Taxpayers’ Brief Filed in Woods

The taxpayers have filed their response brief in the Supreme Court in the Woods case, contending first that the courts lacked jurisdiction to impose the penalties requested by the IRS and, second, that, if jurisdiction exists, the Fifth Circuit correctly held that the valuation misstatement penalty could not be imposed.

On the jurisdictional point, the brief emphasizes the same basic point made by the courts that have questioned jurisdiction in similar partnership cases (see our previous report here) – namely, that the statute allows for partnership-level jurisdiction in a TEFRA proceeding only over a penalty that relates to adjustment of a “partnership item.”  It is undisputed that outside basis is not a partnership item, and the taxpayers contend that the “penalty at issue in this case undeniably relates to the adjustment of a nonpartnership item—outside basis—not to a partnership item.” The taxpayers’ brief dismisses the government’s argument on this point as having “an Alice-in-Wonderland feel to it” and, at any rate, as proving too much.  The taxpayers concede that the outside basis determination does relate to the adjustment of a partnership item, specifically, whether the partnership transaction should be disregarded for lack of economic substance.  But the brief maintains that, if that attenuated connection were enough for jurisdictional purposes, then the statute’s jurisdictional limitation “would be rendered essentially meaningless and could be readily circumvented.”  The result would be to “rewrite Section 6226(f) to create precisely the jurisdiction that Congress withheld.”

On the merits of the penalty, the brief begins with a different argument from the one relied upon by the Fifth Circuit – maintaining that “there was no ‘valuation misstatement’ to begin with.”  Pointing to the common meaning of the word “valuation” in the statutory text, and to the legislative history, the taxpayers argue that “Congress meant the penalty to address misstatements about valuation—an inherently factual concept concerning the worth or cost of property.”  Therefore, the penalty should not be “triggered by transactions that are accurately reported but deemed not to exist based on a legal conclusion that they lack economic substance,” even if the result of that legal conclusion is to restate the basis claimed by the taxpayer.

The government argues, of course, that the text of the penalty provision is not limited strictly to classic “valuation” misstatements, because the statute defines those misstatements as occurring when “the value of any property (or the adjusted basis of any property)” is overstated on the return.  The taxpayers argue, however, that the government is overreading the parenthetical “adjusted basis” reference and, read in context, it should apply “only when basis is incorrectly reported due to a factual misrepresentation of a property’s worth or cost.”  For the government to read this language as authorizing application of the valuation overstatement penalty to cases where there is a “basis overstatement that is in no way dependent on a valuation error” – that is, one that is traceable to a legal conclusion that the transaction creating the basis was devoid of economic substance – is in the taxpayers’ view “essentially blowing [the penalty provision] up and transforming it into a penalty scarcely recognizable to the one Congress intended.”

The taxpayers also point to the penalty provision added in Congress’s recent enactment of an economic substance provision.  They argue that the penalty associated with that provision (see Code section 6662(b)(6) and (i)) could impose a 40% penalty for the reporting in this case and therefore its enactment indicates that the existing valuation misstatement penalty should not be construed to cover economic substance cases.

As a fallback argument, the taxpayers argue for adopting the rationale of the Fifth Circuit – namely, that the underpayment of tax is “attributable to” a finding of no economic substance and hence is not attributable to a basis overstatement.  Finally, the taxpayers rely on language from Supreme Court decisions in the 1930s to argue that doubts about the meaning of ambiguous tax statutes should be resolved in favor of the taxpayer.

An amicus brief in support of neither party was filed by Professor Andy Grewal.  That brief discusses the state of the law in the courts of appeals regarding the substance of the economic substance doctrine, but urges the Court to “reserve its opinion on the broader economic substance issues implicated in this case.”  Four amicus briefs were filed in support of the taxpayers, on either one or both issues, by other taxpayers involved in pending litigation that would potentially be affected by the Court’s holding.  See here, here, here, and here.

The government’s reply brief is due August 18.  Oral argument has been scheduled for October 9.

Woods – Taxpayers’ Response Brief

Supreme Court Briefing Underway in Woods on Penalty and TEFRA Issues

The government has filed its opening brief in the Supreme Court in the Woods case, which involves whether the 40% gross valuation overstatement penalty applies in the context of a basis-inflating transaction held not to have economic substance.  See our earlier report here.

The government’s arguments on the question whether the penalty can be applied in these circumstances are similar to those discussed here previously and addressed in several court of appeals decisions.  It relies on the “plain text” of the statute, arguing that “[t]he word ‘attributable’ means ‘capable of being attributed’” and therefore a finding of lack of economic substance does not defeat the conclusion that the tax underpayment is “attributable” to a basis overstatement.  And the brief responds at length to the Fifth Circuit’s reliance on the “Blue Book” to justify a narrower interpretation of the statute.  The government characterizes the court’s approach as reflecting “a misinterpretation of the relevant passage” in the Blue Book and goes on to say that, “[i]n any event, the Blue Book, a post-enactment legislative report, could not trump the plain text of Section 6662.”  Finally, the government asserts that a contrary rule “would frustrate the penalty’s purpose of deterring large basis overstatements.”

The brief also addresses a question not presented in the petition for certiorari, but instead added to the case by the Supreme Court – namely, whether the district court had jurisdiction under Code section 6226 to decide the penalty issue.  This issue concerns the two-level structure established by TEFRA for judicial proceedings involving partnerships.  Partnerships are not taxable entities themselves; tax attributes from the partnership flow through to the tax returns of the individual partners.  Accordingly, before 1982, tax issues raised by a partnership tax return could be resolved only through litigation with individual partners, leading to duplicative proceedings and often inconsistent results.  The TEFRA scheme calls for proceedings at the partnership level to address “the treatment of any partnership item,” which would be issues common to all the individual partners.  Adjustments that result from those proceedings flow down to the individual partners, and the IRS can make assessments on the individual partners based on those partnership-level determinations without having to issue a notice of deficiency or otherwise initiate a new proceeding.  Issues that depend on the particular circumstances of individual partners, however, are determined in separate partner-level proceedings.

In this case, the penalty determination was made at the partnership level.  That seems logical in one sense because the conclusion that the transaction lacked economic substance – and therefore did not have the effect on basis claimed by the taxpayer – was a partnership-level determination that would not depend on an individual partner’s circumstances.  The Tax Court agrees with that approach, but the D.C. Circuit and the Federal Circuit have stated that such determinations do not involve “partnership items” within the meaning of TEFRA and hence a penalty determination like the one in this case should  be made at the individual partner level.  See Jade Trading, LLC v. United States, 598 F.3d 1372 (Fed. Cir. 2010); Petaluma FX Partners, LLC v. Commissioner, 591 F.2d 649 (D.C. Cir. 2010).  The reason is that the basis at issue here is an “outside basis,” that is, the partner’s basis in his or her partnership interest.  A partner’s outside basis is not a tax attribute of the partnership entity (unlike, for example, the basis of an asset held by the partnership).  These courts did not dispute the assertion that outside basis is an “affected item” (that is, an item affected by a partnership item) and that the conclusion underlying the penalties obviously follows from the partnership item determination; it is obvious that there is zero outside basis in a partnership that must be disregarded on economic substance grounds.  But these courts ruled that obviousness is not a good enough reason to get around the jurisdictional limitations of the statutory text; “affected items” must be determined in a partner-level proceeding.

In its brief in Woods, the government argues that the statutory text allows the penalty determination to be made at the partnership level because the text affords jurisdiction over a penalty that “relates to an adjustment to a partnership item.”  I.R.C. § 6226(f) (emphasis added).  According to the government, “[w]hen a partnership item is adjusted in a way that requires an adjustment to an affected item and triggers a penalty, the penalty ‘relates to’ the adjustment to the partnership item.”  The statute thus should be understood as providing that “the court [considering the partnership-level issues] should decide whether an error with respect to a partnership item, if reflected in a partner’s own return, could trigger the penalty.”  The government’s brief then argues forcefully that its interpretation “best effectuates the objectives” of TEFRA because requiring this kind of penalty determination – involving “a pure question of law whose resolution does not depend on factors specific to any individual partner” – to be made at the partner level “would restore the inefficient scheme that Congress intended to do away with.”

The taxpayer’s brief is due July 22.

Woods – Government’s Opening Brief

Supreme Court Agrees to Hear Penalty Issue in Woods

The Court this morning granted the government’s petition for certiorari in United States v. Woods, No. 12-562.  As we recently reported, the issue presented in the petition concerns the applicability of the valuation overstatement penalty — specifically, whether tax underpayments are “attributable to” overstatements of basis when the inflated basis claim has been disallowed based on a finding that the underlying transactions lacked economic substance.

The Court also added a second question for the parties to brief — “Whether the district court had jurisdiction in this case under 26 U.S.C. section 6226 to consider the substantial valuation misstatement penalty.”  This issue involves the general question under TEFRA of which issues are to be resolved in a partner-level proceeding and which should be resolved at the partnership level.  See Petaluma FX Partners, LLC v. Commissioner, 591 F.3d 649, 655-56 (D.C. Cir. 2010).

The government’s opening brief is due May 9.  Oral argument will likely be scheduled for late 2013, with a decision expected by June 2014.

Supreme Court Poised to Consider Penalty Issue in Woods

March 13, 2013 by  
Filed under Penalties, Supreme Court, Woods

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.

Woods – Petition for Certiorari

Woods – Brief in Opposition

Woods – Reply Brief in Support of Certiorari

Fifth Circuit decision in Bemont

Ninth Circuit to Rule on Timing for Filing a Qualified Amended Return for an Undisclosed Listed Transaction

May 1, 2012 by  
Filed under Bergmann, Penalties, Procedure

The taxpayers in Bergmann v. Commissioner are appealing an adverse Tax Court decision, 137 T.C. No. 10, holding that they failed to timely file a qualified amended return for 2001 and thus are liable for the 20-percent accuracy related penalty.   The taxpayers participated in a listed transaction promoted by KPMG, known as the Short Option Strategy.  In 2004, two years after the IRS issued a summons to KPMG specifically identifying the Short Option Strategy transaction, the Bergmanns filed an amended return disclaiming the tax benefits of the transaction.  The case concerns the interpretation of Treas. Reg. § 1.6664-2(c)(3)(ii) (2004), which establishes rules on the timing of filing a qualified amended return for undisclosed listed transactions.  If an amended return is filed before certain terminating events, additional tax reported on the amended return will be treated as if it were reported on the original return.  Under the “promoter provision,” the amended return must be filed before the IRS first contacts a person concerning liability under section 6700 (a promoter investigation).   The Tax Court rejected the taxpayers’ argument that the IRS must establish that the target of the promoter investigation is in fact liable for a promoter penalty.  The Tax Court also held that, in investigating the promoter, the IRS need only identify the “type” of transaction in which the taxpayer engaged, not the specific transaction or the identity of the taxpayer.

In 2000-2001, taxpayer Jeffrey Bergmann was a tax partner in KPMG’s Stratecon Group, which the Tax Court characterizes as “focused on designing, promoting and implementing aggressive tax planning strategies for high-net-worth individuals.”  In tax years 2000 and 2001, Bergmann entered into a “Short Option Strategy” transaction promoted by fellow KPMG partner Jeffrey Greenberg.  This transaction was identified by the IRS as an abusive tax shelter in Notice 2000-44, 2000-2 C.B. 255 (transactions generating losses by artificially inflating basis).  The taxpayers (Bergmann and his wife) claimed losses for the 2000 and 2001 Short Option Strategy transactions on their 2001 return, but filed an amended return in March 2004 removing the losses attributable to the transactions and paying approximately $200,000 in additional tax.  The IRS treated the qualified amended return as untimely and assessed accuracy-related penalties.

Under Treas. Reg. § 1.6664-2(c)(3)(ii), as in effect when the Bermanns filed their amended return, the time to file a qualified amended return terminates when the IRS first contacts a person “concerning” liability under section 6700 (a promoter investigation) for an “activity” with respect to which the taxpayer claimed a tax benefit.  The IRS served KPMG with two summonses in March 2002, one of which was specifically targeted at KPMG’s involvement in promoting transactions covered by Notice 2000-44.  Attempting to disassociate their transaction from those that were the subject of the KPMG investigation, the taxpayers argued that Greenberg acted in his individual capacity in advising them, not as an agent of KPMG.  The Tax Court rejected this argument, concluding that the transactions in which the taxpayers engaged were within the scope of Greenberg’s responsibilities as a KPMG partner and also concluding that KPMG had not limited Greenberg’s authority to engage in Notice 2000-44 transactions with other KPMG partners, including Bergmann.   The Tax Court also rejected the taxpayers’ argument that the promoter investigation must specifically identify the “activity” that gave rise to the tax benefit.  The Tax Court held that the summons need only refer to the “type” of transaction in which the taxpayer participated.  The court found that the March 2002 summons met this requirement because it specifically identified the transaction as the same or substantially similar to the transaction identified in Notice 2000-44.

The Tax Court noted that disclosure of the transaction after the Notice 2000-44 summons was served on KPMG would not have been voluntary.  The Tax Court explained that the purpose of the promoter provision is to encourage taxpayers to voluntarily disclose abusive tax shelters.  That purpose is effectuated by terminating the period to file a qualified amended return when disclosure would no longer be voluntary.

The Tax Court addressed a second issue as well.  At first glance, the taxpayers appeared to be subject to the 40% gross overvaluation penalty because the scheme depended on what was found to be an artificially inflated based.  They argued, however, that the tax underpayment was not “attributable to” the overvaluation because the Commissioner contended (and the taxpayers eventually conceded) that the entire transaction should be disallowed for lack of economic substance, thereby making the valuation irrelevant.  The Tax Court noted that this type of bootstrapping argument has been rejected by several circuits, which have held that the 40% penalty applies when overvaluation is intertwined with a tax avoidance scheme, but that Ninth Circuit precedent has accepted the argument.  Keller v. Commissioner, 556 F.3d 1056.  Accordingly, the Tax Court rejected the IRS’s attempt to impose a 40% penalty, and the taxpayers were assessed only the standard 20% accuracy-related penalty.  The IRS has not appealed this issue.

The taxpayers’ opening brief is due on May 16.  The case is docketed in the Ninth Circuit as No. 12-70259.

Tax Court Opinion

NPR Oral Argument

On December 7th, oral argument was held in the Fifth Circuit in the NPR case before Judges Dennis, Clement, and Owen.  You can find a detailed explanation of the issues here but in summary the questions involve whether, in the context of a Son of BOSS case: the gross valuation penalty applies when the basis producing transaction is not invalidated solely due to a bad valuation; whether other penalties apply; how the TEFRA jurisdictional rules function as to those penalties; and whether an FPAA issued after a non-TEFRA partnership no-change letter falls afoul of the no-second-FPAA rule. 

Although both parties appealed, as the initial appellant DOJ began the argument.  DOJ counsel argued that the Supreme Court’s decision in Nat’l Cable & Telecomm. Ass’n v. Brand X Internet Servs., 545 U.S. 967, 982 (2005), allowed Treas. Reg. § 1.6662-5(d) to override the Fifth Circuit’s position in Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990), that a valuation misstatement cannot apply where there are grounds for invalidating the transaction other than an incorrect valuation — such as where the transaction is totally disallowed under economic substance or on technical grounds.  In this regard, DOJ requested that the court submit the matter for en banc review to address this issue and to consider the impact of Weiner v. United States, 389 F.3d 152 (5th Cir. 2004), which counsel characterized (as DOJ had in the brief) as calling the “total disallowance” rule into question. 

As to the substantive application of penalties, DOJ argued that the complete concession by the taxpayer of the substance of the transaction compelled the conclusion that the position lacked substantial authority.  Furthermore, counsel argued that there was no substantial authority at the time the transaction was reported on the taxpayer’s return.  In this regard, DOJ posited that although Helmer v. Commissioner, 34 T.C.M. (CCH) 727 (1975), had held that a contingent liability was not a liability for purposes of section 752, it did not address the questions of buying and selling offsetting options and of contributing them to a partnership only to arrange for a distribution and sale.  As to these points, the only authority on point was Notice 2000-44, which stood for the proposition that the transaction did not work.  This appears to be a repackaged version of the argument that there can never be substantial authority for transactions lacking economic substance. 

Argument transitioned to the question of whether the district court had jurisdiction to consider a penalty defense put on by the partners and not by the partnership in this partnership action.  For a prior discussion of this confusing question see our analysis here.  Citing Klamath Strategic Inv. Fund, LLC v. United States, 568 F.3d 537 (5th Cir. 2009), DOJ counsel argued that the Fifth Circuit had already decided that an individual reasonable cause argument (such as one based on a legal opinion issued to the partner) cannot be raised in a TEFRA proceeding.  The court seemed to recognize the impact of Klamath on this point.  DOJ counsel then attempted to box the partnership in (as it had in the brief) on the question of whether the defense was raised by the partner or the partnership (several statements in the district court’s opinion seem to view the defense as a partner-level defense).  

Moving on to the question of the merits of the reasonable cause position, DOJ argued that the district court erred in considering reliance on the tax opinion (which was written by R.J. Ruble) to be reasonable.  Initially, counsel questioned whether the partners’ testimony that they did not believe Ruble had a conflict was reasonable in light of the partners’ knowledge of fee sharing and of the fact that Ruble had written opinions for other shelters for the same promoter.  The court seemed to be honed in on this question.  In closing, DOJ attempted to poison the well of partner good faith by reminding the Court that the partners in this case were repeat tax-shelter offenders and had attempted to hide the Son-of-BOSS losses as negative gross revenue from their law firm business. 

Perhaps indicating a weakness on the penalty issues raised by DOJ, taxpayer’s counsel spent most of his time on the question of whether the second FPAA was invalid.  The Court focused counsel on the fact that an error on the tax return (the Form 1065 did not check the TEFRA box although it did check the flow-through partner box (which would indicate a TEFRA partnership)) led the agent originally to pursue the case as non-TEFRA.  Undeterred, counsel argued that this error was not material and that the agent had indicated in a deposition that he eventually learned that the partnership was TEFRA.  Testimony was also offered in the district court that the reporting was an innocent mistake and not negligent or deceptive.  The Court spent significant time questioning why the agent did not testify at trial (which appears to have been due to a mix-up on the part of DOJ).  In summarizing his position, taxpayer’s counsel tried to focus the court on the language of the partnership no-change letter but to us it appears that the real question has to be whether the agent intended this to be a TEFRA audit.  An FPAA simply cannot come out of a non-TEFRA audit.  Based on the agent’s deposition transcript it seems clear that he did not believe he was involved in a TEFRA audit when he opened the audit and thus it is impossible that the initial notice was an FPAA. 

Rebutting DOJ’s reasonable cause position, taxpayer’s counsel focused on the trial testimony and factual determinations by the district court that the taxpayers were acting reasonably and in good faith.  On the question of jurisdiction, the taxpayer reverted to the tried and true (but not very strong) argument that requiring a later refund suit to address the reasonable cause question would be a waste of judicial resources and, in essence, a meaningless step.  A cynic might say that the purpose of TEFRA is to waste judicial resources and create meaningless steps. 

In rebuttal, DOJ counsel focused on the no-second-FPAA question and did a good job from our perspective.  He noted that you have to have a TEFRA proceeding to have a TEFRA notice.  Undermining the district court’s determination that the finality of the notice is relevant, counsel noted that all non-TEFRA notices are “final” but that doesn’t mean they are FPAAs.  TEFRA is a parallel audit procedure and it is simply not enough that the IRS intended a final determination in a non-TEFRA partnership audit.  The question is whether the IRS intended to issue a final notice in a TEFRA proceeding; since there was no “first” TEFRA proceeding, there was no “first” FPAA.  We think this argument is right on target. 

With limited questions coming from the Court it is difficult to see where this is headed.  Our best guess is that the partnership will prevail on the reasonable cause position (it is difficult for an appellate court to overturn credibility determinations of witnesses) but lose on everything else including the no-second-FPAA issue.

NPR Calendared for Argument

The NPR case (involving penalty application and TEFRA issues in the context of a Son of BOSS transaction: see latest substantive discussion here) has been calendared for argument in New Orleans on December 7th in the East Courtroom.

Briefing Complete in NPR

As we mentioned in our last post, the only brief remaining to be filed in NPR was the taxpayer’s reply brief.  That brief has now been filed and with it a DOJ motion to strike part of that reply as an inappropriate sur-reply.  The motion concerns a section in the reply in which the taxpayer takes on DOJ for arguing (in its previously filed reply brief ) that the only relevant factor in determining the incidence of the valuation misstatement penalty (between partnership and partner) is whether there are partnership items involved and not where the specific misstatement results in a loss.

The taxpayer’s view is that DOJ is trying to have its cake and eat it too – arguing that the penalty applies at the partnership level because it is related to partnership items but refusing to allow section 6664 arguments to be heard on the grounds that those are specific to the partner.  DOJ’s position is that it would be barred from raising the penalty outside of the context of a partnership proceeding because the penalty relates to a partnership item (or items) and that it is not inconsistent to require section 6664 intent to be evaluated at the partner level (and, in any event, it is required by the regulations).  All of this, as we have extensively discussed, is intertwined in the silliness of trying to separate partner and partnership intent between TEFRA levels something the regulations perhaps should not have done but clearly do.  It will be interesting to see how the Fifth Circuit handles the case.

NPR Update

It has been a while since we published an update on NPR (please no comments on Supreme Court Justices, schoolchildren, and bloggers taking summers off).  Since our last post discussing the government’s opening brief, the taxpayer filed its brief responding to the government and opening the briefing on their cross-appeal.  The government also filed its response/reply.  All that remains now is the taxpayer’s reply brief on its cross-appeal, currently due on August 15.  There are a slew of technical TEFRA issues that are raised by the parties.  The taxpayer is appealing the district court’s rulings regarding whether a no change letter can ever be an FPAA and, if it can be, whether an erroneously checked box on the tax return (claiming that the partnership was not a TEFRA partnership) can constitute a misrepresentation of a material fact such that the no-second-FPAA rule of section 6223(f) is inapplicable.  As we discussed last post, the parties are jointly briefing — in the government’s appeal — the application of the Heasley/Weiner line of cases to the taxpayer’s concession strategically made to circumvent the gross valuation misstatement penalty.  Mayo is implicated by the application of Treasury Regulation section 1.6662-5(d) (DOJ relies on Brand X to argue that the regulation controls over the contrary rule previously announced in Heasley).

However, as we discussed in prior posts, the main issue here is good faith reliance on counsel — R.J. Ruble — by the taxpayer for purposes of the section 6664 reasonable cause defense and when, procedurally, that defense can be raised.  The government continues to hew to the line that reliance is inappropriate (because of a technical conflict and because reliance was just not reasonable under the circumstances).  DOJ also argues that the defense can be raised only in a partner-level proceeding pursuant to then Temporary Treasury Regulation section 301.6221-1T(d) (the judges may want to get a cholesterol test with all of this Mayo being spread around).  For its part, the taxpayer argues that the district court already determined — after seeing the witness testimony — that the reliance was in good faith.  Furthermore, since one of the partners is the TMP, the reasonable cause defense is being raised by the partnership as much as by the partners.  Setting aside whether you believe the testimony (which the district court judge did), if we could decide cases based on the fact that section 301.6221-1T(d) of the TEFRA penalty regulations is stupid, this would be easy.  As we have said before, separating partner and partnership intent in a transaction involving a partnership that was purposefully created by the partners to implement that very same transaction is like trying to dance on a headless pin.  With deference under Mayo, however, “stupid is as stupid does” is not the test for striking down regulations.  We will just have to wait and see how much patience the Fifth Circuit has for this Forrest Gump of a regulation.

NPR Still Dragging Itself Out of the Minefield

The Government has filed its brief in its Fifth Circuit appeal from the denial of penalties in the NPR Investments case (for prior discussion go here).  There are no surprises.  The Government takes the position that the district court’s reliance on Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990) (likely abrogated by Treas. Reg. § 1.6662-5(g) and certainly weakened on these facts by Weiner v. United States, 389 F.3d 152 (5th Cir. 2004)) is misplaced.  Thus, the government argues that the mere fact that the taxpayer’s entire transaction (and not just a valuation or basis item) was concededly devoid of substance is not a bar to valuation misstatement penalties.  The Government also takes issue with the alleged consideration by the district court of the partners’ (as opposed to the partnership’s) reasonable cause defenses in this TEFRA proceeding contrary to Temp. Treas. Reg. § 301.6662-1T(c)-(d).  At a big picture level, the Government is still none-too-pleased with the district court’s open reliance on an R.J. Ruble opinion as contributing to such defenses, an act of reliance that it argues is contrary to case law prohibiting a taxpayer from relying on conflicted advisers for reasonable cause and also contrary to, among other things, the restriction on relying on a legal opinion that is based on representations the taxpayer knows are untrue.  Treas. Reg. Sec. 1.6662-4(c)(1)(i).

This case has the potential to be another Mayo/Brand X battle-royale (what tax case doesn’t these days?) given that there are at least three regulations explicitly relied on by the Government some of which post-date contrary court opinions.  But at bottom the case is just about a district court judge who looked into the eyes of the taxpayers and found not malice but, rather, an objectively good faith belief in the adviser who was hired to bring them safely past the landmines and snipers that fill the no-man’s land also known as the tax code.  Although they didn’t make it across (the taxpayers abandoned defense of the claimed tax benefits and R.J. – metaphorically shot – is serving time), the district court apparently couldn’t fault them for trying.  The government’s view is much harsher.  In essence, it thinks that in trying to find a way to make it to the tax-free promised land, the taxpayers should have tried a little harder to explore the obstacles in their way before taking their guide’s word for it.  At least their place shall never be with those cold and timid souls who know neither victory nor defeat.

The taxpayer’s brief is due May 17th.  We will keep you posted.

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