FEDERAL TAXATION
by Marilyn E. Phelan *
I.
II.
INTRODUCTION
CLOSELY HELD CORPORATIONS
A.
Accumulated Earnings Penalty Tax
B.
Working Capital Needs
Corporate Business Needs in General......
Reduction of Accumulated Taxable Income for
Contested Taxes
385
Unreasonable Compensation
386
1.
2.
3.
C.
III.
Donation of Stock Between Dividend Declaration
Date and Record Date
387
DISALLOWANCE OF
A.
B.
DEDUCTIONS
Limited Partnerships
Straddle Sales
Voluntary Payments
1.
2.
C.
Loss
Sham Transactions
1.
2.
IV.
Misappropriated Funds
Forfeited Drug Smuggling Proceeds
TAX EXEMPT ORGANIZATIONS-UNRELATED BUSINESS TAXFAILURE TO FILE A TAX RETURN
A.
B.
VI.
391
391
391
392
393
393
394
Penalty Tax on Valuation Overstatements as Applicable to Disallowed Deductions
398
ABLE INCOME
V.
380
380
380
380
384
Innocent Spouse
Tax Protestors
TAX PROCEDURE
A.
Jurisdiction of the Tax Court
1.
2.
400
401
401
406
407
407
Mailing of a Tax Deficiency Notice-the Taxpayer's Last Known Address
407
Timely Filing of a Petition with the Tax
Court
411
• Professor of Law, Texas Tech University. B.A., Texas Tech University, 1959; M.B.A.,
1967, Ph. D., 1971. J.D. 1972, University of Texas.
379
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B.
Review of a Tax Court Decision-Appeal to the
412
Wrong Court
C. Foreclosure on Property Subject to a Junior Tax
Lien-The Government's Right of Redemption ..... 413
D. Award of Attorney's Fees to Prevailing Taxpayers
in Suits Against the IRS
414
VII.
CONCLUSION..........................................................
I.
417
INTRODUCTION
The Fifth Circuit issued opinions in twenty cases involving
federal taxation questions during the current survey period. The cases
involved a wide spectrum of issues; a few involved unprecedented
issues. The court rendered several noteworthy opinions in cases
addressing the definition and/or application of various tax concepts,
such as "innocent spouse," "working capital needs" of a corporation, and "sham transaction"; it also issued a highly questionable
opinion relating to the application of the "assignment of income"
doctrine. I One unprecedented case, addressing the redemption rights
of the Internal Revenue Service ("IRS") regarding property subject
to a junior tax lien, caused adverse. consequences to a first lien
mortgagor who bid less than the fair market value for the property
at a foreclosure sale. 2
II.
A.
CLOSELY HELD CORPORATIONS
Accumulated Earnings Penalty Tax
J.
Working Capital Needs
Closely held corporations scored a pyrrhic victory regarding the
use of the Bardahl formula in determining working capital needs of
a corporation in J.H. Rutter Rex Manufacturing Co. v. Commissioner. 3 A temporary or permanent accumulation of earnings in a
1. Caruth Corp. v. United States, 865 F.2d 644 (5th Cir. Jan. 1989); see infra notes 5475 and accompanying text.
2. Delta Sav. & Loan Ass'n, Inc. v. Internal Revenue Serv., 847 F.2d 248 (5th Cir. June
1988). See infra notes 280-87 and accompanying text.
3. 853 F.2d 1275 (5th Cir. Sept. 1988).
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corporation results in a deferral of the tax at the shareholder level.
Congress has attempted to prevent such accumulations by imposing
a penalty tax on corporations "formed or availed of for the purpose
of avoiding the income tax with respect to its shareholders or the
shareholders of any other corporation, by permitting earnings and
profits to accumulate instead of being divided or distributed."4 There
is evidence of a purpose to avoid income taxes if earnings and profits
of a corporation are permitted to accumulate beyond the "reasonable
needs" of the business. s On the other hand, if earnings are accumulated only to meet the "reasonable needs of the business," a
corporation will not be subject to the accumulated earnings penalty
tax regardless of the amount of its accumulated earnings. 6 The
question of what constitutes "reasonable needs" of a particular
corporation is often difficult to ascertain. 7
Closely held corporations frequently encounter controversies with
the IRS regarding the amount of the "reasonable needs," particularly
with respect to their "working capital needs."8 In Rutter Rex, the
Fifth Circuit permitted a taxpayer-corporation greater latitude in
computing its working capital needs; as a result some closely held
corporations will be able to demonstrate greater working capital
needs and thereby may be able to avoid some, if not all, of the
4. I.R.C. § 532(a) (1982); see 853 F.2d at 1284.
5. I.R.C. § 533(a) (1982).
6. See 853 F.2d at 1285. As the Fifth Circuit noted, "a corporation properly can finance
its various financial needs from its retained earnings. The [tax) laws do not force [a corporation)
to turn to available commercial financing." [d. "Whether a taxpayer's accumulation of earnings
and profits is in excess of the reasonable needs of its business is a question of fact." [d.
7. See I.R.C. § 537 (1982). The "reasonable needs of the business" is defined to include
the "reasonably anticipated needs of the business, ... the redemption needs of the business,
and the excess business holdings redemption needs of the business." [d. § 537(a). A more
definitive listing of reasonable business needs are set out in the Treasury Regulations. See
Treas. Reg. § 1.537-2(b) (1987) (listing the following as examples of reasonable accumulation
of earnings and profits: expanding a business or replacing a plant, acquiring a business
enterprise through purchasing stock or assets; providing for the retirement of bona fide
indebtedness created in connection with the trade or business, such as the establishment of a
sinking fund for the purpose of retiring bonds issued by the corporation; providing necessary
working capital for the business, such as the procurement of inventories; providing for
investments or loans to suppliers or customers if necessary in order to maintain the business
of the corporation; or providing for the payment of reasonably anticipated product liability
losses).
8. See Bardahl Mfg. Corp. v. Commissioner, 24 T.C.M. (CCH) 1030 (1965); Bardahl
Int'l Corp. v. Commissioner, 25 T.C.M. (CCH) 935 (1966).
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penalty tax. 9 Unfortunately, though, for some corporations, the
decision will have the opposite effect.
In determining working capital needs, which is recognized in
Treasury Regulations as a part of the "reasonable needs" of a
corporation,1O courts generally calculate a single, complete "operating
cycle" for the corporation in question; for this purpose most courts
use the so-called "Bardahl formula. "11 The Bardahl formula, named
for the case in which the formula was first utilized,12 breaks the
operating cycle into two sub-cycles: an inventory cycle and an accounts receivable cycle. 13 The inventory cycle, which is the annual
cost of goods sold divided by the average inventory for the year, is
added to the accounts receivable cycle, computed by dividing net
sales for the year by average accounts receivable; the result is then
reduced to a decimal percentage of a year .14 The sum of the corporation's cost of goods sold and general, administrative, and selling
expenses are then multiplied by the decimal percentage to arrive at
the corporation's working capital needs. IS A variation of the Bardahl
formula includes a credit cycle modification; the length of a corporation's credit cycle, computed by dividing the corporation's accounts
payable by its purchases for the year, is subtracted from the sum of
the ·inventory and accounts receivable cycles before reducing the
result to a decimal percentage. 16
The issue facing corporations in determining their working capital needs has been whether the credit cycle must be included in the
computation of the operating cycle. 17 The use of the credit cycle will
reduce the length of the operating cycle and, thus, can cause a
corporation's working capital needs to be a substantially lesser
amount. IS The assumption in using the credit cycle is that a corporation which delays in paying its accounts payable has a lesser need
9.
10.
11.
12.
13.
14.
15.
853 F.2d at 1286-91.
Treas. Reg. § l.537-2(b)(4) (1987).
See 835 F.2d 1286-87.
See 24. T.C.M. (CCH) 1030 (1965).
See 853 F.2d at 1287; 25 T.C.M. (CCH) at 938-39.
See 853 F.2d at 1287; 25 T.C.M. (CCH) at 938-39.
See 853 F.2d at 1287-88; 24 T.C.M. (CCH) at 1034-35, 1044; 25 T.C.M. (CCH) at
939.
16. 853 F.2d at 1288. The Tax Court developed the credit cycle modification in Bardah!
Int'! Corp. v. Commissioner, 25 T.C.M. 935 (1966), a case related to Bardah! Manufacturing.
17. See 853 F.2d at 1288-89.
18. Id.
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for cash, and, in turn, a lesser working capital requirement. 19 The
problem with this argument is that corporations with the most acute
working capital problems generally have a large accounts payable
balance. By using the large accounts payable as part of the credit
cycle, the corporation will have less computed working capital needs
and, thus, will be required to pay a higher accumulated earnings
penalty tax.
The Fifth Circuit determined that Rutter Rex was not required
to reduce its operating cycle computation by the credit cycle. 20 Still
the court did not base its decision on the fact that a corporation's
accumulated earnings tax should not be tied to its credit payment
policies. Quite the contrary, the Fifth Circuit ruled that the credit
cycle modification to the Bardah/ formula can be considered in
determining the operating cycle and the working capital needs of a
corporation "if there is sufficient evidence to justify its consideration. "21 Apparently, that evidence is proof that a corporation is slow
in paying its accounts payable. 22 Because the Fifth Circuit found that
there was a "dearth of evidence that Rutter Rex utilized an extension
of credit from any of its major suppliers to any significant degree, "23
it remanded the case to the Tax Court to determine the corporation's
working capital needs without the imposition of the credit cycle. 24
Although beneficial for Rutter Rex, the Fifth Circuit's decision
is detrimental for slow-paying corporations. The imposition of a
credit cycle for a corporation that finds itself with insufficient funds
to pay its accounts payable on a timely basis may cause a slowpaying corporation, already saddled with liquidity problems, to have
a higher accumulated earnings penalty tax than a corporation having
more liquid assets.
The Fifth Circuit considered other aspects of the Bardah/ formula
in Rutter Rex. The Bardah/ formula used the so-called peak cycle
approach in computing the operating cycle; under the original formula, the inventory and accounts receivable figures would be computed during the peak months, when inventory and accounts receivable
19.
20.
21.
22.
23.
24.
See id. at 1288.
[d. at 1290.
[d. at 1289-90.
See id. at 1290.
[d.
[d. at 1298.
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are the greatest amounts. 25 Still even by permitting a restriction of
the computation to the "peak" months, there are several ways of
computing the inventory and accounts receivable cycles. The corporation in Rutter Rex computed its cycles by using the average of the
three highest consecutive months of inventory of each year in computing the inventory cycle, and the three highest consecutive months
of accounts receivable in computing the accounts receivable cycle. 26
The IRS, on the other hand, used a "net-peak" month method to
determine the cyclesY It used the inventory, accounts receivable, and
accounts payable figures from the year's "peak month" to calculate
the corporation's demand for working capita1.28 The peak month was
the one month "in which the total of inventory plus accounts
receivable minus accounts payable was the greatest. "29 The Tax Court
made its own independent calculations of the cycle components by
using a "true average" method for determining the turnovers. 30 The
Fifth Circuit decided that none of the methods was acceptable by
concluding that the figures from the month in which the corporation
had the highest combined level of inventory and accounts receivable
should be used to determine inventory and accounts receivable for
each year. 31 According to the Fifth Circuit, the computation must be
made without applying accounts payable as a factor since the court
had ruled that the application of a credit cycle was not appropriate. 32
2.
Corporate Business Needs in General
Rutter Rex asserted other justifications for accumulating its
earnings beyond its needs for working capital; it pointed to plans
for expansion, modernization, diversification, replacement of equipment, and provisions for adverse business risks and contingencies. 33
The Fifth Circuit noted that a corporation must have specific, definite, and feasible plans for the use of such accumulations. Whether
25.
in both
26.
27.
28.
29.
30.
31.
32.
33.
See 25 T.C.M. (CCH) at 938. The peak cycle approach was used by the Tax Court
Bardahl decisions. See 25 T.C.M. (CCH) at 938-39; 24 T.C.M. (CCH) at 1034-35.
853 F.2d at 1291-92 n.27.
Id.
Id.
Id.
Id.
Id. at 1291.
Id.
Id. at 1291-92.
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the corporation has such plans during the relevant tax years is a
question of fact. 34 The court commented that a taxpayer corporation
need not have "formal blueprints for action," but the intent to
undertake the plan must be manifested by some "substantial active
move toward .implementation, " such as the corporation incurring
expenditures to further the plan. 35 The test of whether the accumulation of earnings is reasonable is determined by the facts and
conditions as they existed in the tax year in question and not by
subsequent events. 36 Although subsequent events that throw light
upon the facts in the earlier tax year are relevant, a mistaken, good
faith belief as to the necessity for the accumulation of funds does
not later render the accumulation unreasonable. 37
3.
Reduction of Accumulated Taxable Income for Contested
Taxes
In computing a corporation's "accumulated taxable income"
(the figure that is subject to the accumulated earnings tax penalty),
a corporation may deduct its paid or accrued federal income taxes. 38
Rutter Rex deducted tax deficiency amounts based upon the IRS
disallowing a deduction for alleged excessive compensation paid to
its officer-stockholders. 39 The Tax Court agreed with the IRS that
the amount of the tax deficiency could not reduce accumulated
taxable income because the corporation was contesting the deficiency.4O However, the Fifth Circuit permitted Rutter Rex a reduction
in its accumulated taxable income by the amount of the contested
taxes on the reasoning that the corporation had paid the tax prior
to the final Tax Court ruling after which the company's accumulated
34.
See id. at 1292.
35. [d. at 1292-93 (quoting Motor Fuel Carriers v. Commissioner, 559 F.2d 1348, 135153 (5th Cir. 1977».
36. [d. at 1293.
37. [d. at 1295.
38. I.R.C. § 535(b)(I) (1982).
39. 853 F.2d at 1295.
40. [d. at 1296-97. In Dixie Pine Prods. Co. v. Commissioner, 320 U.S. 516, 519 (1944),
the Supreme Court determined that a tax liability that is being contested has not accrued;
thus, the taxpayer is not entitled to a tax deduction. Section 461(0 of the Internal Revenue
Code provides that a contested tax can accrue and be deducted in the year the contest is
resolved, or, under some circumstances, in the year .the tax is actually paid. I.R.C. § 461(0
(1982 & Supp. III 1985).
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earnings tax liability was assessed. 41 The Fifth Circuit was concerned
that the disallowance of a deduction for contested taxes, that were
nonetheless paid prior to the final assessment of the accumulated
earnings tax penalty, would be "an overt upward distortion in the
company's accumulated taxable income that has no basis in economic
reality. "42 The court stated that the disallowance of a deduction for
the taxes would cause a corporation to pay an accumulated earnings
tax on money it had already paid to the IRS.43 The court concluded
that distinctions from the general rules relating to the deductibility
of contested taxes should be made to determine more realistically the
economic realities of the corporation for the tax year at issue. 44
B.
Unreasonable Compensation
Section 162(a)(l) of the Internal Revenue Code grants a deduction for "a reasonable allowance for salaries or other compensation
. . . ."45 The IRS often questions the reasonableness of compensation
in a closely held corporation; the interest of all parties is served by
characterizing amounts distributed to a shareholder-employee as compensation rather than as a dividend since compensation is deductible
to the corporation and a dividend is not. 46 The deductibility of
compensation is seldom questioned in large publicly held corporations
because the corporation generally deals at arm's length with its
employeesY In the small closely held corporation, the IRS will permit
a corporation to deduct compensation only to the extent it is reasonable, characterizing any payment that is "unreasonable" as a
disguised dividend. 48 The reasonableness of compensation paid by a
corporation is a question of fact in which the trial court must consider
a number of factors, such as the employee's qualifications, the nature
and scope of the employee's work, the size and complexities of the
business, and the prevailing rates of compensation in comparable
41.
853 F.2d at 1296-97.
42.
[d. at 1297.
43.
44.
45.
[d.
[d.
I.R.C. § 162(a)(I) (1982).
See Rutter v. Commissioner, 853 F.2d 1267, 1270-71 (5th Cir. Sept. 1988).
See Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1322 (5th Cir. 1987).
[d. at 1322-23.
46.
47.
48.
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concerns. 49 In Rutter v. Commissioner,so the Fifth Circuit agreed with
the taxpayer that the application of the appropriate facts in the
determination of reasonable compensation is reviewable de novo as
a question of law. SI Still, the court concluded that the Tax Court
did not err as a matter of law in its finding that compensation paid
to two officer-shareholders was in part unreasonable. S2 The court
acknowledged that the prevailing rates of compensation for comparable positions in comparable concerns can be the most significant
factor in determining reasonable compensation. s3
C.
Donation of Stock in a Closely Held Corporation Between
Dec/oration Date and Record Date
The taxpayer in Caruth Corp. v. United States,S4 scored a
substantial, but highly questionable, victory when the Fifth Circuit
failed to distinguish between a publicly owned corporation and a
closely held corporation and, thus, refused to apply the assignment
of income doctrine to a donation of stock between the dividend
declaration date and the dividend record date. ss The controlling
shareholder in Caruth, who owned seventy-five percent of the voting
stock and one hundred percent of the nonvoting preferred stock,
donated his preferred shares to a charity after the corporation had
49. See 853 F.2d at 1271. The factors were set out in Mayson Mfg. Co. v. Commissioner,
178 F.2d 115 (6th Cir. 1949). Additional factors that a court should consider are the size and
complexities of the business, a comparison of salaries paid with gross income and net income,
the prevailing general economic conditions, a comparison of salaries with distributions to
stockholders, the salary policy of the taxpayer as to all employees, and in the case of small
corporations with a limited number of officers the amount of compensation paid to the
particular employee in previous years. [d. at 119.
50. 853 F.2d 1267 (5th Cir. Sept. 1988).
51. [d. at 1271-72.
52. [d. at 1272, 1275.
53. [d. at 1273.
54. 865 F.2d 644 (5th Cir. Jan. 1989).
55. [d. at 649-50. Although the "record" date is the determining date as to when a
shareholder is legally entitled to receive a dividend where stock is transferred after a corporation
has declared a dividend but before it has paid the dividend, the IRS has deemed the
"declaration" date to be the controlling date for tax purposes in a closely held corporation.
[d. at 648-49; see Rev. Rul. 74-562, 1974-2 C.B. 28 (holding that a gift to a charity of stock
and declared dividends after the record date, but before the date of payment, does not prevent
the inclusion of the dividends in the gross income of the donor). In that revenue ruling, the
IRS noted the ruling of the Supreme Court in Helvering v. Horst, 311 U.S. 112 (1940) that
the power to dispose of income is the equivalent of ownership of it. 1974-2 C.B. at 28.
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declared a $1,500,000 dividend applicable to his preferred shares. 56
The donation was made prior to the record date for payment of the
dividend so that the dividend was paid to the charity. 57 The Fifth
Circuit determined that the assignment of income doctrine was not
applicable and that, because the dividend did not legally vest until
the record date, the charity, rather than the donor, was "entitled"
to the dividend for tax purposes. 58 The preferred stock's call value
of $100,000 plus the $1,500,000 dividend, declared prior to the date
of the gift, provided the donor with a total charitable contribution
deduction of $1,600,000. 59 The donor was not, however, required to
report the $1,500,000 as dividend income, because, as the Fifth
Circuit concluded, the charity was "entitled" to the dividend payment
on the date of the gift. 60 The court was unimpressed with the fact
that the donor, through his controlling stock ownership, could determine the amount and the timing of the dividend payment. 61
The court in Caruth considered the assignment of income doctrine in the context of the "fruit tree" metaphor enunciated by
Justice Holmes in 1930 in Lucas v. Earl. 62 Although the court
conceded that the "fruit tree" metaphor has legitimacy, the court
refused to recognize the long-standing extension of that doctrine to
embrace a "ripeness of fruit" metaphor, wherein a transferor of
"property," or the "tree," remains taxed on "fruit" that has "ripened" on the date of the transfer. 63 Nonetheless, had the court
56. See 865 F.2d at 647-48.
57. See id. The shareholder had a charitable contribution deduction of $1,500,000 resulting
from the dividend declaration with no corresponding dividend income. See id.
58. [d. at 648-49.
59. [d. at 650-51.
60. [d. at 648.
61. [d. at 647-48.
62. 281 U.S. III (1930); see 865 F.2d at 648-49.
63. 865 F.2d at 649. Overall the coun was unimpressed with the use of metaphors to
decide tax issues. There is a question whether the "fruit tree" metaphor can be substituted in
all respects (if in any respects) for rational analysis. Cenainly it cannot if the "orchard" is
not extended to include the "ripened fruit" metaphor. The coun in Caruth stated: "We fail
to see why the ripeness of the fruit matters, so long as the entire tree is transplanted before
the fruit is harvested." [d. The ripeness of fruit clearly matters; had the court deemed the
fruil to be ripe, it would have held that the taxpayer in Caruth had taxable income of
$1,500,000. See id. at 647. Whatever the status of metaphors in the mind of the coun, if their
use is impugned, some rational approach must be substituted. Some would question whether
the coun achieved a substituted rational approach in its use of "doctrinal particulars."
The ripe fruit metaphor was characterized in Austin v. Commissioner, 161 F.2d 666, 668
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accepted the "ripened fruit" metaphor as an appropriate extension
of the "fruit tree" doctrine, it still would have had the problem of
determining when the fruit had "ripened" in the context of dividend
income. Appreciation in the value of stock is not "fruit" and is not
recognized as income until there is realization. 64 On the other hand,
when the appreciation in value of the stock occurs because the
corporation has declared a dividend, the appreciation should have
"ripened" into fruit. 6s Still, a difficult question remains concerning
the time the fruit has ripened-on the declaration date, the record
date, or the date of payment of the dividend. 66
The Fifth Circuit, apparently not impressed with metaphors,
based its ruling on treasury regulations stating that dividends are
taxed to the person "entitled" to the dividends. 67 Although the court
conceded that "entitlement" does not necessarily correspond with
any of the relevant dates provided for in state corporate statutes (the
declaration date, the record date, or the payment date), it decided
that the "entitlement" date is the date which, for state corporate
(6th Cir. 1947), cert. denied, 332 U.S. 767. In He/vering v. Horst, 311 U.S. 112 (1940), the
Supreme Court stated: "Where the taxpayer does not receive payment of income in money or
property, realization may occur when the last step is taken by which he obtains the fruition
of the economic gain which has a/ready accrued to him." [d. at 115 (emphasis added). In
Harrison v. Schaffner, 312 U.S. 579 (1940), the Supreme Court commented that "one who is
entitled to receive at a future date, interest or compensation for services and who makes a
gift of it by an anticipatory assignment, realizes taxable income quite as much as if he had
collected the income and paid it over to the object of his bounty." [d. at 580. The Court
pointed out that it had ruled in He/vering that "the power to dispose of income is the
equivalent of ownership of it .... " [d.
64. See Eisner v. Macomber, 252 U.S. 189 (1920).
65. See H. BALLATINE, BALLATINE ON CORPORATIONS §§ 235, 241 (1946). Dividends on
stock do not accrue until the board of directors of a corporation declares a dividend. [d. §
235. Once a dividend is declared, the corporation has a legal obligation to pay the dividend,
and the so-called "record date" determines which shareholders have the right to receive the
dividend. [d. § 241. Presumably for a publicly held corporation, the record date then would
be the date on which the fruit had ripened. A particular shareholder would have no enforceable
right to the dividend until that point. In Bishop v. Shaughnessy, 195 F.2d 683 (2nd Cir. 1962),
the Second Circuit determined that the fruit had ripened on the record date. [d. at 685. In
Estate of Smith v. Commissioner, 292 F.2d 478 (3rd Cir. 1961), the court held that for a
closely held corporation wherein the shareholder controls the timing of dividend payments, as
well as the initial determination of whether any dividends will be paid, the declaration date is
undoubtedly the more appropriate date on which the fruit ripens. [d. at 479-80. In Caruth,
the Fifth Circuit determined that the holding in Estate of Smith was not controlling, because
it was based upon New Jersey law which recognizes vested rights at the declaration date for
the dividend. 865 F.2d at 649.
66. See 865 F.2d at 649.
67. [d.
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law purposes, establishes the time when a dividend legally vests. 68
The court referred to article 2.26 of the Texas Business Corporation
Act,69 which provides that a dividend vests as of the record date,
not as of the declaration date. 70 Thus, the court concluded that the
donor would not be taxed on the dividend. The court failed to
acknowledge that federal concepts of taxable income do not necessarily follow state law. 71 Nor did it consider its ruling seven days
earlier in Wood v. United States,72 wherein the court recognized that
the test for taxable income is not title, but rather actual dominion
and control.73
The taxpayer in Caruth, through his controlling interest in the
corporation, could control the date on which dividends were declared
and the shareholders who would receive the dividends (which he did
by setting the record date after a gift of the "pregnant" stock).74
However, the court determined that the taxpayer-donor was not
"entitled" to the dividend and, thus, would not be taxed on the
$1,500,000 dividend payment. 7S If the Fifth Circuit's decision in
Caruth is sustained, it will have the effect of insulating completed
gifts of stock in closely held corporations from assignment of income
consequences.
68.
[d.
69. TEX. Bus. CORP. ACT ANN. art. 2.26 (Vernon 1980).
70. 865 F.2d at 649.
71. The Supreme Court ruled in Estate of Putnam v. Commissioner, 324 U.S. 393 (1945)
that federal law rather than state law controls the determination of when a shareholder is
entitled to receive a dividend. [d. at 395. In Rev. Rul. 74-562, 1974-2 C.B. 28, the IRS
determined that date to be the declaration date when a corporation is closely held. The Second
Circuit agreed with Rev. Rul. 74-562 in Estate of Smith. See Estate of Smith v. Commissioner,
292 F.2d 478, 479-80 (3rd Cir. 1961). The Caruth court's reliance on Estate of Putnam and
Rev. Rul. 82-11, 1982-1 C.B. 51 to determine that the controlling date is the record date was
misplaced. The purchase of stock in Rev. Rul. 82-11 occurred after the record date; therefore,
the IRS ruled that the purchaser was not entitled to the dividends received deduction because
it was not "entitled" to the dividend since the stock was purchased after the record date. Rev.
Rul. 82-11, 1982-1 C.B. at 52. But that revenue ruling did not address the issue of who is
entitled to a dividend when stock is either purchased or donated before the record date.
72. 863 F.2d 417 (5th Cir. Jan. 1989).
73. [d. at 418. In He/vering v. Horst, 311 U.S. 112 (1940), the Supreme Court ruled that
the power to dispose of income is the equivalent of ownership in it. The Court also held that
"[t]he exercise of that power to procure the payment of income to another is the enjoyment,
and hence the realization, of the income by him who exercises it." 3!l U.S. at !l8.
74. See 865 F.2d at 645-47.
75. [d. at 650.
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III.
DISALLOWANCE OF
A.
1.
Loss
391
DEDUCTIONS
Sham Transactions
Limited Partnerships
In Merryman v. Commissioner,76 the Fifth Circuit concluded
that an investment in a limited partnership, allegedly formed to
operate drilling rigs, represented a sham transaction even though the
court agreed that the operation of the drilling rigs had economic
substance. 77 The court was concerned that the partners executed notes
for most of their capital contributions to the partnership.78 In addition, the managing partner sold the drilling rig equipment to the
partnership in consideration of the execution of a note from the
partnership, with the partnership simultaneously surrendering complete control of the equipment to the managing partner.79 The court
noted that the partnership held no property, maintained no books
or records and did not hold itself out as being engaged in business. 8o
The court determined that the managing partner was, in effect, both
the mortgagee and the mortgagor on the note used as consideration
to purchase the rig equipment. 81 The court commented that, throughout the partnership's existence, the managing partner remained in
sole control and possession of the rig and continued to operate it
without informing third parties of the change of ownership.82 The
managing partner operated the rig, collected the revenues, and remitted the net revenues to the partnership, wherein the money was
returned to the managing partner in the form of note payments from
the partnership.83 The court opined that once the rig management
agreement was signed, there was little evidence of the existence of a
partnership.84 The Fifth Circuit affirmed the ruling of the Tax Court
that the partnership should be disregarded for income tax purposes,
76.
77.
78.
79.
873 F.2d 879 (5th Cir. May 1989).
Id. at 882-83.
Id. at 882.
Id.
80. Id. at 883.
81. Id. at 882.
82. Id.
83. Id. The court commented, "such a circular flow of funds among related entities does
not indicate a substantive economic transaction for tax purposes." Id.
84. Id. at 882-83.
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agreeing with the Tax Court that although the oil rig was built and
operated for a profit, the formation and role of the partnership
served no purpose other than tax avoidance. 85 As a result, the partners
were denied tax deductions and tax investment credits attributable to
their interests in the partnership. 86
2.
Straddle Sales
The Fifth Circuit considered the issue of whether losses incurred
as a result of trading on a foreign metal exchange would be tax
deductible in Killingsworth v. Commissioner. 87 The transaction involved the so-called "straddle transaction" traditionally used by
investors to minimize market risks associated with commodities trading. 88 The Tax Court found that the taxpayer did not enter the
transactions primarily for profit, and consequently, upheld the IRS's
disallowance of the loss deductions. 89 The Fifth Circuit held that the
Tax Court's finding that the straddle transactions were, in substance,
shams, was not clearly errcneous. 90 The court found that the option
transactions were designed to deliver ordinary losses that could be
deducted against unrelated ordinary income and that each transaction
"consisted of nothing more than the sale for a fee of tax deductions
to American taxpayers. "91
85. [d. at 883. The court noted the long-settled rule of law, as set out in Gregory v.
Helvering, 293 U.S. 465 (1935) and Knetsch v. United States, 364 U.S. 361 (1960), "that
transactions which have no economic purpose or substance other than the creation of income
tax losses or credits are disregarded for tax purposes." 873 F.2d at 881. The court pointed
out that the form of a transaction can be rejected even when the underlying activity is not a
sham. [d; see Packard v. Commissioner, 85 T.e. 397,419 (1985). The Fifth Circuit referred
to the test used by the Supreme Court in Frank Lyon Co. v. United States, 435 U.S. 561
(1978) to determine when a transaction should be recognized for tax purposes. 873 F.2d at
881. According to the Supreme Court, a transaction that involves genuine multiple party
transactions "with economic substance which is compelled or encouraged by business or
regulatory realities, . . . imbued with tax independent considerations, and not shaped solely
by tax-avoidance features that have meaningless labels attached," should be "honored" by
the IRS. 435 U.S. at 583-84.
86. 873 F.2d at 880, 883.
87. 864 F.2d 1214 (5th Cir. Feb. 1989).
88. See id. at 1216. The case involved over 1,100 investors who had claimed tax deductions
of over $100,000,000 for option straddle or hedge transactions through trading on the London
Metal Exchange. [d.
89. See id.
90. [d. at 1219.
91. [d. at 1218-19. Section 108 of the Tax Reform Act of 1984, Pub. L. No. 98-369, 98
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393
In Herrington v. Commissioner,92 the Fifth Circuit ruled that a
gain on the second half of a straddle transaction, resulting ,from
tr:ading on the same foreign metal exchange as in Killingsworth,
would be taxed. 93 Although the Tax Court in Her.rington agreed that
the foreign straddle transactions were sham transactions, the Tax
Court was concerned that the taxpayers had deducted a loss for the
first leg of the same straddle in a previous tax year, and that tax
year could, not, be audited because the statute of limitations had
run. 94 Relying on the general principle of estoppel, the Fifth Circuit
agreed with the Tax Court that the gain should be taxed. 95 The Fifth
Circuit commented that the "duty of consistency" prevents' a taxpayer
from taking one position one year and a contrary position in a later
year (after the limitations period has run on the first year).96 Thus,
the taxpayers in Herrington were estopped from disavowing their
transaction as being real ill a tax year in which they incurred a gain. 97
.B.
1.
Voluntary Payments
Misappropriated Funds
In Murphree v. United States,98 a federal district court ruled
that taxpayers who had misappropriated funds belonging to their
closely held corporation' were not entitled t9 a loss deduction when
they returned the money to the corporation, even though the taxpayers had reported the appropriated funds as taxable income. 99 The
Stat. 494, 630-31 (1984) is applicable to straddle transactions. As amended, it provides that
losses will be deductible in the case 'of 'any disposition of one or more positions for the taxable
year of the disposition if the loss was incurred in a trade or business or in a transaction
entered into for profit. [d. According to some courts, this language dictates a subjective
standard such as that used for § 165(c)(2) of the Internal Revenue Code. See 864 F.2d at
1218. The taxpayers in Killingsworth urged that the test was objective and that the proper
standard should be whether the transactions at issue had a reasonable prospect of profit
independent of tax considerations. [d. The court concluded that regardless of the test used,
the transactions involved appeared to be "devoid of profit making potential." [d.
92. 854 F.2d 755 (5th Cir. Sept. 1988), cert. denied, _ _ U.S. _'_, 109 S. Ct. 2062,
104 L. Ed. 2d 62~ (1989).
93. [d. at 758.,
94. See id. at 757.
95. [d.
96.
[d.
,97. Id. at 757-58.
98. 867 F.2d 883 (5th Cir. Mar. 1989).
99. See id. at 884.
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district court disallowed the loss deduction based upon its conclusion
that the taxpayers did not have a pre-existing legal obligation under
state law to repay the amount of the misappropriation. loo The Fifth
Circuit, on the other hand, agreed with the taxpayers that they did
have a legal obligation to return the corporate funds, 101 According
to the Fifth Circuit, the taxpayers would be personally liable for the
amount of repayment inasmuch as theft of corporate funds is a
breach of due care. 102 The court disagreed with the IRS that because
the corporation was controlled by the taxpayer, any repayment was
voluntary,I03 As a result of the Fifth Circuit's determination that the
taxpayers had a legal obligation to repay the misappropriated funds,
the court ruled that the taxpayers were entitled to a loss deduction
under section 165 of the Internal Revenue Code,l04
2.
Forfeited Drug Smuggling Proceeds
In Wood v. United States, lOS a drug dealer, who was required
to report as income the proceeds from his drug smuggling, was not
as fortunate as the taxpayer in Murphree; the drug dealer was denied
a loss deduction when the proceeds were forfeited to the government
even though there was no question but that the forfeiture was
involuntary.l06 In Wood, the taxpayer had received commissions for
handling marijuana. 107 The money was eventually channeled into a
real estate development project that was later turned over to the
federal government; because the property was acquired with proceeds
from drug smuggling, the property was at all times impressed with
100. See id.
101. [d. at 885.
102. [d.
103. [d. at 886. The IRS contended that the taxpayers, as the controlling shareholders of
the corporation, would not permit the corporation to bring suit against them to obtain the
funds. [d. The court, however, pointed to the fact that minority stockholders or creditors
could bring suit against the corporation. [d.
104. 867 F.2d at 886. The court commented that a contrary result would encourage attorneys
to advise corporate officers to keep the proceeds of questionable "deals" until and unless suit
was brought. [d. The court was concerned that this could lead to unnecessary or sham litigation
and would also delay the corporation's receipt of its misappropriated funds. [d.
105. 863 F.2d 417 (5th Cir. Jan. 1989).
106. [d. at 419-22. In the context of a repayment of an ill-gotten gain, a "voluntary"
payment is apparently more likely to generate a tax deduction than an "involuntary" payment.
See id. at 421.
107. [d. at 418.
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FEDERAL TAXATION
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a constructive trust in favor of the government. IOS The IRS asserted
substantial tax deficiencies and fraud penalties against the taxpayer
for failure to report the commissions. as taxable income,I09 but
disallowed a deduction to the taxpayer when the property purchased
with the commissions was forfeited to the government. 110
The taxpayer contended that the IRS was acting inconsistently
by imposing a tax on proceeds from illegal activities that had already
been forfeited to the government. III The Fifth Circuit, on the other
hand, pointed out that the test for taxable income is not title but
rather actual dominion and control. ll2 According to the court, the
taxpayer exercised complete dominion and control over the proceeds
from drug smuggling, and the fact that by operation of law all right
and title vested in the government as soon as the money was earned
was immaterial. 113
The taxpayer in Wood also contended that if he was required
to report the drug proceeds as income, he was surely entitled to a
tax deduction for the value of the property purchased with the
proceeds when the property was forfeited to the government. 114
Section 165 of the Internal Revenue Code provides a tax deduction
for any "loss" sustained during a taxable year that is incurred in a
trade or business or in a transaction entered into for profit. lIs Further,
section 162 provides the general rule that ordinary and necessary
"expenses" incurred in a trade or business are deductible for tax
purposes.1 16 Still, section 162(f) specifically disallows a deduction for
a "fine" or "penalty" paid to a government. ll7 In Holt v. Commissioner,lIs the Tax Court determined that forfeiture of property to the
government as an economic penalty for drug trafficking represents a
108.
109.
interest
110.
111.
112.
[d.
[d. The taxpayer received $600,000 in commissions; the tax deficiency, including
and penalties, totaled $735,556. [d.
[d.
[d.
Id.
113. [d.; cf. Caruth Corp. v. United States, 865 F.2d 644 (5th Cir. Jan. 1989) (concluding
that dividend income would be taxed to the person or entity who had "entitlement" to the
income under state law).
114. 863 F.2d at 421.
115. I.R.C. § 165(c) (1982 & Supp. I 1983).
116. I.R.C. § 162(a) (1982).
117. I.R.C. § 162(1) (1982).
118. 69 T.C. 75 (1977), afl'd per curiam, 611 F.2d 1160 (5th Cir. 1980).
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"loss" to a taxpayer"rather than an "expense," since the property
is confiscated rather· than sold,l19 Thus, section 165, rather than
section 162; is the applicable Code· section. In Holt, the Tax Court
held that if a taxpayer were entitled to deduct such a "loss," the
government would, in effect, carry a portion of the loss inflicted by
the government. I2°According to the Tax Court, such a result would
be "absurd."121 By deducting the value of the property forfeited to
the government as a loss under section 165, the taxpayer in Wood
followed the ruling of the Tax Court in Holt that section 165, rather
than section 162, is applicable. 122 However, as in Holt, the taxpayer
in Wood was denied the loss deduction. 123
Section 162(0, relating to the "payment" of fines and penalties,
was a codification of the decision of the Supreme Court in Tank
Truck Rentals, Inc. v. Commissioner,124 that, because a tax deduction
would reduce the "sting" of a penalty, tax deductions for payment
of fines and penalties should be disallowed. 12s The Fifth Circuit in
Wood cited Tank Truck Rentals as authority for its position that
the drug dealer should not be permitted a loss deduction for the
value of the forfeited property. 126 Thus, the court imposed the "public
policy'! limitation, enunciated in Tank Truck Rentals and codified
in section 162(f) of the Code, upon section 165 as well.
In denying the taxpayer in Wood a loss deduction because of
"the sharply defined national" policy against the possession and sale
of marijuana," 127 the Fifth Circuit followed the congressional policy
of disallowing a tax deduction for any "expenditures" in connection
with the illegal sale of drugs ..l 28 Congress has not imposed such
limitation on taxpayers involved in other types of illegal activities. 129
119. [d. at 78-79.
120. 69 T.C. at 80.
121. [d.
122. 863 F.2d at 421.
123. [d.
124. 356 U.S. 30 (1958).
125.. [d. at 35.
126. 863 -F.2d at 422.
127. 863 F.2d at 420 (quoting Tank Truck Rentals, Inc. v. Commissioner, 356 U.S. 30,
33-34 (1958».
128. See I.R.C. § 280E (Supp. I 1983) (disallowing a tax deduction for any expenditures
incurred in connection with the illegal sale of drugs).
129. Congress has not enacted any Code provision similar to § 280E for other types of
illegal activities. In Commissioner v. Sullivan, 356 U.S. 27 (1958), the Supreme Court held
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. FEDERAL TAXATION
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For illegal activities other than the illegal sale of drugs, the otherwise
legitimate expenses in producing the illegal income, such as rent,
utilities, and salaries, have been permitted as tax deductions so that
only the net income from an illegal activity is taxed. 130 Still, the Fifth
Circuit's decision in Wood raises the question of whether the court
might be inclined to impose a public policy limitation on the deductibility of expenditures in other types of illegal endeavors as well.
With respect to "restitution" payments, the court apparently
would not limit its decision to disallow a deduction only with respect
to payments incurred in connection with the illegal sale of drugs.!3!
The Fifth Circuit in Wood expressed doubts whether any restitution,
but at least forced restitution, should be deductible in any context. 132
In Waldman v. Commissioner,133 the Tax Court stated that restitution
as a condition of probation is for the purpose of enforcing the law
and is a penalty.134 If restitution can properly be termed a penalty,
a tax deduction for the "payment of money" in the form of
restitution would be disallowed under section 162(f),135 Given the
Fifth Circuit's imposition of a public policy limitation on the deduction of losses under section 165, a loss deduction could likewise be
disallowed for the "forfeiture" of property in the nature of restitution
in other forms of illegal activities. How far the Fifth Circuit will
carry the "public policy" limitation to disallow tax deductions for
that rent and salary expenses incurred in operating an illegal bookmaking enterprise were
deductible. [d. at 29. The Court opined that if such expenditures were not deductible, an
illegal business would be taxed on its gross receipts, whereas other businesses are taxed on net
income.ld.
130. Commissioner v. Sullivan, 356 U.S. 27 (1958). In James v. United States, 366 U.S.
213 (1960), the Supreme Court ruled that embezzled funds constituted taxable income. Id. at
221. In James, wholly in dicta as the Fifth Circuit pointed out in Wood, the Supreme Court
commented that when the victim of embezzled funds recovered the funds from the embezzler,
the embezzler would be entitled to a tax loss (in the year of restitution). Id. at 220; 863 F.2d
at 317. It has been assumed that a tax deduction is also permitted for payments in the form
of restitution. As for the payment of fines and penalties incurred in an illegal activity, § 162(f)
prevents a deduction. I.R.C. § 162(f) (1982). If a payment as restitution would not be
characterized as a fine or penalty, a tax deduction would not be denied because of the
prohibition of § 162(f). The Fifth Circuit in Wood decided that James is not authority on the
issue of whether a public policy concept can be applied to permit or to deny certain tax
deductions. 863 F.2d at 421.
131. 863 F.2d at 421.
132. [d.
133. 88 T.C. 1384 (1987), aff'd, 850 F.2d 611 (9th Cir. 1988).
134. Id. at 1388.
135. See I.R.C. § l62(f) (1982).
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losses and expenses incurred in illegal activities, other than the illegal
sale of drugs, remains to be seen.
Penalty Tax on Valuation Overstatements as Applicable
Disallowed Loss Deductions
C.
In Todd v. Commissioner,136 the Fifth Circuit considered the
application of the thirty percent penalty tax, set out in section 6659
of the Code (for valuation overstatements),137 to disallowed investor
depreciation deductions on property in a tax shelter .138 The Todds
were denied any depreciation deductions attributable to property from
a tax shelter in which they had invested because the tax shelter had
not placed the depreciable property in service in the two tax years
in question. 139 The IRS imposed the thirty percent penalty as an
addition to the Todds' tax liability for the two tax years in question. l40
The Tax Court, on the other hand, had determined that section 6659
was not applicable because, considering that the Todds were denied
any depreciation deduction, the value of the depreciable property
played no part in calculating the tax the Todds actually owed. 141 The
Fifth Circuit agreed with the Tax Court that section 6659 should not
be applicable when deductions are inappropriate altogether .142 The
court pointed out that the Todds' "valuation" of the property that
supposedly generated their tax benefits had no impact whatsoever on
the amount of tax they actually owed inasmuch as the Todds were
denied depreciation deductions altogether. 143 The deductions were
disallowed because the property had not been placed in service, not
because the cost of the property was inflated. l44
The IRS expressed concern that the Fifth Circuit's decision in
Todd would lead to anomalous results. 145 For example, those investors
136. 862 F.2d 540 (5th Cir. Dec. 1988).
137. LR.C. § 6659 (1982 & Supp. III 1985).
138. 862 F.2d at 541. Section 6659 provides for a penalty when a tax payment is attributable
to an overstated valuation if the underpayment is at least $1000 and the adjusted basis or
value of the claimed property is at least 150010 of the actual value or basis. [d.
139. [d.
140.
141.
142.
143.
144.
145.
See id.
See id.
[d. at 545.
[d. at 543.
[d. at 545.
[d.
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in the tax shelter whose property had been placed in service were
disallowed depreciation deductions on the full claimed cost of the
equipment, the Tax Court agreeing with the IRS that these investors
could only take depreciation deductions as to the amount of their
total cash payments for their investment in the tax shelter. 146 Investors
in the tax shelter had paid only a fraction of the alleged purchase
price of the property, signing a promissory note for the baianceY7
The Tax Court found the obligations represented by the promissory
notes to be illusory and limited the maximum tax basis the investors
could claim as the lesser of the fair market value of the equipment
or the actual cash payments made by the investors. 148 For these
investors, the Tax Court agreed with the IRS that the penalty tax
under section 6659 was applicable because the disallowance of their
deductions was based on their proper "cost" basis in the property}49
Thus, some investors had their tax deficiency increased by the thirty
percent penalty whereas the Todds did not. 150
The Fifth Circuit tracked the language of section 6659. The
statute provides a penalty tax for that portion of a tax underpayment
"that is attributable to a valuation overstatement." 151 The court
found no legislative intent to apply the thirty percent penalty tax to
any tax deficiencies other than those attributed to an overvaluation
of property}52 The court commented that "once a court knows
Congressional intent, it may not vary the rules to avoid what it
considers an undesirable outcome. "153
146. [d.
147. See id. at 540.
148. See id. at 541.
149. See id.
ISO. [d.
lSI. I.R.C. § 6659 (1982 & Supp. III 1985); see 862 F.2d at 543.
152. 862 F.2d at 543.
153. [d. at 545. The court pointed out that the results were not as inequitable as the IRS
contended. [d. The Todds were denied their claimed deductions and investment tax credits.
[d. The other investors were entitled to some depreciation deductions but had to pay the §
6659 penalty. [d. The court noted that negligence penalties can be imposed pursuant to other
provisions of the Code. [d. Further, § 6653(b) provides for civil fraud penalties of 75f1lo of a
tax underpayment attributable to fraud. I.R.C. § 6653(b) (West 1989). The IRS had contended
that if a taxpayer could escape the 30070 penalty tax under § 6659 by not claiming any
deductions relating to depreciable property, the taxpayer might contend that he had not entered
a particular transaction for profit. 862 F.2d at 545. If such were the case, no deductions
would be permitted; thus, there would be no 30% penalty tax based on overvalued property.
[d. The Fifth Circuit was not concerned that such a result might occur. The court commented
that such a taxpayer would well win a pyrrhic victory. [d. The taxpayer might escape the §
6659 penalty but subject himself to a much larger 75% fraud penalty. [d.
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IV.
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TAX EXEMPT ORGANIZATIONS-UNRELATED BUSINESS TAXABLE
INCOME
Tax exempt organizations are subject to income tax liability in
the same manner as are taxable organizations if they engage in certain
activities that are unrelated to their exempt purpose.IS 4 The theory
for such taxation is that an unrelated business activity distorts the
exempt purposes of the organization and is a form of unfair competition to taxable organizations. ISS Taxable income for an otherwise
tax exempt organization is determined by computing the net income
from any "unrelated" trade or business. ls6 An unrelated trade or
business is one in which the conduct of business transactions is not
substantially related to the exercise or performance of the exempt
purposes of the organization (aside from the need for income or the
use made of the profits).157
Determining whether activities are substantially related to an
organization's exempt purposes necessitates an examination of the
relationship between the business activities generating the income and
the accomplishment of the exempt purposes. ISS A trade or business
is related to the exempt purposes only where conduct of the business
has a causal relationship to the achievement of those purposes;
further, it is substantially related only if the causal relationship is a
substantial one. IS9 The production or distribution of goods or the
performance of services by a tax exempt organization must contribute
importantly to the accomplishment of its exempt purposes or else
the income from such activities will be taxed. 160
In Texas Apartment Association v. United States,161 the Fifth
Circuit considered whether the sale of preprinted lease forms and a
landlord's manual containing statutes, case law, commentary, and
copies of lease forms was substantially related to the tax exempt
154.
I.R.C. § 51 I(a)(I) (1982).
155.
See Texas Apartment Ass'n v. United States, 869 F.2d 884, 886 (5th Cir. Apr. 1989).
156.
157.
158.
159.
I.R.C. § 512(a)(I) (1982).
I.R.C. § 513(a) (1982).
Treas. Reg. § l.513-I(d) (1983).
Treas. Reg. § l.513-I(d)(2) (1983).
160. [d. The Fifth Circuit had earlier ruled in Louisiana Credit Union League v. United
States, 693 F.2d 525, 543 (5th Cir. 1982) that a statewide business league for credit unions
had unrelated business taxable income fees for promoting insurance, debt collection and data
processing.
161. 869 F.2d 884 (5th Cir. Apr. 1989).
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purposes of a trade association formed to promote the apartment
industry within a state. 162 The objectives of the trade association were
to improve apartment management practices and to develop a sense
of responsibility to the public among apartment owners and managers. 163
The Fifth Circuit in Texas Apartment Association restated its
earlier position in Louisiana Credit Union League v. United States,l64
that the question of whether the production or distribution .of goods
contributes importantly to the accomplishment of an organization's
exempt purpose depends upon the facts and circumstances involved
in each case. 165 The Fifth Circuit noted that the Association's dissemination of its updated materials improved management practices
within the state, helped to standardize rights and duties under the
state landlord-tenant law, and raised the level of sophistication of
the questions from owners and managers; consequently, the court
determined that the Association's materials did contribute to industrywide improvements in landlord practices and legislation. l66 The Fifth
Circuit found that the sales met the substantial relationship test set
out in Louisiana Credit Union League that an income-producing
activity will be substantially related to the exempt function of the
organization if (1) the "activity is 'unique to the organization's taxexempt purpose'" and (2) "direct benefits flowing from a business
league's activities inure to its members in their capacities as members
of the organization. "167
v.
FAILURE TO FILE A TAX RETURN
A.
Innocent Spouse
The Fifth Circuit refused to hold a spouse guiltless for her
former husband's sins in Roberts v. Commissioner. 168 In Roberts,
the taxpayer-spouse's former husband was instrumental in acquiring
some real estate for an investment group of which he was a mem-
162.
163.
164.
165.
166.
167.
530-31
168.
[d. at 885.
See id.
693 F.2d 525 (5thCir. 1982).
869 F.2d at 888-89.
[d. at 889.
[d. at 887 (quoting Louisiana Credit Union League v. United States, 693 F.2d 525,
(5th Cir. 1982».
860 F.2d 1235 (5th Cir. Nov. 1988).
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ber .169 However, unknown to other members of the group, the exhusband received and accepted from the sellers an illegal kickback
totaling $268,541. 170 Because of marital difficulties, the taxpayerspouse separated from her husband shortly after he received the
kickback and later was divorced from him. l7l The taxpayer's exhusband did not file an income tax return for the year he obtained
the illegal commission. 172 When the taxpayer-spouse was informed by
an IRS agent of the failure to file (seven months after the due date),
she filed a separate return and reported only her income from a few
real estate transactions she had handled. 173 The IRS later issued a
notice of deficiency against her asserting a $59,204 income tax
deficiency, representing the tax on one-half of the illegal commission
(less applicable deductions), and a penalty tax of $14,801 for failure
to file a timely income tax return. 174 The taxpayer-spouse contended
she should not be required to include the illegal commission as
income because she was an "innocent spouse."175 She further contended that she had "reasonable cause" for her failure to file a
timely return. 176
Section 66 of the Internal Revenue Code provides that income
from community property will be taxed to the person earning the
income, and thus not treated as community property income, if
certain requirements are met. 177 Section 66 states that the individual
who did not earn the income must establish that he or she did not
169. See id. at 1236.
170. See id. at 1237.
171. See id. at 1236-37.
172. See id. at 1238.
173. See id.
174. See id.
175. Id.
176. [d.
177. I.R.C. § 66(c) (Supp. III 1985). Section 6013(e) of the Internal Revenue Code is
known as the "innocent spouse" section. Section 66 provides the innocent spouse with
additional benefits; § 66(c) and § 6103(e) provide that an individual who did not file a joint
return and did not include any item of community income that was earned by the other spouse
is not required to report any community income attributed to the effects of the other spouse
if the individual established that he or she did not know of, and had no reason to know of
the item of community income, and, taking into account all facts and circumstances, it would
be inequitable to include the item of community income in that individual's gross income. Id.
§§ 66(c), 6013(e). Section 66 was amended in 1984 to liberalize the innocent spouse joint return
relief provision. Pub. L. No. 98-369, § 424, 98 Stat. 494, 802-03 (1984) (codified as amended
at I.R.C. § 66 (1982 & Supp. III 1985». If one taxpayer acts as though he or she were solely
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FEDERAL TAXATION
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403
know of, and had no reason to know of, the item of community
income. 178 Under this circumstance, one-half of the community income will not be attributed to the so-called "innocent" spouse if
"taking into account all facts and circumstances," it is inequitable
to include the item in the individual's gross income. 179
The taxpayer-spouse in Roberts contended that her husband was
"extremely secretive" about the source of funds he gave her to
operate the community household. 180 She discovered that her husband
carried large sums of money on his person; she also realized that
they were living beyond their means. 181 When she questioned her
husband about the money, he explained that it belonged to someone
else. 182 At that point she did become suspicious of his financial
affairs, and based upon pressure from another member of the investment group, who informed her of his belief that her husband
had defrauded the group, she provided the other member of the
group some of her husband's files. 183 She later relinquished to him
her entire claim and interest in the house and its belongings as well
as some stock. 184 The taxpayer-spouse was divorced from her husband
within a year after he received the illegal commission; she began
living apart from him within eight months thereafter .185 Thus, except
for the short period of time when she shared a higher standard of
living with her husband because of his receipt of the commission,
she apparently had no real benefit from the kickback. 186
The Tax Court found that the taxpayer-spouse could not be an
innocent spouse because she could not establish that she did not
know, or had no reason to know, of the item of community income. 187
entitled to an item of community income and fails to notify his or her spouse before the due
date for filing a return for the year in which the income was derived, of the nature and
amount of the income, the taxpayer earning the income may be required to report the entire
amount. I.R.C. § 66(b) (Supp. III 1985).
178. 860 F.2d at 1239.
179.
180.
181.
182.
183.
184.
[d.
[d.
See id. at 1237.
See id.
See id.
See id. The other member of the investment group discovered that her husband had
obtained the kickback when the wife delivered to the member some documents which her
husband had supplied to the attorneys during the divorce proceedings. See id.
185. See id. at 1236.
186. [d. at 1239.
187. See id. at 1238-39.
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Upon appeal, the Fifth Circuit determined that the finding of the
tax Court was not clearly erroneous. 188 The Fifth Circuit pointed to
the fact that the taxpayer-spouse knew that her former husband had
participated in real estate transactions during the tax year in question. 189 The taxpayer-spouse was a licensed real estate broker; and,
as such, the court opined that she would know het husband would
generate income from such transactions. l90 She kriew of the investmentgroupobtairiing the real estate, and she had drawn checks on
the joint checking account in which the commission money had been
deposited. 191 The court noted that she relinquished all her interest in
her marital property to the Other member of the investment group.192
According to the Fifth Circuit, these facts indicated the taxpayerspouse should have known of her husband's receipt of the kickback. 193
At least if she did not know, she should have made. the inquiry
necessary to have obtained the actual knowledge. 194
The Fifth Circuit agreed with the Tax Court that the taxpayerspouse could be assessed a penalty for late filing of her return. 195
The court determined that the Tax Court had correctly concluded
that the taxpayer-spouse had not demonstrated a "reasonable cause"
for her failure to file by the due date. l96 The court commented that
because her husband stored his materials in his office in their. home,
she had access to the books and records and could have filed a
timely return. l97
The taxpayer~spouse in Roberts was forced to pay approximately
$74,000 in taxes and penalties on money she never controlled or
used, except for a limited time prior to her separation from her exhusband. 198 There clearly is a question of equity in Roberts, since
188.
189.
190.
191.
192.
193.
194.
195.
196.
197.
[d. at 1240.
[d. at 1239.
[d.
[d.
[d.
[d.
[d.
[d. at 1242.
[d.
[d. The court refused to accept her emotional distress. aggravated by the fact that
her ex-husband later attempted to kill her son and the man she later married, as "reasonable
cause." [d. at 1237. The court pointed out that some of her problems occurred after the due
date for filing the return. [d. at 1241.
198. [d. at 1237-38.
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FEDERAL TAXATION
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without the efforts of the taxpayer-spouse, the kickback payment
might not have been discovered)99 In addition, the taxpayer-spouse
apparently divested herself of any interest in the property obtained·
with the ill-gotten money. 200 Her only benefit from use of the funds
was a higher standard of living for the short time after her exhusband acquired the funds until she separated from him. 201 Even
then she seemed to have little actual benefit from the funds because,
as the court noted, the parties were having substantial marital difficulties during this period. 202 .
Section 66(b) was added to the Code by the Deficit Reduction
Act of 1984. 203 This alllendment to section 66 provides that the
Secretary may disaIiow the ,benefits of any community property law
to a taxpayer for any income if (a) the taxpayer acted as if he or
she were solely entitled to the income and (b) the. taxpayer failed to
notify his or her spouse of the nature and amount of the income
before the due date for filing a return for the taxable year in which
the income was derived. 204
Unfortunately for the taxpayer-spouse in Roberts, section 66(b)
is effective for tax years beginning after December 31, 1984. 205 The
taxpayer's ex-husband obtained the kickback in tax year 1975. 206
Presumably section 66(b) would now apply to a situation, such as
occurred in Roberts, to attribute all income from a commission
kickback to the husband. 207 The facts in the case seem to indicate
that the husband exercised control over the funds and did not inform
his spouse of the income prior to the due date of the return. 2OS Given
199. See id.
200. [d. at 1237.
201. [d. at 1237-39.
202. [d. at 1237.
203. Pub. L. No. 98-369, 98 Stat. 494 (1984).
204. See Pub. L. No. 98-369, § 424(b), 98 Stat. 494, 802 (1984). The section was added
to the Code to liberalize the innocent spouse provisions by expanding the circumstances in
which relief could be granted the innocent spouse. H.R. REp. No. 432, Part II, 98th Cong.,
2d Sess. 1501-03, reprinted in 1984 U.S. CODE CONGo & ADMIN. NEWS 697, 1l42-44. In
applying § 66(b), community property laws will be disregarded in determining to whom an
item is attributable. [d. The section does not require that a determination be made of whether
or not the innocent spouse benefited from the item of income. [d.
205. See Pub. L. No. 98-369, § 424(c)(2), 98 Stat. 494, 803 (1984).
206. 860 F.2d at 1237.
207. See id. at 1238. The husband was taxed on one-half of the commission. See id. He
pled guilty to willfully and knowingly failing tome an income tax return for the tax year in
question. See id.
208. See id. at 1236-38.
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the apparent attempt by Congress, in enacting section 66(b), to
alleviate the harshness relating to the difficulty in claiming "innocent
spouse" status under section 66(c), it is questionable why the court
applied so literally the provisions of section 66(c) to the particular
facts in Roberts. The court aggravated the harshness of its strict
construction of section 66(c) by agreeing that the taxpayer-spouse in
Roberts should be liable for the penalty for late filing of her tax
return. 209 Evidently taxpayers under the emotional distress suffered
by the taxpayer-spouse in Roberts must nonetheless be principally
concerned that all tax returns are properly and timely filed, even if
the taxpayer has incomplete knowledge of the taxable income incurred
by his or her spouse. The apparent lack of concern of the court with
the plight of the taxpayer in Roberts compares unfavorably with its
extremely lenient ruling in Caruth Corp. v. United States. 210
B.
Tax Protesters
The Fifth Circuit was once again faced with criminal sanctions
imposed against two tax protestors, as husband and wife, for failure
to file income tax returns in United States v. FUtcraft. 2l1 The Flitcrafts
had been subjected to two previous trials. 212 The first failed because
of incompetent counsel. 213 The second trial, in which the Flitcrafts
were found guilty of tax fraud, was reversed by the Fifth Circuit
because of an improper jury instruction. 214. The decision of the trial
court in the third trial was reversed in part and remanded for
resentencing in part. 215 The Fifth Circuit decided that "the jury in
the third trial was confused as to what evidence applied to which
charge:" first, as to the failure to file income tax returns, and
second, as to a charge of filing false W-4 forms with the Flitcrafts'
employers. 216
209. [d. at 1242.
210. 865 F.2d 644 (5th Cir. Jan. 1989); see supra notes 54-74 and accompanying text
(discussing the Caruth decision and its impact).
211. 863 F.2d 342 (5th Cir. Dec. 1988), cert. denied, _ _ U.S. _ _, 109 S. Ct. 2100,
104 L. Ed. 2d 661 (1989).
212. See id. at 343.
213.
See id.
214. See id. The jury was improperly instructed on intent. See United States v. Flitcraft,
803 F.2d 184 (5th Cir. 1986).
215. See 863 F.2d at 343-44.
216. [d. at 343-44.
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The Fifth Circuit considered Mrs. Flitcraft's contention that
there was an improper investigation of statements she made as a
juror in a tax fraud case in which she cast the only vote for
acquittal. 217 The jury foreman in that case mentioned possible jury
misconduct to the judge which resulted in a mistrial. 218 While investigating the jury misconduct charge, federal investigators discovered
that the Flitcrafts had not filed income tax returns for two tax years
and that they had filed several false withholding forms claiming
exemptions from tax. 219
The Fifth Circuit was not impressed with Mrs. Flitcraft's allegation that the expression of her views against taxation was a coerced
confession. 220 The court noted that Mrs. Flitcraft was not in custody
at the time, and in addition, Mrs. Flitcraft never asserted a Fifth
Amendment right to silence. 221 The court also commented that there
is no Fifth Amendment violation in requiring an individual to sign
a W-4 form or a 1040 tax return. 222 In addition, as the court stated,
the Fifth Amendment is no defense when an individual reports no
taxable income. 223
VI .
A.
1.
TAX PROCEDURE
Jurisdiction oj the Tax Court
Mailing of a Tax Deficiency Notice-The Taxpayer's Last
Known Addresses
Section 6212(b) of the Internal Revenue Code requires the IRS
to mail a notice of a tax deficiency to a taxpayer's "last known
address" at least ninety days before assessing a tax deficiency.224 If
a taxpayer fails to file a petition with the Tax Court within the
217. [d.
218. See id. at 343.
219. See id.
220. [d. at 344.
221. [d. The court determined that the taxpayer's reliance on Miranda v. Arizona, 384
U.S. 436 (1966), was misplaced. [d.
222. [d.
223. [d.
224. I.R.C. § 6212(b) (West 1989); see also I.R.C. § 6213(a) (West 1989) (restricting
assessment of a tax deficiency for 90 days, or 150 days if the person resides outside the United
States, after the notice of deficiency is mailed).
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statutory period (i.e., the ninety days), the IRS will make an assessment of the tax liability which creates a tax lien on all property
belonging to the taxpayer. 225 Thus, a failure to receive a notice of
tax deficiency has dire consequences for a taxpayer. The Fifth Circuit
considered the meaning of the "last known address" of a taxpayer
and the duty, if any, imposed upon the IRS to ascertain that address
when a notice of deficiency is returned undelivered in three cases in
the survey period. 226
In Keado v. United States,227 the IRS notice of deficiency that
was sent to the taxpayers' last known address by certified mail was
not received by the taxpayers. 228 The Fifth Circuit ruled that a
complete compliance with the procedures set out in the Internal
Revenue Manual regarding the mailing of a notice of tax deficiency
would provide sufficient proof of mailing. 229 The Fifth Circuit pointed
out that the Code does not require that a taxpayer receive the
notice. 230
In Mulder v. Commissioner,231 the taxpayer did not receive a
notice of tax deficiency mailed to his former address because the
taxpayer had moved and the notice was not forwarded. 232 The IRS
made an assessment of the tax liability and sent the taxpayer a Notice
of Intent to Levy on his property.233 Mulder sought a redetermination
of the tax deficiency in the Tax Court after he obtained information
from the IRS regarding the tax audit. 234 The Fifth Circuit looked to
the principle established in Alta Sierra Vista, Inc. v. Commissioner,235
that in the absence of appropriate notification from the taxpayer of
a change of address, the IRS is entitled to consider as the last known
address, the taxpayer's address on the tax return for the year in
question. 236 The Fifth Circuit determined, however, that the "last
225. I.R.C. §§ 6321, 6322 (1982).
226. Pomeroy v. United States, 864 F.2d 1191 (5th Cir. Feb. 1989); Mulder v. Commissioner, 855 F.2d 208 (5th Cir. Sept. 1988); Keado v. United States, 853 F.2d 1209 (5th Cir.
Sept. 1988).
227. 853 F.2d 1209 (5th Cir. Sept. 1988).
228. See id. at 1210.
229. [d. at 1213.
230. [d.
231. 855 F.2d 208 (5th Cir. Sept. 1988).
232. See id. at 210.
233. See id.
234. See id.
235. 62 T.C. 367 (1974), aff'd, 538 F.2d 334 (9th Cir. 1976).
236. See 855 F.2d at 211.
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FEDERAL TAXATION
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known address" should refer to that address which, in light of all
relevant circumstances, the IRS could reasonably consider to be the
address of· the taxpayer at the time the notice of deficiency was
mailed. 237 The court stated that the IRS is required to use reasonable
diligence in its efforts. to ascertain that address. ~38 The IRS in Mulder
contended that it had acted properly because it used the taxpayer's
address as-listed on the audited tax return; it contended that its only
other obligation was to check the central. IRS computer file to
determine if there was a later address for the taxpayer. 239 The taxpayer
countered that this was inadequate since the two mailings to the
address obtained from the IRS's computer files had been returned
which, according to the taxpayer, would have given the IRS knowledge that the taxpayer had moved. 24O The -Fifth Circuit agreed with
the taxpayer that the. IRS did not exercise due diligence in sending
the notice to the taxpayer's "last known address. "241 According to
the court, an inquiry to the taxpayer's tax-preparer, or to the state's
motor vehicle or driver's license bureau, or an examination of the
tax shelter file that triggered the audit, would have disclosed the
taxpayer's current home address. 242 The court decided that such
efforts were within the due diligence requirement in instances when
the IRS knows or should know that the address on the subject tax
return is no longer curr~nt. 243
The Fifth Circuit in Mulder disapproved of the principle established in Alta Sierra Vista that in the absence of appropriate notification from the taxpayer of a change of address, the IRS is entitled
to consider as the last known address the address on the tax return
for the year in· question. 244 The court recognized the technological
advancement of the IRS computer capabilities and, decided that the
IRS must now consider the address on the taxpayer's most recently
filed returns as being the "last known address. "245
237. Id.
238. Id.
239. Id.
240. Id. at 211-12.
241. Id. at 212.
242. Id. The court stated that under the circumstances of the case, wherein two letters
posted shortly before the notice of deficiency were returned undelivered, the IRS did not
exercise due diligence in not attempting to locate the taxpayer's later address. [d.
243. Id. at 212.
244. Id. at 211-12.
245. Id. at 212.
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The Fifth Circuit clarified its position in Mulder in a later
decision, Pomeroy v. United States. 246 In Pomeroy, the IRS mailed
a notice of deficiency to the Pomeroys' address as listed on two
requests for an extension of time for filing their latest tax return;
that address was also the address on the Pomeroys' latest tax return. 247
The IRS obtained the address from its computer file. 248 The Pomeroys
did not receive the notice. 249 After the notice was returned to the
IRS as undeliverable, the IRS verified the address by again checking
its computer file. 250 The IRS did not check its administrative file nor
did it send a duplicate notice to the Pomeroys' accountant. 2S1 After
the ninety-day period lapsed, the IRS made tax assessments against
the Pomeroys.2S2 The Pomeroys then brought suit in federal district
court to enjoin collection of the assessments. 253 The Fifth Circuit
stated that Mulder should be interpreted to stand for the rule that
absent a subsequent, clear and concise notification of an address
change, the IRS is entitled to consider the address on a taxpayer's
most recently filed return as the taxpayer's "last known address. "254
The court commented that its holding in Pomeroy merely reiterates
its position in Mulder that the "focus is on the information available
to the IRS at the time it issued the notice of deficiency. "255 Because
the computer permits IRS agents ready access to the address on a
taxpayer's most recent return, that information should be the focus
of the IRS's inquiry.256 Still, the court stated that its holding did not
do away with the requirement that the IRS exercise reasonable
diligence in ascertaining "the taxpayer's correct address. "257 Referring
to its decision in Keado that the statutes do not require that a
deficiency notice be received, only that it be mailed, the court held
that under the circumstances in the case wherein the IRS mailed the
notice to its latest available address for the taxpayer, the IRS was
246.
247.
248.
249.
250.
251.
252.
253.
254.
255.
256.
257.
864
See
See
See
See
See
See
See
F.2d 1191 (5th Cir. Feb. 1989).
id. at 1193.
id.
id.
id.
id.
id.
id.
[d. at 1194.
[d.
[d.
[d.
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FEDERAL TAXATION
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not required to review the administrative file after the notice of tax
deficiency was returned undelivered.258
2.
Timely Filing of a Petition with the. Tax Court
In Rotenberry v. Commissioner,259 the Fifth Circuit considered
the issue of whether a petition to the Tax Court is timely filed when
it is placed in the mails on the ninetieth day (the last day for filing
the petition), but is postmarked by a private postal meter. 260 In
R Qlenberry, the petition was posted by certified mail, return receipt
requested, around 6:00 p.m. on December 23, which was the ninetieth
day.261 The Tax Court received the petition eight days later.262 One
of the issues considered by the Fifth Circuit was the Treasury
Regulations addressing mail postmarked by private postal meters. 263
According to the regulations, for a document postmarked other
than by a United States Post Office to be timely filed, the document
must be postmarked by the last date for filing and must be received
by the governmental agency in question not later than the date on
which the document properly addressed and mailed would ordinarily
be received. 264 If a document is received later than the normal time
for receipt of mail, the document will nonetheless be deemed to have
been timely filed if the person who is required to file the document
can establish that: (a) the document was actually deposited in the
mail before the last collection of the mail from the place of deposit,
on or before the due date for filing the document; (b) the delay in
receiving the document was due to a delay in the transmission of the
mail; and (c) the cause of the delay.265 Rotenberry contended that
the delay in the Tax Court receiving his petition was caused by the
Post Office having to handle Christmas mail at that time. 266 Although
258. [d. at 1195.
259. 847 F.2d 229 (5th Cir. June 1988).
260. [d. at 230-33.
261. See id. at 230.
262. See id.
263. [d. at 231; see 26 C.F.R. § 301.7502-I(b) (1989) (setting forth the regulations).
264. Treas. Reg. § 301.7502-I(b)(l) (as amended in 1960). A postal specialist testified that
the mail should have reached Washington, D.C. in not more than five days. 847 F.2d at 232.
265. Treas. Reg. § 301.7502-I(b)(2) (as amended in 1960); see 847 F.2d at 231-33 (discussing
the regulations).
266. 847 F.2d at 232. The taxpayer also noted that the IRS mailed 87 million tax return
forms on December 27, that many post office employees take time off during the holidays,
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the Tax Court found that his petition was timely mailed and agreed
that the delay in receipt was occasioned by a delay in the transmission
of the mail, the Tax Court held the petition was nonetheless not
timely filed because Rotenberry did not establish the actual cause of
the delay, a requirement listed in the Treasury Regulations. 267
Fortunately, for the taxpayer, the Fifth Circuit ruled that the
regulations do not require the specificity that the Tax Court had
demanded. 268 According to the Fifth Circuit, the "cause of delay"
element can be satisfied if "the taxpayer offers adequate proof of
the reason for the delay in processing and handling the mail generally
between the receiving station and the addressee during the critical
days involved."269 The proof offered need not specifically pinpoint
the item of mail in question. 270
B.
Review of a .Tax Court Decision-Appeal to the Wrong Court
Section 7482 of the Internal Revenue Code provides that the
United States Courts of Appeals (other than the United States Court
of Appeals for the Federal Circuit) have "exclusive jurisdiction to
review decisions of the Tax Court . . . in the same manner· and to
the same extent as decisions of the district courts in civil actions
tried without a jury."271 Section 7482(b)(l) provides that if a petitioner is seeking a redetermination of tax liability, venue is in the
United States Court of Appeals for the circuit in which the petitioner
legally resides, or, in the case of a corporation, the principal place
of business or the principal office of the corporation. 272 Otherwise,
section 7482(b)(l) provides that decisions of the Tax Court are
reviewable by the Court of Appeals for the District of Columbia. 273
that there is heavy airline passenger traffic during the holidays causing mail to be delayed
further. that inclement weather during the critical period can affect travel in Washington, and
that mail is delivered to the Tax Court only once a day, as additional reasons for the delay.
[d. at 232-33.
267. See 847 F.2d at 232-33.
268. [d. at 233.
269. [d. at 233-34.
270. [d. at 234.
271. I.R.C. § 7482(a)(1) {I 982).
272. [d. § 7482(b){l) (l982 & Supp. V 1987). The appellate court would also have venue
if the person is seeking a declaratory decision under § 7476 or § 7428 and in the case of a
petition under § 6226 or § 6228(a). See id. §§ 6226, 6228(a), 7428, 7476.
273. [d. § 7482(b)(I).
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In Dornbusch v. Commissioner,274 the petitioner filed an appeal
with the Fifth Circuit from a criminal contempt sentence imposed
by the Tax Court upon the petitioner, who was a witness. 275 Because
the petitioner was not seeking a redetermination of tax liability,
venue was in the Court of Appeals for the District of Columbia
rather than in the Fifth Circuit. 276 Thus, the government filed a
motion to dismiss the appeal. 277 The Fifth Circuit noted, however,
that although it did not have venue, it did have jurisdiction; therefore,
it had the inherent power to transfer the petition to the circuit with
proper venue. 278
C.
Foreclosure on Property Subject to a Junior Tax Lien Government's Right oj Redemption
The IRS may redeem real property subject to a federal tax lien,
that is sold at a nonjudicial sale to satisfy a lien having priority over
the tax lien, if it does so within 120 days from the date of the sale. 279
In Delta Savings & Loan, Inc. v. Internal Revenue Service,280 the
Fifth Circuit held that the redemption amount is the amount the
mortgagee paid at the foreclosure sale and not the entire amount of
the underlying first lien debt. 281 The mortgagee in Delta purchased
the property at the foreclosure sale by crediting the taxpayer $50,667
on a debt of $85,312. 282 The IRS had a junior tax lien on the property
and redeemed the property by paying the mortgagee-purchaser $51,660,
which equalled the $50,667 plus interest. 283 Delta Savings and Loan
Association, the mortgagee-purchaser, contended that the IRS was
274. 860 F.2d 611 (5th Cir. Nov. 1988).
275. See id. at 611.
276. [d. at 614; see I.R.C. § 7482(b)(I) (1982 & Supp. V 1987).
277. 860 F.2d at 611.
278. [d. at 611-12. The government contended that the enactment of 28 U.S.C. § 1631,
which authorizes transfer only where the transferor court lacks jurisdiction, left the court with
no authority to transfer the case. [d. at 612. The Fifth Circuit had jurisdiction, but not venue.
Id. The Fifth Circuit determined that § 1631 was not intended to have such a limited meaning.
Id.
279. I.R.C. § 7425(d) (1982). The IRS has this right if it has a right to notice of the sale
because its tax lien has been on record for at least 30 days prior to the sale. See Treas. Reg.
§ 301.7425-4(a)(3) (1976).
280. 847 F.2d 248 (5th Cir. Jun. 1988).
281. Id. at 249.282. See id.
283. See id.
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required to pay the full amount of the underlying debt.2 84 The Fifth
Circuit, however, rejected that argument, agreeing instead with the
IRS.28S The court was concerned that a creditor would otherwise be
encouraged to bid a below-market price and then sell the property
later at a substantial profit, knowing that the IRS would be required
to pay the full amount of the debt, while it could also pursue a
deficiency against the holder. 286
The decision in Delta Savings should serve as a warning to
creditors who bid in property at a foreclosure sale at less than the
fair market value and seek a deficiency against the debtor for the
balance. If the property is subject to a junior tax lien, the IRS is
entitled to redeem the property for the bid price. 287
D.
A ward of Attorneys' Fees to Prevailing Taxpayers in Suits
Against the IRS
Section 7430 of the Code provides for reasonable administrative
and litigation costs in any administrative or court proceeding brought
by or against the United States in connection with the determination,
collection, or refund of any tax, interest, or penalty if the taxpayer
is a "prevailing party. "288 To quality as a "prevailing party," a
taxpayer must "substantially" prevail with respect to the amount in
controversy and must establish in the proceeding that the position
284. [d.
285. [d.
286. [d. at 251.
287. [d.; see Treas. Reg. § 301.7425-4(b)(4) (1976) (outlining the proper procedure to follow
in requesting reimbursement from the government for payments made to a senior lienholder,
that was superior to the lien foreclosed, when the IRS elects to exercise its right of redemption).
The regulations provide that unless a request for reimbursement is timely submitted (15 days
after notice is sent to the purchaser of the property of his right of reimbursement), no amount
will be paid the purchaser for payments made to the senior lienholder. Treas. Reg. § 301.74254(b)(4)(ii). The Ninth Circuit, however, has held that the government's title is nonetheless
encumbered by the first deed of trust until it reimburses the purchaser. Little v. United States,
794 F.2d 484, 485 (9th Cir. 1986).
288. I.R.C. § 7430(a)(I) (1982 & Supp. V 1987). Reasonable costs include the administrative
fees or similar charges imposed by the IRS, fees of expert witnesses, and the expenses of any
studies, analysis, engineering reports, tests, or projects found to be necessary for the preparation
of the case. [d. § 7430(c)(I)(2). Reasonable litigation fees include attorneys' fees up to $75
per hour, "unless the court determines that an increase in the cost of living or a special factor,
such as the limited availability of qualified attorneys for such proceedings, justifies a higher
rate." [d. § 7430(c)(I)(B)(iii) (West. Supp. 1989).
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of the United States was not substantially justified. 289 The Fifth
Circuit considered the interpretation of section 7430 in two cases in
the survey period. 290
In Smith v. United States,291 which involved a suit for refund
of taxes filed in a federal district court, the Fifth Circuit held that
in deciding whether the position of the United States was substantially
justified, the court must focus on the IRS's position at the time the
taxpayers' petition was filed. 292 Because the court determined that
the taxpayers failed to establish that the position of the IRS was not
substantially justified, it refused to award the taxpayers attorneys'
fees. 293
289. 28 U.S.C. § 2412 (1982 & Supp. V 1987). Under the Equal Access to Justice Act, a
"prevailing party" is entitled to an award of attorneys' fees in a suit against the United States
unless the court finds that the position of the United States was substantially justified. [d. §
24 I2(d)(1)(A). Prior to a 1988 amendment, § 7430 provided that a "prevailing party" was
required to establish that the position of the United States was "unreasonable." l.R.C. §
7430(c)(2) (1982). In comparing the definition of a prevailing party provided for in § 7430
(prior to the 1988 amendments to the Equal Access to Justice Act), the Fifth Circuit in Powell
v. Commissioner, 791 F.2d 385 (5th Cir. 1986), concluded that a taxpayer was at a disadvantage
under § 7430. The taxpayer had the burden of demonstrating that the government's position
was unreasonable under § 7430; whereas under the Equal Access to Justice Act, the government
was required to carry the burden of showing that its position was substantially justified. 791
F.2d at 389. The 1988 amendment to § 7430 defines "prevailing party" as one who "establishes
that the position of the United States was not substantially justified." l.R.C. § 7430(c)(4)
(West Supp. 1989). Thus, while the amendment to § 7430 tracks the language of the Equal
Access to Justice Act, the burden remains on the taxpayer under § 7430. [d. The Equal Access
to Justice Act provides that a court will award costs to a prevailing party "unless the court
finds the position of the United States was substantially justified." See 28 U.S.C. § 2412(d)(I)(A)
(1982 & Supp. V 1987) (emphasis added).
290. Sher v. Commissioner, 861 F.2d 131 (5th Cir. Dec. 1988); Smith v. United States,
850 F.2d 242 (5th Cir. July 1988). Although the cases involved the application of § 7430 prior
to the 1988 amendments, the decisions are nonetheless meritorious because they demonstrate
the difficulty in meeting the requirements of § 7430. The 1988 amendments have not eased
the burden.
291. 850 F.2d 242 (5th Cir. July 1988).
292. [d. at 246. This holding was based upon the ruling of the Fifth Circuit in Powell v.
Commissioner, 791 F.2d 385 (5th Cir. 1986). The Powell case was based upon language in
§ 7430 prior to amendments adopted in 1986 and 1988. See 791 F.2d at 388-89. The position
of the United States now includes both its position taken in a judicial proceeding and its
position taken in an administrative proceeding. It is the earlier of the date the taxpayer received
the notice of the decision of the Internal Revenue Service Office of Appeals or the date of
the notice of deficiency. The 1986 amendment provided that the position of the United States
was that position taken in the civil proceeding and any administrative action or inaction by
the District Counsel of the Internal Revenue Service (and all subsequent administrative action
or inaction) upon which the proceeding was based. See l.R.C. § 7430(c)(7) (Supp. V 1987).
293. 850 F.2d at 246-47.
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In Sher v. Commissioner,294 the Fifth Circuit ·again refused to
award taxpayers' attorneys' fees to the taxpayer, despite the fact that
the position of the IRS was erroneous and the case was settled in
the taxpayers' favor. 295 The Shers had reported interest income from
certain investments, however, the investing company had reported to
the IRS that the taxpayers had earned "dividend" income. 296 Based
upon the investment company's report to the IRS and the failure of
the taxpayers to report "dividend" income, the IRS asserted a tax
deficiency against the taxpayers. 297 Although the taxpayers attempted
to resolve the issue by calling the IRS's attention to the error in
reporting, the IRS District Counsel denied the taxpayers' claim and
reasserted the deficiency.298 Later, when the taxpayers' attorney convinced the IRS Appeals Officer of the mistake, the Appeals Officer
determined that the taxpayers did not owe the deficiency.299 The
taxpayers then sought recovery of their attorneys' fees under section
7430 of the Code. 3°O The Fifth Circuit pointed to the language of
section 7430 which defines a "prevailing party" as one who establishes that the position of the United States in the civil proceeding
was not substantially justified. 30l Because the Appeals Officer decided
the issue in the taxpayers· favor when the Appeals Officer was
apprised of the discrepancy, the court ruled that the position of the
IRS was substantially justified. 302
Taxpayers have had difficulties in collecting attorneys' fees when
the IRS takes a minimally unjustified position. This difficulty in
securing awards for unjustified administrative proceedings, as was
evident in Sher, will undoubtedly continue. Section 7430 lacks clarity
294. 861 F.2d 131 (5th Cir. Dec. 1988).
295. Id. at 135.
296. See id. at 132.
297. See id.
298. See id. at 133.
299. See id.
300. See id.
301. Id. The United States' position was based on the 1986 amendments to § 7430 which
provided that the position of the United States included the position taken by the United
States in the civil proceeding and in any administrative action or action by the District Counsel
of the IRS. Id. at 134. The position of the United States, pursuant to the 1988 amendments,
includes its position taken in an administrative proceeding beginning on the date the IRS
expressed its position in the earlier of a notice from its Office of Appeals or in a 90-day
letter. Id.
302. Id. at 135.
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with respect to its application to administrative proceedings to resolve
the conflict.
VII.
CONCLUSION
The cases in the survey period covered a wide range of tax
issues. With a few exceptions, the Fifth Circuit was not as prone to
follow its history of strictly construing the code and regulations. One
taxpayer scored a major victory, albeit a questionable one, in the
court's refusal to apply the assignment of income doctrine to a
transfer of stock between the dividend declaration date and the record
date. 303 The court's lenient position in that case must be compared
to its strict interpretation of the innocent spouse provisions. 304
Taxpayers scored a procedural victory when the Fifth Circuit
decided that the IRS must exercise due diligence in ascertaining a
taxpayer's current address when it mails the taxpayer a notice of tax
deficiency.305
Mortgagors of property subject to a junior tax lien should take
special note of the Fifth Circuit's decision in Delta Savings & Loan,
Inc. v. Internal Revenue Service. 306 The temptation to bid less than
the fair market value for property sold at a foreclosure sale may
lead to unanticipated, and extremely negative, consequences. 307
303. Caruth Corp. v. United States, 865 F.2d 644, 649 (5th Cir. Jan. 1989); see supra
notes 54-75 and accompanying text.
304. Roberts v. Commissioner, 860 F.2d 1235 (5th Cir. Nov. 1988); see supra notes 168210 and accompanying text.
305. Mulder v. Commissioner, 855 F.2d 208 (5th Cir. Sept. 1988); see supra notes 231-58
and accompanying text.
306. 847 F.2d 248 (5th Cir. Jun. 1988).
307. See supra notes 280-87 and accompanying text.
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