Editor's Note: The following is an excerpt from Tax Planning for Partners, Partnerships, and LLCs - §5.04[a] (Matthew Bender). This resource is also available in print at the LexisNexis® Store.
IRC Section 6662 imposes an accuracy-related penalty of 20 percent of a tax underpayment attributable to negligence or disregard of rules or regulations and to any substantial valuation misstatement. [IRC §§ 6662(a), (b)(1), and (b)(3).] A substantial valuation misstatement exists when the value or basis of any property claimed on a return is 150 percent or more of the correct value or basis. [IRC § 6662(e)(1)(A).] If the value or adjusted basis of such property is 200 percent or more of the correct amount, the valuation misstatement constitutes a gross valuation misstatement, and the 20-percent accuracy-related penalty increases to 40 percent. [IRC §§ 6662(h)(1) and (h)(2)(A)(i).]
The Fifth and Ninth Circuit Courts of Appeal have ruled that the overvaluation penalty does not apply where the tax understatement arises from deductions or credits disallowed on grounds that did not require the court to determine the value or basis of property. [Todd v. Comm'r, 862 F.2d 540 (5th Cir. 1988); Keller v. Comm'r, 556 F.3d 1056 (9th Cir. 2009); Heasley v. Comm'r, 902 F.2d 380 (5th Cir. 1990); Gainer v. Comm'r, 893 F.2d 225 (9th Cir. 1990).] These cases hold that a disallowed deduction or credit results in an underpayment from an "improper deduction" rather than from an overvaluation subject to increased penalties. In Bergmann v. Comm'r, 2011 U.S. Tax Ct. LEXIS 42 (T.C. Oct. 11, 2011)], the Tax Court was constrained to rule that participants in a tax shelter transaction were not liable for the 40 percent valuation penalty in a case that could be appealed to the Ninth Circuit. In that case, the taxpayers conceded, prior to trial, the merits of the underlying tax dispute on grounds unrelated to the valuation or basis of the property involved.
The Service disagrees with these rulings [AOD-2011-02 (10/12/2011); AOD-1991-13 (7/3/1991).] maintaining that they conflict with decisions of the Second, Third, Fourth, Sixth, and Eighth Circuits. [See Merino v. Comm'r, 196 F.3d 147, 155 (3d Cir. 1999); Zfass v. Comm'r, 118 F.3d 184 (4th Cir. 1997); Illes v. Comm'r, 982 F.2d 163, 166-67 (6th Cir. 1992); Gilman v. Comm'r, 933 F.2d 143, 149-52 (2d Cir. 1991); Massengill v. Comm'r, 876 F.2d 616, 619-20 (8th Cir. 1989).] Those courts have ruled that the overvaluation penalty may apply when overvaluation is intertwined with a tax avoidance scheme that lacks economic substance. The Service believes that the Fifth and Ninth Circuit holdings are oversimplified and do not reflect the language or purpose of the statute.
In a recent Notice, the Service announced that it will oppose concessions in Tax Court cases involving abusive tax shelter transactions if the issue involves application of the valuation misstatement penalty. [Notice CC-2012-001 (10/17/2011).] The Notice responds to recent cases where the taxpayer conceded the underlying tax liability on grounds unrelated to the value or basis of property involved in order to avoid application of the 40 percent valuation penalty.
The Service states that in future cases a determination will first be made about the court's jurisdiction over the taxpayer's proposed concession. If the court lacks jurisdiction over the ground the taxpayer proposes to concede, the concession will be opposed. If the court has jurisdiction over the ground of proposed concession, a determination will then be made about accepting or rejecting a concession that affects application of valuation penalties.
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