Burden Of Proof Shifted To IRS On Some Issues

One of the most publicized provisions of the Act (§3001, adding new Code §7491) shifts the burden of proof from the taxpayer to the IRS in any court proceeding involving income, self-employment, estate, generation-skipping transfer, or gift taxes. This politically-driven provision leads off the Taxpayer Bill of Rights 3 portion of the Act. Unfortunately, as will be seen below, the provision is subject to such substantial limitations that the outcome of only a small percentage of litigated cases will be affected by the provision. However, the provision will likely have profound effects on the process of examinations and trials.

The burden shift is effective for court proceedings involving examinations commencing after July 22, 1998, regardless of the taxable year or period involved in the examination. The burden shift does not apply to payroll taxes or excise taxes and does not apply at the administrative level of the case; thus, it only applies in court.

The burden shift is available to all individuals and estates. It is also available to those small partnerships, corporations, and trusts which can potentially get attorneys fees under Code §7430 in the case of unreasonable IRS conduct -- i.e., those partnerships, corporations, and trusts with a net worth no greater than $7 million and which have no more than 500 employees.

The burden shift will occur issue by issue. Thus, the IRS may have the burden on one issue, while the taxpayer has the burden on another. For the burden shift to occur, the taxpayer must have maintained all records required to be kept by the Code. Therefore, taxpayers who discard pertinent records will find that they still have the burden of proof.

To place the burden of proof on the IRS, the taxpayer will also have to cooperate with all "reasonable requests" by the IRS for witnesses, information, documents, meetings, and interviews. A whole area of litigation may arise concerning whether a request was "reasonable" and whether cooperation was full. For example, if a taxpayer in an interview answers ten questions, but declines to answer the eleventh or says he or she does not remember, has the taxpayer cooperated?

For items for which the courts have traditionally required the taxpayer to provide substantiation -- e.g., for most deductions and credits -- the taxpayer must still comply with all substantiation requirements. Thus, a taxpayer who never created or maintained the records required by Code §274 to support travel and entertainment deductions will still have the burden of proof on that issue (and can expect to lose). Since most litigated cases involve substantiation of deductions, this is a severe limitation to the burden of proof shift.

There is a distinction in the case law between the "burden of proof" and the "burden of production." While the new provision shifts the burden of proof, it does so while keeping the burden of production on the taxpayer. Thus, the taxpayer must first "introduce credible evidence" to the court going to the issue of the correct tax liability. If this evidence makes a prima facie case that the taxpayer should prevail, then it becomes the IRS' obligation to introduce contrary evidence. By the taxpayer's introducing credible evidence, the burden of proof is shifted to the IRS; thus, the court will have to decide whether the IRS' counter-evidence has overcome the taxpayer's evidence. If the evidence on each side appears equal, the court is directed to rule for the taxpayer.

A final limitation on the new burden-shifting provision is that where the Code already contains a specific statement as to who has the burden of proof (e.g., in Code §534, involving the accumulated earnings tax), that specific statement will govern instead.

Given the above limitations, the question of whether the burden of proof has shifted on an issue will in most cases not be answerable until after the trial. This puts both the IRS and the taxpayer in a difficult position:

The IRS will fear that it may end up with the burden of proof, and so can be expected to press harder in examinations for documents and information. This will run up taxpayer costs in responding to examination requests.

Since taxpayers will also be unsure as to whether they will be held to have shifted the burden or proof, they will probably still try cases the way they always have -- i.e., by taking the initiative and introducing all pertinent documents and testimony. Unfortunately, if the taxpayer intends to argue that the burden of proof has shifted, the taxpayer will also have to expand the trial and introduce evidence about how it cooperated during the examination or show that certain IRS requests were not reasonable (e.g., show the court how burdensome a document request was). Now, more than ever, it will be necessary to carefully document responses to IRS requests for information during an examination and to draft responses to IRS requests in a way that reflects full cooperation. If the taxpayer is a partnership, corporation, or trust, the taxpayer will presumably also have to introduce evidence at trial about its net worth and number of employees or provide that information to the IRS attorney in order to have the matter stipulated. All this additional evidence and trial time will, no doubt, further increase taxpayer litigation costs.

Given the probable increase in audit and litigation costs and the uncertainty as to whether the burden will be shifted after all, one wonders whether the new provision is actually a helpful addition to the Code. Some cases involve issues of law, where the provision will not be relevant. Most cases involve substantiation, where the burden will not shift. The burden shift will apparently have primary benefit in cases involving issues such as valuation or the reasonableness of compensation. The provision may also be of use in other cases when they are before an IRS Appeals Officer prior to trial. The Appeals Officer's concern that the IRS may end up with the burden of proof at trial may cause the Officer to have a more generous settlement attitude.

Finally, new Code §7491 contains a shift in the burden of production (i.e., apparently, not the burden of proof) in cases where the IRS seeks a penalty against an individual. In the past, taxpayers who failed to introduce any testimony or documents going to the issue of penalties often found that the Tax Court automatically found against them on the penalty based on an absence of proof. Now, the IRS will have to first come forward with some evidence that a penalty should apply -- e.g., show that a position taken by the taxpayer was contrary to published authority. Once this is done, the taxpayer will have the burden of proof to rebut the penalty -- e.g., by showing reasonable cause or good faith reliance on a tax advisor. But if the IRS introduces nothing about penalties at trial, any penalties asserted will not be sustained.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.