The Tax Court issued an unusually stern rebuke to the Internal Revenue Service in a case it decided last week involving a huge group of tax shelter defendants.

The so-called "Kersting tax shelter project" was intended to resolve a large group of tax shelter cases by using a test case procedure. About 1,300 taxpayers signed agreements to be bound by the outcome of the test case. However, the IRS's attorneys made a secret settlement with the defendants in the test case.

When the case went to trial, the defendants did not defend the tax shelter successfully, and the result was used against any other defendants who had agreed to abide by the results of the case. When they learned about the secret settlement made by the IRS attorneys with the defendants in the test case, they argued that it should apply to them as well. The Ninth Circuit Court of Appeals agreed in a case called Dixon V, and ultimately the Tax Court did as well in Hartman v. Commissioner.

"The fraud on the court committed by R's attorneys in the test case proceedings constituted fraud on the court in every case bound by the outcome of the test cases and harmed the integrity of the judicial process, not only as the test case procedure was employed in the Kersting project cases, but also as it might be employed in the future," wrote the judge.

There are about 1,173 cases still on the court's inventory of docketed cases in which decisions have never been entered. The Tax Court ordered the IRS to adjust the accounts of all the taxpayers in the Kersting project.

The case has been highlighted on Paul Caron's TaxProf blog, as well as Joe Kristan's Tax Update blog and Megan McArdle's Asymetrical Information blog.

The decision represents the court's attempt to right a wrong committed by seemingly overzealous attorneys working on behalf of the IRS. While the IRS has been winning some tax shelter cases lately (see Government Wins Another Tax Shelter Case), its record has been negative in others (see U.S. Loses Son of Boss Tax Case).

The latest case represents a major setback for the agency, especially when a Tax Court judge takes its attorneys to task for their conduct. While the government is determined to cut down on the abuse of tax shelters, it needs to be careful not to overreach by allowing its attorneys to cut secret side deals that benefit one set of defendants while punishing a much larger set.

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