Reprinted from the November 2000 issue of Corporate Business Taxation Monthly
Like many of my colleagues, I am uncertain whether I chose tax litigation as a profession or it chose me. Whatever the origin, the invitation to write an essay on a topic for which I have passionate views is exhilarating, since, to be candid, no one at the family dinner table is interested in the subject. While my experience derives mostly from Utah law (the reference point for this essay), there seems to be, and I here assume, a "vast tax collector conspiracy" out there whose modus operandi is largely interchangeable throughout the United States. This essay explores the hurly-burly of tax litigation, particularly state tax litigation, and the imperative "right stuff" to represent a taxpayer zealously, ethically and, hopefully, successfully. Within the limited space available, I touch only the highlights.
Evolution in the Tax Lawyer Market
A frequent opening joke at tax seminars about tax lawyers is they are nerds who have fun manipulating numbers but lack the personality to become accountants. My experience is that tax lawyers have periodic panic attacks in "behind-closed-door" marketing retreats about the onslaught of accountants stealing their business. Today's accounting firms offer a potpourri of taxpayer services, allegedly including legal services like preparation and filing of court pleadings. Evidently, a decreasing minority of lawyers deem such "unauthorized practice of law" off-limits to accountants. To date, state bar attempts to stop the accountants from coming are, generally, flops.
Downtrodden tax lawyers have thus been compelled to retool their skills in the face of immutable market forces. The upshot of these trends is that tax lawyers more aggressively market a service that competitor-accountants (as accountants) cannot – i.e., tax litigation. Therein lies another turf war since traditional litigators often see themselves as the only real lawyers, la crème de la crème, possessed of non-transferrable expertise as courtroom gladiators. But "the times, they are a changin'." Tax lawyers litigate and litigators metamorphose into tax lawyers. Neither is hermetically sealed from the other, doubtless because there are enough unique and complex aspects of tax litigation to preclude, say, tort lawyers and criminal defense attorneys from seriously promoting themselves as tax litigators.
Generic litigation skills are a necessary but insufficient prerequisite for tax litigators. To be a player, tax litigators must have an in-depth knowledge of complex substantive law (often rooted in financial and economic theory) and experience in the idiosyncratic world of state tax tribunals (often appointed with neither legal nor tax expertise and designed to minimize resistance to government collection of tax dollars).
By its nature, tax litigation (like all litigation) involves conflicts over law or facts that can be intelligently argued either way. Tax litigation is an especially elusive because it turns on nebulous concepts like "fair market value," and "unitary business." If such disputes were simple, they would likely be resolved without a fight. Yet to many clients, particularly the uninitiated, it is unnerving to think that government auditors cannot or will not concede what to the taxpayers are indisputable facts and clear law in their favor.
A "win" in tax litigation is often a favorable settlement, a mediated compromise, a percentage reduction in tax liability, a victory on some issue, but a loss on another. An out-and-out 100% taxpayer kill is certainly possible, but rare. Even favorable settlements are rare, unless the taxing authority sees some vulnerability to its case, i.e., "on-point" precedents from other jurisdictions, potential erosions of the tax base for similarly situated taxpayers, or recurring problems that will fester unless resolved.
Unlike private trial attorneys, government tax litigators (assistant attorneys general and deputy district attorneys) are paid the same whatever the outcome of the case or revenue increase to the government. More important, these tax litigators, despite their gripes to the contrary, have a virtually inexhaustible revenue source (tax dollars) and fairly flat overhead costs, so they can keep litigating forever to protect the tax base. The only constraint upon them is time allocation and the backlog of cases that may have a higher priority demand on resources. If potential revenue loss to the government is large enough, there is never a shortage of government lawyers to stop what they see as a hemorrhage of public funds.
Settlement and Mediation
I have yet to meet a tax manager who seeks litigation. Instead, they want a quick and cheap remedy for what they often see as a dogmatic and unfair tax assessment. When informal settlement fails, tax managers are usually willing to try mediation; they resolve themselves to litigation as a last resort. Though tax managers, like all good business managers, want predictability in handling their affairs, divining outcomes of tax mediation and litigation is fraught with complexities. Television weather broadcasters have an easier time of prognostication. But if there are any "rules-of-thumb," they include these:
- Favorable settlements almost never occur by appealing to taxing authorities' duty to "do the right thing."
- Favorable settlements almost never occur unless the taxing authorities are made to perceive some vulnerability in their case, such as potential invalidation of a rule that "opens the floodgates" to other taxpayers;
- Favorable settlements almost never occur unless the taxpayer is unrelenting in its resolve to pursue litigation to its definitive end (from administrative agencies through the appellate courts) if settlement or mediation fails.
- Favorable settlements can sometimes occur if the taxpayer can persuade the taxing authorities that the issue is minor, non-recurring and not worth the litigation time and expense, as for example, a corporate franchise case in which the taxpayer has sold the business and departed the state.
- Favorable settlements can occur on all or some of the issues anytime – even after litigation starts, especially if the weaknesses of the taxing authority's case become painfully apparent to everyone in the courtroom.
Assuming settlement efforts fail, litigation follows.
The Unlevel Playing Field
Let us be honest. Taxpayer litigants from the outset should abandon all hope for constitutional safeguards of due process extended to other litigants, like criminals and "garden variety" plaintiffs. Most who read Grisham novels, or watch "The Practice" likely take it for granted the state must prove guilt "beyond a reasonable doubt," and that an "independent judiciary" is essential for impartiality. Tax litigation, on the other hand, is a world unto itself, where what is isn't and what isn't is.
"Presumptively Correct" Assessments
A paramount constitutional safeguard otherwise engrained in American jurisprudence but unavailable to taxpayer-litigants is the "presumption of innocence." This usual presumption owes its parentage to a philosophical/moral premise – that government ought not to deprive anyone of life, liberty or property without due process of law. The government thus has the obligation to prove criminal guilt beyond a reasonable doubt to a jury of a defendant's peers.
In tax litigation, the presumptions are reversed in favor of the government, I suspect because government machinery can continue to grind without incarcerating crooks but not without confiscating money. Liberty (the presumption of innocence) would be an overly expensive indulgence if extended to taxpayer-litigants, so we don't do that. Instead, taxing authorities issue "presumptively correct" assessments, meaning the taxpayer-litigant must disprove an assessment to the agency which issued it. This presumption of assessment correctness has enormous practical significance in tax litigation.
Most obvious, reversing the presumption to favor the taxing authority incentivizes tax auditors to substitute thorough data collection, analysis and thoughtful application of law in an audit with a thrown-together deficiency assessment. Harsh, but true. A few examples will illustrate the point.
Almost every homeowner has surely noticed it is not uncommon for property assessments to increase from year to year to reflect property appreciation (inflation) rates. Though irritating, no one can justifiably consider that inappropriate. Raising assessments on an industry in economic decline is something else.
Consider the following example: Suppose, in such an economic environment, the county assessor assessed a widget manufacturing plant at roughly $168 million. The next year the assessment increased by nearly 60% to $257 million even though the economic outlook for widgets worsened. Why the increase? Nobody, including the county assessor, may have an answer, much less a good one. When pressed in deposition, assessors often suffer inexplicable memory lapses: the assessor reminds us of his oversight responsibility for hundreds of thousands of properties, his limited resources, the necessity for mass appraisals, etc. Sure, but one would expect that properties valued in the county in excess of $160 million ought to command a high profile in the assessor's mind.
Were it legally necessary for taxing authorities to justify tax assessments, as it is for other executive branch agencies of government to convict criminals, logical reasons for the assessment would likely be forthcoming. Because the presumption of correctness is king in tax litigation, the taxpayer is often stuck with the burden of disproving every conceivable reason for an increase – a bit like trying to disprove the presumptive existence of ghosts.
Corporate franchise tax cases can be even worse. Like most states anxious for a piece of the economic pie, Utah imposes a franchise tax on corporations doing business in the state. The tax is 5% of an apportioned share of the taxpayer-corporation's unitary "business income." In a series of decisions, the most recent being in 1992, the United States Supreme Court has reaffirmed the constitutional rule that states may tax their fair share of income derived from a "unitary business" – that is, a business characterized by centralized management, functional integration and economies of scale. Whatever ambiguities inhere in determining the absence or presence of these three factors are simplified in state administrative rules that deem all income "business income," and hence apportionable. The presumption strikes again.
Dinged with an audit deficiency that sweeps all corporate and subsidiary income into one giant "combined reporting" pot, taxpayer-litigant-corporations engaged in multiple businesses end up trying to overcome an almost conclusive presumption against them. In these cases, taxpayer-litigants must disprove the presumption of correctness by demonstrating their out-of-state subsidiaries are not unitary with business activities in the taxing state, and that the state cannot, therefore, tax their combined income. This is necessarily an intense factual combat in which, for the states, even the most superficial ties between businesses are "close enough for government work" (and usually the administrative law judges) to find a unitary relationship.
If that were not bad enough, the auditors often fail to make appropriate factual inquiries about unitary relationships before issuing a deficiency assessment, even though they have a statutory obligation to do so. The auditors instead often exploit the presumption: they issue a deficiency assessment; the taxpayer files a petition for redetermination and the state attorney generally dumps a pile of interrogatories on the taxpayer, essentially forcing it (not the auditors) to undertake a self-audit to ferret out unitary relationships and turn the evidence over to the state.
The situation drips with irony. If the deficiency is presumptively correct (as the taxpayer is repeatedly told), why should the state auditors need any additional information to justify a deficiency? One supposes that factually unjustified deficiencies would not be issued in the first place, right? In the ideal world perhaps. In the real world, auditors issue deficiencies without knowledge of the taxpayer's unitary business relationships.
The tax adjudication system itself encourages such rational slothfulness. With limited resources, would it not make pragmatic sense to dash off an assessment, which most taxpayers will pay without question, and force the recalcitrant few to do the state's homework for it (i.e., dig up unitary relationships) in tax litigation? If the presumptions were reversed in favor of the taxpayer, there would be no such game playing.
"Unseparation of Powers"
Another constitutional safeguard to fall by the wayside in tax litigation is "separation of powers." A key aspect of our founding fathers' genius, taken today for granted as if governments naturally evolved this way, is the notion that those who make the laws are different people from those who administer them and different still from those who adjudicate them. The founders' insistence on separation of powers was intentional. To them, inefficiency, the inevitable result of diffusing powers among the three branches of government, is preferable to despotism, the inevitable result of power concentration. For that reason, our courts are supposed to adjudicate cases according to policy the legislature establishes. That way, so the theory goes, courts can be impartial in deciding cases.
With tax tribunals, it does not work that way. Taxpayers get a "three-in-one bargain," where the agency acts as judge, jury and executioner, presumably because that is more "efficient in collecting money." Thus, the auditors issue a deficiency assessment; the auditors' bosses decide the legal sufficiency of the audit, often according to rules they themselves promulgate.
The problem with disregarding separation of powers in tax adjudication is not that tax commissioners are lacking in virtues all of us wish we had. It is, rather, that they have incompatible roles that often work against fair adjudication. Tax commissioners are, in fact, tax collectors. But they are also judges, whose gubernatorial reappointment should not be contingent upon how much revenue they bring in or "give away." Auditors and commissioners will invariably tell taxpayers that the rule of law and not the amount of revenue controls decision-making. Evidence to the contrary makes such platitudinous assurances hard to believe.
An example is WilTel v. Property Tax Division, a 1995 case in which the Utah State Tax Commission in 1997 decided in favor of the taxpayer's Motion for Summary Judgment that
1. "intangible property" and "intangibles" were synonymous terms;
2. intangibles, such as patents, trademarks, contracts, assembled work force, and "goodwill," are not taxable under Utah law; and
3. the tax commission's property tax division had the duty to identify intangibles in its assessments and remove them.
With the issuance of the WilTel decision, there arose a horrendous hue and cry from government recipients of property taxes the likes of which are seldom seen. Threatened with what the counties saw as a tourniquet on their life-blood source of revenue (intangibles in Utah have been unlawfully taxed for years despite legal interdictions to the contrary), the Utah Legislature moved to save the day for taxing authorities. Leading or at least joining the charge to limit, restrict or reverse its own decision was the tax commission that issued the decision in the first place. The consensus solution (with the tax commission's concurrence) to the WilTel "problem" was to tax goodwill that had previously been defined as a non-taxable "intangible." By analogy, this would be akin to the Chief Justice of the United States lobbying Congress to reverse one of the Court's decisions that caused popular unrest.
In the tax arena, the result of attempting to manage such incompatible roles is that taxpayer-litigants often must resolve to take their fight to the courts where there are less constraints on impartiality. An example is Hercules Inc. v. Comm'r of Revenue. In this case, Hercules Incorporated was hit with a corporate franchise audit deficiency in practically every state in which the company did business. The states' presumptively correct claim was that Hercules' $1.5 billion gain on the sale of stock was apportionable business income. Hercules argued to no avail in every administrative forum throughout the country that the gain had nothing to do with its business in the taxing state. Not until Hercules reached the supreme courts of Minnesota and Maryland were its arguments taken seriously. Ultimately, Hercules prevailed in those states and settled elsewhere, but it lost all the way up the ladder. Wouldn't it have been better for all concerned if the lower administrative forums had faithfully followed United States Supreme Court precedents in the first instance? As long as adjudicators are also tax collectors, the odds of that happening are diminished.
In the Litigation Arena
Discovery
The Utah Supreme Court has declared the tax commission's own rules limit discovery to information within the agency's possession, not the taxpayer's. Conceptually, that makes sense because the auditors should have already done their homework prior to issuance of a deficiency assessment. In theory, the tax commission could amend it rules (permitting discovery of the taxpayer), but that is, at this point, unnecessary since the tax commission itself takes the position that discovery rules run both ways, despite its rules. Discovery, rather than running from taxpayer to the agency, is usually the opposite because the taxpayer has the records of its business affairs. In Utah, the tax commission's discovery rules are deemed to follow the Utah Rules of Civil Procedure, which are newly amended to limit interrogatories to twenty five questions, including subparts.
Having been recently hit with interrogatories in a corporate franchise case numbering into the hundreds, should we advise the taxpayer to answer all of them, none of them, the first twenty five or the twenty-five the Attorney General considers most important. However that is resolved, the point is that in many cases, typically large property tax or corporate franchise tax cases, discovery can be burdensome and time consuming. It is usually better to try and accommodate some sort of compromise with opposing counsel rather than stonewalling. Not only is that cheaper, it is usually the inevitable outcome anyway.
Evidence
While the Utah Rules of Civil Procedure to some extent apply to administrative hearings, the evidentiary rules often do not. Instead, the standard is that which a reasonable person would find probative in the conduct of his own affairs. In practice that means virtually everything is admissible, even though the less relevant or reliable evidence may be given little weight. Though one suspects that even relevant evidence is sometimes given little weight, it is almost always counter productive to engage in evidentiary squabbles. If the outcome of a case depends upon an interpretation of the law as applied to often undisputed facts, evidentiary disputes are irrelevant. For those cases in which the facts are disputed (like property tax cases) the relevance of any particular fact often depends upon the valuation theory the litigant proposes.
Expert Witnesses
Rooted in financial and economic theory, much tax litigation, particularly property tax cases, involves direct and cross examination of expert witnesses. For taxpayers, there is a vast number of budding experts anxious to join the fray, yet from the government's perspective the same faces seem to appear over and over again in tax litigation. Why is that? I presume (1) the government doesn't pay as well as private industry; and (2) there is a more limited pool of experts willing to blacklist themselves from future employment in the private sector by riding circuit as a government expert. One would further presume that professional government experts whose livelihood depends upon raising values and sustaining deficiency assessments would begin to suffer a credibility loss in impartial forums. From the government experts' point of view, they possess "truth," which the administrative forum knows when it sees it; from the taxpayer's point of view, the administrative forum is not impartial.
The most obvious and observable attribute of all expert witnesses in tax litigation is that they believe their theories with an almost religious fervor. Having been schooled and trained by nationally renowned government expert witnesses when in the Utah Attorney General's office, I am (as a private practitioner) somewhat of a pariah, given over to the dark side. To outsiders, it would seem incredible that people could get worked up over valuation theory. But a lot of money often rides on the resolution of esoteric issues in which opinion runs strong, such as:
- Should a "small stock" premium be added to the capitalization rate, thereby raising the rate and lowering the value?
- Can intangibles be valued separately, thereby exempting them from taxation, or are they mere enhancements of tangible property and therefore taxable?
- Can economic obsolescence of a special purpose property be measured as the difference between yearly targeted financial goals and their achievement or the difference between the property's most profitable economic times and the years in question?
This essay does not take a stand on any of these questions, upon which volumes can be and are written. Rather, my purpose in stating the issues above is to highlight the technical nature of tax litigation. Almost always, the opposing expert (certainly in any case of sizable magnitude) will have a doctorate in finance or equivalent experience in appraisal theory.
My general rule of survival, therefore, is to avoid crossing swords with an opposing expert on his own turf. More often than not, attorneys who try and outfox an opposing expert in his own area of expertise are eaten alive. Such an ill-advised tactic simply permits the expert to tell his story twice (on direct and then again on cross examination). Unlike Perry Mason, there will be no breakdowns on the stand with tearful confessions that a capitalization rate is just too low to be fair.
The objective of cross-examination in tax litigation should be much more discrete. Cross examination should be carefully prepared in advance with the party's own expert, and limited to the following:
1. questions to which the tax litigator already knows the answer; and/or are
2. designed to preclude the opposing expert from pontificating about his own brilliance; and/or
3. worded to force the opposing expert to admit obviously true facts (not an easy task).
In short, cross examination should be generally short, crisp, to the point, and well-defined. If those objectives cannot be prepared in advance, the tax litigator is well advised to simply sit down and shut up. Here is an example of what I consider successful cross-examination:
Gov't lawyer: I would object, the case [cited in the government expert's report] speaks for itself. It can be read. [The government attorney did not want the taxpayer's attorney to inquire about the case because it included analysis not only supporting the government's position, but also contrary to it. The government's expert had been selective in his reliance upon the case].
Judge: Objection overruled.
Tax lawyer: This man brought up this case. He is relying on it.
Q. Does the court [in the case the government expert relied upon] accept the capacity utilization methodology as a possible method of measuring economic obsolescence? [This question is significant because the government's expert had essentially trashed the capacity utilization model. He cited the case for a different proposition unrelated to the model].
A. May I read the paragraph again, please?
Q. You bet.
A. It appears that they accept the capacity utilization method, yes. [This may have been the first time it occurred to the government's expert that the case could be read to undermine his position].
Q. All right. I would agree with that. Now, in your prior testimony you testified that capacity utilization methodology was unique to [the taxpayer's expert]. Is that what you said?
A. I don't believe I said unique [to the taxpayer's expert]. [Here, the government's expert is beginning to parse words in a sort of "Clintonesque" defense of his prior statement].
Q. Okay. You said it was unique?
A. Yes.
Q. Now, this case, according to what you just admitted, would contradict your prior testimony, wouldn't it?
A. I don't see how. [The government's expert is being willfully obtuse here. Of course, he can see that the case contradicts his prior testimony].
Q. Didn't you just admit to me that the court endorsed the capacity utilization methodology?
A. Yes, I believe I did.
Q. And you don't see a contradiction [with your denunciation of the model]?
A. Unique doesn't mean that it's – that there's only one, necessarily.
Q. All right. You don't see an inconsistency?
A. I don't. [The government's expert may claim an inability to see a contradiction, but, hopefully, the tribunal will and the government's expert will lose credibility].
Direct examination is critically different. The purpose of direct examination is to allow the taxpayer's expert to tell the client's story. The theory of direct examination is the opposite of cross examination – it is to get out of the taxpayer expert's way. Ask open-ended questions. Allow the taxpayer expert to explain the discrepancies of the government expert's report, and the insight of his own way of thinking. If the taxpayer expert's presentation is well-organized and persuasive the necessity for cross-examining the opposing expert can be narrowed or even eliminated. Here is an example.
Q. Commencing with Exhibit Roman Numeral V, can you identify what the exhibits were you prepared last night on the board? [The taxpayer's lawyer and its expert had prepared exhibits to illustrate a logical and memorable presentation of their case].
A. Surely. Roman Numeral V is an example or illustration of the comments that I made yesterday regarding how a one factor economic obsolescence model tends to understate the total amount of economic obsolescence.
* * * * *
Q. Can you explain that, please? [Here is the open-ended question that allows the taxpayer's expert to elucidate his theory. If the explanation runs too long, the judge may cut off the witness' narrative and require the taxpayer's attorney to ask narrower questions.]
On Appeal
Thanks to passage of the "Proposition 6" amendment to the Utah State Constitution in 1998, Utah district courts finally have jurisdiction to review all final decisions of the Utah State Tax Commission by "trial de novo."
Passage of Proposition 6 reversed the Utah Supreme Court's decision in Evans & Sutherland Computer Corp. v. Utah State Tax Commission, in which the court found that the Utah Constitution precludes district court de novo review of tax commission decisions. Proposition 6 established a tax court consisting of six sitting district court judges who, on a statewide basis, will adjudicate appeals from the tax commission. Under present law, the taxpayer aggrieved by a tax commission's decision has a choice. It may do the following:
1. Appeal the tax commission's final decision for a trial de novo to the tax court division of a state district court, in which case the issues, evidence, witnesses, and strategy may overlap those before the tax commission, or
2. Appeal on the record to the Utah Supreme Court.
The fundamental reason in choosing one option over another is the standard of review the district or appellate court will apply to the case on appeal from the tax commission. If the primary issues are those of fact, i.e., a property tax dispute in which the tribunal must choose between conflicting expert testimony, a trial de novo is likely the best bet since the appellate court will uphold the tax commission's factual findings unless unsupported by substantial evidence (virtually any evidence). On the other hand, if the issues are primarily legal, an appeal should be to the Supreme Court which gives no deference to the tax commission's resolution of legal issues.
Oral Argument
Whether before the trial court or the appellate court, cases can be won or lost at oral argument. One important reason for that is that judges in both forums are busy, often too busy. To keep on top of things, they must read thousands of pages over a year's span, and unless gifted with photographic memories, cannot reasonably be expected to retain arguments made in the memoranda or briefs. Though court notices to litigants remind attorneys not to repeat arguments in the briefs, I have often wondered whether judges even read the memoranda or briefs. If the case has been well briefed, what else could be said at oral argument other than to stress or clarify arguments in the briefs?
The "how to" of oral argument and appellate advocacy is the subject of voluminous writing that precludes extensive coverage here. Yet from a retrospective review of tax cases won and lost come distilled doctrines of successful argument, in addition to those the literature usually stresses.
- Recognize that trial and appellate judges have enormous discretion, though some judges might describe their role as a judicial vending machine dispensing the "one true" answer when fed the facts. In many cases, the "facts" include swirling controversies over such complexities as appraisal methodology, purchase price allocation, and unitary ties between businesses. In other cases in which facts are stipulated, the law is written with such imprecision and ambiguity (such as the definition of "intangible") that good faith arguments are possible on either side of the fence.
- Neither trial judges nor appellate judges want upheaval in the tax system. Seek affirmance or reversal on the narrowest ground possible.
- For trial judges, find and stress those facts (usually amid conflicting facts) you find most compelling in terms of equity and fairness.
- For appellate judges, do not attempt to reargue the facts, but quickly identify the heart of the legal dispute and the reasons compelling a ruling in your favor.
- Try to put yourself in the judges' shoes and explain how and why they can rule in your favor. Give them a peg upon which to hang their hat.
Conclusion
Tax litigation is not for the faint of heart. Almost no one wins everything requested, and certainly not every time. The road to resolution is arduous and nearly always a two or three step process beyond the administrative level – sometimes taking years to resolve. That is because the losing party, whether the taxpayer or the taxing authority, is bound to press for a reversal on appeal if the amount at issue is large enough. More disheartening for taxpayers, tax litigation can be redundant because each assessment year, or each audit "stands on its own," making litigation an ever present concern. Nonetheless, the taxpayers with whom I deal invariably tell me that in the long run taking an aggressive posture saves their companies tax dollars that they should not have to pay.