In Their Opinion : Seventh Circuit Court of Appeals Commentary : Lawyer & Attorney Michael E. Rigney : Kelley Drye & Warren Law Firm

AMERICAN BOAT COMPANY v. UNITED STATES OF AMERICA (October 1, 2009)

David Jump is a wealthy, St. Louis businessman with a variety of business interests. In 1996, he consulted with a Chicago attorney to develop an estate plan. The attorney created a family trust and reorganized many of Jump's businesses into limited partnerships. He also recommended a tax shelter, and provided the firm's opinion of its validity. A few years later, one of Jump’s towboats caused an accident that almost resulted in damages that could have exceeded his insurance coverage. He again sought advice from his Chicago lawyer, this time on how to limit his liability. The lawyer again designed and executed a restructuring of his companies. He again also recommended a series of tax shelter transactions. Beginning in 1999, Jump claimed substantial tax benefits. Over time, other lawyers and accountants became familiar with these transactions and raised no objections. The IRS eventually caught wind of these shelters and determined them to be illegal. It discovered the involvement of one of Jump's partnerships during its investigation and determined that the shelter was invalid. It issued a Notice of Final Partnership Administrative Adjustment, adjusting the partnership's basis of its towboats, and imposed an accuracy-related penalty of forty percent. On judicial review, the court agreed with the IRS that the transactions were invalid but held that the penalty should not have been imposed. The penalty can only be imposed if the partnership had no reasonable cause for its underpayment. The court found reasonable cause. The United States appeals the latter ruling.

In their opinion, Judges Bauer, Flaum and Kanne affirmed. The Court first addressed the issue of the district court's jurisdiction, because of a recent decision in the Court of Federal Claims holding that the reasonable cause exception relied on by the district court cannot be considered during a partnership-level proceeding, which that was. Although agreeing with the fundamental premise that a partner may not raise a partner-level defense at a partnership-level proceeding, the Court concluded that a partnership can raise reasonable cause on behalf of the partnership. Thus, the Court found that the district court had jurisdiction to consider the partnership's claims that it had reasonable cause for its position. On the merits, the Court stated that reasonable cause depends on all the facts and circumstances, including the taxpayer's efforts to properly assess its liability. The Court first rejected the government's position that it is always unreasonable to rely exclusively on a financial advisor who incorporates a tax shelter into a plan for restructuring. Considering the facts and circumstances, the Court concluded that the district court did not clearly err in finding reasonable cause: Jump sought advice from a reputable (at the time) attorney, he had no reason to believe the advice was wrong, the tax shelters were component parts of larger corporate restructurings, two reputable accounting firms raised no objections, and he had engaged in a similar transaction a few years earlier without IRS objection. Calling it a "close case," the Court found no clear error.

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HOOSIER ENERGY RURAL ELECTRIC COOPERATIVE v. JOHN HANCOCK LIFE INSURANCE COMPANY (September 17, 2009)

Hoosier Energy Rural Electric Cooperative and John Hancock Life Insurance Company entered into a lease-leaseback of a Power Plant in order to take advantage of excess depreciation deductions held by Hoosier. Because the transaction exposed John Hancock to substantial financial risks, Hoosier arranged with Ambac Assurance Corporation to pay to Hancock $120 million upon the occurrence of certain events. One of those events was a reduction in Ambac’s credit rating. If that occurred, Hoosier had 60 days to replace the surety. It did occur. Even with an extension, Hoosier did not replace the surety. John Hancock demanded performance. Ambac was ready and able to perform but Hoosier filed suit and obtained a temporary restraining order and a preliminary injunction. Ambac’s performance would require Hoosier to cover the payment, which would drive Hoosier into bankruptcy. John Hancock appeals.

In their opinion, Chief Judge Easterbrook and Judges Kanne and Wood affirmed. The Court began with the requirements for equitable relief: irreparable injury, a plausible claim on the merits and the balance of equities. The Court accepted the district court’s finding of irreparable injury and proceeded to address the merits. The district court had found merit in two Hoosier arguments: that the transaction was illegal and must be unwound and that Hoosier is at least temporarily excused under the doctrine of "temporary commercial impracticability." The Court disagreed with respect to the first prong. Whether or not the IRS allows the parties to take advantage of the intended tax consequences, the Court believed that the parties were still bound by their contractual obligations. With respect to the second prong, the Court noted that New York courts do not recognize "temporary commercial impracticability." Although they do recognize the defense of impossibility, they take a dim view of it and do not excuse performance when the "impossibility" is the result of financial hardship. If, as Hancock claims, Hoosier had the option to replace the surety, the Court did not believe that an impossibility defense would stand. If, however, as Hoosier claims, it had a duty to replace the surety, an impossibility defense might prevail. The Court found enough uncertainty in the contract and the facts surrounding Hoosier's ability or inability to replace the surety that it concluded that the district court was correct with respect to Hoosier's prospect of prevailing. Finally, the Court required the district court to re-examine the amount of the injunction bonds to protect John Hancock and urged the district court to allow Hancock to realize its surety if Hoosier is not able to replace the surety within a few months.

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VALERO ENERGY CORPORATION v. UNITED STATES OF AMERICA (June 17, 2009)

Valero Energy Corp., a large U.S. refiner, acquired Ultramar Diamond Shamrock Corporation ("UDS”) in 2001. Prior to the transaction, Valero received relevant tax advice from Arthur Andersen. With Arthur Andersen's help, Valero initiated a complex set of transactions that resulted in tax deductible losses in excess of $100 million. The size of the deduction caught the eye of the IRS, which issued a summons to Arthur Andersen seeking documents relating to its tax analysis for Valero or UDS. Valero moved to quash the summons, in part based on the tax practitioner-client privilege. The government argued that the tax practitioner-client privilege did not apply because of the statutory exception for documents made in connection with the promotion of a tax shelter. The district court originally upheld Valero’s claim of privilege, concluding that the government failed to meet its burden. On a second round of document production, however, the government again challenged the privilege and supported its challenge with a detailed affidavit. This time the district court concluded the government met its burden with respect to some documents and ordered them produced. Valero appeals.

In their opinion, Judges Rovner, Evans and Tinder affirmed. The Court noted that Congress created the tax practitioner-client privilege in 1998 as a limited shield of confidentiality. It is no broader than the attorney-client privilege and does not protect general accounting advice, even if provided by an attorney. The Court first rejected Valero’s arguments that the bulk of the documents were even covered by the privilege. Although some of the documents contained legal analysis, the Court concluded they were not privileged because they contained the type of information generally collected in the process of preparing a return. With respect to the small group of documents that the district court found were protected, the Court agreed with the government that they fell within the exception for communications in connection with the promotion of a tax shelter. Under the statute, a "tax shelter" includes any plan or arrangement a "significant purpose" of which is the avoidance of income tax. Because the privilege is an exception to the broad summons power of the IRS, the Court declined to broaden the privilege through a narrow interpretation of the exception. Given that the Valero documents addressed the structure of the transactions that resulted in a large tax deduction, the Court concluded that they fit within the exception and were not covered by the privilege.

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UNITED STATES OF AMERICA v. FLETCHER (April 10 , 2009)

Cap Gemini purchased a consulting business from Ernst & Young in 2000. The Ernst & Young partners received shares in the new business in exchange for their partnership shares. The partners preferred to treat the receipt of shares as income in 2000. The company wanted to put some restrictions on the shares to ensure that the partners would remain with the new organization. They all agreed on a methodology that they thought would serve both purposes. The shares were all transferred and fully taxable in 2000 but were restricted for almost five years. One of the partners, Cynthia Fletcher, received shares with a market value of approximately $2.5 million. She reported this as ordinary income in 2000. Fletcher left the organization and collected the shares remaining in her account. Because the market price of the stock plummeted after the acquisition, it turns out that the partners would have been better off not taking the income in the first year. Fletcher filed an amended tax return for 2000 and took the position that her only income in 2000 was the $650,000 that was actually distributed from her account. Although the Internal Revenue Service processed the refund, the United States filed suit to recover. The district court granted summary judgment to the United States and ordered Fletcher to refund the refund. Fletcher appeals.

In their opinion, Chief Judge Easterbrook and Judges Ripple and Tinder affirmed. The Court first made it clear that Fletcher was not attempting to change the form of the transaction. Instead, she argued that the actual terms of the original transaction had tax consequences that are different than originally reported. The Court disagreed with the substance of her argument, however. Although the stock was restricted, the partners bore the economic risk and were the beneficial owners as of 2000. Even though the partners did not have cash in hand, the economic value of the stock was within their control. Therefore, the income was constructively received in the year 2000 and properly reported as such originally.

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BILTHOUSE v. UNITED STATES (January 15, 2009)

Alan and Patricia Bilthouse bought $500,000 worth of stock in S&E Contractors (“S&E”), a heavy construction contractor in Florida. S&E’s principal business was public works projects, for which it needed to be bonded. S&E came upon hard times beginning in early 1994. It suffered severe losses from cost overruns on a large project, eventually defaulting on the bonds in 1995. Without bonding, S&E had to discontinue its public works projects. It did file a lawsuit in late 1995 to recover its losses from the project. The lawsuit was settled in 1997 with S&E receiving no money. The confluence of the IRS regulations and the Bilthouse personal situation made the S&E losses much more valuable to them if their loss occurred in 1997 rather than 1995. The Bilthouses sought a refund from the IRS from their 1997 tax payment, asserting that their interest in S&E became worthless in 1997 and their shares were, therefore, “disposed of” in that year. The IRS denied their claim. The Bilthouses sued in district court. The court granted summary judgment to the United States. The Bilthouses appeal.

In their opinion, Judges Ripple, Kanne and Williams affirmed. The principal question before the Court was whether the stock became worthless in 1995 or 1997. The parties agreed that, for loss computation purposes, the stock is considered “disposed of” the year it became worthless. The Court noted that “worthless” is not defined by the IRS but is a fact question, taking into account both the liquidating value and the potential for value. It is the Bilthouse’s burden, however, to establish the facts supporting the worthlessness in 1997. The Bilthouses rely on two facts: a) the lawsuit was expected to result in an award in excess of $15 million and b) S&E continued its construction activity on small, private projects through 1997. The Court rejected first basis. Although the plaintiffs presented evidence of the subjective belief of many that the lawsuit would succeed, the Court stated that the proper inquiry requires objective evidence of the reasonableness of those beliefs. The Bilthouses presented no such evidence – nor did they present evidence of the basis for the calculation of damages in the event of success. The Court viewed the continued projects as a closer question. Continued operations of a company can establish the potential for value. The plaintiffs again, however, were unable to demonstrate a sufficient evidentiary basis for their claim. The record was silent on the amount of private work S&E was engaged in, its future prospects, and whether the private projects would have eventually been sufficient to revive the company. The Court concluded that the Bilthouses failed to carry their burden.

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GREENE-THAPEDI v. UNITED STATES December 3, 2008

In 1996, Llwellyn Greene-Thapedi filed a tax return for tax year (“TY”) 1992. The government challenged her reported tax liability. Ultimately, the U.S. Tax Court determined that she owed an additional ≈$10,000. In December 1997, the IRS assessed a deficiency for the amounts owed plus interest and asserts that it sent Green-Thapedi a notice of deficiency. Green-Thapedi claims that she never received the notice. When the U.S. threatened to levy assets, Green-Thapedi paid the ≈$10,000 and interest through December 1997 but refused to pay the additional interest on the ground that she did not receive the notice. She also brought suit in tax court to recover a ≈$10,000 overpayment on her tax for TY1999. While her suit was pending, the government applied the TY1999 overpayment to the claimed TY1992 deficiency. Green-Thapedi brought an action in federal district court to recover the TY1999 overpayment. The district court stayed the action pending the outcome in the tax court. The tax court held that her TY1999 claim was moot because the government had credited her claimed overpayment to TY1992. The government moved to dismiss in the district court for Green-Thapedi’s failure to exhaust administrative remedies in that she never made a refund claim with the IRS. The district court denied the motion. It held that Green-Thapedi’s petition in the tax court constituted an informal claim for refund. Green-Thapedi then amended her complaint to add a claim for a refund of ≈$10,000 for TY1992. The court below found that the government properly calculated Green-Thapedi’s taxes and penalties and found that Green-Thapedi did not present sufficient evidence to rebut the government’s position on the notice. Green-Thapedi appeals.

In their opinion, Judges Ripple, Wood and Tinder vacated and remanded. The Court did not address the tax computation and notice issues decided below. Instead, it found that the district court lacked subject matter jurisdiction. Once the government applied Green-Thapedi’s TY1999 overpayment to TY1992, the case became about TY1992. `The Court disagreed with the district court that the informal claim doctrine conferred subject matter jurisdiction. It held that the informal claim doctrine excuses non-compliance with certain formal administrative requirements only when those deficiencies are later corrected. Here, Green-Thapedi never filed an administrative claim for TY1992. The Court vacated and remanded with instructions to the district court to dismiss the complaint.

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KAHN v. UNITED STATES (November 20, 2008)

Shahid Khan was a partner in several investment entities. The IRS was investigating Kahn and his wife because of its belief that the Kahns had sheltered hundreds of millions of dollars from income taxes. The IRS agent assigned to the case issued summonses to Robert Greisman, an accountant and tax shelter expert with whom Khan and his wife had met on several occasions. The Kahns had paid Greisman over $8 million dollars but, according to an IRS affidavit, they could not identify what services he provided. The Kahns filed petitions to quash the subpoenas on a number of grounds. The IRS opposed the petitions and also filed a motion to enforce the summonses. The agent’s affidavit accompanying the motion stated that the purpose of the summonses was to quantify the Kahns’ tax liability. The Kahns opposed the motion on the ground that 26 U.S.C. § 7602(d)(1) prohibited the summons because the IRS did not disclose whether the IRS had referred Greisman to the Justice Department. The district court agreed, and quashed the summons. The IRS appeals.

In their opinion, Judges Flaum, Rovner, and Wood reversed. The Court first recognized the broad power of the IRS to issue summonses. Section 7602(d)(1) provides, however, that “[n]o summons may be issued . . . with respect to any person if a Justice Department referral is in effect with respect to such person.” The Kahns argued that the summonses were issued "with respect to" Greisman and were therefore not allowed if Greisman had been referred to the Justice Department.  The IRS, on the other hand, argued that the summonses were issued "to" Greisman but "with respect to" the Kahns since it was the Kahns' tax liability at issue. The Commissioner of the IRS has promulgated a regulation supporting the IRS'ition.  The regulation interprets the section to apply only when there is a Justice Department referral of the person whose tax liability is at stake. The Court approached the “question of first impression” under the Chevron two-part analysis. Under Chevron, the Court will uphold or strike a regulation if it is supported or opposed, respectively, by the plain meaning of the pertinent statute. If the statute is silent or not clear, the Court will determine in a second step whether the regulation is a reasonable interpretation of the statute. The Court will uphold it if it is. With respect to the plain meaning of § 7602(d)(1), the Court was attracted to the arguments of both parties. Having found their two competing interpretations both plausible, the Court necessarily found ambiguity in the statute. In its second step analysis, the Court found the Commissioner’s regulation consistent with the statute, as well as the legislative history, and a reasonable interpretation of it. As long as the Kahns were not referred to the Justice Department (which they were not), the summons to Greisman can be enforced.
 

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UNIVERSITY OF CHICAGO v. UNITED STATES (October 29, 2008)

The University of Chicago (“the University”) is an Illinois not-for-profit corporation and one of the world’s foremost universities. It maintains two separate retirement plans for employees. Highly compensated and academic employees are covered by the Contributory Retirement Plan (“CRP”). Other employees are covered by the Retirement Income Plan for Employees (“RIPE”). Employees are required to participate by contributing a percentage of their salary. The University, in turn, contributes additional amounts to each employee’s account. The University did not report, withhold, or remit FICA payroll taxes on any of the amounts contributed to the CRP or RIPE in the period 2000-2003. In 2005, the IRS assessed the University with additional FICA taxes and penalties. The University paid a portion of the assessment. The IRS assessed penalties for the University’s failure to pay the full amount. The University again paid only a portion of the assessment. The IRS denied the University’s claim for a refund. The University filed suit. The IRS filed a counterclaim for the still unpaid portions of the assessed amounts. The district court granted summary judgment to the United States. It held the University liable for all the assessed unpaid taxes and penalties. The University appeals.

In their opinion, Judges Kanne, Sykes, and Tinder affirmed. The Court started with the definition of “wages” in the Internal Revenue Code, one of its exceptions, and an exception to that exception. “Wages” includes “all remuneration for employment” but excludes payments made to an employee “under or to an annuity contract.” That exception itself has an exception for annuity contracts “made by reason of a salary reduction agreement.” The University takes the position that its payments to the CRP and RIPE are not wages, and therefore not subject to FICA, under the annuity contract exception to "wages." It also contends that the contributions are not excluded from the annuity contract exception under the “salary reduction agreement” language. The University’s position is that a salary reduction “agreement” must be a voluntary agreement by an employee to accept a reduced salary in return for the contribution to the plan. To resolve the issue, the Court considered the plain language of the exception as well as its context. It first rejected the University’s argument that the plain language of the statute and the use of the word “agreement” must lead to the single conclusion that the contribution must be voluntary. In fact, the Court found that the plain language was more closely aligned with the government’s position that it simply distinguished between salary supplements and salary reductions. The Court then “wade[d] into the murky waters of ‘context’” in the tax code to see if the context supported a different conclusion. After considering prior statutory provisions, revenue rulings, cross-references, and court decisions, the Court concluded that Congress intended “salary reduction agreements” to include both mandatory and voluntary agreements. Since the University failed to properly withhold FICA taxes from its employees, it is liable for both its and its employees’ contributions. The University is excused from paying the employees’ share if it can demonstrate that the obligation was speculative and not precise. Relying on the plain language and the same “context” it examined in reaching a decision on the merits, the Court rejected the University’s argument and held it liable for the assessed taxes.

The IRS also imposed both failure-to-deposit and failure-to-pay penalties. The former addressed the University’s original failure to withhold and deposit the required amounts. The latter addressed the University’s failure to pay the amount assessed. The Court noted that both penalties are required by law unless a taxpayer carries the “heavy burden” of showing that it exercised “ordinary business care and prudence.” The Court held that the University’s “unsupported and unreasonable” interpretation did not met that burden. Finally, the Court rejected the University’s argument that the “divisable tax doctrine” is incompatible with the failure-to-pay penalty. Under the “divisable tax doctrine,” a taxpayer is allowed to challenge an assessed tax without paying the full amount of the assessment, which is generally a jurisdictional requirement. If the tax is divisable, a taxpayer can pay the full amount for one transaction and have the result of its challenge to that transaction control the other transactions. Here, the tax was divisable and the University was able to have its day in court without having to remit the full assessed amount of taxes. Having lost its case, however, the University is still subject to penalties on the unpaid amount.

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JEFFERSON v. UNITED STATES  (October 8, 2008)

Charles Jefferson served as the voluntary, uncompensated president of the board of directors of New Zion Day Care Center (“Center”). Velma Hayes was the paid director of the Center and ran its day-to-day operations. Jefferson had authority to direct the financial affairs of the Center. The United Way provided financial support to the Center . In early 1998, the United Way informed Jefferson that the Center was not paying its payroll taxes properly. The board ordered Hayes to pay any taxes due to the IRS. By 2000, the Center was in severe financial trouble. It did not pay income and FICA taxes from early 2000 through mid-2001. Hayes reported to the board at its monthly meetings that the Center was delinquent in its bills and tax liabilities. The United Way ceased its support of the Center, in part because of the tax issue. Jefferson arranged for the Center to borrow money to pay the delinquent taxes. In August, 2000, Jefferson co-signed two checks to the IRS for penalties and interest. In 2002, the IRS made assessments against both Hayes and Jefferson for the delinquent taxes. Jefferson filed suit to recover the $41,432 he paid pursuant to the assessment. The district court granted the United States’ motion for summary judgment. Jefferson appeals.

In their opinion, Judges Bauer, Williams, and Sykes affirmed. The Court addressed each of Jefferson’s arguments in turn: a) that he was not a “responsible person” under the statute, b) that his conduct was not willful, c) that he was exempt as an honorary board member, d) that the IRS was estopped because of its failure to develop explanatory materials as required by statute, and e) that the IRS failed to disclose evidence. The Court stated that a “responsible person” under Section 6672(a) of the Internal Revenue Code is a person who has enough authority over the organization’s finances to determine which debts will be paid. Jefferson had significant involvement in the Center’s financial affairs. The Court found that Jefferson was a “responsible person,” relying on his position on the board, his review of finances at monthly meetings, his securing of the loan to pay IRS penalties and interest, and his direction to Hayes to pay the taxes. On the “willful” issue, the Court observed that a person acts willfully when he acts in reckless disregard of a known risk that taxes are going unpaid. The Court recognized that the board had directed Hayes to pay the taxes but found that Jefferson had taken no steps to make sure that the taxes were, in fact, paid or that effective controls were in place. This made Jefferson’s conduct willful, even if he did not actually know the taxes were still unpaid. The Court rejected Jefferson’s honorary board member argument, noting that the statutory exemption only applied to board members who did not participate in the financial operations of the organization. Jefferson’s estoppel argument is that the government is required by law to develop explanatory materials relating to the circumstances under which a board member of a non-profit organization could be held liable for tax delinquencies. The Court agreed that the materials are required by law and that they were never developed. However, it refused to adopt a blanket rule that would make the assessment invalid as a result. Instead, the Court required a showing of prejudice, which it said Jefferson could not make. The Court rather summarily rejected Jefferson’s evidence argument, citing the substantial evidence of his liability and the fact that the evidence was relevant, if at all, only to collateral issues (e.g., his knowledge of the delinquencies).

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 UNIV. OF CHICAGO HOSPITALS v. UNITED STATES (September 23, 2008)

The University of Chicago Hospitals (“UCH”) is an Illinois not-for-profit corporation that administers graduate medical education programs. One such program is its residency program, in which medical school graduates perform services at the hospital as part of their medical training. In return for these services, UCH paid residents a salary and paid FICA taxes to the United States on their behalf. UCH applied for a refund of the FICA taxes paid in 1995 and 1996 on the grounds that the residents qualified for the “student exemption” to FICA in the Internal Revenue Code (“IRC”). In the district court, the United States moved for summary judgment, arguing that residents could not qualify as “students” as a matter of law under the IRC. The district court rejected the argument, denied summary judgment, and certified its order for appeal.

In their opinion, Judges Bauer, Cudahy, and Sykes affirmed. The Court started with the language of the student exemption itself, which excludes from the term “employment” any “service performed in the employ of . . . a school . . . if such service is performed by a student who is enrolled and regularly attending classes at such school . . . .” Then the Court addressed the government’s argument that residents did not qualify under the unambiguous, literal language of the statute. The government argued that a resident is not a “student” and a hospital is not a “school” in the common and natural meaning of those words. The Court disagreed with such a narrow reading of the words. In fact, it held that the unambiguous language of the clause did not exclude residents from qualifying.
Although it found the statute unambiguous, the Court nevertheless addressed the government’s arguments that it would have considered had it found ambiguity. The government relied on the legislative histories of the student exemption and the intern exemption, the later repeal of the intern exemption, and a post-1996 amendment to the student exemption that excluded students who worked in excess of forty hours per week. It concluded that, combined, these supported an interpretation that excluded residents from the definition of “student.” The Court did not agree. Instead, it found that, to the extent the statute was ambiguous, the relevant regulations called for a case specific approach to eligibility and that approach was a permissible and proper interpretation of the statute. 
 

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