Chai v. Commissioner
2017 U.S. App. LEXIS 4866
| 2d Cir. | 2017Background
- Jason Chai received a $2 million discretionary bonus from Delta for serving as an "accommodating party" in tax‑shelter transactions but did not report it as income on his 2003 return; his return showed a large partnership loss from Mercato that offset reported income.
- The IRS issued a notice of deficiency in 2009 asserting self‑employment tax (and a 20% accuracy‑related penalty) based on the $2M payment, but did not then assert an income‑tax deficiency because Mercato’s partnership loss was subject to a pending TEFRA partnership proceeding.
- While Chai’s individual deficiency case was pending, the Mercato partnership loss was disallowed in the partnership (TEFRA) proceeding; the IRS then amended its answer in Chai’s Tax Court case to assert an additional income‑tax deficiency and related penalty attributable to the $2M payment.
- The Tax Court (1) dismissed the added income‑tax deficiency for lack of jurisdiction (concluding the IRS should have used a computational adjustment under the TEFRA rules) and (2) sustained the self‑employment tax and the 20% accuracy‑related penalty but declined to consider Chai’s post‑trial contention that the IRS failed to satisfy the written supervisory‑approval requirement for the penalty (I.R.C. § 6751(b)(1)) as untimely.
- On appeal, the Second Circuit held the Tax Court erred on jurisdiction (vacated), affirmed the self‑employment tax determination, and reversed the penalty because the IRS failed to show compliance with § 6751(b)(1) and that compliance is part of the IRS’s burden of production under § 7491(c).
Issues
| Issue | Plaintiff's Argument (Chai) | Defendant's Argument (Commissioner) | Held |
|---|---|---|---|
| Whether Tax Court had jurisdiction to adjudicate the income‑tax deficiency asserted after the Mercato partnership proceeding concluded | Chai: IRS should have applied Mercato result by computational adjustment under TEFRA; Tax Court lacks jurisdiction to entertain the added income‑tax claim | Comm’r: Once the partnership proceeding concluded, the IRS’s amended answer (filed after Mercato) brought the increased deficiency within the Tax Court’s ordinary deficiency jurisdiction (Harris rationale); alternatively, it was an "affected item" | Court: Tax Court erred; once Mercato concluded the Tax Court had jurisdiction to redetermine the increased income‑tax deficiency and the case is remanded for entry upholding that deficiency (Chai concedes payment taxable) |
| Whether the $2,000,000 payment is subject to self‑employment tax (i.e., whether Chai’s accommodating‑party activity was a trade or business under Groetzinger) | Chai: Payment was return of capital or investment; not trade or business | Comm’r: Payment was compensation for services as accommodating party, earned with continuity, regularity, and profit motive | Court: Affirmed Tax Court — payment is taxable self‑employment income; Chai engaged in a trade or business (primary profit purpose; continuity and regularity) |
| Whether the 20% accuracy‑related penalty was properly sustained | Chai: IRS failed to meet its burden because it did not introduce evidence of written supervisory approval required by I.R.C. § 6751(b)(1) | Comm’r: (below) argument on timeliness; (on appeal) IRS argued penalty was excepted as automatically calculated or that written approval can be obtained before assessment and is not part of the burden in deficiency proceedings | Court: Reversed Tax Court — § 6751(b)(1) applies (no electronic exception here), written supervisory approval must be obtained by the time the IRS issues the notice of deficiency (or files an answer/amendment asserting the penalty), and compliance is part of the IRS’s burden of production under § 7491(c); IRS failed to show compliance |
| Procedural timeliness: whether Chai’s post‑trial challenge to § 6751(b)(1) was untimely | Chai: challenge could only be raised after the Commissioner had presented penalty case; sufficiency challenge may be raised post‑trial | Comm’r: Tax Court did not abuse discretion in declining to consider the post‑trial challenge; alternatively, approval can be obtained later and issue is premature | Court: Tax Court should have considered the post‑trial sufficiency challenge because compliance with § 6751(b)(1) is an element of the IRS’s penalty case; lack of proof of supervisory approval requires reversal of the penalty |
Key Cases Cited
- Munro v. Commissioner, 92 T.C. 71 (Tax Ct. 1989) (Munro computation rule: partnership items must be ignored when determining if a nonpartnership deficiency exists prior to partnership adjudication)
- Harris v. Commissioner, 99 T.C. 121 (Tax Ct. 1992) (Tax Court may account for concluded partnership‑level results in an ongoing deficiency proceeding)
- GAF Corp. v. Commissioner, 114 T.C. 519 (Tax Ct. 2000) (Tax Court jurisdiction depends on valid notice of deficiency; dismiss if invalid)
- Commissioner v. Groetzinger, 480 U.S. 23 (U.S. 1987) (defines "trade or business" standard: primary profit purpose and continuity/regularity)
- Flora v. United States, 362 U.S. 145 (U.S. 1960) (taxpayer entitled to judicial determination of tax liability before payment)
- Higbee v. Commissioner, 116 T.C. 438 (Tax Ct. 2001) (burden of production: Commissioner must come forward with evidence appropriate to impose a penalty)