March 13, 2013
The government has asked the Supreme Court to resolve a longstanding conflict in the circuits on the applicability of the penalty for valuation misstatements in United States v. Woods, No. 12-562.
The Code contains a variety of civil penalty provisions for conduct connected with underreporting of tax. The basic penalty is found in section 6662, which imposes an accuracy-related penalty for underpayments of tax “attributable to” different kinds of conduct, including negligence, substantial understatements of tax, and substantial overvaluations. The penalty is 20% of the portion of the underpayment “attributable to” the misconduct. I.R.C. § 6662(a), (b). Section 6662(e) applies the 20% penalty in the case of a “substantial valuation misstatement,” which is defined as occurring when “the value of any property (or the adjusted basis of any property) claimed on any [tax return] is 150 percent or more of the amount determined to be the correct amount of such valuation or adjusted basis.” I.R.C. § 6662(e)(1)(A). That 20% penalty is doubled, however, to 40% in the case of a “gross valuation misstatement,” which is defined in the same way, except that the overvaluation is 200% or more of the correct amount. I.R.C. § 6662(h)(2)(A)(i). (Prior to 2006, the relevant percentages were 200% for a substantial valuation misstatement and 400% for a gross valuation misstatement.)
Congress’s focus in originally enacting this penalty was to address a specific problem of overvaluation. It found that many taxpayers were severely overvaluing difficult-to-value assets like artwork, anticipating that the dispute would ultimately be resolved by “dividing the difference.” Thus, the severe penalties were enacted as a deterrent to these overvaluations. See generally H.R. Rep. No. 97-201, at 243 (1981).
In the last decade or so, however, the government has most frequently invoked this penalty regime in its efforts to combat tax shelters. Oversimplifying a bit, many tax shelters work by using a series of transactions that have the effect of creating a high basis in some particular asset. Disposal of that asset then generates a large tax loss. The IRS often argues in these cases that the high basis is artificially inflated because the transactions lack economic substance. If that argument succeeds, the high basis and attendant tax loss goes away. In such cases, the government also frequently argues that the 40% gross valuation overstatement penalty applies on the theory that the taxpayer claimed a high basis in an asset ultimately found to have a much lower basis; hence, the adjusted basis “claimed on” the return exceeded by more than 200% or 400% “the amount determined to be the correct amount of” the adjusted basis. I.R.C. § 6662(h)(2)(A)(i). The government has not been able to apply this approach in a uniform way across the country, however, because of a persistent disagreement in the circuits over how to construe the penalty statute.
The crux of the dispute centers on the “attributable to” language in the statute. More than 25 years ago, the IRS contested certain taxpayers’ deductions and credits claimed as a result of transactions involving the purchase of refrigerated containers. It argued both that the taxpayers had overstated their bases in the property and that the containers had not been placed in service in the years in which the deductions had been taken. The court ruled for the IRS based on the latter argument. The Fifth Circuit held that, in these circumstances, the valuation overstatement penalty did not apply because the tax underpayment was not “attributable to” the valuation overstatement; even if there were such an overstatement, the deductions were completely disallowed for a reason independent of the overstatement. Todd v. Commissioner, 862 F.2d 540, 541-45 (5th Cir. 1988). Two years later, the Fifth Circuit applied Todd to a case where the two grounds for disallowance were more closely connected, the IRS having contended that the units were overvalued and that the taxpayers did not have a profit motive for the transactions. Heasley v. Commissioner, 902 F.2d 380, 383 (5th Cir. 1990).
The Fifth Circuit has continued to apply Heasley in tax shelter cases, holding that when an asset is found to have an artificially inflated basis because transactions lack economic substance, the tax underpayment is “attributable to” the economic substance conclusion, not to an overvaluation. Last year, it reaffirmed its adherence to that approach in Bemont Invs. L.L.C. v. United States, 679 F.3d 339 (5th Cir. 2012), although the judges indicated that they thought the Fifth Circuit precedent was probably wrong. Shortly thereafter, a different panel rejected the government’s position in a one-paragraph per curiam opinion in Woods v. Commissioner, No. 11-50487 (June 6, 2012), that describes Todd, Heasley, and Bemont as “well-settled,” and the court denied a petition for rehearing en banc. As a result, the 40% penalty is unavailable in the Fifth Circuit in the typical tax shelter case, although a 20% penalty usually will still apply because of negligence or a substantial understatement of tax (I.R.C. §§ 6662(c), (d)(1)).
The government asks the Court to grant certiorari in Woods, contending in its petition that “[t]here is a lopsided but intractable division among the circuits over whether a taxpayer’s underpayment of tax can be ‘attributable to’ a misstatement of basis where the transaction that created an inflated basis is disregarded in its entirety as lacking economic substance.” Although the Ninth Circuit has followed the Fifth Circuit’s approach, the petition states that eight other circuits have gone the other way. Several of those decisions have expressly disagreed with the Fifth Circuit precedent. The petition says the circuit conflict is “ripe for resolution” given that the Fifth and Ninth Circuit have recently denied petitions for rehearing en banc asking them to reconsider their minority view on this issue.
The case is a strong candidate for Supreme Court review, unless the Court concludes that the issue is “overripe.” In 2010, Congress passed section 6662(i), which imposes a 40% penalty on any underpayment of tax attributable to a “nondisclosed noneconomic substance transaction” entered into after March 30, 2010. That new section would make the penalty applicable in such economic substance situations even in the Fifth and Ninth Circuits, and thus makes resolution of the conflict less important for future years. The cert petition addresses this concern, stating that the new statute “has no application to the thousands of taxpayers who engaged in abusive, basis-inflating tax shelters before the provision’s effective date.” In addition, the government argues that the new provision will not affect cases “where value- or basis-related deductions are disallowed in full on a ground other than lack of economic substance.”
In its brief in opposition, the taxpayer does not deny the existence of the circuit conflict. He argues, however, that the issue does not warrant the Court’s attention, largely because the 2010 legislation has resolved the issue presented for future years. In addition, the taxpayer argues that “the imposition of the 40% penalty in cases where the 20% penalty applies is not an important matter” and expresses skepticism about the government’s “sensationalized claim” that “hundreds of millions of dollars” in penalties are riding on this issue. In response, the government identifies a group of eight cases docketed within the Fifth Circuit that involve aggregate basis misstatements of approximately $4 billion.
The Court is expected to announce whether it will hear the case on March 18.