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Can the IRS Assert IRC Section 6676’s Erroneous Refund Penalty on Protective Refund Claims?

We once again want to bring to your attention the Internal Revenue Service’s (IRS) new favorite penalty provision: Internal Revenue Code (IRC) Section 6676. We have reported on this provision several times before (See here, here and here), but this time we’re analyzing it in the context of protective refund claims.

As background, IRC Section 6676 was enacted in 2007 in response to the high number of presumed meritless refund claims being filed at the time. It imposes a 20% penalty to the extent that a claim for refund or credit with respect to income tax is made for an “excessive amount.” An “excessive amount” is defined as the difference between the amount of the claim for credit or refund sought and the amount that is actually allowable. For example, if a taxpayer claims a $2 million refund and the IRS allows only $1 million, the taxpayer can still be penalized $200,000 (e.g., 20% of the amount of the refund that was disallowed). Significantly, IRC Section 6676 does not require the IRS to show any fault or culpability on the part of the taxpayer (e.g., negligence or a disregard of rules or regulations). Neither the IRC nor the regulations provide for any defense to the Section 6676 penalty other than “reasonable cause.” Moreover, the penalty is immediately assessable, and generally taxpayers cannot fight the IRS on the penalty in a prepayment forum like it can the US Tax Court. Instead, the taxpayer must first pay the penalty and seek redress in a refund forum in either the relevant US federal district court or the US Court of Federal Claims.

Now that the IRS is asserting the IRC Section 6676 penalty more frequently, taxpayers are asking whether the penalty can apply to a protective refund claim. A protective refund claim is a judicial creation under which a taxpayer files a “protective” refund claim that is expressly contingent on a specified future event, like a taxpayer-friendly holding in a relevant court case. The Supreme Court of the United States has endorsed protective refund claims to toll the statute of limitations on the refund claim and thereby protect the taxpayer’s right to claim the refund if the favorable event should occur. (See, e.g., United States v. Kales, 314 US. 186 (1941), and CCA 201136021 (describing protective claims in detail).)

So, does the IRC Section 6676 penalty apply to a protective refund claim? Based on IRS internal guidance from 2022, the IRS believes that the IRC Section 6676 penalty applies to any filing that constitutes a “claim for credit or refund” of income tax, including a protective refund claim. To apply the penalty, the IRS would have to process the protective refund claim, deny the claim and then assert the IRC Section 6676 penalty.

Processing and denying a protective refund claim go against most tax practitioners’ experience and understanding of how the IRS treats protective refund claims. Typically, the refund claim is [...]

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Tax Court Rules Limited Partners May Be Subject to Self-Employment Tax

On November 28, 2023, the US Tax Court granted partial summary judgment in favor of the Internal Revenue Service (IRS) in Soroban Capital Partners LP v. Commissioner and held that “limited partners” are defined functionally—not by state law—for purposes of Internal Revenue Code (IRC) Section 1402(a)(13), which excludes distributions to a “limited partner, as such” from self-employment tax.

Partners are generally required to include their distributive shares of partnership income in their net earnings from self-employment under IRC Sections 1402(a) and 702(a)(8). IRC Section 1402(a)(13), however, provides an exception. It excludes “the distributive share of any item of income or loss of a limited partner, as such, other than [certain] guaranteed payments” from self-employment tax. However, in the context of IRC Section 1402(a)(13), “limited partner” is not defined. The Tax Court previously held that “limited partners” are determined functionally (e.g., by what they actually do with respect to the partnership), not by their status or title under state law, in the context of a limited liability partnership. (See Renkemeyer v. Commissioner, 136 T.C. 137 (2011).) Soroban argued that in the distinct context of a limited liability partnership, plain statutory meaning, legislative history, past guidance from the US Department of the Treasury (Treasury) and the IRS, and policy considerations all pointed to the same conclusion: “limited partner” for purposes of the self-employment tax must be determined by reference to state law.

The Tax Court disagreed. The Court fixed its attention on the phrase “limited partner, as such” and found that under the canon of construction against surplusage, the words “as such” demonstrate “that the limited partner exception applies only to a limited partner who is functioning as a limited partner.” To the extent legislative history or Soroban’s “myriad other arguments” suggest otherwise, they cannot “overcome the plain meaning of the statute.”

The Tax Court held that IRC Section 1402(a)(13) applies only to “passive investors” and excludes “earnings from a mere investment” only. Therefore, the Court “must examine the functions and roles of the limited partners in the partnership to determine whether their shares of earnings are excluded from net earnings from self-employment.” The Court concluded that it has jurisdiction to complete this task during partnership-level proceedings because the applicability of IRC Section 1402(a)(13) “is a partnership item” under Treasury Regulation § 301.6231(a)(3)-1.

Practice Point: The Court’s holding in Soroban will likely provide the IRS with additional incentive to audit taxpayers as part of the IRS’s Self-Employment Contributions Act compliance campaign, which the IRS placed on hold to see “what develops in” cases like Soroban. This issue has been hotly contested in the Tax Court, with several cases currently being litigated, including Denham Capital Management LP v. Commissioner, Docket. No. 9973-23, and Point72 Asset Management LP v. Commissioner, Docket. No. 12752-23. We will see whether the taxpayer in Soroban seeks review by an appellate court. In the meantime, if you have this issue, we advise consulting with your tax professional to ensure you are poised to [...]

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Taxpayer Loses Claim for Research Credit

In United States v. Grigsby, Docket No. 22-30764, the US Court of Appeals for the Fifth Circuit held that a refund claim based on claimed Internal Revenue Code (IRC) Section 41 credits was erroneous. Cajun Industries LLC, a subchapter S corporation, filed a refund claim that identified four highly specialized construction projects (two refineries and two flood control systems) as “business components,” which, in turn, gave rise to qualified research expenses (QRE). Cajun fabricated the systems under four separate contracts. The Internal Revenue Service (IRS) granted the claim and issued the refund (ultimately to Cajun’s shareholders who are the taxpayers in this case) but later regretted the decision and filed a suit for recovery of an erroneous refund under IRC Section 7405. The decision turned on two main factors:

  1. A failure to plead
  2. The funded contract exception under IRC Section 41(d)(4)(H)


After discovery, the parties prepared for trial and moved for summary judgment. In its motion for summary judgment (and about a month before trial), for the first time in the litigation, the taxpayers identified certain construction processes as additional “business components,” giving rise to the claimed QRE. The Fifth Circuit held that the district court did not abuse its discretion by declining to consider these new processes as “components” in support of the claimed QRE. In short, the taxpayer was too late and paid the price for its delay. One taxpayer faced a similar problem in 2000 when it sought to put into evidence additional QRE beyond the amount described in its detailed refund claim. There, the Federal Circuit cited the doctrine of variance (i.e., a taxpayer must provide adequate notice of the grounds of the refund claim and any substantial variance from those grounds is not permitted in litigation) and declined to put the additional QRE into evidence. Variance may not have been applicable in the Grigsby case because the refund claim was reviewed and issued, but the taxpayers could have improved their position in court by including the construction processes at the beginning of the litigation or at the latest during discovery.


The Fifth Circuit then analyzed the four contracts and focused particularly on terms pertinent to the ownership of research results and whether payment to Cajun was contingent upon success of its research. (Regulations promulgated under IRC Section 41(d)(4)(h) provide that research is funded and thus not eligible for the credit if the researcher does not retain substantial rights in its research.) The Court held that three of the contracts awarded sole rights in the research to the customer and removed any substantial rights from Cajun. The fourth contract (firm fixed price) was simply considered “funded” because payment was not contingent upon the success of any research performed by the taxpayer. The Court also rejected a Fairchild risk argument negating the funded nature of this fourth contract.

In general, regarding the three contracts, it’s not clear that Cajun retained zero substantial rights in its research. For [...]

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Can the Government Sue for Tax Debts Outside Internal Revenue Code Procedures?

On June 1, 2023, in United States v. Liberty Global, Inc., the US District Court for the District of Colorado held that the US Department of Justice (DOJ) can assert and seek judgment for federal income tax deficiencies using a common law right of action, bypassing the usual statutory tax deficiency procedures outlined in the Internal Revenue Code (IRC). This decision might encourage the DOJ to seek tax collections through court judgments moving forward without following the IRC’s deficiency procedures.

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