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RULE 59 MOTION TO ALTER THE JUDGMENT AND FOR NEW TRIAL
John P. McDonnell, Esq. (State Bar No. 77369)
Law Offices of John P. McDonnell
40 Main Street
Los Altos, CA 94022-2902
Telephone: (650) 991-9909
Facsimile: (844) 607-7525
E-mail: JPMcDON@aol.com
Attorney for Plaintiff
INTERIOR GLASS, INC.
UNITED STATES DISTRICT COURT
NORTHERN DISTRICT OF CALIFORNIA--SAN JOSE DIVISION
INTERIOR GLASS, INC.,
Plaintiff,
v.
UNITED STATES OF AMERICA
Defendant.
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Civil No. 5:13-cv-05563-EJD
NOTICE OF MOTION AND MOTION
UNDER RULE 59 TO ALTER THE
JUDGMENT AND FOR NEW TRIAL
DATE: FEBRUARY 23, 2017
TIME: 9:00 A.M.
COURTROOM: 4
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RULE 59 MOTION TO ALTER THE JUDGMENT AND FOR NEW TRIAL
TABLE OF CONTENTS
INTRODUCTION ............................................................................................................................. 1
LEGAL DISCUSSION ..................................................................................................................... 2
I. GROUNDS FOR A RULE 59 MOTION. .......................................................................................... 2
II . THE NEW DEFINITION OF “SUBSTANTIALLY SIMILAR" IS UNCONSTITUTIONALLY VAGUE. ....... 2
A. The Only Proper Analysis of What Transactions Are Substantially Similar to the
Transaction in Notice 2007-83, Is To Determine If The New Transaction Has The Four
Specific Elements Listed In Notice 2007-83. ............................................................................. 2
1. The IRS has Developed Procedures Establishing that a Transaction Is Substantially
Similar To The Notice 2007-83 Transaction Only if The Transaction Has All of the Four
Specific Elements In The Notice. .......................................................................................... 2
a. The 2010 IRS Workpaper. ............................................................................................. 2
b. The Development of An IRS “Template.” ..................................................................... 3
c. T.D. 9350 Also Indicates That The Elements in the Notice Are Controlling. ............... 3
d. The Form 886A In This Case Tracks the Four Elements in Notice 2007-83. ............... 4
B. Ignoring the Specific Elements of Notice 2007-83 is a Denial of Due Process. .................. 6
III. THE GTLP IS NOT SUBSTANTIALLY SIMILAR TO THE NOTICE 2007-83 TRANSACTION. ......... 10
IV. THE GTLP WAS NOT STRUCTURED TO FUND PAYMENTS ON CASH VALUE WHOLE LIFE
INSURANCE POLICIES. .................................................................................................................. 13
VI. THE REQUIREMENT OF A PRE-COLLECTION HEARING. ........................................................... 17
CONCLUSION ............................................................................................................................... 18
TABLE OF AUTHORITIES
CASES
Altera Corp v. Commissioner, 145 T.C. 91 (July 27, 2015) ................................................. 16, 18
Brown v. Wright (9th Cir. 1978) 588 F.2d 708 ............................................................................. 2
Fang Lin Ai v. United States (9th Cir. 2015) 809 F.3d 503 ........................................................ 10
Grayned v. City of Rockford, 408 U.S. 104 (1972) ................................................................... 20
Greyhound Corp. v. United States, 495 F.2d 863, 869 (9th Cir. 1974) ...................................... 10
Hemp Indus. Ass’n v. DEA, 333 F.3d 1082, 1087 (9th Cir. 2003) .............................................. 17
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RULE 59 MOTION TO ALTER THE JUDGMENT AND FOR NEW TRIAL
Jolly v. United States, 764 F.2d 642 (9th Cir. 1985) ................................................................... 18
Kahn v. United States, 753 F.2d 1208, 1217 (3d Cir. 1985) ....................................................... 18
Mathews v. Eldridge, 424 U.S. 319(1976) .................................................................................. 19
Servants Of The Paraclete v. Does (10th Cir. 2000) 204 F.3d 1005 ............................................ 2
STATUTES
26 U.S.C. §79 ................................................................................................................................ 5
26 U.S.C. §223 ............................................................................................................................ 11
26 U.S.C. §223(f) ........................................................................................................................ 12
26 U.S.C. §264 ............................................................................................................................ 11
26 U.S.C. §401. ............................................................................................................................. 7
26 U.S.C. §401(k) ................................................................................................................ passim
26 U.S.C. §419(e)(3) ............................................................................................................... 5, 10
26 U.S.C. §501(c) ........................................................................................................................ 11
26 U.S.C. §501(c)(6) ................................................................................................................... 11
26 U.S.C. §6011 ............................................................................................................................ 4
26 U.S.C. §6707A ......................................................................................................................... 1
OTHER AUTHORITIES
Rev. Rul. 2007-65 ....................................................................................................................... 11
T.D. 9350 ................................................................................................................................... 3, 4
RULES
FRCP Rule 59(a)(2) ...................................................................................................................... 3
TREATISES
AICPA Report on Civil Tax Penalties: The Need for Reform (August 28, 2009) .................. 13
REGULATIONS
Treas. Reg. §1.6011(b) .................................................................................................................. 3
Treas. Reg. §1.6011(b)(6) ............................................................................................................. 3
Treas. Reg. §1.6011-4(c)(3) ........................................................................................................ 15
Treas. Reg. §1.79-1(a)(2) ............................................................................................................ 14
Treas. Reg. §1.79-1(c) ................................................................................................................. 14
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RULE 59 MOTION TO ALTER THE JUDGMENT AND FOR NEW TRIAL 1
INTRODUCTION
This is the rare Rule 59 Motion that wholeheartedly endorses a major portion of the
Court’s ruling. At pages 9-10 of the Order (Docket Entry #70), the Court addressed the
Plaintiff's argument that the phrase “substantially similar” in the Treasury Regulations at
§1.6011-4(c)(3) is unconstitutionally vague, because as now interpreted by the IRS, it fails to
provide guidance that, “a person of ordinary intelligence could understand” to determine if a
transaction is “substantially similar” to a “listed transaction.” The Court ruled that the phrase
“substantially similar” must be read in conjunction with Notice 2007-83, and noted that the
Notice defines “listed transaction” with four specific elements (p.10, line 13). The Court ruled
that “given this direction” the phrase is not unconstitutionally vague, holding:
As explained, Notice 2007-83 lists specific elements to which an arrangement can
be compared to determine whether it is “substantially similar” to a “listed
transaction.” For that reason, and contrary to Interior Glass’ position, § 6707A
does not “effectively require[] the taxpayer [to] guess what arguments (and what
revised facts) the IRS might come up with in the future to allege that two
different items are ‘substantially similar.’”
Plaintiff Interior Glass Inc. agrees. The phrase “substantially similar” in the regulations
is valid so long as it adheres to the specific elements in the Notice. When the IRS ignores those
specific elements, as it has in this case, and proposes a vague and unpredictable “rule” that does
not provide specific guidance, then the phrase “substantially similar” becomes essentially
useless in providing any guidance as to what transactions must be reported under §6707A.
As explained below, up until the present case, the IRS has always used the four specific
elements in Notice 2007-83 to determine if a transaction is substantially similar to the
transaction in that Notice. In this case, for the first time, the IRS claims that the term
“substantially similar” is independent of those four elements. This new interpretation of the
regulations makes the regulations unconstitutionally vague. In effect, the “guidance” from the
IRS is, “A ‘listed transaction’ is a transaction that contains these four elements OR a transaction
that does not contain these four elements.” That is no guidance at all.
///
///
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RULE 59 MOTION TO ALTER THE JUDGMENT AND FOR NEW TRIAL 2
LEGAL DISCUSSION
I. GROUNDS FOR A RULE 59 MOTION.
Briefly, there are three grounds for a new trial in a court-tried case; (1) error of fact (2)
error of law and (3) newly discovered evidence. Brown v. Wright (9th Cir. 1978) 588 F.2d 708,
710. More expansively, a Rule 59 motion is appropriate, “[W]here the court has misapprehended
the facts, a party's position, or the controlling law,” and the motion can be based on, “(1) an
intervening change in the controlling law, (2) new evidence previously unavailable, and (3) the
need to correct clear error or prevent manifest injustice.” Servants Of The Paraclete v. Does (10th
Cir. 2000) 204 F.3d 1005, 1012. In the present case, the Plaintiff believes the Court has
misapprehended some of the facts presented and has made an error of law.
II . THE NEW DEFINITION OF “SUBSTANTIALLY SIMILAR" IS UNCONSTITUTIONALLY VAGUE.
A. The Only Proper Analysis of What Transactions Are Substantially Similar to the
Transaction in Notice 2007-83, Is To Determine If The New Transaction Has The Four Specific
Elements Listed In Notice 2007-83.
1. The IRS has Developed Procedures Establishing that a Transaction Is Substantially
Similar To The Notice 2007-83 Transaction Only if The Transaction Has All of the Four
Specific Elements In The Notice.
a. The 2010 IRS Workpaper. The IRS has apparently been auditing transactions
like the GTLP since Notice 2007-83 was issued in late 2007. The record in this case contains an
IRS “Workpaper” that was created in March 2010 that provides the guidance to IRS agents for
determining if a transaction is substantially similar to the transaction in Notice 2007-83 and
must be reported under §6707A. This Workpaper is in the record at page 17 of Exhibit 4 of the
April 27, 2015 Declaration of John McDonnell, Docket Entry #60-1, and an additional copy is
attached as Exhibit 1 to the current Declaration of Mr. McDonnell. This Workpaper was in the
audit file of Interior Glass, produced by the Government in discovery in this case, as evidenced
by the “US05507” bates stamp.
As the IRS Workpaper demonstrates, the determination of whether a transaction was
substantially similar to the Notice 2007-83 transaction required a determination of whether the
new transaction had all four of the specific elements in the Notice (page US05509). The Agent
determined that the new transaction did not have all of the elements, and so it was not a listed
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RULE 59 MOTION TO ALTER THE JUDGMENT AND FOR NEW TRIAL 3
transaction that had to be reported (page US05511).
b. The Development of An IRS “Template.” At some point, the IRS developed a
“template” for comparing transactions to the transaction in Notice 2007-83. Under Rule
59(a)(2) the Court may take new testimony on a Motion for New Trial in a non-jury case. It was
previously reported to the Court that Agent Mya Aung was the Agent that conducted the audit of
Interior Glass (Docket Entry #33, page 2 para. 6). In her deposition in this case, Ms. Aung
testified that the IRS had developed a “template” to use to determine if a new transaction was
substantially similar to the transaction in Notice 2007-83. Ms. Aung reviewed the Form 886A
used in the audit of Interior Glass, and identified it the “template” that the IRS used. She
testified that most of the document was already completed, and that her job was to insert the
facts related to the specific taxpayer under audit. The relevant pages from the Aung deposition
are attached as Exhibit 2 to the McDonnell Declaration.
c. T.D. 9350 Also Indicates That The Elements in the Notice Are Controlling.
The regulations covering “substantially similar” were finalized in T.D. 9350, at 42 Fed.
Reg. 43146 (2007). These regulations at Treas. Reg. §1.6011(b) require disclosure of many
types of transactions, in addition to “listed transactions,” including a group called “transactions
of interest.” Treas. Reg. §1.6011(b)(6). The Background Information in T.D. 9350 (attached as
Ex. 2 to the McDonnell Declaration) discloses that when the regulations were first proposed,
many commentators complained that the description of “transactions of interest” was too vague,
and that taxpayers would lack notice of when they would have to report a particular type of
transaction. The commentators suggested that a list of specific factors be included in the
regulations. The IRS acknowledged the problem, but responded:
The IRS and Treasury Department believe that providing a specific definition for
the transactions of interest category in the regulations would unduly limit the IRS
and Treasury Department’s ability to identify transactions that have the potential
for tax avoidance or evasion. In order to maintain flexibility in identifying a
transaction of interest, the description of a transaction of interest will be provided
in the published guidance that identifies the transaction of interest. The published
guidance identifying a transaction of interest will provide taxpayers with the
information necessary to determine whether a particular transaction is the same
as or substantially similar to the transaction described in the published guidance
and to determine who participated in the transaction.
42 Fed. Reg. at 43147.
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RULE 59 MOTION TO ALTER THE JUDGMENT AND FOR NEW TRIAL 4
Although this language does not apply directly to “listed transactions,” it demonstrates
that in crafting the regulations under §6011, the IRS wanted to retain very broad language, and
recognized that having that broad language made it difficult for taxpayers to know which
transactions to report. Therefore, the IRS decided that the solution was to provide information
in the published notice that would enable taxpayers to determine which transactions were
substantially similar to the transaction in the published notice. This is precisely what was done
in Notice 2007-83.
Both the language in T.D. 9350, and the actual practice of the IRS in Notice 2007-83,
show that the language in the regulations was to be general guidance, and that the question of
whether a particular transaction was substantially similar to a transaction in a Notice would be
made based on the specific information contained in the published Notice.
d. The Form 886A In This Case Tracks the Four Elements in Notice 2007-83.
The Form 886A Explanation of Items sent to Interior Glass is in the record at page 25 of
Docket Entry 33-1. As the Plaintiff has previously pointed out to the Court (and the
Government agrees), this Explanation follows the four specific elements in Notice 2007-83 to
determine if the GTLP is substantially similar to the transaction in the Notice. This analysis
begins at page 56 of Docket Entry 33-1. As pointed out in Interior Glass's Motion for Summary
Judgment (Docket Entry 33), the 886A states:
“The Plan involves a trust fund described in §419(e)(3) that purports
to constitute a welfare benefit fund. The Plan document states:
"The primary object of the Plan is to provide ... welfare benefits
for eligible employees of the Employer.... This is not a multiple
employer welfare benefits plan, but merely a trust established to
facilitate welfare benefit plan funding and services. No attempt is
made to meet the requirements of a multiple employer plan
described in Code Section 419A(f)(6) .... "
And the Motion further pointed out:
“However, none of the foregoing language appears anywhere in the GTLP plan or
related documents. None of these documents ever refer to §419 in any manner. The
“Purpose of the Plan” is stated on page 1 of the GTLP “Term Life Insurance Plan” as
follows: “The purpose of this Plan is to provide death benefits to the Employer's eligible
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RULE 59 MOTION TO ALTER THE JUDGMENT AND FOR NEW TRIAL 5
current employees.” Nowhere in any of the Plan documents does it claim to be a “trust.”
The term “multiple employer” does not appear anywhere in the plan documents.”
As the Court noted in its Order (at 13-14), the Government conceded that the GTLP is
not a trust, or “other fund” described in IRC §419(e)(3), that it seeks deductions under IRC §79
and that it does not seek deductions under §419. Thus, the GTLP would not meet the specific
elements listed in Notice 2007-83.
If the IRS followed the procedure in its own “template,” and put in the correct
information, they would have concluded that the GTLP was not a reportable transaction. But
somehow, the Form 886A has incorrect language.
The audit in this case covered not only the GTLP used in 2009-11, but also the “Income
Security Program” (ISP) used in 2008. Everyone involved in this case, the IRS, Interior Glass
and Cronin himself, agree that the ISP was virtually identical to the transaction in Notice 2007-
83. It is possible that IRS was quoting language from the ISP (or some similar older program)
and applying it to the GTLP. This is buttressed by the fact that the language at the bottom of
page 57 (“Death Benefits payable under this Section 4.01 shall be provided through the purchase
of whole life insurance policies…”) also does not appear in the GTLP documents.
In summary, Interior Glass followed the proper, logical procedure to determine if the
GTLP was substantially similar to the transaction in Notice 2007-83. It reviewed the four
specific elements in the Notice, found that the GTLP did not have element one, and thus was not
a reportable transaction. In the Form 886A in this case, the IRS followed the same analysis and
did follow its established procedures, but mistakenly concluded that the GTLP met Element One
in Notice 2007-83. Without that mistake, they IRS would have also concluded (as it did in the
2010 Workpaper) that the GTLP did not have all four elements, and so it was not a reportable
transaction.
In the view of Interior Glass, the proper analysis in this case is simple; follow the
analysis of the Form 886A. The GTLP lacks the first specific element in Notice 2007-83. The
inquiry ends there. It is not a reportable transaction.
///
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RULE 59 MOTION TO ALTER THE JUDGMENT AND FOR NEW TRIAL 6
B. Ignoring the Specific Elements of Notice 2007-83 is a Denial of Due Process.
As shown above, it is possible that this entire case exists solely due to an IRS mistake.
Alternatively, it may be that the IRS has targeted Interior Glass.
The existence of the 2010 IRS Workpaper, and the fact that there is a “template” for
determining what transactions are substantially similar to those in Notice 2007-83, strongly
suggest that in all previous cases, the IRS consistently reviewed the suspect transaction to
determine if it had all four of the specific elements in Notice 2007-83. If the transaction lacked
an element, then it was not a reportable transaction (IRS Workpaper). If the IRS had adhered to
its prior procedures and templates in this case, then it should have recognized the error in the
Form 886A and rescinded the proposed penalties. The IRS has failed to follow its own
procedures.
Instead, in this case, the IRS has rejected the elements of Notice 2007-83, in favor of
arguing that “substantially can mean “some sort of similarity” to the transaction in the Notice.
But as shown in the Plaintiff's Motion for Summary Judgment, this provides no guidance for
people to determine what transactions need to be reported. A taxpayer would logically conclude
that a transaction that lacked one of the four listed elements was not a reportable transaction.
But under the new “broader” view of substantially similar, untethered by any references to the
elements in Notice 2007-83, the taxpayer’s conclusion is wrong.
Thus, the first denial of due process is that Notice 2007-83 is a trap. It misleads people
into thinking that a plan that lacks one of the four specific elements is not reportable, but the IRS
later claims that this is not the case, and many additional transactions must be reported.
Moreover, the certainty of the guidance in Notice 2007-83 is replaced with the vague
shifting sands of “evolving” IRS arguments. This is shown by the record in this case, which
shows that the IRS initially argued that the GTLP was “substantially similar” to the Notice
2007-83 transaction because is allowed the employer to claim a deduction but the employee to
avoid reporting income;
“The GTLP was expected to obtain the same tax consequences as the transaction
described in Notice 2007-83: The employer (Plaintiff) deducted its contributions
to the scheme, while the employee (Michael Yates) received economic benefits
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RULE 59 MOTION TO ALTER THE JUDGMENT AND FOR NEW TRIAL 7
(that is, the accumulated value of the life insurance policies, and the value of the
current death benefit coverage), but he did not report them on his own income
tax returns.” [U.S. Opposition to Plaintiff's Motion for Summary Judgment,
Docket Entry #40, page 9.]
But Plaintiff showed that this description (employer claims deduction for a payment that
confers an economic benefit on the employee, which the employee does not report as income)
covers a huge number of legitimate “employee benefits” under the Internal Revenue Code. For
example, it covers all types of “employee fringe benefits” (see IRS Publication 15-B, listing,
among others, employee health plans, employee education assistance, employer-provided Health
Saving accounts, commuting benefits, and Group Term Life insurance under IRS §79). Of
course, it also covers all qualified retirement plans under IRC §401.
Even court was skeptical, suggesting that there needs to be something more than just a
deduction. [Transcript at Docket Entry #57 at p. 13.]
In response, the IRS argued that there was a unique tax benefit under both the Notice
2007-83 transaction and the GTLP; both permitted the employee to permanently exclude any
income due to the value of the employer-paid premiums. From pp. 15-16 of the April 9, 2015
Transcript at Docket Entry #57:
Mr. Pitman: But then the idea is that the plan runs its course over a certain
number of years, and then eventually the cash value of the life insurance policy is
eventually distributed back to the employee and the employee –
The Court: Employee?
Mr. Pitman: Employee. So basically the employer is taking money and putting it
into a pot and he's taking a deduction. There's no one who is reporting any income
from that. And it's showing essentially [on] an employee's return when it goes
through the S Corp. And then years later when the money gets put into that
pot and gets distributed to the employee and he doesn't pay any taxes, and
that's what the I.R.S. was trying to define I think in the Notice. And this case
is a good, a good -- so those are the fundamental characteristics that I find
troubling about the ISP [sic] and essentially the transaction that is described
in the Notice.
At page 25 of the Transcript, Mr. Pitman made the point even clearer. He stated:
And finally that the employee receives, or it’s anticipated that eventually the
employee will receive the cash value of those without reporting any of it as
income. ….
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RULE 59 MOTION TO ALTER THE JUDGMENT AND FOR NEW TRIAL 8
I'm using money ostensibly from my business to create an asset, I’m taking a
deduction, and then later on I get the value back and it's never reported as income.
So that circle is really common to both plans.
Plaintiff’s counsel responded that this “fundamental characteristic” did exist in Notice
2007-83, but it did not exist in the GTLP. The GTLP did not provide for permanent exclusion
of income, and instead provided merely deferral of that income until the plan terminated in the
future. This information was not in the record at that point, so the Court requested supplemental
briefing on this. Interior Glass submitted the Supplemental Brief at Docket Entry #60 that
demonstrated that the GTLP provided only for deferral of the income, not permanent exclusion.
The IRS also filed a Supplemental Brief (at #61). In that Brief, the IRS abandoned any
claim that the GTLP contained the “fundamental characteristic” of permanent exclusion, but
claimed that the phrase “substantially similar” in the regulations alone was broad enough to
make the GTLP substantially similar to the Notice 2007-83 transaction. The new argument
appeared to be that any type of similarity was enough. At page 2, the Brief stated that it was
sufficient that the employer paid the premiums on the cash value life insurance policy (which
would grow in value), “while, at the same time, allowing the individual to avoid (or at least
defer) reporting the investments made for their benefit…” So permanent exclusion, a feature of
the transaction in Notice 2007-83, was no longer required; mere deferral was enough. Page 2
also contained four “bullet points” that made the transactions “substantially similar”:
· A business made a large investment in a cash value life insurance policy which
accumulated value for the benefit of an individual;
· The investment was made through an entity that acted as an intermediary;
· The business deducted the contributions; and
· The individual did not report the contributions as income.
But as Plaintiff’s counsel pointed out at the hearing on May 4. 2015, these bullet point
also describes every a standard retirement plan. The employer makes a large payment to the
plan; through an intermediary (the Plan Trustee); the value of the contribution will increase and
accumulate value for the employee,1 and the employee does not report the value of the
1 It should be noted that whether the “plan” accumulates value, either as a retirement plan or a
cash value life insurance plan, depends on the investments made by the plan. Poor investment
decisions by the employee in the retirement plan, or poor investment decisions by Mr. Yates in the
policy investments, could cause the value of the “pot” (Mr. Pitman’s term) to decrease in value to
lower than the original contributions.
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RULE 59 MOTION TO ALTER THE JUDGMENT AND FOR NEW TRIAL 9
contribution in income. (See Transcript of May 4, 2015 hearing at Entry #73, page 14). In fact,
as described in Section III below, there are several ways in which a §401(k) plan or an
employer-provided Health Savings Account, are more similar to the Notice 2007-83 transaction
then the GTLP is. It was impossible for Interior Glass to predict the eventual “definition” of
substantially similar that the IRS would make in this case.
The point is that even the IRS, during the course of the litigation in this case, could not
settle on a definition of “substantially similar.” Yet the IRS has imposed a penalty on Interior
Glass because it did not anticipate in 2009 the evolution of the definition that would take place
during the course of the audit and examination in this case.
The question is not whether a government attorney can make a plausible argument for
“substantially similarity” in a brief filed six years after the taxpayer files his return. The
question is whether the Notice gives the taxpayer sufficient information to determine if a
transaction is substantially similar to the transaction in the Notice. Here that was not the case.
The Interior Glass Motion for Summary Judgment also stressed that the IRS did not
conclude that the GTLP was substantially similar to the Notice 2007-83 transaction until over a
year after the beginning of the audit. The taxpayer’s argument was that if it was so “readily
apparent” that the GTLP was substantially similar to the Notice 2007-83 transaction, so clear
that Mr. Yates should have seen this in 2009, then it should not have taken the IRS a year to
make this determination. The Court’s Order notes this argument at page 11, but seems to treat it
as unimportant. “The court observes, however, that whether a statute is void for vagueness does
not turn on whether the IRS applies or interprets § 6707A consistently, or how long it takes an
agency to render a penalty decision (citing Fang Lin Ai v. United States (9th Cir. 2015) 809 F.3d
503, 514).” However, the Ai case did not involve a delay in reaching a decision and did not deal
with at statutory regime that requires a taxpayer to make a determination of what comprises a
“reportable transaction.”2 Interior Glass continues to believe that the fact that the IRS could not
2 The Ai case also restated the rule, “that ‘taxing statute[s] must be construed most strongly in
favor of the taxpayer and against the government.’ Greyhound Corp. v. United States, 495 F.2d
863, 869 (9th Cir. 1974)” Ai, supra, at 506.
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determine, for over a year, if the GTLP was substantially similar to the Notice 2007-83
transaction, is powerful evidence that, “a person of ordinary intelligence” could not understand
the term. Fang Lin Ai, supra, also at 514. Moreover, the issue in Ai was whether the taxing
statute was so unconstitutionally vague that the employer would not have to pay the FICA taxes.
This is different from a statute the imposes a penalty for failure to report a transaction.
In this case, the IRS followed a consistent interpretation of “substantially similar” from
at least as far back as 2010, all the way through the completion of the Interior Glass audit. That
interpretation was that a transaction had to include all four specific elements in the Notice to be
substantially similar. That is the same interpretation that Interior Glass used in 2009. Only after
this lawsuit began has the Government shifted to a new, amorphous (and apparently shifting)
definition. This is the denial of due process.
III. THE GTLP IS NOT SUBSTANTIALLY SIMILAR TO THE NOTICE 2007-83 TRANSACTION.
During the course of its Motion for Summary Judgment, Interior Glass pointed out the
many elements of the Transaction in Notice 2007-83. These include:
1. The Plan involves a trust or
2. The Plan involves a “welfare benefit fund” under §419(e).
3. The Plan claims benefits under §419.
4. The Employer claims a current deduction for payments to the trust or fund,
5. The payments by the employer provide an economic benefit to the employee,
6. The employee has no current taxable income,
7. The employee can permanently exclude the income
8. The Plan involves a single employer
9. The Single employer controls the trust or fund.
Most of the items on this list are not disputed. However a few need to be explained (as
they were in prior submissions). Element One in Notice 2007-83 says that a plan must involve a
trust or any other “welfare benefit fund.” Item 2 is listed separately to emphasize how broad
Element One is. Under IRC §419(e)(3) a fund includes, “any trust, corporation or other
organization not exempt from the tax imposed by this chapter.” So any taxable entity can be a
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fund. In addition, the tax-exempt entities listed at §501(c)(7), (9), (17) and (20) are also “funds”
under that Code section. The universe of entities excluded from Element One is extremely
small; only limited types of §501(c) tax exempt entities and tax exempt trusts under §401 can
avoid being a “fund.”. So very few plans could meet Element One. But the GTLP plan does
meet it, in part because it involves a tax-exempt §501(c)(6) business league.
Items 8 and 9 are disputed by the IRS, and the Court did not find these items significant,
since they are not included in the four elements. However, as pointed out in prior submissions,
the fact that made these types of plans “abusive” was the fact that the employer made a
contribution to a trust, and the employer controlled the trust and hence could have access to the
cash value of the policy. This was the explicit holding of the Revenue Ruling that is the
companion to Notice 2007-83, Rev. Rul. 2007-65. The abuse is that the employer claims a
deduction for a “payment” when the employer can get the money back. This makes the
employer an indirect beneficiary under the policy, and the deduction is disallowed under IRC
§264. If the employer does not control the trust, then arguably IRS §264 would not apply and
the deduction would be allowed. The ASBE business league involved in the GTLP had over
130 members, so no single member could control the funds.
The Court ruled that the GTLP is not a trust, is not a welfare benefit fund, and does not
seek deductions under §419. As shown below, when the above list of 9 items is used to compare
the GTLP with other “employer plans,” it appears that other plans such as a §401(k) are closer
to Notice 2007-83.
In addition, the Code allows an employer-provided Health Savings Account (“HSA”)
under IRC §223. In such a plan, the employer establishes a “high-deductible” health insurance
plan (e.g. a $10,000 deductible) to obtain lower annual premiums, and then contributes $10,000
to the HSA for the employee. If the employee has medical expenses, he can use the funds in the
HSA to pay the deductible. The plan involves a trust, and works much like a 401(k); the
employer has a current deduction for payments to the trust, but the employee reports no income,
and the assets in the plan grow tax-free. However, distributions are treated differently.
Distributions from a 401(k) are taxable to the employee when distributed, but a distribution from
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the HSA is excluded from the employee’s income if the employee uses it to pay qualified
medical expenses (IRC§223(f)). Thus, the HSA provides a form of permanent exclusion from
the employee’s income. This makes the HSA even closer to the Notice 2007-83 transaction than
a 401(k) or the GTLP. The following chart shows the comparison.
Notice 2007-83 GTLP 401(k) HSA
1. The Plan involves a trust or No Yes Yes
2. The Plan involves a “welfare
benefit fund” under §419(e).
No No No
3. The Plan claims benefits under
§419.
No No No
4. The Employer claims a current
deduction for payments to the trust
or fund (or ABSE),
Yes Yes Yes
5. The payments by the employer
provide an economic benefit to the
employee,
Yes Yes Yes
6. The employee reports no current
taxable income,
Yes Yes Yes
7. The employee can permanently
exclude the income
No No Yes
8. The Plan involves a single
employer
No Usually-but multiple
employer possible
Yes
9. The Single employer controls
the trust or fund.
No Yes Yes
Thus, other “employer plans” are actually more similar to the Notice 2007-83 transaction
than the GTLP is. Using the new, broader IRS definition of substantially similar would appear
to make these other employer plans “reportable transactions.”
It is widely recognized among tax practitioners that a vague definition of “substantially
similar” can apply to routine, Congressionally-sanctioned transactions.
Transactions that are “substantially similar” to listed transactions and
transactions of interest – two categories of reportable transactions – must be
properly disclosed in order to avoid penalties.
But the term “substantially similar” is not clearly defined, and the Treasury
regulations require that the term be “broadly construed.” It is possible for the
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reportable transaction rules to cover routine, common, and clearly non-abusive
transactions.
AICPA Report on Civil Tax Penalties: The Need for Reform (August 28, 2009)
IV. THE GTLP WAS NOT STRUCTURED TO FUND PAYMENTS ON CASH VALUE WHOLE LIFE
INSURANCE POLICIES.
The record in this case shows that insurance broker Lawrence Cronin created the ISP
perhaps as far back as 2006, in order to take advantage of what he perceived was a “loophole” in
IRC §419.3 He, and insurance agents working with him, marketed the ISP to small businesses
such at Interior Glass to induce the owners to buy very expensive life insurance policies. This
worked spectacularly well. Like many other small businesses, Interior Glass bought a
$5,000,000 policy, and the business paid $100,000 per year in premiums ($59,000 by Interior
Glass and $41,000 by Mike Yates). Cronin made great deal of money on the commissions on
these expensive policies.
But all that fell apart in late 2007 when the IRS issued Rev. Rul. 2007-65 stating that
premiums paid under plans like the ISP would not be deductible, and also released Notice 2007-
83, ruling that plans like the ISP were reportable transactions. In response, Cronin developed
the GTLP, a plan that, in his view, was substantially different from the Notice 2007-83
transactions and a plan that would not be a “reportable transaction.”
But it is important to remember that Cronin didn’t care about tax savings; he cared about
selling insurance. He made his money not from selling a “tax shelter,” but from getting
businesses to pay for expensive life insurance policies. His objective in designing the GTLP was
to make sure the customers kept paying the annual premiums on the policies so he would continue
to collect his lucrative commissions. So his only objective in designing the GTLP was to make
sure that is was substantially different from Notice 2007-83, to avoid scaring off lucrative
customers. He did not care if the customers ever got any substantial deductions from the GTLP.
So he made a number of changes.
As the record shows, he located a tax-exempt business league, the ASBE, to use instead of
3 Actually Cronin was just one of many insurance agents promoting similar plans, as he explained
at his deposition. The epidemic of these types of plans forced the IRS to issue Notice 2007-83.
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a trust. He made sure there were over 100 members, so no single member could control the
ASBE and direct payments from it. As discussed above, he changed the GTLP so that it merely
deferred income, rather than permanently excluding it. In addition, he changed the fundamental
tax structure of the plan, abandoning any claim to deductions under §419 and instead creating a
plan that relied upon the deduction under §79 for payments for up to $50,000 of group-term life
insurance. The Court’s Order stated at page 14: “In addition, Interior Glass and the Government
concur that the GTLP seeks tax deductions under §79 of the Internal Revenue Code, not § 419.”
And here’s the rub. Because Cronin did not care if his customers actually qualified for
any deductions, he ended up designing a flawed a plan where his customers would not actually
get any deduction at all. Section 79 allows a deduction only for premiums for group-term life
insurance. The GTLP policy fails on two counts. First, the policy is not offered to a group, but
only to a single employee in violation of Treas. Reg. §1.79-1(a)(2). Second, “term” life insurance
is normally a policy with a fixed term, usually 10, 15, 20 or 25 years. At the end of the term the
policy terminates and the coverage ends. If the purchaser of the policy is still alive at the end of
the term, he receives nothing. To qualify under §79, the benefits under the policy generally can
not be permanent. Treas. Reg. §1.79-1(c). Term life insurance is temporary, while “whole life”
insurance is permanent. It is much less expensive than “whole life” policies that have an
investment component that builds over time and which remain in force permanently. These
policies are more expensive than term policies, but always have a cash value and have a
permanent death benefit. The “VME” policy covering Michael Yates is a permanent whole life
policy (see the description in the Form 886A at pg. 48 of Docket Entry 33-1).
So Interior Glass was never entitled to any deductions under §79 for payments on the
VME policy, because it is not a group-term life insurance policy.
Now we come to the only remaining fact in this case that the IRS can argue creates
substantially similarity: the employer (Interior Glass) claimed a deduction for the full amount of
the premium it paid on a cash value whole life policy. That is true, but it is not a feature of the
GTLP. Remember that Cronin’s objective in designing the GTLP was to make it a “non-
reportable” transaction. He did not care if customers claimed deductions that were not available
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under §79. The audits disallowing those deductions would not take place until many years after
he pocketed the commissions. So Mr. Cronin and the agents working with him were, shall we
say, “less than diligent” in informing customers like Interior Glass that they could not claim
deductions for the whole-life premiums. In fact, their promotion of the GTLP seems outright
fraudulent. The IRS files contain a document in which someone tried to make the nonsensical
claim that the proper annual deduction under §79 for $50,000 of term insurance was actually
$55,000. Obviously, it does not cost $55,000 per year for a person to obtain $50,000 of
insurance. That deduction would certainly be disallowed on audit. Interior Glass did claim the
deduction for the whole-life premium, but that was because Interior Glass was the victim of
fraud, not because the GTLP permitted this deduction.
The key point is that the GTLP is not “substantially similar” to the Notice 2007-83
transaction because the GTLP is not a “transaction that is expected to obtain the same or similar
types of tax consequences…” Treas. Reg. §1.6011-4(c)(3).
V. THE COURT SHOULD CONSIDER THE NEW LAW IN THE ALTERA CASE
After this case was submitted, the Tax Court decided the important case of Altera Corp v.
Commissioner, 145 T.C. 91 (July 27, 2015). In that case, a unanimous Tax Court invalidated
Treasury Regulations issued under IRC §482. Technically, the court ruled that the regulations
were invalid because the IRS did not follow the provisions of the Administrative Procedures Act
(APA), but the case is much broader, and some commentators have called it a “sea change” in
the law of determining whether Treasury Regulations are valid. The case is noteworthy not only
due to the rare unanimity of the decision, but also because the case is appealable to the Ninth
Circuit (it is on appeal), so the Tax Court relied a great deal on administrative law rules in Hemp
Indus. Ass’n v. DEA, 333 F.3d 1082, 1087 (9th Cir. 2003).
There are at least two parts of the decision that affect this case. First, the Tax Court held
that in order to comply with the notice and comment requirements of §553 of the APA, the IRS
must respond to significant comments received in response to proposed regulations. And the
regulations may be invalid under the APA, if the IRS response, “demonstrates that the agency's
decision was not based on a consideration of the relevant factors. Sherley v. Sebelius, 689 F.3d
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776, 784 (D.C. Cir. 2012).” This rule is relevant because, as demonstrated above, the IRS
received comments to the proposed regulations under Treas. Reg. §1.6011 that indicated that
commentators were concerned that the regulations failed to provide specific guidance on what
transactions were substantially similar to “transactions of interest.” The IRS responded that it
understood the problem, but rather then making the regulations more specific, it would provide
specific information in the published Notice that would enable taxpayers to determine if a
transaction is substantially similar to a “transaction of interest.” This seems to qualify as a
proper “consideration of the relevant factors” under the above rule. However, if the IRS takes
the view, as it does in this case, that the determination of “substantially similar” can be made
without reference to the information provided in the published Notice, then this would seem to
be ignoring the relevant factors and would tend to render this part of the regulations invalid.
The second major aspect of the Altera case is the requirement that in making regulations,
the agency (here the IRS) must engage in “reasoned decisionmaking.
Pursuant to APA sec. 706(2)(A), a court must "hold unlawful and set aside
agency action, findings, and conclusions" that the court finds to be "arbitrary,
capricious, an abuse of discretion, or otherwise not in accordance with law". A
court's review under this "standard is narrow and a court is not to substitute its
judgment for that of the agency." Motor Vehicle Mfrs. Ass'n of the U.S. v. State
Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983); see also Judulang v. Holder,
565 U.S. ___, 132 S. Ct. 476, 483 (2011); Citizens to Pres. Overton Park, Inc. v.
Volpe, 401 U.S. 402, 416, (1971)…. However, a reviewing court must ensure that
the agency "engaged in reasoned decisionmaking." Judulang, 565 U.S. at ___,
132 S. Ct. at 484. To engage in reasoned decisionmaking, "the agency must
examine the relevant data and articulate a satisfactory explanation for its action
including a 'rational connection between the facts found and the choice made.'"
State Farm, 463 U.S. at 43…
Altera Corp. v. Comm'r (2015) 145 T.C. 91, 112-113.)
In Plaintiff's view, this requirement imposes an obligation on the IRS to, “articulate a
satisfactory reason for its actions….” Throughout this case, the IRS has claimed that it needs to
interpret “substantially similar” extremely broadly, because it can not anticipate every minor
tweak or modification that a tax shelter promoter may make in a plan. Yet that does not justify
having a completely open-ended definition that imparts no useful information to taxpayers; a
definition that, as outlined above, could sweep in hundreds of thousands of supposedly
“unreportable” transactions such as 401(k)s and Health Savings Accounts. Moreover, the
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language in T.D. 9350 discussed above, demonstrates that the IRS was comfortable with the idea
of using specific guidelines in the published Notice to narrowly define transactions
“substantially similar” to “”transactions of interest.” There is no need for vague and
unpredictable interpretations that disregard the language in the published Notice. The current
IRS interpretation of “substantially similar” appears to violate the requirement of “reasoned
decisionmaking.”
VI. THE REQUIREMENT OF A PRE-COLLECTION HEARING.
Interior Glass believes that the Court erred in ruling that the §6707A penalty can be
collected without a pre-collection hearing. The IRS’s Reply Brief cited the holdings in Jolly v.
United States, 764 F.2d 642 (9th Cir. 1985) and Kahn v. United States, 753 F.2d 1208, 1217 (3d
Cir. 1985), which upheld penalties for “frivolous returns” without a pre-collection hearing.
However, those cases (and others) hold that such actions are not always permitted. Instead, if
the taxpayer can show irreparable harm, a pre-collection hearing is required. When there is no
showing of irreparable harm (as would be the case here), then there must be a balancing of (1)
the interests of the government, (2) the private interests of the taxpayer and (3) the risk of an
erroneous deprivation. Jolly, supra at 645, citing Mathews v. Eldridge, 424 U.S. 319(1976).
Both Jolly and Kahn involved the small $75 penalty for a frivolous return, and the courts did not
see a large private interest in having to pay this small amount prior to filing a refund suit. More
significantly, the court found there was no risk of erroneous deprivation. The fact that a return
is frivolous is apparent on the fact of the return (usually containing just zeroes as each entry or
completely blank), so it was easy to see the validity of the penalty, and the risk of error was
almost non-existent. In contrast, in this case the penalties are $10,000 for each year. More
important is the fact that the risk of erroneous deprivation is very real. This case demonstrates
that at the very least, the question of “substantially similar” is complicated and an error is
certainly possible. The validity of the penalty certainly can not be seen on the face of the return
and requires examination of hundreds of pages of documents. An error is certainly possible (and
in fact, errors were made in the Form 886A). Finally, the Government has not presented any
interest that requires collecting this penalty before a hearing. It seems the Government’s interest
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in requiring disclosure of “abusive transactions” is equally served if the penalty is imposed after
a hearing. Based on the standards in the Jolly case, a pre-trial hearing is required prior to
collection of the §6707A penalty.
CONCLUSION
The Court’s ruling presents the IRS with a dilemma; in order for the phrase “substantially
similar” to avoid being void for vagueness, the phrase, “must be read in conjunction with Notice
2007-83.” But in order to claim that the GTLP is “substantially similar” to the transaction in
Notice 2007-83, the IRS must disregard the four elements in that Notice. Under either “horn” of
this dilemma, the penalties for 2009 through 2011 can not stand.
And it is important to repeat that in this case the question is not whether a government
attorney can make a plausible argument for “substantially similarity in a brief filed six years
after the taxpayer files his return. The question is whether the Notice gives the taxpayer
sufficient information to determined if a transaction is substantially similar to the transaction in
the Notice and must be reported. That did not occur.
The Supreme Court provided a clear statement of the purposes of the “void for vagueness
doctrine” in Grayned v. City of Rockford, 408 U.S. 104 (1972). The Court explained that the
doctrine serves two principal functions:
“[First] vague laws may trap the innocent by not providing fair warning. Second,
if arbitrary and discriminatory enforcement is to be prevented, laws must provide
explicit standards for those who apply them. A vague law impermissibly
delegates basic policy matters to policemen, judges, and juries for resolution on
an ad hoc and subjective basis, with the attendant dangers of arbitrary and
discriminatory application.” Id. at 108-109.
In this case, both evils are present. The vague phrase, “substantially similar” standing alone,
provides no warning that the GTLP is a reportable transaction. Second, in this case, it appears
that the IRS is relying on that phrase, instead of the four elements in Notice 2007-83, for the
first time since at least 2010. This is an arbitrary and discriminatory application of the law. The
regulations are unconstitutionally vague, and should be ruled invalid.
Dated September 12, 2016 /s/ John McDonnell
JOHN P. McDONNELL, ESQ.
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