Tax Court Allows Predictive Coding for Electronic Discovery

us_Tax_Court_fasces-with-red-ribbonIn Dynamo Holdings v. Commissioner, 143 T.C. No. 9, the Tax Court upheld the taxpayers’ motion to use predictive coding to respond to the IRS’s discovery request. The decision is an important development for e-discovery providers and taxpayer representatives who can now use predictive coding in response to electronic discovery requests.

Predictive Coding 

Tax Court Judge Buch cited Magistrate Judge Andrew Peck’s article, Search Forward: Will Manual Document Review and Keyboard Searches be Replaced by Computer-Assisted Coding?, L. Tech. News (Oct. 2011), to explain the technology and the accuracy of predictive coding.

Predictive coding is a technology-assisted review tool that uses human inputs and established algorithms to allow the computer to determine the relevance of a specific document.  Typically, the human reviewer reads and codes a set of documents and the system identifies properties in those documents that it can use to identify other documents.  Once the system establishes a pattern and can make confident predictions, counsel can use specific qualifiers to produce relevant documents and narrow the review.  The court referred to the effective use of predictive coding by individuals at home and at work to filter out spam email.

Dynamo Holdings v. Commissioner

The case came to Tax Court on the IRS’s motion to compel production of documents in cases concerning several transfers from Beekman Vista, Inc. (“Beekman”), to a related entity, Dynamo Holdings Limited Partnership (“Dynamo”).  Notably, Dynamo is the limited partnership involved in U.S. v. Clarke, 573 U.S.      (No. 13-301, June 20, 2014).  The IRS alleged that these transfers are disguised gifts to Dynamo’s owners.  The taxpayers argue that the transfers are loans.

The IRS requested that the taxpayers produce Electronically Stored Information (“ESI”) contained on two specific backup storage tapes, or produce the tapes (or copies) themselves.  The taxpayers argued that it would cost at least $450,000 and take many months to fulfill this discovery request.  They contend they would need to review each document on the tapes (between 3.5 million and 7 million), identify responsive documents, and withhold privileged or confidential information.  The taxpayers requested the Tax Court deny the IRS’s motion or, in the alternative, the Court allow the use of predictive coding.

Judge Buch noted that the taxpayers’ request to use predictive coding was “somewhat unusual” because Rule 70(a)(1) requires the parties to use informal discovery prior to resorting to the formal discovery process.  The Court explained that it is “not normally in the business of dictating to parties the process that they should use when responding to discovery.”  However, the Tax Court held that it would publish an opinion in this case because the Court has not previously addressed computer-assisted review tools.

The Tax Court refused the taxpayers’ request to deny the IRS’s motion to compel because a party is generally required to produce ESI in the form in which it is maintained under Rule 72(b)(3).  The Court found that Rule 70(c)(2) did not apply because the IRS showed good cause for the discovery.  However, the Court did find that the taxpayers were reasonable in objecting to the IRS’s proposed solution of a clawback agreement.  The clawback agreement would allow the IRS to see all of the confidential and privileged information on the tapes, but preserve the taxpayers’ right to later claim that all or part of the information is privileged and not subject to discovery.

Each party presented an expert witness to address the use of predictive coding in this case.  The taxpayers’ expert examined certain details of the two tapes requested, interviewed the person most knowledgable about the backup process and backup tapes, and performed cost calculations comparing the IRS’s suggested method of discovery with the predictive coding approach.  The taxpayers’ expert found that using the predictive coding approach 200,000 to 400,000 documents would be subject to review at a cost of $80,000 to $85,000.  He found that under the IRS’s approach 3.5 million to 7 million documents would be subject to review at a cost of $500,000 to $550,000.  The Court did not find anything in the IRS expert’s testimony to discredit the taxpayers’ expert’s analysis.

The Court disagreed with the IRS’s argument that predictive coding is an unproven technology finding that “the technology industry now considers predictive coding to be widely accepted for limiting e-discovery to relevant documents and effecting discovery of ESI without an undue burden.”  The Court also cited several federal cases allowing computer-assisted review, and specifically predictive coding, as acceptable means to search for relevant ESI documents including Moore v. Publicis Groupe, 287 F.R.D. 182 (S.D.N.Y 2012), Hinterberger v. Catholic Health Sys., Inc., No. 08-CV-3805(F), 2013 WL 2250603 (W.D.N.Y. May 21, 2013), and In Re Actos, No. 6:11-md-2299, 2012 WL 7861249 (W.D. La. July 27. 2012).  Thus, the Court granted the taxpayers’ order to allow use of predictive coding to fulfill the IRS’s discovery request.

Read the full opinion here: Dynamo Holdings v. Commissioner, 143 T.C. No. 9 (2014)

 

Amended Returns Don’t Help Taxpayer Minimize §6707A Penalties

us_tax_courtIn Yari v. Commissioner, 143 T.C. No. 7, the Tax Court upheld a $100,000 statutory maximum, penalty under IRC § 6707A(b)(2)(A) assessed against the taxpayer for failing to report a listed transaction.  The case presents an issue of first impression on the proper calculation of a penalty under IRC § 6707A(b).

The taxpayer participated in a listed Roth IRA transaction from 2002 to 2007.  The transaction involved the taxpayer forming a disregarded entity, Topaz Global Holdings, LLC, and a Nevada corporation, Faryar, Inc., which elected to be treated as an S-Corporation for federal income tax purposes.  The taxpayer opened a Roth IRA account in 2002 with an initial contribution of $3,000.  The Roth IRA acquired all of Faryar, Inc.’s stock for $3,000 and became the sole shareholder of the corporation.

From 2002 to 2007, Faryar, Inc. reported management fees from related entity Topaz Global Holdings, LLC and interest income of $1,221,778.  Because Faryar, Inc. was an S-Corporation with a Roth IRA as the sole shareholder, the income was not taxed at either the corporate level or the shareholder level.  The structure allowed the taxpayer to exceed Roth IRA contribution limits and decrease the income he otherwise would have reported because Topaz Global deducted the management fee paid to Faryar, Inc.

In IRS Notice 2004-8, the IRS designated these Roth IRA transactions as “abusive.”  The taxpayer filed a federal income tax return for 2004 in on October 17, 2005.  This return did not disclose the taxpayer’s participation in the Roth IRA transaction.  The IRS audited the taxpayer’s returns for 2002 through 2007 and issued notices of deficiency for each year.  The IRS determined that the taxpayer should have included $482,912 from the management fee transaction as income in the 2004 tax year.  After computational adjustments, this increased the taxpayer’s tax liability by $135,215.  The IRS issued notices of deficiency and the taxpayer when to the Tax Court.

During the course of the audit, the taxpayer amended his 2004 tax return to correct reported Schedule K-1 information.  The amended return also included $482,912 from the management fee transaction as income. The taxpayer then filed a second amended return claiming a net operating loss carryback from 2008, and again reporting the $482,912 management fee as income.

The taxpayer and the IRS settled the deficiency cases and entered into a closing agreement in 2011.  The closing agreement required the taxpayer to include certain amounts in his income for each of the tax years, including $482,912 for the 2004 tax year.  The Court entered stipulated decisions in the deficiency cases that reflected the closing agreement.

In September 2008, the IRS issued a IRC § 6707A penalty of $100,000 for the 2004 tax year because the taxpayer failed to disclose his participation in a listed transaction.  The IRS issued a Notice of Intent to Levy in February 2009 and the taxpayer timely requested a Collection Due Process (CDP) hearing.  Prior to the hearing, Congress amended IRC § 6707A as part of the Small Business Jobs Act (SBJA) to change the method of calculating the penalty.  The change was effective retroactively for penalties assessed after December 31, 2006.  The new statute designated a penalty of 75% of the decrease in tax shown on the return as a result of the listed transaction and set minimum and maximum penalties of $5,000 and $100,000, respectively, for individuals under IRC § 6707A(b).

The IRS suspended the CDP hearing to reconsider the calculation of the penalty and determined that the penalty did not need to be modified under the new statute.   The taxpayer took the position that the amended returns should be used to calculate the decrease in tax, and thus the penalty should be the statutory minimum of $5,000 under IRC § 6707A(b)(2)(B).  The revenue agent disagreed and used the original return to calculate the penalty, resulting in a maximum $100,000 liability under IRC § 6707A(b)(2)(A).  At the taxpayer’s request, the settlement officer issued a notice of determination sustaining the collection action.  The taxpayer challenged the calculation of the penalty and petitioned the Tax Court.

Despite stipulations to the Tax Court’s jurisdiction over this matter, the Court determined its jurisdiction over the matter and distinguished this case from Smith v. Commissioner, 133 T.C. 424 (2009).  In Smith, the Court found it lacked jurisdiction to redetermine an IRC § 6707A penalty because the penalty did not fit the statutory definition of deficiency and because the IRS could assess and collect the penalty without issuing a statutory notice of deficiency.  However, the Tax Court held that the Court does have jurisdiction to redetermine a liability challenge asserted by a taxpayer in a Collection Due Process hearing pursuant to IRC § 6330(d)(1).  Notably, the Tax Court reviewed the CDP determination de novo because the underlying tax liability was properly at issue.  Sego v. Commissioner, 114 T.C. 604, 610 (2000).

The taxpayer stipulated that he participated in a listed transaction and that he failed to properly disclose his participation.  The taxpayer argued that the amended returns should be used to calculate the decrease in tax, and thus the penalty should be the statutory minimum of $5,000, rather than the $100,000 maximum assessed by the IRS.  He based his argument on the plain language of the statute, the statutory scheme, and legislative history.

The Court held that “the statute is clear and unambiguous: The penalty is calculated with reference to the ‘tax shown on the return’. IRC § 6707A(b).”  In its analysis of legislative intent, the Tax Court found that Congress intended to penalize the failure to disclose participation in a listed transaction, not the tax savings produced by the transaction.  The Court also noted that Congress could have referenced “a” return in the statute, rather than “the” return, if it intended for the IRS to use amended returns in calculating the penalty under IRC § 6707A.  Thus, the Court upheld the maximum penalty of $100,000 assessed against the taxpayer.

The Tax Court did leave the door open for taxpayers who file an amended return prior to the due date of the original return.

Read the full opinion here: Yari v. Commissioner, 143 T.C. No. 7.

 

 

 

 

 

 

 

Tax Court Rejects Taxpayers’ Reliance on Home Concrete Decision

us_Tax_Court_fasces-with-red-ribbonIn Barkett v. Commissioner, 143 T.C. No. 6 (2014), the Tax Court held that gains reported from the sales of investments (not the amount realized) are used to determine whether the taxpayers understated gross income by more than 25% for purposes of the extended six-year statute of limitations under IRC § 6501(e)(1)(A).  The issue came before the Tax Court on the taxpayers’ motion for partial summary judgment.

In Barkett, the taxpayers realized more than $7 million from the sale of investments in 2006, and reported $123,00 in gain.  In 2007, the taxpayers realized more than $4 million from the sale of investments and reported $314,000 in gain.  The gross income reported in 2006 and 2007 was $271,440 and $340,591, respectively. The IRS issued a Notice of Deficiency more than three years but less than six years after taxpayers filed their 2006 and 2007 returns.

The IRS asserted that taxpayers omitted $629,850 and $432,957 in gross income for tax years 2006 and 2007, respectively.  The taxpayers stipulated to the amounts that were omitted but challenged the validity of the Notice of Deficiency on the grounds that the three year statute of limitations expired under IRC § 6501(a) and the amount omitted from gross income did not exceed the 25% threshold to extend the statute of limitations to six years under IRC § 6501(e).

The taxpayers’ relied upon the Supreme Court’s decision in United States v. Home Concrete & Supply, LLC, 566 U.S. ___, ___, 132 S. Ct. 1836 (2012), which invalidated a portion of Treas. Reg. § 301.6501(e)-1 and held that the six-year statute of limitations under IRC § 6501(e) does not apply to a taxpayer’s overstatement of basis.  The taxpayers argued that amounts realized should be included in the denominator of the 25% omitted calculation for purposes of IRC § 6501(e)(1)(A).

The Tax Court rejected the taxpayers’ interpretation of Home Concrete and held that gross income stated in the return only includes gains reported from investment property – the excess of the amount realized over the basis in the assets sold.  The Court cited Insulglass v. Commissioner, 84 T.C. 203 (1985) and Schneider v. Commissioner, T.C. Memo. 1985-139, stating that “capital gains, not the gross proceeds, are to be treated as the amount of gross income stated in the return for purposes of section 6501(e).”  The Court distinguished this case from the Intermountain line of cases that led to the Supreme Court’s decision in Home Concrete because those cases addressed when gross income is omitted from the return, not how to calculate gross income (the issue in this case).

Read the full Tax Court opinion here: Barkett v. Commissioner, 143 T.C. No. 6 (2014).

Record Your Easement: Tax Court Adjusts Timing & Valuation of New York Facade Easement

us_Tax_Court_fasces-with-red-ribbonIn Zarlengo v. Commissioner, T.C. Memo 2014-161, the Tax Court held that a New York facade easement is not protected in perpetuity under IRC § 170(h)(5)(A) until the easement is recorded.  The Court followed its decision in Rothman v. Commissioner, TC Memo 2012-163 and New York state law, specifically NY. Env. Law § 49-0305(4), requiring that a “conservation easement shall be duly recorded and indexed as such in the office of the recording officer for the county or counties where the land is situate in the manner prescribed by article nine of the real property law.”  The Court disallowed the charitable deduction taken in the year before the easement was properly recorded and all carryover deductions from that year.

The taxpayer found some success with their appraisal and valuation experts, as they were able to keep a portion of the charitable deduction claimed after the easement was properly recorded.  They were also able to avoid accuracy-related penalties for years prior to the Pension Protection Act of 2006 by presenting a successful reasonable cause defense.

Read the full opinion here: Zarlengo v. Commissioner, T.C. Memo 2014-161

United States v. Clarke: Supreme Court Upholds Integrity of IRS Summons Process

us-supreme-courtIn a unanimous decision, the U.S. Supreme Court upheld the integrity of IRS summons enforcement proceedings.  In United States v. Clarke, 573 U.S.        (No. 13-301, June 20, 2014), the high court rejected the IRS position and held that a taxpayer has the right to conduct an examination of IRS officials regarding their reasons for issuing a summons when the taxpayer shows facts raising a plausible inference of bad faith.

The IRS sought to disregard taxpayer affidavits attesting that the IRS issued the summonses to punish the taxpayer for refusing to extend the statute of limitations and that the summons enforcement action was designed to evade limitations on Tax Court discovery. The IRS characterized the taxpayer’s claims as bare assertions.

For more about the underlying matter and the parties’ positions, please see our article in the current issue of the Federal Lawyer: Bare Assertions, Naked Allegations, & Improper Purposes.

The Supreme Court rejected the IRS arguments and established the appropriate standard for reviewing the proper purpose required to enforce an IRS summons. The Court ruled that the taxpayer is entitled to examine an IRS agent as part of a summary enforcement proceeding when the taxpayer “can point to specific facts or circumstances plausibly raising an inference of bad faith.” Stated differently, “the taxpayer need only make a showing of facts that give rise to a plausible inference of improper motive.”

Though the Court dismissed the IRS arguments, it also found the intermediate decision of the 11th Circuit in favor of the taxpayers lacking. The Supreme Court found the 11th Circuit’s brief opinion potentially too far ranging in its result and remanded the matter for a more specific findings on the errors adduced to the district court. It also suggested that certain legal issues discussed in the district court opinion, specifically those related to the interplay between summons enforcement and Tax Court discovery, might be subject to review by the 11th Circuit. So while the taxpayer has secured a certain victory, there likely will be more clarification to come on this issue.

Read the U.S. Supreme Court’s opinion here:
U.S. v. Clarke, 573 U.S. ___ (No. 13-301, June 20, 2014)

Second Circuit Affirms Importance of Proper Valuations for Facade Easements

Second Circuit Court of AppealsOn Wednesday, June 18, 2014, the Second Circuit Court of Appeals affirmed the U.S. Tax Court’s ruling in Scheidelman v. Commissioner, TC Memo 2013-18.

This is Scheidelman’s second, and likely final, visit to the Second Circuit Court of Appeals. See our previous discussion of the Second Circuit’s decision to vacate and remand the case back to the U.S. Tax Court.

Read the full opinion here:  Scheidelman v. Commissioner, No. 13-2650 (2d. Cir., June 18, 2014).

Famous Fridays: Nicolas Cage, Spending A Fortune In Sixty Seconds

nicolas-cage-240

Regardless of your opinions on his talent as an actor, Nicolas Cage amassed a fortune for his consistent roles in movies since 1981. Cage won an Oscar for his performance in Leaving Las Vegas, but he may be best known for his roles in adventure movies Con Air, Face/Off, Gone in Sixty Seconds, Lord of War, and Ghost Rider. He earned more than $150 million from acting between 1996 and 2011, and found a way to spend almost all of it.

Cage accumulated 15 personal homes between 2000 and 2007 ranging from a castle in England to a Bel Air mansion that was taken off the market when nobody could meet Cage’s $35 million asking price. He also spent $7 million on a private island in the Bahamas, purchased 4 yachts, and a $30 million private jet. His car collection would have made Memphis Raines proud with nine Rolls Royces, 30 motorcycles, a $500,000 Lamborghini, and a $1 million Ferrari Enzo.

He earned $40 million and was the fifth-highest paid actor by Forbes in 2009, but on the whole it was a bad year financially for Cage. Even this income wasn’t enough to sustain Cage’s lifestyle. His Bel-Air mansion was foreclosed upon by each of the six lenders supplying six mortgages totaling nearly $20 million. The IRS placed a lien on his New Orleans home to collect over $13 million in unpaid taxes and penalties for tax years from 2002-2007. A large part of the bill stemmed from using a company he owned to write off $3.3 million in personal expenses including costs for limos, meals, gifts, travel, and his private jet. Among other things, the IRS adjusted his taxable income from $430,000 to $1.9 million in 2003 and from $17 million to $18.5 million in 2004. The IRS reduced the expenses for his private jet by over $500,000 in several other tax years.

He fired and sued his business advisor and began making headway on his back taxes by selling some of his properties, a dinosaur skull worth over $250,000 and Action Comics #1 for $2.16 million. In 2012, Cage made a payment of over $6.2 million to the IRS cutting his debt in half. His marketability as an actor and the rumored National Treasure 3, should put Cage well on his way to paying off the IRS.

 

Conservation Easement Yields New Rule on Reasonable Cause Penalty Defense

us_Tax_Court_fasces-with-red-ribbonThe Tax Court disallowed another charitable deduction for the donation of a façade easement in Boston’s South End Historic District. This time the decision was based on valuation principles, not technical foot faults, and the taxpayers were able to avoid certain penalties.

In Chandler v. Commissioner, 142 TC No. 16 (2014), the taxpayers owned two homes in Boston’s South End Historic District, the Claremont Property and the West Newton Property. The homes were purchased in 2003 and 2005, respectively. The taxpayers entered into an agreement in 2004 to grant the National Architectural Trust (“NAT”) a façade easement on the Claremont Property. They then executed a similar arrangement when they purchased the West Newton Property in 2005.

The taxpayers used an NAT recommended expert to value the easements. He valued the Claremont easement at $191,400 and the West Newton easement at $371,250. The taxpayers took charitable deductions related to the easements of more than $450,000 between 2004 and 2006.

The IRS did not challenge the easements’ compliance with §170(h). However, the IRS did allege that the easements had no value because they did not meaningfully restrict the taxpayers’ properties beyond the provisions under local law. The taxpayers’ countered that the easement restrictions were broader than local law because they limited construction on the entire exterior of the home and required the owners to make repairs. Local law only restricted construction on portions of the property visible from a public way and did not require owners to make repairs. The taxpayers’ also noted that the easement subjected the property to stricter monitoring and enforcement of the restrictions. The Tax Court, citing its recent opinion in Kaufman v. Commissioner, T.C. Memo 2014-52, (discussed below), rejected the taxpayers’ arguments because “buyers do not perceive any difference between the competing sets of restrictions.”

The only remaining issue was valuation. The taxpayers abandoned their original appraisals and presented new expert testimony at trial. The taxpayers’ new expert used the comparable sales approach to calculate a before value of $1,385,000 for the Claremont Property and $2,950,000 for the West Newton Property. The taxpayers’ expert chose seven properties for comparison: four properties in Boston and three properties in New York City. On the basis of data from these properties, he estimated that the taxpayers’ easements diminished the value of both properties by 16%.

The Tax Court found the taxpayers’ expert unpersuasive. The Court dismissed the three New York City comparables because they “tell us little about easement values in Boston’s unique market.” The court also found that three of the four Boston properties were “obviously flawed.” The Court took particular exception to the expert’s use of a comparable unencumbered property that was not actually unencumbered. The Court stated that the “error undermines [the expert’s] credibility concerning not only this comparison, but the entire report.”

The Tax Court also found the respondent’s expert report unpersuasive. The respondent’s expert examined nine encumbered Boston properties that sold between 2005 and 2011. He compared the sales prices immediately before and after the imposition of the easements. Each property sold for more after it had been encumbered by the easement. However, the expert failed to account for significant renovations that took place on many of the properties after they were encumbered. Thus, the Court found the expert’s analysis unpersuasive because “it does not isolate the effect of easements on the properties in his sample.” However, in the final analysis, the Court sided with the IRS and disallowed the taxpayer’s deductions.

However, the Court did accept the taxpayers’ reasonable cause defense for gross valuation misstatement penalties in 2004 and 2005. Unfortunately, the reasonable cause exception for gross valuation misstatements of charitable contribution property was eliminated with the Pension Protection Act of 2006, so the Court denied the taxpayers’ reasonable cause defense for the 2006 tax period.

Read the full opinion here: Chandler v. Commissioner, 142 T.C. No. 16