FEDERAL TAXATION
by Marilyn E. Phelan·
I.
II.
INTRODUCTION................................
DEDUCTIONS-WHAT EXPENDITURES ARE DEDUCTIBLE? ..
A. Gambling Losses
B. Fees Incurred During Bankruptcy. . . . . . . . . . . . . . ..
C. Shareholder Loan to Corporation. . . . . . . . . . . . . . ..
III.
RETIREMENT PLANS
A. Taxation of Lump-Sum Distributions. . . . . . . . . . . . ..
B. Transfer of Property to a Qualified Pension Plan. . . ..
IV.
ESTATE TAXES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..
A. Charitable Deduction
B. Marital Deduction. . . . . . . . . . . . . . . . . . . . . . . . . ..
C. Special Use Valuation. . . . . . . . . . . . . . . . . . . . . . ..
V.
VI.
VII.
VIII.
TRUST FUND TAXES
TAX PROCEDURE
707
709
709
710
710
711
711
712
714
714
717
718
719
722
722
723
A. Taxpayer Standing to Challenge Tax Act . . . . . . . . . ..
B. Tax Liens . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..
C. Recovery of Attorneys' Fees from the Internal
725
Revenue Service
D. Disclosure of Taxpayer Information
728
E. Suit for Refund of Penalty Taxes. . . . . . . . . . . . . . . .. 731
TAX EVASION
731
INNOCENT SPOUSE
733
I. INTRODUCTION
The Fifth Circuit issued opinions in twenty-nine cases involving federal
taxation issues during the current survey period. An analysis of the
decisions leads to the conclusion that the court has abandoned the previous
tradition of strictly construing provisions of the Internal Revenue Code (' 'the
Code") against the taxpayer for a more balanced approach, conceivably to
a present posture of construing the Code in favor of the taxpayer. For
example, taxpayers scored several major victories in the survey period.
Indeed, two decisions granted taxpayers substantial, albeit somewhat
• Associate Dean and Professor of Law. Texas Tech University; B.A.• Texas Tech University.
1959; M.B.A.• 1967; Ph.D.• 1971; J.D.• University of Texas. 1972.
707
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questionable, tax benefits. I Still, the Fifth Circuit's current propensity to
construe the Code favorably to the taxpayer was recently rebuffed by the
Supreme Court. The Supreme Court overruled an opinion rendered by the
Fifth Circuit in the previous survey period that would have benefitted
taxpayers. 2
Decisions supporting the taxpayer were varied. The Fifth Circuit ruled
that an estate charitable deduction need not be reduced by administrative
expenses of the estate, even though the will provided that such expenses
must be paid from the residual estate, when a state court, in an adversarial
proceeding, decided that the expenses could be paid out of income from the
estate. 3 The Fifth Circuit also permitted a taxpayer, who pled guilty to tax
evasion, to recover in excess of five million dollars in penalties against the
IRS for its releasing facts regarding the taxpayer's conviction to the media. 4
The Fifth Circuit opted in favor of a liberal construction of the term
"qualified terminable interest property" ("QTIP") to allow an estate to
claim a marital deduction for an otherwise terminable interest passing to a
surviving spouse. s The court liberalized the election requirements under §
2032A of the Code so that taxpayers could value estate property at a lower
figure in determining estate tax liability.6 In a case of first impression, the
court applied an "equitable subrogation" doctrine, recognized under Texas
law, to permit a purchaser of property to have an "equitable lien" on the
purchaser's own property which the court then ruled had priority over a tax
lien on the property.7 The Fifth Circuit was quite generous in allowing
taxpayers to recover attorneys' fees from the IRS. s
I. See Estate of Warren v. Commissioner, 981 F.2d 776 (5th Cir. Jan. 1993); Johnson v.
Sawyer, 980 F.2d 1490 (5th Cir. Dec. 1992); infra notes 51-73, 184-208 and accompanying texL The
two decisions jointly drained the federal fisc of nearly $10 million.
2. See Keystone Consolo Indus., Inc. v. Commissioner, 951 F.2d 76 (5th Cir. Jan. 1992);
Commissioner v. Keystone Conso!. Indus., Inc., 113 S. CL 2006 (1993); infra notes 37-49 and
accompanying text.
3. See 981 F.2d at 776; infra notes 51-73 and accompanying texL Because administrative
expenses in Warren exceed nine million dollars, the Fifth Circuit's decision saved the estate several
million in estate taxes.
4. See 980 F.2d 1490; infra notes 184-208 and accompanying text.
5. See Estate of Clayton v. Commissioner, 976 F.2d 1486 (5th Cir. Nov. 1992); infra notes 7481 and accompanying texL
6. See McAlpine v. Commissioner, 968 F.2d 459 (5th Cir. Aug. 1992); infra notes 82-101 and
accompanying text.
7. See Dietrich Industries, Inc. v. United States, 988 F.2d 568 (5th Cir. Apr. 1993); infra notes
149-58 and accompanying text. The court ruled that the purchaser was subrogated to a senior deed of
trust lien when the purchaser paid the deed of trust note. This "equitable" lien of the purchaser had
priority over a tax lien on the property.
8. See Portillo v. Commissioner, 988 F.2d 27 (5th Cir. Apr. 1993); Estate of Johnson v.
Commissioner, 985 F.2d 1315 (5th Cir. Mar. 1993); Heasley v. Conunissioner, 967 F.2d 116 (5th Cir.
Jul. 1992); Hanson v. Commissioner, 975 F.2d 1150 (5th Cir. OcL 1992); infra notes 161-83 and
accompanying text.
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Taxpayers did not fare well in all cases, however. The Fifth Circuit
denied a taxpayer standing to challenge the technique Congress has utilized
to grant certain favored taxpayers substantial benefits (by exempting these
special classes of taxpayers from provisions of new tax acts via transitional
rules).9 The court denied one "luckless" taxpayer an offset of his
gambling losses against his income from "wagering tokes."10 The court
refused to narrow the definition of a "responsible party" so as to limit the
range of taxpayers liable for the 100% penalty when a business fails to pay
"trust fund taxes" to the IRS. ll
II. DEDUCTIONS-WHAT EXPENDITURES ARE DEDUCTIBLE?
A. Gambling Losses
Losses from wagering transactions during a tax year are allowed as
itemized deductions, but only to the extent of any gains from such
transactions incurred during the tax year. 12 Thus, a taxpayer has a tax
benefit from a gambling loss only if the taxpayer also has gambling
winnings. The Fifth Circuit strictly construes the term "wagering transaction" in permitting a taxpayer to offset losses against gains from such
transactions.
In Allen v. United States Government Department of
Treasury,13 the taxpayer, a blackjack dealer, sought to reduce his income
from "wagering tokes" by gambling losses incurred during the taxable
year. 14 The Fifth Circuit ruled that toke income constitutes compensation
for services rendered by casino dealers rather than gain from a "wagering
9. See Apache Bend Apts. v. United States, 987 F.2d 1174 (5th Cir. Apr. 1993); infra notes 13043 and accompanying text.
10. See Allen v. United Stales Gov't Dept. of Treasury, 976 F.2d 975 (5th Cir. Nov. 1992); infra
notes 13-16 and accompanying text.
II. See Barnett v. Internal Revenue Serv., 988 F.2d 1449 (5th Cir. Apr. 1993); Raba v. United
States, 977 F.2d 941 (5th Cir. Nov. 1992); infra notes 104-24 and accompanying text.
12. I.R.e. § 165(d) (1988). Losses of nonprofessional gamblers are nonbusiness losses and are
deductible only if the taxpayer itemizes deductions. I.R.C. § 67(b) (1988). However, the deduction is
not subject to the two percent of adjusted gross income limitation on miscellaneous itemized deductions.
I.R.C. § 67(a) (1988).
The Supreme Court ruled in Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987) thal a
professional gambler is engaged in a trade or business and, thus, is entitled to deduct gambling losses
as a trade or business expense. Consequently, if gambling is conducted as a business, gambling losses
are deductible as business losses, but again only to the extent of gains. IRe. § 165(d) (1988).
13. 976 F.2d 975 (5th Cir. Nov. 1992).
14. [d. al 976. Gambling tokes are bets placed by a palron for a dealer's benefit. [d. al 975.
Tokes differ from gratuities because a casino dealer, unlike a waiter, bellhop, or other service employee.
does not provide better service in hopes of receiving more gratuities. [d. al 977 n.lI. As the Fifth
Circuit noted in Allen, casino policy prohibits dealers from perfonning favors of any kind for any patron.
[d.
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transaction. "15 Thus, the Fifth Circuit posited that gambling losses may
not offset toke income. 16
B. Fees Incurred During Bankruptcy
The Fifth Circuit discussed the deductibility of professional fees incurred
during bankruptcy proceedings in In re Placid Oil Co. J7 Placid Oil
categorized its professional fees into three categories:
"substantive
bankruptcy-related fees and expenses; procedural bankruptcy-related fees and
expenses; and 'claims, operations, etc.' which included ordinary business
transactions and ongoing business operations." 18 The Fifth Circuit
concluded that such characterization satisfied the corporation's initial burden
of producing sufficient evidence that its professional fees and expenses
qualified for ordinary and necessary business expense deductions. 19 The
Fifth Circuit indicated that in deciding the deductibility of a particular fee
or expense, a bankruptcy court should consider various factors, including:
(l) the nature of the fee or expense; (2) the relationship between the fee
or expense and the reorganization; (3) the person or entity who incurred
the expense; (4) the fonn and structure of the particular transaction; (5)
whether the transaction was actually consummated; and (6) the ability of
the taxpayer to identify with reasonable exactitude the functional steps of
the reorganization to which the fees and expenses relate. 20
As for professional fees and expenses related to restructuring a specific debt,
the Fifth Circuit ruled that these coJ;1fer a specific long-teno benefit and
must "be capitalized with an amortization period equivalent to the useful
life" of the underl ying transaction. 21
C. Shareholder Loan
to
Corporation
The Fifth Circuit considered the recurring issue of the characterization
of a shareholder loan to a corporation (as a business or a nonbusiness bad
debt) in Garner v. Commissioner. 22 As the Fifth Circuit recognized, a debt
is "characterized as business or nonbusiness depending upon the relationship
between the debt and the taxpayer's trade or business.' ,23 The Fifth Circuit
15. [d. at 976-77. The Fifth Circuit noted the decision of the Ninth Circuit in Olk v. United
States, 536 F.2d 876,879 (9th Cir.), cert. denied, 429 U.S. 920 (1976). in which the Ninth Circuit
concluded that tokes constitute compensation for services. [d. at 976.
16. 976 F.2d at 976.
17. 988 F.2d 554 (5th Cir. Apr. 1993).
18. [d. at 558.
19. [d. at 557-58.
20. [d. at 558.
21. [d. at 559.
22. 987 F.2d 267 (5th Cir. Mar. 1993).
23. [d. at 270. Section I66(d)(1 ) provides that a nonbusiness bad debt is treated as a short-term
capital loss subject to the limitations on deductibility set out in I.R.C. §§ 1211 and 1212. I.R.C. §
166(d)(I) (1988). A business bad debt, on the other hand. is an ordinary business deduction.
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acknowledged that when a "taxpayer makes a loan to a corporation" in
which the taxpayer is "both a shareholder and an employee," a detennination must be made whether the loan was made to protect the shareholder's
investment or to protect the shareholder's employee status.24 Although
investing does not constitute a trade or business for purposes of the bad debt
deduction, being an employee, on the other hand, may represent a trade or
business?S The court understood that "[i]n detennining whether a loss is
proximate to a trade or b~iness as an employee" rather than a shareholder
investment interest, the dominant motive for making the loan must be to
protect employee statuS.26 The court noted the Supreme Court decisions
in United States v. Generes,27 and Whipple v. Commissioner,28 which
established objective criteria to aid courts in their search for the dominant
motive?9 The court articulated that the investigation must center around
three factors: "the size of the taxpayer's investment," the size of the
taxpayer's after-tax salary, "and other sources of gross income available to
the taxpayer at the time of the guarantees.' '30 The court commented that
the taxpayer in Garner had invested $200,000 in the corporation, withdrew
a maximum annual salary of $50,000 from the corporation, had substantial
income from other sources, and testified he did not need a salary on which
to live. 3l Understandably, the court ruled that the tax court's decision that
the taxpayer's dominant motive was to protect his investment was not
clearly erroneous. 32
III. RETIREMENT PLANS
A. Taxation of Lump-Sum Distribution
Pursuant to § 72(d) of the Internal Revenue Code, a lump-sum
distribution from a defined contribution plan when such contributions were
taxed to the employee, is treated as a return of the employee's contribution
and is not taxed. Section 72(d) states: "[E]mployee contributions and (any
income allocable thereto) under a defined contribution plan may be treated
as a separate contract."33 Section 414(k) states that a defined benefit plan
that provides a benefit derived from employer contributions based partly on
24. 987 F.2d at 270.
Jd.
Jd.
27. 405 U.S. 93 (1972).
28. 373 U.S. 193 (1963).
29. 987 F.2d at 270.
30. Jd.
31. Jd. at 268, 273.
32. Jd.
33. I.R.C. § 72(d) (1988).
25.
26.
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the balance of the "separate account of a participant" is treated as a defined
contribution plan to the extent benefits are based on the separate account of
the participant.34 Such a plan is treated as a defined benefit plan as to the
remaining portion of benefits under the plan. 35 In Guilzon v. Commissioner,36 the Fifth Circuit ruled that part of a defmed benefit plan can qualify
as a "separate account" even though no earnings and losses are allotted to
it. 3? In Guilzon, the taxpayer contended that a lump-sum payment upon his
retirement was exempt from taxation under § 72(d).38 The Fifth Circuit
agreed with the IRS that a lump-sum payment must be made from a defined
contribution plan to be exempt from taxation. 39 Although it agreed that
part of a defined benefit plan can qualify as a defined contribution plan
pursuant to § 414(k), it decided that the plan in Guilzon could not qualify.
Because Guilzon's retirement benefits were not derived from employer
contributions, the plan did not qualify initially as a defined benefit plan.40
B. Transfer of Property to a Qualified Pension Plan
Although contributions to a qualified retirement plan need not be made
in cash, an employer must be aware that a transfer of property to a qualified
plan to satisfy funding requirements is a "sale or exchange" and, as such,
is subject to an excise tax under § 4975. Section 4975(a) of the Internal
Revenue Code imposes a tax of five percent of the amount involved with
respect to a "prohibited transaction" between a disqualified person and a
qualified pension plan. A disqualified person includes a fiduciary of the
plan, any person providing services to the plan, and the employer of
employees covered by the plan. A "prohibited transaction" is defined in
§ 4975(f)(3) to encompass a "sale or exchange" of property by a disqualified person to a plan "if the property is subject to a mortgage or similar lien
which the plan assumes or if it is subject to a mortgage or similar lien
which a disqualified person placed on the property within the ten year
period ending on the date of the transfer."
The Fifth Circuit earlier ruled, in Keystone Consolidated Industries, Inc.
v. Commissioner,41 that transfers to a qualified pension plan of property
"unencumbered" by a mortgage or other similar lien would not be subject
34.
I.R.C. § 414(k) (1988).
35.
Id.
36. 985 F.2d 819 (5th Cir. Mar. 1993).
37. Id. al 823.
38. Id. al 821.
39. Id.
40. Id. at 823. The court noted that § 414(k) expressly requires that a "defined benefit plan"
provide a benefil "derived from employer contributions." I.R.C. § 414(k) (1988). All the taxpayer's
retirement benefits were based upon his contributions made over more than a thirty-year period.
41. 951 F.2d 76 (5th Cir. Jan. 1992).
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to the penalty tax imposed by §, 4975, concluding that § 4975(1)(3) limited
the meaning of "sale or exchange" to transfers of property subject to a
mortgage or similar lien. 42 The Fourth Circuit, on the other hand, had held
that § 4975(1)(3) was an expansion, rather than a limitation, of a "sale or
exchange, " concluding that a transfer of property to a qualified plan to
satisfy funding indebtedness is a sale or exchange under general tax theory,
and, thus, need not be covered by § 4975(f)(3).43 In Commissioner v.
Keystone Consolidated Industries,44 the Supreme Court agreed with the
Fourth Circuit and reversed the Fifth Circuit.45
The Supreme Court held, in Keystone, that a transfer of property in
satisfaction of a funding obligation is "at least both an indirect type of sale
and a form of exchange" because, according to the Supreme Court, property
is exchanged for "diminution of the employer's funding obligation.' ,46
The Supreme Court reasoned that a sponsor could sell property to a plan at
an inflated price or could satisfy the sponsor's funding obligation by a
contribution of property that was "overvalued or nonliquid. ,,47 The court
determined that § 4975 of the Code was Congress's response to these
potential abuses, commenting that Congress's goal was "to bar categorically
a transaction that was likely to injure the pension plan.' ,48 The Supreme
Court acknowledged that the transfer of encumbered property could
jeopardize the "ability of the plan to pay promised benefits," but it also
recognized that the transfer of overvalued property, the substitution of the
employer's judgment as to investment policy, as well as the burden of
disposing of the property, could injure a pension plan.49 Although the
properties at issue were neither unencumbered nor overvalued at the time of
their transfers, the Supreme Court observed that there were exclusive saleslisting agreements calling for sales commissions. 50 Thus, the Supreme
Court decided that it was "neither easy nor costless" to dispose of the
properties.51 According to the Supreme Court, Congress intended to solve
problems relating to property contributions to retirement plans by its
enactment of § 4975. 52 The Supreme Court concluded that language in §
4975, providing that a transfer of property by a disqualified person to a plan
42. Id. at 79. See also Marilyn Phelan, Fifth Circuit Survey, Federal T=tion, 24 TEx. TECH
L. REv. 693-94 (1993) (discussing the Fifth Circuit's holding in Keystone that section 4975 does not
include the transfer of unencumbered property).
43. Wood v. Commissioner, 955 F.2d 908, 913-14 (4th Cir. 1992).
44. 113 S. Ct. 2006 (1993).
45. Id. at 2013.
46. Id. at 2012.
47. Id.
48. Id.
49. Id.
50. Id.
51. Id.
52. Id.
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•'shall be treated as a sale or exchange if the property is subject to a
mortgage or similar lien," expanded rather than limited the scope of the
•'prohibited-transaction provision.' ,53 The Supreme Court ruled that a
transfer of property to satisfy funding requirements is a "sale or exchange"
under general tax principles and that Code language in § 4975(c)(l)(A)
"extends the reach of 'sale or exchange'... to include contributions of
encumbered property that do not satisfy funding obligations.,,54
IV. ESTATE TAX
A. Charitable Deduction
One decision of the Fifth Circuit in the current survey period may
warrant review by the Supreme Court. The Fifth Circuit declined to adopt
the IRS's position, that a charitable contribution deduction must be reduced
by administrative expenses regardless of how the expenses are actually paid
if a decedent's will provides that such expenses must be paid "out of the
residuary estate,' ,55 at least in an instance where a state trial court, in an
adversarial proceeding, rules that all pr a portion of the expenses can be
charged against income. 56 In Estate of Warren v. Commissioner,57 the
Fifth Circuit ruled that the value of a charitable bequest for purposes of
determining the amount of a charitable deduction for estate tax purposes
must reflect a probate court decision that only a portion of estate administrative expenses should be charged against the fair market value of assets
bequeathed to the charity. 58 In criticizing the decision, the Federal Circuit
Court of Appeals asserted that Warren would subject the federal tax system
to the "whim of the state courts or legislatures" and would permit
agreements between beneficiaries of a will to "dictate federal estate tax
law. ,,59
53. Id. at 2012-13.
54. Id. at 2013. The Supreme Court illustrated the expanded coverage by the following example.
Id. at 2013 n.2. An employer with no outstanding funding obligations wishes to contribute property to
a pension fund to reward its employees for an especially productive year of service. The property
contribution is permissible if the property is unencumbered because it will not be "exchanged" for a
diminution in funding obligations and, thus, would not fall within the prohibition of § 4975(c)(l)(A).
On the other hand, according to the Supreme Court, "the property contribution is impermissible if the
property is encumbered, because § 4975(0(3) specifically prohibits all contributions of encumbered
property." Id.
55. See Rev. Rul. 73-98; 1973-1 C.B. 407; Priv. Ltr. Rul. 9326002 (Mar. 18, 1993). (The IRS
is of the opinion that a deduction for a residuary bequest to a charity must be reduced to reflect
administration expenses incurred whether the expenses are paid from income or from corpus of the
residue.).
56. See Estate of Warren v. Commissioner, 981 F.2d 776, 783-84 (5th Cir. Jan. 1993).
57. Id.
58. Id. at 784.
59. See Burke v. United States, 994 F.2d 1576, 1583-84 (Fed. Cir. 1993).
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The decedent's will in Warren provided that all estate adminfstrative
expenses should be paid out of the decedent's residuary estate.60 However,
in settling a will contest, the probate court ordered that only 27.5% of
administrative expenses should be charged against estate assets (cOrpUS).61
The estate claimed a charitable deduction on the estate tax return in the
amount of the initial fair market value of assets transferred to charitable
trusts less 27.5% of administrative expenses.62 The IRS, on the other hand,
contended that the value of the assets, for purposes of detennining the
amount of the charitable deduction, has to be reduced by 100% of the
administrative expcnses. 63 In agreeing with the IRS, the tax court ruled it
was not bound by the probate court's decision. 64 The tax court relied on
Commissioner v. Estate of Bosch,65 in which the Supreme Court reviewed
decisions of other courts concerning the issue of whether state trial court
decisions were to be given "controlling" effect. 66 The Fifth Circuit
interpreted the Supreme Court decision in Bosch contrary to that of the tax
court, deciding that Bosch is limited to situations in which state court
decisions are the result of non-adversarial proceedings. 67 Thus, it ruled the
tax court erred in not giving effect to the probate court judgment. 68 The
Fifth Circuit noted that charitable deductions have been upheld based on
"court approved bona fide settlements of adversarial positions. ' '69 Because
the court decided a charitable deduction should be measured by the "actual
benefit" passing to charitable organizations, it ruled that the estate tax
charitable deduction must be computed on the basis of what the charities
received. 70
60.
981 F.2d at 777.
61.
[d.
62.
[d. at 778.
63.
64.
[d.
[d.
65. 387 U.S. 456 (1967).
66. 981 F.2d at 780. The Fifth CiraJit, in Estate a/Warren, commented that the Supreme Court
in Bosch described, without evaluating, three positions that had emerged among the ciraJits respecting
the effect of state trial court decrees when the issue was "detenninative of federal estate tax
consequences." Based upon later language in the Court's opinion, the Fifth Circuit concluded that the
Supreme Court intended to adopt the position which "seemed to approach" methodology used in
diversity cases to determine state law. That position is that federal couns are bound by state court
rulings "only after independent examination of the state law as determined by the highest court of the
.
State." [d. at 780.
67. [d. at 781.
68. [d. The Fifth Circuit noted its earlier decision in Brown v. United States, 890 F.2d 1329,
124143 (5th Cir. 1989) in which it concluded that "the relevance of a state court's judgment to the
resolution of a federal tax question will vary, depending on the particular tax statute involved as well as
the nature of the state proceeding that produced the judgment." See 981 F.2d at 781.
69. 981 F.2d at 782.
70. [d. at 784.
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In a later opinion, the Federal Circuit Court of Appeals refused to adopt
the Fifth Circuit's analysis in Warren, ruling that a charitable deduction
must be reduced by all administrative expenses even if the expenses were
paid from post-mortem income.71 The Federal Circuit decided the correct
interpretation of Bosch is that a decision of a trial court is not controlling
in determining federal tax law. The Federal Circuit endorsed what it termed
the general rule that state law is determinative of property rights, while the
manner and extent to which such rights are taxed is determined by federal
law. 72 The Federal Circuit maintained that the amount a charity is to receive
as set out in a will, not the "actual" amount received, determines the estate
charitable deduction. 73 Warren does not alter that result according to the
Federal Circuit. The Federal Circuit ruled that when a decedent dies, a
"finite" amount, known as the gross estate, is legally created. According
to the Federal Circuit, any administrative expenses are theoretically derived
from that amount regardless of the source of payment, and must be
accounted for within the gross estate. 74 Therefore, the Federal Circuit
concluded that the amount that passes to the charity and, thus, that qualifies
for the charitable deduction, is the amount a charity is to receive under the
wiles The Federal Circuit agreed with the IRS that the charitable deduction
is not increased when the charitable donation is "augmented" by an
executor paying administrative expenses from post-mortem income. 76 The
Federal Circuit ruled that, for federal estate taxation purposes, the gross
estate is obligated to pay administrative expenses when the will provides
such expenses are to be paid from the residual estate. 77 The Federal
Circuit specifically declined to follow Warren, concluding that the reduction
of federal estate tax was at least one aspect of the settlement agreement in
Warren. 78
To avoid the problem that surfaced in Warren, a will should provide
that administrative expenses are to be paid from post-mortem income and
not from the residual estate.
71. Burlce v. United States. 994 F.2d 1576, 1584 (Fed. Cir. 1993). The Sixth Circuit reached a
similar conclusion with respect to the marital deduction in Estate of Street v. Commissioner, 974 F.2d
723 (6th Cir. 1992).
72. 994 F.2d at 1580. The Federal Circuit ruled that the allowable sources of payment for
administrative expenses under state law do not necessarily affect the source from which a deduction for
administrative expenses must be made under federal law, citing Lyeth v. Hoey. 305 U.S. 188 (1938).
73. 994 F.2d at 1582.
74. [d. at 1581.
75. [d. at 1582.
76.
77.
[d.
[d. at 1584.
78. The IRS alleged that the settlement agreement in Warren, whereby only 27.5% of
administrative expenses would be paid from the residual estate, was "collusive and designed simply to
avoid payment of taxes." 981 F.2d at 783. The IRS contended it should not be forced "to abide by
a settlement in which it had no voice." Jd.
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B. Marital Deduction
Section 2056 of the Internal Revenue Code excludes from taxability,
in the estate of the first spouse to die, those properties or interests in
property used in calculating the gross estate that passes from the decedent
to the surviving spouse. 79 Similar to the approach taken under income tax
provisions, spouses are treated as one economic unit for estate tax pUlpOSes. 80 Section 2056 has been liberally interpreted in favor of the taxpayer
for, as the Fifth Circuit concluded in Estate of Clayton v. C@mmissioner,81
the marital deduction is not "unlimited in both quantum and share. ,,82
Although the marital deduction generally is not available for interspousal
transfers of terminable interests in property (interests that will terminate or
fail after passage of time upon the occurrence of some contingency or the
failure of some event to occur), there are exceptions. One of the exceptions
is the so-called "qualified terminable interest property," or QTIP. 83 In
Estate of Clayton, the Fifth Circuit ruled that the QTIP exception "enjoys"
the same favored and liberal construction as that given the marital deduction
itself. 84 Before a terminable interest meets the definition of a QTIP, the
executor must make an irrevocable, affirmative election on the estate tax
return. 85 The court stated in Clayton that the election "need not be 'all or
nothing'; rather, the executor may choose QTIP treatment for any percentage
or share of the property interest, from zero to 100%. ,,86
79. See supra note 5 and accompanying text (discussion of Estate of Dayton v. Commission, 976
F.2d 1486, 1500 (5th Cir. Nov. 1992».
80. See I.R.C. § 2056 (West Supp. 1993). The marital deduction was enacted as part of the
Revenue Act of 1948. The Revenue Act of 1948 also added the spousal income splitting provisions
available through the filing of joint returns. The purpose of both provisions was to eliminate tax
variations that developed between taxpayers residing in community property states and those residing in
common law states.
81. 976 F.2d 1486 (5th Cir. Nov. 1992).
82. [d. at 1494.
83. I.R.c. § 2056(b)(7) (West Supp. 1993). See 976 F.2d at 1500. The other exceptions include
(1) legacy conditioned on survivorship for a limited period, (2) life estate with power of appoinunent in
the surviving spouse, (3) life insurance or annuity payments with power of appoinunent in the surviving
spouse, and (4) a charitable remainder trust l.R.C. §§ 2056(b)(3), (5), (6), (8). See 976 F.2d at 1494.
84. 976 F.2d at 1498.
85. I.R.C. § 2056(b)(7)(B)(v) (West Supp. 1993). See 976 F.2d at 1494. The court noted that
the election may be made at any time before the date of filing of the estate tax Form 706. [d. at 149495.
86. 976 F.2d at 1495. The IRS contended that a portion of the residue of the decedent's estate
passing to a trust created in the will for the benefit of the surviving spouse was not eligible for the
marital deduction because a provision in the will specified that any portion of the residue for which a
timely QTIP election was not made would pass to and constitute a part of the corpus of another trust
created by the will. [d. at 1487 -88.
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C. Special Use Valuation
Section r2032A of the Code pennits heirs of family fanns and
businesses to elect to value inherited property on the basis of its actual use
rather than its most profitable use. 87 As the Fifth Circuit pointed out in
McAlpine v. Commissioner,88 the purpose of the provision is to grant relief
to heirs "who might otherwise fmd the financial burden imposed by the
estate tax so great that it would be necessary to sell the fann or business to
pay the tax. ,,89 Because the provision pennits heirs of qualified fanns and
businesses to write down the value of the property they inherit, they can
escape higher taxation based on actual market values. 90 Still, as the Fifth
Circuit noted, "[t]here are strings attached... 91 The heirs must "continue
to use the property as a family fann or business for at least ten years after
the decedent's death to avoid recapture of part of the tax savings resulting
from special use valuation... 92 Further, the election process is "fairly
laborious.' '93 One requirement is that the estate attach a recapture
agreement to its election expressing consent to personal liability for
collection of any additional estate taxes that may be imposed if the property
is put to uses other than qualified ones.94 The recapture agreement "must
be signed and executed by all parties [who] have interests in the property
designated in the agreement for special use valuation.' ,95 Trustees of trusts
holding an interest in the property are specifically included among those
required to sign and execute the recapture agreement 96
In McAlpine, the heirs of a qualified family ranch elected to value their
inherited property according to the special use valuation provision of §
2032A. 97 The decedent had bequeathed the family ranch "to three
discretionary spendthrift trusts for the benefit of his three grandchildren.' ,98
The estate timely filed a properly documented and completed notice of
election and attached a recapture agreement signed by the trustee of the
trusts. 99 Although the names and addresses of the beneficiaries were listed
on the agreement, as well as on the notice of election, the beneficiaries did
87.
88.
89.
90.
91.
92.
93.
94.
95.
96.
97.
98.
99.
I.R.C. § 20q2A(c) (1988).
968 F.2d 459 (5th Cir. Aug. 1992).
Jd. at 460.
Jd.
Jd.
Jd.; see I.R.C. § 2032A(c).
968 F.2d at 460.
Jd. at 461; see I.R.C. § 2032A(c).
968 f.2d at 461.
Jd.
Jd. at 461-62.
Jd. at 461.
Jd. at 462.
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not sign the recapture agreement. 100 After the IRS notified the estate that
the recapture agreement was invalid because it had not been executed by
beneficiaries of the trusts, the estate filed an amended notice of election and
an amended recapture agreement within ninety days, signed by all trust
beneficiaries except a beneficiary who was only nine years old. IOI The
minor child's signature was made by her mother as guardian ad litem. 102
Asserting that the election could not be perfected because the recapture
agreement required the beneficiaries' signatures, the IRS found an estate tax
deficiency of $333,363. 103 The Fifth Circuit, on the other hand, noted that
the estate supplied all necessary information and that the trustee's signature
on the recapture agreement bound the trusts. 104 Thus, based upon the
Fifth Circuit's decision to "give the statute a common sense interpretation,
with an eye towards protecting the family farm and business,' ,105 the court
ruled that the estate was entitled to perfect its election of substantial use
valuation under § 2032A(d)(3).I06
V. TRUST FUND TAXES
Employers must retain taxes withheld on employee wages in a special
trust fund for the United States. 107 Section 6672(a) of the Code provides
that if an employer fails to pay the so-called "trust fund taxes" to the IRS,
the' 'responsible persons," (directors, officers oremployees) who' 'willfully"
fail to collect and pay the trust fund taxes are personally liable for a penalty
equal to the amount of the delinquent taxes. I08 The Fifth Circuit considered "responsible party" status in two cases during the survey period.
100. Id.
101. Id.
102. Id.
103. Id.
104. Id. at 464.
105. Id.
106. Id. at 465. The Fifth CiraJit commented that the IRS's fear that it would be unable to
recapture taxes from "trust beneficiaries whose failure to sign recapture agreements goes undetected
seem[ed] groundless." Id. The court noted that the IRS could "reach [the] trust property directly by
a proceeding in lXJuity to the extent it had benefited the estate." Id. at 464. Further, it pointed out that
"the act of filing an election under § 2032A gives the [government] a lien on the qualified real property
that continues until the recapture tax liability is satisfied or becomes Wlenforceable through lapse of
time." Id.; see l.R.C. § 63248 (1988). As the Fifth CiraJit acknowledged, ..the recapture agreement
is not a prerlXJuisite to the lien." 968 F.2d at 464.
107. See l.R.C. § 7501(a) (Supp. 1 1989). Section 7501(a) provides that federal income taxes
and social security contributions required to be withheld from employees' wages are held by an employer
"in a special fund in trust" for the United States.
108. l.R.C. §§ 6672(a), 7202 (Supp. I 1989).
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In Barnett v. Internal Revenue Service,I09 the Fifth Circuit reiterated
the obligation of a "responsible person" to pay over trust funds to the
IRS. llo The court noted that certain facts "will almost invariably prove
dispositive of a fmding of responsibility."I11 The court reviewed the
principles of law that "narrowly constrain a factfinder's province in § 6672
cases.,,112 According to extensive case law, responsibility is determined
by looking to a person's status within a corporation, Le., the person's "duty
and authority to withhold and pay taxes.,,113 The Fifth Circuit pointed out
that "responsibility does not require knowledge that one has that duty and
authority.... Thus, a person may be a responsible person ... even though
he or she does not know that withholding taxes have not been paid."1l4
Further, a person "does not cease to be a responsible person merely by
delegating the responsibility to others.,,115 As the court noted, § 6672
"expressly applies to 'any' responsible person, not just to the person most
responsible for payment of the taxes.' ,1l6 The court stated:
There may be-indeed, there usually are-multiple responsible persons
in any company. That another person in the company has been delegated
the jobs of withholding and paying employees' taxes and generally paying
creditors is beside the point. The crucial inquiry is whether a party... by
virtue of his position in (or vis-a-vis) the company, could have had
"substantial" input into such decisions, had he wished to exert his
authority.117
The Fifth Circuit set out the "circumstantial indicia" it weighs in
deciding "responsible person status when an [sic] party lacks the precise
responsibility of withholding or paying employees' taxes.,,118 The court
considers whether a person is
(i) an officer or member of the board of directors; (ii) owns a substantial
amount of stock in the company; (iii) manages the day-to-day operations
of the business; (iv) has authority to hire or fire employees: (v) makes
decisions as to disbursement of funds and payment of creditors; and (vi)
possesses authority to sign company checks. 119
Although § 6672 imposes liability only if a responsible party "willfully"
failed to collect, aycount for, or pay over withheld taxes, the Fifth Circuit
stated in Barnett that willfulness requires "only a voluntary, conscious, and
109. 988 F.2d 1449 (5th Cir. Apr. 1993).
Jd. at 1453.
lll. Jd. at 1454.
ll2. Jd.
110.
113.
114.
115.
ll6.
117.
ll8.
ll9.
Jd.
Jd.
Jd.
Jd. at 1455.
Jd.
Jd.
Jd.
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FEDERAL TAXATION
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intentional act, not a bad motive or evil intent. ,,120 The court commented
that willfulness is "nonnally proved by evidence that the responsible person
paid other creditors with knowledge that withholding taxes were due at the
time to the United States. "121 In Barnett, the Fifth Circuit observed that
"cases not finding § 6672 responsibility are relatively few and far
between.,,122 The court's research of case law revealed only three cases
decided by the Fifth Circuit that failed to fmd responsible party status "as
contrasted with almost two dozen cases involving analogous fact-patterns"
in which the court ruled a party was a "responsible person." 123 In Raba
v. United States,l24 the Fifth Circuit acknowledged that it generally takes
a "broad view of who qualifies as a responsible person. ,,125 The taxpayer
in Barnett contended that he should not be a responsible person because he
had no effective control over fmances as his company "was run out of two
offices" and he did not operate out of the office where tax and payroll
matters were handled. 126 The Fifth Circuit responded that to permit a
corporate officer to avoid the status of a responsible party simply because
he or she operated out of a separate office "would open the door to a host
of evasive tactics."127 The court then quipped that "such an exception
to the broad defmition of responsibility would create a slippery slope." 128
Interestingly, the IRS has apparently become concerned that the 100%
penalty, described as one of the the IRS's "most aggressive and controversial collection practice[s],,129 should be relaxed. The IRS has changed the
name of the fine from the 100% penalty to the "trust fund recovery
penalty. "130 Under new guidelines, the penalty will be recovered from a
person or entity that significantly controls the finances of a business or
"detennines which creditors should or should not be paid.' 0131 The IRS
defines a responsible person as one who is in a position to exercise authority
over the financial affairs of a business. Factors the IRS will consider in
detennining whether a person has the status to control payment of taxes
120.
12!.
122.
123.
[d. at 1457.
[d.
[d. at 1456.
[d.
124.
977 F.2d 941 (5th Cir. Nov. 1992).
125.
[d. at 943. The court stated that detennining "whether an individual is a responsible person
is a question of 'status, duty, and authority..., [d. The majority ruled that the "crucial examination is
whether a person had 'effective power to pay taxes.'" [d. As the Court noted in Raba, it looks "behind
a person's official title or job description to detennine whether he had the actual duty or ability to pay
over the taxes owed." [d.
126. 988 F.2d at 1455-56.
127. [d. at 1456.
128.
[d.
129. Rita L Zeidner, [R.s.[ssues Guidelines/or Applying the 100 Percent Penalty, TAX NOTES,
June 7. 1993, at 1303.
130.
[d.
13!. [d.
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include: (1) whether the person is an officer, director, or shareholder of the
corporation; (2) the duties of the individual; and (3) whether the individual
has authority to sign checks. 132 Undoubtedly, the new guidelines would not
have erased liability for the taxpayer in Barnett. Those who will be
excluded from "responsible person" status will generally be lower level
employees, such as secretaries and bookkeepers. In addition, volunteer
directors and trustees of tax-exempt organizations will be responsible parties
only if they have the authority to control disbursement of corporate funds
and could ensure that taxes are paid. 133
VI. TAX PRocEDURE
A. Taxpayer Standing to Challenge Tax Act
In Apache Bend Apartments v. United States,l34 the Fifth Circuit held
that the taxpayers lacked standing to challenge the constitutionality of a tax
act based on an equal protection claim. 135 In Apache Bend, the taxpayers
challenged "transition rules" of the 1986 Tax Reform Act which granted
exemptions from designated provisions of the act to "a very, very few
specified favored taxpayers. "136 Obviously, the plaintiff taxpayers were
"not among the very, very favored few. ,,137 Still, the majority of the
court, on rehearing en bane, made short shrift of the plaintiff taxpayers'
"suit to scotch the wheels of the greased wagon... 138 The court referred
to decisions of the Supreme Courtl39 ruling that in order to have "standing," a plaintiff must have suffered an "injury in fact," caused by the
challenged government conduct that is likely to be redressed by the relief
sought. 140 Because the Fifth Circuit decided the plaintiff taxpayers were not
"seeking to litigate their own tax liability, but [rather] the tax liability of
[those] taxpayers granted transition relief" 141 and because the court
decided that the "injury of unequal treatment alleged by the plaintiffs [was]
shared in substantially equal measure by a 'disfavored class' that include[d]
132.
133.
[d.
[d. at 1304.
987 F.2d 1174 (5th Cir. Apr. 1993).
[d. at 1180.
[d. at 1175.
134.
135.
136.
137. [d.
138. [d.
139. See Lujan v. Defenders of Wildlife, 112 S. Ct 2130 (1992); Valley Forge Christian College
v. Americans United for Separation of Church & State, Inc., 454 U.S. 464 (1982); Warth v. Seldin, 422
U.S. 490 (1975); Hast v. Cohen, 392 U.S. 83 (\968).
140. See 987 F.2d at 1176. In addition, a plaintiff generally must assert an individualized legal
right and interest. 422 U.S. at 499. F!nally, the complaint must fall within "the zone of interests to be
protected or regulated by the statute or constitutional guarantee in question." 454 U. S. at 474-75.
141. 987 F.2d at 1177.
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all taxpayers who did not receive transition relief,' ,142 the court concluded
plaintiff taxpayers lacked standing to· challenge the constitutionality of the
transition rules. 143
In a dissenting opinion, Justice Goldberg compared the majority's
decision denying taxpayers standing to the displacement of the Apache
Nation. l44 Justice Goldberg noted that in 1886 the •• Apaches made their last
stand.' ,145 Although Justice Goldberg recognized that the Apache Bend
plaintiffs bore no genetic kinship to members of the Apache tribe, he stated
that the plaintiffs were "emboldened by the indefatigable Apache spirit. ,,146 As Justice Goldberg gibed: •• [T]he lamentable consequence of the
en banc court's majority opinion is not that the Apache Bend plaintiffs lost
their constitutional battle, the tragedy lies in the fact that the majority
opinion denies the Apache Bend plaintiffs their last stand. ' >147
B. Tax Liens
The priority of federal tax liens is governed by the Federal Tax Lien
Act. 148 The Act provides that the first lien in time has first priority, but
certain secured creditors have a superior interest until a tax lien is filed. 149
Tax liens apparently are also superior to inchoate liens. 150 To have
142.
143.
144.
145.
146.
147.
148.
[d. at 1177-78.
[d. at 1180.
[d.
[d.
[d.
[d.
See l.R.C. § 6323 (West Supp. 1993). The Federal Tax Lien Act was in part an attempt to
confonn the lien provisions of the Internal Revenue Code to concepts set out in the Unifonn Commercial
Code. See S. REp. No. 1708. 89th Cong., 2d Sess. I (1966), reprinted in 1966 U.S.C.C.A.N. 3722,3722.
Many of the definitions set forth in § 6323 were taken from provisions of article 9 of the Unifonn
Commercial Code.
149. A federal tax lien attaches when an assessment is made. It takes priority over liens attaching
subsequent to assessment. There is an exception for purchasers, holders of security interests, mechanic's
lienors, and judgment lien creditors. In these situations, the tax lien has priority when the IRS has filed
notice of the tax lien with the proper authority. See l.R.C. § 6323(a). (There is a separate 45-day rule
that protects some security interests that do not qualify as commercial financing securities.' See l.R.C.
§ 6323(0. The rule grants an added period of protection (45 days) to these security interests, but such
a security interest must have been in existence when a tax lien was filed.).
Section 6323(b) provides that certain enumerated interests are protected even though notice of a
federal tax lien has been filed. These include certain purchasers of securities and holders of security
interests; certain purchases of motor vehicles and personal property purchased at retail, in a casual sale
or subject to a possessory lien; real property taxes and special assessment liens; mechanic's liens on
residential property for certain repairs and improvements up to $1,000; certain attorneys' liens; certain
insurance contracts; and some passbook loans. See § 6323(b) for requirements that give such liens superpriority status.
150. See United States v. Central Bank of Denver, 843 F.2d 1300, 1307 (lOth Cir. 1988). After
the Federal Tax Lien Act was enacted in 1966, some courts ruled that the act superseded the choate lien
doctrine. See Donald v. Madison Industries, 483 F.2d 837, 840 (lOth Cir. 1973). Most courts continue
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priority over a federal tax lien then, a competing lien must be first in time
and probably must have become choate, Le., it must be identified as to the
lienor, the amount of the lien and the property subject to the lien. 151 Still,
the general rule that the first secured choate lien in time has priority has an
important exception with respect to a federal tax lien. If the IRS is not
given proper notice of a nonjudicial sale, or is not joined in a court
proceeding, as required under § 7425(b) of the Code, a federal tax lien on
the property will follow the property into the hands of a third party
purchaser. 152
In Dietrich Industries, Inc. v. United States,I53 the Fifth Circuit
sustained a means to escape the exalted position of federal tax liens. In
Dietrich, the IRS had properly recorded tax liens on property subject to a
superior deed of trust; the deed of trust lien secured debt in excess of $3.8
million. l54 Dietrich Industries, Inc. (Dietrich) agreed to purchase the
property for $385,000. Sales proceeds in the amount of $319,892 were paid
to the holder of the deed of trust in release of its lien. 155 Dietrich had no
actual knowledge of junior tax liens on the property at the time of the
purchase. 156 When it became aware of the tax liens, Dietrich asserted it
was entitled to equitably subrogate to the position of the deed of trust holder
as senior lienholder. 157 The Fifth Circuit agreed and ruled that the
purchaser had an equitable lien on its own property, citing Texas law which
recognizes "equitable subrogation." \58
to apply the doctrine, however.
151. See United States v. Equitable Life Assurance Soc'y, 384 U.S. 323, 327-28 (1966).
152. See. e.g., Myers v. United States, 647 F.2d 591, 599 (5th Cir. 1981), Simon v. United States,
756 F.2d 696, 698 (9th Cir. 1985).
153. 988 F.2d 568 (5th Cir. Apr. 1993).
154. Id. at 570.
155. Id. The biLlance of the sale proceeds were used to pay closing costs. The seller received
nothing from the sale. Id.
156. Id.
157. Id.
158. Id. at 570, 573. In discussing Texas law, the Fifth Circuit concluded that Texas law
recognizes conventional subrogation and legal subrogation. Id. at 570. According to the Fifth Circuit,
conventio~ subrogation generally depends on an agreement between the parties while legal, or
equitable, subrogation is controlled by principles of equity. Id. The Fifth Circuit decided that in Texas,
equitable subrogation permits a purchaser to hold an equitable lien on the purchaser's own property. Id.
at 571. According to the Fifth Circuit, Texas law provides that any person who pays the debt of another
to protect his or her own interest in property is entitled to subrogate to the rights of the creditor whose
claim was paid. See Fears v. Albea, 69 Tex. 437,6 S.W. 286, 289 (1887) and McDermott v. Steck Co.,
138 S.W.2d 1106, 1109 (Tex. Civ. App.-Austin 1940, writ ref'd), discussed at 988 F.2d 571. As the
Fifth Circuit noted, the rule extends to purchasers who pay an existing mortgage debt as part of the
purchase transaction. 988 F.2d at 571. See First Nat'l Bank v. Ackerman, 70 Tex. 315, 8 S.W. 45, 47
(1888); Fears, 6 S.W. at 288-9. According to the Fifth Circuit's interpretation of Texas law, the
purchaser/payor is an equitable assignee of the lienholder (or mortgagee); as such, the purchaser/payor
is permitted to keep the lien alive and to enforce the lien for his or her own benefiL 988 F.2d at 57 I.
The Fifth Circuit declared that the equitable assignment is a legal fiction that does not depend on the
parties' intent to keep the lien alive. Nor, according to the Fifth Circuit, is the equitable assignment
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In concluding that equities were in Dietrich's favor, the Fifth Circuit
ruled that Dietrich purchased the property with the expectation the property
would be free of encumbrances and that the IRS would have an unearned
windfall if Dietrich were denied subrogation because. according to the court.
"it would elevate the government's lien for no good reason... 159 The
Fifth Circuit ruled that Dietrich was entitled to subrogate only to the extent
of its payment to the deed of trust holder ($312.892).160
The court
pointed out that permitting Dietrich to subrogate to the rights of the deed of
trust holder did not extinguish the tax liens. 161 While foreclosure proceeds
would be used to satisfy Dietrich's equitable lien before being used to
satisfy the federal tax liens, any proceeds after satisfaction of the $312,892
lien would be paid to the government. 162
The decision in Dietrich can be applied to alleviate the harsh result of
§ 7425 of the Code. Absent subrogation, a purchaser of property subject to
a junior tax lien would be required to pay the tax lien. As noted above. if
the IRS is not notified of a foreclosure sale or is not joined in a court
proceeding, a junior tax lien is not erased by a foreclosure or judicial sale.
As a result, the tax lien is elevated to priority status. The query is whether
the Fifth Circuit's ruling in Dietrich effectively writes § 7425 out of the
Code in states that recognize the equitable subrogation doctrine. Following
the reasoning of the Fifth Circuit in Dietrich, it would seem that a purchaser
at a judicial or nonjudicial sale would also be subrogated to a creditor's
rights under a prior deed of trust lien.
C. Recovery of Attorneys' Fees from the Internal Revenue Service
Section 7403 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,
affected by the doctrine of merger-of-title, which in certain situations calls for the lien to merge into the
title. Id.
The IRS contended that the case was controlled by McDowell v. M.T. Jones Lumber Co., 42 Tex.
Civ. App. 260, 93 S.W. 476, 477 (1906, no writ), wherein the court of appeals refused to allow a
purchaser to subrogate to the rights of a senior lienholder. 988 F.2d at 571. The Fifth Circuit decided
the court of appeals' decision in McDowell contravened the Texas Supreme Court's decisions in Fears
and Ackerman. Id. (The Fifth Circuit decided that the law in Texas is unclear whether a purchaser who
assumes the senior debt, rather than paying it, is subrogated to the rights of the lien holder.).
159. Id. at 573. The Fifth Circuit reasoned that Dietrich's subrogation did not place the
government in a worse position than it occupied before the sale to Dietrich. Id. Before the sale to
Dietrich, the government's tax liens were subordinate to the deed of trust lien. Id.
160. Id.
161. Id.
162. Id. The Fifth Circuit decided the government was in a better position than it was before
the sale to Dietrich. It was entitled to proceeds after satisfaction of the $319,892 senior lien. Prior to
the sale to Dietrich, its tax liens were subordinate to a deed of trust lien in excess of $2 million. Id. at
573 n.5.
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or refund of any tax, interest, or penalty if the taxpayer is a "prevailing
party.' ,(63 To qualify 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 of the United States was not substantially
justified. l64 The Fifth Circuit considered the issue of whether the position
of the United States "was not substantially justified" in four cases during
the survey period.
In Heasley v. Commissioner,165 the Fifth Circuit noted that a "position is 'substantially justified' when it is 'justified to a degree that could
satisfy a reasonable person.'" (66 It determined that the IRS position in
assessing negligence penalties against a taxpayer with limited education and
limited investment experience, who relied on the expertise of financial
advisors and accountants in deducting certain costs and expenses of
investing in a tax shelter, was "not substantially justified, ,,167
In Portillo v. Commissioner,168 the Fifth Circuit ruled that the IRS
was not "substantially justified" in issuing a notice of tax deficiency based
upon one person's word, Le., "a naked assertion," that a taxpayer received
163. Reasonable administrative costs include administrative fees or similar charges imposed by
the IRS, fees of expert witnesses, and expenses of any studies, analyses, engineering reports, tests, or
projects found to be necessary for preparation of the case. I.R.C. § 7430(c)(2) (Supp. I 1989).
Reasonable litigation fees include such expenses and fees, as well as attorneys' fees up to $75 per hour,
unless the court determines an increase in cost of living or a special factor, such as limited availability
of qualified attorneys for such proceeding, justifies a higher rate. I.R.C. § 7430(c)(I) (1989).
164. I.R.C. § 7430(c)(4)(A)(i) (1989). The language somewhat tracks the language of the Equal
Access to Justice Act, 28 U.S.C.A. § 2412 (West Supp. 1993), with respect to attorneys' fees. Under
the Equal Access to Justice Act, attorneys' fees and costs may be awarded to a "prevailing party" in
any civil action brought by or against the United States or any agency of official of the United States
acting in his or her official capacity. 28 U.S.C.A. § 2412(2)(b) (West Supp. 1993). A "prevailing
party" is entitled to an award of attorneys' fees under the Equal Access to Justice Act unless a court
finds the position of the United States was "substantially justified." Jd. § 2412(d)(I)(a).
Taxpayers must exhaust administrative remedies available within the Service in order to recover
administrative and litigation costs. I.R.C. § 7430(b)(I) (1988).
165. 967 F.2d 116 (5th Cir. July 1992).
166. Jd. at 120. The Fifth Circuit cited the Supreme Court's decision in Pierce v. Underwood,
487 U.S. 552 (1988), wherein the Supreme Court ruled that a position is substantially justified if there
is a reasonable basis both in law and in fact. Jd. at 565.
In determining whether a taxpayer is entitled to attorney fees, a court of appeals reviews for "abuse
of discretion" a trial court's determination of whether the government had "substantial justification" for
the position it took. Hanson v. Commissioner, 975 F.2d 1150, 1153 (5th Cir. Oct. 1992).
167. 967 F.2d at 119-21. The court recognized that the IRS may penalize taxpayers for any
underpayment of taxes due to negligence or disregard of the rules or regulations. Jd. See I.R.C. §
6653(a)(I ). However, the court noted that "negligence" includes any failure to make a reasonable
attempt to comply with the Tax Code, including the failure to do what a reasonable person would do
under similar circumstances. 967 F.2d at 119-21. It also noted that "disregard" includes any careless,
reckless, or intentional disregard. Jd. The court decided that due care does not require moderate income
investors to investigate their investments independently. Instead, they may rely upon the expertise of
their financial advisors and accountants. Jd.
168. 988 F.2d 27 (5th Cir. Apr. 1993).
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a certain amount of unreported income for a tax period. 169 In Portillo, the
IRS assessed tax liability against taxpayers based upon what the Fifth
Circuit characterized as an "unsubstantiated and unreliable 1099 Form"
submitted to the IRS. l7O
Regarding the failure of the taxpayer's husband to report embezzlement
funds, the Fifth Circuit ruled in Estate of Johnson v. Commissioner l71 that
the IRS was not "substantially justified" in denying a taxpayer "innocent
spouse" status until later settlement of a tax deficiency suit filed against
her. 172 The Court noted that the IRS had access to her bank records and
other documents indicating that she qualified as an "innocent spouse.,,173
The Court decided that, even if the IRS did not see the documents, it was
not substantially justified in pursuing a tax deficiency against the taxpayer
spouse .• without examining all the information that they had in their
possession... 174
In Hanson v. Commissioner,175 the Fifth Circuit decided that "substantially justified" means •'justified in substance or in the main" or
"justified to a degree that could satisfy a reasonable person. ,,176 The
court reiterated that the government's position must have a reasonable basis
both in law and fact. 177 The court concluded that, while the fact that the
government lost in the underlying litigation did' 'not compel an award, the
outcome of the lawsuit" remained "a factor to be considered.,,178
Responding to the taxpayers' assertion that the statute of limitations barred
a tax assessment against them, the IRS maintained in Hanson that the statute
of limitations did not apply because the taxpayers "were guilty of
fraud. ,,179 But, as the Fifth Circuit pointed out, "at no time did the
government allege that the return" filed by the Hansons was fraudulent. lso
The court ruled that the statute of limitations was indeed applicable and,
thus, barred assessment. ISI The court concluded that the IRS had "no
Id. at 29.
Id. Taxpayers reported $10,800 as the amount received from a general contractor. using
receipt books to reach that figure since the contractor did not supply a Form 1099. Id. at 28. A year
later. the contractor filed a Form 1099 reporting that he had paid $35,305 to the taxpayers in the previous
year. Id. Upon investigation. the contractor informed the IRS that he could not provide documentary
support for the amount reportedly paid to the taxpayers. Id. Despite the "apparent unreliability" of the
1099. the IRS issued a notice of deficiency to the taxpayers. Id.
171. 985 F.2d 1315 (5th Cir. Mar. 1993).
172. Id. at 1319-20.
173. Id. at 1319.
174. Id.
175. 975 F.2d 1150 (5th Cir. Oct. 1992).
176. Id. at 1153.
177. Id.
178. Id.
179. Id. at 1154.
180. Id.
181. Id.
169.
170.
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basis in law and fact-reasonable or otherwise-to avoid the statute of
limitations. ,,182 The Fifth Circuit was unimpressed with the government's
defense that taxpayers were tax protesters. 183 According to the Fifth
Circuit, even if a taxpayer is a protestor, that status does not deprive
taxpayers of "the statutory protection under § 7430 that they be treated
reasonably by the IRS.',I84
The Fifth Circuit considered proof required to validate a claim for
attorneys' fees and the statutory maximum hourly rate to establish amount
of recoverable fees. In Heasley, the court ruled that lack of contemporaneous billing records does not preclude recovery of attorney's fees if taxpayers
can present adequate evidence to permit a trial court to determine the
number of reimbursable hours. 185 The Fifth Circuit did limit the award of
attorneys' fees to the statutory maximum hourly rate of $75.00 (with a costof-living increase from January I, 1986).186 The court held that a "going
rate" in a particular locality did not qualify as a "special factor" within the
meaning of § 7430 to justify a higher hourly rate. 18?
D. Disclosure of Taxpayer Information
In Johnson v. Sawyer,188 the Fifth Circuit "countenanced" what a
dissenting judge termed a taxpayer's creation of "a silk purse from a sow's
ear. ,,189 Johnson pled guilty to felony tax evasion based upon the
government's agreement to keep his prosecution from becoming known to
the public. 190 Johnson alleged that he was not "really guilty of felony tax
evasion, but was merely negligent at worst, carelessly relying on his wife's
confused bookkeeping" and that he "sacrificed himself to protect his
182. Id.
183. Id. at 1157.
184. Id. Apparently the Fifth Circuit would not impose a corresponding requirement that
taxpayers treat the IRS .. reasonably...
185. 967 F.2d 116, 123 (5th Cir. July 1992). The court agreed with the IRS that § 7430 places
the burden of establishing the number of attorney hours expended on the taxpayer. The court also agreed
that by failing to submit a detailed affidavit setting forth the nature and amount of each item for which
costs and fees were claimed, the taxpayers failed to comply with Tax Court Rule 23 I (d). Id. But the
Fifth Circuit decided that the tax court did not abuse its discretion in the manner in which it calculated
a fee award on the basis of evidence taxpayer's attorney provided in his affidavit. Id. at 124. In the
affidavit, taxpayer's attomey stated that he was a certified specialist in tax law and that he had devoted
a substantial number of hours to the taxpayer's penalty issues. The attorney did not submit
contemporaneous billing records in support of his motion for attorneys' fees and litigation costs. Id.
186. Id. at 124-25.
187. Id. at 124.
188. 980 F.2d 1490 (5th Cir. Dec. 1992).
189. Judge Garwood's characterization of taxpayer's suit in his dissenting opinion. Id. at 1513
(Garwood, J., dissenting).
190. Id. at 1492-93.
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FEDERAL TAXATION
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wife. ,,191 Johnson was concerned that his employer would terminate him
if knowledge that "the second most senior officer of the corporation had
pleaded guilty to a criminal tax charge. ,,192 Despite the efforts of attorneys to prevent the matter from becoming public, the IRS issued a news
release on the third business day after Johnson's plea, disclosing "vital"
information not contained in court records. 193 After Johnson's attorney
contacted the IRS to remind them the release contained confidential as well
as erroneous information, the IRS issued a second release, but over "the
strenuous objections of Johnson's counsel.,,194 Although the release
corrected the error regarding the exact charge to which Johnson had pleaded
guilty, the statement repeated the specific facts concerning Johnson and his
tax problems. 195 Once the information concerning Johnson's tax evasion
charge became publicly and widely known, Johnson was "asked" to resign
from his employment. 196
Johnson sued several IRS officials alleging the press release disclosed
tax information in violation of § 6103 of the Code. 197 Johnson filed his
claim under the Federal Tort Claims Act (FfCA),198 contending the act
constituted a general waiver of government immunity.199 Because the
FTCA provides that the United States will be liable in tort "in the same
manner and to the same extent as a private individual under like circumstances,' ,200 Johnson had to be able to succeed against the government in
a state law tort cause of action to recover damages from the IRS. 20l The
government contended that Johnson could not establish liability under the
FTCA because § 6103 does not "ipso facto" create FTCA liability.202
The Fifth Circuit, however, ruled that Texas does recognize a tort in the
191. See Judge Garwood's characterization of the taxpayer's claim. /d. at 1513 (Garwood, J.,
dissenting).
192. /d. at 1493.
193. /d.
194. /d. at 1494.
195. /d.
196. /d.
197. /d.
198. 28 U.S.C.A. § 2674 (West Supp. 1993).
199. /d.
200. /d.; see 980 F.2d at 1494.
201. 980 F.2d at 1494. The Johnson court stated:
Johnson's theory of state law negligence is: (I) in Texas, violation of a statute is negligence
per se when a member of the class of persons protected by the statute is injured by the
violation; (2) the government owed him a duty, under 26 U.S.c. § 6103 not to release any
of his confidential tax information; (3) through its agents, the government breached its duty
to Johnson under § 6103 by issuing protected information in the press release; and (4) the
breach of the duty established by § 6103 caused Johnson's injury.
/d. at 1494-95.
202. /d. at 1495.
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type of incident occurring in Johnson. 203 The court explained that § 6103
"creates a duty and in so doing sets an applicable standard of care...204
As the Fifth Circuit stated, § 6103 imposes on the government a "general
duty of confidentiality as to infonnation disclosed made by taxpayers.' '205
The Fifth Circuit determined that the IRS agents' violations of the required
standard of behavior and the duty established by § 6103, amounted to
negligence under Texas law. 206
The Fifth Circuit refused to adopt the rule promulgated by the Ninth
Circuie07 that' 'once infonnation is disclosed in open court or is in some
other manner stripped of the confidentiality requirement of § 6103, the IRS
may release that information with impunity...208 The Fifth Circuit decided
that the facts of the case were such that it was not required to adopt a rule
regarding whether infonnation disclosed in open court loses its confidentiality.209 In this case, infonnation released concerning the taxpayer was not
contained in court records. 2lO
The Fifth Circuit's decision in Johnson v. Sawyer pennitted a taxpayer
who pleaded guilty to felony tax evasion to collect $5,075,857 from the
federal government. 2I1 As Judge Garwood stated in a dissenting opinion:
Having received a short, probated sentence for what we must presume
was the willful, knowing, and intentional cheating of the United States out
of several thousand of dollars, and protected by that sentence from more
severe punishment, he now collects several million dollars from the
United States because this matter of public record-which he admits all
the shareholders of his publicly-held company would have to have been
specifically informed of anyway-was mentioned in two brief Galveston
press releases. 212
203.
204.
Jd.
Jd.
Jd.
Jd. at 1497.
205.
206.
207. See Lampert v. United States, 854 F.2d 335, 338 (9th Cir. 1988), cert. denied, 490 U.S.
1034 (1989).
208. 980 F.2d at 1496. The Seventh Circuit holds that the "immediate source" of the
information, at least in cases of information being taken from a court opinion or record, might control
confidentiality. Jd. (citing Thomas v. United States, 890 F.2d 18, 20-1 (7th Cir. 1989». In other words,
the Seventh Circuit has held that when facts disclosed are "gleaned from court records, no § 6103
violation occurs." See 980 F.2d at 1496. The Tenth Circuit holds that "information protected by §
6103 never loses its confidentiality, even when it is disclosed in a court record." Jd. (citing Rodgers v.
Hyatt, 697 F.2d 899, 906 (10th Cir. 1983) and Chandler v. United States, 887 F.2d 1397, 1397-8 (10th
Cir. 1991».
209. 980 F.2d at 1496.
210.
211.
212.
Jd.
Jd. at 1505 (The Fifth Circuit reduced the district court award of $5,902,117 by $826,260.).
Jd. at 1513.
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FEDERAL TAXATION
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Judge Garwood was of the opinion that Johnson neither established a
cause of action under Texas law, as required by the FfCA, nor suffered any
material damage as a result of a violation of § 6103. 213
E. Suit for Refund of Penalty Taxes
As the Fifth Circuit recognized in Nielson v. United States,214 the
payment of the full assessment of tax liability is a jurisdictional prerequisite
to commence a suit for refund in a district court.215 Still, the procedural
mechanism to contest imposition of penalties for promoting abusive tax
shelters pursuant to §§ 6700 and 6701 provides a different rule. 216
Taxpayers need only deposit fifteen percent of such an assessment to
commence a refund suit in district court. 217 In Nielson, the taxpayer was
assessed penalties for establishing numerous partnerships formed to take
advantage of research and development tax credits.218 After the IRS
assessed tax liabilities in excess of $165,000 against the taxpayer for
promoting abusive tax shelters and filed a tax lien against his property,
taxpayer paid fifteen percent of the assessment and filed a claim for refund
in a district court.219 The district court held the taxpayer liable for
$110,000 in penalties. 220 The Fifth Circuit ruled that the district court did
not step outside its "jurisdictional boundaries" in adjudicating the entire
penalty.221
VII. TAX EVASION
The Fifth Circuit addressed issues relating to tax evasion in three cases
during the survey period. In United States v. Sa/lee,222 the Fifth Circuit
affirmed a taxpayer's conviction for tax evasion, based upon a jury finding
that, because a payment to the taxpayer was a "kickback" rather than a
"loan," the taxpayer should have reported the payment as income.223 The
court noted the three elements of tax evasion: (l) existence of a tax
deficiency, (2) affirmative act constituting an evasion or attempted evasion
Jd. at 1506-13.
214. 976 F.2d 951 (5th Cir. Nov. 1992).
215. Jd. a1954. See I.R.C. § 7422(a) (1988).
216. 976 F.2d at 954. See I.R.C. § 6703(c) (1988).
217. 976 F.2d at 954.
218. Jd. at 952-53.
219. Jd. at 954.
213.
220.
Jd.
22 I. Jd. at 955.
222. 984 F.2d 643 (5th Cir. Feb. 1993).
223. Jd. at 649.
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of the tax, and (3) willfulness. 224 The Court decided that a rational jury
could fmd beyond a reasonable doubt that the taxpayer received a taxable
kickback rather than a non-taxable loan225 and that a rational jury could
easily infer the taxpayer knew he was receiving a kickback rather than loan
proceeds.226
In Robinson v. United States,227 the Fifth Circuit ruled that the
"affinnative act" of evasion can be "any conduct, the likely effect of which
would be to mislead or to conceal.' '228 The court commented that conduct
could, but need not, include filing a false tax return. 229 As the court
noted, filing unsigned "false documents which purport to be income tax
returns" may constitute an attempt to evade taxation. 230 Thus, the court
disagreed with the taxpayer that a conviction for tax evasion could not be
upheld if the taxpayer failed to sign a Fonn 1040.231 The taxpayer
contended that her unsigned Fonn 1040 was not a "return." As she pointed
out, the charge in the indictment described she had filed a false "return. ' ,232 The Fifth Circuit reasoned that the charge was "mere surplusage"
and ruled that the government was not required to prove a false Fonn 1040
was a "return" in order to show an affinnative action of evasion.233
In United States v. Stafford,234 the Fifth Circuit ruled that a trial
court, in a felony tax evasion charge, did not err in failing to instruct the
jury on a lesser included misdemeanor, the failure-to-file offense. 235
Previously, in United States v. Doyle,236 the Fifth Circuit had ruled that a
tax protestor was entitled to a lesser included offense instruction in a felony
tax evasion charge.237 However, in Stafford, omission from the jury
charge was raised for the first time on appeal. 238 As the court noted, in
224. [d. at 646.
225. [d. at 648.
226. [d. at 649.
227. 974 F.2d 575 (5!h Cir. sept. 1992).
228. [d. at 577.
229. [d.
230.
231.
232.
233.
[d.
[d. at 578.
[d.
[d.
234.
235.
236.
983 F.2d 25 (5!h Cir. Jan. 1993).
[d. at 27.
956 F.2d 73 (5!h Cir. 1992).
237. [d. at 76. The court in Doyle noted !he elements of a misdemeanor failure to file a tax
return: willfulness and failure to make a retum when due. [d. at 74. As !he Fif!h Circuit pointed out
in Doyle. !he "critical difference between !he 1wo crimes is !hat the charged felony offense requires an
affirmative act constituting !he evasion:' [d. at 75. The court recognized !hat, while !he element of
willfulness is common to bo!h the felony and !he misdemeanor, "willfulness" requires different states
of mind in !he two offenses. [d. According to !he Fifth Circuit in Doyle. to be convicted of a
misdemeanor, a taxpayer need only willfully fail to file an income tax return. [d. A felony conviction.
on !he o!her hand. requires a specific intent to defeat or evade !he payment of tax. [d.
238. 983 F.2d at 26.
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such situations it reviews cases only for plain error. 239 According to the
court, error is "plain" only when, "considering the entire charge and
evidence presented against the defendant, there is a likelihood of a grave
miscarriage of justice.' '240 The Stafford court determined that the trial
court did not err in not giving the instruction to the jury because Stafford
made the choice to forego the lesser included offense instruction.241 The
Fifth Circuit noted that Stafford's attorney emphasized during closing
arguments that Stafford was charged with tax evasion and not with the
failure to file. 242
VIII. INNOCENT SPOUSE
Section 66(c) of the Code relieves from a spouse's reporting requirement an item of community property that would under § 879(a) of the Code
be treated as income of the other spouse if the so-called "innocent" spouse
establishes that he or she did not know of, and had no reason to know of,
such item of community income. The item of gross income will be included
in the gross income of the other spouse (rather than the innocent spouse)
provided that, taking into account all facts and circumstances, it would be
inequitable to include the item of community income in the innocent
spouse's gross income. In interpreting § 66(c), the so-called "innocent
spouse" provision, the tax court has consistently held that a spouse's
unawareness of the exact amount of an item of community income is not
determinative of knowledge for purposes of § 66(c).243 Instead, knowledge of an item of community income is "determined with reference to
knowledge of a particular income-producing activity."244
In McGee v. Commissioner/A5 the Fifth Circuit ruled that a spouse
who (1) was aware her husband had earned income from a dental practice
(even though she did not know the exact amount), (2) was aware of her
husband's "irresponsible behavior in financial matters," (3) made no effort
to review tax documents before signing them, and (4) testified at trial that
she could have determined her husband's income by asking his accountant,
did not qualify for innocent spouse status under § 66(c).246 The Fifth
Circuit reiterated that innocent spouse relief is "designed to protect the
239. Jd.
240. Jd.
241. Jd. at 27.
242. Jd.
243. See. e.g., McPherson v. Commissioner, 62 T.C.M. 1039, 1042 (1991); Costa v.
Commissioner, 60 T.C.M. 1178, 1191 (1990); and Abrams v. Commissioner, 57 T.C.M. 1433, 1435
(1989). See McGhee v. Ccmmissioner, 979 F.2d 66, 70 (5th Cir. Dec. 1992).
244. 979 F.2d at 70.
245. See supra note 243 and accompanying text.
246. 979 F.2d at 70.
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innocent. not the intentionally ignorant.' .247
247. [d. The Fifth Circuit affirmed the Tax Court's decision that a taxpayer was subject to
penalties for failing to fJIe timely returns and for negligent underpayment of tax. [d. at 70-71.
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