CIVIL & CRIMINAL TAX PENALTIES COMMITTEE OF THE ABA SECTION OF TAXATION MAY MEETING

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1 CIVIL & CRIMINAL TAX PENALTIES COMMITTEE OF THE ABA SECTION OF TAXATION MAY MEETING UPDATE ON THE ACCURACY PENALTY: THE SLIPPERY SLOPE TO STRICT LIABILITY By John Colvin Chicoine & Hallett, P.S. Seattle, WA May 7, 2011

2 I. The Basic Structure of the Accuracy Penalty A. Negligence Sections 6662(b)(1) and (c) of the Code impose a penalty equal to 20 percent of the amount of any underpayment attributable to negligence or disregard of rules or regulations. The term negligence includes any failure to make a reasonable attempt to comply with tax laws, and disregard includes any careless, reckless, or intentional disregard of rules or regulations. 6662(c). Negligence also includes any failure to keep adequate books and records or to substantiate items properly. Treas. Reg (b)(1). B. Substantial Understatement Sections 6662(b)(2) and (d) of the Code impose a penalty equal to 20 percent of the amount of the underpayment in the case of any substantial understatement 1 of tax. A substantial understatement of income tax is one involving an understatement of 10% of the tax that should have been shown as due, or $5,000, whichever is larger. 1. Substantial Authority The substantial understatement penalty will not apply if there is substantial authority for the position taken on the return. Treas. Reg (d)(1). The substantial authority standard is less stringent than more likely than not (which is greater than 50% likelihood), but more stringent than a reasonable basis standard (the standard which would prevent negligence). Treas. Reg (d)(2). There is substantial authority for tax treatment of an item if the weight of the authorities supporting the treatment is substantial in relation to the weight of the authorities supporting a contrary treatment. Treas. Reg (d)(3)(i) (Emphasis supplied.) The weight to be accorded an authority depends upon its relevance, persuasiveness, and the type of document providing the authority. If the applicable statutory provision is subject to a wellreasoned construction, there may be substantial authority, despite the absence of a certain type of authority. Treas. Reg (d)(3)(ii). 2. Adequate Disclosure If the tax return provides adequate disclosure of the relevant facts and the legal position underlying an item on the taxpayers return or an attachment to the return, the item will not be subject to the substantial understatement penalty. 6662(d)(2)(B). Disclosure must ordinarily be made on a Form 8275 or 8275-R (or fully disclosed on a schedule UTP), but the IRS issues an annual Revenue Procedure setting out methods of making adequate disclosure for certain types of positions. See, e.g., Rev. Proc For a thorough discussion of the concept of an understatement for purposes of the 6662 penalty including how credits interact with the computation, see PMTA

3 The adequate disclosure exception does not apply unless the position has at least a reasonable basis, ( 6662(d)(2)(B)(ii)(II)), so disclosure of a frivolous position will not provide penalty protection. An item arising out of multi-party corporate financing transactions is not treated as having a reasonable basis unless the treatment of the item clearly reflects the income of the corporation. 6662(d)(2)(B). Finally, the adequate disclosure exception does not apply to any items attributable to a tax shelter as that term is (loosely) defined in the regulations under 6662(d). 3. Special Rules for Tax Shelters If the matter is viewed as a tax shelter for purposes of 6662(d), one additional requirement applies. Beyond showing the existence of substantial authority supporting the return position, the taxpayer must also show that he reasonably believed at the time the return was filed that the tax treatment claimed was more likely than not proper treatment. Treas. Reg (g)(1)(i)(B). A taxpayer is considered to reasonably believe that the tax treatment of an item is more likely than not the proper treatment if the taxpayer himself (or herself) analyzes the pertinent facts and authorities and reasonably concludes in good faith that there is a greater than 50 percent likelihood that the tax treatment of the item will be upheld if challenged by the Service. Recognizing that taxpayers are necessarily dependent upon their advisors to analyze and determine the proper treatment of complicated tax shelter arrangements, the regulations provide that a taxpayer will be considered to have reasonably believed that the tax treatment claimed was more likely than not the proper tax treatment: [If] the taxpayer reasonably relies in good faith upon the opinion of a professional tax advisor, if the opinion is based upon the tax advisor s analysis of the pertinent facts and legal authorities in the manner described in paragraph (d)(3)(ii) of this section and unambiguously states that the tax advisor concludes that there is a greater than 50-percent likelihood that the tax treatment of the item will be upheld if challenged by the Internal Revenue Service. Treas. Reg (g)(4)(i)(B). In the case of tax shelter items attributable to a pass-through entity, the actions taken by the entity (e.g., the general partners of a partnership) to establish reasonable belief are deemed taken by the taxpayer. Neither the presence of substantial authority nor the existence of reasonable belief will relieve a corporation from the imposition of the substantial understatement penalty when the item at issue is attributable to a tax shelter. Therefore, if a corporate taxpayer has a substantial understatement that is attributable to a tax shelter item, the accuracy-related penalty

4 applies to the understatement unless the reasonable cause and good faith exception under 6664 applies. (See (g)(1)(ii)(B) for special rules relating to transactions entered into by a corporation prior to December 9, 1994.) 4. What is a Tax Shelter? For transactions entered into on or after August 6, 1997, the definition of tax shelter includes, among other things, any entity, plan or arrangement a significant purpose of which is the avoidance or evasion of Federal income tax. 6662(d)(2)(C)(ii). For transactions entered into before August 6, 1997, the relevant standard was whether tax avoidance or evasion was the principal purpose of the entity, plan, or arrangement. Treas. Reg (g)(2)(i). The former principal purpose standard was more difficult for the government to meet than the current significant purpose standard. While tax shelters come in many varieties, the IRS is more apt to focus on transactions structured with little or no probability for the realization of economic gain, as well as transactions that involve: (1) a mismatching of income and deductions; (2) overvalued assets or assets with values subject to substantial uncertainty; (3) nonrecourse financing; and/or (4) financial techniques that do not conform to standard commercial business practices. See Treas. Reg (g)(2)(i)(c). C. Valuation-Based Penalty Components 1. Substantial Valuation Misstatement Sections 6662(b)(3) and (e) of the Code impose a 20 percent penalty in the case of a substantial valuation misstatement in connection with an income tax return. For the accuracyrelated penalty to apply in the case of a substantial valuation misstatement, the portion of the underpayment attributable to a substantial valuation misstatement must exceed $5,000 ($10,000 in the case of a corporation other than an S corporation or a personal holding company). A substantial misstatement of value is one in which the claimed value of any property (or the adjusted basis of any property) on the return is 150% or more than the value determined to be the correct value or adjusted basis, as the case may be (e)(1). 2 There are special rules for valuation misstatements arising out of section 482 transfer pricing adjustments (including a more liberal 200% threshold before the penalty applies). See 6662(e)(1)(B) and 6662(e)(3); Treas. Reg These rules are provide penalty relief provided that the taxpayer has adopted one of the pricing methods set out in the 482 regulations, the method adopted was reasonable, and adequate documentation regarding the pricing determination was kept and provided to the IRS promptly upon request. These rules are highly technical, extensive and beyond the scope of this outline.

5 The penalty is determined on a property-by-property basis, so that if one property is overvalued by 120% and the other property is overvalued by 180%, the penalty will only apply to the 180% overvalued property. Treas. Reg (f). 2. Overstatement of Pension Liabilities Sections 6662(b)(4) and (f) of the Code impose a 20 percent penalty in the case of an substantial overstatement of pension liabilities in connection with an income tax return. A substantial overstatement of pension liabilities exists if the actuarial determination of the amount of liabilities taken into account for purposes of computing the deduction under 404(a) is 200% or more than the correct valuation of the pension liabilities. For the accuracy-related penalty to apply in the case of a substantial overvaluation of pension liabilities, the portion of the underpayment attributable to overstatement of pension liabilities must exceed $1, Substantial Estate or Gift Tax Valuation Understatement Sections 6662(b)(5) and (g) of the Code impose a 20 percent penalty in the case of an substantial estate or gift tax valuation understatement. There is a substantial estate or gift tax valuation understatement if the value of property claimed on an estate or gift tax return is 65% or less than the amount determined to be the correct value of the property. For the accuracy-related penalty to apply in the case of a substantial estate or gift valuation understatement, the portion of the underpayment attributable to a the valuation understatement must exceed $5, Gross Valuation Misstatement In the event that the any of the valuation misstatement penalties set out in subsection (e), (f), or (g) are approximately twice the level necessary to impose the penalty, a penalty of 40 percent, rather than 20 percent is applicable (h). D. Reasonable Cause and Good Faith Section 6664(c)(1) provides an exception to the imposition of the accuracy-related penalty if the taxpayer establishes that there was reasonable cause for, and the taxpayer acted in good faith with respect to, the underpayment (a). The determination of whether the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, 3 In most cases, the gross valuation misstatement penalty is triggered when the percentage misstatement of value (or basis) is exactly twice the level necessary to trigger the substantial misstatement penalty. However, the percentage necessary to trigger the gross (non- 482) valuation misstatement penalty is 200% (which is only slightly more than the 150% necessary to trigger the substantial valuation misstatement penalty), and the percentage necessary to trigger the gross estate and gift tax valuation understatement penalty is 40% (as compared to the 65% necessary to trigger the normal estate and gift tax valuation understatement penalty).

6 taking into account the pertinent facts and circumstances (b)(1). 4 Generally, the most important factor is the extent of the taxpayer s effort to assess the proper tax liability for such year. Section 6664(c) provides that none of the components of the accuracy-related penalty apply if the taxpayer acted with reasonable cause and in good faith. Section of the Treasury Regulations, discussing what behavior shows reasonable cause and good faith, provides in part that: Reliance on an information return, professional advice or other facts, however, constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith. Treas. Reg (b)(1). In United States v. Boyle, 469 U.S. 241 (1985), the Supreme Court reasoned that, generally, taxpayers may rely upon the analysis of their tax advisers as a defense to most penalties under the Code: Boyle, 469 U.S. at 250. When an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely upon that advice. Most taxpayers are not competent to discern error in the substantive advice of an accountant or attorney. To require the taxpayer to challenge the attorney, to seek a second opinion, or try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking advice of a presumed expert in the first place. With respect to just what circumstances will count in determining if a taxpayer had reasonable cause and good faith in connection with seeking and following tax advice obtained from a professional, the regulations provide the following example: A, an individual calendar year taxpayer engages B, a tax professional, to give him advice concerning the deductibility of certain state and local taxes, A provides B with full details concerning the taxes at issue. B advises A that the taxes are fully deductible. A, in preparing his own tax 4 There is a longstanding statutory exception to the applicability of the reasonable cause and good faith rule of 6664(c)(1). In the case of valuation overstatements attributable to charitable deduction property, the reasonable cause and good faith rule does not apply unless the valuation of the property was based on a qualified appraisal performed by a qualified appraiser, ( 6664(c)(3) and (4)), and the taxpayer has also made a good faith investigation into the value of the contributed property.

7 return, claims a deduction for the taxes. Absent other facts, and assuming the facts and circumstances surrounding B s advice and A s reliance satisfy paragraph (c) of this section, A is considered to have demonstrated good faith by seeking the advice of a tax professional, and has shown reasonable cause for any underpayment attributable to the deduction claimed for the taxes. Treas. Reg (b)(2)(Example 1); See Houchin v. Comm r, T.C. Memo (accrual basis taxpayer relied on accountant in determining that income reportable in year funds received rather than in year settlement agreement executed); Mauerman v. Comm r, 22 F.3d 1001, (10th Cir. 1994)(taxpayer had two independent tax advisors review tax sheltered investment). In determining whether the taxpayer reasonably relied in good faith on a tax advisor, the taxpayer s education, sophistication and business experience are relevant (c)(1). Subsection (c)(1) of Treas. Reg sets out two minimum requirements that tax advice must meet before a taxpayer can claim the reasonable reliance on expert advice defense: First, the tax opinion must take into account all of the pertinent facts and apply the authorities to them, including the taxpayer s purposes for entering into the transaction: [T]he advice must take into account the taxpayer s purposes (and the relative weight of such purposes) for entering into the transaction and structuring the transaction in a particular manner. In addition, the requirements of this paragraph (c)(1) are not satisfied if the taxpayer fails to disclose a fact that it knows or reasonably should know, to be relevant to the proper tax treatment of an item. Second, the tax opinion must not be based on unreasonable facts: The advice must not be based on unreasonable factual or legal assumptions (including assumptions as to future events) and must not unreasonably rely on the representations, statements, findings or agreements of the taxpayer or any other person. For example, the advice must not be based upon a representation or assumption which the taxpayer knows, or has reason to know, is unlikely to be true, such as an inaccurate representation or assumption as to the taxpayer s purposes for entering into a transaction or for structuring a transaction in a particular manner. Treas. Reg (c)(1)(i) and (ii).

8 The regulations provide additional rules with respect to the tax shelter items of a corporation. Treas. Reg (f). Subsection (f)(3) of , sets out additional facts and circumstances to be evaluated in considering reasonable cause and good faith in the corporate tax shelter context: Satisfaction of the minimum requirements of paragraph (f)(2) is an important factor to be considered in determining whether a corporate taxpayer acted with reasonable cause and good faith, but is not necessarily dispositive. For example, if the taxpayer s participation in the tax shelter lacked significant business purpose, if the taxpayer claimed tax benefits that are unreasonable in comparison to the taxpayer s investment in the tax shelter, or if the taxpayer agreed with the organizer or promoter of the tax shelter that the taxpayer would protect the confidentiality of the tax aspects of the structure of the tax shelter. Treas. Reg (f)(3). 1. Example of Reliance on Tax Advice In Melnik v. Commissioner, T.C. Memo , knowing that their scrap metal company was going to be acquired by an independent third party, two taxpayer-brothers sold their stock to Clend, a BVI holding company organized for this purpose, in exchange for a private annuity. (Clend was owned by two offshore trusts, the trustee of which was a former Israeli army buddy of one of the taxpayers, and the permissible beneficiaries were the taxpayers and their families.) This arrangement, if respected, would have had the effect of deferring income on the sale to the third party until the taxpayers actually received distributions from Clend or the trusts. Subsequent to the sale of the scrap metal company, Clend made available almost the entire $4 million in proceeds received on the sale for use by the taxpayer-brothers, either through loans or through purchasing U.S. real estate selected by the taxpayer-brothers. The Tax Court found lack of any independent business purpose on the part of Clend and determined that the arrangement was a sham. In reaching this conclusion, it relied substantially on its findings that certain key documents with respect to the annuity transaction were backdated and that the taxpayer had attempted to manipulate the chronology to make the transaction appear more supportable. Citing Commissioner v. Court Holding Co., 324 U.S. 331 (1945), the Tax Court found the arrangement merely a conduit for funds from a sale that had already been agreed to by the taxpayer-brothers. Despite these factual findings, the Tax Court declined to impose the accuracy penalty. The Tax Court explained that the accuracy penalty could not be imposed in light of the significant role played by the taxpayers attorney, Mr. Pennoni, in structuring the transaction: The record consisted solely of a substantial number of stipulated exhibits and the testimony of three witnesses called by petitioners. The witnesses

9 testified, among other things, that the private annuity transactions were planned and implemented by Mr. Pennoni, who assured petitioners that the transactions were legitimate and were entitled to respect under Federal income tax law. The exhibits reflect the planning and implementation of the private annuity transactions and, on their faces, do not support a conclusion that petitioners decision to enter into the transactions was per se negligent. The uncontroverted record establishes that petitioners relied upon Mr. Pennoni, who was the driving force behind the planning of the annuity transactions and who assured petitioners that there was a reasonable basis for the income tax reporting of the private annuity transactions and the HouTex stock sale. We conclude that, under the circumstances, petitioners reliance upon Mr. Pennoni was reasonable, that petitioners had reasonable cause for the underpayment, and that petitioners acted in good faith with respect to the underpayment within the meaning of section 6664(c)(1). In Melnik, reliance upon an apparently qualified tax professional precluded imposition of the accuracy penalty in a case where: (1) the purpose of the plan was not to govern the prospective relationship between the parties, but to attempt to avoid the consequences of an already agreed sale; (2) there was no independent third party all parties were under the control of the taxpayer-brothers; (3) virtually all of the funds were made available for the taxpayers immediate benefit; and (4) documents were backdated. 2. Reliance Upon Investment Advisors Regarding Profitability Taking slightly difference approaches, several courts have addressed under what circumstances reliance on investment advice is reasonable for purposes of the establishing a defense to the imposition of the accuracy penalty. In Goldman v. Comm r, 39 F.3d 402, 404 (2d Cir. 1994), the Second Circuit considered investment advice from an accountant serving as sales representative for a promoter. The Second Circuit found reliance on such advice to be unreasonable, in part because the adviser expressed no knowledge of drilling technology or the oil and gas business, relied solely on the offering memorandum, and made no independent inquiries regarding the [investment]. Id at 408. But see Addington v. Comm r, 205 F.3d 54, 58 (2d Cir. 2000) (noting that it may be possible for taxpayer to rely upon adviser lacking expertise in particular industry if the adviser adequately investigates the proposed investment). In Durrett v Comm r, 71 F.3d 515, 518 (5th Cir. 1996), the Fifth Circuit reversed a Tax Court opinion that taxpayers were negligent in relying upon an attorney who gave financial advice, but who was not an expert in financial markets or in tax advantaged investments, and that an accountant who advised them had no experience with financial

10 transactions of the type involved. Also see Chamberlain v. Comm r, 66 F.3d 729, 732 (5th Cir. 1995). In Anderson v. Comm r, 62 F.3d 1266, 1268, 1271(10th Cir. 1995), the court considered a case where the taxpayer had received investment advice from a securities dealer. The Tenth Circuit held that an investment adviser does not have to be an expert in a particular industry before he can recommend an investment to another, and that such advice can be reasonably relied upon provided the investment adviser investigates the investment in question. Id. at However, if the taxpayers are aware of information that would tend to raise doubts about the investment, they must reasonably verify or investigate matters themselves. Id. at (finding that structure of transaction and mismatch between useful life of cargo containers and the seller s obligation to attempt to lease them should have induced greater scrutiny from the taxpayers). Thompson v. United States, 223 F.3d 1206, 1210 (10th Cir. 2000) (holding financial advisor does not have to be an expert in the industry or a certified investment advisor for reliance to be reasonable in case involving investment in recycling shelter found by court to be sham). In Allison v United States, 80 Fed. Cl. 568 (2008), the court held that reliance upon investment advisor, even one without experience in a particular industry or transaction could be reasonable. However, the Allison court held that, because sophisticated investors are generally more competent to discern error in the substantive advice of an investment adviser than in that of a lawyer or accountant, cf. Boyle, 469 U.S. at 251, it is not reasonable for a taxpayer to rely upon an investment adviser when the taxpayer knows that the adviser did not reasonably investigate the business opportunity. Id. at 587. Rules analogous to those involving reliance on an investment advisor should apply when the taxpayer claims reliance on someone with valuation expertise to defeat the imposition of the various valuation components of the accuracy penalty. For example, it should be possible for a taxpayer to rely on an actuary to determine the correct pension liability unless the taxpayer is aware of information that would raise doubts about the actuarial computation. 3. Independence of Advisor Some courts have held that an advisor s lack of independence as a result of an association with the promoter of a tax shelter eliminates reliance as a defense to the accuracy penalty. See Goldman v. Comm r, 39 F.3d 402, 404 (2d Cir. 1994); Neonatology v. Comm r, 299 F.3d 221 (3d Cir. 2002); Ryback v. Comm r, 91 T.C. 524, 565 (1988) (holding that reliance may be unreasonable when placed upon insiders or promoters, or when the person relied upon has an inherent conflict of interest); Pasternak v. Comm r, 990 F.2d. 893, 903 (6th Cir. 1993) (finding reliance upon promoters or their agents unreasonable because advice of such persons can hardly be described as that of independent professionals ). However, other courts have stressed that, in light of the fact specific inquiry mandated by the accuracy penalty, the existence of an advisor s financial incentive with respect to the subject matter of the advice is only one factor to be considered:

11 Given the fact-specific nature of the question of a taxpayer s negligence, the Court rejects the per se rule urged by the government. An adviser s connections with the promoters of an investment, including a financial interest in the subject matter of the advice, is certainly one factor to be considered in determining if taxpayers could reasonably rely on that adviser s advice. But is it not necessary the decisive factor. See Klein [v. United States], 94 F. Supp.2d [838] at , 852 [(E.D. Mich. 2000)]. As the Tenth Circuit explained, commissions on an investment adviser s sales are common. See Anderson [v. Comm r], 62 F.3d [1266] at 1271 [(10th Cir. 1995)]. And countervailing factors may be present, on net rendering reliance reasonable. Indeed, financial interests can cut both ways, and in some circumstances the fact that an adviser had also participated in the investment could be taken as a reason to have greater confidence in his advice. Id.; see also Klein, 94 F. Supp. 2d at 850 n.13. Advisers with good reputations, or preexisting relationships with their clients, may have a stronger personal interest in providing honest advice to clients than in earning a one-time commission. See Anderson, 62 F.3d at 1271 (concluding that taxpayer could reasonably rely on an investment adviser who was a friend and possessed a good reputation in the community); Klein, 94 F. Supp. 2d at 850 (explaining that it might have been reasonable to rely on an adviser who was highly recommended by a taxpayer s long-time trusted friend and accountant ); cf. Zidanich v. Comm r, 70 T.C.M. (CCH) 367, 374 (1995) (holding that unsophisticated investors could rely on a conflicted adviser when they had a long-term relationship with that adviser). And it may be reasonable to rely on the advice of investment advisers who extensively investigate the business prospects of an investment opportunity, even though (or perhaps because) the adviser has a financial stake in the investment. See Klein, 94 F. Supp. 2d at 850. In sum, even when an investment adviser has a potential conflict of interest, other considerations may be present that would make a taxpayer s expectation of loyalty reasonable under the circumstances. Allison, 80 Fed. Cl. at (2008). E. The Qualified Amended Return Retrospectively Eliminating Liability for the Accuracy Penalty If the taxpayer files a qualified amended return as that term is defined for purposes of (c)(3)(ii) of the Treasury Regulations, then there is no underpayment of tax. Treas. Reg (c). If there is no underpayment of tax, then the government cannot raise an unasserted accuracy penalty under 6662 as an offset, because the imposition of the accuracy penalty is predicated on the existence of an underpayment. For non-listed transactions, a qualified amended return is an amended return filed before the any of the following events occur:

12 (1) the taxpayer is first contacted regarding an examination of the return (e.g., when the taxpayer receives a notice of audit), (c)(3)(i)(A); (2) a third party is contacted regarding a promoter penalty audit under 6700 with respect to the activity through which the taxpayer claimed a tax benefit, (c)(3)(i)(B);. (3) a partnership through which the taxpayer claimed the tax benefit is first contacted by the IRS, (c)(3)(i)(C); (4) the date that the IRS serves a John Doe summons relating to the tax liability of a group that includes the taxpayer, with respect to any activity to which the taxpayer claimed a tax benefit on his return, even if the time frame of the summons does not include the year in which the tax benefit was claimed, (c)(3)(i)(D); or (5) the date that the Commissioner announces a settlement initiative to waive penalties (in whole or in part) with respect to a listed transaction, (c)(3)(i)(E). For undisclosed listed transactions, a qualified amended return is an amended return filed before the earlier of the following occur: (1) any of the triggers for non-listed transactions, (c)(3)(ii)(A); (c)(3)(i)(A) to (E); (2) the IRS contacts a third party regarding a tax shelter registration audit of that party under 6707(a) with respect to the undisclosed listed transaction of the taxpayer (c)(3)(ii)(B); or (3) the date the IRS requests from any material advisor the information required to maintained under the list maintenance rules, (c)(3)(ii)(C). In short, the accuracy penalty does not apply when the taxpayer self-reports changes to his or her tax return before a disqualifying audit or certain information seeking activities are commenced by the IRS. This policy underlying this regulation is to encourage taxpayers to file amended returns voluntarily (saving scarce auditing resources) by not subjecting them to penalties when they do so. F. Burden of Proof With respect to a taxpayer s liability for any penalty, 7491(c) places the burden of production on the Commissioner, thereby requiring the Commissioner to come forward with sufficient evidence indicating that it is appropriate to impose the penalty. Once the Commissioner meets his burden of production, the Tax Court holds that the burden of proof regarding the applicability of the penalty is placed with the taxpayer. Higbee v. Comm r, 116 T.C. 438, (2001). Taking a position contrary to Higbee, the Court of Federal Claims has indicated in dicta that 7491 places the burden of proof on the Commissioner. Allison v.

13 United States, 80 Fed. Cl. 568, 582 n.32 (2008). The Higbee ruling is faithful to the text of the statute, but does not take into account the other portions of the statute, which generally places the burden of proof on the IRS on all tax matters, provided the taxpayer cooperates during the audit. Especially with respect to reasonable cause and good faith, the Allison ruling does not take into account the fact that this is a defense to a penalty: the facts are uniquely in the taxpayer s possession and he must show the IRS that the provision applies. II. Changes in Law and Practice Over the Last Several Years A. New Penalties 1. Reportable Transaction Accuracy Penalty 6662A In 2004, Congress enacted section 6662A to provide an enhanced accuracy penalty for understatements of tax due to reportable transactions. The penalty is 30%, rather than 20%, of any undisclosed reportable transaction understatement, and 20% for disclosed reportable transactions. 6662A(c). The understatement for the 6662A penalty is defined differently from the 6662 accuracy penalty. A reportable transaction understatement is not simply measured by the difference in tax for the current year arising from the disallowance of the reportable transaction, but rather by the product of the change in taxable income and the highest marginal tax rate. 6662A(b)(1). Thus, transactions designed to generate losses that could be used in subsequent years may generate little additional tax, but relatively large penalties. Suppose a transaction generates a $1 million loss which is used against income in the year of the transaction, along with a $9 million NOL which is carried forward. The taxpayer may only face additional tax in the year of the transaction of $250,000 (assuming that is the tax on the million dollar adjustment in the year of the transaction), but assuming a 33% marginal rate - could have a penalty of $990,000 (0.3 x $10 million x 0.33). The reasonable cause exception is slightly different for the 6662A penalty. The reasonable cause exception only applies if: 6664(d)(3). (1) the facts of the transaction are adequately disclosed pursuant to the rules governing reportable transactions under 6662; (2) there was substantial authority for the taxpayer s treatment of the transaction; and (3) the taxpayer reasonably believed that the transaction was more likely than not the proper treatment. A taxpayer is treated as having reasonable belief only if the belief is based on the facts and law that existed at the time the tax return was filed, and based solely on the merits of

14 the position (and NOT the audit lottery). 6664(d)(4)(A). In determining reasonable belief, taxpayers cannot rely on disqualified tax advisors to provide advice, and cannot rely on disqualified opinions. 6664(d)(4)(B)(i). A disqualified tax advisor is defined as person who meets any of the following criteria: 6664(d)(4)(B)(ii). (1) who is a material advisor who participated in the organization, management, promotion or sale of the transaction, or is related (within the meaning of 267 or 707(b)(1)) to any person who participates; (2) who is compensated by a material advisor with respect to the transaction; (3) who has a fee arrangement contingent on all or part of the tax benefits from the transaction being sustained; or (4) who, pursuant to regulations promulgated by the Secretary, has a disqualifying financial interest with respect to the transaction. A disqualified opinion is an opinion that meets any of the following criteria: 6664(d)(4)(B)(iii). (1) is based on unreasonable factual or legal assumptions; (2) unreasonably relies on representations, statements, findings or agreements of the taxpayer or any other person; (3) does not identify and consider all relevant facts; or (4) fails to meet any other requirement prescribed by the Secretary 2. Erroneous Refund Penalty 6676 In 2007, Congress enacted a new assessable penalty (i.e., not subject to deficiency procedures) on certain erroneous claims for refund or credit The penalty is 20% of any excessive amount. The penalty does not apply if the taxpayer can show that the refund claim had a reasonable basis. 6676(a). The IRS has provided guidance to its agents in the form of an internal FAQ (that was disclosed to Tax Analysts pursuant to a FOIA request). The following are notable features of the FAQ: While reasonable basis is not defined for purposes of 6676, it is defined for purposes of 6662 at Treas. Reg (b)(3). The regulations under

15 6662 indicate that reasonable basis is a relatively high standard of tax reporting, significantly higher than non-frivolous, and is not satisfied by return positions that are merely colorable. The penalty can be imposed multiple times (like the 6702 frivolous submission penalty) with respect to the same tax period, but the IRS will apply a rule of equity and good conscience in determining whether to impose the penalty multiple times. While the statute is silent as to a statute of limitations, the best practice is to assess the 6676 penalty within three years of the date of the claim for refund. The penalty applies to both formal and informal claims. In a program manager technical assistance document, the IRS concluded that the 6676 penalty can be imposed on both spouses who sign a joint claim for refund. PMTA (Thus, a single excessive refund claim can result in two separate 20% penalties.) The advice also notes that, because reasonable basis is an objective determination, it would be inappropriate to separately test whether each spouse had a subjective reasonable basis. B. Administrative Changes 1. New Focus on Penalties In 2004, the IRS issued a revision of its penalty policy statement. New Policy Statement It required examiners to consider and fully develop the application of penalties in every case. Abusive transactions were singled out as areas where penalty application was important for the functioning of the tax system. Policy Statement 20-1 (Formerly P 1 18), is reprinted below. Effective Date: June 29, Penalties enhance voluntary compliance: The Internal Revenue Service has a responsibility to collect the proper amount of tax revenue in the most efficient manner. Penalties provide the Service with an important tool to achieve that goal because they enhance voluntary compliance by taxpayers. In order to make the most efficient use of penalties, the Service will design, administer, and evaluate penalty programs based on how those programs can most efficiently encourage voluntary compliance. 2. Penalties encourage voluntary compliance by: (1) demonstrating the fairness of the tax system to compliant taxpayers; and (2) increasing the cost of noncompliance. 3. In order to effectively use penalties to encourage compliant conduct, examiners and their managers must consider the applicability of penalties in each case, and fully develop the penalty issue when the initial consideration indicates that penalties should apply. That is, examiners and their managers must consider the elements of each potentially applicable penalty and then fully develop the facts to support the application of the penalty, or to establish that the penalty does not apply, when the

16 initial consideration indicates that penalties should apply. Full development of the penalty issue is important for Appeals to sustain a penalty and for Counsel to successfully defend that penalty in litigation. 4. Abusive transactions, frivolous returns, and other abusive taxpayer conduct undermine the fairness and integrity of the federal tax system and undercut voluntary compliance. Thus, it is particularly important in those cases for examiners and their managers to consider the potential applicability of penalties, and to develop fully the facts to either support the application of the penalty or to demonstrate that penalties should not apply. Consistent development and proper application of the accuracy-related and fraud penalties in abusive transaction cases will help curb this activity by imposing tangible economic consequences on taxpayers who engage in those transactions. In addition, consistent development and proper application of the promoter and preparer penalties in abusive transaction cases will help curb this activity by providing an economic deterrent for promoting abusive transactions and preparing returns claiming tax benefits from abusive transactions. An abusive transaction is one where a significant purpose of the transaction is the avoidance or evasion of Federal tax. 5. Special Rule for Listed Transactions. The Service will fully develop accuracy-related or fraud penalties in all cases where an underpayment of tax is attributable to a listed transaction. For purposes of this Policy Statement, a listed transaction is a transaction the Service has identified as a listed transaction pursuant to the regulations under 6011 of the Code. 6. In limited circumstances where doing so will promote sound and efficient tax administration, the Service may approve a reduction of otherwise applicable penalties or penalty waiver for a group or class of taxpayers as part of a Servicewide resolution strategy to encourage efficient and prompt resolution of cases of noncompliant taxpayers. 7. In considering the application of penalties to a particular case, all Service functions must develop procedures that will promote: a. Consistency in the application of penalties compared to similar cases; b. Unbiased analysis of the facts in each case; and c. The proper application of the law to the facts of the case. 8. The Service will demonstrate the fairness of the tax system to all taxpayers by: a. Providing every taxpayer against whom the Service proposes to assess penalties with a reasonable opportunity to provide evidence that the penalty should not apply; b. Giving full and fair consideration to evidence in favor of not imposing the penalty, even after the Service s initial consideration supports imposition of a penalty; and c. Determining penalties when a full and fair consideration of the facts and the law support doing so. This means that penalties are not a bargaining point in resolving the taxpayer s other tax adjustments. Rather, the imposition of penalties in appropriate cases serves as an incentive for taxpayers to avoid careless or overly aggressive tax reporting positions. 9. The Service will continue to develop, monitor, and revise programs to help taxpayers voluntarily comply with the law and avoid penalties. 10. To promote consistent development, consideration, and application of penalties, the Service prescribes guidelines in a Penalty Handbook that all operating divisions and functions will follow. The Office of Penalty and Interest Administration must review and approve changes to the Penalty Handbook for consistency with Service Policy

17 before making recommended changes. 11. The Service collects statistical and demographic information to evaluate penalties and penalty administration, and to determine the effectiveness of penalties in promoting voluntary compliance. The Service continually evaluates the impact of the penalty program on compliance and recommends changes when the Internal Revenue Code or penalty administration does not effectively promote voluntary compliance. 12. Approved: Mark E. Matthews, Deputy Commissioner for Services and Enforcement 2. Increased Coordination of Issues with Technical Experts While the IRS has always attempted to coordinate the treatment of similar transactions, the challenge posed by the technical tax shelters in the late 1990s and early 2000 led to significant centralization of decision-making with respect to a variety of transactions. For example, LB&I prepares coordinated issue papers for many types of transactions, both tax shelters and otherwise. Similarly, Appeals attempts to coordinate any issue coordinated at the exam level. See This ordinarily means that every coordinated transaction requires concurrence for any settlement, including any settlement with respect to penalties asserted. For example, while the IRS provided no appeal rights to taxpayers in Son of Boss cases, it is providing appeal rights to Son of Boss taxpayers who exercise CDP rights. In a Memorandum issued on October 6, 2010, by James Wallace, the Acting Director of Appeals for Tax Policy and Valuation, Appeals issued interim guidance, designed to ensure that the cases are handled consistently. (Son of Boss is a coordinated issue, and any decision accordingly requires the concurrence of the Appeals Technical Guidance Coordinator). Any Appeals decisions on the merits of the liability, including penalties or innocent spouse relief, require the approval of the Chief of Appeals. C. Revisions to Thresholds for Certain Substantial and Gross Valuation Penalties ( 6662) Section 1219 of the 2006 Pension Act altered the trigger percentages for the imposition of the substantial and gross income tax valuation misstatement penalties and the substantial and gross gift and estate tax valuation penalties under section With respect to the income tax valuation misstatement penalty, under pre-2006 law, a 20% penalty applied when the claimed value or basis was at least twice (200%) of the proper amount, and a 40% penalty applied when the claimed value or basis was four times (400%) the correct amount. The new law alters those percentages to 150% and 200%, respectively. In short, what had been the threshold for the 20% penalty became the new threshold for the 40% penalty, and the threshold for the 20% penalty drops significantly lower. Similarly, with respect to gift and estate taxes, under prior law, a 20% penalty applied if the value claimed was 50% of the correct value, and a 40% penalty applied if the value

18 claimed was 25% of the correct value. The new law alters these percentages from 50% to 65% and from 25% to 40%. Given the number of cases in which the IRS takes the position that the taxpayer s valuations are significantly different than the correct value by more than one third, this penalty (or the threat of this penalty being sustained) now plays a much more prominent role. D. A New Component of the Accuracy Penalty Applicable to Transactions That Lack Economic Substance Section 1409 of the Health Care and Educational Reconciliation Act of 2010 (P.L. No ), titled Codification of Economic Substance Doctrine and Penalties, sets out a statutory economic substance doctrine and significantly alters the contours of the penalty structure with respect to transactions that are treated as lacking economic substance. The changes set out in section 1409 both the substantive changes to the economic substance doctrine and the penalty provisions are generally effective with respect to transactions entered after March 30, Clarification of the Economic Substance Doctrine 7701(o) Section 1409 enacts new 7701(o) of the Code, which purports to clarify the application of the economic substance doctrine: (1) APPLICATION OF DOCTRINE. In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction. (2) SPECIAL RULE WHERE TAXPAYER RELIES ON PROFIT POTENTIAL. (A) (B) IN GENERAL. The potential for profit of a transaction shall be taken into account in determining whether the requirements of subparagraphs (A) and (B) of paragraph (1) are met with respect to the transaction only if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected. TREATMENT OF FEES AND FOREIGN TAXES. Fees and other transaction expenses shall be taken into account as expenses in determining pre-tax profit under subparagraph (A). The Secretary shall issue regulations requiring foreign taxes to be treated as expenses in determining pre-tax profit in appropriate cases.

19 (3) STATE AND LOCAL TAX BENEFITS. For purposes of paragraph (1), any State or local income tax effect which is related to a Federal income tax effect shall be treated in the same manner as a Federal income tax effect. (4) FINANCIAL ACCOUNTING BENEFITS. For purposes of paragraph (1)(B), achieving a financial accounting benefit shall not be taken into account as a purpose for entering into a transaction if the origin of such financial accounting benefit is a reduction of Federal income tax. (5) DEFINITIONS AND SPECIAL RULES. For purposes of this subsection (A) (B) (C) (D) ECONOMIC SUBSTANCE DOCTRINE. The term "economic substance doctrine" means the common law doctrine under which tax benefits under subtitle A with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose. EXCEPTION FOR PERSONAL TRANSACTIONS OF INDIVIDUALS. In the case of an individual, paragraph (1) shall apply only to transactions entered into in connection with a trade or business or an activity engaged in for the production of income. DETERMINATION OF APPLICATION OF DOCTRINE NOT AFFECTED. The determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted. TRANSACTION. The term "transaction" includes a series of transactions. 2. Complimentary Changes to the Penalty Regime a) A New Component of the Accuracy Penalty New subsection (b)(6) of section 6662, provides a 20% penalty for any disallowance of claimed tax benefits by reason of a transaction lacking economic substance (within the meaning of section 7701(o)) or failing to meet the requirements of any similar rule of law. It is unclear what is meant by a similar rule of law. Sham transaction? Form over substance? Too good to be true? The smell test? b) A New 40% Penalty For Undisclosed Transactions Lacking Economic Substance New subsection (i) of section 6662 provides for a 40% penalty in the case of nondisclosed economic substance transactions. 6662(i)(1). The phrase nondisclosed

20 economic substance transactions means any portion of a transaction described in subsection (b)(6) [i.e. transactions lacking economic substance] with respect to which the relevant facts affecting the tax treatment are not adequately disclosed in the return nor in a statement attached to the return. 6662(i)(2). Disclosure does not eliminate the application of the penalty as it does in the case of the substantial understatement penalty. Rather, it only reduces the rate to 20%. c) No Reasonable Cause Defense New subsection 6664(c)(2) provides that the reasonable cause and good faith defense to penalties set out in 6664(c)(1) shall not apply to any portion of an underpayment which is attributable to one or more transactions described in section 6662(b)(6) [i.e. transactions lacking economic substance]. Note that this elimination of the defense does not just apply to non-disclosed economic substance transactions, but also to transactions which were fully disclosed on the tax return. d) Excessive Refund Penalty for Transactions Lacking Economic Substance Refund claims which lack a reasonable basis are subject to a 20% penalty New 6676(c) provides that an excessive [refund claim] which is attributable to any transaction described in section 6662(b)(6) [i.e. transactions lacking economic substance] shall not be treated as having a reasonable basis. Accordingly, transactions which may fail on the basis of economic substance cannot be litigated in a refund forum without the possibility that the government will assert a 20% penalty. Again this penalty need not be asserted in a deficiency notice. e) Notice Interim Guidance Ending months of speculation by practitioners, in interim guidance issued recently, the IRS announced that it would not issue general administrative guidance regarding the types of transactions to which the economic substance doctrine applies or does not apply. In other words, there will be no angel list. The IRS also stated that it would not issue private letter rulings or determination letters regarding whether the economic substance doctrine is relevant to any transaction or whether the transaction complied with the requirements of 7701(o). Notice indicated that the IRS would apply the conjunctive test (objective economic substance and non-tax business purpose) required by the statute ( 7701(o)(1)(A) and (B)), rather than the disjunctive test applied by some courts. With respect to when and how foreign taxes could be treated as expenses of a transaction in determining the pre-tax profit, the IRS indicated that it would issue regulations on this subject as required by the statute ( 7701(o)(2)(B)). In determining whether the transaction changed the taxpayer s economic position and had a substantial non-tax business purpose ( 7701(o)(1)(A) and (B)), the potential for profit of a transaction can only be taken into account if the present value of the reasonably expected