Contesting an IRS Summons: The Impact of United States v. Clarke

The Supreme Court recently issued a brief but significant ruling concerning a taxpayer’s right to contest an IRS summons. Per 26 U.S.C. 7602, the IRS has a right to request information from a taxpayer through examination of books, papers, records, testimony, etc. pursuant to a civil or criminal IRS investigation. The court in United States v. Clarke ruled unanimously that an IRS summons enforcement action may be challenged where the taxpayer can point to specific facts or circumstances that raise an inference that the IRS issued its summons in bad faith.

The Clarke Facts

The IRS, having suspicions regarding large interest expenses reported in Dynamo Holdings Limited Partnership’s (Dynamo) tax returns, launched an investigation for the years 2005, 2006 and 2007. In the course of the lengthy investigation, Dynamo agreed to two one-year extensions to the usual 3-year limitations period. Dynamo refused to grant a third extension. Shortly thereafter, the IRS issued summonses to four individuals which it believed had information regarding Dynamo’s tax obligations – none of these individuals complied. The IRS then issued a Final Partnership Administrative Adjustment, in which changes were proposed to the tax returns at issue that would result in greater tax liability for the partnership. Dynamo filed suit in the US Tax Court to challenge those adjustments, in a separate litigation which is still pending.

A few months later, the IRS filed suit in District Court to compel compliance with its summonses. This developed into a dispute regarding the reasons for issuing the summonses:

         The IRS attested to the four Powell factors, claiming that the testimony and records sought were necessary to properly investigate the accuracy of Dynamo’s tax reporting, and that the summonses were “not issued to harass or for any other improper purpose.”

         The respondents replied by pointing to circumstantial evidence that, in their view, suggested two ulterior motives: (1) that the IRS issued the summonses to punish Dynamo for refusing to agree to a further extension, and (2) that the action to enforce the summons was made only after Dynamo filed suit to challenge the adjustments, indicating that the IRS was attempting to “evade the Tax Court’s limitations on discovery” and “gain an unfair advantage in that litigation.”

As is generally the case, the District Court ordered the respondents to comply with the summonses. The District Court stated that the respondents claim was “mere conjecture”, with “no meaningful allegations of improper purpose.” The District Court also dismissed the respondent’s second claim since by law, the validity of a summons is determined on the date it was issued, not enforced, and the summonses were issued before the commencement of the Tax Court proceedings.

The 11th Circuit Court of Appeals reversed, holding that the respondents should have had the opportunity to examine the IRS agents-that a simple “allegation of improper purpose,” regardless of “factual support”, is sufficient to entitle a taxpayer to question the IRS agents’ motivation for issuing the summons.

The Decision

In a concise opinion written by Justice Elena Kagan, the Supreme Court vacated the Eleventh Circuit’s opinion, stated that the Circuit Court applied the wrong standard. Justice Kagen wrote that “a bare allegation of improper motive” in the issuance of an IRS summons does not entitle a taxpayer to examine IRS officials. The taxpayer must point to “specific facts or circumstances plausibly raising an inference of bad faith.” Any credible evidence, even if circumstantial, is sufficient, since direct evidence is unlikely to be found in these early stages. It is the role of the District Court to review the facts and circumstances to determine whether the taxpayer’s inquiry is appropriate, or whether the taxpayer is engaging in a “fishing expedition.”

The opinion notes that the Eleventh Circuit never evaluated the respondent’s declarations regarding the timing of the summonses, nor whether any other documents supported the taxpayer’s claim of improper motive. Instead, the Eleventh Circuit ignored the evidence and decided to apply a categorical rule which would allow a taxpayer to examine IRS agents with mere “conclusory allegations.”

Since the correct standard had not been applied by the lower court, the case was sent back to the Eleventh Circuit with instructions to “take into account on remand the District Court’s broad discretion to determine whether a taxpayer has shown enough to require the examination of IRS investigators.”

Implications of the Clarke Decision

The Court has aimed at striking a balance between allowing taxpayers to challenge summonses and facilitating IRS attempts at bridging the information gap through its investigations.  The Supreme Court has affirmed Powell, which places a very light burden on the IRS by requiring only that the investigation have a legitimate purpose, that the inquiry be relevant to that purpose, that the information is not already in the possession of the IRS, and that all administrative steps required under the Internal Revenue Code are followed.  However, the Clarke Decision also opens the door to taxpayers who now can expect at least an evidentiary hearing at the District Court level rather than the typical rubber-stamp enforcement of summonses.

In our practice we routinely see Summons issued in tax collection matters, tax audits, and criminal tax investigations.   This decision is a rare win for taxpayer rights and will prove useful when enforcing the rights of our clients. Our knowledgeable tax attorneys at Moskowitz, LLP have more than 30-years of experience representing clients with income tax audits and tax problems.  Our intimate knowledge of the Internal Revenue Code and the U.S. Constitution, combined with our tough approach with the IRS, is placed at the disposal of all our valued clients.  Please do not hesitate to contact us with your tax problem.   We can help.