March 1998
Fifth Circuit Announces Taxpayer-Friendly Rule for Proper Deference for Revenue Rulings
In McClendon v. Commissioner, __ F3d __ (5th Cir. 3/9/98), the Fifth Circuit declared a victory of major proportions to the taxpayer and, in the process, also declared a significant victory for other taxpayers.
The issue in McClendon turned upon mortality -- there the mortality of a "wealthy man." (As the Court noted, mortality "hovers over the castle as well as the cottage;" with this cute turn of a phrase suggest the Court suggests that mortality leavens the field between rich and poor, but the case well illustrates that the rich face mortality with advantages unavailable to the poor.) The taxpayer there had terminal cancer (2-3% survival rate) but one which was not sufficiently aggressive (in response to chemotherapy) to make the chances of his survival beyond one year "negligible." (We shall return to the key word "negligible" for it forms the crux of the substantive merits of the case.) In clear anticipation of his reduced life expectancy, the taxpayer entered into a private annuity transaction with his son and a "newly minted McClendon Family Trust." The transfer involved the transfer of remainder interests in partnership holdings in exchange for $250,000 and an annuity to be paid to the taxpayer for life. In determining the consideration to be paid to the taxpayer by the son and the trust, the parties used the actuarial tables from the regulations. The taxpayer died about 6 months after the transaction.
The planning transaction is, of course, transparent. By using mortality tables that reflect "normal" life expectancy when it was known that the father had an illness with only a 2-3% survival rate, the odds were overwhelming that the consideration the son and trust paid was really far less than the remainder interest was worth. In planning this transaction, therefore, the taxpayer was not playing the lottery but a hand of poker with a stacked deck. If the planning succeeded, a major transfer of wealth from the father to the son and family trust is rendered free of estate and gift taxation. The Fifth Circuit held that the planning worked.
In an earlier decision, Miami Beach First National Bank v. United States, 443 F.2d 116, 119-20 (5th Cir. 1971), the Fifth Circuit held that "where there is sufficient evidence regarding the actual life expectancy of a life tenant, the presumptive correctness of the Treasury tables will be overcome." The IRS then issued Revenue Ruling 80-80, holding that, where the actual facts of a taxpayer’s condition indicate that the actuarial tables should not apply, they will not apply. The Commissioner then, in that ruling, posited the test as follows:
[t]he current actuarial tables in the regulations shall be applied if valuation of an individual's life interest is required for purposes of the federal estate or gift taxes unless the individual is known to have been afflicted, at the time of the transfer, with an incurable physical condition that is in such an advanced stage that death is clearly imminent. Death is not clearly imminent if there is a reasonable possibility of survival for more than a very brief period. For example, death is not clearly imminent if the individual may survive for a year or more and if such a possibility is not so remote as to be negligible.
The Fifth Circuit panel was, of course, bound by its decision in Miami Beach. Moreover, it was clear in the case that the taxpayer clearly had a reduced life expectancy that might otherwise fall within the general language of Miami Beach. But, the Revenue Ruling, the Fifth Circuit found, fleshed out the general language of Miami Beach and established a test which the taxpayer met in this case to qualify for the actuarial tables. Specifically, the Fifth Circuit found that the possibility that the taxpayer might survive more than one year was not negligible. In this regard, a low survival rate (which indicates significantly reduced life expectancy) does not per se indicate a negligible chance of life expectancy beyond one year.
Accordingly, the case turned upon whether the IRS was bound by the interpretation in the Revenue Ruling. This required the Court to address the issue of the proper judicial deference to give revenue rulings. The Fifth Circuit addressed the issue as follows (footnotes omitted):
We note at the outset that the Tax Court has long been fighting a losing battle with the various courts of appeals over the proper deference to which revenue rulings are due. Whereas virtually every circuit recognizes some form of deference, the Tax Court stands firm in its own position that revenue rulings are nothing more than the legal contentions of a frequent litigant, undeserving of any more or less consideration than the conclusory statements in a party's brief. Although the Supreme Court has not spoken definitively on the subject, its recent jurisprudence tends to support the view that the courts owe revenue rulings a bit more deference than the Tax Court would have us believe. /12/ Still, revenue rulings are odd creatures unconducive to precise categorization in the hierarchy of legal authorities. They are clearly less binding on the courts than treasury regulations or Code provisions, but probably (and in this circuit certainly) more so than the mere legal conclusions of the parties. Apart from that, little can be said with any certainty, and in the absence of a definitive statement from on high, the Tax Court continues its crusade to ignore them in toto.
With that introduction, the Court held, based on its prior precedent in Silco, Inc. v. United States, 779 F.2d 282, 286 (5th Cir. 1986), that a taxpayer can rely upon a revenue ruling and the IRS will be bound by the revenue ruling. In a footnote, the Court acknowledged that the IRS could retroactively revoke a revenue ruling upon which taxpayers have relied to their detriment, citing Automobile Club of Michigan v. Commissioner, 353 U.S. 180, 183-84 (1957); and Dixon v. United States, 381 U.S. 68, 72-73 (1965). The IRS had not revoked the revenue ruling in question here. In the footnote, the Court also set forth its reasoning, based on Silco for holding the IRS to the unrevoked revenue ruling: "The essence of the Silco rule is that traditional notions of equity and fair play prevent the Commissioner from changing his position after inviting reliance with his own regulations."
Thus, the rule as now applicable in the Fifth Circuit (and perhaps in other circuits) is that the revenue ruling is entitled to no deference if the IRS relies upon it (i.e., it is just another lawyer's opinion) but is entitled to deference if the taxpayer relies upon it. The drill for taxpayers now, more than ever, will be to hammer their transactions into revenue rulings as closely as possible so that they can rely upon this rule.
In Norfolk Southern Corp. v. Commissioner, __ F.3d __ (4th Cir. 3/20/98), aff'g 104 T.C. 13 (1995), the Fourth Circuit held that cargo containers used in international commerce did not meet the tax credit statutory requirement of being ""used in the transportation of property to and from the United States" unless the taxpayer establishes that the cargo containers had some minimum contact with the United States in each taxable year. The merits of that construction of the statute is "ho-hum." So why address the matter here?
First, and least important, a lot of dollars potentially rode on the issue. So too do a lot of dollars ride on the garden-variety tax protester issue of whether the constitution permits taxation of wages, and those cases do not draw even a yawn from us.
Second, and more importantly, was the issue of what the Court had to say about the retroactive application of a revenue ruling adopting a proper construction of the law. As we noted in the preceding article, many courts treat a revenue ruling as simply one lawyer's interpretation of the law, entitled to no deference beyond that point. In this case, ten years after the enactment of the statute in question, the IRS issued a revenue ruling adopting the interpretation and applied the interpretation retroactively. As a relief measure against the proof problems in determining whether the cargo containers had the requisite nexus to the United States, the IRS permitted taxpayers to elect to claim ITC on 50% of the containers without further proof. Not satisfied with 50%, the taxpayer in Norfolk Southern and the industry through an amicus brief argued that, wholly apart from whether the Revenue Ruling interpretation was a valid interpretation of the law (which the Court easily found it was), the interpretation should not be applied retroactively, asserting notions of fairness and fair play because they had been lulled into not maintaining adequate records to get above 50%. In essence, they were arguing that they had relied in good faith upon the lack of guidance from the IRS.
Rejecting the taxpayer's argument, the Court repeated the black letter law from old, but still good, Supreme Court cases establishing that the statute is the law, not the IRS's ruling. Hence, an interpretation of the statute that the Court approves (as it did in this case) is controlling even if a ruling incorporating the interpretation is not issued for many years and, indeed, the correct interpretation of the statute is controlling even if the IRS had issued an intervening ruling incorrectly interpreting the law in a taxpayer's favor. Addressing the equitable underpinnings of the taxpayer's argument, the Court, having found that the interpretation of the statute was consistent with the plain meaning of the statute, had no sympathy with the taxpayer for having failed to maintain adequate records to establish its claims to the credits. How could the taxpayer rely upon the lack of guidance when the statute clearly placed the risk of this interpretation squarely upon the taxpayer. Finally, also consistent with a long line of cases virtually uninterrupted except for the IBM blip, the Court held that the mere fact that other taxpayers (Norfolk Southern's competitors) may have achieved the benefit in question contrary to the statute does not entitle Norfolk Southern to claim a benefit that the statute does not allow.
T&J Comment: McClendon (first case above) teaches that the Fifth Circuit may be willing to provide relief where the taxpayer has specifically relied upon an outstanding revenue ruling even where the taxpayer is gaming the system, particularly where the IRS has not revoked the ruling and issued a contrary interpretation in advance of the taxpayer action in reliance. But, as in Norfolk Southern, a Court will not estop the IRS from adopting and applying retroactively an interpretation consistent with the statute where there is no suggestion that the taxpayer relied to its detriment on a contrary IRS interpretation. Hence, McClendon may stand out as a rare instance of a taxpayer victory (much as the IBM case was the rare victory in the context of a favorable private letter ruling issued to a competitor), which will be of little use to most taxpayers. Nevertheless, McClendon is there for skilled advocates to convince agents, appeals officers or courts that their cases are sufficiently like McClendon to allow a taxpayer to seize victory from the jaws of defeat.
Norfolk Southern also reminds us that the IRS's current penchant for issuing guidance -- at least in terrorem guidance -- through "notices" may not be as bad as many taxpayers would make it out to be. These notices which are not promulgated with the fanfare of formal regulations clearly warn taxpayers of an IRS interpretation to come more formally. The process may certainly be abused. But taxpayers more sympathetic than Norfolk Southern should welcome the opportunity to know the IRS tentative positions on big-dollar issues so that they can plan accordingly.