Tax Court Reaffirms Soroban Holding that “Active” Limited Partners are Subject to Self-Employment Tax
On December 23, 2024, the Tax Court ruled in Denham Capital Management LP v. Commissioner (T.C. Memo. 2024-114)[1], that limited partners that actively participated in the activities of a fund manager formed as a state law limited partnership were subject to self-employment tax on all of their distributive share of income from the partnership. The Tax Court found that, consistent with its earlier ruling in Soroban Capital Partners LP v. Commissioner, 161 T.C. 310 (2023), limited partners of a state law limited partnership are not automatically entitled to the “limited partner exception” to self-employment tax under Section 1402(a)(13).[2] Rather, a functional analysis test must be applied to determine whether any state law limited partner should be considered a “limited partner, as such”[3] for purposes of the limited partner exception. The Tax Court applied the functional analysis test and found that each of the Denham limited partners’ activities, roles, and responsibilities rose to the level of those of an “active partner,” and therefore the limited partners did not qualify for the limited partner exception.
A similar case challenging the Soroban interpretation of the term “limited partner” in Section 1402(a)(13), Sirius Solutions LLLP v. Commissioner (Docket No. 30118-21), is pending in the Fifth Circuit Court of Appeals. In the meantime, however, the Denham and Soroban rulings have further entrenched the IRS’ position that a limited partner actively participating in a partnership will be subject to self-employment tax.
Our prior summary of Soroban is linked here.
[1] Denham Capital Management LP v. Commissioner (T.C. Memo. 2024-114)
[2] All Section references are to the Internal Revenue Code of 1986, as amended.
[3] Section 1402(a)(13) (which excludes from the definition of “self-employment income” the “distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in Section 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services. . .” (emphasis added)).
Federal Government Urges Court of Appeals to Uphold Constitutionality of FCA Qui Tam Provisions
Headlines that Matter for Companies and Executives in Regulated Industries
Federal Government Urges Court of Appeals to Uphold Constitutionality of FCA Qui Tam Provisions
In a brief filed earlier this week, the US federal government has urged the Eleventh Circuit Court of Appeals to uphold the constitutionality of the False Claims Act’s (FCA) qui tam provisions, challenging a Florida district court’s ruling that found them to be unconstitutional.
The appeal stems from an underlying case with relator Clarissa Zafirov, who filed a qui tam action in 2019 against several health care entities, accusing them of misrepresenting patient conditions to Medicare. While the government initially declined to intervene, it later elected to defend the constitutionality of the FCA’s provisions.
At the district court level, the court found that whistleblowers are officers of the United States and must be appointed according to the appointments clause, leading to the dismissal of Zafirov’s suit. Per the government’s appellate brief, the district court decision is an “outlier ruling” that contradicts US Supreme Court precedent. The government specifically pointed to the decision in Vermont Agency of Natural Resources v. United States ex rel. Stevens, 529 US 765 (2000), in which the Supreme Court held that the FCA’s qui tam provisions are consistent with Article III and argued that this makes clear that relators do not exercise executive power when they sue under the Act. Instead, relators are “pursuing a private interest in the money they will obtain if their suit prevails.” As such, they do not exercise executive power and do not require appointment under the appointments clause.
The government further emphasized that qui tam actions are subject to government oversight and cannot proceed without the government’s decision on intervention. Accordingly, the federal government now seeks to reverse the district court’s decision and has urged the Eleventh Circuit Court of Appeals to maintain the established legal framework supporting whistleblower actions under the FCA.
The case is Clarissa Zafirov v. Florida Medical Associates LLC et al., Nos. 24-13581 and 24-13583, in the US Court of Appeals for the Eleventh Circuit. The government’s appellate brief is available here.
Community Health Network Reaches Third FCA Settlement in 10 Years, Agreeing to Pay $135 Million to Resolve Outstanding Claims
In a deal reached two years after the Indiana health care system agreed to pay $345 million to settle FCA allegations with the federal government, Community Health Network has now agreed to pay $135 million to resolve federal health care fraud claims brought by its former chief financial officer.
Over 10 years ago, in 2014, Community Health CFO and COO Thomas Fischer filed a lawsuit under the FCA’s qui tam provisions, alleging that Community Health overpaid physicians to secure referrals in violation of state and federal laws, including the federal Stark Law and Anti-Kickback Statute (AKS). Per the complaint, Community Health utilized an “aggressive strategy” to grow its physician network and garner referrals, including the recruitment of doctors by providing payment in excess of the market rate through large base salaries and sizable bonuses, among other means.
The US Department of Justice (DOJ) elected to intervene in the case. The $345 million settlement addressed some of Fischer’s claims, leaving others unresolved. In 2020, the district court allowed Fischer to file an amended complaint that asserted additional FCA claims separate from those pursued by the government. This latest settlement with Community Health resolves those remaining claims. Among other things, the deal resolves claims that (1) Community Health paid above fair-market value rent to a physician-owned real estate partnership to induce those doctors to refer patients to a Community Health-owned ambulatory surgical center in violation of the AKS, and (2) Community Health overpaid physicians employed by the organization and also by an independent oncology group that contracted exclusively with the health nonprofit.
Notably, Community Health additionally reached a $20.3 million settlement with the DOJ in 2015 to resolve civil allegations that the health nonprofit submitted false claims to Medicare and Medicaid programs. All told, Community Health has now paid more than half a billion dollars to resolve three FCA matters over the past 10 years. Nonetheless, Community Health has emphasized that all claims were resolved with no finding of wrongdoing, and the issues were unrelated to the quality or appropriateness of the health care provided by Community Health to its patients.
The case is US and State of Indiana ex rel Fischer v. Community Health Network, Inc., et al., Case No. 1:14-cv-1215, in the US District Court for the Southern District of Indiana.
The DOJ’s press release on the 2015 $20.3 million settlement is available here. The DOJ’s press release on the 2023 $345 million settlement is available here.
Athira Pharma Inc. Agrees to Pay Over $4 Million to Settle FCA Allegations
Athira Pharma Inc., based in Bothwell, Washington, has agreed to pay $4,068,698 to settle allegations that it violated the FCA.
Per the DOJ, this settlement will resolve allegations that, between January 1, 2016, and June 20, 2021, Athira failed to report allegations of research misconduct regarding grant applications and grant award progress reports and assurances to both the National Institutes of Health (NIH) and the US Department of Health and Human Services (HHS) Office of Research Integrity. The alleged misconduct included that Athira’s former CEO, Leen Kawas, falsified and manipulated scientific images in her doctoral dissertation and in published research papers that were referenced in several grant applications submitted to NIH, including in a grant that NIH funded in 2019.
Notably, Athira immediately notified NIH of the research misconduct after the full board of directors learned of it. Underscoring the significance of cooperation credit, the DOJ noted specifically that “the company’s transparency significantly helped Athira mitigate its damages and demonstrated its resolve towards coming into compliance with the relevant law and regulations.”
The settlement additionally resolves claims brought under the FCA’s qui tam provisions, with whistleblower Andrew P. Mallon, Ph.D., receiving $203,434.
The DOJ’s press release is available here.
Iron Man 2 Actor Sentenced for COVID-19 Scam
Earlier this week, Keith Lawrence Middlebrook, a bodybuilder and actor known for his role in Iron Man 2, was sentenced to over eight years in prison for attempting to defraud investors by falsely claiming he had discovered a cure for COVID-19 and that National Basketball Association legend Magic Johnson was a major investor.
Middlebrook was arrested in March 2020, becoming the first person in the United States charged with a COVID-19-related scam. The case included recorded calls with an undercover FBI agent where Middlebrook claimed his treatments could generate significant profits. Middlebrook’s scheme involved promoting fake COVID-19 treatments and soliciting investments through social media and other channels, falsely claiming Johnson’s involvement to lend credibility.
The recent sentencing follows a guilty verdict on all 11 counts of wire fraud faced by Middlebrook, rendered by a 12-person jury after a three-day trial. During sentencing, and among other things, Middlebrook denied any wrongdoing and claimed to have a relationship with Johnson, who testified that he did not recall meeting Middlebrook. While video evidence showed Middlebrook and Johnson at the same event, the court was unmoved by the defense counsel’s suggestion at trial that Johnson gave false testimony. Specifically, the court noted that it was “inconceivable” that Johnson would have forgotten some of the lengthy interactions that Middlebrook had alleged occurred between them.
In the end, the court’s sentence of 98 months aligned with the sentence sought by the prosecutors.
The case is USA v. Keith Middlebrook, No. 2:20-cr-00229, in the US District Court for the Central District of California.
Interoperability Doesn’t Imply Derivative Work
The US Court of Appeals for the Ninth Circuit explained that to be a derivative work, a program interoperative with another must actually incorporate aspects of the underlying work. The Court further ruled that licensees of a copy of a computer program are not “owners” of the copy and therefore are not entitled to make copies for the purposes permitted by 17 U.S.C. § 117(a). Oracle International Corp. v. Rimini Street, Inc., Case No. 23-16038 (9th Cir. Dec. 16, 2024) (Bybee, Bumatay, Bennett, JJ.)
Rimini provides third-party support for Oracle software and is a direct competitor with Oracle in the software support services market. For more than a decade, Oracle and Rimini have been involved in what the Ninth Circuit describes as a “pitched copyright war.” This latest battle relates to changes Rimini made to its business model after a district court determined that Rimini had infringed Oracle’s copyrights. Rimini developed a new process for servicing customers using Oracle software and sought a declaratory judgment that its revised process did not infringe Oracle’s copyrights. Oracle counterclaimed for copyright infringement and Lanham Act violations.
The district court found that Rimini created infringing derivative works because its new process interacted and was usable with Oracle software. The district court found that Rimini violated Oracle’s PeopleSoft and Database licensing agreements and made several statements violating the Lanham Act. The court struck Rimini’s affirmative defense to copyright infringement under 17 U.S.C. § 117(a), granted Oracle summary judgment that Rimini infringed Oracle’s copyrights, and issued a permanent injunction against Rimini. Rimini appealed.
Derivative Works
The Ninth Circuit disagreed with the district court’s analysis of Rimini’s new process, noting that the district court focused on an “interoperability test,” which does not exist under the text of the Copyright Act or in precedent. In effect, the district court’s test would find that if a product interoperates with a preexisting copyrighted work, then it must be derivative. The Ninth Circuit explained that while the Copyright Act uses broad language to describe derivative works, the derivative work must actually incorporate the underlying work. For Rimini’s new process to be a derivative work, it must incorporate Oracle’s copyrighted work, either literally or nonliterally. The Court found that just because Rimini’s new process interacted with Oracle’s software, that was insufficient to find it was a derivative work.
Affirmative Defense: Section 117(a)
The Copyright Act permits an owner of a copy of a computer program to make a copy or adaptation of that program for certain purposes under 17 U.S.C. § 117(a). The Ninth Circuit vacated the district court’s ruling, striking Rimini’s affirmative defense under Section 117(a), because the district court erred in determining whether Oracle’s customers “owned” a copy of Oracle’s software, PeopleSoft. The Court explained that to determine whether a party is an “owner of a copy” of a computer program, the courts look to whether the party has “sufficient incidents of ownership” over the “copy” of the software, in view of the totality of the parties’ agreement. Factors that the Court considered include:
Whether the copyright owner specifies that a user is granted a license
Whether the parties’ arrangement significantly restricts the user’s ability to transfer the software
Whether the agreement imposes notable use restrictions
The Ninth Circuit noted that other incidents of ownership may be considered, including whether the user paid significant consideration to develop the programs for the sole benefit of the user and whether the user could use the program forever, regardless of whether the parties terminated their relationship.
Copyright Infringement
The Ninth Circuit vacated the district court’s ruling that Rimini’s creation of “gap customer” environments on its systems containing Oracle’s Database program infringed Oracle’s copyright because the plain language of the licensing agreement did not prohibit third-party support providers from possessing a copy of Oracle’s software to further a client’s internal business operations. The Ninth Circuit also vacated the district court’s ruling that Rimini’s use of automated tools to deliver PeopleSoft program updates to clients constituted copyright infringement, to the extent that the conclusion rested on the district court’s erroneous view of “derivative work.”
False Advertising
The Lanham Act prohibits a person from making a false or misleading description or representation of fact about goods or services in commercial advertising or promotion. But false advertising doesn’t extend to statements of opinion and puffery. The Ninth Circuit found that Rimini’s security-related statements did not constitute false advertising under the Lanham Act, except for a statement about “holistic security.” Some of the statements were about the relative security of services offered by Oracle and Rimini, which the Court held were puffery. Some of the statements were about the need for software patching, which the Court could not say were so specific and measurable as to become actionable under the Lanham Act. The Ninth Circuit reversed the district court’s ruling as to these statements.
However, the Ninth Circuit affirmed the district court’s finding that Rimini’s offer of holistic security, which the Court accepted to mean multilayered security protection, was false because Rimini does not offer multilevel security.
Motivation MIA? Federal Circuit Sends IPR Back to the Drawing Board
The US Court of Appeals for the Federal Circuit vacated and remanded a Patent Trial & Appeal Board decision, finding that the Board erred by failing to explain its holding and reasoning regarding a motivation to combine prior art references. Palo Alto Networks, Inc. v. Centripetal Networks, LLC, Case No. 23-1636 (Fed. Cir. Dec. 16, 2024) (Stoll, Dyk, Stark, JJ.)
Centripetal Networks owns a patent directed to correlating packets in communications networks, introducing an innovative system designed to enhance network security. The patent focuses on packets (small data segments that collectively form larger communications) and their correlation across network boundaries.
Palo Alto Networks challenged the patent’s validity in an inter partes review (IPR) and argued its obviousness based on three prior art references. The first reference described a system using hashing techniques to identify packets traversing network address translation boundaries and teaching how to correlate packets across such boundaries to identify hosts transmitting or receiving them. The second reference detailed methods for detecting unauthorized traffic directed to unused IP addresses, notifying administrators of potential threats, and enabling automated responses, such as blocking or filtering malicious traffic. The reference taught notifying administrators how to manage packets involved in malicious activity after they crossed a network boundary.
Palo Alto argued that combining the packet correlation techniques of the first reference with the notification mechanisms of the second addressed a key claim limitation of the challenged patent. Palo Alto contended that transmitting an indication of a malicious host, as taught by the second reference, naturally followed from the correlation system described in the first. However, the Board found that Palo Alto failed to provide sufficient evidence or argument to show that a person of ordinary skill in the art (POSITA) would recognize the claimed responsiveness between the first reference’s packet correlation and the second reference’s notification mechanisms. Palo Alto appealed.
The Federal Circuit vacated and remanded the Board’s decision, finding that the Board erred by failing to clearly articulate its rationale regarding the motivation to combine the prior art references and whether their combination satisfied the critical limitation of the challenged patent claim. The Court emphasized that the proper inquiry in an obviousness analysis is not whether each reference individually discloses all claim elements but whether their combination would have rendered the invention obvious to a POSITA.
Palo Alto maintained that the Board did not dispute the existence of a motivation to combine and improperly searched for a “bridge” solely within the two references. Centripetal countered that Palo Alto had not established a motivation or provided evidence of a necessary connection – or “bridge” – between the prior art and the claimed invention.
The Federal Circuit determined that the Board’s decision lacked a definitive finding on whether a POSITA would have been motivated to combine the first reference’s correlation techniques with the second reference’s notification step. The Court noted that Palo Alto presented logical and evidentiary support as to why such a combination would make sense, arguing that without a notification step, the correlation techniques alone would be ineffective for mitigating malicious activity – a gap that the second reference could address.
The Federal Circuit also rejected Centripetal’s claim that the Board had analyzed the proposed combination. It clarified that Centripetal’s assertion was based solely on the Board’s recital of Centripetal’s arguments, not an independent evaluation. The Court explained that summarizing a party’s position does not constitute a substantive analysis or finding.
Practice Note: The Federal Circuit’s ruling highlights the necessity of thorough and holistic analysis in obviousness inquiries and reinforces that references must be considered together to determine their combined effect on the claimed invention.
“9999” SCAM OR LEAD FUNNEL RUN AMUCK?: Zillow Hit With New TCPA Class Action Over Text Messages and It Could Be a Serious Problem or A Serious Scam
With the new FCC TCPA one-to-one consent rules about to take effect in just 18 days everyone at (and in) Lead Generation World was (and is) focused on finalizing their go-to-market strategies with their new solutions.
One company I am constantly asked about is Zillow.
The real estate monster seems to be adopting a multi-pronged approach in response to the new rules and many of its strategies are raising eyebrows as they don’t seem to be completely consistent with one-to-one requirements (not throwing shade, just an observation.)
But if the allegations in a new class action are true Zillow may have a very serious problem with its lead gen funnel that is even more basic than anything having to do with one-to-one. (or it could just be the latest version of one of the oldest TCPA scams in the books.)
In CHET MICHAEL WILSON v. ZILLOW, INC. (W.D. Wash. Case No. 2:25-cv-00048) a Plaintiff sues Zillow over the receipt of multiple text messages related to various Zillow services–including apparently both mortgage and real estate offerings– related to multiple properties.
Per the complaint the plaintiff did not request the messages and the messages continued after Plaintiff texted “stop.”
Most problematically the text messages seem to have all been sent to a single number but are related to different properties and are directed to different recipient names. This suggests the messages are related to different form fills by different consumers, or that Zillow has a big problem with its lead gen engine.
Then again, the last four digits of the Plaintiff’s alleged phone number are allegedly “9999” so this could be another one of those “designed number” lawsuit scams where a Plaintiff buys a speciality number–like (310) 999-9999– just to collect TCPA dollars from companies errantly calling fake numbers. (I helped fight off a series of these sorts of cases any years ago and the experience made me realize how terrible frivolous lawsuits are.)
Still for a company as large as Zillow preventing multiple leads from looping to the same number for different people and property should be viewed as a priority– again Zillow is a massive lead gen engine relied on by so many– so I would be shocked if this is as simple as Zillow not picking up on a simple 9999 scam (but maybe it is.)
I should note I have no idea if the claims are even true and the Plaintiff could be lying. But the complaint does contain multiple screenshots like this one:
In addition to the text messages Zillow also apparently used prerecorded calls to contact the Plaintiff–eesh– so the TCPA’s regulated technology provisions are also at play here.
The Complaint seeks to represent three classes:
Robocall Class: All persons in the United States (1) to whom Zillow, Inc. placed,or caused to be placed, a call, (2) directed to a number assigned to a cellulartelephone service, but not assigned to a person with an account with Zillow, Inc.,(3) in connection with which Zillow, Inc. used an artificial or prerecorded voice,(4) from four years prior to the filing of this complaint through the date of classcertification.
IDNC Class: All persons in the United States who, within the four yearsprior to the filing of this lawsuit through the date of class certification,received two or more telemarketing calls within any 12-month period,from or on behalf of Zillow, Inc., regarding Zillow, Inc.’s goods orservices, to said person’s residential telephone number, including at leastone call after communicating to Zillow, Inc. that they did not wish toreceive such calls.
DNC CLASS: All persons in the United States who, within the four yearsprior to the filing of this action through the date of class certification, (1)were sent more than one telemarketing call within any 12-month period;(2) where the person’s telephone number had been listed on the NationalDo Not Call Registry for at least thirty days but not assigned to a personwith an account with Zillow, Inc.,; (3) regarding Zillow, Inc.’s property,goods, and/or services; (4) to said person’s residential telephone number.
Very interesting stuff and we will keep an eye on it for you.
Full complaint here: Zillow Complaint
The Tax Court Recently Decides Two Research Credit Cases – One Favorable on Funding (Smith) and One Unfavorable on the Four-Part Test (Phoenix Design Group)
Taxpayers had mixed success in two recent research credit cases in the United States Tax Court.
In Smith v. Commissioner,[1] the taxpayer was an architectural firm. The Tax Court denied the Commissioner’s motion for summary judgment, allowing the case to proceed to trial on the issue of whether the taxpayer’s clients funded its research activities.
In Phoenix Design Group, Inc. v. Commissioner,[2] disputed questions of fact proceeded to trial. Based on its findings, the court concluded that the taxpayer, a firm employing professional engineers, had not engaged in qualified research, and was not entitled to research credits.
Smith: The Architectural Case: In Smith, the IRS continued to apply the “funding exception” to disallow federal income tax credits for a taxpayer’s qualified research activities. The “funding exception excludes from credit-eligible qualified research “any research to the extent funded by … contract…by another person….”[3]
Research is funded if the client’s payment to the taxpayer is not contingent on the success of the taxpayer’s research activities.[4] Research is also funded if the taxpayer does not retain substantial rights in the research.[5]
The taxpayer was a member in a limited liability partnership that sold its “innovative architectural design services” worldwide to its clients.[6] The taxpayer asserted that it conducted credit-eligible research to formulate architectural designs as required by contract with its clients. The IRS denied the credits on the theory that the clients funded the taxpayer’s research activities.
Relying on selective provisions in contracts between the taxpayer and its clients, the IRS moved for summary judgment on the theory that the taxpayer was contractually required to perform its architectural services in accordance with professional standards, which alone did not put the taxpayer at risk if its research to effectuate the designs failed. The court ruled, however, that the contracts tended to provide that the clients were obligated to pay the taxpayer only if the taxpayer satisfied design milestones, which raised an issue about whether payment to the taxpayer was contingent on success of the research.
The court also ruled that local law provisions appeared to vest copyright protection for the designs in the taxpayer, which tended to rebut the IRS argument that the taxpayer did not retain substantial rights in the research, and thus preserved for trial the issue of retention of substantial rights in its research.[7]
Phoenix Design: The Engineering Case: In Phoenix Design, the IRS successfully argued that the taxpayer, a firm employing professional engineers, failed to prove that it engaged in qualified research to design mechanical (air handling), electrical, plumbing, and fire protection systems (“MEPF Systems”) for laboratory and hospital building projects.
Research is qualified if it passes a “four-part test.”[8] At issue in Phoenix Design are only Test One – the Section 174 Test – and Test Four – the Process of Experimentation Test. The Section 174 Test requires a taxpayer to (i) identify uncertainty in the development or improvement of a product, process, technique, or formula and (ii) show that this uncertainty exists because the information objectively available does not establish the capability or method to develop or improve the product, process, technique, or formula or its appropriate design. The Process of Experimentation Test requires a taxpayer to use a process that is capable of evaluating one or more alternatives, for example, modeling, simulation, or a systematic trial and error methodology.
In Phoenix Design, the taxpayer argued that its professional engineers met the Section 174 Test by eliminating uncertainty in the design of the MEPF Systems. The taxpayer explained that, at the outset of the projects, it was uncertain about the specifications and designs that would achieve the air handling and other attributes of the systems, and that it intended to eliminate the uncertainty by performing sophisticated and iterative engineering calculations.
The court rejected the argument. The Section 174 Test requires investigatory activity, that is, the attempted acquisition of information. The court cited e-mails and meetings as examples of processes of acquiring information, but only if there is uncertainty about developing or improving the product. However, “basic calculations on available data is [sic] not an investigative activity because the taxpayer already has all the information necessary to address that unknown.” Moreover, the taxpayer “failed to identify the specific information that was not available to PDG [the taxpayer’s] engineers at the start of the project.”
For the Process of Experimentation Test, the taxpayer argued that it performed iterative calculations to determine the appropriate designs of the MEPF Systems, but the court rejected the argument because “performing calculations and communicating the results to the architect is not an evaluative process that mirrors the scientific method.”[9]
Comment: An architectural or engineering service is not intrinsically precluded from qualifying for research credits. The service may constitute a “business component,” which includes a process, technique, or formula. [10] The business component need not be a tangible product to quality for tax credits.
Care should be taken to ensure that the agreement between a service provider and its client does not inadvertently use terminology that, from the IRS perspective, mistakenly appears to disqualify the research – as could have occurred in Smith. Also, activities intended to eliminate technological uncertainty through a rigorous engineering process should be carefully documented when they occur or soon thereafter to avoid the documentation deficiency that occurred in Phoenix Design. And note that a showing of the brilliance of a scientist or engineer will not qualify the research for tax credits. The taxpayer must still work through the statutory provisions and clearly show the IRS and court how the activities satisfy these provisions.
[1] No. 13382-17 (U.S. Tax Ct. Dec. 18, 2024).
[2] T.C. Memo. 2024-113 (Dec. 23, 2024).
[3] I.R.C. §41(d)(4)(H).
[4] The rationale is that the taxpayer is not the researcher because the taxpayer is not at economic risk for the success of the research.
[5] The rationale is dubious. See “Tax Court Denies Research Credits for Research Activities,” https://natlawreview.com/article/tax-court-denies-research-credits-research-activities (Feb. 9, 2021).
[6] The architectural services at issue were for six projects located in Dubai, UAE, and Saudi Arabia.
[7] Retention of “other intellectual property rights” was an additional basis to deny the IRS’s motion for the Kingdom Tower, one of the architectural projects.
[8] (i) The expenditures may be deductible under I.R.C. §174. The deduction is available if the taxpayer’s activities are of an investigative nature that are intended to discover information that would eliminate uncertainty in development or improvement of a product, process, technique, or formula. The Tax Cuts and Jobs Act, Pub. L. 115-97, now requires that the expenditures be specified research and experimental expenditures, which are amortizable rather than currently deductible.
(ii) The expenditure is intended to discover information that is technological.
(iii) The information to be discovered is intended to develop or improve a product, process, technique, or formula.
(iv) Substantially all the research activities constitute elements of a process of experimentation for the purpose of developing or improving new or improved function, performance, reliability, or quality of the product, process, technique, or formula.
[9] The taxpayer’s failing was primarily one of documentation of its engineers’ activities. The fault may lie, however, not with the taxpayer’s trial preparation but with a flaw in the Congressional design of the credit. Congress intended the credit be available to businesses that “apply” scientific principles to develop or improve products. Congress did not require taxpayers to discover basic scientific principles to claim the credit. However, Congress left the door open to the IRS to require a taxpayer to document its applied research as it the research were “basic research.” Businesses that apply research often do not think of documenting their applied research as if it were basic research.
[10] I.R.C. §41(d)(2)(B)
Weekly IRS Roundup December 23 – December 27, 2024
Check out our summary of significant Internal Revenue Service (IRS) guidance and relevant tax matters for the week of December 23, 2024 – December 27, 2024.
December 23, 2024: The IRS released Internal Revenue Bulletin 2024-52, which includes the following:
Treasury Decision 10015: These final regulations update the previous regulations under Section 48 of the Internal Revenue Code (Code), which provides for an investment tax credit for energy property (energy credit), and respond to changes made by the Inflation Reduction Act of 2022 (IRA).
The final regulations update the types of energy property eligible for the energy credit, including additional types of energy property added by the IRA; clarify the application of new credit transfer rules to recapture because of failure to satisfy the prevailing wage requirements, including notification requirements for eligible taxpayers; and include qualified interconnection costs in the basis of certain lower-output energy properties.
The final regulations also provide rules generally applicable to energy property, such as rules regarding functionally interdependent components, property that is an integral part of an energy property, application of the “80/20 rule” to retrofitted energy property, dual use property, ownership of components of an energy property, energy property that may be eligible for multiple federal income tax credits, and the election to treat qualified facilities eligible for the renewable electricity production credit under Code Section 45 as property eligible for the energy credit.
Notice 2024-82, which sets forth the 2024 Required Amendments List. The list applies to both individually designed plans under Code Section 401(a) and individually designed plans that satisfy the requirements of Code Section 403(b).
Notice 2024-86, which announces the extension of certain timeframes under the Employee Retirement Income Security Act of 1974 and the Code for group health plans; disability and other welfare plans; pension plans; and participants, beneficiaries, qualified beneficiaries, and claimants of these plans affected by Hurricane Helene, Tropical Storm Helene, or Hurricane Milton.
Revenue Procedure 2024-42, which updates the list of jurisdictions with which the United States has in effect a relevant information exchange agreement or an automatic exchange relationship under Treasury Regulation §§ 1.6049-4(b)(5) and 1.6049-8(a).
Announcement 2024-42, which provides a copy of the competent authority arrangement entered into by the competent authorities of the US and the Kingdom of Norway under paragraph 2 of Article 27 (Mutual Agreement Procedure) of the Convention between the US and Norway for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income and Property, signed on December 3, 1971.
The IRS issued a notice of proposed rulemaking, setting forth proposed regulations related to the definition of “qualified nonpersonal use vehicles.” Qualified nonpersonal use vehicles are excepted from the substantiation requirements that apply to certain listed property. The proposed regulations add unmarked vehicles used by firefighters or members of a rescue squad or ambulance crew as a new type of qualified nonpersonal use vehicle. The regulations affect governmental units that provide firefighter or rescue squad or ambulance crew member employees with unmarked qualified nonpersonal use vehicles and the employees who use those vehicles. Comments on the proposed regulations are due by March 3, 2025.
The IRS acquiesced to Green Rock LLC v. Internal Revenue Serv., 104 F.4th 220 (11th Cir. 2024). In that case, the US Court of Appeals for the Eleventh Circuit held that notices identifying certain conservation easement arrangements as reportable transactions are invalid under the Administrative Procedure Act because they failed to follow notice-and-comment rulemaking procedures.
December 23, 2024: The US Department of the Treasury and the IRS released final regulations regarding supervisory approval of penalties assessed pursuant to Code Section 6751(b). Section 6751(b) provides that no penalty “shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination….” The final regulations clarify the application of Section 6751(b) as to the timing of supervisory approval, the identities of the individual who first proposes the penalty and their supervisor, the requirement that the approval be “personally approved (in writing)” by the supervisor, and other aspects of the statute.
December 27, 2024: The IRS announced via Notice 2025-3 transitional relief with respect to the reporting of information and backup withholding on digital assets for digital asset brokers providing trading front-end services.
Transparency Is the Best Medicine: Device Parts Don’t Justify Orange Book Listing
The US Court of Appeals for the Federal Circuit affirmed a district court’s delisting of patents from the Orange Book because the patent claims did not “claim the drug that was approved” or the active ingredient of the drug that was approved. Teva Branded Pharmaceutical Products R&D, Inc., et al. v. Amneal Pharmaceuticals of New York, LLC, et al., Case No. 24-1936 (Fed. Cir. Dec. 20, 2024) (Prost, Taranto, Hughes, JJ.)
Teva owns the product that Amneal sought to delist, ProAir® HFA Inhalation Aerosol. The ProAir® HFA combines albuterol sulfate (the active ingredient) with a propellant and an inhaler device to administer the drug. Although the US Food and Drug Administration (FDA) approved Teva’s ProAir® HFA as a drug, the ProAir® HFA contains both drug and device components (the device components being the physical machinery of the inhaler). Teva lists nine nonexpired patents in the Orange Book for its ProAir® HFA.
Amneal filed an abbreviated new drug application (ANDA) seeking approval to market a generic version of the ProAir® HFA that uses the same active ingredient. Amneal asserted that it did not infringe Teva’s nine patents listed for the ProAir® HFA. Teva sued for infringement of six of those patents. Amneal filed counterclaims for antitrust and for a declaratory judgment of noninfringement and invalidity and sought an order requiring Teva to delist the five patents that it asserted against Amneal. Amneal moved for judgment on the pleadings on the ground that Teva improperly listed the asserted patents. The district court granted Amneal’s motion, concluding that Teva’s patents “do not claim the drug for which the applicant submitted the application.” The district court ordered Teva to delist its patents from the Orange Book. Teva appealed.
On appeal, Teva argued that a patent can be listed in the Orange Book if the claimed invention is found in any part of its new drug application (NDA) product. Teva argued that a patent “claims the drug” if the claim reads on the approved drug (i.e., if the NDA product infringes that claim). Teva also argued that according to the Federal Food, Drug, and Cosmetic Act’s broad definition of the word “drug,” any component of an article that can treat disease meets the statutory definition of a “drug.” With this interpretation, Teva’s patents “claim the drug” as the claim dose counter and canister components of the ProAir® HFA.
The Federal Circuit rejected Teva’s interpretation as overbroad because it would allow the “listing of far more patents than Congress has indicated.” The Court rejected Teva’s argument that a patent claiming any component of a drug is listable, explaining that Teva cannot list its patents just because they claim the dose counter and canister parts of the ProAir® HFA.
The Federal Circuit also rejected Teva’s argument that even if Teva’s statutory arguments were rejected, the Federal Circuit must remand the case to the district court to construe the claims. In doing so, the Court rejected Teva’s interpretation of the word “claims” in the listing and counterclaim/delisting provisions, explaining that the listing provision identifies “infringing” and “claiming” as two distinct requirements, and that to be listed, a patent must both claim the drug and be infringed by the NDA product.
The Federal Circuit explained that “infringing the claimed invention has several distinct features that differentiate it from claiming the invention.” In contrast to infringement, which is assessed by facts “out in the world,” claims require “examining the intrinsic meaning of the written patent document.” A product can infringe a patent “without meeting all of the claim elements” and often has additional features.
Teva further argued that a claim qualifies as claiming a drug “even if it only claims device parts.” The Federal Circuit rejected this contention, stating that “it is apparent that a product regulatable and approvable as a drug contains an active ingredient” and noting that “devices have a distinct approval pathway.” The presence of distinct drug and device pathways means that even if a product can simultaneously satisfy the linguistic elements of both, it can only be regulated as a drug or a device, and devices are “characterized more by their purely mechanical nature” (as was the case with Teva’s patents). The Court determined that the “active ingredient” ultimately classifies a drug or biological product, and not the “dosage form.”
Teva further argued that since the FDA designated ProAir® HFA as a combination product, the device components were statutorily a drug. In rejecting this contention, the Federal Circuit again noted the statutory focus on a drug’s active ingredient: an “approved drug” is “an active ingredient,” and to be listed it must meet several requirements, “including that it was identified in an NDA and that the FDA considered whether the active ingredient is safe and effective.” The Court concluded that “including a drug in a combination product does not transform each and every component of that combination product into a drug,” and that “a combination product does not become a drug just because it is regulated as a drug.”
Finally, Teva argued that its patents did claim an active ingredient since each patent has one claim that requires “an active drug.” The Federal Circuit explained that the FDA does not approve drugs based on “reference to some vague active ingredient in the abstract” and that the mere presence of those words was far too broad and would permit “any active ingredient in any form.”
Practice Note: In the slip opinion, at pp 4-12, the Federal Circuit delivers extraordinarily detailed treatise on FDA practice, NDA process, the Hatch-Waxman Act (ANDA practice), Paragraph IV certification, the delisting statute (21 U.S.C. § 355(j)(5)(C)(ii)(I)) and the Orange Book Transparency Act of 2020 (21 U.S.C. § 355(b)(1)(A)(viii)).
This Week in 340B: December 17, 2024 – January 6, 2025
Find updates on 340B litigation from December 17, 2024 – January 6, 2025 to help you stay in the know on how 340B cases are developing across the country. Each week we comb through the dockets of more than 50 340B cases to provide you with a quick summary of relevant updates from the prior week in this industry-shaping body of litigation.
Issues at Stake: HRSA Audit Process, Contract Pharmacy; Other
In a Health Resources and Services Administration (HRSA) audit process case, the government filed a brief in opposition to the plaintiff’s motion for preliminary injunction and the plaintiff filed a reply brief in support of the same motion.
In four HRSA audit process cases, the plaintiffs filed responses to the defendants’ motions to dismiss and briefs in opposition to Johnson & Johnson Health Care System Inc.’s motions for leave to file as amicus curiae.
In an appealed case challenging a proposed state law governing contract pharmacy arrangements, the appellants filed their opening brief.
In a breach of contract claim filed by a 340B Covered Entity against several related party Medicare Advantage plans, plaintiffs filed a second amended complaint under seal with jury demand. Additionally, defendants filed an answer and defenses to plaintiffs’ second amended complaint
In a case challenging HRSA’s policy prohibiting manufacturer rebate models, defendants filed a consent motion to vacate the answer deadline and set summary judgment briefing schedule.
A covered entity filed a breach of contract claim against an insurance company, alleging that it failed to pay the covered entity the proper amounts because it relied on an outpatient prescription reimbursement rate ruled unlawful by the US Supreme Court.
A group of drug manufacturers filed a claim against HRSA, alleging that HRSA’s decision to certify a group of entities as 340B-eligible was arbitrary, capricious, and not in accordance with law.
In seven cases challenging a proposed state law governing contract pharmacy arrangements in West Virginia, Missouri, and Mississippi:
WV: In three cases, the court issued a memorandum opinion and order granting plaintiffs’ preliminary injunction motions, denying defendants’ motions to dismiss, and ordering defendants to file answers to plaintiffs’ complaints. In three of the cases, the court granted the parties’ joint motion for extension of time for plaintiff to respond to defendants’ motions to consolidate. In another one of the cases, plaintiffs filed a memorandum in opposition to defendants’ motion to consolidate and stay deadlines pending the court’s ruling on motions for preliminary injunction. In one of the cases, defendants filed an answer to plaintiff’s complaint.
MS: The court denied the plaintiff’s motion for preliminary injunction.
MO: The court denied defendant’s motion for transfer in two cases. In one case, plaintiff filed reply suggestions in support of the motion for preliminary injunction. In another case, plaintiff filed suggestions in opposition to a motion to dismiss for failure to state a claim.
The Second Circuit Revives Sarah Palin’s Defamation Suit Against The New York Times
The Second Circuit Court of Appeals has once again revived Sarah Palin’s longstanding defamation suit against The New York Times.
The Second Circuit’s opinion highlights important procedural and substantive issues in defamation actions involving public figures, particularly in the current polarized media environment.
Palin’s lawsuit, which we previously wrote about here, relates to a 2017 Times editorial that incorrectly linked a political ad from the 2008 Republican vice presidential candidate and former governor of Alaska to a 2011 mass shooting in Arizona that killed six people and injured 13 more, including Congresswoman Gabby Giffords. After an initial dismissal that was reversed on appeal, Palin’s case proceeded to trial in February 2022.
During jury deliberations, the District Court Judge announced in open court that he believed Palin had failed to produce sufficient evidence of actual malice, and, for that reason, would grant judgment in favor of the Times. However, the judge allowed the jury to continue deliberations and the jury subsequently returned a verdict for the Times. The court later revealed in a public filing that members of the jury had learned about the judge’s decision to dismiss the case during deliberations after receiving push notifications on their smartphones. This unusual procedural sequence, compounded by errors during the trial, led the Second Circuit to vacate the judgment and order a retrial, which is scheduled to begin on April 14, 2025.
The Second Circuit found that the “district court’s Rule 50 ruling improperly intruded on the province of the jury by making credibility determinations, weighing evidence, and ignoring facts or inferences that a reasonable juror could plausibly have found to support Palin’s case.” The appellate panel also identified “several major issues at trial,” including the erroneous exclusion of critical evidence, inaccurate jury instructions regarding defamatory malice, a legally erroneous response to a mid-deliberation jury question, and jurors receiving push notifications on their smartphones about the district court’s Rule 50 ruling in favor of the Times during deliberations. The Second Circuit held that these errors impugned the reliability of the jury’s verdict and warranted a retrial.
Although Palin ultimately succeeded on appeal, Palin’s broader efforts to have the Supreme Court revisit the “actual malice” requirement set by New York Times v. Sullivan may have hit a dead end. Public-figure defamation plaintiffs need to prove actual malice, which requires showing that an allegedly defamatory statement was made “with knowledge that it was false or with reckless disregard of whether it was false or not.” Sullivan, 376 U.S. at 280. In St. Amant v. Thompson, the Supreme Court explained that proof that a defamatory article was published “recklessly, though not knowingly” is not sufficient to prove actual malice. Rather, the evidence must show that the defendant had “an awareness…of the probable falsity” of the publication. Later, in Gertz v. Robert Welch, Inc., the Court defined “reckless disregard of the truth” to mean “subjective awareness of probable falsity.”
On appeal, Palin argued that “the actual malice standard is either no longer good law or should not apply to her case.” The Second Circuit rejected these arguments as barred by the “law of the case” doctrine because they were ripe for review at the time of Palin’s initial appeal but were not raised. Additionally, Palin challenged the district court’s ruling that, regardless of the First Amendment, she was required to prove actual malice as an element of her claim under New York’s amended Anti-SLAPP law, N.Y. Civil Rights Law § 76-a. The November 2020 amendment to New York’s Anti-SLAPP law imposes an actual malice fault standard in any action concerning the “exercise of the constitutional right of free speech in connection with an issue of public interest.” However, “because the First Amendment and New York’s amended Anti-SLAPP Statute share the same substantive requirement (that a public-figure defamation plaintiff must prove actual malice by clear and convincing evidence),” the Second Circuit stated, “we need not decide—and do not decide—whether the Anti-SLAPP Statute’s amendment applies retroactively.”
The Second Circuit’s decision to defer ruling on this issue is significant. The retroactive application of New York’s amended Anti-SLAPP statute effectively insulates Palin’s case from a future challenge to the current First Amendment standard because the outcome of the new trial will presumably rest independently on both federal law and New York State statutory law. While Palin’s case has reignited debates about Sullivan’s actual malice standard, it is unlikely that her case will provide the vehicle for the United States Supreme Court to revisit this line of precedent.
The Tax Court Recently Decides Two Research Credit Cases One Favorable on Funding (Smith) and One Unfavorable on the Four-Part Test (Phoenix Design Group)
Taxpayers had mixed success in two recent research credit cases in the United States Tax Court.
In Smith v. Commissioner,[1] the taxpayer was an architectural firm. The Tax Court denied the Commissioner’s motion for summary judgment, allowing the case to proceed to trial on the issue of whether the taxpayer’s clients funded its research activities.
In Phoenix Design Group, Inc. v. Commissioner,[2] disputed questions of fact proceeded to trial. Based on its findings, the court concluded that the taxpayer, a firm employing professional engineers, had not engaged in qualified research, and was not entitled to research credits.
Smith: The Architectural Case: In Smith, the IRS continued to apply the “funding exception” to disallow federal income tax credits for a taxpayer’s qualified research activities. The “funding exception excludes from credit-eligible qualified research “any research to the extent funded by … contract…by another person….”[3]
Research is funded if the client’s payment to the taxpayer is not contingent on the success of the taxpayer’s research activities.[4] Research is also funded if the taxpayer does not retain substantial rights in the research.[5]
The taxpayer was a member in a limited liability partnership that sold its “innovative architectural design services” worldwide to its clients.[6] The taxpayer asserted that it conducted credit-eligible research to formulate architectural designs as required by contract with its clients. The IRS denied the credits on the theory that the clients funded the taxpayer’s research activities.
Relying on selective provisions in contracts between the taxpayer and its clients, the IRS moved for summary judgment on the theory that the taxpayer was contractually required to perform its architectural services in accordance with professional standards, which alone did not put the taxpayer at risk if its research to effectuate the designs failed. The court ruled, however, that the contracts tended to provide that the clients were obligated to pay the taxpayer only if the taxpayer satisfied design milestones, which raised an issue about whether payment to the taxpayer was contingent on success of the research.
The court also ruled that local law provisions appeared to vest copyright protection for the designs in the taxpayer, which tended to rebut the IRS argument that the taxpayer did not retain substantial rights in the research, and thus preserved for trial the issue of retention of substantial rights in its research.[7]
Phoenix Design: The Engineering Case: In Phoenix Design, the IRS successfully argued that the taxpayer, a firm employing professional engineers, failed to prove that it engaged in qualified research to design mechanical (air handling), electrical, plumbing, and fire protection systems (“MEPF Systems”) for laboratory and hospital building projects.
Research is qualified if it passes a “four-part test.”[8] At issue in Phoenix Design are only Test One – the Section 174 Test – and Test Four – the Process of Experimentation Test. The Section 174 Test requires a taxpayer to (i) identify uncertainty in the development or improvement of a product, process, technique, or formula and (ii) show that this uncertainty exists because the information objectively available does not establish the capability or method to develop or improve the product, process, technique, or formula or its appropriate design. The Process of Experimentation Test requires a taxpayer to use a process that is capable of evaluating one or more alternatives, for example, modeling, simulation, or a systematic trial and error methodology.
In Phoenix Design, the taxpayer argued that its professional engineers met the Section 174 Test by eliminating uncertainty in the design of the MEPF Systems. The taxpayer explained that, at the outset of the projects, it was uncertain about the specifications and designs that would achieve the air handling and other attributes of the systems, and that it intended to eliminate the uncertainty by performing sophisticated and iterative engineering calculations.
The court rejected the argument. The Section 174 Test requires investigatory activity, that is, the attempted acquisition of information. The court cited e-mails and meetings as examples of processes of acquiring information, but only if there is uncertainty about developing or improving the product. However, “basic calculations on available data is [sic] not an investigative activity because the taxpayer already has all the information necessary to address that unknown.” Moreover, the taxpayer “failed to identify the specific information that was not available to PDG [the taxpayer’s] engineers at the start of the project.”
For the Process of Experimentation Test, the taxpayer argued that it performed iterative calculations to determine the appropriate designs of the MEPF Systems, but the court rejected the argument because “performing calculations and communicating the results to the architect is not an evaluative process that mirrors the scientific method.”[9]
Comment: An architectural or engineering service is not intrinsically precluded from qualifying for research credits. The service may constitute a “business component,” which includes a process, technique, or formula. [10] The business component need not be a tangible product to quality for tax credits.
Care should be taken to ensure that the agreement between a service provider and its client does not inadvertently use terminology that, from the IRS perspective, mistakenly appears to disqualify the research – as could have occurred in Smith. Also, activities intended to eliminate technological uncertainty through a rigorous engineering process should be carefully documented when they occur or soon thereafter to avoid the documentation deficiency that occurred in Phoenix Design. And note that a showing of the brilliance of a scientist or engineer will not qualify the research for tax credits. The taxpayer must still work through the statutory provisions and clearly show the IRS and court how the activities satisfy these provisions.
[1] No. 13382-17 (U.S. Tax Ct. Dec. 18, 2024).
[2] T.C. Memo. 2024-113 (Dec. 23, 2024).
[3] I.R.C. §41(d)(4)(H).
[4] The rationale is that the taxpayer is not the researcher because the taxpayer is not at economic risk for the success of the research.
[5] The rationale is dubious. See “Tax Court Denies Research Credits for Research Activities,” https://www.millercanfield.com/resources-Tax-Court-Tangel-Commissioner.html (Feb. 9, 2021).
[6] The architectural services at issue were for six projects located in Dubai, UAE, and Saudi Arabia.
[7] Retention of “other intellectual property rights” was an additional basis to deny the IRS’s motion for the Kingdom Tower, one of the architectural projects.
[8] (i) The expenditures may be deductible under I.R.C. §174. The deduction is available if the taxpayer’s activities are of an investigative nature that are intended to discover information that would eliminate uncertainty in development or improvement of a product, process, technique, or formula. The Tax Cuts and Jobs Act, Pub. L. 115-97, now requires that the expenditures be specified research and experimental expenditures, which are amortizable rather than currently deductible.
(ii) The expenditure is intended to discover information that is technological.
(iii) The information to be discovered is intended to develop or improve a product, process, technique, or formula.
(iv) Substantially all the research activities constitute elements of a process of experimentation for the purpose of developing or improving new or improved function, performance, reliability, or quality of the product, process, technique, or formula.
[9] The taxpayer’s failing was primarily one of documentation of its engineers’ activities. The fault may lie, however, not with the taxpayer’s trial preparation but with a flaw in the Congressional design of the credit. Congress intended the credit be available to businesses that “apply” scientific principles to develop or improve products. Congress did not require taxpayers to discover basic scientific principles to claim the credit. However, Congress left the door open to the IRS to require a taxpayer to document its applied research as it the research were “basic research.” Businesses that apply research often do not think of documenting their applied research as if it were basic research.
[10] I.R.C. §41(d)(2)(B).