Procedure & Administration
The Supreme Court held that a taxpayer is entitled to question IRS officials about the reasons the IRS issued a summons only if the taxpayer points to specific facts and circumstances that plausibly raise an inference of bad faith on the part of the IRS.
Background
Suspicious about large interest expenses claimed in 2005 through 2007 by Dynamo Holdings Limited Partnership (Dynamo), the IRS initiated an examination of the partnership's returns for those years. As the investigation proceeded, Dynamo agreed to two yearlong extensions of the usual three-year limitation period for assessing tax liability. In 2010, with the second extension period drawing to a close, Dynamo refused to grant the IRS a third extension. Shortly afterward, the IRS issued summonses to four individuals associated with Dynamo (the taxpayers) who the IRS believed had information and records relevant to Dynamo's tax obligations. None of the taxpayers complied with the summonses. In December 2010 (still within the extended limitation period), the IRS issued a final partnership administrative adjustment proposing changes to Dynamo's returns that would result in greater tax liability. Dynamo filed a suit (which is currently pending) in February 2011 in Tax Court to challenge the adjustments. In April 2011, the IRS filed suit in district court to compel the taxpayers to comply with the summonses.
Those enforcement proceedings developed into a dispute about the IRS's reasons for issuing the summonses. The IRS submitted an affidavit from the Service's investigating agent stating that (1) the summonses met the factors from Powell , 379 U.S. 48 (1964), among other things; (2) the testimony and records sought were necessary to properly investigate the correctness of Dynamo's federal tax reporting; and (3) the summonses were not issued to harass or for any other improper purpose.
The taxpayers claimed the IRS had two ulterior motives for issuing the summonses: (1) to punish Dynamo for refusing to agree to a further extension of the applicable statute of limitation and (2) to evade the Tax Court's limitations on discovery and thus gain an unfair advantage in that litigation.
As evidence of the first motive, the taxpayers pointed out that although the IRS had not asked for information in its investigation for some time, it suddenly issued the summonses immediately after Dynamo refused to grant a third extension. As evidence of the second motive, the taxpayers introduced an affidavit of one of their attorneys, who reported that the attorneys handling the Tax Court case, and not the original investigating agents, were present at the interview of his client. In light of this evidence, the taxpayers asked for an opportunity to question the agents about their motives.
The district court denied that request and ordered the taxpayers to comply with the summonses, finding that they "ha[d] made no meaningful allegations of improper purpose" warranting examination of IRS agents and that their statute-of-limitation theory was mere conjecture. The district court further determined that the respondents' evasion-of-discovery-limits claim was incorrect as a matter of law because the validity of a summons is tested as of the date of issuance, not at the time of enforcement, and the Tax Court proceedings had not begun when the IRS issued the summonses.
The taxpayers appealed the district court's decision, and the Eleventh Circuit reversed, holding that the district court's refusal to allow the respondents to examine IRS agents constituted an abuse of discretion. The Eleventh Circuit found that its precedent dictated that simply making an allegation of improper purpose, even if the allegation lacked any factual support, entitled a taxpayer to question IRS officials concerning the IRS's reasons for issuing a summons.
However, every other appellate circuit that has addressed this issue has rejected the Eleventh Circuit's view. Therefore, the Supreme Court agreed to hear the case to resolve the conflict between the circuits.
The Supreme Court's Decision
The Supreme Court vacated the Eleventh Circuit's decision and remanded the case with specific instructions to the Eleventh Circuit on how it should determine whether the individuals were entitled to examine the IRS investigators. The Court explained that while an individual is entitled to contest a summons in an enforcement proceeding, these proceedings should be summary in nature and courts may ask only whether the IRS issued a summons in good faith. The Court further stated that under its precedent, absent contrary evidence, the IRS could satisfy the good-faith standard by submitting an affidavit from the investigating agent.
According to the Court, in the adversarial process concerning a summons's validity, the applicable rule is that "the taxpayer is entitled to examine an IRS agent when he can point to specific facts or circumstances plausibly raising an inference of bad faith." Under this rule, a taxpayer must offer some credible evidence of the IRS's improper purpose, not merely a naked allegation that the IRS had one. However, circumstantial evidence could be used to meet this burden because direct evidence of bad faith at that stage of the proceedings will rarely, if ever, be available. In addition, it is not necessary for the taxpayer to present a "fleshed out" case, and the taxpayer only needs to show facts that support a plausible inference of improper motive. The Court noted that following this standard would ensure that an inquiry was allowed where appropriate "without turning every summons dispute into a fishing expedition for official wrongdoing." Because the Eleventh Circuit had not even assessed what evidence it had before it regarding the taxpayers' allegations, it did not apply the standard.
On remand, the Court instructed the Eleventh Circuit in making its determination to consider the evidence submitted by the individuals in light of this standard. Observing that the correct standard of review in the case was abuse of discretion, the Court told the Eleventh Circuit that it must take into account the district court's broad discretion to determine whether the taxpayers had shown enough that they should be allowed to examine the IRS investigators. However, it gave two caveats to its general instruction. First, it stated that the district court's decision was entitled to deference only if was based on the correct legal standard. Second, the Court stated that the district court's latitude in making its decision did not extend to legal issues about what counts as an illicit motive. As an example, the Court pointed out that the question of when a summons's validity should be judged is a pure question of law, so if the question was raised again on remand, the Eleventh Circuit was not required to defer to the district court.
Reflections
While the standard for evaluating a summons requires some evidence of improper purpose to trigger a hearing, the Court gives lower courts considerable leeway to decide whether a taxpayer has met the standard and what evidence they can consider. If a taxpayer has a legitimate allegation of improper purpose, seemingly the taxpayer should be able to meet the standard if a court applies it properly.
Clarke, No. 13-301 (U.S. 6/19/14)
