501 F.3d 555 (6th Cir. 2007), 03-4486, Mikulski v. Centerior Energy Corp.

Docket Nº:03-4486.
Citation:501 F.3d 555
Party Name:Jerome R. MIKULSKI; Elzetta C. Mikulski, On Behalf of Themselves and All Others Similarly Situated, Plaintiffs-Appellants, v. CENTERIOR ENERGY CORPORATION; First Energy Corporation; Cleveland Electric Illuminating Company; The Toledo Edison Company, Defendants-Appellees.
Case Date:August 21, 2007
Court:United States Courts of Appeals, Court of Appeals for the Sixth Circuit

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501 F.3d 555 (6th Cir. 2007)

Jerome R. MIKULSKI; Elzetta C. Mikulski, On Behalf of Themselves and All Others Similarly Situated, Plaintiffs-Appellants,


CENTERIOR ENERGY CORPORATION; First Energy Corporation; Cleveland Electric Illuminating Company; The Toledo Edison Company, Defendants-Appellees.

No. 03-4486.

United States Court of Appeals, Sixth Circuit.

Aug. 21, 2007

Argued: Sept. 13, 2006.

Appeal from the United States District Court for the Northern District of Ohio at Cleveland. Nos. 02-02440; 03-00191; 03-00192; 03-07043 -Donald C. Nugent, District Judge.

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[Copyrighted Material Omitted]

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Eric H. Zagrans, ZAGRANS LAW FIRM, Elyria, Ohio, for Appellants.

Mitchell G. Blair, CALFEE, HALTER & GRISWOLD, Cleveland, Ohio, for Appellees.


Eric H. Zagrans, ZAGRANS LAW FIRM, Elyria, Ohio, Eben O. McNair IV, SCHWARZWALD & McNAIR, Cleveland, Ohio, Robert D. Gary, Lorain, Ohio, Thomas R. Theado, GARY, NAEGELE & THEADO, Cleveland, Ohio, for Appellants.

Mitchell G. Blair, Colleen M. O'Neil, Tracy S. Johnson, CALFEE, HALTER & GRISWOLD, Cleveland, Ohio, for Appellees.


BATCHELDER, J., delivered the opinion of the court, in which BOGGS, C. J., GILMAN, GIBBONS, ROGERS, SUTTON, McKEAGUE, and GRIFFIN, JJ., joined. DAUGHTREY, J. (pp. 574-77), delivered a separate opinion concurring in part and dissenting in part, in which MARTIN, MOORE, COLE, and CLAY, JJ., joined.



The issue to be decided in the present case is whether the substantial-federal-question doctrine provides federal subject-matter jurisdiction over a state law claim on the basis that an embedded element of the claim concerns 26 U.S.C. § 312(n)(1), an accounting rule in the federal tax code. We hold that it does not.


Plaintiffs Jerome and Elzetta Mikulski filed a class action suit against Centerior

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Energy Corporation ("Centerior") 1 in the Cuyahoga County (Ohio) Court of Common Pleas, alleging fraudulent misrepresentation and breach of contract. For ease of introduction, we can ignore certain details until later in the analysis and set out the underpinnings of this case without all their rough edges. Simply put, Centerior interpreted 26 U.S.C. § 312(n)(1) to mean that, beginning with its 1985 fiscal year, it could no longer deduct certain interest expenses from its calculation of taxable earnings. Therefore, Centerior did not deduct these expenses from its earnings, which made Centerior appear more profitable but also increased Centerior's tax liability. Because Centerior declared and distributed dividends based on these reported earnings, the increased tax liability was passed on to its shareholders via IRS forms 1099-DIV.

The plaintiffs contend that Centerior's interpretation of § 312(n)(1), in regard to this particular interest expense, was not only incorrect, but was fraudulent. The plaintiffs accuse Centerior of intentionally overstating its earnings and profits during the time periods in question, in order to make itself appear more profitable. In what turned out to be a critical response to an interrogatory, the plaintiffs explained their theory in terms of 26 U.S.C. § 312:

Section 312(n)(1) states that no construction expenses incurred before January 1, 1985, may be considered in calculating a corporation's earnings and profits.

Centerior [] included in its earnings and profits calculations for 1986 (and subsequent years) more than $1.5 billion of construction expenses that its subsidiaries had incurred in 1984 and earlier.

[Therefore,] Centerior violated the Internal Revenue Code by doing what Section 312(n)(1) of the Code specifically forbids.

Pls.' Supp. Resp. to Interrog. No. 1 of Defs.' Second Set of Interrogs (rearranged from original). To be clear, these "construction expenses" are actually interest expenses on long-term construction loans that span the years in question, which are labeled "construction period carrying charges" in § 312(n)(1). Section 312(n)(1) actually states: "In the case of any amount paid or incurred for construction period carrying charges ... no deduction shall be allowed with respect to such amount," and there is no date provision in the codified statute. The essential point of this interrogatory response, however, is that it invoked federal law, namely § 312(n)(1), as the basis for the plaintiffs' state law claim. Thus, the plaintiffs' contend, based on this interpretation of § 312(n)(1), that Centerior (by overstating its earnings and profits) misrepresented to its shareholders (via IRS forms 1099-DIV) that their dividends were taxable, which caused those (now plaintiff-class) shareholders to erroneously overpay their federal and state income taxes.

Centerior disputed the plaintiffs' interpretation of § 312(n)(1), particularly its effective date 2 provision, which led to the

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question of whether § 312(n)(1) applied only to interest expenses actually incurred after January 1, 1985 (as the plaintiffs argued), or if it instead applied to accumulated interest expenses that related to construction projects that remained ongoing after January 1, 1985 (as Centerior had assumed). The plaintiffs concede that their claim will fail under the latter construction; if Centerior complied with the accounting requirements in the statute, then it would not be culpable for overstating its taxable earnings and profits or misreporting taxable dividends.

Centerior removed the case to federal court by asserting, based on the plaintiffs' response to the above-referenced interrogatory, that the complaint raised a substantial federal question, the resolution of which was essential to the disposition of the plaintiffs' claims. The plaintiffs moved for a remand to state court, and the district court denied the motion, finding that the plaintiffs' cause of action, although presented as breach of contract and fraudulent misrepresentation, was actually aimed at a tax refund and raised a substantial federal question involving federal tax law.

Centerior next filed a motion for judgment on the pleadings, arguing that the action was expressly preempted by 26 U.S.C. § 7422, and implicitly preempted by the scope and complexity of the Internal Revenue Code. The district court referred the case to a magistrate judge who recommended judgment on the pleadings and documented three findings. First, the plaintiffs could have raised the issue with the IRS, filed for a refund, or pursued administrative remedies, but they did not. Second, if the court allowed the lawsuit to proceed, then it could be opening the federal courts to litigation by every shareholder for misstatement of earnings and profits, by every employee for overstatement of earnings on W-2 forms, and by every independent contractor for an overstated 1099 form. Third, the Internal Revenue Code was designed to avoid these types of actions and instead allows injured taxpayers to proceed directly against the government for a refund.

The plaintiffs objected to the magistrate judge's report and recommendation, arguing that its principal error was in mischaracterizing their claim as one for a tax refund, which led to the erroneous conclusion that the claims were preempted by federal tax law. At a hearing before the district court, the plaintiffs refuted preemption and once again disputed removal jurisdiction. The plaintiffs emphasized that their suit was based on state law claims for breach of contract and fraud, not the alleged violation of the Internal Revenue Code. The district court rejected the plaintiffs' arguments, adopted the magistrate judge's recommendation, and granted judgment on the pleadings in favor of Centerior. The district court concluded that the complaint relied on the interpretation of the Internal Revenue Code, and therefore jurisdiction was proper based on either preemption or a substantial question of federal law. The district court granted judgment on the pleadings based on the plaintiffs' failure to exhaust their remedies with the IRS.

The plaintiffs appealed to this court on the issue of federal subject-matter jurisdiction. Mikulski v. Centerior, 435 F.3d 666, 671 (6th Cir.2006) (rehearing en banc granted, opinion vacated Apr. 26, 2006). The majority reversed, finding that the district court had misapplied both the preemption and the substantial-federal-question doctrines, and consequently lacked subject-matter jurisdiction. The entire panel agreed that the district court had erred in finding the plaintiffs' claims preempted by 26 U.S.C. § 7422. The majority further held that the mere presence of a federal statute as an element of a

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claim does not present a substantial federal question. The dissent relied on Grable & Sons Metal Products, Inc. v. Darue Engineering & Manufacturing, 545 U.S. 308, 125 S.Ct. 2363, 162 L.Ed.2d 257 (2005), to argue that the federal government has a substantial interest in the construction of 26 U.S.C. § 312(n)(1) because it affects the amount of federal tax a security holder must pay.

Centerior petitioned for rehearing en banc, asking: "Whether federal question jurisdiction exists over state law claims when plaintiffs' recovery depends upon a contested interpretation of federal tax law?" This court granted the rehearing and vacated the panel opinion.


When a decision on subject-matter jurisdiction concerns pure questions of law or application of law to the facts, this court conducts a de novo review. Rodriguez v. Tenn. Laborers Health & Welfare Fund, 463 F.3d 473, 475 (6th Cir. 2006). If the district court's...

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