Justice is not a word that is often mentioned in tax cases. While justice may be handed out in the opinions, the term “justice” isn’t usually expressly stated in the opinion or in the rules that the courts go by. There are exceptions.
One exception is in the rules that allow IRS attorneys to raise new issues for the first time in litigation in U.S. Tax Court cases. The only limitation on the court granting these requests is a reference to “justice.” The rule says that the court is to freely grant these requests if justice requires it. The term “justice” is cited for the court routinely granting these requests by the IRS.
Taxpayers may wonder how the IRS can have several years to conduct audits and administrative appeals only to then have the court cite “justice” as the rationale for the IRS being able to raise new issues in court for the first time. To many taxpayers, this type of last-minute surprise is the opposite of justice.
The Furrow v. Commissioner, T.C. Memo. 2022-100, case provides an opportunity to consider this situation. The case is an example of the taxpayer who was worse off for choosing to exercise their right to a day in court as they chose to litigate their case in the U.S. Tax Court rather than the U.S. District Court.
Facts & Procedural History
The taxpayers are farmers. They contributed crops to a Charitable Remainder Trust (“CRT”). The taxpayers deducted the costs to grow the crops on their tax return.
The CRT sold the crops, tax-free, purchased an annuity, and distributed a portion of the annuity payments to the taxpayers. The distributions included a small amount of interest and the balance was annuity payments.
The CRT distributed a portion of the sales proceeds to the non-profit entities that were the remainder beneficiaries of the CRT.
The taxpayers reported the small interest portion of the distributions on their tax returns. They did not report the balance of the distributions. They also failed to report the charitable deductions for the payment to the remainder beneficiaries of the CRT.
On audit, the IRS determined that the distributions were taxable and included this as ordinary income for the taxpayers. The IRS auditor also allowed the taxpayers a charitable deduction for the payment to the non-profits. This was a deduction that was not included on the taxpayer’s income tax return.
About Charitable Remainder Trusts
This article is not about CRTs per se; however, it helps to consider some of the applicable rules.
The court had little difficulty disposing of the substance of this case. The CRT pays no tax on the sale of contributed assets. The taxpayers got this part correct and it was not disputed in the case. Distributions from a CRT are taxable, typically. The taxation of distributions depends on the circumstances. If the CRT has sales proceeds (as it did in this case), distributions up to this amount are ordinary income. They are then capital gains in excess of that. They are then a tax-free return of capital. The court noted that the distributions were taxable.
The taxpayers in this case seem to be using the CRT to avoid paying tax on the sale of crops while not reporting the distributions. That isn’t really what CRTs are for. The CRT is intended to allow taxpayers to sell an appreciated asset and offset the sales price with charitable deductions, while still maintaining a set lifetime payout. This facilitates the sale and, depending on the investments in the CRT, provides guaranteed income over time. There are a few variations on CRTs and the goals and benefits are different.
The IRS’s Power to Raise New Issues
This article isn’t about the CRT per se. It is about the procedural issue involving the charitable deduction.
The taxpayers did not claim the charitable deduction on their income tax return. They presented the deduction as an affirmative issue on audit. The IRS auditor allowed the charitable deduction. So the taxpayers had already secured this benefit before deciding to press on with the U.S. Tax Court.
The taxpayers filed a petition with the U.S. Tax Court to challenge the IRS’s assessment of tax on the distribution. The IRS then filed an answer responding to the issues in the petition. It then filed a supplemental answer raising the charitable deduction as a new issue in the case. The IRS attorney asserted for the first time that the taxpayers were not entitled to the charitable deduction.
The U.S. Tax Court rules allow the IRS attorneys to make these requests. The rules say that the court is to grant these requests as long as justice requires it and it is not an unfair surprise for the taxpayer. This type of language is cited for the court’s practice of routinely granting these requests.
The Risk in Pursuing Cases in the U.S. Tax Court
Deficiency cases are those where the IRS has proposed to increase tax or penalties and the court is asked to consider whether the tax or penalties are actually due and owning.
Deficiency cases in the U.S. Tax Court are de novo. This means that the court hears the case anew. It usually does not consider events that transpried (or did not transpire) during the IRS audit. This is unique to the tax court.
Compare this to tax cases in the U.S. District Court. The U.S. District Court does usually not hear deficiency cases. The U.S. District Court considers refund cases. This means that the tax has been assessed, has been paid, and the taxpayer is suing for a refund. With these cases, the government generally cannot raise new issues. This happens as the time limit for assessing tax has usually expired by the time the government attorney gets the case and has an opportunity to raise additional issues. The government attorney could raise other issues to negate the amount of the refund as an alternative, but it generally cannot collect more than the amount of the tax at issue. This provides some certainty as to the downside risk for the taxpayer.
Why would taxpayers ever pursue a case in U.S. Tax Court then? The answer is usually that the tax court offers a pre-payment forum. Taxpayers who cannot or do not want to pre-pay the tax and sue for a refund may prefer filing in the U.S. Tax Court. In making this decision, the taxpayer who chooses tax court is also not getting the benefit of the certainty as to the downside risk. There are other downsides too, such as the inability to get a jury trial in tax court. There are policy concerns raised by this–i.e., whether those who cannot afford to pre-pay and sue for a refund are offered an inferior judicial option over those who can afford to pre-pay and sue for a refund.
The Furrer case shows how this works. In the Furrer case, it was the charitable deductions that were allowed by the IRS auditor on audit. The taxpayer probably would not have lost this tax deduction had they litigated in the U.S. District Court instead of the tax court. This shows that if there is any possible downside risk for the taxpayer (i.e., any other issue the IRS attorney might raise in the case), the taxpayer has to consider whether the tax court is even a viable option for litigating their matter.
The Furrer case helps explain why some taxpayers may want to avoid litigating their cases in tax court. If the IRS could challenge another position on the taxpayer’s return, the taxpayer may be worse off for having sought their day in court. The risk of new issues and tax due combined with the inability to have a jury trial in the U.S. Tax Court have to be weighed against the cost of prepaying and suing the IRS for a refund in the U.S. District Court. Those who can afford to litigate in U.S. District Court may be able to avoid these limitations.