The Joint Project of International Tax and Investment Center and
Supreme Court of the Republic of Kazakhstan
Workshop on Tax Disputes
Presentation Materials
Astana, Kazakhstan
October 11-12, 2006
“Rixos” President Hotel, Shanyrak Hall
I. The U.S. Tax System
A.
General Information: History
Taxes are the principal source of revenue for the federal government and account for
about two-thirds of all budget receipts. The U.S. tax system is built upon the idea of “voluntary
compliance”: that is, each person is expected to account annually for his income and deductions
and to pay the proper amount of tax.
The United States has not always had an income tax system.1 After the nation declared
its independence in 1776, it did not have an income tax and relied heavily on tariffs (taxes on
imported goods). The United States Constitution allowed for the collection of income taxes, but
there were strict limits to this power. With the exception of a brief period during and after the
Civil War (1861-1865), income taxes were nonexistent. In fact, an 1895 Supreme Court decision
held that income taxes were unconstitutional.
In 1913, the Sixteenth Amendment to the Constitution was ratified. This Amendment
allowed for income taxes as we now know them. Congress enacted the first income tax shortly
thereafter. Less than one percent of Americans paid the first individual income tax, and those
who were subject to the tax paid at modest rates.
As the United States entered World War II, the government’s need to raise revenue
increased. The threshold for paying taxes was dramatically reduced, and millions of Americans
were subjected to the income tax for the first time. Employers were also required to withhold
taxes from the salaries of their employees. By the end of World War II, almost 75% of
Americans were subject to the income tax, compared with just 5% in 1939. However, unlike
previous taxes that were enacted during wartime and then either reduced or abolished, tax rates
after World War II remained and were not lowered.
Beginning in the 1960s, the idea of using the tax code to achieve policy goals other than
Information in this Section is based on material from Chapter Two of the Final Report of the President’s
Advisory Panel on Federal Tax Reform (2005).
1
raising revenue gained momentum. For example, tax provisions were enacted that provided a
refundable tax credit to low income taxpayers (the earned income tax credit) and tax benefits for
retirement accounts. These types of tax benefits are often referred to as “tax expenditures.”
The Internal Revenue Code (Code), which codifies tax laws, was overhauled by the
passage of the Tax Reform Act of 1986. However, in the 20 years since the 1986 Code was
enacted, Congress has changed it nearly 15,000 times. The complexity of the Code has come
under frequent criticism, and calls for tax reform are common.
B.
Internal Revenue Service (IRS)
The Internal Revenue Service (IRS) is a branch of the U.S. Treasury Department, and it is
headed by the Commissioner of Internal Revenue (Commissioner). The Secretary of the
Treasury Department (Treasury Secretary or Secretary) has the authority and responsibility to
administer the internal revenue laws2 but has delegated much of this authority to the IRS
Commissioner. Both the Treasury Secretary and the Commissioner are appointed by the U.S.
President, with the advice and consent of the Senate.
Today, the IRS employs more than 114,000 employees nationwide.3 Its main office
(known as the National Office) is in Washington, DC. The Office of the Chief Counsel furnishes
legal advice to the IRS in all matters pertaining to the administration and enforcement of the
internal revenue laws. Lawyers from the Office of the Chief Counsel represent the
Commissioner in Tax Court litigation.
The IRS consists of 4 operating divisions: (1) the Wage and Investment Income Division,
which serves taxpayers whose income taxes are paid primarily through third-party withholding,
(2) the Small Business and Self-Employed Division, which serves fully or partially selfemployed taxpayers and small businesses with assets of $10 million or less, (3) the Large and
Mid-Size Business Division, which serves taxpayers with assets over $10 million, and (4) the
Tax Exempt Organizations and Governmental Entities Division, which serves filers who
generally pay no income tax.
The IRS collects over $1.7 trillion annually to fund the nation’s government. This
requires the processing of over 200 million tax returns, issuing over 90 million refunds,
distributing over 1 billion tax forms and publications, and assisting over 130 million taxpayers. 4
II. IRS Examination, Audit, and 90-Day Letter
Once the IRS has begun an examination, the IRS has the authority to obtain whatever
documentation it determines is relevant to the development of the case. The first step in
information gathering is obtaining from the taxpayer information that provides the IRS agent
with a background of the case and the taxpayer’s manner of doing business.
After the IRS has concluded its examination, the taxpayer has the option of settling its
case at the examination level and working with the examiners to conclude the issues and
adjustments. While the taxpayer can resolve many of the proposed adjustments with the
examining agent and the case manager on a mutually agreeable basis, certain issues are typically
not susceptible to settlement at the audit level because of the complexity of the issues and the
2
Internal Revenue Code (26 U.S.C.) section 7801; see Camilla E. Watson, Tax Procedure and Tax Fraud 3
(3d edition 2006).
3
Camilla E. Watson, Tax Procedure and Tax Fraud 3 (3d edition 2006).
4
TIGTA website, www.treasury.gov.
magnitude of the proposed adjustments.5 Case managers and examining agents generally have
no authority to settle matters based upon the hazards of litigation or any other indicies of
settlement.
If the taxpayer chooses to appeal the IRS’s proposed adjustments directly to the IRS
Office of Appeals (Appeals Office), the taxpayer must file a written Protest and a supporting
Protest Brief with the IRS.6 The IRS examination team will review the Protest Brief and prepare
written comments, and the Brief will be sent to the Appeals Office. Appeals conferences are
informal and strive to promote mutual understanding and prompt settlement. Unlike the case
managers and examining agents, the Appeals officers have the authority to take into account the
hazards of litigation in attempting to reach a settlement with the taxpayer.7 If, however, the
taxpayer and the IRS are unable to resolve their controversy administratively at the audit or
Appeals level, the IRS Commissioner will issue to the taxpayer a notice of deficiency.
III. The American Legal System: Sources of Law and Choice of Courts
A.
Structure of the American Legal System
The laws of the states of the United States may conflict with federal law. When this
happens, federal law trumps, and all courts, state and federal, must follow federal law under the
doctrine of supremacy. State law issues are resolved in state court, but such issues are beyond
the scope of this Paper.
1.
The U.S. Constitution, Statutes, and Regulations
The United States Constitution is the supreme law of the United States. If the U.S.
Constitution speaks to an issue, it trumps any other law. To the extent any other law conflicts, it
is unconstitutional and invalid.
The statutes of the United States, enacted by the U.S. Congress and contained in the
United States Code, are the next level of authority in the federal system. Where a state law
conflicts, the federal statute controls. The Code deals with complex issues, and Congress usually
does not attempt to write minute administrative details into statutes, instead delegating its
decisionmaking authority to the U.S. Treasury Department.
By empowering the Treasury to make its decisions, Congress avoids dealing with
administrative issues and eases the daily functioning of the tax administration. When a statute
delegates congressional decisionmaking to the Treasury, the rules created by the Treasury are
called regulations and are published in the Code of Federal Regulations (CFR).
2.
The Courts: Statutory Interpretation and Common Law
Within the federal system, the United States is divided into twelve judicial circuits,
numbered 1 through 11, and the District of Columbia. A thirteenth circuit, the Federal Circuit,
has no geographic boundaries; its jurisdiction is defined by its subject matter. The Federal
5
See Dennis I. Meyer, A. Duane Webber, & Rueven S. Avi-Yonah, 888 Tax Management, Transfer Pricing:
Judicial Strategy and Outcomes A-1 (2003).
6
The Protest Brief must include items set forth in the Internal Revenue Manual.
7
See Dennis I. Meyer et al., 888 Tax Management, Transfer Pricing: Judicial Strategy and Outcomes ch. 2II (2003), for an in-depth discussion of the conduct of Appeals Office settlement negotiations.
Circuit has exclusive jurisdiction of all patent cases as well as appeals from the Court of Federal
Claims. By contrast, the twelve geographic circuits have general jurisdiction of all claims within
their geographical boundaries, regardless of subject matter.
Within each federal circuit (an archaic name left over from the days when United States
appellate judges still “rode the circuit” on horseback to hear cases), there are district courts. The
district courts have jurisdiction of all cases that involve an issue of federal law or that meet
certain other requirements. At trials, witnesses are examined and cross-examined, each side’s
case is argued, and then the judge or jury determines what the facts are and who should win.
There are also three federal courts with specialized jurisdiction--the U.S. Tax Court, the U.S.
Court of Federal Claims, and the U.S. Court of International Trade.
3.
Seven Principles of the Judicial System of the United States
1. The Rule of Law – The rule of law is a concept that embraces a body of recognized or
established principles, statutes, rules, and regulations to which all citizens are subject and that are
applied objectively by independent judges acting through established procedures. Under it, the
legal system is sufficiently separated from the political authority so that the rights of citizens and
other subjects will be upheld if they follow the law.
2. Separation of Powers – Separation of powers is a principle in which each of the three
branches of government – the legislative branch, the executive branch, and the judicial branch –
have separate and distinct responsibilities and functions. The legislative branch, which is made
up of representatives of citizens, creates or makes laws; the executive branch enforces these
laws; and the judicial branch interprets the laws and applies them in cases and controversies.
3. Independent Judiciary – Under this principle, the judicial branch is free from outside
influences of persons or institutions in the executive and legislative branches of government and
from private persons and organizations. Judicial orders and decisions are made by a judge on the
principles and rules, and not on the basis of the status of the parties before the court or the
dictates or influence of some person within or without the government or by the direction or
influence of some governmental or non-governmental agency.
4. Judicial Review – Judicial review is the right and the duty of a judge in a case or controversy
to declare an act of the legislative or executive branch of the government invalid as being
contrary to the Constitution.
5. Federalism – Under this principle, two systems of government, including the judicial branch,
coexist – one for the central government, which is applicable to all states and their citizens
equally; and one for each of the individual states, which operates within the geographical
boundaries of each of the individual states and to which citizens and others within those
boundaries are subject.
6. Adversarial Process – The adversarial process provides the means by which cases are present
in court. In this process, lawyers completely and vigorously develop and present evidence and
legal arguments on behalf of their clients – the litigants – from which all of the facts and
positions of a case are presented to the judge or jury so that a just decision can be rendered.
7. Due Process – The requirement of Due Process guarantees to an individual who may be
injured by or suffer loss as a result of the action of a government or the enforcement of
legislation or other governmental decisions the right to an institutional hearing, to present the
grievance and positions arguments related to it, and to request redress of and relief from that
grievance.
B.
Tax Law
1.
The Code
Tax law’s primary source is, of course, the Internal Revenue Code (Code). Created by
Congress, the Code is a product of society’s perceived needs, current political philosophy, and
complex political compromises. Not surprisingly, this array of sometimes contradictory
considerations often produces the most complex legislation to emerge from Congress and not
infrequently produces inadvertent aberrations called loopholes.
Any research into a tax issue should start in the Code. Despite its daunting complexity,
the Code frequently offers creative ways to solve a tax problem. In drafting the Code, however,
Congress often uses a broad brush, choosing to leave to the Treasury Department the chore of
interpreting what the Code is intended to accomplish. Thus, the Treasury has broad authority to
further define the intent of a section and to issue “all needful rules and regulations” for the
enforcement of its provisions.8 As a result, a large body of tax law has its source in
administrative regulations.
2.
Administrative Regulations
In exercising the power delegated to the Treasury by Congress, the IRS often issues
“interpretive regulations.” These are intended to show how a particular Code section operates
and to illustrate what Congress intended the Code section to accomplish. Ambiguities and other
drafting issues are frequently addressed by such regulations.
Another form of regulation promulgated by the IRS is the “legislative regulation,” done
under specific directives from Congress--as, for example, when Congress simply delegates to the
Treasury the authority to make law on a particular tax issue. Legislative regulations are not
interpretive, because the Treasury is actually making the law under a direct delegation of
authority from Congress.
Both forms of Treasury regulations, whether interpretive or legislative, are accorded
considerable weight by the courts. Legislative regulations generally may be accorded more
weight than interpretive regulations.
Treasury regulations are typically issued in a tentative form called a “proposed
regulation,” which allows for public comment prior to adoption. When the process of public
comment on a proposed regulation is completed, the IRS may withdraw it or promulgate it as a
final regulation in the Code of Federal Regulations.
Occasionally, temporary regulations may be issued without the usual protocol of public
comment, and these are flagged by adding the suffix “T” to the citation. In general, Treasury
regulations are cited in numerical format, with the number 1 followed by a decimal and the Code
section they refer to. For example, a regulation applicable to section 482 of the Code would be
cited as Treas. Reg. ྷ 1.482. (Were this a temporary regulation, the cite would be ྷ 1.482T.)
8
26 U.S.C. ྷ 7805(a).
3.
Acquiescence
When issues are decided in the court, the IRS may publish an acquiescence or
nonacquiescence to the result. The latter simply means that the IRS does not agree with the
outcome and will continue to challenge the issue should others raise it in court.
4.
Revenue Rulings and Revenue Procedures
Revenue rulings (abbreviated as “Rev. Rul.”) are published by the IRS in the Internal
Revenue Bulletin each week, and are later complied in the Cumulative Bulletin. They are cited
numerically, using the year of the revenue ruling followed by a dash, followed by the number of
the ruling. For example, the twenty-fifth ruling issued in 1999 would be Rev. Rul. 99-25.
Revenue rulings provide a detailed analysis by the IRS of certain tax issues. The facts of
the issue being addressed will be described and the IRS will analyze the law on the subject and
then reach a conclusion as to how the issue should be decided.
Revenue procedures (abbreviated as “Rev. Proc.”) are similar to revenue rulings and deal
with ways in which the IRS will administer the Code and litigate cases. To the extent that there
is a distinction between them, it is that revenue rulings deal with the substantive law while
revenue procedures deal with administrative issues. Both should be consulted, however, because
the IRS may put substantive law into revenue procedures.
5.
Private Letter Rulings
Private letter rulings are responses by the IRS to a taxpayer’s request for an advance
ruling on a specific tax issue. The taxpayer specifies the factual elements of the transaction and
requests a ruling on its tax effect. Private letter rulings are deemed by the IRS to apply only to
the taxpayer in question. Private tax services publish these, and they can be useful in
determining what the IRS’s position is likely to be given similar facts. Often, they are used as
the basis for opinion letters by tax attorneys.
One can find private letter rulings by using their numerical citations. The first four
numbers represent the year in which the ruling is issued, the second two numbers represent the
week in which the ruling was issued, and the last three numbers represent the number of the
ruling that week.
C.
Tax Litigation
1.
United States Tax Court
The Tax Court is a court with national jurisdiction over income, estate, gift, and many
other federal tax cases. The Tax Court has nineteen judges, each of whom is appointed by the
President with the consent of the Senate. The perpetual defendant in the Tax Court is the
Commissioner of the Internal Revenue Service. Cases begin when the taxpayer petitions the
court asking for a redetermination of the deficiency in taxes that the IRS has proposed in its
notice of deficiency. After the petition is filed, it generally takes about a year or less for the
taxpayer’s case to come before one of the Tax Court judges.9
9
See David Laro & Shannon P. Pratt, Business Valuation and Taxes (2005), for more in-depth discussion of
the Tax Court.
The Tax Court may hear a case in Washington, D.C., where the court maintains its
offices, or in various cities around the United States. The court tries to accommodate the
preferences of the taxpayer so as to make it as convenient as possible for the taxpayer to litigate.
The clerk of the court prepares trial calendars for various cities on the basis of the number of
cases eligible for trial in each city. Cases are not placed on calendars until the IRS
Commissioner has filed an answer to the taxpayer’s petition. Generally, the petitioning taxpayer
designates the city where the case should be heard, choosing among approximately sixty-five
cities where the Tax Court officially sits. The court sits in each of these cities at least once a
year and in some of the larger cities several times a year. The chief judge of the Tax Court
circulates among the judges a list of the trial sessions, and the judges make their preferences
known. The chief judge then assigns the calendars to the judges on the basis of their seniority
and preferences.
Following a trial in the Tax Court, the judge receives the trial briefs of the parties and
deliberates on the case. In due course, the judge will write a report. The report, generally
speaking, consists of two section, the first being the findings of fact and the second being the
opinion as to those facts. It is in the opinion portion of the report that the judge sets forth her
legal analysis. Unlike a judge in U.S. district court, who is not subject to any peer-level review
of that opinion before its release, the Tax Court judge must follow a statutory review process
before the opinion is released. After the report is written, it is sent to the chief judge of the Tax
Court, who reviews it. In this manner, the opinions of the Tax Court are reviewed in part to
make sure that the legal analysis is compatible with the views of a majority of the judges on the
court. There are nineteen judges, and accordingly, views may differ on a point of law. It is
important that the federal tax laws be uniformly applied to all taxpayers. The review process
attempts to assure that the various opinions of the court will be consistent and uniform.
During review, the chief judge may take several actions upon reviewing a proposed
report. First, the chief judge may approve the report as a “division opinion.” Division opinions
are officially published by the Government Printing Office in the Tax Court Reports and are
binding precedent on all the judges of the court. Second, the chief judge may approve a report as
a “memorandum opinion.” Memorandum opinions are not officially published and generally
turn on the facts of the case or on established law. Memorandum opinions are not considered by
some judges as binding precedent. Other judges and some appellate courts view the
memorandum opinions differently. Third, the chief judge may return the proposed report to the
authoring judge with comments and suggestions. If the authoring judge does not accept the
suggestions, then the chief judge may send the proposed report to the court conference for review
by all of the regular judges. Each regular judge has one vote on each conference decision.
Generally, the court conferees meet monthly. In preparation for their conference, the
conferees receive copies of each proposed report set for review, and each conferee independently
researches and analyzes the underlying issues. Typically, one or more conferees will circulate a
memorandum before conference, articulating his or her position as to the case.
At the conference, the conferees discuss and vote upon the case. If a majority of the
judges participating in the conference vote for the proposed report, the proposed report is
adopted and becomes a division opinion. An exception to this rule is where the proposed report
overrules a previous Tax Court opinion. In that case, the proposed report is adopted only if it
receives a vote of the majority of the conferees. If a proposed report is not adopted, the
authoring judge may ask that the case be reassigned to another judge. In that case, the presiding
judge usually files a side opinion in which he or she dissents to the majority’s contrary opinion.
Traditionally, a proposed report is sent to the court conference if it (1) overrules a prior
Tax Court opinion, (2) invalidates a Treasury Department regulation, or (3) decides an issue
inconsistently with an opinion of a court of appeals other than the court to which an appeal of the
case lies.
A proposed report may also be sent to the court conference for other reasons, such as (1)
the issue is recurring in nature, (2) the issue is a matter of first impression, (3) the chief judge of
the Tax Court questions the validity of the legal approach that the proposed report has adopted,
and (4) the chief judge receives notification from other judges that there is disagreement on a
report that is about to be issued. In the latter case, opinions that have been adopted by the court,
either with or without review, are circulated around the court the morning of the day they are to
be issued. The judges have until 3:00 p.m. on the day when the opinion is officially released to
the parties and to the public to notify the chief judge of any disagreement.
2.
Federal District Court
The U.S. district courts are located throughout the United States. The U.S. district courts
are the only courts where a taxpayer can have a federal tax-related case tried before a jury. A
taxpayer wishing to litigate in U.S. district court must have the deficiency assessed then must
pay the deficiency. The taxpayer must then file a claim for refund with the IRS within two years
of paying the deficiency or three years from the filing of the return, whichever is later. If the
refund claim is ignored or rejected, the taxpayer can file suit no earlier than six months after the
claim is filed and no later than two years after the IRS rejects the claim. Appeals from the U.S.
district courts are made to the U.S. court of appeals for the circuit in which the taxpayer
resides.10
3.
Court of Federal Claims
The Court of Federal Claims is located in Washington, D.C., and here taxpayers and
others may sue the United States for various claims within the jurisdiction of the court. Included
among the claims for which one may sue are federal tax refunds. The taxpayer must follow the
same refund procedures as would be taken in the instance of preparing a case to go to the U.S.
district court. Cases before the Court of Federal Claims are tried before a single judge and
without a right to a jury. Tax cases are a small percentage of the court’s caseload. A claim for
refund can be filed at any time within two years after paying the tax or three years from the filing
of the return. Appeals from the Court of Federal Claims are made to the U.S. Court of Appeals
for the Federal Circuit.
IV. Litigating in the United States Tax Court
Once the taxpayer has made the decision to proceed to litigation and has chosen the Tax
Court as the forum in which to litigate, there are a number of pretrial procedures and
considerations.11 This Section will discuss these and other issues relevant to many cases,
including burden of proof considerations and issues pertaining to the use of expert testimony at
10
For further information on litigating tax cases in either of the two refund forums, see Gerald A. Kafka &
Rita A. Cavanagh, Litigation of Federal Civil Tax Controversies (1997 & Supp. 2004).
11
The Tax Court’s emphasis on informal discovery procedures and cooperation among the parties is
reflected in the Tax Court Rules of Practice and Procedure, which differ from the Federal Rules of Civil Procedure
followed by the district courts. See Dennis I. Meyer et al., 888 Tax Management, Transfer Pricing: Judicial Strategy
and Outcomes A-15 (2003).
trial.
A.
Pretrial Considerations
1.
Filing the Petition
Within 90 days of the date on which the notice of deficiency is mailed, the taxpayer may
file a petition with the Tax Court.12 The petition generally must include (1) the taxpayer’s name
and legal residence (or principle place of business if the taxpayer is a corporation), the taxpayer’s
mailing address and identification number, and the IRS office in which the tax return for the
period in controversy was filed, (2) the date of the notice of deficiency, (3) the amount of the
deficiency or liability, the nature of the tax, the year or years for which the determination was
made, and the approximate amount of the taxes in controversy, (4) clear and concise statements
of the errors that the taxpayer alleges that the Commissioner committed in the determination of
the deficiency, (5) clear and concise statements of the facts on which the taxpayer bases the
assignment of errors, (6) a prayer of relief sought, (7) appropriate signatures.13 The petition
generally does not need to contain a detailed explanation of either the relevant facts or the
taxpayer’s legal argument.
2.
Issues Memoranda and Pretrial Memoranda
In larger cases, the Tax Court judge assigned to the case may order each of the parties to
file an “issues memorandum.”14 A typical such order directs that the memoranda shall set forth
(1)(a) the issues of fact (including any issues subsidiary to ultimate issues) and (b) the issues of
law (including any issues subsidiary to ultimate issues) to be resolved by the Court15; (2) a clear,
complete, and concise exposition of each party’s position and the theory underlying that position
with respect to each of the issues that are set forth pursuant to (1) above16; (3)(a) an indication as
to whether expert witness testimony is anticipated, (b) the nature of the expert witness testimony,
if any, and (c) the questions the parties are expecting to ask the witness on which to opine. The
parties’ responses will control the admissibility of evidence at trial, and evidence offered at trial
will be deemed irrelevant unless it pertains to one or more of the issues set forth by the parties in
the memoranda. Parties directed to file issues memoranda will also not be permitted to advance
positions or theories underlying those positions with respect to any of the issues set forth that are
different from the positions or theories set forth in the memoranda.17
The judge will also request the parties to submit a pretrial memorandum that contains,
among other things: (1) a statement of the issues involved in the case, (2) a comprehensive
statement of the applicable law, (3) a summary of the facts the parties expect to be developed, (4)
a preliminary list of witnesses expected to be called and with statements on the testimony to be
given, (5) a proposed discovery schedule, (6) a list of potential evidentiary problems and
26 U.S.C. ྷ 6213; see also 26 U.S.C. ྷ 7502.
Tax Court Rule 34.
Orders requiring the parties to file issues memoranda are typically issued in cases in which the amount in
controversy exceeds $1,000,000.
15
Such issues should be set forth in sufficient detail to enable the court to decide the case in its entirety by
addressing each of the issues listed.
16
In this regard, each party shall include a statement in narrative form of what each party expects to prove.
17
A sample of such an order directing the filing of an issues memorandum is attached as Appendix A.
12
13
14
suggested solutions, (7) requests for a trial date and place of trial, (8) an estimate of the time
needed to try the case, (9) the possibility of settlement, and (10) a statement of any other matters
the parties believe require the court’s attention.
3.
Discovery in the Tax Court
After the pretrial conference, the judge will issue an order that sets forth the issues that
will be tried, the date and place of the trial, and a discovery schedule. Discovery is a critical
aspect of litigation, and the Tax Court expects the parties to cooperate with one another during
this phase.
The Tax Court typically favors the informal stipulation of facts process rather than formal
discovery. There are rules in the Tax Court Rules of Practice and Procedure (Tax Court rules),
however, that permit formal discovery. Tax Court rules, for example, permit discovery by
written interrogatory,18 by document request,19 by deposition of the opposing party with the
consent of that party,20 and by deposition of third parties without the consent of the opposing
party as an extraordinary means.21 In contrast to the Federal Rules of Civil Procedure used by
the United States district courts, the Tax Court rules do not permit deposition discovery of the
opposing party without consent.22 The Tax Court has the inherent power to control the trial of a
case before it, and therefore may limit abusive discovery. At times, protective orders may be
warranted. Also, a Tax Court judge faced with an uncooperative taxpayer may use his or her
authority under the Tax Court rules to direct the taxpayer to submit his employees to discovery
deposition by the government.23 At all times, the judge is responsible for balancing the interests
of the government in seeking relevant information with the interests of the taxpayer, and the
objective is always fairness to litigants on both sides and proper use of process, including
discovery tools.
B.
Trial
Trials can vary significantly in length--from several hours to several weeks--depending
on the number of witnesses that the parties present and the degree to which the parties stipulate
the relevant facts. In large cases, the parties are not usually successful in stipulating to a
significant portion of the relevant facts. Because a taxpayer generally bear the burden of proof,
it is important for the taxpayer to present its case-in-chief to the Tax Court judge clearly and
coherently. The taxpayer must establish the facts necessary to support each legal element of its
legal position, and to do so it must gather and introduce as evidence exhibits, stipulations, and
testimony.
1.
Federal Rules of Evidence
Trials before the Tax Court are conducted in accordance with the rules of evidence
applicable in nonjury trials in the United States district court for the District of Columbia, that is,
18
19
20
21
22
23
Tax Court Rule 71.
Tax Court Rule 72.
Tax Court Rule 74.
Tax Court Rule 75.
Cf. Federal Rule of Civil Procedure, Rule 26.
Tax Court Rule 1(a).
the Federal Rules of Evidence.24 Evidence must be both material and relevant.
Selected Federal Rules of Evidence
Rule 104. Preliminary Questions
(a) Questions of admissibility generally. Preliminary questions concerning the
qualification of a person to be a witness, the existence of a privilege, or the admissibility
of evidence shall be determined by the court, subject to the provisions of subdivision
(b). In making this determination it is not bound by the rules of evidence except those
with respect to privileges.
(b) Relevancy conditioned on fact. When the relevancy of evidence depends upon the
fulfillment of a condition of fact, the court shall admit it upon, or subject to, the
introduction of evidence sufficient to support a finding of the fulfillment of the condition.
Rule 402. Relevant Evidence Generally Admissible; Irrelevant Evidence
Inadmissible
All relevant evidence is admissible, except as otherwise provided by the Constitution of
the United States, by Act of Congress, by these rules, or by other rules prescribed by the
Supreme Court pursuant to statutory authority. Evidence which is not relevant is not
admissible.
Rule 611. Mode and Order of Interrogation and Presentation
(a) Control by court. The court shall exercise reasonable control over the mode and
order of interrogating witnesses and presenting evidence so as to (1) make the
interrogation and presentation effective for the ascertainment of the truth, (2) avoid
needless consumption of time, and (3) protect witnesses from harassment or undue
embarrassment.
(b) Scope of cross-examination. Cross-examination should be limited to the subject
matter of the direct examination and matters affecting the credibility of the witness. The
court may, in the exercise of discretion, permit inquiry into additional matters as if on
direct examination.
(c) Leading questions. Leading questions should not be used on the direct examination
of a witness except as may be necessary to develop the witness' testimony. Ordinarily
leading questions should be permitted on cross-examination. When a party calls a hostile
witness, an adverse party, or a witness identified with an adverse party, interrogation may
be by leading questions.
Rule 1006. Summaries
The contents of voluminous writings, recordings, or photographs which cannot
conveniently be examined in court may be presented in the form of a chart, summary, or
calculation. The originals, or duplicates, shall be made available for examination or
copying, or both, by other parties at reasonable time and place. The court may order that
they be produced in court.
Rule 1008. Functions of Court and Jury
When the admissibility of other evidence of contents of writings, recordings, or
24
Internal Revenue Code (26 U.S.C.) section 7453.
photographs under these rules depends upon the fulfillment of a condition of fact, the
question whether the condition has been fulfilled is ordinarily for the court to determine
in accordance with the provisions of rule 104. However, when an issue is raised (a)
whether the asserted writing ever existed, or (b) whether another writing, recording, or
photograph produced at the trial is the original, or (c) whether other evidence of contents
correctly reflects the contents, the issue is for the trier of fact to determine as in the case
of other issues of fact.
2. Tax Court Rules of Practice and Procedure
The Tax Court judges also abide by the Tax Court Rules of Practice and Procedure, a
copy of which is attached as an Appendix.
3. Burden of Proof
The concept of “burden of proof” is used to assess facts in trials, and it determines which
party must do two distinct things. First, the burden of proof determines which party bears the
burden of production (that is, which party must initially produce evidence so as to avoid having
its suit dismissed). Second, it determines which party bears the burden of persuasion (that is,
which party must ultimately persuade the court as to the correctness of its position). The two
burdens are totally distinct. Thus, the burden of production is not inevitably assigned to the party
that bears the burden of persuasion.
The burden of proof can be outcome determinative in cases where there is little evidence
on the issue in controversy. Normally, the burden rests upon the taxpayer,25 and the position of
the IRS Commissioner as set forth in the notice of deficiency is presumed to be correct. This is
not inevitable, however. The burden may be shifted by the court, in its discretion, or by statute,
where the taxpayer establishes four threshold facts: (1) all items required by law to be
substantiated are substantiated, (2) the taxpayer has maintained all records required by law to be
maintained, (3) the taxpayer cooperates with the IRS, (4) the taxpayer does not exceed a certain
net worth (not applicable to individuals).
a. Audits and Appeals
Although burden of proof is a concept utilized in court, the importance of who has the
burden of proof should be analyzed and considered long before the controversy goes to court.
For example, when the IRS audits a taxpayer, the auditing agent may dispute issues with the
taxpayer. About ninety-five percent of these disputes are resolved at the audit state, but the
remaining five percent move to the IRS’s appeals stage for resolution. There, a representative of
the IRS’s Appeals Office will meet with the taxpayer and the taxpayer’s representative to resolve
issues. It is at this level that the appellate conferee is able to take into consideration a multitude
of factors in an effort to settle the case. A very important consideration from the government’s
perspective is an understanding of what litigation hazards--the potential downsides to litigation-the government will encounter if it declines to settle.
If the appellate conferee concludes that the government has a litigation hazard, the
conferee will factor that in when deciding whether and how to settle the case. A litigation hazard
is, among other things, whether the government has the burden of proof should the case go to
25
Tax Court Rule 142(a)(1).
court. Thus, without ever having set foot in a courtroom, the taxpayer may be able to achieve a
better settlement at the administrative level merely by establishing that the government has the
burden of proof.26
b. Presumption of Correctness
To explain the nature and importance of the burden of proof, it is helpful to understand
some basics relating to federal tax litigation. The IRS Commissioner issues a notice of
deficiency if the taxpayer and the IRS cannot resolve their controversy administratively at the
audit or appeals level.27 The notice serves to advise the taxpayer that the Commissioner means
to assess a deficiency and proceed in court.28
The U.S. Supreme Court has stated that the notice of deficiency has a presumption of
correctness. Thus, the government is presumed to be correct when it informs the taxpayer that
the taxpayer owes the government taxes. If the taxpayer is to prevail in a dispute with the
government, the taxpayer now bears the burden of proving the government’s deficiency notice
erroneous. In some sense, the presumption of correctness may be nothing more than a way of
characterizing who bears the burden of proof. The presumption of correctness is essentially the
same hurdle of proof, in loose terms, as is the burden of proof.
If the deficiency notice is found to be “arbitrary and erroneous” or “arbitrary and
excessive,” the presumption of correctness is negated and the burden of proof may shift to the
government.29 Note, however, that there is a difference between a deficiency notice that is
arbitrary and erroneous and one that is merely incorrect. An incorrect notice may still be entitled
to a presumption of correctness, while an arbitrary and erroneous notice may lose the
presumption of correctness.
All that is required to support the presumption of correctness is that the Commissioner’s
determination have some minimal factual predicate. It is only when the Commissioner’s
assessment is shown to be “without rational foundation” or “arbitrary and erroneous” that the
presumption should not be recognized. The general rebuttable presumption that the
Commissioner is correct is a fundamental element of any federal tax controversy. If the taxpayer
decides to go to court to dispute the determination set forth in the deficiency notice, the taxpayer
must begin by offering some evidence or else the taxpayer will lose. The presumption of
correctness therefore imposes on the party against whom it is directed the burden of going
forward with evidence to rebut the presumption.
c. Components to the Burden of Proof
Judge Richard A. Posner, in his book Economic Analysis of Law explains that the burden
See 26 U.S.C. ྷ 7491(a). Some taxpayers prefer to skip proceeding to the Appeals Office and go directly
to court to resolve their controversies. However, in order to shift the burden of proof from the taxpayer to the
government under a motion pursuant to 26 U.S.C. ྷ 7491, the taxpayer must first cooperate with the IRS.
Cooperation means, in part, that the taxpayer must first exhaust all administrative remedies. This includes taking the
issues to the Appeals Office for resolution. For more information, see the legislative history of 26 U.S.C. ྷ 7491.
27
26 U.S.C. ྷ 6212(a) provides that such notice shall include a notice to the taxpayer of the taxpayer’s right
to contact a local office of the taxpayer advocate and the location and phone number of the appropriate office.
28
Olsen v. Helvering, 88 F.2d 650 (2d Cir. 1937).
29
Welch v. Helvering, 290 U.S. 111 (1933). If, however, the deficiency notice is found to be “arbitrary and
erroneous” or “arbitrary and excessive,” the presumption of correctness is negated and the burden of proof may shift
to the government.
26
of proof has two components. He states the following:
Burden of proof has two aspects. The first is important only in an adversarial system,
where the tribunal does not participate in the search for evidence. This is the burden
of producing (submitting) evidence to the tribunal, as distinct from the burden of
persuading the tribunal that one ought to win the case. Failing to carry either burden
means that the party having the burden loses. The two burdens are intertwined; for
one thing the burden of persuasion generally determines who has the burden of
production. The plaintiff’s burden in an ordinary civil case is to show that his
position is more likely than not correct. In other words, if at the end of the trial the
jury either thinks the defendant should win or doesn’t know which side should win-the evidence seems in equipoise--the plaintiff loses.30
i. Burden of Production Component
The burden of production is the obligation to go forward with evidence or lose the case.
Because this burden is normally on the taxpayer, the taxpayer must begin by introducing some
evidence of a credible nature that supports the taxpayer’s argument. The burden of production
serves to ensure that the evidence is of a certain minimum level to satisfy the trier of fact.
Customarily, once this minimum has been met, the burden of production will then shift to the
opposition.
ii. Burden of Persuasion Component
The second part of the burden of proof is the burden of persuasion. In civil tax cases, one
carries the burden of persuasion by producing a preponderance of credible evidence. Taxpayers
can prevail in a non-criminal tax case, in most instances, by convincing the trier of fact that they
have provided a preponderance of evidence. To carry the burden of persuasion by a
preponderance of evidence means essentially that one has produced and supported the case with
more than fifty percent of the credible evidence required to prove the point.
The burden of persuasion is yet another hurdle. After satisfying the procedural burden of
producing evidence to rebut the presumption in favor of the Commissioner, the taxpayer must
still carry his ultimate burden of proof or persuasion.
d. Who Bears the Burden of Proof
It is customary in litigation for each party to inform the court as to who bears the burden
of proof. In most cases there is no dispute. In some instances, the issue of who has the burden of
proof is contested, and the parties will pursue their arguments on this issue as vigorously as any
substantive issue of the case. Who has the burden of proof is determined according to one or
more of the following: (1) Court rules of practice and procedure, for example, the Tax Court
Rules of Practice and Procedure, Rule 142(a); (2) the Code; (3) relevant case law.
In the Tax Court, the burden of proof is provided for by Tax Court rule 142(a), which
states, in part, the following:
The burden of proof shall be on the petitioner, [the taxpayer,] except as otherwise
30
Judge Richard A. Posner, Economic Analysis of Law (2002).
provided by statute or determined by the Court; and except that, in respect of any new
matter, increases in deficiency, and affirmative defenses, pleaded in the answer, it
shall be upon the respondent [the government].
Reasons that are often given for placing the burden of proof on the taxpayer are
historically founded. In the early years of the income tax, before there was a Tax Court, a
common remedy for taxpayers to dispute their taxes was to sue for a refund after first paying the
tax. Typically, in a refund suit, the plaintiff has the burden of proof. This historical foundation
has generally carried over to modern-day tax litigation.
In addition, taxpayers presumably have, or should have, the dispositive records within
their possession. If a taxpayer has the records, it makes sense that the taxpayer should have the
burden of presenting those records to prove that the government’s determination of tax liability is
in error.
Finally, if the government has the burden of proof, one can question whether the
government would have to be more intrusive in order to sustain its burden. If the records to
prove the correct tax liability are in the possession of the taxpayer, and the government has the
burden of proof, the government would be expected to take efforts to obtain that evidence and
thus become more intrusive. Generally, it is felt that a more intrusive government is not
desirable.
e. Burden of Proof: Exceptions to the General Rule
There are certain exceptions to the general rule that the taxpayer has the burden of proof
in tax litigation. Generally, there are two ways by which the burden may shift from the taxpayer
to the government. First, a court has discretion under certain circumstances to shift the burden to
the government and away from the taxpayer.31 Second, the burden can be shifted to the
government if the taxpayer meets certain statutory thresholds, enacted by Congress in response
to the public’s concerns that it is unfair to have the burden of proof on the taxpayer.
i. Shifting the Burden of Proof by Statute: Section 7491
There are other circumstances where the burden of proof will shift to the government
when the taxpayer meets certain thresholds established by Congress. Congress recently changed
the rules relating to burden of proof because it felt that individuals and small business taxpayers
were at a disadvantage when they litigated against the government in tax matters. Congress felt
that shifting the burden of proof to the Commissioner would create a better balance between the
IRS and such taxpayers, without encouraging tax avoidance.32
In 1998, Congress enacted Code section 7491 to provide that the Commissioner shall
bear the burden of proof in any court proceeding with respect to a factual issue if the taxpayer
introduces credible evidence on the issue that is relevant to ascertaining the taxpayer’s income
tax liability. For the taxpayer to shift the burden to the government, four conditions must be
met33: The taxpayer must (1) substantiate any item required by law to be substantiated, (2)
maintain records required by law to be kept, (3) cooperate with reasonable requests by the IRS
31
32
See Tax Court Rule 142(a)(1).
See the committee reports to the Internal Revenue Service Restructuring and Reform Act of 1998, Section
3001.
33
26 U.S.C. ྷ 7491(a)(2).
for meetings, interviews, witness information, and documents,34 and (4) meet certain net worth
limitations, except in the case of an individual.35
Finally, the taxpayer bears the burden of proving that each of these conditions is met
before it can be established that the burden of proof is on the government. The burden will shift
to the government only if the taxpayer meets these conditions and introduces credible evidence
with respect to a factual issue relevant to ascertaining the taxpayer’s liability.
In addition, if the case involves the imposition of penalties or additions to tax, the
Commissioner bears the burden of production in any court proceeding.36
Credible evidence is the quality of evidence that the court would find sufficient to base a
decision upon if no contrary evidence were submitted, without regard to the judicial presumption
of governmental correctness. A taxpayer has not produced credible evidence if the taxpayer
merely makes implausible factual assertions, frivolous claims, or tax-protester arguments. For
the evidence to be credible, the court must be convinced that it is worthy of belief. If, after
evidence from both sides, the court believes that the evidence is equally balanced, the court
likely will find that the taxpayer has not sustained its burden of proof.
4. Witnesses
Witnesses play an important role in the litigation of many issues. There are typically two
types of witnesses involved in these cases: fact witnesses and expert witnesses.
a. Fact Witnesses
Often, parties in cases call fact witnesses to testify to help establish the facts. Each case
is different, and the specific types of testimony from fact witnesses that may be required varies
significantly from case to case depending upon the nature of the factual and legal issues
involved. Large cases will often require the taxpayer to introduce the testimony of as many as
forty fact witnesses in order to make its case.
b. Expert Witnesses
In addition to the use of fact witnesses, the complexity of issues involved in some cases
almost always means that the taxpayer will also retain expert witnesses.37 To qualify under the
Federal Rules of Evidence as an “expert,” a person must have sufficient training or experience.
Before trial, the expert will compile all the information needed, review it, and render a written
opinion. This opinion will then be presented to the Tax Court judge.
Cooperation includes the taxpayer’s providing reasonable access to, and inspection of, witnesses,
information, and documents. Cooperation also includes providing reasonable assistance to the IRS in obtaining
access to evidence not within the control of the taxpayer, including witnesses, information, and documents. This
element of cooperation implies that the taxpayer will also cooperate with respect to any witnesses, information, or
documents located in a foreign country. A necessary element of cooperation is that the taxpayer must exhaust other
administrative remedies, including any appeal rights provided by the IRS.
35
Corporations, partnerships, and trusts whose net worth exceeds $7 million are not eligible for the benefits
of shifting the burden of proof.
36
26 U.S.C. ྷ 7491(c).
37
See John E. McDermott, Jr., & Adam J. Safer, How to Use Expert Testimony in International Tax Cases, 6
Journal of International Taxation 25 (1995); see also Thomas H. Steele et al., Use of Experts in Transfer Pricing
Cases, in 2 Transfer Pricing Handbook, at 47-1 (1998).
34
Effective use of experts requires five conditions: (1) The expert must be qualified to
perform the necessary analysis and formulate the needed expert opinions. (2) The expert has
credibility with the court. Credibility means that the expert is worthy of belief. One way in
which credibility of the witness may be discovered is by researching prior cases where the expert
has testified; courts often comment on the qualifications and reliability of the expert, providing a
treasure chest of knowledge on the consistency and thoroughness of that expert. (3) The expert
refrains from advocacy. In theory, the expert is a dispassionate analyst who will guide the trier
of fact to truth, even if that truth conflicts with the client’s position. In practice, expert opinions
are perceived to be purchased by the word, lessening their credibility. Attorneys should thus
refrain from making the expert nothing more than a surrogate advocate for the client’s position.
Because of these concerns, some courts are now avoiding the expert-advocate problem altogether
by appointing their own experts under Federal Rule of Evidence 706. (4) If the expert is a public
accountant, it is recommended that the expert refrain from providing audit and valuation services
at the same time. (5) The expert must offer reliable and relevant analysis and opinions.
i. Various Roles of Experts
An expert’s role in a case may include the following: (1) advising counsel or a client on a
valuation independent of, and prior to, a controversy relating to the valuation, (2) providing an
opinion that will be used before the IRS in an audit, or at the Appellate Division in an appeals
conference, (3) assisting counsel out of court in understanding technical issues and preparing for
the case, and (4) testifying in court to an opinion that will be included in a trial record. Each of
these tasks requires different skills from the expert, and one needs to select an expert based on
the purpose for which the expert is needed, as well as the skills and abilities of the expert.
ii. Litigation Witnesses
First, it is important to distinguish lay opinion testimony from expert opinion testimony.
If a witness is testifying in court but is not qualified as an expert, the witness’s opinion testimony
is limited to those opinions that are rationally based on the personal knowledge and perception of
the witness, are helpful in determining a fact in issue, and are not based on hypothetical facts.
This is called lay opinion testimony.
In contrast to lay witness testimony, the purpose of expert witness testimony is to help the
Tax Court judge better understand the evidence, or to decide a fact in issue that is based on
scientific, technical, or specialized knowledge. Once qualified as an expert, the witness can offer
ultimate opinions and conclusions on issues that the judge might not otherwise understand.
iii.
Admissibility of Evidence Underlying Expert
The Federal Rules of Evidence govern the admissibility of evidence in federal court. 38
Federal Rule of Evidence 702 provides the following:
If scientific, technical or other specialized knowledge will assist the trier of fact to
38
See Tax Court Rule 143(a). Trials before the Tax Court will be conducted in accordance with the rules of
evidence in trials without a jury in the United States District Court for the District of Columbia. See 26 U.S.C. ྷ
7453. To the extent applicable to such trials, those rules include the rules of evidence in the Federal Rules of Civil
Procedure and any rules of evidence generally applicable in the federal courts.
understand the evidence or to determine a fact in issue, a witness qualified as an
expert by knowledge, skill, training, or education, may testify thereto in the form
of an opinion or otherwise, if (1) the testimony is based upon sufficient facts or
data, (2) the testimony is the product of reliable principles and methods, and (3)
the witness has applied the principles and methods reliably to the facts of the case.
The rule is broadly worded, and the fields of knowledge for which a witness can qualify
as an expert are not just scientific and technical, but include skills such as business appraisal.
The expert assembles before trial all of the necessary information, data, and documents upon
which to base an opinion. The expert then reviews those records and forms an opinion. Expert
testimony need not be in opinion form, however. The Federal Rules of Evidence recognize that
an expert may give an explanation of the principles relevant to the case and leave the trier of fact
to apply them to the facts. Generally, experts reveal their data in written reports. Often,
opposing counsel will seek to discover the expert’s raw data or prior drafts of written reports for
trial purposes.
Generally, the expert is given considerable discretion in selecting the data that will form
the basis of the opinion. A good expert is trained to know which resources are available and the
reliability of those resources. If the expert utilizes the wrong data or outdated information, the
ultimate opinion will be affected. Thus, anyone examining the opinion of the expert should first
review the data and information underlying the expert’s opinion. Remember, however, that
simply because the expert may rely upon certain data does not mean that such data will be
admissible at trial. Accordingly, Federal Rule of Evidence 703, Bases of Opinion Testimony by
Experts, provides the following:
The facts or data in the particular case upon which an expert bases an opinion or
inference may be those perceived by or made known to the expert at or before the
hearing. If of a type reasonably relied upon by experts in the particular field in
forming opinions or inferences upon the subject, the facts or data need not be
admissible in evidence in order for the opinion or inference to be admitted.
Facts or data upon which the expert’s opinion is based may be derived from three
possible sources. The first source is the firsthand observation of the witness. In many cases,
however, experts are asked to opine on events that occurred months or years earlier. In such
cases, firsthand observation is not possible. Therefore, a second source of data comes from
experts attending the trial and gaining information from the testimony of others; based on this
information, the expert is then asked to give an opinion. Third, the facts may be presented to the
expert outside of court and before trial, and the expert is then asked to review those facts and
express an opinion.
iv.
Limitations to Admissibility
(a)
Hearsay
Various documents or other evidence are often not admitted because of a party’s
objections that such material is hearsay. Hearsay evidence is generally not admissible, with
some objections, because of its presumed unreliability.39
39
Federal Rule of Evidence 801(c) describes hearsay as a statement, other than one made by the declarant
Experts, however, may rely on hearsay. Federal Rule of Evidence 703
specifically allows the expert to rely upon such otherwise inadmissible evidence. Thus, Rule 703
is, in essence, an exception to the hearsay rule, allowing inadmissible evidence to be
incorporated into the record through an expert. This clever back door around the hearsay rule
must be used carefully, however, because an expert’s utilization of such evidence may contribute
to the court’s skepticism as to the reliability of the expert’s opinion.
(b)
Scope of Expert Testimony
Experts may testify in the form of an opinion based on underlying facts or data. Experts
may also testify in response to hypothetical questions, unlike most fact witnesses, who must
answer based on personal knowledge or observation. Federal Rule of Evidence 705, Disclosure
of Facts or Data Underlying Expert Opinion, provides the following:
The expert may testify in terms of opinion or inference and give reasons therefor
without first testifying to the underlying facts or data, unless the court requires
otherwise. The expert may in any event be required to disclose the underlying
facts or data on cross-examination.
In the Tax Court, expert testimony is governed by Tax Court rule 143(f), which provides
the following:
Unless otherwise permitted by the Court upon timely request, any party who calls
an expert witness shall cause that witness to prepare a written report for
submission to the Court and to the opposing party. The report shall set forth the
qualifications of the expert witness and shall state the witness's opinion and the
facts or data on which that opinion is based. The report shall set forth in detail the
reasons for the conclusion, and it will be marked as an exhibit, identified by the
witness, and received in evidence as the direct testimony of the expert witness,
unless the Court determines that the witness is not qualified as an expert.
Additional direct testimony with respect to the report may be allowed to clarify or
emphasize matters in the report, to cover matters arising after the preparation of
the report, or otherwise at the discretion of the Court. After the case is calendared
for trial or assigned to a Judge or Special Trial Judge, each party who calls any
expert witness shall serve on each other party, and shall submit to the Court, not
later than 30 days before the call of the trial calendar on which the case shall
appear, a copy of all expert witness reports prepared pursuant to this
subparagraph.
In the Tax Court, the expert may be given little or no opportunity at trial to supplement
the report, except to discuss matters that arose subsequent to the submission of the report. By
having a written report serve as the expert’s direct testimony, the expert’s testimony at trial
generally is limited to clarification of the report.
v.
Reliability of the Expert
while testifying at the trial or hearing, offered in evidence to prove the truth of the matter asserted.
The trial judge must decide whether a particular witness qualifies as an expert. Once that
is determined, the judge must rule on whether the expert’s testimony is admissible into the trial
record. In almost half of the reported cases in a recent survey of federal judges, the judges
indicated that admissibility of the expert testimony was not disputed.40
Federal Rule of Evidence 702 requires the federal trial judge to act as a gatekeeper to
“ensure that any and all scientific testimony or evidence admitted is not only relevant, but
reliable.”41 In Kumho Tire Co. v. Carmichael, the Supreme Court clarified that the requirements
of relevance and reliability apply not only to scientific testimony, but to all expert testimony.42
Therefore, in order for expert testimony to be admissible in court, the testimony must be both
relevant and reliable. In ruling on the issue of reliability, the court must consider all relevant
facts, including the methodology employed by the expert, the facts and data relied upon by the
expert in formulating conclusions, and the expert’s application of the specific methodology to
those facts and data. In ruling on the issue of whether the expert’s testimony is reliable, trial
judges may consider the following four nonexclusive factors: (1) whether the theory or technique
can be and has been tested, (2) whether the theory or technique has been subjected to peer review
and publication, (3) the method’s known or potential rate of error, and (4) whether the theory or
technique finds general acceptance in the relevant subject matter’s community.
These factors are not exclusive, and courts have found four other factors to be relevant in
determining whether expert testimony is reliable: (1) whether the expert is proposing to testify
about matters related to research conducted independent of the litigation, (2) whether the expert
has unjustifiably extrapolated from an accepted premise to an unsubstantiated conclusion, (3)
whether the expert has accounted for alternative explanations, and (4) whether the expert
employs in the courtroom the same level of intellectual rigor that characterizes the practice of the
expert in the expert’s workplace.43
vi.
Attorney Assistance to the Expert
There is little published authority that discusses the proper limits of attorney assistance to
the expert in the formulation of the expert’s report. Experienced counsel and experts know that
in order to preserve the independence and integrity of the expert’s opinion, counsel should
refrain from assisting the expert in the formulation of the analysis and in the ultimate opinion of
the expert.
Counsel’s role is appropriately that of an advocate, but this does not extend to expert
witnesses. If counsel exceeds the legitimate limits of assistance by influencing the expert’s
opinion, counsel has tainted the expert’s opinion with advocacy and thus rendered the expert
unreliable. If an expert is found to be unreliable, the court may disregard the expert testimony in
its entirety, admit only portions of it, draw a negative inference against the expert, or exclude the
expert from testifying altogether.
There are several ways in which an expert may appear unreliable to the court as a result
of attorney assistance. The first deals with “spoliation” of the evidence, which is a legal term for
40
Molly Treadway Johnson et al., Expert Testimony in Federal Civil Trials: A Preliminary Analysis, Federal
Judicial Center (2000).
41
Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579, 589 (1993).
42
Kumho Tire Co. v. Carmichael, 526 U.S. 137 (1999).
43
See David Laro & Shannon P. Pratt, Business Valuation and Taxes (2005), for further discussion of expert
testimony. For a discussion of the parameters of the use of expert opinions in a Tax Court case, see Estate of True et
al. v. Commissioner, T.C. Memo. 2001-167, aff’d, 390 F.3d 1210 (10th Cir. 2004).
destruction of evidence. In the context of expert opinions, recent case law suggests that
spoliation rules have broad application. To avoid appearing unreliable, experts should retain
copies of all their work in a given case so that the court can see the factual background for its
analysis and conclusions. Without such background, the court will be unable to determine the
basis for the expert’s opinion and can impose any of the sanctions previously outlined.
Federal Rule of Civil Procedure 26(a)(2)(B) prescribes what experts must disclose to
opposing counsel prior to trial in a federal district court. In relevant part, it requires that lawyers
disclose to opposing counsel the expert’s report, as well as the following:
a complete statement of all opinions to be expressed and the basis and reasons
therefore; the data or other information considered by the witness in forming the
opinions; any exhibits to be used as a summary of or support for the opinions; the
qualifications of the witness, including a list of all publications authored by the
witness within the preceding ten years; the compensation to be paid for the study
and testimony; and a listing of any other cases in which the witness has testified
as an expert at trial or by deposition within the preceding four years.
This rule is broadly worded, and some courts have shown a willingness to strictly enforce
its provisions. If the expert (or the lawyer) has destroyed any evidence covered by this rule, the
expert’s opinion will likely be deemed unreliable. To be safe, the expert should retain such
things as (1) drafts of reports and opinions, (2) results of studies, (3) copies of all treatises,
articles, reports, and so forth relied upon by the expert, (4) memoranda from subordinates whose
research and opinions are incorporated into the expert’s report at any state, even if such work is
not used in the final draft of the report.
Another way in which an expert may appear unreliable is by becoming nothing more than
a surrogate advocate for the attorney. When experts do not write their own opinions, but instead
sign off on those drafted by the lawyers, they have abandoned their impartial role. The notes to
Federal Rule of Civil Procedure 26(a)(2)(B) state the following:
[The rule] does not preclude counsel from providing assistance to experts in
preparing the reports, and indeed, with experts such as automobile mechanics, this
assistance may be needed. Nevertheless, the report, which is intended to set forth
the substance of the direct examination, should be written in an manner that
reflects the testimony to be given by the witness and it must be signed by the
witness.
Assistance, however, may exceed the limits acceptable to the court. In one recent case,
for example, the taxpayer alleged that the government’s experts had not authored their opinions,
but had instead signed off on opinions ghostwritten by others. The court could not find enough
evidence to support the taxpayer’s contention and held for the government. In the process,
however, the court defined ghostwriting as “the preparation of the substance writing of the report
by someone other than the expert purporting to have written it,” and held such to be a violation
of Federal Rule of Civil Procedure 26. The court further explained that, although the rule does
not preclude some assistance from counsel in the preparation of the report, the report itself must
not be prepared by a third party, and it must be “based on the expert’s own valid reasoning and
methodology.”44
44
Trigon Insurance Co. v. United States, 204 F.R.D. 277, 291, 294 (E.D. Va. 2001)..
Experts, rather than counsel, should thus be responsible for drafting both the analysis and
the ultimate opinion in the report. Counsel’s participation should be minimal and nonessential,
and should relate only to assisting the expert in complying with the court rules or the Federal
Rules of Civil Procedure. Further, good practice suggests that experts should be cautious in
blindly relying on the work of others. An expert’s report should be drafted by the expert: The
broad language of Rule 26(a)(2)(B) could operate to preclude the expert from testifying to a
report written in substance by a colleague or the client’s attorney.
Another problematic area is where the expert report is authored by more than one person
but only one expert is available to testify as to its contents. In some courts, such as the Tax
Court, the report is the direct testimony of the witness. Thus, if the report of the expert is
admitted, it is the equivalent of live, in-court testimony by the expert. When the report is
authored by more than one person, but only one expert is available to be cross-examined, the
court and the opposing party are unable to examine all of the report’s authors. This inability may
be sufficient for a court to deny admission of the report. Even in cases where all of the authors
can be cross-examined, the report may still be excluded if the authors cannot clearly establish
who wrote precisely what. In the final analysis, good practice will ensure that all of the signers
of a report are available to testify as to, and can confidently identify, their portion of the work.
The IRS has recently opined that the witness must sign expert opinions and must be
available for trial testimony. The chief counsel put it this way:
The proponent of the report must establish that the words, analysis, and opinions
in the report are the expert’s own work and a reflection of the expert’s own
expertise. . . .
To avoid the possibility that the Tax Court will exclude all or a portion of
an expert witness report signed by nontestifying experts, Counsel attorneys must
produce as witnesses all of the experts who prepared the report.45
vii.
Concerns About Expert Testimony
Not surprisingly, experts’ opinions are susceptible to abuse, as well as error and
misjudgment. The U.S. Supreme Court recognized the difficulties and uncertainty of expert
opinion when it stated the following:
Experience has shown that opposite opinions of persons professing to be experts
may be obtained to any amount; and it often occurs that not only many days, but
even weeks, are consumed in cross-examinations, to test the skill or knowledge of
such witnesses and the correctness of their opinions, wasting the time and
wearying the patience of both court and jury, and perplexing, instead of
elucidating, the questions involved in the issue.46
The literature and case law are replete with discussions concerning the problems
associated with expert opinion. Among the noteworthy concerns are these: (1) experts who
abandon objectivity and become advocates for the side that hired them, (2) excessive expense of
party-hired experts, (3) expert testimony that appears to be of questionable validity or reliability,
(4) conflict among experts that defies reasoned assessment, (5) disparity in the level of
45
46
CC-2004-023.
Winans v. New York & Erie Railroad Company, 62 U.S. 88, 99 (1958).
competence of experts, (6) expert testimony that is not comprehensible to the trier of fact, (7)
expert testimony that is comprehensible but does not assist the trier of fact, (8) failure of the
parties to provide discoverable information concerning experts, (9) attorneys who are unable to
adequately cross-examine experts, and (10) experts who are poorly prepared to testify.47
Another very important concern is whether the expert is able to support the expert’s
opinions with empirical, solid data. Judges permit experts to testify in controversies because
they find the specialized knowledge of the experts to be helpful in understanding the facts of the
case. Where, however, the experts do not adequately connect the data to the analysis, and the
analysis to the conclusion, the expert is not helpful to the trier of fact.
5.
Privileges
a.
Attorney-Client Privilege
The attorney-client privilege is the oldest of the privileges protecting confidential
communications and protects communications from clients to their attorneys made for the
purpose of securing legal advice.48 The purpose of the privilege is to encourage frank and full
communications between attorneys and their clients, and to encourage clients to make full
disclosure to their attorneys.49 The privilege applies if (1) the asserted holder of the privilege is,
or has sought to become, a client of the attorney; (2) the person to whom the communication was
made (a) is a member of the bar of the court or a subordinate and (b) is acting as a lawyer in
connection with the communication; (3) the communication relates to a fact (a) of which the
attorney was informed by his or her client, (b) without the presence of strangers and with the
expectation of confidentiality, (c) to secure primarily (i) an opinion of law, (ii) legal services, or
(iii) assistance in some legal proceeding, and (iv) not for the purpose of committing a crime or
tort; and (4) the privilege has been (a) claimed and (b) not waived by the client.50 The burden of
establishing the attorney-client privilege is borne by the party claiming the privilege.51
b.
Work Product Doctrine
The work product doctrine provides that work product materials that an attorney prepared
in anticipation of litigation are not subject to discovery.52 The rationale of the doctrine is that
such discovery would harm the orderly defense and prosecution of claims under an adversary
system of litigation. While the attorney-client privilege belongs solely to the client, both the
client and the attorney may claim that materials are privileged under the work product doctrine.53
c.
47
Governmental Privilege
Molly Treadway Johnson et al., Expert Testimony in Federal Civil Trials: A Preliminary Analysis, Federal
Judicial Center (2000).
48
See Baker & McKenzie, Federal Income Tax Controversies 40-52 (2005).
49
Upjohn Co. v. United States, 449 U.S. 383, 389 (1981).
50
See United States v. United Shoe Mach. Corp., 89 F. Supp. 357, 358-59 (D. Mass. 1950); United States v.
White, 950 F.2d 426, 430 (7th Cir. 1991); Baker & McKenzie, Federal Income Tax Controversies 41 (2005).
51
Fisher v. United States, 425 U.S. 391 (1976).
52
Hickman v. Taylor, 329 U.S. 495 (1947); Baker & McKenzie, Federal Income Tax Controversies 52
(2005).
53
In re Special September 1978 Grand Jury (II), 640 F.2d 49, 62 (7th Cir. 1980).
The governmental privilege is intended to cover confidential intra-agency advisory
opinions and reports to the extent they reflect the mental impressions, opinions, reasoning, and
conclusions of government officials.54 The privilege does not extend to purely factual portions
of the advisory opinions and reports. No formalities are required to claim the privilege, and it
potentially encompasses all materials prepared during the deliberative process. The privilege is
qualified and can be overcome by a taxpayer-litigant’s compelling need which extends beyond
purely factual matters.
C.
Post-trial Procedures
Following a trial in the Tax Court, the judge receives the trial briefs of the parties and
deliberates on the case. After the opinion has been released, the parties may file an appeal in the
appropriate circuit court of appeals.
V.
Tax Shelters
A.
Background
There are a number of different definitions of “tax shelter,” but the one most common is
that a tax shelter is any transaction with a principle purpose of tax avoidance.55 Tax shelters can
be grouped into three broad categories: legitimate tax shelters, gray area tax shelters, and abusive
tax shelters.
(a) Legitimate tax shelters usually involve tax-favored investments clearly sanctioned by the tax
laws, typically where tax benefits have been enacted expressly as incentives for particular
activities (for example, oil exploration and real estate).
(b) Gray area tax shelters. In other cases, the result sought by taxpayers may be available under
current law, but the tax preference is in fact unintended. Corporate-owned life insurance is a
good example. These are the tax shelters that reside in the hazy, middle ground between
legitimate tax shelters and abusive tax shelters.
(c) Abusive tax shelters, on the other hand, typically involve transactions that, if the facts were
known, would not be upheld in court. These investments enable taxpayers to take a reporting
position for claiming deductions or credit that, while not ultimately allowable, may produce
significant tax savings either because the return will not be examined by the IRS, or, if it is
examined and the claimed deduction is disallowed, the tax will be deferred at a low interest cost.
Abusive tax shelter investments are entered into primarily, if not exclusively, to reduce federal
income tax liability. Often they yield negligible returns (and sometimes negative returns) before
tax, but offer significant after-tax returns.56
54
Gerald A. Kafka & Rita A. Cavanagh, Litigation of Federal Civil Tax Controversies 6-59 (1997 & 2004
Supp.).
55
See generally Michael L. Schler, Ten More Truths About Tax Shelters: The Problem, Possible Solutions,
and a Reply to Professor Weisbach, 55 TAX L. REV. 325, 328-32 (2002) for a discussion of the definition of tax
shelters. Schler states that a tax shelter “should” be defined as a transaction that (1) arguably complies as a literal
matter with the Code and regulations, (2) is accompanied by some level of tax motivation, and (3) reaches a tax
result unintended by Congress or the regulations. Id. at 331.
56
Donald L. Korb, Internal Revenue Service, Shelters, Schemes, and Abusive Transactions: Why Today’s
Thoughtful U.S. Tax Advisors Should Tell Their Clients to “Just Say No,” Tax Law and Estate Planning Course
A number of judicial doctrines have sprung up that further define what it means for a
transaction to be deemed a tax shelter and allow courts to disallow the tax benefits claimed by
taxpayers. A discussion of several of these doctrines follows.
B.
Judicial Anti-Abuse Doctrines
1.
Sham Transaction Doctrine
The sham transaction doctrine allows courts to use several tests to combine steps of a
transaction if the intermediary steps are determined unnecessary to the overall result from a
transaction. Sham transactions are those in which the economic activity that is purported to give
rise to the desired tax benefits does not actually occur. The transactions have been referred to as
“facades” or mere “fictions” and, in their most egregious form, one may question whether the
transactions might be characterized as fraudulent.57
At a minimum, the sham transaction doctrine can be said to apply to a “sham in fact.”
For example, where a taxpayer purported to buy Treasury notes for a small down payment and a
financing secured by the Treasury notes in order to generate favorable tax benefits, but neither
the purchase nor the loan actually occurred, the court applied the sham transaction doctrine to
deny the tax benefits.58 Note that although many of the cases raising this doctrine deal with
individual tax shelters, it also has been applied in the corporate context.59
Although the sham transaction doctrine generally applies when the purported activity
giving rise to the tax benefits does not actually occur, in certain circumstances, a transaction may
be found to constitute a sham even when the purported activity does occur. For example, if a
transaction is entered into to generate loss for the taxpayer, and the taxpayer actually has risk
with respect to the transaction, but that risk has been eliminated through a guarantee by a broker
that the broker will bear the market risk and that the only consequences to the taxpayer will be
the desired tax benefits, such transaction may be found to be a "sham in substance."60 Finally, it
should be noted that the delineation between this doctrine (particularly as applied to shams "in
substance") and the "economic substance" and the "business purpose" doctrines (both discussed
below) is not always clear. Some courts find that if transactions lack economic substance and
business purpose, they are "shams" notwithstanding that the purported activity did actually
occur.61
2.
Economic Substance Doctrine
The economic substance doctrine, which requires that a transaction have economic
substance in order to be respected, mandates that a transaction cannot be used as the basis for a
Handbook Series (June 2006).
57
Donald L. Korb, Internal Revenue Service, Shelters, Schemes, and Abusive Transactions: Why Today’s
Thoughtful U.S. Tax Advisors Should Tell Their Clients to “Just Say No,” Tax Law and Estate Planning Course
Handbook Series (June 2006).
58
See Goodstein v. Commissioner, 267 F.2d 127 (1st Cir. 1959).
59
See. e.g., ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998), aff’g in part, rev’g in part 73
T.C. Memo. 1997-115; ASA Investerings v. Commissioner, 76 T.C.M. 325 (1998).
60
In general, see the COLI cases (particularly American Electric Power, 136 F.Supp 2d at 779-80, and Dow
Chemical, 250 F. Supp. 2d at 799-811) for a good decision of sham in substance versus sham in fact.
61
See e.g., United States v. Wexler, 31 F.3d 117 (3rd Cir. 1994).
deduction if it lacks a realistic possibility for profit. The requirement that a transaction have
economic substance is meant to ferret out “sham” transactions that have no purpose other than
the creation of a tax deduction.
The courts generally will deny claimed tax benefits where the transaction giving rise to
those benefits lacks economic substance independent of tax considerations -- notwithstanding
that the purported activity did actually occur. The Tax Court recently described the doctrine as
follows:
“The tax law . . . requires that the intended transactions have economic substance separate and
distinct from economic benefit achieved solely by tax reduction. The doctrine of economic
substance becomes applicable, and a judicial remedy is warranted, where a taxpayer seeks to
claim tax benefits, unintended by Congress, by means of transactions that serve no economic
purpose other than tax savings.”62
The seminal authority most often credited for laying the foundation of the economic
substance doctrine is the Supreme Court and Second Circuit decisions in Gregory v. Helvering.63
In Gregory, a transitory subsidiary was established to effectuate, utilizing the corporate
reorganization provisions of the Code, a tax advantaged distribution from a corporation to its
shareholder of appreciated corporate securities that the corporation (and its shareholder) intended
to sell. Although the court found that the transaction satisfied the literal definition of a tax-free
reorganization, the Second Circuit held (and the Supreme Court affirmed) that satisfying the
literal definition was not enough: “[T]he underlying presupposition is plain that the readjustment
shall be undertaken for reasons germane to the conduct of the venture in hand, not as an
ephemeral incident, egregious to its prosection. To dodge the shareholder's taxes is not one of
the transactions contemplated as corporate ‘reorganizations.’” Since the time of Gregory, several
cases have denied tax benefits on the grounds that the subject transactions lacked economic
substance. The economic substance doctrine can apply even when a taxpayer exposes itself to
risk of loss and where there is some profit potential (i.e., where the transactions are real) if the
facts suggest that the economic risks and profit potential were insignificant when compared to
the tax benefits. In other words, the doctrine suggests a balancing of the risks and profit
potential as compared to the tax benefits in order to determine whether the transactions had
“purpose, substance or utility apart from their anticipated tax consequences.”64
3. Business Purpose Doctrine
Another doctrine that overlays and is often considered together with (if not part and
parcel of) the sham transaction and economic substance doctrines is the business purpose
doctrine. Although numerous authorities apply this doctrine in the context of individuals or
partnerships, the doctrine equally applies in the corporate context. Additionally, the doctrine is
not limited to cases where the relevant statutory provisions by their terms require a business
purpose or profit potential.
In its common application, the courts use business purpose (in combination with
economic substance, as discussed above) as part of a two-prong test for determining whether a
transaction should be disregarded for tax purposes: (a) the taxpayer was motivated by no
62
63
64
ACM Partnership v. Commissioner, T.C. Memo. 1997-115.
293 U.S. 465 (1935).
Donald L. Korb, Internal Revenue Service, Shelters, Schemes, and Abusive Transactions: Why Today’s
Thoughtful U.S. Tax Advisors Should Tell Their Clients to “Just Say No,” Tax Law and Estate Planning Course
Handbook Series (June 2006).
business purpose other than obtaining tax benefits in entering the transaction, and (b) the
transaction lacks economic substance. In essence, a transaction will only be respected for tax
purposes if it has “economic substance which is compelled or encouraged by business or
regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by
tax-avoidance features that have meaningless labels attached.”65
The business purpose test is a subjective inquiry into the motives of the taxpayer -- that
is, whether the taxpayer intended the transaction to serve some useful nontax purpose.
Finally, where appropriate, the court may bifurcate a transaction in which independent
activities with nontax objectives have been combined with an unrelated transaction having only
tax-avoidance objectives in order to establish a business purpose for the overall transaction.
Thus, a taxpayer cannot utilize an unrelated business objective to hide the lack of business
purpose with respect to the particular tax-motivated activities.66
4. Substance Over Form Doctrine
The concept of the substance over form doctrine is that the tax results of an arrangement
are better determined based on the underlying substance rather than an evaluation of the mere
formal steps by which the arrangement was undertaken. For instance, two transactions that
achieve the same underlying result should not be taxed differently simply because they are
achieved through different legal steps. The Supreme Court has found that a “given result at the
end of a straight path is not made a different result because reached by following a devious
path.”67 However, many areas of income tax law are very formalistic and, therefore, it is often
difficult for taxpayers and the courts to determine whether application of the doctrine is
appropriate.
While tax cases have been decided both ways, the IRS generally has the ability to
recharacterize a transaction according to its underlying substance. Taxpayers, however, are
usually bound to abide by their chosen legal form.68 In National Alfalfa Dehydrating & Mill
Co., the Supreme Court ruled as follows: “This Court has observed repeatedly that, while a
taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must
accept the tax consequences of his choice, whether contemplated or not . . . , and may not enjoy
the benefit of some other route he might have chosen to follow but did not.”69
5. Step Transaction Doctrine
A business transaction often does not have a sharply defined beginning or ending. One
step in a transactional sequence often bears a strong relationship to that which came before it and
65
66
Frank Lyon Co. v. United States, 435 U.S. 561, 561 (1978).
Donald L. Korb, Internal Revenue Service, Shelters, Schemes, and Abusive Transactions: Why Today’s
Thoughtful U.S. Tax Advisors Should Tell Their Clients to “Just Say No,” Tax Law and Estate Planning Course
Handbook Series (June 2006).
67
Minnesota Tea Co. v. Helvering, 302 U.S. 609, 613 (1938); Donald L. Korb, Internal Revenue Service,
Shelters, Schemes, and Abusive Transactions: Why Today’s Thoughtful U.S. Tax Advisors Should Tell Their
Clients to “Just Say No,” Tax Law and Estate Planning Course Handbook Series (June 2006).
68
Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967).
69
Commissioner v. National Alfalfa Dehydrating & Mill Co., 417 U.S. 134, 149 (1974). See also Higgens v.
Smith, 308 U.S. 473, 477 (1940); Donald L. Korb, Internal Revenue Service, Shelters, Schemes, and Abusive
Transactions: Why Today’s Thoughtful U.S. Tax Advisors Should Tell Their Clients to “Just Say No,” Tax Law and
Estate Planning Course Handbook Series (June 2006).
that which follows it. For analytical purposes, however, it is often necessary to examine a
transaction as an organic whole. To that end, the IRS and courts often fuse formally separate
transactional steps to determine the tax consequences of the overall transaction. This step
transaction doctrine is as pervasive in corporate tax law as it has iterations. More than one
iteration may be appropriately applied to a single set of circumstances; however, the satisfaction
of only one of the tests is sufficient for a court to disregard transitory or unnecessary steps.70
VI.
Tax Fraud: Basic Concepts
Tax avoidance is perfectly legal. Tax evasion, or tax fraud, is not.71 The difference
between the two, however, is often unclear and may depend on the taxpayer’s state of mind. A
taxpayer who takes a position that he honestly believes to be legal has not engaged in tax fraud
or evasion, even if that position is ultimately found to be prohibited under the Code. On the
other hand, a taxpayer who takes a position on his return that the taxpayer knows or believes to
be contrary to the law has gone beyond mere avoidance and into the realm of evasion.72
In practice, the U.S. tax laws are so complex that the line between legal avoidance and
unlawful evasion is often difficult to draw. Even when the law is perfectly clear, the taxpayer
may not understand the law or how it applies to the situation at hand. In these circumstances,
imprisoning the taxpayer would clearly be inappropriate, but some civil penalty may be justified
in order to encourage more diligent taxpayer behavior.
The Internal Revenue Manual73 distinguishes between the concepts as tax avoidance and
evasion as follows: “One who avoids tax does not conceal or misrepresent. He shapes events to
reduce or eliminate tax liability and, upon the happening of the events, makes a complete
disclosure. Evasion, on the other hand, involves deceit, subterfuge, camouflage, concealment,
some attempt to color or obscure events, or make things seem other than they are.”74
A. How to Detect?
The IRS has established two tracks to determine if what a taxpayer believes is tax
avoidance fits the government’s definition of tax evasion--civil fraud audit and criminal
investigation. A case works its way from a civil fraud audit to a criminal investigation through
the IRS’s longstanding fraud referral program. When a revenue agent or revenue officer
investigates a case and determines that there are “firm indications of fraud,” the agent or officer
is required to transfer or refer the case to the IRS Criminal Investigation Division.75
Within the IRS’s Small Business/Self-Employed Division, fraud referral specialists
70
For the various iterations of the test, see Penrod v. Commissioner, 88 T.C. 1415 (1987); King Enterprises,
Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969); Commissioner v. Gordon, 391 U.S. 83 (1968); and McDonalds
Restaurants of Ill. v. Commissioner, 688 F.2d 520 (7th Cir. 1982).
The above discussion of the judicial doctrines applicable to tax shelters, including the information in the
footnotes, has been taken in large part from Appendix II to JCX 82-99: Description of Analysis of Present-Law Tax
Rules and Recent Proposals Relating to Corporate Tax Shelters prepared by the Staff of the Joint Committee on
Taxation (JCX-84-99) November 10, 1999.
71
See Camilla E. Watson, Tax Procedure and Tax Fraud 294-96 (2006).
72
Camilla E. Watson, Tax Procedure and Tax Fraud 294-296 (2006).
73
The Internal Revenue Manual is available online at www.irs.gov/irm.
74
Internal Revenue Manual 9781 (Jan. 18, 1980).
75
Dennis L. Perez & Nathan J. Hochman, How the IRS Distinguishes Civil and Criminal Tax Fraud, 26 Los
Angeles Lawyer 12 (2003).
(FRS), both on the civil audit side and the collection side, have been selected to identify civil
fraud cases that have civil fraud penalty and criminal referral potential. Those agents designated
as FRS are generally experienced and have special training in detecting and developing fraud
cases. There are now approximately 64 fraud referral specialists, who act as consultants to
revenue agents as they conduct civil audits. The FRS have the job of helping the examining
agent identify badges of fraud and develop fraud cases through the gathering of documentation
and the interviewing of witnesses, including the taxpayer.76
The Internal Revenue Manual provides a lengthy list of “badges of fraud” that may
trigger scrutiny by the FRS. As described in the Fraud Handbook, the badges fall into 6
categories: (1) income, (2) expenses or deductions, (3) books and records, (4) allocations of
income, (5) conduct of taxpayer, and (6) methods of concealment. Badges of fraud involving
income include unreported sources of income, unexplained increases in net worth over a period
of years, unusually high personal expenditures, and unexplained bank deposits that substantially
exceed reported income. Badges of fraud involving expenses or deductions include substantial
deductions for personal expenditures claimed as business expenses, lack of substantiation for
unusually large deductions, or making a claim for dependency exemptions for nonexistent,
deceased, or self-supporting persons.77
The FRS is also sure to scrutinize taxpayers who keep the classic two sets of books--one
for their bank that inflates their net income, and one for the IRS that deflates the same income-or engage in similar mischief with invoices, purchase orders, gift receipts, and the like.
Taxpayers whose business books and tax returns do not reconcile, who move income or
deductions out of the correct account and into a more taxpayer friendly line item, or who issue
checks to third parties that are then returned and endorsed back to the taxpayer will likewise
draw the attention of the FRS. The FRS will also look at distributions of profits to fictitious
parties or inclusions of income or deductions in the tax return of a related person whose tax rate
is substantially different.78
In addition, a taxpayer’s conduct is one of the more important variables that can
transform a civil inquiry into a criminal investigation. These badges of fraud include hindering
examinations by failing or refusing to answer important questions, repeatedly cancelling
appointments, refusing to provide records or consistently omitting key records, and attempting to
threaten or corruptly influence witnesses. When taxpayers assert that they completed their
returns on the basis fo a good faith reliance on an accountant or lawyer, the FRS will analyze
whether the taxpayer actually followed the advice or fully disclosed the relevant facts to the
professional in question. The FRS will also consider the tax sophistication, education, training,
and experience of the taxpayer.79
If any of the badges of fraud concerning concealment emerge, the likelihood of a criminal
referral looms large. Signs of concealment include placing assets in others’ names, transferring
assets in anticipation of a tax assessment or during an investigation, using secret bank accounts
or entities (particularly offshore entities) to disguise the source and destination of a financial
76
Dennis L. Perez & Nathan J. Hochman, How the IRS Distinguishes Civil and Criminal Tax Fraud, 26 Los
Angeles Lawyer 12 (2003).
77
Dennis L. Perez & Nathan J. Hochman, How the IRS Distinguishes Civil and Criminal Tax Fraud, 26 Los
Angeles Lawyer 12 (2003).
78
Dennis L. Perez & Nathan J. Hochman, How the IRS Distinguishes Civil and Criminal Tax Fraud, 26 Los
Angeles Lawyer 12 (2003).
79
Dennis L. Perez & Nathan J. Hochman, How the IRS Distinguishes Civil and Criminal Tax Fraud, 26 Los
Angeles Lawyer 12 (2003).
transaction, and using nominees for property or banking transactions.
B. How to Prove?
The three elements of tax evasion are set forth in the Internal Revenue Code at section
7201: (1) the existence of a tax deficiency, (2) an affirmative act constituting an evasion or
attempted evasion of the tax, and (3) willfulness. The state-of-mind requirement for imposing
the civil fraud penalty is identical to what must be proven in a criminal prosecution for tax
evasion under section 7201. “Willfulness” is defined for criminal purposes as a “voluntary,
intentional violation of a known legal duty,” and in the civil fraud arena, as an “intentional
wrongdoing on the part of the taxpayer with the specific purpose to evade a tax believed to be
owing,”80
While a conviction under section 7201 of the Code requires an affirmative act evidencing
an intent to conceal income from the imposition of tax, assessing a civil fraud penalty does not
technically require such an overt act.81 The better view, however, is that some affirmative act is
also required to impose the civil fraud penalty.82 Thus, for all practical purposes, the government
may establish civil and criminal tax fraud through virtually the same elements.
C. Standards of Proof
A key distinction between civil and criminal fraud is the burden of proof. In a criminal
prosecution, fraud must be proven beyond a reasonable doubt. Civil fraud, however, requires
only clear and convincing evidence. However, if the government establishes that any portion of
any underpayment of tax is attributable to fraud, the entire underpayment is treated as
attributable to fraud, potentially triggering fraud penalties on the full amount of the tax liability.
The taxpayer, however, may establish by a preponderance of the evidence that all or a portion of
the tax liability is not attributable to fraud.
VII. Concepts of Guilt and Innocence: How Do You Differentiate Guilt with “Innocent
Mistakes?”
A. Defenses to Criminal Charges: Third Party Reliance
In criminal tax cases, a criminal defendant may use the excuse that he relied on the
advice of a professional and thus is not guilty of a tax offense because he did not act willfully.
This defense seldom succeeds, however, for two reasons. First, the more complex the issue, the
more successful the defense; if the issue involves an aspect of tax law that is not very
complicated, such as the requirement to file a return, the defense usually will fail. Second, there
are specific requirements for the defense; for example, the defendant must have chosen a
competent professional, must have made full disclosure to the professional, and must have acted
80
United States v. Pomponio, 429 U.S. 10, 12 (1976); McGee v. Commissioner, 61 T.C. 249, 256 (1976),
aff’d, 519 F.2d 1121 (5th Cir. 1975); see Dennis L. Perez & Nathan J. Hochman, How the IRS Distinguishes Civil
and Criminal Tax Fraud, 26 Los Angeles Lawyer 12 (2003).
81
Paddock v. Commissioner, T.C. Memo. 1985-586; see Dennis L. Perez & Nathan J. Hochman, How the
IRS Distinguishes Civil and Criminal Tax Fraud, 26 Los Angeles Lawyer 12 (2003).
82
Zel v. Commissioner, 763 F.2d 1139, 1143 (10th Cir. 1985); Dennis L. Perez & Nathan J. Hochman, How
the IRS Distinguishes Civil and Criminal Tax Fraud, 26 Los Angeles Lawyer 12 (2003).
on the advice of the professional. A defendant who travels down a path of criminality and
merely seeks advice that will allow him to continue on that path will not be able to assert the
defense.83
B. Defenses to Criminal Charges: Mistake of Law
The maxim that “ignorance of the law is no defense” may not hold true in a tax
prosecution because the Tax Code provisions tend to be highly complex and technical, and
because it would be too easy for a taxpayer to be convicted of a crime for an error or omission in
applying some Code provision about which even tax experts might be confused. Similarly, an
illiterate taxpayer could be convicted of a tax crime based on a clear but innocent mistake. On
the other hand, permitting every defendant to escape conviction on the mere assertion that he
misunderstood the law would hardly be acceptable. The difficulty in reconciling the two
extremes has plagued the courts and was most frequently cast in terms of whether the willfulness
element should be construed as requiring subjective or objective intent. In other words, can a
defendant’s honestly-held but mistaken view of the law shield him from prosecution, or is there a
standard of reasonableness by which such beliefs should be tested?
The U.S. Supreme Court resolved a split in the circuits on the question of subjective
versus objective standards for a misunderstanding of the law in Cheek v. United States, 498 U.S.
192 (1991). In Cheek, the Court held that a good-faith misunderstanding of the law is a valid
defense to tax evasion. To avoid conviction, of course, the defendant must convince the jury that
his misunderstanding of the law is genuine.
VIII. Liability of Tax Authorities the Administration of Tax Law
The Treasury Inspector General for Tax Administration (TIGTA) was established in
January 1999 in accordance with the Internal Revenue Restructuring and Reform Act of 1998 to
provide independent oversight of IRS activities. Before TIGTA was established, the IRS
Inspection Service oversaw IRS activities.
TIGTA consists of approximately 960 auditors, investigators, attorneys, and support staff.
TIGTA is formally part of the Department of the Treasury, but is independent of the Department
and all other Treasury offices, including the Treasury Office of the Inspector General (OIG).
TIGTA’s focus is devoted entirely to tax administration while Treasury OIG is responsible for
overseeing the other Treasury bureaus.
TIGTA’s Office of Investigations investigates activities related to fraud, waste, abuse,
and mismanagement concerning the activities of the IRS. There are various offices and divisions
of TIGTA that investigate different types of complaints. Complaints can be made anonymously
by either phone or mail. Once an investigation has been completed, the Office of Investigations
issues a Report of Investigation. If there is sufficient evidence of criminal conduct, then the case
is referred to the Department of Justice or local authorities for prosecution. All misconduct
investigations concerning IRS employees that substantiate or refute administrative misconduct
allegations are referred to IRS management for administrative action.
IX.
83
Tax Legislative Process
See United States v. Cheek 3 F.3d 1057 (7th Cir. 1993); Camilla E. Watson, Tax Procedure and Tax Fraud
294-96 (2006).
The authority of the U.S. government to impose taxes derives from the United States
Constitution and is one of the government’s most pervasive and fundamental powers.84 U.S.
courts almost always affirm the government’s power to tax in the face of constitutional
challenges; this “presumption of constitutionality” afforded most tax legislation is a longstanding and well-accepted proposition. This Section will provide a brief overview of the
process by which tax legislation in the United States is enacted.
Section 8 of Article 1 of the Constitution grants Congress the power “To lay and collect
Taxes . . . .” Federal tax legislation originates in Congress, which must legislate within the limits
proscribed by the Constitution. Within Congress’s House of Representatives (House), the Ways
and Means Committee has jurisdiction over tax legislation, and within the Senate, the Finance
Committee has jurisdiction over tax legislation.
A. House Ways and Means Committee
Tax legislation must originate in the House of Representatives. Most of this proposed
legislation, however, is actually conceived in the Treasury Department.85 Proposals come into
the House and are referred to the appropriate committee, which is almost always the House Ways
and Means Committee. Membership on the Committee is divided between the majority and
minority parties roughly in proportion to their representation in the House. The Committee’s
work begins with a hearing at which witnesses present their views, ordinarily by summarizing
previously submitted written statements, and are questioned by Committee members. The
Committee as a whole considers general tax legislation. When the Committee is considering
legislation on some other topics, it sometimes acts through one of its six subcommittees.
Depending on the nature, importance, and origin of the proposal, the first witness may be
the Secretary of the Treasury, a less august representative of the Treasury Department, or a
representative of private interests, and the House members who attend the hearing may receive
the testimony in a friendly, hostile, or perfunctory manner. After the chief proponent and other
supporters of the legislation have spoken, the Committee or subcommittee hears the views of
critics and, in some instances, invited witnesses, such as academic lawyers and economists. The
hearings may be brief or extended, depending on the importance of the bill to those affected. For
example, the Ways and Means Committee held 28 days of hearings in 1985 on the bill ultimately
enacted as the Tax Reform Act of 1986.86
Following the hearing, the Committee generally considers the proposed legislation at a
so-called markup session, reaching tentative decisions on specific issues. These decisions are
ordinarily not based on statutory language but are instead directions to the legislative drafters,
and they are subject to reconsideration before the bill's final approval. Since 1974, markup
sessions, like the Committee's other business meetings, have been open to the public unless
closed by a roll call vote of a majority of the members of the Committee. Open meetings are an
article of democratic faith to some, but others argue that by requiring members to state their
positions publicly to those in attendance (primarily, lobbyists), open meetings strengthen the
influence of special interests. The option of closed markup sessions is exercised routinely.87
84
See Stephen W. Mazza & Tracy A. Kaye, Restricting the Legislative Power to Tax in the United States, 54
American Journal of Comparative Law 641 (2006) for a comprehensive discussion of the tax legislative process in
the United States.
85
Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts 116.2 (2005).
86
Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts 116.2 (2005).
87
Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts 116.2 (2005).
In its deliberations, the Committee has at hand a virtual secretariat of specialists,
consisting of the tax attorneys, economists, econometricians, accountants, and statisticians who
make up the staff of the Joint Committee on Taxation, and assistance is also provided by the
Committee's own staff and the staffs of individual members of the Committee. The markup
sessions are attended by representatives of the Treasury Department, who supply advice,
statistical data, revenue estimates, and other information as requested. The Committee's
decisions may also be influenced by views of other standing House committees, each of which
has the authority to review and study the effect of tax policies on subjects within its
jurisdiction.88
Decisions reached at markup sessions are converted from generalizations into statutory
language by the staff of the House Legislative Counsel, aided by staff from the Joint Committee,
the Ways and Means Committee, the Treasury's Office of Tax Legislative Counsel, and the
Internal Revenue Service. As drafting proceeds, the staff of the Joint Committee prepares an
accompanying report, describing and justifying the bill as recommended by the Ways and Means
Committee. The House Rules and the Congressional Budget Act require that the report cover
several matters. For example, if the bill amends or repeals existing statutes, the report must
contain a comparative print indicating the changes with stricken-through type, italics, or other
typographical devices. The most important part of the report, however, is its detailed
explanation of the bill, ordinarily section by section, which becomes part of the legislative
history that the IRS, taxpayers, and the courts will ponder and cite in construing the statutory
language.89
After the Committee approves and reports the bill and the accompanying report, it
requests a "rule" providing a procedure for the bill's consideration by the House. Typically, the
Rules Committee issues either a "closed rule," under which the bill must be accepted or rejected
in its entirety, save for amendments offered by the Committee, or a modified closed rule,
permitting specified amendments to be offered from the floor, usually to permit consideration of
a proposal made by a member of the Committee who could not gather enough votes to
incorporate it into the bill as reported.90
Once the requisite rule is granted, the bill is scheduled for debate on the House floor.
The allotted time for deliberation is divided evenly between the majority and minority parties,
each party's time being controlled by its manager for the bill, generally the chairman and the
ranking minority member of the Committee. When the time for deliberation expires, the bill's
opponents may move to recommit it to the Committee with instructions to report it back to the
House with specified changes; if this motion carries, the bill is in effect amended. If the motion
fails, which is its usual fate, the House proceeds to a vote on the bill itself. A favorable vote on
this motion makes the bill an Act of the House of Representatives, and it is then sent to the
Senate.91
B. Senate Finance Committee
The Senate's consideration of the legislation commences with hearings by the Senate
Committee on Finance, which usually hears from many of the witnesses who testified before or
submitted statements to the House Committee on Ways and Means, but, having explicit statutory
88
89
90
91
Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts 116.2 (2005).
Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts 116.2 (2005).
Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts 116.2 (2005).
Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts 116.2 (2005).
language as a target, they can direct their attention to details, as well as to the larger issues. The
Senate Finance Committee may confine its recommendations to minor changes in the bill as
enacted by the House, or it may recommend that the Senate exercise to the hilt its constitutional
power to propose amendments to revenue bills originating in the House by stripping the bill
entirely of its House-approved provisions and substituting what is in effect a new bill. For
example, the Tax Equity and Fiscal Responsibility Act of 1982, which made major income tax
changes, was fashioned by the Finance Committee and added to a House bill consisting of five
miscellaneous tax provisions. The legislation, as reported by the Committee, goes to the Senate
floor for consideration, with a committee report that is usually identical to the report of the
House Ways and Means Committee, except for an explanation of the changes recommended by
the Senate Finance Committee.92
On reaching the Senate floor, the bill is subject to unlimited debate and unrestricted
amendment unless cloture--a rare event--is invoked. The resulting free-for-all not only enables
individual Senators to propose and obtain a vote on amendments opposed by the Senate Finance
Committee and the administration but also provides a forum in which the administration can seek
to persuade its supporters to reject the recommendations of the Committee and its chairman.
When engaging in this tactic, however, the administration plays for high stakes because the
chairman is certain to fight back and, if defeated, will not quickly forget or forgive the
humiliation.Unless the Senate approves the House version in its entirety, the Senate version of
the bill is returned for consideration by the House. It may accept the Senate changes, but usually
a Conference Committee, composed of the ranking members by party of the House Ways and
Means Committee and the Senate Finance Committee, endeavors to reconcile the differences
between the two chambers. A compromise is ordinarily reached, but sometimes--especially if
the Senate has adopted a significant amendment on an issue that was not previously considered
by the House--the conferees refer one or more items back to their respective bodies for separate
action. In the absence of such a "technical disagreement," the bill agreed upon by the conferees
is reported back to both bodies, with a report containing a list of the Conference Committee's
decisions on the Senate amendments and a Joint Explanatory Statement comparing the two
versions and explaining the compromise provisions agreed upon by the conferees.93
If the conference compromise is approved by both houses, the enrolled bill is forwarded
to the President. Since the administration plays a major role in shaping tax bills as they move
through Congress, they are rarely vetoed. When they are, the veto may be overridden by a two
thirds vote in both houses. When signing a bill, the President may voice criticism of particular
provisions in an accompanying message, and tax bills are occasionally allowed to become law
without the President's signature.94
Under the Line Item Veto Act, the President could veto any provision of a bill that
provided a "limited tax benefit." A limited tax benefit was either (1) an exclusion, deduction, or
credit that would benefit 100 or fewer taxpayers or (2) transition relief available to 10 or fewer
beneficiaries. The veto applied to a tax provision unless the 100- or 10- taxpayer threshold
would be exceeded for every year that the provision will be in effect, but little guidance was
provided on how the President was to determine the number of affected taxpayers.
However, after first finding that members of Congress did not have standing to challenge
the Line Item Veto Act, the Supreme Court decided that a city affected by an expenditure veto
and taxpayers that would have benefitted by a vetoed tax item did have standing to challenge the
92
93
94
Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts 116.2 (2005).
Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts 116.2 (2005).
Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts 116.2 (2005).
Act and further held that the Act was unconstitutional. Under the Line Item Veto Act, the
President would first sign a measure passed by Congress and then could "cancel" particular
spending and tax portions of the bill. The constitution's presentment clause requires legislation to
be presented to the President, who may either sign it into law or veto it, but according to the
Court, no provision of the constitution vests the President with power to amend or repeal
portions of legislation already enacted into law with the President's signature, and the
cancellation feature of the Act purported to give the President just that authority.95
Congress and the President, being a human institution, not a machine, do not always
follow all of the steps in this orderly pattern. Much legislation is enacted without ever being the
subject of congressional hearings, primarily because it is added to a bill after hearings have been
concluded. Sometimes, changes made in the conference committee introduce new subjects or
radically different approaches to problems covered in the original legislation, thereby
shortcutting most of the deliberative process. Legislation generally moves when the politics are
right, which may be long before or after the normal gestation of the legislation is completed.96
C.
Joint Committee on Taxation
The staff of the Joint Committee on Taxation has prepared postenactment explanations of
many major revenue acts, including the Tax Reform Acts of 1969 and 1976, the Revenue Act of
1978, the Economic Recovery Tax Act of 1981, the Tax Equity and Fiscal Responsibility Act of
1982, and the Tax Reform Acts of 1984 and 1986. These explanations, often known as
Bluebooks, synthesize the relevant material in the committee reports and sometimes suggest
answers for questions not anticipated when the statute was drafted. Because the Joint Committee
explanations concentrate on provisions that were actually enacted into law, they are easier to use
than the original reports, which describe unenacted proposals as well as the surviving provisions
and, except for the conference report, do not reflect all amendments made as the legislation
moved through the process. Moreover, they can pick up important explanations made during
floor debate, which are not reflected in the pre-enactment committee reports. On the other hand,
the original reports, having been available to the legislators when they were acting on the bill, are
more authoritative than the Bluebooks.97
X.
Forms of Doing Business
The choice of business organization will have a role in how that organization is taxed.
Among the major organizational choices or forms are (1) corporations, (2) limited liability
companies, (3) partnerships, (4) limited partnerships, and (5) sole proprietorships. In the United
States, corporations represented approximately one-fifth of all business entities but account for
roughly 90 percent of all business income.98
A.
Corporation
A corporation is an artificial person or legal entity created under the laws of a state. The
biggest downside of traditional corporations is double taxation. C corporations, which are
95
96
97
98
Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts 116.2 (2005).
Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts 116.2 (2005).
Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts 116.2 (2005).
U.S. Census Bureau, Statistical Abstract of the United States 545 (1999).
governed by Subchapter C of the Internal Revenue Code, are taxed as legal entities separate from
their shareholders. Income taxed at the corporate level is taxed again, either as ordinary income
when distributed as a dividend or as capital gains when shareholders sell their shares.
To avoid this double taxation, a corporation may elect to become a pass-through entity
under Subchapter S of the Internal Revenue Code. The virtue of this election is that the taxable
income of the corporation is passed through to the shareholders without first being taxed at the
corporate level. At the same time, the shareholders continue to enjoy the benefits of limited
liability.
B.
Limited Liability Company (LLC)
A limited liability company (LLC) is a hybrid, unincorporated business organization that
shares some aspects of corporations and partnerships. An LLC can be taxed as a partnership if
the taxpayers so elect. Gains and losses are not taxed at the entity level, but are passed through
to its members. LLC members can actively participate in management.
C.
General Partnership
A general partnership is an association of two or more people or entities engaged in an
activity for profit. The partnership is not taxed; the gains and losses are passed through to the
partners, who are taxed on their shares of partnership gains. Each partner is jointly and severally
liable for the partnership obligations, for the acts of the other partners, and for acts of the
partnership’s agents in furtherance of partnership business. Potential liability is unlimited, and
partners can be pursued personally for partnership debts.
D.
Limited Partnership
A limited partnership has at least two classes of partners: a general partner, who has
unlimited liability and is responsible for making the major partnership business decisions, and
limited partners, whose liability exposure is limited to the capital that they have invested.
Because the limited partnership is a partnership for federal tax purposes, the entity pays no
federal tax. Income or losses pass through to the partners, who have the responsibility to report
it and pay any resulting tax. An important consideration is that, while gains and losses are
passed through to the partners, the decision to distribute cash is left to the general partner. Thus,
if a general partner withholds cash distributions, a limited partner must pay taxes on money he
does not receive.
E.
Sole Proprietorship
A sole proprietorship is an individual carrying on business under the individual’s own
name or under an assumed name. The sole proprietorship is taxed for federal purposes as an
individual.
Appendix A
UNITED STATES TAX COURT
WASHINGTON, DC 20217
XYZ CORPORATION,
Petitioner,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent.
)
)
)
)
)
)
)
)
)
Docket Nos. XXXX-XX
ORDER
For cause, it is
ORDERED that each of the parties shall file no later than January 1, 2007, a
memorandum setting forth(1)(a) The issues of fact (including any issues subsidiary to ultimate issues), and
(b) the issues of law (including any issues subsidiary to ultimate issues) to be resolved by the
Court. Such issues should be set forth in sufficient detail to enable the Court to decide the case
in its entirety by addressing each of the issues listed.
(2) A clear, complete, and concise exposition of each party’s position and the
theory underlying that position with respect to each of the issues that are set forth pursuant to (1)
above. In this regard, each party shall include a statement in narrative form of what each party
expects to prove.
(3) (a) An indication as to whether expert witness testimony is anticipated, (b) the
nature of the expert witness testimony, if any, and (c) the questions the parties are expecting to
ask the witness on which to opine.
It is further
ORDERED that the statement of issues set forth pursuant to (1) above shall control the
admissibility of evidence at trial above. It is further
ORDERED that neither party will be allowed to advance a position or theory underlying
that position with respect to any and evidence offered at trial will be deemed irrelevant unless it
pertains to one or more of the issues set forth pursuant to (1) above that is different from the
positions or theories set forth pursuant to (2) above.
Judge Laro
Dated: Washington, D.C.
(Date)