A couple of months ago, the Tax Court issued an interesting decision in the case Canal Corporation v. Commissioner. (If you're interested in reading it, the written opinion is here.) It involved a fairly typical scenario. The taxpayer wanted to sell part of its business, but the business was worth much more than the taxpayer's basis/cost. Selling the business outright would have meant a huge gain and associated taxes. Needless to say, the taxpayer wanted to avoid -- or at least delay -- taxes on that gain. Congress and the IRS have, over the years, recognized that in a lot of situations taxpayers shouldn't have to pay taxes on their gain in a business. Canal Corporation tried to fit within the rules set up by Congress and the IRS.
The Tax Court decided that Canal Corporation's approach -- a "leveraged partnership structure," a strategy that a lot of tax lawyers and taxpayers use -- didn't work in this case. The court also decided that Canal Corporation didn't have "reasonable cause" for taking that position on its original return and therefore owed a penalty, 20% of the additional taxes owed.
Tax lawyers and CPAs have been discussing the case a lot since it came out, mostly about whether the Tax Court was right and what other taxpayers can do differently to avoid the tax or at least the penalty. But there are a couple of things about the penalty that haven't been discussed much, although I thought they were very interesting.
The mistake that Canal Corporation or its lawyers (apparently) made is a result of the different ways that taxpayers can challenge the IRS in court. They have two options, essentially. When the IRS informs you that it thinks you owe additional tax, you can file a petition in Tax Court and have the court decide whether you are correct or the IRS is. You can file in Tax Court without first paying the amount the IRS thinks you owe. Or you can pay the additional tax the IRS claims you owe, and then file a complaint seeking a refund, in federal district court or the Court of Federal Claims.
There are various factors that go into the decision of which court is better for you. (I've giving a webinar next month on that topic.) Being able to have your day in Tax Court without paying first is attractive to a lot of taxpayers. Another important consideration, though, is whether the government can raise new issues that weren't included in its original notice that you're disputing.
In federal district court or the Court of Federal Claims, if you wait to file your refund suit until after the statute of limitations expires, the attorneys for the IRS [*] can bring up new issues to reduce any refund the court might decide you're owed from the original issues. But the most the court can do is reduce the refund to $0. The government can't recover any more money from you than you've already paid.
In Tax Court, though, the government can raise new issues and the court can decide that you owe more money than the government requested in its original notice to you. The price of not having to pay before your day in court is that the amount you have to pay may go up. That includes penalties, if the IRS didn't initially apply them. The fact that the Tax Court can decide that you owe more money than originally asked is settled law and fairly well known among tax attorneys.
It appears, from the opinion, that the original notice of deficiency the IRS sent Canal Corporation did not apply a penalty. The IRS brought the penalty up only in the court case. And since the Tax Court agreed with the IRS both about the underlying taxes and also about the penalty, Canal Corporation (apparently) wound up paying more than if it had just paid the amount the IRS originally asked for and filed a refund suit instead. There may be something that's not apparent from the Tax Court's opinion but it certainly appears to be a tactical mistake by Canal Corporation or its lawyers. And a costly one, at that. The 20% penalty amounted to over $36 million.
First lesson for other taxpayers and attorneys: If the IRS doesn't ask for penalties (or some other issue) but there's some risk that a court might decide against you . . . unless there's a very good reason for going to Tax Court, pay the amount in the notice, wait until the statute of limitations has expired, and file a refund suit.
[*] In Tax Court, the government is represented by attorneys from the IRS. In federal district court or the Court of Federal Claims, the government is represented by attorneys from the Department of Justice.