Sections 6111 and 6112 of the Internal Revenue Code currently impose certain reporting obligations on individuals who are involved in “reportable transactions,” including an obligation to file information returns and maintain lists of participants. The current code provisions were substantially revised in 2004. Historically, Sections 6111 and 6112 were aimed at “tax shelter organizer[s].” See I.R.C. § 6111(a) (2003). Both the historical and the current versions of Sections 6111 and 6112 of the Code are reinforced by Sections 6707 and 6708 of the Code, which provide for the imposition of significant penalties in the event of a violation.
Last week, a district court issued an interesting decision, denying a motion for judgment on the pleadings filed by a law firm challenging penalties assessed for violations of Sections 6111 and 6112. Callister Nebeker & McCullough v. United States, No. 2:14-cv-919-TC, 2015 U.S. Dist. LEXIS 138646 (D. Utah Oct. 9, 2015). The decision suggests that anyone challenging penalty assessments under Section 6707 and 6708 should be prepared for lengthy litigation.
The taxpayer, a law firm, focused on providing clients with advice concerning employee benefit plans and related tax issues. Callister Nebeker & McCullough, 2015 U.S. Dist. LEXIS 138646 at *3. It was challenging a penalty of $195,081 under Section 6707 for its failure to furnish information on a tax shelter, and a penalty of $11,280,000 under Section 6708 for its failure to maintain lists of the clients it had advised. Id.
The law firm had actually been involved in two different shelters. First, it had been involved in an ESOP-related shelter that the IRS concluded was abusive. A typical transaction had several steps:
- One of the firm’s clients would create an S Corporation that would serve as a management company, and create an ESOP that would serve as its sole shareholder.
- The client’s operating company would transfer its employees to the management company, which would lease them back to the operating company.
- The lease payments were set at a level equal to the amount of deferred compensation due to key managers and owners of the operating company, and the payments flowed through to the ESOP without any tax. This structure also accelerated the deductions associated with the operating company’s deferred compensation structure. Id. at *5-*8.
Then, when given an opportunity to unwind the first shelter, the law firm crafted an option that the IRS concluded was also abusive: in January of 2004, it sent a letter to its clients suggesting that one way to unwind the initial shelter was to have the ESOP sell the management company stock to the owners and management of the operating company “for fair market value, pay out the deferred compensation, and terminate the ESOP.” Id. at *8.
Since the IRS concluded that this was also an abusive tax shelter arrangement, it asserted that the law firm had violated Section 6111 by failing to register the tax shelter and Section 6112 by failing to maintain lists of participants. Id. at *8-*9. Administrative proceedings ensued:
- The IRS sought relevant information by summons (twice) but the law firm failed to comply.
- The IRS assessed penalties under the current versions of Section 6707 and 6708.
- The Section 6708 penalty was particularly painful: 1,128 days had passed since the second IRS summons, yielding a penalty of $11.28 million, which represented $10,000 for every day that had passed. Id. at *12.
The law firm filed an administrative claim for a refund; the IRS failed to act on that request, and the firm filed a refund action in district court. When the IRS filed a counterclaim, the law firm sought dismissal of the penalty claim under Rule 12(c) of the Federal Rules of Civil Procedure, arguing (among other things) that it had reasonable cause for its failure to comply with Sections 6111 and 6112, that the $10,000 per day penalty under Section 6708 violated the Eighth Amendment, and that the penalties were an abuse of discretion under the Administrative Procedure Act.
The district court made short work of the matter. Starting with the contention that the law firm had “reasonable cause,” which would provide a complete defense to any penalty, the court noted that the law firm’s reasonable cause defense rested upon attorney-client privilege and advice of counsel, both of which called for fact-intensive determinations that were inappropriate for disposition on a motion for judgment on the pleadings. Id. at *17-*19.
Next, the court addressed the Eighth Amendment challenge to the penalty. The Eighth Amendment bars “excessive fines.” U.S. Const. amend. 8. A fine is “a payment to a sovereign as punishment for some offense.” United States v. Bajakajian, 524 U.S. 321, 327 (1998) (quoting Browning-Ferris Indus. of Vt. V. Kelco Disposal, 492 U.S. 257, 265 (1989)). A fine is excessive “if it is grossly disproportional to the gravity of the relevant offense.” Id. at 334. The law firm asserted that the Eighth Amendment was implicated because it was being punished for failing to turn over lists of its clients, and because the fine of $10,000 per day had included long periods of inactivity, including a year-long period in which the IRS apparently did nothing between the time it sought to enforce its second administrative summons and the time it issued a penalty assessment.
In the court’s view, however, the need to weigh the amount of the penalty against the gravity of the offense made the Eighth Amendment argument unsuitable for disposition on a motion for judgment on the pleadings, as a decision would require “a fully developed record.” 2015 U.S. Dist. LEXIS 138646 at *19. The court also commented that it would be called upon “to weigh competing allegations,” which suggests that a summary judgment disposition would not be likely.
The need for a fully developed record also drove the court’s ruling on the law firm’s argument that the IRS had abused its discretion within the meaning of the Administrative Procedure Act, which it refused to address.
The lesson here is that a challenge to penalties assessed under Sections 6707 and 6708 is likely to be protracted.