Can the IRS Raise New Issues on the Eve of Trial?

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Irs Can Raise New Issues On The Eve Of Trial
Irs Can Raise New Issues On The Eve Of Trial

Life isn’t like a Hollywood movie. The good guy doesn’t always win. The underdog does not overcome insurmountable odds to prevail. The events do not culminate in a struggle that results in justice being done. And, worse yet, with time, it isn’t even clear who the good guy is or what justice really means. With hindsight, it just is–not good or bad. It just is.

This is an apt description of the litigation process. It continues on. Case after case. Year after year. The people change. Different judges, different attorneys, different parties. But it is all the same. That is by design given the judicial process. A process that is as flawed as the humans that created it and those that function within it and that are subject to it.

It is in this process, this judicial process, that concepts of justice and fairness are portrayed in the movies. Outside of the movies, these are not concepts that are argued in trial courts. The focus is on moving cases through the process, and living with the idiosyncratic results that it produces.

This brings us to the Ax v. Commissioner, 146 T.C. 10 (2016) case. This is a case that addresses the question as to whether the IRS raise new arguments against taxpayers on the eve of trial.

Facts & Procedural History

The taxpayers in this case formed a captive insurance company and deducted the insurance premiums they paid. The IRS disallowed these deductions, stating in the notice of deficiency: “You did not establish that the amount shown was (a) insurance expense, and (b) paid.”

The taxpayers petitioned the U.S. Tax Court to dispute the notice of deficiency. The IRS filed an answer that did not make any affirmative allegations regarding the disallowed insurance expense deductions. However, after the case was stricken from a trial calendar and continued generally, the IRS moved for leave to amend its answer to add new arguments.

Understanding Captive Insurance

Before getting into the procedural issue in this case, let’s pause and consider captive insurance.

Captive insurance is an arrangement where a business creates its own insurance company to insure its own risks. The captive insurance company is typically owned and controlled by the business or its owners. The business pays premiums to the captive insurer, which in turn provides insurance coverage to the business.

The primary benefits of captive insurance include cost savings, customized coverage, and potential tax advantages. By insuring through a captive, businesses can avoid the overhead and profit margins of traditional insurance companies. Captives also allow businesses to tailor coverage to their specific needs and potentially deduct the premiums paid as business expenses. This is why the IRS hates captive insurance companies. They can be a great way to save on taxes.

The IRS has long been skeptical of captive insurance arrangements, particularly those involving small or closely-held businesses. The IRS often challenges the validity of these arrangements, questioning whether they constitute genuine insurance and whether the premiums paid are deductible.

Tax Court Rules & Mayo Foundation Case

With that background, let’s get back to the procedural issue in this case.

The tax court has specific rules governing the amendment of pleadings, such as petitions and answers. Generally, the court will freely grant leave to amend a pleading once, as a matter of course. However, subsequent amendments are more difficult to obtain and are subject to the court’s discretion, particularly if the request is made late in the litigation process.

In Mayo Foundation for Med. & Educ. Research v. United States, the U.S. Supreme Court addressed the issue of judicial deference to administrative agencies’ interpretations of their own regulations. The taxpayers in the current case relied on this case to argue that the IRS should not be allowed to raise new grounds beyond those stated in the notice of deficiency.

The taxpayers argued that under the Administrative Procedure Act and the Supreme Court’s decision in SEC v. Chenery Corp., the IRS could not raise new grounds to support its position beyond those originally stated in the notice of deficiency. This argument is based on the principle that an agency’s action must be judged solely on the grounds invoked by the agency at the time of the action, not on post hoc rationalizations.

The “Surprise” Factor in Amending Pleadings

In addition to the general principles governing the amendment of pleadings, the U.S. Tax Court Rules of Practice and Procedure specifically address the issue of “surprise” in Rule 41(a). This rule states that leave to amend “shall be given freely when justice so requires.” However, the court may deny a motion for leave to amend if the amendment would result in “surprise” to the opposing party.

In the context of tax litigation, “surprise” typically refers to a situation where the opposing party is confronted with new issues or arguments that they could not have reasonably anticipated based on the original pleadings. The purpose of this rule is to ensure that all parties have a fair opportunity to prepare their cases and are not unfairly disadvantaged by last-minute changes to the scope of the litigation.

In this case the taxpayers could have argued that the IRS’s proposed amendments, which introduced new arguments challenging the economic substance of the captive insurance arrangement and the ordinary and necessary nature of the premium payments, constituted “surprise” under Rule 41(a). These new arguments went beyond the original grounds for disallowance stated in the notice of deficiency, which focused on whether the payments qualified as insurance expenses and whether they were actually paid.

However, the court’s opinion does not indicate whether the taxpayers raised the issue of “surprise” in their opposition to the IRS’s motion for leave to amend. The court’s analysis focused primarily on the broader question of whether the IRS is bound by the grounds stated in the notice of deficiency under the Administrative Procedure Act and the Chenery doctrine.

The IRS Can Raise New Issues

The tax court acknowledged the principles set forth in Chenery but noted that they apply only to matters that Congress has exclusively entrusted to administrative agencies. In contrast, Congress has expressly authorized the tax court to redetermine tax liabilities in deficiency cases under Sections 6212 and 6213 of the tax code.

The court emphasized that the enactment of the Administrative Procedure Act did not alter the long-standing regime for deficiency litigation in the tax court. Consequently, the court held that in a deficiency case, where the taxpayer asks the court to determine their tax liability, the IRS may raise grounds not stated in the notice of deficiency. The court found this consistent with the uniform approach to judicial review of administrative action called for in Mayo Foundation.

The Tax Court’s Unique Role as a Prepayment Forum

To fully understand the implications of this court case, it’s important to consider the unique role of the tax court in the federal tax system. Unlike most other courts, the tax court is a prepayment forum, meaning that taxpayers can petition the court to challenge an IRS deficiency determination before they have to pay the disputed tax.

The tax court’s prepayment jurisdiction is intended to provide taxpayers with a remedy against erroneous or unfair IRS assessments without forcing them to first pay the tax and then sue for a refund in federal district court or the court of federal claims. This is a critical protection for taxpayers, as it allows them to contest the IRS’s determinations without having to bear the financial burden of paying the disputed tax upfront.

However, the IRS’s ability to raise new issues late in the tax court litigation process arguably undermines this taxpayer protection. When the IRS introduces new arguments or theories for the disallowance of deductions or the imposition of tax that were not included in the original notice of deficiency, it forces the taxpayer to defend against these new issues without the benefit of the prepayment forum.

In essence, the taxpayer is put in a position where they may have to choose between continuing to litigate the case in tax court, with the added complexity and expense of addressing the new issues, or paying the tax and pursuing a refund claim in another court. This choice can be particularly difficult for taxpayers with limited resources, as the cost of litigating new issues in tax court may be prohibitive.

The tax court’s prepayment jurisdiction is meant to level the playing field between taxpayers and the IRS, giving taxpayers a meaningful opportunity to challenge the IRS’s determinations before facing the financial consequences of an assessment. When the IRS is allowed to introduce new issues late in the tax court litigation process, it tilts that playing field back in favor of the government, potentially depriving taxpayers of the full benefit of the prepayment forum.

The Takeaway

This case confirms that the IRS is not limited to the arguments raised in its notice of deficiency or its original answer in a tax court deficiency case. Despite the Administrative Procedure Act and the principles articulated in Chenery, the IRS can raise new arguments for the first time in these proceedings.

This holding highlights the importance of thorough trial preparation and the potential for unexpected twists in tax litigation. Taxpayers must be prepared to address not only the issues raised in the notice of deficiency but also any new arguments the IRS may raise as the case progresses.

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