IRS Chief Counsel: Continue Applying Valuation Misstatement Penalties

Editor: Jon Almeras, J.D., LL.M.

Procedure & Administration

The IRS Office of Chief Counsel in October issued an action on decision (AOD-2011-02) and a chief counsel notice (CC-2012-001) that both address the application of the valuation misstatement penalties contained in Secs. 6662(b)(3) and 6662(h). The AOD announces the IRS’s decision that it will not acquiesce to the Ninth Circuit Court of Appeals decision in Keller, 556 F.3d 1056 (9th Cir. 2009), rev’g T.C. Memo. 2006-131. In addition, the chief counsel notice provides direction to chief counsel attorneys for handling Tax Court cases in which a taxpayer concession on the merits of a tax dispute could preclude the application of a valuation misstatement penalty.

Sec. 6662 imposes a variety of accuracy-related penalties for tax underpayments. Under Sec. 6662(b)(3), a 20% accuracy-related penalty is imposed on any underpayment of tax attributable to a “substantial valuation misstatement.” A substantial valuation misstatement occurs when the value or the adjusted basis of any property claimed on a return is 150% or more of the amount ultimately determined to be the correct value or adjusted basis (Sec. 6662(e)(1)(A)). Under Sec. 6662(e)(1)(B), a substantial valuation misstatement also occurs in connection with certain transactions between persons described in Sec. 482.

Sec. 6662(h)(1) increases the accuracy-related penalty from 20% to 40% if the underpayment is attributable to one or more “gross valuation misstatements.” A gross valuation misstatement occurs when the value or adjusted basis of any property claimed on a return is 200% or more of the amount determined to be the correct value or adjusted basis (Sec. 6662(h)(2)(A)(i)). Under Secs. 6662(h)(2)(A)(ii) and (iii), a gross valuation misstatement can also occur in connection with certain transactions between persons described in Sec. 482. This item focuses on the valuation penalties imposed under Secs. 6662(e)(1)(A) and 6662(h)(1).

The IRS’s recent releases highlight one area of disagreement in the application of the valuation misstatement penalties. The circuits are currently split over whether these penalties apply when the underlying deduction or credit is disallowed on grounds unrelated to overvaluation. The Fifth and Ninth Circuits have held that a valuation misstatement penalty is not applicable when the entire deduction is disallowed on grounds unrelated to an overvaluation.

In Todd, 862 F.2d 540 (5th Cir. 1988), aff’g 89 T.C. 912 (1987), the Fifth Circuit affirmed a Tax Court decision that held a valuation penalty (at the time under Sec. 6659) was precluded once the IRS disallowed the taxpayer’s deduction on the grounds that the underlying assets had not been properly placed in service for the year in which the taxpayer was claiming the deduction. Based on its interpretation of the statute and reading of the legislative history, the Fifth Circuit agreed with the Tax Court that, when an entire deduction is disallowed on grounds unrelated to valuation, the resulting tax underpayment cannot be considered “attributable” to an overvaluation and, thus, the valuation penalties did not apply. A couple of years later, the Fifth Circuit reiterated this position in Heasley, 902 F.2d 380 (5th Cir. 1990), rev’g T.C. Memo. 1988-408, and stated:

Whenever the I.R.S. totally disallows a deduction or credit, the I.R.S. may not penalize the taxpayer for a valuation overstatement included in that deduction or credit. In such a case, the underpayment is not attributable to a valuation overstatement. Instead, it is attributable to claiming an improper deduction or credit. [Heasley, 902 F.2d at 383]

The Ninth Circuit ruled in a similar fashion on the application of the valuation misstatement penalties. In Keller, the taxpayer purported to purchase cattle and then claimed deductions from the investment, which resulted in large losses that eliminated his tax liabilities. The cattle investment was ultimately determined to be a tax shelter. The IRS then issued the taxpayer a notice of deficiency denying the deductions related to the cattle investment on a number of grounds, including the taxpayer’s overstatement of his basis in the cattle. The IRS also proposed a gross valuation misstatement penalty on the tax underpayments attributable to the disallowed deductions.

In the Tax Court proceeding, the taxpayer and the IRS stipulated the taxpayer was not entitled to the deductions and losses related to the cattle investment on the grounds that they were unlawful. The Tax Court held that the gross valuation misstatement penalty applied to the taxpayer’s underpayment. The taxpayer then appealed the Tax Court’s decision on the valuation misstatement penalty to the Ninth Circuit, which overturned the Tax Court’s decision. The Ninth Circuit found that the taxpayer’s tax underpayments were attributable to the “unlawful deductions” stipulated to by the parties, rather than the valuation misstatements. The Ninth Circuit stated:

When a depreciation deduction is disallowed in total, any overvaluation is subsumed in that disallowance, and an associated tax underpayment is “attributable to” the invalid deduction, not the overvaluation of the asset. [Keller, 556 F.3d at 1061]

On October 31, 2011, the Office of Chief Counsel released an AOD recommending that the IRS not acquiesce to the Ninth Circuit’s Keller decision. The AOD notes that the Ninth Circuit’s decision conflicts with that of every other circuit, except the Fifth, that has addressed the applicability of the valuation misstatement penalty under similar circumstances (see Merino, 196 F.3d 147 (3d Cir. 1999); Zfass, 118 F.3d 184 (4th Cir. 1997); Illes, 982 F.2d 163 (6th Cir. 1992); Gilman, 933 F.2d 143 (2d Cir. 1991); and Massengill, 876 F.2d 616 (8th Cir. 1989)). According to the AOD, the IRS will continue to argue, even in cases appealable to the Ninth Circuit, that the valuation misstatement penalties are applicable if a valuation misstatement is an integral part of a transaction, regardless of the grounds for disallowing the related deductions or credits.

In addition to releasing the AOD on Keller, the Office of Chief Counsel released Chief Counsel Notice CC-2012-001, dated October 5, 2011, to provide guidance to chief counsel attorneys handling Tax Court cases in which a valuation misstatement penalty has been asserted and the taxpayer proposes to concede the underlying tax dispute on grounds unrelated to the valuation or basis of the relevant property. In prior guidance (Litigation Guideline Memorandum TL-68 (8/12/92)), the chief counsel had advised that, when a taxpayer concedes a tax deduction or credit prior to trial on grounds unrelated to valuation, the valuation misstatement penalties should not be imposed. According to the chief counsel, this bright-line rule has invited the use of abusive litigation tactics. The chief counsel notice cites examples of some taxpayers’ taking a wait-and-see approach, whereby they vigorously defend the deduction through the audit and pretrial process but then, on the eve of trial, concede the underlying tax dispute on grounds unrelated to the overvaluation, to avoid the overvaluation penalties.

As a result, the chief counsel notice revised the prior guidance. According to the notice, if a taxpayer proposes to concede the adjustment based on a ground over which the court does not have jurisdiction, then the docket attorney should oppose the concession. For example, in a partnership-level proceeding, taxpayers may not concede a nonpartnership item, such as the partner’s profit motives, to avoid a valuation misstatement penalty asserted on a partnership item.

If the court has jurisdiction over the grounds for concession, the previous guidance should not be taken to mean that, if a concession is made, it should be accepted. Instead, the impact of the concession on the valuation misstatement penalties should be determined on a case-by-case basis. Factors to be considered include the underlying facts, the legal authority governing the applicability of the valuation misstatement penalties, and the evaluation of the concession in relation to the overall development of the case from audit to trial. The chief counsel notice concludes that the IRS should oppose a concession in cases involving abusive tax shelters that concern the application of the valuation misstatement penalties.

The chief counsel has advised that the IRS should continue asserting the valuation penalties where the deduction or credit is disallowed on grounds unrelated to the overvaluation; however, the recent guidance may not be the last word on this issue. There are indications that the government will urge the Fifth Circuit to reconsider its position on the matter and adopt the IRS’s position, as a number of cases are currently on appeal in that circuit. (See Elliott, “IRS Hopes Fifth Circuit Reconsiders Valuation Misstatement Penalty,” 2011 TNT 210-5 (October 31, 2011).) Furthermore, other circuits have not yet ruled on the issue. Therefore, taxpayers and practitioners should stay tuned to follow the latest on this split over the application of the valuation misstatement penalties.

EditorNotes

Jon Almeras is a tax manager with Deloitte Tax LLP in Washington, DC.

For additional information about these items, contact Mr. Almeras at (202) 758-1437 or jalmeras@deloitte.com.

Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.