Cracks are starting to form in the shield that largely has kept the tax system from scrutiny under new US Supreme Court precedent on when federal monetary penalties require a jury trial.
Lower courts mostly rebuffed taxpayers’ attempts to negate IRS penalties following last year’s Supreme Court decision in Securities and Exchange Commission v. Jarkesy, which held that the Seventh Amendment requires a jury trial before the government can impose certain civil fines.
But the justices’ decision left a lot of room for plaintiffs to test its bounds, said Ryan Regula, a partner at Snell & Wilmer LLP.
At least one case recently worked out favorably for a taxpayer, who was able to avoid a $1 million IRS penalty for failing to report interests in a foreign account, or FBAR, that was imposed without a jury trial.
That case “turns things on their head,” Regula said. “If you don’t like the government or see it enforcing things as a draconian process, this gives you some hope.”
David Coale, a tax lawyer at Lynn Pinker Hurst & Schwegmann, said Jarkesy adds an “unpredictable” element as courts take a fresh look at the relevant tax code provisions and whether they constitutionally allow the IRS to impose its own penalties.
The case adds a new dimension to taxpayer challenges, as they now can ask the courts to interpret the law and determine whether a particular penalty mandates a pre-assessment trial, he said.
And in the tax world, that could mean some surprising rulings.
“These tax matters just aren’t as clear” on how to characterize penalties, Coale said.
Public Rights Exception
Jarkesy held that the Seventh Amendment requires a jury trial before the Securities and Exchange Commission can impose fraud penalties because the statutory provisions at issue “replicate common law fraud,” and it’s “well established” such claims require a jury’s determination.
Although the high court limited its holding to the SEC, legal observers believe the decision will flow to other agencies enforcing similar laws.
Taxpayer plaintiffs challenging IRS penalties now are asking courts to interpret Jarkesy as applying to the IRS and the tax code’s penalty provisions.
Dru Stevenson, a professor of law at South Texas College of Law, Houston, said the result is that application of Jarkesy has been anything but consistent.
“The courts are all over the place,” he said. “The way they interpret it can depend on the day of the week.”
Lower federal courts initially ruled in favor of the IRS’s ability to unilaterally impose tax-related fines.
For example, the US Tax Court determined that that fines under IRC Section 6663(a)—which allows the IRS to charge 75% of the underpaid tax as an added penalty if the agency can prove the tax avoidance was attributable to fraud—don’t need trials.
Those penalties, the court said, fall within the “public rights” exception to the Seventh Amendment because they’re a part of the core government function of revenue collection, which isn’t a common-law right. Congress can delegate enforcement of such public rights to agencies and non-Article III courts.
A federal judge in Louisiana reached a similar conclusion in a case that included penalties under Section 6662, which allows up to 40% penalties for “gross valuation misstatement” or substantial underpayment of tax. The company there sought a trial under Jarkesy, but the court said the Anti-Injunction Act bars suits that restrain tax collection.
The AIA and the public rights exception are “well entrenched” law that make challenges to IRS tax assessments and penalties an uphill battle, said Matthew Wiener, who teaches administrative law at the University of Pennsylvania’s Carey Law School.
But in United States v. Sagoo, a federal judge in Texas Sept. 19 cited Jarkesy in dismissing an IRS attempt to reduce to judgment penalties against a taxpayer in an FBAR case.
The government conceded a trial would be necessary before a judgment on the penalties. But Judge
No More ‘Stacked Deck’
“This is the hottest thing people aren’t talking about, because Jarkesy was a game changer on how to view administrative law,” Regula said.
Tax practitioners always assumed the IRS has a “stacked deck” in tax cases because of the “public rights” exception and the AIA, he said.
Jared Carter, a professor at Vermont Law and Graduate School, said plaintiffs hope a jury trial is more likely to result in a win because their peers will view them more favorably than a judge or agency.
That’s not always the case, and many of those jury trials may well reach the same conclusions as the IRS about whether a penalty is warranted, he said.
There ultimately may be an appetite from the Supreme Court to “chip back and narrow” the public rights doctrine to ensure it’s applied only to the most “historically-based categories of public rights,” Wiener said.
But the high court will be careful about which case involving the issue that it decides to take, he said.
Stevenson said the US Tax Court is the one to watch for “influence and consistency” in applying Jarkesy in the tax context because of its specialization in that area of the law.
Jarkesy “conceded that public rights cases are messy and don’t lend themselves easily to a clear doctrinal formulation,” he said.
In the meantime, Regula expects more cases over penalties based on taxpayer intent—such as willfulness—and other, similar charges that the IRS can tack on when pursuing someone for unpaid taxes.
Those kinds of penalties may require the IRS to meet a higher burden of proof and present it at a jury trial, he said.
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