Lennox v. C.I.R. ( 1993 )

UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT
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No. 92-4826
_________________________________________
MICHAEL L. LENNOX AND
GLENDA J. LENNOX,
Petitioners,
VERSUS
COMMISSIONER OF
INTERNAL REVENUE,
Respondent.
_________________________________________________________________
Appeal from the Decision of the
United States Tax Court
_________________________________________________________________
(August 4, 1993)
Before POLITZ, Chief Judge, REAVLEY, and BARKSDALE, Circuit Judges.
BARKSDALE, Circuit Judge:
In reviewing the Tax Court's denial of costs to the Lennoxes,
after the government conceded their challenge to its notice of
deficiency, we consider for the first time the definition of the
"position of the United States" on "the date of the notice" as
contained in 26 U.S.C. § 7430(c)(7)(B)(ii), as amended by the
Technical and Miscellaneous Revenue Act of 1988, Pub. L. No. 100-
647, § 6239(a), 102 Stat. 3342, 3743. Concluding that a
determination of the reasonableness of that position must include
a review of the actions leading to its establishment, we hold that
the government's position was not substantially justified.
Therefore, we REVERSE the denial of costs and REMAND to the Tax
Court for their determination.
I.
The Internal Revenue Service began to question the Lennoxes'
tax returns during the course of its investigation of Ron Piperi,
an attorney who had represented Glenda Lennox's family since the
early 1970's. Michael Lennox first met Piperi in 1981, when Piperi
handled the probate of Glenda's mother's estate, from which Glenda
Lennox and her children inherited property worth approximately $1
million. Piperi advised the Lennoxes that they needed a tax
shelter and recommended investing some of the inheritance in
apartment projects.
The first project was the Quail Creek Apartments (the
apartments) in Killeen, Texas, which Piperi was already developing,
and in which he offered to sell the Lennoxes an interest. In 1983,
he sold his interest to Michael Lennox, making him the sole owner.
At the closing, Lennox executed, among other documents, a $6.25
million note on which he was personally liable. The loan was
arranged by Piperi through a savings and loan for which he served
as chairman of the board.1 Title was recorded in the county
records.
After experiencing some difficulty with the company managing
the apartments, Lennox contracted with Asset Plus, a management
company in which Piperi held an interest. Lennox visited the
1
Piperi later came under criminal investigation because this
loan, which he arranged in 1983, was a construction loan.
Construction had been completed in 1982.
2
property regularly and handled the insurance and major repairs, but
Asset Plus was to provide him with monthly reports, collect rents,
and administer all expenditures, including making interest payments
on the $6.25 million note. At the hearing on costs, Lennox
testified that, as far as he knew, those payments were made.
Within the first two years, Lennox realized that the apartments
were not going to generate enough income to service the interest on
the note. Piperi then approached him with an offer: his savings
and loan would refinance the loan at a lower rate, but the existing
loan must first be placed in default. Lennox testified that he
understood Asset Plus was taking the amount it had been paying
toward the interest and placing it in escrow. However, Lennox
began to have difficulty obtaining an accounting or other records
from Asset Plus. The new financing did not go through, the savings
and loan foreclosed on the apartments,2 and Lennox filed
bankruptcy.
Meanwhile, IRS agent George Gilbert, in El Paso, was
investigating Piperi. During the course of that investigation, he
discovered that Piperi was receiving the rental income from the
apartments and using it for personal expenses, that no principal or
interest payments had been made on Lennox's $6.25 million note, and
that Piperi had arranged other similar loans, assuring the
"borrowers" that they would never have to pay, and in some cases,
2
In February 1983, Lennox had borrowed an additional $660,000
to use for interest payments on the larger note. He put up 120
acres of land from his mother-in-law's estate as collateral. That,
too, was lost in the foreclosure.
3
paying them $20,000 for signing the notes. This information caused
Gilbert to suspect that Lennox was only a nominee owner of the
apartments, and he concluded that Lennox should be investigated to
determine the true ownership. On August 10, 1990, Gilbert sent a
memorandum to his branch chief, alerting him to these concerns and
suggesting that the Lennoxes' tax returns be examined.
On August 22, having received a copy of Gilbert's memorandum,
IRS agent Phelps Brookshire, in Waco, began an examination of the
Lennoxes' returns for 1983, 1984 and 1985. For each of those
years, the Lennoxes had claimed deductions related to the
apartments, including large net operating losses. Brookshire
examined those returns and spoke with Gilbert, but did not conduct
an investigation of his own. When Brookshire realized, in late
August, that the limitations period would expire that October 27,
he determined that he would "have to do something fast".
On September 11, Brookshire telephoned Lennox and explained
that all losses associated with the apartments would be disallowed.
Lennox and Brookshire spoke again the following day, and Brookshire
stated that he would have to issue a notice of deficiency unless
Lennox agreed to extend the limitations period. Several days
later, Lennox's accountant called Brookshire, advised him that the
tax rolls listed Lennox as the owner of the apartments and that
Lennox had filed bankruptcy because of his debt on them, and
offered, on behalf of Lennox, to sign a limited extension,
extending the period only as to questions related to the
apartments. Brookshire refused. He later testified that his
4
manager said that there was not enough time (in the approximately
35 days remaining in the limitations period) to get approval for
the specific language for a limited extension.
Not having received an extension, Brookshire issued a
statutory notice of deficiency on October 2, disallowing the losses
claimed on the apartments due to questions of actual ownership. On
January 3, 1991, the Lennoxes petitioned the Tax Court for a
redetermination of the deficiencies. The Commissioner of Internal
Revenue answered on March 5, denying all facts of ownership as
alleged in the petition. On April 10, the Lennoxes' attorney, John
D. Copeland, had a one-hour telephone conversation with an IRS
appeals officer and discussed evidence that Michael Lennox was the
true owner. (Nothing in the record, however, describes that
evidence.)
Eight months later, Copeland received settlement documents
from the IRS. He testified that, after the April telephone
conversation, he intended to send the appeals officer copies of
documents showing ownership but "never got around to sending them
to him, but [the IRS] went ahead and dropped the case, even without
my sending those documents".
On March 16, 1992, the day this matter was set for trial, the
parties filed a stipulation of settled issues, stating that there
were no deficiencies or additions due from, nor overpayments due
to, the Lennoxes for 1983, 1984 or 1985. The Lennoxes filed a
motion for administrative and litigation costs that same day, and
the Tax Court heard evidence on the motion on March 19. On June
5
25, the Lennoxes supplemented their motion, adding additional
costs. The Tax Court filed an opinion on July 8, concluding that
the government's position, beginning with the date of issuance of
the notice of deficiency, was substantially justified.
Accordingly, costs were denied.
II.
Internal Revenue Code § 7430 allows the "prevailing party" in
tax proceedings to recoup reasonable costs, including attorney's
fees. Determining a "prevailing party" includes several factors,
only one of which is at issue here: whether "the position of the
United States in the proceeding was not substantially justified".
26 U.S.C. § 7430(c)(4)(A)(i). This determination requires us to
resolve two subissues. Because our court has not interpreted the
applicable definition of "position of the United States", we must
first determine when that position becomes fixed and what actions
can be considered for purposes of this analysis. Then, against
that backdrop, we must determine whether the position was
substantially justified.
A.
When § 7430 was first enacted in 1982, the term "position of
the United States" was not defined. 26 U.S.C. § 7430 (1982). It
was first defined when the section was amended in 1986, and that
definition was amended in 1988. Applicable to all proceedings
commenced after November 10, 1988, that version is at issue here,
and reads in pertinent part:
6
The term "position of the United States" means --
(A) the position taken by the United States
in a judicial proceeding to which subsection (a)
applies, [as quoted in note 3, infra,] and
(B) the position taken in an administrative
proceeding to which subsection (a) applies as of
the earlier of --
(i) the date of the receipt by the
taxpayer of the notice of the decision of the
Internal Revenue Service Office of Appeals, or
(ii) the date of the notice of
deficiency.
26 U.S.C. § 7430(c)(7) (1988).3
The Lennoxes contend that the position of the United States on
October 2, 1990, the date of the notice of deficiency, was not
substantially justified. There is no question that it is the
position taken by the United States on that day which we must
consider. The question, however, is what actions the Tax Court can
look to in determining the justification for that position. This
issue of statutory interpretation is, of course, one of law, which
3
Subsection (a) provides:
In any administrative or court proceeding
which is brought by or against the United States in
connection with the determination, collection, or
refund of any tax, interest, or penalty under this
title, the prevailing party may be awarded a
judgment or a settlement for --
(1) reasonable administrative costs
incurred in connection with such administra-
tive proceeding within the Internal Revenue
Service, and
(2) reasonable litigation costs incurred
in connection with such court proceeding.
26 U.S.C. § 7430(a) (1988).
7
we review de novo. E.g., Dresser Industries v. C.I.R., 911 F.2d
1128, 1132 (5th Cir. 1990); Sliwa v. C.I.R., 839 F.2d 602, 605 (9th
Cir. 1988).
Although the Tax Court found that there had been sufficient
time to have the limited extension prepared and executed, it
nevertheless refused to consider any actions which took place
before October 2, summarily holding: "[I]t is clear from section
7430(c)(7)(B) that the only position taken by the United States in
an administrative proceeding which is to be considered in this case
in determining whether [the Lennoxes] are the prevailing part[ies]
is the position taken by [the United States] beginning with the
date of the deficiency notice. ... Therefore the reasonableness
of the actions of the revenue agent in not accepting the restricted
[limitations] waiver are not relevant since those actions were
taken prior to October 2, 1990."
The Lennoxes challenge this interpretation of § 7430, and
contend that such a rule will require courts to decide cases in a
vacuum. We agree. Although we have not previously interpreted the
amended subsection of § 7430 in issue (§ 7430(c)(7)(B)(ii)), at
least one prior opinion by our court foreshadows this result. In
Hanson v. C.I.R., 975 F.2d 1150 (5th Cir. 1992), in considering the
United States' position in a judicial proceeding, § 7430(c)(7)(A),
our court did so "against the backdrop of the administrative
actions that have gone before", concluding that such a backdrop "is
relevant to a determination whether the government's position in
litigation is substantially justified". Id. at 1153 n.2 (emphasis
8
in original). In sum, our court declined to construe §
7430(c)(7)(A) (judicial proceeding) as strictly as the Tax Court
here construed § 7430(c)(7)(B)(ii) (administrative proceeding).
Instead, our court interpreted the government's position at a
particular time in the context of what led to the formulation of
that position.
We agree with the Hanson analysis, and apply the same
interpretation to § 7430(c)(7)(B)(ii). We hold that the govern-
ment's position on "the date of the notice of deficiency" must be
analyzed in the context of what caused it to take that position.
The IRS would not have issued the notice on October 2 (forcing the
Lennoxes to file suit) if the Lennoxes had extended the limitations
period. They declined to do so, offering a limited extension
instead. Because the IRS refused the limited extension, it issued
the notice which set this proceeding in motion. Certainly we must
consider the reasonableness of that refusal, among other factors,
in determining whether the issuance of the notice was substantially
justified.
B.
The position of the United States is substantially justified
if it is "justified to a degree that could satisfy a reasonable
person". Pierce v. Underwood, 487 U.S. 552, 565 (1988).4 It is
not enough that a position simply possesses enough merit to avoid
4
Pierce v. Underwood, concerning the Equal Access to Justice
Act (EAJA), 28 U.S.C. § 2412(d), interprets the same words at issue
here. Where the language is the same, "courts read the EAJA and §
7430 in harmony". Kenagy v. United States, 942 F.2d 459, 464 (8th
Cir. 1991).
9
sanctions for frivolousness; it must have a "`reasonable basis both
in law and fact'". Id.; see, e.g., Hanson, 975 F.2d at 1153. The
burden of proving no substantial justification is with the
taxpayers. Estate of Johnson v. C.I.R., 985 F.2d 1315, 1318 (5th
Cir. 1993). We review the Tax Court's ruling on substantial
justification for abuse of discretion, id., and will reverse only
if we have a definite and firm conviction that an error of judgment
was committed. See TKB International, Inc. v. United States, __
F.2d __, 1993 WL 184021 (9th Cir. June 3, 1993).
Of course, the ultimate failure of the government's legal
position does not necessarily mean that it was not substantially
justified. It is, however, a factor to be considered. Estate of
Perry v. C.I.R., 931 F.2d 1044, 1046 (5th Cir. 1991). In this
case, the Tax Court was not swayed by the government's concession,
because it concluded that, after the notice was filed, the
government "ascertained the facts and conceded the case as
expeditiously as might be expected".
To the extent that this is a finding of fact that the IRS
obtained new evidence between notice and concession, we hold that
it is clearly erroneous. When the notice was issued, the IRS knew
that the tax rolls showed Michael Lennox as the owner of the
apartments and that he had filed for bankruptcy because of his debt
on them. There is nothing in the record to reveal what information
was later obtained, or how it might have persuaded the IRS to
concede. It is undisputed that the Lennoxes' attorney spoke to an
IRS appeals officer for one hour on April 10, 1991; but, obviously,
10
the mere length of that conversation is not evidence of its
contents.5
In the face of the rapidly expiring limitations period, the
government staked its position on October 2, and then, given no
additional information, surrendered that position more than a year
later. The Lennoxes concede, and we agree, that the IRS had a
basis for suspicion regarding ownership of the apartments. But, on
this record, that suspicion was not a sufficient basis for issuance
of the notice, in light of the opportunity for further, and much
needed, investigation. The restricted extension of the limitations
period, offered by the Lennoxes, would have afforded the government
that opportunity; and, as the Tax Court found, there was sufficient
time to formulate and execute that extension.6 In sum, we conclude
5
Indeed, at oral argument before us, government counsel
conceded that the "record is scant" regarding any new information
which could have come to light between notice and concession. Also
at oral argument, the Lennoxes' counsel explained that the only
evidence discussed in the telephone conversation was documents from
the public record which would show Michael Lennox's ownership of
the apartments. It is clear that the IRS knew, before issuance of
notice, that title had been transferred to Lennox and that the tax
records reflected such ownership. Moreover, because the IRS has
never contested Lennox's record ownership, it seems unlikely that
it would find such evidence persuasive. Of course, statements made
before us could not have been considered by the Tax Court in
reaching a factual finding. The statements only reinforce the
conclusion we reached from our review of the record.
6
The Commissioner cites Harrison v. C.I.R., 854 F.2d 263 (7th
Cir. 1988), cert. denied, 489 U.S. 1053 (1989) (concerned pre-1988
version of § 7430) as authority for its position that it is
reasonable to issue a notice of deficiency in order to toll the
statute of limitations. Harrison, however, is distinguishable, and
entirely consistent with our holding today. In Harrison, the IRS
sent the taxpayers a consent form for extension of the limitations
period. The taxpayers signed the form and returned it, but it
never reached the IRS. Faced with imminent expiration of the
period, the IRS issued the notice. Today we conclude that issuance
11
that the Tax Court abused its discretion in finding the
government's position substantially justified on issuance of the
notice.
III.
Accordingly, that part of the Tax Court's Order and Decision
denying costs is REVERSED, and this proceeding is REMANDED for
their determination.
REVERSED in part and REMANDED.
of notice to the Lennoxes was unreasonable, partially because the
IRS had, but declined, the opportunity to extend the period as to
the matter in question. We need not decide whether, absent the
Lennoxes' counter-offer, the position of the United States would
have been substantially justified.
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