Abatti v. Commissioner

Ben and Tony Abatti (plaintiffs) conducted business through three entities that engaged in undocumented intercompany transfers. In auditing the entities’ 1971 through 1973 taxes, the Internal Revenue Service (IRS) met with Charles Pinney and Mickey Macklin—the Abattis’ lawyer and accountant, respectively—and received a binder regarding the transfers. In April 1976, the IRS sent revenue agent’s reports for 1971 and 1972 to the Abatti entities and Pinney, in which the IRS proposed adjustments to the income and deductions pursuant to Internal Revenue Code § 482 because the intercompany transfers did not clearly reflect income. The IRS also issued deficiency notices regarding the Abatti entities. The notices did not mention § 482 or fraud. The Abattis filed petitions against the IRS commissioner (defendant) with the United States Tax Court challenging the IRS’s determinations. The petitions referred to § 482. In June 1976, the IRS received a second binder with additional intercompany-transfer information. In March 1977, the IRS issued deficiency notices regarding the Abatti entities for 1974. These notices did not mention § 482 or fraud. In around June 1978, the Abattis replaced Pinney with James Hewitt, an experienced tax lawyer. On June 7, Hewitt asked counsel for the commissioner what legal theories the commissioner intended to pursue at the June 21 trial. The commissioner’s lawyer responded that he could not answer until the next week. On June 16, the commissioner’s lawyer advised that the commissioner would rely on § 482. At trial, the Tax Court granted the Abattis’ motions to (1) exclude the commissioner’s reliance on § 482 because the commissioner did not provide fair warning of his intended reliance on § 482, (2) shift the burden of proof to the commissioner because the commissioner effectively was alleging fraud due to differences between the Abattis’ individual tax returns and the entities’ returns despite the deficiency notices’ not alleging fraud, and (3) limit the commissioner’s reliance to properly raised issues. The Tax Court also allowed the commissioner to amend his answer to allege fraud, which shifted the burden of proof to the commissioner. The Tax Court ruled for the Abattis. The commissioner appealed, arguing that the Tax Court erred by precluding him from relying on § 482 and by shifting the burden of proof to him.