Court Agrees with Taxpayer and Quashes Summonses to Third-Party Record Keeper

In a rare win for a taxpayer, a federal district court in Idaho turned down an IRS request to enforce third-party summonses for information and granted the taxpayers’ motion to quash the summonses. The court said the IRS failed to properly notify the taxpayers of its intent to contact a third party during the course of the examination and therefore, the summonses was not enforceable.

During an IRS examination, collection matter, or particularly in a criminal investigation, the IRS will often seek information from a third party, such as a return preparer or bank. Pursuant to IRC Section 7602(a)(2), the IRS is authorized to issue an administrative summons for a third party to appear before an IRS representative to produce documents or electronic data or give testimony under oath. Just like a summons to a taxpayer, the IRS must comply with strict procedures in issuing and serving a summons on a third party. Failure to comply with these procedures could invalidate the summons and render it unenforceable.

To be enforceable, a summons must include the following:

1. The name and address of the person whose tax returns are under examination and the tax periods under examination.
2. The identity of the person summoned. In the case of a corporation, the summons must be served on a corporate officer, director, managing agent or other person authorized to accept service of process.
3. A description of the items summoned, with reasonable certainty. The IRS cannot require a person to create a document, such as a summary chart, that does not exist.
4. The date, place and time for compliance. A summoned party may not be ordered to appear sooner than 10 days from the date of service of the summons. Section 7605(a).

In addition, the IRS must give the taxpayer notice of a summons issued to a third party. Notice must be given within three days of service of a third-party summons, but not less than 23 days before the compliance date. IRC Section 7609(a)(1). The notice must include a copy of the summons and an explanation of the taxpayer’s rights. Section 7609(1)(a). This notice allows the taxpayer to file a petition to quash the summons if necessary. If the taxpayer files a petition to quash a summons, the IRS cannot examine the requested documents without the permission of the court or the consent of the taxpayer who files the petition.

When a summoned person fails to respond or raises objections, the IRS agent can either take no further action or recommend that the Department of Justice bring an action to enforce the summons pursuant to Section 7604(b). The Department of Justice initiates an enforcement proceeding by filing a petition in the U.S. District Court where the person summoned resides or is to be found. Included with the petition is an affidavit of the issuing IRS agent establishing the following requirements set forth by the U.S. Supreme Court in U.S. v. Powell, 379 U.S. 48 (1964):

1. The examination to which the summons relates is being conducted pursuant to a legitimate purpose.
2. The summons seeks information that may be relevant to that purpose.
3. The IRS is not already in possession of that information.
4. The administrative steps required by the IRS have been followed.

If the government satisfies the Powell requirements, the U.S. District Court may issue an order requiring the summoned party to appear and show cause why compliance should not be required. The burden then shifts to the person resisting the summons to rebut the IRS allegations or present affirmative defenses such as procedural defects or privileges.

In United States v. Vaught, et. al, the IRS was examining Stanley D. Crow to determine whether he was subject to penalties under IRC Sections 6700, 6707 and 6708. The IRS was assessing whether installment sales plans promoted by Crow and his company qualify as tax shelters subject to registration and disclosure requirements, as well as whether Crow made false statements regarding tax benefits associated with such transactions. Upon initiating the examination, the IRS sent Crow a general notice entitled “Your Rights as a Taxpayer” which included a notification that the IRS may contact third parties during the course of the examination. In addition, the IRS agents told Crow during the initial meeting that the IRS “may contact other persons or entities”.

More than two years after starting the examination of Mr. Crow, the IRS issued the summonses at issue to Steve Vaught and his companies. Mr. Vaught neither appeared as directed nor did he produce any of the records requested and the Department of Justice filed a petition to enforce the summonses. Crow intervened in the summons enforcement proceeding, asking the court to quash the summonses claiming the IRS had failed to properly notify him of the intent to contact third parties, citing the 9th Circuit opinion in J.B. v. United States.

As a matter of first impression, the J.B. court interpreted 26 U.S.C. Section 7602, which states the IRS must provide the taxpayer with “reasonable notice in advance“ before seeking a taxpayer’s financial records from third parties. The J.B. court held “reasonable notice in advance means notice reasonably calculated, under all the relevant circumstances, to apprise interested parties of the possibility that the IRS may contact third parties, and that affords interested parties a meaningful opportunity to resolve issues and volunteer information before third-party contacts are made.” (Emphasis added).

In Vaught, the court found that the IRS had complied with the first three Powell requirements for the summons enforcement, i.e., the summonses were issued for legitimate purpose of investigating Crow, the summonses were requesting testimony and documents relevant to the investigation of Crow, and the summonsed information was not already in the possession of the IRS. However, the court found that the IRS failed to follow the required administrative steps because it failed to provide reasonable notice of the intent to contact third parties. In denying the government petition to enforce the summons and granting Crow’s request to quash the summons, the court referenced the time between Publication 1 and the summonses, twenty-six months.

For questions regarding this blog post or any other civil or criminal tax related matter, please feel free to contact Joel Crouch at (214) 749-2456 or jcrouch@meadowscollier.com.