As we previously reported, on April 23, 2014, the United States Supreme Court heard oral argument in United States v. Clarke, a case which involved the extent to which a taxpayer may investigate the underlying reasons or motivations for the IRS’s issuance of a summons. Under IRC § 7602, the IRS may issue a summons to:
a person liable for the tax or required to perform the act, or any officer or employee of such person, or any person having possession, custody, or care of books of account containing entries relating to the business of the person liable for tax or required to perform the act, or any other person the Secretary may deem proper, to appear before the Secretary at a time and place named in the summons and to produce such books, papers, records, or other data, and to give such testimony, under oath, as may be relevant or material to such inquiry.
On June 19, 2014, in a unanimous opinion delivered by Justice Kagan, the Supreme Court held that “a bare allegation of improper purpose does not entitle a taxpayer to examine IRS officials. Rather, the taxpayer has a right to conduct that examination when he points to specific facts or circumstances plausibly raising an inference of bad faith.”
UNITED STATES V. CLARKE
As we previously reported, Clarke arose out of an IRS examination of a partnership called Dynamo Holdings for tax years 2005-2007. During the course of the examination, Dynamo agreed to extend the statute of limitations for assessment two times. When the IRS requested a third extension of the statute of limitations, the partnership refused. Soon thereafter, the IRS issued five summonses, including one to Michael Clarke, the CFO of two partners of Dynamo. The focus of the IRS’s summonses was interest deductions of $34 million taken by Dynamo during two of the years subject to the IRS’s examination.
The IRS issued a Final Partnership Administrative Adjustment (FPAA) in December 2010, three days before the expiration of the statute of limitations. In February 2011, Dynamo challenged the FPAA in the Tax Court. Meanwhile, Clarke had refused to obey the summons, and the IRS began summons enforcement proceedings in April 2011, well after commencement of the Tax Court case.
Before the district court, Clarke argued that the IRS did not have a legitimate purpose in issuing the summonses because, among other reasons, they were (1) issued in retaliation for the partnership’s refusal to extend the statute of limitations period a third time and (2) designed to circumvent the U.S. Tax Court’s limitations on the scope of discovery. United States v. Clarke, 111 AFTR 2d 2013-1697 (S.D. Fla. Apr. 16, 2012).
Clarke presented some evidence supporting the contention that the summons was designed to circumvent the Tax Court’s discovery limitations, including (1) the fact that the IRS sought to continue the Tax Court proceeding on the ground that the summonses were still outstanding and (2) a declaration from the lawyer of the sixth summoned individual (who ultimately complied with the summons request) that her IRS interview was conducted exclusively by the two lawyers representing the IRS in the Tax Court proceeding and that the examining agent was not even in attendance. According to Clarke, this fact was significant because in United States v. Powell, 379 U. S. 48 (1964), the Supreme Court ruled that only examining agents, and not lawyers representing the IRS in Tax Court proceedings, were allowed to interview summoned individuals.
Clarke also requested an evidentiary hearing to inquire into the government’s purposes for issuing and enforcing the summonses (and also requested pre-hearing discovery). The district court, however, ordered enforcement of the summonses. It rejected Clarke’s first argument as a “naked assertion” unsupported by evidence. The Court then dismissed Clarke’s second contention because it determined that, even if the IRS had used the summons process to sidestep discovery limitations, such a finding was not a valid reason to quash a summons. Cf. Mary Kay Ash v. Commissioner, 96 T.C. 459, 462, 472-73 (1991) (denying taxpayer’s motion for protective order barring IRS from using evidence obtained through a summons but emphasizing that it was not deciding the enforceability of the summons since that issue was in the district court’s jurisdiction). The district court also denied Clarke’s request for an evidentiary hearing.
On appeal, the Eleventh Circuit Court of Appeals reversed and held that the district court abused its discretion in refusing to hold an evidentiary hearing. The Eleventh Circuit held that an allegation of improper purpose is sufficient to trigger a limited adversary hearing before enforcement is ordered, and that, at the hearing, the taxpayer may challenge the summons on any appropriate ground. The Eleventh Circuit’s reasoning was based in part on a prior summons enforcement case, Nero Trading. In that case, the Eleventh Circuit reasoned that requiring the taxpayer to provide support for an allegation of improper purpose without giving the taxpayer the opportunity to obtain such facts “saddles the taxpayer with an unreasonable circular burden.”
THE SUPREME COURT’S OPINION
In its opinion, the Supreme Court stated that a person receiving an IRS summons is entitled to contest it, but only in an enforcement proceeding. Further, the Court reasoned that because Congress recognized that the power vested in tax collectors may be abused, as all power may be abused, enforcement of an IRS summons must be contingent on a court’s approval. In addition, the Court held that that requisite judicial proceeding is adversarial, the summoned party must receive notice and may present argument and evidence on all matters bearing on a summons’s validity.
While the Court recognized a taxpayer’s right to challenge a summons, it emphasized that summons enforcement proceedings must be “summary in nature.” Further, the Court reasoned that as part of the adversarial process concerning a summons’s validity, the taxpayer is entitled to examine an IRS agent regarding facts or circumstances plausibly raising an inference of bath faith; that is, the taxpayer must offer some credible evidence supporting his charge. The Court recognized that although a bare assertion or conjecture is not enough, neither is a fleshed out case demanded – the taxpayer need only make a showing of facts that give rise to a plausible inference of improper motive.
In light of competing interests between the parties involved, the Supreme Court struck a balance between preventing abuse from IRS officials when issuing a summons, and preventing taxpayers from making naked allegations of improper purpose. Therefore, the Supreme Court held that “a bare allegation of improper purpose does not entitle a taxpayer to examine IRS officials. Rather, the taxpayer has a right to conduct that examination when he points to specific facts or circumstances plausibly raising an inference of bad faith.”
The Supreme Court also ruled that the standard it announced will allow for inquiry where the facts and circumstances make inquiry appropriate, without turning every summons dispute intro a fishing expedition for official wrongdoing. Nevertheless, the Court did not decide whether the evidence provided by those summoned in connection with Dynamo Holdings was insufficient to meet that standard. Rather, it sent the issue back to the district court to apply the “correct legal standard” to the facts.
UNRESOLVED ISSUES: IMPROPER PURPOSE AND BAD FAITH
This case presented two issues which the Supreme Court left unresolved: (1) whether the IRS can punish taxpayers for not extending the statute of limitations, and (2) whether the IRS was attempting to use its summons enforcement power in bad faith.
As we previously reported, the IRS is authorized to use a summons for the purposes described in IRC §7602, which are generally related to tax determination and collection. When the IRS uses its summons power for an unauthorized purpose or for any purpose reflecting on the good faith use of its power, the Supreme Court has said that the summons will not be enforced. Reisman v. Caplin, 375 US 440 (1964). Further, in Powell the Supreme Court ruled that an “improper purpose” includes harassing the taxpayer, pressuring the taxpayer to settle a collateral dispute, or any other purpose reflecting negatively on the good faith of the particular investigation. (See also IRM 220.127.116.11.2, which discusses summonses legal authority). In addition, case law and IRC §7602(c) make it clear that the IRS is not authorized to use this power to assist another agency by, for example, using a summons to investigate a matter already being investigated by a grand jury, or by gathering evidence for the Department of Justice in its prosecution of a criminal case. United States v. LaSalle Nat’l Bank, 437 US 298 (1978).
In general, since it is the court’s process that the IRS invokes in an enforcement proceeding to obtain compliance with a summons, a court will not order compliance unless it is satisfied that the IRS has served the summons in a good faith pursuit of its summons authority.
Before 1982, the IRS’s authority to issue summons did not expressly include power to use a summons to investigate a criminal violation of the tax laws. As a result, there was much litigation over the question whether the IRS was using a summons for an improper criminal purpose. In 1982, IRC §7602 was amended to provide that the statutorily authorized purposes for which a summons may be issued include “the purpose of inquiring into any offense connected with the administration or enforcement of the internal revenue laws.” Accordingly, the IRS is permitted to use a summons to gather evidence of a criminal violation of the tax laws. IRC §7602 was further amended to prohibit the use of a summons when a Department of Justice referral for criminal prosecution or grand jury investigation is in effect.
Significantly, persons affected by a summons have made objections that the summons has been issued for improper purposes other than for gathering evidence for use in a criminal prosecution. In United States v. LaSalle Nat’l Bank, 437 US 298 (1978), the Supreme Court recognized that a summons might be unenforceable for reasons other than an improper criminal purpose. Further, in Pickel v. United States, 746 F2d 176 (3d Cir. 1984), the third circuit stated that it did not doubt that portions of the Powell and LaSalle discussions of bad faith retain vitality even after the 1982 amendment to IRC §7602 and that where the taxpayer can prove that the summons is issued solely to harass him, or to force him to settle a collateral dispute, or that the IRS is acting solely as an information-gathering agency for other departments, such as the Department of Justice, the summons will be unenforceable because of the IRS’s bad faith. Further, where a substantial preliminary showing of abuse of the court’s process has been made, a summoned party is entitled to substantiate his allegations by way of an evidentiary hearing. United States v. Millman, 765 F2d 27 (2d Cir. 1985) (at the hearing, the agents responsible for the investigation and other witnesses may be called). See also United States v. Church of Scientology, 520 F2d 818, 824 (9th Cir. 1975)(limited evidentiary hearing approved).
When the challenge to a summons is based on an improper purpose, discovery and an evidentiary hearing are critical to prove the challenge, and it is by no means certain that the moving party will have either one or both opportunities. The district court’s decision to deny discovery and an evidentiary hearing is reviewed by a court of appeals under an abuse of discretion standard—that is, only if the taxpayer demonstrates in the summons enforcement hearing that the district court abused its substantial discretion in denying discovery and an evidentiary hearing.
The Internal Revenue Manual (“IRM”) and IRS standard operating procedures require IRS employees to review taxpayer documents with enough time to make a tax assessment before the statute of limitations period ends. See IRM 18.104.22.168. Further, the IRM requires that statute of limitations extensions be requested with enough time and based on a genuine need for more time to investigate a matter before making a tax assessment. Id. A taxpayer has a right to refuse to extend the normal statute of limitations period and the IRS should not retaliate for a taxpayer’s refusal to do so. See IRM 22.214.171.124.
In Clarke, the taxpayer alleged that the IRS had an improper purpose in issuing the summons, and thus was not entitled to enforce its subpoena. Specifically, Clarke asserted that the IRS was retaliating against the Dynamo’s refusal to extend the statute of limitations for a third time and that the IRS was seeking to circumvent the limited discovery rules available to litigants in Tax Court proceedings.
While there seemed to be enough evidence to support the contention that the IRS was in fact punishing the taxpayers for not agreeing to extend the statute of limitations and that the summons were issued for an improper motive, the Supreme Court did not rule on those issues. Instead, the Supreme Court sent the issues back to the district court to decide.
As a matter of law, the Supreme Court’s reasoning in this case is understandable. If any naked allegation of impropriety triggered a full blown evidentiary hearing, the resulting litigation would create a log jam in courts which would bring the justice system to a standstill. Nevertheless, the Supreme Court’s reasoning does not reflect the practical realities of most people who receive IRS summons. While Justice Kagan’s opinion rightly sets forth that a summons represents an inquiry rather than an accusation, the person receiving the summons has no choice but to act as though it is an accusation.
Because the Supreme Court left certain issues unanswered – sending them back to the court below to apply what it called the “correct legal standard” to the facts – it is difficult to predict what the lower courts will consider “credible evidence supporting [the taxpayer’s] charge” or what facts will the taxpayer need to show which “give rise to a plausible inference of improper motive.” In light of this new legal standard, it is hard to predict whether the court below will find that the IRS was punishing taxpayers for not extending the statute of limitations, and whether the taxpayers pointed to specific facts or circumstances plausibly raising an inference of improper motive in enforcing the summons.