Tax Court rules against corporate taxpayers who relied on advice from in-house professional

On June 7, 2011, Judge Foley in writing for the Tax Court held that corporate taxpayers cannot rely on the advice of a tax professional as a reasonable cause defense to penalties when the tax professional is an employee of the taxpayer.  The case was decided on a consolidated basis with the cases captions of Seven W. Enterprises, Inc. & Subsidiaries, v. Commissioner, and Highland Supply Corp. & Subsidiaries, v. Commissioner.

The facts are relatively straight-forward.  From February 2001 until March 2002, the tax professional worked as an outside consultant for the taxpayers.  During this period, the tax professional prepared Sevens 2000 tax return and Highlands 2001 tax return. In March 2002, both taxpayers hired the tax professional as their vice president of taxes. As  the taxpayers vice president of taxes, the tax professional prepared and signed, on behalf of the taxpayers, Sevens 2001, 2002, and 2003 tax returns and Highlands 2002, 2003, and 2004 tax returns. In 2000 through 2004, the taxpayers incorrectly concluded that they were not liable for personal holding company taxes and, as a result, understated their tax liabilities relating to those years.  The IRS  issued Seven a notice of deficiency relating to 2000 through 2003 and Highland a notice of deficiency relating to 2003 and 2004. In the notices, the IRS determined that the taxpayers were liable for accuracy-related penalties.

The taxpayers contend that they had reasonable cause for their underpayments and acted in good faith. Alternatively, the taxpayers contend that they reasonably relied on the advice of the tax professional in 2000 when the tax professional served as an outside consultant and in 2001 through 2004 when he served as vice president of taxes.

The Tax Court explicitly held that pursuant to sec. 1.6664-4(b)(1) and (c)(1), Income Tax Regs., Seven is not liable for an accuracy-related penalty relating to 2000 because it reasonably relied on the then outside consultant/tax professional to prepare its tax return.  The Tax Court further held that the then in-house tax professional does not qualify as “a person, other than the taxpayer”, pursuant to sec. 1.6664-4(c)(2), Income Tax Regs., with respect to the returns which he signed on behalf of taxpayers, and therefore the aforementioned regulation is not applicable to the taxpayers underpayments of taxes relating to 2001 through 2004.  The Tax Court finally held that the taxpayers were liable for accuracy related penalties relating to 2001 through 2004.

Treas. Reg. 1.6664-4 provides that:  (a) In general. No penalty may be imposed under section 6662 with respect to any portion of an underpayment upon a showing by the taxpayer that there was reasonable cause for, and the taxpayer acted in good faith with respect to, such portion.  The full text of the regulation can be found here.

In general, a penalty defense is a factually intensive analysis and will be unique to each individual taxpayer.  However, the over-riding principle is the extent that a taxpayer attempted to properly report and calculate the taxes due for each taxable year will determine if penalty relief is applicable. 

The full decision can be found here.

The implication of this decision is that reliance on in-house professionals is not a defense to penalties, and as a result, taxpayers need to consult with outside professionals on tax treatment as reflected on their income tax returns.  The attorneys at Fuerst Ittleman have extensive experience advising individuals, partnerships, and corporations on all aspects of the Internal Revenue Code and have extensive experience litigating against the IRS.  You can reach an attorney by emailing us at:  contact@fidjlaw.com.

Tax Court Finds no “reasonable cause” for income omission where taxpayer provided information to and relied on tax return preparer

In Woodsum v. Commission, 136 T.C. No. 129 (June 13, 2011), Judge Gustafson addressed the taxpayers’ petition for redetermination of accuracy-related penalty of $104,295 that the Internal Revenue Service (IRS) determined against the taxpayers for tax year 2006, pursuant to section 6662(a). The issue for decision was whether the petitioners had “reasonable cause” under section 6664(c)(1) for omitting $3.4 million of income from their joint 2006 Federal income tax return.

In 1998 the taxpayers participated in a financial transaction described as a “ten year total return limited partnership linked swap.” In entering into this transaction, the taxpayers were advised by an attorney who supervised the preparation of the tax return for the year at issue. The taxpayers provided to their tax return preparer 160-plus information returns, including the Form 1099-MISC reporting $3.4 million from the termination of the swap and Form 1099-INT reporting $60,291.69 of interest income from the swap.  The Form 1040 prepared for the taxpayers was 115 pages long. The return did report the $60,291.69 of interest income that the taxpayers received from the swap. Likewise, the return did not include the $3.4 million from the swap.

The IRS received a Form 1099-MISC reporting the $3.4 million for the swap, compared with taxpayers’ return, and determined a deficiency in tax of $521,473 and an accuracy related penalty under section 6662(a) of $104,295.  The taxpayers agreed to the assessment of tax in the amount determined by the IRS. As a result, their tax due, which they reported as $3,719,454, was actually $4,240,927.  The taxpayers paid the tax deficiency plus interest. However, the taxpayers petitioned the Tax Court disputing the accuracy-related penalty.

The Tax Court held that the taxpayers did not receive advice from tax professionals that would justify the omission of income.  In so holding, the Court held that because the taxpayers knew that their Form 1099 should have been included, they lacked reasonable cause for their return preparer’s failure to include the income.  The Court also held that the taxpayers failed to show that they were entitled to the “computational or transcription error” exception.  The Tax Court’s decision requires taxpayers to perform more than a cursory review of the return to ensure of its accuracy. 

The full decision can be found here.

The attorneys at Fuerst Ittleman, PL have extensive experience litigating tax issues against the U.S. Government.  You can reach an attorney by emailing us at:  contact@fidjlaw.com.

Bill Proposes to Change How FDA Reviews Medical Devices

On October 14, 2011, Representative Brian Bilbray introduced a bill before the U.S. House of Representatives, entitled the “Novel Device Regulatory Relief Act of 2011.” The Bill, which seeks to amend the federal Food, Drug and Cosmetic Act (FDCA), focuses specifically on altering the way that medical devices are reviewed by the U.S. Food and Drug Administration (FDA).

Found here, the Bill focuses on changing the FDA’s de novo review process. The de novo process is currently a separate review pathway for medical devices, created to be particularly useful for manufacturers of lower risk devices that do not require formal FDA approval via the Premarket Approval (PMA) process. Differing from the 510(k) process, de novo review may currently only be initiated after a device has been issued a Not Substantially Equivalent (NSE) letter by the FDA. In short, this means that the only devices that may seek de novoreview are those that have not been cleared via the 510(k) process. The newly introduced legislation may revamp this underutilized pathway by allowing manufacturers to submit a request for de novo review “. . . without regard to whether such person has received written notice of classification into class III.”

While the de novo review process has not proven effective in practice and has been widely criticized for lack of transparency, the FDA has been working to change the process throughout 2011. As we previously reported, the FDA recently released its plans to streamline the de novo review process, publishing its draft guidance entitled “De Novo Classification Process (Evaluation of Automatic Class III Designation),” on September 30, 2011. However, as shown in the guidance, the FDA’s plans may not have proven as effective as industry had hoped. Where the FDA had planned to introduce a process whereby a pre de novo submission (PDS) would be submitted concurrently with a 510(k) petition, it is unclear how this would have resolved the issues confronting the de novo process. Because the statutory language of the FDCA only allows for initiation of de novo review upon the issuance of a NSE letter, this new legislation may actually result in increased utilization of the de novo review process.

Fuerst Ittleman has extensive experience successfully navigating medical devices through FDA review. For more information on FDA’s review of medical devices, please contact us at contact@fidjlaw.com.

Par Pharma Brings Suit Against FDA Over Promotional Claims

On October 14, 2011, Par Pharmaceutical, Inc. (Par Pharma) brought suit against the U.S. Food and Drug Administration (FDA) challenging the Agencys rules that restrict claims made in marketing pharmaceutical products. Filed in the U.S. District Court in Washington D.C., the suit seeks a declaratory judgment and an injunction against the Agencys enforcement of the speech restrictions. Found here, the Complaint alleges that FDAs rules prevent Par Pharma from promoting its drug for both approved and unapproved uses.

Par Pharmas drug, Megace ES, was approved by the FDA in 2005 for the treatment of anorexia and cachexia, an AIDS-related wasting syndrome. Since its approval, the drug has been prescribed by doctors to treat other, related disorders, a practice known as “off-label” use. However, the FDA prohibits companies from promoting drugs for off-label uses, and it regularly enforces against companies which do so. For instance, the pharmaceutical manufacturer Allergan has been targeted for utilizing off-label marketing in the past. For more information regarding the Allergan suit, see our previous report here.

The FDAs jurisdiction to restrict off-label use is a contentious issue. While the FDA currently prohibits manufacturers from marketing FDA-regulated products for unapproved uses, the agency does not have the authority to prevent doctors from issuing prescriptions for off-label uses. Rather, the latter fits squarely within the practice of medicine, an area traditionally regulated by the states. Even where the FDA only attempts to restrict manufacturers without encroaching on the practice of medicine, FDAs efforts relating to off-label use are often viewed as hindering innovation inasmuch as manufacturers and doctors are prevented from discussing new, alternative uses for FDA-approved drugs and devices.

Although Par Pharma challenges the FDAs restrictions on off-label marketing, its suit also alleges that the Agency is unlawfully prohibiting the marketing of its drug for its approved uses. Specifically, Par Pharma claims that FDA is encroaching on its First Amendment rights by preventing the company from marketing its drug for its approved uses to physicians who are likely to prescribe the drug off-label. While this issue is slightly different than that regarding the promotion of off-label uses, it will be interesting to see who ultimately prevails.

For more information on FDA regulations and acceptable pharmaceutical marketing practices please contact us at contact@fidjlaw.com.

Company Pleads Guilty to Selling Misbranded Drug

On October 14, 2011, Medisca, Inc. pled guilty to introducing a misbranded drug into interstate commerce in violation of the federal Food, Drug and Cosmetic Act (FDCA). The Complaint, which was filed on October 14, alleged that Medisca purchased a drug called “Somatropin” from China and then proceeded to distribute the drug to various pharmacies throughout the United States.

The primary issue in the case was that Somatropin, a type of human growth hormone (HGH), was being marketed as having approval from the U.S. Food and Drug Administration (FDA). According to the Complaint, the drug was not FDA approved, rendering the drug’s labeling false and misleading and therefore misbranded under the FDCA. Although it was Medisca’s contention that it possessed a valid National Drug Code (NDC) pursuant to FDA’s rules requiring every manufacturer and/or distributer to register and list all drugs in commercial distribution, the FDA warned that a NDC does not denote a drug approval. Rather, in order for drugs to be properly distributed under the FDCA and accompanying FDA regulations, a New Drug Application (NDA) must be obtained for all new drugs prior to entering interstate commerce.

Additionally, only drugs that possess an NDA may be marketed as “FDA approved.” The Office of Prescription Drug Promotion (OPDP), formerly the Division of Drug Marketing, Advertising, and Communication (DDMAC), is a division within the FDA specifically tasked with overseeing promotional claims and labeling of drugs. OPDP ensures that marketing claims are within FDA regulations and limited to what the FDA has actually approved. Further, because drugs must possess a valid NDA before lawfully being advertised as “FDA approved,” the FDA flatly prohibits other types of products, like over-the-counter (OTC) drugs and medical devices with FDA clearance, from being marketed as approved by the FDA.

For more information regarding the FDA’s regulation of drugs and the requirements pertaining thereto contact us at contact@fidjlaw.com.

U.S. Marshals Seize Detained Food under Authority of FSMA

An illustration of FDA’s increased powers, a recent seizure was the first directed by the FDA under the authorization of the Food Safety Modernization Act (FSMA). Specifically, on October 11, 2011, the U.S. Food and Drug Administration (FDA) announced that U.S. Marshals seized food products at the FDA’s request. The food, which was being held at a storage and processing facility in Washington, was originally detained due to an infestation found during a FDA inspection. After having ordered the detention of the food products on September 2, 2011, FDA sought a warrant for the arrest of the products in federal court, ultimately resulting in the seizure.

As we previously reported, the FSMA expanded FDA’s powers in a number of areas, including those dealing with the administrative detention of goods. While FDA formerly had the authority to order the detention of goods, the Agency had to possess “credible evidence or information indicating that the article of food presents a threat of serious adverse health consequences or death to humans or animals.” 21 C.F.R. § 1.378 (2011). Today, pursuant to the FSMA, the FDA may detain foods where there is “reason to believe” that the food is adulterated or misbranded.

On May 5, 2011, the FDA issued its interim final rule, relaxing the “credible evidence” standard to require only a “reasonable basis” to believe that food is either adulterated or misbranded, and thus marking an increased burden on industry as well as the Agency. First, because the FDA must only have a reasonable basis for believing that a food is adulterated or misbranded, industry must be increasingly-vigilant in ensuring that its products are at all times compliant with FDA regulations, including the minute particularities concerning the labeling of products. Additionally, this increased power “ if fully enforced “ could strain the FDA’s overburdened resources.  

Fuerst Ittleman will continue to monitor the FDA’s measures under the FSMA. For more information regarding the FSMA or FDA regulations, please contact us at contact@fidjlaw.com or (305) 350-5690.

FDA and CMS Launch Voluntary Parallel Review for Innovative Products

On October 7, 2011, the U.S. Food and Drug Administration (FDA) and Centers for Medicare & Medicaid Services (CMS) announced the official launch of the parallel review program. An effort to increase patient access to a variety of medical devices and drugs, the program is designed to facilitate the development of innovative medical products and reduce the time between FDA approval and CMS national coverage determinations.

In September 2010, FDA and CMS announced their intentions to implement a pilot parallel review program for innovative medical devices, drugs, and biological products. Please see our previous report for more information regarding the announcement of the program. In response to the initial Federal Register Notice, the Agencies received 36 public comments regarding what products would be appropriate for parallel review, what procedures should be developed, and how a parallel review process should be implemented.

The Federal Register Notice announcing the implementation of the program details the procedures for the programs voluntary participation and guidelines for the Agencies to follow during the review of a product. The program will not change the existing separate review standards for FDA product approval and CMS coverage determinations. However, parallel review may ultimately benefit patients by expediting the time involved with the review process, as the separate determinations will run concurrently. In order to qualify for the program, product candidates must meet one of the following criteria:

  1. New technologies for which the sponsor/requester has a pre-investigational device exemption (IDE) or an approved IDE application designation;
  2. New technologies that would require an original or supplemental application for premarket approval (PMA) or a petition for de novo review; or
  3. New technologies that fall within the scope of a Part A or Part B Medicare benefit category and are not subject to a national coverage decision (NCD).

The FDA and CMS are currently accepting submissions for products seeking parallel review. The Agencies intend to perform parallel reviews for up to five products per year for the next two years, with the possibility for extension.

Fuerst Ittleman, PL will continue to monitor the progress of the FDA and CMS parallel review program. For more information on how FDA and CMS review medical products and how the parallel review process may be beneficial to your product, please contact us at contact@fidjlaw.com.

FDA Extends Comment Period for New Dietary Ingredient Draft Guidance

On September 8, 2011, the U.S. Food and Drug Administration (FDA) announced that the comment period for its draft guidance, entitled Dietary Supplements: New Dietary Ingredient Notifications and Related Issues, will be extended until December 2, 2011. The draft guidance, issued on July 5, 2011, consists of more than 120 Q&As aimed at helping industry determine whether a dietary ingredient is a NDI, whether a notification is required, and what information should be included in the notification. Please see our previous report here for more information regarding NDIs.

Having been a controversial issue, various industry associations submitted requests for extension to the FDA, including the Natural Products Association (NPA), Council for Responsible Nutrition (CRN), United Natural Products Alliance (UNPA), American Herbal Products Association (AHPA), and Consumer Healthcare Products Association (CHPA). Additionally, the Alliance for Natural Health USA (ANH-USA) and other health advocacy groups claim that over 355,000 emails have been sent utilizing an online template to petition Congress regarding the draft guidance. Many activists view the draft guidance as a barrier to nutritional supplement access and claim the proposed regulations are beyond the scope of FDA authority. After receiving numerous requests to extend the comment period in order to provide a more comprehensive response, the FDA agreed to the extension.

Found here, the draft guidance is currently available for public comment. Fuerst Ittleman, PL will continue to monitor the progress of the draft guidance. For more information regarding the regulation of dietary supplements, please contact us at contact@fidjlaw.com.

IRS Seeks to Reduce the Impact of Its Economic Substance Doctrine Field Directive by Stating it is Not Legal Precedent

On October 6, 2011, the Internal Revenue Service (IRS) announced that its July 15, 2011 field directive (the “directive”) pertaining to the codified economic substance doctrine (the “doctrine”) should not be viewed as legal precedent because the IRS reserves the ability to modify the directive at any time.

According to Mark Periwen, special counsel to the Associate Chief Counsel, the directive is “just that,” and therefore does not have the force of law.  Notably, the function of field directives issued to employees of the IRS is similar to the function of the Internal Revenue Manual (IRM), which directs IRS personnel in their day-to-day activities. Smith v. U.S., 478 F.2d 398 (5th Cir. 1973).  This does not follow, however, that field directives and the IRM will not be taken into consideration by reviewing courts.

Instead, as discussed in Griswold v. United States, 59 F.3d 1571, 1575 n. 8 (11th Cir. 1995), "[w]hile the IRS Manual does not have the force of law, the manual provisions do constitute persuasive authority as to the IRS’s interpretation of the statute and the regulations." (emphasis added).  Similarly, each field directive provides insight as to the IRS’s interpretation of the laws it is entrusted to enforce.

As we previously reported here, transactions shall be treated as having economic substance only if the transaction changes the taxpayer’s economic position in a meaningful way and the taxpayer has a substantial purpose for entering into the transaction. The doctrine only applies to a transaction entered into in connection with a trade or business or activity engaged in for income.

Taxpayers are concerned how the IRS will apply the doctrine due to the no-fault penalty of up to 40 percent. Tax practitioners speculate the issuance of the directive suggests the IRS wants to ensure that the doctrine is appropriately applied.  In fact, the directive specifically provides that agents should limit the assertion of penalties to transactions that implicate the doctrine and not a “similar rule of law” as provided in the statute.

The IRS’s original field directive regarding the application of IRC §7701(o) was issued on September 14, 2011 with the objective “to ensure consistent administration of the strict liability penalty related to the application of the doctrine.”  The July 15, 2011 field directive was issued to “instruct examiners and their managers how to determine when it is appropriate to seek the approval of the Director of Field Operations in order to raise the economic substance doctrine.”

As further elaborated in the directive:

Once an examiner determines that raising the doctrine may be appropriate, this directive sets forth a series of inquiries the examiner must develop and analyze in order to seek approval for the ultimate application of the doctrine in the examination.

The directive, which is publicly available to all Taxpayers, clearly provides the IRS’s interpretation of IRC §7701(o).  Although it may not be binding as legal precedent, it is nonetheless highly persuasive and will not be ignored by courts that are deciding issues pertaining to the application of the doctrine.

Fuerst Ittleman will continue to monitor the progress of cases where the doctrine may be an issue. Our professionals at are knowledgeable in the newly codified economic substance doctrine. If you believe you have been affected by the new law, please contact our professionals at contact@fidjlaw.com.

Tax Court denies taxpayer’s attempt to recharacterize punitive damages as ordinary income

In Healthpoint Ltd. v. Comr., T.C. Memo 2011-241 (10/3/11), available here, the Tax Court held that a company could not rely on a settlement agreement to recast a jury award and settlement to avoid paying taxes at ordinary income rates.

The taxpayer filed suit against a rival company and received a jury verdict of $16.47 million, awarding actual damages ($5 million), punitive damages ($3,174,515), disgorgement of profit ($1,640,000), and Lanham Act enhanced damages ($6,349,030). While litigation was pending, the taxpayer filed suit against the same company on different grounds, however, both parties agreed to settle both law suits for $12 million and $4.5 million, respectively.

The parties allocated damages in the settlement agreement differently than the jury’s allocation.  In particular, the settlement agreement provided for no punitive damages, even though the jury had awarded punitive damages in the first suit.  As a result, the taxpayer reported $14.5 million in long-term capital gain and $1.8 million in ordinary income. The IRS conceded that the Lanham Act enhanced damages, which totaled $6,349,030 for loss of goodwill, are taxable as long-term capital gain. However, the IRS challenged the remaining allocations in the settlement agreement.

The Tax Court held that damages were not to be allocated in accordance with the parties settlement agreement but, rather, in accordance with the jury verdict in the first law suit.  The Tax Court determined that proceeds of a settlement agreement attributable to goodwill or damage to reputation are taxable as capital gains, but those determined to be lost or disgorged profits and/or punitive damages are taxable as ordinary income.   The court stated that normally express allocations in settlement agreements will be followed in determining tax consequences.  However, there is an exception if the settlement agreement is not entered into in an adversarial context, at arm’s length, or not in good faith.

The Tax Court ultimately held that damages should be allocated in accordance with the jury verdict because the verdict accurately reflected the economic realities versus the settlement agreement.

The attorneys at Fuerst Ittleman, PL have extensive experience structuring settlement agreements and litigating against the IRS in the event that a settlement agreement is not respected.  If you can contact an attorney by emailing us at: contact@fidjlaw.com.