Aroeste v. The United States of America

• Court: District Court, S.D. California
• Decided: February 13, 2023
• Docket: 3:22-cv-00682
• Status: Unknown

Opinion

1 2 3 4 5 6 7 8 UNITED STATES DISTRICT COURT 9 SOUTHERN DISTRICT OF CALIFORNIA 10 11 ALBERTO AROESTE and ESTELLA Case No.: 22-cv-682-AJB-KSC AROESTE, 12 ORDER ON JOINT DISCOVERY Plaintiffs, 13 MOTION [Doc. No. 36] v. 14 UNITED STATES OF AMERICA, 15 Defendant. 16

17 I. Introduction 18 Plaintiffs Alberto and Estella Aroeste sued the United States seeking to recoup 19 penalty payments and to discharge their liability for penalties still outstanding for the non- 20 filing of a Report of Foreign Bank and Financial Accounts (“FBAR”) for the years 2012 21 and 2013 pursuant to 31 U.S.C. § 5321. Doc. No. 1 ¶ 9. The FBAR penalties at issue were 22 assessed against the plaintiffs after a three-year administrative audit of their filings for tax 23 years 2011 through 2015. See Doc. No. 1 ¶¶ 11, 40-44. The United States counterclaimed 24 against plaintiffs to recover the balance of unpaid penalties. Doc. No. 11. On September 25 26, 2022, the District Court partially stayed this case pending the Supreme Court’s 26 resolution of United States v. Bittner, 19 F.4th 734 (9th Cir. 2021), cert. granted 142 S. Ct. 27 2833 (2022), on grounds the Bittner decision will control the monetary penalties allegedly 28 1 owed by plaintiffs to the United States. See Doc. Nos. 24, 25. Notwithstanding the stay, 2 the parties are permitted to litigate the following two issues: “(1) whether Alberto Aroeste 3 was a resident of Mexico under the United States – Mexico income tax treaty; and (2) 4 [whether Alberto was] a ‘United States person’ required to file a Report of Foreign Bank 5 and Financial Accounts (FBAR) for 2012 and/or 2013.” Doc. No. 25. 6 On January 3, 2023, counsel for both parties jointly spoke with the Court’s staff 7 about a discovery dispute. Based on the information provided by counsel, the Court 8 understands that plaintiffs seek in discovery the entire administrative record generated by 9 the Internal Revenue Service (“IRS”) during the (now completed) IRS audit of plaintiffs. 10 See Doc. No. 34 at 2. After hearing the parties’ basic positions on the issue, the Court 11 ordered the parties to file a Joint Discovery Motion. See id. at 3-4. The Court specifically 12 directed the parties to focus their briefing on the following two issues: 13 1. How is Alberto Aroeste’s status under the United States – Mexico tax treaty 14 germane to the issue of whether Mr. Aroeste was required to file the FBAR reports at issue 15 in this case? 16 2. Assuming Mr. Aroeste’s status under the tax treaty is relevant, how is 17 discovery of the entire administrative record in this matter relevant and proportional 18 (within the meaning of Rule 26) to determining Mr. Aroeste’s status under the tax treaty 19 and determining whether he was a “United States person” for purposes of filing an FBAR? 20 See Doc. No. 34 at 3 21 The parties filed the Joint Motion on January 17, 2023. See Doc. No. 36. On January 22 20, 2023, the Court held a discovery conference at which counsel for both parties argued 23 their respective positions. See Doc. Nos. 37, 41. Having reviewed the papers and heard 24 argument from the parties, the Court GRANTS IN PART AND DENIES IN PART the 25 plaintiffs’ request to discover the entire administrative record for the reasons set forth in 26 this Order. 27 // 28 // 1 II. Factual Background of This Discovery Dispute 2 Based on the briefing and the Court’s multiple colloquies with counsel for the 3 parties, the Court understands the following facts are essentially undisputed: The IRS 4 audited both plaintiffs’ tax filings for the 2011 through 2015 tax years. That audit resulted 5 in an assessment of approximately $3,000,000 of tax and penalty liability. The bulk of 6 plaintiffs’ liability arose from penalties assessed for failure to file so-called “information 7 returns.” Those amounts are not directly at issue in this lawsuit, and the plaintiffs are not, 8 at least at this time, directly contesting them in any judicial or administrative forum. Post- 9 audit income tax assessments accounted for another portion of plaintiffs’ liability to the 10 government. Those tax assessments are likewise not at issue in this lawsuit, but the 11 plaintiffs have challenged them before the United States Tax Court. Finally, the audit led 12 to the FBAR penalties at issue in this lawsuit, which were assessed only for tax years 2012 13 and 2013, because, whether rightly or wrongly, the plaintiffs did not disclose their holdings 14 in various foreign bank accounts during those tax years. 15 Plaintiffs served a first set of requests for production of documents in November 16 2022. The parties have narrowed the scope of the requests through the meet-and-confer 17 process such that plaintiffs only seek the complete administrative record, including those 18 portions of the record generated during the administrative appeal process. The complete 19 administrative file for the IRS’s audit is a voluminous document that will, if fully produced, 20 include over 7,000 pages of documentary evidence. Only a portion of the IRS’s audit 21 directly concerned the actual imposition of FBAR penalties. The majority of the audit 22 concerned the IRS’s determination of the plaintiffs’ residency under the United States – 23 Mexico Tax Treaty (hereinafter “the Treaty”) for the tax years subject to audit. The 24 complete administrative record will contain not only information provided to the IRS by 25 the plaintiffs during the audit, but also evidence gathered as part of the IRS’s independent 26 investigation. The United States has thus far produced between 800 and 900 pages of 27 documents, at least some of which have been extracted from the administrative record, but 28 1 it has limited its production to those portions of the record it contends are related solely to 2 imposing the FBAR penalties at issue in this lawsuit. 3 III. ANALYSIS 4 The parties herein dispute the threshold issue of whether the IRS’s entire 5 administrative record is relevant to this action. The discovery process should, in theory, be 6 cooperative and require little to no supervision from the Court. Sali v. Corono Reg’l Med. 7 Ctr., 884 F.3d 1218, 1219 (9th Cir. 2018). However, a party seeking discovery may move 8 the Court to issue an order compelling production. Fed. R. Civ. P. 37(a). This Court has 9 broad discretion to permit or deny discovery. Hallett v. Morgan, 296 F.3d 732, 751 (9th 10 Cir. 2002). Discovery must be “relevant to any party's claim or defense and proportional 11 to the needs of the case.” See Fed. R. Civ. P. 26(b)(1). Ninth Circuit case law does not 12 clearly answer the question of whether the party seeking discovery bears an initial burden 13 of demonstrating the relevance of that discovery, or whether the party resisting discovery 14 must make a showing of irrelevance to sustain an objection. See Fei Fei Fan v. Yan Yao 15 Jiang, 2023 U.S. Dist. LEXIS 6544, at *5-6 (D. Nev. Jan. 13, 2023); V5 Techs v. Switch, 16 Ltc., 334 F.R.D. 306, 309-10 (D. Nev. 2019). It is settled, however, that if the information 17 sought is relevant, the party resisting discovery bears the ultimate burden of convincing the 18 Court that the discovery sought should not be permitted. See V5 Techs, 334 F.R.D. at 309 19 (citing Blankenship v. Hearst Corp., 519 F.2d 418, 429 (9th Cir. 1975)). 20 Whether this relevance standard is satisfied here depends on two distinct issues. The 21 first issue is purely legal: does Alberto Aroeste’s tax residency status under the Treaty have 22 any legal effect on whether he was required to file FBAR forms in 2012 and 2013? The 23 second issue is more inherently factual: if Mr. Aroeste’s tax residency status under the 24 treaty is relevant to this matter, does discovery of the administrative record properly further 25 that determination (as well as the determination of whether he was required to file FBARs 26 more generally)? 27 // 28 // 1 (A) Whether Mr. Aroeste’s Tax Residency Status Under the Treaty is Legally 2 Relevant to the IRS’s Imposition of FBAR Penalties 3 The answer to whether Alberto Aroeste’s status under the Treaty has any effect on 4 the issue of the FBAR filing requirement in tax years 2012 and 2013 depends on the 5 application of multiple, interconnected statutes and regulations. Anyone who qualifies as a 6 “United States person” must file an annual FBAR report to disclose foreign bank holdings, 7 and the IRS assesses penalties against those “United States persons” who fail to file. See 8 31 C.F.R. § 1010.350(a); Bedrosian v. U.S. Dep’t of Treasury, 912 F.3d 144, 147 (3d Cir. 9 2018). Thus, as the government acknowledges, whether Mr. Aroeste was a “United States 10 person” is potentially outcome determinative of his liability for the FBAR penalties at issue 11 in this case. See Doc. No. 36 at 7. 12 The parties dispute whether Mr. Aroeste’s status under the Treaty has any bearing 13 on whether he was properly considered a “United States person” for purposes of filing 14 FBARs. Compare id. at 2-4 with id. at 7-9. Plaintiffs contend that, if Mr.Aroeste was 15 treated as a Mexican resident under the Treaty, that fact would disqualify him from being 16 counted as a “United States person” under the FBAR regulations. See id. at 2-3. Defendant 17 contends Mr. Aroeste’s status under the Treaty is irrelevant because the Treaty solely 18 concerns residency for purposes of income tax and excise tax assessments under Title 26 19 of the United States Code, whereas FBAR penalties are assessed under Title 31. See id. at 20 7-8. 21 “United States person,” as used in the context of FBAR assessments, is a term of art 22 specifically defined in the applicable Title 31 regulations. See generally 31 C.F.R. 23 § 1010.350(b). The term applies to, among other things, “[a] resident of the United States.” 24 Id. § 1010.350(b)(2). “[R]esident of the United States” is further defined to include an 25 individual who is a “resident alien” under 26 U.S.C. 7701(b) and the regulations 26 thereunder. Id. 27 A non-U.S. citizen is treated as a “resident alien” if he or she is a “lawful permanent 28 resident of the United States at any time” during an applicable calendar year. 26 U.S.C. 1 § 7701(b)(1)(A)(i). An individual is a “lawful permanent resident” if he or she has been 2 “lawfully accorded the privilege of residing permanently in the United States as an 3 immigrant in accordance with immigration laws” and if “such status has not been revoked 4 (and has not been administratively or judicially determined to have been abandoned).” Id. 5 § 7701(b)(6). However, “lawful permanent resident” status ceases to exist—at least for tax 6 purposes—if an individual “commences to be treated as a resident of a foreign country 7 under the provisions of a tax treaty between the United States and the foreign country, does 8 not waive the benefits of such treaty applicable to residents of the foreign country, and 9 notifies the Secretary of the commencement of such treatment.” Id.1 10 The upshot of this statutory and regulatory framework applicable to this action, in 11 which tax treaties provide a potential escape hatch that excuses certain “United States 12 persons” from filing FBARs, can be expressed as a 5-step process: 13 (1) Under 26 U.S.C. § 7701(b)(6), anyone allowed to permanently reside within 14 the United States by virtue of US immigration laws is a “lawful permanent 15 resident” for tax purposes unless an applicable tax treaty allows that person 16 to be treated as a resident of a foreign country for tax purposes only; 17 (2) Under 26 U.S.C. § 7701(b)(1)(A)(i), any “lawful permanent resident” is a 18 “resident alien”; 19 (3) Under 31 C.F.R. § 1010.350(b)(2), any “resident alien” is a “resident of the 20 United States”; 21 (4) Under 31 C.F.R. § 1010.350(b), Any “resident of the United States” is a 22 “United States person” required to file an FBAR; 23

24 25 1 Plaintiffs’ counsel emphasizes that one can remain a lawful permanent resident for immigration purposes, but at the same time be treated as a resident of a foreign country for 26 tax filing purposes under a tax treaty. See Doc. No. 41 at 15:16-17:9. Thus, Mr. Aroeste’s 27 country of “residency” under the Treaty might be “Mexico” when it comes to filing his taxes, but he can remain a lawful permanent resident who, as a matter of immigration law, 28 1 (5) Therefore, any person allowed to permanently reside in the United States by 2 virtue of US immigration laws must file an FBAR unless that person is entitled 3 to be treated as a resident of a foreign country under a tax treaty. 4 It is undisputed that Mr. Aroeste is, and for many years has been, a “lawful 5 permanent resident” of the United States as a matter of immigration law. Doc. No. 41 at 6 15:11-24. To use the colloquial terminology, he has a “green card.” Id. His status as a 7 “lawful permanent resident” in turn makes him a “resident alien,” which means he is a 8 “resident of the United States” and therefore, by operation of the statutes and regulations, 9 at least presumptively a “United States person” required to file FBARs. The question is 10 whether the Treaty provides him an escape hatch. Because the United States and Mexico 11 indisputably have a tax treaty, Mr. Aroeste would not be a lawful permanent resident within 12 the meaning of 26 U.S.C. section 7701(b)(6) if he commenced to be treated as a resident 13 of Mexico under the Treaty (with the additional caveats enumerated in the statute); which 14 might in turn have ultimately excused him from the requirement to file FBARs as a “United 15 States person.” The Court therefore concludes a determination of Mr. Aroeste’s tax 16 residency under the Treaty is directly relevant to—indeed it is outcome determinative of— 17 the issue of whether he was required to file the FBARs at issue in this lawsuit. 18 The United States first suggests application of the Treaty is irrelevant here because 19 the Treaty only concerns income taxes and excises taxes, and Mr. Aroeste was assessed 20 FBAR penalties under a wholly different body of law. See Doc. No. 36 at 7. But this 21 argument does not refute the plain language of the FBAR regulations, which explicitly 22 invoke provisions of Title 26, including the provision that requires consideration of an 23 individual’s status under an applicable tax treaty for the purpose of determining whether 24 an individual is a “United States person” subject to FBAR filing. 25 The United States further suggests it “does not matter” how Mr. Aroeste was treated 26 under the Treaty because “[i]t only matters that Mr. Aroeste has lawful permanent 27 residence and has not rescinded that residency.” Doc. No. 36 at 8. But, again, the statutory 28 framework explicitly provides that “lawful permanent resident” status can be abrogated, 1 for tax purposes only, by application of the Treaty, without requiring individuals to forsake 2 their immigration status to claim the taxation benefits of a tax treaty. See 26 U.S.C. 3 § 7701(b)(6). Based on the Court’s reading of the controlling law, the Court 4 OVERRULES defendant’s objection that considerations of the Treaty are legally 5 irrelevant to this lawsuit. Accordingly, if the administrative record is factually relevant and 6 proportional to determining Mr. Aroeste’s residency status under the Treaty (and also to 7 assessing whether Mr. Aroeste was a “United States person” for any other reasons), it is 8 discoverable. 9 (B) Whether the Administrative Record is Relevant to Determining Mr. 10 Aroeste’s Status Under the Treaty or Determining Whether He Was Otherwise 11 a “United States Person” For Purposes of Filing an FBAR 12 Plaintiffs have acquired a redacted copy of the IRS’s administrative record from the 13 audit through a provision of the Taxpayer First Act. Doc. Nos. 1 ¶ 42; 36 at 5-6; 41 at 7:24- 14 8:7. That copy is, according to plaintiffs, incomplete because it omits any information 15 added to the record after the initial audit, and it was heavily redacted by the IRS when 16 produced to plaintiff during the administrative appeal. Doc. No. 41 at 7:24-8:7, 8:19-9:4.2 17 According to plaintiffs, their review of the documents suggests the vast majority of the 18 IRS’s audit concerned whether Mr. Aroeste was a resident of the United States or of 19 Mexico under the Treaty. See Doc. Nos. 36 at 5; 41 at 7:5-18. As represented, the IRS’s 20 record includes information gathered by the IRS auditor to determine how much time Mr. 21 Aroeste spent in the United State and Mexico during the tax years at issue, which country 22 was his permanent home, and in which country he has the most significant economic and 23 family relationships. Doc. No. 41 at 7:5-18. All this information bears upon whether he is 24

25 2 Plaintiffs’ counsel further suggests the administrative record is still being augmented 26 as the IRS commences further penalty proceedings against the plaintiffs. See Doc. No. 41 27 at 10:22-11:4. If that is true, then the United States could conceivably be under a continuing duty to supplement if newly incorporated documents fall within the scope of any order 28 1 a resident, for tax-filing purposes only, of the United States or of Mexico under the Treaty. 2 Id. at 4:19-5:17, 7:10-18. The United States does not appear to meaningfully dispute this 3 assertion about the nature and contents of the record. 4 As the Court has already concluded, Mr. Aroeste’s residency under the Treaty is a 5 potentially dispositive issue in this matter. If, under the Treaty, he was a Mexican resident 6 in 2012 and 2013, he would have no obligation to file FBARs; but if he was a resident of 7 the United States during this time frame, he is liable for some amount of FBAR penalties. 8 Mr. Aroeste seeks to prove he was a Mexican resident for tax purposes, and thereby avoid 9 any liability for his admitted failure to file FBARs. Doc. No. 41 at 5:21-6:7. The IRS’s 10 administrative record bears directly on that issue. It is, therefore, relevant to this matter. 11 However, Mr. Aroeste was only assessed FBAR penalties in 2012 and 2013, and the 12 administrative audit encompassed tax years 2011 through 2015. See Doc. No. 1 ¶¶ 9, 11, 13 40-44. Mr. Aroeste has not explained to the Court how his residency in any years other 14 than 2012 or 2013 has any bearing on whether he was a resident of the United States during 15 those years. Indeed, his counsel appears to agree it would be sufficient to consider only the 16 information bearing on the tax years in which Mr. Aroeste was assessed FBARS, i.e., 2012 17 and 2013. Doc. No. 41 at 18:6-20.3 Thus, the Court concludes the only portions of the 18 record relevant to this case are those portions that bear upon Mr. Aroeste’s residency under 19 the Treaty for tax years 2012 and 2013. 20 The United States argues discovery of the administrative record would violate the 21 stay in this case. Doc. Nos. 36 at 9-10; 41 at 11-12. This Court disagrees. Mr. Aroeste’s 22 residency under the Treaty is open to discovery notwithstanding the partial stay. See Doc. 23

24 25 3 Plaintiffs’ counsel asserts that it does not matter when information entered the record, e.g., if it were added to the record after the initial audit yet bore upon Mr. Aroeste’s 26 residency during 2012 and 2013, it should nonetheless be discoverable. See Doc. No. 41 at 27 19. The Court agrees. The proper focus here is on whether the information in the record pertains to determining Mr. Aroeste’s residency in 2012 and 2013 under the Treaty, not 28 1 Nos. 25, 27. Insofar as portions of the administrative record relate to Mr. Aroeste’s 2 residency under the Treaty for tax years 2012 and 2013, they are relevant and within the 3 permissible scope of discovery set forth in the District Court’s September 26, 2022, Order. 4 The United States further states the bulk of the record is not relevant because it 5 concerns liability for income taxes and information penalties not at issue in this lawsuit 6 and that discovery should be limited exclusively to the assessment of FBAR penalties. Doc. 7 No. 36 at 9. The United States claims it can parse the information in the record and produce 8 that which it “deems relevant to the income tax treaty and the 2012, 2013 FBAR penalty” 9 while at the same time withholding those portions that pertain to the assessment of Mr. 10 Aroeste’s residency under the Treaty but are somehow “not relevant to the FBARs.” See, 11 e.g., Doc. No. 41 at 24:5-25:8, 28:25-30:22. Mr. Aroeste’s counsel correctly notes 12 residency under the Treaty is a single question that is not divisible into ‘FBAR purposes’ 13 or ‘income tax purposes.’ Doc. No. 41 at 26:12-28:24, 31:3-32:23. There is simply no 14 authority for the government’s contention that application of the Treaty’s test for tax 15 residency differs on the basis of the taxes or penalties assessed against a taxpayer. Thus, 16 although Mr. Aroeste’s residency under the Treaty may be relevant to assessing liabilities 17 not at issue in this case, the United States’ argument creates an illusory distinction. In sum, 18 assessment of the Title 26 (tax and information penalty) issues are resolved on the same 19 factual basis as the Title 31 (FBAR penalty) issues in the audit. Doc. No. 36 at 6. The Court 20 therefore concludes that all information related to determining Mr. Aroeste’s residency 21 under the Treaty in 2012 and 2013 is discoverable, not just that information related to the 22 imposition of FBAR penalties.4 23

24 25 4 Plaintiff’s counsel has expressed concern about the United States construing the scope of relevant information narrowly, and thereby refusing to produce otherwise 26 discoverable information. See, e.g., Doc. No. 41 at 26:12-28:24, 30:24-32:23. The Court is 27 confident the United States will abide by the Court’s determination of what is relevant and discoverable as delineated in this Order. The Court’s Order requires the United States to 28 1 The United States also argues evidence related to Mr. Aroeste’s residency under the 2 Treaty is not relevant to this case because Mr. Aroeste did not timely claim the benefits of 3 the Treaty. See Doc. No. 41 at 13:25-15:1, 20:3-23:8. Litigants, however, are not required 4 to supply proof of their claims as a precondition of obtaining discovery. See generally Big 5 City Dynasty v. FP Holdings, L.P., 336 F.R.D. 507, 512-13 (D. Nev. 2020) (collecting 6 cases); accord Reed v. 1-800 Contacts, Inc., 3:12-cv-2359-JM-BGS, 2013 U.S. Dist. 7 LEXIS 192753, at *5-6 (S.D. Cal. Mar. 29, 2013). Rather, discovery must merely be 8 relevant to an asserted claim. Fed. R. Civ. P. 26(b)(1). Whether a litigant can satisfy the 9 ultimate burden of persuasion is a factual question wholly separate from the discoverability 10 of facts and information relevant to those claims. Big City Dynasty, 336 F.R.D. at 512-13. 11 The United States’ final argument derives from a concern that plaintiffs are trying 12 to obtain the entire IRS administrative record so they can use it for “leverage” in their case 13 currently pending before the United States Tax Court or to prepare for a yet-unfiled action 14 challenging the information penalties. See Doc. No. 36 at 8-9. The Court is responsible for 15 determining whether the administrative record is discoverable in this case. In any event, 16 the Court has already restricted the information that will be disclosed to the plaintiffs to 17 that which is germane to this lawsuit and the FBAR penalties at issue. The Court, having 18

19 turn over any information that is relevant to determining Mr. Aroeste’s residency under the 20 Treaty, whether that information tends to inculpate or exculpate him in this matter. The 21 Court also notes the United States has a subject matter expert on hand, namely, the IRS auditor who compiled the record at issue. Because the IRS was presumably competent to 22 assess Mr. Aroeste’s status under the Treaty when it imposed penalties against him, the 23 IRS is likewise competent to assist the United States’ counsel in determining the scope of responsive documents. The Court notes, however, that counsel for the United States may 24 not rely entirely on the IRS to make this determination, because an attorney appearing 25 before this Court has an independent obligation, imposed as a function of her signature on a party’s discovery responses, to ensure all responses and disclosures comply with a party’s 26 discovery obligations. See Fed. R. Civ. P. 26(g). As such, counsel for the United States 27 must be involved in the process of identifying responsive documents and must independently determine that any information withheld in discovery falls outside the scope 28 1 concluded the portions of the record that pertain to Mr. Aroeste’s status under the Treaty 2 || for tax years 2012 and 2013 are discoverable, accordingly OVERRULES IN PART AND 3 || SUSTAINS IN PART the United States objection that the administrative record exceeds 4 ||the scope of discovery permissible under Rule 26. 5 Ht. CONCLUSION 6 The legal question of Mr. Aroeste’s residency under the Treaty during tax years 2012 7 2013 is directly relevant to this matter. The IRS’s administrative record contains 8 ||information that is relevant to that issue because it contains the information the IRS 9 ||considered in determining that Mr. Aroeste was a resident of the United States under the 10 || Treaty for tax years 2012 and 2013. It is, therefore, discoverable. However, only 11 |/information in the record related to determining Mr. Aroeste’s status under the Treaty 12 || during tax years 2012 and 2013 is relevant and subject to production because other tax 13 || years are not at issue in this matter. 14 Accordingly, the United States must produce all portions of the administrative 15 ||record, whether generated during the initial audit or during any subsequent 16 || proceedings, which are relevant to Mr. Aroeste’s residency under the Treaty during 17 || tax years 2012 and 2013. To the extent the United States seeks to withhold information 18 |/on the basis of a privilege, the government must simultaneously produce a privilege log 19 || that fully complies with Paragraph IX of this Court’s Chambers’ Rules. The United States 20 |/is ordered to produce all documents as delineated herein within 14 days of the date of this 21 || Order. 22 IT IS SO ORDERED. 23 || Dated: February 13, 2023 Jk. Kn 24 Mian □□ 25 Hori. Karen 8S. Crawford United States Magistrate Judge 26 27 28