Wednesday, February 1, 2017
The Burden of Proof in Tax Cases – What are the Rules?
The burden of proof in litigation is an important procedural matter. In civil litigation, the plaintiff bears the burden to prove their case by a preponderance of the evidence. In criminal cases, the government bears the burden to prove that the facts to support the government’s position beyond a reasonable doubt. But, what about the burden of proof in tax litigation? The rule is a bit different. Normally, the taxpayer bears the burden. But, there are circumstances in which the burden can shift to the government. That’s today’s focus.
The Shifting Burden
When a taxpayer gets a notice of deficiency, the taxpayer normally bears the burden of proof. The deficiency is, essentially, presumed to be correct. Thus, the taxpayer bears the burden to prove that the IRS is wrong. But, there is a burden-shifting statute. I.R.C. §7491 states that “If, in any court proceeding, a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer for any tax imposed by subtitle A or B, the Secretary shall have the burden of proof with respect to such issue.” Of course, to shift the burden, the taxpayer must properly substantiate all issues in controversy, maintain records, and reasonably cooperate with the IRS with respect to its requests for meetings, witnesses, information, documents and interviews. However, the statutory burden shifting doesn’t apply to corporations, partnerships, and trusts with a high net worth. For partnerships, a recent law change places the burden on the partnership rather than the partners, which creates issues of its own. But, remember, even if the burden does shift, the taxpayer has the burden of going forward with evidence throughout the trial process.
Facts. A recent case, Cavallaro v. Comr., 842 F.3d 16 (1st Cir. 2016), aff’g. in part, and rev’g. in part, and remanding, T.C. Memo. 2014-189, involved the merger of two corporations, one owned by the parents and one owned by a son. The parents' S corporation developed and manufactured a machine that the son had invented. The son did not patent the invention, and the parents' corporation claimed the research and development credits associated with the machine. The sons' corporation sold the machine (liquid dispenser) to various users, but the intellectual property rights associated with the machine were never formally received. The two corporations were merged for estate planning purposes, with the parents' receiving less stock value than their asset ownership value. The lawyers involved in structuring the transaction "postulated" a technology transfer for significant value from the son to the parents that had occurred in 1987. The transfer was postulated because there were no documents concerning the alleged transaction executed in 1987. Instead, the lawyers executed the transfer documents in 1995. The IRS asserted that no technology transfer had occurred and that the merger resulted in a gift from the parents to the son of $29.6 million for which no gift tax return had been filed and no taxes paid. In essence, the IRS claimed that the parents’ corporation was valueless. But, later, the IRS determined that part of the deficiency was wrong and that the parents’ corporation actually did have some value.
I.R.C. §7491. The parents claimed that the burden of proof shifted under I.R.C. §7491(a)(1). However, the IRS started the examination of the return at issue in the case before the statute took effect. The statute only applies to IRS examinations commenced after July 22, 1998. The IRS beat that effective date by a few months.
Excessive and arbitrary. The parents also claimed that the initial deficiency was excessive and arbitrary (bore no factual relationship to their tax liability) and, as a result, shifted the burden of proof to the IRS. The Tax Court noted that an excessive and arbitrary notice of deficiency can shift the burden of proof to the IRS, but concluded that the deficiency involved valuation issues of the corporations, and that the IRS had a sufficient foundation for the initial notice. Basically, according to the Tax Court, all the IRS had to do was make some sort of evidentiary showing in support of the deficiency and the burden won’t shift.
Procedural rule. But, there is also a procedural rule (Rule 142(a)(1)) that says that even though a notice of deficiency is presumed to be correct, the burden shifts when a “new matter” is raised at trial. This was also tied into the valuation issue. The parents pointed out that the IRS initial notice asserted that their corporation had no value, but then the IRS later claimed that it had some value. That, according to the parents, would shift the burden of proof. But, the Tax Court didn’t think so. The court noted that the issue was valuation throughout the entire process and that the taxpayers knew that. There was no “new matter” so there was no burden shifting under the procedural rule.
Expert witness. One other area where the burden can shift involves expert witnesses. In the case, the Tax Court rejected the expert reports of the taxpayers because the court thought they were based on the assumption that the son’s corporation owned technology that the parents’ corporation owned. That court believed that was an incorrect assumption. Consequently, the government’s expert produced the only report that was based on a correct assumption – that the parents’ corporation owned the technology. So, there was no burden-shifting on this point either.
Tax Court’s conclusion. So, the burden of proof didn’t shift to the IRS and they bore the burden to show the proper amount of their tax liability. But, they didn’t have any valuations to help them do so and had no basis to claim that the government got the valuation issue wrong. The Tax Court was left with adopting the government’s valuation claim even though noting that the court was troubled by the government’s numbers. The end result was that the resulting gift tax (at 1995 rates) was $14.8 million.
Appellate decision. On appeal, the parents claimed that the Tax Court erred by not shifting the burden of proof to the IRS because the original notices of deficiency were arbitrary and excessive and/or because the IRS relied on a new theory of liability. The parents also alleged that the Tax Court incorrectly concluded that the parents’ company owned all of the technology and that the Tax Court erred by misstating their burden of proof and then failing to consider alleged flaws in the IRS expert’s valuation of the two companies. The appellate court reversed and remanded on the issue of the nature of the parents’ burden of proof and the Tax Court’s failure to allow them to rebut the IRS expert’s report. However, the appellate court determined that the parents bore the burden to prove that the deficiency notices were in error and that the burden of proving a gift tax deficiency didn’t shift to the IRS even though the IRS later conceded somewhat on the valuation issue because the initial conclusion of IRS on value was not arbitrary.
The appellate court also determined that the parents could not shift the burden of proof on the grounds that the IRS raised a new matter because the IRS theory that their corporation was undervalued was consistently postulated throughout and the original notices that implied that undervaluation of the parents’ corporation allowed for a disguised gift transfer from the parents to their adult children. The Tax Court’s finding that the parents’ corporation owned the technology was also upheld. But, the appellate court did allow the parents to challenge the IRS expert’s valuation and how the Tax Court handled the objections to the valuation. Thus, the court remanded on that issue.
The end result was that the taxpayers didn’t have to prove the correct amount of their tax liability. They also get a shot to challenge the government’s expert report. If they are successful on the challenge, the Tax Court will have to determine what the tax liability is.
To shift the burden of proof to the IRS in a tax case, substantiate everything, keep good records, and cooperate with the IRS throughout the process. Also, make sure that any experts that are utilized are qualified and base their reports on correct assumptions. If the IRS raises a “new matter” during the litigation, that can also shift the burden.