Unpublished Disposition, 931 F.2d 896 (9th Cir. 1989)

No. 90-15806.

United States Court of Appeals, Ninth Circuit.

Before D.W. NELSON, KOZINSKI and THOMAS G. NELSON, Circuit Judges

MEMORANDUM^* 

Morgan Cashman appeals the district court's affirmance of the Commissioner of the Internal Revenue Service's ("Commissioner" or "IRS") denial of a tax refund for 1976, 1977, 1978, 1980, and 1981. He argues that carrying back net operating losses from 1982 to 1979 and 1980 should allow him to free investment tax credits and deductions in those latter years for carrying back to 1976-78 and forward to 1981, thus earning refunds for those last years. The government retorts that it need not permit those deductions and credits because they were for sham investments. Appellant counters that reconsideration of those deductions is time-barred and that they were legitimate anyway. We affirm the district court because neither does the statute of limitations apply, nor were the investments entered into for a business purpose or likely to produce economic benefits.

Whether the IRS was bound by the statute of limitations in reexamining past tax years to offset claimed refunds is a legal question that the panel reviews de novo. Cf. Trust Services of America, Inc. v. United States, 885 F.2d 561 (9th Cir. 1989) (review de novo holding that government foreclosed by estate tax closing letter from claiming setoff defenses in refund action).¹ 

The statute of limitations requires that "the amount of any tax imposed by this title shall be assessed within 3 years after the return was filed ..." 26 U.S.C. § 6501(a). Appellant argues that this means that after this time period the IRS may not reexamine a taxpayer's filings to discover additional liabilities with which to offset potential refunds. While not disputing its inability to assess new deficiencies for those years, the government argues that it may use erroneously unassessed liabilities in those returns to offset claimed refunds. It believes that this case falls squarely within the ambit of Lewis v. Reynolds, 284 U.S. 281, modified, 284 U.S. 599 (1932), while appellant protests that Lewis has been implicitly overruled both by subsequent cases and by revisions of the Internal Revenue Code.

In Lewis trustees of an estate sued the IRS for failure to grant a refund. The petitioners asked that the IRS refund to them money paid on the basis of the IRS' incorrect refusal to allow a deduction for state inheritance taxes. While admitting this error, the Commissioner stated that another deduction for attorney's fees had been improperly allowed. Offsetting the refund with this greater amount, the Commissioner determined that no refund was owed. Petitioners claimed that the Commissioner could not redetermine and reassess the tax as an offset after the statute had run. The Supreme Court disagreed.

It first quoted with approval from the Court of Appeals decision below:

" [T]he ultimate question presented for decision, upon a claim for refund, is whether the taxpayer has overpaid his tax. This involves a redetermination of the entire tax liability. While no new assessment can be made, after the bar of the statute has fallen, the taxpayer, nevertheless, is not entitled to a refund unless he has overpaid his tax ... it is incumbent upon the claimant to show that the United States has money which belongs to him."

Id. at 283 (quoting id., 48 F.2d 515, 516 (10th Cir. 1931)). The Court then concluded:

While the statutes authorizing refunds do not specifically empower the Commissioner to reaudit a return whenever repayment is claimed, authority therefor is necessarily implied. An overpayment must appear before refund is authorized. Although the statute of limitations may have barred the assessment and collection of any additional sum, it does not obliterate the right of the United States to retain payments already received when they do not exceed the amount which might have been properly assessed and demanded.

Id. This is quite a difficult obstacle for appellant to overcome.

Lewis, despite appellant's protestations to the contrary, has become a fixture of tax law. For example, in Trust Services of America, Inc. v. United States, 885 F.2d 561 (9th Cir. 1989), we looked at whether sending an estate tax closing letter foreclosed the government from claiming setoff defenses in a refund action. The court first quoted the tax court: " 'Although the government has the right to re-audit a return and raise any tax deficiency as a setoff to any refund due, see Lewis ... the government is estopped [here because of the letter].' " Id. at 565 (quoting Law v. United States, 83-1 U.S.T.C. p 13,514 (N.D. Cal. 1982)). Trust Services went on to reverse the district court in part, holding that even the letter did not bar the government from asserting one of its setoff claims. Commentators, too, have found the Lewis principle to be well established. See, e.g., Saltzman, IRS Practice and Procedure p 11.02 at 11-6, 11-7 (1981); 4 Bittker, Federal Taxation of Income, Estates and Gifts p 115.7 at 115-40, 115-41 (1981).

B. Lewis Overruled?

Cashman argues that other Supreme Court cases have overruled Lewis sub silentio. He relies on the recent case of United States v. Dalm, 110 S. Ct. 1361 (1990), for the "unspoken premise" that a setoff is insufficient to avoid the statute of limitations bar. "Unspoken" is a great exaggeration; unconsidered would be a more appropriate adjective. Dalm ruled that the doctrine of equitable recoupment did not allow the taxpayer to institute a suit for refund of an earlier paid gift tax after the taxpayer had agreed to pay tax on the transaction. Equitable recoupment, which permits the taxpayer to offset tax paid on an erroneous theory against tax properly asserted and due, has no bearing on this case.² 

Appellant also draws our attention to Rothensies v. Electric Battery Co., 329 U.S. 296 (1946), where the Court held that the taxpayer could not, in this proceeding against 1935 tax liability, recoup a refund of excise taxes improperly paid in 1919-22, as such were barred by the statute of limitations. Once again, the relevance to the present case is slight. Cashman argues that the key is Rothensies' emphasis on the idea that the statute of limitations bars claims arising from different transactions or taxable events. He analogizes to his case by saying that the 1982 net operating loss is a different transaction from the investment tax credits and deductions in 1978-80. For additional support, he cites to McEachern v. Rose, 302 U.S. 56 (1937), for the principle that an offset may not be claimed for a year other than the year in which a refund is claimed. As a result, the government is barred from raising the supposed invalidity of those credits and deductions in this action.

This argument is not convincing. First of all, the government does not contest either the net operating losses from 1982 or appellant's ability to carry them back. The taxpayer, however, seeks refunds for the years 1976-78 and 1980-81. The potential for those refunds arises only because he believes he may now carry elsewhere the credits and deductions in 1979-80 that he no longer needs. Yet, to determine whether he may carry these back and forward to reduce tax liability in the five claimed years, the government must accept their validity. It may reexamine those investments to assess whether the deductions and credits are actually due. The whole underlying point of Lewis is that the government may "retain payments already received when they do not exceed the amount which might have been properly assessed and demanded," id. at 283, that this process "involves a redetermination of the entire tax liability." Id. Here, the taxpayer's action led the IRS into a reexamination of the credits and deductions he wishes to carry. Isolated years are not involved here; rather, the government's holistic view is preferable.

In a related issue, appellant claims that the government cannot prevail because it did not timely plead its proposed setoffs and counterclaims. This misapprehends what this case concerns. The case does not revolve around the validity of the 1982 net operating losses, with the setoffs being a possible counterclaim. Instead, this case concerns whether taxpayer may obtain a refund for the five claimed years. The government correctly explains that he should not because his credits and deductions should be disallowed. There is no counterclaim to be pleaded.

Cashman offers another implicit overruling of Lewis in the guise of Code sections 1311-14, which are mitigation provisions introduced in 1954. He quotes from Sec. 1314, entitled "Adjustment unaffected by other items," which says, in part:

The amount to be assessed and collected in the same manner as a deficiency, or to be refunded or credited in the same manner as an overpayment, under this part, shall not be diminished by any credit or set-off based upon any item other than the one which was the subject of the adjustment.

26 U.S.C. § 1314(c). Read alone, this may be alluring; read properly in context, it is irrelevant. Section 1311(b), entitled "Conditions necessary for adjustment," makes clear that a Sec. 1314 adjustment occurs only when the position of the taxpayer or the IRS is inconsistent as to different tax years. In other words, if either party attempted to treat the same item differently in two different tax years, an adjustment would not be diminished or enhanced by a setoff. In this case, the IRS is treating the 1978-80 deductions and credits similarly. Cashman perceives the inconsistency to occur between its treatment of those investments before his claim for a refund and after. That is not the inconsistency to which this section refers. It only covers inconsistent treatment of the same action in different years. His argument under this section must fail.

In sum, appellant's position is based too largely on flimsy parallels and supposed inferences to defeat long-understood premises. We uphold the district court's ruling that the statute of limitations does not act as a bar.

Whether the district court properly imposed the burden of proof is a question of law reviewed de novo. See United States v. Janis, 428 U.S. 433, 440-43 (1976) (implies this is an issue of law).

Cashman argues that the government bears the burden of proving that its offsets were correct. Since both sides admit the validity of the net operating loss in 1982, taxpayer claims, the government must prove the investments were shams, nullifying the refund. In other words, he assumes that the offsets are in the form of an affirmative defense or counterclaim. Furthermore, he argues, this is only logical in that it is exceedingly difficult to prove that a bad investment was not a sham.

The government, in response, has the benefit of the caselaw. Trust Services is rather dispositive on the issue:

The government here bears a threshold burden of "going forward," of establishing that its equitable setoff defenses to this tax refund suit are "made in good faith, rather than for improper purposes of deterence and harassment." ... Once the government has shouldered this burden, the taxpayer bears the burden of persuading the court that the deductions, exclusions or valuations in question were proper.

Id. at 566-67 (quoting Ahmanson Foundation v. United States, 674 F.2d 761, 777 (9th Cir. 1981)) (citations omitted). Ahmanson explains:

If the taxpayer bears the burden of proving the amount he is entitled to recover, then, as a general matter, the taxpayer should also have the burden with respect to all issues bearing upon the recovery amount--including the issues raised when the government asserts as a defense, in the nature of a setoff, the impropriety of some deduction previously allowed with respect to the same return.

Id. at 776-77. After setting out this threshold point, Ahmanson then goes on to say, as quoted by Trust Services, that the government must make some demonstration that its setoff claims are made in good faith. As long as it has done so, the taxpayer bears the burden. See also United States v. Janis, 428 U.S. 433, 440 (1976) ("In a refund suit, the taxpayer bears the burden of proving the amount he is entitled to recover.").

Since the government clearly made a showing that this was a good faith offset and that taxpayer's investments leading to credits and deductions was of dubious nature, it met its preliminary burden. We uphold the district court's placement of the burden.

The government argues that the issue of whether the taxpayer met his burden of proving his entitlement to the deductions and credits presented factual issues, which we should review under the clearly erroneous standard. Casebeer v. C.I.R., 909 F.2d 1360, 1362 (9th Cir. 1990). Yet that case mentions that this circuit's standard "appears inconsistent with Supreme Court authority, from which perhaps we should infer a de novo standard." Id. at 1362, n. 6. As in Casebeer, we "reach the same result applying a de novo standard to the ultimate sham determinations." Id.

The test that we employ to determine whether investments are shams designed entirely for tax losses has both a subjective and an objective component. Subjectively, the taxpayer must have entered into the transaction with a bona fide business purpose other than tax avoidance. Objectively, the transaction must have been likely to produce economic benefits aside from tax benefits. Id. at 1363. This, however, is not a "rigid two-step analysis," Id.

Instead, the consideration of business purpose and economic substance are simply more precise factors to consider in the application of this court's traditional sham analysis; that is, whether the transaction had any practical economic effects other than the creation of income tax losses.

Id. (quoting Sochin v. Commissioner, 843 F.2d 351, 354 (9th Cir.), cert. denied, 488 U.S. 824 (1988)).

We first look to see if Cashman showed any business purpose other than tax avoidance in making his investments in the publishing and videotapes.

In the publishing ventures, Cashman claimed as investment tax credits $22,700 for The Triumph, the mass-market paperback, in 1978 and $30,782 for "The Dover Collection" of books in 1979. Further, he deducted as net losses $99,000 total for the former in 1978-79 and $20,000 for the latter in 1979. As for the country and western music videotapes, he claimed as a credit in 1980 the sum of $6,667, and in the same year he claimed $75,000 as a loss.

His accountant testified that Cashman had asked him "to help him find tax sheltered investments," for which he specifically looked. Neither Cashman nor his accountant had any experience in publishing or music. Cashman could not produce copies of contracts, promissory notes, or canceled checks. As to the videotapes, Cashman did not even know who the performers on the tape were. The tape contained 5 songs, priced at $20,000 each, a price he did not seek to get lowered, though that was possible. He did not see the tapes, nor did he know where they were kept. As the party on whom the burden rested, he did not provide any solid evidence to show that he subjectively expected this to be a profitable venture.

The government's witness, Gloria R. Mosesson, testified that the fair market value of the tapes and the publishing ventures was zero. Appellant's brief is devoted to an excoriation of the witness and her qualifications, instead of an attempt to argue for the value of his investments. In fact, while his brief is fifty pages in length, only briefly does he argue that these investments pass the objective test.

The brief is not wanting in length of discussion about the government witness, whom appellant refers to as unqualified. He also posits that the evidence on which she based her opinion was insufficient to justify her conclusions. It is unclear what he is appealing: the district court's misapplication of the objective part of the test, its permitting this expert to testify, or the evidence of which she spoke. None of his jumbled allegations is tenable.

He insists that his investments need not have resulted in a profit, but rather that all he needed was a profit motive. This is not in dispute, though, and the government never argues a demonstrated profit is required. He claims that the expert was not versed in country and western music and therefore unknowledgeable about his videotape venture. While she admittedly did not walk into court whistling Loretta Lynn tunes, she had spent over 30 years as an editor, in supervising production and promotion of books, and in negotiating publishing, audio, and video rights. Further, the fact that she had testified for the IRS over the past five years is not a black mark against her qualifications as an expert; in fact, it is probably the reverse.

In addition, appellant stresses that the promissory note involving the videotapes was recourse, from which he argues that the court should have inferred legitimacy. Neither was this note ever paid, nor did the owner of the videotape venture state that the note was even important to him. This one piece of evidence is not dispositive on the objective test.

Appellant concludes this section of his brief with the contention that it was error for the court to rely on the expert witness as a principal support for the court's judgment. As noted above, only briefly does appellant directly argue that the investments were legitimate. He mentions that the two artists on the music videotapes were country and western stars, yet he admitted never having heard of them. He talks in similar glowing terms about the publishers, but those books were explained to be worthless. His only substantive reasoning is that the court failed to reopen discovery, thus depriving him of the opportunity to secure evidence to support the legitimacy of the investments.

We conclude that the taxpayer did not meet his burden of proving that the investments were made with a profit motive or that they had economic substance.

We review the district court's rulings concerning discovery for an abuse of discretion. Ah Moo v. A.G. Becker Paribas, Inc., 857 F.2d 615, 619 (9th Cir. 1988).

Discovery was originally opened from January 16, 1985, to August 15, 1986, then from January 23, 1987, to April 23, 1987, and again from August 21, 1987, to October 20, 1987. Appellant claims that when the pretrial order was extended to January 15, 1988, he assumed discovery was also extended. Prior to that date, he argues, he had not known what he needed to discover and thus afterward asked the district court for another extension.

The district court refused to grant such, finding that taxpayer had not exercised due diligence in pursuing his discovery needs in this case. Such a reopening, it held, would work a hardship on the government. Appellant raises no strong argument why the district court erred in not opening discovery, let alone abused its discretion in not doing so. We uphold the denial.

We will not reverse a trial court's decision to exclude expert testimony unless it is "manifestly erroneous." Taylor v. Burlington N. R.R. Co., 787 F.2d 1309, 1315 (9th Cir. 1986).

Cashman advised defense counsel on April 25, 1989, that he intended to use as an expert witness, James McPhee, a librarian at the University of Nevada. This was necessary, he argues, because another witness, who had been previously lined up, refused to come to Las Vegas from New York. The court denied the right to use this witness on the grounds that he had not been identified prior to the pretrial order of October 1987.

Refusal to permit the testimony of a witness who was not mentioned until 18 months after the pretrial order is not manifestly erroneous. We affirm.

We affirm the district court both because the statute of limitations does not bar the offsets and because the investment tax credits and deductions were rightfully disallowed.

AFFIRMED.