Tax matters can be litigated in a number of different courts. One of the advantages of bringing suit in U.S. Tax Court is that the tax does not have to be paid prior to bringing suit. For tax matters litigated in the U.S. District Courts or the Court of Federal Claims, the tax has to be full-paid prior to bringing suit. There is an exception whereby a portion of the tax can be paid if the tax is divisible. The United States Court of Appeals for the Federal Circuit recently addressed this exception in Diversified Group, Inc. v. United States, No. 2016-1014.
The facts and procedural history for the case are as follows:
- The Diversified Group, Inc. was in the business of selling tax shelters.
- The IRS assessed two Sec. 6707 reportable transaction penalties against the taxpayer for not registering its tax shelters with the IRS.
- Each penalty was computed based on the two separate tax shelters that the taxpayer did not register.
- Combined, the penalties were $42 million. The $42 million was computed by taking the amount Diversified’s clients invested in the tax shelters, times one percent.
- The taxpayer made a payment of $15,500 to the IRS, which was the portion of the penalty that it incurred for one of the tax shelters for a single client (technically there were two taxpayers and a refund claim from both, but this post will only address Diversified to make it easier to follow).
- The taxpayer filed a refund claim, which the IRS disallowed, and the taxpayer brought suit in the Court of Federal Claims to recover the $15,500 it paid.
On appeal, the issue was whether the Court of Federal Claims had jurisdiction given that the taxpayer did not full-pay the entire amount of the penalty before bringing suit. The full-pay rule is often referred to as the Flora rule, which is a reference to the court case that established the rule. The exception to the Flora rule is found in the Boynton case, which says that a divisible tax need not be full-paid prior to bringing suit to recoup a refund. This brings us to the Diversified Group case. It explains whether the Sec. 6707 penalty is divisible.
In Diversified Group, the taxpayers argued that the Sec. 6707 reportable transaction penalties were divisible. It reasoned that the penalties were assessed for each of the 192 instances in which it implemented the tax shelters for clients. It noted that a separate Form 8264, the form by which a tax shelter is registered, would need to be filled out for each of the 192 instances.
The IRS disagreed. It argued that the reportable transaction penalties were not divisable. It viewed the penalties as just two penalties, the liability for each of which was triggered by a single event, namely, the failure to register the tax shelter. The IRS focused on the number of registrations, not the number of times the tax shelter was sold. As only two penalties, the IRS argued that the reportable transaction penalties had to be full-paid before the taxpayer could bring suit.
The court agreed with the IRS. It concluded that the liability arises from a single event–the failure to register a tax shelter–Sec. 6707 penalties are not divisible into the individual transactions or investors that may comprise a single tax shelter.
Compare this to other types of taxes and penalties, such as the Sec. 6672 trust fund recovery penalty in Boynton. In that case, the court concluded that the trust fund recovery penalty is divisable. So paying a single employee’s wages for one quarter suffices.
The disparate treatment for the Sec. 6707 reportable transaction penalties in Diversified Group and the Sec. 6672 trust fund recovery penalties in Boynton is difficult to reconcile. The trust fund recovery penalty is computed based on the individual employee withholding for each employee. Following the rationale in Diversified Group, it seems that the court in Boynton should have concluded that the failure to pay over the withholdings was a single event that triggered the penalty and, therefore, the penalty was not divisable.