On June 19, the U.S. Supreme Court ruled that taxpayers may question IRS officials regarding their reasons for issuing a summons by presenting credible evidence that the IRS issued the summons with an improper motive.

The IRS has broad authority to issue summonses to determine “the correctness of any return.” I.R.C. § 7602. If the taxpayer fails to voluntarily comply with the summons, the IRS may bring an enforcement action. I.R.C. §§ 7402(b), 7604(a). To succeed in the enforcement action, the IRS must satisfy the Powell factors. Specifically, the IRS must show that “the investigation will be conducted pursuant to a legitimate purpose, that the inquiry may be relevant to the purpose, that the information sought is not already within the [IRS’s] possession, and that the administrative steps required by the [Internal Revenue] Code have been followed.” United States v. Powell, 379 U.S. 48, 57-58 (1964). The IRS typically satisfies the Powell factors by filing an affidavit with the court. To quash the summons, the taxpayer may challenge the affidavit on an “appropriate ground,” including improper motive, and in certain circumstances taxpayers may question IRS officials regarding their motives in issuing the summons. See Reisman v. Caplin, 375 U.S. 440, 449 (1964). Circuit courts have disagreed over the level of evidence that taxpayers must produce to question IRS officials in this context.

In this case, the IRS audited Dynamo Holdings L.P.’s 2005 through 2007 tax returns and took particular concern in a large interest expense deduction. Dynamo agreed to two separate two year extensions of the assessment period but refused to agree to a third extension in 2010. Shortly after Dynamo’s refusal, in September and October 2010, the IRS issued summonses to four individuals associated with Dynamo to obtain information about Dynamo’s tax obligations. None of the individuals complied with the summonses and in December 2010 the IRS issued a Final Partnership Administrative Adjustment that increased Dynamo’s tax liability. Dynamo then filed suit in February 2011 in the U.S. Tax Court challenging the adjustments; the litigation is ongoing. Several months later, in April 2011, the IRS brought an action in District Court to enforce the summonses it had sent earlier.

Respondents challenged the enforcement action, arguing that the IRS issued the summonses for improper motives. Specifically, respondents alleged that the IRS issued the summonses to punish respondents for refusing to extend the statute of limitations for assessment. Second, respondents alleged that the IRS issued the summonses after respondents commenced litigation in Tax Court to obtain otherwise undiscoverable information. The IRS denied the allegations and the respondents then asked for an opportunity to question the IRS officials regarding their motives for issuing the summonses. The District Court denied respondents’ request to question the IRS officials and stated respondents did not present meaningful evidence of improper motive.

Respondents appealed the District Court’s decision to the 11th Circuit, which ultimately reversed the District Court’s ruling and cited 11th Circuit precedent holding that an “allegation of improper purpose”, even if lacking in “factual support,” entitles taxpayers to an evidentiary hearing to challenge an IRS summons. Every other Circuit Court of Appeals had held that taxpayers must provide at least some evidence to question IRS officials regarding their motives for issuing a summons, and the U.S. Supreme Court granted certiorari to resolve the conflict.

The Supreme Court ruled that a “taxpayer is entitled to examine an IRS agent when he can point to specific facts and circumstances plausibly raising an inference of bad faith. Allegations of improper purpose are not enough: The taxpayer must offer some credible evidence supporting his charge. But circumstantial evidence can suffice to meet that burden.” The ruling strikes a balance between maintaining the integrity of the Service’s investigatory powers, which are of paramount importance in a system based on self-reporting, and protecting taxpayer rights.

The Court held that the 11th Circuit incorrectly categorized allegations of improper purpose as sufficient to allow taxpayers to question IRS officials. The Court stated that the 11th Circuit must reconsider whether respondents may question IRS officials regarding their motives for issuing the summons in light of the Court’s newly articulated standard. Specifically, the 11th Circuit must ask whether the respondents presented some credible evidence supporting their charges that the IRS issued the summonses for improper motives.

In light of this decision, taxpayers under audit and who face the possibility of a summons should closely document their interactions with the IRS to facilitate the presentation of credible evidence should they need to question IRS officials regarding the issuance of a summons. This caution becomes all the more important with new IDR enforcement procedures that culminate in a summons following continued taxpayer noncompliance. Taxpayers should document whether the IRS properly followed all of the steps outlined in the IDR enforcement process prior to issuing the summons and may point to the IRS’ failure to do so as evidence of improper motive. We are also telling our clients to comply with the IDR as much as practicable which also will hold them in good stead as any enforcement is being considered for enforcement first by the Department of Justice and ultimately by the Courts.

Steven Miller is National Director of Tax at alliantgroup.
John Dies is Managing Director of Tax Controversy Services at alliantgroup.