IRS Fraud on the Court

Larry L. Hartman, et al. v. Commissioner.

Dkt. Nos. 1371-85 , 48690-86 , 4116-87 , 15673-87 , 16761-87 , 18551-88 , 29429-88 , TC Memo. 2008-124, May 1, 2008.

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Tax Court Rules: Kersting tax shelter litigation: Stipulated settlement: Order to vacate. --
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LARRY L. HARTMAN, ET AL.,1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent*



MEMORANDUM OPINION


Introduction

Petitioners' motions arise from the misconduct of respondent's attorneys in implementing the Court's test case procedure used by the Court in the Kersting tax shelter project to try and decide Dixon v. Commissioner [Dec. 47,801(M)] T.C. Memo. 1991-614 (Dixon II), vacated and remanded sub nom. DuFresne v. Commissioner [94-1 USTC ¶50,286] 26 F.3d 105 (9th Cir. 1994), on remand Dixon v. Commissioner [Dec. 53,314(M)] T.C. Memo. 1999-101 (Dixon III), supplemented by [Dec. 53,832(M)] T.C. Memo. 2000-116 (Dixon IV), revd. and remanded [2003-1 USTC ¶50,194] 316 F.3d 1041 (9th Cir. 2003) (Dixon V), culminating with our disposition of the second remand in Dixon v. Commissioner [Dec. 56,502(M)] T.C. Memo. 2006-90 (Dixon VI), supplemented by [Dec. 56,615(M)] T.C. Memo. 2006-190 (Dixon VIII).3 We have entered decisions in the 27 docketed cases that participated in the second remand; 13 of those cases are on appeal to the Court of Appeals for the Ninth Circuit,4 where, we assume, they will be considered by the panel that decided Dixon V.5

In Dixon V, the Court of Appeals held that the misconduct of respondent's trial attorney and his supervisor was a fraud on the Court that violated the rights of all Kersting project petitioners who had agreed to be bound by the outcome of the Tax Court proceeding. The Court of Appeals ordered this Court to sanction respondent by entering decisions in the cases of the remaining test case petitioners and other Kersting project petitioners before the Court of Appeals on terms equivalent to those provided in the secret Thompson settlement.





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II. Analysis

A. The Fraud on the Court Committed by Respondent's Attorneys, the Harm Done Thereby, and the Sanction Mandated by the Court of Appeals

In Dixon V at 1045, the Court of Appeals for the Ninth Circuit held that the misconduct of McWade and Sims during the test case proceedings, including its persistence and concealment, was a fraud on the Tax Court. "Fraud on the court occurs when the misconduct harms the integrity of the judicial process, regardless of whether the opposing party is prejudiced." Id. at 1046 (citing Alexander v. Robertson, 882 F.2d at 424).

McWade and Sims perpetrated a fraud on the Court that harmed the integrity of the judicial process. That judicial process was the test case procedure that the parties, with the Tax Court's participation and encouragement, invoked in their efforts to resolve the more than 1,800 cases arising from respondent's disallowance of deductions claimed by participants in the Kersting programs.

When the Court, taxpayers, and the IRS agree to employ the test case procedure, the taxpayers whose cases are bound (whether by piggyback agreement or the Court's order to show cause procedure) by the outcome of the test cases expect (and have a right to do so) that the test cases will be well and fairly tried. The fraud on the Court committed by McWade and Sims in the Kersting project test cases violated the rights of all Kersting project petitioners who were bound by the outcome of the test case proceedings and betrayed the confidence of all future litigants in the test case procedure. Id. at 1047. The test case procedure is a valuable judicial procedure, and, as the Court of Appeals recognized, the continued viability of that procedure requires the confidence of all future litigants.

The fraud on the Court committed by respondent's attorneys in the Kersting project test cases violated the rights of not only the test case petitioners but every petitioner whose case was bound by the outcome of the test cases. The fraud committed by McWade and Sims was a fraud on the Court in every one of those cases.

The appropriate sanction against respondent for the fraud committed on the Court by McWade and Sims should remedy the harm done to the judicial process, restore public confidence in the test case proceedings, rectify the violation of the rights of the Kersting project petitioners whose cases were bound by the outcome of the test cases, and deter future violations by the offending party. After expressing indignation at the odiousness of the Government attorneys' misconduct and the Tax Court's repeated failures to "get it right", the Court of Appeals formulated and mandated an intermediate sanction that provides both an appropriate remedy for the violation of the rights of Kersting project petitioners and an effective deterrent to further misconduct by Government attorneys. Holding the limited sanctions we initially imposed in Dixon III and IV to be grossly inadequate, but recognizing that the power to sanction is to be "'exercised with restraint and discretion'", Dixon V at 1047 (quoting Roadway Express, Inc. v. Piper, 447 U.S. 752, 764 (1980)), the Court of Appeals held that it would be inappropriate to force the taxpayers to endure a remand for a trial on the merits,41 but also declined to enter judgment eradicating all tax liability of the Kersting project petitioners --"Such an extreme sanction, while within the court's power, is not warranted under these facts." Id. at 1047 (citing Chambers v. NASCO, Inc., 501 U.S. 32, 45 (1991)).

The Court of Appeals recognized that the fraud on the court committed by respondent's attorneys in the Kersting project test cases was a fraud on the court in every case bound by the outcome of the test cases and sanctioned respondent in each of those cases before the Court of Appeals. The Court of Appeals held that the appropriate remedy to be applied to all Kersting project petitioners who were bound by the test cases (test case and nontest case petitioners alike) properly before it was to enter decisions that put them, as nearly as possible, in the same position as provided for in the Thompson settlement. Id. at 1047 n.11. Putting every Kersting project petitioner (test case and nontest case petitioners alike) whose cases were part of the test case proceedings in the same position as provided for in the Thompson settlement is the appropriate remedy for the violation of their rights and the sanction that should have the necessary deterrent effect.

We have granted petitioners leave to file and petitioners have filed motions to vacate the stipulated decisions entered in their cases. In effect, they have asked the Court to impose on respondent in their cases the sanction mandated by the Court of Appeals in Dixon V. Motions in this Court to vacate or revise a decision are covered by Rule 162, which provides: "Any motion to vacate or revise a decision, with or without a new or further trial, shall be filed within 30 days after the decision has been entered, unless the Court shall otherwise permit." Rule 162 provides no guidance as to when this Court will grant leave to file a motion to vacate more than 30 days after a decision is entered or, more importantly, when this Court will grant a motion to vacate.

A stipulated decision falls within the purview of Rule 91(a), which requires parties to stipulate "all matters not privileged which are relevant to the pending case, regardless of whether such matters involve fact or opinion or the application of law to fact." The stipulation process has broad scope and is not confined to the stipulation of facts or evidence. Willamette Indus., Inc. v. Commissioner [Dec. 50,570(M)] T.C. Memo. 1995-150 (citing Explanatory Note to Rule 91(a), 60 T.C. 1118). "The Court will not permit a party to a stipulation to qualify, change, or contradict a stipulation in whole or in part, except that it may do so where justice requires." Rule 91(e) (emphasis added). Where Rule 91(e) applies, the Tax Court must proceed in accordance with the provisions of that Rule. Farrell v. Commissioner [98-1 USTC ¶50,194] 136 F.3d 889, 893-897 (2d Cir. 1998), revg. and vacating Spears v. Commissioner [Dec. 51,468(M)] T.C. Memo. 1996-341. The Court is reluctant to set aside a stipulated decision in absence of fraud, mutual mistake of fact, or other like cause. MacElvain v. Commissioner [Dec. 44,073(M)] T.C. Memo. 1987-366 (citing Saigh v. Commissioner [Dec. 21,694] 26 T.C. 171, 176 (1956), and Estate of Jones v. Commissioner [Dec. 40,973(M)] T.C. Memo. 1984-53, affd. [86-2 USTC ¶13,675] 795 F.2d 566 (6th Cir. 1986)).

When a taxpayer files a motion to vacate a decision after it has become final, our authority to vacate the decision, though limited, may be exercised in situations where the taxpayers establish the existence of a fraud on the Court. Cinema '84 v. Commissioner [Dec. 55,593] 122 T.C. 264, 270 (2004). Fraud on the Court is a fraud that harms the integrity of the judicial process. Standard Oil Co. of Cal. v. United States, 429 U.S. 17 (1976); Hazel-Atlas Glass Co. v. Hartford-Empire Co., 322 U.S. 238, 245 (1944). Fraud on the court includes any unconscionable plan or scheme that is designed to improperly influence the court in its decision. Abatti v. Commissioner [88-2 USTC ¶9548] 859 F.2d 115, 118-119 (9th Cir. 1988), affg. [Dec. 43,138] 86 T.C. 1319 (1986). The limited definition of fraud on the Court reflects the policy of putting an end to litigation and serves the important legal and social interest in preserving the finality of judgments. Toscano v. Commissioner, 441 F.2d at 934.

Recognizing that the fraud on the Court committed by respondent's trial attorneys (1) was a fraud on the Court in every Kersting project case that was bound by the test case cases and (2) violated the rights of all Kersting project petitioners in those cases, we are convinced that justice will best be served by vacating the stipulated decisions and imposing on respondent the sanction mandated by the Court of Appeals in Dixon V.

Respondent's position in these cases is that Kersting project petitioners are not entitled to the benefit of the final Thompson settlement unless they can directly connect conduct amounting to fraud on the Court to the decisions entered in their cases. Respondent does not object to vacating the decisions in nontest cases that were entered after December 11, 1991, the date the Court filed its Dixon II opinion, and before June 9, 1992, the date respondent disclosed the misconduct of McWade and Sims to the Court in the motions to vacate the decisions in the Thompson, Cravens, and Rina test cases. Respondent concedes that decisions in Kersting project cases that were entered during that "gap period" (see supra note 39 and accompanying text) were obtained by fraud on the Court and that decisions in those cases should be vacated. Respondent agrees that taxpayers who agreed to stipulated decisions "in possible reliance on Dixon II and in apparent ignorance of the misconduct in the test cases" are entitled to have their decisions vacated because of the fraud on the Court.

Respondent objects to vacating stipulated decisions in these and other Kersting project cases that were entered before the publication of Dixon II (such as the Hartman cases) or after the discovery and disclosure to the Court of the misconduct of respondent's attorneys (such as the Lewis and the Liu cases). Respondent objects to vacating decisions entered in these and other similar cases on the ground that the misconduct of McWade and Sims had no influence on those petitioners' decisions to settle their cases.

Respondent contends that before Dixon II was issued no one knew with absolute certainty how the Court would rule on the merits of the Kersting programs and that implicit in prior decisions to settle was petitioners' belief that "they would lose under a fairly tried case". In our view, petitioners, irrespective of whether they had concluded that their position on the merits was well-nigh hopeless or had some chance of success, were entitled to assume that the test cases whose outcome would determine the tax effects of the Kersting programs would be well and fairly tried. That assumption was defeated by McWade's and Sims's intervening misconduct.




C. Subsequent Voluntary Disclosure of the Fraud on the Court Does Not Purge the Fraud

Although respondent reported the secret settlements to the Court and counsel for the remaining test case petitioners promptly after discovering McWade's and Sims's misconduct, those disclosures did not purge any of the Kersting project cases of the fraud committed on the Court. Once a fraud is committed, subsequent voluntary disclosure of the fraud does not purge the fraud. Badaracco v. Commissioner [84-1 USTC ¶9150] 464 U.S. 386, 394 (1984). A taxpayer who files a fraudulent return, regardless of the taxpayer's subsequent voluntary disclosure, remains subject to criminal prosecution and the civil fraud penalty. Id. The fraud is committed and the offense completed when the original fraudulent return is prepared and filed. Id. Where a taxpayer files a false or fraudulent return but later files a nonfraudulent amended return, section 6501(c)(1) applies and a tax may be assessed "at any time", regardless of whether more than 3 years have expired since the filing of the amended return. Id. (citing United States v. Habig [68-1 USTC ¶9243] 390 U.S. 222 (1968), and Plunkett v. Commissioner [72-2 USTC ¶9541] 465 F.2d 299, 302-303 (7th Cir. 1972), affg. [Dec. 30,349(M)] T.C. Memo. 1970-274); see also George M. Still, Inc. v. Commissioner [Dec. 19,511] 19 T.C. 1072, 1077 (1953), affd. [55-1 USTC ¶9172] 218 F.2d 639 (2d Cir. 1955).


A party cannot avoid sanctions for committing a fraud on the court by settlement or withdrawal from the case. See, e.g., Bader v. Itel Corp. (In re Itel Secs. Litig.), 791 F.2d 672 (9th Cir. 1986). It is well settled that an agreement between private parties cannot deprive the Court of its power to investigate, to render rulings, or to impose sanctions for an alleged fraud upon the court. Chambers v. NASCO, Inc., 501 at 44 (citing Universal Oil Prods. Co. v. Root Ref. Co., 328 U.S. 575, 580 (1946)); see also Hazel-Atlas Glass Co. v. Hartford-Empire Co., 322 U.S. 238 (1944); Bush Ranch, Inc. v. E.I. du Pont de Nemours & Co., 918 F. Supp. 1524 (M.D. Ga. 1995), revd. and remanded on other grounds 99 F.3d 363 (11th Cir. 1996). "Of particular relevance here, the inherent power also allows a federal court to vacate its own judgment upon proof that a fraud has been perpetrated upon the court." Chambers v. NASCO, Inc., supra at 44 (citing Hazel-Atlas Glass Co. v. Hartford-Empire Co., supra, and Universal Oil Prods. Co. v. Root Ref. Co., supra at 580); see also Cooter & Gell v. Hartmarx Corp., 496 U.S. 384, 396 (1990) ("A court may make an adjudication of contempt and impose a contempt sanction even after the action in which the contempt arose has been terminated."); Bush Ranch, Inc. v. E.I. DuPont De Nemours & Co., 99 F.3d at 367-368 (District Court had power to investigate an alleged fraud upon the court and impose civil sanctions for the fraud in a case where the plaintiffs had voluntarily moved for dismissal of their claims with prejudice 2 years earlier).

Further, we agree with petitioners that their acceptance of the posttrial settlement offer did not release respondent from the consequences of the fraud on the Court. In Lewis v. Commissioner [Dec. 56,128(M)] T.C. Memo. 2005-205, we stated that the Lewises settled their cases with the understanding, set forth explicitly in respondent's posttrial settlement offer, that accepting the offer would "'preclude any further challenge or appeal with respect to the Kersting programs or the merits of the Dixon opinion'." On reconsideration, we now conclude that petitioners' requests that sanctions be imposed on respondent for the fraud committed in their cases is not a challenge to the Kersting programs or to the merits of the Dixon II opinion within the meaning of respondent's posttrial settlement offer.

A settlement "is a contract and thus is a proper subject of judicial interpretation as to its meaning, in light of the language used and the circumstances surrounding its execution." Robbins Tire & Rubber Co. v. Commissioner [Dec. 29,612] 52 T.C. 420, 435-436 (1969); see also Brink v. Commissioner [Dec. 25,815] 39 T.C. 602, 606 (1962), affd. [64-1 USTC ¶9257] 328 F.2d 622 (6th Cir. 1964); Saigh v. Commissioner, 26 T.C. at 177; Davis v. Commissioner [Dec. 12,461] 46 B.T.A. 663, 671 (1942); Himmelwright v. Commissioner [Dec. 44,644(M)] T.C. Memo. 1988-114. The circumstances in the Kersting test case proceedings and the terms of the posttrial settlement offer show that petitioners did not release respondent from claims arising from or related to McWade's and Sims's misconduct during the Kersting test case proceedings.

cases remains unchanged" was misleading, because it conveyed the impression that Dixon II and the Court's rulings were the last word on the subject. It failed to disclose that the other test cases were on appeal and that appellants were asserting fraud on the court as a ground for vacating the decisions in the other test cases.

The failure of the offer to disclose and identify the test case petitioners who had received a very different settlement, giving them much more favorable treatment, and that giving preferential treatment violated IRS policy and the Department of the Treasury Minimum Standards of Conduct renders disingenuous the statement in the posttrial settlement offer "we have concluded that in fairness all petitioners be afforded an opportunity to settle their cases".








Conclusion

We hold that neither the posttrial settlement offer nor the stipulated decisions thereby generated bar the Court from considering the fraud on the Court as it affected all cases pending at the time the offer was made or imposing sanctions to remedy the harm caused by the fraud on the Court. We also hold that all Kersting project petitioners whose cases were bound by the results in the Kersting project test cases are entitled to the benefit of the Thompson settlement regardless of when they settled their cases. All taxpayers whose cases are part of a test case procedure should be assured that the test cases will be well and fairly tried, regardless of whether or when they settle their cases. The misconduct that was a fraud on the Court began long before the trial of the test cases that resulted in Dixon II. The Kersting project test case proceedings began June 10, 1985, the first day of the June 1985 session during which the Court agreed with Seery and McWade to use the test case proceeding to resolve all Kersting project cases. We do not think that justice would be served if we were to require another trial in each previously settled case to determine whether sanctions should be imposed for the fraud committed on the Court during the Kersting test case proceedings. As expressed by the Court of Appeals in Dixon V at 1047:

Here, it plainly would be unjust to remand for a new, third trial. The IRS had an opportunity to present its case fairly and properly. Instead its lawyers intentionally defrauded the Tax Court. The Tax Court had two opportunities to equitably resolve this situation and failed. Enormous amounts of time and judicial resources have been wasted. * * *

In Hazel-Atlas Glass Co. v. Hartford Empire Co., 322 U.S. 238 (1944), the Supreme Court explained that the inquiry into whether a judgment should be set aside for fraud on the court focuses not so much on whether the alleged fraud prejudiced the opposing party but on whether the alleged fraud harms the integrity of the judicial process. The misconduct of McWade and Sims was a fraud on the Court because it harmed the integrity of the judicial process. The judicial process that was harmed by the misconduct was more than just the trial of the test cases; the judicial process that was implicated is the test case procedure that encompassed the cases of all taxpayers before this Court that were bound by the results in the test cases. The judicial process referred to by the Court of Appeals also encompasses all future cases employing test case procedures. Taxpayers' confidence in future test case proceedings was undermined by the misconduct. Dixon V at 1046-1047. In deciding the proper sanction to impose for the fraud on the Court, we must "carefully balance the policy favoring adjudication on the merits with * * * the need to maintain institutional integrity and the desirability of deterring future misconduct." Aoude v. Mobil Oil Corp., 892 F.2d 1115, 1118 (1st Cir. 1989) (finding that the District Court considered the relevant factors and in dismissing the action acted well within its discretion).

Respondent's attorneys committed a fraud on the Tax Court during the Kersting test case proceedings that was a fraud on the Court in every case bound by the results of the test cases. Extending to every petitioner whose case was bound by the results of the Kersting project test cases, by piggyback agreement or the Court's order to show cause procedure, the benefit of the Thompson settlement strikes us as an appropriate accommodation of the competing considerations; it is a sanction for the misconduct that is consistent with Dixon V and is "no more than necessary" to maintain public trust in the judicial process that employs test case procedures. See, e.g., Gomez v. Vernon, 255 F.3d 1118, 1135 (9th Cir. 2001). We have considered the relevant factors with the standard set by the Court of Appeals in Dixon V. We are protective of the integrity of our judicial process and concerned about deterrence. We are "entitled to send a message, loud and clear." Aoude v. Mobil Oil Corp., supra at 1122. We hold that sanctions should be imposed in the cases of all Kersting project petitioners in which stipulated decisions were entered on or after June 10, 1985, the date the Kersting project test case proceedings began.

Our holding is limited to the unique and narrow circumstances of these cases --where we are imposing sanctions for a fraud committed on the Court in a test case proceeding that bound more than a thousand cases. Compare Dixon V with Abatti v. Commissioner, 859 F.2d at 117.

Having reconsidered Lewis v. Commissioner [Dec. 56,128(M)] T.C. Memo. 2005-205, and addressed the merits of petitioners' arguments and respondent's objections, we shall grant petitioners' motions to vacate the stipulated decisions entered in the cases at hand and enter new decisions in accordance with Dixon VI and Dixon VIII, giving effect to the opinion of the Court of Appeals for the Ninth Circuit in Dixon V.


Implementation of Sanction

Recognizing that "Enormous amounts of time and judicial resources have been wasted", the Court wishes to relieve other Kersting project nontest case petitioners who had stipulated decisions entered in their cases on or after June 10, 1985, of the burden of filing motions for leave to file motions to vacate decisions. We believe that the most expeditious and efficient means of implementing the sanction is to allow respondent to adjust administratively the accounts of all Kersting project petitioners, other than Hartman, the Lewises, and the Lius, without requiring further action from the Kersting project petitioners.47 Administrative adjustments would eliminate the need for other Kersting project petitioners to file motions for leave to file motions to vacate the decisions in their cases and the attorney's fees that otherwise might be incurred and claimed for the preparation and filing of such motions.

To facilitate the implementation of this sanction, we shall issue an order (the implementation order) directing respondent to send a copy of this opinion and the implementation order to all taxpayers who filed petitions in this Court contesting the adjustments at issue in Dixon II who had stipulated decisions entered in their cases (closed cases) on or after June 10, 1985. That notification action by respondent is to be completed within 60 days after the decisions entered in these cases become final; i.e., after the Court of Appeals for the Ninth Circuit renders its decision, if and when the decisions herein should be appealed. See Bush Ranch, Inc. v. E.I. du Pont de Nemours & Co., 918 F. Supp. at 1556.

Respondent shall have 9 months after the date the decisions in these cases becomes final (the implementation period) to adjust administratively the accounts of all Kersting project petitioners who had stipulated decisions entered in their cases on or after June 10, 1985. The implementation order will require respondent to provide the following additional information to the Kersting project petitioners:

1.The name of IRS contact personnel who can answer any questions Kersting project petitioners may have concerning the adjustments of their accounts;

2.the date the decisions in these cases became final; and

3.the expiration date of the implementation period.

The implementation order will require respondent, on or before the expiration of the implementation period, to file a status report with the Court, listing the cases of all Kersting project petitioners to whom respondent sent copies of this opinion and the implementation order and identifying any petitioner whose account has not been adjusted administratively.

During the implementation period, the Court will not grant leave to file motion to vacate decision in any case where motions for leave have been filed. If respondent adjusts administratively the accounts of those Kersting project petitioners who have filed motions for leave and the parties notify the Court of the adjustment, the Court will deny as moot the motions for leave. Additionally, the Court will not accept for filing any motions for leave to file motions to vacate the decisions in the cases of any other Kersting project petitioner unless and until respondent fails to adjust administratively the account of the Kersting project petitioner before the expiration of the implementation period. If respondent does not timely adjust administratively the account of any Kersting project petitioner, the Court will accept for filing a motion for leave to file motion to vacate decision, will grant leave to file such a motion, and will order respondent to show cause why the Court should not grant the motion to vacate decision and enter a new decision in accordance with this opinion.

To reflect the foregoing, Appropriate orders will be issued, and decisions will be entered under Rule 155.