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Davison v. Commissioner (T.C. Memo. 2020-58)

On May 14, 2020, the Tax Court issued a Memorandum Opinion in the case of Davison v. Commissioner (T.C. Memo. 2020-58). The primary issue before the court in Davison was whether petitioner is liable for a penalty under IRC § 6700 (promoting abusive tax shelters, etc.) for consistently promoting a tax avoidance scheme that everyone and their mother told him (and that he objectively knew himself) to be contrary to the law. (This case is the companion case (tried together) of Lemay v. Commissioner, T.C. Memo. 2020-59, and, as in Lemay, the Tax Court found, without great difficulty, that the petitioner was liable for penalties under IRC § 6700.)

Brief(ish) Background to a Not-So-Brief Opinion

The petitioner was a lawyer and a CPA. For 11 years, the petitioner served as the “key legal and tax planning advisor” to Cash Management Systems, Inc. (CMS), whose entire purpose was to promote and operate “tool plans.” CMS designed its “tool plans” to allow both employers and employees to claim substantial tax savings by bifurcating an employee’s base pay into a taxable labor portion and a nontaxable portion for tool reimbursement or use. This bifurcation was based upon a proprietary formula. CMS promised the avoidance of Federal income tax withholding, employment taxes, or both, depending on the tool plan.

At the inception of the “tool plan” plan, the petitioner sought advice from a partner in his firm (Grant Thornton), who advised vehemently against their use and indicated that the IRS believed that the tool use plan lacked economic substance, that there was limited legal authority supporting tool reimbursement plans generally, and that the IRS had an interest in litigating against taxpayers promoting tool reimbursement plans such as those proposed by CMS.

Not dissuaded, the petitioner drafted a “justification paper” under the imprimatur of Grant Thornton and under the thumb of the petitioner’s partner, who directed what was included in the paper itself. (In fairness to Grant Thornton, when they found out about the paper 10 years later, they quickly “disavowed” it.) The executive summary of the paper concluded that the “reimbursement plan for the cost of the employee’s tools qualifies as an accountable plan under IRC § 62(a)(2)(A)” and that “there is a long line of authority leading to the conclusion that the usage payments under CMS’s plan should be treated as other income not subject to the self-employment tax.”

Under IRC § 62(a)(2)(A), an employee can deduct certain business expenses incurred in connection with the performance of services for an employer under a reimbursement or other expense allowance arrangement. If these expenses are reimbursed by the employer pursuant to an “accountable plan,” then the reimbursed amount is excluded from gross income and is not considered wages or other compensation and are, therefore, exempt from withholding and payment of employment taxes. Treas. Reg. § 1.62-2(c)(4).

For whatever reason, the petitioner and CMS sought the opinion of top law and accounting firms (KPMG and McDermott Will & Emery (twice) to name a few), which all summarily rejected the arguments in the justification letter. Nonetheless, CMS proceeded full speed ahead until 2008 when the dam burst and the IRS issued a coordinated paper concluding that tool plans failed to meet the accountable plan requirements. CMS’s goose was close to being fully cooked by the time that its clients began to be audited in 2008. When all was said and done, 24 clients were audited with the total resulting tax due of $4.6m (exclusive of penalties and interest).

Ultimately, the petitioner was asked politely (read: ordered) by a federal district court to stop promoting tax advice, because, it turns out, that the advice he had been giving was, to use the court’s words, “false” and “fraudulent.” With his CPA license revoked, the petitioner was ordered to provide a copy of the order to every client he had even mentioned taxes to within the last five years.

He neither provided the order to clients, nor did he even mention the whole misunderstanding to CMS, who continued keeping on keeping on with promotion of their tool plans. An audit commenced, and after much back and forth between petitioner and the IRS, a notice of determination sustained the proposed levy with respect to penalties against the petitioner under IRC § 6700 (promoting abusive tax shelters, etc.).

Challenging Promoter Penalties

IRC § 6700 penalties are not subject to deficiency procedures. IRC § 6703(b). The Tax Court has jurisdiction to review the IRS’s determination when the underlying tax liability stems from IRC § 6700 penalties. Gardner v. Commissioner, 145 T.C. 161, 174 (2015), aff’d, 704 F. App’x 720 (9th Cir. 2017). The burden of proof of the taxpayer’s liability for IRC § 6700 penalties lies with the IRS under the “preponderance of evidence” standard pursuant to IRC § 6703(a). Id.; United States v. Hartshorn, 751 F.3d 1194, 1198 (10th Cir. 2014); United States v. Estate Pres. Servs., 202 F.3d 1093, 1098 (9th Cir. 2000); Barr v. United States, 67 F.3d 469, 469 (11th Cir. 1995).

To satisfy the burden of proof with respect to IRC § 6700, the IRS must prove by a preponderance of the evidence that the petitioner: (1) organized (or assisted in the organization of) or participated (directly or indirectly) in the sale of an interest in an investment plan or arrangement, or any other plan or arrangement and (2) made material “statements concerning the tax benefits” to be derived from that plan or arrangement that petitioner knew or had reason to know were false. See IRC § 6700(a).

For purposes of IRC § 6700, “statements concerning the tax benefits” means a statement with respect to the allowability of any deduction or credit, the excludability of any income, or the securing of any other tax benefit by reason of holding an interest in the entity or participating in the plan or arrangement. IRC § 6700(a)(2)(A). Neither the Code nor the Treasury Regulations define the terms “plan or arrangement,” and so the Tax Court turned to caselaw on the subject.

A “plan or arrangement” under IRC § 6700 should be defined broadly, and that the “sale of a plan or arrangement” component of IRC § 6700 is satisfied simply by selling an illegal method by which to avoid paying taxes. See United States v. Stover, 650 F.3d 1099, 1107 (8th Cir. 2011); United States v. Benson, 561 F.3d 718, 722 (7th Cir. 2009). Any plan or arrangement having some connection to taxes can serve as a “tax shelter” and will be “abusive” if the promoter makes requisite false or fraudulent statements concerning the tax benefits of participation. United States v. Raymond, 228 F.3d 804, 811 (7th Cir. 2000). Importantly, simply marketing such plans or arrangements is considered participation in the “sale” of an abusive tax shelter. Id.; see also United States v. Kaun, 827 F.2d 1144, 1149-50 (7th Cir. 1987). In short order, the Tax Court found that the petitioner and CMS administered a multistep benefits program, which constituted a “plan or arrangement,” the primary purpose of which was the reduction of Federal income and employment taxes. See Kaun, 827 F.2d at 1144, 1149-50.

The IRC § 6700 penalty applies when the organizer (or adviser thereto) or seller (or adviser thereto) of a subject plan makes or causes to be made any statement with respect to tax benefits arising from participation in such a plan that is material and that he knows or has reason to know is false. See IRC § 6700(a). Statements covered by IRC § 6700 include factual matters that are relevant to the availability of tax benefits and those directly addressing the availability of tax benefits. See Stover, 650 F.3d at 1108; United States v. Gleason, 432 F.3d 678, 683-84 (6th Cir. 2005). Whether the promoter’s statements were “knowingly false” is evaluated through an objective “reasonable person” standard. United States v. Campbell, 897 F.2d 1317, 1321-22 (5th Cir. 1990).*

*Author’s Note: In addition to the “reasonable person” standard, the Tax Court applied the “you’ve got to be kidding me” standard, through which disbelief is suspended until, like a rubber band stretched past its tensile integrity, the Tax Court snaps. Though not “recognized” by any actual court, this extension of the reasonable person standard, colloquially known as the “f*cking duh” standard, is quite useful and should be employed with far more regularity.

False statements under IRC § 6700 include representations that a plan qualifies for special tax treatment when, in fact, the plan does not even remotely comply with the law. See Koresko v. United States, 123 F. Supp. 3d 654, 682-89 (E.D. Pa. 2015). Further, statements are false when promoters fail to qualify assertions about the availability of tax benefits and notify clients that following the statements could subject them to IRS scrutiny. See Stover, 650 F.3d at 1109-1110. Courts have repeatedly held that a tax promoter’s failure to advise his clients of the requirements to qualify for a tax benefit qualifies as a false statement. See Gleason, 432 F.3d at 682, 683; Pres. Servs., 202 F.3d at 1101.

Ultimately, Counsel did not have to work too hard on actually litigating the matter. The legwork was done by Appeals in gathering the rather substantial record, each element of which further sunk the petitioner into the morass (of his own making) of IRC § 6700. Having said that, neither did Counsel drop the ball at any point, which is a distinct risk when a case is served up so nicely on a silver platter as this one was. Kudos, Counsel.

Original opinion: (T.C. Memo. 2020-58) Davison v. Commissioner

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