A Litigator's Approach to Tax Disputes and Litigation
By: STEVEN Z. KAPLAN
Initially presented at a Hennepin County Bar Association tax seminar; revised in July 2003.
I want to talk to you about what those of us who represent taxpayers in tax disputes and tax litigation do poorly and how we can give ourselves the best chance for a successful outcome. What I have to say in the first half of my remarks may strike some of you as somewhat Zen-like, but I hope that you will hang in there with me for a few minutes, even if you do.
A lawyer handling a tax dispute straddles two disciplines that could not be more disparate, intellectually and temperamentally. First, we have the exacting science of tax law, absurdly detailed, often algebraic in its expression, and frequently impenetrable. The people who enjoy mucking around in this field of law are the same types who find attending a German opera after a hard day at the office to be a cathartic activity. These types would rather spend a day locked in a 6-by-6-foot cell with a life insurance salesman than ten minutes in a courtroom.
Then there are the litigation types, the thrill-seekers who crave the crap shoot world of the courtroom knowing (often hoping) that some cheap rhetorical trick might overcome some intellectually impeccable theory that their adversary is advancing. This type would rather get up close and personal with a proctologist than wade through the spin-off rules.
So, what is the right mindset for representing a large taxpayer in a significant tax dispute? Is our approach more like that of Prof. Bittker or, instead, more akin to that of Johnnie Cochran (or a combination of the two)? As the title of this presentation suggests, when we are representing a taxpayer in a controversy, we are either already in, or moving quickly toward, Johnnie's world, even if we have to inhabit Boris' as well. While we need to be scholarly students of the tax law to effectively represent a taxpayer, we also need to recognize that a complete understanding of the tax law alone will not get the job done. Advocacy requires not merely technical tax law competence, but the capacity to motivate, cajole, flatter, and ultimately persuade whomever will decide the case.
The most profound mistake that lawyers and taxpayers make about a tax dispute is assuming that it is somehow divorced from the larger world of advocacy. Tax litigation, for all of its procedural rules, is really nothing more than a business dispute that gets squeezed through the meat-grinder of the Internal Revenue Code or some state tax statute. As in all business disputes, the only question is what are the keys to high-quality oral and written advocacy, either before the agency or in court?
So what is advocacy all about? Reduced to its core, advocacy is storytelling and the side that tells the best story wins. When I say that advocacy is "storytelling," I mean that word in its highest and most honorable sense. First and foremost, the story that the advocate tells has to be factually true, both in terms of what the evidence shows and its harmony with our collective sense of how the world is ordered, our shared experiences as reasonable adults, and our common perception of what is fair, just, and moral. The story must explain everything that happened and it must support the conclusions for which we are arguing. If the story is neither accurate, appealing, nor complete in answering the essential questions of what happened and who is right, it has little chance of winning.
When I say that the advocate must tell a story, I mean one that is told not only from the head, but also from the lawyer's heart after seeing the case from taxpayer's own head and heart. Only by telling the story from the taxpayer's perspective can the advocate stand a chance of humanizing the company and enabling the judge or jury to see the truth from the taxpayer's perspective, to care about the taxpayer, and to want it to prevail.
The story should tell the facts not only in a manner that is factually accurate, but in a manner that is organized thematically, so that its essence makes the greatest possible impression in the mind's eye of the reader or listener. We can bury the decider of the case in a jumble of disjointed facts or we can marshal the facts into word pictures and vignettes that enable the decider to absorb and accept the essential themes that we are promoting. By presenting our story, as does the author of any compelling novel, in a thematic and stylized manner, we enable the decider to digest what is praiseworthy, contemptible, tragic, or right.
As with the facts, so, too, with the law. The advocate needs to present and argue the law in terms of the overriding theories, principals, and guiding reasons for the tax law's treatment of the transactions in dispute. As we learned in law school, where the reason for the rules stops, the rule itself should also stop. Judges want to understand why the Code, Regulations, or case law says what it says and how it accomplishes its purposes in a manner that makes intellectual sense. So, in the legal argument section of our memoranda and briefs, the law should be explained in terms of its purpose and how it has evolved over time to govern the area before the court.
The case decisions should never be presented simply in terms of their specific facts and holdings, but as part of a coherent story of how all of the case law articulates the larger, unified principles that can be distilled from those decisions. If we have ten decisions in a particular area of tax law, we should never settle for an approach that says "the ABC case held this" and "the XYZ case held that." Instead, we must discuss the case law in terms of what it teaches us as whole, so that we can then make sense of it for the court and have the best possible chance of convincing the judge that we are the ones who are intelligent, insightful, reliable, and right. In fact, the more disparate and chaotic the case decisions may seem, the greater the premium upon, and reward for finding, the harmonious principles that will enable the court to see them through our eyes.
Lawyers adopt every conceivable mode of indirect expression designed to leave us room to wiggle, weasel, and hedge, lest we be accused of some "admission" that damages our client. To be effective advocates, however, we have to abandon the pluperfect subjunctive, the double negatives, and the other circumlocutions that stamp us as lawyers. When we are acting as advocates, we have to put aside the linguistics that we use in conversing with other lawyers, remember that we have grown to adulthood having experienced what most normal people in the community have experienced, and, above all, call a spade a spade. When lay people want to convince someone of the truth of what they are saying, they speak with conviction, from the heart, and without weaseling. As advocates, we must also find the phrases, images, and emotions that make our stories come alive and ring true for the listener or reader.
If the story demands it, we should not shrink from communicating sarcasm, irony, frustration, sadness, humor, or hope, not in lawyer-speak, but in the language and terms of real people. If we can enhance the story and hammer our themes more deeply into the skulls of our readers and listeners with a reference to a TV character, a phrase from Shakespeare, a line from a nursery rhyme, or a parable, we need to do so. Just because we are dealing with a tax case does not mean that we are confined to technical terminology or the linguistic style of Ways and Means Committee Reports. Advocacy is a far more liberating calling than that.
Suppose that the case centers on the interpretation of a supply contract that the taxpayer had negotiated. How can we make that story come alive so that the decider of the case will care about the taxpayer and will want to accept its version of what the contract was meant to accomplish? First of all, I can assure you that neither a judge nor a jury will care a fig about our Fortune 500 widget manufacturing client, but I will wager that we can make them care about the procurement manager, Mary Smith, who negotiated the contract. I will bet that if we spend some intensive and thoughtful time getting to know Mary, understanding her company's business, and learning what motivated and worried her before, during, and after she negotiated that contract, we will make people in the courtroom care about her. If they care about Mary, they will then care about Widgets International. Our job is to probe what was going on at the company during the time in question and what was in Mary's head, so that we can explain, with commitment and passion, what Mary wanted to accomplish, why her motivations were honest and honorable, and why the court should accept her truth as the truth of the case.
In a tax dispute, effective advocacy usually centers on persuading the court to accept our characterization or classification of some event, transaction, or state of mind and to reject that of the government. This is so because most issues in taxation are definitional. If the court accepts our argument that what, on its face, looks like a purchase of inventory items was, in fact, a hedging transaction, the tax law then dictates the proper tax accounting treatment for that item in a manner that will likely not be disputed. If tax law were comprised of animals in a zoo, our job would be to convince the court that the four-legged large beast at which the judge or jury is looking is, say, an elephant and not a giraffe.
The preparation of a complex corporate tax case should begin (long before the complaint or petition is filed) with a methodical search for the witnesses and documents through which the story will later be told. I cannot overstate the importance of getting an in-depth understanding of the facts from the outset of the examination while the dispute is still in its earliest stages. In a courtroom, an advocate cannot win if he/she or the taxpayer lack credibility. That credibility is undermined whenever the taxpayer's story has to be changed during the course of the examination, an appeal, or the trial of the case. It is absolutely critical to convey to the taxpayer, from the beginning, the essential principle that it cannot provide the IRS or a court with any rendition of the facts that is not as absolutely accurate as is possible. It is not enough to get the facts of the story correct at some point before the case is decided. It has to be right from the beginning, otherwise the story will be impeached throughout the case and the taxpayer will be damaged simply because it said one thing on one occasion and another thing after it learned the correct facts. Giving the IRS information or statements that we later learn are inaccurate creates needless grist for the government's mill.
Getting control over the gathering of the facts and documents means educating the taxpayer to the need for compulsively locating the sources of information and safeguarding the information against loss or destruction. Even the most sophisticated businesses may not appreciate the completeness of effort that the fact-gathering exercise demands. It is our job to educate them to that need, if only by our own consistent attention to the investigative exercise. More than lecturing the client, our doing the work and making the requests for the facts will communicate the seriousness of this aspect of the case.
Obtaining the relevant documents at the earliest possible time will ensure that the documents are not lost or destroyed. Corporations may have document retention policies that will result in the destruction of documents after a certain period of years. Given the enormous time lag (often 10 years or longer) that typically occurs between the filing of any particular tax return and the time when the corporation's potential additional tax liability for that tax year is finally resolved, the corporation may find that many of the key documents have been lost or destroyed in the interim.
This is damaging to the corporation for a variety of reasons, both substantive and cosmetic. First of all, the corporation has the burden of proving its case and the absence of key documents will be an obvious obstacle to carrying that burden. Moreover, if it is determined during the litigation that the corporation had the documents at one time, but later misplaced or destroyed them, even inadvertently, the corporation may be prejudiced in the eyes of the judge or the jury. Because the taxpayer bears a heavy burden of proof in a tax case and because the government is certain to come looking for the relevant business records during the course of the examination and litigation, the time that is necessary early on to locate, preserve, and study all relevant documents is well spent.
The preservation and location of key documents and business records is so vital that the taxpayer's tax and law departments should periodically review and seek the modification of any document retention policies that are unrealistically short in terms of their potential relevance to a tax controversy. Preserving all potentially relevant documents, however, is certainly easier said than done. Because essentially any transaction, foreign or domestic, in which the corporation engages carries a tax consequence, there is a limitless universe of documents that could possibly become relevant at some future time. The tax and law departments should therefore consider what transactions or events are most likely to come across the IRS's radar screen and become the subject of an un-agreed adjustment. If the tax and law departments can envision that certain transactions may cause potential tax issues, then steps should be taken to preserve all documents relating to those transaction. Many taxpayers are required, for financial accounting purposes, to estimate their reserves for potential future tax deficiencies. The documents and electronic information relating to whatever transactions may give rise to those potential liabilities should be isolated and preserved at least until those issues cease to be matters for possible IRS examination.
A necessary corollary to the rule that a corporation should locate all relevant documents is the equally compelling principle that neither the corporation nor its outside tax accountants should create any non-privileged documents that can damage the corporation's case. People within the company may be tempted to write memoranda that question the business purposes underlying a transaction, management's motivations for the transaction, or the accounting treatment that management has given or proposes giving to it. In some cases, these memoranda are authored to convince the addressees to change some decision that the writer of the memorandum believes is ill-conceived. In other cases, the motivation may be more one of documenting a disagreement in order to protect the writer's interests or to express displeasure with another member of the organization.
Writings of this latter type are often not privileged and, unfortunately, are likely to fall squarely within the broad discovery requests of the government in the examination or litigation. Consequently, writers of an unnecessarily critical memorandum may later find themselves in the uncomfortable role of witnesses whom the government uses to attack the corporation's position.
No one with any business experience would doubt for a moment that people within a large corporation will differ, and differ seriously, on the wisdom of certain transactions, the accounting treatment given to them, or the company's overall accounting policies for certain items and transactions. As the saying goes, when everyone thinks alike, no one is thinking very much at all. Differences of opinion are the sign of a vibrant and healthy corporation, provided that such differences are channeled constructively. When they take the form, however, of memoranda bitingly critical of management, the company runs the strong risk that the documents will be used against it in litigation. Trial counsel must then attempt to explain away or make a virtue out of the existence of the internal differences that the writer has now documented for the world to see. Although turning lemons into lemonade is what litigators do for a living, most would much prefer having challenges of this type avoided in the first place.
As this discussion suggests, people within the tax department and throughout the company need to understand (and be periodically reminded) that whatever they are writing may well turn up as an exhibit in a courtroom. They need to be encouraged to refrain from writing any memorandum that is potentially destructive and embarrassing (though directing people not to write such memos may, in some limited cases, be a bit like telling a young child not to stick peas up his nose). Within every company there are avenues of communication that are open to a concerned employee for frank and honest expression of concerns and these avenues must be used whenever necessary. The corporation should make clear throughout its executive and administrative offices that frank discussion is both welcome and the life-blood of the company, but that the mindless writing of memoranda designed only to vent or embarrass is unnecessary and damaging.
To avoid self-inflicted wounds that result from mistaken representations of the fact, it is essential to avoid permitting the IRS to pressure the taxpayer (or us) into making representations or arguments before we are absolutely confident that we know the facts. Consequently, we have to resist entreaties by the agents that we communicate the facts or the taxpayer's position on some issue before we and the taxpayer have done the necessary homework that enables us to become confident that we know the facts, what information exists, and what does not. If the agents complain, we simply have to push back, remind that they would not want us to give them incomplete or erroneous information, and that obtaining the information is a high priority for us. (They also know quite well that you will give them what they are seeking long before they could ever get a court order enforcing an administrative summons for the same information.)
To the fullest extent possible, wall off the IRS agents from direct contact or interviews with the taxpayer' people, even if you think that they are knowledgeable and competent. We are, after all, the taxpayer's representative and no matter how galling that may be to the examining agents, our job is to force them to funnel all requests for information through us. Doing so not only allows us to know what is being requested and what the taxpayer is providing in response, but also to learn the facts of the case and what is important to the agents. We should not view our role as one in which we sit back passively and wait for the client's tax or law department to ask us for some isolated piece of legal advice. The taxpayer will benefit most if we are involved in knowing whatever is communicated between the taxpayer and the IRS.
One of the most important decisions that the corporation and its trial counsel need to consider before litigation begins is the choice of the best forum in which to pursue the dispute. Each available forum poses certain advantages and disadvantages that must be weighed in light of the particular type of controversy that is involved.
In an income tax case, the corporation will always have the opportunity to proceed on a pre-assessment and pre-payment basis in the United States Tax Court or, instead, to allow the assessment to be made, pay the tax, and to then sue for a refund either in the federal district court for the jurisdiction in which it has its principal place of business or in the United States Court of Federal Claims. Corporate taxpayers and their counsel should realize that they have this choice and they should not, as a knee jerk reaction, simply assume that every tax dispute belongs in the Tax Court. On the contrary, there are often compelling reasons to avoid the Tax Court like the plague and to embrace a refund suit as the best option.
The Tax Court, of course, is populated by judges who are scholarly in the field. The fact of their expertise, however, may be a mixed blessing. These judges view themselves as able tax lawyers and may have fixed views concerning a particular issue long before we and the taxpayer show up to argue a conflicting interpretation. On the other hand, the district court or Court of Federal Claims judges may be far more educable precisely because they are not students of the tax law.
Because the Tax Court judges have opinions on most tax law issues, even the existence of favorable Tax Court decision in a prior case is no guarantee that other Tax Court judges will adopt that precedent in the case before them. A taxpayer who selects the Tax Court because of a seemingly favorable Tax Court precedent may find, quite to its surprise, that the judge to whom its case is assigned has another view of the matter.
On the other hand, a favorable Tax Court decision may have powerful weight in a district court refund suit because the district court regards the author of that decision as expert in the field and the district court judge may be quite happy to defer to that decision, rather than attempting to reinvent the wheel on a matter of substantive tax law that may be difficult to understand and foreign to the district court's experience. As a court of general federal jurisdiction, a district court judge hears the fullest range of criminal and civil disputes. District judges are, therefore, expert in some fields and, at best, generalists in the rest. No doubt, they will have had little experience with the tax law and will often have the same dread of tax law that an art major has of calculus. If a Tax Court decision reads in a logical and coherent way, it may actually have more force in the district court than it may have in a similar Tax Court case before a different Tax Court judge.
The district court refund process also offers the taxpayer numerous strategic and practical advantages in prosecuting the litigation. The taxpayer commences the refund suit in its principal place of business and before a judge who may well know and, perhaps, respect the corporation's activities. Certainly, as a resident of the local community, district court judges know that the corporation is a credible member of the community and not prone to meritless litigation. The corporation's selection of highly-regarded local counsel may also enhance the consideration that the court is likely to afford to it. Certainly, local counsel will know the preferences, proclivities, and demeanor of the particular judge assigned to the case. On the other hand, in a Tax Court proceeding, the corporation and its counsel are often complete strangers to the judge who, of course, does not reside in the taxpayer's community.
Beyond the knowledge that the court and counsel may have of each other, the district court offers numerous advantages that may be extremely attractive to the corporation. These benefits include the opportunity for conducting a full range of discovery when obtaining information from third parties is necessary; the prompt resolution of motions; and the hands-on management of Magistrate Judges who are responsible for making sure that the case proceeds in a timely fashion and that the possibility for settlement has been exhausted before the case is tried.
Furthermore, because large corporations become liable for the "hot interest" at certain stages of the examination period, there may be strong reasons to pay the tax and then sue for a refund, rather than exposing the corporation to this high cost of money. (On the other hand, achieving a settlement in a refund suit can be among the most painful experiences imaginable, given the need to convince the Tax Division trial attorney, his or her section chief, the Tax Division Review Section, the IRS Chief Counsel's Office, and, on occasion, the Office of the Assistant Attorney General of the Tax Division that some amount of what the corporation has paid should actually be viewed as belonging to it and not to the government.) In Tax Court cases in which the taxpayer has not paid the tax, settlement of the case may be considerably easier. The IRS counsel, however, may be hamstrung by some revenue ruling or litigating position that the Justice Department Tax Division would not find an obstacle to settling a refund suit. In some cases, only by getting the case to the Tax Division in a refund suit is any settlement a possibility.
There are also types of cases that play well to juries which are available only in a district court refund suit. For example, if the corporation has charitably donated real estate, the fair market value of which is being disputed by the government, the corporation may well wish to take its chances with a jury consisting of persons living in the community that is benefiting from the donation.
On some (rare) occasion, the corporation may find that the court of appeals for the taxpayer's judicial circuit has adopted some rule of tax law that is inhospitable to the taxpayer's case. Both Tax Court and district court are obligated to follow any controlling precedent in that judicial circuit. By filing a refund suit in the United States Court of Federal Claims, however, the corporation can sidestep the adverse circuit court precedent because cases filed in that court are reviewable by the Court of Appeals for the Federal Circuit and the Court of Federal Claims will follow precedent, if any, in that Circuit; otherwise, it is free to follow its own precedent or whatever view of the law it believes is correct.