The Supreme Court held on June 19, 2014, that taxpayers are entitled to examine IRS agents in a summons-enforcement proceeding where taxpayers “point[] to specific facts or circumstances plausibly raising an inference of bad faith.” The Court held that circumstantial evidence could meet this burden but that naked allegations were insufficient. This case has implications for all taxpayers under audit, especially regarding how they handle Information Document Requests (IDRs) under the new IDR-enforcement program.
Section 7602(a) of the Internal Revenue Code authorizes the Service to summon documents and testimony to, among other things, “ascertain[] the correctness of any return.” If a summons recipient refuses to comply, the Service may bring an enforcement action in district court. Enforcement proceedings are summary in nature and the Service makes a prima facie case by showing that it satisfied the so-called Powell factors: (i) that the investigation was for a legitimate purpose, (ii) that the inquiry may be relevant to that purpose, (iii) that the Service does not already have the requested information, and (iv) that the Service followed the administrative steps required by the Code. See United States v. Powell, 379 U.S. 48, 57–58 (1964). Because the proceedings are summary, district courts often deny requests for evidentiary hearings, as was the case here.
In 2010, Dynamo Holdings Limited Partnership refused the Service’s third request to extend the statute of limitations for assessing the partners’ tax liabilities for the tax years 2005 through 2007. Shortly after that refusal, the Service summoned several individuals associated with the partnership. None complied. The Service issued a Final Partnership Administrative Adjustment in December 2010, and Dynamo petitioned the Tax Court for readjustment two months later, in February 2011. Two months after that, the Service brought a summons-enforcement action in district court. In response, the taxpayer argued that the Service had two improper purposes, (i) punishing Dynamo for refusing to extend the statute of limitations and (ii) evading the Tax Court’s limitations on discovery. The district court found these defenses irrelevant and declined to conduct an evidentiary hearing. The Eleventh Circuit reversed, holding that the allegation of an improper purpose entitled the taxpayer to an evidentiary hearing.
In a unanimous opinion by Justice Kagan, the Supreme Court vacated the judgment of the Eleventh Circuit. The Court agreed with the Eleventh Circuit that a taxpayer is entitled to examine an IRS agent when the taxpayer “can point to specific facts or circumstances plausibly raising an inference of bad faith,” including circumstantial evidence, but concluded that “[n]aked allegations of improper purpose are not enough.” Because the Eleventh Circuit held that the mere allegation of improper motive entitled the taxpayer to an evidentiary hearing, the Court remanded the case for application of the new standard.
Lessons Learned and Best Practices
Clarke offers several lessons for taxpayers under audit. First, the Court left open the possibility that affidavits could establish the needed circumstantial evidence for an evidentiary hearing. Second, the Court left several possibilities open as improper purposes making summonses unenforceable. Third, the case demonstrates the need for taxpayers to document their interactions with the Service during an audit to establish their need for an evidentiary hearing.
The Court did not resolve the so-called Westreco question—whether the Service can summon information for use in Tax Court litigation once that litigation has begun. The Court deemed that question beyond the scope of the question presented by this case.
The Court’s opinion should also remind taxpayers of the importance of documenting their interactions with the Service. The opinion comes as the Service is establishing its new IDR enforcement process. That process, described in directive LB&I-04-0214-004 (Feb. 28, 2014), sets out specific deadlines and notice requirements for escalating an IDR to summons enforcement, including a delinquency notice (Letter 5077), a pre-summons letter (Letter 5078), and then a summons. Depending on the circumstances, the Service’s failure to follow these procedures could plausibly raise an inference of bad faith. For that reason—among others—taxpayers should consider establishing robust procedures for documenting their interactions with the Service, especially regarding requests for information.
