying conduct is subject to investigation under Title 26 or under the [Bank Secrecy Act]."21
Penalties
Prior to the American Jobs Creation Act of 2004 (P.L. 108-357) (AJCA), trades or businesses committing negligent FBAR violations were subject to general penalties under the Bank Secrecy Act (31 USC §5321(a)(6)) up to $500 per violation and an additional penalty of up to $50,000 for a pattern of negligent violations. For willful violations, the IRS could impose a minimum FBAR penalty of $25,000 and maximum penalty of $100,000.22 Although Reg. §1.6664-4, Reasonable Cause and Good Faith Exception to Code Sec. 6662 penalties, does not apply, the IRM directs examiners to that regulation and describes it as "useful guidance in determining the factors to consider" when determining whether the negligence penalties should apply.23
The AJCA added a new penalty for nonwillful FBAR violations occurring after October 22, 2004, up to $10,000 for each nonwillful failure to file, and dramatically increased the penalties for willful violations.24 The penalties may be imposed for each foreign account, for each year, and for each violation. The current penalties, shown in Chart 1, are from the IRS Web site.25
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Nonwillful Penalties and Reasonable Cause
The government is statutorily barred from imposing FBAR penalties if the FBAR violation is due to reasonable cause and "the amount of the transaction or the balance in the account at the time of the transaction was properly reported."26 While it may appear that the reasonable cause exception does not apply unless an FBAR is filed, the IRS clearly states that the reporting requirement under the reasonable cause exception "means that the examiner must receive the delinquent FBARs from the nonfiler in order to avoid application of the non-willfulness penalty."27 In guidance issued to the Large and Mid-Sized Business (LMSB) division on October 31, 2008, the IRS stated: "However, no [civil FBAR] penalty will be assessed if there is reasonable cause for not filing the FBAR."28 In addition, "examiners are to use discretion, taking into account the facts and circumstances of each case, in determining whether a warning letter or penalties that are less than the total amounts provided for in the mitigation guidelines are appropriate."29 "The sole purpose for the FBAR penalties is to serve as a tool to promote compliance with respect to the FBAR reporting and recordkeeping requirements."30
Under the IRS Offshore Voluntary Disclosure Initiative announced on March 23, 2009, the IRS will not impose penalties on taxpayers who reported and paid tax on all their taxable income, including the income from the foreign accounts, for prior years but did not file the FBARs.31
Mitigation
It will come as no surprise that no reasonable cause exception exists for willful violations.32 Prior to the enactment of the AJCA, the IRS issued Guidelines for Calculation of the FBAR Civil Penalty for Willful Violations, which instructed IRS employees to consider the following as grounds for imposing less than the maximum penalty:33
• No history of past FBAR penalty assessments exists.
• No money in the foreign account was from an illegal source or used for a criminal purpose (based on available information—the revenue agent is not required to conduct a criminal investigation).
• The person is cooperating with the IRS.
• A civil fraud penalty has not been asserted against the person for an underpayment of tax that was connected to the person’s failure to file the FBAR.
The maximum penalty was the amount in the foreign account at the time of the violation up to $100,000, unless the maximum amount in the account at the time of the violation was less than $25,000 (in which case the maximum penalty was $25,000).34
If a person satisfied the mitigation criteria for violations before October 23, 2004, IRS examiners were instructed to impose penalties as follows:35
• Level I—If the highest aggregate balance for all unreported accounts does not exceed $20,000, the penalty is five percent of the maximum balance during the year for each of the unreported accounts.
• Level II—If the maximum balance of an unreported account does not exceed $250,000, the penalty is 10 percent of the maximum amount during the year for each unreported account. The maximum Level II penalty is $25,000.
• Level III—If the maximum balance of an unreported account is greater than $250,000 but does not exceed $1 million, the penalty is the lesser of:
• (a) 10 percent of the maximum amount in each unreported account during the year, or
• (b) the amount in the account as of the last day for filing the FBAR, unless this amount is less than or equal to $25,000 (in which case the penalty is $25,000, the maximum penalty in such cases, under section 5321).
Level IV—If the maximum balance of an unreported account is greater than $1 million, The amount of the penalty is the lesser of:
• (a) $100,000 for each unreported account; or
• (b) the amount in the account as of the last day for filing the FBAR unless this amount is less than $25,000 (in which case the penalty is $25,000).
For violations occurring after October 22, 2004, the IRS notes that discretion in determining the amount of FBAR penalties has been delegated to the FBAR examiner, who "may determine that the facts and circumstances of a particular case do not justify a penalty."36 The mitigation criteria for violations occurring after October 22, 2004, follow:37
• The person has no history of criminal tax or BSA convictions for the preceding 10 years and has no history of prior FBAR penalty assessments.
• No money passing through any of the foreign accounts associated with the person has been from an illegal source or used to further a criminal purpose.
• The person cooperated during the examination.
• IRS did not determine a fraud penalty against the person for an underpayment of income tax for the year in question due to the failure to report income related to any amount in a foreign account.
According to the INTERNAL REVENUE MANUAL, in cases where an FBAR violation occurred but no penalty is appropriate, the examiner will issue the FBAR warning letter—Letter 3800. In cases where a penalty is warranted, the INTERNAL REVENUE MANUAL directs the examiner to consider the post–October 22, 2004, mitigation guidelines to promote uniformity, but does not require that the guidelines be strictly applied.38 The examiners are instructed to consider the following:39
• Whether compliance objectives would be achieved by issuance of a warning letter
• Whether the person who committed the violation had been previously issued a warning letter or has been assessed the FBAR penalty
• The nature of the violation and the amounts involved
• The cooperation of the taxpayer during the examination
The examiner’s work papers must document the mitigating factors, and his or her decision is subject to manager approval.
Burden of Proof
To establish a willful violation for purposes of the civil FBAR penalty under 31 USC §5321 or to sustain the heavy burden of proof to obtain a criminal conviction under 31 USC §5322, the government must establish "a voluntary intentional violation of a known legal duty."40 The government must prove that the taxpayer was aware of the requirement to file the FBAR and intentionally failed to do so (or filed a false FBAR).41 Short of a concession or a confession, the government will rely on circumstantial evidence and infer willfulness based on a course of conduct.42
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In Sturman, the defendant was convicted of willfully failing to maintain records and file FBARs. The Sixth Circuit affirmed the conviction, holding that the government proved willfulness through circumstantial evidence.43 Specifically, Sturman "concealed his signature authority, his interests in various transactions, and his interest in corporations transferring cash to foreign banks."44 The court also noted that Sturman admitted knowledge of and failure to answer a question concerning signature authority at foreign banks on Schedule B of his income tax return.45 Since Schedule B made specific reference to a "booklet" that referenced the duty to file an FBAR, the court found:46
... that the defendant could have learned of the additional requirements quite easily. It is reasonable to assume that a person who has foreign bank accounts would read the information specified by the government in tax forms. Evidence of acts to conceal income and financial information, combined with the defendant’s failure to pursue to knowledge of further reporting requirements as suggested on Schedule B, provide a sufficient basis to establish willfulness on the part of the defendant.
Of interest is the government’s use of records obtained from Switzerland under the Treaty Between the United States of America and the Swiss Confederation on Mutual Assistance in Criminal Matters.47 In addressing Sturman’s objection to the government’s request and ultimate use of the Swiss records, the court analyzed the Treaty and found that Sturman’s constitutional rights to privacy and due process had not been violated. Sturman also objected to the use of depositions taken of four Swiss bank officials in Switzerland on due process grounds. The Sixth Circuit affirmed the district court’s finding that the foreign depositions were taken and introduced in accordance with Federal Rule of Criminal Procedure 15(d).48
In considering whether to impose the civil penalty for willful violations, the IRS will use the same criteria established for the civil fraud penalty under Code Sec. 6663, and bear the same burden of proving willfulness by clear and convincing evidence.49 To assist in their review, FBAR examiners may request a wide range of documents, from the tax returns to correspondence with investment managers and brokers.50
Unlike assessments of tax or civil tax penalties, there is no presumption of correctness in connection with the imposition of FBAR penalties.51 Similarly, Code Sec. 7491(c), which imposes on the IRS the burden of production with respect to all penalties and additions to tax asserted under Title 26, does not apply to the FBAR penalty.
Statute of Limitations for Civil FBAR Penalties
The IRS has six years after "the transaction with respect to which the penalty is assessed" to assess a civil penalty related to an FBAR violation. [31 USC §5321(b)(1).] While the civil statutes on assessment and collection of the FBAR penalty can be waived, a waiver of limitations for purposes of a Title 26 audit will not extend the limitations with respect to the FBAR penalties.52 The IRS has two years from the later of the date of assessment or the date any judgment becomes final in a criminal action involving the same transaction that resulted in the penalty, to sue to recover the civil penalty.53 The FBAR assessment date is the date the IRS stamps the Form 13448.54
FBAR Examination Procedures
The procedures for FBAR examinations are unlike those established for tax cases under the Internal Revenue Code and regulations. The IRS instructs an examiner to set up a separate FBAR file if an FBAR violation has occurred, regardless of whether the examiner intends to assert penalty.55 The first step is to determine if an FBAR should have been filed, whether it was in fact filed, and what records have been retained.56 If a revenue agent conducting a Title 26 audit seeks information regarding potential FBAR violations, the agent must obtain a "relevant statute memorandum" (Form 13535) (RSM) signed by a Territory Manager before the information from the tax examination can be obtained and used in the FBAR investigation.57 An RSM is required because the audit involves information subject to the disclosure rules of Code Sec. 6103. In a pure Bank Secrecy Act (BSA) investigation, no RSM is required, but the examiner is also prevented from accessing Code Sec. 6103 protected information using the IRS databases.
In the October 2008 Guidance to LMSB, the IRS noted the need to "heighten awareness among LMSB personnel" of the FBAR reporting requirements.58 The memorandum noted that while FBAR filings had increased from 205,000 in 2003, to more than 322,000 in 2007, based on available information, the IRS believed that "as many as one million U.S. taxpayers are required to file the FBAR in any given year." LMSB examiners were advised to determine the existence of foreign bank accounts and whether an FBAR was required, whether the records were being maintained, whether the income was being reported and whether any FBAR violations were in furtherance of Title 26 offenses.
The RSM is the "initial input document for the monitoring of FBAR cases."59 It is a "good faith determination" by the revenue agent, group manager and Territory Manager that "the apparent FBAR violation was in furtherance of an apparent Title 26 violation."60 If the Territory Manager determines that the FBAR violations are not in furtherance of a Title 26 violation, this determination terminates the examiner’s FBAR responsibilities.61 The RSM is placed in the audit file and the FBAR examination will not be pursued.62 If the Territory Manager believes that the FBAR violation was in furtherance of a Title 26 violation, the FBAR investigation will proceed.63
In requesting the administrative files related to FBAR penalties pursuant to the Freedom of Information Act, it is important to know what should be there. In a Bank Secrecy Act investigation, the examiner is instructed to use the Title 31 FBAR lead sheet to commence the investigation. If the examiner finds an FBAR violation, he or she must establish a separate file, distinct from the Bank Secrecy Act file, since the FBAR penalties are imposed by the IRS, while non–FBAR-related Bank Secrecy Act penalties are assessed by FinCEN.64 An FBAR examination case file may include the following documents:
• Agent Activity Record—FBAR Activity Code 545
• Related Statute Determination, if appropriate
• FBAR lead sheet and work papers
• Brief summary memorandum explaining any FBAR violation(s)
• Copy of any delinquent FBAR(s) annotated in red on the top "Secured by Examination"
When the FBAR examination is closed, the following documents should be added to the file (where applicable):65
• FBAR Monitoring Document (FMD), providing closing information for the FBAR database
• Letter 3800, Warning Letter for Apparent Foreign Bank and Financial Accounts Report Violations
• Letter 3709, FBAR 30-Day Letter (transmitting Agreement for Assessment and Collection, F-13449)
• Form 13449, Agreement to Assessment and Collection of Penalties Under 31 USC §§5321(a)(5) and 5321(a)(6)
• Notice 1330, Information on Making FBAR Penalty Payment by Check
• Power of Attorney (Form 2848) or general power of attorney
• Form 13448, Penalty Assessments Certification Summary
• Letter 3708, Notice and Demand for Payment of FBAR Penalty
• Notice 1330, Information on Making FBAR Penalty Payment by Check
Examiners have various resources within the IRS when in need of assistance with an FBAR investigation, including Technical Services FBAR specialists, SB/SE Counsel Area FBAR Coordinators (and other SB/SE attorneys), and Bank Secrecy Act FBAR Analysts. If an examiner is seeking information that is limited to Bank Secrecy Act violations, he may not issue a Title 26 summons; he is limited to a Bank Secrecy Act summons (TD F 90.22-31). If the case also involves a tax related offense, a Title 26 summons may be used.66 Under either option, if a taxpayer refuses to comply, the examiner will consult with Counsel with regard to summons enforcement action under Code Sec. 7604.
If the examiner decides that a FBAR penalty is appropriate, and either has opted not to refer the case to Criminal Investigation or a referral was declined, the examiner determines the penalty based on the FBAR penalty Guidelines and submits the case file to SB/SE Counsel Area FBAR Coordinator for review.67 If Counsel finds that a penalty should not be asserted, the memorandum should state the basis for disagreement with the examiner and whether further investigation is recommended. If Counsel agrees with the examiner, he or she will prepare a memorandum recommending the issuance of a Letter 3709 (the FBAR 30-day letter) and stating the basis for that decision to assist in the event the taxpayer appeals.
With the approval of Counsel, the examiner issues a Letter 3709 and Form 13449 (FBAR Agreement to Assessment and Collection), which also serves as the examiner’s report and the basis for the assessment.68 If the taxpayer agrees to the penalty, he or she may file the delinquent FBARs and send in full payment of the penalty within 30 days of the date on the Letter 3709 without incurring interest.69 If the taxpayer fails to pay within 30 days of the date of the notice, interest will accrue from the date of assessment and a six-percent delinquency penalty will be assessed based on the amount of penalty that remains unpaid 90 days after the notice date.70 If the taxpayer is unable to pay the penalty in full, a Letter 3708 (Notice and Demand for Payment of FBAR Penalty) will be issued reflecting the interest accrued.
Administrative Appeal Rights
If the taxpayer does not agree with the penalty, the taxpayer has 30 days from the date of the Letter 3709 to file an appeal. The written protest is filed with the examiner and must be postmarked by the deadline set forth in the Letter 3709.71 The examiner forwards the file to his or her group manager, who then sends the file to Appeals.72 The Appeals Officer assigned to the case will contact the Appeals FBAR Coordinator prior to scheduling the initial appeals conference with the taxpayer, and will follow the IRS Foreign Bank and Financial Account Requirements Guidance for Appeal Officers.73 If the case involves both FBAR reporting violations and Title 26 offenses, the examiner may choose to hold the FBAR case until the tax issues are resolved.74 The INTERNAL REVENUE MANUAL cautions the examiner to monitor the period of limitations.75
FBAR penalties are considered an Appeals Coordinated Issue, Category of Case (ACIcc) and are listed on the Appeals Technical Guidance Issues Index (July 2009). The IRS defines an Appeals Coordinated Issue (ACI) or ACIcc as:76
An issue or category of case, is an issue of Service-wide impact or importance that requires Appeals’ coordination to ensure uniformity and consistency nationwide. This is achieved through the coordination of efforts between Appeals Officers (AO) and designated Appeals Technical Guidance Coordinators (TGC). The ACI program encompasses legal issues and factual issues and category of case.
When an Appeals Officer is assigned a case involving an ACI, as opposed to an ACIcc, he or she is required to consult with the TGC prior to scheduling the initial conference to obtain current information. Since the FBAR penalty appeals are considered an ACIcc, not an ACI, the TGC need not review and concur with any settlement proposals before the Appeals Officer discusses the proposal with the taxpayer.
Judicial Review (U.S. Tax Court)
In J.B. Williams III, the U.S. Tax Court held that it does not have jurisdiction to review the IRS’s decision to impose an FBAR penalty. The court noted that the FBAR penalties arise under Title 31, and are not subject to the deficiency procedures under Code Secs. 6212–6214.77 The court acknowledged that if a taxpayer receives a Final Notice of Intent to Levy under Code Sec. 6331 or Notice of Federal Tax Lien under Code Sec. 6321 with respect to an assessable penalty not otherwise subject to deficiency procedures under Code Sec. 6212, and files a timely Collection Due Process appeal under Code Sec. 6330 or 6320, a resulting notice of determination issued by the IRS Appeals Office would be subject to the court’s review.78 However, unlike other assessable penalties, the FBAR penalty does not fall within the scope of the collection procedures under Title 26 and therefore, there is no opportunity to file a collection due process appeal or seek the Tax Court’s review.79
With the door to the Tax Court firmly closed, those persons facing FBAR penalties appear to be left with two options to obtain judicial review. Either pay the penalty and file a refund suit, or wait until the government files suit in district court to collect the penalty and challenge the assessment.80
Suits to Collect the FBAR Penalty
The government has two years from the date of assessment of the FBAR penalty to file suit to collect in U.S. district court.81 In Simonelli,82 the government filed a complaint seeking a judgment for the FBAR penalty, accrued interest and the failure to pay penalty that arises under 31 USC §3717(e)(2). Simonelli conceded liability for the FBAR penalty but argued that the liability was discharged in his bankruptcy. After rejecting this contention, an issue addressed in greater detail infra, the district court entered judgment on behalf of the United States.
It appears that a person assessed with the FBAR penalty may challenge liability in response to a suit to collect. An exception would arise in cases where the FBAR penalty was assessed following a criminal conviction under 31 USC §5322 for willful failure to file an FBAR penalty. In such a case, it appears clear that the person against whom the penalty is assessed would be estopped from challenging liability in a later civil proceeding. For those individuals and entities that are permitted to challenge liability, it appears that there is a right a jury trial.83
Dischargeability of FBAR Penalty
In Simonelli, the government moved for summary judgment on the issue of whether the FBAR penalty was subject to discharge in bankruptcy. It argued that the penalty is a civil penalty and therefore excepted from discharge under 11 USC §523(a)(7), which provides that a debtor will not be discharged from any debt "for a fine, penalty, or forfeiture payable to and for the benefit of a governmental unit, and is not compensation for actual pecuniary loss, other than a tax penalty."
The court agreed, noting that 11 USC §523(a)(7) "creates a broad [exception to discharge in bankruptcy] for all penal sanctions, whether they be denominated fines, penalties, or forfeitures. Congress included two qualifying phrases; the fines must be both ‘to and for the benefit of a governmental unit,’ and ‘not compensation for actual pecuniary loss.’"84 There are two types of tax penalties that are specifically excluded from this broad exception to discharge: certain kinds of "tax or customs dut[ies]" listed at 11 USC §523(a)(1), and penalties for taxes that are "imposed with respect to a transaction or event that occurred before three years before the date of the filing of the petition."85
Simonelli argued that the FBAR penalty is a tax penalty that, in this case, was "imposed with respect to a transaction or event that occurred before three years before the date of the filing of the petition."86 He asserted that the FBAR penalty was assessed "in lieu of assessing taxes on him because his failure to file the FBAR deprived the IRS of any information about his foreign bank transactions, making it impossible for the IRS to know how much tax to assess on him."87 Simonelli maintained that "the FBAR penalty is a tax penalty because the IRS uses it to penalize persons who fail to file FBARs, frustrating the IRS’s ability to track, assess and collect their would-be taxes."88
The court rejected these arguments, finding that the FBAR penalty is a civil penalty under the BSA, not a tax or tax penalty, and nothing ties the amount of the FBAR penalty to an amount of tax due.89 Accordingly, the court held that the FBAR penalty is not subject to discharge in bankruptcy.
If a taxpayer is under an FBAR examination at the time the taxpayer files for bankruptcy, the IRS will notify the IRS Insolvency Unit and then complete the FBAR examination. The Insolvency Unit will file the proof of claim and collection will be handled by Financial Management Service (FMS).90
Criminal Violations
In addition to substantial civil penalties, a willful violation of the FBAR reporting requirements is subject to a maximum term of imprisonment of five years, a maximum fine of $250,000, or both.91 If the defendant violates any other U.S. law or if the violation was part of a pattern of any illegal activity involving more than $100,000 in a 12-month period, the penalties are increased to a fine of not more than $500,000 and imprisonment of not more than 10 years.92 Willful violations of 31 USC §5314 can also result in charges for false statements under 18 USC §1001, for filing false returns under Code Sec. 7206(1),93 or for evasion under Code Sec. 7201.94 Each FBAR filing or lack thereof constitutes a separate violation and is subject to a five-year statute of limitations.95
In Clines,96 Thomas Clines participated in a covert operation supervised by Air Force Major General Richard V. Secord to provide arms and ammunition to the Nicaraguan Contras ("the Iran Contra affair"). Secord also enlisted Albert Hakim, who retained Compagnie de Services Fiduciaires S.A. ("CSF"), a Swiss company offering financial and investment management services, to form shell corporations to collect funds to finance the weapon purchases. CSF also invested funds in bonds, securities and commodities. Clines’ compensation was a percentage of the profits. Secord and Hakim calculated the profit after each sale and directed CSF to credit Clines’ share to "TC capital account," a ledger account of one of the shell corporations.
After the funds were credited to the TC capital account, Clines was able to direct CSF to withdraw or transfer funds on his behalf. CSF would record the request on the TC capital account ledger and disburse the funds in accordance with Clines’ instructions. Clines did not report all of these earnings on his income tax return and did not file FBARs with respect to the TC capital account.
Clines was convicted of filing false tax returns in violation of Code Sec. 7206(1), and failing to file FBARs in violation of 31 USC §5314. On appeal, Clines argued that the shell corporation holding the TC capital account was not a "financial institution"; that the TC capital account was not an "other financial account"; and that he had no reportable "financial interest in, or signature or other authority over" the TC capital account.
The Fourth Circuit held that CSF, not the shell corporation, constituted a financial institution for purposes of the FBAR requirements because it held funds for third parties, invested those funds on their behalf, and disbursed or wired funds at their direction. In offering these services, CSF functioned as a bank,97 an "investment banker or investment company,"98 and "a licensed sender of money."99 The court also rejected Clines’ contention that the TC capital account was merely a bookkeeping entry on a corporate ledger and therefore, was not an "other financial account" within the meaning of 31 USC §5314, since the broad definition of "other financial account" includes "any other account maintained with a financial institution or other person who accepts deposits, exchanges or transmits funds."100 Finally, the court found no merit in the claim that Clines lacked a "financial interest" in the TC capital account since he had no control over the funds until Secord and Hakim allocated his share of the profits.101 Based on Clines’ ability to direct CSF to wire or transfer the funds at his direction, the court found that the definition of "financial interest" in FBAR Instruction H was satisfied.102
International Information Returns
U.S. persons are required to file certain information returns depending on their interests in, control over, transfers to or distributions from foreign corporations, partnerships, other entities and trusts. Penalties are imposed under various sections of the Internal Revenue Code for failure to file or filing incomplete or inaccurate required returns. Most of these penalties are considered "assessable penalties" that are not subject to the deficiency procedures under Code Sec. 6211. The IRS may assess such penalties without prior notice, although the INTERNAL REVENUE MANUAL provides that examiners should (not must) inform the taxpayer prior to assessing the penalties.103 To make matters worse, these penalties generally have no statute of limitations for assessment.104 With that cheery opening, we review some of the information returns frequently required with offshore accounts.
Form 5471—Information Return of U.S. Persons with Respect to Certain Foreign Corporations
The Form 5471 must be filed by U.S. persons that have a certain level of control (i.e., officers, directors or shareholders) of certain foreign corporations to report information required by Code Secs. 6038 and 6046. This information includes foreign corporation entity data, stock ownership data, financial statements and intercompany transactions with related persons.105 The taxpayer must report the information required by Code Secs. 6038 and 6046, and must compute income from controlled foreign corporations under Code Secs. 951–964. The Form 5471 must be filed with a taxpayer’s income tax return.106
Persons subject to the Form 5471 reporting requirements fall within five filing categories.107 Penalties imposed for failure to file complete and accurate Forms 5471 are outlined in Code Sec. 6046 (filing category 2 and 3) and Code Sec. 6038 (filing category 4).108
Penalties
Any person who fails to report information required by Code Sec. 6046 on a Form 5471 (filing category 2 and 3) is subject to a $10,000 penalty per reportable transaction.109 Failing to report information required by Code Sec. 6038(a) (filing category 4 and 5), results in a similar penalty of $10,000 for each Form 5471 that is filed after the due date of the income tax return (including extensions) or that does not include the complete and accurate information described in Code Sec. 6038(a).110
If the required information is not provided within 90 days of a notice from the IRS of such failure (a "notice letter"), an additional penalty of $10,000 will be imposed for each 30-day period, or fraction thereof, during which the failure continues up to a maximum of $50,000 per return (the "continuation penalty").111
Continuation penalties apply to many of the information returns addressed in this article. Examiners are instructed to issue notice letters "at the earliest date possible."112 Examiners also may send reminder letters 45 days after a notice letter is issued.113 If no response is received, the penalty is assessed with manager approval.114
In addition to the foregoing, U.S. persons failing to file a required Form 5471 will be subject to a 10-percent reduction of the foreign tax credit available under Code Secs. 901, 902 and 960.115 If the IRS mails a notice of the delinquency to the taxpayer, and the taxpayer fails to correct the problem within 90 days, an additional reduction of five percent will be imposed for each three-month period, or fraction thereof, that the failure continues, subject to limitations set forth in Code Sec. 6038(c).
In addition to the foregoing penalties, failure to file a complete and accurate Form 5471 will extend the period of limitations on assessment and collection of any tax imposed with respect to any event or period to which the Form 5471 applies to three years after the date on which the required information is reported.116
Since January 1, 2009, the IRS Service Center has been automatically asserting penalties with regard to taxpayers that file late Forms 1120 with Forms 5471 attached.117 Information return penalties that are not subject to deficiency proceedings are assessed on a Form 8278 with a Form 886-A attached.118
When imposing information return penalties, examiners are advised to send the initial assessment package between 125 and 150 days after the notice letter has been issued. The penalty assessed will include the initial penalty, plus two months of the continuation penalty.119
Reasonable Cause
Penalties for failure to timely file a complete and accurate Form 5471 may be avoided or abated for reasonable cause. The requirements for establishing reasonable cause are set forth in Reg. §1.6038-2(k)(3)(ii):120
To show that reasonable cause existed for failure to furnish information as required by section 6038 and this section, the person required to report such information must make an affirmative showing of all facts alleged as reasonable cause for such failure in a written statement containing a declaration that it is made under the penalties of perjury. The statement must be filed with the district director for the district or the director of the service center where the return is required to be filed. The district director or the director of the service center shall determine whether the failure to furnish information was due to reasonable cause, and if so, the period of time for which such reasonable cause existed. In the case of a return that has been filed as required by this section except for an omission of, or error with respect to, some of the information required, if the person who filed the return establishes to the satisfaction of the district director or the director of the service center that the person has substantially complied with this section, then the omission or error shall not constitute a failure under this section.
An examiner should consider reasonable cause prior to assessing any information return penalty.121 "Examiners must consider any reason a taxpayer provides in conjunction with the guidelines, principles and evaluating factors relating to reasonable cause based on the facts and circumstances."122 A taxpayer must be in full compliance before reasonable cause will be considered.123
IRS Campus employees are authorized to abate information return penalties that are assessed by the Campus. Other abatements must be approved by the organizational unit that asserted the penalty (LMSB or SBSE Examination).124
With respect to Form 5471 penalties, the IRS has taken the position that "[a]ny person required to file Form 5471 and Schedule J, M, or O who agrees to have another person file the form and schedules for him or her may be subject to the above penalties if the other person does not file a correct and proper form and schedule."125
In late 2008, the IRS issued recommendations for seeking reasonable cause relief with respect to amended Forms 5471. For amended Forms 5471 filed with Forms 1120 after December 31, 2008, the IRS recommends that taxpayers wait to submit any request for reasonable cause relief until the IRS notifies the taxpayer that penalties will be proposed. For amended Forms 5471 filed with other income tax returns, the IRS suggests that taxpayers attach a statement titled "Reasonable Cause 5471" to the return.126
Post-Assessment Review and Reconsideration
Persons against whom information return penalties have been imposed may seek reconsideration of the penalty determination.127 The examiner is advised to determine whether all relevant facts were considered and, in appropriate cases involving hardship or specific requests for referral to the Taxpayer Advocate Service, to refer to the TAS Guidelines for Referral or TAS Criteria.128
Under Code Secs. 6320 and 6330, after the IRS files a Notice of Federal Tax Lien under Code Sec. 6321 and prior to the IRS issuing a Notice of Levy under Code Sec. 6331, a person is entitled to notice and a hearing with respect to the collection action. If the Appeals Office issues an adverse notice of determination with respect to a timely collection appeal, the person may, within 30 days of that notice, appeal the determination to the U.S. Tax Court.129
Judicial Review
A penalty imposed for failure to file a Form 5471 is an "assessable penalty" that is not subject to the deficiency procedures under Code Secs. 6211–6214. To obtain judicial review, a person must pay the amount due and file suit for refund.130
In Wheaton,131 the court acknowledged the heavy burden this imposes on taxpayers, but was without authority to rule otherwise under the Anti-Injunction Act.132 In that case, the IRS issued several notices advising Wheaton of his obligation to file Form 5471 based on his ownership of numerous foreign corporations. The IRS also issued statutory notices of deficiency proposing income tax adjustments, but omitting any reference to Form 5471 penalties. Wheaton filed timely petitions with the U.S. Tax Court. When he failed to file the required Forms 5471, the IRS assessed the applicable penalties and subsequently denied Wheaton’s request for reasonable cause relief.
In response to Wheaton’s administrative appeal, the appeals officer abated certain penalties related to corporations for which Wheaton filed late Form 5471, reserved ruling on penalties related to the corporations at issue in the U.S. Tax Court proceedings, and refused to consider abatement of the remaining penalties. The IRS eventually filed a Notice of Federal Tax Lien in the amount of $2,599,432.39 representing the penalties imposed under Code Sec. 6038, and issued a Notice of Levy in an effort to collect the amounts due.133
Wheaton filed a complaint in district court seeking a preliminary injunction compelling the government to release the tax liens, to prevent any further collection proceedings, and to require the government to adjudicate the penalties in the U.S. Tax Court. The government moved to dismiss, arguing that Wheaton’s claims were barred by the Tax Anti-Injunction Act, Code Sec. 7421, which provides in relevant part, "Except as provided in §§6212(a) and (c), 6213(a), ... no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person, whether or not such person is the person against whom such tax was assessed."
The court rejected Wheaton’s argument that penalties asserted under Code Sec. 6038(b) are subject to the deficiency proceedings under Code Secs. 6212 and 6213, finding that the penalties, which arise under Subtitle F, Chapter 61 of the Code, did not fall within the definition of "deficiency," which is limited by Code Sec. 6211 to "income, estate, and gift taxes imposed by subtitles A and B and excise taxes imposed by chapters 41, 42, 43, and 44."134 The court also rejected Wheaton’s attempt to bootstrap the Form 5471 penalties to the statutory exception provided in Code Sec. 6665(b) for additions to tax (i.e., late filing penalties under Code Sec. 6651(a)) where the additions are "attributable to a deficiency."135 Finally, while the court recognized that a reduction to foreign tax credits under Code Sec. 6038(c) is subject to the deficiency procedures, since the credit arises under Code Sec. 901, Subtitle A, Chapter 1 (falling within Code Secs. 6211–213), it maintained that penalties for failure to file a Form 5471 under Code Sec. 6038(b) clearly fall outside any exception to the Anti-Injunction Act.136
In Heydemann,137 the district court considered whether the bankruptcy court erred in refusing to abate penalties imposed for failure to file Form 5471 under Code Sec. 6038. Heydemann argued that "the bankruptcy court erred because: (1) her cooperation with the IRS obviated the need for her to file Form 5471, (2) she was entitled to prior notice of the penalties, and (3) the bankruptcy court had the discretion to waive the penalties."138
The district court reviewed the penalty scheme under Code Sec. 6038 and found that while Heydemann provided the IRS with the required information during the IRS’s investigation of her husband, she did not file the Form 5471 and, therefore, was subject to the penalties. The court further held that the IRS is not required to provide notice prior to assessing penalties under Code Sec. 6038.139 Finally, the court held that it lacked authority under 11 USC §505(a)(1) to waive the penalties.140
Criminal Violations
Willful failure to file a required Form 5471 constitutes a criminal offense under Code Sec. 7203. Filing a false or fraudulent Form 5471 falls within the scope of Code Secs. 7206 and 7207.141
Form 5472—Information Return of a 25-Percent Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business
The Form 5472 reports transactions between a 25-percent foreign-owned domestic corporation or a foreign corporation engaged in a trade or business in the United States and a related party as required by Code Secs. 6038A and 6038C.142
Penalties
The penalty for failing to file a Form 5472, or to keep certain records regarding reportable transactions, is $10,000 for each tax year with respect to which such failure occurs.143 A continuation penalty of $10,000 will be added for each 30-day period, or fraction thereof, that such failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.144 No penalties will be imposed if the failure is due to reasonable cause.145
Enforcement
Under Code Sec. 6038A, the IRS may issue a summons to enforce a request for certain records pursuant to Code Secs. 7602–7604.146 A taxpayer served with a summons may move to quash within 90 days after the summons is issued.147 In response to a determination by the IRS that a taxpayer has not substantially complied with a summons, the taxpayer has 90 days to appeal that determination or the determination becomes final and is not subject to judicial review.148 Any motion to quash or appeal of an adverse determination suspends the period of limitations for assessment and collection of the tax, and for criminal prosecution, during the pending action.149 A penalty will be asserted for failure to comply with the summons provisions of Code Sec. 6038A.150 If such a penalty is asserted, there is no reasonable cause relief.151
Criminal Violations
Willful failure to file a required Form 5472 constitutes a criminal offense under Code Sec. 7203.152
Form 926—Return by a U.S. Transferor of Property to a Foreign Corporation
U.S. persons, U.S. domestic corporations and domestic estates and trusts must report any exchanges of property to a foreign corporation as set forth in Code Sec. 6038B(a)(1)(A) and Reg. §§1.6038B-1 and 1.6038B-1T. The information is reported on a Form 926 and filed with the taxpayer’s income tax return for the tax year that includes the date of the transfer. There are certain exceptions to these filing requirements, as well as additional rules that must be considered for transfers by U.S. partnerships, transfers by a husband and wife, and transfers of cash to a foreign corporation.153
Penalties
The penalty for failing to file a Form 926 is 10 percent of the fair market value of the property at the time of the transfer, up to a maximum of $100,000 per return, with no limit if the failure to report the transfer was intentional.154 In addition, the period of limitations to assess tax due on the transfer is extended to three years after the required information under Code Sec. 6038B is provided. The penalty will not apply if the failure to file is due to reasonable cause.155
Limitations
In addition to the foregoing penalties, failure to file a complete and accurate Form 926 will extend the period of limitations on assessment and collection of any tax imposed with respect to any event or period to which the Form 926 applies to three years after the date on which the required information is reported.156
Form 3520—Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts
The Form 3520 reports various transactions involving foreign trusts, including creation of a foreign trust by a U.S. person, transfers of property from a U.S. person to a foreign trust and receipt of distributions from foreign trusts under Code Sec. 6048. This return also reports the receipt of gifts that, in the aggregate, exceed $10,000 from foreign entities under Code Sec. 6039F.157 Subject to certain exceptions set forth in the Instructions, you are required to file the Form 3520 in any of the following circumstances:
• You are the responsible party for reporting a reportable event that occurred during the current tax year, or you held an outstanding obligation of a related foreign trust (or a person related to the trust) that you treated as a qualified obligation during the current tax year.
• You are a U.S. person who, during the current tax year, is treated as the owner of any part of the assets of a foreign trust under the grantor trust rules.
• You are a U.S. person who received (directly or indirectly) a distribution from a foreign trust during the current tax year or a related foreign trust held an outstanding obligation issued by you (or a person related to you) that you treated as a qualified obligation during the current tax year.
• You are a U.S. person who, during the current tax year, received either:
• more than $100,000 from a nonresident alien individual or a foreign estate (including foreign persons related to that nonresident alien individual or foreign estate) that you treated as gifts or bequests; or
• more than $13,561 (adjusted each year) from foreign corporations or foreign partnerships (including foreign persons related to such foreign corporations or foreign partnerships) that you treated as gifts.
The Form 3520 is due on the same date as the related income or estate tax return (including extensions), but must be filed separately with the Internal Revenue Service Center, P.O. Box 409101, Ogden, UT 84409.
Penalties
The penalty for failing to file a complete and accurate Form 3520 with information required by Code Sec. 6048 is 35 percent of the gross reportable amount.158 For U.S. donees that fail to file the Form 3520, the penalty is five percent of the gift per month, up to 25 percent of the gift pursuant to Code Sec. 6039F(c)(1)(B). A continuation penalty of $10,000 will be added for each 30-day period, or fraction thereof, that such failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.159
Reasonable Cause
The total penalty cannot exceed the amount of money transferred. The penalties will not apply if the failure to file is due to reasonable cause and not willful neglect.160 The fact that a foreign country would impose penalties for disclosing the required information, or reluctance of a foreign fiduciary to provide such information, does not constitute reasonable cause.161
Limitations
In addition to the foregoing penalties, failure to file a complete and accurate Form 3520 will extend the period of limitations on assessment and collection of any tax imposed with respect to any event or period to which the Form 3520 applies to three years after the date on which the required information is reported.162
Judicial Review
Deficiency procedures do not apply to the initial monetary penalties assessed for failure to timely file a complete and accurate Form 3520.163 However, when the required information under Code Sec. 6048 is not provided, the IRS is authorized to treat any distribution from a foreign trust to a U.S. beneficiary as an accumulation distribution includible in gross income of the distributee.164 Moreover, when information required by Code Sec. 6039F is not provided to the IRS, it can determine the tax consequences of a gift.165 These determinations and related adjustments to tax are subject to deficiency procedures.166
Form 3520-A—Annual Information Return of Foreign Trust with a U.S. Owner
Any U.S. person with ownership interests in a foreign trust is responsible for ensuring that the trustee files a Form 3520-A for each tax year of the trust, setting forth a full and complete accounting of all trust activities and operations, Code Sec. 6048(b)(1)(A), and issues income information to each U.S. grantor and trust beneficiary who directly or indirectly receives a trust distribution for that year.167 The Form 3520-A is due on the 15th day of third month after the end of the trust’s tax year and is filed with the Internal Revenue Service Center, P.O. Box 409101, Ogden, UT 84409.
Penalties
The penalty for failing to file a Form 3520-A is five percent of the gross reportable amount.168 A continuation penalty of $10,000 will be added for each 30-day period, or fraction thereof, that such failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000 per return.169
Reasonable Cause
No penalties shall be imposed if the failure to file is due to reasonable cause and not willful neglect.170 The fact that a foreign country would impose penalties for disclosing the required information, or reluctance of a foreign fiduciary to provide such information, does not constitute reasonable cause.171
Judicial Review
Deficiency procedures do not apply to the penalties assessed under Code Sec. 6677.172
Criminal Violations
Willful failure to file a required Form 3520-A constitutes a criminal offense under Code Sec. 7203. Filing a false or fraudulent Form 3520-A falls within the scope of Code Secs. 7206 and 7207.
Form 8865—Return of U.S. Persons with Respect to Certain Foreign Partnerships
U.S. persons with certain interests in foreign partnerships must file Form 8865 to report interests in and transactions of the foreign partnerships (Code Sec. 6038) (category 1 and 2 filers), transfers of property to the foreign partnerships (Code Sec. 6038B) (category 3 filers), and acquisitions, dispositions and changes in foreign partnership interests (Code Sec. 6046A) (category 4 filers).173
Form 8865 must be attached to the related income tax return (or partnership or exempt organization return) or, if no income tax return is required, filed by the date and to the same place you would have filed that return.
Penalties
Penalties depend on the filing category. Category 1 and 2 filers who fail to timely submit all information required by Form 8865 face penalties of $10,000 for each year of each foreign partnership. An additional $10,000 penalty is imposed for 30-day period, or fraction thereof, that such the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to $50,000 per return. Those persons failing to submit the required information will also face a reduction in their foreign tax credits under Code Secs. 901, 902 and 960. Code Sec. 6038(c). Willful violations can also result in criminal penalties under Code Secs. 7203, 7206 and 7207.
Category 3 filers that fail to report a contribution to a foreign partnership that is required to be reported under Code Sec. 6038B can be assessed a penalty equal to 10 percent of the fair market value of the property at the time of the contribution, not to exceed $100,000 unless the failure is due to intentional disregard.174 In addition, the transferor must recognize gain on the contribution as if the contributed property had been sold for its fair market value at the time of the contribution.175
Category 4 filers who fail to properly report all the information requested by Code Sec. 6046A are subject to a $10,000 penalty.176 A continuation $10,000 penalty is imposed for 30-day period, or fraction thereof, that such the failure continues beginning 90 days after the taxpayer is notified of the delinquency, up to $50,000 per return. Those persons failing to submit the required information will also face a reduction in their foreign tax credits under Code Secs. 901, 902 and 960.177 As is the case with other penalties imposed under Code Sec. 6677, deficiency procedures to not apply.
Limitations
Failure to file a complete and accurate Form 8865 will extend the period of limitations on assessment and collection of any tax imposed with respect to any event or period to which the Form 8865 applies to three years after the date on which the required information is reported.178

Footnotes


*
I want to thank Lucy S. Lee, Caplin & Drysdale, Chartered in Washington, D.C., for laying a foundation with her article, Information Reporting and Civil Penalties (in a Nutshell), J. Tax Practice & Procedure, Apr.–May 2009, along with Steve Toscher and Michel R. Stein of Hochman, Salkin, Rettig, Toscher & Perez, P.C. for their seminal articles on this subject: FBAR Enforcement is Coming! J. Tax Practice & Procedure, Dec. 2003–Jan. 2004; FBAR Enforcement—An Update, J. Tax Practice & Procedure, Apr.–May 2006; and FBAR Enforcement—Five Years Later, J. Tax Practice & Procedure, June–July 2008. In reviewing this article, they will recognize their work and I have tried to give proper attribution. Thank you for letting us stand on your shoulders. Finally, I need to thank Diana L. Erbsen of DLA Piper US, LLP, and Paula M. Junghans of Zuckerman, Spaeder, LLP, whose time spent reviewing and editing this article is immensely appreciated.
1
12 USC §§1951–1959, 31 USC §§5311–5330.
2
See Lee A. Sheppard, FBAR Filing For Hedge Funds, Tax Notes, Aug. 10, 2009, at 509–18.
3
IRS Workbook on Report of Foreign Bank and Financial Accounts (last visited Sept. 7, 2009), www.irs.gov/businesses/small/article/0,,id=159757,00.html ("IRS Workbook").
4
IRM §4.26.16.3.7.3 (July 1, 2008).
5
TD F 90.22-1 (Revised Oct. 2008) ("Privacy Act Notification").
6
31 USC §5314; 31 CFR §103.24.
7
IRM §4.26.16.3.1 (July 1, 2008).
8
Announcement 2009-51, IRB 2009-25, 1105.

9
IRM §4.26.16.3.1.1; see also Arthur V. Pearson, Foreign Bank Account Reporting, www.camico.com/portal/server.pt?in_hi_space=SearchResult & in_hi_control=bannerstart & in_hi_userid=45684 & in_tx_query=FBAR, Murphy, Pearson, Bradley & Feeney, San Francisco, CA (2009).
10
New York State Bar Association, Tax Section, Request for Formal Guidance on FBAR Reporting Obligations (July 17, 2009), 2009 TNT 137-13; Letter from Managed Funds Assoc. to IRS Commissioner Shulman (June 19, 2009), Application of FBAR Requirements to Private Investment Funds.
11
IRS Workbook, supra note 3.
12
See Sheppard, supra note 2, at 517.
13
See United States v. Clines, 958 F2d 578, 582–83 (4th Cir. 1992).
14
IRS Workbook, supra note 3.
15
31 CFR §103.32.
16
IRM 4.26.16.3.8 (July 1, 2008).
17
Id.
18
See Treasury Directive 15-41 (Dec. 1, 1992), 31 CFR §103.56(b).
19
See 31 CFR §103.56(g); IR-2003-48 (Apr. 10, 2003).

20
IRM 4.26.16.2.2. (July 1, 2008).
21
31 CFR §103.56(c)(2); IRM §§4.26.16.4.1 (July 1, 2008) and 4.26.17.5.4 (May 5, 2008).
22
31 USC §5321(a)(5).
23
IRM §4.26.16.4.3.1 (July 1, 2008).
24
31 USC §5321(a)(5)(B)(i); Act Sec. 821(a) of P.L. 108-357.
25
IRS Workbook, supra note 3.
26
31 USC §5321(a)(5)(B)(ii); IRS Frequently Asked Questions Regarding Report of the Foreign Bank and Financial Accounts, Q & A 18 (Mar. 13, 2009).
27
IRM §4.26.16.4.4 (July 1, 2008) (emphasis added).
28
LMSB-4-0908-047 (Oct. 31, 2008).
30
Id.
31
IRS Voluntary Disclosure Frequently Asked Questions, Q & A 9 (May 6, 2009).
32
31 USC §5321(a)(5)(C)(ii).
33
IRM §4.26.16-1 (Pre–Oct. 23, 2004, Normal FBAR Civil Penalty Mitigation Guidelines) (July 1, 2008); see also Toscher & Stein, supra note *.
34
Id.
35
IRM §4.26.16-1 (Pre–Oct. 23, 2004, Normal FBAR Civil Penalty Mitigation Guidelines) (July 1, 2008).
36
IRM §4.26.16-2 (July 1, 2008).
37
IRM §4.26.16.4.6.1(3) (July 1, 2008).
38
IRM §4.26.16.4.6 (July 1, 2008).
39
IRM §4.26.16.4.7 (July 1, 2008).
40
W. Ratzlaf, SCt, 94-1 ustc ¶50,015, 510 US 135; IRM 4.26.16.4.5.3 (July 1, 2008).

41
CCA 200603026 (Jan. 20, 2006); Dollar Bank Money Market Account, 980 F2d 233, 238, note 2 (3d Cir. 1992).
42
See Sturman, 951 F2d 1466, 1476 (6th Cir. 1991); see also R.L. Lerch, 53 TCM 1101, Dec. 43,977(M), TC Memo. 1987-295 (court characterized failure to disclose foreign bank account, failure to report income from foreign bank account, and failure to file accurate FBARs as clear and convincing evidence of fraud for purposes of Code Sec. 6653(b)).

43
Id. (citing J.L. Check, SCt, 91-1 ustc ¶50,012, 498 US 192; M.R. Spies, SCt, 43-1 ustc ¶9243, 317 US 492).

44
Sturman, supra note 42, 951 F2d, at 1476.
45
Id., at 1477.
46
Id.; see also Bank of New England, N.A., 821 F2d 844, 855 (1st Cir. 1987) (finding willfulness can be inferred from a conscious effort to avoid learning about reporting requirements); IRM §4.26.16.4.5.3 (July 1, 2008) (examples of willfulness).
47
United States—Switzerland, 27 U.S.T. 209, T.I.A.S. 8302 (May 25, 1973).
48
Sturman, supra note 42, 951 F2d, at 1480–81 (citing Salim, 855 F2d 944, 953 (2d Cir. 1988), and Casamento, 887 F2d 1141, at 1172–75 (2d Cir. 1989)).
49
CCA 200603026 (Jan. 20, 2006).
50
See IRM 4.26.16.4.5.4 (July 1, 2008) (list of documents helpful in establishing willfulness).
51
18 USC §3282.
52
IRM §4.26.17.3.1 (May 5, 2008).
53
31 USC §5321(b)(2).
54
IRM §4.26.17.5.5.2 (Jan. 1, 2007).
55
IRM §4.26.17.1 (May 5, 2008).
56
Id.
57
IRM §4.26.17.2 (Jan. 1, 2007).
58
LMSB-4-0908-047 (Oct. 30, 2008).
59
IRM §4.26.17.2.1 (Jan. 1, 2007).
60
Id.
61
IRM §4.26.17.2.2 (May 5, 2008).
62
Id.
63
Id.
64
IRM §4.26.17.2.3 (May 5, 2008).
65
IRM §4.26.17.3 (May 5, 2008).
66
IRM §4.26.17.3 (May 5, 2008).
67
IRM §4.26.17.4.3 (May 5, 2008) (Counsel review is not required if a taxpayer enters a special program, such as the Last Chance Compliance Initiative in 2003 or the current Offshore Voluntary Disclosure Program).
68
IRM §4.26.17.4.3 (May 5, 2008).
69
31 USC §3717(b).
70
IRM §4.26.17.4.3 (May 5, 2008).
71
IRM §4.26.17.4.6 (Jan. 1, 2007).
72
IRM §4.26.17.4.7 (Jan. 1, 2007).
73
Id.
74
Id.
75
Id.
76
IRS Technical Guidance Programs, www.irs.gov/individuals/article/0,,id=128327,00.html (last visited Sept. 11, 2009).
77
J.B. Williams III, 131 TC No. 6 (Oct. 2, 2008), at *3.
78
Id., at *3–4, note 4–5; see also Callahan, 130 TC 44, 48 (2008) (court has jurisdiction to review collection efforts directed to assessable penalties not otherwise subject to deficiency procedures); Mason, 132 TC No. 14 (May 6, 2009) (court considered liability for trust fund recovery penalty under Code Sec. 6672).

79
Williams, supra note 75, at *4, note 6.
80
31 USC §5321(b)(2); 28 USC §§1345 and 1346(a).
81
31 USC §5321(b)(2); 28 USC §1345.
82
United States v. Simonelli, 614 FSupp2d 241 (D. Conn. 2008).
83
See Tull v. United States, 481 US 412, 425 (1987) (finding right to jury trial in suit by government to assess penalties under Clean Water Act).
84
Simonelli, supra note 82, 614 FSupp2d, at 242 (quoting Kelly v. Robinson, 479 US 36, 52 (1986)).
85
11 USC §§523(a)(7)(A), (B).
86
11 USC §532(a)(7)(B).
87
Simonelli, supra note 82, 614 FSupp2d, at 243.
88
Id.
89
Simonelli, supra note 82, 614 FSupp2d, at 244 (citing 29 CFR §§103.56(g) (2004) (authorizing the IRS "to assess and collect civil penalties under 31 U.S.C. §5321 ... [and] investigate possible civil violations of these provisions")).
90
IRM §4.26.17.5.6. (Jan. 1, 2007).
91
31 USC §5322(a); see McCarthy, CR No. 09-00784 (C.D. Calif.) (Aug. 14, 2009) (plea to failing to file FBAR (31 USC §5322(a)), civil FBAR penalties equal to 50 percent of highest year balance in the account (31 USC §5321(a)(5)), and 75-percent civil tax fraud penalty (Code Sec. 6663)); Clines, 958 F2d 578 (4th Cir. 1992) (defendant convicted of FBAR violation under 31 USC §5322); Sturman, supra note 42, 951 F2d, at 1473 (defendant convicted of FBAR violation under 31 USC §5322).
92
31 USC §5322(b).
93
Chernick, CR No. 09-60182 (S.D. Fl.) (July 13, 2009) (plea to filing false return under Code Sec. 7206(1) for failing to disclose interest in foreign account); Rubenstein, CR No. 09-60166 (S.D. Fl.) (June 25, 2009) (plea to filing false return under Code Sec. 7206(1) for failing to disclose interest in foreign account); Gosman, CR No. 09-80041 (S.D. Fl.) (Mar. 27, 2009) (plea to filing false return under Code Sec. 7206(1) for failing to disclose interest in foreign account); King, 2000 WL 362026 (W.D.N.Y. March 24, 2000) (court rejects argument that failure to answer question on income tax return regarding filer’s interest in a foreign account is not a material omission or affirmatively false statement for purposes of Code Sec. 7206(1)); R.D. Franks, CA-10, 84-1 ustc ¶9118, 723 F2d 1482, 1485 (affirming convictions for filing false returns under Code Sec. 7206(1) for failing to disclose foreign accounts, where defendants also convicted of evasion under Code Sec. 7201 for the same years).

94
See Comisky, Feld & Harris, Tax Fraud & Evasion, WG & L §11.06[3][b].
95
18 USC §3282; see also Lowry, 409 FSupp2d 732, 740–41 (W.D. Va. 2006).
96
Clines, supra note 91.
97
31 USC §5312(a)(2)(C); 31 CFR §103.11(e)(1).
98
31 USC §5312(a)(2)(I).
99
31 USC §5312(a)(2)(R)); 31 CFR §103.11(e)(5).
100
Clines, supra note 91, at 582.
101
Id., at 583.
102
Id.
103
IRM §§20.1.9.1.1 and 20.1.9.2 (Nov. 20, 2007); see also Wheaton, 888 FSupp 622, 625–26 (D.N.J. 1995).
104
Id.
105
Reg. §1.6038-2; IRM §20.1.9.3.1 (Nov. 20, 2007).

106
See Heydemann, 2008 WL 2502188 (D. Md. Apr. 23, 2008).
107
The Form 5471 Instructions define each category as follows:
• Category 1 Filer. This filing requirement was repealed by Act Sec. 413(c)(26) of the American Jobs Creation Act of 2004.
• Category 2 Filer. This includes a U.S. citizen or resident who is an officer or director of a foreign corporation in which a U.S. person (defined below) has acquired (in one or more transactions): stock which meets the 10 percent stock ownership requirement (described below) with respect to the foreign corporation or an additional 10 percent or more (in value or voting power) of the outstanding stock of the foreign corporation. A U.S. person has acquired stock in a foreign corporation when that person has an unqualified right to receive the stock, even though the stock is not actually issued. See Reg. §1.6046-1(f)(1) for more details.
• Stock ownership requirement. For purposes of Category 2 and Category 3, the stock ownership threshold is met if a U.S. person owns: 10 percent or more of the total value of the foreign corporation’s stock; or 10 percent or more of the total combined voting power of all classes of stock with voting rights.
• U.S. person. For purposes of Category 2 and Category 3, a U.S. person is: a citizen or resident of the United States; a domestic partnership; a domestic corporation; and an estate or trust that is not a foreign estate or trust defined in Code Sec. 7701(a)(31). See Regulations §1.6046-1(f)(3) for exceptions.
• Category 3 Filer. This category includes: a U.S. person (defined above) who acquires stock in a foreign corporation which, when added to any stock owned on the date of acquisition, meets the 10 percent stock ownership requirement (described above) with respect to the foreign corporation; a U.S. person who acquires stock which, without regard to stock already owned on the date of acquisition, meets the 10 percent stock ownership requirement with respect to the foreign corporation; a person who is treated as a U.S. shareholder under §953(c) with respect to the foreign corporation; a person who becomes a U.S. person while meeting the 10 percent stock ownership requirement with respect to the foreign corporation; or a U.S. person who disposes of sufficient stock in the foreign corporation to reduce his or her interest to less than the stock ownership requirement. For more information, see Code Sec. 6046 and Reg. §1.6046-1.
• Category 4 Filer. This includes a U.S. person who had control (defined below) of a foreign corporation for an uninterrupted period of at least 30 days during the annual accounting period of the foreign corporation.
• U.S. person. For purposes of Category 4, a U.S. person is: a citizen or resident of the United States; a nonresident alien for whom an election is in effect under Code Sec. 6013(g) to be treated as a resident of the United States; an individual for whom an election is in effect under Code Sec. 6013(h), relating to nonresident aliens who become residents of the United States during the tax year and are married at the close of the tax year to a citizen or resident of the United States; a domestic partnership; a domestic corporation; and an estate or trust that is not a foreign estate or trust defined in Code Sec. 7701(a)(31). See Reg. §1.6038-2(d) for exceptions.
• Control. A U.S. person has control of a foreign corporation if, at any time during that person’s tax year, it owns stock possessing: more than 50 percent of the total combined voting power of all classes of stock of the foreign corporation entitled to vote or more than 50 percent of the total value of shares of all classes of stock of the foreign corporation. A person in control of a corporation that, in turn, owns more than 50 percent of the combined voting power, or the value, of all classes of stock of another corporation is also treated as being in control of such other corporation. For more details on "control," see Regs. §§1.6038-2(b) and (c).
• Example. Corporation A owns 51 percent of the voting stock in Corporation B. Corporation B owns 51 percent of the voting stock in Corporation C. Corporation C owns 51 percent of the voting stock in Corporation D. Therefore, Corporation D is controlled by Corporation A.
• Category 5 Filer. This includes a U.S. shareholder who owns stock in a foreign corporation that is a CFC for an uninterrupted period of 30 days or more during any tax year of the foreign corporation, and who owned that stock on the last day of that year.
• U.S. shareholder. For purposes of Category 5, a U.S. shareholder is a U.S. person who: (1) owns (directly, indirectly, or constructively, within the meaning of Code Secs. 958(a) and (b)) 10 percent or more of the total combined voting power of all classes of voting stock of a CFC or (2) owns (either directly or indirectly, within the meaning of Code Sec. 958(a)) any stock of a CFC (as defined in Code Sec. 953(c)(1)(B) and 957(b)) that is also a captive insurance company.
• U.S. person. For purposes of Category 5, a U.S. person is: a citizen or resident of the United States; a domestic partnership; a domestic corporation; and an estate or trust that is not a foreign estate or trust defined in Code Sec. 7701(a)(31). See Code Sec. 957(c) for exceptions.
• CFC. A CFC is a foreign corporation that has U.S. shareholders that own (directly, indirectly, or constructively, within the meaning of Code Secs. 958(a) and (b)) on any day of the tax year of the foreign corporation, more than 50 percent of: the total combined voting power of all classes of its voting stock; or the total value of the stock of the corporation.
108
Heydemann, supra note 106 (affirming penalties imposed under Code Sec. 6038).

109
Code Sec. 6679(a)(1).

110
Code Sec. 6038(b)(1).

111
Code Sec. 6038(b)(2); Code Sec. 6679(a)(2); IRM §20.1.9.2 (Nov. 20, 2007).

112
IRM §20.1.9.2 (Nov. 20, 2007).
113
Id.
114
Id.; Code Sec. 6751.

115
Code Sec. 6038(c)(3).

116
Code Sec. 6501(c)(8).

117
See www.irs.gov/businesses/corporations/article/0,,id=188039,00.html (last visited Sept. 12, 2009).
118
IRM §20.1.9.1.1 (Nov. 20, 2007).
119
IRM §20.1.9.2 (Nov. 20, 2007).
120
Reg. §1.6038-2(k)(3)(ii); see also Code Sec. 6679(a) (imposing penalties for failure to provide information required by Code Sec. 6046 "unless it is shown that such failure is due to reasonable cause").
121
IRM §20.1.9.1.1 (Nov. 20, 2007) (referencing IRM §20.1.1).
122
IRM §20.1.9.2 (Nov. 20, 2007).
123
Id.; see also CCA 200645023 (Nov. 10, 2006) (request for reasonable cause relief denied based on large number of incomplete Forms 5471 filed and despite history of compliance and belief that Forms 5471 were not required).
124
IRM §20.1.9.1.
125
Instructions to Form 5471.
126
www.irs.gov/businesses/corporations/article/0,,id=188039,00.html (last visited Sept. 12, 2009).
127
IRM §20.1.9.2.3 (Nov. 20, 2007).
128
TAS Guidelines for Referral, IRM §21.1.3.18; TAS Criteria, IRM §13.1.7.2.
129
Code Sec. 6330(d)(1); Wagenknecht, 533 F3d 412, 415, note 3 (6th Cir. 2008) (recognizing expansion of U.S. Tax Court jurisdiction in collection due process appeals by the Pension Protection Act of 2006 (P.L. 109-280), Act Sec. 855).
130
28 USC §1346(a); see also Wheaton, supra note 103, 888 FSupp, at 627 (citing W.W. Flora, SCt, 60-1 ustc ¶9347, 362 US 145).

131
Wheaton, supra note 103.
132
Id. (citing Iannelli v. Long, CA-3, 73-2 ustc ¶16,098, 487 F2d 317, 318 (Anti-Injunction Act "reflects an evident purpose to protect the public revenue from court imposed delays in the collection of taxes, leaving aggrieved taxpayers to sue for refunds of any amounts improperly collected").
133
Wheaton, supra note 103, arose prior to the enactment of the collection appeal procedures in Code Secs. 6320 and 6330.

134
Wheaton, supra note 103, at 625.
135
Code Sec. 6665(b)(1).

136
Wheaton, supra note 103, at 626.
137
Heydemann, supra note 106.
138
Id.
139
Id. (citing Wheaton, supra note 103, 888 FSupp, at 625–26).
140
Id.
141
Reg. §1.6038-2(k)(4).

142
Reg. §1.6038A-2.

143
Code Sec. 6038A(d)(1).

144
Code Sec. 6038A(d)(2).

145
Code Sec. 6038A(d)(3); Reg. §1.6038A-4(b).

146
Code Sec. 6038A(e)(2).

147
Code Sec. 6038A(e)(4)(A).

148
Code Sec. 6038A(e)(4)(B).

149
Code Sec. 6038A(e)(4)(D).

150
See Code Sec. 6038A(e)(3).

151
IRM §20.1.9.6.1 (Nov. 20, 2007).
152
Code Sec. 6038A(f).

153
See Instructions to Form 926.
154
Code Sec. 6038B(c).

155
Code Sec. 6038B(c)(2).

156
Code Sec. 6501(c)(8).

157
See Notice 97-34 1997-1 CB 422.

158
Code Sec. 6677(a).

159
Id.
160
Code Secs. 6039F(c)(2) and 6677(d).

161
Code Sec. 6677(d).

162
Code Sec. 6501(c)(8).

163
Code Sec. 6677(e).

164
Code Sec. 6048(c)(2).

165
Code Sec. 6039F(c)(1)(A).

166
IRM §20.1.9.10 (Nov. 20, 2007).
167
Code Sec. 6048(b)(1)(B).

168
Code Sec. 6677(b).

169
Code Sec. 6677(a).

170
Code Sec. 6677(d).

171
Code Sec. 6677(d).

172
Code Sec. 6677(e).

173
Category 1 filer. A Category 1 filer is a U.S. person who controlled the foreign partnership at any time during the partnership’s tax year. Control of a partnershkjhgspoisaip is ownership of more than a 50 percent interest in the partnership. There may be more than one Category 1 filer for a partnership for a particular partnership tax year.
• Category 2 filer. A Category 2 filer is a U.S. person who at any time during the tax year of the foreign partnership owned a 10 percent or greater interest in the partnership while the partnership was controlled by U.S. persons each owning at least 10 percent interests. However, if the foreign partnership had a Category 1 filer at any time during that tax year, no person will be considered a Category 2 filer.
• Category 3 filer. A Category 3 filer is a U.S. person who contributed property during that person’s tax year to a foreign partnership in exchange for an interest in the partnership (a Code Sec. 721 transfer), if that person either: (1) owned directly or constructively at least a 10 percent interest in the foreign partnership immediately after the contribution, or (2) the value of the property contributed (when added to the value of any other property contributed to the partnership by such person, or any related person, during the 12-month period ending on the date of transfer) exceeds $100,000. If a domestic partnership contributes property to a foreign partnership, the domestic partnership’s partners are considered to have transferred a proportionate share of the contributed property to the foreign partnership. However, if the domestic partnership files Form 8865 and properly reports all the required information with respect to the contribution, its partners will not be required to report the transfer. Category 3 also includes a U.S. person that previously transferred appreciated property to the partnership and was required to report that transfer under Code Sec. 6038B, if the foreign partnership disposed of such property while the U.S. person remained a direct or indirect partner in the partnership.
• Category 4 filer. A Category 4 filer is a U.S. person that had a reportable event under Code Sec. 6046A during that person’s tax year. There are three categories of reportable events under Code Sec. 6046A: acquisitions, dispositions, and changes in proportional interests.
174
Code Sec. 6038B(c).

Badges of fraud analys - also loan vs dividend

Attached is most of the discussion of two issues. The badges of fraud analysis is classic, but it helps in cases where there is a filed retun and only one or two "badges of fraud." I think the dividend result should have been avoided by an argument that the funds received were "compensation" for services.

Mohammad Enayat v. Commissioner. Woodbury Rug Company, Inc., v. Commissioner., U.S. Tax Court, CCH Dec. 57,988(M), T.C. Memo. 2009-257, (Nov. 10, 2009)


U.S. Tax Court, Dkt. Nos. 1488-07, 1489-07, TC Memo. 2009-257, November 10, 2009.

A rug dealer, who operated his business as a wholly owned C corporation in some years and as a single-member limited liability company (LLC) in other years, had unreported constructive dividend income and unreported officer's compensation from the corporation and additional income from the LLC, and the corporation had unreported gross receipts. Checks made payable to the corporation that were deposited in his personal accounts were constructive dividends and he offered insufficient evidence to refute this determination. The IRS used the bank deposit method to reconstruct income since his records were extremely sloppy. Although he argued that the bank deposit analysis was flawed, he failed to show that any distributions he received were repayments of loans rather than compensation. He was denied a capital loss deduction on the sale of investment real estate because he failed to substantiate any additions to basis beyond the purchase price of the real estate. He was liable for an addition to tax for his failure to timely file his tax returns for the four years at issue since he did not show that he exercised reasonable care. In addition, he was liable for the fraud penalty for three of those years because he failed to report income that he later conceded he should have reported, namely gambling winnings, rental income, business interruption insurance payments, and misappropriated funds from a stolen check. Although the IRS issued notices of deficiency more than three years after the personal returns were filed, the assessments were not barred because the filed returns were fraudulent. In the case of the nonfraudulent return, assessment is not barred because the rug dealer omitted more than 25 percent of the gross income stated on the return. Even though the corporate return was not timely filed in the first year, an additional deduction for the amount of the compensation determined paid to the rug dealer brought the tax liability to zero; therefore, any addition to tax and penalty would also be zero since based on a percentage of the zero underpayment. The corporation was liable for the penalty for fraudulent failure to file a tax return in the second tax year. The IRS could assess at any time with regard to the corporation since gross receipts were fraudulently understated on one return and no return was filed for the other tax year. The rug dealer did not have additional income from money transferred to him that was actually a debt he owed to the transferror since he remained obligated on the debt.
.
OPINION
I. Unreported Income of Woodbury and Sutter
Mr. Enayat operated his rug business through Woodbury in 1998 and 1999 and through Sutter in 1999 through 2001, kept sloppy records for both entities, and failed to report much of their income. Taxpayers bear the responsibility to maintain books and records that are sufficient to establish their income. See sec. 6001; DiLeo v. Commissioner, 96 T.C. 858, 867 (1991), affd. 959 F.2d 16 (2d Cir. 1992); sec. 1.446-1(a)(4), Income Tax Regs. (26 C.F.R.); see also Estate of Mason v. Commissioner, 64 T.C. 651, 656 (1975), affd. 566 F.2d 2 (6th Cir. 1977). Mr. Enayat failed to fulfill that responsibility both as to himself and as to his C corporation, Woodbury.
A. The IRS's Use of the Bank Deposits Method
When a taxpayer fails to keep adequate books and records, the IRS is authorized to determine the existence and amount of the taxpayer's income by any method that clearly reflects income. Sec. 446(b); Mallette Bros. Constr. Co. v. United States, 695 F.2d 145, 148 (5th Cir. 1983); Webb v. Commissioner, 394 F.2d 366, 371-372 (5th Cir. 1968), affg. T.C. Memo. 1966-81; see also Holland v. United States, 348 U.S. 121, 131-132 (1954). The IRS's reconstruction of a taxpayer's income need only be reasonable in light of all surrounding facts and circumstances. Schroeder v. Commissioner, 40 T.C. 30, 33 (1963); see also Giddio v. Commissioner, 54 T.C. 1530, 1533 (1970). The IRS is given latitude in determining which method of reconstruction to apply when taxpayers fail to maintain adequate books and records. Boyett v. Commissioner, 204 F.2d 205, 208 (5th Cir. 1953), affg. a Memorandum Opinion of this Court; Kenney v. Commissioner, 111 F.2d 374, 375 (5th Cir. 1940), affg. a Memorandum Opinion of this Court; Petzoldt v. Commissioner, 92 T.C. 661, 693 (1989).
II. Income Mr. Enayat Did Not Report
Whether a withdrawal of funds by a shareholder from a corporation or an advance made by a shareholder to a corporation creates a true debtor-creditor relationship is a factual question to be decided on the basis of all of the relevant facts and circumstances. Haag v. Commissioner, 88 T.C. 604, 615 (1987), affd. without published opinion 855 F.2d 855 (8th Cir. 1988); see also Haber v. Commissioner, 52 T.C. 255, 266 (1969), affd. 422 F.2d 198 (5th Cir. 1970); Roschuni v. Commissioner, 29 T.C. 1193, 1201-1202 (1958), affd. 271 F.2d 267 (5th Cir. 1959). For disbursements to constitute true loans, there must have been, at the time that the funds were transferred, an unconditional obligation on the part of the transferee to repay the money and an unconditional intention on the part of the transferor to secure repayment. Haag v. Commissioner, supra at 615-616; see also Haber v. Commissioner, supra at 266. Direct evidence of a taxpayer's state of mind is generally unavailable, so courts have focused on certain objective factors to distinguish repayments of bona fide loans from disguised dividends, compensation, and returns of capital. The factors considered relevant for purposes of identifying bona fide loans include (1) the existence or nonexistence of a debt instrument; (2) provisions for security, interest payments, and a fixed payment date; (3) treatment of the funds on the corporation's books; (4) whether repayments were made; (5) the extent of the shareholder's participation in management; and (6) the effect of the “loan” on the shareholder/employee's salary. Haber v. Commissioner, supra at 266; see also United States v. Stewart ( In re Indian Lake Estates, Inc.), 448 F.2d 574, 578-579 (5th Cir. 1971); Haag v. Commissioner, supra at 616-617 & n.6. When the individuals are in substantial control of the corporation, as Mr. Enayat was in this case, such control invites a special scrutiny of the situation. Haber v. Commissioner, supra at 266; Roschuni v. Commissioner, supra at 1202. For the reasons set forth below, we conclude that the facts of record do not support Mr. Enayat's attempt to characterize the distributions that he received from Woodbury in 1998 and 1999 as repayments of bona
That is, we conclude that Mr. Enayat did not give and receive transfers pursuant to a true debtor-creditor relationship with Woodbury. Rather, Mr. Enayat treated Woodbury's bank accounts as if they were his personal accounts, depositing and withdrawing funds at will. Accordingly, we find that the transfers made from Woodbury to Mr. Enayat during 1998 and 1999 did not constitute repayments of bona fide loans, but instead represented compensation to Mr. Enayat. Therefore, we find, as the IRS determined, that Woodbury paid Mr. Enayat officer's compensation income of $349,356 in 1998 and $67,200 in 1999 by transferring funds to his personal accounts. 34 (This finding is adverse to Mr. Enayat but is favorable to his C corporation Woodbury, as we explain below.)
B. Transfer From Dr. Willitts
We have found that in 1998 Mr. Enayat received $455,485 from Dr. Willitts, which Mr. Enayat was obliged to pay back to Dr. Willitts at his instruction (originally expected to be in rials in Iran). Mr. Enayat freely used the money for his rug business and his own options trading, and he substantiated repayments of only $148,899. The IRS determined that Mr. Enayat's use of those funds for his own purposes demonstrates that he embezzled, stole, or misappropriated those funds from Dr. Willitts and that once he did so the funds became income to him. Under section 61(a), “gross income means all income from whatever source derived”. The Supreme Court “has given a liberal construction to the broad phraseology of the ‘gross income’ definition statutes in recognition of the intention of Congress to tax all gains except those specifically exempted.” James v. United States, 366 U.S. 213, 219 (1961) (citing Commissioner v. Jacobson, 336 U.S. 28, 49 (1949), and Helvering v. Stockholms Enskilda Bank, 293 U.S. 84, 87-91 (1934)). The Supreme Court held that embezzled funds and, more generally, “wrongful appropriations” are includable in gross income. Id. at 219-220.
However, Mr. Enayat's uncontradicted explanation of his arrangement with Dr. Willitts was that he was to deliver rials in Iran in exchange for dollars received in the United States, without any restriction on his use of the dollars he received because both parties understood that the rials provided in Iran would come from a different source. The record indicates an express obligation by Mr. Enayat to repay the money to Dr. Willitts—in rials if Dr. Willitts had made it to Iran, or if not then in dollars as affirmed in the November 1999 Agreement and Release. Mr. Enayat repaid some of the funds on demand and a portion later. None of these facts demonstrates that Mr. Enayat wrongfully appropriated Dr. Willitts's money; rather, he owed a debt to Dr. Willitts.
Generally, a taxpayer must recognize income from the discharge of indebtedness. Sec. 61(a)(12); United States v. Kirby Lumber Co., 284 U.S. 1 (1931). “The moment it becomes clear that a debt will never have to be paid, such debt must be viewed as having been discharged.” Cozzi v. Commissioner, 88 T.C. 435, 445 (1987). There is no evidence that such a moment had arrived during the years in issue with respect to Mr. Enayat's obligation to repay Dr. Willitts. On the contrary, Dr. Willitts petitioned a New Hampshire State court in late 1999 for attachment of Mr. Enayat's assets. Mr. Enayat had not fully repaid Dr. Willitts during the years in issue, but there is no evidence that Dr. Willitts had released Mr. Enayat from his repayment obligation in any year before us.
. Enayat is liable for the section 6651(a)(1) addition to tax for all four of those years. Section 6651(a)(1) imposes an addition to tax for failure to file a timely return, unless the taxpayer establishes that the failure did not result from “willful neglect” and that the failure was due to “reasonable cause”. “Willful neglect” has been interpreted to mean a conscious, intentional failure or reckless indifference. United States v. Boyle, 469 U.S. 241, 245-246 (1985). “Reasonable cause” requires the taxpayer to demonstrate that the taxpayer exercised ordinary business care and prudence and was nevertheless unable to file a return within the prescribed time. Id. at 246; sec. 301.6651-1(c)(1), Proced. & Admin. Regs.
Mr. Enayat has not shown or even argued that he exercised reasonable care with regard to his failure to file his returns. We find that Mr. Enayat is liable for the section 6651(a)(1) addition to tax for taxable years 1998, 1999, 2000, and 2001.
2. Fraud Penalty Under Section 6663(a)
The IRS determined that Mr. Enayat is liable for the fraud penalty under section 6663(a) for fraudulently understating his income on his 1998, 1999, 2000, and 2001 income tax returns. Section 6663(a) imposes a penalty equal to 75 percent of the portion of any underpayment attributable to fraud.
a. Legal Principles Regarding Fraud
Respondent has the burden of proving fraud by clear and convincing evidence. See sec. 7454(a); Rule 142(b); Parks v. Commissioner, 94 T.C. 654, 660 (1990). Respondent must prove by clear and convincing evidence (1) that Mr. Enayat underpaid his taxes in each year and (2) that Mr. Enayat intended to evade taxes by conduct intended to conceal, mislead, or otherwise prevent tax collection. See Parks v. Commissioner, supra at 660-661. Fraud is an actual wrongdoing with an intent to evade a tax believed to be owing. Marshall v. Commissioner, 85 T.C. 267, 272 (1985). Fraud is never presumed and must be established by independent evidence of fraudulent intent. Petzoldt v. Commissioner, 92 T.C. at 699. Accordingly, the existence of fraud is a question of fact that a court must consider on the basis of an examination of the entire record and the taxpayer's entire course of conduct. Id. However, “Fraud ‘does not include negligence, carelessness, misunderstanding or unintentional understatement of income.’” Zhadanov v. Commissioner, T.C. Memo. 2002-104 (quoting United States v. Pechenik, 236 F.2d 844, 846 (3d Cir. 1956)). If respondent shows that any part of an underpayment is due to fraud, the entire underpayment is treated as due to fraud unless Mr. Enayat shows by a preponderance of the evidence that part of the underpayment is not due to fraud. See sec. 6663(b).
Courts have developed a nonexclusive list of factors that demonstrate fraudulent intent. These “badges of fraud” include: (1) understating income; (2) maintaining inadequate records; (3) implausible or inconsistent explanations of behavior; (4) concealment of income or assets; (5) failing to cooperate with tax authorities; (6) engaging in illegal activities; (7) an intent to mislead which may be inferred from a pattern of (3) conduct; (8) lack of credibility of the taxpayer's testimony; (9) filing false documents; (10) failing to file tax returns; and (11) dealing in cash. Spies v. United States, 317 U.S. 492, 499 (1943); Douge v. Commissioner, 899 F.2d 164, 168 (2d Cir. 1990); Bradford v. Commissioner, 796 F.2d 303, 307-308 (9th Cir. 1986), affg. T.C. Memo. 1984-601; Recklitis v. Commissioner, 91 T.C. 874, 910 (1988). Although no single factor is necessarily sufficient to establish fraud, the combination of a number of factors constitutes persuasive evidence. Solomon v. Commissioner, 732 F.2d 1459, 1461 (6th Cir. 1984), affg. per curiam T.C. Memo. 1982-603.
Respondent contends that the following badges of fraud are present with respect to Mr. Enayat: (1) understating income, (2) maintaining inadequate records, (3) implausible or inconsistent explanations of behavior, (4) concealment of assets, (5) engaging in illegal activities, (6) lack of credibility in testimony, (7) dealing extensively in cash, (8) pattern of conduct which implies an intent to mislead, and (9) failing to file tax returns.
b. Mr. Enayat's Underpayments Due to Fraud
We find some of those badges of fraud to be present in this case. First, Mr. Enayat understated his income for every year at issue. Second, Mr. Enayat admittedly maintained inadequate records. Third, Mr. Enayat engaged in illegal activities (i.e., theft). Fourth, Mr. Enayat dealt extensively in cash. Fifth, Mr. Enayat has exhibited a pattern of conduct which implies an intent to mislead by admittedly receiving income in 1998, 2000, and 2001 that he did not report on his income tax returns, yet offering no explanation for his failure to do so. Lastly, Mr. Enayat failed to timely file his tax return for every year at issue. As a result, we find Mr. Enayat's actions were intended to conceal, mislead, or otherwise prevent tax collection.
Specifically, we find that Mr. Enayat's failure to report income he now concedes he should have reported—i.e., $16,800 in gambling income in 1998, $2,000 in rental income in 1998, $201,929 in insurance proceeds in 2000, and $113,800 in theft income in 2001—was fraudulent. These were not trivial amounts that might have been overlooked or forgotten. Mr. Enayat offered no explanation for how he could have filed a tax return for any of these years and omitted these items out of carelessness or negligence. On the basis of Mr. Enayat's concession and our finding of fraud, we find that respondent has shown that some portion of Mr. Enayat's underpayment in each of the three years involving those items—1998, 2000, and 2001—was due to fraud. As a result, the entire underpayment for each of those years is treated as due to fraud unless Mr. Enayat shows by a preponderance of the evidence that part of the underpayment is not due to fraud. See sec. 6663(b).
c. Mr. Enayat's Underpayments Not Due to Fraud
i. Capital Loss
As for taxable year 1998, we have already found that failure to report $16,800 in gambling income and $2,000 in rental income was fraudulent. With respect to the capital loss claimed by Mr. Enayat on the sale of the Elm Street property but disallowed in the notice of deficiency and in this opinion, we do not find Mr. Enayat's actions to be fraudulent. Mr. Enayat disclosed the sale of the property on his return by claiming a loss, and it was his failure to prove his basis in the property that resulted in the capital gain. Mr. Enayat's failure to report this capital gain was due to his negligence in not properly substantiating his renovation expenses. As a result, we do not find fraud in this particular issue.
ii. Woodbury Checks and Transfers
The rest of Mr. Enayat's underreporting of income for taxable year 1998 results from our finding that he received $203,273 in dividend income from checks payable to Woodbury, as well as $349,356 in officer's compensation transferred to him from Woodbury, totaling $552,629. On the totality of facts, we do not find these transactions to be fraudulent, despite their magnitude.
In 1998 money flowed back and forth between Woodbury and Mr. Enayat in roughly equal amounts. In 1998 Woodbury gave Mr. Enayat a total of $552,629, while Mr. Enayat gave Woodbury $548,188 ($346,238 in capital contributions mistakenly characterized as shareholder loans by Mr. Enayat, and $201,950 in redeposits of diverted checks). While we do not approve of the haphazard flow of money between the two, or of Mr. Enayat's using Woodbury's accounts as his personal checking accounts, we have addressed those issues in deciding whether these transactions resulted in taxable income to Mr. Enayat. Under our opinion, Mr. Enayat is liable for income tax on his end of those transfers, and we have held that the rough balance in money given and received does not excuse his liability. However, what cannot be ignored is that of all the money that flowed between the two, the total amounts going either way were very close—$552,629 versus $548,188. As a result, we do not find that Mr. Enayat intended to conceal, mislead, or otherwise prevent tax collection in his dealings with Woodbury in taxable year 1998. His error—i.e., his assumption that the rough equivalence of the back-and-forth transfers eliminated their taxability—amounted to negligence but not fraud.
We likewise find that to be so for the year 1999. Throughout 1999 Woodbury made transfers to Mr. Enayat totaling $98,723 (i.e., $67,200 in direct transfers and $31,723 in diverted checks), while Mr. Enayat made transfers to Woodbury totaling $164,429 (all in capital contributions mistakenly considered shareholder loans by Mr. Enayat, because Mr. Enayat did not redeposit any of the diverted checks in 1999). Again, because throughout 1999 he actually transferred more money to Woodbury than he received—$164,429 versus $98,723—we find that Mr. Enayat's non-reporting of this income was negligent but not fraudulent.
The only other unreported income in taxable year 1999 was $1,228 in gross receipts for Sutter. In the broader context of the facts of this case, these receipts were de minimis, and we do not find that Mr. Enayat fraudulently tried to hide this small amount. As a result, we do not find any fraud with respect to taxable year 1999.
However, the same cannot be said for Mr. Enayat's underreporting of Sutter's gross receipts in taxable year 2000. As we already decided, Mr. Enayat fraudulently failed to report $201,929 in insurance proceeds in 2000. As a result, the entire underpayment will be treated as attributable to fraud, absent proof as to non-fraudulent portions. See sec. 6663(b). This places the burden on Mr. Enayat to show that his failure to report $252,721 in gross receipts for Sutter in 2000 was not fraudulent. He has failed to do so. Mr. Enayat did argue that the IRS's bank deposits analysis was flawed and that he accurately reported Sutter's gross receipts because he reported the figure shown on his sales report, but we have already disposed of those challenges and found them to be without merit. Mr. Enayat has introduced no other evidence to persuade us that such a substantial understatement of Sutter's gross receipts would be anything other than fraudulent. As a result, we find Mr. Enayat's understatement of Sutter's gross receipts in taxable year 2000 to be fraudulent.
B. Whether Woodbury Is Liable for the Additions to Tax and Penalty As Determined by the IRS
1. Failure-To-File Addition to Tax Under Section 6651(a)(1) and Fraud Penalty Under Section 6663(a) in 1998
The IRS determined that Woodbury is liable for the section 6651(a)(1) addition to tax for taxable year 1998 because Woodbury failed to timely file its tax return for that year, and that Woodbury is liable for the fraud penalty under section 6663(a) for fraudulently understating its gross receipts on its 1998 income tax return. It is true that Woodbury filed its 1998 Form 1120 late (i.e., more than four years late on September 10, 2003), that Woodbury has not shown that it exercised reasonable care in this matter, and that the return Woodbury eventually filed did understate its gross receipts. However, because we find (as the IRS determined) that Woodbury paid additional compensation to Mr. Enayat in the form of the Woodbury-to-Enayat transfers totaling $349,356, and because we hold (as the IRS concedes) that Woodbury was entitled to an additional deduction in the amount of those transfers, Woodbury ends up with no net income in 1998, but rather a loss. Woodbury therefore has no income tax liability for 1998. Since the addition to tax and penalty at issue would be a percentage of the underpayment of Woodbury's now-zero income tax liability, the addition to tax and penalty are also zero.
2. Fraudulent Failure-To-File Addition to Tax Under Section 6651(f) in 1999
The IRS determined that Woodbury was liable for the addition to tax pursuant to section 6651(f) for fraudulently failing to file a timely income tax return for taxable year 1999. In failing to file that return, the IRS determined, Woodbury failed to report $162,050 in gross receipts for taxable year 1999. To determine whether Woodbury fraudulently failed to file its tax return for taxable year 1999, we examine the same badges of fraud we used when considering the imposition of the fraud penalty against Mr. Enayat under section 6663(a), see Clayton v. Commissioner, 102 T.C. at 653, but we necessarily focus on Woodbury's decision not to file its return when due. If that decision was made with the intent to evade tax, then the addition to tax under section 6651(f) may properly be imposed. Again, respondent has the burden of proving fraud by clear and convincing evidence. See sec. 7454(a); Rule 142(b); Parks v. Commissioner, 94 T.C. at 660-661. To find tax fraud against the corporation, respondent is required to prove that Mr. Enayat engaged in fraudulent conduct on behalf of the corporation. E.J. Benes & Co. v. Commissioner, 42 T.C. 358, 382 (1964), affd. 355 F.2d 929 (6th Cir. 1966).
Respondent contends that the following badges of fraud are present in 1999 with respect to Woodbury: (1) maintaining inadequate records, (2) concealment of assets, (3) dealing extensively in cash, and (4) failing to file tax returns. Mr. Enayat infused the corporation with his personal funds and withdrew funds at will, and he admittedly did not keep accurate books for Woodbury. Mr. Enayat, as the operator and sole shareholder of Woodbury, abdicated his responsibility to accurately report Woodbury's financial dealings and tax obligations. We have found that Woodbury failed to file its return or report gross receipts of $162,050 for taxable year 1999, and when the IRS determined that Woodbury had gross receipts in that amount, Mr. Enayat did not introduce any evidence to prove Woodbury's gross receipts were other than as the IRS determined. Woodbury failed to file its return for 1999 altogether after filing its return for 1998 four years late. In view of all these facts, Mr. Enayat's management of Woodbury went beyond haphazard and was fraudulent. Mr. Enayat undoubtedly knew that a tax return was required to be filed for Woodbury, and his failure to file one indicates that he was trying to evade taxes. As a result, given Mr. Enayat's pattern of filing his own tax returns late, as well as his filing Woodbury's 1998 tax return late, we do not find that his failure to file Woodbury's 1999 tax return was unintentional.
Therefore, on the basis of our examination of the entire record and Mr. Enayat's entire course of conduct, we find that Woodbury fraudulently failed to file its tax return for taxable year 1999. However, because we find (as the IRS determined) that Woodbury paid additional compensation to Mr. Enayat in the form of the Woodbury-to-Enayat transfers totaling $67,200 in 1999, and because we hold (as the IRS concedes) that Woodbury is entitled to an additional deduction in the amount of those transfers, Woodbury ends up with less income (i.e., $162,050 minus $67,200, or $94,850)—and therefore a lower tax liability—than the amount the IRS used in calculating the penalty.
IV. Whether the Statute of Limitations Bars Assessment of Mr. Enayat's or Woodbury's Tax Liabilities
Generally, the IRS must assess tax within three years after the return is filed. 35 Sec. 6501(a). This general rule would provide that assessments against Mr. Enayat would be restricted as follows:
Tax Year Due Date Return Filed 3-Year Limitation on Assessment
1998 Apr. 15, 1999 Apr. 14, 2000 Apr. 14, 2003
1999 Apr. 15, 2000 Oct. 9, 2002 Oct. 9, 2005
2000 Apr. 15, 2001 Oct. 22, 2002 Oct. 22, 2005
2001 Apr. 15, 2002 Oct. 22, 2002 Oct. 22, 2005
The IRS issued to Mr. Enayat a notice of deficiency for 1998, 1999, 2000, and 2001 on October 17, 2006. This was well after the three-year period of limitations on assessment had expired for each of these years, so respondent bears the burden of proving that an exception to the three-year limit on the time to assess tax applies. See Wood v. Commissioner, 245 F.2d 888, 893-895 (5th Cir. 1957), affg. in part and revg. in part on other grounds T.C. Memo. 1955-301; Bardwell v. Commissioner, 38 T.C. 84, 92 (1962), affd. 318 F.2d 786 (10th Cir. 1963). Respondent has shown that Mr. Enayat filed fraudulent returns by fraudulently underreporting his income for taxable years 1998, 2000, and 2001. Because section 6501(c)(1) allows assessment at any time in the case of a fraudulent return, we conclude that the statute of limitations does not bar assessment of Mr. Enayat's tax for 1998, 2000, or 2001.
With respect to taxable year 1999, respondent failed to prove Mr. Enayat filed a fraudulent return, but we nevertheless conclude on other grounds that the statute of limitations does not bar assessment of Mr. Enayat's tax for 1999. Section 6501(e) permits a six-year period of limitations for assessment in the case of a taxpayer who omits from gross income an amount properly includable therein which is more than 25 percent of the amount of gross income stated on the return. On his 1999 return, Mr. Enayat reported his gross income, i.e., total income, to be $301,904. The IRS determined (and we have found) that Mr. Enayat understated his income for 1999 by $100,151—i.e., $31,723 in constructive dividends from Woodbury, $67,200 in compensation from Woodbury, and $1,228 from Sutter's additional gross receipts. The IRS will be afforded a six-year period of limitations for assessment if Mr. Enayat's understatement of income ($100,151) exceeds 25 percent of $301,904 (i.e., $75,476). We find that it does.
As for Woodbury, the IRS issued a notice of deficiency for taxable year 1998 on October 17, 2006, which was more than three years after Woodbury had filed its return for that year. 36 However, because we find that Woodbury fraudulently understated its gross receipts on its return, section 6501(c)(1) permits the IRS to assess at any time. As for taxable year 1999, Woodbury failed to file a tax return. Section 6501(c)(3) likewise permits the IRS to assess at any time where no return is filed. As a result, we conclude that the statute of limitations does not bar assessment of Woodbury's tax for 1998 or 1999.
V. Summary of Findings
To resolve the issues presented in this case, we find as follows with respect to Mr. Enayat:
(1) He received unreported gambling income of $16,800 in 1998, which he concedes.
(2) He received unreported rental income of $2,000 in 1998, which he concedes.
(3) He received unreported constructive dividends from Woodbury totaling $203,273 in 1998.
(4) He received unreported compensation from Woodbury totaling $349,356 in 1998.
(5) He did not receive unreported income during any year in issue from the funds Dr. Willitts transferred to him in 1998.
(6) He is not entitled to a capital loss of $118,619 (or any other amount) on the 1998 sale of the Elm Street house, and accordingly, the capital gains he offset in 1998 and 1999 are taxable; but he is not liable for tax on capital gain from that sale.
(7) He received unreported constructive dividends from Woodbury of $31,723 in 1999.
(8) He received unreported compensation from Woodbury of $67,200 in 1999.
(9) He received unreported Schedule C income from Sutter of $1,228 in 1999.
(10) He received unreported income from insurance proceeds of $201,929 in 2000, which he concedes.
(11) He received unreported Schedule C income from Sutter of $252,721 in 2000.
(12) He received unreported theft income of $113,800 from a stolen check in 2001, which he concedes.
(13) He is liable for failure-to-file additions to tax under section 6651(a)(1) for taxable years 1998, 1999, 2000, and 2001.
(14) He is liable for the fraud penalty under section 6663(a) on the portion of his underpayment attributable to the following items:
1998: $16,800 in gambling income and $2,000 in rental income;
2000: $201,929 in insurance proceeds and $252,721 in gross receipts from Sutter;
2001: $113,800 in theft income from the stolen check.
(15) He is not liable for the fraud penalty on the portion of his underpayments attributable to the following items:
1998: $203,273 in constructive dividends from Woodbury;
$349,356 in compensation from Woodbury; and
$118,619 in disallowed capital loss from the sale of the Elm Street house;
1999: $31,723 in constructive dividends from Woodbury;
$67,200 in compensation from Woodbury; and
$1,228 in additional gross receipts from Sutter.
As for Woodbury, we find as follows:
(1) Woodbury had no taxable income in 1998 and therefore is not liable for tax, additions to tax, or penalties in that year.
(2) Woodbury had unreported net taxable income of $94,850 in 1999.
(3) Woodbury is liable for the fraudulent failure-to-file addition to tax under section 6651(f) for 1999.
To reflect the foregoing and to allow the parties to resolve the computational issues that will be affected by these findings,
Decisions will be entered under Rule 155.

proving tax fraud by net worth analysis

USTC Cases, United States of America v. Matthew Fox, Defendant., U.S. District Court, D. New Jersey, 2009-2 U.S.T.C. ¶50,724, (Oct. 21, 2009)
OPINION
I. INTRODUCTION
Simandle, U. S. District Judge: This matter is before the Court on the motion of Defendant Matthew Fox for acquittal notwithstanding a jury verdict, pursuant to Fed. R. Crim. P. 29(c), and, alternatively, for a new trial on Counts Two through Six of the indictment against him, pursuant to Fed. R. Crim. P. 33(a). The motion is opposed. The Court received written submissions from the parties, held argument on the motions, and received supplemental submissions after the argument. The Court has considered all of the submissions and arguments of the Defendant and the United States. For the reasons explained, the Court shall deny the motion for acquittal and a new trial.
II. BACKGROUND
On March 1, 2006, a federal grand jury returned an indictment charging Matthew Fox and Melody Willis Fox with one count of conspiracy to defraud the United States in violation of 18 U.S.C. § 371, and Matthew Fox with five counts of attempted evasion of income taxes for the years 1998 through 2002 in violation of 26 U.S.C. § 7201. Specifically, the Indictment alleged that the correct tax due and owing was substantially understated, as follows:

Count Year Taxable Income Reported Tax Reported Actual Taxable Income Actual Tax

2 1998 0 0 $29,688 $5,014

3 1999 $2,550 $384 $24,810 $3,724

4 2000 $10,248 $1,519 $112,580 $29,581

5 2001 $21,843 $3,706 $154,007 $41,870

6 2002 $46,744 $11,150 $170,662 $49,173

On July 30, 2007, following a three week trial before this Court, the jury convicted Matthew Fox of attempting to evade his individual income taxes for the years 1998 through 2002 (Counts Two through Six of the Indictment) and acquitted Matthew Fox and Melody Fox of conspiring to defraud the United States (Count One of the Indictment).
The Government adduced evidence at trial that Matthew Fox failed to report substantial income for each of the tax years 1998 through 2002. The Government utilized the net worth and expenditures method of proof in computing Fox's actual income for each of those years. The Government presented evidence of Fox's personal expenditures (including payments from his checking account, and purchases made with cash and/or money orders), and increases/decreases in his net worth, to establish by inference that his substantial increase in net worth came from unreported taxable income.
More specifically, the evidence showed that Mr. Fox began working at an Atlantic City gentleman's club called Bare Exposure as a doorman in 1997. (Tr. July 17 at 158.) Fox confirmed, in loan applications in 2001, that he had been employed at Bare Exposure for six years, establishing that he had certainly worked there since at least 1997 and perhaps as early as 1995. (Gov. Ex. 24.2 & 38.1.) The Bare Exposure manager, Anthony Ariemma, testified that Fox was promoted to manager in early 1998, when the prior manager was fired. (Tr. July 17 at 162.) Ariemma testified that he paid Fox $100 per shift and that Fox worked three and sometimes four shifts per week. ( Id. at 162-163.) In addition, by the beginning of 1999, Fox began receiving a share of the tips for each shift, typically an additional $100-120 in tips on a Saturday shift, or $60-70 in tips on a Friday shift, or as little as $20-30 in tips on a weekday shift. ( Id. at 163-165) He continued to work at Bare Exposure as a manager until 2004.
Fox filed tax returns for 1998-2002, the years at issue. He declared taxable income from Bare Exposure of $0 in 1998 (a year in which he stated he received only wages from a casino in the amount of $3,173, which is not at issue). He declared only $9,600 in wages from Bare Exposure for 1999 (declaring nothing for tips), $20,800 in wages from Bare Exposure for 2000 (again declaring nothing for tips), $14,400 in wages and $10,325 in tips from Bare Exposure for 2001, and finally, $16,800 in wages and $28,600 in tips from Bare Exposure for 2002, which return was not filed until April 2004.
According to evidence at trial, the IRS analysis of Fox's expenditures over these years revealed much higher levels of expenditures than explainable by the expenditure of the current years' declared income and any non-taxable income or assets. IRS Revenue Agent Ken Kelly testified to his opinion, based on the available evidence, that Fox's actual taxable income for the years in question was as follows: $29,688 in 1998, $24,244 in 1999, $112,529 in 2000, $149,406 in 2001, and $167,845 in 2002. (Gov. Ex. 43.1(a)). Agent Kelly testified that Fox therefore owed additional income taxes for the years 1998, 1999, 2000, 2001, and 2002 in the amounts of $5,257, $3,294, $28,046, $36,831, and $37,037, respectively. (Tr. July 19 at 162-164.)
As discussed in detail below, Defendant Fox took the position that his spending came from non-taxable sources, namely, a pre-existing “cash hoard” (derived from several sources including Social Security benefits as a minor, insurance payments, and cash from family sources) and beginning in August 2000 from the earnings of his then-girlfriend Melody Willis, a dancer at his gentleman's club who moved to New Jersey from Florida in July 2000, and whom he married in 2003. For the years 2000, 2001, and 2002, according to his defense, Melody's earnings exceeded $100,000 per year and were used by Matthew Fox to fund the high expenditures of those last three years at issue in this case.
The expenditures uncovered by the IRS are not disputed in this motion, but the sources of those expenditures were hotly contested at trial — whether Matthew Fox had a cash hoard as of January 1998 (the beginning of the tax period) and whether Melody Fox was actually employed and earning the income to explain the expenditures Matthew Fox made in 2000-2002. To be sure, the jury heard evidence on both sides of these issues and was called upon to make determinations of credibility and weight of the competing evidence.
At trial, former retired IRS Special Agent Paula Lipski (“Agent Lipski”) testified about the steps she took to investigate the alleged tax evasion in this case. She testified that after informing Mr. Fox's attorney in April of 2003 that Mr. Fox was under investigation for failing to report income for 1998-2002, she met with Fox's attorney, Louis Barbone, Esq., in July of 2003. (Tr. July 12 at 81-82.) At an August 14, 2003 meeting with Mr. Barbone, Agent Lipski received copies of Melody Willis tax returns for the years 2000, 2001, and 2002, which had been signed on July 29, 2003. ( Id. at 83.) In Agent Lipski's words, those returns showed “substantial income that was consistent with the amount of income I stated was not reported on Mr. Fox's tax return.” ( Id. at 84.) As she explained, if those returns were true, they would have been a legitimate source of funds explaining Mr. Fox's expenditures for the latter half of 2000 and for the years 2001 and 2002 at issue.
Accordingly, Agent Lipski tried to determine whether there was any truth to the belated Melody Willis Fox returns. Agent Lipski examined sworn testimony by Melody Fox in a Florida child custody dispute with her ex-husband indicating that she hadn't worked since August of 2000 and that Matthew Fox was supporting her. ( Id.) She also reviewed Melody Willis' affidavit submitted in the Florida case in which she claimed she was “unemployed.” Agent Lipski also consulted IRS databases to determine whether any tax documents were available to indicate Melody Fox's employment or independent contractor status, including W-2 and 1099 forms, and there were none. ( Id. at 84-85.) Agent Lipski also interviewed the person who prepared the Melody Willis tax returns, namely Maureen Dougherty, and tried to determine where Melody Fox was claiming to have worked because the forms apparently indicated only that she worked at “various locations.” ( Id. at 85.) When Agent Lipski asked the tax preparer where those “various locations” are, she received no reply. ( Id.) She testified, “when I asked for records specifically just telling me the name of the employer,… no one came up with the name of an employer.” ( Id. at 94.) As a result of this investigation, the IRS determined that the Melody Willis Fox tax returns were not truthful, that is, that Melody Fox was reporting hundreds of thousands of dollars of income for 2000, 2001, and 2002 that had not in fact been earned, after learning of the IRS investigation, apparently in the effort to conceal Matthew Fox's alleged unreported income, and Melody Fox also became a target of the IRS investigation.
The government also introduced evidence of Matthew Fox's net worth as of the beginning of 1998, the first tax year in question, and for the beginning and end of each subsequent tax year through 2002. In the course of her investigation of Matthew Fox, Agent Lipski testified, she determined that on January 1, 1998 Matthew Fox had $500 cash on hand and $1,000 in his bank account. (Tr. July 12 at 86:18-23.) She based her determination in part on a loan application Matthew made on April 7, 1998, in which he stated that he had $500 cash on hand, $1,000 in the bank. Further, the application was to finance a motor boat at 13.5% interest, which, Agent Lipski noted, was inconsistent with having significant cash available. ( Id. at 87.) However, on cross examination, Agent Lipski also testified that she learned during her investigation that Mr. Fox made a loan to his employer, in December of 1998, of $6,000. (Tr. July 17 at 38:15-17.) Mr. Ariemma, the employer, corroborated that Mr. Fox made such a loan in December 1998. (July 17 Tr. at 173.)
Agent Lipski also obtained credit card records indicating that Matthew Fox had a balance on his credit card in early 1998, and thereby incurring credit card fees, which was also inconsistent with having access to cash. (Tr. July 12 at 88.) In addition, Agent Lipski testified that Mr. Fox borrowed money from his sister, Jennifer, with whom he was living, to buy a car because, she said, he didn't have any money. ( Id. at 133:7-8.) Matthew's sister Jennifer also told Agent Lipski that he did not keep cash in the safe (sometimes also called the gun-safe) in the house, as Matthew Fox later claimed.
According to Agent Lipski, in her August 2003 meeting with Matthew Fox's attorney, Louis Barbone, she was told that Mr. Fox received payments, totaling approximately $54,053 from 1987 to 1994, from an insurance settlement as a result of his mother's death ( id. at 89), including a lump sum of $34,053 in 1994 ( id. at 118). Agent Lipski noted that none of that money appeared in Defendant's bank accounts at the beginning of 1998. ( Id.) Agent Lipski determined that the insurance payments received from 1987 to 1994 were not relevant to the years under investigation in this case or Defendant's opening net worth because the money did not appear to be available to him at the beginning of 1998. ( Id.)
Mr. Barbone also told Agent Lipski that Matthew Fox received Social Security payments, of about $40,000, as a result of his mother's death twenty years earlier in 1981. Agent Lipski determined that those funds were also unavailable to Defendant as of January 1, 1998 because she believed the money would have been long since spent many years before 1998, since Social Security payments would have ended at age 21 in 1990. ( Id. at 90-91.)
Defendant's attorney also told Agent Lipksi that Matthew Fox received cash from his parents' business over the years that was available to him in January 1998. ( Id. at 91.) Defendant's attorney indicated that Fox had received and saved approximately $34,000 as a child from his parents' business. ( Id.) No other information was given to Agent Lipski about when this money was received, what the nature of Defendant's parents' business had been, or where it was located. Agent Lipski did not attempt to interview Defendant's parents because his mother had passed away in the 1981 accident and his father was not mentally competent in 2003. ( Id. at 92.)
At the August 2003 meeting, Agent Lipski was also told by attorney Barbone that Mr. Fox's father and grandmother had held money for him and gave it to him in 1996 or 1997. ( Id. at 148-49.) No proof of this assertion was furnished to her, nor was the amount of this money, if any, revealed to her.
Mr. Barbone, as Defendant's attorney, also showed Agent Lipski $20,000 in cash in 2003, claiming that this was part of Matthew Fox's cash hoard. Agent Lipski indicated that the availability of that cash at a meeting in August 2003 did not indicate, to her, that it had been available in January of 1998, but rather, that it likely had been earned from 1998-2002; alternatively, the existence of the $20,000 cash in 2003 was irrelevant to the expenditures she found he made in 1998-2002, because it would not explain the money he had spent during those five years.
Agent Lipski also testified that in her endeavor to determine whether Defendant had a cash hoard, she learned that Mr. Fox had a safe in his home. ( Id. at 116.) She investigated the safe. Thereafter, she spoke with Mr. Fox's sister, Jennifer, who lived with Mr. Fox at the time and told Agent Lipski that no money was being stored in the safe. ( Id. at 116-17.) Agent Lipski also testified that Mr. Fox's bills for these years were not “being paid off timely.” ( Id. at 117:11-12.)
Based on all this evidence and evidence of cash withdrawals from Defendant's bank account during the early part of 1998, as well as the absence of other bank or investment accounts containing the money, Agent Lipski determined that he had no cash hoard, from any of these sources, in January 1998. His financial behavior, such as financing relatively small purchases and paying interest, taking cash advances from his credit card with interest and transaction fees, borrowing from his own sister because he had no money, lack of cash secured in his home's safe, and the absence of money in his bank account from the previous insurance payments and Social Security benefits that had been paid by check, led Agent Lipski to rule out the existence, as of January 1998, of a cash hoard from which his expenditures could be explained for the 1998-2002 period.
Agent Lipski further determined that Melody Fox's tax returns were not accurate because of her testimony and Matthew Fox's testimony in the Florida custody case, the lack of documentation of her employment, and her inability to provide the name of her employer. (Tr. July 12 at 94:13-18.) Agent Lipski received from the preparer of the returns, Maureen Dougherty, “a schedule that reflected her methodology in computing the income that was reported” as Melody's. ( Id. at 94:19-22.) That schedule indicated that Melody Fox was claiming certain deposits into Matthew Fox's bank accounts represented income she had earned and deposited in his account. Agent Lipski testified that her investigation revealed Matthew and Melody did not meet until July 2000, but that the schedule indicated in February of 2000, $4,500 deposited into Matthew's account was Melody's income, which had to be impossible because the couple did not even know each other before July 2000. ( Id. at 95-96.) Similar large deposits to Matthew's account were credited to Melody that could not have been her earnings, for example in March ($6,000), April ($6,600), and May ($8,720), all before Melody and Matthew met in July 2000, leading Agent Lipski to conclude the new Melody Fox tax returns were not factually correct. ( Id. at 96.) At the very least, those large deposits from February through May 2000, totaling $25,820, could not have come from Melody's earnings.
Agent Lipski also testified about what she did to verify whether or not Matthew Fox was working for the charged years. On July 11, 2003 she interviewed Anthony Ariemma, an owner of Bare Exposure, a club where Agent Lipski believed Matthew Fox had been employed. (Tr. July 12 at 159.) Ariemma confirmed that Matthew Fox worked at Bare Exposure and described his income and tips, as noted above. Lipski also obtained W-2 status from Bare Exposure for Matthew Fox from the IRS database beginning with 1999, there being none for 1998, a year in which Fox claimed no income from Bare Exposure despite working there as a manager and receiving tips.
The jury also heard the testimony of Matthew Fox and Melody Willis Fox. Contrary to his many written and testimonial statements, Matthew Fox testified at trial that he started working at Bare Exposure in 1999 (Tr. July 24 at 124); he was confronted on cross-examination, by his own testimony in the Florida custody hearing, that he was the manager at Bare Exposure since March 1995, as reflected in the Florida transcript at Ex. 7.1(a), p.77. ( Id. at 190.) Likewise, he admitted his March 2001 credit application (Ex. 38.1) stated he had worked at Bare Exposure (identified as “PRBA”) for six years, i.e., since 1995, earning $4,500/month salary. ( Id. at 191-192.) His Kensington Furniture credit application in April 2001 (Ex. 24.2) likewise acknowledged six years of continuous employment, at $70,000 per year, at Bare Exposure (“PRBA”), see id. at 193. He likewise admitted he stated on his Ford Credit application (Ex. 11.1) in June 1999 that he has been a manager at Bare Exposure for four years earning $36,000/year. ( Id. at 195-196.)
At trial, Matthew Fox claimed he had received $137,000 in cash from his father in a Shop-Rite grocery bag full of money on March 17, 1997, that he believed was money his father had held for him, (Tr. July 24 at 148), of which he surmised $55,000 came from the settlement of his mother's death case and other money may have come from the Social Security checks his father had received years before in his behalf when he was a minor, although he didn't know what his father did with those checks. ( Id. at 149.)
He claimed at trial to have stashed this money into a gun safe which also held shotguns for hunting. ( Id. at 155.) He explained that he borrowed small amounts of money rather than use this cash in order to build up credit. He also described how he met Melody Willis in the end of June 2000 and claimed she continued as a dancer earning $500 to $1,000 on weeknights, $1,000 to $2,000 on Fridays, and $1,200 to $3,300 on Saturdays. ( Id. at 170.) He explained how, after he came under IRS investigation, he went to Maureen Dougherty for tax assistance for preparation of Melody Fox's tax returns in 2003, resulting in the 2000, 2001, and 2002 Melody Willis Fox returns that were eventually filed.
Again, on cross-examination about his claimed receipt of a large bag of cash from his father, Matthew Fox claimed he kept that sum in his home and that he was unaware of federally-insured banks, or of the fact that banks would pay him interest upon his bank deposits, (Tr. July 24 at 209-211.) which the jury could well have found incredible, undermining whatever else he offered about this secret cash resource.
He claimed he lied to the Florida court to help Melody win her child custody case, although he later admitted he was concerned Melody's ex-husband could discover she was still employed as a dancer at Bare Exposure. (Tr. July 24 at 175; Tr. July 25 at 16-18, 20-21.) Again, the jury would have found that his testimony in this trial was unbelievable and contradicted by his Florida testimony that she had quit dancing, since it would not have been difficult for a private investigator to learn the truth if Melody was dancing.
Melody Fox's testimony described her earlier marriage to Michael Willis, with whom she had a daughter born in 1998, how she had worked as a dancer and model in Florida, and how their marriage failed. She testified about moving to New Jersey and working at Bare Exposure after August 2000. She also acknowledged her child custody deposition, hearing, and trial in Florida in which she testified she was not working in New Jersey and was supported by Matthew Fox. (Tr. July 25 at 66-69). She claimed she falsely swore to an affidavit in the custody battle that she was “unemployed” and a “stay-at-home mother.” ( Id. at 68.) She confirmed that after Matthew Fox came under IRS investigation, she met with Maureen Dougherty in June 2003, who advised her to file her tax returns if she had earned income for those years. ( Id. at 57-61.) She also testified she had no discussion about her tax returns with Matthew Fox. ( Id. at 62:16-20.)
On cross examination, Melody Fox stated she made four false statements under oath in the custody proceedings (emergency hearing, deposition, trial, and financial affidavit). She acknowledged that if she was trying to hide her employment as a nude dancer, it may have failed since anyone, including an investigator, could come in off the street and see her if she were working. ( Id. at 86-87.) She also attempted to explain how money she earned in early 2000 came to be reflected as claimed deposits in Matthew's bank account at a time before they knew one another. ( Id. at 95-96.)
III. DISCUSSION
A. Standard
Under Rule 29(c) of the Federal Rules of Criminal Procedure,
a court may enter a judgment of acquittal if it finds that as a matter of law the evidence is insufficient to sustain a conviction. In reviewing a motion for Judgment of Acquittal, the court must “‘review the record in the light most favorable to the prosecution to determine whether any rational trier of fact could have found proof of guilt beyond a reasonable doubt based on the available evidence.’” United States v. Smith, 294 F.3d 473, 476 (3d Cir. 2002) (quoting United States v. Wolfe, 245 F.3d 257, 262 (3d Cir. 2001)). Further, the court is required to draw “‘all reasonable inferences in favor of the jury's verdict.’” Smith, 294 F.3d at 476-77 (quoting United States v. Anderskow, 88 F.3d 245, 251 (3d Cir. 1996)).
The defendant must also overcome the jury's special province in evaluating witness credibility and conflicting testimony. United States v. Hakim, 2002 U.S. Dist. LEXIS 18151, No. 02-CR-131, 2002 WL 31151174, at *6 (E.D. Pa. Sept. 24, 2002) (citing United States v. McGlory, 968 F.2d 309, 321 (3d Cir. 1992)). Further, the court in United States v. Scarfo, 711 F. Supp. 1315, 1334 (E.D. Pa. 1989) held that “a court may not grant a motion for acquittal based on conflicting testimony, that is, testimony of a questionable quality; it is up to the jury to weigh conflicting testimony, determine credibility, and ultimately draw factual inferences.” Thus, “a finding of insufficiency should be confined to cases where the prosecution's failure is clear.” Smith, 294 F.3d at 477 (quoting United States v. Leon, 739 F.2d 885, 891 (3d Cir. 1984)).
United States v. Carmichael, 269 F. Supp. 2d 588, 594-595 (D.N.J. 2003) (Simandle, J.).
[A] trial court's ruling on the sufficiency of the evidence is governed by strict principles of deference to a jury's findings. In deciding whether to grant the motions for acquittal, the trial court [is] required to view the evidence in the light most favorable to the prosecution and to draw all reasonable inferences therefrom in the government's favor. Viewing the evidence in this light, the trial court [is] obliged to uphold the jury's verdict unless no rational jury could conclude beyond a reasonable doubt that the defendant[] willfully attempted to evade [his] tax obligations.
United States v. Ashfield, 735 F.2d 101, 106 (3d Cir. 1984) (citations omitted). More recently, in reversing a district court's granting of a judgment of acquittal, the Court of Appeals found:
The evidence was not overwhelming, but all that was required was that “any rational juror could have found the elements of the crime beyond a reasonable doubt.”
United States v. Carbo, 572 F.3d 112, 119 (3d Cir. 2009), quoting United States v. Cartwright, 359 F.3d 281, 286 (3d Cir. 2004).
Federal Rule of Criminal Procedure 33(a) states that “upon the defendant's motion, the court may vacate any judgment and grant a new trial if the interest of justice so requires.” Such a remedy is available in exceptional cases where an injustice would occur if the court failed to act. United States v. Lebovitz, 586 F. Supp. 265, 267 (W.D. Pa.), aff'd, 746 F.2d 1468 (3d Cir. 1984); United States v. Phifer, 400 F. Supp. 719, 722 (E.D. Pa. 1975), aff'd, 532 F.2d 747 (3d Cir. 1976). Rule 33 affords relief if, for example, the trial court finds prosecutorial misconduct or when the trial court does not believe the evidence supports the jury's verdict. United States v. Dixon, 658 F.2d 181, 193 (3d Cir. 1981) (reversing judgment of acquittal but remanding for consideration whether to grant new trial under Rule 33 on grounds of juror confusion and insufficient limiting instructions).
This Circuit has described a district court's consideration of a Fed. R. Crim. P. 33 motion for a new trial based on the “weight of the evidence” as follows: A district court can order a new trial on the ground that the jury's verdict is contrary to the weight of the evidence only if it “believes that ‘there is a serious danger that a miscarriage of justice has occurred—that is, that an innocent person has been convicted.’” United States v. Santos, 20 F.3d 280, 285 (7th Cir. 1994) (quoting United States v. Morales, 902 F.2d 604, 606 (7th Cir. 1990)). Unlike an insufficiency of the evidence claim, when a district court evaluates a Rule 33 motion it does not view the evidence favorably to the Government, but instead exercises its own judgment in assessing the Government's case. See United States v. Lacey, 219 F.3d 779, 783-84 (8th Cir. 2000); United States v. Ashworth, 836 F.2d 260, 266 (6th Cir. 1988). United States v. Johnson, 302 F.3d 139, 150 (3d Cir. 2002). Thus, “motions for a new trial based on the weight of the evidence are not favored. Such motions are to be granted sparingly and only in exceptional cases.” Government of Virgin Islands v. Derricks, 810 F.2d 50, 55 (3d Cir. 1987) (citations omitted).
United States v. Brennan, 326 F.3d 176, 188-89 (3d Cir. 2003)
B. Net Worth & Expenditures Method for Proving Tax Evasion
In this case, the United States sought to prove that Defendant Matthew Fox evaded his taxes by showing he spent considerably more money during each year between 1998 and 2002 than he could have if he had earned only the income he declared on his tax returns for those years, taking into account his net worth at the beginning of 1998 and making reasonable efforts to exclude non-taxable sources for such expenditures. This so-called net worth and expenditures method for proving tax evasion is an indirect method for proving that an individual has earned unreported income during a given period of time. As the Supreme Court explained in Holland, the methodology depends on an accurate understanding of an individual's net worth at the beginning of the period and a calculation of money spent during the period:
In a typical net worth prosecution, the Government, having concluded that the taxpayer's records are inadequate as a basis for determining income tax liability, attempts to establish an “opening net worth” or total net value of the taxpayer's assets at the beginning of a given year. It then proves increases in the taxpayer's net worth for each succeeding year during the period under examination and calculates the difference between the adjusted net values of the taxpayer's assets at the beginning and end of each of the years involved. The taxpayer's nondeductible expenditures, including living expenses, are added to these increases, and if the resulting figure for any year is substantially greater than the taxable income reported by the taxpayer for that year, the Government claims the excess represents unreported taxable income.
Holland v. United States, 348 U.S. 121, 125 (1954). An assumption underlying this methodology is that money expended during this period that is in excess of reported income plus opening net worth derives from a reportable but unreported source of income, “and that when this is not true the taxpayer is in a position to explain the discrepancy.” Id. at 126.
The application of such an assumption raises serious legal problems in the administration of the criminal law. Unlike civil actions for the recovery of deficiencies, where the determinations of the Commissioner have prima facie validity, the prosecution must always prove the criminal charge beyond a reasonable doubt.
Id. Thus, there are several required safeguards on the use of the net worth and expenditures methodology to prove criminal guilt.
The first requirement is that the Government must establish the opening net worth with reasonable certainty. Id. at 132.
[A]n essential condition in cases of this type is the establishment, with reasonable certainty, of an opening net worth, to serve as a starting point from which to calculate future increases in the taxpayer's assets. The importance of accuracy in this figure is immediately apparent, as the correctness of the result depends entirely upon the inclusion in this sum of all assets on hand at the outset.
Id.
The second safeguard is the requirement that the Government investigate “reasonable leads” provided by the accused that would explain the spending or increase in net worth. In other words, the Government cannot prosecute a person for tax evasion who has provided a reasonable explanation of a non-taxable source for his or her income that the Government has not investigated.
When the Government rests its case solely on the approximations and circumstantial inferences of a net worth computation, the cogency of its proof depends upon its effective negation of reasonable explanations by the taxpayer inconsistent with guilt. Such refutation might fail when the Government does not track down relevant leads furnished by the taxpayer — leads reasonably susceptible of being checked, which, if true, would establish the taxpayer's innocence. When the Government fails to show an investigation into the validity of such leads, the trial judge may consider them as true and the Government's case insufficient to go to the jury. This should aid in forestalling unjust prosecutions, and have the practical advantage of eliminating the dilemma, especially serious in this type of case, of the accused's being forced by the risk of an adverse verdict to come forward to substantiate leads which he had previously furnished the Government. It is a procedure entirely consistent with the position long espoused by the Government, that its duty is not to convict but to see that justice is done.
Id. at 135-36.
Third, the Government must prove either that there is a likely source of unreported income or negate all possible nontaxable sources of that income. Thus, as the Third Circuit summarized in United States v. Goichman, 547 F.2d 778, 781 (3d Cir. 1976):
… Under the net worth method, the government attempts to establish by circumstantial proof the existence of unreported income by selecting an opening year for which it can reasonably ascertain the defendant's net worth and comparing that amount with a closing year's net worth. Any estimated nondeductible living expenses during that period are added to the closing net worth. The opening net worth is subtracted from the closing net worth to gauge the amount of unreported income the defendant must have had. But the government's burden does not rest there, it must then either prove that there is a likely source of the unreported income, Holland v. United States, 348 U.S. 121, 75 S. Ct. 127, 99 L.Ed. 150 (1954), or negate all possible nontaxable sources of that income. United States v. Massei, 355 U.S. 595, 78 S. Ct. 495, 2 L.Ed.2d 517 (1958).
Even if the prosecution proves increases in net worth, it must also show such increases are the result of receipt of taxable income, as the Supreme Court has made clear: “Also requisite to the use of the net worth method is evidence supporting the inference that the defendant's net worth increases are attributable to currently taxable income.” Holland, 348 U.S. at 137.
Increases in net worth, standing alone, cannot be assumed to be attributable to currently taxable income. But proof of a likely source, from which the jury could reasonably find that the net worth increases sprang, is sufficient … Any other rule would burden the Government with investigating the many possible nontaxable sources of income, each of which is as unlikely as it is difficult to disprove. This is not to say that the Government may disregard explanations of the defendant reasonably susceptible of being checked. But where relevant leads are not forthcoming, the Government is not required to negate every possible source of nontaxable income, a matter peculiarly within the knowledge of the defendant.
Id. at 137-38.
Thus, in the absence of relevant leads to nontaxable sources of income, the law does not require the IRS to negate every possible source of nontaxable income. Id.
In the present case, the United States pursued its net worth and expenditures method of proof by negating all possible nontaxable sources. It is well-established that “[s]hould all possible sources of nontaxable income be negated, there would be no necessity for proof of a likely source.” United States v. Massei, 355 U.S. 595 (1958). In Massei, the Supreme Court reviewed an order of the First Circuit which was based in part on the absence of “proof of likely source” of the taxpayer's net worth increases, which the Court of Appeals had regarded as an “indispensable” element of the net worth method of proof under Holland, supra. The Supreme Court stated that, although proof of a likely source was “sufficient” to convict in a net worth case where the Government did not negate the possible nontaxable sources, “[t]his was not intended to imply that proof of a likely source was necessary in every case.” United States v. Massei, 355 U.S. 595. The Government sustains this burden if the evidence shows that there was a thorough investigation of relevant leads “which removes any reasonable doubt that the defendant's unreported income came from nontaxable sources.” United States v. Hiett, 581 F.2d 1159, 1202 (5 th Cir. 1978).
Whether the Government has sufficiently pursued reasonable leads to negate nontaxable sources is a jury question, as both parties recognize, in accordance with United States v. Greene, 698 F.2d 1364, 1371 (9 th Cir. 1983) (“However, the government is not the final arbiter in determining which leads are relevant or reasonably susceptible of investigation. These questions involve factual determination by the jury as to whether the government was unreasonable in its failure to investigate the taxpayer's alleged sources of nontaxable income.”)
The Court properly instructed the jury, without objection, regarding these essential elements of the United States' burden of proving this case under the net worth and expenditures method of proof. See Instruction No. 36 at pp. 49-56 (as instructed, July 26 th). On this particular point, the Court instructed the jury:
To prove that there is unreported income, the government must either prove that there is a likely source of the unreported income, or negate all possible nontaxable sources of that income of which the government was specifically informed or which it reasonably could have discovered. When the government bases its case on circumstantial evidence, it has the additional burden of investigating any possible sources offered by the defendant as legitimate explanations of the increase in his net worth. This depends entirely on the defendant's offer of relevant leads; the government is not required to negate every possible source of nontaxable income, a matter peculiarly within the knowledge of the defendant. If you do not conclude that the government has negated a nontaxable source of income of which it was specifically informed or which it reasonably could have discovered, then you must regard that source as nontaxable income in determining whether defendant Matthew Fox had unreported income for the year or years under consideration.
Id. at 51-52.
Thus, the government's obligation to establish the opening net worth by tracking down all reasonable leads or explanations was summarized to the jury as follows:
In determining whether or not the opening net worth is reasonably accurate, you may consider whether the government has tracked down all “reasonable leads” or explanations, if any, suggested to the government by the defendant (or his representative) during the investigation which tend to establish the defendant's innocence.
If you are satisfied that any such reasonable leads and explanations have been exhausted or refuted, then this would be evidence which you could consider in determining whether the opening net worth included all of the defendant's assets. Obviously, improbable explanations would not be entitled to as much weight as plausible and reasonable explanations. If you should find that the government's investigation has failed to refute what seem to you to be plausible explanations, then such failure may be considered by you in determining the validity of the opening net worth.
If you find that the government has not established the opening net worth of the defendant to a reasonable certainty as of the beginning of any year named in the indictment, then you will return a verdict of not guilty as to any such count of the indictment.
If you find as to any year that the funds reflected in increased net worth and expenditures are not substantially in excess of the income reported by the defendant on his return for that year, or if you have a reasonable doubt as to whether such funds are substantially in excess of the reported income, then you will return a verdict of not guilty as to any such count of the indictment.
If you find, on the other hand, that the government has established the opening net worth of the defendant to a reasonable certainty as of the beginning of any year named in the indictment, and if you also are convinced beyond a reasonable doubt that the funds reflected in increased net worth and expenditures during such year are substantially in excess of the income reported on the defendant's tax return, then you will proceed to inquire whether the government has established that those funds represented taxable income on which the defendant willfully attempted to evade or defeat the tax.
Id. at 53-55. The Court similarly instructed the jury on taxable vs. nontaxable sources of income. Id. at 55-56. The Court reminded the jury that the government had to prove either that “the funds reflected in increased net worth and expenditures arose from a taxable source or sources or that the funds did not come from nontaxable sources.” Id. at 56 (emphasis added). Clearly, the government was not required to both negate all nontaxable sources and prove that the increased net worth arose from specific taxable sources, as the Court's instructions made clear:
… In other words, the government must establish either a likely source of income from which you believe the net worth increases and expenditures sprang, or that nontaxable sources of income have been negated as a source of the net worth increases and expenditures.
If you find that the defendant offered timely explanations of the source of his funds, which were reasonably susceptible of being checked, the government may not disregard them; and you may take into consideration any failure by the government to run down such explanations, if any were made, or the results of any investigation made by the government into the truth of the explanations. On the other hand, if relevant leads are not forthcoming, the government is not required to negate every conceivable source of nontaxable funds, and if the defendant failed to supply information in that regard, you may take such failure into account. The defendant is not required, however, to provide any explanations to prove the source of his net worth, for, as I have said, the burden is on the government to prove beyond a reasonable doubt that the increases arose from taxable sources.
Id. at 56.
Applying these legal standards, the Court next addresses the parties' arguments as to the sufficiency of the evidence under Rule 29(c), Fed. R. Crim. P.
C. Parties' Arguments
Defendant Matthew Fox argues that evidence at trial showed the Government failed to investigate reasonable leads his attorney provided of available nontaxable sources that would negate the Government's calculation of his opening net worth. Specifically, there were four categories of money that Defendant claims the Government failed to investigate:
1. $54,000 in insurance proceeds paid out between 1987 and 1994, including a bulk payment of $34,000 in 1994;
2. Social Security payments related to his mother's death and totaling approximately $40,000, which were allegedly held by his father for him until nine months before the investigation period;
3. $34,000 in cash his father gave him as a gift in 1997;
4. Melody Fox's income after July 2000, which she initially failed to report but later voluntarily disclosed.
The thrust of this argument by Defendant is that the Government failed to perform an adequate investigation necessary to determine what cash on hand he had on January 1, 1998, the beginning of the investigation period, especially in light of information Defendant provided during the investigation that he had received significant money from his family shortly before the period began.
Defendant Fox also argues that the Government provided insufficient evidence to prove that Bare Exposure was the likely source of any unreported income.
The Government concedes that it did not investigate whether Defendant received insurance proceeds totaling $54,000 stemming from his mother's death in 1981 (Tr. July 12 at 127:7-9), but argues that is not relevant because, as IRS Agent Lipski testified, that money was not visible in any of his bank accounts as of January 1, 1998. In other words, because the insurance payments were from a prior period and the Government adequately established Defendant's opening net worth valuation, there was no obligation to follow that lead and determine whether Defendant received the money. The Government assumed the money had been paid but that it was spent in the years before the beginning of the investigation period.
The Government provides a similar rationale for the Social Security payments and adds, further, that Defendant never indicated during the investigation that the money had been held for Defendant until 1997. The Government argues that Agent Lipski testified that she assumed it was true that Fox had received $40,000 in Social Security Survivor's benefits as a result of his mother's death, beginning in 1981 and ending at the latest at age 21 in 1990, and therefore did not attempt to obtain documentation to verify or rebut this claim. (See Tr. July 12 at 90-91, 136-37.) Agent Lipski explained however, that she did not consider the Social Security payments to be a nontaxable source of funds available to Fox as of January 1, 1998, because it was her understanding that such payments would have ended years earlier on his twenty-first birthday, would have been made by check not cash, and an analysis of his bank account revealed no significant balance as of January 1, 1998.
As for the money Defendant allegedly received from his father in 1997, the Government concedes that during the investigation it was informed of money coming from a family business but that the details of those payments were so sketchy that this did not constitute a reasonable lead that they were obligated to check. The Government argues that Agent Lipski noted that Fox's mother had passed away in 1981 and that no information regarding the nature, name or location of the family business was provided to her. The Government argues that in the absence of any such information about the nature of the business and the inability to interview either of Fox's parents (Fox's father had been institutionalized in 2003 as the result of a brain injury), the assertion by Defendant's attorney that Fox received $34,000 in cash from his parents' business was not a lead reasonably susceptible of being checked.
Further, the Government argues, it had no obligation to follow this lead because when Defendant presented a pile of cash in 2003, worth $20,000, during the investigation intending to show that he had this money still and had not spent it, that nullified the importance of the money for the net worth and expenditures analysis. That method, which assumes money spent during the prosecution period had an unlawful source, does not account for money, however earned, that is not spend during the period. Thus, the Government argues, this was not a reasonable lead because the cash displayed was simply unspent cash, more than five years after the beginning of the 1998 tax year. At oral argument on these motions, a dispute arose over what occurred at trial concerning another purported explanation for Defendant's expenditures. At trial, Matthew Fox testified that he had received $137,000 in cash from his father in 1997. During the argument of this motion it became unclear whether the testimony by IRS Agent Lipski at trial revealed that she had or had not been informed during her investigation of this transaction. Defendant argues that she was so informed and that her failure to investigate it was a failure to investigate a reasonable lead that dooms the Government's case. The Government argues that Agent Lipski was not told about this purported transaction and that her testimony at trial does not reveal otherwise. The Government is correct. Agent Lipski testified that her leads related to the claim of a cash hoard came from Mr. Fox's attorney, Louis Barbone, with whom she met, as reflected in her memo of 2003. (Tr. July 12 at 8.) She recalled Mr. Barbone telling her that his client had received $34,000 from his parents' business that he had received over the years and saved as a child ( id. at 18) but there is no evidence that Mr. Barbone told her that Fox had also received a secret gift of $137,000 in cash from his father in 1997. That assertion was first made by Mr. Fox at trial. Apparently that “lead” was not given to Lipski, as the claim was made for the first time at trial in Matthew Fox's testimony. The Government cannot be faulted for failing to follow up on information that it had never received. 1
As for Melody Fox's initially unreported income for 2000, 2001, and 2002, the Government contends that it thoroughly investigated whether Melody was actually working during those years in order to determine whether that income was a potential source of funds available to Matthew Fox that could explain his spending during this period. The Government notes that Agent Lipski testified that she investigated this lead by reviewing transcripts of Melody Fox's sworn testimony in an unrelated Florida child custody matter in which Melody Fox stated repeatedly that she had not worked at all after August 15, 2000, as well as Matthew Fox's sworn testimony in that matter, in which he stated that Melody Fox had not worked after August 15, 2000 and that he was completely providing for her support. (Tr. July 12 at 84). Agent Lipski also reviewed Melody Willis' affidavit in the Florida court in 2001 in which she swore to “unemployed” status. Agent Lipski testified further that she checked IRS databases and found no information provided by employers indicating that Melody Fox had worked during this period. ( Id.) Agent Lipski testified that she concluded, based on this evidence and Mr. Ariemma's statement during a July 11, 2003 interview, that he had heard that Melody Fox only worked at Bare Exposures for a short time, that Melody Fox had not worked during this time and had not earned the income reported on these belated returns. (Tr. July 17 at 149-50). Eventually, Melody Fox was indicted for conspiracy to evade taxes, and her tax returns, according to the Government, rather than exonerating her husband, provided evidence of an unsuccessful attempt to cover up his evasion by her supplying of a large annual income, previously unreported, during their relationship.
Ariemma confirmed meeting with Lipski in July 2003, and providing documents she requested through Ariemma's attorney, Morris Pinsky, Esq., on several occasions. Ariemma testified that he and Matthew Fox hired Melody in July 2000 as a dancer at Bare Exposure (Tr. July 17 at 176), and she worked there for only three weeks or a month before stopping. ( Id. at 178-179). He testified that Matthew Fox informed him in August 2000 that they were dating, and that he doesn't want her working as a stripper anymore. ( Id. at 180.) Matthew Fox also told Ariemma that he thought a private investigator could be following them and detecting that she was dancing, which would hurt her chances in the Florida custody battle. ( Id. at 181.) They talked about this in 2001 when Matt would bring up the subject of the custody battle, including how it was costing him a lot of money. (Tr. July 18 at 100-102.) Lipski also spoke with Melody Willis Fox's tax preparer, Maureen Dougherty, who had no documentation of where Melody was employed in 2000-2002,the years for which Dougherty had assisted in preparing her tax returns. (Tr. July 17 at 72.) Dougherty did mention Melody's employment at Bare Exposure at some point between 2000 and 2002 ( id. at 73-74), which Lipski regarded as consistent with the Florida testimony of working there briefly before August 15, 2000.
Finally, the Government argues that it provided legally sufficient evidence of a likely source of nontaxable income by negating the Defendant's proffered nontaxable sources of income, particularly his wife's income. Namely, the investigation revealed that Melody worked only a few weeks at Bare Exposure after she met Matthew Fox, as confirmed by his and her testimony in Florida and Lipski's interview of club owner Ariemma. She sought and found no W-2's or 1099's for Melody Willis covering the period, and she reasonably determined that her work at Florida strip clubs before July of 2000 was not a source of Matthew's income, since Melody supported her family and was not even acquainted with Matthew before July 2000.
D. Analysis
1. Reasonable Leads & Opening Net Worth
At the outset, the Court must provide some background for Defendant's arguments that the Government failed to investigate relevant information about non-taxable sources of income received by him prior to 1998. When the Government undertakes a tax investigation such as this one, the accuracy of a Defendant's opening net worth is critical. As the Supreme Court explained in Holland, the accuracy of the opening net worth figure is paramount and “the correctness of the result depends entirely upon the inclusion in this sum of all assets on hand at the outset.” 348 U.S. at 132. The Government's case cannot go to the jury unless it has provided evidence that establishes the Defendant's opening net worth with reasonable certainty. Stated another way, in this case, the Government had an obligation to investigate what money and assets were available to Defendant on January 1, 1998. That obligation included the obligation to investigate information the Defendant gave to the Government relevant to that figure.
For example, the Government was aware of certain bank accounts that had insignificant funds in them at the beginning of 1998. If the Defendant had alerted the Government that he had ownership of or access to other accounts, the IRS, of course, would have had an obligation to investigate whether that was so. If the Defendant owned assets on January 1, 1998, of which the Government was made aware, it would have had an obligation to investigate those as well, and take the value of those assets into account when establishing or recalculating Defendant's opening net worth.
However, the opening net worth investigation did not require the Government to track the sources of funds in the years before 1998 and to investigate all pre-1998 expenditures in order to rule out these funds as nontaxable sources of opening net worth. Whatever funds Defendant allegedly received prior to 1998 were only relevant to opening net worth if they were still available to Defendant at the beginning of 1998. Although a nontaxable source of income available to the Defendant during the investigation period may include money earned or acquired prior to the investigation, that is so only if the money is available to the Defendant during the tax years at issue, from 1998 to 2002. If Defendant cannot provide any reasonable lead as to where the money, received in prior years, was located on January 1, 1998, there is no information for the Government to investigate. Or, put another away, having established to a reasonable certainty that the money was not in Defendant's possession on January 1, 1998 was the equivalent of investigating the whereabouts of those funds. If the Defendant had provided information about the location of that money on January 1, 1998, the Government would have been obligated to look into that information and re-determine, as accurately as it could in 2003-2004 when the investigation was performed, what Defendant's net worth was on January 1, 1998, the beginning of the first charged year.
Thus, when Defendant alleged he had received some money from family in the past, the Government fulfilled its obligation by investigating Defendant's opening net worth to the degree that one could confidently determine such old funds no longer existed at the beginning of the tax period, or that such funds existed but were not expended during the tax period. Although the term “reasonable lead” often refers to sources of information about nontaxable income received during the charged years, the information Defendant provided about Social Security, insurance, and family sources was relevant only to Defendant's opening net worth, since it all predated 1998. Because the jury could reasonably find that the Government performed an adequate investigation of that opening net worth, it was able to conclude that his finances and his financial behavior were highly inconsistent with someone who had preserved a cash hoard of funds received from his family, Social Security, or insurance in years prior to 1998.
Defendant claimed at trial that money received in the past was held by him on January 1, 1998 as cash in a safe at his home and that his spending from 1998-2002 is explained, in part, by his access to and use of this cash. The Government therefore had an obligation to investigate whether that money was present in the safe on January 1, 1998. The Government investigator testified that she spoke to Defendant's sister who said she had seen the safe and that it was empty. Further, the Government analyzed Defendant's spending and banking habits and determined that they were inconsistent with the behavior of an individual who had access to a large cash hoard at the beginning of 1998, such as borrowing comparatively small sums to finance a boat and to buy a motor vehicle. Many other examples were given in the Government's evidence at trial.
Defendant provided no other reasonable information tending to show that significant money was in his possession and control on January 1, 1998. Thus, regardless of the veracity of his claims as to what he received either shortly or long before that date, the Government had no additional obligation to determine whether that money was received or to document how it was spent, as Defendant seems to argue, beyond the investigation it actually performed. So long as the opening net worth figure was adequately investigated, and this Court finds that a reasonable jury could conclude that it was, investigating the receipt of money and expenditures in prior years was not required before charging or prosecuting Defendant with tax evasion in this case. 2
Further, the jury heard all of the evidence regarding the funds Defendant received in the past, how and why he held it until after 1998, and where he kept it. These explanations, even though they were more detailed at trial than the cursory “leads” given in the investigation, did not raise a reasonable doubt with any juror. Although this jury decision does not negate any obligation on the Government's part to perform a thorough investigation of opening net worth, it shows that the jury, when properly instructed, similarly understood that the cash hoard was not a reasonable explanation for Defendant's spending, given the inability of Defendant to account for its whereabouts prior to the charged years. Compare Marshall, 557 F.2d at 530-31 (“The issue was essentially one of defendant's credibility and viewed in its entirety, the evidence presented of Marshall's opening net worth in 1969 and his expenditures and receipts during the following two years was sufficient to allow a reasonably minded jury to validly draw the inference that Marshall possessed no cash hoard at the beginning of 1971, the year in question.”) Indeed, a significant cash hoard that exists during the charged years but not prior to the opening date only indicates that Defendant is receiving significant sums of money in cash during those charged years, as is essentially alleged by the Government in this case.
Although, as noted above, Defendant identified several potential sources of nontaxable income that he allegedly received, in the 1980's and early 1990's long prior to January 1, 1998, Agent Lipski assumed that information was not relevant because she had already determined that as of January 1, 1998, the money was spent and Defendant's net worth was relatively low. If Defendant had provided any evidence tending to show that large amounts of money were still available to him on January 1, 1998, the Government would have had an additional obligation to investigate that evidence. By carefully examining the financial habits and documented expenditures around the 1998 period, the Government could reasonably conclude that there was no corroboration of the supposed cash hoard, and indeed that the Defendant's own behavior pointed at the absence of such a hoard. Without being supplied with a confirmable source for the cash (the elder Mr. Fox being unavailable) or an amount, or the claimed location of the cash, the IRS could hardly do more to follow the lead it was given.
In this case, IRS Agent Lipski calculated Defendant's opening net worth from two principal sources: (1) Defendant's bank statement in January 1998 and (2) Defendant's statement on a credit application in April 1998. In addition, the Government used its observations of Defendant's spending and banking habits, including his apparent need to borrow money for a boat and a vehicle, to determine that no significant amount of cash was in his possession.
Defendant argues that he understated his net worth on the credit application because he assumed the application was asking how much money he had brought with him to the store. Although he was entitled to make that argument to the jury, and he did, the Government was not unreasonable to use this information, along with other evidence, to establish Defendant's opening net worth. In fact, an individual with an interest in securing financing or credit has an incentive to overstate, rather than understate, his financial worth on a credit application, so as to appear more creditworthy. There's certainly no reason to believe he would have been denied credit if he indicated he had cash assets in six figures.
Thus, the Court finds that there is substantial evidence the Government followed all reasonable leads provided to it in determining, to a reasonable certainty, Mr. Fox's net worth as of January 1, 1998. Viewing the evidence in favor of the prosecution, a reasonable jury could have found that he had limited cash available to him at that time.
2. Reasonable Leads and Melody Fox's Income
Mr. Fox also makes a more standard argument about so-called “reasonable leads” — that his wife, Melody Fox, was earning income during some of the years for which he is charged with failing to report his income, that her income explains his spending beginning when she moved from Florida to New Jersey in mid-2000, and that when he informed the Government of her income, it failed to adequately investigate her employment. Of course, Melody's income could be a source of nontaxable income to Mr. Fox, as Special Agent Lipski concedes, if it were true. If Melody was earning money that Matthew was spending, her earnings could explain some of his expenditures.
First, the Court notes that undisputed evidence at trial established that Matthew and Melody Fox met in the summer of 2000 and began sharing resources soon thereafter. They were married in February of 2003. Thus, even under Mr. Fox's version of facts, Melody's income could not explain any of his expenditures for the early years for which he is charged with evading income taxes, 1998 and 1999, nor January through July of 2000. 3
As for the later years, the Government argues that it adequately investigated whether Melody Fox was working during those years and determined that she was not working after August 2000, when they began living together. The Government's investigation consisted of two categories of evidence: evidence from the Defendants themselves and evidence from Bare Exposure, purportedly Melody's employer during those years.
On three occasions in 2001 and 2002, Matthew and Melody Fox testified under oath, in a child custody dispute in Florida, that Melody was no longer working, and thus, no longer earning income, after only a brief employment at Bare Exposure after moving to New Jersey in July 2000. That testimony was provided to Agent Lipski during her investigation of the Foxes by the attorney for Mrs. Fox's ex-husband, with whom Melody had a custody dispute. (July 17 Tr. at 72.) That testimony also indicated that Melody Fox earned money throughout 2000, prior to August, from named clubs in Florida, from Bare Exposure, and from a photo shoot in France. ( Id. at 76-78.) Agent Lipski investigated these sources of income by checking the IRS databases to determine whether 1099's or W-2's were issued to Mrs. Fox, then named Melody Willis, and to ask Mr. Ariemma, in her July 11, 2003 meeting with him and his attorney, whether Melody worked at Bare Exposure, his club. Mr. Ariemma told Agent Lipski that he heard Melody worked at his club for a short period of time but he didn't know when. (Tr. July 17 92:13-15, 142:7-9.) Lipski asked Ariemma for records of dancers, and he said the club had no records. (Tr. July 17 at 145). If Lipski had made a more pointed inquiry of Ariemma about Melody Fox, he presumably would have told her what he told the jury at trial, namely, that he hired her in July 2000 and she worked for only three weeks or a month before stopping when she began dating Matthew Fox, and never resuming, being wary of the custody battle. (Tr. July 17 at 176, 179-181.) In any event, from what Agent Lipski learned from the Florida testimony of Matthew Fox and Melody Willis and from the lack of corroboration of her sustained employment at Bare Exposure and the absence of any lead identifying some other source of her income, the IRS could reasonably conclude that further investigation was not necessary.
At trial, Mr. Ariemma testified that he kept Bare Exposure's door sheets, which included the records of which dancers and managers were working on a given night and how much money was coming in for admission, as well as some indication of the number of dances performed, in a box at his home from 2002 up until 2005, when the club began a computer system. (Tr. July 18 at 28-29, 35-36, 38, 54.) He did not make the IRS aware of these door sheets, but in any event, they would have been unavailable because Ariemma never saw Melody Fox dancing after the brief period in 2000.
On July 11, 2003, Agent Lipski met with Anthony Ariemma, an owner of Bare Exposure, and his attorney, to discuss Matthew Fox's work history there. (Tr. July 17 at 27-29.) She obtained no employment records from Mr. Ariemma, related either to Mr. or Mrs. Fox. ( Id. at 30.) Mr. Ariemma stated Bare Exposure did not issue a W-2 or a 1099 for the period of time that Melody Fox worked there.
During the course of the investigation, on July 30, 2003, Melody Fox belatedly filed tax returns for the years 2000, 2001 and 2002, which indicated that she earned substantial income. Mr. Barbone presented these tax returns to Agent Lipski as an explanation of his spending for those years. After receiving these forms, Agent Lipksi asked Ms. Dougherty to identify the “various locations” vaguely mentioned as places of employment on these returns and, as Agent Lipski testified, she received no response identifying any workplace.
At trial, Ariemma testified that Melody Fox was not working at the club in 2001, but that he listed her as an employee on his health insurance plan for employees as a favor to Matthew, who was the manager at that time. (Tr. July 17 at 167.) Ariemma testified that Melody was hired to work at the club in July of 2000 ( id. at 175) and that she worked there for three weeks to a month ( Id. at 179-80). Another manager, a former close friend of Mr. Fox, Aldo Esposito, also testified that Melody was not working at Bare Exposure in 2001 and 2002, and that she had worked only a month or month-and-a-half at the beginning, in 2000. (Tr. July 18 at 18, 23.)
Most significantly, Aldo Esposito also testified that Matthew Fox approached him in the fall of 2006 to sign two forged documents (Exs. 42.1 and 42.2) to try to establish that Melody was working at Bare Exposure in 2001 and 2002 when she was not. (Tr. July 19 at 19-23.) He signed these back-dated documents at Matthew Fox's request to manufacture subcontractor forms bearing Melody's name for a period of time when he worked as an assistant manager but she was no longer a dancer. ( Id.)
There was contradictory testimony at trial from patrons — including Matthew's friends — and the defendants, that indicated Melody was working at Bare Exposure after August of 2000. No corroborating employer or patron was identified to the IRS at any point in the investigation, and the IRS's duty of a reasonable investigation of leads does not include guessing where a taxpayer might be working. While the Government did not know of the existence of any “door sheets” during 2003 and 2004, and therefore did not seek them, one can only speculate what those sheets contained. A single specimen of unknown origin was shown to Mr. Esposito at trial (Ex. D-15), but it was unauthenticated as a business record under Rule 803(6), Fed. R. Ev., and not admitted into evidence, although Esposito's past recollection recorded was admissible under Rule 803(5), that he signed a sheet as a manager in 2002 indicating that among the dancers that day was a “Melanie”, which was a name Melody Willis had used when dancing. It was up to the jury to decide on the weight to be given to this stray “door sheet” as well as the IRS's failure to learn the existence of door sheets before they were destroyed in 2005.
Nevertheless, there was ample evidence at trial from which a jury could believe, beyond a reasonable doubt, that Melody Fox ceased working at Bare Exposure in August of 2000. Furthermore, evidence that the defendants passed off her income from early 2000 as a source available to him, even though they had not met at the time, was evidence of consciousness of guilt from which the jury could infer that Mrs. Fox's tax returns were not proof of a source of income funding Matthew Fox's expenditures from August 2000 through December 2002.
3. Likely Source
As stated above, the Government has an additional obligation either to prove there was a likely source of taxable income that Defendant did not report or to disprove all possible sources of nontaxable income. The Government chose the second method — disproving the possible sources of nontaxable income for which it had reasonable leads — and the government did not argue or attempt to show a likely source of taxable income.
The parties agree that there are two permissible approaches to circumstantially proving unreported income: the Government must either negate all possible non-taxable sources of income or show a likely source of unreported income. See United States v. Goichman, supra, 547 F.2d at 781; see also Spear v. Commissioner (Estate of Spear), 41 F.3d 103, 108 (3d Cir. 1994) (“In a net worth case, the Commissioner must: (1) establish with reasonable certainty an opening net worth; and (2) either (a) show a likely income source, or (b) negate possible nontaxable income sources.”). Of course, this methodology does not change the burden of proof, so that if the Government attempts to disprove all possible sources of nontaxable income, it must do so by proof beyond a reasonable doubt.
If the Government chooses not to prove likely source but to negate the possible nontaxable sources of the alleged net worth, there is no further obligation to prove a likely source of taxable income. United States v. Goichman, 547 F.2d at 781; see United States v. Chu, 779 F.2d 356, 366 (7th Cir. 1985) (“the government investigated all ‘relevant leads … reasonably susceptible of being checked,’ thus negating possible sources of non-taxable income.”).
For the reasons discussed above, the Government produced evidence of the leads it received and its investigation and surrounding circumstances from which the jury could reasonably find, beyond a reasonable doubt, that it negated all nontaxable sources of income of which it was made aware. The jury was free to find that the leads given to the IRS were vague or irrelevant, government's investigation was reasonably performed, that its conclusions about the non-existence of a pre-1998 cash hoard and Melody Fox's earnings after July 2000 were logical, and that Matthew Fox neither expended funds from a pre-existing secret cash hoard nor did he receive money from earnings of Melody Fox as claimed. While Defendant Fox can, and does, suggest measures that the government, in hindsight, might have employed in proving these negatives, such as examining door sheets for Bare Exposure that the IRS did not know to exist, the law does not require the government, in a net worth and expenditures case, to eliminate every conceivable possibility of nontaxable sources. The jury also heard evidence undermining Matthew Fox's credibility, such as his attempt to use Aldo Esposito to manufacture evidence and his profession of ignorance of the fact that savings accounts earn interest, among other statements, which tended to erode his overall credibility. The jury evaluated all the relevant circumstances and applied a correct statement of the law in determining the government met its burden beyond a reasonable doubt.
The jury's verdicts on Counts Two through Six are amply supported by evidence, and the motion for acquittal under Rule 29(c) will be denied.
E. Motion for New Trial under Fed. R. Crim. P. 33(a)
Defendant Matthew Fox urges the Court to set aside the verdicts and order a new trial under Rule 33(a) based upon an alleged “confluence of multiple errors and prejudicial events at trial.” Def. Br. at 40. Four such situations are mentioned, namely: (1) the acquittal of both Defendants on the conspiracy count is inconsistent with convicting Matthew Fox on Counts Four, Five, and Six; (2) a remark in the prosecutor's opening statement about the possibility of Melody Fox's ex-husband hiring a private investigator to see if she was still dancing; (3) questions asked by the Court of prosecution witness Maureen Dougherty; and (4) the prosecutor's exclamation in front of the jury that Melody Fox's attorney, who possessed the prosecutor's documents that the prosecutor had not given to him, must have “taken” the documents from the prosecutor's table. These are addressed in order.
1. Inconsistency of Verdicts
Defendant points at the alleged inconsistency of the jury's verdicts, in which Matthew and Melody Fox were acquitted of conspiracy to defraud the United States in violation of 18 U.S.C. § 371 in Count 1, while Matthew Fox was convicted of evasion of income taxes for 1998-2002 in violation of 26 U.S.C. § 7201 in Counts 2-6. Defendant argues that there is no rational explanation for the jury to find Melody not guilty of a conspiracy if the central predicate of the government's theory was accepted. (Def. Br. at 40.) Defendant invokes the “rule of consistency” and cites to Government of the Virgin Islands v. Hoheb, 777 F.2d 138, 141 (3d Cir. 1985). The “rule of consistency” is inapplicable here, because neither defendant was convicted of conspiracy. It applies only when one defendant is convicted of conspiracy where the remaining defendants are acquitted of conspiracy. Id. at 140-41. Even in Hoheb, the Third Circuit noted the narrow application, and observed that a conviction for conspiracy will still stand if the government proves that the defendant conspired with an unknown person. Id. The Third Circuit also noted that the “rule of consistency” might be a “vestige of the past.” Id. at 142 n.6.
The present case presents the far more common situation where a jury convicts on some criminal charges and acquits on another where the crimes arose from largely the same facts and circumstances but the elements of proof are different, as they assuredly are between tax evasion under 26 U.S.C. §7201 and conspiracy to defraud the United States under 18 U.S.C. §371. Moreover, the acquittal on conspiracy pertained, at most, to the years 2000-2002, and had nothing to do with the tax evasion in 1998 and 1999.
Even if there were an inconsistency, it is by now wellestablished that in a criminal case “jury verdicts cannot be set aside solely on the ground of inconsistency.” United States v. Vastola, 989 F.2d 1318, 1329 (3d Cir. 1993), citing United States v. Powell, 469 U.S. 57, 67 (1984); City of Los Angeles v. Heller, 475 U.S. 796, 805-06 (1986) (J. Stevens, dissenting) (observing the “clear” rule that “[i]n a criminal case, a jury's apparently inconsistent verdict is allowed to stand”).
The Court of Appeals in United States v. Uzzolino, 651 F.2d 207 (3d Cir. 1981), reversed the district court's order setting aside an allegedly inconsistent jury verdict and reinstated the conspiracy conviction where the defendant was acquitted of the substantive offense. The Third Circuit summarized the law in this area:
First, we note, as did the trial court, that even if a jury's verdicts are inconsistent, inconsistency alone is not an appropriate legal basis to reverse an otherwise valid jury verdict. See Hamling v. United States, 418 U.S. 87, 101, 94 S.Ct. 2887, 2899, 41 L. Ed.2d 590 (1973); United States v. Continental Group, Inc., 603 F.2d 444, 455 (3d Cir. 1979), cert. denied, 444 U.S. 1032, 100 S.Ct. 703, 62 L.Ed.2d 668 (1980). The general rule is that inconsistent verdicts will be left to stand as a hallmark to the jury's “assumption of a power which they had no right to exercise, but to which they were disposed through lenity.” D unn v. United States, 284 U.S. 390, 393 [1932], quoting Steckler v. United States, 7 F.2d 59, 60 (2d Cir. 1925).[FN10] Only in a rare case will such verdicts demonstrate that there was no legal basis for the jury's decisions. See, e.g., United States v. Hannah, 584 F.2d 27 (3d Cir. 1978).[FN11] Certainly, where, as in this case, there is some question as to whether the verdicts are inconsistent, the jury's verdicts will not be disturbed. See United States v. Varkonyi, 611 F.2d 84, 86 (5th Cir.), cert. denied, 446 U.S. 945, 100 S.Ct. 2173, 64 L.Ed.2d 801 (1980).
Uzzolino, 651 F.2d at 213. The one instance referenced by the Uzzolino opinion where a verdict was set aside due to inconsistency was the Hannah case, in which “the conspiracy for which the defendant had been acquitted was a predicate offense to the substantive offense of using the mails to facilitate that same conspiracy,” so that the facilitation conviction was insufficient as a matter of law. Uzzolino, 651 F.2d at 213 n.11. Since both Hanna and Uzzolino, the Supreme Court has reaffirmed the principle that a verdict cannot be set aside solely based on inconsistency, so long as the conviction is supported by sufficient evidence. United States v. Powell, 469 U.S. 57, 67 (1984).
Thus, the perceived inconsistency of verdicts in the present case is not the basis for a new trial on any of the counts of conviction. If defendant is searching for a rational explanation of how Matthew Fox could be found guilty of the tax evasion counts and not guilty, with Melody Fox, of the conspiracy count, defendant might look no further than the jury's exercise of its power of lenity in not convicting the Foxes of conspiracy, as recognized above, in Dunn v. United States, 284 U.S. 390, 393 (1932), quoting Steckler v. United States, 7 F.2d 59, 60 (2d Cir. 1925). In any event, counsel for Melody Fox, in closing arguments, principally invited the jury to find there was not sufficient evidence that Melody Fox knowingly agreed to defraud the government of money, a question he posed to the jury in different ways in his closings. The jury may have taken up counsel's suggestion and found reasonable doubt as to the existence of the agreement between Matthew and Melody Fox that was necessary to convict on Count 1 but not necessary for Counts 2-6.
In summary, the Court finds no grounds arising from any inconsistency of verdicts to set aside the convictions under Rule 33(a), Fed. R. Crim. P.
2. Prosecutor's Remark about Private Investigation
Defendant Fox objected to a portion of the prosecutor's opening statement in which he pondered whether it would have been difficult for the ex-husband of Melody Fox to hire an investigator to see if in fact she was still dancing, as part of the custody battle. The prosecutor's statement was intended to preview evidence that the government would introduce at trial regarding Defendants' concern that if Melody Fox were to continue dancing, it could be easily detected by a private investigator for use against her in the custody case.
The government indeed introduced such evidence at trial. As noted above, Anthony Ariemma testified that Matthew Fox told him about the custody battle and that he was concerned a private investigator could be following them to see if Melody was dancing. (Tr. July 17 at 180-181; see also Tr. July 18 at 100-102). Although Ariemma explained that Fox's custody battle began after Melody Willis Fox quit dancing, “he [Matt] thinks like PI's are following them.” (Tr. July 17 at 181.)
The prosecutor's remarks in opening, intended to preview trial testimony, were indeed linked to the testimony that was presented and those remarks are not objectionable. The jury, as always, was instructed many times that counsel's opening statement and arguments are not evidence. There was no prejudice to Matthew Fox in these remarks, which were not inflammatory nor wide of the mark from evidence later introduced at trial. The prosecutor's remarks raise no concern to be further addressed under Rule 33(a).
3. Questions by the Court
Defendant alleges that several questions asked by the Court of witness Maureen Dougherty, who prepared the Melody Fox tax returns in 2003, were prejudicial to Matthew Fox. Ms. Dougherty was called by the government in its direct case. She is an attorney with a civil tax practice. (Tr. July 11 at 4-5.) She testified that Matthew Fox first consulted her about his own tax problems in the Spring of 2003, and she referred him to a criminal attorney. ( Id. at 5-7.) Matthew Fox next consulted her in June or July of 2003 with concerns for his wife Melody's tax situation, so she made an appointment and saw both Foxes on June 11, 2003. ( Id. at 8.) They told Dougherty that Melody had earned income as an exotic dancer in prior years but had filed no tax returns. ( Id. at 9-10.) She met with them several times and attempted to reconstruct Melody's income for 2000-2002. ( Id. at 11-13.) She filed the returns with IRS under a voluntary disclosure program on July 30, 2003. ( Id. at 30-31.)
Upon cross-examination, testimony revealed that Ms. Dougherty was a tax expert with a Masters in Taxation from NYU Law School, who also taught law school courses in Florida, including two semesters of civil procedure, conflicts of law, and property in 2004-05. ( Id. at 57.) Ms. Dougherty testified to her intention or plan to “give [Melody] the best chance at having these returns respected and not being dragged into something in term of her spouse's issues with the IRS. My only focus was on my client and my client was solely Melody.” ( Id. at 71.) Over the government's hearsay objection, defense counsel examined Dougherty about Melody's concerns about how her exotic dancing had affected her child custody of her daughter. ( Id. at 74.) Dougherty added that Melody said she had lied in depositions or to the judge about her dancing. ( Id. at 74-75.) Dougherty revealed that she advised her client to “file the returns and deal with the custody issue,” and predicted that if her exhusband would seek to reopen the custody issue after these returns are filed, she told Melody that “you have a decent shot at defending any attempt on his part to obtain custody of the minor child.” ( Id. at 74-75.) Finally, on this topic, Ms. Dougherty again indicated, in response to defense counsel's questions, that Melody Fox “was very upset about the investigation. She was very concerned about my advice to her to go and file… That's why she was stressed, she was pregnant, she was upset about the investigation, and she was upset about the potential impact on custody.” ( Id. at 90.)
Because the testimony about Ms. Dougherty's advice to Ms. Fox needed clarification, the Court determined, at the end of all questioning, to ask a follow-up question under Rule 614(b), Fed. R. Ev., 4 which included the following:
THE COURT: Okay. And you mentioned in your testimony that Melody Fox had lied during the course of her Florida court testimony. Do you recall that?
THE WITNESS: I do recall that.
THE COURT: And did you know that at the time when you were advising Melody Fox about filing correct tax returns?
THE WITNESS: I can't say that I knew. I can say what she represented to me, yes, I did, and I went through that issue with her in private, just Melody and I.
THE COURT: Did you advise her then to correct her false testimony in the Florida court?
THE WITNESS: The case was closed, the divorce was complete, the custody issue was over, and I felt — and she was no longer dancing and I didn't, frankly, think that I had a responsibility to do that. I'm not sure —
THE COURT: So you did not?
THE WITNESS: I did not. Had I thought I had a responsibility to do so, I would have.
(Tr. July 11 at 102:5-22.)
Counsel voiced no objection, and each attorney had the opportunity to ask follow-up questions. ( Id. at 103-104.) Two more witnesses testified that day — Lloyd Jones and Violet Meyer. The next day, July 12, Mr. Poplar first raised an objection, arguing that the jury might infer from the Court's question, that Ms. Dougherty had a duty to advise Ms. Fox to correct the misstatements in the Florida court; Mr. Poplar opined it would be inappropriate for a lawyer to advise a client to return to court to correct materially false statements. He requested that the Court five the jury an advisory instruction that they should not presume, from the question on the witness's answer, that there was any duty to so advise the client. After reviewing the transcript, and discussing the clarifying instruction with counsel, the Court gave a curative instruction on the next trial day, July 17, clarifying that the Court, in its questioning of Ms. Dougherty, did not mean to imply that Ms. Dougherty had an ethical obligation to advise Ms. Fox to take corrective action about her false testimony in Florida. 5
The Court's questioning of Maureen Dougherty was not improper under Rule 614(b). She was a government witness, the subject of advice she gave to Melody Fox about the possibility of a reopened custody hearing in Florida was elicited by defense counsel, and the question about whether she advised Ms. Fox to voluntarily come forward to the Florida court and admit she gave false testimony was a relevant question. The Court did not dwell on this issue or act confrontational toward this witness, nor did the Court express any skepticism about the witness's answers. The witness seemed to accept Ms. Fox's version that her Florida statements were false, and the question was an exploration of whether Dougherty, as an experienced New Jersey attorney and Florida law professor, considered and discussed the jeopardy Fox might place herself into by subscribing tax returns under oath that so directly contradicted her Florida testimony, also under oath. The questions were probative because the more Dougherty recalled Melody Fox's statements to her that her Florida testimony was false, the more likely it may be that Defendant's explanation at trial regarding the falsity was consistent with her statements to Dougherty four years earlier. The answer given — that she gave Melody Fox no such advice and that she had no duty to do so — aided Defendants, especially Melody Fox, who could not be accused of failing to follow her attorney's advice to file her returns first and not worry about the implications for child custody in Florida.
Moreover, the Court acquiesced in defense counsel's request for a clarifying instruction and gave it, after reviewing it with all counsel, so that no juror could misinterpret the question as implying criticism of Dougherty for breaching some ethical duty.
Trial judges have discretion to ask questions of witnesses, to a greater extent in a complex case (such as this one) than in a simpler case, United States v. Green, 544 F.2d 138 (3d Cir. 1976). A judge must understandably be cautious in questioning a defendant in a criminal case, but direct, specific questions to clarify a defendant's testimony will not give rise to error where the judge's impartiality remains intact. United States v. Gonzalez-Torres, 980 F.2d 788 (1 Cir. 1992). For example, st judicial questions that telegraph to the jury that the judge disbelieves the defendant can result in reversal of a conviction, United States v. Tilghman, 134 F.3d 414 (D.C. Cir. 1998). No such questioning occurred here. Similarly, if a trial judge continually interrupts the examination of a witness, posing numerous questions in succession and talking over the examination, the discretion of Rule 614(b) is exceeded, although even in such a case, a new trial may not be necessary. United States v. Wilensky, 757 F.2d 594 (3d Cir. 1985). Again, no such questioning occurred here, as the few questions asked of the witness came at the end of all questioning and involved an effort to clarify the nature of her advice to her client. “Overzealous” cross-examination by a judge of the defendant's alibi witnesses, in a manner conveying skepticism about the defendant's alibi, could likewise cross the line, as in United States v. Beaty, 722 F.2d 1090 (3d Cir. 1983), but nothing of the sort occurred here.
The Court's questions at issue here trigger none of these concerns. Any implication of possible unethical behavior by the witness was eliminated by the clarifying instruction to the jury. Finally, the jury was instructed, before the questioning of Ms. Dougherty (Tr. July 11 at 99:27-14), that the judge is permitted to ask clarifying questions and that the fact a judge asks a question or two does not invest the question or answer with any more or less significance than any other question that's answered.
The questioning to which defense counsel now objects was well within the bounds of Rule 614(b) and of the defendant's fair trial rights and does not give rise to a concern under Rule 33(a).
4. Comment of Prosecutor toward Mr. Poplar
Lastly, Defendant Matthew Fox argues that a comment made by government counsel, Andrew Kameros, to Melody Fox's counsel, Carl Poplar, when Mr. Poplar attempted to examine a witness with a document Mr. Poplar had inadvertently take from the prosecutor's table, caused prejudice to Matthew Fox that was not cured by the Court's curative instruction to the jury. This episode requires little comment.
Briefly, this mini-drama unfolded as Mr. Poplar attempted to cross-examine Mr. Ariemma, one of the owners of Bare Exposure, about a series of Ariemma's corporate tax returns for 2000 through 2003, Exs. D-20, D-21, D-23, and D-24, respectively, which had been furnished to Poplar by the government as a result of a subpoena for those years. (Tr. July 18 at 155-158.) When Mr. Poplar then proceeded to use a 2004 corporate return (Ex. D-25) that was not within the subpoena and had not be produced to Mr. Poplar by Mr. Kameros, the government objected and the following ensued:
KAMEROS: Objection. Your Honor, the subpoena was for 2001 through 2003, the 2004 return was not called for.
THE COURT: I think that's correct.
MR. POPLAR: I had this in my file, your Honor.
KAMEROS: I don't know where they got it from, they didn't get it from us.
MR. POPLAR: In any event —
THE COURT: It seems to be beyond the scope of —
MR. POPLAR: But it's —
THE COURT: — of the issues in this case if it's 2004.
MR. POPLAR: No, but he said that it's 50/50 up through the present time. And 2004, you know, shows that the accountant's faux pas perpetuated itself, meaning it wasn't an accountant faux pas.
THE COURT: So this next return, D-25, is a 2004?
MR. POPLAR: Right.
THE COURT: And the objection is?
MR. KAMEROS: Objection. Those were not among the copies that we turned over.
MR. POPLAR: That was in the stack of documents I reviewed last night.
MR. KAMEROS: The order was for 1998 through 2002.
THE COURT: If that's the objection, can you ask the witness if that was one of the documents turned over?
BY MR. POPLAR:
Q. Is this one of the documents you turned over to the courthouse last week?
A. I gave the ‘04 to them.
MR. KAMEROS: That was not turned over to them.
MR. POPLAR: It sure was. I wouldn't have had it.
MR. KAMEROS: You took it. It was not turned over.
MR. POPLAR: Judge, can I ask for some kind of admonition to the prosecutor?
MR. KAMEROS: We need to go to sidebar.
MR. POPLAR: Judge, I would like to have an instruction right now that admonishes the prosecutor.
THE COURT: I'm going to sort this out at sidebar. There was, ladies and gentlemen, a subpoena that required this witness to produce certain tax documents through the year 2003 and he did so. Apparently his testimony is that he produced beyond what was required in the subpoena and that Mr. Poplar received a copy, I'm sorry, that Mr. Kameros received these documents from the witness and so we'll see what comes next. Just a moment.
(Tr. July 18 at 159-160.) The jury was excused and the Court, with counsel, sorted out what had happened and addressed Mr. Poplar's request for an instruction admonishing Mr. Kameros for accusing him of taking the document. It emerged that the questioned document came into Mr. Poplar's possession when he indeed did take it, by inadvertence, from the prosecutor's table which he had used as a platform in questioning other witnesses. ( Id. at 165-166.) The Court found that “Mr. Poplar did inadvertently take the documents to which he wasn't entitled.” ( Id. at 165:25-166:1.) Mr. Poplar eventually agreed with these facts, stating: “There's no question about it, your Honor. There's no question about it, as I'm reconstructing it now, you know, what transpired is Mr. Kameros or the government left these papers clearly on this side of the table and I walked away with them. And last night when I was going through them, if I was focused on that subpoena, I would have had a better recollection that they weren't mine, but I didn't.” ( Id. at 173:21-174:2.)
While the Court declined to admonish Mr. Kameros for his choice of words in front of the jury, the Court did craft a detailed instruction which it reviewed and improved with input from all counsel. ( Id. at 174:13-179:22.) The jury was immediately returned to the courtroom and, before any further testimony was taken, the Court correctly instructed them that Mr. Poplar inadvertently obtained these tax documents from the table behind the prosecutors when Mr. Poplar used that table for his own records, and that the matter of production of documents is a procedural matter and not for the jury, and finally, to disregard Mr. Kameros' statement and give the matter no further thought. ( Id. at 180:1-24.) 6 No juror could have been left with the impression that Mr. Poplar purloined the documents, and all jurors were told that counsel's objection should have been addressed to the Court at sidebar, rather than the colloquy that took place before the jury for a moment until they were excused.
How any of this could even arguably prejudice Matthew Fox is unclear. Mr. Poplar represented Melody Fox who was acquitted. Mr. Barbone was never implicated in Mr. Poplar's mistaken taking of the documents.
The next day, Mr. Poplar raised the subject again, this time accusing Mr. Kameros of making an accusation of purloining that was a “volitional and non-inadvertent” comment. (Tr. July 19 at 6:14-19.) Mr. Poplar then moved for a mistrial and the Court denied the motion, recapitulating the events and the Court's reasoning in a detailed oral opinion. ( Id. at 7:21 to 10:17.)
In summary, nothing about this brief exchange in front of the jury, and its prompt resolution and explanation in a curative instruction to the jury, causes concern about the overall fairness of the trial or prejudice to Matthew Fox's fair trial right.
IV. CONCLUSION
For the reasons discussed above, the motions for judgment and for a new trial are denied. The appropriate Order has been entered.

Footnotes


1
The United States also presented evidence at trial negating the existence of such a cash gift. It's also apparent that any attempt to follow up on this claim would not have pointed to evidence confirming this nonreportable source. The Government's rebuttal witness, Dorothy Fox, was the widow of Matthew Fox's father, having lived with him from 1992 until his institutionalization in 2003. She testified that he had never indicated he had any such cash. She was familiar with his finances and retirement accounts, and they pooled their earnings in a joint account. She testified quite clearly that Matthew Fox, Sr. never said he gave a large sum to his son, nor to her knowledge did he do so. She also confirmed that, due to a brain injury suffered in 1998, Matthew, Sr. was in declining mental health to the point of requiring institutionalization as a Medicaid patient in 2003, passing away in 2005. This further confirmed Agent Lipski's testimony of her understanding when her investigation began in 2003 that the elder Mr. Fox was unavailable to be interviewed.
2
This Court notes, also, that the Fifth, Seventh and Eleventh Circuits have held that the IRS has no obligation prior to prosecution to investigate a defendant's statement that he had a private cash hoard because such statements by the defendant are not reasonable leads as they are virtually impossible to investigate. See, e.g., United States v. Scrima, 819 F.2d 996, 999 (11th Cir. 1987) ( "After everything possible is done to verify the opening net worth, the issue of the amount of the defendant's cash hoard is properly submitted to the jury.").
3
Further, evidence clearly showed Matthew Fox willfully omitted claiming any income from Bare Exposure in 1998, when in fact he was earning $400 weekly plus tips. He claimed a small amount of income but no tips in 1999 and 2000, when the evidence was to the contrary, according to the testimony of Bare Exposure owner Anthony Ariemma, who testified that Fox's share of tips was $100-$120 on a Saturday shift, $60-$70 on a Friday night, and $20-$30 on other nights. (Tr. July 17 at 163-165.) Assuming Matthew Fox worked Fridays, Saturdays, and one or two other nights, his tip income was more than $200 per week, or more than $10,000 per year, all unreported taxable income. This is, of course, sufficient evidence of tax evasion for the years 1998, 1999, and 2000 based upon failure to declare any wages for 1998 and any tips for 1998-2000.
4
Rule 614(b) states: "Interrogation by court. The court may interrogate witnesses, whether called by itself or by a party."
5
The clarifying instruction stated to the jury:
… I wanted to give you one clarifying instruction for your information in this case. The clarifying instruction concerns … a question that I had asked of the witness Maureen Dougherty last week on Wednesday. Last Wednesday I asked the witness Maureen Dougherty if she had advised her client to contact the Florida authorities regarding Melody Willis Fox's untrue statements in the Florida legal proceedings. By that question, ladies and gentlemen, I did not mean to infer that Ms. Dougherty had a duty to advise her client to contact the Florida authorities. To the contrary, under the facts of the case, Maureen Dougherty had no ethical duty or obligation to advise her client to contact the Florida authorities about Ms. Fox's untrue statements and you may consider Ms. Dougherty's answers in this light. And that's my clarifying instruction.
Tr. July 17, 2007 at 4-5.
6
The entire instruction on this point follows:
Ladies and gentlemen, before we proceed, let me give you the following instruction:
There was an exchange of words between counsel before the break in which Mr. Kameros was surprised to learn that Mr. Poplar was using a tax document that had not been produced to Mr. Poplar in this case. Mr. Kameros indicated that he thought Mr. Poplar took the extra documents, which Mr. Poplar denied. Now, the production of documents concerns a procedural matter and it is a matter for the Court and not for the jury. Counsel have been instructed to raise such matters with the Court only at sidebar and this exchange between counsel should not have occurred. But because this occurred in your presence, I sorted out this matter and I concluded that Mr. Poplar inadvertently obtained these tax documents from the table behind the prosecutors when Mr. Poplar used that table from his own records in crossexamining a witness yesterday. Mr. Kameros did not produce these records to Mr. Poplar nor was he required to produce these records. But because the documents came into Mr. Poplar's possession unintentionally and inadvertently, I will hereby instruct you to disregard Mr. Kameros' statement and to give the matter no further thought.
Does everyone understand my instruction? Does anyone need to have it repeated? Very well.
(Tr. July 18 at 180:1-24.)

Tax motivated transaction not given effect

Custom Adjustable Rate Debt Structure (CARDS) transactione loss from the CARDS transaction, which resulted from the swap of euros for dollars as part of a cross-currency swap, was used to offset gain from the sale of an unrelated business. The CARDS transactions lacked economic substance and stood no chance of earning a profit. There were no third parties involved in the transaction, and all parties, which included the lender, the initial borrower and the LLC that assumed the loan, were involved specifically to enter into the CARDS transaction. The transaction consisted of a number of prearranged steps entered into to generate a tax loss. Further, the loan proceeds were never at risk because they never left the lender's control. Although the members of the LLC asserted that the purpose of the CARDS transaction was to finance a real estate investment, the members knew that the bank would not allow the substitution of real estate as collateral and that the members would have to purchase the bank's promissory notes to pledge as collateral. None of the parties made additional contributions to capital or used the loan proceeds. Loans that became due were paid back with promissory notes. The terms and interest rates of the currency swap and forward contract allowed the LLC to back out of the transactions and pay nothing but fees. Additionally, there was credible expert testimony that the CARDS transaction was cashflow negative. The claimed loss was also disallowed because the members did not have a nontax business purpose for entering into the CARDS transaction. Testimony that the transaction was to secure financing for future real estate investments was not credible.


The key rationale in this case is that no substance would be given to the transaction because it did not have a business purpose and was tax motivated.

The loophole in this case is that the court signaled that it would reach a favorable result if there was a profit motive and a good business purpose (which is always a profit motive).


Country Pine Finance, LLC, Richard A. Phillips, Tax Matters Partner v. Commissioner., U.S. Tax Court, CCH Dec. 57,982(M), T.C. Memo. 2009-251, (Nov. 5, 2009)

U.S. Tax Court, Dkt. No. 1399-07, TC Memo. 2009-251, November 5, 2009.

An LLC that was treated as a partnership was not entitled to claim a loss that ; Elizabeth R. Edberg and John W. Stevens, for respondent.

MEMORANDUM OPINION

GOEKE, Judge: During 2001 the members of Country Pine Finance, L.L.C. (Country Pine Finance), sold an unrelated insurance business, generating gain and leaving them facing a contingent tax liability. The members entered into a Custom Adjustable Rate Debt Structure (CARDS) transaction in order to reduce their tax liabilities. The CARDS transaction generated a loss on Country Pine Finance's 2001 Form 1065, U.S. Return of Partnership Income. The issue for decision is whether Country Pine Finance is entitled to this loss. For the reasons stated herein, we find that Country Pine Finance is not entitled to the claimed loss.
The stipulations of fact and the attached exhibits are incorporated herein by this reference. Charles C. Burnham, Terry L. Stewart, Wayne R. Sharp, Jan P. Blick, Thomas E. Kolassa, Edward M. Burnham, David L. Burnham, James M. Burnham, James L. Harvin III, Thomas A. Reitan, John S. Avery, Richard A. Phillips (petitioner), John R. Bromley, and Stephen C. Adams were the members of Country Pine Finance during its existence (collectively, the members).
Background
1. The Burnhams
Charles C. Burnham, Edward M. Burnham, David L. Burnham, and James M. Burnham are brothers. The four were involved in two business ventures: (1) Blue Marlin, a real estate business; and (2) Burnham Insurance Group (BIG), an insurance broker.
A. Burnham Insurance Group
Charles Burnham and his brothers formed BIG in 1978. BIG existed until its sale in 2001. Between 1978 and 2001 BIG merged with or acquired 12 other entities, usually smaller insurance brokerages. Typically the owner of the merged or acquired entity would become a BIG stockholder. Most of the members other than the Burnhams became BIG shareholders through these mergers and acquisitions.
B. Blue Marlin
The Burnham brothers and two unrelated individuals, Al Ivany (Mr. Ivany), and George Markham (Mr. Markham), formed Blue Marlin in the 1980s to develop a corporate office park on Country Pine Lane in Calhoun, Michigan. The corporate park was made up of three buildings: (1) 100 Country Pine Lane; (2) 300 Country Pine Lane; and (3) 500 Country Pine Lane. Blue Marlin built the 100 and 500 Country Pine Lane buildings.
Later, Blue Marlin divested itself of its holdings. The 500 Country Pine Lane building was sold to three individuals, Thomas Kolassa (Mr. Kolassa), Don Karsten (Mr. Karsten), and Mills Mayo (Mr. Mayo). The 100 Country Pine Lane building was sold to Mr. Ivany. The 300 Country Pine Lane building was sold to BIG.
2. Sale to HUB
Sometime before 2001 the BIG stockholders decided to sell the company. At that time the members and four unrelated individuals owned 84 percent of the shares outstanding, with the remaining 16 percent owned by an employee stock ownership plan. The BIG stockholders decided to sell the company to HUB International (HUB). The stockholders of BIG and HUB entered into an agreement and plan of merger whereby BIG was merged into a wholly owned subsidiary of HUB. The stockholders of BIG received shares of HUB stock and cash in exchange for their BIG shares.
BIG was valued by an appraiser before the stockholders entered into the merger agreement. However, one of BIG's business lines could not be valued accurately at that time. The parties to the merger agreement agreed that they would value that business line 2 years later, in 2003, and that if the results of that future valuation showed this business line to be worth more than originally thought, HUB might make additional payments to the BIG stockholders in 2003.
A. Requirements of Sale
During negotiations HUB informed the BIG stockholders that it was not interested in owning any real estate and would not purchase the 300 Country Pine Lane building. The stockholders decided to sell the 300 Country Pine Lane building to Country Pine Enterprises, L.L.C. (Country Pine Enterprises).
B. Country Pine Enterprises
Country Pine Enterprises was formed to hold the 300 Country Pine Lane building, which was conveyed to Country Pine Enterprises on June 29, 2001. Country Pine Enterprises then leased the 300 Country Pine Lane building to HUB. As a result, the BIG offices remained in the 300 Country Pine Lane building after the merger. Country Pine Enterprises later acquired the 500 Country Pine Lane building and some adjacent land.
C. Results of Sale
On June 18, 2001, HUB and BIG executed a letter of intent whereby the stockholders of BIG agreed to sell their shares to HUB. The merger was put into effect on July 20, 2001, through a subsidiary of HUB. The stockholders of BIG received HUB stock and cash in exchange for their shares in BIG. The BIG shareholders all recognized gain on the exchange of their stock and reported it on their individual Forms 1040, U.S. Individual Income Tax Return, for tax year 2001. Facing large contingent tax liabilities as a result of this gain, the members sought ways to offset their gains. One possible solution was a CARDS transaction.
3. Introduction to CARDS
The members participated in a CARDS transaction in 2001. The transaction was developed by Chenery Associates, Inc. (Chenery). The members decided to participate after viewing two presentations by Chenery.
A. Chenery Associates, Inc.
Chenery was incorporated in 1993. Roy Hahn (Mr. Hahn) was a principal at Chenery. Chenery developed and marketed tax shelters and worked with different investment banks in New York to implement its transactions. Chenery developed and implemented numerous CARDS transactions, including the CARDS transaction at issue, and received fees for each. A portion of the fees was used to pay the third parties involved in the specific CARDS transaction and their counsel.
B. Bob Baker
Bob Baker (Mr. Baker) was an insurance executive who later founded his own wealth management company, Asset Strategies. Mr. Baker met Mr. Hahn in the mid-1990s, and they remained in contact during their careers. Mr. Hahn introduced Mr. Baker to the CARDS transaction.
Mr. Baker also met Mr. Kolassa during the mid-1990s. Mr. Baker became acquainted with BIG and the other BIG stockholders through Mr. Kolassa after Mr. Kolassa joined BIG. Later, Mr. Baker and David Burnham discussed tax planning before the BIG-HUB merger was consummated. Mr. Baker referred the members to Mr. Hahn.
C. Miller Canfield
Miller, Canfield, Paddock & Stone, P.L.C. (Miller Canfield), was a law firm located in Michigan. John Campbell was an attorney at Miller Canfield who provided legal advice to the members and Country Pine Finance on implementing the CARDS transaction. Mr. Campbell and Miller Canfield did not provide any advice to the members or Country Pine Finance other than in connection with the CARDS transaction.
D. Decision To Enter Into a CARDS Transaction
On August 30, 2001, petitioner told Mr. Hahn that the members wanted to enter into a CARDS transaction. The three parties involved were: (1) Zurich Bank; (2) Fairlop Financial Trading, L.L.C. (Fairlop Trading); and (3) Country Pine Finance.
4. The CARDS Transaction in General
A CARDS transaction has three phases: (1) The loan origination phase; (2) the loan assumption phase; and (3) the operational phase. In general, three parties are required to carry out a CARDS transaction: (1) A bank; (2) a borrower; and (3) an assuming party.
A. Loan Origination
During the loan origination phase, the bank agrees to lend funds to the borrower. The borrower is a Delaware limited liability company with two members, both of whom are United Kingdom citizens to ensure that there are no U.S. income tax effects at the borrower level. The bank requires the borrower to be capitalized in an amount equal to 3 percent of the funds to be borrowed.
The loan is typically for 30 years, with principal due after 30 years but interest due annually. The credit agreement memorializing the loan imposes restrictions on what the loan proceeds can be used for. Collateralization requirements imposed by the bank require the borrower to use the loan proceeds to acquire highly stable items such as Government bonds or highly rated commercial paper. After initially collateralizing the loan with high-value, stable assets, such as Treasury bonds or promissory notes from the bank, the borrower can substitute collateral and gain access to the loan proceeds. In effect, the loan proceeds are initially used to purchase high-value items to serve as collateral for the loan until an equally high-value item can be swapped for the purchased items. This swapping of collateral purportedly frees some of the loan proceeds to be used for investment purposes as the borrowers see fit. However, the decision to swap collateral is not left to the discretion of the borrower. The bank ultimately decides whether and on what terms a certain asset or security can be used as collateral.
B. Loan Assumption
The second phase is the loan assumption phase—when the assuming party would assume a portion of the loan on behalf of the borrower. The assuming party would receive only a portion of the loan proceeds but would agree to become jointly and severally liable for the entire amount of the original loan to the borrower. 1 The assuming party would assume a portion of the loan equal to the present value of the principal amount due in 30 years.
C. Operational Phase
The operational phase consists of periodic “reset dates”. Each reset date allows the borrower to exchange collateral, with corresponding adjustments of the interest rate, and of the term until the next reset date. The decision to swap collateral or adjust the interest rate at a reset date is left to the discretion of the bank. If new collateral is proposed, it often results in a change of loan terms to reflect any adjustments to the amount of risk the parties face.
The purported purpose behind a CARDS transaction was to provide investment financing. A CARDS participant would enter into the CARDS transaction and use the assumed portion of the loan proceeds to make an investment. The investment property would then be swapped as collateral. In theory, the investment would be successful if the rate of return on the investment property exceeded the costs of entering into the CARDS transaction.
5. Country Pine Finance and Third Parties
A. Zurich Bank
Zurich Bank acted as the lender in the CARDS transaction at issue. Chenery had previously engaged Deutsche Bank in its transactions, but Mr. Hahn's contact at Deutsche Bank had moved to Zurich Bank. Shortly thereafter Zurich Bank was engaged. ZCM Matched Funding Corp. acted as Zurich Bank's agent for purposes of the CARDS transaction. 2
B. Fairlop Trading
Fairlop Trading, the borrower, was organized as a Delaware limited liability company on July 13, 2001, with Elizabeth A. D. Sylvester and Michael Sherry, citizens and residents of the United Kingdom, the members.
The Fairlop Trading members contributed $444,182 to Fairlop Trading. Cash of $6,296 was contributed with the remaining $437,885 due pursuant to notes payable. Fairlop Trading was set up solely to take part in this CARDS transaction.
C. Country Pine Finance
Articles of incorporation for Country Pine Finance were filed on November 14, 2001. A certificate of dissolution for Country Pine Finance was filed 1 year later, on November 14, 2002. Petitioner served as Country Pine Finance's tax matters partner at all relevant times.
The members made capital contributions to Country Pine Finance on November 21, 2001, and February 27, 2002, as follows:
Member 11/21/01 2/27/02
Charles C. Burnham $145,497 $42,010
Terry L. Stewart 132,425 38,235
Wayne R. Sharp 76,335 22,040
Jan P. Blick 48,720 14,067
Thomas E. Kolassa 61,761 17,832
Edward M. Burnham 41,087 11,863
David L. Burnham 36,063 10,413
James M. Burnham 32,862 9,488
James L. Harvin, III 31,483 9,090
Thomas A. Reitan 22,144 6,394
John S. Avery 21,651 6,251
Richard A. Phillips 24,550 7,088
John R. Bromley 17,807 5,141
Stephen C. Adams 17,613 5,085
Total (rounded) 710,000 205,000
Country Pine Finance was formed specifically to carry out the CARDS transaction. The amounts contributed were based on the amount of the fees to be paid to Chenery. A portion of the fees paid to Chenery was used to pay the third parties for their participation in the transaction.
6. The CARDS Transaction at Issue
A. Origination
On November 9, 2001, Zurich Bank and Fairlop Trading entered into a credit agreement. Fairlop Trading was required to pledge collateral in order to borrow funds. Fairlop Trading entered into a master pledge and security agreement on November 9, 2001, in order to satisfy the collateral requirement.
Zurich Bank applied a “haircut” to any pledged collateral. The haircut varied depending on the type of collateral pledged. For example, promissory notes from Zurich Bank or cash would not be subject to a haircut, while long-term commercial paper might receive a 10-percent haircut. The effect of the haircut would be to require the borrower to contribute or acquire additional assets to serve as collateral to make up for the haircut applied.
On December 4, 2001, Fairlop Trading informed Zurich Bank that it intended to borrow €16,613,000. The notice of intent to borrow indicated that the €16,613,000 would be used to purchase assets from Zurich Bank to collateralize the loan.
On December 4, 2001, €16,613,000 was deposited into Fairlop Trading's Zurich Bank account. The €16,613,000 was used to purchase two promissory notes from Zurich Bank, one for €13,662,660, the other for €2,990,340. Both promissory notes matured on December 4, 2002, and were used to collateralize the €16,613,000 loan from Zurich Bank to Fairlop Trading.
Fairlop Trading borrowed €16,613,000 from Zurich Bank, then exchanged the €16,613,000 for Zurich Bank promissory notes worth €16,613,000. This left Fairlop Trading owing Zurich Bank €16,613,000, and Zurich Bank owing Fairlop Trading €16,613,000. The €13,662,660 and €2,990,340 promissory notes were pledged as collateral for the loan. If Fairlop Trading defaulted on the loan, Zurich Bank could use the promissory notes to satisfy the debt.
Zurich Bank did not apply a haircut to promissory notes issued by Zurich Bank pledged as collateral, so no haircut was applied and Fairlop Trading did not have to contribute additional collateral. The terms of the loan from Zurich Bank to Fairlop Trading matched the terms of the promissory notes except that Fairlop Trading was required to pay 50 additional basis points of interest. This 50-basis-point spread served as a portion of the fees paid to Zurich Bank for entering into the CARDS transaction.
The €13,662,660 note remained with Fairlop Trading. The €2,990,340 note was later exchanged for a new note from Zurich Bank and €1,015,493.60. The note had a principal amount of €1,981,671. 3 Fairlop Trading immediately pledged the €1,981,671 note and the euro as collateral.
B. Assumption by the Members
On December 26, 2001, the members entered into a purchase agreement to purchase the €1,981,671 promissory note and €1,015,493.60 from Fairlop Trading. In exchange for the note and euro, the members agreed to become jointly and severally liable for the entire €16,613,000 loan from Zurich Bank to Fairlop Trading and waived any right of contribution against Fairlop Trading. The purported purpose of the waiver was to make the members fully liable for the entire €16,613,000 even if Fairlop Trading still maintained control over any portion of the proceeds. The members immediately pledged the promissory note and euro as collateral for the loan.
The members contributed the €1,981,671 note and €1,015,493.60 to Country Pine Finance. In exchange, Country Pine Finance guaranteed the loan. Country Pine Finance claimed bases in the €1,981,671 promissory note and the €1,015,493.60 of $9,658,146 and $4,938,036, respectively. Country Pine Finance's claimed bases were based on the members' purportedly becoming jointly and severally liable for the entire €16,613,000.
Shortly thereafter Country Pine Finance pledged the €1,981,671 note and the €1,015,493.60 as collateral for the loan. Again all amounts lent by Zurich Bank were guaranteed by collateral purchased from Zurich Bank with those loan proceeds. None of the “liable” parties ever contributed any additional collateral. If Country Pine Finance had wanted to substitute collateral for the note and euro, Zurich Bank would have had to consent.
On December 28, 2001, Country Pine Finance and Zurich Bank entered into a cross-currency swap. Section 1.988-2(e)(2)(ii), Income Tax Regs., defines a currency swap contract as a contract involving different currencies between two or more parties to exchange periodic interim payments on or before maturity of the contract and exchange the swap principal amount upon maturity of the contract. The exchange of periodic interim payments is the exchange of a payment in one currency for a payment in another currency, with both payments being determined by reference to an interest index applied to the swap principal amount. Sec. 1.988-2(e)(2)(ii)(C), Income Tax Regs.
The cross-currency swap was a combination of an interest-rate swap and a foreign exchange forward contract. Initially Country Pine Finance transferred the €2,997,640 to Zurich Bank, and Zurich Bank transferred $2,633,308 to Country Pine Finance. These were the notional amounts of the swap.
On December 28, 2001, the $2,633,308 Country Pine Finance received from Zurich Bank was used to purchase a promissory note with a principal amount of $2,633,308 from the bank. The promissory note was then pledged as collateral.
The interest portion of the currency swap required Zurich Bank to pay to Country Pine Finance annual interest on the €2,997,162 at the euro Interbank Offered Rate (EURIBOR), 4 and Country Pine Finance to make monthly interest payments at the U.S. dollar London Interbank Offered Rate (LIBOR) 5 to Zurich Bank on the $2,633,308.
The interest-rate swap allowed petitioner to receive interest payments equal to the amount of interest it would eventually owe on the €1,981,671 note and the €1,015,493.60.
The foreign exchange forward contract allowed Country Pine Finance to convert the $2,633,308 value of the promissory note purchased from Zurich Bank back into euro on December 4, 2002, at the same rate used to convert the euro into dollars on December 28, 2001. This in effect would allow Country Pine Finance to end up in the same economic position upon the closing of the cross-currency swap as it was on the day it entered into the swap. The cross-currency swap was closed out less than 1 year later on December 4, 2002.
C. Operational Phase
The members asserted that the purpose for entering into the CARDS transaction was to finance a real estate investment. According to the members, they would purchase real estate and use the real estate as collateral. If the members' investment was profitable, earnings from the real estate would exceed the costs of the CARDS transaction.
Zurich Bank told the members at the initiation of the CARDS transaction at issue that they would not be able to use real estate as collateral. On October 30, 2001, Mr. Hahn sent petitioner an email informing him that Zurich Bank would not allow the members to swap commercial real estate as collateral for the loan at that time because Zurich Bank could not properly evaluate any possible real estate before the initiation of the CARDS transaction. The members decided to enter into the CARDS transaction even though it would be some time before real estate could possibly be used as collateral. The members decided to enter into the CARDS transaction in 2001 anyway because the tax loss was needed in 2001.
Real estate was never substituted as collateral, and neither the members nor Country Pine Finance ever attempted to substitute any specific piece of real estate as collateral. During 2002 petitioner made attempts to determine whether real estate in a general sense could be substituted, but the members never attempted to purchase or use a specific piece of real estate as collateral. Nor did the members have any specific piece of real estate evaluated by Zurich Bank for collateralization purposes. Likewise the members never attempted to substitute any type of collateral other than real estate for the promissory notes.
On August 15, 2002, Zurich Bank informed Fairlop Trading and the members that Zurich Bank was no longer willing to maintain the loan. All of the borrowed funds were paid back with the pledged collateral, and no additional capital contributions were ever made. Country Pine Finance was dissolved on November 14, 2002, by unanimous vote of the members.
7. Country Pine Finance's and Members' Returns
Country Pine Finance filed a Form 1065 for tax year 2001 on September 16, 2002, claiming a $7,917,051 net short-term capital loss on a “Euro Promissory Note” and a $4,045,820 loss on the sale of business property. The $4,045,820 loss was reported on a Form 4797, Sales of Business Property, as an ordinary loss on a “Euro Deposit”.
The losses resulted from Country Pine Finance's swapping the note and euro for U.S. dollars as part of the cross-currency swap. Country Pine Finance claimed a basis of $14,596,182 in the euro. This was the U.S. dollar value of the initial loan from Zurich Bank to Fairlop Trading, €16,613,000. The members claimed this high basis in the euro because of the members' agreeing to be liable for the amount of the entire loan from Zurich Bank to Fairlop Trading.
The euro were a nonfunctional currency within the definition of section 988. 6 See sec. 1.988-1(c), Income Tax Regs. When Country Pine Finance exchanged the €2,997,640 for $2,633,308, it claimed a loss on the disposition of the euro equal to the difference between $14,596,182 and $2,633,308. Section 1.988-1(a)(1), Income Tax Regs., provides that disposition of a nonfunctional currency is a section 988 transaction. Thus the members' transfer of the euro was treated as a section 988 transaction. The loss was split between the promissory note and the euro. This resulted in a $7,917,051 net short-term capital loss on the promissory note and a $4,045,820 loss on the euro.
Country Pine Finance filed a document titled “Disclosure Statement For Reportable Transaction Under Reg. 1.6011-4T” (the disclosure statement). The disclosure statement stated that Country Pine Finance had entered into a “Custom Adjustable Rate Debt Program” and that the principal tax benefits were the $7,917,000 short-term capital loss and the $4,045,000 ordinary loss. The disclosure statement further indicated that Country Pine Finance estimated a reduction in Federal income tax liability of its members for 2001 of $3,120,000 as a result.
Attached to the Form 1065 were Schedules K-1, Partner's Share of Income, Credits, Deductions, etc., for all of the members. Each Schedule K-1 reported a member's share of the net short-term capital loss and the ordinary loss.
Each member filed his own Form 1040 reporting both his gains from the exchange of BIG stock and the claimed flow-through losses from Country Pine Finance. The losses from Country Pine Finance were used to offset the members' various gains on the disposition of BIG stock. However, some of the members decided not to claim all of the losses available to them, on the advice of their personal return preparers who had determined that the transaction might be challenged by the Internal Revenue Service (IRS). The percentage of the loss claimed by each member who did not claim the entire loss available to him was based on his return preparer's estimation of a hypothetical future settlement with the IRS should the IRS challenge the transaction.
On October 17, 2006, respondent issued a notice of final partnership administrative adjustment (FPAA) to Country Pine Finance for taxable year 2001. The FPAA disallowed the claimed net short-term capital loss and the ordinary loss. The FPAA did not assert any penalties against Country Pine Finance or its members.
The FPAA included a document titled “Explanation of Adjustments” which provided numerous alternative arguments in support of the adjustments made in the FPAA, including that:
(1) The CARDS transaction lacked economic substance, was entered into primarily for tax-avoidance purposes, and was prearranged or predetermined;
(2) application of the substance-over-form or step-transaction doctrine would disallow the loss; or
(3) neither Country Pine Finance nor any member was entitled to a deduction under section 165, 465, or 988.
On January 17, 2007, petitioner filed his petition contesting the determinations in the FPAA. A trial was held on January 26-30 and February 5-6, 2009, at a special session of the Court in Chicago, Illinois. Both petitioner and respondent presented fact witnesses and expert witnesses.
Respondent submitted two expert reports prepared by Dr. A. Lawrence Kolbe (Dr. Kolbe) and Dennis Logue (Mr. Logue). Dr. Kolbe's report focused on a financial analysis of the CARDS transaction and the lack of rationality of entering into the CARDS transaction versus standard mortgage-based real estate financing. Mr. Logue's report evaluated the relationships among Zurich Bank, Fairlop Trading, and Country Pine Finance in the context of the banking industry and the bona fides of the purported loans. Mr. Logue concluded that the loan transactions to which Zurich Bank, Fairlop Trading, and Country Pine Finance were parties were not carried out in accordance with industry norms.
Petitioner submitted expert reports by Gordon L. Klein (Mr. Klein) and Frank A. De Lisi (Mr. De Lisi). Mr. Klein focused on Country Pine Finance's business purpose for entering into a CARDS transaction and whether Country Pine Finance could have generated a nontax economic profit from the CARDS transaction. Mr. De Lisi studied the documents memorializing the various stages of the CARDS transaction and concluded that it would have been reasonable for Zurich Bank to allow Country Pine Finance to substitute commercial real estate as collateral for the loan.
Discussion
I. TEFRA in General
Partnerships do not pay Federal income taxes, but they are required to file annual information returns reporting the partners' distributive shares of tax items. Secs. 701, 6031. The individual partners then report their distributive shares of the tax items on their Federal income tax returns. Secs. 701-704. Upon formation a limited liability company with two or more members is treated as a partnership unless it elects to be treated as a corporation. Sec. 301.7701-3(b)(1)(i), Proced. & Admin. Regs. Country Pine Finance did not elect to be treated as a corporation and thus is treated as a partnership for Federal income tax purposes.
To remove the substantial administrative burden occasioned by duplicative audits and litigation and to provide consistent treatment of partnership tax items among partners in the same partnership, Congress enacted the unified audit and litigation procedures of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Pub. L. 97-248, sec. 402, 96 Stat. 648. See Randell v. United States, 64 F.3d 101, 103 (2d Cir. 1995); H. Conf. Rept. 97-760, at 599-600 (1982), 1982-2 C.B. 600, 662-663.
Under TEFRA, all partnership items are determined in a single partnership-level proceeding. Sec. 6226; see also Randell v. United States, supra at 103. The determination of partnership items in a partnership-level proceeding is binding on the partners and may not be challenged in a subsequent partner-level proceeding. See secs. 6230(c)(4), 7422(h). This precludes the Government from relitigating the same issues with each of the partners.
In partnership-level proceedings such as the case before us, the Court's jurisdiction is limited by section 6226(f) to a redetermination of partnership items and penalties on those partnership items. Section 6231(a)(3) defines the term “partnership item” as any item required to be taken into account for the partnership's taxable year under any provision of subtitle A of the Code to the extent the regulations provide that such item is more appropriately determined at the partnership level than at the partner level. The loss claimed on Country Pine Finance's Form 1065 is a partnership item properly determined at a partnership-level proceeding. Sec. 301.6231(a)(3)-1(a)(1)(i), Proced. & Admin. Regs.
II. Burden of Proof
Tax deductions are a matter of legislative grace, and a taxpayer has the burden of proving that he is entitled to the deductions claimed. Rule 142(a)(1); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). The burden of proof on factual issues that affect a taxpayer's liability for tax may be shifted to the Commissioner where the “taxpayer introduces credible evidence with respect to * * * such issue.” Sec. 7491(a)(1). Petitioner does not claim that the burden shifts to respondent under section 7491(a). In any event, petitioner has failed to establish that he has satisfied the requirements of section 7491(a)(2). On the record before us, we find that the burden of proof does not shift to respondent under section 7491(a).
III. Economic Substance Doctrine
“The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted.” Gregory v. Helvering, 293 U.S. 465, 469 (1935). However, even if a transaction is in formal compliance with Code provisions, a deduction will be disallowed if the transaction is an economic sham. Am. Elec. Power Co. v. United States, 326 F.3d 737, 741 (6th Cir. 2003).
The parties have not formally stipulated where an appeal of this case will lie. At trial counsel for both petitioner and respondent indicated that appeal would likely lie with the Court of Appeals for the Sixth Circuit, and both petitioner and respondent focus on caselaw of that circuit in their posttrial briefs. However, absent stipulation to the contrary, appeal may lie in the Court of Appeals for the District of Columbia Circuit because Country Pine Finance was dissolved. See sec. 7482(b)(1) (flush language). Whether appeal lies in the Court of Appeals for the Sixth Circuit or the District of Columbia Circuit does not affect our decision.
The Court of Appeals for the Sixth Circuit has stated that “‘The proper standard in determining if a transaction is a sham is whether the transaction has any practicable economic effects other than the creation of income tax losses.’” Dow Chem. Co. v. United States, 435 F.3d 594, 599 (6th Cir. 2006) (quoting Rose v. Commissioner, 868 F.2d 851, 853 (6th Cir. 1989), affg. 88 T.C. 386 (1987)). “[W]hen ‘it is patent that there [is] nothing of substance to be realized by [the taxpayer] from [a] transaction beyond a tax deduction,’ the deduction is not allowed despite the transaction's formal compliance with Code provisions.” Am. Elec. Power Co. v. United States, supra at 741 (quoting Knetsch v. United States, 364 U.S. 361, 366 (1960)). “If the transaction has economic substance, ‘the question becomes whether the taxpayer was motivated by profit to participate in the transaction.’” Dow Chem. Co. v. United States, supra at 599 (quoting Illes v. Commissioner, 982 F.2d 163, 165 (6th Cir. 1992), affg. T.C. Memo. 1991-449). “‘If, however, the court determines that the transaction is a sham, the entire transaction is disallowed for federal tax purposes,’” id., and no subjective inquiry into the taxpayer's motivation is made, id. at 599. A court “will not inquire into whether a transaction's primary objective was for the production of income or to make a profit, until it determines that the transaction is bona fide and not a sham.” Rose v. Commissioner, supra at 853.
In Horn v. Commissioner, 968 F.2d 1229, 1239 (D.C. Cir. 1992), revg. Fox v. Commissioner, T.C. Memo. 1988-570, the Court of Appeals for the D.C. Circuit stated that a transaction lacked economic substance if: (1) The taxpayer had no business purpose other than obtaining tax benefits in entering the transaction; and (2) the transaction lacks any reasonable possibility of earning a profit. See also Andantech L.L.C. v. Commissioner, T.C. Memo. 2002-97, affd. in part and remanded in part 331 F.3d 972 (D.C. Cir. 2003). The test in Horn is disjunctive; satisfaction of either prong satisfies the conditions for a determination that the subject transaction has economic substance. Countryside Ltd. Pship. v. Commissioner, T.C. Memo. 2008-3 n.20.
IV. Petitioner's Arguments
Petitioner argues that the CARDS transaction had economic substance and was entered into to permit Country Pine Finance to finance real estate investments on the members' behalf. Petitioner contends that the CARDS transaction satisfies both the objective and subjective requirements of the economic substance test and that the claimed loss should be allowed.
Petitioner argues that the CARDS transaction had legal significance to Country Pine Finance and the members because the loans were bona fide and the members were jointly and severally liable for the entire €16,613,000. Petitioner also argues that Fairlop Trading, the members, and Country Pine Finance were all at risk for the loan proceeds.
Petitioner focuses on the profit potential of the CARDS transaction as if real estate had been substituted for collateral and points to his expert reports in support of this contention. Petitioner argues that if real estate had been allowed as collateral, the members would have used the proceeds to invest in real estate and attempt to earn a profit.
V. Respondent's Arguments
Respondent argues that the claimed loss should be disallowed because the CARDS transaction lacked economic substance and that the members did not have a nontax reason for entering into the transaction.
Respondent first argues that the CARDS transaction lacked economic substance and had no practical effect other than the creation of income tax losses because: (1) The initial loan, (2) the members' assumption of the loan and contribution to the capital of Country Pine Finance, and (3) the members' entering into the cross-currency swap served no purpose other than the creation of tax losses. Respondent argues that none of the parties were ever at risk because the various credit agreements required Fairlop Trading and Country Pine Finance to pledge high-value collateral and it was in Zurich Bank's discretion to allow any collateral to be swapped. Respondent argues that Zurich Bank would not allow collateral to be swapped because it would be against Zurich Bank's financial interest to do so, as it would expose the bank to unnecessary risk.
Respondent disagrees that we should evaluate the CARDS transaction as if Country Pine Finance had been able to substitute real estate as collateral. Respondent contends that this would be inappropriate because any potential profit from an investment in real estate that the members could earn would be profit from a separate transaction, not the transaction that gave rise to the tax loss at issue. Respondent further contends that whatever profit Country Pine Finance may or may not have been able to earn from substituting collateral, the artificial tax losses at issue would remain. Respondent contends that even if we were to assume that real estate could be substituted, the substitution would result in an entirely new loan between Zurich Bank and Country Pine Finance because it would require the parties to negotiate new loan terms. Respondent concludes that because substitution of real estate would lead to an entirely new loan, the initial CARDS transaction that was consummated and carried out would have been irrelevant to the real estate financing but for the tax losses generated.
Respondent next argues that even if we were to accept that the initial loan and assumption were necessary and that real estate could be substituted as collateral, the new loan would still be a sham designed solely to achieve tax benefits because Country Pine Finance and its members had no chance of making a profit on any future real estate investment. Respondent points to his expert witness reports and argues that Country Pine Finance would still not earn a profit because Zurich Bank would require onerous loan terms requiring payments that would far exceed any potential profit. Respondent contends that in order for Country Pine Finance to make a profit, Zurich Bank would have to both allow real estate as collateral and agree to loan terms that would be contrary to its own financial interests.
In the alternative respondent argues that even if we find that the CARDS transaction had economic substance, the loss should be disallowed because the members participated in the CARDS transaction only in order to create an artificial tax loss. Respondent contends that Country Pine Finance fails the subjective prong because testimony of the members shows that they had no knowledge or understanding of the CARDS transaction, did not read, review, or remember the CARDS transaction documents, and decided to enter into the transaction for the tax loss. Respondent points to the members' failure to research or obtain any assurance of the availability of real estate as collateral both before and after they entered into the CARDS transaction as evidence that the members were just after the tax loss and not truly interested in financing a real estate investment.
VI. Analysis
A. Objective Analysis
We begin by analyzing the objective profit potential of the transaction giving rise to the claimed tax loss. The transaction giving rise to the loss was the swap of €2,997,164 for $2,633,308 as part of the cross-currency swap. Country Pine Finance claimed a basis totaling $14,596,182 in the euro and the promissory note. As a result of this inflated basis, Country Pine Finance claimed losses totaling $11,962,871 when it received the $2,633,308 from Zurich Bank as part of the cross-currency swap.
There were no third parties in this transaction. Country Pine Finance, Fairlop Trading, and Zurich Bank were involved specifically to enter into this CARDS transaction. Fairlop Trading's operating agreement indicates that its only purpose was the CARDS transaction, it could not enter into any other business transactions, and it was never able to access the loan proceeds. The CARDS transaction consisted of prearranged steps entered into to generate a tax loss; the loan proceeds were never at risk and the transaction giving rise to the tax loss was cashflow negative.
None of the loan proceeds ever left Zurich Bank's control, as both Fairlop Trading and Country Pine Finance used Zurich Bank accounts. Although Country Pine Finance and the members purportedly became liable for the loan proceeds, the various loan agreements required Fairlop Trading, the members, and Country Pine Finance to immediately pledge trustworthy collateral for those loan amounts. The proceeds of the initial loan from Zurich Bank to Fairlop Trading were used to purchase promissory notes from Zurich Bank that were then used to collateralize the initial loan. The members immediately pledged the €1,981,671 note and the €1,015,493 as collateral after assuming the loan. Later, Country Pine Finance immediately pledged the euro contributed by the members as collateral for the loan that it now guaranteed. After the euro were swapped for dollars as part of the cross-currency swap, the $2,633,108 received was used to purchase a promissory note from Zurich Bank as collateral for that amount. There was no chance that Zurich Bank, Fairlop Trading, or the members would ever lose any money on the CARDS transaction other than fees. See Am. Elec. Power Co. v. United States, 326 F.3d at 743 (holding that in corporate-owned life insurance plan, although individual parts of transaction represented actual transfers of risk among parties, overall structure of transaction ensured that no risk existed for taxpayer at overall plan level).
The members knew in October 2001 that they would not be able at that time to substitute real estate as collateral. Because the parties knew that they would not be able to substitute real estate as collateral and that the only collateral that would be accepted by Zurich Bank without the bank's imposing a haircut was Zurich Bank promissory notes, t