Advisory of November 15, 1999, announcing request for written comments on recent recommendations on tax penalty and interest provisions

Smith, Stuart A., Law Offices of Stuart A. Smith, New York, NY, statement

Statement of Stuart A. Smith, New York, NY

I am a tax lawyer practicing in New York City. I have been involved in federal tax law for more than 35 years. After my graduation from law school, I served as a law clerk to a United States Tax Court Judge, as a lawyer in the Appellate Section of the Tax Division of the Department of Justice, and thereafter as Tax Assistant to the Solicitor General in the Department of Justice. During my tenure with the Department of Justice, I was privileged to argue more than 60 tax cases in various federal courts of appeals and more than 50 tax cases in the United States Supreme Court. As a private tax lawyer, I have appeared on behalf of clients in the United States Tax Court, the United States Court of Federal Claims, and various courts of appeals throughout the nation. As a result of my professional experience, I believe that I am well qualified to determine the merits of a federal tax dispute.

In connection with the Subcommittee's current mission to review the current penalty and interest provisions in the Code and to consider recommendations to simplify penalty administration and to reduce the burdens upon taxpayers, I would like to describe for the Subcommittee an episode of extraordinary abuse by the Internal Revenue Service of the procedures governing the examination of TEFRA partnerships. This abuse by the Internal Revenue Service, which several members of Congress have recently brought to the attention of the Commissioner, has inflicted substantial damage upon a large number of taxpayers by subjecting them to eleven years of unnecessary accruals of penalties and interest at the astronomical rates that were extant during the early 1980s.

In 1982, Congress enacted uniform partnership audit procedures as part of the Tax Equity and Fiscal Responsibility Act ("TEFRA"). These procedures, set forth in Sections 6221-6233 of the Code, subject a TEFRA partnership to audit at the partnership level to determine the correct amount of all "partnership items." The statute is designed to eliminate the duplicative audits of members of a partnership who are subject to a common set of audit adjustments. Thus, the audit is conducted on behalf of all of the partners at the partnership level. The partnership is represented by the tax matters partner ("TMP") throughout the administrative and judicial stages of the proceeding. The Internal Revenue Service proposes audit adjustments to a TEFRA partnership by issuing a final partnership administrative adjustment ("FPAA") to the TMP. The FP AA is akin to the notice of deficiency issued to an individual taxpayer.

In 1982, during the energy crisis, approximately 200 persons invested in eight TEFRA partnerships that had the same general partner, Sam Winer of Clearwater, Florida. The machinery leased by the partnerships was manufactured by a well-known and reputable company called Packaging Industries of Hyannis, Massachusetts. The machinery was designed to grind material such as Styrofoam scrap into reusable pellets for transformation into recycled plastic. The energy crisis had increased the cost of oil-based plastics. As a result, the economic viability of the investment was premised upon an increase in the cost of manufacturing new plastic material so as to make the manufacture of recycled plastic a viable investment.

Ultimately, the Internal Revenue Service attacked these partnerships claiming that the machinery was overvalued to yield excessive tax credits. To prevent further promotion of these partnerships, the Internal Revenue Service obtained federal court injunctions against certain of the promoters, including Winer. Pursuant to injunctions entered by the United States District Court for the Middle District of Florida, Winer was prohibited from making any representation as the federal income tax benefits to be derived by a partner in such partnerships. In addition, Winer consented to resign as the TMP of this various partnerships and "personally waived his right to intervene in any court proceeding as tax matters partner on behalf of . . . [his partnerships.]" The injunction further ordered Winer to send a letter to each partner in which he would tender his resignation as TMP and waive his right to intervene as TMP on behalf of these partnerships. Winer's letter, drafted by a Department of Justice attorney, further stated that a new TMP would be appointed in his stead.

Even though the government charged that Winer was untrustworthy and unfit to serve as TMP of his partnerships and imposed substantial promoter penalties against him, the government thereafter sought to reinstate Winer as the TMP of the partnerships. This action by the government was prompted by the fact that the Internal Revenue Service found it inconvenient to deal with a large number of substitute TMPs rather than deal solely with Winer. As a result, the government changed direction in order to importune Winer to sign consents to extend the statute of limitations of the various partners and thereby facilitate the government's processing of its tax claims against the partners in Winer's partnerships. Accordingly, on September 17, 1986, in a secret proceeding of which neither the substitute TMPs nor any of the limited partners were informed, the federal court was persuaded by Winer and the government to reinstate Winer to act as TMP for the purpose of providing "administrative services" to the various partnerships. The court's order did not define the scope of the term "administrative services." Significantly, neither Winer, the government, nor the Internal Revenue Service informed the limited partners of the partnerships, or the substitute TMPs of this proceeding. Despite the terms of the federal court's order reappointing Winer as TMP for the sole purpose of providing "administrative services," the Internal Revenue Service actively sought and secured Winer's signature on consent forms extending the statute of limitations of the partnerships. Despite his lack of authority to do so, Winer continued to sign such forms as requested by the Internal Revenue Service solely to facilitate the processing of deficiency claims against the various investors.

The violation of the TEFRA rules occasioned by the Internal Revenue Service's conduct in these cases is beyond serious question. Once the successor TMPs were appointed, the Internal Revenue Service was required to deal with them for all purposes and could not deal with Winer, the predecessor TMP whose ouster it obtained. This was especially the case here because the Internal Revenue Service had alleged that Winer, the ousted TMP, was unfit to serve as the fiduciary for the partnerships. As a result, the Service had sought to impose substantial promoter penalties against him. Despite these allegations and his ouster as TMP, the Service thereafter pressured Winer to sign consents extending the statute of limitations, falsely assuring him that he had the authority to sign them.

Thereafter, Winer, the ousted TMP, appeared in the Tax Court on behalf of the partners of his various partnerships in knowing violation of a federal court injunctive order obtained by the Internal Revenue Service. In these proceedings, Winer filed petitions falsely alleging that he was the TMP of these various partnerships and the Internal Revenue Service filed answers falsely admitting the correctness of Winer's allegation. After the petitions were filed in the Tax Court, Winer took no action to represent the partners of his various partnerships during the litigation. Rather, the sole affirmative act Winer took was to concede the cases. Thereafter, the Internal Revenue Service issued tax assessments to the partners of the various partnerships based upon Winer's concession. These assessments came as a complete shock to the various partners. Such assessments, which sought sums exceeding ten times the amount of the partners' original investments, authorize the Internal Revenue Service to engage in enforced collection activity, which includes levies upon bank accounts and the forced sale of assets owned by the various taxpayers. As a result, the Internal Revenue Service is vigorously pursuing collection efforts against many of Winer's victims who were able to pay the tax bills they received.

Thus, Winer, the ousted TMP, appeared in the Tax Court on behalf of the partners of his partnerships in knowing violation of a federal court injunctive order obtained by the Internal Revenue Service. The Internal Revenue Service likewise knew that Winer was prohibited by court order from representing the partnerships because it has obtained that very court order. It also knew that Winer's allegation that he was the TMP of the various partnerships was false. Thus, the Internal Revenue Service's own actions served to prevent the effective representation of these various partners under TEFRA. Where, as here, the Internal Revenue Service severs the connection between the TMP and the partners and uses an unauthorized TMP for its own purposes, the underlying assumptions of TEFRA are violated and the partners should not be deemed to be parties to any action brought by such a TMP. Indeed, if the TEFRA statutes were read to permit such manipulation by the Internal Revenue Service, I believe that they would violate the taxpayers' constitutional rights under the Due Process Clause.

A TMP has a fiduciary obligation to the members of a TEFRA partnership, which are akin to a class action representative. Hence, a TMP must be able to make representations to both the Internal Revenue Service and the Tax Court with respect to the validity of the tax benefits claimed by the TEFRA partnership. Once Winer was barred from doing so by a federal court order, he could not function as a TMP of his partnerships. Although the Internal Revenue Service knew these facts, it continued to pretend that Winer was the authorized TMP of his partnerships. Thus, by its own actions, the Internal Revenue Service bears full responsibility for the misrepresentations by Winer. Its knowing acquiescence and affirmative participation in such misrepresentations deprived the partners of a fully-functioning TMP who could represent their interests unburdened by any conflict. Instead, Winer became a pliant surrogate of the Internal Revenue Service to the detriment of the very persons whose interests he was charged by statute to protect as a fiduciary.

Simply put, once Winer was prohibited from advancing any arguments in support of the partnerships' claimed tax benefits, the outcome of the Tax Court's proceedings, in which he improperly appeared as TMP, was a foregone conclusion. By conceding all of the taxes and penalties at issue in the various cases, unbeknownst to the partners, Winer acted hand in glove with the Internal Revenue Service. Together they improperly converted what should have been a full and fair adversarial litigation into a collusive proceeding.

Faced with the receipt of assessments for taxes, penalties, interest, and penalty interest, the partners became subject to enforced collection, property seizures, and levies by the Internal Revenue Service. In response, some partners have declared bankruptcy and suffered all of the damage that ensues from such an action. Other partners paid the amounts demanded by the Internal Revenue Service and have challenged the assessments in federal courts in refund suits. In those suits, they have argued that Winer lacked authority to extend the statute of limitations and that the assessments are therefore barred by the statute of limitations. But these efforts have been thwarted in part by provisions of the Internal Revenue Code that bar individual refund suits to recover taxes paid in response to partnership adjustments. There is a strong argument that these provisions should not apply where, as here, the Internal Revenue Service had improperly used an ousted TMP solely for the purpose of extending the statute of limitations. Nevertheless, the federal district courts have thus far been unwilling to accept this argument.

Moreover, an effort has been made to reopen the Tax Court partnership cases based upon the fact that Winer did not have the authority to represent the partnerships in those proceedings so that the Court lacked jurisdiction to enter judgments against the partnerships. However, the Internal Revenue Service is vigorously opposing this effort. Incredible as it seems, the Department of Justice has taken the position in such a case that Winer's resignation as TMP was not effective and that he never actually resigned. But apart from the fact that the government should not be able to foolishly argue Winer did not resign when it itself demanded and arranged for the resignation of Winer as TMP, Winer's resignation was indeed effective and the substitute TMPs were validly appointed in his stead. Moreover, the government has further taken the position that even if Winer did resign as TMP, it reinstated him. But this so-called reinstatement was done entirely in secret, without any notification to the partners. Surely, if the Internal Revenue Service determined that it was necessary under the statute to insure that Winer informed the partners of his resignation as TMP, it was likewise necessary for it to insure that Winer notified the partners of his reinstatement.

Finally, the Internal Revenue Service has thwarted the taxpayers' efforts to demonstrate that its attorneys committed fraud on the Tax Court because they continued to deal with Winer as TMP of the partnerships despite their knowledge of the federal court's injunctive orders. In this respect, the Internal Revenue Service lawyers have resisted efforts to subject them to a detailed examination of their state of knowledge of the Winer injunctive proceeding. In these circumstances, the Internal Revenue Service lawyers, as public employees, should be forced to explain their claimed ignorance of facts pertaining to the Winer injunctive proceeding that are contained in their very files. The public interest in the fair administration of the tax laws demands that the cloak of secrecy be thrust aside and that their testimony be taken.

During my tenure with the Department of Justice and my advocacy on behalf of the Internal Revenue Service in the federal courts, I was confronted with many situations in which I concluded that the government's position was not correct. In those instances, my colleagues and I did not proceed to advance any argument in support of the Internal Revenue Service. Rather, we regarded ourselves as independent lawyers who were charged to protect the public interest. As a result, in such cases we took steps to remedy the situation and concede the correctness of the taxpayers' position. We did so because as public officials we adhered to the maxim inscribed upon the Attorney General's doorway that the government prevails not when it wins its case in court but when justice is done. Here, a wise tax administrator would not attempt to compound its maladministration of the TEFRA statutes by collecting vast sums of taxes, penalties, interest, and penalty interest that are the fruit of time-barred assessments and collusive court proceedings. A wise administrator would recognize that public institutions must act with an extra measure of fairness to ensure that justice is done and that the rules governing the proper and timely assessment of taxes are obeyed. The root requirement of the Due Process Clause of the Constitution requires that an individual be given an opportunity to a hearing before he is deprived of any significant property interest. In light of this constitutional standard, there is no basis for the Internal Revenue Service's position that the taxpayers received adequate notice of the potential assessments against them by the issuance of notices to the ousted TMP, Sam Winer.

Our income tax law is the envy of the world because it rests upon a system of honest self-assessment. But a system of honest self-assessment itself depends upon public confidence in the integrity of the tax collector. Recent events brought to the attention of the Senate Finance Committee at the hearings in 1997 and 1998 have unfortunately eroded that public confidence. But legislation enacted by the Congress and the appointment of a new Commissioner are encouraging signs that augur improvement. Surely, public confidence would be enhanced by the Internal Revenue Service's concession that it acted wrongly in this case and that it seriously violated the rights of the taxpayers. While the Internal Revenue Service bears the responsibility of collecting the revenue, it has a primary obligation to preserve the integrity of the tax collection process. That obligation now requires a thorough and complete examination of all of the facts relating to this sorry episode, acknowledgment of wrongdoing, and prevention of its reoccurrence.