Abandoning its own precedent, the Tax Court held that a taxpayer may not avoid application of the gross valuation misstatement penalty by conceding that adjustments made in an IRS notice of final partnership administration adjustment (FPAA) were correct on grounds unrelated to valuation or basis. Shortly after, the Supreme Court agreed to hear a case from the Fifth Circuit involving the same issue.
Background of Tax Court Case
During the years involved, Alan Ginsburg was a partner, but not the tax matters partner (TMP), of AHG Investments. The IRS issued an FPAA to Ginsburg. The major adjustment in the FPAA disallowed $10,069,505 in AHG losses that the partnership had allocated to Ginsburg for tax years 2001 and 2002. The FPAA listed 14 alternative grounds in support of the adjustments, including gross valuation misstatements of partnership items on the AHG return. Consequently, the IRS asserted a 40% accuracy-related penalty against Ginsburg under Sec. 6662(a) for the portion of his underpayment of tax attributable to gross valuation misstatements.
Ginsburg challenged the IRS’s application of the gross valuation misstatement penalty in Tax Court. In his Tax Court petition, Ginsburg conceded the FPAA adjustments were correct on the ground that he was not at risk under Sec. 465 with respect to AHG and thus was not entitled to deduct certain attributed losses. In an amendment to the petition, Ginsburg also conceded that the FPAA adjustments were correct on the ground that the transaction at issue did not have substantial economic effect under Regs. Sec. 1.704-1(b). Both of these were among the grounds that the IRS listed in the FPAA as supporting the adjustments in it.
Ginsburg sought a ruling from the Tax Court that the 40% gross valuation misstatement penalty did not apply as a matter of law because he had conceded that proposed FPAA adjustments were correct on grounds unrelated to valuation or basis.
Valuation Misstatement and Gross Valuation Misstatement Penalties
Under Secs. 6662(a) and (b)(3), a taxpayer is subject to a 20% penalty for any underpayment that is attributable to a substantial valuation misstatement (the valuation misstatement penalty). There is a substantial valuation misstatement if the value or adjusted basis of any property claimed on any income tax return is 150% or more of the amount determined to be the correct amount.
This penalty, which was originally included in the same form in Sec. 6659, was the only valuation misstatement penalty until 2006. In that year, an increased penalty of 40% for gross valuation misstatements of 200% or more of the amount determined to be correct (the gross valuation misstatement penalty) was added (Sec. 6662(h)). Under both versions of the penalty, taxpayers have claimed that the IRS cannot apply the penalty to an underpayment if a taxpayer concedes that the deduction that caused the underpayment should be disallowed for some reason other than a valuation misstatement.
Prior Tax Court Cases
The Tax Court first addressed the application of the valuation misstatement penalty in Todd, 89 T.C. 912 (1987) (Todd I), which was affirmed by the Fifth Circuit in Todd, 862 F.2d 540 (5th Cir. 1988) (Todd II). In Todd, rather than the taxpayer conceding that he was not entitled to a deduction on grounds other than a valuation misstatement, the Tax Court had already disallowed the claimed credits and deductions that gave rise to the tax underpayment on a different basis in another related case.
The Tax Court in Todd I and the Fifth Circuit in Todd II both found that the only formula for determining the amount of a tax underpayment attributable to a valuation misstatement was in the legislative history, specifically the Joint Committee on Taxation’s General Explanation of the Economic Recovery Act of 1981 (JCS-71-81) (the Blue Book), which contained an explanation of Sec. 6659, the predecessor of Sec. 6662. The Blue Book stated: “The portion of a tax underpayment that is attributable to a valuation overstatement will be determined after taking into account any other proper adjustments to tax liability” (Blue Book, p. 333).
The Tax Court and the Fifth Circuit concluded that this meant that an adjustment to tax liability due to the disallowance of a credit or deduction on grounds other than a valuation misstatement fell into the category of “any other proper adjustments” to tax liability. Thus, if a credit or deduction could have been disallowed on the grounds of a valuation misstatement, but it was actually disallowed on other grounds, for purposes of determining the gross valuation misstatement penalty, there would be no underpayment attributable to a valuation misstatement on which to assess a penalty.
In McCrary, 92 T.C. 827 (1989), the Tax Court, citing Todd I and Todd II, expanded its position to situations involving a taxpayer concession of an adjustment. In McCrary, the taxpayers had conceded that they were not entitled to an investment tax credit related to a purported lease of a master recording because the agreement was not a lease. In Gainer, 893 F.2d 225 (9th Cir. 1990), the Ninth Circuit adopted the holding and the reasoning of the Fifth Circuit in Todd II.
Other Circuits’ Opinions
As the Tax Court explained in its AHG opinion, the majority of appellate circuits that have faced the issue of the application of a valuation misstatement penalty have disagreed with the holdings in the Todd case, finding that the Tax Court and the Fifth Circuit misinterpreted the Blue Book formula. The Tax Court discussed decisions from the First, Eleventh, and Federal Circuits where the courts all found that the phrase “other proper adjustments” should be interpreted to mean that where two different deductions are disallowed, one on the grounds of a valuation misstatement and one on other grounds, the valuation misstatement penalty should apply only to the deduction related to the valuation misstatement. According to the courts, the Blue Book was not excusing an underpayment from the valuation misstatement penalty simply because independent reasons other than a valuation misstatement existed for disallowing the deduction that caused the underpayment.
The Tax Court further pointed out that after Todd II and Gainer, both the Fifth Circuit and the Ninth Circuit continued to follow their holdings in those cases on the basis of stare decisis, but “strongly suggested” that the holdings were erroneous. In Bemont Investments, LLC, 679 F.3d 339 (5th Cir. 2012), in a concurring opinion, one of the judges specifically stated that the Todd II court had misread the Blue Book and that opposition to the holding in the case was nearly unanimous at the appellate court level.
The Tax Court’s Decision in AHG
Departing from its precedent in McCrary, the Tax Court held that an underpayment of tax may be attributable to a valuation misstatement even when the IRS’s determination of an underpayment of tax may also be sustained on a ground unrelated to basis or valuation. The court found, as has the majority of appellate circuits that have considered the issue, that the Blue Book formula for determining whether an underpayment was attributable to a valuation misstatement only requires that the valuation misstatement penalty not be applied to a tax infraction that is unrelated to (i.e., incapable of being attributed to) the valuation misstatement. Although the Tax Court stated its agreement with this interpretation was the primary reason for changing its position, it also discussed a number of secondary factors that it considered in making its decision.
The most prominent of these factors was judicial economy. In McCrary, the Tax Court had supported its decision in part by noting that the holding would encourage taxpayers to settle cases involving the valuation misstatement penalty and thus avoid trials on difficult valuation issues. Although more cases might go to trial under its new position, the Tax Court stated that concerns for judicial economy “are not a sufficient reason to disregard or continue to incorrectly apply the clear formula and example in the Blue Book.” In addition, the Tax Court posited that changing its position might actually improve judicial economy by discouraging taxpayers from engaging in tax-avoidance activities.
The Tax Court also discussed other reasons it had given in support of its holding in McCrary. The court asserted in McCrary that Congress may have wanted to moderate the application of the valuation overstatement penalty so that it would not be imposed on taxpayers whose overvaluation was irrelevant to the determination of their actual tax liability. It also found that taxpayers were not likely to concede to an adjustment on other grounds to avoid a valuation misstatement penalty because they would still be subject to significant penalties. The court stated that it now found those reasons “unconvincing,” averring that since the Todd and McCrary cases, taxpayers had purposefully relied on those holdings to avoid a gross valuation misstatement penalty and that this had frustrated the purpose of the penalty.
Supreme Court Agrees to Hear Woods
In June 2012, the Fifth Circuit affirmed a district court’s decision in Woods, No. 11-50487 (5th Cir. 6/6/12). In this case, which involved a basis-inflating tax-shelter transaction called COBRA, the deductions in question were disallowed because the COBRA transaction lacked economic substance. The district court had found that under Fifth Circuit precedent “whenever the Internal Revenue Service totally disallows a deduction, it may not penalize the taxpayer for a valuation overstatement included in that deduction.” The IRS petitioned the Supreme Court to hear the case, and on March 26, the Supreme Court granted the IRS’s request.
In his reply to the IRS’s petition to the Supreme Court, Gary Woods (who was the TMP of the partnership involved) argued that Sec. 6662(i), which was added to the Code in 2010, made the gross valuation misstatement issue both obsolete and unimportant in his case. Under Sec. 6662(i), an underpayment due to a transaction that lacks economic substance is subject to a 40% penalty.
The IRS countered that after the addition of Sec. 6662(i), the construction of Sec. 6662 espoused by the Fifth and Ninth Circuits would continue to apply in cases where a deduction is entirely disallowed on a ground other than that the transaction totally lacked economic substance, so it was still necessary for the Supreme Court to grant review to decide the valuation misstatement penalty issue. The IRS also contended that even if the issue was totally obsolete after the enactment of Sec. 6662(i), there were still hundreds of cases that predate the subsection’s enactment pending in the Fifth and Ninth Circuits, and they involve billions of dollars of alleged basis misstatements. Thus, the resolution of the issue was not unimportant.
The Tax Court made the right decision in changing to the majority position. In abusive tax shelters involving valuation misstatements, the valuation misstatement is virtually always at the heart of the shelter and the reason it creates a tax benefit. Congress was well aware of the central role that valuation misstatements frequently play in abusive tax shelters when it enacted the original valuation misstatement penalty in 1981. Given lawmakers’ frequent expressions of distaste for abusive tax shelters before and after the enactment of the penalty, it seems highly unlikely that Congress’s intent was to give shelter participants a pass on the penalty simply because the deduction giving rise to the underpayment could also be disallowed for other reasons.
It is somewhat surprising that the Supreme Court agreed to hear the Woods case because the minority position appeared to be on very shaky ground already in both the Fifth and Ninth Circuits, and the circuit split on the issue may have soon been resolved on its own. Based on the overwhelming support for the majority position in the appellate circuits, it seems likely that the Supreme Court will overturn the Fifth Circuit and adopt the majority position.
AHG Investments, LLC, 140 T.C. No. 7 (2013)
Woods, Sup. Ct. Dkt. No. 12-562 (U.S. 3/25/13) (cert. granted)