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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
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. § 1.6662-3(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 understatement1 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. § 1.6662-4(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. § 1.6662-4(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. § 1.6662-4(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. § 1.6662-4(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. 2011-13.
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 2010-01.
1
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.
§ 1.6662-4(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. § 1.6662-4(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
applies to the understatement unless the reasonable cause and good faith exception under
§ 6664 applies. (See § 1.6662-4(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. § 1.6662-4(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. § 1.6662-4(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.2 § 6662(e)(1).
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. § 1.6662-6. 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.
2
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. § 1.6662-5(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 $1,000.
3.
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 $5,000.
4.
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.3 § 6662(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. § 1.6664-4(a). The determination of whether
the taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis,
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).
3
taking into account the pertinent facts and circumstances. § 1.6664-4(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 1.6664-4 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. § 1.6664-4(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:
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.
Boyle, 469 U.S. at 250.
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
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.
4
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. § 1.6664-4(b)(2)(Example 1); See Houchin v. Comm’r, T.C. Memo 2006-119
(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, 1005-1006 (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. § 1.66644(c)(1).
Subsection (c)(1) of Treas. Reg. § 1.6664-4 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. § 1.6664-4(c)(1)(i) and (ii).
The regulations provide additional rules with respect to the “tax shelter items of a
corporation.” Treas. Reg. § 1.6664-4(f). Subsection (f)(3) of § 1.6664-4, 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. § 1.6664-4(f)(3).
1.
Example of Reliance on Tax Advice
In Melnik v. Commissioner, T.C. Memo. 2006-25, 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
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
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 1271. 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 1272-73 (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:
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 84950, 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 587-88 (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
§ 1.6664-2(c)(3)(ii) of the Treasury Regulations, then there is no “underpayment of tax.”
Treas. Reg. § 1.6664-2(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:
(1) the taxpayer is first contacted regarding an examination of the return (e.g., when
the taxpayer receives a notice of audit), § 1.6664-2(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, § 1.66642(c)(3)(i)(B);.
(3) a partnership through which the taxpayer claimed the tax benefit is first contacted
by the IRS, § 1.6664-2(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, § 1.6664-2(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, § 1.6664-2(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, § 1.6664-2(c)(3)(ii)(A); § 1.66642(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.
§ 1.6664-2(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, § 1.6664-2(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, 446-447 (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.
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:
(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.
§ 6664(d)(3).
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
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:
(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.
§ 6664(d)(4)(B)(ii).
A “disqualified opinion” is an opinion that meets any of the following criteria:
(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
§ 6664(d)(4)(B)(iii).
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. § 6676. 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. § 1.6662-3(b)(3). The regulations under
§ 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 2010-003.
(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 20-1. 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, 2004
1.
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
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
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 http://www.irs.gov/pub/irs-utl/tg_issues_index.pdf.
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 6662.
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
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.
111-152), 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, 2010.
1.
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)
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.
(B)
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.
(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)
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.
(B)
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.
(C)
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.
(D)
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
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. § 6676.
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 2010-62 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 2010-62 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
pre-tax profit is “substantial” in comparison to the value of the expected tax benefits (if the
transaction were respected). § 7701(o)(2)(B). Notice 2010-62 provides that, “in performing
this calculation, the IRS will apply existing relevant case and other published guidance.” The
difficulty faced by practitioners on this score is that there is no case law or any other guidance
describing whether expected profits are “substantial” in relation to tax benefits.
With respect to disclosure (which limits penalty exposure), the IRS stated that the
adequate disclosure requirement of new § 6662(i) would be satisfied if the taxpayer makes a
disclosure (which fully sets out the facts underlying the return position) on a Form 8275 or
8275-R (or as otherwise prescribed by subsequent guidance), attached to an original or
qualified amended return. For CEP taxpayers, disclosures may be made pursuant to Rev.Proc.
94-69. If the transaction is a “reportable transaction,” the IRS takes the position that the
adequate disclosure requirement is met only if disclosure is made on the Form 8275 and the
disclosure requirement under the § 6011 regulations is also met (Form 8886 filed with return
and separately sent to OTSA).
f)
LMSB: Economic Substance Penalty Must Be Approved By A
Director Of Field Operations
On September 14, 2010, LMSB issued a directive requiring that any proposal to impose
the economic substance prong of the accuracy penalty must be reviewed and approved by the
appropriate Director of Field Operations. (LMSB Control No. LMSB-4-0910-024.) The
purpose of this requirement is to ensure consistency in the administration of this new penalty.
E.
HIRE Act – FATCA Disclosure and Associated Penalties
On March 18, 2010, the “Hiring Incentives to Restore Employment Act” (P.L. No.
111-147) or “HIRE Act” was signed into law by the President. The HIRE Act contains
several modifications to the foreign tax reporting rules, tax penalty structure, as well as the
statute of limitations.
1.
Foreign Financial Account Disclosure (New § 6038D) – “FBAR Plus”
Section 511 of the HIRE Act creates new § 6038D of the Code. This new section
requires individual taxpayers with an interest in a “specified foreign financial asset” to attach a
disclosure statement to their return if the aggregate value of all such assets exceeds $50,000.
§ 6038D(a). “Specified foreign financial assets” are depositary and custodial accounts at
foreign financial institutions, as well as the following (if not held in an account at a financial
institution): (1) stocks or securities issued by foreign persons; (2) any financial instrument or
contract issued by (or which has a counterparty that is) a non US person; and (3) any interest
in a foreign entity. § 6038D(b).
The failure to make the required disclosures is subject to a penalty of $10,000 for the
taxable year. § 6038D(d). If the IRS notifies the individual regarding his failure to make the
required disclosures, and the failure continues for more than 90 days after the mailing of the
notification, there is an additional $10,000 penalty for each 30 day period that passes, up to a
maximum of $50,000. § 6038D(d)(2).
2.
Undisclosed Foreign Financial Asset Understatement Penalty
New subsection (b)(7) of section 6662, provides a 20% penalty for “any undisclosed
foreign financial asset understatement.” New subjection (j) of section 6662 provides the
following definitions:
(j) UNDISCLOSED FOREIGN FINANCIAL ASSET UNDERSTATEMENT.
(1)
IN GENERAL.—For purposes of this section, the term ‘undisclosed
foreign financial asset understatement’ means, for any taxable year, the
portion of the understatement for such taxable year which is attributable
to any transaction involving an undisclosed foreign financial asset.
(2)
UNDISCLOSED FOREIGN FINANCIAL ASSET.—For purposes of
this subsection, the term ‘undisclosed foreign financial asset’ means,
with respect to any taxable year, any asset with respect to which
information was required to be provided under section 6038, 6038B,
6038D, 6046A, or 6048 for such taxable year but was not provided by
the taxpayer as required under the provisions of those sections.
There is also a new enhanced (i.e. 40%) penalty for any “undisclosed foreign asset
understatement.” § 6662(j)(3).
This penalty is effective for taxable years beginning after March 18, 2010 (the date of
enactment). HIRE Act, § 512(b).
F.
Definition of a “Promoter”
In January 2011, the Tax Court released 106 Ltd v. Comm’r, 136 T.C. No. 3,
addressing when one can have good faith reliance on a legal professional. The 106 Ltd opinion
defines a “promoter” as “an adviser who participated in structuring the transaction or is
otherwise related to, has an interest in, or profits from the transaction.” 5 The Tax Court notes
The definition offered by the 106 Ltd. court is based on the working definition of a promoter
offered in dicta by the court in Tigers Eye Trading, LLC v. Comm’r, T.C. Memo. 2009-121.
Tigers Eye Trading cited a number of cases in support of its definition of promoter, including
Goldman v. Comm’r, 39 F.3d 402, 408 (2d Cir. 1994) (taxpayer could not reasonably rely on
professional advice of someone known to be burdened with an inherent conflict of interest – a
sales representative of the transaction), affg. T.C. Memo. 1993-480; Pasternak v. Comm’r,
990 F.2d 893, 903 (6th Cir. 1993) (reliance on promoters or their agents is unreasonable
because such persons are not independent of the investment), affg. Donahue v. Comm’r, T.C.
Memo. 1991-181; Illes v. Comm’r, 982 F.2d 163, 166 (6th Cir. 1992) (finding negligence
where taxpayer relied on person with financial interest in the venture), affg. T.C. Memo.
5
that some care must be given in applying this definition to some types of transaction (e.g., a
tax lawyer is asked by a businessman on how to sell the family business through a tax favored
stock might be said to have “participated in structuring the transaction”), but notes that “when
the transaction involved is the same tax shelter offered to numerous parties, the definition is
workable.”
The 106 Ltd. court notes a tax adviser is not a “promoter” when he or she:
III.

has a long-term and continual relationship with his client;

does not give unsolicited advice regarding the tax shelter;

advises only within his field of expertise (and not because of his regular
involvement in the transaction being scrutinized);

follows his regular course of conduct in rendering his advice; and

has no stake in the transaction besides what he bills at his regular hourly rate.
Offset
In cases where the IRS did not assert an accuracy penalty in the examination (or there
was no examination), and the taxpayer brings a claim for refund on a transaction unrelated to
the one potentially subject to an accuracy penalty, it is possible for the Department of Justice to
argue that the IRS is entitled to setoff any amount due the taxpayer against an accuracy related
penalty owed, but not assessed.
A valid setoff requires three elements: (i) a decision to effectuate a setoff, (ii) some
action accomplishing the setoff, and (iii) a recording of the setoff. Citizens Bank v. Strumpf,
516 U.S. 16, 19 (1995).
In Lewis v. Reynolds, 284 U.S. 281 (1932), aff’g 48 F.2d 515 (10th Cir. 1931), the
foundation case which established the setoff defense in tax cases, the taxpayers paid tax and
filed a claim for a refund (on the grounds that he was not a non-resident alien) after the statute
of limitations for making additional assessments had expired. The IRS reviewed the matter,
and, while it conceded that the taxpayers were factually correct in the residency position, it
determined that other deductions on the return (attorney’s fees) were not allowable. The IRS
therefore denied the refund claim. The taxpayers argued that, because the statute of limitations
1991-449; see also Hansen v. Comm’r, 471 F.3d 1021, 1031 (9th Cir. 2006) (“a taxpayer
cannot negate the negligence penalty through reliance on a transaction’s promoters or on other
advisors who have a conflict of interest”), affg. T.C. Memo. 2004-269; Van Scoten v.
Comm’r, 439 F.3d 1243, 1253 (10th Cir. 2006) (“To be reasonable, the professional adviser
cannot be directly affiliated with the promoter; instead, he must be more independent”), affg.
T.C. Memo. 2004-275; Barlow v. Comm’r, 301 F.3d 714, 723 (6th Cir. 2002) (“courts have
found that a taxpayer is negligent if he puts his faith in a scheme that, on its face, offers
improbably high tax advantages, without obtaining an objective, independent opinion on its
validity”), affg. T.C. Memo. 2000-339. See 106 Ltd. at footnote 14.
had expired, the IRS was “restricted in [its] consideration of the claim for refund … to a
determination of whether the [taxpayers] were entitled to deductions of specific items set up in
the claim for refund” (48 F.2d at 516), and could not consider issues outside the claim. On the
other hand, the IRS argued that it had “the power, upon consideration of the claim for refund,
to reconsider the entire assessment and determine whether or not the [taxpayer] had overpaid
the tax.” 48 F.2d at 516 (emphasis supplied).
The Tenth Circuit in Lewis v. Reynolds held that the fundamental question presented in
the statutes authorizing the IRS to refund money was whether a taxpayer had overpaid his tax,
and that “this involves a redetermination of the entire tax liability.” 48 F.2d at 516. The
Supreme Court agreed, stating that:
It follows that the ultimate question presented for decision, upon a claim for
refund, is whether the taxpayer has overpaid his tax. This involves a
redetermination of the entire tax liability.
…
While the statutes authorizing refunds do not specifically empower the
Commissioner to reaudit a return whenever repayment is claimed, authority
therefore is necessarily implied.
284 U.S. at 283 (emphasis supplied).
In Lewis v Reynolds, the Supreme Court and Tenth Circuit recognized that the statute
authorizing refunds implicitly authorized the IRS to review the taxpayer’s entire tax liability
for the year and determine if there was any money due, including the determination of whether
any refund otherwise due should be offset by other liabilities owing to the IRS, but which had
not been assessed.6
Likewise, in Dysart v. United States, 340 F.2d 624, 627 (Ct. Cl. 1965), in light of an
unfavorable court decision regarding a penalty imposed on the taxpayers,
6
[T]he IRS abandoned its previous grounds for disallowance of the refund of the
penalty but asserted that judgment damages, reported as capital gain in the 1954
return, should have been taxed as ordinary income and that, although the statute
of limitations barred the deficiency, it should be used as a setoff against the
refund due taxpayers.
Also see Patterson v Belcher, 302 F.2d 289, 295 (5th Cir. 1962), amended on other grounds,
305 F.2d 557, cert. denied, 371 U.S. 921 (1962); Fisher v. United States, 80 F.3d 1576, 1581
(Fed. Cir. 1996) (“The IRS’s right to assert its setoff covering interest cannot be defeated by
reference to the alleged ‘equities’ … .”); Pacific Gas & Electric Company v. United States,
417 F.3d 1375, 1377 (Fed. Cir. 2005) (“[T]he IRS discovered the interest computation errors
… and determined that it had erroneously overpaid PGE $3,370,535 in statutory interest. The
Similarly, in Allen v. United States, 51 F.3d 1012 (11th Cir. 1995), the IRS was
permitted to offset the refund of a fraud penalty with otherwise time-barred delinquency and
negligence penalties:
While the IRS was attempting to extract the fraud penalties from Allen, the Tax
Court, in Kotmair v. Commissioner, 86 T.C. 1253, 1259-1262, 1986 WL 22144
(1986) (en banc), held that the assessment of such penalties in a tax protestor
case like Allen’s was improper. In light of Kotmair, the IRS decided, in
December of 1990, to refund the fraud penalty assessment. The agency
concluded, however, that it was entitled to offset about $1,800 from the $6,600
refund by imposing instead, delinquency and negligence penalties for the 1975
and 1976 tax years.
51 F.3d at 1013 (emphasis supplied).
Thus, if a taxpayer was involved in a transaction potentially subject to the accuracy
penalty and the penalty was not asserted, the taxpayer cannot file a claim for refund after the
statute of limitations for assessing the penalty expires without the risk that the government will
reduce the amount of any refund due by the amount of an unasserted accuracy penalty. If the
amount of the penalty asserted as an offset exceeds the amount of the taxpayer’s claim for
refund, the taxpayer will recover nothing.
IRS then used [this] amount … to offset and reduce the tax and interest … that it refunded to
PGE in 1992.”); Loftin and Woodward, Inc. v. United States, 577 F.2d 1206, 1245 (5th Cir.
1978) (“Lewis permits the Commissioner to reopen the prior return to determine whether there
were any deficiencies in that return which were undetected at the time it was filed.”)