It goes without saying that taxpayers and tax practitioners should be careful in drafting settlement documents. But horror stories -- some of which we are about to recount -- remind us that there is merit in being thorough and open in this area unless the client is willing to accept and assume responsibility for risks that can prove very expensive..
In Miller Tabak Hirsch & Co. v. Commissioner, T.C. Memo. ___, rev'd ___ F.3d ___ (2d Cir. 11/21/96), unofficially reported at 1996 DTR 226 d20 (11/22/96), the taxpayer (a partnership) had entered a tax deferral transaction in which it would claim deductible interest in one year and take in a roughly equivalent amount of interest income the next year. The IRS took the protective and inconsistent positions that the interest was not deductible in the first year (1982) and the interest income was includible in income in the second year (1982). From a tax logic standpoint, if the transactions were shams, both the deductions and the income should be ignored. Nevertheless, since two years were involved, the IRS was forced to take protective and inconsistent positions.
Shortly before trial was scheduled on this and the only other issue then remaining in the case, the IRS and the taxpayer agreed upon a settlement and announced the agreement to the Tax Court (Judge Laro). As respects the interest deferral transaction, the parties advised the Court that they had agreed to settle by disallowing $1,000,000 of interest in the year 1982. No mention was made about the interest income in 1983. The IRS then proceeded to make the calculations based on these two adjustments so that a decision document could be agreed upon and entered with the Court. At that time, the taxpayer objected, asserting that an implicit corollary in the denial of the $1,000,000 in interest in 1982 is the backing out of the interest income in 1983. The parties then went to the Tax Court to resolve the dispute as to the scope of the settlement agreement they had reached.
In that dispute, the IRS conceded that had it prevailed on the interest deduction issue after trial in the Tax Court, it would have been required to back out the interest income in 1983. That, of course, would be an implicit corollary of a court holding to that effect. The IRS argued, however, that the settlement on the specific adjustments agreed upon was just that -- a limited basis settlement that did not extend what might be considered logical corollaries in other contexts.
The Tax Court held for the taxpayer on the basis that, if the deductions are disallowed, then, for tax purposes, the offsetting income in 1983 did not exist and could not be taxed.
On appeal, the Second Circuit reversed the Tax Court, zapping the taxpayer. Its reasoning proceeded as follows:
The parties agreed that their agreement was unambiguous, thus rendering any extrinsic evidence as to their "intent" inadmissible and irrelevant.
The agreement does not mention the $1,000,000 in interest income in 1983.
The fact that the $1,000,000 in interest income would be backed out if the Tax Court had denied the interest deduction after trial is not dispositive or even relevant.
This was a settlement, not a trial disposition in which logical corollaries would flow naturally. In a settlement, by contrast, the settlement is as to the items compromised and no others. In reaching settlement, parties are not constrained to logical corollaries and may, indeed, reached wholly illogical settlements.
This is obviously a very bad result for the taxpayer and perhaps its trial counsel.
We obviously do not know from the case what the parties' real intent on this matter was and whether, as to the interest income issue, there was a failure to agree as to a material item -- i.e., the taxpayer thinking this interest income adjustment was logically included in the settlement reached and the IRS thinking that it was not. In such mutual mistake circumstances, of course, the aggrieved party might try to void the settlement, on the basis that they had not reached agreement on a material issue. However, given the unambiguous nature of the settlement agreement and the parties' agreement that it was unambiguous, this position may have been foreclosed.
In our experience it is not unheard of that one party will negotiate a settlement with another party (in this context, the IRS) with the thought that once the basis for settlement is reached, the first party will be able to spring a "logical corollary" that perhaps the other party has not yet considered in order to sweeten the settlement for the first party. The first party may not want to put that issue on the table in the negotiations, fearing that it might blow the negotiations and reasoning that, once the other party becomes committed in settlement negotiations to a theory of the disallowance (in this case disallowance of sham interest), it will follow through with the "logical corollary," even though it means giving up more than the other party may have initially contemplated. That may work in some cases, but as you must have concluded by now, that strategy involves great risk.
The scenario is reminiscent of a recent case involving an IRS settlement using a form 870-AD. In K-Mart Corp. v. United States, 31 Fed. Cl. 677 (Cl. Ct. 1994), the taxpayer filed two claims for refund relating to transfer pricing adjustments (section 482) and entitlement to work incentive credits. The revenue agent's report dealt only with the former issue. In the Appeals Office consideration, the taxpayer and the IRS entered a Form 870-AD without reservation. However, both the taxpayer and the Appeals Officer (as evidenced by the Appeals Officer's affidavit) felt that entering the Form 870-AD left the work incentive credit issue open for future resolution. Nevertheless, the Court held that the unqualified Form 870-AD resolved the open issues (which, of course, had been identified by the parties but had been omitted from the settlement).
The lesson from these two cases is that, if either or both parties are aware of any matter that has not been specifically agreed upon, the party or parties must raise it specifically or the party who stands to benefit from the matter not specifically included in the settlement agreement runs the substantial risk of losing out.
The lesson: get it all out on the table and deal with it specifically unless the dynamics of the negotiations require you to run the risk and the risk is an acceptable risk. In the latter event, of course, the cautious tax practitioner who spotted the risk and adequately advised the client of the risk will want written acknowledgment from the client that the client made the key decision to run the risk. Such risks are business risks the client is entitled to make for itself, but the practitioner should not make the client's business risk decisions the practitioner's business risk decisions.
In DecisionOne Holding Corp. v. United States, ___ Cl. Ct. ___ (12/3/96), unofficially reported at 1996 DTR 243 d 13, the taxpayer and the IRS entered a Form 870-AD (the standard "unofficial" settlement document) The standard printed language of the Form provided that the taxpayer agreed to the deficiency and "interest provided by law." Several documents accompanied the Form 870-AD (Forms 4549, 886A and 5278). The Form 886A, entitled "Interest Computation," indicated that taxpayer was assessed $682,290 in additional interest, so that the deficiency and the indicated interest totaled $1,128,749. The IRS thereafter assessed a much larger amount representing restricted interest. Apparently the extra amount was $2,130,450, but the Department of Justice Tax Division advised the Court that the correct amount was $1,448,160. The taxpayer, believing that the additional interest was contrary to the settlement, then sued the United States "on the contract," arguing to the Claims Court -- the traditional court for contract claims against the Government -- that the United States was subject to specific enforcement of the contract and damages. The United States moved to dismiss. The Court dismissed the action:
The Court relied prominently upon the fact that the action, should it be recognized, would be the equivalent of an injunction against the collection of the additional assessed interest and injunctions are strictly prohibited by Section 7421 (the Anti-Injunction Act).
That the suit was, in reality an end run around the channels that Congress had provided to litigate tax disputes. The Court cited the Flora rule requiring full payment, which under an extension of the Federal Circuit's holding in Shore would require at least full payment of the contested interest. The taxpayer had not paid the interest and was seeking to avoid payment before litigating liability for the interest. The taxpayer sought to avoid the Flora rule by urging that the Form 870-AD, and its interpretation by many courts, waived the key predicate to the Flora rule -- a refund suit which is deemed adequate -- thus making the refund suit inadequate. The United States urged instead, and the Court accepted, that the taxpayer could indeed bring a refund suit, for the Form 870-AD only precludes suit as to matters resolved by the Form 870-AD and the restricted interest the taxpayer seeks to contest was not resolved by the Form 870-AD.
It thus appears that the taxpayer can get his day in Court, but at a significant cash flow cost. More importantly, here again a critical settlement term was left unaddressed, with the parties left to construe what was actually contracted as their positions required (either expansively to include logical further adjustments or restrictively to prohibit them).
Settlements are, of course, just a genre of contract. For an article addressing contract and contract-type issues for extensions of the statute of limitations, see Consents to Extend the Statute of Limitations: Is the IRS Bound by the Language it Uses
Settlements Are Binding: A Nonstartling Proposition? (Plus Ethics/Malpractice)
In Dorchester Industries Inc., et al. v. Commissioner, 108 T.C. No. 16 (4/29/97), the Tax Court in a reviewed decision, addressed two issues of importance to attorneys in the tax controversy arena:
- Settlement Agreements are Binding. The Court held that a litigant can be bound to a settlement agreement even though it was not incorporated into a final stipulated decision document. In an earlier decision, the Tax Court had suggested that a party could repudiate a settlement agreement by simply refusing to sign a document with the court reflecting the settlement agreement. Such a document is most often an agreed decision document, but may also be a stipulation of settled issues. In the case, the facts were clear that a settlement agreement had been reached between the parties. When the IRS presented the decision document reflecting the consequences of the agreement, however, the taxpayer refused to sign. The Court enforced the agreement. In a lone dissent, Judge Foley (a relatively new Tax Court judge with no significant trial experience), urged without persuasive analysis that he would have followed the implications of the prior decision that a taxpayer entering a settlement agreement can repudiate it by refusing to sign documents that are filed in court.
- Husband-Wife Conflict of Interest Can be Waived. The court addressed important conflict of interest issues. The case, involving about $40,000,000 in taxes pursuant to the settlement, involved three taxpayers -- a husband and ex-wife and the husband’s wholly owned corporation. In the initial petitions before the Court, all taxpayers were represented by the same counsel who pled an innocent spouse defense on behalf of the ex-wife (although they testified that they did not think she would prevail on the defense). At this point, lawyers’ eye-brows should be raised because, if the ex-wife were to succeed in that defense, then the entire joint return liability falls on the husband. The potential for a conflict of interest is apparent. In order to avoid the settlement agreement, the husband asserted that the alleged conflict of interest permitted the husband and the corporation to set aside the agreement. The Court found that the parties were advised of the potential conflict and knowingly waived it in order to permit the same counsel to represent them. Further, after the settlement agreement in question, the IRS permitted the ex-wife to claim innocent spouse treatment. The corporation and the husband urged that this subsequent agreement constituted a rescission of the whole agreement, because the subsequent agreement put the ex-wife’s assets beyond the reach of the IRS to satisfy the large tax liability. The Court rejected the defense.
- T&J Comments: Both issues are important to tax controversy lawyers. The first aspect -- holding a party to its agreement to settle -- is nonstartling, despite Judge Foley’s lone dissent (which we find wholly unpersuasive and impractical which is precisely why no other Tax Court judge would subscribe to it). The second aspect is the one of more immediate consequence to most tax practitioners. That issue raises the question of whether and under what circumstances a practitioner may represent parties having potential conflicts of interest. The issue is perhaps most accentuated in the husband and wife situation when one of the two (not always the wife) may have an innocent spouse defense and may be far less sophisticated than the other. Taxpayers frequently do not want to incur the cost of having two lawyers (or sets of lawyers) involved in litigating essentially the same underlying tax liability. Depending on the facts, there may be an unavoidable conflict of interest. Indeed, we are aware of tax practitioners testifying in malpractice suits that it is unethical per se to represent husband and wife in tax litigation where there is any possibility that the defense might be successfully asserted. (Fortunately, we are not aware that such a per se position has been adopted by judge or jury in such cases.) The Tax Court Dorchester did not believe that it was unethical per se and believed that the conflict could be waived. From a malpractice risk management perspective, lawyers considering undertaking such joint representation must deal with it up front and obtain knowing waivers after fully informing both parties. Indeed, in our practice, we do not undertake such joint representation if one spouse has a viable shot at the defense unless the husband specifically waives the conflict (which would occur where he might feel himself ethically or legally (e.g., by divorce decree) bound to pay even if the wife were unsuccessful in the defense). Further, we require the parties to acknowledge in writing that they have been advised to seeek separate legal advice from each party’s own separate attorney as to whether it is appropriate to waive the conflict so that both parties can be represented by the same counsel.