by Stephen G. Salley and Anthony J. Scaletta
As part of the Internal Revenue Service Restructuring and Reform Act of 1998, Congress enacted new Internal Revenue Code §7491(a). This “new” statute provides, in part, that if a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the taxpayer’s liability, and has complied with certain substantiation and record-keeping requirements imposed by the Internal Revenue Code, then the burden of proof in any court proceeding with respect to such issue is on the Internal Revenue Service.1 The new statute applies to court proceedings arising in connection with examinations beginning after July 22, 1998.2 Given the time it takes for a tax audit to move from initial administrative examination to litigation, to date there have been few published opinions interpreting §7491(a), a provision in the law for nearly four years. The U.S. Tax Court, in Griffin v. Comm’r, T.C. Memo 2002-6 (2002), and the U.S. Court of Appeals for the Eighth Circuit, in Griffin v. Comm’r, 315 F.3d 1017 (8th Cir. 2003), have provided one of the first windows into how the statute may impact taxpayers, their counsel, and the IRS’s own attitude toward tax litigation.
By enacting I.R.C. §7491 into law, Congress attempted to address the perceived concern that individual and small business taxpayers are frequently at an unfair disadvantage when litigating with the IRS.3 The disadvantage derives, in part, from the rules regarding the burden of proof in tax litigation. Historically, the statutory notice of deficiency has been presumed to be correct and the taxpayer is forced to assume the initial burden of coming forward not only with prima facie evidence to support a finding contrary to that of the notice of deficiency, but also must carry the ultimate burden of persuasion on the merits of the dispute.4 This burden on taxpayers to disprove an assessment has left taxpayer representatives with a sense that they begin many factual cases climbing uphill, the presumption of correctness of the notice of deficiency becoming the handicap in a litigation race, with all ties going to the house, the Internal Revenue Service.5
Since the most frequent trier of fact and law in tax cases is the U.S. Tax Court,6 the procedures and approaches implemented by that court with respect to the burden of proof are key in establishing the “hazards of litigation” assessments of the IRS and the taxpayer and, hence, not only for the trials themselves but the very process of tax dispute settlement. Because of this indirect “trickle down” influence over the totality of the tax process, the Tax Court’s attitude toward evidence and persuasion color the entire atmosphere of tax audit and dispute.
In enacting I.R.C. §7491, Congress sought to implement a litigation regime very different from that under the “presumption of correctness” for the Commissioner’s findings, and requiring that facts asserted by a taxpayer be accepted as evidence shifting the burden of proof to disprove the assertion of the IRS, so long as the taxpayer meets minimum standards of credibility.7 If this express Congressional intent is thoughtfully implemented by reviewing courts, §7491 may effect a quiet revolution, rebalancing the playing field between the IRS and the taxpayer in the hundreds of factual tax disputes in which subjective intent, behavior, business purpose, valuation, or other issues subject to testimony by a taxpayer on his or her own benefit is treated presumptively as real evidence rather than merely special pleading.
Historically, the Tax Court, like all courts and triers of fact, has been able to disregard testimony of a taxpayer, utilizing the rubric that it need not accept mere “self-serving” or implausible evidence.8 Not surprisingly, when the Tax Court labels evidence as “self-serving” it is usually signaling that such evidence is about to be disregarded, virtually as an exercise of judicial notice or clairvoyance, leaving the commissioner armed with a now unrebutted presumption of correctness. Inside the tangle of cases dealing with “self-serving” testimony reside a motley of often unanalyzed law and attitudes which, if §7491(a) is to be respected, will require the Tax Court (and indeed all courts with tax jurisdiction) to revisit and analyze with greater precision. Simply stated, the courts will need to accommodate §7491 by determining the threshold for credibility.9
Under the new statute, the burden of proof shifts to the IRS when the taxpayer introduces “credible evidence” with respect to a factual issue. The legislative history defines credible evidence broadly:
[T]he quality of evidence which, after critical analysis, the court would find sufficient upon which to base a decision on the issue if no contrary evidence were submitted (without regard to the judicial presumption of IRS correctness.) A taxpayer has not produced credible evidence for these purposes if a taxpayer merely makes implausible factual assertions, frivolous claims, or tax protestor-type arguments.10
The second sentence defines credibility in the negative, not as requiring inherent believability or plausibility but, instead, as not being frivolous or implausible. How the courts apply this standard is the key to the future effectiveness of §7491.
In Griffin, the Tax Court provided taxpayers with a glimpse into how narrowly it would apply this statute. The U.S. Court of Appeals for the Eighth Circuit approach in vacating the Tax Court’s decision in Griffin may signal a sea change, forcing the Tax Court and the IRS to scrutinize more sympathetically what appears to be either “self-serving” or uncorroborated testimony.
The taxpayer, in Griffin, owned all of the stock of a subchapter S corporation which, in turn, owned 60 percent of two distinct partnerships.11 Each of the partnerships owned commercial real property. The taxpayer, however, owned no interest in the real properties owned by these partnerships other than indirectly through his ownership of the subchapter S corporation. In order to allow each partnership to secure financing for its real property, the taxpayer personally guaranteed certain notes for each of the partnerships. In addition, the taxpayer personally paid real property taxes that had accrued with respect to each partnership’s real property. On his federal income tax return, the taxpayer claimed the real property tax payments as a deductible expense.12
The IRS selected the taxpayer’s return for audit, and recharacterized the payment of the real property taxes by the taxpayer as capital contributions to the subchapter S corporation and as a deductible expense of each of the partnerships. This recharacterization resulted in a flow-through to the taxpayer of only 60 percent of the deductions he had initially claimed personally.
The taxpayer filed a petition in the U.S. Tax Court claiming that the payment of the real property taxes by the taxpayer were individually deductible by the taxpayer.13 The issue at trial was whether the taxpayer was engaged in a trade or business, and, if so, whether the taxpayer’s payment of the real property taxes were attributable to an ordinary and necessary expense of that trade or business or as a payment to protect such business. The taxpayer testified that he had been a building contractor and land developer for 30 years; that the makers of the partnership loans were looking to the taxpayer to satisfy the real property tax assessments; and that if he had not satisfied the tax assessment he would have been subject to a judgment which could have been executed against his other property holdings. Significantly, the IRS did not present any witnesses at all. The IRS’s entire trial evidence consisted of merely cross-examination of the witnesses and reliance on its presumption of correctness.
In ruling for the IRS, the Tax Court remarked that “[t]he only evidence regarding the nature of [the taxpayer’s] business activities consists of [the taxpayer’s] summary and uncorroborated testimony.”14 The Tax Court determined that the “sparse evidence” introduced by the taxpayer would not be sufficient upon which to base a decision on the issue as to whether the taxpayer was actually engaged in a trade or business. In addition, the Tax Court found that the “only” evidence that the partnerships’ lenders looked to the taxpayer to satisfy the delinquent tax assessments, or that if the taxpayer had not made the tax payments he would have been subject to risk of judgment brought against him, was the taxpayer’s own uncorroborated testimony. The Tax Court found no evidence to indicate how the failure of the taxpayer to make the tax payments would have resulted in damage to the taxpayer’s reputation or creditworthiness other than the taxpayer’s oral testimony that he made the payments “in order to preserve [his] integrity and [his] standing with the bank, and [his] good name and goodwill.”15 The Tax Court ruled, in short, that the taxpayer had failed to introduce “credible” evidence to support his position. The taxpayer appealed.
In vacating the order of the Tax Court and remanding the case for further proceedings, the U.S. Court of Appeals for the Eighth Circuit provided some insight into the “credible evidence” standard with respect to I.R.C. §7491(a).16 In reviewing the Tax Court’s interpretation of §7491(a), the Eighth Circuit, interestingly, adopted the definition of the term “credible evidence” suggested by the IRS itself, a definition
which is sensible, consistent with the law’s underlying purpose, and derived from the legislative history. . . .Accordingly, . . . . “credible evidence,” for purposes of interpreting and applying [Section] 7491(a)(1), is “the quality of evidence which, after critical analysis, the court would find sufficient upon which to base a decision on the issue if no contrary evidence were submitted (without regard to the judicial presumption of IRS correctness).”17
The Eighth Circuit went on to hold:
[v]iewing [the taxpayer’s] testimony in the absence of any evidence or presumptions to the contrary, we conclude that [the taxpayer] did produce sufficient “credible evidence” to support [the] personal deductions of the real property tax payments at issue. We therefore hold that the Tax Court erred in failing to shift to the [IRS] the burden to provide the non-applicability of the [exception to the general rule] in the present case.18
The Eighth Circuit acknowledged that it was not resolving the merits of the deficiency issues, because it could not determine on the record before it whether the IRS had met its burden of proof. It was not sufficient to summarily conclude that the outcome would be the same regardless of who bears the burden of proof; otherwise, the new statute would have no meaning. The Eighth Circuit cautioned, however, that if the Tax Court, upon remand, reached the same conclusion without holding a new hearing or taking additional evidence, it would require an explanation as to how the existing record justifies the conclusion that the IRS carried its burden of proof.19 In short, the Eighth Circuit took seriously the phrase “after critical analysis” in rejecting self-serving or allegedly implausible evidence.
The Eighth Circuit’s interpretation of I.R.C. §7491(a) in Griffin could be the beginning of a new era in the adversarial relationship between the IRS and taxpayers, or it may become a mere footnote. The answer, of course, will lie not only with the Tax Court, but also with each individual court of appeals, since the appellate courts will be the ones asked to grade the Tax Court on whether it has, in fact, properly overseen the shift of the burden of proof. The new statute should, at a minimum, require the Tax Court (and other courts with tax jurisdiction) to add crispness to its analysis of taxpayer testimony. In addition, the new statute may fundamentally change the at times passive role of the IRS in a Tax Court trial, often little more than cross-examination of taxpayer witnesses and reliance on the presumption of correctness, as in Griffin. As the new statute gains a foothold, the Tax Court should require the IRS to shoulder its new burden of proof with the same enthusiasm it previously insisted it be imposed on taxpayers. As the legislative history seems to imply, taxpayer evidence is evidence unless it reaches the level of implausibility, frivolousness, or tax protest nonsense.
By the same token, taxpayer counsel would be ill-advised to rely on uncorroborated taxpayer testimony where any corroboration is available. The level of “credibility” is inherently a matter for the trier of fact. Frequently, the pressures both from the taxpayer (to minimize the expense of preparation for and trial itself) or from the court (to stipulate cases, reduce time for trial, reduce cumulative witnesses, and the like) result in preparation for trial which is all to often “bare bones.” Perhaps the Internal Revenue Manual’s guidance for district counsel, in dealing with preparation and with the burden of proof and the presumption of correctness, is now equally applicable to taxpayers preparing for trial, even when they believe §7491 will shift the burden of proof. The Internal Revenue Manual instructs district counsel to “develop, to the extent practicable, all affirmative evidence to sustain the commissioner’s determination, even though [the taxpayer] has the burden of proof on the issues,” and not to rely solely on cross-examination of the taxpayer and the taxpayer’s witnesses.20
While many taxpayer representatives who have litigated in the Tax Court have found this advice honored in the breach by district counsel who have been, at times, all too ready to rely on the presumption of correctness, the same may well be true of taxpayer counsel overly relying on §7491. Credibility under the statute will require taxpayer counsel to establish both the logical backdrop for taxpayer testimony (plausibility) and whatever consistent testimony or evidence is available to undergird the taxpayer’s testimony (corroboration). Both at administrative appeal and trial, the minimum level of proof adduced by the taxpayer, in the words both of the IRS and of the Eighth Circuit, must meet the test of “critical analysis.”
1 The new statute reads as follows:
“(a) BURDEN SHIFTS WHERE TAXPAYER PRODUCES CREDIBLE EVIDENCE. –
(1) GENERAL RULE. – If, in any court proceeding, a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer for any tax imposed by subtitle A or B, the Secretary shall have the burden of proof with respect to such issue.
(2) LIMITATIONS. – Paragraph (1) shall apply with respect to an issue only if –
(A) the taxpayer has complied with the requirements under this title to substantiate this item;
(B) the taxpayer has maintained all records required under this title and has cooperated with reasonable requests by the Secretary for witnesses, information, documents, meetings, and interviews; and
(C) in the case of a partnership, corporation, or trust, the taxpayer is described in section 7430(c)(4)(A)(ii).
Subparagraph (C) shall not apply to any qualified revocable trust (as defined in section 645(b)(1)) with respect to liability for tax for any taxable year ending after the date of the decedent’s death and before the applicable date (as defined in section 645(b)(2)).
(3) COORDINATION – Paragraph (1) shall not apply to any issue if any other provision of this title provides for a specific burden of proof with respect to such issue.”
2 Neither the statute nor its legislative history defines the term “examination” for purposes of the effective date. In Jombo v. Comm’r, T.C. Memo 2002-273, the Tax Court treated the taxpayer’s examination as beginning on the date the IRS sent the taxpayer a letter informing the taxpayer that his income tax return had been selected for examination. In O’Toole v. Comm’r, T.C. Memo 2002-265, the Tax Court ruled that the examination began when the IRS requested transcripts of third-party reports showing amounts paid to the taxpayer.
3 H. Conf. Rept. No. 105-599 (1998).
4 See Rockwell v. Comm’r, 512 F.2d 882 (9th Cir. 1975). The initial presumption that the statutory notice of deficiency is presumed to be correct is a “procedural device” which requires the taxpayer to come forward with enough evidence to support a finding contrary to that of the notice of deficiency. After satisfying this procedural burden, the taxpayer must still carry the ultimate burden of proof or persuasion. Id.
5 The Internal Revenue Service’s Manual for District Counsel cautions against blithe reliance on the statutory presumption but the experiences of the authors is that district counsel can and do rely on the taxpayer’s burden to drive trial stipulations, discovery, and witness examinations. See Internal Revenue Manual §18.104.22.168. The manual states, in part, that “[a]n attorney should not rely solely upon cross-examination of the petitioner and petitioner’s witnesses to establish the respondent’s case if there is affirmative evidence available which can be presented on behalf of respondent” Id.
6 The U.S. Tax Court is the primary prepayment tribunal for tax-related litigation. If a taxpayer chooses to litigate in the U.S. Court of Claims or the U.S. district courts, the taxpayer is required to first pay all taxes, penalties, and interest, and then litigate his claim in the form of a refund action. The other prepayment tribunal is the U.S. Bankruptcy Courts, but the external restrictions on the ability of a taxpayer to file for bankruptcy makes this forum unavailable in most common tax disputes.
7 H. Conf. Rept. No. 105-599 (1998).
8 See Chin v. Comm’r, T.C. Memo 2003-30 (2003) (“we do not need to accept self-serving testimony without corroborating evidence,”); Niedringhaus v. Comm’r, 99 T.C. 202 (1992) (“The Court is not required to accept petitioner’s self-serving testimony.”); Tokarski v. Comm’r, 87 T.C. 74 (1986) (“Under all the circumstances, we are not required to accept the self-serving testimony of petitioner or that of his mother as gospel.”).
9 When the Tax Court labels taxpayer testimony as self-serving or uncorroborated, it usually summarily disregards such testimony as evidence. See Woodall v. Comm’r, T.C. Memo 2002-318 (2002); Hastings v. Comm’r, T.C. Memo 2002-310 (2002); Mantakounis v. Comm’r, T.C. Memo 2002-306 (2002); Penfield v. Comm’r, T.C. Memo 2002-254 (2002). While the decision on the merits of these cases may not be objectionable, the evidentiary analysis with respect to the taxpayer’s testimony should be revisited in light of the new statute.
10 H. Conf. Rept. No. 105-599 (1998) (emphasis added).
11 Griffin v. Comm’r, T.C. Memo 2002-6 (2002).
13 Under normal circumstances, a taxpayer may not deduct a payment made on another’s behalf unless the payment represents an ordinary and necessary expense of the taxpayer’s own business. There is an exception to this rule, however, where a taxpayer may deduct the payment of expenses of a third party if the payment qualifies an ordinary and necessary expense of the taxpayer’s own business or trade. Id. Generally, the cases which have allowed deductions under the exception to the general rule involve a taxpayer’s payment of financial obligations of a third party in financial distress. The cases generally require the taxpayer to show direct and proximate adverse consequences to the taxpayer’s own business from the failure to pay the other party’s obligations. Id.
14 Id. (emphasis added).
16 Griffin v. Comm’r, 315 F.3d 1017.
17 Id. (internal citations omitted) (emphasis added).
20 Internal Revenue Manual §22.214.171.124.
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