The Government Flexes Its Summons Muscles

Polselli v. Internal Revenue Service[1]

Mr. Polselli owed over $2 million to the IRS, was not forthcoming with payment and, moreover, appeared to be hiding assets with accommodating parties. The IRS assigned a revenue officer to track down where his assets might be. The investigation pointed to several potential repositories of relevant financial information, including a law firm, the taxpayer’s wife and a company through which Mr. Polselli had made one tax payment of $300,000. The officer issued summonses under the authority of IRC section 7602 to three banks where the law firm, the wife and the company had accounts. The officer did not give notice to any of the third parties prior to issuing the summons. After learning of the summonses from the banks, the third parties moved to quash.

The precise question was whether the third parties were entitled to notice under IRC section 7609(a)(1) and thereby had standing to move to quash the summonses or whether the exception to the notice requirement under IRC section 7609(c)(2)(D)(i), where a summons is “issued in aid of the collection of an assessment made [against the delinquent taxpayer],” applied, thus resulting in lack of standing and ultimately lack of jurisdiction. The petitioners relied upon a Ninth Circuit decision that narrowed the scope of the IRC section 7609(c)(2)(D)(i) exception to those circumstances where the delinquent taxpayer had proprietary interest in the information sought by the summons. The Sixth, Seventh and Tenth Circuits found no such limitation on the exception in part because the statute did not contain one.

The Supreme Court unanimously rejected the Ninth Circuit’s application of IRC section 77609(c)(2)(D)(i) and found the petitioners had no standing to quash. At the risk of oversimplification, the Supreme Court opened the American Heritage Dictionary of 1969, looked up the word “aid” and determined, consistent with other relevant parts of the statute, that Congress intended to use the ordinary meaning of the word “aid,” i.e., help or assist. Was the effort to locate the taxpayer’s financial connections and maneuvers through the petitioners’ bank records intended to “help” in the goal of collecting the $2 million? Yes. Implicit in this conclusion is a requirement that there is some evidence that third parties have a financial connection with the taxpayer, as opposed to the IRS randomly picking bank accounts. However, the Court declined to opine on any such requirement as that question was not specifically argued. It did note the Government’s admission that some financial connection must exist to establish “aid” in the collection of the assessment.

United States v. State of Delaware Dept. of Insurance [2]

This case centers on the intersection between the broad statutory authority granted to the IRS to collect tax and the scope of “reverse preemption” in the context of state regulation of insurance companies. In general, the IRS’s audit and collection authority preempts state laws that might otherwise prevent IRS investigations. However, the McCarran-Ferguson Act, 15 U.S.C. §§ 1011 et seq. (the MFA), broadly prohibits Congressional regulation of “the business of insurance,” leaving the states free to so regulate. What happens when the IRS collection machine is opposed by a state citing the MFA?

In this case, the IRS issued a summons directly to the Delaware Department of Insurance (the Department) in connection with the IRS’s audit of a firm and its wholly owned LLC which the IRS believed promoted micro-captive structures.[3] The IRS had previously obtained emails relating to (1) the issuance of certificates of authority by the Department to one of the firm’s insurance clients and (2) one of the Department’s directors accepting a breakfast invitation from the firm. The IRS had also determined that the Department had issued certificates of authority to 191 insurance companies which the firm helped create. As a result, the IRS wanted to know more about the communications between the Department and the firm and so issued the summons for testimony and records, including all emails between the Department and the firm. The Department agreed to respond to the summons only on the condition, pursuant to Title 18, section 6920 of the Delaware Code, that the IRS agree to keep all information confidential. The IRS declined and sued to enforce the summons in district court.

The district court reasoned that for the Department to effectively invoke the MFA, and thus prevent enforcement of the federal summons, it had to show that its effort to oppose the summons constituted the “business of insurance.” The court held that resisting an IRS summons was not an insurance business activity. The Department appealed.

After an extended discussion of relevant MFA precedent, the Third Circuit determined that the key threshold issue was whether the relevant conduct of the Department constituted the business of insurance. Declining to look behind the purpose of section 6920, the Third Circuit agreed with the lower court that the relevant conduct was the Department’s refusal to comply with the summons. Thus, the question became whether this conduct constituted the business of insurance. The state argued yes. It asserted that adherence to the confidentiality provision encourages insurers to be forthcoming in their submissions to the state regulators. Without confidentiality, insurers would hold back important information and the regulators would be hampered in determining the solvency and safety of insurers. This in turn would impact the Department’s prime mandate to protect the insured. Thus, at least indirectly, the confidentiality provision in section 6920 related to the business of insurance and the Department’s adherence to the provision by refusing to comply with the summons constituted engaging in the business of insurance. The Third Circuit disagreed, noting that if insurers make deficient filings the Department can require supplemental filings and penalize those insurers who don’t comply. In other words, whether or not the information submitted by insurers is kept confidential the Department has full authority to obtain it from the insurers, thus rendering the connection between section 6920 and the business of insurance too tenuous to support the Department’s reverse preemption claim.

Practice Point: As these cases exemplify, the IRS is generally successful in defending its summons power.  It must comply with what are called the Powell factors, after the Supreme Court decision of the same name:[4]  1) legitimate audit or collection purpose; (2) the information summoned is relevant to that purpose; (3) the information sought through the summons is not already in the IRS’s possession; and (4) compliance with procedural steps required by the IRC. Once these factors are established (usually by declaration of the issuing IRS agent or officer), the summoned party has the burden to quash or modify the summons. One viable defense is to assert an applicable privilege or other defense, such as attorney-client privilege or IRC section 7525, but these typically do not apply to financial records such as bank statements, account documentation, etc. Third parties are equally subject to the summons power of the IRS as taxpayers themselves.