J. B. v. U.S., (CA9 2/26/2019) 123 AFTR 2d ¶2019-458
The Court of Appeals for the Ninth Circuit, affirming a district court order quashing IRS’s third-party summons to the taxpayer’s employer, has concluded that IRS failed to provide sufficient notice to taxpayers, in violation of Code Sec. 7602(c)(1)‘s requirement that the IRS provide “reasonable notice in advance” to taxpayers. The decision resolves a conflict among the district courts in the circuit.
Background. IRS has power to issue summonses “[f]or the purpose of… determining the liability of any person for any internal revenue tax.” (Code Sec 7602(a)(2))
An IRS employee “may not contact any person other than the taxpayer with respect to the determination or collection of the tax liability of such taxpayer without providing reasonable notice in advance to the taxpayer that contacts with persons other than the taxpayer may be made.” (Code Sec 7602(c)(1); Reg § 301.7602-2(a))
Facts. Taxpayers J.B and P.B. are an elderly married couple who were selected at random for a compliance research examination, as part of the IRS’s National Research Program (NRP), which randomly selects taxpayers for exhaustive audits to help the IRS “better understand tax compliance and improve the fairness of the tax system.” J.B. is an attorney who accepts appointments from the California Supreme Court to represent indigent criminal defendants in capital cases.
The IRS letter indicating that they had been selected for the NRP audit instructed J.B. and P.B. to contact a revenue agent at the IRS to discuss items on their 2011 tax return, as well as the “examination process” and “[a]ny concerns or questions you may have.” In the same mailing, IRS enclosed a two-page notice entitled “Your Rights as a Taxpayer.” IRS refers to this notice as “Publication 1” or “The Taxpayer Bill of Rights.” On the second page of the notice, under a heading entitled “Potential Third Party Contacts,” the notice warns:
“Generally, the IRS will deal directly with you or your duly authorized representative. However, we sometimes talk with other persons if we need information that you have been unable to provide, or to verify information we have received. If we do contact other persons, such as a neighbor, bank, employer, or employees, we will generally need to tell them limited information, such as your name… Our need to contact other persons may continue as long as there is activity in your case. If we do contact other persons, you have a right to request a list of those contacted.”
When IRS requested documents from J.B. and P.B., they asked IRS to excuse them from the NRP audit because of J.B.’s poor health and the couples’ advanced age. J.B. remitted doctor’s declarations to IRS showing that the NRP audit would worsen his hypertension and contribute to hypertensive retinopathy, a deteriorating eye condition, as well as his serious hearing loss. IRS refused the couple’s request for an exemption, leading J.B. and P.B. to file a separate suit to stop the audit.
In connection with the audit, IRS issued a summons to the California Supreme Court seeking various documents. J.B. and P.B. did not learn that IRS had issued the summons until after the fact, when J.B. and P.B.’s daughter, whom they had listed as a personal representative, received a notice of service of summons in the mail.
Observation: The Ninth Circuit noted that according to the National Taxpayer Advocate, J.B. and P.B.’s experience receiving notice after a third party has been contacted is becoming more common. In 2015, IRS did not first ask the taxpayer for documents requested from a third party in 22.8% of field examination cases and 11.1 % of field collection cases. (2015 Nat’l Taxpayer Advocate Ann. Rep. vol. 1, at 128, see here). In June 2017, the National Taxpayer Advocate identified “third party contacts” as one of thirteen “areas of focus” needed to improve taxpayer rights. (2018 Nat’l Taxpayer Advocate Objectives Rep. to Congress vol. 1, at 98–101, see here)
In October 2015, J.B. and P.B filed a timely petition to quash the summons.
District court proceeding. The district court concluded that IRS had failed to satisfy its “administrative duty” of giving J.B. and P.B. a meaningful opportunity to respond before contacting the California Supreme Court, as required by Code Sec. 7602(c)(1).
The district court evaluated J.B. and P.B.’s petition under U.S. v. Powell, (S Ct 1964) 14 AFTR 2d 5942, which sets out four requirements that IRS must satisfy to enforce an administrative summons. Under Powell, IRS must establish good faith by showing that the summons: (1) is issued for a legitimate purpose; (2) seeks information relevant to that purpose; (3) seeks information that is not already in IRS’s possession; and (4) satisfies all of the administrative steps set forth in the Code. A court may quash a summons if the resisting party disproves any of the four Powell elements or successfully challenges the summons on “any appropriate ground.”
The district court concluded that IRS had satisfied the first three steps of the Powell test, but it found the last step unsatisfied. It concluded that IRS had not provided sufficient notice to J.B. and P.B. that it would contact the California Supreme Court. Accordingly, IRS was in violation of Code Sec. 7602(c)(1)‘s requirement that IRS provide “reasonable notice in advance” to the taxpayer.
The district court rejected the IRS’s argument that IRS Publication 1 provided sufficient advance notice, and instead concluded that the advance notice procedure cannot be satisfied by the transmission of a publication about the audit process generally. The court explained that “advance notice should be specific to a particular third party,” reasoning that the implementing regs contemplated notice for each contact, not a generic publication’s reference that IRS may talk to third parties throughout the course of an investigation.
Ninth Circuit’s conclusion. The Ninth Circuit affirmed the district court’s order quashing IRS’s summons to the California Supreme Court. Because the district court’s decision conflicted with the decisions of other district court in the Ninth Circuit (see Estate of Chaiken, (DC CA 2/14/2017. 119 AFTR 2d 2017-981), the Ninth Circuit reviewed de novo (i.e., as new).
In its analysis, the Ninth Circuit first determined that the phrase “reasonable notice in advance” in Code Sec. 7602(c)(1) was not ambiguous. A term is ambiguous only if it is “susceptible to more than one reasonable interpretation.”
Drawing on case law in this area, the Ninth Circuit concluded that reasonable notice in advance under Code Sec. 7602(c)(1) meant notice that was reasonably calculated, under all the relevant circumstances, to apprise interested parties of the possibility that IRS may contact third parties, and that afforded interested parties a meaningful opportunity to resolve issues and volunteer information before third-party contacts were made. The Court rejected IRS’s contention that its Publication 1 provided adequate notice. The Court further found that a reasonable notice must provide the taxpayer with a meaningful opportunity to volunteer records on his own, so that third-party contacts may be avoided if the taxpayer complied with IRS’s demand.
This standard requires a balancing of the interest of the U.S. in administering an effective auditing system against the individual interest in receiving notice of the potential third-party contact and an opportunity to respond. The notice requirement is context specific. IRS must consider unique information about an intended recipient regardless of whether a statutory scheme is reasonably calculated to provide notice in the ordinary case. And if IRS receives information that the notice was not received, it must take additional reasonable steps to ensure that it provides notice.
Here, the sole notice that IRS provided J.B. and P.B. that it might contact the California Supreme Court was in Publication 1, which IRS sent to them as part of its initial, introductory letter to the couple explaining that they had been selected for an audit. The Publication did not accompany a specific request for documents, nor was there any evidence that IRS revisited the notice later in the audit when it knew that J.B. and P.B. had requested an exemption from the research audit and had not provided documents for the audit. More than two years elapsed between when IRS sent Publication 1 to J.B. and P.B., and when IRS sought to obtain the billing records and invoices from the California Supreme Court. The Ninth Circuit stated that it did not think that an agency that actually desired to inform a taxpayer of an impending third-party contact would consider Publication 1 adequate notice in these circumstances.
Nothing about the audit required IRS to move quickly. IRS issued the summons to the California Supreme Court as part of its NRP audit, not an audit in the normal course. The NRP program was designed to help IRS improve its tax collection system, but unlike an audit in the normal course where the subjects are selected because of red flags in their tax returns, the subjects of a research program audit are randomly selected, without any reason to believe that they are deficient on their taxes. IRS had no reason to believe that J.B. and P.B. might evade its review, hide assets, or abscond. Nor, the Ninth Circuit noted, was the California Supreme Court going anywhere soon.
Indeed, with a research audit, where the taxpayer is offering information to help the U.S. in its tax collection efforts, IRS has every reason to proceed cautiously, ensuring that the taxpayer has adequate notice that IRS may contact third parties and that the taxpayer’s reputational interests are protected. The lack of urgency is further reflected in IRS’s willingness to wait two years between requesting the documents from J.B. and P.B. in September 2013 and issuing the summons to the California Supreme Court in September 2015.
Moreover, IRS should have known that it was requesting information from a particularly sensitive source. IRS sent the summons to J.B.’s employer, not a remote third party like a bank or financial institution. A taxpayer’s reputational interest is heightened when IRS requests information from an employer, which knows the taxpayer intimately and upon which the taxpayer relies for decisions about hiring, firing and promotion. And, IRS did not just request this information from any employer. IRS sought billing records and invoices for J.B.’s work representing capital defendants for the state government. IRS should have known that these materials were potentially covered by the attorney-client privilege and other litigation-related privileges, and could have revealed J.B.’s litigation strategy representing persons on death row. Issuing the summons without specifically notifying J.B. and P.B. was rendered even more unnecessary because the billing records and invoices that IRS requested were exactly the type of records that IRS should have expected J.B. to have in his possession, and to have readily been able to provide once the dispute as to whether J.B. and P.B. should have remained in the research audit was resolved. In fact, under Code Sec. 6001 (requiring taxpayers to maintain income records), J.B. was required to maintain exactly those records.
The Court stated that IRS must comply with its statutory obligation to provide reasonable notice in advance of contacting third parties. While courts are not in the position to prescribe the exact form of notice that is reasonable in every circumstance, under the circumstances here, IRS’s reliance on Publication 1 was plainly unreasonable. When IRS seeks information from an employer of a party with whom it is currently in litigation and much of the information sought is covered by common law and state-recognized privileges, additional reasonable measures must be taken to provide meaningful notice and an opportunity to respond, in order to avert the potential third-party contact. The Court further stated that there were no doubt numerous other circumstances where IRS needs to take further steps to provide the reasonable and meaningful notice Congress mandated.
The Ninth Circuit found that there were several reasonable additional steps that IRS could have taken to notify J.B. and P.B. before turning to the California Supreme Court. The ongoing litigation between J.B. and P.B., and IRS, meant that IRS lawyers had opportunities to notify the couple that it would begin contacting third parties to collect information that J.B. and P.B. continued to withhold.
Another reasonable step would have been for IRS to, once again, renew its request for documents, and tell J.B. and P.B. that, if the documents were not provided, it would begin reaching out to third parties. Because more than two years had elapsed between the date IRS sent Publication 1 to the couple, and the date IRS issued its summons to the California Supreme Court, it was not unreasonable to expect IRS to renew its request for documents and to remind J.B. and P.B. that if they did not comply, IRS would begin contacting third parties. Other reasonable notice measures, directed at the possibility that J.B. and P.B. did not understand or remember the third-party contacts notice in Publication 1, would have been to re-mail Publication 1, call the taxpayer, or issue a more tailored letter indicating that IRS would begin contacting third parties.
But, because IRS took no additional steps to notify J.B. and P.B. that it would be sending a summons to the California Supreme Court, the Ninth Circuit affirmed the district court’s conclusion that issuing Publication 1 two years before the third-party contact did not satisfy Code Sec. 7602(c)(1)‘s “reasonable notice in advance” requirement in this instance.
References: For IRS’s power to enforce summonses, see FTC 2d/FIN ¶T-1212; United States Tax Reporter ¶76,024. For taxpayers’ Code Sec. 7609 rights regarding third-party summons, see FTC 2d/FIN ¶T-1274; United States Tax Reporter ¶76,024.03.