Before the end of the U.S. Supreme Court’s term in June, the Court issued a landmark decision in SEC v. Jarkesy, et al., holding that the Seventh Amendment entitles a defendant to a jury trial when the U.S. Securities and Exchange Commission (“SEC”) pursues civil penalties for securities fraud. The Court’s opinion will have a significant impact on tax penalties imposed by the Internal Revenue Service (the “IRS”).
Chief Justice Roberts authored the majority opinion. Justice Sotomayor dissented, and Justice Gorsuch concurred.
The Jarkesy decision is apt to be regarded as a landmark opinion in the coming months and years, because the Court’s opinion arguably applies to “punitive” civil penalties imposed by other administrative agencies, including the IRS. In particular, 26 U.S.C. § 6700 tax promoter penalties, as well as other penalties enforced by the IRS, share many of the hallmarks of the “punitive” civil fraud penalties at issue in Jarkesy.
Congress created the SEC to enforce the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Advisers Act of 1940 (collectively, the “Acts”), including the respective “antifraud provisions.” At issue in Jarkesy were civil penalties imposed pursuant to the antifraud provisions of the Acts (the “civil fraud penalties”). After Congress passed the Dodd-Frank Act in 2010, the SEC could ostensibly “seek civil [fraud] penalties in federal court, or . . . impose them through its own in-house proceedings.”
In Jarkesy, the Court explained that the “threshold issue is whether this action implicates the Seventh Amendment. It does. The SEC’s antifraud provisions replicate common law fraud, and it is well established that common law claims must be heard by a jury.” The Seventh Amendment provides, in relevant part: “In suits at common law, where the value in controversy shall exceed twenty dollars, the right of trial by jury shall be preserved[.]” If the SEC seeks to impose civil fraud penalties, the Court’s opinion, in effect, requires the SEC to file suit in federal court and try the issue before a jury.
In analyzing whether the civil fraud penalties implicate the Seventh Amendment, the Court considered whether civil fraud penalties resembled a common law action, including the remedy provided. The Court noted that the remedy was the “more important” consideration in the analysis. Accordingly, the Court found “the remedy [was] . . . all but dispositive.”
The Court reasoned that the monetary damages sought from the civil fraud penalties are the “prototypical common law remedy.” In particular, the Court noted that, historically, “civil penalties are a type of remedy at common law that could only be enforced in courts of law.”
The Court also analyzed whether the civil fraud penalties were remedial or punitive in nature. In other words, the Court analyzed whether the monetary damages were “designed to punish or deter the wrongdoer, or, on the other hand, solely to ‘restore the status quo’”? Under the Securities Exchange Act and the Investment Advisers Act, six factors are relevant to whether the SEC may seek to impose the civil fraud penalties. Of the six factors, the Court explained that “several concern culpability, deterrence, and recidivism,” and the availability of the civil fraud penalties is tied to the perceived need to punish the defendant rather than restore the victim’s status quo. As summarized by the Court, “the civil penalties in this case are designed to punish and deter, not to compensate. They are therefore ‘a type of remedy . . . that could only be enforced in courts of law.”
After holding that the civil fraud penalties implicated the Seventh Amendment, the Court then analyzed whether the “public rights” exception did not require a jury trial. Pursuant to the public rights exception, Congress is permitted to provide that certain matters may be adjudicated internally by an agency without initial involvement by an Article III federal district court. The majority concluded that an enforcement action for the civil fraud penalties involved a “matter[] of private rather than public right,” and Congress may not withdraw the action from the judiciary.
Implications for Penalties Asserted by the Internal Revenue Service
Jarkesy will be cited by those seeking to avoid “punitive” civil penalties imposed by other administrative agencies, including the IRS. In her dissent, Justice Sotomayor noted the “momentous consequences that flow from the majority’s insistence that the Government’s rights to civil penalties must now be tried before a judge in federal court.” In addition, Justice Sotomayor noted there are, at the very least, more than two dozen agencies that can impose civil penalties in administrative proceedings, including the Department of Treasury and the Department of Justice.
In particular, the Section 6700 tax promoter penalty is one of more draconian weapons in the IRS’s arsenal. Under Section 6700, the IRS can assess a penalty for the promotion of certain “tax shelters” where an individual makes statements with respect to the allowability of any deduction or credit, the excludability of any income, or the securing of any other tax benefit, which the person knows or has reason to know is false or fraudulent as to any material matter. The penalty is 50 percent of the gross income derived from the activity. Recently proposed legislation would increase this penalty to 200% of gross income.
Deficiency procedures do not apply with respect to the assessment or collection of the Section 6700 penalty, meaning that the taxpayer cannot challenge the penalty in Tax Court prior to payment. A taxpayer can challenge a promoter penalty by making a payment of at least 15 percent of the penalty amount and submitting an administrative claim for refund. If the IRS rejects the refund claim, the taxpayer may file a complaint in district court to obtain a refund within 30 days after the denial of the claim, or the taxpayer can pay the penalty in full and bring a traditional refund claim within two years. Compared to judicial review of the SEC civil fraud penalties in Jarkesy, judicial review of a refund action occurs post-assessment, after the taxpayer has been forced to pay a portion, or all of, the penalty.
Although the application of Jarkesy to the IRS has not yet been addressed by the courts, the Section 6700 tax promoter penalty shares many of the hallmarks of the “punitive” civil fraud penalties at issue in Jarkesy. The Court’s opinion in Jarkesy limits the IRS’s ability to assess Section 6700 tax promoter penalties without first bringing suit in federal district court.
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