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IRS Failure to Abide by Closing Agreement Does Not Invalidate Assessment

In the case of Davis v. United States, CA9, No. 13-16458, 117 AFTR 2d ¶ 2016-368 there was no question the IRS had failed to comply with a closing agreement reached with the partnership of which Mr. and Mrs. Davis were partners (with the “Mr. Davis” being Al Davis, long time controlling partner of the Oakland/Los Angeles Raiders during his life).  But the matter to be decided was whether the IRS’s failure to follow that agreement meant the assessment against Mr. and Mrs. Davis as partners was invalid.  Or, in the alternative, did the closing agreement constitute an agreement with the partners that triggered a shorter statute that the IRS had missed, also rendering the assessment invalid.

The trial court believed the violation of the closing agreement itself simply rendered the assessments invalid.  But the Ninth Circuit panel, hearing the appeal, did not agree that invalidation of the assessment itself was the proper remedy when the IRS violated the agreement.  Rather the panel held that the taxpayers rather had access to other remedies to make themselves whole for any damage the breach may have caused.

The matter involved the Oakland Raiders partnership.  Al Davis was the president of A.D. Football, Inc. which was the sole general partner of the Oakland Raiders partnership and was also the tax matters partner of the partnership.

The matter at hand is summarized in the appellate opinion as follows:

The Partnership and the IRS were involved in long-running Tax Court litigation. See Milenbach v. Comm'r, 318 F.3d 924 (9th Cir. 2003). In 2005, the Partnership and the IRS reached a settlement over tax years 1988 through 1994. The Closing Agreement, which concluded the litigation, was signed by Davis, as President of the TMP. Under the Agreement, the IRS was required to make “computational adjustments” to determine the effect of the settlement on each partner's tax liability.  I.R.C. § 6231(a)(6). Paragraph Q of the Closing Agreement gave the partners the following procedural rights related to those computations:

[E]ach partner of the [Raiders] will be permitted at least 90 days to review and comment on computational adjustments proposed by the IRS with respect to the implementation of this settlement (and at least 60 days to review any revised computational adjustments) prior to the IRS assessing such amounts.

It is this particular clause that the IRS clearly violated with regard to the assessment against Mr. and Mrs. Davis.  As the Court continues:

The IRS did not distribute its calculations of each partner's computational adjustments until June 2007. Davis responded a few weeks later, but by the time the IRS sent revised calculations on August 27, 2007, it had no time to wait 60 days for Davis to review these calculations (as provided for by Paragraph Q of the Closing Agreement) because the statute of limitations to make assessments was about to expire. On September 4, 2007, the IRS issued assessments against Davis in the amounts of $501,661 for 1990, $1,820,400 for 1992, and $159,287 for 1995.3 The IRS applied a portion of refunds otherwise due to Davis for earlier years to satisfy those assessments.

Clearly the IRS had ended up between a rock and a hard place here—it managed to create a situation where there simply wasn’t time for 150 days of review by the time it submitted its original calculations of adjustments.  Though the Tax Court had approved the agreement and entered its stipulations in June of 2006, the IRS had taken a year to compute those adjustments.  Had the agency waited that long, the statute of limitations would have run and any assessment would not have been valid.  So the agency simply scrapped the waiting periods and issued the assessments anyway.

Al Davis cried foul at this point, noting that they had been denied the time promised to review the revised computations and, as well, the problem had been created by the IRS taking a full year from the date the agreement was approved by the Tax Court until issuing their calculation of adjustments to each partner.  Mr. Davis argued that the assessment should be deemed invalid since the agency failed to comply with the agreements.  As well, he argued alternatively that due to the failure the actual assessments against him as a partner were also outside the statute for assessment.

The District Court granted Mr. Davis his request to treat the assessment as invalid based on his first argument—that the IRS had violated the closing agreement and that the proper remedy for that was to invalidate the partner assessment since Al Davis did not have the promised time to review it before assessment.  The trial court did not consider the second argument since it wasn’t relevant after the court accepted the initial argument.

The Ninth Circuit panel, however, disagreed that the proper remedy for the IRS’s violation of the agreement was to treat the assessment as invalid. 

The panel notes that a closing agreement is a contract and that an award of damages is the default remedy for a breach of contract.  But the panel notes:

But Davis does not seek damages; instead, he argues that any assessments made in breach of the Closing Agreement are invalid. Davis relies primarily onI.R.C. § 7121(b)(2), which provides that closing agreements are “final and conclusive.” He notes that the Tax Court incorporated the Closing Agreement into its decision, making it enforceable as a court order.

The panel, however, does not read §7121 to require the assessment be rendered invalid.  The panel notes:

But, the “final and conclusive” nature of closing agreements simply means that they “settle an existing dispute with finality,” Nat’l Steel, 75 F.3d at 1150, and may not be modified or disregarded “except upon a showing of fraud or malfeasance, or misrepresentation of a material fact,” I.R.C. § 7121(b); see also In re Hopkins, 146 F.3d 729, 732 (9th Cir. 1998) (“In applying § 7121, courts unanimously have held that closing agreements are meant to determine finally and conclusively a taxpayer’s liability for a particular tax year or years.”). That a contract is “final” does not dictate the remedy for its breach. Cf. Jeff D. v. Andrus , 899 F.2d 753, 759 (9th Cir. 1989) (noting that even after court approval, “[a]n agreement to settle a legal dispute is a contract and its enforceability is governed by familiar principles of contract law”). And, Davis offers no support for the unlikely proposition that, because a settlement with the IRS is “final” and court-approved, the remedy for any breach, however small, is to free the taxpayer from his pre-existing obligation to pay taxes. If this were the case, the IRS justifiably would be reluctant to enter into closing agreements, for fear that a minor error could have major consequences.

Rather, the Court found, the proper remedy would have been to award damages to Mr. Davis for any additional costs incurred due to his inability to challenge the recalculation before assessment, such as the costs of having to take his challenge to court:

The IRS breached its contract. That entitled Davis to a remedy, but only one in contract. Moreover, although the breach denied Davis an opportunity to comment on the amounts of the assessments before they were made, it did not prevent him from challenging the assessed amounts; Davis could have sought to challenge those amounts in an administrative refund claim or a refund action. See I.R.C. § 6230(c)(1)(A). He did not. And, had he done so, Davis might have sought consequential damages resulting from his having to challenge the assessments in a more expensive manner than that provided for by Paragraph Q. Again, he did not. Instead, he threw a Hail Mary and sought a full refund. That pass falls incomplete. We hold that the IRS's breach of Paragraph Q did not invalidate the assessments.

So now the second argument comes into play, relating to the rules that apply to TEFRA partnership exams, specifically looking at IRC §6231(b)(1)(C) which provides:

(b) Items cease to be partnership items in certain cases

(1) In general

For purposes of this subchapter, the partnership items of a partner for a partnership taxable year shall become nonpartnership items as of the date—


(C) the Secretary or the Attorney General (or his delegate) enters into a settlement agreement with the partner with respect to such items,

In such a case, the statute of limitations period on that assessment is governed by IRC §6229(f)(1) which provides:

(f) Special rules

(1) Items becoming nonpartnership items

If before the expiration of the period otherwise provided in this section for assessing any tax imposed by subtitle A with respect to the partnership items of a partner for the partnership taxable year, such items become nonpartnership items by reason of 1 or more of the events described in subsection (b) of section 6231, the period for assessing any tax imposed by subtitle A which is attributable to such items (or any item affected by such items) shall not expire before the date which is 1 year after the date on which the items become nonpartnership items. The period described in the preceding sentence (including any extension period under this sentence) may be extended with respect to any partner by agreement entered into by the Secretary and such partner.

The taxpayers contends the IRS’s assessments, not issued until September of 2007, fail this test.  As the Court explains:

The Tax Court approved the stipulated decision documents in this case on June 6, 2006. Davis argues that these documents were each a “settlement agreement with the partner,” I.R.C. § 6231(b)(1)(C), so that the statute of limitations expired on June 6, 2007, one year after their entry. Davis relies on the prefatory language of the stipulated decisions, which provide that the adjustment to the Partnership’s returns is made “[p]ursuant to the agreement of the parties in this case.” Davis argues that, under I.R.C. § 6226, all partners were parties to the Tax Court proceeding, so each stipulation was “a settlement agreement with the partner” underI.R.C. § 6231(b)(1)(c). Because the one-year statute of limitations under I.R.C. § 6229(f) ended on June 6, 2007, Davis claims that the government’s September 4, 2007 assessments were too late.

The IRS position is that this was not a settlement agreement with the partners as defined in IRC §6231 cited above, but rather a closing agreement with the partnership that led to a Tax Court decision which is binding on the individual partners.  The IRS position is that the proper governing rule for the statute of limitations on assessment is found in the TEFRA rules at §6229(d), one year and 90 days after the stipulated decisions were entered.

The Court agreed with the IRS that this was not a case of an agreement with the partners individually and thus §6231(b)(1)(C) wasn’t invoked.  The Court held:

Under the plain language of I.R.C. § 6231(b)(1)(C), we conclude that the IRS does not “enter into a settlement agreement with the partner” when it enters into a settlement agreement with the TMP and the individual partner is bound merely by operation of the tax court’s decision to which the partner is a party. Here, the stipulations were not agreements with Davis individually. He did not sign them, nor did anyone purporting to represent him in his individual capacity. Instead, each stipulation was signed only by an attorney for the IRS and Stuart Lipton, in his capacity as “Counsel for Petitioner.” The “Petitioner” in the Tax Court proceeding was the Partnership and its TMP, A.D. Football. Thus, the stipulations, like the Closing Agreement, were agreements only between the IRS and the Partnership. To be sure, these documents had consequences for Davis, but they were not agreements “with” him under I.R.C. § 6231(b). Nothing in TEFRA indicates that Congress meant the word “partner” in§ 6231(b) to mean “tax matters partner;” to the contrary, Congress appears to have chosen its wording carefully throughout the statute, differentiating between partners in general and the tax matters partner repeatedly. See, e.g., I.R.C. §§ 6223, 6224(c), 6226(a)-(b), 6226(g), 6227, 6228(a), 6229(b).

Because the Closing Agreement and stipulations were not a “settlement agreement with” Davis within the scope of I.R.C. § 6231(b), the assessments made on September 4, 2007 were timely, as they occurred within one year after the Tax Court decision became final.  I.R.C. § 6229(d)