On April 23, 2014, the United States Supreme Court heard oral argument in United States v. Clarke, a case which may affect every taxpayer subject to a future IRS examination.
At issue in the case is the extent to which a taxpayer may investigate the underlying reasons or motivations for the IRS’s issuance of a summons, a subpoena-like document that allows the IRS to demand documents, interview witnesses, and seek other information during the course of an examination. 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.
IRS SUMMONS POWER
The IRS’s summons power is immense, and the limitations placed on it, either by statute or by the courts, are limited. The basic limitations placed on the IRS summons power were set forth in a seminal case, United States v. Powell, 379 U.S. 48 (1964), in which the Supreme Court held that in order to enforce a summons against an uncooperative recipient, the IRS must establish that (1) the examination is being conducted for a legitimate purpose; (2) the information sought may be relevant to that purpose; (3) the IRS does not already possess the information sought; and (4) the IRS has followed all necessary administrative steps, particularly regarding notice and service of the summons.
The Service’s burden to prove these matters is “slight.” An affidavit from the examiner attesting to these facts is sufficient. United States v. Samuels, Kramer and Co., 712 F.2d 1342, 1345 (9th Cir. 1983).
Once the IRS makes it prima facie showing, the burden shifts to the party opposing the summons to either disprove one of the four Powell elements or convince the court that enforcement of the summons would constitute an abuse of the court’s discretion.
Appropriate defenses to summons enforcement include asserting that (1) the summons was issued after the IRS had recommended criminal prosecution to the Department of Justice; (2) the summons was issued in bad faith; (3) the materials sought are already in the possession of the IRS; and, (4) the materials sought by the IRS are protected by either the attorney-client privilege, the work-product doctrine, or other traditional privileges and limitations. United States v. Riewe 676 F.2d 418, 420 n.1 (10th Cir. 1982).
IMPROPER PURPOSE AND BAD FAITH
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 stated 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 188.8.131.52.2, 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 obtain 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. Discovery on motivation of an audit is permitted by some circuit courts only when the movant has shown “extraordinary circumstances” that take the movant out of “the class of the ordinary taxpayer, whose efforts at seeking discovery, would if allowed universally, obviously be too burdensome” to the IRS. United States v. Fensterwald, 553 F2d 231, 231–232 (DC Cir. 1977), cited in United States v. Judicial Watch, Inc., 371 F3d 824 (DC Cir. 2004). Another statement of the showing that is required to be entitled to discovery and an evidentiary hearing is that the movant need only establish the possibility of an improper motive before obtaining further discovery. This standard is more rigid than the standard that must be met by a party opposing a motion for summary judgment. Under this standard, the moving party must have evidence sufficient to raise a genuine issue of fact material to whether the audit is an act of political retaliation, or some other improper purpose. Further, requiring a taxpayer to produce records already in the IRS’s possession is arguably an abuse of the court’s process (or a bad faith use of the summons power). However, courts generally have enforced a summons in this situation.
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 (The scope of documents and information that can be requested in a summons is generally wider than that which is permitted in a Tax Court Request for Production.) This allegation was supported by the fact that when the IRS conducted its investigation with regard to a summons that was not challenged, attorneys representing the IRS in the Tax Court proceeding, rather than the agent in charge of the examination of Dynamo, performed the investigation. In essence, Clarke argued that the IRS was attempting to use its summons power in bad faith – as if it was a grand jury proceeding – to be able to obtain information which it would not otherwise obtain under normal Tax Court discovery rules, and thus have the upper hand in the case.
UNITED STATES V. CLARKE
Clarke arises out of an examination conducted by the IRS 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. Generally, the IRS has three years from the later of the due date for a return or the date the return is actually filed to assess a tax. A tax is not collectible unless it is first assessed.
When the IRS requested a third extension of time within which to complete the assessment, 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 over the course of 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. By issuing the FPAA, the IRS tolled the statute of limitations period, formally set forth the amount it claimed the partnership owed, and began the process of assessing the tax deficiency and collecting the tax from the partnership’s partners. Notably, the FPAA issued by the IRS in December 2010 was dated and signed in August 2010, before the IRS had issued the at-issue summons to Clarke.
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.
In the typical enforcement proceeding, the IRS submits an affidavit of an agent familiar with the case establishing the Powell factors. From there, the burden shifts to the taxpayer to allege and prove that one or more of the factors has not been established. The district court, the forum for summons enforcement litigation, has discretion to determine whether to hold an evidentiary hearing or permit discovery regarding the summons recipient’s allegation that one or more of the Powell factors has not been established.
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 brought forth some evidence supporting the contention that the summon was designed to circumvent the U.S. Tax Court’s limitations on the scope of discovery, 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. Notably, when Powell was decided, lawyers representing the IRS in Tax Court proceedings were not allowed to interview summoned individuals, only examining agents could do that.
To further prove their contentions, the Respondents 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 the first argument as a “naked assertion” unsupported by evidence. It then dismissed the 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 United States District Court for the Southern District of Florida denied Clarke’s request for an evidentiary hearing. On appeal, the Eleventh Circuit Court of Appeals reversed and held that the district court had 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.”
Given the clear structure applicable to deciding summons enforcement proceedings, the parties’ arguments before the Supreme Court focused on narrow issues dictated by the facts specific to the case and the standard of review applicable to a district court’s decision to allow, or deny, an evidentiary hearing. The goals of the parties, specifically to persuade the Supreme Court to either affirm or reverse the Eleventh Circuit’s judgment based on the narrow facts of the case, were somewhat at odds with the Supreme Court’s goal of providing instruction to the district courts across the country that regularly face summons enforcement proceedings.
The government argued, and Clarke seemed to concede, that merely alleging bad faith in response to a summons does not necessarily entitle a summons objector to an evidentiary hearing during which IRS personnel can be examined by the objector. The differences arose with regard to what type of showing, beyond a mere allegation, an objector must make before being entitled to an evidentiary hearing. Clarke argued that the affidavits he submitted highlighting the questionable actions of the IRS—the close proximity between Dynamo’s refusal to extend the statute of limitations and issuance of the summonses, the issuance of the summonses well after the date the FPAA was signed, and the IRS’s use of its Tax Court attorneys to conduct the summons investigation—were sufficient to require the district court to hold an evidentiary hearing during which he would be permitted to question IRS personnel. The government countered that the district court’s decision, which took into account all of the reasons for improper purpose raised by Clarke before the Eleventh Circuit and Supreme Court, should be respected because the district court did not abuse its discretion.
The Court’s focus during argument seemed to be on fashioning a rule of more general applicability from the specific and somewhat unique facts of the Clarke case. What is clear from the Court’s questioning during oral argument is that any type of “automatic hearing” rule, in which a mere allegation of bad faith or impropriety will allow a summons objector the opportunity to participate in an evidentiary hearing, will not be permitted. What is not as clear is whether the Court will adopt a generally applicable standard, rather than deciding the case before it on narrow grounds, and, if a general standard is adopted, what it will be.
There were hints from some of the Justices that they need to provide guidance to the district courts, and that limiting their decision to the narrow facts presented in Clarke would not be helpful. Furthermore, there were indications that some of the Justices could seek to adopt more familiar litigation standards for application in the summons enforcement process. Specifically, Justice Sotomayor raised the question of whether the heightened pleading standards set forth in two fairly recent Supreme Court cases called Twombly and Iqbal is the proper guide or whether the more rigorous standard applicable to summary judgment motions—in which the litigants must set forth specific, admissible evidence to support or oppose a motion for summary judgment—is more appropriate. Not surprisingly, the government argued that the more rigorous summary judgment standard is more analogous, while Clarke argued that the Court’s rule should more closely follow the scrutiny applied to pleadings facing a motion to dismiss.
As with all SCOTUS cases, it is virtually impossible to determine precisely how the Court will rule. If the questions posed by the Justices during oral arguments were any indication of how the Court will rule, it is likely the Justices will side with the IRS. Further, it is probably safe to assume that the Court will err on the side of requiring some clear, probative evidence before permitting a summons objector to question IRS personnel in Court. This is because a rule that is too lenient, i.e. one that requires an evidentiary hearing upon the objector’s proffer of any evidence tending to show an improper purpose, would be seen as too damaging to the IRS’s examination process.
Moreover, the IRS is in the process of implementing more efficient processes relating to information gathering in the process of auditing large businesses. A rule that takes a permissive approach toward entitling summons objectors to an evidentiary hearing, particularly one in which the agent conducting the exam can be questioned, would contravene the IRS’s stated focus on efficiency in gathering information during exams.
The impact of the Clarke decision will be especially relevant to taxpayers in South Florida. As we have blogged about previously, South Florida has been a focus of recent IRS summons issuance. Under the language of Nero Trading, taxpayers residing in the Eleventh Circuit (Alabama, Georgia, and Florida) had seemingly the most accommodating appellate court in the country to hear their appeal when a district court had denied a request for an evidentiary hearing. If the Supreme Court issues a broad decision, the Eleventh Circuit’s prior decision to taxpayers seeking an evidentiary hearing to support their claims of an improper motive in summons issuance may no longer be precedential.
Notably, on April 28, 2014 – only five days after the Supreme Court heard oral arguments on Clarke – the Tenth Circuit Court of Appeals, in Jewell v. United States, Nos. 13–7038, 13–6069(2014), quashed IRS summonses that were issued after the 23-day period required under IRC §7609(a)(1). IRC §7609(a)(1) requires the IRS to notify summons recipients that it will examine records at least 23 days before the date fixed in the summons as the date upon which such records are to be examined. In deciding whether to quash the summonses, the appeals court examined whether the IRS had complied with the Powell requirements and determined that the 23-day period is an administrative step required by statute. In doing so, the Court acknowledged that it was creating a split between circuits. However, the Tenth Circuit emphasized that the Supreme ruled clearly in Powell when it said that “if the IRS does not comply with the administrative requirements of the Internal Revenue Code, its summonses are unenforceable.” In this battle between taxpayers and the government regarding IRS summons power, the ruling in Jewell and the split that now exists only serve to add fuel to the fire, and make the upcoming Supreme Court’s decision in Clarke all the more significant.