Tax Court in Brief | Smith v. Comm’r | Closing Agreement and Malfeasance of Fact

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Tax Litigation:  The Week of December 26th, 2022, through December 30th, 2022

Smith v. Comm’r, 159 T.C. No. 3 August 25, 2022| Toro, J. | Dkt. No. 5191-20

Short SummaryThe case discusses the validity of a closing agreement and if a taxpayer can set aside such agreement under malfeasance or misrepresentation of fact.

Mr. Smith (the taxpayer) was employed by Raytheon Company, a private defense contractor with operations in Australia, specifically at the Pine Gap facility. The Pine Gap facility is a joint surveillance facility established back in 1966 in Australia in a joint effort with the U.S. Dozens of U.S. citizens moved to Australia to staff the Pine Gap facility. Given that such U.S. citizens could be double taxed (by Australia and the U.S.), these countries entered into the “Pine Gap Agreements”, two agreements that basically exempted from Australian tax withholding any compensation received by U.S. citizens from personal services provided in connection with the Pine Gap facility, provided that such compensation was taxed in the U.S. Although the Pine Gap Agreements were entered before the signature of the 1982 tax treaty between the U.S. and Australia, such agreements remained valid under the language of the new treaty.

As consequence of the Pine Gap Agreements, the U.S. and Australia competent authorities worked together to coordinate the benefits of the Agreements with U.S. domestic statutes, specifically section 911, which provides for the foreign earned income exclusion. In that regard, the U.S.-Australian competent authorities agreed that  U.S. citizens working at Pine Gap would need to give up their election under section 911 to avoid being taxed in Australia, and they further agreed that an employee who desired this result could achieve it by entering into a closing agreement with the IRS.

In this case, Mr. Smith entered a closing agreement with the IRS to not claim the 911 exclusion. Mr. Smith claimed that his employment was contingent on the execution of the closing agreement. He signed a first closing agreement for years 2010, 2011 and 2012. In later years, he also signed agreements for the 2016-2018 period. In each case, the IRS provided a blank form to the employer of Mr. Smith, which provided a copy for Mr. Smith’s signature. Mr. Smith signed such agreement and returned to the employer, who remitted to the IRS.

For the 2016 and 2017 taxable years, Mr. Smith prepared his personal tax returns and did not make a 911 election. However, Mr. Smith later amended his returns and made the election. The IRS issued a notice of deficiency. In Tax Court, Mr. Smith and the IRS filed competing motions for partial summary judgment. The Tax Court granted the IRS’ motion.

Key Issues: Whether a closing agreement could be avoided if there is malfeasance or misrepresentation of a material fact?

Primary Holdings: Yes. A closing agreement could be avoided if there is malfeasance or misrepresentation of a material fact. However, the closing agreement is generally valid and final unless the taxpayer provides evidence to support the existence of such circumstances. In this case, the closing agreement was properly signed by the Director, Treaty Administration and the recitals contained in the closing agreement did not constitute malfeasance in the making of the agreement nor constituted misrepresentations of material facts.

Key Points of Law:

A closing agreement is an agreement that the IRS enters in writing with any person relating to the liability of such person, in respect of any internal revenue tax for any taxable period. I.R.C. § 7121(a). These agreements are final and conclusive. I.R.C. § 7121(b). Also, shall not be annulled, modified, set aside or disregarded. I.R.C. § 7121(b)(2). The Tax Court has reaffirmed the finality of such agreements and has found them “binding and conclusive on the parties”. See Hopkins v. Commissioner, 120 T.C. 451, 457 (2003) (quoting Hopkins v. United States (In re Hopkins), 146 F.3d 729, 733 (9th Cir. 1998)).

However, a closing agreement can be avoided if there is a showing of fraud or malfeasance, or misrepresentation of a material fact. I.R.C. § 7121(b). The validity and enforceability of the closing agreements is governed by the Code. See Rink v. Commissioner, 100 T.C. 319, 325 n.4 (1993)

In this case, Mr. Smith challenged the validity of the 2016-2018 closing agreement based on two arguments: (i) that the agreement was not properly approved and (ii) there was malfeasance or misrepresentation of a material fact.

As to the first argument, the Court ruled that the closing agreement was properly approved by the Director, Treaty Administration. This is because the Secretary of the Treasury can delegate its authority to enter into closing agreements to the IRS’ Commissioner. Treas. Reg. § 301.7121-1(a), § 301.7701-9(b). The Commissioner has also delegated the authority to act as competent authority under a tax treaty to the Commissioner LB&I, under Delegation Order 4-12. This delegation order requires this authority not to be redelegated, but the same Order delegates portion of this authority to the Director, Treaty Administration. Accordingly, the Court ruled that the Director, Treaty Administration can execute the closing agreement because was acting as competent authority with respect to the application of the tax treaty between the U.S.-Australia, under article 24(2) of such treaty.

Additionally, the Court determined that the actions of the Director, Treaty Administration must be analyzed under the presumption of official regularity. See, e.g., Mecom v. Commissioner, 101 T.C. 374, 388 (1993). Also, the Court determined that there were comity considerations, such as that the IRS and Mr. Smith were not the only stakeholders in the case, but also the Australian tax authorities, which did not tax Mr. Smith on the basis that such income was supposed to be taxed in the U.S.

As to the second argument, the Court determined that there was not malfeasance or misrepresentation of fact on the closing agreement. First, malfeasance must be determined upon the making of the closing agreement. See Ingram v. Commissioner, 32 B.T.A. 1063, 1065 (1935), aff’d per curiam, 87 F.2d 915 (3d Cir. 1937). Second, a common meaning of malfeasance includes “wrongful or dishonest acts or misconduct by a public official. Here, Mr. Smith claimed that the disclosure of confidential return information was prohibited under I.R.C. § 6103(a)(1). The Court stated that assuming that the disclosure of the information of the closing agreement constituted malfeasance, such would not exist here. This is because the transmission of the template of the agreement to the employer of Mr. Smith, did not constitute return information because it was not covered by I.R.C. § 6103(b)(2)(D), was not associated with any taxpayer and was not obtained by the IRS. As to the transmission of the agreement through the employer, this was attributable to Mr. Smith not the IRS, and finally, the transmission of the executed agreement to Mr. Smith via the employer was after the agreement became final, and not before the execution.

As to the misrepresentation of material fact, the Court determined that the misrepresentation in this case, if any, could have been of a legal nature, which is not included within the claim of misrepresentation as required by I.R.C. § 7121. Thus, this argument was invalid.

Finally, as to the existence of duress, the Court disregarded such argument, because Mr. Smith did not fully brief such argument in his motion papers. Even if allowed, no duress existed because Mr. Smith signed multiple closing agreements and he voluntarily took the decision to sign the agreement.

Insight: This case shows that taxpayers must seek legal counsel before signing a closing agreement with the IRS. As seen here, once the agreement is signed, it will be hard fight to avoid such agreement under theories such as malfeasance or misrepresentation of material facts. In the case of taxpayers with international operations, this type of agreements is relatively frequent, which requires taxpayers to be fully aware of the consequences of entering into such agreements.