CORBIN A. McNEILL; DORICE S. McNEILL, Petitioners - Appellants, v. UNITED STATES OF AMERICA, Respondent - Appellee.
No. 15-8095
UNITED STATES COURT OF APPEALS TENTH CIRCUIT
September 6, 2016
PUBLISH. Appeal from the United States District Court for the District of Wyoming (D.C. No. 2:14-CV-00172-NDF). Elisabeth A. Shumaker, Clerk of Court.
Gordon B. Nash, Jr., Drinker Biddle & Reath LLP, Chicago, Illinois (Paul J. Hickey, Hickey & Evans, LLP, Cheyenne, Wyoming, and Gabriel G. Tsui, Leech Tishman Fuscaldo & Lampl, LLC, Oak Brook, Illinois, with him on the briefs), for Petitioners-Appellants.
Michael J. Haungs, Attorney, Appellate Section, Tax Division of the United States
Before LUCERO, GORSUCH, and PHILLIPS, Circuit Judges.
GORSUCH, Circuit Judge.
After commanding an attack submarine and eventually retiring from the Navy, Corbin McNeill pursued a second career as a utility company executive. It proved a much more lucrative line of work. When he approached his second retirement he found himself slated to receive an $18 million payment. And faced with the promise of a correspondingly prodigious tax bill, Mr. McNeill began fishing around for ways to ease the bite. Eventually, he came across a complicated little scheme suggested by some well-heeled tax advisors. At bottom, the idea was to transfer to Mr. McNeill losses that foreign debt holders had already suffered. Both sides had an incentive to deal: Mr. McNeill wanted to claim the losses as deductions against his income; the foreign debt holders wanted to transfer their assets for a slight premium over their current (and much reduced) market value because Mr. McNeill could use them to secure a tax advantage they didn‘t need. See Dep‘t of the Treasury, The Problem оf Corporate Tax Shelters, at v (1999).
Of course, the deal had to be structured gingerly. Not least to avoid the appearance of any sale of the debt instruments when they transferred from the foreign debt holders to Mr. McNeill, for that risked revealing Mr. McNeill‘s true basis in them was quite low and his losses insignificant. So it is that his tax advisors established a partnership (really a series of partnerships) to which the foreign debt holders contributed their underwater debt instruments and their basis in them, and to which Mr. McNeill contributed relatively small sums of money. As structured, Mr. McNeill owned over 90% of the relevant and final partnеrship. All so that when the partnership proceeded to sell the debt to third parties, it (rather than the foreign debt holders) could claim to realize the whole of the losses and Mr. McNeill could claim on his tax returns that his $18 million in income was offset by $20 million in losses — losses that, well, he never really suffered. In aid of the scheme, various accounting and law firms supplied opinion letters offering their views that it would withstand IRS scrutiny.
That it did not. When a partnership is employed in a tax avoidance scheme the government wishes to unwind, the IRS has historically followed a two step process prescribed by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). First and out of an apparent desire to avoid inefficiencies that might arise if it had to audit and adjust each partner‘s tax return separately, the IRS begins by adjusting whatever it deems misreported by the partnership at the partnership level and assigning a provisional overall penalty. See
But that wasn‘t quite the end of the story. The second step in TEFRA‘s historically prescribed process remained to unfold. Partnerships are, of course, generally but pass-through entities when it comes to income and taxes: it‘s not the partnership but the partners themselves who usually pay the taxes. So after deciding a partnership‘s overall tax liability and penalties TEFRA usually requires the IRS to proceed to issue a tax assessment for each individual partner, one representing his share of the overall partnership assessment, though along the way the IRS may make adjustments it thinks appropriate for individual partners. Id.
That‘s the step where we find ourselves in this case. The IRS determined that Mr. McNeill‘s share of the partnership‘s liability was $7.75 million. Mr. McNeill duly paid that amount in full and then proceeded to file this lawsuit seeking a partial refund. By now proceeding a bit more cautiously with the IRS, Mr. McNeill didn‘t suggest that the partnership scheme was lawful or that he should be excused the taxes the IRS assessed. Instead, he argued only that he should be excused from the penalties and associated interest the IRS had imposed (about $4.6 million). Mr. McNeill noted that, under TEFRA, a taxpayer may be excused penalties and interest even after pursuing an unsuccessful tax strategy so long as he can prove that he had “reasonable cause” for the position he took and that he filed his tax return in “good faith.” See id.
But the district court declined to decide the merits of Mr. McNeill‘s partner level defense. Instead of passing on the question whether Mr. McNeill could prove reasonable cause and good faith for his tax position, the district court held it was precluded from doing so. Not by operation of the judicial doctrines of claim or issue preclusion. The judicial order dismissing the partnership level case expressly indicated that it was without prejudice and no order in that casе ever passed on the reasonable cause/good faith question. Neither the district court in its decision nor the government in its brief before us suggests this was sufficient to trigger claim or issue preclusion principles. Instead, the district court held only that TEFRA itself — as a matter of statute — precludes a managing partner like Mr. McNeill from pursuing at the partner level a reasonable cause/good faith defense where (as here) the IRS in administrative proceedings has rejected the partnership‘s assertion of reasonable cause/good faith at the partnershiр level.
So much, however, we cannot find anywhere in the law. The relevant portion of TEFRA says just this:
No review of substantive issues.--For purposes of any claim or suit under this subsection, the treatment of partnership items on the partnership return, under the settlement, under the final partnership administrative adjustment, or under the decision of the court (whichever is appropriate) shall be conclusive. In addition, the determination under the final partnership administrative adjustment or under the decision of the court (whichever is appropriate) concerning the applicability of any penalty . . . which relates to an adjustment to a partnership item shall also be conclusive. Notwithstanding the preceding sentence, the partner shall be allowed to assert any partner level defenses that may apply or to challenge the amount of the computational adjustment. Id. § 6230(c)(4) .
To be sure, the government argues that the second sentence supports the district court‘s judgment. As the government observes, this language indicates that the IRS‘s administrative partnership level determinations about penalties and interest “shall . . . be conclusive.” And to be conclusive, the government suggests, these determinations must be conclusive not just against the partnership itself but also against the managing partner in any later partner level refund action.
It‘s an argument that is sound as far as it goes but one that doesn‘t go quite far enough. It fails to account for the statute‘s very next and last sentence, which expressly says that “[n]otwithstanding the preceding sentence, the partner shall be allowed to assert any partner level defenses that may apply or to challenge the amount of the computational adjustment.” Here, then, Cоngress pretty clearly seemed to contemplate a regime in which any partner may assert any “partner level defenses” that may apply. And by statute the reasonable cause/good faith defense appears to be one available at the partner level: after all, it applies when (among other things) the “taxpayer” can show he acted in good faith and (again) under TEFRA it is usually the partner who is the taxpayer. Id.
The government replies that it is inappropriate to allow managing partners to pursue a good faith defense at the partner level when the partnership already raised a good faith defense because оften it‘s the managing partner‘s good faith that‘s tested at the partnership level. But even if an arrangement like the government suggests would make some sense, it just isn‘t the one the statute provides. Nothing in the last sentence of the statute carves out managing partners and prevents them alone from taking advantage of its terms. If Congress had wished to single out managing partners for special treatment, it certainly could have done so — as it has done for other types of partners in other settings. See, e.g., id.
What the language of the controlling statute suggests the surrounding statutory environment and the government‘s own implementing regulations confirm. In TEFRA Congress indicated that “partnership item[s]” are those that the Secretary of the Treasury has deemed “more appropriately determined at the partnership level than at the partner level.” Id.
It‘s a position that turns out to be in tension, too, with a good bit of judicial precedent, much of it invited by the government. The Supreme Court itself has suggested that under TEFRA a partner‘s reasonable cause and gоod faith defense cannot be “conclusively” determined at the partnership level. Woods, 134 S. Ct. at 564 (“[T]he partner may nonetheless have acted in good faith with reasonable cause, . . . see
At the end of the day, the government seems pretty much left to suggest only that its current (if not erstwhile) interpretation of the statute would yield a more efficient process. If partnership level determinations about reasonable cause and good faith were conclusive against (some) partners, it notes, there would be no need for a fact-finder to consider that defense when raised by (those) partners at the partner level. But while we readily admit this arrangement might save labor in some cases, it‘s not even clear whether it would in all or perhaps even most. For surely in at least some cases the parties would spend much time litigating collateral questions — questions like who is bound (really just the managing partner? what about others?) or what was conclusively determined in the earlier partnership level proceedings (this reasonable cause/good faith argument or another one? or are all foregone if not contested at the partnership level?) — that сould be avoided by simply focusing the parties on the merits of the defense. Neither, of course and far more importantly, can any claim of efficiency substitute for the statute‘s text and structure as a basis for discerning statutory meaning.
In saying this much we do not mean to deny that there‘s often a strong identity of interests between a managing or tax matters partner and a partnership. Neither do we mean to suggest that issues addressed in partnership level proceedings always may be contested by individual partners in partner level proceedings. So, for example, our case doesn‘t involve the question whether TEFRA would (or could) permit parties to relitigate matters that the doctrine of issue preclusion might otherwise forbid thanks to their final determination in an earlier judicial proceeding by parties with sufficient commonality of interests to qualify as privies. See Entek GRB, LLC v. Stull Ranches, LLC, 763 F.3d 1252, 1258 (10th Cir. 2014) (discussing use of offensive issue preclusion against parties and their privies). The only question before us is whether, when no party argues that a final judicial ruling exists that triggers judicial preclusion principles, an adverse decision in a TEFRA administrative partnership level proceeding prevеnts a managing (or tax matters) partner from pursuing a reasonable cause/good faith defense in later partner level proceedings.
It is not only a narrow question but one of receding importance too, for Congress has recently revamped the process for auditing partnerships in order to permit the IRS, beginning in 2018, to recoup taxes from the partnership itself rather than the partners individually. See Bipartisan Budget Act of 2015,
The judgment is reversed and the case remanded for further proceedings consistent with this opinion.
McNeill v. United States
No. 15-8095
PHILLIPS, Circuit Judge, dissenting.
I agree that, in the usual case, adjustments to partnership items concerning penalties announced in a Final Partnership Administrative Adjustment (FPAA) aren‘t conclusive against partners in partner-level proceedings. This makes sense because TEFRA disallows partners from barging into partnership-level proceedings to assert partner-level defenses. Instead, TEFRA requires partners to await completion of the partnership-level proceedings, and to pay assessed penalties and interest, before asserting partner-level defenses in refund actions.
But this case is an unusual one. Mr. McNeill is no ordinary partner but is Dulwich LLC‘s managing partner. And Mr. McNeill is also Dulwich‘s tax-matters partner, which enabled him to have Dulwich sue in Wyoming federal court to oppose adjustments the IRS had made in the Dulwich FPAA. And more unusual yet, Mr. McNeill ultimately allowed Dulwich‘s challenge to its FPAA‘s adjustments to be dismissed. TEFRA takes note of those details аnd imposes consequences. For instance, upon the dismissal of Dulwich‘s FPAA challenge, the FPAA‘s findings rise to the level of final and correct findings of the district court itself. Though Mr. McNeill remained free in his penalty-refund action to assert a partner-level defense based on his reasonable cause in pursuing the sham tax scheme, in doing so he faced the FPAA‘s already-conclusive determination that he hadn‘t acted with reasonable cause or in good faith. In view of this conclusive determination on his refund action‘s key question, the district court granted summary judgment in the government‘s favоr. I agree with the district court‘s reasoning and would affirm.
Before examining the applicable law, I think it‘s worth circling back to how this case arose and has made its way to us. In its thorough order, the district court recounts in detail Mr. McNeill‘s activities leading up to his $7.75 million tax underpayment and $4.59 million assessment for penalties and interest. Soon before participating in the 2002 tax-avoidance activity, Mr. McNeill had served on a board of directors of a corporation that had filed for bankruptcy. There, he dealt with creditors, some of which were distressed-debt investors. Later that year, when Mr. McNeill was set to get an $18 million payout from a company he‘d worked for, Mr. McNeill began investigating opportunities to use distressed debt to his advantage. With the help of his attorneys and accountants, Mr. McNeill orchestrated a scheme under which he wrongly claimed about $20 million in losses and correspondingly underpaid his taxes. The district court‘s order shows Mr. McNeill to be a financially sophisticated person, fully active in the decisions leading to his tax underpayment and penalty.
Even before filing his 2002 tax return and continuing until now, Mr. McNeill has driven this case. This is unsurprising because Mr. McNeill is Dulwich‘s managing partner and tax-matters partner, and, by the end of 2002, its 98% owner. And, in turn, Dulwich owns 99% of Livrpol LLC, the entity that reported over $22 million in losses from the sale of underwater debt instruments, of which Mr. McNeill ultimately claimed $20 million of the losses. That‘s how Mr. McNeill set it up.
In December 2006, the IRS issued FPAAs for Dulwich and Livrpol. The two FPAAs contained almost-identical findings. The Dulwich FPAA‘s penalty section included a finding that Dulwich and its partners (obviously including Mr. McNeill) “lacked substantial authority for the positions taken, and that the [sic] they did not have a reasonable belief that those positions were more likely than not the correct treatment of such items.” R. vol. 9 at 22. It
In May 2008, in the United States District Court for the District of Connecticut, Mr. McNeill (as Dulwich‘s managing partner) filed a petition for reаdjustment of Livrpol‘s FPAA (Dulwich was eligible to do so because Livrpol‘s tax-matters partner hadn‘t filed a challenge,
In October 2012, Mr. McNeill filed a claim for a refund of his then-paid penalty and interest. In August 2014, after the IRS hadn‘t responded to the claim, Mr. McNeill filed his present action for a Petition for Refund of Penalties and Interest, asserting as a partner-level defense his alleged reasonable cause and good faith. That put front and center the issue we must now decide: Did the Dulwich FPAA‘s determinations about Dulwich‘s lack of reasonable cause and good faith conclusively establish in Mr. McNeill‘s penalty-refund action his own lack of reasonable cause for his tax activity? The district court said yes. It noted that the Dulwich FPAA‘s findings became final and correct when Mr. McNeill didn‘t reopen Dulwich‘s Wyoming case and allowed its dismissal.2 And because the Dulwich FPAA rejected the same reasonable-cause defense Mr. McNeill offered in his penalty-refund action, the district court treated the Dulwich FPAA as conclusively establishing Mr. McNeill‘s own lack of reasonable cause too.
In determining that Dulwich‘s partnership-level defense based on its reasonable cause for its tax activity must fail, the IRS in its FPAA needed to measure Dulwich‘s conduct and state of mind.3 When evaluating a partnership‘s conduct and state of
Here, the district court determined that Mr. McNeill‘s reasonable cause fоr his tax activity is identical to Dulwich‘s reasonable cause. Mr. McNeill hasn‘t contested that. In view of this, I agree with the district court that the Dulwich FPAA‘s determination that Mr. McNeill lacked reasonable cause for his tax activity is conclusive in Mr. McNeill‘s later partner-level refund action. I see nothing in
(4) No review of substantive issues
For purposes of any claim or suit under this subsection, the treatment of partnership items on the partnership return . . . under the final partnership administrative adjustment . . . shall be conclusive. In addition, the determination under the final partnership administrative adjustment . . . concerning the applicability of any penalty . . . which relates to an adjustment to a partnership item shall also be conclusive. Notwithstanding the preceding sentence, the partner shall be allowed to assert any partner level defenses that may apply . . . .
Nor does the TEFRA regulation guarantee all partners an absolute right to assert reasonable-cause defenses in their partner-level refund actions. It does, however, allow partner-level defenses based on reasonable cause if the defenses are personal to the partner and “cannot be determined at the partnership level.”