Sec. 6700 penalty based on income from entire tax-avoidance scheme

The Ninth Circuit held that a taxpayer was liable for a Sec. 6700 penalty on the entire gross income from a time-share donation tax-avoidance scheme, rather than on only the fees charged for inflated appraisals of donors’ timeshares that were provided as part of the scheme.

Background

James Tarpey, a lawyer and businessman, formed Project Philanthropy Inc., doing business as Donate for a Cause (DFC), around 2006 as a nonprofit organization and obtained tax-exempt status for DFC from the IRS. DFC accepted donations of timeshares from timeshare owners who no longer wanted to pay timeshare fees or otherwise wanted to dispose of their timeshare properties, with Tarpey promising potential donors that they could receive generous tax savings from the donations.

Tarpey himself appraised the value of some of the properties donated to DFC, and other properties were appraised by his sister, Suzanne Tarpey, and real property appraisers Ron Broyles and Curt Thor. Donors paid a donation fee to DFC, plus shouldered the timeshare transfer fees. DFC accepted at least 7,600 timeshare donations during the period at issue, 2010–2013.

However, the IRS determined that DFC was a tax-avoidance scheme, with Tarpey and the other appraisers providing inflated appraisals of timeshares to donors, who would use the appraisals as support for taking a charitable contribution deduction for the donation of the timeshares. The IRS assessed penalties against Tarpey under Sec. 6700, which targets promoters and others involved in the organization or sale of tax shelters if they make false statements or exaggerate valuation. The IRS claimed Tarpey had done so in the form of inflated timeshare appraisals. The penalty imposed equals 50% of the gross income “derived (or to be derived) from such activity by the person on which the penalty is imposed” (Sec. 6700(a)(2)).

Tarpey paid a portion of the penalties and then filed suit in district court, alleging that he was not liable for penalties with respect to the timeshare donation scheme because he did not make false or fraudulent statements concerning the tax benefits of the timeshare donation scheme, or, if he did, he did not know or have reason to know that the statements were false or fraudulent. He argued in the alternative that the IRS’s penalty calculations were inaccurate.

The district court held on summary judgment that Tarpey was liable for penalties under Sec. 6700. The court determined that Tarpey, his sister, Broyles, and Thor were not qualified appraisers under the applicable regulations because they did not have sufficient independence from DFC, and, consequently, the appraisals of the timeshares to be donated to DFC were false statements. It found Tarpey had made false statements by preparing appraisals himself and caused others to make or furnish similar appraisals.

The district court also found that Tarpey had reason to know that the appraisals he performed were false or fraudulent statements, and he was liable for the appraisals of Broyles and Thor because he knew or had reason to know Broyles and Thor were disqualified as appraisers under the applicable regulations.

The district court also held on summary judgment that the scope of the “activity” to be penalized under Sec. 6700(a) encompassed Tarpey’s entire timeshare donation business and not just the funds coming directly from the false statement appraisals. Finally, after a bench trial, the court held that Tarpey was liable for a penalty amount of $8,465,000 plus interest.

Tarpey appealed the district court’s decision to the Ninth Circuit, where he challenged (1) the court’s liability holding with respect to the appraisers Broyles and Thor; (2) the court’s “cumulative definition of ‘activity,’” which he claimed contravened the text of Sec. 6700(a); and (3) the propriety of the definition of “gross income” the court used in determining the penalty amount.

The Ninth Circuit’s decision

The Ninth Circuit affirmed the district court’s holdings on all three issues Tarpey raised and its imposition of the penalty of $8,465,000 plus interest.

Tarpey’s liability for other appraisers: The Ninth Circuit held that the district court had correctly determined that, as a matter of law, Broyles and Thor were disqualified as appraisers. It also held that Tarpey had forfeited his argument that he did not know or have reason to know that the appraisals would be imputed to DFC.

On appeal, Tarpey disputed the IRS’s interpretation of the phrase “regularly used” in the regulations regarding the requirements to be a qualified appraiser. As the Ninth Circuit explained, Regs. Secs.

1.170A-13(c)(5)(iv)(B), (C), and (F) disqualify any “appraiser who is regularly used by” the donor — or is “regularly used” as an appraiser by a “party to the transaction in which the donor acquired the property being appraised” or the “donee of the property” — “and who does not perform a majority of his or her appraisals made during his or her taxable year for other persons.”

Focusing on the first half of the exclusion in Regs. Sec. 1.170A-13(c) (5)(iv)(F), Tarpey argued the appraisals were not “used by” DFC; rather, they were used by the donors of the timeshares seeking charitable deductions because it is the donor who “is required to attach an appraisal to their income tax return.” However, the Ninth Circuit found that Tarpey was “mistaking a form of use for the exclusive use in contravention of ” the regulation’s text. Tarpey’s proposed limitation of the meaning of “use” to mean “use by the donor” would read out Regs. Secs. 1.170A-13(c)(5)(iv) (B) and (C). Rather, the court found the exclusion refers to three different persons: the donor, a party to the transaction, and the donee.

The Ninth Circuit additionally found that the record also belied Tarpey’s “creative position” that DFC did not use, but merely recommended, appraisers. Tarpey earned money each time an appraiser other than himself was used for DFC’s timeshare donation program, so Tarpey profited from the appraisals. Furthermore, DFC used the appraisals as a selling point in its timeshare donation program by advertising that an appraisal “by an independent licensed appraiser” was an “included benefit” of the program.

With regard to Broyles’s and Thor’s appraisals, the Ninth Circuit noted that, in selling the program, DFC employees identified Broyles and Thor as DFC’s appraisers. Therefore, the Ninth Circuit found that the district court had properly concluded that DFC “used” Broyles’s and Thor’s appraisals.

Broyles and Thor were disqualified because they were not sufficiently independent from DFC, as they appraised timeshares primarily, if not exclusively, for DFC. Nearly 100% (97.5%) of Broyles’s income was from appraisals for DFC, and DFC constituted 57% of Thor’s appraisal business. The district court had determined at summary judgment that Tarpey knew or had reason to know that Broyles and Thor were disqualified as appraisers.

On appeal, Tarpey argued that a trial was needed on this issue. The Ninth Circuit, however, pointed out that Tarpey’s sole argument with respect to the knowledge element of liability was that he had relied on the advice of his counsel. Consequently, the court held that because he had not argued in district court that a trial was needed on this issue, he had forfeited his right to make this claim on appeal.

Scope of “activity” under Sec. 6700: The district court concluded that the entire timeshare donation business was part of a tax-avoidance scheme and that, under the plain language of Sec. 6700, the entire scheme fell within the scope of “activity.” On appeal, focusing instead on the “separate activity” language in the second sentence of Sec. 6700(a) (described below), Tarpey argued that the penalty applied only to the appraisal portion of his business, which he claimed was the only activity for which he had made a false statement.

The Ninth Circuit explained that, for purposes of Sec. 6700, an activity is broadly defined to include any “plan” or “arrangement,” and the DFC’s timeshare donation business, which Tarpey organized, easily fit within this definition. To understand the scope of the activity, the Ninth Circuit further analyzed the statutory language.

The flush language of Sec. 6700(a) (2) provides that a penalty is applied with respect to each separate activity described in Sec. 6700(a)(1). Sec. 6700(a)(1) includes the “organization” of “any other plan or arrangement.” The Ninth Circuit found that the activity, which it had already determined for purposes of Sec. 6700 to be DFC’s entire timeshare donation business, was not limited to making false statements in furtherance of the tax scheme but rather the organization and sale of the entire scheme. Thus, the statute required that Tarpey’s gross income be calculated from his actions in the entire activity, including his organizational and sale conduct, and not solely from the false statements he made about the activity. According to the court, “[it] would go against the text and common sense to limit liability only to the false statements when Congress’s goal was to punish abusive tax shelters.”

The Ninth Circuit also found that, while the activity included DFC’s entire timeshare donation business, at the same time, it was made up of the individual timeshare donation transactions. In calculating Tarpey’s penalty, the IRS did not need to limit itself to the fees charged for the false statement appraisals, as “the 7,600 transactions made up an overarching scheme that flowed into further gross income for Tarpey and DFC.” Thus, the court concluded, for purposes of the penalty, the activity was an aggregation of the individual transactions without being limited to only those transactions that explicitly contained a false statement.

Calculation of gross income: Finally, Tarpey argued that the district court had applied the wrong definition of “gross income” in determining it for the penalty calculation. The Ninth Circuit held that the district court had used the proper definition, relying on the Code’s general definition of gross income of “all income from whatever source derived” (Sec. 61(a)).

In determining the amount of the penalty that should be imposed against Tarpey, the district court had relied on the calculations of an IRS expert witness. Tarpey pointed to a statement by the IRS expert in his testimony at trial as evidence that the district court had strayed from the Code’s definition of gross income. In his testimony, the IRS expert stated that his penalty calculation was not “quote/unquote ‘the gross income’ of Mr. Tarpey in the normal sense of taxation.”

The Ninth Circuit found that Tarpey had misleadingly portrayed the IRS expert’s use of the phrase “normal sense of taxation” as an acknowledgment that the district court had departed from the Code’s definition of gross income. Instead, in using that phrase, the IRS expert was clarifying that his calculation included income attributable to Tarpey’s alter ego, DFC. The agent had done this because the district court had determined that DFC was Tarpey’s alter ego, a determination that Tarpey had not challenged on appeal. Thus, the Ninth Circuit concluded that “Tarpey’s definitional challenge is a red herring.”

Reflections

Originally, the penalty under Sec. 6700 for knowingly making false and fraudulent statements was $1,000 or, if less, 100% of the gross income derived or to be derived from the activity. In 2004, Sec. 6700 was amended by Section 818(a) of the American Jobs Creation Act, P.L. 108-357, to change the penalty to the current amount of 50% of the gross income derived (or to be derived) from the activity by the person on which the penalty is imposed.

The rationale in legislative history given for the increase was that “the present-law $1,000 penalty for tax shelter promoters is insufficient to deter tax shelter activities” (H.R. Rep’t No. 108-548 (2004). However, if Tarpey’s case is any guide, perpetrators of fraudulent or abusive tax schemes are likely to go forward with their schemes regardless of the size of the potential penalty waiting at the end of the road.

Tarpey, No. 22-35208 (9th Cir. 8/17/23)

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.