When we discuss or research a tax issue, we often are first confronted with a client's factual situation which is not clearly defined. For example, it may not be clear whether activities are those of a corporation or of a shareholder, whether the client's relationship with another is a joint venture or an employer/employee relationship, whether a transaction will be deemed "arms-length", etc.
When evaluating the calculated risk of adopting a less-than-conservative tax position, risk vs. reward analysis becomes a prime consideration. The "risk" (assuming the position is not so aggressive as to trigger civil fraud penalties or worse) is the chance and amount of other penalties. Once you have determined that the taxpayer's conduct or intent is such that it would avoid the twenty percent "negligence" penalty, you enter the world of the "no-fault" substantial understatement penalty.
For better or for worse, a position must be taken in order to file a return. The position may certainly seem reasonable, but it can ultimately be "second-guessed" by the government. What happens if that "reasonable" position does not prevail?
You have had the phrases "substantial authority" and "adequate disclosure" forced to your attention all too often. (See "Exhibit A" at the end of this newsletter for an abbreviated version of the substantial understatement penalty provisions.) Two recent cases, Osteen and Lawinger, are illustrative of the best and the worst facing your clients. After reviewing them, we will review how the penalty evolved, then finally look at other cases to see if any consistent pattern in how the courts handle the penalty can be detected. Hopefully, you will then be in a better position to assist your clients in the "risk/reward" analysis.
The Osteen Case:
November 10, 1993 - In a memorandum opinion, the Tax Court found that Harry Osteen (a bank executive) and his wife did not operate a horse raising and breeding activity "for profit". This conclusion came after comparing the taxpayers' facts to the nine factors listed in regulation §1.183-2(b).
As a result, the second issue to be resolved was whether the taxpayers were liable for the substantial understatement penalty. Upon narrowing the issue to whether the taxpayers had "substantial authority" for their position, the discussion was limited to the basic mechanics of the code section. In a pattern that had been set by most of the previous cases dealing with this issue, the Court switched directly to its conclusion:
"... the only issue is whether there is substantial authority ... (taxpayers) have the burden of proof on this issue. Rule 142(a); Welch v. Helvering, 290 U.S. 111 (1933). BASED ON THE DISCUSSION ABOVE, we are convinced that there was not substantial authority for (taxpayers') position." (Emphasis added)
Osteen v. Comm., T. C. Memo 1993-519
August 25, 1995 - The Appeals Court would have none of this. The opinion is summarized here:
"The application of a substantial authority test is confusing in a case of this kind ... Nobody argues ... that because the taxpayers lose on a factual issue, they also must lose on what would seem to be a legal issue. The Tax Court in this case, as it seems to do in most of the cases, gives little explanation as to why there is substantial authority in one case, but not in another ...
"There are no court decisions that give us guidance, and THE REGULATIONS THEMSELVES, ALTHOUGH SPEAKING IN TERMS OF A TEST, ARE UNSATISFACTORY IN APPLICATION TO AN ALL OR NOTHING CASE OF THIS KIND ...
" ... we reverse because of the plethora of cases in which the Tax Court has found a profit motive in the horse breeding ACTIVITIES of taxpayers that were SIMILAR TO THOSE AT HAND. E.g., ..." [Here, the opinion lists fifteen cases, with commentary of one or more facts in each, presumably in common with the Osteen case, but decided in favor of the taxpayer - cases which were NOT cited in the memorandum opinion.]
"Although it can be properly argued that THOSE CASES are distinguishable from the case at hand, as well they are because the ultimate facts were found for the taxpayer rather than against the taxpayer as in this case, they ARE NOT SO DISSIMILAR THAT THEY MUST BE DISCARDED as providing no substantial authority ..." (Emphasis added)
Osteen v. Comm., (CA-11)
76 AFTR 2d ¶95-5263, 8/25/95
The appeals court judge winds up his discussion citing an excerpt from a 1990 memorandum case (Harston v. Comm., T.C.Memo 1990-538) which was a case favorable to the taxpayers on this issue: "Although (the taxpayers) were not successful enough to show that they were entitled to the losses claimed [due to §183], (they) have convinced us that they had substantial authority for their position."
This 1995 Osteen opinion by the Appeals Court is a welcome change from the many pro-government cases which have emerged since the "substantial understatement" penalty was enacted. However, it stopped well short of creating a safe environment for taxpayers, for reasons which we shall discuss after looking at some cases preceding the decision.
The Lawinger Case:
MARGARET LAWINGER restructured a loan with the Farmers Home Administration. In the process, there was cancellation of indebtedness, for which she received four Forms 1099-G. If 50 percent or more of Mrs. Lawinger's gross receipts for the previous three years were "attributable to the trade or business of farming", the cancellation income would be excludable from income.
In a 1994 opinion, the Tax Court analyzed Mrs. Lawinger's gross receipts for the three years. The receipts were broken down into seven categories - three of the seven categories were in dispute, thus to be resolved by the Court. (The government had concluded that 25.5 percent qualified as farming, the taxpayer contended 55.76 percent qualified.)
With four pages of analysis and fact finding, the Court concluded that 48.2 percent qualified, thus just missing the necessary 50 percent. Within the opinion, the Court acknowledged that "(t)he term ‘attributable to the trade or business of farming' has no particular technical significance under the tax laws; nowhere in the Internal Revenue Code is such term defined." (An example of one of the categories disputed was "Wisconsin Farmland Preservation Act Credits" - concluded by the Court to not "rise to the level of gross receipts attributable to the trade or business of farming ...").
With the taxpayer having missed "factually" by 1.8 of 50 percent (but only after thorough analysis by the Court of the gross receipts), the Court sustained the 20 percent "substantial understatement" penalty.
Lawinger, Margaret A. - 103 T.C. No. 23 (9/1/94)
The Beginnings:
The origins of the substantial understatement penalty were in 1982 legislation. Per Struntz and Braverman, 63 Jtax 2 (7/85):
"Congress enacted (the penalty) as a "no fault" penalty for taxpayers who erroneously take aggressive BUT HIGHLY QUESTIONABLE filing positions that result in substantial understatements of tax liability.
"The requirement that the understatement be substantial was intended to protect low- and moderate-income taxpayers ‘both because of the greater access of higher income taxpayers to sophisticated tax advice and because these taxpayers appear more often to play the audit lottery.' S. Rep't No. 97-494, Vol. 1 (7/12/82), pp. 272-4." (Emphasis added)
Considering the inflation we have experienced since the commentary in the 1982 Senate Report, the $5,000 de minimis trigger as "substantial" doesn't just hit high-income taxpayers - with the passage of time it is applying to an increasing percentage of our clients. Also, as the Lawinger and Osteen cases illustrate, the penalty may not just affect "highly questionable" positions.
AN EDITORIAL COMMENTARY by the Congressional Joint Committee (3/88) describing the development of the penalty structure:
"One important aspect of (the negligence penalty) ... is fault: the intent of the taxpayer is vital to determining whether the penalty applies in a particular circumstance. Indeed, an element of fault seems inherent to concepts of negligence ...
"The element of fault ... created several difficulties ... (t)hese difficulties led to the establishment of no-fault penalties, such as the substantial understatement ... penalt(y) ... imposed on the basis of the return position taken by the taxpayer, which can be established by objective evidence, as opposed to the more subjective element of knowledge or state of mind of the taxpayer."
Rubenstein and Linck, 42 TA 232 (4/89):
"The ... penalty is a no-fault penalty. That is, (it is) imposed by the examining agent at the conclusion of the audit whenever the mathematical test is met, regardless of the taxpayer's conduct or intent. ...Examining agents ... do not routinely consider waiving the penalty ... "
There has been SOME progress - in 1992 the IRS "Consolidated Penalty Handbook" added a provision that any understatement penalty be reviewed in advance of assertion by the examining officer's group manager.
The Code and Regs:
As the Osteen court points out, the "substantial authority" required to escape the penalty may be very elusive when it depends upon resolution of factual issues, rather than what the law based on given facts may be. In evaluating "authority", the regulations (written before the penalty was renumbered to IRC §6662) do mention the role that the "facts" play:
"... the weight of authorities depends on their persuasiveness and relevance as well as their source. For example, a case or revenue ruling having SOME FACTS in common ... would not be considered particularly relevant if the authority is MATERIALLY DISTINGUISHABLE on its facts ...". (Emphasis added)
[Reg. § 1.6661-3(b)(3)]
Just how identical to the facts in a ruling must your client's facts be in order for the ruling to constitute "substantial authority"? This test may prove both difficult to meet and inconsistent in interpretation, leaving the protection of "substantial authority" only to issues of law, rather than questions of fact. Note that the Appeals Court in Osteen did not cite the above regulation in its discussion - it merely stated " ... the regulations are ... unsatisfactory in ... (a) case of this kind".
The second "safe harbor" in the Code allows a taxpayer to avoid the penalty through "adequate disclosure". This appears to be a way out of the dilemma - but often an undesirable "red flag" - where the "factual" position may not prevail. More specifically (assuming that the item is not a "tax shelter", has a "reasonable basis", is properly substantiated and adequate books and records are maintained) the amount subject to the penalty will not include that portion:
"... attributable to ... any item if ... the relevant facts affecting the item's tax treatment are adequately disclosed in the return ..."
[IRC §6662(d)(2)(B)]
Now, let's look at some -
Other Cases:
JAMES MILLS (a doctor) and his wife owned, bred, "showed" and sold Arabian horses through an S corporation. They did maintain separate personal breeding activities. The S corporation activities routinely reflected losses, due partly to what may be considered excessive personal concern for the health and welfare of the horses. The Tax Court disallowed the S corporation losses as "not for profit".
In sustaining the substantial understatement penalty as determined by the government, this 1990 memorandum decision did make extensive observations about substantial authority, adequate disclosure, and failure of the taxpayer to show "abuse of discretion" by the government in not waiving the penalty. (Maybe the Judge was ahead of his time!) Following are some comments in the opinion with respect to substantial authority:
"(Taxpayers) argue that for the same reasons argued by them in support of their claimed loss deductions ... the claimed losses were based on substantial authority. As pointed out in Schirmer v. Commissioner, 89 T.C. 277, 283 (1987), "substantial authority" exists only when the facts and authorities ... show that the weight of the authorities that support the taxpayer's position is substantial when compared with those supporting the contrary position ...
"In this case, there is little, if any, authority supporting (taxpayers') position. Numerous CASES ... under circumstances SOMEWHAT SIMILAR ... have held that the activity was not one engaged in for a profit. The cases holding ... engaged in for profit ... involve MUCH MORE evidence of a business operation and MUCH MORE showing of profit objective ..." (Emphasis added)
Mills, James E. - T.C. Memo 1990-432
AS FOR THE "REASONABLE CAUSE" AND "GOOD FAITH" TESTS REQUIRED TO HAVE THE PENALTY WAIVED, JUST HOW MUCH OF A "HARD LUCK" STORY DOES THE TAXPAYER NEED? Here's what it may take:
"... (TAXPAYER) cut, hauled, and sold timber ... sustained a job-related injury in 1986 wherein all the fingers on one hand were nearly cut off ... would need additional surgery on his hand but could not afford to take time off from work ... maintained a large garden every year which served as the only source of food for his family ... nine children. (A) tornado destroyed ... business records ...
" ... We find ... based on facts ... (including) petitioner's experience, education, and limited knowledge of the tax laws, (the Commissioner) abused her discretion by failing to waive the (penalty) ...".
Huff v. Comm., T.C. Memo 1994-451 (Also disclosed while discussing the basis of land sold was the destruction years earlier of the taxpayer's home due to a fire. Note that the Commissioner would not waive the substantial understatement penalty - the Court had to do it.)
Where Are We Now?:
Today's cost of an audit lottery ticket? I propose that the cost is now an almost "automatic" twenty percent of the potential prize - at least in the category of "factual" issues where a taxpayer's facts and circumstances are not "on all fours" with rulings which hold in their favor. Requesting a private ruling may be impractical or impossible.
As mentioned at the beginning of this newsletter, familiarity with some of the court opinions is essential background. When we discuss a tax issue, resolution is often in shades of gray rather than black and white. With this information, we will both be in a better position to assist your client in evaluation of alternative courses of action.
Some comfort can be taken in the fact that the appeals court in Osteen has acknowledged that the test is "confusing" and that the regulations are "unsatisfactory" when seeking substantial authority in all or nothing situations. Nevertheless, this writer is left with the impression that the penalty was born "no-fault", and remains "no-fault".
For individuals, there is a substantial understatement of tax if the understatement exceeds the greater of: 10 percent of the tax required to be shown, or $5,000.
There shall be added ... 20 percent of the portion of the underpayment ... attributable to ... any substantial understatement ... reduced by that portion ... attributable to ...
(i) ... any item ... if there is ... substantial authority
or
(ii) ... any item if ... the relevant facts ... are adequately disclosed in the return ... AND ... there is a reasonable basis for the tax treatment ...
Other rules apply to corporate taxpayers, or where the item is a tax shelter, is not properly substantiated or where adequate books and records are not maintained.
Exhibit A
SUMMARY OF THE "SUBSTANTIAL UNDERSTATEMENT" PENALTY
This material should be viewed only as a general summary of the tax law as of its indicated date, and not as a substitute for tax consultation in a particular case. Your questions and comments would be appreciated.
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