For fair and reasonably efficient resolution of federal tax disputes, the United States Tax Court is a remarkable institution. Two of the principal reasons it's still economically possible for a taxpayer to pursue a lawsuit in the Tax Court are:
- the Court's traditional (but, of late, wavering) hostility to the costly formal discovery process which has metastasized almost everywhere else in civil litigation; and
- the Court's monomaniacal insistence that Tax Court Rule 91 means what it says: the parties must "stipulate, to the fullest extent to which complete ... agreement can ... be reached ...."
While much of the requirements are set out in the Tax Court Rules, there's also a lot of unwritten tradition behind these outlooks. It's cultural as much as rule-driven. In the recent case of Farrell v. Commissioner, the Court of Appeals for the Second Circuit offered a rare look at the stipulation process in the Tax Court.
The dispute in Farrell brings us back to the excesses of the 1970s, when bogus investments to cheat the IRS were in vogue. Tax shelter promoters coupled the investment tax credit (which allowed a credit against tax for the value of certain property placed in service), the energy tax credit (ditto), and nonrecourse financing (which ostensibly made a debtor liable, but only to the extent of the value of the property), to produce tax benefits far in excess of the investor's cash outlay. Typically, a promoter would take an asset qualifying for one or more of the tax credits, and having genuine worth, cause it to be sold one or more times to entities under the influence of the promoter for ever-increasing paper amounts, until it was ripe for syndication to taxpayers seeking write-offs. The taxpayers would pay some amount in cash, with the rest of the debt secured by nonrecourse financing, and thereafter take tax treatments based on the artificially-inflated cost of the asset.
The Farrells' shelter package fit the pattern. In 1982, they bought for $25,000 a 4.5% limited partnership interest in plastics recycling equipment from the SAB Resource Reclamation Associates Partnership. The manufacturing cost of the recycling equipment was only $18,000; the manufacturer sold it to the first of two intermediaries for $981,000; the second intermediary bought the equipment for $1,162,667; and a third intermediary leased it to the limited partnership for monthly payments of $103,814. Consistent with the typical tax shelter pattern, the first intermediary purchased the equipment by paying only 7% in cash, and offering notes for the balance with 10% recourse and 90% nonrecourse, and the recourse portion due only after the nonrecourse portion was paid.
The idea, of course was to pump up the value of the equipment so that the limited partnership interest purchasers could get more tax benefits, while eliminating genuine downside risk to the taxpayers. For their $25,000 payment in 1982, the Farrells claimed an operating loss of $20,500, but more impressively, investment tax and business energy credits, which reduce tax dollar for dollar, of $41,856.
In time, the IRS picked up the Farrells for audit. At the end of the audit, the IRS disallowed tax benefits connected to the shelter, and other items. In 1989, the IRS issued a Notice of Deficiency demanding the amount of the additional tax it believed the Farrells owed. The Farrells elected to contest the case in the U.S. Tax Court by filing a Petition for Redetermination.
By 1992, the parties seemed to be close to settling the case. They entered into a Stipulation of Settled Issues which resolved most of the issues in the Notice of Deficiency, but left open issues concerning the ITC and a $20,050 deficiency relating to the plastics shelter. Sometime later, the IRS filed a Motion for Leave to Amend its Answer to add penalties attributable to the shelter investment for 1982. Over the taxpayers' objection, the Tax Court granted that motion. The effect of this procedural move by the IRS was to increase the taxpayers' exposure considerably.
Almost two years after the parties entered the First Stipulation, they signed a Second Stipulation. This time, the taxpayers conceded what they would not in the First Stipulation - the ITC and $20,050 adjustment for the shelter as to 1982 - but left open the issues added in the Amended Answer. After a trial, the Tax Court ruled against the taxpayers on these issues, too.
The taxpayers appealed on the ground that the Tax Court erred when it allowed the IRS Leave to Amend its answer to add the penalties. Pointing to language in the First Stipulation that the "only" issues remaining to be resolved were ITC and the $20,050 adjustment, the taxpayers contended that allowing the Amendment to the IRS's Answer (to add the penalties issues) effectively changed the terms of the First Stipulation. The IRS countered by pointing to a Tax Court Rule providing that leave to amend pleadings should be freely given, absent prejudice, undue delay or bad faith, and insisted that the Tax Court judge was within his discretion in granting the amendment. The Court of Appeals ruled that in allowing the IRS to amend its Answer, the Tax Court failed to consider just how bound the IRS should have been to the First Stipulation. The plain intention of the First Stipulation was to remove issues like unasserted penalties from the case. Having done that, the Court ruled, it was fundamentally unfair for the IRS to thereafter try to re-open issues that were effectively closed. The Court of Appeals vacated the judgment of the Tax Court.
There is a reflexive attitude these days that what's bad for the IRS is good for taxpayers. The IRS lost here, so the decision in Farrell must be good for taxpayers, right?
Well, it's not that simple. This case illustrates that what's good for a taxpayer organism may not be so good for the species of taxpayers.
I wasn't there during the Tax Court portion of the proceedings, but it looks like one of two things happened: either someone at IRS District Counsel's office was asleep for years on the penalties; or, someone at District Counsel's office felt antagonized when the Farrells refused to settle the case entirely in 1992, and decided to turn up the negotiating heat by upping the Farrells' risk with the penalties issues. The first option seems unlikely because this was just the kind of shelter on which the IRS customarily dropped all of its bombs, and hence the situation where nothing would be overlooked. More likely, the IRS's idea was to use the motion to amend the answer as a negotiating lever and to use the window between the filing of the motion and the Tax Court's ruling as the deadline.
The Second Circuit reached the right result here. But it's really a close call. The idea of a Tax Court proceeding is to re-determine the correct tax, no matter which side benefits. If information comes to light during the pendency of the proceedings which improves the accuracy of the tax computation, it ought to be considered. Taxpayers do this all the time, and no one wants that situation to change. And there is nothing wrong with a party pressing an advantage from a changing legal or factual environment, as the IRS did here. The IRS employed a classic negotiating tactic - one that was entirely lawful - but which seems unfair here because of the length of time passing after the case was commenced and the First Stipulation was entered.
What makes me uneasy about this case is whether it will be interpreted to reduce the Tax Court's flexibility in allowing amendments to pleadings. The harsh reality is that mistakes sometimes get made in the litigation process, and stipulations can be improvidently entered into by the parties. Relief from such a stipulation, or any other pleading, if sought sufficiently in advance of trial, can be in the interest of justice. And the provision in the Rules to allow relief recognizes that fact.
If the effect of the decision in Farrell is to decrease the range of flexibility available to the Tax Court judge as to a party seeking relief from an improvidently entered stipulation, then the decision in Farrell may not be so good after all. No one can say who is more likely to be filing for relief from a stipulation, the taxpayer or the Commissioner. So you can't say that the decision in Farrell is a categoric victory for taxpayers.
Neither the decision in Farrell nor the Tax Court Rule governing stipulations takes formal notice of what, to me, at least, is significant here, namely, that in practice, there are different kinds of stipulations in the Tax Court. The kinds of stipulations range from, in order of increasing importance, stipulations of expected testimony, to stipulations of evidentiary foundations for the admissibility of documents, to stipulations of fact, to, as in Farrell, stipulations of Issues. These stipulations impose differing degrees of conclusiveness concerning the subject matter, ranging from this is what the guy would say if he were here to testify' with a stipulation of expected testimony, to, both sides agree that this issue is settled,' with a Stipulation of Issues.
For the Court of Appeals to have distinguished among the different kinds of stipulations might have been of some help to practitioners. The less conclusive the stipulation, the more lenient ought the court be in affording relief from the stipulation. Even without explicit articulation, that is probably recognized in the Tax Court judge's calculation. And when you get to a stipulation of Issues, both sides know they're dealing with a 50,000 volt issue, and they can't make any mistakes at the time they enter into the Stipulation.
The taxpayers here showed a genuine Profile in Courage by hanging in there each time the IRS increased the pressure: when they refused to settle the remaining issues(and, in effect, electing to go to trial) att he time of the First Stipulation; when they resisted the refused to settle the penalties issues at the time of the Second Stipulation (and taking the case to trial); and when they didn't knuckle under after the Tax Court judgment and took the case through appeal.