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IN RE TAX REFUND LITIGATION

March 29, 1991

IN RE TAX REFUND LITIGATION.


The opinion of the court was delivered by: Platt, Chief Judge.

    MEMORANDUM AND ORDER

By jury verdict rendered July 11, 1990, the seven plaintiffs were found to have promoted an abusive tax shelter and thus to be liable for the penalty prescribed by I.R.C. § 6700 (1982). By agreement of the parties, this Court will now determine the correct amount of the penalty owed by each of the plaintiffs.

Facts

The tax shelter promoted by the plaintiffs centered around the purchase and subsequent leasing of what the parties have referred to as "book properties." In broad brush, it was structured in the following manner. Plaintiff Geoffrey Townsend Ltd. ("Townsend") purchased certain book properties, that is, the plates, films, computer discs and other equipment which are used in the printing of hard and soft cover books, from various book publishers in 1982. It paid for the properties with small cash down payments and larger recourse notes at a rate of 9% per annum. At trial, it was established that the purchase price vastly exceeded the fair market value of the book properties.

Later in 1982, Townsend leased its book properties to 35 limited partnerships. The individual limited partnerships oversaw the production and distribution of the books produced using the book properties. For their investment, the limited partners were promised certain tax advantages: a deduction for the lease payments, and a proportionate share of the investment tax credit, based upon the inflated purchase price, which Townsend elected to pass through to its lessees.

In 1983, plaintiff Universal Publishing Resources, Inc. ("Universal") essentially repeated the actions of Townsend in the previous year. It purchased book properties on the same terms as Townsend, then leased them to 65 limited partnerships and elected to pass through the investment tax credit.

Plaintiff Barrister Associates ("Barrister"), a New York general partnership, was the general partner in all of the limited partnerships which leased book properties from Universal and Townsend. For its services, it collected substantial general partner fees. Plaintiffs Paul Belloff and Robert Gold are the sole general partners of Barrister Associates. Plaintiff Chadwick Investor Services, Inc. (a/k/a Chadwick Securities Corp.) ("Chadwick") is a company which the limited partnerships employed as an agent in selling limited partnership interests. Plaintiff Madison Library, Inc. provided administrative and clerical services to Universal and Townsend.

In 1986, the IRS determined that this series of transactions constituted the promotion of abusive tax shelters and assessed the following penalties against each of the plaintiffs:

    Townsend ....................... $2,739,013
    Universal ...................... $5,399,811
    Madison Library ................ $400,000
    Barrister ...................... $5,306,000
    Belloff ........................ $5,306,000
    Gold ........................... $5,306,000
    Chadwick ....................... $5,211,000

The penalties against Universal and Townsend were computed as a percentage of the gross income each entity derived from its promotions. The penalties against Barrister, Belloff, Gold and Chadwick were computed based upon the theory that each act of organizing a limited partnership and each sale of a limited partnership interest constituted a separate violation of the statute justifying the imposition of a separate $1000 penalty.

In February 1987, pursuant to I.R.C. § 6703 (1982), the plaintiffs paid 15% of these assessments and filed this refund action. The Government brought a counterclaim seeking payment of the remaining 85% of the assessed penalty. By Memorandum and Order dated November 2, 1988, this Court rejected the government's theory regarding the imposition of multiple $1000 penalties and directed that the penalties be reassessed. See In re Tax Refund Litigation, 698 F. Supp. 439, 443-44 (E.D.N Y 1988). On July 24, 1989, the IRS assessed the following penalties against each of the plaintiffs:

    Townsend ....................... $4,395,925
    Universal ...................... $8,994,367
    Madison Library ................ $400,000
    Barrister ...................... $534,693
    Belloff ........................ $124,672
    Gold ........................... $124,672
    Chadwick ....................... $1,446,713

The increase in the penalties assessed against Universal and Townsend resulted from a change in the theory upon which the Government computed their gross income. The penalties assessed against the remaining plaintiffs were now computed as a percentage of the gross income each derived from the promotions.

Discussion

As it existed at the time the events in question occurred, section 6700 required promoters of abusive tax shelters to "pay a penalty equal to the greater of $1,000 or 10% of the gross income derived or to be derived by such person from such activity." I.R.C. § 6700(a) (1982).*fn1 Because the Government has now chosen to calculate all of the penalties as a percentage of the gross income each plaintiff derived, in their post-trial memoranda the parties dispute whether certain items were properly included in the government's calculation of that gross income.

A. General Matters

1. Variance Doctrine

Before considering each plaintiff's specific objections to the IRS' computation of its gross income derived from the tax shelters, we first must confront two general arguments presented by the Government which are applicable to all plaintiffs. First, the Government seeks to erect the so-called variance doctrine as a bar to certain arguments made by the plaintiffs with regard to the calculation of their gross incomes. In brief, the variance doctrine prevents a taxpayer from raising issues or claims in a refund action before the district court, if it has not previously raised them in its administrative claim filed with the IRS. Real Estate-Land Title & Trust Co. v. United States, 309 U.S. 13, 17-18, 60 S.Ct. 371, 373, 84 L.Ed. 542 (1940); United States v. Felt & Tarrant Mfg. Co., 283 U.S. 269, 272, 51 S.Ct. 376, 377, 75 L.Ed. 1025 (1931).*fn2 The doctrine is designed to promote thorough administrative investigation of claims by ensuring that the IRS gets a sufficiently detailed claim. United States v. Memphis Cotton Oil Co., 288 U.S. 62, 70-72, 53 S.Ct. 278, 281-282, 77 L.Ed. 619 (1933). It also provides the IRS with notice of all claims and thus prevents factual surprise at trial. Mayer v. United States, 285 F.2d 683, 685-86 (9th Cir. 1960).

Two factors present in this case render application of the variance doctrine inappropriate. First, it was not until well after the plaintiffs first filed their refund claims that the IRS adopted its present, modified calculation of the penalty owed by each. Moreover, the IRS not only altered its calculation of the penalties but it did so based upon a modification in the theory upon which the penalties were calculated. Given the IRS' change of position, this Court may not seriously entertain the argument that it should bar plaintiffs from advancing new arguments to address the IRS' changed computation and theory because those arguments were not contained in a claim filed with the IRS before the Government reversed its field. Furthermore, there is no chance of the sort of factual surprise or surprise at trial which the variance doctrine was intended to avoid. Trial has concluded and the facts are firmly established. This Court will therefore entertain all arguments made by the plaintiffs regarding the computation of their gross income.

2. Allocation of Burden of Proof

Second, the government contends that the plaintiffs must bear the burden of proof with regard to any reduction in the IRS' penalty assessment. It arrives at this conclusion by arguing that IRS assessments are presumptively correct and can be rebutted only through the introduction of competent and relevant evidence to the contrary. Welch v. Helvering, 290 U.S. 111, 115, 54 S.Ct. 8, 9, 78 L.Ed. 212 (1933); Valley Title Co. v. Commissioner, 559 F.2d 1139, 1141 (9th Cir. 1977). In a penalty assessment, it argues, this presumption extends to two issues: 1) whether the person against whom the penalty is assessed is liable for the penalty and 2) the amount of the penalty assessed. In the case of section 6700 penalties, the government concedes that this allocation of burdens is partially modified. Section 6703 prescribes the procedures to be followed in the assessment of section 6700 penalties and specifically states that "[i]n any proceeding involving the issue of whether or not any person is liable for a penalty under section 6700 . . . the burden of proof with respect to that issue shall be on the Secretary." I.R.C. § 6703(a) (1988) (emphasis added). Because section 6703(a) explicitly assigns the burden of proof to the Government only on this issue, the Government concludes that the plaintiffs retain the burden of proof with respect to the amount of the penalty.

Far from twisting the language of section 6703(a), as the plaintiffs contend, the Government's construction is faithful to the plain language of the statute. It is well-settled that the penalty assessments of the IRS are generally presumed to be correct and that the plaintiff in a refund action bears the burden of proof in challenging such an assessment. Welch, supra, 290 U.S. at 115, 54 S.Ct. at 9. The parties do not dispute that section 6703(a) alters this allocation of burdens with respect to the conduct creating liability for section 6700 penalties. As the Government aptly points out, the plain language of section 6703(a), however, indicates that this alteration is a limited one. The section places upon the IRS the burden of establishing only that the plaintiffs' conduct renders them liable for a civil penalty.

It must be conceded that in many cases this allocation would not result in a split allocation of burdens, but would place the burden of proof on all relevant issues squarely on the shoulders of the Government. Most of the penalty provisions to which section 6703(a) applies impose fixed dollar penalties upon each violation of the statute. See id. §§ 6700-6702. Therefore, in many cases, it would be unnecessary to consider the burden of proof with respect to the amount of the penalty. Rather, proof of liability would subsume proof of the amount of the penalty.*fn4

The fact that often proof of liability would include proof of the amount of liability, however, does not dictate that the burden of proof with respect to both issues must always lie with the Government. The penalty imposed by section 6700 is considerably more complicated than that imposed by its companion sections: violators must pay a penalty equal to the greater of $1000 per violation or a stated percentage of the gross income derived from the violation. Id. § 6700(a). Clearly, in certain cases, the issue of the amount of the plaintiff's gross income derived from the promotion would remain in section 6700 cases even after liability had been established. In drafting this provision, Congress must have anticipated that this would be the case and yet, in assigning the burdens of proof in the refund action created by section 6703, it required the government to prove only that the plaintiff was liable for the penalty.*fn5

Moreover, this Court can think of no policy considerations which require that the Government bear the burden of proof on both issues. Rather, the Government having shouldered the considerable burden of proving to a jury that the plaintiffs have promoted abusive tax shelters, this Court can conceive of no reason to justify upsetting the customary allocation of the burden of proof in penalty assessments. Once it establishes liability under section 6700 and the only remaining issue is the amount of gross income derived by the plaintiff, there is simply no reason to regard the IRS calculation of the plaintiffs' gross income with any more suspicion than one might in the case of a penalty based upon a tax deficiency. The same policies which support this allocation in ordinary penalty cases are equally applicable in this situation. See generally, Martinez, Tax Collection and Populist Rhetoric: Shifting the Burden of Proof in Tax Cases, 39 Hast. L.J. 239, 266-72. (1988). Perhaps most importantly, it is the plaintiffs and not the IRS who are most likely to possess the information necessary to determine the gross income derived from the abusive shelters upon which the calculation of the penalty is based.

It cannot avail the plaintiffs to argue that this allocation of burdens is peculiar to tax deficiency actions and thus inapplicable in this case where no deficiency is alleged. First, as outlined above, once liability is established, the same policies which underlie the allocation of the burden to the taxpayer in the case of deficiency assessments justify allocation to the plaintiff of the burden of disproving the Government's calculation of their gross income here. Second, contrary to plaintiffs' assertions, section 6703(b) does not dictate that the government bear this burden. Section 6703(b) merely indicates that the procedures outlined in Subchapter B of Chapter 63 of the Internal Revenue Code do not apply to the assessment of section 6700 penalties. See I.R.C. § 6703(b) (1988). Subchapter B of Chapter 63, however, does not direct that the taxpayer bear the burden of disproving IRS deficiency assessments. Rather, it defines deficiencies and sketches the procedures to be followed in challenging them before the Tax Court. See id. §§ 6211-6216. Furthermore, the legislative history of section 6700-6703 reveals that section 6703(b) was not intended to reverse the allocation of the burden of proof in cases where a deficiency is found. It was, instead, intended to allow the IRS to assess section 6700 penalties without prior review by the Tax Court and to relieve those whom the IRS determined were liable for such penalties of the requirements that they first seek review of that determination in the Tax Court and pay any penalty assessed in full before being permitted to challenge it directly in the district courts. See S.Rep. No. 494, 97th Cong., 2nd Sess. at 270, reprinted in 1982 U.S.Code Cong. & Admin.News 781, 1017. Thus, section 6703(b) does not require that the Government, as opposed to the plaintiffs, bear the burden of proving the amount of the penalty to be paid by the plaintiffs.

B. Plaintiffs' Specific Challenges to the Penalty Assessments

The plaintiffs challenge the IRS's calculation of their gross income on various grounds. Those challenges will be dealt with serially, in the order in which ...


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