Error: Bad annotation destination
United States Court of Appeals for the Federal Circuit
04-5151, -5154
INFORMATION SYSTEMS &
NETWORKS CORPORATION,
Plaintiff-Cross Appellant,
v.
UNITED STATES,
Defendant-Appellant.
Norman H. Singer, Singer and Associates, P.C., of Bethesda, Maryland, argued
for plaintiff-cross appellant. Of counsel was Benjamin M. Kahrl.
David B. Stinson, Trial Attorney, Commercial Litigation Branch, Civil Division,
United States Department of Justice, of Washington, DC, argued for defendant-
appellant. With him on the brief were Peter D. Keisler, Assistant Attorney General,
David M. Cohen, Director, and Mark A. Melnick, Assistant Director. Of counsel were
Gregory T. Allen, Attorney, Defense Contract Management Agency, of Manassas,
Virginia, and Raymond J.M. Wong, Attorney, of Alexandria, Virginia.
Thomas M. Abbott, McKenna Long & Aldridge LLP, of Los Angeles, California for
amicus curiae United States Chamber of Commerce. With him on the brief was Mark R.
Troy. Of counsel on the brief was Robin S. Conrad, National Chamber Litigation
Center, of Washington, DC.
Appealed from: United States Court of Federal Claims
Senior Judge Bohdan A. Futey
United States Court of Appeals for the Federal Circuit
04-5151, -5154,
INFORMATION SYSTEMS &
NETWORKS CORPORATION,
Plaintiff-Cross Appellant,
v.
UNITED STATES,
Defendant-Appellant.
__________________________
DECIDED: February 6, 2006
__________________________
Before RADER, LINN, and PROST, Circuit Judges.
PROST, Circuit Judge.
This case arose from a dispute over the allowable costs in a cost-reimbursement
contract between the United States and Information Systems and Networks Corporation
(“ISN”), a Maryland S corporation. The United States Court of Federal Claims granted
summary judgment in favor of ISN. It held that, under 48 C.F.R. § 31.205-41, the state
income tax payments made by ISN’s sole shareholder resulting from dividends received
from ISN were allowable costs in the cost-reimbursement contract. Because the Court
of Federal Claims improperly interpreted 48 C.F.R. § 31.205-41, we reverse and
remand.
I
ISN is a Maryland corporation with one sole shareholder, Roma Malkani. ISN
provides services to the United States through cost-reimbursement contracts. Under
these contracts, the United States reimburses ISN for allowable costs incurred during
performance of the contract. See 48 C.F.R. § 16.301-1 (2004). Each year ISN
negotiates with the United States to determine ISN’s allowable costs for that year. See
48 C.F.R. § 52.216-7(d)(2)(ii) (2004). A cost is allowable only when the cost complies
with all of the following requirements:
(1) Reasonableness.
(2) Allocability.
(3) Standards promulgated by the CAS Board, if applicable,
otherwise, generally accepted accounting principles and practices
appropriate to the circumstances.
(4) Terms of the contract.
(5) Any limitations set forth in this subpart.
48 C.F.R. § 31.202-2 (2004). As provided by the last of these requirements, allowable
costs must conform to any of the specific limitations set forth in 48 C.F.R. §§ 31.201-
205. Many of these limitations are enumerated in 48 C.F.R. § 31.205 and include rules
for determining the allowability of forty-seven different types of costs. This case turns
on the allowability of certain tax-related costs. Taxes are discussed in 48 C.F.R.
§ 31.205-41. That subsection states that some but not all taxes paid by an entity are
allowable. See 48 C.F.R. § 31.205-41 (2004).
ISN elected to be a subchapter S corporation pursuant to 26 U.S.C. § 1362(a).
In a traditional subchapter C corporation, there is what is known as double taxation. A
corporation pays income tax on its corporate income. And, when the corporation
distributes income to its shareholders, those shareholders also pay income tax on those
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dividends. In contrast, an S corporation is only subject to single taxation. The
corporation does not pay income tax on the income it generates. Rather, only the
shareholders of the S corporation pay income tax on their corporate dividends. As
discussed by the Court of Federal Claims,
“S corporations” as they are known, are small businesses, closely held by
no more than 75 shareholders, 26 U.S.C. § 1361 (b)(1)(A), and often held
by a sole shareholder. S corporation status is a tax election designed to
make the decision of small businesses to incorporate “tax neutral;” i.e., a
business will incur the same tax liability on its income whether the owners
of the business incorporate or not. Subchapter S accomplishes this by
eliminating the “double taxation” that usually befalls normal corporate
income.
Info. Sys. & Networks Corp. v. United States, 48 Fed. Cl. 265, 266 (2000). Many states
have aligned their tax codes with the Federal Internal Revenue Code and these states
treat S corporations for state income taxes just as the Internal Revenue Code treats S
corporations for federal income taxes. In those states that recognize the single taxation
of an S corporation, ISN has never paid state income tax. Instead, Ms. Malkani, ISN’s
sole shareholder, has received dividend income from ISN and Ms. Malkani has paid
state income tax on those dividends.
As part of its proposal for reimbursement under its contract with the United
States, ISN submitted proposals for reimbursement for costs associated with Ms.
Malkani’s state income tax payments. The Defense Council Audit Agency (the “DCAA”)
denied all of ISN’s relevant claims for allowable costs for Ms. Malkani’s state income tax
payments. The DCAA found that, because ISN was an S corporation and not subject to
state income taxes, the state income taxes paid by Ms. Malkani were not allowable
costs for ISN. On April 16, 1998, the Contracting Officer issued a final decision denying
ISN’s claims.
04-5151, -5154 3
On August 18, 1998, ISN filed suit in the Court of Federal Claims. ISN alleged
that it had reimbursed Ms. Malkani for her state income tax and ISN asked the Court of
Federal Claims to declare those reimbursements to be allowable costs under the cost-
reimbursement contract. The court issued its decision on liability on November 30,
2000. The Court of Federal Claims granted ISN’s motion for summary judgment and
held that state income tax payments made by ISN’s sole shareholder of an S
corporation were allowable costs. As allowable costs, ISN was to receive
reimbursement for them. As a result, on July 7, 2004, the Court of Federal Claims
issued its decision on damages and it held that $1,133,176 that had been paid for state
income taxes by Ms. Malkani were allowable costs and should be included in the
compensation for the cost-reimbursement contract. Info. Sys. & Networks Corp. v.
United States, No. 98-663C (Ct. Fed. Cl. July 21, 2004).
The United States filed this appeal on September 10, 2004. This court has
jurisdiction to entertain this appeal pursuant to 28 U.S.C. § 1295(a)(3). ISN cross-
appeals the Court of Federal Claims’ denial of ISN’s request for a money judgment as
well as interest under the Contracts Dispute Act of 1978. See 41 U.S.C. § 601.
II
This court reviews grants of summary judgment by the Court of Federal Claims
de novo. Costain Coal, Inc. v. United States, 126 F.3d 1437, 1440 (Fed. Cir. 1997). “On
appeal, this court conducts a ‘complete and independent review’ of the record to
determine whether summary judgment is appropriate.” Arqent v. United States, 124
F.3d 1277, 1281 (Fed. Cir. 1997) (quoting Tabb Lakes, Ltd. v. United States, 10 F.3d
796, 799 (Fed. Cir. 1993)). A grant of summary judgment is appropriate “where the
04-5151, -5154 4
record shows ‘that there is no genuine issue as to any material fact and that the moving
party is entitled to a judgment as a matter of law.’” Id. at 1280.
The Court of Federal Claims concluded that state income taxes incurred by a
shareholder of an S corporation are allowable costs. The court reached this conclusion
based on its interpretation of both subparts (a) and (b) of 48 C.F.R. § 31.205-41.
Discussing which taxes are specifically not allowable, the Court of Federal Claims held
that costs are not allowable for “[t]axes from which exemptions are available to the
contractor directly . . . . The term exemption means freedom from taxation in whole or
in part and includes a tax abatement or reduction resulting from mode of assessment,
method of calculation, or otherwise.” 48 C.F.R. § 31.205-41(b) (2004); see also Info.
Sys. & Networks, 48 Fed. Cl. at 270. In addition, the Court of Federal Claims noted that
subpart (a) of the regulation states that some income taxes are allowable. The
regulation states that “[t]he following types of costs are allowable: . . . State . . . taxes
. . . that are required to be and are paid . . . .” 48 C.F.R. § 31.205-41(a) (2004); see
also Info. Sys. & Networks, 48 Fed. Cl. at 270. Addressing these two provisions the
Court of Federal Claims concluded that the state income taxes claimed by ISN were
allowable costs because they were not exempted taxes under 48 C.F.R. § 31.205-41(b)
and that they were instead allowable taxes under 48 C.F.R. § 31.205-41(a). The court
held that “the state income taxes were required to be paid and were paid, and because
the tax liability on the corporate income was not subject to abatement or reduction, the
state income taxes claimed by the plaintiff for reimbursement are allowed under the
Taxes Provision.” Id. We agree with the United States that the Court of Federal Claims’
interpretation of the regulation was incorrect.
04-5151, -5154 5
The language of the regulation makes it clear that the term exemption “means
freedom from taxation in whole or in part.” 48 C.F.R. § 31.205-41(b) (2004). After
stating that general standard, the regulation states that a tax exemption “includes a tax
abatement or reduction.” Id. There is nothing that supports the Court of Federal
Claims’ interpretation of the regulation wherein tax abatements and tax reductions
represent the exhaustive list of exempt taxes. Tax abatements or tax reductions are not
the only types of exempt taxes. Instead, they are only two examples. Furthermore, the
Court of Federal Claims also held that “the state income taxes were required to be paid
and were paid,” and therefore the costs claimed by ISN were allowable under 48 C.F.R.
§ 31.205-41(a). Info. Sys. & Networks, 48 Fed. Cl. at 270. But this inference is also
incorrect. The allowable taxes described in 48 C.F.R. § 31.205-41(a) apply to taxes
paid by the contracting entity. As an S corporation, ISN never paid any state income
taxes. Only Ms. Malkani paid state income taxes on dividends paid to her from ISN.
Because she is not the contracting entity, 48 C.F.R. § 31.205-41 is inapplicable to Ms.
Malkani’s state income tax payments. The Court of Federal Claims incorrectly
concluded that, because the state income tax liability was not a tax reduction nor a tax
abatement, the state income tax liability could not be an exempt tax under 48 C.F.R.
§ 31.205-41(b).
The Court of Federal Claims’ review of various state tax provisions relating to S
corporation taxation does not change our view. In discussing those provisions, the
court noted that “[i]nspection of the tax codes of the states involved in this case . . .
shows that the relationship between an S corporation and its shareholders is an
important and intermingled one for state tax purposes.” Info. Sys. & Networks, 48 Fed.
04-5151, -5154 6
Cl. at 271. The Court of Federal Claims found that “[i]n general, the state tax codes
explain that any corporation which fails to pay its state income taxes, no matter what tax
election status it holds, will be subject to penalty and encumbrance on its ability to do
business within the state.” Id. This, however, is not enough to establish that the tax
liability of an S corporation shareholder is an allowable cost for the corporation. In fact,
the Court of Federal Claims’ characterization of these state tax provisions suggests,
though not conclusively, the opposite result. As the reviewed state tax liabilities are
described as penalties and encumbrances, this suggests that these costs are generally
not allowable costs. Another subpart of the regulations discusses the allowability of
penalties:
Costs of fines and penalties resulting from violations of, or failure of the
contractor to comply with, Federal, State, local, or foreign laws and
regulations, are unallowable except when incurred as a result of
compliance with specific terms and conditions of the contract or written
instructions from the contracting officer.
48 C.F.R. § 31.205-15(a) (2004). The Court of Federal Claims’ reliance on state tax
provisions that describe penalties for failure to have shareholders pay the proper state
income tax does not establish that an S corporation shareholder’s state income tax
payments should be an allowable cost to the corporation.
The plain language of 48 C.F.R. § 31.205-41(b) states that taxes from which the
contracting entity is exempt are not allowable costs. This is the case here. ISN is free
from taxation on Ms. Malkani’s income derived from ISN’s corporate dividends.
Therefore, in its cost-reimbursement contract, Ms. Malkani’s state income tax payments
themselves cannot be an allowable cost for ISN.
04-5151, -5154 7
III
For the reasons stated, the Court of Federal Claims improperly interpreted 48
C.F.R. § 31-205-41(b) too narrowly and it therefore improperly concluded that Ms.
Malkani’s state income tax payments were allowable costs. This court reverses the
Court of Federal Claims’ grant of summary judgment in favor of ISN and remands the
case to the Court of Federal Claims for further proceedings consistent with this opinion.
As this court reverses the grant of summary judgment, ISN’s counterclaim for money
damages and interest is rendered moot.
COSTS
No costs.
REVERSE AND REMAND
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