Tax Court Jurisdiction: What, When and Which

 PART I: WHAT

This is the first in a three-part series on Tax Court jurisdiction addressing what, when and which jurisdiction the Court has. Recent cases have made all three of these aspects somewhat murky. This part discusses “what” jurisdiction Tax Court has.

Fifty years ago, the Tax Court’s jurisdiction was simple. If IRS determined a “deficiency,” IRS issued a notice of deficiency. If the taxpayer filed a petition within 90 days, the Tax Court acquired jurisdiction over the tax periods in the notice of deficiency to determine any additional tax or refund due. That was essentially it.

In the past 50 years, however, the Tax Court has acquired jurisdiction over a variety of additional issues. These can generally be grouped as follows:

1.  Declaratory judgment actions concerning retirement plan qualification (§7476 in 1974), exempt organization qualification (§7428 in 1976), tax exemptions for governmental obligations (§7478 in 1978), employee / independent contractor determinations (§7436 in 1997), estate tax installment agreement determinations (§7479 in 1997), and gift tax valuation determinations (§7477 in 1997).

2.  Partnership determinations for TEFRA partnerships (§6226 & 6228 in 1982), oversheltered tax returns (§6234 in 2002), and BBA partnerships (§6234 in 2015).

3.  Collection-related determinations for collection due process (§6320 & 6330 in 1998),
“stand-alone” innocent spouse issues (§6015 in 1998), and passport certification (§7345 in 2015).

4.  Miscellaneous determinations involving public disclosure of rulings (§6110 in 1976), interest abatement (§6404 in 1996), and whistleblower awards (§7623 in 1976).

Even though the statutory jurisdiction expanded to different subjects, the common requirement giving rise to the Court’s jurisdiction remained the same, a statutory notice of a determination. For each of the above types of jurisdiction, a notice making a determination authorized by statute was required.

Notwithstanding the seeming simplicity of this jurisdictional requirement, however, the Tax Court recently rejected jurisdiction over a notice squarely within the literal statutory grant of Tax Court jurisdiction. Our case of Jenner v. Commissioner, 163 T.C. ____ (No. 7) (2024), presented a slightly different twist on the Tax Court’s statutory jurisdiction. Jenner involved an FBAR penalty under Title 31, not Title 26 (the Internal Revenue Code). FBAR penalties are under the jurisdiction of the Treasury, but only certain audit and appeal functions have been delegated to the IRS. The IRS Appeals Office terminated the Jenners’ appeal contesting the FBAR penalties prematurely, and the FBAR penalties were assessed after expiration of the statute of limitations.

The “Secretary” (of the Treasury) issued a notice that the Secretary intended to levy the Jenners’ Social Security benefits to collect the (unlawfully assessed) FBAR penalties. In general, collection activities related to FBAR penalties have not been delegated to the IRS. The Jenners filed a timely request for a collection due process (CDP) hearing under I.R.C. §6330(b), which applies when the “Secretary” informs a taxpayer of the intent to levy. The Secretary issued a notice rejecting the Jenners’ right to a CDP appeal and the Jenners filed a timely petition for Tax Court review under I.R.C. §6330(d).

In spite of the fact that the Secretary issued a notice of intent to levy and then a notice rejecting the Jenners’ CDP appeal, the Tax Court refused to accept jurisdiction and consider the Secretary’s decision to levy. The Court did not quibble with the form of the statutory notice but found that a notice of intent to levy by the “Secretary”  was not what the statute meant, even though that is what the statute says. The Court inferred a limitation to IRS levies by the Secretary for tax amounts due under the Internal Revenue Code. Therefore, the Court concluded it lacked jurisdiction over the Secretary’s notice rejecting the Jenners’ CDP appeal of Title 31 FBAR penalties, thereby allowing the Secretary to proceed with the Social Security levies.

Even though Tax Court jurisdiction can no longer be considered as limited or as clear as it was 50 years ago, the “what” component of that jurisdiction seems like the simplest. As Jenner illustrates, however, even an express grant of jurisdiction in the statute may not prevent the Tax Court from clinging to its historical self-imposed restrictions on its “jurisdiction,” at least in instances in which the Court does not want to get involved.

- Steve Mather

Is the Suspense (Account) Over?

         Determining a partner’s basis in a partnership is a requirement that has existed since partnership tax rules were implemented. As a result, many would not expect it to be an area open to novel litigation. However, our recent case, Surk, LLC v. Commissioner, T.C. Memo. 2024-99, has shed a new light, or at least a new Tax Court interpretation, on this issue.

         Section 704(d) only allows a partner to take losses to the extent of their “outside” basis in the partnership. Surk held an interest in a partnership (the “Partnership”). Due to a computational error, Surk claimed losses from the Partnership in excess of Surk’s outside basis in the Partnership. IRS audited Surk in the year the excess losses were claimed but did not adjust these excess losses. As a result, the losses in excess of basis remained claimed and not disallowed. Based on the literal language of §705(a)(2), however, Surk’s basis in the Partnership could not be reduced below zero, so Surk argued a zero basis (not a “negative basis”) carried over to the next year.

         In a later year, the IRS sought to correct their slip-up and attempted to reduce Surk’s outside basis in the Partnership to account for the prior excess losses. IRS initially argued that the earlier losses in excess of basis did not create negative basis but were captured in a “suspense account” until they could be offset in later years when there were increases in basis. This “suspense account” concept had appeared previously in partnership treatises and been used by IRS, but it had never been subject to serious litigation, and for good reason. As this case progressed, it became apparent there was little support in the Code for the “suspense account” concept.

         Realizing this lack of support, IRS changed course for the first time in IRS’s opening brief. IRS completely abandoned the suspense account argument and presented an entirely new theory. IRS argued that a partner’s outside basis was in fact a cumulative calculation going back to the partnership’s very formation. IRS did not dispute or disallow the losses claimed in excess of basis in the prior year, but instead argued that those losses needed to be taken into account in a cumulative calculation in a later year by reducing basis. We argued the basis computation was a sequential annual computation. Since §705(a)(2) clearly precludes reducing basis below zero, we argued the prior year error could not be corrected after expiration of the statute of limitations for the year in which the error occurred.

The Tax Court agreed with IRS and stated that this new IRS position was consistent with the basis calculation rules of §705(a). The Tax Court reasoned that §705(a) was not implicated because the cumulative computation did not result in negative basis in the year before the Court. The Tax Court further stated that not accounting for these prior year excess losses would allow Surk to receive a tax benefit in excess of Surk’s investment in the Partnership.

         Because Surk had more than enough basis in the year at issue, there was no actual tax consequence in our case. Still, this ruling may have large practical effects. IRS seems to have no desire to pursue the “suspense account” concept any longer. Instead, the new IRS position adopted by the Tax Court allows IRS to adjust a partner’s outside basis all the way back to the partnership’s formation. The statute of limitations is never closed on an issue to the extent it involves computation of a partner’s outside basis. IRS now seems to be able to make taxpayers account for prior year excess losses (and potentially verify every other cumulative component of the basis computation) in later open years. Only time will tell how successful IRS will be.  

— James and Steven Mather

WHAT WILL IRS DO WITH LOPER BRIGHT?

The Supreme Court recently turned the regulatory world on its head in Loper Bright Enterprises v. Raimondo,144 S.Ct. 2244 (2024). The Court rejected the “Chevron deference” standard that the courts had applied to agency regulations (including Treasury Regulations) for the past 40 years. See, Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc.  467 U.S. 837 (1984).  Instead of being forced to adopt any reasonable IRS interpretation in a Treasury Regulation, Loper Bright now requires the courts to decide if a regulation correctly implements the statute. IRS has relied heavily on Chevron deference over the years. The question is how will IRS address Loper Bright?

 We have a pending case that provides some insight into this question. The Tax Court issued an opinion on our case, basing its opinion on a prior Chevron deference case. We filed a motion for reconsideration based on the intervening Loper Bright ruling.

 The IRS response was illuminating. IRS first argued that Loper Bright changed nothing in our case because IRS was not relying solely on a Treasury Regulation, but rather on a case that adopted the regulation under Chevron. IRS argued that the Tax Court’s judicial precedent should be honored even though the result in the prior case was dictated by Chevron. IRS quoted Loper Bright that prior cases are “still subject to statutory stare decisis despite [the Court’s] change in interpretive methodology,” 144 S.Ct. at 2273.

 The Supreme Court in Loper Bright, however, made clear that weight should be given to prior precedent only based on the quality of its analysis. 144 S.Ct. at 2270.  As in our case, there are many prior cases that evaluated regulations under Chevron by explicitly declining to do any interpretive work beyond determining if the regulation was a reasonable implementation of the statute. Since the standard is no longer reasonableness, little of value is left in these cases for stare decisis now that Chevron deference is gone.

 IRS next seemed to harken back to the popular characterization of Treasury Regulations summarized in Rogovin, “The Four Rs: Regulations, Rulings, Reliance and Retroactivity: A View from Within.” (49 CCH Federal Tax Guide Reports No.8 (1965)). This analysis broke Treasury Regulations down into three categories with differing degrees of judicial deference: legislative regulations, interpretative regulations and procedural regulations.

 IRS argued in our case that if a regulation was a legislative regulation (i.e., there was an express delegation to IRS to enact regulations to flesh out the statute), Loper Bright really doesn’t change anything. IRS focused particularly on this quote discussing express statutory delegation of authority: “When the best reading of a statute is that it delegates discretionary authority to an agency, the role of the reviewing court under the APA is, as always, to independently interpret the statute and effectuate the will of Congress subject to constitutional limits … , and ensuring the agency has engaged in  ‘reasoned decisionmaking’  within those boundaries,” Loper Bright, 144 S.Ct. at 2263.

 While this may suggest some deference to an agency interpretation when there has been an express delegation, it is important to note the Supreme Court also specifies that the courts should always independently review and interpret the statute before deferring. IRS asked for more time to respond in our case to coordinate with National Office on the positions taken. It is therefore likely that IRS will persist with this position. This argument will inevitably lead to IRS grasping at straws to find express delegations of regulatory authority, often (as in our case) when none exists.

 Ultimately, based on what we have seen from IRS so far, IRS has made a weak argument that cases that deferred to agency interpretations and explicitly declined to independently interpret statutes based on Chevron are useful precedent.  Loper Bright clearly requires independent judicial analysis of legislative intent, both for the case at issue and for any precedent upon which IRS seeks to rely.

 IRS’s attempt to revive the old “legislative regulation” deference is similarly unconvincing. In the new Loper Bright world, judges (not IRS) decide if a regulation validly enacts the legislative purpose. As is stated in the Supreme Court’s main gripe regarding Chevron, “Chevron does not prevent judges from making policy. It prevents them from judging.” 144 S.Ct. at 2267.

—James and Steven Mather

AGAIN, IT'S BETTER TO LOSE by C. David Anderson

Here is another illustration that taxes are so complicated that it’s hard to understand whether it’s better to win or lose until you do the numbers carefully.

A client had a massive operating loss in the 2008/9 Great Recession and got a large refund by carrying the losses back to profitable 2004/5 years.  This carryback refund got pulled into the IRS special examination program for wealthy taxpayers.

The IRS decided that the client acted more like a passive investor in the business, not like an active manager.  As a result, the losses were “passive losses,” which can only be carried forward, not backward.  Therefore, the refund from the carryback to earlier years had to be repaid.

We thought that the client was in fact quite active in the business, but a lack of email records made this hard to prove to the examiners.  We wound up having to take our argument for a carryback refund to Appeals.   

While in Appeals, we started to think hard about what would happen if we lost the case, besides having to repay the carryback refund.  The natural reaction was to fight the immediate tax from surrendering the carryback refund. 

The main effect of conceding that the losses were passive, however, was that the losses were still allowed but could only be carried forward to later years, and that the losses could only be used against future passive income.  This need for future passive income was a potential problem, because we still thought the client was an active investor. 

By digging deeper and doing the numbers, we realized that the client would actually be far better off if he could use the carried-over passive losses in the future years!  This is because the tax rate in the carryback years, 2004/5, was around 35%, while the tax rate in the future years, after 2010, was more like 43%.  Therefore, the savings from claiming the active loss carryback was quite a bit less than the benefit of carrying the losses forward to the again-profitable years after the Great Recession.  An additional benefit was that California freely allows carryovers of passive losses but restricts carryovers of active losses.

Now the worry was that the IRS might change its position in the later years and argue that the client was actually “active” – so that future income was active and couldn’t be offset by carried-forward passive losses.  The IRS is certainly capable of taking whichever side of the active/passive issue that maximizes the tax at the time.  Hmmm.

We decided this risk was worth taking, since the client actually became less active once the business no longer faced the insolvency risks of the recession years.  Also, we believed that, once the IRS reached a formal finding that the client was a passive investor, it would continue to follow this position as long as the facts didn’t show greater activity in the later years.

Bottom line – we realized that we could concede the audit disallowances in Appeals and be way ahead.

Takeaway – tax calculations are so complicated that sometimes it is hard to tell if you are winning or losing.  Dig deeper to determine all of the consequences of an IRS determination.  Get out your spreadsheets!

TAX COURT "WHACK-A-MOLE" by Steve Mather

         It can be a good move strategically to force an audit to a conclusion to get IRS’s position established in the notice of deficiency (“NOD”). Pursuant to I.R.C. §6212(a), an NOD is only authorized if IRS “determines” a deficiency.

         The vast majority of contested NODs are petitioned to Tax Court.  The reasons for the IRS determination are beyond the scope of Tax Court’s review. Greenberg’s Express v. Commissioner, 62 T.C. 324 (1974). The Court will not “go behind” the NOD to determine the reasons the notice was issued even if IRS issued multiple self-contradictory notices. Bedrosian v. Commissioner, 940 F.3d 467, 473 (9th Cir. 2019). The NOD therefore determines the issues in the Tax Court case before the case is filed.

         The typical “reward” that IRS receives for clearly determining a deficiency is that the burden of proof in the Tax Court proceeding is generally imposed on the taxpayer for those determinations. Tax Court Rule 142. When IRS wants to increase the deficiency or raise a new issue that requires different evidence, however, the new issue is considered to be a “new matter.” Shea v. Commissioner, 112 T.C. 183, 191 (1999). IRS assumes the burden of proof on any new matter IRS raises. Tax Court Rule 142. For new matters on which IRS has the burden of proof, IRS must seek to file an amended answer and affirmatively plead “a clear and concise statement of every ground, together with the facts in support thereof on which [IRS] relies.” Tax Court Rules 36(b), 41(a).

         In several recent cases, IRS tried to change positions shortly before trial. This change of position occurred during trial preparation when IRS Counsel apparently felt there was a “better” position than the position taken in the NOD.  Examples include:  (1) IRS asserting for the first time in the pretrial memo that the real issue in the case was a change of accounting method from accrual to cash rather than the taxpayer’s eligibility to use the cash method in the first place as determined in the NOD; (2) IRS arguing for the first time in the pretrial memo that the challenge to the character of an amount as debt in the NOD should be expanded to include whether the debt was worthless; and (3) IRS seeking leave to amend its answer two months before trial to raise a profit motive issue not stated in the NOD.

These attempted changes must be resisted at the first instance. Otherwise, Tax Court is likely to allow the new position to be tried and briefed. The Court will typically find that the taxpayer consented to try the new issue and will allow IRS to later conform the pleadings to the proof, if need be. Tax Court Rule 41(b). Often the taxpayer may be unaware of this “implied consent.”

         In the three examples above, IRS Counsel felt entitled to raise the new issue whenever IRS wanted. The Court allowed the new position in the accounting method case, but refused to let IRS to raise the new issue in the other two cases.  Even after the Court rejected IRS’s effort to raise the new issue in the latter two cases, however, IRS tried again after trial, ultimately without success.

         Committing IRS to a position in the NOD is a useful strategy. Immediate and emphatic objection is required to avoid letting IRS push up a new “mole” once the original position has been “whacked,” however.

IT'S BETTER TO LOSE by C. David Anderson

Shortly after Reagan’s 1981 ERTA tax cuts, a major client asked if I could help with a troubled tax project. 

The client was working with a real estate tax specialist firm to see if a three-cornered like-kind exchange could be arranged for him.  The problem was that this was then a technically unsettled issue, and the legal bill had ballooned to well over $100k in today’s dollars – still with no certain answer.

I had recently joined the planning committee for the USC Tax Institute, which gave me an opportunity to ask the committee – all distinguished senior practitioners – a question which bothered me:  Just how good were the tax planning moves which were our bread and butter?  Were tax free reorganizations and like-kind exchanges really that good financially for taxpayers?

Surprisingly, everyone, including the accountants, said they hadn’t really done the analysis.  They just relied on the taxpayer-attractive idea that paying tax later is better.  The committee talked me into writing an article for the Institute on the “quantitative dimension” of tax planning.

Writing the presentation caused me to realize that ERTA’s combination of faster depreciation and lower capital gain rates had stood real estate tax deferral on its head.  The new faster depreciation meant that the tax benefit of the depreciation after a taxable sale was greater than the new lower capital gain paid up front to get the additional depreciable basis.  So, after ERTA, real estate tax deferral was bad!

Armed with this insight, I gave the client a simple spreadsheet present value calculation which showed that the client would be better off if the three-cornered exchange failed.  If it did fail, he would pay a capital gain tax up front which was smaller than the value of the resulting increased depreciation deductions against future ordinary income.

The client agreed to shut down the expensive tax analysis and just finish the exchange, which was well along.  My strategy, if the transaction was audited, was to ask IRS to please disqualify the exchange, let us pay tax on the gain, but then to give us a refund for the increased depreciation deductions in the later years under audit.  

The specialty tax firm’s partner was incredulous – this turned-on-its-head result was a shock – but the client was delighted.

ARE THE MATERIAL PARTICIPATION REGS INVALID? by Steve Mather

Steve’s recent case of Rogerson v. Commissioner, T.C. Memo. 2002-49, raises an interesting question. Activities are classified as passive or nonpassive based on whether the taxpayer meets the “material participation” standard in I.R.C. §469(h). IRS for decades has relied on “temporary” regulations to apply this material participation standard. The opinion in Rogerson suggests these regulations are no longer valid.

         As added to the Code in 1986, the definition of material participation is: 

         (h) MATERIAL PARTICIPATION DEFINED, -- For purposes of

              this section –

                  (1) IN GENERAL – A taxpayer shall be treated as

                       materially participating in an activity only if the

                       taxpayer is involved in the operations of the activity on

                       a basis which is –

                       (A)         regular,

                       (B)         continuous, and

                       (C)         substantial

100 Stat. 2237, reprinted at 1986-3 C.B. (Vol. I) 154. 

         Treasury Regulations are generally acknowledged as the appropriate exercise of respondent’s authority to administer the Internal Revenue Code. Bittiker & Lokken, Federal Taxation of Income, Estates and Gifts, ¶110.5; I.R.C. §7805(a). In fact, I.R.C. §469(k) as originally enacted in 1986 specifically delegated the authority to IRS to “. . .prescribe such regulations as may be necessary or appropriate to carryout the provisions of this [passive activity] section. . .” 100 Stat. 2240, reprinted at 1986-3 C.B. (Vol. I) 157.  

         The material participation regulations were enacted as temporary regulations in February 1988. T.D. 8175. The assumed benefit of a temporary tax regulation was it could be issued without complying with the notice and comment process required for regulations generally under the Administrative Procedure Act (APA). 

         This belief in the “tax exceptionalism” of temporary tax regulations was rejected by the Supreme Court in Mayo Foundation for Medical Research v. United States, 562 U.S. 44 (2011).  Mayo ultimately upheld the Treasury Regulation at issue because it had been promulgated following notice and comment procedures. See, Hickman, “Unpacking the Force of Law,” 66 Vand. L. Rev. 465, 502 (2013).

         More recent authorities go even further. Recent case law and commentary asserts that temporary regulations are entirely invalid without a notice and comment process. Chamber of Commerce of the U.S. v. IRS, 120 AFTR 2d 2017-5967 (W.D. Tex. 2017). See also, Salzman & Book, IRS Practice and Procedure, at ¶3.02(3)(d).

          Congress also limited the life of temporary regulations issued after November 20, 1988 by causing them to expire within three years of enactment. I.R.C. §7805(e); Pub. L. 100-647 §6232(b).

         The material participation temporary regulations pre-date the Congressional sunset provision but are nevertheless of questionable effect after Mayo because they were issued without notice and comment. The Tax Court showed this concern in Rogerson. The Court acknowledged the doubtful status of the material participation regulations and (sort of) refused to apply them. The Court nevertheless ruled against Rogerson, holding the concepts underlying the regulations were consistent with the statutory material participation definition so it did not matter if the regulations were valid.

         We have appealed Rogerson to the Ninth Circuit and will challenge the Tax Court’s tacit use of these otherwise invalid regulations. More to come.