Examining the Limitations a Closing Agreement Places on Tax Litigation

OVDP Penalty Refund – Setting Aside the Closing Agreement on the Theory of Duress

This is the conclusion of our 4 part series examining Offshore Voluntary Disclosure Program (OVDP) penalty refunds.  Thus far, we have looked at the history of OVDP, the Internal Revenue Service’s (IRS) position on disclosures outside of OVDP, and the administrative procedure required before pursuing an OVDP penalty refund through tax litigation.  In this last segment, we will discuss the limitations an OVDP closing agreement places on tax litigation, look at setting aside the closing agreement using the theory of duress, and address the importance of selecting the right forum when litigating an OVDP refund.

Once a civil action is filed in a federal court, the first challenge a taxpayer faces is the daunting task of setting aside the closing agreement that he or she executed through an OVDP.  All participants of an offshore voluntary disclosure initiative must execute a Form 906 entitled “Closing Agreement on Final Determination Covering Specific Matters.”

Form 906 states in relevant part:

Under Section 7121 of the Internal Revenue Code, [the taxpayer] and the Commissioner of Internal Revenue make the following closing agreement.

The Taxpayer agrees to pay, and the Internal Revenue Service may assess under Title 26 of the United States Code a miscellaneous [offshore] penalty.

By signing this closing agreement, [the participant] consents to the assessment and collection of the liabilities for tax, interest, additions to tax, and penalties determined by or resulting from the determinations of this agreement, including any defense based on the expiration of the period of limitations on assessment or collection.

By executing the Form 906, the taxpayer has entered into a closing agreement with the IRS.  A closing agreement is a written agreement between an individual and the Commissioner of the IRS which settles or “closes” the liability of that individual with respect to any internal revenue tax for a taxable period.1  The Internal Revenue Code (IRC) provides that if a closing agreement is signed and accepted by the Commissioner or his delegate, the agreement is final and conclusive as to both the taxpayer and the IRS.2  A closing agreement will not be final and conclusive if there is a showing of “fraud or malfeasance, or misrepresentation of a material fact.”3  In order for a closing agreement to be set aside by reason of misrepresentation, there must be misrepresentation of a material fact that goes to the essence of the agreement.4

Some participants may argue that the IRS’s threats of criminal and civil penalties forced them to execute a closing agreement as a result of fraud, malfeasance, or misrepresentation.  Such a position will not likely persuade a federal court.  This is because federal courts uniformly have held that closing agreements are binding and conclusive upon parties even if the tax or penalties are later declared to be unconstitutional or in conflict with other internal revenue sections.5  Furthermore, the Ninth Circuit Court of Appeals has even held that the IRS is “not under any sort of duty” to provide taxpayers with legal advice regarding the signing of a closing agreement.6  Given the reluctance of federal courts to find fraud, malfeasance, or misrepresentation, even if the IRS may have potentially overstated the true risk of criminal or civil penalties to certain individuals that participated in an OVDP, a closing agreement will not likely be set aside on these grounds.

Even though it does not appear that a closing agreement can be set aside on its face under a theory of fraud, malfeasance, or misrepresentation; other contractual theories may be utilized to set aside an IRS closing agreement.  For example, closing agreements are analyzed in a manner similar to other contracts.7  Although closing agreements are governed by federal contract principles rather than state contract law, closing agreements under IRC Section 7121(a) “are contracts and generally are interpreted under ordinary contract principles.”8  Under ordinary contract principles, a contract will be unenforceable if the contract was arrived at through duress.

Having found that an OVDP’s closing agreement will not likely be set aside on the grounds of fraud, malfeasance, or misrepresentation; we arrive at the next question.  Do the IRS’s threats of criminal prosecution and severe civil penalties against any individual with undisclosed foreign financial accounts amount to duress?  If so, will a federal court set aside a closing agreement if it is determined that it was executed under duress?  Federal courts recognize the doctrine of duress.  However, the Federal Court of Claims and the district courts have applied the doctrine of duress in regards to contracts with the government differently.  Therefore, the importance of selecting a proper court is extremely important in litigating for the refund of an OVDP penalty.

The Contractual Concept of Duress in the Federal Court of Claims 

Our analysis of the doctrine of duress begins in the context of the enforceability of a closing agreement in cases argued before the Federal Court of Claims.  The United States Federal Court of Claims has stated that duress exists where 1) one side involuntarily accepted the terms of another; 2) that circumstances permitted no other alternative; and 3) that said circumstances were the result of coercive acts of the opposite party.9  The court also determined that an agreement is voidable on the grounds of duress if a party’s manifestation of assent was induced by an improper threat which left the recipient with no reasonable alternative but to agree.10  It is also important to note that the Court of Claims tests duress through an objective, not subjective, standard.11

In applying their three part test, a number of taxpayers that participated in an OVDP can conceivably argue that the IRS’s threatened severe criminal and civil penalties forced them to accept the terms of an OVDP.  Given the IRS’s position regarding quiet disclosures discussed in part 2, some participants may have believed that they had no viable alternatives outside of the program and were forced into a choice between forfeiting an OVDP miscellaneous civil penalty to the IRS or risk paying enormous civil penalties along with the possibility of criminal prosecution and lengthy periods of incarceration.

In deciding whether the IRS’s threats of criminal prosecution and severe civil penalties amount to duress, the Court of Claims will not inquire whether these threats are indeed actions that the IRS could pursue.  Instead, the court must measure, from an objective standpoint, whether the IRS’s overt or subtle threats would be enough to “defeat…the will of the party coerced.”12  It is important to note that threats made against individuals who willfully or recklessly failed to disclose foreign financial accounts are justified.  In these cases, “[i]t is not duress for a party to do or threaten to do what it has a legal right to do.”13  However, IRS threats of criminal prosecution and severe civil penalties have likely been exaggerated to individuals who mistakenly or innocently failed to disclose a foreign financial account on an FBAR.

In these cases, can the IRS’s threats be considered so overpowering as to have inhibited the unfettered exercise of reasoned judgment in taxpayers who mistakenly or innocently failed to disclose a foreign financial account?  Whether or not such IRS threats may be considered so overpowering will depend upon the facts and circumstances of each individual case.14  As a preliminary observation; incompetent, unsophisticated, or elderly individuals will have a stronger case than other taxpayers when using duress to set aside a closing agreement.  This may be good news for taxpayers with facts similar to the hypothetical foreign-born elderly man discussed in the second segment.  However, the threshold to find a closing agreement contract unenforceable on the theory of duress will be greater for educated individuals that have access to counsel.  In these cases, the court is likely to take the position that the government’s threats of legal action are not usually sufficient to overcome the free will of the person.15

Even though it appears that the Court of Claims is more likely to grant relief from a Form 906 to taxpayers that are more easily swayed by IRS pressures such as incompetent, unsophisticated, or elderly taxpayers, rather than sophisticated taxpayers who have access to legal representation; a comprehensive definition of the circumstances constituting duress is impossible.  Cases decided by the Court of Claims have pointed out that each case must be decided on its own facts.16  The fact that the court will review each case on its own facts should offer some hope to taxpayers that erroneously entered into an OVDP out of a fear of prosecution or enormous civil penalties.  With that said, any individual bringing a case before the Court of Claims, who is attempting to set aside a closing agreement under a theory of duress, must be prepared to demonstrate that IRS’s threats were enough to “defeat…the will” of that particular individual.  On a positive note, case law indicates that the Court of Claims will at least review the facts of each case carefully.  This may provide some hope to taxpayers who believe that they were mistakenly compelled to enter into an offshore voluntary disclosure program and paid the hefty offshore penalty.

The Contractual Concept of Duress in District Courts

Similar to the Federal Court of Claims, district courts in jurisdictions throughout the United States recognize that the threat of criminal prosecution may constitute duress whether or not the threatened party is actually guilty of a crime.17  With that said, district courts do not employ the three part test for duress enunciated by the Court of Claims in Fruhauf Southwest Garment.18  Rather, district courts seem to review the facts and circumstances of each case to determine if duress exists.  When exercising discretion in applying the concept of duress to contracts with government agencies such as the IRS, some district courts weigh public interest in the enforcement of these contracts heavily in favor of the government.19  This means that a district court will likely find a closing agreement unenforceable on the grounds of duress only in cases of extraordinary circumstances.  A fear of criminal prosecution or severe civil penalties will not likely convince a district court that a closing agreement was entered into under duress.

As an example, in Thomas L. Largen and Patricia K. Largen; Franklin D. Clontz and Jean T. Clontz, et al., v. United States,20 Dr. Largen and Dr. Clontz attended a seminar at which International Capital Management (ICM) promoted investment packages.  Dr. Largen and Dr. Clontz were convinced by ICM to invest in various investments packages.  The taxpayers took personal income tax deductions for business losses related to the investments for tax years 1982 and 1983.  In March of 1984, an IRS criminal investigator visited the taxpayers.  The criminal investigator told the taxpayers that they were suspects in a criminal tax evasion scheme.  The criminal investigator then told the taxpayers that he intended to put the taxpayers in jail.  Although the taxpayers were apparent targets of a criminal investigation, they were never indicted by a grand jury.  Ultimately, the taxpayers executed a settlement agreement with the IRS and then filed suit before a United States district court seeking to have the settlement agreement set aside.

The taxpayers alleged that they were forced into signing a settlement agreement through emotional and economic coercion, which included a choice between criminal penalties that would damage their reputations and potentially enormous civil fraud penalties to the tune of millions of dollars or foregoing their right to have their tax claims heard before a court for a certain sum forfeited to the IRS.  The district court stated that:

“while [the taxpayers’] choice was difficult and painful, it is far from unique.  All parties to potential litigation, when offered a settlement, must weigh the odds of prevailing upon a claim and potential gains against possible liabilities.  The choice is never easy, but it is not unfair or inequitable.”

Similarly, in Federal Deposit Insurance Corporation v. John A. White,21 the defendants John White and Donna White attempted to repudiate a settlement agreement with the Federal Deposit Insurance Corporation (“FDIC”).  The defendants alleged that they were threatened with criminal prosecution throughout the settlement process and felt coerced into signing the settlement agreement just to keep from going to jail.  Even though the district court acknowledged that the defendants’ concern about their potential criminal exposure was “for good reason,” the court refused to find that the settlement agreement between the FDIC and the Whites was the result of duress.  Both the Largen and White cases demonstrate the reluctance of a district court to set aside a written agreement on the grounds of duress with the government, despite threats of criminal or civil penalties.

The only conceivable fact pattern in which a district court may find a contract with the government unenforceable as a result of duress was in Robertson v. Commissioner.22  Although Robertson was decided by the United States Tax Court, it is conceivable that a district court could align itself with the Tax Court if the issues were similar to the facts and circumstances of Robertson.  In Robertson, an IRS revenue agent offered an uncounseled taxpayer the choice between signing a consent form and subjecting his property to seizure.  The Tax Court found duress under those circumstances.  It is difficult to imagine any participants of an OVDP being subjected to the same overreaching from the IRS as the taxpayer in Robertson suffered.  Given the weight that district courts place in the public interest regarding contracts with the government, it is difficult to imagine a case where a district court would find that a closing agreement was executed under duress.

The discussion above demonstrates that a United States district court may only find duress in extreme cases.  Therefore, an individual seeking court intervention to set aside a closing agreement executed in an offshore voluntary disclosure program using the argument of the theory of duress should not litigate before a United States district court.

The Closing Agreement is Set Aside, Now What?

If a court determines that a closing agreement is valid, the case will likely be disposed of through a dispositive motion such as a motion to dismiss; on the other hand, if a court were to determine that a closing agreement was executed under duress, there are two potential outcomes.  First, a court could rescind the closing agreement compelling the IRS to refund the offshore penalty paid through an OVDP, and at that point, litigation would come to an end.  In the second and more likely scenario, the government would file a counterclaim for all penalties that could have been assessed in lieu of the offshore penalty paid during a voluntary disclosure program settlement.  In this case, the individual bringing suit to recover the offshore penalty would be forced to defend against the offshore and domestic penalties that could have been assessed against the participant outside of the OVDP.

In summary, the government has marshaled its forces in a battle against offshore tax evasion during recent years.  The well-publicized crackdown on the use of secret offshore bank accounts appears to have encouraged a number of taxpayers to participate in the voluntary disclosure initiatives that the IRS has offered.  Even though the IRS boasts a huge success rate with the various offshore voluntary disclosure programs, they fail to take into consideration individuals that may have erroneously enrolled in the program as the result of their threats.  Currently, there is no administrative relief available to individuals who enrolled in a voluntary disclosure program by error.  The only conceivable theory to obtain relief from the miscellaneous penalty is through tax litigation, and the major hurdle to taxpayers litigating a claim for refund is the closing agreement that they executed in order to participate in an OVDP.  Taxpayers wishing to move forward with litigating a refund claim must convince a court to determine that the closing agreement is unenforceable, and the only viable theory at this time to accomplish that is to argue that the individual entered into a closing agreement as the result of duress.  In any case, convincing a federal court to find a closing agreement unenforceable on the grounds of duress is a daunting task, and the only court to offering a glimmer of hope is the Federal Court of Claims.  In cases brought before the Court of Claims, the participant must be prepared to demonstrate that the IRS’s threats of criminal and civil penalties overpowered their unfettered exercise of reasoned judgment and resulted in the erroneous execution of a closing agreement.

For more information, contact Moskowitz, LLP.

  1. A closing agreement is a final agreement between the IRS and a taxpayer on a specific issue or liability. Under Internal Revenue Code 7121, the IRS can negotiate a written closing agreement with any taxpayer to make a final resolution of any of the taxpayer’s tax liabilities for any period.
  2. IRC Section 7121.
  3. IRC Section 7121(b).
  4. Ingram v. Comm’r, 32 B.T.A. 1063, 1064, 1935 WL 287 (1935).
  5. Aetna Life Ins. Co. v. Eaton, 43 F.2d 711, 714 (2d Cir.), cert. denied, 282 U.S. 887, 51 S.Ct. 90, 75 L.Ed. 782 (1930) (holding tax levied and collected illegally under a statute declared unconstitutional cannot be avoided when included in closing agreement); Wolverine Petroleum Corp. v. Comm’r, 75 F.2d 593, 596 (8th Cir) (holding closing agreement takes priority over conflicting statute).
  6. In re Guy Miller v. Internal Revenue Service, 174 B.R. 791 (1994).
  7. See U.S. v. Nat’l Steel Corp., 75 F.3d 1146 (CA7 1996); Rink v. Comm’r., 47 F.3d 168 (CA6 1995); Alexander v. U.S., 44 F3d 328 (CA5 1995).
  8. Roach v. United States, 106 F.3d 720, 723 (6th Cir. 1997).
  9. Fruhauf Southwest Garment Co. v. United States, 111 F.Supp. 945, 951 (Ct.Cl.1953).
  10. David Nassif Assocs. v. United States, 644 F.2d 4, 12 (Ct.Cl.1981); See Sys. Tech. Assocs., Inc. v. United States, 699 F.2d 1383, 1387 (Fed.Cir.1983) (Systems Technology). (Citing David Nassif and other cases to explain that “[t]he standard [for duress] now looks more closely at the defeat of the will of the party coerced”).
  11. Christie v. United States, 518 F.2d 584, 587 (Ct.Cl.1975).
  12. See Systems Technology, 699 F.2d at 1387.
  13. Beatty v. U.S., 168 F.Supp. 204 (Ct.Cl.1958).
  14. Morrill v. Amoskeag Sav. Bank, 90 N.H. 358, 9 A.2d 519, 524.
  15. David Robinson v. U.S., 95 Fed.Cl. 480 (2011).
  16. Johnson, Drake & Piper, Inc. v. U.S., 531 F.2d 1037, 1042 (Ct.Cl.1976).
  17. See Fed. Deposit Ins. Corp. v. John A. White, 76 F.Supp.2d 736 (1999) (citing Sims v. Jones, 611 S.W.2d 461, 462 (1980).
  18. 111 F.Supp. 945, 951 (Ct.Cl.1953).
  19. See Fed. Deposit Ins. Corp., supra note 40 (citing Sims v. Jones, 611 S.W.2d 461, 462 (1980))
  20. 1995 WL 556621 (M.D.Fla).
  21. 76 F.Supp.2d 736 (1999).
  22. 32 T.C.M. (CCH) 955 (1973).