IRS can amend answer, grounds not listed in deficiency notice

IRS can amend answer, grounds not listed

The U.S. Tax Court today held that in a tax deficiency case, the IRS may plead grounds not originally listed in the notice of deficiency, and that this would not violate a uniform approach to judicial review of the IRS administrative action. Also, the Tax Court held that when no trial date has been set and there is ample time for discovery, no prejudice results to the taxpayer from the IRS being allowed to add a “new matter” to its answer to the taxpayer’s petition—in this case, the IRS added an a claim that the taxpayer’s use of a captive insurance company lacked economic substance.

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The case is: Ax v. Commissioner, 146 T.C. No. 10 (April 11, 2016). Read the Tax Court opinion [PDF 127 KB]

Summary

The taxpayer formed a “captive insurance company” to cover certain risks that his limited liability company (LLC) faced. In 2009 and 2010, the LLC paid premiums to the captive insurance company for coverage of the risks, and deducted the premiums (so that the deductions were passed through to the taxpayer’s tax returns). 

The IRS disallowed the deductions and stated in the notice of deficiency: “You did not establish that the amount shown was (a) insurance expense, and (b) paid.”

The taxpayers filed a petition in the Tax Court disputing the deficiency notice, and the IRS filed an answer that did not make any affirmative allegations as to the disallowed insurance expense deductions. After the case was stricken from a trial calendar and continued generally, the IRS moved for leave to amend the answer to assert that the taxpayer’s use “through solely controlled flow-through entities, of a micro-captive insurance arrangement in 2009 and 2010 lacked economic substance” and that the “amounts paid as premiums through the micro-captive arrangement were neither ordinary nor necessary” and to allege facts in support of those assertions. 

The taxpayer opposed the IRS motion for leave to amend, citing the 2011 Supreme Court decision in the Mayo Foundation case and asserting that the Administrative Procedure Act and a 1943 decision of the Supreme Court in Chenery Corp. prevented the IRS from raising new grounds to support a final agency action beyond those originally stated in the deficiency notice.

The Tax Court held that in a tax deficiency case, the IRS may plead grounds not listed in the notice of deficiency and that this would not be at odds with the uniform approach to judicial review of administrative action that as called for by the Supreme Court in Mayo Foundation case.

Also, the Tax Court concluded that when no trial date has been set and there is “ample time” for discovery, no prejudice results to the taxpayer from allowing the IRS to add a “new matter” (in this instance, the lack of economic substance) to its answer. 

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