The Ninth Circuit Court of Appeals ruled in the case of J.B.; P.B. v. United States of America, No. 16-15999, CA9 that the IRS failed to provide the taxpayers with reasonable notice in advance of the agency’s intent to contact third parties as required by §7602.

IRC §7602(c)(1) provides the following mandate before the IRS contacts third parties in an examination:

(c) Notice of contact of third parties

(1) General notice

An officer or employee of the Internal Revenue Service may not contact any person other than the taxpayer with respect to the determination or collection of the tax liability of such taxpayer without providing reasonable notice in advance to the taxpayer that contacts with persons other than the taxpayer may be made.

IRS Publication 1, Your Rights as a Taxpayer, contains the following text on page 2 of the two page publication:

Potential Third Party Contacts

Generally, the IRS will deal directly with you or your duly authorized representative. However, we sometimes talk with other persons if we need information that you have been unable to provide, or to verify information we have received. If we do contact other persons, such as a neighbor, bank, employer, or employees, we will generally need to tell them limited information, such as your name. The law prohibits us from disclosing any more information than is necessary to obtain or verify the information we are seeking. Our need to contact other persons may continue as long as there is activity in your case. If we do contact other persons, you have a right to request a list of those contacted. Your request can be made by telephone, in writing, or during a personal interview.

The IRS argued that, since the taxpayer had been given that notice at the start of the exam, that served as the required reasonable notice in advance of any contact with a third party in an exam.

In this case the taxpayers were the unlucky “winners” in the National Research Program (NRP) audit, the exam where the IRS meticulously goes through the taxpayer’s documents in order to help the agency determine tax compliance in general and design more effective targeted programs. Such exams are very time consuming and stressful for the taxpayers involved.

In this case the taxpayers had asked the IRS to excuse them from the NRP audit program due to the taxpayer’s age and health. The IRS denied the request and the taxpayers filed suit to stop the audit in US District Court.

Although the suit continued, the IRS wanted to move forward with the audit. The taxpayer in this case was an attorney who accepted assignments to represent indigent defendants from the California Supreme Court in capital cases. Since the taxpayers were fighting the exam, the IRS decided to attempt to obtain information from the California Supreme Court for “billing statements, invoices or other documents” that lead to payment to the taxpayer. The IRS took this step without giving notice to the taxpayers that they were going to seek information from the party that was controlling the cases the taxpayer was assigned, information that could contain significant information regarding the individuals the taxpayer had represented.

The taxpayers eventually discovered the IRS was pursuing this information when their daughter, who was listed as their personal representative, received a notice of service of summons in the mail. The taxpayers challenged the summons in District Court. The District Court found that the IRS had failed to provide sufficient advance notice of the request, specifically rejecting the IRS’s contention that the statement in Publication 1 they had issued to the taxpayers two years earlier served as sufficient notice for requests for third parties throughout the exam. The District Court granted the taxpayer’s request to quash the summons and the IRS appealed that decision to the Ninth Circuit Court of Appeals.

The Appeals Court noted that the advance notice rule helps protect a taxpayer’s reputation when the IRS goes too far afield in its request. While the taxpayer is allowed, under §7609, to attempt to quash a summons once it is issued, the mere issuance of a summons to a third party can damage the taxpayer’s reputation. To prevent the contact with third parties, the taxpayer could decide to voluntarily provide the information, avoiding the negative inference a party (such as an employer) might draw when it appears the party in question is “in trouble” with the IRS.

The panel noted that §7602 provides three exceptions which, in the view of the Court, provided evidence the intent was to allow the taxpayer to provide information in most cases prior to the IRS seeking information from third parties. Those exceptions under §7602(c)(3) allow the IRS to skip giving advance notice if:

The taxpayer had already authorized the contact;
The IRS believes, with good cause, that the notice might jeopardize the IRS’s ability to collect the tax due or risk a reprisal against a third party; or
There is a pending criminal investigation against the taxpayer.

None of those situations applied in this case and so, the Court concluded, the notice to the taxpayer should have been sufficient to allow the taxpayer a chance to provide the information before the third party was contacted.

The panel ruled that the notice in Publication 1 was not sufficient to meet that obligation. As the panel noted:

Publication 1, alone, does not offer this level of specificity. It simply tells the taxpayer that the IRS may “sometimes talk with other persons if we need information that you have been unable to provide . . .”; it does not reference specific documents or people, or even categories of documents or people. When the IRS uses Publication 1 as it was used here, mailed with an introductory letter and divorced from any specific request for documents, we do not think it reasonable for the IRS to fear that a person who received the publication would have enough information to spoil a criminal investigation or retaliate against a potential third-party source.

The Court also found that their reading requiring the taxpayer to get notice in a fashion that would reasonably apprise the taxpayer of the contact had support in the legislative history of IRC §7602, noting:

The notice requirement’s proponents were the members of the Senate Finance Committee, which adopted an amendment that prohibited the IRS from contacting “any person other than the taxpayer” unless the IRS provided “reasonable notice to the taxpayer that such contact will be made.” H.R. 2676, 105th Cong. § 3417 (as passed by Senate May 7, 1998). The Committee recognized that taxpayer protections needed to be robust because “[s]uch contacts may have a chilling effect on the taxpayer’s business and could damage the taxpayer’s reputation in the community.” S. Rep. No. 105-174, at 77 (1998), reprinted in 1998-3 C.B. 537, 613 (1998)

Ultimately, the panel concludes:

A reasonable notice must provide the taxpayer with a meaningful opportunity to volunteer records on his own, so that third-party contacts may be avoided if the taxpayer complies with the IRS’s demand.