section 6694 and business purpose"

The following IRS Private Ruling Letter concludes that there was no "substantial authority" because a sale/leaseback transaction lacked a business propose. It appeared to the IRS that the complex transactions were solely motivated by tax savings. The IRS used substance over form principles (i.e., economic substance rationale) to reach its conclusion. What is striking about the IRS analysis is that they did not take into account or consider Taxpayer authority and analysis under Reg. section 1.6662-4(d)(3) which governs the "substantial authority" analysis. Now that "substantial authority" is the standard of conduct for section 6694(a)(2)(A) positions (under the Emergency Stabilizagion Act), IRS precedent for this term under section 6662 is directly relevant to the IRS mandate under the proposed 6694 regulations. In this ruling, the IRS did not even bother to mention the Taxpayer's argument under the law under Reg. 1.6662-4(d)(3), thereby ignoring its own regulations. The IRS is likely to do this when they sense tax motivated transactions.

Nevertheless, lessions can be learned from this PLR:

1. Beware of complex trancations because the IRS will analze them, not by their form, but by their economic substance.
2. Beware of tax motivated transactions. The IRS, as it should, treats "business purpose" as the dominant factor in its analysis. The IRS based its conclusion solely on its conclusion about "business purpose."
3. Tax return preparers will be at a high risk for the 6694 penalty by preparing tax returns that reflect a series of complex interrelated transactions.
4. If section 6694 were an issue in this case, it would be likely that the IRS examiners would shoot for the $5,000 per position penalty.
5. Tax return preparers will be well advised to avoid preparing tax returns that reflect any type of aggressive tax position.
6. Get the guidance of a tax expert for a reliable technical opinion on the facts and the law before you even think of preparing a tax return that reflects complex interrelated transactions.


Chief Counsel Advice 200338009, August 8, 2001

LTR Report Number 1386, September 24, 2003

IRS REF: Symbol: CC:PSI:B01-POSTF-149350-01


Uniform Issue List Information:


UIL No. 0061.43-01



Gross income v. not gross income; Form v. substance; Lease of property.



UIL No. 9214.03-00



Leasing shelter; Railroad car leasing.


[ Code Secs. 61 and 9214]




MEMORANDUM FOR ASSOCIATE AREA COUNSEL, CC:LM:CTM:LA2



FROM: Associate Chief Counsel, Passthroughs & Special Industries



SUBJECT: Leasing Transaction



This Chief Counsel Advice responds to your memorandum dated April 10, 2002. In accordance with section 6110(k)(3) of the Internal Revenue Code, this Chief Counsel Advice should not be cited as precedent.




ISSUES


With respect to the transactions described below:



1. Whether the transactions lack economic substance.



2. Alternatively, whether the transactions should be recharacterized as a financing, rather than a sale-leaseback.



3. Whether A received original issue discount income as a result of the transactions.



4. Whether A is liable for negligence penalties, pursuant to section 6662, for entering into the transactions.




CONCLUSIONS


1. The facts set forth below suggest that the transactions lack economic substance and should not be respected.



2. Alternatively, the transactions described below should be recharacterized as a financing, rather than a sale-leaseback.



3. If the transaction can be described as a sale-leaseback, A received original issue discount income as a result of the transactions.



4. A is liable for negligence penalties, pursuant to section 6662, for entering into the transactions.




FACTS


Pursuant to a Participation Agreement dated Date 1, A, B, Lender, and Trust 1 , entered into a purported sale-leaseback transaction. A is a U.S. corporation. B's core business is C and is wholly-owned by the government of Country C.



On Date 1, B sold the Equipment to Trust and simultaneously leased the Equipment back pursuant to the Lease and Lease Agreement. The initial term of the Lease comprises an interim term of Z months followed by a Base Term. The Base Term commences on Date I and ends on Date 4. The Replacement Term of the Lease commences on Date 4 and extends for X years thereafter.



A invested in the transaction by providing $1 (Equity Contribution), which was J percent of the cost of the Equipment, to Trust and by paying the expenses in connection with the transaction. Trust borrowed from Lender the balance of the purchase price, $2, which was D percent of the cost of the Equipment. Also, on Date 1, the parties entered into a Loan Agreement, Lease Agreement, Lease Supplement, Swap Agreement, Custodial Agreement and additional agreements 2 to effectuate the Participation Agreement. To finance the purported purchase of the Equipment, A entered into a Loan Agreement with Lender and Trust. The Loan and Security Agreement is dated Date 7. Under the Loan and Security Agreement, Trust issued loan certificates to Lender and pledged the Loan Estate 3 as security for the loan certificates. The proceeds of the loan certificates were to be used by Trust to pay for a portion of the cost of the Equipment. Pursuant to the Loan Agreement, Lender agreed to lend to Trust D percent of the cost of the Equipment subject to the Lease, which was equal to $2. Payments on the loan certificates were to be made solely from the Loan Estate.



B sold the Equipment to Trust pursuant to a Deed of Conveyance. Trust pledged the Equipment and the Lease to Lender as collateral for Trust's loan from Lender. Trust agreed to pay all of the transaction costs. Trust and Lender agreed that they would not take any action that would increase the interest rate in the Loan Agreement which would, in turn, affect B's rent obligation under the lease. The parties further agreed that they could not exit from the agreement and could not transfer any of the property and/or leases and/or loans involved in the agreement unless the transferee agreed to undertake the transferor's obligations under the Participation Agreement.



The Lease sets forth a formula for calculating the rent due each month. Nonetheless, the Lease Agreement provides that the amount of rent due will, at a minimum, be sufficient to pay the principal installment and accrued principal due on all the loan certificates outstanding under the Loan Agreement. No lease payments were due during the interim term. Generally, lease payments were due biannually from Date 2 to Date 4. Additionally, no lease payment was due on Date 4.



The Lease is a net lease and B is liable for all costs and expenses in connection with the Equipment for construction, delivery, ownership, use, possession, registration, control, subleasing, operation, maintenance, repair, insurance, improvement and return of the Equipment.



According to the Appraisal, the Equipment has a useful life of approximately W years, which exceeds the Base Term by V years. Even if the term of a New Lease is aggregated with the Lease to B, the combined lease term is U years, which is T years less than the Equipment's useful life. In accordance with the Lease, B will cause each piece of Equipment to be serviced, repaired, maintained, overhauled and tested during the term of the Lease, which should allow the Equipment to reach or exceed the estimated useful life.



According to the Loan Agreement, the Lease specifies that B pay, directly to Lender, B's rent obligations to Trust, at the address specified by Lender. Pursuant to the Loan Agreement, Trust agreed that when Trust received money that was part of the Loan Estate, Trust would transfer such funds to Lender.



Lender and B entered into a currency swap transaction ("Swap") purportedly to protect B from the currency exchange risk involved in making its Lease obligation payments in U.S. dollars rather than Currency A. Pursuant to the Swap Agreement, fixed interest payment obligations were swapped for floating rate payment obligations. B gave Lender an amount equivalent to $2. Additionally, Lender was obligated to pay B a stream of payments in U.S. dollars. The termination date for the stream of payments for the Swap Agreement is Date 4. The Swap Agreement payments from Lender to B were due biannually each year from Date 2 through Date 4. On Date 4, the amount due under the Swap Agreement would be $3.



As a result of all of the above, the stream of payments due on the Loan Agreement, Lease Agreement and Swap Agreement are equivalent in amount and are due and payable on the same dates, except that on the first payment date, the Lease payment exceeds the Loan and Swap payments.



B and A entered into a Tax Indemnity Agreement on Date 7. Pursuant to the Tax Indemnity Agreement, B and A agreed to the following:



A will be treated as the owner of the Trust Estate and will be required to take into account in computing its taxable income all items of income, gain, loss and deduction flowing from the Trust Estate;



The Lease will be treated as a true lease by Trust as owner and lessor to B and the obligations on the Loan will constitute indebtedness of the Lessor; and



A, as the beneficial owner of the Equipment, will be treated as the purchaser, owner and lessor of each Piece of Equipment and will be entitled to depreciation deductions for the Equipment, interest deductions on the Loan and amortization of transaction expenses related to the Lease.



Significantly, at the end of the Base Term, the Lease Agreement requires B to exercise one of the three following options:



1. to purchase the Equipment pursuant to a "Purchase Option";



2. to cause a New Lessee to enter into a new lease pursuant to a "New Lease Option"; or



3. to return the Equipment to Trust pursuant to the "Return Option."



(1) The Purchase Option.



Assuming all rents due were paid and the loans were not defaulted, on Date 4, B could purchase the Equipment from Trust for a price equal to E percent of the cost of the Equipment, or $4. Additionally, B would pay all the unpaid rent due and payable as of Date 4. When B paid these amounts, rent would stop accruing, the term of the lease would terminate, and title to the Equipment would be conveyed to B. Additionally, Trust would request that upon payment of all amounts due under the Loan Agreement and upon termination of the Loan Agreement, Lender would release Trust from its liabilities under the Loan Agreement and related pledge agreements. At B's expense, Trust would execute and deliver to B the appropriate documents conveying Trust's right, title and interest in and to the Equipment to B or B's designee.



B entered into an agreement with Foundation, purportedly to protect itself from currency fluctuation risk by providing a source of U.S. dollars to pay the Purchase Option price if B chooses to exercise the Purchase Option on Date 4. B transferred funds from the Equity Contribution to the Foundation. Foundation used the funds to purchase two treasury strips. The first strip matured in an amount equal to the Net Rent amount due on Date 3. The Net Rent equals the amount by which a Lease payment exceeds a Loan payment. The second strip matured on Date 4 in an amount equal to the Net Purchase Option price. The Net Purchase Option price is the extent to which the Purchase Option price would exceed the principal and interest scheduled to be paid on the Loan certificates on Date 4. On Date 4, the Purchase Option price will exceed the principal and interest scheduled to be paid on the Loan certificates, in an amount equal to the amount that the second treasury strip will mature to.



(2) The New Lease Option.



To exercise the New Lease Option, B would have to find a new replacement lessee ("New Lessee") who would 1) use the Equipment in its business; 2) lease the Equipment to another business; 3) sublease the Equipment to another entity; or 4) enter into subleases for terms of less than three years with sublessees that are tax exempt entities. The new lease would begin on Date 4 and would extend for a period of X years or less. B could compensate the New Lessee to induce it to enter into the new lease. The rental payments on the new lease must preserve Trust's net economic return so that Trust's net economic return is the same as it was under the original lease. The Equipment must be delivered in Country C at the commencement of the new lease. If 30 days prior to the expiration date of the Base Term of the lease, Trust and the New Lessee have not entered into a new lease, then, no later than 25 days before the expiration date of the Base Term of the lease, B will give irrevocable notice to Trust of its election to exercise the Return Option or the Purchase Option. If either B gives notice that it is electing the New Lease option or Trust and New Lessee have not agreed to a new lease at least 30 days prior to the expiration date of the Base Term of the Lease, Trust may unilaterally make a preemptive election to require the return of the Equipment on the expiration date of the Base Term of the lease. In its notice of making a preemptive election, B must agree to pay Lender all amounts due and payable on Date 4 under the Loan Agreement. If Trust exercises this preemptive election, B will have to return the Equipment.



(3) The Return Option



If B exercises the Return Option, then B must return the Equipment to Trust on Date 4. On Date 4, B will have to pay Trust all the rent due and payable on that date and a Lump Sum Payment. 4 Trust would use commercially reasonable efforts to sell and dispose of the Equipment to the highest bidder at auction. If the loan certificates have been repaid in full, then the proceeds of the sale in excess of F percent of the Equipment's cost will be paid to B up to the amount of the Lump Sum Payment. However, if at Trust's option, Trust retained the Equipment and the entire principal amount and accrued interest of the loan certificates has been paid or the interest rate has been reset or the loan certificates have been purchased at par plus accrued interest through Date 4, then Trust will pay B an amount equal to the fair market value of the Equipment in excess of F percent of the Equipment's cost, up to the amount of the Lump Sum Payment.



According to the Appraisal of the Equipment obtained by A from Appraiser, B will not be under any economic compulsion to exercise any particular option. Thus, it was not possible for the appraisal to conclude which option A would be most likely to exercise at the end of the Lease Term.




LAW AND ANALYSIS


I. Whether The Sale-Leaseback Transaction Lacks Economic Substance



In order to be respected, a transaction must have economic substance separate and distinct from the economic benefit achieved solely by tax reduction. If a taxpayer seeks to claim tax benefits, which were not intended by Congress, by means of transactions that serve no economic purpose other than tax savings, the doctrine of economic substance is applicable. United States v. Wexler, 31 F.3d 117, 122, 124 (3d Cir. 1994) [ 94-2 USTC ¶50,361]; Yosha v. Commissioner, 861 F.2d 494, 498-99 (7\th/ Cir. 1988) [ 88-2 USTC ¶9589], aff'g, Glass v. Commissioner, 87 T.C. 1087 (1986) [CCH Dec. 43,495]; Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966) [ 66-2 USTC ¶9561], aff'g 44 T.C. 284 (1965) [CCH Dec. 27,415]; ACM Partnership v. Commissioner, T.C. Memo. 1997-115 [CCH Dec. 51,922(M)], aff'd in part and rev'd in part 157 F.3d 231 (3d Cir. 1998) [ 98-2 USTC ¶50,790].



Whether a transaction has economic substance is a factual determination. United States v. Cumberland Pub. Serv. Co., 338 U.S. 451, 456 (1950) [ 50-1 USTC ¶9129]. This determination turns on whether the transaction is rationally related to a useful nontax purpose that is plausible in light of the taxpayer's conduct and useful in light of the taxpayer's economic situation and intentions. The utility of the stated purpose and the rationality of the means chosen to effectuate it must be evaluated in accordance with commercial practices in the relevant industry. Cherin v. Commissioner, 89 T.C. 986, 993-94 (1987) [CCH Dec. 44,333]; ACM Partnership, supra. A rational relationship between purpose and means ordinarily will not be found unless there was a reasonable expectation that the nontax benefits would be at least commensurate with the transaction costs. Yosha, supra; ACM Partnership, supra.



In determining if a transaction has economic substance, both the objective economic substance of the transaction and the subjective business motivation of the taxpayer must be determined. ACM Partnership, 157 F.3d at 247 [ 98-2 USTC ¶50,790]; Horn v. Commissioner, 968 F.2d 1229, 1237 (D.C. Cir. 1992) [ 92-2 USTC ¶50,328]; Casebeer v. Commissioner, 909 F.2d 1360, 1363 ((9\th/ Cir. 1990) [ 90-2 USTC ¶50,435]. The two inquiries are not separate prongs, but are interrelated factors used to analyze whether the transaction had sufficient substance, apart from its tax consequences, to be respected for tax purposes. ACM Partnership, 157 F.3d at 247 [ 98-2 USTC ¶50,790]; Casebeer, 909 F.2d at 1363 [ 90-2 USTC ¶50,435]. Consequently, in considering whether a sale-leaseback case has economic substance, the Tax Court in Levy v. Commissioner, 91 T.C. 838, 856 (1988) [CCH Dec. 45,152], found the following factors to be "particularly significant":



The presence or absence of arm's-length price negotiations, Helba v. Commissioner, 87 T.C. 983, 1005-1007 (1986) [CCH Dec.43,474], affd. 860 F.2d 1075 (3d Cir. 1988); see also Karme v. Commissioner, 73 T.C. 1163, 1186 (1980) [CCH Dec. 36,843], affd. 673 F.2d 1062 (9\th/ Cir. 1982) [ 82-1 USTC ¶9316]; the relationship between the sales price and fair market value, Zirker v. Commissioner, 87 T.C. 970, 976 (1986) [CCH Dec. 43,473]; Helba v. Commissioner, supra at 1005-1007, 1009-1011; the structure of the financing, Helba v. Commissioner, supra at 1007-1011; the degree of adherence to contractual terms, Helba v. Commissioner, supra at 1011; and the reasonableness of the income and residual value projections, Rice's Toyota World, Inc. v. Commissioner, 81 T.C. 184, 204-207 [CCH Dec. 40,410].



Accordingly, an equipment sale-leaseback will be considered a sham if it (1) was not motivated by any economic purpose outside of tax considerations, and (2) was without any real potential for profit. See Rice's Toyota World v. Commissioner, 752 F.2d 89 (4\th/ Cir. 1985) [ 85-1 USTC ¶9123].



Courts recognize that offsetting legal obligations, or circular cash flows may effectively eliminate any real economic significance of the transaction. For instance, in Knetsch v. United States, 364 U.S. 361 (1960) [ 60-2 USTC ¶9785], the taxpayer repeatedly borrowed against increases in the cash value of a bond. Since the bond and the taxpayer's borrowings constituted offsetting obligations, the taxpayer could never derive any significant benefit from the bond. The Supreme Court found the transaction to be a sham because it would produce no significant economic effect and had been structured only to provide the taxpayer with interest deductions.



Subsequently, the Court of Appeals for the Second Circuit applied an economic substance analysis in Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966) [ 66-2 USTC ¶9561], affg. 44 T.C. 284 (1965) [CCH Dec. 27,415]. In that case, the taxpayer won the Irish Sweepstakes. In an attempt to shelter her winnings from tax, she borrowed from two banks and invested the loan proceeds in Treasury notes. The loans required her to pay interest at 4 percent, while some Treasury notes yielded one-half percent and others yielded 1-1/2 percent. Her financial advisers estimated that these transactions would produce a pretax loss of $18,500 but a substantial after-tax gain. The court disallowed the interest deductions because it found that the taxpayer's purpose in entering into the loan transactions "'was not to derive economic gain or to improve here [sic] beneficial interest; but was solely an attempt to obtain an interest deduction as an offset to her sweepstakes winnings." Id. at 738. The court stated further that the loan arrangements did not "have purpose, substance, or utility apart from their anticipated tax consequences," and that the transactions had no "realistic expectation of economic profit." Id. at 740.



Goldstein is significant because unlike many purported tax shelters, the tax-motivated transactions in that case were not fictitious. Goldstein v. Commissioner, supra at 737- 738. They were real and conducted at arm's length. The taxpayer's indebtedness was enforceable with full recourse and her investments were exposed to market risk. Yet, the strategy was not consistent with rational economic behavior in the absence of the expected tax benefits.



Other courts have applied the teaching of Goldstein in varied settings. For example, in Sheldon v. Commissioner, 94 T.C. 738 (1990) [CCH Dec. 46,602], the Tax Court denied the taxpayer the tax benefits of a series of Treasury bill sale-repurchase transactions because they lacked economic substance. In the transactions, the taxpayer bought Treasury bills that matured shortly after the end of the tax year and funded the purchase by borrowing against the Treasury bills. The taxpayer accrued the majority of its interest deduction on the borrowings in the first year while deferring the inclusion of its economically offsetting interest income from the Treasury bills until the second year. The transactions lacked economic substance because the economic consequence of holding the Treasury bills was largely offset by the economic cost of the borrowings. The taxpayer was denied the tax benefit of the transactions because the real economic impact of the transactions was "infinitesimally nominal and vastly insignificant when considered in comparison with the claimed deductions." Sheldon, 94 T.C. at 769 [CCH Dec. 46,602].



Even in cases in which a circular flow of funds was not the predominant feature, courts have indicated that a minimal profit should not be conclusive in finding economic substance or practical economic effects. Minimal or no profit has been held to be acceptable in highly risky circumstances, where a chance for large profits also existed. See Bryant v. Commissioner, 928 F.2d 745 (6\th/ Cir. 1991) [ 91-1 USTC ¶50,157]; Jacobson v. Commissioner, 915 F.2d 832 (2d Cir. 1990) [ 90-2 USTC ¶50,532]. Conversely, a minimal profit should be less acceptable when a ceiling on profits from a transaction is all but certain. Thus, if tax considerations predominate, the courts will find that an equipment leasing transaction is a sham even if it holds out the promise of minimal profit. See Hines v. Commissioner, 912 F.2d 736 (4\th/ Cir. 1990) [ 90-2 USTC ¶50,477]; Prager v. Commissioner, T.C. Memo. 1993-452 [CCH Dec. 49,309(M)]. The fact that the taxpayer is willing to accept minimal returns in a transaction with little additional profit potential is evidence that the transaction was tax motivated.



In ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998) [ 98-2 USTC ¶50,790], the taxpayer entered into a near-simultaneous purchase and sale of debt instruments. Taken together, the purchase and sale "had only nominal, incidental effects on [the taxpayer's] net economic position." ACM Partnership, 157 F.3d at 250 [ 98-2 USTC ¶50,790]. The taxpayer claimed that, despite the minimal net economic effect, the transaction had economic substance. The Third Circuit Court of Appeals held that transactions that do not "appreciably" affect a taxpayer's beneficial interest, except to reduce tax, are devoid of substance and are not respected for tax purposes. ACM Partnership, 157 F.3d at 248 [ 98-2 USTC ¶50,790]. The court denied the taxpayer the purported tax benefits of the transaction because the transaction lacked any significant economic consequences other than the creation of tax benefits. In addition, the court specifically affirmed the Tax Court's adjustment of future income to net present value to determine the profit potential of a transaction under the judicially created economic substance doctrine. The court rejected the argument that there is no statutory basis for using present values, and cited several cases sustaining the use of present value computations to determine the true profit potential of a transaction.



In United Parcel Service of America, Inc., 254 F.3d 1014 (11\th/ Cir. 2001) [ 2001-2 USTC ¶50,475] the Eleventh Circuit recently reversed the Tax Court on the issue of economic substance finding that UPS' restructuring of its excess-value business had both real economic effects and a business purpose. The Court reasoned that setting up a transaction (that otherwise has economic substance) with tax planning in mind is permissible as long as it figures in a bona fide, profit-seeking business purpose. We do not believe that this opinion will have a negative effect on the instant case because, for the reasons articulated below, we do not believe that the transactions had a bona fide profit-seeking business purpose. Also, unlike UPS, A is not in C in business. Moreover, the Eleventh Circuit recently affirmed the Tax Court's determination that a transaction entered into by the taxpayer was a substantive sham. Winn-Dixie Stores, Inc. v. Commissioner, 254 F.3d 1313 (11\th/ Cir. 2001) [ 2001-2 USTC ¶50,495].



In Compaq Computer Corp. v. Commissioner, 277 F.3d 778 (5\th/ Cir. 2001) [ 2002-1 USTC ¶50,144], the Fifth Circuit found that Compaq made a pretax profit and had a non-tax business purpose on Royal Dutch ADR transactions. See also, IES Indus. v. United States, 253 F.3d 350 (8\th/ Cir. 2001) [ 2001-2 USTC ¶50,471]. While these cases have not changed our analysis in the instant case, we recommend that you carefully scrutinize any claim of pretax return and determine if it is insubstantial when compared to the post-tax returns.



A. The Circular Flows of Funds Involved in the Sale-Leaseback Transaction Entered into by A, Trust, B, and Lender Illustrates that A had no subjective profit motive and the transactions had no objective economic substance



On the funding date, the sale, leaseback, loan and swap transactions all commenced, creating two complete circular flows of funds yielding a net cash flow of zero. According to the Documents, the following three transfers of $2 took place on the funding date: (1) Lender lent $2 to Trust; (2) Trust contributed the $2 together with the Equity Contribution from A to B for the purchase of the Equipment; and (3) B transferred $2 to Lender pursuant to the Swap Agreement. Accordingly, $2 ended where it started, with Lender. Additionally, according to the Documents, the following three streams of payments were agreed to and initiated as of the funding date: (1) Pursuant to the Lease Agreement, B would pay lease payments to Trust for use of the Equipment; (2) Pursuant to the Loan Agreement, Trust would make loan payments to Lender for principal and interest owed on the purported $2 loan from Lender to Trust and the Loan Agreement also provided that B would pay the lease payments it owed Trust directly to Lender; and (3) Lender would make payments to B pursuant to the Swap Agreement. The amounts of all of the payments were equivalent and the payments were all due on the same date. However, the Lease payment made on Date 3 exceeded the amount of the Loan payments and Swap payments due on Date 4. Except for the payment made on Date 3, the three streams of payments yielded a net cash flow of zero. Thus, A does not appear to have an expectation of profit from the rental payments independent of tax benefits.



The Custodial Agreement entered into by B and the Foundation completed the circular flow of funds. B transferred funds from the Equity Contribution to the Foundation. The Foundation used the funds from the Equity Contribution to purchase two Treasury strips. One strip matured to the Net Rent due on the first Lease payment. The second strip matured to the Net Purchase Option price in the amount of $8. The remaining portion of the Purchase Option Price, $3 is part of another circular flow of funds. On Date 4, the amount due from A to Lender outstanding on the loan certificates is $3 and the amount due from Lender to B on the Swap Agreement also equals $3. On Date 4, the $3 makes a complete circle between the three parties to the transaction with no net outflow of cash from any of the parties. Accordingly, the amount of the matured treasury strip provided B with sufficient cash to exercise the Purchase Option price without any further outlay of cash by B. Thus, A has no risk that B would have insufficient funds to exercise the Purchase Option on Date 4.



Additionally, B has business motives to reacquire the Equipment. The acquisition of the Equipment was part of B's modernization program. Furthermore, B is in the business of C in Country C and is the likely party to wish to operate the Equipment. Since A had no opportunity to earn a profit on the deal during the Lease Term, the only opportunity for A to earn a profit was on Date 4. However, the following analysis of the three options shows that A would not earn a profit on Date 4, either.




1. The Purchase Option


The Purchase Option is the most economically preferable option. By drawing on the funds held by Foundation, by Date 4, B would have the funds necessary to exercise the Purchase Option without any additional costs. If the Equipment appreciated to a fair market value greater than the Purchase Option price, B, acting rationally, would exercise the Purchase Option to take advantage of the bargain price. If the Equipment depreciated to a fair market value lower than the Purchase Option price, B, acting rationally, would still exercise the Purchase Option because, as will be illustrated in the following discussion, the Purchase Option is still the most economically advantageous option. Additionally, B has a business motive to exercise the Purchase Option and retain the Equipment.



If B exercises the Purchase Option on Date 4, A receives a very small profit on its Equity Contribution. The Purchase Option Price is $4. However, A will owe Lender $3 leaving A a net return of $8 which is the Net Purchase Option Price. On Date 4, Lender will owe B $3 pursuant to the Swap Agreement. Accordingly, the $3 goes in a complete circle and ends where it started, with B. B can take the funds from the treasury strip that matures on Date 4 to $8 to pay the Net Purchase Option price. Accordingly, B has no additional outlay of costs to exercise the Purchase Option.




2. The New Lease Option


It also appears that exercising the New Lease Option would put B in a worse position, economically, than exercising the Purchase Option. Under the New Lease Option, the Lease payments were predetermined as of the funding date. Thus, if B were to find a New Lessee, the parties would not be able to renegotiate the New Lease payments so that they would be in accord with the then fair market value. If B wished to find a New Lessee and the Equipment appreciated in value so that the New Lease payments were less than fair market value, B, acting rationally, would exercise the Purchase Option and then lease the Equipment, itself, to take advantage of the appreciation in value. If the Equipment depreciated in value so that the New Lease payments would be a higher price than the market would otherwise bear, B would have to pay an inducement to the New Lessee. In this circumstance, B would have to pay the inducement and not have the Equipment. Acting rationally, we believe that B would exercise the Purchase Option and then lease the Equipment, itself. In doing so, B would be able to find another entity to lease and operate the Equipment but would not have any further costs with respect to the sale-leaseback transaction with Trust.



However, there are significant litigation hazards unless it can demonstrate that the New Lease Option is purely illusory. The New Lease Option could be viewed as a negotiated protection inserted into the Lease Agreement. For the Trust and Lender, the New Lease Option offers the protection of a long term, fixed rate of return based on a lease term of as many as X years for the Equipment in the event B does not exercise its Purchase Option. For B, the New Lease Option offers protection against being forced to either buy the Equipment or walk away with a large expenditure and no Equipment. Nonetheless, we believe that the rational choice is the Purchase Option.




3. The Return Option


Exercising the Return Option would put B in a worse position, economically than exercising the Purchase Option. If B exercises the Return Option, then B will be required to pay A the Lump Sum Payment equal to H percent of the original Equipment cost which is $5 and A will sell the Equipment at auction. A will pay B proceeds from A's sale of the Equipment greater than F percent of the Equipment Cost and up to the amount of the Lump Sum Payment. If B exercised the Return Option, B would have funds available in the Foundation to pay the Lump Sum; however, B would not have any Equipment. Pursuant to the terms of the Return Option, B would get some of A's Equipment sale proceeds. However, B would not be able to receive the first $7 5 of A's Equipment sales proceeds and would not be able to receive more than the Lump Sum amount. B would not be able to recoup a sufficient amount to purchase the same or alternative Equipment. Thus, B would be in a worse economic position if it exercised the Return Option than if it exercised the Purchase Option. Since it is the economically rational choice to select the Purchase Option, regardless, of whether the property appreciates or depreciates in value, A has no opportunity to profit from appreciation in the property, nor to suffer a loss from depreciation in the property.



A's only net return on the transaction is the Net Rent paid on Date 3 and the Net Purchase Option price paid on Date 4. Those amounts are very small compared to the tax benefits that A enjoys during the Lease Term. A minimal profit should not be conclusive in finding economic substance or practical economic effects. Minimal or no profit has been held to be acceptable in highly risky circumstances, where a chance for large profits also existed. See Bryant v. Commissioner, 928 F.2d 745 (6th Cir. 1991) [ 91-1 USTC ¶50,157]; Jacobson v. Commissioner, 915 F.2d 832 (2d Cir. 1990) [ 90-2 USTC ¶50,532]. However, a minimal profit should conversely be less acceptable when a ceiling on profits from a transaction is all but certain. A's willingness to accept minimal returns in a transaction with a limitation on profit potential demonstrates that the transaction was tax motivated. Thus, a minimal profit in an equipment leasing transaction will not prevent the finding of a sham if tax considerations predominate. See Hines v. Commissioner, 912 F.2d 736 (4th Cir. 1990) [ 90-2 USTC ¶50,477]; Prager v. Commissioner, T.C. Memo. 1993-452 [CCH Dec. 49,309(M)].



Arguably, the only motivation for this transaction was A's desire to "purchase" tax benefits. This transaction could reasonably be viewed as a "sale" of tax benefits by an entity which cannot use them to a taxable entity which can. In exchange for its equity investment, A received a substantially greater amount of tax benefits by claiming depreciation, amortization and interest expenses each year over the life of the transaction. Because it appears likely that Trust will exercise the Purchase Option, and all amounts have been pre-funded, this transaction shares many factual similarities with other cases decided under economic substance principles. See Knetsch supra (offsetting legal obligations).



In form, this transaction was a sale/leaseback between A and B financed by a loan from Lender, with an embedded currency swap with the purported purpose of protecting B from currency exchange risk. In the instant case, a currency swap was used to complete a circular flow of funds. A currency swap agreement is two offsetting loans in two different currencies. By substituting a currency swap between Lender and B for a loan from B to Lender, the transaction embeds what is in substance a loan from Lender to B in what would otherwise be a sham transaction involving a circular flow of funds.



All the cash flows were circular and yielded net proceeds of zero, thus, A had no economic risk in undertaking the transaction; and A has a cap on the possibility of earning a profit from this transaction or bearing any significant costs either during or at the expiration of the Lease Term, this series of transactions lacked the potential for any significant economic consequences and therefore lacked economic substance and had no business purpose. See, e.g., Rice's Toyota World; Nicole Rose; Levy. For this reason we believe economic substance principles may be applied in this case.



Accordingly, A is not entitled to deduct the depreciation deductions claimed for the Equipment purportedly purchased by A pursuant to the transaction. Further, the interest deductions at issue in the instant case stem directly from the Loan taken by A through Trust. The loan cannot be separated from the purported sale transaction whose sole purpose was for A to obtain tax benefits. As such, the Loan was an integral part of the transaction and a deduction for the interest on the Loan is not allowable under section 163.



II. Whether The Transaction Should Be Treated As a Financing Rather Than As a Sale-Leaseback



Alternatively, the transaction should be treated as a financing. Whether a sale-leaseback is respected for federal income tax purposes is not determined by the labels of the parties. In Helvering v. F. & R. Lazarus & Co., 308 U.S. 252 (1939) [ 39-2 USTC ¶9793], the Supreme Court stated that, "taxation ... [is] concerned with substance and realities, and formal written documents are not rigidly binding." 308 U.S. at 255. In Lazarus, the taxpayer conveyed property to a bank and then leased the property back for a term of ninety-nine years. The Court concluded that the transaction, though structured in the form of a sale-leaseback, was in substance a loan secured by the property. It held that the taxpayer was the party who bears the burden of exhaustion of capital investment in the property and thus, is entitled to deduct depreciation regardless of the fact that the taxpayer had by agreement designated another party as the legal owner. Lazarus stands for the proposition that, in the sale-leaseback area, the substance of the transaction rather than its form is controlling for federal tax purposes.



In Frank Lyon Co. v. United States, 435 U.S. 561 (1978) [ 78-1 USTC ¶9370], the Supreme Court set forth standards for determining when a sale-leaseback may not be ignored as a sham, holding that "so long as the lessor retains significant and genuine attributes of the traditional lessor status, the form of the transaction adopted by the parties governs for tax purposes." Id. at 584. In Frank Lyon, the Frank Lyon Company's (Company) majority shareholder and board chairman also served on the board of Worthen Bank (Bank). The Company invested $500,000 of its own funds to acquire a new office building from the Bank and lease it back to the Bank for an initial term of 25 years. The Company financed the remainder of the building with a full recourse loan of $7,140,000 obtained from an unrelated insurance company. The rent for the first 25 years equaled the principal and interest payments that would amortize this loan. The Company also leased the land under the building from the Bank for 76 years. The Bank had the right to renew its lease of the building for eight additional 5-year intervals at a fixed rent making its total potential leasehold 65 years long. The Bank had the option to purchase the building at 11 years and at other points in the lease for the Company's investment with compound interest at 6 percent plus repayment of the loan balance. The Bank also had the option to purchase the building at fair market value under certain conditions involving a transfer of the Company's interest. Under applicable federal and state law, the Bank was precluded from financing an office building of that magnitude for its own use. However, the state and federal regulators approved the sale and leaseback so long as the Bank had an option to purchase the property after 15 years at a fixed price where another party owned the building.



The Government argued that the sale leaseback should be disregarded as a sham, because the Company was only acting as a conduit to forward rent payments to pay the mortgage and was doing so for a guaranteed return. In rejecting the sham argument, the Court distinguished Lazarus because it involved two rather than three parties. The third party (the lender) was necessary to the transaction in Frank Lyon because of the restrictions on borrowing imposed on the Bank. The Court found it significant that the Bank could not legally own and finance its own building. The Court emphasized that the Company had assumed recourse liability in the debt, and thus it had exposure to real and substantial risk. Moreover, the Court rejected the contention that the purchase options allowed the Bank to accumulate equity in the property over time because the Bank was free to walk away without further obligation without exercising any lease extension and, alternatively, the option prices represented fair estimates of market value on applicable dates. The Court also noted that the Company would be free to do with the building as it chose if the lease were not extended, but would remain liable for the ground rent. The Court concluded, at 583-84, that:



Where ... there is a genuine multi-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached, the Government should honor the allocation of rights and duties effectuated by the parties. Expressed another way, so long as the lessor retains significant and genuine attributes of the traditional lessor status, the form of the transaction adopted by the parties governs for tax purposes. What those attributes are in any particular case will necessarily depend upon its facts.



The decision in Frank Lyon rested strongly upon the risks incurred by the Company, including the recourse debt, the ground rent, and the possibility the lease would not be extended (significantly, without any compensation to the Company), and the rewards of the use of the property if the Bank did not extend the lease. Such risks gave the Company the significant attributes of a lessor. No similar risks were incurred in the present case. Here, the Loan is subject to satisfaction and the risks as well as the potential gains from the transaction have been carefully collared to limit both potential loss and profit by A. While it is true that Frank Lyon suggests rental payments in a lease may match up to the amount of principal and interest necessary to amortize a loan, that case involved the construction of a building that, implicitly at least, could be used by any lessee. That the payments match up, therefore, is not significant unless it reinforces the view that the lessor's risks and rewards indicate the lessor is not the owner of the property. Significantly, therefore, the below analysis will show that the risks and the potential gains from the transaction to A have been carefully collared to limit both potential loss and profit to A.



Moreover, in Frank Lyon the Bank was precluded by federal and state regulations from financing and constructing the building itself. No such restrictions are present in this case because B owned the Equipment prior to the effective date of the transaction here. Accordingly, although the legal principles of Frank Lyon (that is, focusing on the substance of the transaction) are appropriate to an analysis of this transaction, that case is factually distinguishable from the present case.



Despite the government's inability to demonstrate, on the facts in Frank Lyon, that the Company was simply financing the Bank's building purchase, many courts have addressed whether a sale-leaseback was, in substance, a financing, that is, whether the purported owner/lessor simply lent money to the purported seller/lessee. A particularly instructive example is Pacific Gamble Robinson and Affiliated Companies v. Commissioner, 54 T.C. Memo. 915 (1987) [CCH Dec. 44,281(M)]. There, petitioner (PER) sold its Yakima Apple Facility to Third Birkenhead Properties Inc. for $500,000; $490,000 of which was financed with a nonrecourse note payable to Minnesota Mutual Life Insurance Company. At the same time, the facility was leased back to PER for a 25-year primary term and six 5-year renewal terms. During the primary lease term, the rental payments equaled the payments due from Third Birkenhead to Minnesota Mutual on the note. Third Birkenhead had the right to require PER to buy the facility at the end of the basic lease term under a predetermined price schedule for a stated purchase price nearly equal to the then outstanding balance owed on the note. This lease provision was amended to require PER to offer to buy the facility at the end of the primary term for the greater of its then fair market value or the outstanding balance owed on the note. It was unlikely that the fair market value of the facility would exceed the outstanding balance on the note. New notes were later issued that provided that the lenders would look solely to the facility and to the sums due from PER under the lease for repayment on the notes. Under the new notes, PER agreed to pay the installments when they became due.



The Tax Court disregarded the form of the transaction as a sale-leaseback as inconsistent with its economic substance. It held that PER was in substance the "owner" of the facility for federal tax purposes. The court cited several factors to support its holding: (1) As a matter of economic reality, PER (the "lessee"), not the lessor, was principally liable on the debt; (2) PER, not the lessor, retained the primary benefits and burdens of ownership associated with the facility; and (3) the lessor had no reasonable opportunity for economic profit from the transaction absent tax benefits.



Similarly, in situations involving the characterization of sale-leaseback transactions, the Service consistently has held that the substance of a transaction is controlling for federal tax purposes. For instance, Rev. Rul. 72-543, 1972-2 C.B. 87, concluded that a transaction in the form of a "sale-leaseback" is in fact a financing where under the terms of the leaseback, the taxpayer-lessee never actually parted with the benefits and burdens of ownership to the property for federal income tax purposes. In that ruling, the taxpayer, a shipping company financed reconstruction of a vessel by "selling" title to the vessel to the subsidiary of a bank for the vessel's then fair market value. The subsidiary borrowed the cost of the acquisition and reconstruction from a group of lenders under a "charter party," an agreement whereby the subsidiary leases the vessel to the taxpayer for use in its transportation business. At the same time, the subsidiary assigned all of its rights, title and interest to the monies due under the charter party to the lenders. Under the agreement, the subsidiary chartered the vessel to the taxpayer for a 21-year term at a rental rate sufficient to pay the total costs of acquiring and reconstructing the vessel plus interest over the 21-year period. The 21-year term exceeded the vessel's useful life. The taxpayer was at risk for the vessel at all times during this term and had to maintain insurance. The charter gave the taxpayer the right to buy the vessel on the 9th anniversary of delivery for a predetermined price equal to the unamortized principal amount of the loan on that date.



Rev. Rul. 72-543 concluded that the taxpayer held the benefits and burdens of ownership to the vessel since (I) it was obliged to repay the costs of acquisition and reconstruction plus interest in the form of rentals; (ii) it had to pay the vessel's operating and insurance costs; (iii) it had an option to purchase the vessel for the unamortized principal amount of the loan at a specific anniversary date; and (iv) the parties intended for legal title to pass to taxpayer. Although cast in the form of a sale-leaseback, the ruling held that the transaction, when viewed in its entirety, was a financing arrangement with ownership of the vessel in the taxpayer.



Thus, whether a transaction is a sale, a lease, or a financing arrangement is a question of fact, which must be ascertained from the intent of the parties as evidenced by the written agreements read in light of the attending facts and circumstances. Haggard v. Commissioner, 24 T.C. 1124, 1129 (1955) [CCH Dec. 21,249], aff'd, 241 F.2d 288 (9\th/ Cir. 1956) [ 57-1 USTC ¶9230]. The judicial test for determining if a transaction is a sale, as opposed to a lease or a financing arrangement, is whether the benefits and burdens of ownership have passed to the purported purchaser. Larsen v. Commissioner, 89 T.C. 1229 (1987) [CCH Dec. 44,401]. For this purpose, the "refinements of title" are not dispositive. Corliss v. Bowers, 281 U.S. 376, 378 (1930). In fact, even if the vesting of title in someone other than taxpayer created a prima facie case that the taxpayer was not the owner of certain equipment for depreciation purposes, the Tax Court, in Coleman v. Commissioner, 87 T.C. 178, 202 n. 18 (1986) [CCH Dec. 43,193], aff'd, 833 F.2d 303 (3d Cir. 1987), acknowledged that the location of title did not mean that it was holding that taxpayer was not the owner. Instead, the location of title meant only that the taxpayer had the burden of producing "strong proof" that the other benefits and burdens of ownership were held by the taxpayer. 87 T.C. at 203-04 [CCH Dec. 43,193]. The court's opinion in Coleman analyzed the benefits and burdens of ownership of the equipment and concluded that the taxpayers failed to demonstrate that it held the incidents of ownership to the equipment.



The Tax Court analyzes the following factors to determine if the benefits and burdens of ownership pass in a transaction: (1) whether legal title passed; (2) whether the parties treated the transaction as a sale; (3) whether the purchaser acquired an equity interest in the property; (4) whether the sale contract obligated the seller to execute and deliver a deed and obligated the purchaser to make payments; (5) whether the purchaser is vested with the right of possession; (6) whether the purchaser pays property taxes after the transaction; (7) whether the purchaser bears the risk of economic loss or physical damage to the property; and (8) whether the purchaser receives the profit from the property's operation, retention and sale. Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237-38 (1981) [CCH Dec. 38,472]. Although the potential for gain and amount of risk have been deemed the pivotal factors, the overall concentration should lie on the economic substance of the transaction. Mapco, Inc. v. United States, 556 F.2d 1107, 1111 (Ct. Cl. 1977) [ 77-2 USTC ¶9476].



The Tax Court has also considered the following factors as being relevant to determining whether a sale has occurred (that is, whether to respect a sale-leaseback): (1) the existence of a useful life of the property in excess of the leaseback term; (2) the existence of a purchase option at fair market value; (3) renewal rental at the end of the leaseback term set at fair market rent; and (4) the reasonable possibility that the purported owner of the property can recoup his investment in the property from the income producing potential and residual value of the property. Torres v. Commissioner, 88 T.C. 702, 721 (1987) [CCH Dec. 43,809] citing Estate of Thomas v. Commissioner, 84 T.C. 412, 436 (1985) [CCH Dec. 41,943]; Mukerji v. Commissioner, 87 T.C. 926 (1986) [CCH Dec. 43,469]. The Tax Court in Torres has found the taxpayer's equity interest as a percent of the purchase price to be significant, and it further noted that a sale-leaseback involving a net lease has certain specific characteristics, 88 T.C. at 721 [CCH Dec. 43,809]:



[B]ecause net leases are common in commercial settings, it is less relevant that petitioner was not responsible for the payment of property taxes or that petitioner bears less of a risk of loss or damage to the property because the lessee is required to maintain insurance on the property. Similarly, a lessor is normally not vested with the right to possession during the term of the lease and, therefore, the relevant consideration in this regard is whether the useful life of the property extends beyond the term of the lease so as to give the purchaser a meaningful possessory right to the property. Also, in a leaseback transaction it is normal for the lessee to receive profits from the operation of the property while the lessor's receipt of payments is less dependent upon the operation of the property.



Since no one factor is dispositive of the issue of whether a sale has occurred, the facts and circumstances determine the importance of each factor. For example, whether the buyer has acquired an equity interest in the property may be considered substantive evidence of a sale. See Estate of Franklin v. Commissioner, 544 F.2d 1045, 1048 (9th Cir. 1976) [ 76-2 USTC ¶9773]. However, a taxpayer who acquires no equity interest in the property has no depreciable interest in the property, but instead will be viewed as having attempted to acquire mere tax benefits. Houchins v. Commissioner, 79 T.C. 570, 602 (1982) [CCH Dec. 39,387]. In this context, equity consists of a positive differential between the fair market value of the property and the balance of any loans owed on the property.



Equity may also be viewed as the amount of the purchaser's funds at risk in the property. Thus, a true owner has potential for gain or loss from increase or decrease in the market value of the property. In contrast, a mortgagee's economic return, consisting of interest payments and return of principal, is generally fixed at the time of the initial transaction, irrespective of fluctuations in market value of the property.



Given these overlapping lists of factors, we proceed first to examine the factors set out in Grodt & McKay and then analyze the factors set out in Torres to determine if the benefits and burdens of ownership pass in a transaction and whether a sale has occurred. This analysis will then determine whether A is entitled to the depreciation deductions A claimed for the Equipment purportedly purchased pursuant to the sale-leaseback transaction.




A. Grodt & McKay Factors



1. Whether Legal Title Passed


Pursuant to the Participation Agreement and Deed of Conveyance, B sold, assigned and transferred to Trust all of B's right, title, and interest in the Equipment. The Participation Agreement further provided that if B elects to exercise the Purchase Option on Date 4, Trust "shall execute and deliver to B appropriate instruments conveying Trust's right, title and interest in and to the Equipment to B or its designee." Even though title passed from B to Trust at the outset of the transaction, the facts also suggest the likelihood that B will exercise the Purchase Option to regain all right, title and interest to the Equipment on Date 4. Additionally, the purchase of the Equipment is part of B's modernization program giving B a business incentive to retain the Equipment. If B exercises the Purchase Option on Date 4, this feature indicates that title is only held temporarily by Trust in a form more akin to holding it as security. As such, the Sale-Leaseback Transaction looks more like a secured financing than a sale. See Rev. Rul. 72-543.




2. Whether the Parties Treated the Transaction as a Sale of Equipment


The Documents were prepared in the form of a sale. Moreover, A reported this transaction for federal income tax purposes as a sale and claimed United States tax ownership of the Equipment. A is deducting depreciation expenses for the Base Term and A treated the transaction on its books as an asset purchase. Pursuant to the Tax Indemnity Agreement, B agreed not to claim ownership of the Equipment for United States tax purposes which is consistent with treating the transaction as a sale. This factor appears to favor sale-leaseback treatment.




3. Whether A Acquired an Equity Interest in the Equipment


The Documents are drafted to indicate that A made a J percent equity contribution to the purchase of the Equipment. If "equity" is defined as the difference between the Equipment's fair market value and the amount of the Loan, 6 and assuming the sale price represents fair market value, then A has an equity interest equal to J percent of the Equipment. An owner's equity interest in property is distinguished from a mortgagee's security interest in property by the potential for appreciation or depreciation in the value of the property, the potential to profit from use of the property at the expiration of the lease term, and the nature of its risk of loss.



Here, A's funds are more in the nature of principal on a secured financing than an equity interest in the Equipment since, as a result of the nature of the three options held by B at the end of the Base Term, it appears that A has capped its right to potential appreciation in the Equipment at the difference between the Purchase Option price and the amount necessary to repay Lender. If the value of the Equipment at the end of the Base Term exceeds this differential, B, acting rationally in its economic interest, will exercise the Purchase Option and reacquired title to the Equipment. As discussed above, the Purchase Option is the most economically advantageous option for B to exercise. Acting rationally, B would exercise the Purchase Option regardless of whether the Equipment had appreciated or depreciated in value compared to the projected fair market value set forth in the appraisal. Given B's exercise of the Purchase Option, A is prevented from obtaining a profit from potential appreciation in the fair market value and A is protected from suffering a loss due to depreciation in fair market value. Accordingly, A's position is more in the nature of a secured mortgagee rather than as an equity owner. See Lazarus.




4. Whether the Sale Contract Obligated B to Execute and Deliver a Deed and Obligated A to Make Payments


B transferred to Trust all of B's right, title and interest in the Equipment. Additionally, according to the Documents, A must make semiannual payments to Lender on the Loan. However, pursuant to the Loan Agreement, those payments were to be paid to Lender by B in the form of B depositing its lease payments to Trust directly to Lender. Moreover, since the most economically realistic option for B to exercise on Date 4 is the Purchase Option, which will return title to the Equipment to B, it appears that the documents created a circular delivery of the deed. That is, it appears that A only has a "loan" of the deed or bill of sale during the Base Term, after which the title to the Equipment returns to B. Such circular delivery, or "loan," of the deed is more consistent with treating A as holding a security interest in the Equipment. See Lazarus.



This view is supported by the flow of funds concerning A, which is, with the exception of the first Lease payment, offset by the remaining Loan payments with rental income it receives from B. This point is further illustrated by the fact that pursuant to the Loan Agreement, B was to deposit its lease payments directly to Lender. In each instance, the amount of the rental income equals the amount of the Loan payment and the rent and loan payments are due and payable on the same date. If B exercises the Purchase Option, B is essentially "lending" title of the Equipment to Trust for A for the Base Term. In substance the deed transfer may only be temporary since it is more than reasonable to contemplate the return of the Equipment to B.




5. Whether the Purchaser Is Vested with the Right of Possession


The right of possession factor favors a financing since there is no indication that the parties ever manifested an intent for Trust or A to actually "possess" the Equipment. Generally a sale-leaseback contemplates that the buyer-lessor wants possession of the property at the end of the lease term. In a financing, however, the mortgagee typically does not want use or possession of the property. When A acquired the Equipment pursuant to the Documents, A, through Trust, had no right to sell the Equipment to anyone other than B or even hold it out for lease to the highest bidder prior to its leaseback to B. In fact, B already had possession of the Equipment at the time the transaction was entered into. All of Trust's activities thus were circumscribed so as to keep the Equipment under the possession and control of B at all times. B also controls whether A will possess the Equipment on Date 4 by unilaterally determining which option it will exercise. Arguably, such limitations on possession are inconsistent with the benefits and burdens of ownership. A does not have control to determine if it will ever obtain possession of the Equipment.



In addition, the Lease prevents Trust, acting for A, from taking possession of the Equipment unless necessary to protect its rights, as in the event of default. These conditions are essentially the same as the conditions in which a secured creditor would take possession of the secured property. See Rev. Rul. 72-543. However, while the Documents appear to make possession by A a possibility, this possibility is unlikely since B is most likely to exercise the Purchase Option on Date 4. Consequently, when this transaction is taken as a whole, A has not shown any intent to possess the Equipment. This factor favors financing treatment.




6. Whether the Purchaser Pays Property Taxes after the Transaction


B is responsible for all property taxes. Under the Participation Agreement, B is responsible for all applicable customs duties and stamp taxes and all other taxes in respect of the Equipment. However, this factor is neutral since this is common to net leases. See Torres, 88 T.C. at 721 [CCH Dec. 43,809].




7. Whether the Purchaser Bears the Risk of Economic Loss or Physical Damage


As discussed above, if the Equipment declines in value such that its fair market value on Date 4 is lower or higher than the fair market value projected in the Appraisal, then B, acting rationally, will still exercise the Purchase Option. This factor insulates A from suffering a loss due to depreciation in the market place. Rather, the loss would be suffered by B since B would reacquire its Equipment at a lesser value. Thus, B is the party that ultimately is affected by market decline.



The Lease requires B to maintain insurance on the Equipment and to replace or repair the Equipment in the event of damage or destruction. These requirements are typical in a net lease situation, nonetheless they do insulate A from obligations in the event of physical loss of the property. As noted above regarding the risk of loss of value of the Equipment, the Purchase Option price amount and the rental stream for any New Lease apparently were determined by reference to the amount necessary to repay the Loan and guarantee that A would receive a certain rate of return on the transaction. These provisions essentially insulate A from any risk of physical loss of the property. Further, these conditions essentially shift the risks to B. B's risk of loss is more like that of an owner/mortgagor, while A's fixed return and entitlement to payment without regard to damage to the collateral are consistent with the risks of a mortgagee. See, e.g., Helvering v. F. & R. Lazarus & Co.




8. Whether the Purchaser Receives the Profit from the Property's Operation


Courts have consistently found that the potential for profit or loss on the sale or release of the property is a crucial benefit or burden of owning property. Gefen v. Commissioner, 87 T. C. 1471, 1492 (1986) [CCH Dec. 43,600]. At all times after the transaction is initiated, B operates the Equipment and receives the profit, if any, therefrom. This is consistent with a lessee's right to operate property under a valid lease. In this case, however, as previously discussed, the amount B must pay under the Purchase Option, the Return Option, or the New Lease Option, results in either a ceiling on A's potential for profit or a floor under its potential for loss. For example, if the Equipment appreciates to a fair market greater than that projected by the Appraisal, B will exercise the Purchase Option. As such, A's potential profit from the Sale-Leaseback Transaction is capped at the difference between the Purchase Option price and the amount owed by Trust to Lender on Date 4. Since the Purchase Option price is preset as of the funding date, A is not able to profit from appreciation in fair market value. Rather, B, having exercised the Purchase Option, will be able to benefit from appreciation in the fair market value. This factor indicates that the transaction has the character of a financial arrangement.




B. Torres Factors



1. The Existence of a Useful Life of Property in Excess of the Leaseback Term


According to the Appraisal, the Equipment has a useful life of approximately W years, which exceeds the Base Term by V years. Even if the term of a New Lease is aggregated with the Lease to B, the combined lease term is U years, which is T years less than the Equipment's useful life. In accordance with the Lease, B will cause each piece of Equipment to be serviced, repaired, maintained, overhauled and tested during the term of the Lease, which should allow the Equipment to reach or exceed the estimated useful life. However, since B is expected to exercise the Purchase Option at the end of the Base Term, the additional useful life may not benefit A. Because control of whether to exercise the Purchase Option rests with B and because the Purchase Option is the most likely to be exercised by B, this factor does not strongly support sale-leaseback treatment.




2. The Existence of a Purchase Option at Fair Market Value


The Appraisal provides that the fair market value at the end of the Base Term is estimated to be I percent of the cost of the Equipment. Under the Lease, the Purchase Option Price is set at E percent of the cost of the Equipment. Thus, the Purchase Option price exceeds fair market value by a small amount. Nevertheless, because the appreciation potential of the Equipment is capped by this amount, this factor arguably favors treatment as a financing arrangement.




3. Renewal Rental at the End of the Leaseback Term Set at Fair Market Value


The rental schedules appear to have been determined by reference to the amount required to repay the loan and Equity Contribution and to guarantee A's return on investment. This coupled with the fact that B may have to pay an inducement in order to acquire a New Lessee, indicates that the renewal rent is not set at fair market value.



Moreover, assuming rental rates increase, under the Documents, Trust has the right to reject the New Lessee chosen by B and recover the Equipment. This feature would seem to indicate that Trust has some appreciation potential in that it can find its own lessee to rent the Equipment at a higher rental rate. However, if the Equipment appreciates in value, B could simply exercise the Purchase Option, recover title to the Equipment, and either use it, or release it at the higher rental rate reflected by the Equipment's then fair market value. This factor actually indicates that the risks of a decline, or the rewards of an increase, in the then fair market rental value of the Equipment have shifted to B. This shift is inconsistent with the risks and rewards to a lessor associated with the requirement that any renewal or release of property be set at fair market value. Therefore, this factor supports treatment of the transaction as a financing arrangement.




4. The Reasonable Possibility That the Purported Owner of the Property Can Recoup its Investment in the Property Based on its Income-Generating Potential and Residual Value of the Property


Under the structure of the transaction, A actually received very little net income stream during the Base Term since, except for the first Lease payment, all Lease payments made by B equal all Loan payments made by Trust for principal and interest. Consequently, since the rental stream essentially equals the debt service, there is very little income-generating gene rating potential to A during the Base Term. Accordingly, A can only look to either the payment received upon exercise of the Purchase Option or the Return Option, or to payments under an extension of the Lease under the New Lease Option, for the recoupment of, and a return on, its investment.



In the event the Purchase Option is exercised, A would only recover its investment out of the Purchase Option payment and thus its profit is capped at the difference between the Purchase Option option price and the amount owed to Lender on Date 4. If the New Lease Option were exercised, A would see a positive cash flow during the New Lease Term. Superficially, this factor favors the treatment of the transaction as a sale-leaseback since A would receive a profit on the New Lease. However, as the above analysis indicates, the terms of the transaction have shifted the risks and rewards of ownership essentially to B from Trust and A. Only if the transaction continues through the end of the New Lease term and the Equipment then returns to Trust, would A have an uncollared risk of loss and opportunity for appreciation. This will likely never occur because it is economically more advantageous for B to exercise the Purchase Option. Therefore, although A will recoup its investment, the specified rate of return and collared risk and reward indicate that it is in the position of a mortgagee, not a bona fide owner.



Since the above factors indicate that A stands more in the position of a mortgagee than a bona fide owner, the benefits and burdens of ownership did not pass to A as a result of this transaction. Accordingly, the transaction should be treated as a financing rather than as a sale-leaseback. As such, A is not treated as the owner of the Equipment and therefore is not entitled to the depreciation deductions A claimed on the Equipment.



III. Whether A Received Oriqinal Original Issue Discount Income as a Result of this Purported Sale-Leaseback Transaction.



If (1) the Sale-Leaseback transaction lacks economic substance and (2) the purchase price option will be exercised, A may be required to accrue income on a deemed loan from A to Lender. Section 1273(a)(1) provides "[t]he term 'original issue discount' means the excess (if any) of (A) the stated redemption price at maturity, over (B) the issue price." To impute OlD income in a sale-leaseback transaction, there must be an unconditional obligation to return the principal sum. A "substantial likelihood" is not enough to characterize the Purchase Option as an unconditional obligation. Original issue discount (OID) is imputed on a constant yield basis. See section 1.1272-1(b).



Indebtedness is defined, for federal income tax purposes, as an unconditional obligation to pay a sum certain at a fixed maturity date. Gilbert v. Commissioner, 248 F.2d 399, 402 (2\nd/ Cir. 1957) [ 57-2 USTC ¶9929]. If we successfully argue that the purchase price will always be exercised, A's equity payment might be appropriately viewed as a loan with the unconditional obligation to repay a principal sum being both the net rent payment due on Date 3 and the net Purchase Option payment due on Date 4. It is represented that the net rent payment and the net Purchase Option payment constitute the return on A's equity investment. The amount by which the net rent payment and the net Purchase Option payment exceed the equity payment could be asserted to be OlD includable in A's income. If we are unable to prove that A will receive a fixed amount of cash at the end of the transaction, we will not be able to deem a loan between A and Lender.



Thus, we should also be able to argue that A's equity payment is a loan if we demonstrate that either the Purchase Option or the Return Option will be exercised. Whether the Purchase Option or the Return Option is exercised, A will be receiving an amount that exceeds its equity payment. The OlD calculation is slightly more complicated if we deem the equity payment a loan with repayment being either the amount of the Purchase Option (and net rent payment) or the Return Option (and net rent payment). As a loan with alternative payment schedules, the rules of section 1.1272-1(c) of the Income Tax Regulations would apply to determine the amount of OlD includable in A's income.



A accrues interest based on the ownership of the Treasury strips only if it can be shown that A has control over and derives readily realizable economic value from the Treasury strips. See James v. United States, 366 U.S. 213, 219 (1961) [ 61-1 USTC ¶9449]. The issue price of the strips is the amount at which the Treasury strips were issued. As owner of the Treasury Strips, A would include in income the OlD on the Treasury strips.



If the Sale-Leaseback transaction is viewed as a financing between A and Lender, we believe that A should properly include OlD income from the deemed financing. The amount of OlD income from the deemed financing would be calculated in the same manner as described above under the economic substance argument.



IV Whether A Is Liable for Penalties, Pursuant to Section 6662 as a Result of this Transaction.



Section 6662 imposes an accuracy-related penalty equal to twenty percent of the portion of the underpayment attributable to, among other things, negligence or disregard of rules or regulations, and any substantial understatement of income tax. Section 1.6662-2(c) provides that there is no stacking of the accuracy-related penalty components and, thus, the maximum accuracy-related penalty imposed on any portion of an underpayment is twenty percent. The accuracy-related penalty does not apply to any portion of an underpayment with respect to which it is shown that there was reasonable cause and that A acted in good faith. Section 6664(c)(1).




A. Negligence


Pursuant to section 6662(c) and section 1.6662-3(b)(1) of the Income Tax Regulations, negligence includes any failure to make a reasonable attempt to comply with the provisions of the Internal Revenue Code or to exercise ordinary and reasonable care in the preparation of the tax return. Negligence has been defined as the failure to do what a reasonable and ordinary prudent person would do under the circumstances. Marcello v. Commissioner, 380 F.2d 499, 506 (5th Cir. 1967) [ 67-2 USTC ¶9516]; Neely v. Commissioner, 85 T.C. 934, 947 (1985) [CCH Dec. 42,540]. Section 1.6662-3(b)(1)(ii) provides that negligence is strongly indicated where a taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction, credit, or exclusion on a return that would seem to a reasonable person to be "too good to be true" under the circumstances. Where the taxpayer is sophisticated, the court may still find liable even though highly paid professionals were involved. In Nicole Rose v. Commissioner, 117 T.C. No. 27, 2001 [CCH Dec. 54,578] TNT 251-11 ¶64, the Tax Court found the taxpayer was liable for an accuracy related penalty pursuant to section 6662 for entering into a series of transactions lacking in business purpose and economic substance and stating that "[t]he participation of highly paid professionals provides petitioner no protection, excuse, justification, or immunity from the penalties in issue. Petitioner participated in a clear and obvious scheme to reap the benefits of claimed ordinary business expense deductions that had no business purpose and no economic substance. The facts and circumstance of this case reflect no reasonable cause and no good faith for petitioner's participation in the transactions before us."



The Tax Court likewise sustained the application of the negligence penalty in Sheldon v. Commissioner, 94 T.C. 738 (1990) [CCH Dec. 46,602], stating that the taxpayer intentionally entered into loss-producing repurchase agreements to generate and claim tax benefits.




B. Substantial Understatement


Pursuant to section 6662(d)(1), a substantial understatement of income tax exists for a taxable year if the amount of the understatement exceeds the greater of ten percent of the tax required to be shown on the return or $5,000 ($10,0000 in the case of corporations other than S corporations or personal holding companies). Section 6662(d)(2)(B) provides that understatements are generally reduced by the portion of the understatement attributable to: 1) the tax treatment of items for which there was substantial authority for such treatment, and 2) any item if the relevant facts affecting the item's tax treatment were adequately disclosed in the return or a statement attached to the return, and there is a reasonable basis for the taxpayer's tax treatment of the item. These exceptions, however, do not apply to tax shelter items of corporate taxpayers. Section 6662(d)(2)(C)(ii). Thus, if a corporate taxpayer has a substantial understatement attributable to a tax shelter item, the accuracy-related penalty applies to the understatement unless the reasonable cause exception applies. Treas. Reg. §1.6664-4(e), discussed below contains special rules relating to the definition of reasonable cause in the case of a tax shelter item of a corporation. However, section 6662(d)(2)(C)(iii) which is applicable to the years at issue, defines a tax shelter, among other things, as a plan or arrangement the principal purpose of which is tax avoidance or evasion.




C. Reasonable Cause


Section 1.6664-4(b)(1) provides that the determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, generally taking into account all pertinent facts and circumstances. The most important factor is generally the extent of the taxpayer's effort to assess its proper tax liability. Reliance on professional advice may constitute reasonable cause and good faith if, under all the circumstances, such reliance was reasonable. See United States v. Boyle, 469 U.S. 241 (1985) [ 85-1 USTC ¶13,602]. The advice must also be based upon all pertinent facts and circumstances and the law relating to those facts and circumstances. For example, the advice must take into account the taxpayer's purpose and the relative weight of such purpose for entering into a transaction and for structuring a transaction in a particular manner.



With respect to reasonable cause for the substantial understatement penalty attributable to a corporation's tax shelter items, a corporation is deemed to have acted with reasonable cause and in good faith if the corporation had substantial authority, as that term is defined in section 1.6662-4(d), for its treatment of the tax shelter item, and if at the time of filing the return, the corporation reasonably believed such treatment was more likely than not the proper treatment. Treas. Reg. §1.6664-4(e)(2)(I).



The "more likely than not" standard can be met by the corporation's good faith and reasonable reliance upon the opinion of a tax advisor if the opinion is based on the advisor's analysis of the pertinent facts and authorities in the manner described in Section 1.6662-4(d)(3)(ii), and the opinion unambiguously states the advisor's conclusion that there is a greater than fifty percent likelihood the tax treatment of the item will withstand a challenge by the Service. Section 1.6664-4(e)(2)(I)(B)(2). A cannot hide behind an appraisal for a transaction lacking in economic substance and claim that it had reasonable cause for entering into the transaction. Nicole Rose.



The circular cash flows and the lack of a valid business purpose evidence that A's involvement in the sale-leaseback transaction was solely due or primarily motivated by the tax benefits, and thus is totally devoid of economic substance. Moreover, if the transaction lacked economic substance and/or A did not truly acquire the benefits and burdens of ownership of the Equipment, then A cannot, in good faith, claim depreciation and interest deductions flowing from the transaction. Therefore, based on the facts presented, assertion of the section 6662 accuracy-related penalty is appropriate in this case.



CASE DEVELOPMENTS, HAZARDS AND OTHER CONSIDERATIONS



In our view, there are several aspects of this case which must be further developed.



First, to support the view that B is compelled to exercise its Purchase Option to acquire the Equipment upon termination of the Basic Lease term, the Field must develop firm evidence that B has effected either a legal or economic defeasance of its obligations. Although it is possible to hypothesize that B purchased stripped bonds in order to meet any of the three options provided for at the end of the Lease, the term, "defeasance" is used as if it were a fact. In a true defeasance situation the lessee is either required by the documents (or informal agreement by the parties) to deposit into an escrow account an amount (in absolute terms or net present value terms) (economic defeasance), or it gives legal notice at the initiation of the lease (or shortly thereafter) of its intent to exercise its Purchase Option at the end of the lease term and reacquire the property (legal defeasance). We did not find either in the facts provided. Accordingly, to make this argument, the Field needs to develop facts that demonstrate a true defeasance.



In light of the hazards with the New Lease Option, we recommend that you develop additional facts to show that the New Lease Option is truly illusory. Such facts would include those that demonstrate that the Equipment is "limited use" property. See Rev. Proc. 2001-28, 19 I.R.B. 1156 (May 7, 2001). That is, if the facts developed show that the Equipment has little value to operators other than those in Country C, the ownership rights claimed by Trust become easier to challenge because its ability to release the Equipment to any lessee or operator other than B or to operate the Equipment itself would be severely limited. Development of such facts may require outside engineers and other experts. If such facts demonstrate that no one but B may have any commercially reasonable use for the Equipment, then exercise of the New Lease Option would be impracticable.



In addition, the Field should verify, that if Country C privatizes the B's business and restricts B's ability to own or acquire the Equipment, the only viable option for B may be the New Lease Option. Also, helpful facts include those that would demonstrate that it is highly unlikely that Country C will decide to acquire even more modern Equipment at the end of the Base Term.



Examination of any presentations to the Trust concerning this transaction may provide insight into whether its participation is primarily tax motivated. It is also recommended that the Field investigate any prearrangement aspects of the transaction. Persuasive evidence of prearrangement includes any additional evidence that the parties understood that B would exercise the Purchase Option.



Moreover, we note that this transaction is dissimilar to the lease-in, lease-out transaction described in Rev. Rul. 99-14, 1999-1 C.B. 835. In that revenue ruling, the taxpayer retained the power to require the lessee to continue with the lease of the property for an additional period of time by virtue of a put renewal option in the agreements. In this case, however, the facts as presently developed indicate that B, not A, has the sole power to determine which option will be exercised at the end of the Base Term. Thus, this feature of the transaction makes it important to develop facts which will demonstrate that the New Lease is not a viable option for B and, therefore, the transaction has little probability of continuing beyond the Base Term. Consequently, such facts will indicate if the return of the Equipment to B at that time is a foregone conclusion.



We recommend that you carefully scrutinize the pretax return and determine if it is insubstantial when compared to the post-tax returns. This analysis should be made using both constant dollars and relevant present value assumptions. The Field should compare its facts to those in other economic substance cases or in Rev. Rul. 99-14, in which the taxpayer's profit pretax in constant dollars was insignificant compared to the amount invested. In furtherance of this strategy, case development should include the employment of independent appraisers, economists and financial consultants, whose analyses could affect the results of these calculations.



With respect to the OlD issue, a "substantial likelihood" is not enough to characterize the net Purchase Option as an unconditional obligation, and thus is a high hazard in this case.



If, upon further development, the facts do not indicate that the transactions lack economic substance or constitute a financing arrangement, we recommend you contact CC:ITA to develop whether A's depreciation deductions are based on a lease term that includes the period of the New Lease. In that case, the tax-exempt use property rules could apply to limit the availability of the deductions. I.R.C. Section 168(g)(3)(A) and Treas. Reg. Section 1.168(i) -2. We encourage you to raise this argument as early as possible in order to preserve it in case the transaction is determined to neither lack economic substance nor constitute a financing. 7



This writing may contain privileged information. Any unauthorized disclosure of this writing may have an adverse effect on privileges, such as the attorney client privilege. If disclosure becomes necessary, please contact this office for our views.



Please call if you have any further questions.



William P. O'Shea, Acting Associate Chief Counsel, Passthroughs and Special Industries, Carolyn H. Gray, Senior Legal Counsel, Branch 2, Office of the Associate Chief Counsel, Passthroughs and Special Industries.


1 A entered into a trust agreement with Trust on Date I authorizing Trust to execute all documents and rights and perform all of A's duties with respect to this transaction.

2 These agreements will be collectively referred to as the "Documents."

3 The Loan Estate consists of the following:

Trust's rights and interests in the Equipment, the documents involved in the sale-leaseback transaction, all amounts of rent due under the Lease, any moneys arising out of the documents that are required to be deposited on Trust's account and any other property or rights of Trust arising out of the documents involved in the sale-leaseback transaction.

4 The Lump Sum Payment is equal to the Appraisal's projected Fair Market Value of the Equipment over F percent of the Equipment Cost, where the Equipment Cost equals Equipment Cost. The Appraisal projects that the Fair Market Value of the Equipment on Date 4 will be I percent of Equipment Cost. I percent of the Equipment Cost equals $6. The Lump Sum Payment is equal to H percent of Equipment Cost which equals $5.

5 F percent of the Equipment Cost is $7.

6 Crane v. Commissioner, 331 U.S. 1, 7 (1947) [ 47-1 USTC ¶9217].

7 The enactment of the extended lease period in section 168 was not designed to supplant the traditional arguments challenging sale-leaseback transactions. The Conference Committee Report of the Deficit Reduction Act of 1984 provides "the primary objective of the conferees is that there be no relaxation of administrative rules and practices that would result in lease treatment for financing transactions in which the purported lessor does not have a significant ownership interest in the property." H.R. Rep. No. 98-861, 98th Congress, 2nd Sess. at 772.


Assuming the 6694 penalty is an issue in the following Rosenblatt case decided yesterday, the conclusion is reached that a tax motivated transaction will not automatically result in a taxpayer negligence penalty under 6662. However, the 6694 penalty would still be applied under the position taken without technical support. My view is that if 6694 would have been an issue in the following case, the 6694 penalty would be applied. There are two standards: 1) return preparer negligence or lack of technical support and 2) client negligence. Sometimes the two issues are interrelated. The Rosenblatt case is a client negligence case. However, the case suggsest that if the 6694 penalty were an issue in the case, the fact that the client was tax motivated would not necessarily impact on the 6694 analysis. I would still expect that tax return preparers have a duty to penetrate these transactions. The standards of the proposed regulations are quite simple: the return preparer can either provide support for the position (whether or not disclosed) or not have analysis and technical support. I do not think there would be technical support under the facts of Rosenblatt.

Ronald and Susan Rosenblatt v. Commissioner.Docket No. 17002-06S .

Filed October 30, 2008.





Respondent determined deficiencies in petitioners' Federal income taxes of $33,583 and $20,684 and section 6662 accuracy-related penalties of $6,716.60 and $4,136.80 for the taxable years 2002 and 2003, respectively. The issues for decision are: 2 (1) Whether petitioners' aircraft activity during 2002 and 2003 was engaged in for profit within the meaning of section 183; (2) whether petitioners are entitled to deductions for worthless stock and bad debts incurred in 2002; and (3) whether petitioners are liable for section 6662 accuracy-related penalties for 2002 and 2003. 3





Background



Some facts have been stipulated and are so found. The stipulation of facts and the attached exhibits are incorporated by this reference. At the time of filing the petition, petitioners resided in Iowa.



Ronald Rosenblatt (petitioner) is a graduate of Columbia University with a bachelor's degree in art history, a minor in economics, and a master's of art. Petitioner also holds a Ph.D. in economics from the University of Idaho. Petitioner worked as a professor and taught economics for 7 years after he received his Ph.D.



In 2002, petitioner was employed by Principal Residential Mortgage, Inc. (PRM), a subsidiary of Principal Financial Group. Petitioner directly managed six or seven people. Indirectly, he managed approximately 500 people. Petitioner worked approximately 50 hours per week in 2002, and he spent most of his work week in the offices of PRM in downtown Des Moines. Most of petitioner's income in 2002 came from his position at PRM.



Between 2002 and 2003, PRM sold the division that petitioner managed to American Home Mortgage (AHM). In 2003, petitioner was employed by AHM as an executive vice president of sales support and development. Petitioner's work hours and responsibilities did not change very much between 2002 and 2003. Petitioner Susan Rosenblatt (Mrs. Rosenblatt) is an anchor reporter for the local FOX news network in Des Moines, Iowa. Petitioners reported wages on their Federal income tax returns in excess of $593,000 for 2002 and $742,000 for 2003.



Petitioner always had an interest in flying. Petitioner had been interested in being a pilot since his youth. In 1965, when petitioner graduated from high school, he had an appointment to the Air Force Academy, and he intended to become an Air Force pilot. However, petitioner did not attend the Air Force Academy because his eyesight did not meet the requirements for him to train as a pilot.



Petitioners' daughter Katie received flight instruction from Executive One Aviation (EOA), beginning in 2001. In the fall of 2001, petitioner also began taking flight training lessons from EOA. On June 6, 2002, petitioner formed KAR RRR Aviation Leasing, LLC (KAR RRR). Mrs. Rosenblatt purchased a one-half interest in KAR RRR on September 30, 2002. Before Mrs. Rosenblatt became a member of KAR RRR, petitioner was the sole member, and they were the only two members thereafter. 4 Aside from petitioners, KAR RRR had no employees.



In June 2002, KAR RRR purchased a Cessna 172 R (N3529D) aircraft (Cessna) from EOA. Petitioner has never been a licensed pilot. Before the Cessna was purchased, petitioner had no experience in the aviation industry other than being a "frequent flyer". Petitioner described his decision to purchase the Cessna "as a way of having a good new plane upon which to learn, and as a way of starting a new business with the plane."



KAR RRR financed the Cessna with Cessna Finance Corp. (CFC). Petitioners paid 10 percent of the purchase price for the Cessna as a down payment, and KAR RRR financed $144,350, the balance of the purchase price for the Cessna, through CFC. Petitioner personally guaranteed the loan from CFC to KAR RRR. The Cessna was hangared at Ankeny Regional Airport in Ankeny, Iowa.



On May 6, 2002, before petitioner purchased the Cessna, EOA provided a written projection of net income to petitioners related to a purchase and leaseback of a Cessna. EOA projected that if the Cessna was rented out for 700 hours per year at $95 per Hobbs hour, 5 it could potentially generate $66,500 in gross receipts. 6 After subtracting expenses for insurance, hangar, fuel, maintenance, engine reserve, and management fees totaling $44,725, EOA projected a net income of $21,775 on a leaseback by EOA of the Cessna. Petitioner did not produce any other formal business plan for KAR RRR. 7



EOA's projection did not include finance expenses, commissions, legal and professional services expenses, or depreciation. Reported expenses for petitioners' 2002 and 2003 aircraft activity were as follows:



2002 Expenses





Deductions Schedule C Schedule E Total

Repairs and maintenance $1,210 $2,146 $3,356

Interest 1,777 1,777 3,554

Depreciation (and
sec. 179) 73,447 5,924 79,371

Commissions (and fees) 1,595 1,160 2,755

Fuel 3,513 2,385 5,898

Hangar 375 375 750

Insurance 2,495 2,709 5,204

Miscellaneous -- 39 39

Legal and professional
services 3,100 -- 3,100

Management fees 2,087 -- 2,087

Total 89,599 16,515 106,114





2003 Expenses





Deductions Schedule E

Repairs and maintenance $8,739

Interest 5,942

Depreciation (and
sec. 179) 35,882

Commissions (and fees) 4,282

Fuel 6,203

Hangar 1,500

Insurance 10,762

Miscellaneous 906

Legal and professional
services 1,500

Instruction 591

Total 76,307





On June 14, 2002, KAR RRR, CFC, and EOA entered into a "Consent to Lease Agreement" (lease agreement), related to the Cessna. CFC required the lease agreement as a condition precedent to obtaining financing on the Cessna because the Cessna would be rented out to the general public. Under the lease agreement, KAR RRR was designated the "Lessor" and EOA was designated the "Lessee". The lease agreement stated in pertinent part: "Neither Lessor [KAR RRR] nor Lessee [EOA] shall further lease the * * * [Cessna] or assign the Lease without first obtaining the prior written consent of CFC, which consent may be withheld at the sole discretion of CFC."



KAR RRR and EOA also entered into an "Aircraft Marketing Agreement" (marketing agreement), drafted by Advocate Consulting, which stated as follows:



AIRCRAFT MARKETING AGREEMENT



This agreement, made on this 14th day of June, 2002 by and between KAR RRR Aviation Leasing, LLC., hereinafter referred to as the Owner, and * * * [EOA], hereinafter referred to as the Agent.



WITNESSETH



WHEREAS, Owner is the owner of one (1) Cessna 172R, Registration Number N3529D;



WHEREAS, Agent in the ordinary course of business develops relationships with prospective customers for owner seeking to rent aircraft;



WHEREAS, Agent is willing to serve as marketing and compliance agent on a non-exclusive basis upon the terms and conditions herein set forth.



NOW, THEREFORE, in consideration of the mutual covenants and agreements herein contained, the parties hereto do hereby agree as follows;



1) Aircraft: Owner hereby authorizes Agent to serve as a nonexclusive marketer for the aircraft outlined on Exhibit A.



2) Terms of Agreement: The term of this agreement shall be for a period of seven (7) days commencing on the date hereof, and automatically renew each seven (7) days thereafter. This agreement shall be subject to termination by either the Owner or Agent for any reason whatsoever upon five (5) days advance written notice given to the other party.



3) The aircraft will be based at the Ankeny Airport, and the owner will assume all responsibility for storage fees in the amount of $125.- per month for heated, community hangar space.



4) Owner has had the aircraft inspected by * * * [EOA], verifying that the aircraft meets the standards required by the Federal Aviation Regulations and that a valid Airworthiness Certificate exists in respect thereto, and that all other requirements and paperwork are in good order and effect.



5) The fees payable by Owner to Agent for the rental of said aircraft shall be calculated at the rate of 15% of the gross Hobbs rental charge. At the start of this agreement, said hourly rate shall be $90.00, and may be adjusted with approval of both parties. The rent shall be paid within ten days after the end of each calendar month, based upon the hours rented during each prior month. Agent agrees to waive charges for the use of the aircraft by Owner. Owner agrees to follow scheduling procedures established by Agent for the reservations of aircraft and to return aircraft with full fuel to the Agent.



6) Owner shall maintain the aircraft to satisfactorily retain its airworthiness certificate thereby meeting the requirements of the Federal Aviation Administration.



7) Owner shall furnish at their own expense all fuel, oil, lubricants and other materials necessary for the operation of said aircraft. Fuel shall be priced by Agent to Owner at the leaseback rate of twenty (20) cents below the then current retail rate. In addition all shop labor shall be priced at $5 per hour below current list and parts shall be charged at 15% above cost, plus freight or other added charges. All required & routine maintenance may be performed by the * * * [EOA] maintenance facility without prior notice to Owner.



8) Renters shall be required at a minimum to have 12 hours total time plus a sign-off from an FAA Approved Current Flight Instructor in order to solo this aircraft. Other than for maintenance down time, this aircraft shall be available for scheduled rent at all times.



9) Owner shall provide and keep insurance in full force and effect, at their own expense. Such insurance shall be written by an underwriter satisfactory to all parties and naming the Owner, Agent and Current Lienholder as insured, and shall protect the interests of the Owner, Agent and Current Lienholder. If the risk is covered by the insurance policy of the Agent, the Owner shall prepay Agent the amount of such insurance at the first of each calendar month and Agent shall provide Owner evidence of such Insurance coverage in force and satisfactory to the Owner and Current Lien holder. Agent shall be responsible for deductible if the aircraft is damaged while hangared at * * * [EOA], if such damage is caused by an * * * [EOA] employee or by a customer renting the aircraft through * * * [EOA].



10) The term of this agreement shall be 5 years, commencing on the below mentioned execution date. Owner may terminate this agreement for any reason upon thirty (30) days written notice to Agent.



Petitioner provided documents (logs) indicating his involvement with KAR RRR during 2002 and 2003. These logs show that petitioner spent approximately 197.05 8 and 208.25 hours on KAR RRR activities in 2002 and 2003, respectively. 9 Petitioner prepared these logs himself, though he admits they are incomplete. Much of the time reflected in petitioner's logs represents time during which he participated in flight instruction, ground school, and test flights.



Petitioners relied on the services of EOA for taking reservations for the Cessna, providing storage for the Cessna, and providing licensed flight instructors to fly the Cessna. The customers who rented the Cessna did not enter into written lease agreements, but they did sign a document ensuring that the people who flew the Cessna were licensed pilots. These agreements were maintained by EOA. The people who flew the Cessna included both flight instruction students and private pilots. KAR RRR's Cessna was one of three or four aircraft available to rent at the Ankeny Regional Airport in 2002 and 2003.



Benefit Technologies, Inc. (BTI), is a research and development business specializing in full flexible benefit plans for small to midsize companies. Andrew Hyman (Mr. Hyman) was the founder of BTI and is still actively involved with BTI. BTI filed for chapter 7 bankruptcy protection in February 2001, shortly after BTI defaulted on a $250,000 interest payment to a venture capital firm on January 15, 2001. Sometime after filing for bankruptcy, BTI's bankruptcy proceedings were converted from chapter 7 to chapter 11.



Petitioner owned BTI stock, lent money to BTI, and served on BTI's board of directors, but petitioner was not an employee of BTI. Petitioner was never actively involved in BTI, other than having attended occasional board meetings. Petitioners claimed losses of $432,346 in 2002 relating to the alleged worthlessness of their BTI stock and loans that petitioner made to BTI.





Discussion



Generally, the Commissioner's determinations in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving that the determinations are incorrect. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).




I. Claimed Losses From Aircraft Activity


Pursuant to section 183(b), deductions with respect to an activity "not engaged in for profit" generally are limited to the amount of gross income derived from such activity. Section 183(c) defines an activity not engaged in for profit as "any activity other than one with respect to which deductions are allowable for the taxable year under section 162 or under paragraph (1) or (2) of section 212."



Deductions are allowed under section 162 for the ordinary and necessary expenses of carrying on an activity which constitutes the taxpayer's trade or business. Deductions are allowed under section 212 for expenses paid or incurred in connection with an activity engaged in for the production or collection of income, or for the management, conservation, or maintenance of property held for the production of income. With respect to either section, however, the taxpayer must demonstrate a profit objective for the activities in order to deduct associated expenses. Dreicer v. Commissioner, 78 T.C. 642, 644-645 (1982), affd. without published opinion 702 F.2d 1205 (D.C. Cir. 1983); Warden v. Commissioner, T.C. Memo. 1995-176, affd. without published opinion 111 F.3d 139 (9th Cir. 1997); sec. 1.183-2(a), Income Tax Regs. In order to meet the required profit objective, "the taxpayer's primary purpose for engaging in the activity must be for income or profit." Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987); Bot v. Commissioner, 353 F.3d 595, 599 (8th Cir. 2003), affg. 118 T.C. 138 (2002); Am. Acad. of Family Physicians v. United States, 91 F.3d 1155, 1157-1158 (8th Cir. 1996).



Section 1.183-2(b), Income Tax Regs., provides factors to be considered when determining whether an activity is engaged in for profit as follows:



(b). Relevant factors. --In determining whether an activity is engaged in for profit, all facts and circumstances with respect to the activity are to be taken into account. No one factor is determinative in making this determination. In addition, it is not intended that only the factors described in this paragraph are to be taken into account in making the determination, or that a determination is to be made on the basis that the number of factors (whether or not listed in this paragraph) indicating a lack of profit objective exceeds the number of factors indicating a profit objective, or vice versa. * * *



Nine nonexclusive factors are set forth in the regulations which are to be considered when determining profit intent. Those factors are: (1) The manner in which the taxpayer carried on the activity; (2) the expertise of the taxpayer or his advisers; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value; (5) the success of the taxpayer in carrying on other similar or dissimilar activities; (6) the taxpayer's history of income or losses with respect to the activity; (7) the amount of occasional profits, if any, which are earned; (8) the financial status of the taxpayer; and (9) whether elements of personal pleasure or recreation exist. Id. Not all of the factors are applicable in every case, and no one factor is controlling. See Abramson v. Commissioner, 86 T.C. 360, 371 (1986); sec. 1.183-2(b), Income Tax Regs. We begin by applying each of these factors to the facts relating to petitioners' aircraft activity.



The fact that a taxpayer carries on an activity in a businesslike manner and maintains complete and accurate books and records may indicate that the activity was engaged in for profit. See Engdahl v. Commissioner, 72 T.C. 659, 666 (1979); sec. 1.183-2(b)(1), Income Tax Regs. During the years at issue, petitioner kept logs noting his involvement with KAR RRR, but he admitted that those logs were incomplete. The logs were not made contemporaneously with the activities petitioner noted therein. Much of the time memorialized in the logs is attributable to travel time and time that petitioner spent on his own flight training activities and classes.



Petitioner failed to develop a formal business plan. Although petitioner testified that he used a "pro forma", it was not produced at trial. EOA's financial projections overestimated the profitability of renting the Cessna, and the projected expenses did not include finance expenses, sales tax, or registration fees and did not take into account actual depreciation of the Cessna.



Petitioner testified that he was active in advertising the Cessna throughout the community, but he failed to adequately corroborate that testimony with evidence of such marketing activities. Petitioner also did bookkeeping for KAR RRR, including the establishment and maintenance of the company bank account. However, petitioners relied on the services of EOA for the day-to-day rental of the Cessna, including taking reservations for the Cessna, providing storage for the Cessna, and providing licensed flight instructors to fly the Cessna. Moreover, the maintenance, rental of the aircraft, and collection of rental receipts were performed by either EOA or the flight instructors associated with the rental flights. Petitioner explained at trial that student pilots and renters would pay EOA directly for the use of the Cessna at the end of the rental period. EOA would then credit the account of KAR RRR for the fee generated. At the end of the month, EOA would deduct their commission and other expenses, such as fuel and maintenance. Petitioner was not qualified to perform the maintenance on the Cessna necessary to keep it airworthy. Petitioner reviewed some of these activities but did not perform them himself and otherwise had limited involvement in the day-to-day activities involving the Cessna. Consequently, consideration of the first factor weighs against the finding of a profit objective.



A taxpayer's expertise or that of his advisers is a factor in determining profitability. Sec. 1.183-2(b)(2), Income Tax Regs. Before his purchase of the Cessna, petitioner had no relevant experience in the aircraft industry. Petitioner spent time "going on the FAA's website" to understand what rules and regulations governed private aviation. He also researched Cessna's advisories about his type of aircraft to determine "whether there were recalls or anything like that."



Petitioner sought advice in selecting the appropriate aircraft for the activity, relying in part on the knowledge of local flight instructors. Otherwise, petitioner relied on EOA, the seller of the Cessna, and Advocate Consulting. Before the purchase of the Cessna, petitioner was informed by EOA's president that the Cessna could be rapidly depreciated for tax purposes. At the same time, employees of EOA informed petitioner that Advocate Consulting could structure the purchase of the Cessna in a tax-advantageous manner. Petitioner's independent research on Advocate Consulting entailed going online and trying "to get a little background on the * * * company." Petitioner did not know anyone else who was referred to Advocate Consulting. Petitioner testified that Advocate Consulting agreed to represent petitioners before the IRS as part of their agreement with KAR RRR.



Petitioners retained the services of Advocate Consulting on a yearly basis. Petitioners sought the advice of Advocate Consulting because aircraft leasing "was a field that * * * [petitioner] really didn't know in terms of legal or tax issues." When asked at trial if he ever thought that the tax advice he received was too good to be true, petitioner responded that if he's "paying for their advice and their counsel tells me that this is the way it is, then * * * I believe them."



As we have already noted, EOA provided a written projection of net income that did not include finance expenses, commissions, legal and professional services expenses, or tax depreciation expenses related to the Cessna. Given petitioner's educational background in economics and his discussions with employees of EOA and Advocate Consulting about structuring the purchase of the Cessna in a tax-advantageous manner, it is reasonable to assume that petitioner recognized the significant distortions these omissions would create between the projected profits and the profits or losses from the aircraft activity that petitioners would report on their tax returns. In preparing for an activity, a taxpayer need not make a formal market study, but might be expected to undertake a basic investigation of the factors that would affect profit. Westbrook v. Commissioner, T.C. Memo. 1993-634, affd. 68 F.3d 868 (5th Cir. 1995). Yet petitioner failed to seek an objective opinion about the profit potential of such an undertaking and relied heavily on parties with their own subjective interest in the transaction. Under the circumstances, petitioner's independent research of profitability of the aircraft activity was insufficient. Consequently, the second factor weighs against a finding of a profit objective.



The fact that a taxpayer devotes much of his personal time and effort to carrying on an activity, particularly if there are no substantial personal or recreational elements, may indicate a profit motive. Sec. 1.183-2(b)(3), Income Tax Regs. Much of the time that petitioner spent on the aircraft activity involved his own flying lessons. Petitioner and his daughter had decided to learn how to fly, and petitioner purchased the Cessna as a way to do that. Petitioner had long wanted to learn to fly airplanes, having attempted to join the Air Force when he was younger. Petitioner created logs documenting his activities related to the Cessna. The logs, though incomplete, indicate that petitioner spent approximately 197.05 and 208.25 hours on KAR RRR activities in 2002 and 2003, respectively. Much of that time represents petitioner's own flying instruction. While the logs petitioner kept indicate some activity that could be construed as business related, it could also be construed as a genuine interest in a recreational activity. Regardless, the relatively small amount of time spent on this activity that was substantiated in the record does not outweigh the evidence indicating that petitioner had a significant interest in the recreational elements of the activity. Consequently, the third factor does not support a finding of a profit objective.



An expectation that the assets used in the activity will appreciate in value might indicate a profit objective. Sec. 1.183-2(b)(4), Income Tax Regs. It is unlikely that petitioner expected the Cessna, the only asset owned by KAR RRR, to appreciate in value. Additionally, absent extenuating circumstances, none of which were established in this case, the regular wear and tear on a Cessna would likely cause economic depreciation. Accordingly, the fourth factor weighs against finding a profit objective.



The fact that the taxpayer has engaged in similar activities in the past and converted them from unprofitable to profitable enterprises may indicate that he is engaged in the present activity for profit, even though the activity is presently unprofitable. Sec. 1.183-2(b)(5), Income Tax Regs. Petitioner had no previous experience in the aircraft industry, and provided no evidence that he had engaged in any similar activities for profit. Consequently, the fifth factor is neutral.



A series of losses during the initial or startup stage of an activity may not necessarily be an indication that the activity is not engaged in for profit. Sec. 1.183-2(b)(6), Income Tax Regs. However, where losses continue to be sustained beyond the period that customarily is necessary to bring the operation to profitable status, such continued losses, if not explainable as due to customary business risks or reverses, may be indicative that the activity is not being engaged in for profit. Id. Ultimately, a taxpayer must demonstrate an ability to make a profit in the long term to offset any startup losses. See Bessenyey v. Commissioner, 45 T.C. 261 (1965), affd. 379 F.2d 252 (2d Cir. 1967).



There was no prior history of either profits or losses from petitioner's aircraft activity because the years at issue were the first 2 years in which petitioner's aircraft activity existed. In neither 2002 nor 2003 did the aircraft activity generate a profit. 10 Petitioner testified and submitted evidence indicating that in the years following the years at issue, several flight instructors who had used petitioner's Cessna to give lessons decided to start their own flight instruction business using petitioner's Cessna at Des Moines International Airport. Petitioner explained that he became very involved in the marketing and organization of this new business and had plans to merge his aircraft activity with the flight instructors' business. However, petitioner failed to submit evidence regarding the profitability of the aircraft activity in the years after 2003. Without any proof of profitability in later years, the sixth factor is neutral.



The amount of occasional profits earned in relation to the amount of losses incurred may provide useful criteria in determining the taxpayer's intent. Sec. 1.183-2(b)(7), Income Tax Regs. As we have established, there is no history of the aircraft activity's being profitable. Consequently, the seventh factor is neutral.



Substantial income from sources other than the activity may indicate that the activity is not engaged in for profit, especially if there are personal or recreational elements involved. Sec. 1.183-2(b)(8), Income Tax Regs. Petitioner worked approximately 50 hours per week in 2002, and he spent most of his work week in the offices of PRM in downtown Des Moines. Most of petitioner's income came from his position at PRM. Petitioner's hours and responsibilities did not change very much between 2002 and 2003. Petitioners reported salaries in excess of $593,000 in 2002 and $742,000 in 2003. The losses created by the aircraft activity, if found to be deductible, would offset some of petitioners' substantial salaries and generate a significant tax savings in the years at issue. Consequently, the eighth factor weighs against a profit objective.



Finally, the presence of personal motives in carrying on an activity may indicate that the activity is not engaged in for profit, especially where there are recreational or personal elements involved. Sec. 1.183-2(b)(9), Income Tax Regs. Petitioners' daughter Katie received flight instruction from EOA beginning in 2001. In the fall of 2001, petitioner also began taking flight training lessons from EOA. Before taking flying lessons, petitioner always had an interest in flying. Being a pilot had been a long-term interest of petitioner since his youth. Petitioner acknowledges the purchase of the Cessna as "a way of having a good new plane upon which to learn". Consequently, the ninth factor weighs against a finding of a profit objective.



When considering whether a taxpayer engaged in an activity for profit, greater weight must be given to the objective facts than to a taxpayer's mere statement of intent. Beck v. Commissioner, 85 T.C. 557, 570 (1985). While some of petitioner's efforts could support an argument in favor of a profit objective, they could also be construed as a genuine interest in and an effort to contribute to an activity that provided personal pleasure in the form of a hobby. Regardless, petitioner's testimony and the evidence on record in favor of petitioners' argument are insufficient to overcome the weight of the objective facts indicating that petitioners were not engaging in the activity primarily for profit. 11 Accordingly, we will sustain respondent's determination with regard to the disallowance of losses created by the aircraft activity.




II. Claimed Loss from Worthless Stock and Loans


On their 2002 Federal income tax return, petitioners claimed losses of $432,346 relating to the alleged worthlessness of their BTI stock and loans petitioner made to BTI. On petitioners' 2002 Schedule D, Capital Gains and Losses, they reported a short-term capital loss of $332,346 related to BTI, which contributed to a total net short-term loss of $412,033 reported for that year. Petitioners also reported a $100,000 long-term capital loss related to BTI on their Schedule D for 2002, which contributed to a total net long-term capital loss of $26,245. Petitioners were limited by section 1211(b)(1) to a recognized capital loss of $3,000 on their 2002 Federal income tax return. Petitioners carried forward a short-term capital loss of $409,033 and a long-term capital loss of $26,245 to 2003.



Respondent disallowed petitioners' claimed capital losses relating to BTI. However, respondent concedes that after application of the section 1211(b)(1) capital loss limitation in 2002, petitioners' Federal income tax return for 2002 reflected the appropriate amount of capital losses (i.e., capital loss of $3,000). Accordingly, the disallowance of the reported loss with respect to BTI affects only petitioners' taxable income for 2003.



Petitioners argue that the BTI stock became worthless and that their loans to BTI became nonbusiness bad debt when BTI "ran out of opportunities to sell the company" in 2002. Respondent argues that neither the stock nor the loans became worthless in 2002.



In order for a taxpayer to claim a loss for worthless securities in a taxable year, the security must become worthless in that taxable year. Sec. 165(g)(1). A loss shall be treated as sustained during the taxable year in which the loss occurs as evidenced by closed and completed transactions and as fixed by identifiable events occurring in such taxable year. Sec. 1.165-1(d)(1), Income Tax Regs. Total worthlessness of the security is required for the deduction. Sec. 1.165-4, Income Tax Regs. No loss deduction is allowed for partial worthlessness or for mere decline in value. Sec. 1.165-5, Income Tax Regs. Stock becomes worthless and the loss is sustained only when the stock has no liquidating value and there is no reasonable hope and expectation that at some future point in time it will become valuable. Duncan v. Commissioner, T.C. Memo. 1986-122. The burden is on the taxpayer to establish the worthlessness of the stock and the year in which it became worthless. Id. (citing Boehm v. Commissioner, 326 U.S. 287, 292 (1945)). The loss can be established satisfactorily only by some "identifiable event" in the corporation's life which extinguishes all hope and expectation of revitalization, such as bankruptcy, cessation of business operations, liquidation of the corporation, or appointment of a receiver for it. Morton v. Commissioner, 38 B.T.A. 1270, 1279 (1938), affd. 112 F.2d 320 (7th Cir. 1940).



In the case of a taxpayer other than a corporation, where any nonbusiness debt becomes worthless within the taxable year, the loss resulting therefrom shall be considered a loss from the sale or exchange, during the taxable year, of a capital asset held for not more than 1 year. Sec. 166(d)(1)(B). A loss on a nonbusiness debt is treated as sustained only if and when the debt has become totally worthless. Sec. 1.166-5(a)(2), Income Tax Regs. The burden is on the taxpayer to establish the worthlessness of the debt and the year in which it became worthless. Crown v. Commissioner, 77 T.C. 582, 598 (1981). It is generally accepted that the year of worthlessness is to be fixed by identifiable events which form the basis of reasonable grounds for abandoning hope of recovery. Id.



Whether petitioner's loans made to BTI should be evaluated for fitting the definition of worthless securities or nonbusiness bad debt depends on whether the debt is evidenced by a security as defined in section 165(g)(2)(C). 12 Sec. 166(e). However, each of these alternatives requires petitioners to show that, at the end of 2002, there was no reasonable prospect for recovery. See Boulafendis v. Commissioner, T.C. Memo. 1984-321 (citing Boehm v. Commissioner, supra at 291-292; Crown v. Commissioner, supra at 598). Accordingly, we begin our analysis by addressing this issue.



Mr. Hyman testified that BTI owned furniture, fixtures, and a patent on the use of linear programming at the time it filed for bankruptcy in 2001. He testified that BTI had substantial value at that time. Almost immediately after the bankruptcy filing, the venture capital firm on whose interest payment BTI defaulted and another company submitted separate bids to purchase the assets of BTI for $2 million. Mr. Hyman testified that if a sale had occurred in 2001, BTI shareholders would have benefited. However, Mr. Hyman believed that BTI could be sold for, and the assets were worth, significantly more than $2 million. According to Mr. Hyman, that is the reason that BTI's bankruptcy trustee turned down both of the $2 million offers.



Mr. Hyman testified that it was reasonable for petitioner to believe that he could get something for his investment in BTI at the end of 2001, even after it filed for bankruptcy. At that time, Mr. Hyman was hopeful that a sale was going to occur. Mr. Hyman testified that, when no sale occurred, the company was "put into cold storage" with the goal of trying to raise money. BTI's bankruptcy proceeding was later converted from chapter 7 to chapter 11. BTI is presently operating as a business in chapter II, and Mr. Hyman testified that "there's activity now starting to try to raise capital within the chapter 11 environment to be able to, to bring the company potentially out of chapter 11 and operate * * * the company."



The evidence presented at trial, combined with Mr. Hyman's testimony, indicates that BTI had value at all times in 2002 and still has value. Petitioners have failed to carry their burden of proof to show that there was no reasonable prospect of recovery for their stock and loans in 2002. Accordingly, we hold that petitioners are not entitled to deductions for worthless securities or nonbusiness bad debt.




III. Accuracy-Related Penalty


With respect to the accuracy-related penalty under section 6662(a), the Commissioner has the burden of production. Sec. 7491(c). To prevail, the Commissioner must produce sufficient evidence that it is appropriate to apply the penalty to the taxpayer. Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Once the Commissioner meets his burden of production, the taxpayer bears the burden of supplying sufficient evidence to persuade the Court that the Commissioner's determination is incorrect. Id. at 447.



Section 6662(a) and (b)(1) provides accuracy-related penalties equal to 20 percent of the underpayment of tax required to be shown on a return if the underpayment is due to negligence or disregard of rules or regulations. 13 For purposes of section 6662, the term "negligence" includes "any failure to make a reasonable attempt to comply with the provisions of * * * [the Code], and the term 'disregard' includes any careless, reckless, or intentional disregard." Sec. 6662(c). "Negligence" also includes any failure by a taxpayer to keep adequate books and records or to substantiate items properly. Sec. 1.6662-3(b)(1), Income Tax Regs.



An accuracy-related penalty is not imposed with respect to any portion of the underpayment as to which the taxpayer acted with reasonable cause and in good faith. Sec. 6664(c)(1); see Higbee v. Commissioner, supra at 448. This determination is made based on all the relevant facts and circumstances. Higbee v. Commissioner, supra at 448; sec. 1.6664-4(b)(1), Income Tax Regs. Relevant factors include the taxpayer's efforts to assess his proper tax liability.



While we have held that petitioners did not have profit as their primary objective for entering into the aircraft activity, we believe that they had both personal and profit objectives in the sense that they actually hoped that their activity might produce a profit. See Warden v. Commissioner, T.C. Memo. 1995-176. Sometimes it is difficult to determine which of two motives for engaging in an activity is primary. That is one of the basic reasons for using objective facts to determine subjective intent. But a finding that profit was not the primary motive does not automatically result in a conclusion that petitioners were negligent or intentionally disregarded the rules and regulations. See Bernardo v. Commissioner, T.C. Memo. 2004-199; Sherman v. Commissioner, T.C. Memo. 1989-269. On the basis of the previously stated facts, we find that petitioners' reporting of their aircraft activity was not due to negligence and that they are not liable for the penalties with respect to the portions of the underpayments due to their aircraft activity. Likewise, we find that petitioners are not liable for the penalty on the portion of the 2003 underpayment due to their claimed losses from worthless stock and loans. The determination of worthlessness in the situation described in this case is not without some doubt, and while we have found that petitioners have not proven worthlessness, we believe that they honestly believed that their stock and loans were worthless in 2002. 14 We therefore hold that petitioners are not liable for the section 6662 penalties.



To reflect the foregoing,



Decision will be entered for respondent as to the deficiencies and for petitioners as to the accuracy-related penalties.


1 Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

2 Before trial, petitioners' counsel submitted to the Court a document entitled "Petitioners' Consolidated Pre-Trial Motion", which the Court treated as petitioners' pretrial memorandum. At trial, petitioners' counsel requested that the Court treat part of their pretrial memorandum as a motion for partial summary judgment (motion). The Court obliged the request but denied the motion and declined to rule on petitioners' counsel's request to shift the burden of proof. Petitioners failed to pursue some of the arguments made in their motion at trial or in their post-trial briefs. Accordingly, we deem those arguments to have been abandoned and will decide only the issues that petitioners' counsel disputed in their posttrial briefs. See Nicklaus v. Commissioner, 117 T.C. 117, 120 n.4 (2001).

3 Respondent also determined that petitioners' itemized deductions should be decreased by $2,534 in 2002 and $2,052 in 2003. These are computational adjustments that depend on our disposition of the other issues in this case.

4 Petitioners apparently accounted for the aircraft activity as a sole proprietorship on a Schedule C, Profit or Loss From Business, until Mrs. Rosenblatt became a member of KAR RRR in 2002. Thereafter, petitioners accounted for the aircraft activity as a partnership on a Schedule E, Supplemental Income and Loss.

5 A Hobbs meter is a device used to measure the amount of time an aircraft is in operation.

6 Petitioners had actual gross receipts from the aircraft activity of $21,645 in 2002 and $31,865 in 2003.

7 Petitioner testified that he "worked off * * * [a] pro forma and * * * [his] own notes about marketing and so on" and that those materials indicated that, "given a certain number of hours per month of * * * lease that it would be profitable." Petitioner's "pro forma" and marketing notes were not offered into evidence.

8 The total time on petitioner's log for 2002 is listed as 191.3 hours but actually adds up to 197.05 hours.

9 The logs separate petitioner's "Business Time" and "Travel Time" spent on KAR RRR. In 2002, petitioner's log reflects 52.75 hours of travel time and 144.3 hours of business time. In 2003, petitioner's log reflects 41 hours of travel time and 167.25 hours of business time.

10 The aircraft activity generated losses of $84,469 for 2002 and $44,442 for 2003.

11 Because we find that petitioners' aircraft activity was not engaged in with the required profit objective, we need not decide whether petitioners' losses were nondeductible passive activity losses subject to the limitations imposed under sec. 469.

12 Sec. 165(g)(2)(C) defines a "security" as "a bond, debenture, note, or certificate, or other evidence of indebtedness, issued by a corporation or by a government or political subdivision thereof, with interest coupons or in registered form."

13 Sec. 6662 can also apply when there is a substantial understatement of tax. See sec. 6662(b)(2). However, since the only reason given in the notice of deficiency for imposing the penalty was negligence or intentional disregard of rules and regulations, and respondent did not raise sec. 6662(b)(2) until after trial, we will only consider the issue raised in the notice of deficiency.

14 In petitioners' posttrial brief, they requested the following finding of fact:

62. Dr. Rosenblatt believes his investments in Benefit Technologies became worthless in 2002 because during that year the bankruptcy trustee ran out of opportunities to the [sic] sell the company.

In his answering brief, respondent had no objection to this proposed finding of fact.

6694 penalty - IRS ruling on "substantial authority"

Now that "substantial authority" is the standard of conduct for the 6694(a) penalty, the IRS private letter rulings on that topic are educational and will be used by the IRS as guidance. The following PLR is interesting because taxpayer's position was supported by the opinion of an attorney. The issue is a simple basis issue. The facts deal with a tax shelter; therefore, the more likely than not standard was applied, as indicated. The same standards are applied in section 6694(a)(C) under the Emergency Economic Stabilization Act of 2008 which still applies the "more likely than not" standard for tax shelters. For this reason, this PLR is instructive. Return preparers will have to provide a similar relevant analysis of applicable technical authority under §1.6662-4(d)(3)(ii) and(iii). You will be nailed with the draconian 6694 penalties unless you meet this standard for either disclosed or undisclosed positions. Indeed, notwithstanding the opinion of an attorney, the opinion did not follow applicable legal preident; therefore, the position taken could be viewed as "reckless" with the resulting $5,000 penalty under section 6694(b) (assuming that the section 6694 penalty is an issues). Do you think that the current body of tax return preparers are prepared to meet this standard?

IRS Letter Ruling 200326034, March 3, 2003

LTR Report Number 1374, July 2, 2003

IRS REF: Symbol: CC:ITA:B05-TAM-152677

Uniform Issue List Information:

UIL No. 1012.06-00

Basis of property costs; Liabilities assumed as purchase price.

[Code Sec. 1012]


ISSUES:



(1) Whether Taxpayer's claimed loss on the disposition of FC is disallowed on the grounds that Taxpayer improperly determined basis in the FC.



(2) Whether the I.R.C. §6662 accuracy-related penalty can be asserted against Taxpayer if the loss is disallowed.



CONCLUSIONS:



(1) Taxpayer's claimed loss on the disposition of FC is disallowed because basis in the FC was limited to its fair market value when acquired.



(2) Taxpayer did not have substantial authority for the tax treatment of the loss, and therefore the accuracy-related penalty can be asserted against Taxpayer.



FACTS:



Taxpayer is a member of LLC1. LLC1 purchased some FCa from LLC2. LLC2 had borrowed FCb from a lender group. 1 According to an opinion letter from Counsel, the terms of this loan provided for payment of principal at the end of 30 years, with interest payable annually in arrears. The interest rate was to be reset annually by the lender group. If LLC2 did not accept a reset rate, the debt was to be prepaid.



The Counsel opinion characterizes LLC1's purchase of the FCa as the creation of a "synthetic zero coupon foreign currency debt instrument." 2 The opinion refers to the fact that LLC1 purchased the present value of the FCb due at the end of 30 years (i.e., FCb) and assumed the obligation to pay the full principal amount (i.e., FCa). LLC1 assumed joint and several liability for payment of the loan. In addition, both LLC2 and LLC1 were required to pledge collateral that was required to total the full amount of principal and interest owed to the lender group. LLC1's portion of this collateral was the FC equivalent of approximately $U. Between LLC1 and LLC2, it was agreed that LLC1 would be responsible for payment of principal to the extent principal was not repaid with collateral. LLC2 agreed to make required interest payments.



LLC1 disposed of the FCa. 3 As a result of membership in LLC1, Taxpayer's share of the amount realized on this disposition was approximately $Y. However, Taxpayer's share of the claimed basis in the FCa was approximately $Z, based on the U.S. dollar equivalent of the entire principal amount of the FCb loan. Taxpayer thus reported a loss of approximately $X on his tax return. Approximately one year after the FCb loan was made, it was repaid with collateral that had been pledged by both LLC2 and LLC1.



Taxpayer received a legal opinion from Counsel stating that it was "more likely than not" that, for Federal income tax purposes, LLC1 could claim basis equal to the full amount of the assumed debt.



LAW AND ANALYSIS:



Issue 1



Section 1012 of the Internal Revenue Code (Code) provides that the basis of property is equal to the cost of that property. Section 1.1012-1(a) of the Income Tax Regulations defines "cost" to mean the "amount paid" for the property in cash or other property. Under general tax law principles, the amount paid for property generally includes the amount of the seller's liabilities assumed by the buyer. Consolidated Coke Co. v. Commissioner, 70 F.2d 446 (3d Cir. 1934) [5 USTC ¶1436] (basis of purchased plant includes debt assumed by taxpayer); Oxford Paper Co. v. United States, 86 F.Supp. 366 (S.D. N.Y. 1949) [49-2 USTC ¶9402] (basis of purchased plant includes assumed lease obligation). The inclusion of liabilities in basis by a buyer, however, is predicated on the assumption that the liabilities will be paid in full by the buyer. See Commissioner v. Tufts, 461 U.S. 300, 308 (1983) [83-1 USTC ¶9328], 1983-1 C.B. 120, 123.



While there can be no argument that the cost basis of property includes the amount of assumed liabilities, it appears equally clear that one dollar of debt should result in no more than one dollar of basis. Accordingly, in the case of joint and several liability and co-ownership of property, an allocation of debt for purposes of basis is necessary to avoid multiple basis.



Thus, Estate of Leavitt v. Commissioner, 90 T.C. 206 (1988) [CCH Dec. 44,557], aff'd, 875 F.2d 420 (4th Cir. 1989) [89-1 USTC ¶9332], illustrates the principle that one dollar of debt should produce no more than one dollar of basis. In that case, the Tax Court refused to give S corporation shareholders additional basis in their stock as the result of guarantees of a loan made to the S corporation. In a concurring opinion, Judge Williams pointed out that if each of the shareholders was allowed to recast the loan as one to the shareholder followed by a capital contribution to the S corporation, each shareholder's basis would be increased by the full amount of the loan, which would result in "multiplication of basis." Id. at 219.



Counsel's opinion cites Hovis v. Commissioner, T.C. Memo. 1995-60 [CCH Dec. 50,469(M)], for the proposition that each co-obligor is liable for the full amount of a recourse obligation. However, the case does not foreclose allocating debt for various tax purposes. To the contrary, in that case taxpayers were not permitted to deduct more than their pro rata share of a joint obligation incurred to finance the unsuccessful start-up of a bank.



Although Estate of Leavitt involved a shareholder guarantee of a loan to an S corporation, the principle it expresses, that debt should not produce multiple basis, is equally applicable in the context of this transaction. Consequently, once it has been determined that basis stemming from the FCb loan in this case must be allocated between LLC2 and LLC1 -- the joint and several obligors - it becomes necessary to determine the method for making the allocation.



In the absence of direct authority, a supportable method of allocating basis looks to the amount of the total debt that each co-obligor can be expected to pay. This approach has been used to determine the portion of a mortgage that a co-obligor can treat as a "cost" of acquiring a replacement residence for purposes of section 1034. For instance, in Snowa v. Commissioner, T.C. Memo. 1995-336 [CCH Dec. 50,774(M)], rev'd, 123 F.3d 190 (4th Cir. 1997) [97-2 USTC ¶50,614], the taxpayer had shared a former residence with one spouse but purchased a replacement residence with another spouse. Section 1034 permitted deferral of gain recognition on the sale of one residence to the extent proceeds were used to purchase a second residence. For this purpose, section 1034(g) allowed a taxpayer to elect to treat as a "cost" of the second residence any consideration supplied by either the taxpayer or her spouse. The Tax Court concluded that this relief provision was not applicable because the old and new residences were shared with different spouses. Because section 1034(g) did not apply, the taxpayer's cost of the new residence included only consideration she supplied, including only her "share" of the mortgage debt incurred to purchase the new residence:



Petitioner argues, however, that the entire amount of the mortgage should be included in her cost because the lender could require her to pay the full amount of the debt. [Taxpayer's argument in this transaction.] Petitioner fails to recognize that, although the lender could enforce the obligation against one of the joint and several debtors, in such event, the debtor who pays the debt would have the right to seek contribution from the nonpaying debtor. ...



1995 RIA TC Memo ¶95,336 at 2064-95 (emphasis supplied).



The appellate court reversed the Tax Court and allowed the taxpayer to defer her gain because it found that section 1034(g) did not require that the old and new residences be shared with the same spouse. Thus, the relief provision applied, and the taxpayer could consider as her cost of the second residence all consideration supplied by herself and her new spouse, including the entire amount of the mortgage. Snowa suggests that absent a statutory override, co-obligors who jointly own property must allocate debt used to acquire the property when they determine their respective costs.



Other cases have limited the portion of an assumed indebtedness that may be taken into account for federal income tax purposes. For example, where two or more persons are liable on the same indebtedness, or hold separate properties subject to the same indebtedness, the amount taken into account for federal income tax purposes by each person generally is based on all the facts and circumstances, including the economic realities of the situation and the parties' expectations as to how the liabilities will be paid. See Maher v. United States, No. 16253-1 (W.D. Mo. 1969) (property was not in substance "subject to" liability where lender was not actually relying on property as collateral); Maher v. Commissioner, 469 F.2d 225 (8th Cir. 1972) [72-2 USTC ¶9728] (corporation's assumption of primary liability on shareholder's indebtedness becomes taxable dividend only as corporation makes payments as promised). 4



In this case, LLC1 is responsible for the principal balance of the loan only to the extent that it has not been satisfied from collateral. Thus, the collateral is the primary and expected source of repayment. At the inception of the transaction, LLC2 supplied X percent of the collateral, while LLC1's share of the collateral is some Y percent (FCa).



In addition, in appropriate cases, courts have rejected attempts to assign an inflated basis to property and have limited the basis of property to its fair market value. For example, the basis of property acquired with the issuance or assumption of recourse indebtedness has been limited to the acquired property's fair market value where "a transaction is not conducted at arm's-length by two economically self-interested parties or where a transaction is based upon 'peculiar circumstances' which influence the purchaser to agree to a price in excess of the property's fair market value." Lemmen v. Commissioner, 77 T.C. 1326, 1348 (1981) [CCH Dec. 38,510] (citing Bixby v. Commissioner, 58 T.C. 757, 776 (1972)) [CCH Dec. 31,493]; Webber v. Commissioner, T.C. Memo. 1983-633 [CCH Dec. 40,541(M)], aff'd, 790 F.2d 1463 (9th Cir. 1986) [86-1 USTC ¶9456]. See also Majestic Securities Corp. v. Commissioner, 42 B.T.A. 698, 701 (1940) [CCH Dec. 11,304], aff'd, 120 F.2d 12 (8th Cir. 1941) [41-2 USTC ¶9525] ("The general rule that the price paid is the basis for determining gain or loss on future disposition presupposes a normal business transaction.")



The concept of limiting basis from debt to the fair market value of the property acquired also is found in case law concerning nonrecourse debt. The effect of nonrecourse debt on basis was considered by United States Supreme Court in Crane v. Commissioner, 331 U.S. 1 (1947) [47-1 USTC ¶9217], where the Court held that a taxpayer's basis in inherited property was its fair market value on the date of decedent's death and was not reduced by the amount of nonrecourse debt that encumbered the property. The Court also held that upon disposition of the property, the amount realized included the amount of the debt.



In Commissioner v. Tufts, 461 U.S. 300 (1983) [83-1 USTC ¶9328], the taxpayer challenged the second Crane holding, which treated the nonrecourse debt as part of the amount realized upon disposition of the encumbered property. The taxpayer argued that this rule should not apply when the amount of debt exceeds the fair market value of the property. The Court rejected this argument and noted that the taxpayer had included the debt in basis for depreciation purposes and had (based upon a repayment expectation) failed to include the loan proceeds in income upon receipt: "[A] taxpayer must account for the proceeds of obligations he has received tax-free and included in basis." Id. at 313.



Tufts, however, does not foreclose an inquiry into whether the amount of nonrecourse debt so unreasonably exceeds the fair market value of encumbered property that repayment is unlikely. This is explained in Odend'hal v. Commissioner, 748 F.2d 908 (4th Cir. 1984) [84-2 USTC ¶9963]:



We see nothing in Tufts to alter the well-established rules that a taxpayer may not inflate his depreciation deductions, as did taxpayers here, by including in his basis for depreciation nonrecourse debt when that debt so far exceeds actual value at the time that it is incurred that there is no economic incentive to pay it.... In reaching these conclusions, we note that while Tufts did state that "Crane also stands for the broader proposition ... that a nonrecourse loan should be treated as a true loan," 461 U.S. at 313 [83-1 USTC ¶9328], it emphasized that Crane was "predicated on the assumption that the mortgage will be repaid in full," id. at 308, and that "the original inclusion of the amount of the mortgage in basis rested on the assumption that the mortgagor incurred an obligation to repay." Id. This crucial assumption is lacking in our case. Since the value of the property failed to approach the amount of prior liens and the face amount of the nonrecourse obligations to RCA, taxpayers had no economic incentive to repay the obligations at issue here.



Id. at 913.



In Regents Park Partners v. Commissioner, 1992 RIA TC Memo ¶92,336, the court limited a partnership's basis in property to the property's fair market value. The court noted that one rationale for disregarding the nonrecourse debt in its entirety from basis is the theory that a taxpayer in such circumstances lacks incentive to pay the debt:



[T]he purported purchaser had no incentive to pay off the nonrecourse note because by abandoning the transaction the taxpayer "can lose no more than a mere chance to acquire an equity in the future should the value of the acquired property increase." Estate of Franklin v. Commissioner, supra at 1048.



1992 RIA TC Memo ¶92,336 at 1742-92. The court also cites Pleasant Summit Land Corp. v. Commissioner, 863 F.2d 263 (3d Cir. 1988) [88-2 USTC ¶9601], as authority for a more limited approach that, in lieu of disregarding debt in its entirety, limits basis to the fair market value of the encumbered property. Without resolving the issue of whether excessive nonrecourse debt should be disregarded in its entirety or only in part, the court in Regents Park did find that under the circumstances of that case (the debt was to be renegotiated, bore below-market interest, etc.), a partnership did have an incentive to continue to make payments so that it was appropriate to grant basis, but only to the extent of the encumbered property's fair market value. Id. at 92-1743.



The underlying rationale of these cases, that a taxpayer acquires basis as the result of debt only when the circumstances indicate that the taxpayer will pay the debt, is very relevant to this transaction. The amount that LLC1 was likely to pay is much less than FCb, and its claim to basis premised on payment of this amount is unreasonable.



Based in large part on many of the above authorities, the Service in Notice 2002-21, 2002-14 I.R.B. 730, announced its position with respect to the basis of property acquired by taxpayers in transactions substantially similar to the transaction at issue here. Notice 2002-21 concludes that losses purportedly resulting from such transactions are not allowable to the extent the taxpayer derives a tax benefit that is attributable to a basis in excess of the fair market value of the assets that are the subject of the conveyance. In addition, the Service announced that it may impose penalties, including the accuracy-related penalty under section 6662 of the Code, on participants in such transactions.



In this case, LLC1 assumed joint and several liability for the FCb loan when it acquired FCa from LLC2. Citing this fact, LLC1 claims basis equal to the U.S. dollar equivalent of FCb, the full face amount of the assumed debt. LLC1's basis in the FC, however, should be limited to the fair market value of the FC when acquired, and Taxpayer's claimed loss therefore should be disallowed.



Issue 2



Section 6662(a) of the Code imposes a penalty of 20 percent on a portion of an underpayment of tax required to be shown on the return. The penalty applies to the portion of the underpayment that is attributable to one or more of the following: (1) negligence or disregard of rules or regulations, (2) any substantial understatement of income tax, (3) any substantial valuation misstatement under chapter 1 [Normal Taxes and Surtaxes], (4) any substantial overstatement of pension liabilities, (5) any substantial estate or gift tax valuation understatement. See I.R.C. §6662(a), (b).



For purposes of section 6662, the term "underpayment" is defined as the amount by which any tax imposed exceeds the excess of the sum of the amount shown as the tax by the taxpayer on his return, plus amounts not so shown previously assessed (or collected without assessment), over the amount of rebates made. I.R.C. §6664(a)(1), (2); Treas. Reg. §1.6664-2(a). An understatement is the excess of the amount of the tax required to be shown on the return for the taxable year, over the amount of tax imposed which is shown on the return, reduced by any rebate. I.R.C. §6662(d)(2)(A). Generally, there is a substantial understatement of income tax for an individual if the amount of the understatement exceeds the greater of ten percent of the tax required to be shown on the return, or $5,000.00. See I.R.C. §6662(d)(1)(A).



Section 6662(d)(2)(B) provides that the amount of the understatement is reduced by any portion of the understatement attributable to an item if (1) the tax treatment of any item by the taxpayer is or was supported by substantial authority for such treatment, or (2) the facts relevant to the tax treatment of the item were adequately disclosed in the return or in a statement attached to the return and there is a reasonable basis for the tax treatment of such item by the taxpayer. For a taxpayer other than a corporation, if an item is attributable to a tax shelter, the understatement can only be reduced by an item that is supported by substantial authority and if the taxpayer reasonably believed that the treatment of the item was more likely than not the proper treatment. For purposes of section 6662(d), the term "tax shelter" means: a partnership or other entity, any investment plan or arrangement, or any other plan or arrangement if a significant purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of Federal income tax. I.R.C. §6662(d)(2)(C)(iii).



When determining if an understatement exists, if there is substantial authority for the tax treatment of an item, the item is treated as if it were shown properly on the return for the tax year. Treas. Reg. §1.6662-4(d)(1). "The substantial authority standard is an objective standard involving an analysis of the law and application of the law to relevant facts." Treas. Reg. §1.6662-4(d)(2). There is substantial authority for the tax treatment of an item only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment. "The weight accorded an authority depends on its relevance and persuasiveness, and the type of document providing the authority." Treas. Reg. §1.6662-4(d)(3)(ii). Types of authority include the following: Internal Revenue Code and other statutory provisions; proposed, temporary and final regulations; revenue rulings and revenue procedures; tax treaties and regulations thereunder; court cases; congressional intent as reflected in committee reports; General Explanations of tax legislation prepared by the Joint Committee on Taxation (the Blue Book); private letter rulings and technical advice memoranda issued after October 31, 1976; actions on decisions and general counsel memoranda issued after March 12, 1981; Internal Revenue Service information or press releases; and notices, announcements and other administrative pronouncements published in the Internal Revenue Bulletin. Treas. Reg. §1.6662-4(d)(3)(iii). In addition, a taxpayer can have substantial authority for a position even if it is supported only by a well-reasoned construction of the applicable statute. Treas. Reg. §1.6662-4(d)(3)(ii).



In this case, disallowance of the losses from the instant transaction will result in an underpayment. Further, this underpayment is a substantial understatement, because the difference between the amount of tax required to be shown on the Taxpayer's return and the amount of tax which the Taxpayer reported on the return is greater than 10 percent of the tax which the Taxpayer is required to show on the return.



Because this transaction is a tax shelter as defined in section 6662(d), the amount of the understatement is reduced only if Taxpayer satisfies the substantial authority standard and reasonably believed that the tax treatment of this transaction was more likely than not the proper treatment. Regardless of whether Taxpayer can meet the reasonable belief standard, Taxpayer fails to satisfy the substantial authority requirement. While Counsel's opinion concludes that the loss deductions were proper, none of the cases or other authorities cited therein directly, or indirectly, address the type of transaction described in this case. That is, none of the authorities cited by Counsel supports giving the Taxpayer an adjusted basis equal to the U.S. dollar equivalent of FCb in the FCa actually acquired and disposed of by the Taxpayer. In addition, Notice 2002-21 and the authorities cited therein strongly indicate that Taxpayer did not have substantial authority for its reporting position. Consequently, our office concludes that the Taxpayer lacked substantial authority for the position taken. Therefore, the understatement is not reduced, and the accuracy-related penalty can be imposed under section 6662.



CAVEAT(S):



A copy of this technical advice memorandum is to be given to the taxpayer(s). Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.


1 This memorandum assumes, without having determined, that the loan to LLC2 represented genuine debt and that the sale of FC to LLC1 in fact and in substance occurred.

2 This transaction is commonly known as known as a Custom Adjustable Rate Debt (CARD) transaction and is similar to transactions recently addressed by the Service in Notice 2002-21, 2002-14 I.R.B. 730.

3 The exact manner of disposition is not clear. However, the realization event could have been conversion of the FC to U.S. dollars.

4 Debt for which there is joint and several liability has been allocated between co-obligors for other federal income tax purposes, with allocation based on who bears ultimate responsibility for the debt. For instance, among joint and several obligors, interest deductions are available to those debtors that pay the interest. In Mason v. United States, 453 F.Supp. 845 (N.D. Cal. 1978) [78-2 USTC ¶9594], two co-obligors both made payments on a debt. The court held that the taxpayer making interest payments could deduct the interest. For this purpose, payments by the two co-obligors were considered as being applied first to accrued interest and then to principal, because there was no agreement with the creditor that ordinarily would have required a different allocation.

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For questions on the above, contact ab@irstaxattorney.com

Reality check - "substantial authority"

The West Covina Motors case was decided on October 27 at a time that Congress has authorized the “substantial authority” standard under section 6694(a) for return preparers. This case illustrates the difficulty of meeting the “substantial authority” standard. You will have to thank the ABA, the AICPA, and the NAEA for pushing for the “substantial authority” standard instead of keeping the size of the penalty at $250 or near that amount. If this would have been a case under section 6694(a), as amended, it would be difficult to defend against the section 6694(b) $5,000 penalty by using a method of accounting contrary to published regulations. Another mistake was not capitalizing an expensed that the court determined should be capitalized. The potential return preparer penalty under the facts could be $10,000 if section 6694 were an issue. Going forward for the 2008 taxable year, you can be sure that the examiners will seek 6694 penalties. In this case the substantial authority exception did not apply. The adequate disclosure exception was inapplicable because there was insufficient information on the return to identify the potential controversies.


West Covina Motors, Inc. v. Commissioner. TC Memo. 2008-237, October 27, 2008.

Capital expenditures: Legal expenses: Title protection or determination: Acquisition of assets. --


MEMORANDUM FINDINGS OF FACT AND OPINION

KROUPA, Judge: Respondent determined a $380,652 deficiency in petitioner's Federal income tax for 1999 and a $415,073 deficiency for 2000. Respondent also determined a $54,880 accuracy-related penalty under section 6662 1 for 1999 and a $63,548 penalty for 2000.

After concessions, 2 we are left to decide five issues. We first decide whether petitioner may deduct legal expenses it incurred in the bankruptcy of its landlord, Hassen Imports Partnership (HIP) for 1999 and 2000 (the years at issue). We find that petitioner may not deduct these expenses. The second issue is whether petitioner may deduct legal expenses related to the purchase of Clippinger Chevrolet (Clippinger) for the years at issue. We find that it may not. The third issue is whether petitioner may deduct $54,558 in miscellaneous legal expenses for 1999. We find that petitioner is not entitled to the deduction. The fourth issue is whether petitioner is entitled to claim cost of goods sold attributable to the write-down of inventory for the years at issue. We find that petitioner is not entitled to such costs. The final issue is whether petitioner is liable for accuracy-related penalties under section 6662(a) for the years at issue. We find that petitioner is liable for the penalties.


FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulation of facts and the accompanying exhibits are incorporated by this reference. Petitioner is a California corporation with its principal place of business in West Covina, California. Zaid Alhassen (Mr. Alhassen) owned 100 percent of the stock in petitioner, which operated a Dodge dealership.



Legal Fees Incurred in the HIP Bankruptcy
Mr. Alhassen and his two brothers owned 100 percent of Hassen Holding Co., the parent and owner of Hassen Imports Inc. Hassen Imports, Inc. was a 1-percent general partner of HIP, petitioner's landlord, which owned and leased to petitioner the site of the Dodge dealership (West Covina property).

HIP filed for chapter 11 bankruptcy in April 1998 to prevent foreclosure of the West Covina property. The mortgagor bank expressed its intent to "toss out" petitioner from the property during the bankruptcy proceeding. The leases between petitioner and HIP provide, however, that a foreclosing mortgagor is deemed to have assumed and agreed to carry out the covenants and obligations of the leases. Mr. Alhassen signed these leases as the representative for both petitioner and HIP. Petitioner participated in HIP's bankruptcy reorganization and was able to expand its business to two additional parcels of land that HIP acquired as a result of the reorganization. Petitioner directly paid $46,897 of bankruptcy-related fees in 1999 and $194,802 in 2000. Petitioner reimbursed HIP for $21,192 of bankruptcy-related fees in 1999 and $52,833 in 2000. Petitioner claimed these fees as deductions on its returns for the respective years.



Legal Fees Incurred in the Clippinger Acquisition
In an unrelated transaction, Mr. Alhassen entered into an agreement to purchase (purchase agreement) the assets of Clippinger, an established new car dealership in Covina, California. Mr. Alhassen assigned the purchase rights to petitioner, who consummated the purchase agreement with Clippinger in November 1999. Petitioner acquired Clippinger's inventory of new and used automobiles, automobile parts and accessories, new automobile deposits, fixed assets including shop equipment and machinery, and intangible assets including goodwill and trademark rights. Escrow documents list the Clippinger purchase price as $6,206,813.81. The purchase agreement assigned specific dollar values to the assets as follows: $250,000 to fixed assets, $1 to miscellaneous assets, and $3,500,000 to goodwill and other intangible assets.

Clippinger also required petitioner to assume Clippinger's legal fees for structuring a seller-financing arrangement when petitioner was unable to proceed with the transaction on a cash basis. Petitioner paid $100,000 in fees to Clippinger's counsel in 1999 for preparing multiple loan documents and lease agreements, and petitioner incurred $19,251 of legal fees in 1999 and $19,214 in 2000 for its own representation in the Clippinger acquisition. Petitioner claimed all these fees, including those paid to Clippinger's counsel, on its returns for the respective years.

The parties also dispute whether $54,558 of miscellaneous legal expenses may be deducted for 1999. 3



Inventory Write-Down
Respondent also challenges petitioner's method of writing down inventory. 4 Petitioner assigned a stock number to each new and used automobile in its inventory. Petitioner referenced the stock number in records comparing the cost and the market value of each automobile for purposes of determining the proper writedown, if any. Petitioner did not include, however, complete information concerning the year, make, and model for several automobiles in these records, nor did these records indicate the condition, mileage, or equipment options of any of the automobiles. Petitioner's accountants estimated market value based on the Kelly Blue Book average wholesale prices without reference to the actual condition, mileage, or equipment options of any of the automobiles.

Petitioner's write-down calculations show that the inventory write-down should have been $309,172.04 for 1999 and $344,207.67 for 2000. Petitioner recorded the inventory write-down adjustment for the years at issue, however, as a trial balance sheet item titled "UV Res for Writedown." Petitioner offset $340,181.09 against a reserve for each of the years at issue, rather than using the write-down amounts from its records.

Petitioner's ending inventory for 2000 consisted of 96 automobiles, 35 of which had been listed in petitioner's ending inventory for 1999. Petitioner did not adjust the cost of these automobiles at the beginning of 2000 by the write-down taken at the end of 1999, resulting in a $79,824.75 overstatement of inventory write-down in 2000.

Petitioner timely filed its Federal income tax returns for the years at issue. Respondent examined petitioner's returns and issued a deficiency notice disallowing various deductions and cost of goods sold. The amounts still in dispute include legal fees incurred in the HIP bankruptcy, in the Clippinger acquisition, and for other legal expenses, as well as the cost of goods sold attributable to inventory write-down.


OPINION




I. Character of Legal Fees
We are asked to decide whether petitioner is entitled to deduct various legal expenses as ordinary and necessary business expenses under section 162 or must capitalize them under section 263. It is well established that attorney's fees that are paid as ordinary and necessary expenses may be deductible. See Bagley v. Commissioner [ Dec. 15,561], 8 T.C. 130, 134 (1947). No deduction is allowed, however, for attorney's fees that are considered capital expenditures. Sec. 263; Woodward v. Commissioner [ 70-1 USTC ¶9348], 397 U.S. 572, 575 (1970); Flint v. Commissioner [ Dec. 47,565(M)], T.C. Memo. 1991-405. The parties agree that the legal expenses at issue here must be analyzed under the "origin of the claim" doctrine. See Mosby v. Commissioner [ Dec. 42,881], 86 T.C. 190 (1986).

Courts apply the origin of the claim test to determine whether expenses are deductible under section 162 or subject to capitalization under section 263. Woodward v. Commissioner, supra; United States v. Gilmore [ 63-1 USTC ¶9285], 372 U.S. 39 (1963). The substance of the underlying claim or the nature of the transaction out of which the expenditure in controversy arose governs whether the item is a deductible expense or a capital expenditure, regardless of the payor's motives or the consequences resulting from the failure to defeat the claim. See Woodward v. Commissioner, supra at 578; Newark Morning Ledger Co. v. United States [ 76-2 USTC ¶9523], 539 F.2d 929, 935 (3d Cir. 1976); Clark Oil & Ref. Corp. v. United States [ 73-1 USTC ¶9214], 473 F.2d 1217, 1220 (7th Cir. 1973); Anchor Coupling Co. v. United States [ 70-1 USTC ¶9431], 427 F.2d 429, 433 (7th Cir. 1970). This test requires examination of all the facts and events underlying the claim, and each case turns on its special facts. Boagni v. Commissioner [ Dec. 31,873], 59 T.C. 708, 713 (1973).



II. Legal Fees Incurred in the HIP Bankruptcy
Against this background, we address whether the legal fees petitioner incurred must be capitalized or are currently deductible. First we address the legal fees petitioner paid to defend HIP in the bankruptcy reorganization. Respondent determined that the bankruptcy-related legal fees were ordinary and necessary expenses of petitioner but nevertheless were not deductible because they were rooted in the defense of title. Petitioner argues that these expenses were paid to stave off its extinction and are therefore deductible. We agree with respondent.

Legal expenses incurred to defend claims that would injure or destroy a business are ordinary and necessary expenses. Commissioner v. Heininger [ 44-1 USTC ¶9109], 320 U.S. 467, 471-472 (1943). The expenses incurred in defending legal title, however, are not deductible and must be capitalized. Duntley v. Commissioner [ Dec. 43,670(M)], T.C. Memo. 1987-579; sec. 1.263(a)-2(c), Income Tax Regs. We have held that legal expenses incurred in defending or postponing foreclosure actions must be capitalized because they are actions in defense of title. Flint v. Commissioner, supra; Boyajian v. Commissioner [ Dec. 30,042(M)], T.C. Memo. 1970-78. We see no difference where a tenant, as here, takes the highly unusual action of paying expenses to defend its landlord's title.

A taxpayer may not deduct the expenses of another as a general rule. See Deputy v. du Pont [ 40-1 USTC ¶9161], 308 U.S. 488 (1940). We have recognized a narrow exception where the original obligor is unable to make payment and the taxpayer satisfies the obligation to protect its own business interests. See Hood v. Commissioner [ Dec. 54,020], 115 T.C. 172, 180-181 (2000) (and cases cited thereat); Lohrke v. Commissioner [ Dec. 28,570], 48 T.C. 679 (1967). The adverse consequences for the payor taxpayer's business must be direct and proximate, however, as demonstrated by the impact on the payor's business of an obligor's inability to meet its obligations. Hood v. Commissioner, supra at 180-181. Here, there is no suggestion that HIP was unable to pay the bankruptcy-related legal fees. In fact, HIP had paid some of the fees, and petitioner reimbursed HIP. Accordingly, we conclude that petitioner may not deduct these expenses because the benefits to petitioner are not as direct and proximate as required for the narrow exception set out in Lohrke.



III. Legal Fees Incurred in the Clippinger Acquisition
We now turn to the legal fees petitioner incurred to acquire Clippinger. Respondent argues that the $119,251 of legal expenses in 1999 and the $19,214 of legal expenses in 2000 are capital expenditures because petitioner incurred them while acquiring a capital asset. Petitioner counters that these fees are deductible because they relate to inventory, which turns over every 90 to 150 days and does not provide significant benefit beyond a taxable year. Petitioner further argues that these fees were either directly linked to physical inventory and inventory financing or were related to the Clippinger purchase in which 74 to 90 percent of the purchase price was attributable to inventory.

We agree with respondent that the expenses incurred in the Clippinger acquisition are not deductible because they constitute capital expenditures. It is well settled that legal expenses incurred in the acquisition or disposition of a capital asset are capital expenditures. Woodward v. Commissioner, 397 U.S. at 574.

Moreover, we find petitioner's argument that most of the Clippinger purchase price represented automobile inventory conflicts with the evidence in the record. Escrow documents list the Clippinger purchase price at $6,206,813.81, and removing the amounts allocated in the purchase agreement to non-inventory items 5 leaves less than $2,400,000 (i.e., less than 40 percent) of the purchase price allocated to Clippinger's inventory and other assets. We find Mr. Alhassen's uncorroborated testimony concerning the portion of the purchase price allocated to inventory insufficient to overcome the information found in the escrow documents and purchase agreement. 6 We are not required to, nor do we in this instance, accept the self-serving testimony of interested parties without probative corroboration. See Tokarski v. Commissioner [ Dec. 43,168], 87 T.C. 74, 77 (1986); Yang v. Commissioner [ Dec. 54,011(M)], T.C. Memo. 2000-263.

In addition, petitioner's records contradict its position that inventory turned over every 90 to 150 days as 35 of the 96 automobiles included in the 2000 year-end inventory were also listed in the 1999 year-end inventory. We conclude that the acquisition-related legal fees are not deductible as ordinary and necessary business expenses.



IV. Miscellaneous Legal Fees
Respondent also disallowed $54,448 of miscellaneous legal fees for 1999. Petitioner has not provided the Court with any information regarding these miscellaneous legal fees. Accordingly, we find that petitioner is not entitled to deduct these fees.



V. Cost of Goods Sold Related to the Write-Down of Inventory
We now turn to petitioner's method of accounting for inventory write-down. Respondent disallowed $306,163 of cost of sales expenses related to inventory write-down for the years at issue. Respondent argues that petitioner both failed to substantiate the write-downs and violated the regulations under section 471 by using a reserve amount. Petitioner argues that its accounting complied with industry standards and the writedowns should be allowed. 7 We disagree with petitioner.

A taxpayer is required to use a method of accounting for inventory that clearly reflects the taxpayer's income. Sec. 471; Best Auto Sales, Inc. v. Commissioner [ Dec. 54,950(M)], T.C. Memo. 2002-297, affd. 90 Fed. Appx. 388 (11th Cir. 2004). The taxpayer has a heavy burden of proving that the Commissioner's determination is plainly arbitrary and constitutes an abuse of discretion if the Commissioner determines that the taxpayer's method of accounting for inventory under section 471 is improper. Thor Power Tool Co. v. Commissioner [ 79-1 USTC ¶9139], 439 U.S. 522, 532-533 (1979).

A taxpayer using the lower of cost or market method of valuing inventory may write-down a decline in the value of merchandise from its cost to a lower market value in the year in which the decline occurs, even though the goods have not been sold. Sec. 471; sec. 1.471-2(c), Income Tax Regs. This is referred to as an inventory write-down. If the market value of the inventory at the end of the year is lower than its cost, the taxpayer writes down the basis of the inventory to the lower market value, thereby reducing gross income. Thor Power Tool Co. v. Commissioner, supra at 534-535; sec. 1.471-4(c), Income Tax Regs. Deducting a reserve for price changes from the inventory or writing down inventory based on mere estimates, however, is not allowable. Sec. 1.471-2(f)(1), Income Tax Regs. Further, we will not disturb the Commissioner's determination disallowing a taxpayers's write-downs without objective evidence substantiating an item-by-item comparison of cost-to-market value. See Thor Power Tool Co. v. Commissioner, supra at 536; Import Specialties, Inc. v. Commissioner [ Dec. 38,753(M)], T.C. Memo. 1982-41.

Petitioner's accountant determined market value for writedown purposes as the wholesale Kelly Blue Book value with the assumption that the automobiles were in average condition. 8 Petitioner's accountant testified that it is necessary to know the make, model, and year of the automobile, as well as the automobile's condition, mileage, and equipment options to determine the Kelly Blue Book value. Yet petitioner's write-down records do not include complete information. Petitioner's records lack the make, model, and year of several automobiles and do not include the mileage, condition, or options of any automobiles. Petitioner argues that this method is the industry standard and any differences between the method used and a more detailed analysis would have been immaterial. We are not persuaded given the incomplete write-down records and absence of any corroborating evidence to support the estimated Kelly Blue Book values.

In addition, petitioner did not then use its write-down calculations of $309,172.04 in 1999 and $344,207.67 in 2000 to determine its cost of goods sold. Rather, petitioner violated the regulations when it substituted a reserve amount of $340,181.09 as the write-down for both years. See sec. 1.471-2(f)(1), Income Tax Regs.

We find that petitioner did not adequately substantiate the inventory write-downs and relied on a reserve in violation of the section 471 regulations. We also find that petitioner failed to prove that the Commissioner's determination was arbitrary and an abuse of discretion. Accordingly, we sustain respondent's determination as to this issue.



VI. Section 6662(a) Penalties
We next address whether petitioner is liable for the accuracy-related penalties under section 6662(a). Respondent has the burden of production under section 7491(c) and must come forward with sufficient evidence that it is appropriate to impose a penalty. See Higbee v. Commissioner [ Dec. 54,356], 116 T.C. 438, 446-447 (2001). Respondent determined that petitioner was liable for substantial understatements of income tax under section 6662(b)(2) for the years at issue. 9 A taxpayer is liable for an accuracy-related penalty of 20 percent of any part of an underpayment attributable to, among other things, a substantial understatement of income tax. See sec. 6662(a) and (b)(2); sec. 1.6662-2(a)(2), Income Tax Regs. There is a substantial understatement of income tax if the understatement amount exceeds the greater of 10 percent of the tax required to be shown on the return, or $10,000. Sec. 6662(d)(1)(B); sec. 1.6662-4(b)(1), Income Tax Regs.

Petitioner reported income tax of zero for the years at issue and reported negative taxable income of $258,427 for taxable year 1999 and zero taxable income for 2000. Respondent has met his burden of production because the adjustments related to the conceded issues alone are sufficient to meet the threshold amounts under section 6662(d)(1). 10

Petitioner urges us to waive the section 6662(a) penalties for three reasons. First, petitioner claims there was substantial authority for the positions taken on its tax returns. Next, petitioner argues it provided adequate disclosure of the relevant facts affecting its tax treatment of the items on the returns. Finally, petitioner claims to have reasonable cause for its positions on the returns.

While the Commissioner bears the burden of production under section 7491(c), the taxpayer bears the burden of proof with regard to issues of reasonable cause, substantial authority, or similar provisions. 11 Higbee v. Commissioner, supra at 446. We address these arguments in turn.

A. Substantial Authority for Positions Taken

Substantial authority for the tax treatment of an item exists only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary positions. See Norgaard v. Commissioner [ 91-2 USTC ¶50,378], 939 F.2d 874, 880 (9th Cir. 1991), affg. in part and revg. in part [ Dec. 45,896(M)], T.C. Memo. 1989-390; sec. 1.6662-4(d)(3)(I), Income Tax Regs. The weight of an authority depends on its source, persuasiveness, and relevance. Sec. 1.6662-4(d)(3)(ii), Income Tax Regs.

The weight of authority consistently favored respondent. We found no merit to petitioner's arguments concerning the deductibility of the attorney's fees. In addition, petitioner's position regarding the inventory write-down explicitly contradicts the relevant income tax regulations. Sec. 1.471-2(f)(1), Income Tax Regs. Accordingly, we find that the substantial authority exception does not apply.

B. Disclosure of a Position and Reasonable Basis for Treatment

We now address whether petitioner adequately disclosed its position. No accuracy-related penalty may be imposed for a substantial understatement of income tax when the taxpayer adequately discloses the relevant facts affecting the tax treatment of an item and there existed a reasonable basis 12 for the treatment of that item. Sec. 6662(d)(2)(B); sec. 1.6662-4(e), Income Tax Regs. A taxpayer may make adequate disclosure if the taxpayer provides sufficient information on the return to enable the Commissioner to identify the potential controversy. Schirmer v. Commissioner [ Dec. 44,113], 89 T.C. 277, 285-286 (1987). Merely claiming the loss without further explanation, however, is insufficient to alert the Commissioner to the controversial nature of a loss claimed on the tax return. McConnell v. Commissioner [ Dec. 57,486(M)], T.C. Memo. 2008-167 (citing Robnett v. Commissioner [ Dec. 54,221(M)], T.C. Memo. 2001-17).

Petitioner did not provide sufficient facts to supply respondent with actual or constructive knowledge of the tax treatment of the disputed items. See Robnett v. Commissioner, supra. The returns do not mention petitioner's inventory writedown method, or that petitioner deducted legal fees related to HIP's bankruptcy and the Clippinger purchase. We find that petitioner did not adequately disclose its position, and the adequate disclosure exception does not apply.

C. Reasonable Cause

We now address whether petitioner had reasonable cause. The accuracy-related penalty under section 6662(a) does not apply to any portion of an underpayment if it is shown that there was reasonable cause for, and that the taxpayer acted in good faith with respect to, that portion. Sec. 6664(c)(1); sec. 1.6664-4(a), Income Tax Regs. The determination of whether the taxpayer acted with reasonable cause and in good faith depends on the pertinent facts and circumstances, including the taxpayer's efforts to assess his or her proper tax liability, the knowledge and experience of the taxpayer, and the taxpayer's reliance on the advice of a professional. Sec. 1.6664-4(b)(1), Income Tax Regs.

Petitioner argues that it is not liable for the accuracy-related penalties because it relied upon the advice of its accountant concerning the tax treatment of the disputed items. Reliance on the advice of a competent adviser can be a defense to the accuracy-related penalty. United States v. Boyle [ 85-1 USTC ¶13,602], 469 U.S. 241, 250 (1985); Zfass v. Commissioner [ 97-2 USTC ¶50,503], 118 F.3d 184 (4th Cir. 1997), affg. [ Dec. 51,275(M)], T.C. Memo. 1996-167; sec. 1.6664-4(b)(1), Income Tax Regs. Reliance must be reasonable, in good faith, and based upon full disclosure, however. Ewing v. Commissioner [ Dec. 45,018], 91 T.C. 396, 423-424 (1988), affd. without published opinion 940 F.2d 1534 (9th Cir. 1991); Metra Chem Corp. v. Commissioner [ Dec. 43,787], 88 T.C. 654, 662 (1987).

Petitioner has not shown that it supplied its accountant with all the correct and necessary information needed to establish its position, that its error in underreporting was the result of the preparer's mistake, or that it discussed the tax treatment of the legal fee deductions with its accountant before filing the returns.

After considering all of the facts and circumstances, we find that petitioner has not established that it had reasonable cause and acted in good faith with respect to the substantial understatements of income tax. Accordingly, we sustain respondent's determination regarding the accuracy-related penalties for the years at issue.



VII. Conclusion
In reaching our holdings, we have considered all arguments made, and to the extent not mentioned, we consider them irrelevant, moot, or without merit.

To reflect the foregoing and the concessions of the parties,

Decision will be entered under Rule 155.

1 All section references are to the Internal Revenue Code in effect for the years at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated.

2 The parties resolved issues relating to the deductibility of management fees, imputed interest, employee benefits expenses, transit expenses, and prepaid expenses, resulting in an $87,225 net increase in taxable income for 1999 and a $275,459 increase for 2000. Other issues are computational. In addition, we find no merit to petitioner's racial profiling argument.

3 Respondent originally disallowed $358,711 in miscellaneous legal fees but conceded that petitioner had substantiated and was entitled to claim $304,153.

4 The parties stipulated that it is industry custom to use the lower of cost or market method of inventory valuation under which items are valued at the lower of cost or market value. This method usually results in an adjustment to inventory, by means of a write-down of inventory to market value.

5 The amount representing non-inventory items includes $100,000 for legal fees paid to Clippinger's counsel, $250,000 for fixed assets, $1 for miscellaneous assets, and $3,500,000 for goodwill and intangible assets.

6 Petitioner also failed to provide invoices or records for the acquisition-related legal services, indicating that these services related specifically to physical inventory or inventory financing, nor did we find the accountant's testimony credible as to this issue.

7 Petitioner also argued that the inventory write-down had no taxable effect. We find this argument to be without merit.

8 We acknowledge than an official guide for used automobiles may be used to determine the market value for write-down purposes. Brooks-Massey Dodge, Inc. v. Commissioner [ Dec. 32,133], 60 T.C. 884, 895 (1973).

9 Respondent determined in the alternative that petitioner was liable for accuracy-related penalties for negligence or disregard of rules or regulations under sec. 6662(b)(1) for the years at issue. Because respondent has proven that petitioner substantially understated its income tax for the years at issue, we need not consider whether petitioner was negligent or disregarded rules or regulations.

10 See supra note 2.

11 Petitioner presented no evidence concerning the issues of reasonable cause, substantial authority, or disclosure and reasonable basis in relation to its positions for the conceded issues and did not carry its burden as to these issues. See supra note 2.

12 A return position generally has a reasonable basis if it is reasonably based on one or more of the following authorities, among others: The Internal Revenue Code and other statutory provisions; proposed, temporary, and final regulations construing the statutes; court cases; and congressional intent as reflected in committee reports. Sec. 1.6662-4(d)(3)(iii), Income Tax Regs. The reasonable basis standard is not satisfied by a return position that is merely arguable or is merely a colorable claim. Sec. 1.6662-3(b)(3), Income Tax Regs.

6694 - multiple tax years - assessments - appeals

Rev. Rul. 81-171, cited in full below, is precedent for the current tax law on swection 6694. It provides an opportunity to see how the penalty will apply where there is an understatement and a net operating loss, and I took the opportunity to also discuss the lack of guidance on the assessment of the penalty and the appeal of the penalty.


Rev. Rul. 81-171, 1981-1 CB 589


Section 6694.--Understatement of Taxpayer's Liability by Income Tax Return Preparer



Separate penalties may be asserted under section 6694(a) of the Code for each taxable year return affected by a return preparer's negligent or intentional overstating of expenses on a taxpayer's return thereby creating a net operating loss that was carried back on amended returns for 3 years to claim refunds and carried forward to the succeeding year's return. The penalty for the succeeding year will apply even though that year's return was prepared by a second preparer who used the information from the prior years' returns. No penalty may be imposed against the second preparer.


[Text]


ISSUE 1


May the penalty under section 6694(a) of the Internal Revenue Code, for understating tax liability on a return, be separately applied for other taxable year returns affected by the preparer's negligent or intentional disregard of rules and regulations?


ISSUE 2


May the penalty under section 6694(a) of the Code be imposed against an income tax return preparer when an understatement of liability on a return prepared by that preparer is caused by the negligent or intentional disregard of rules and regulations by another preparer?


FACTS


B, an income tax return preparer, in preparing A's 1979 return, negligently or intentionally overstated A's expenses, thereby creating a net operating loss for the year. B then prepared amended income tax returns for the years 1976, 1977, and 1978 and claimed refunds for those years based on the net operating loss carryback from 1979. Because the carryback was not exhausted in 1978, a portion of the loss was available to be carried forward to 1980. C, another income tax return preparer, prepared A's 1980 return, using the information presented to C by A, including a copy of the 1979 return. C was not aware of the negligent or intentional overstatement of expenses by B but checked the amount of the net operating loss deduction claimed in 1976, 1977, and 1978 so that C could show what appeared to C to be the proper amount of net operating loss deduction on the 1980 return. The net operting loss deduction constituted a substantial portion of A's 1980 return.


The Internal Revenue Service determined that the overstatement of A's expenses for the taxable year 1979 had resulted in an understatement of tax liability on A's 1979 return and that the erroneous net operating loss deduction had resulted in an understatement of tax liability on A's 1980 return and on the amended returns for the taxable years 1976 through 1978.


LAW AND ANALYSIS


Section 6694(a) of the Code provides that if any part of any understatement of liability with respect to any return is due to the negligent or intentional disregard of rules and regulations by any person who is an income tax return preparer with respect to such return, such person shall pay a penalty of $100 with respect to such return.


Section 6696(e) of the Code defines "return" to mean any return of tax imposed by subtitle A. This definition would include an amended return as well as an original return.


Under section 1.6694-1(d) of the Income Tax Regulations, an understatement of liability exists if, viewing the return as a whole, there is an understatement of the net amount payable of any income tax, or viewing the claim for refund as a whole, there is an overstatement of the net amount creditable or refundable.


Section 301.7701-15(b) of the Regulations on Procedure and Administration provides that only a person who prepares all or a substantial portion of a return or claim for refund shall be considered to be a preparer of the return or claim for refund. A preparer of a return is not considered to be a preparer of another return unless the entry or entries reported on the prepared return are directly reflected on the other return and constitute a substantial portion of the other return.


Under section 172 of the Code, a net operating loss may generally be carried back to the 3 years immediately preceding the year in which the loss occurs and, if not entirely used to offset income in those years, may be carried forward for as many as 7 years. Section 172(c) defines "net operating loss" as the excess of allowable deductions over gross income.


In this situation, the negligent or intentional overstating of expenses on A's 1979 return by B created a net operating loss and resulted in an understatement of tax liability on the 1979 return. Such understatement subjected B to the penalty under section 6694(a) of the Code with respect to the 1979 return. In addition, the carryback and carryover of the net operating loss to the years 1976, 1977, 1978, and 1980 resulted in understatements of liability for those years.


B is considered the preparer of the 1980 return because the net operating loss from the 1979 return was directly reflected as a deduction on the 1980 return and constituted a substantial portion of that return. C is also the preparer of the 1980 return. However, the understatement of A's 1980 tax liability was not due to the negligent or intentional disregard of rules and regulations by C.


HOLDING

ISSUE 1


The penalty imposed by section 6694(a) of the Code for negligent or intentional disregard of rules and regulations may be asserted against B with respect to A's return for 1979. Penalties may also be asserted against B with respect to the amended returns prepared by B for 1976, 1977, and 1978 based on the erroneous net operating loss deduction. A penalty may also be asserted against B because of the understatement of liability on A's 1980 return caused by the erroneous net operating loss deduction. Furthermore, if the Service establishes willfulness on the part of B under these circumstances, the penalty under section 6694(b) of the Code also applies for each of the years 1976 through 1980. See Rev. Proc. 80-40, 1980-2 C.B. 774, for a listing of some of the factors that will be taken into considerating in determining whether the penalty under section 6694(a) will be applied to a negligent preparer. See also Rev. Rul. 80-262, 1980-2 C.B. 375, Rev. Rul. 80-263, 1980-2 C.B. 376, Rev. Rul. 80-264, 1980-2 C.B. 377, and Rev. Rul. 80-265, 1980-2 C.B. 377, which consider the applicability of the penalty under section 6694(a) in various situations.


ISSUE 2


No penalty may be imposed against C.
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In my view, the term "reckless" in section 6694(b) could be measured in part by the impact of an error on other tax years. The IRS could argue that there is a greater duty of care when the negligent error has an impact on other tax years.

These issues are quite serious because of the large size of the penalties. The $5,000 penalty could be applied to multiple years. In this revenue ruling, the $5,000 penalty would have applied 5 times and would have amounted to $25,000 (assuming the penalty under current law). For planning purposes, I believe we have to assume that the IRS will be aggressive in trying to apply the 6694(b) penalty.

Understand that the IRS examiners are not your personal friends. The statutory relief to appeal the penalty is limited and harsh. The IRS can be expected to hit you with the 6694 penalties even if they are not justified by a reasonable analysis of the facts. I have previously discussed the difficulty of proving "reasonable cause" under section 6694(a)(3), as amended under the Emergency Economic Stabilization Act of 2008.

The proposed regulations do not discuss the procedure for assessing the penalty. From my experience with similar penalties, the IRS Examiner just assesses it with or without notice and with or without discussion.

The proposed regulations 1.6694-4(a) requires an examination report for the return preparer before the assisement of the penalty. Note the following IRM provision:

20.1.6.1.4.1 (02-08-2008)

Pre-Assessment Appeals IRC Section 6694 and IRC Section 6695

Treas. Reg.1.6694-4(a)(1) allows for pre-assessment appeal rights of IRC section 6694 penalties. Although the regulation only relates to IRC section 6694 penalties, Area and Campus examiners will follow the same guidelines for IRC section 6695 penalties. With the exception of IRC section 6695(f), all IRC section 6694 and IRC section 6695 penalties will have pre-assessment appeal rights. A return preparer may appeal IRC section 6695(f) and IRC section 6713, Disclosure or Use of Information by Preparers of Returns , penalties using the post-assessment penalty appeal procedures or the denial of a claim for refund procedures.


Examination sends the return preparer a 30-day letter, Letter 1125 (DO), Transmittal of Examination Report, with an examination report and Publication 5, Your Appeal Rights and How To Prepare a Protest If You Don't Agree, for appeal procedures. If there is no timely response to the letter, the penalty is assessed. Pre-assessment appeals consideration will be granted if requested for IRC section 6694 and IRC section 6695 penalties (except IRC section 6695(f)).

Everyone should understand that these penalties will apply to the 2008 tax year. For this reason, if you have any tax issues that you find problematical, you should have them resolved now before the returns are filed. The key to your safety for these massive penalties is to file returns that will not result in any understatement of tax - that means no mistakes and no negligence.

I do not think these administrative rules are consistent with section 6694(c) which gives you the remedy of paying 15% of the assessment and allowing you a claim for refund if you file the claim withing 30 days. If the claim for refund is denied, your remedy is the District Court. Treat the liberal administrative appeal rights as a "gift" from the IRS.

IRS Plans Compliance Checks for Practitioners Filing POAs


The IRS intends to check the personal tax compliance history of practitioners filing Form 2848, Power of Attorney and Declaration of Representative. Michael Chesman, director of the IRS Office of Professional Responsibility (OPR), recently announced the new procedure and the Service confirmed the compliance checks for CCH on October 24. However, the IRS declined to indicate when the compliance checks would begin.


Power of Attorney


A power of attorney authorizes an individual to act as a representative for either an individual or an entity. Form 2848 is routinely executed by taxpayers and practitioners, Cindy Hockenberry, enrolled agent, National Association of Tax Professionals (NATP) explained. "The preparer wants to know when the IRS is contacting the taxpayer."



Speaking at the Tax Executives Institute's annual conference in Boston on October 20, Chesman said that the new compliance checks would be automatic for practitioners filing a power of attorney. The IRS will review if the practitioner has timely filed and paid his or her personal taxes, he indicated.



This new procedure "raises the bar" to make sure that individuals who represent taxpayers are compliant with their filing and tax obligations, Hockenberry noted. It also complements the IRS' efforts to make OPR more transparent.



Hockenberry also noted that the IRS performs a tax compliance check when an individual applies to become an enrolled agent. "An individual who is not compliant will not be granted enrolled agent status."

negligence & 6694 expanded

There was a great deal of interest in the blog published yesterday. Given the large amount of interest in this topic, I expanded the discussion and analysis of that blog and have copied it, as follows:


Prior to the Omnibus Budget Reconciliation Act of 1989, the section 6694 penalty was triggered if “any part of any understatement of liability with respect to any return or claim for refund is due to the negligent or intentional disregard of rules and regulations by any person who is an income tax return preparer”.

Mere “negligence” triggered the penalty under section 6694(a).

The Omnibus Budget Reconciliation Act set forth a new technical standard by providing for the section 6694(a) penalty for any part of any understatement of liability by a return preparer is due to a position for which there was “not a realistic possibility of being sustained on its merits.”Presently, and effective as of May 25, 2007, the Emergency Economic Stabilization Act of 2008 provides that the 6694(a) penalty applies if there is an understatement of liability and the return preparer “knew (or reasonably should have known) of the position” and there was no “substantial authority” for an undisclosed position.

The reason for this review is to put the term “negligence” into perspective. This legislative history makes it clear that any understatement of liability attributable to either a disclosed or undisclosed position caused by “negligence” will always trigger the 6694(a) penalty of $1,000 and if sufficiently “reckless” will trigger the $5,000 penalty (or the greater of 50% of the income derived by the return preparer). The high threshold for “reasonable cause” under section 6694(a)(3), as amended by the Emergency Act, is limited by the proposed section 6694 regulations to the analysis and technical issues identified in section 1.6662-4(d)(3)(ii) and (iii).

For perspective on the term “negligence,” Rev. Proc. 80-40, 1980-2, CB 774 is instructive and contains the following statement: “The case of Marcello v. Commissioner, 380 F. 2d 499, 506 (5th Cir. 1967) holds that negligence is lack of due care or failure to do what a reasonable and ordinary prudent person would do under the circumstances.”

Rev. Rul. 80-263, 1980-2 CB 376 held that the 6694(a) penalty applied when the return preparer made two errors: not including an amount in one of the Forms 1099-INT and made an adding error in totaling the amount of itemized deductions.

In Rev. Rul. 80-28, 1980-1 CB 304, the 6694(a) penalty was applied because the return preparer failed to report the minimum tax liability of $300. Rev. Ru. 80-28 holds the return preparer to the standard of “due diligence.”

The above is enough to give the return preparation industry a “wake up” call. Your mistakes or lack of due diligence will trigger the section 6694(a) penalty. The reason for this observation is that Congress has legislated higher standards of conduct - in 1989, 2007 and now in 2008 (amending 6694 in the Small Business Act of 2007). The legislative history is clear that Congress and Treasury are adamant in cutting down abusive tax return preparation. Lack of negligence is not enough because higher standards of conduct were legislated by Congress. This explains the reason the current proposed regulations on 6694 require an "analysis" of the relevant "authorities" to support both disclosed and undisclosed postions.

In effect, the 6694 proposed legislative regulations expect strong technical support for the posiitons taken, whether disclosed or not disclosed. The same technical requirements should be anticipated in the final 6694 amended regulations.

I do not give too much credence to the lower reasonable basis standard for section 6694 disclosed positions because the proposed regulations still require an "analysis" of the relevant authority to support the disclosed positions. Furthter, "reasonable basis" is a subjective standard, and I do not expect IRS examiners to understand the nuance between "substantial authority" and "reasonable basis" when the distinction is one that is subject to their discretion.

The additional reason return preparers need to provide strong technical support for disclosed positions is that the disclosure of a position to the IRS is an automatic "red flag" for an audit examination. The 6694 statute uses the term "unreasonable position" when referencing the positions disclosed and not disclosed. One has to expect the IRS to audit any disclosed postion that is identified as an "unreasonable position." For this reason, the technical support for a disclosed position should be just as high or higher for an undisclosed position to both discourage the return from being selected from examination and also to prevent the negligence penalty for your client.

Back to the "negligence" issue. There can never be technical support for computational mistakes, not using a required IRS Form, failure to understand the complexity of an issue, failure to know then data is patently wrong, etc. Although the proposed regulations suggest that you can rely on information given to you by a client, do not count on that relief when the tax return is audited. How will you be able to defend against an accusation by the IRS examiner that you were "reckless" for not verifying documentation for a number and proposes to assess a $5,000 penalty for each position in the return that was not substantiated? Even if you were not "reckless," who needs that kind of aggrivation given the complexity and difficulty of opposing the imposition of the section 6694(b) penalty? The penalty can be assessed without immediate appeal rights and without notice to you during the examination or after the examination. I have discussed the problematical appeal issues in a prior blog.

Reliance on client data is high-risk reliance due to the large size of the potential penalties. If any of the client data is wrong, as it often wrong, the return preparer will be on shaky ground when arguing with a return preparer who argues that the return preparer should have investigated the documentation for the data. Does anyone want to be in a position to defend that accusation? The conservative return preparer will not want to rely on client data without confirming the accuracy of that data because the penalty risk is far too high. I do not see the downside to taking a conservative approach if the return preparer is being compensated for that extra effort.

Due to the size of the penalties, you cannot take the chance of "negligence" in preparing a tax return. Anytime the IRS examines a tax return and finds that a taxpayer is subject to penalty under section 6662(a) for negligence (in all cases where there is not substantial authority), the return preparer will be hit with either the penalty under section 6694(a) or (b). I expect the IRS go push for the section 6694(b) penalty in most of these cases because the term "reckless" in section 6694(b) is the same term used in the definition of "negligence" in section 6662(c).

Section 6662(c) states: For purposes of this section, the term "negligence" includes any failure to make a reasonable attempt to comply with the provisions of this title, and the term "disregard" includes any careless, reckless, or intentional disregard." Any understatement of tax for conduct described in section 6662(c) will likely be subject to the section 6694(b) penalty which also uses the term "reckless."

Most IRS examinations cover multiple tax adjustments; therefore, mutiple $5,000 penalties could be assessed in any examination for any tax year. Since IRS examinations normally cover a three year period, the same penalties could apply for three years. I would not be surprised to see section 6694(b) assessments totaling $30,000 or more (asuming two $5,000 penalties for each of three years). That number can go higher, using my assumption that IRS examiners can treat any negligent error as a "reckless" error un der section 6694(b).

It is obvious that the risk of these kinds of penalties is so large that the return preparer has little choice but to spend much more time documenting the data used in a tax return and also documenting the positions taken in a tax return, whether or not the positions are disclosed to the IRS as required in the section 6694 proposed regulations.


Once you understand the higher standards for return preparation for the 2008 tax year and beyond, you will have to reevaluate your fee schdules to account for the addtional time you will need to spend on each return. Given the much higher risk for penalties on return preparers, your engagement letters should factor in the higher risk.

An equally serious question is: are you qualified to support "disclosed" or "undisclosed" positions based on the the requirments to provide the "analysis" required under section 1.6662-4(d)(3)(ii) and the authority referenced under section 1.6662-4(d)(3)(iii)? There is no "analysis" or "authority" for "negligence." This is the reason that the "reasonable cause" exception for "negligence" under section 6664(c) (i.e., relying on section 6664(c) case law and the 6664(c) regulations) will not apply to "negligence" under section 6694 with its much higher legislative standards of conduct and with a much higher threshold for "reasonable cause."

How can you support the posiiton disclosed or not disclosed if you do not have the resources to research the applicable and relevant technical support for the positions taken? Even if you have those technical resources, do you have the skill-set to be able to find the relevant technical support? You can see that the section 6694 penalties are a large trap for the unskilled, unwary and unprepared tax return preparer on the technical issues as well as the potential for negligent error.

The inability of a return preparer to provide an "analysis" of the relevant "authorities" for positions taken in a return should be expected to be viewed by the IRS as automatic negligence. I can testify that as a tax attorney I find the IRS is frequently wrong even on simple tax law issues. You cannot expect that the IRS examiners will be well trained on any tax issue. It follows that in a situation where the IRS is wrong and the tax return preparer correct, the 6694 penalty can still apply IF the position of the return preparer is not supported with the requisite "analysis" and relevant "authority." The brden of proof is on the return preparer that the positions taken are based on "substantial authority" or "reasonable basis."

My personal observation is that the return preparation industry is “in denial” about the impact of section 6694, as amended. I believe it is because this penalty has been previously ignored by the IRS in examinations (even criminal examinations) because of the prior small size of the penalties (i.e. prior to May 25, 2007). Due to the very large size of the preparer penalties under current law, you can expect that the IRS examiners will eagerly make section 6694 penalty assessments. They can make that assessment without notice. For that reason, the IRS software programs could automatically apply the 6694 penalty anytime there is a substantial understatement of income under the objective standards of section 6662(d).

My experience with the current IRS examiners is that they have become extremely aggressive. Forget “fair and balanced” determinations. The IRS will assess the penalty for mistakes of all forms and varieties. Obviously, technical mistakes will trigger the penalty with the further risk that the mistake will be treated as “reckless” and make you vulnerable to the $5,000 penalty. I am certain that the IRS examiners will be motivated by the large size of the penalty in the same way that the IRS is aggressive in assessing the negligence penalty.

I am personally taken aback by the fact that professional organizations like the ABA, the AICPA and NAEA have not made members aware of the new high risk for those who are in the trenches preparing tax returns. I am personally “pounding the table” to make return preparers aware of that risk. And why did these professional organizations not lobby against the large draconian size of the 6694 penalties instead of the standard of conduct which is still a very high standard? Without question, return preparers will be targeted for these large penalties when errors are found in any filed tax return.

Factual and legal issues that will be taken for the 2008 tax year to be filed in 2009 should be resolved now before the filing season begins.

Continue to sent requests for technical opinions to ab@irstaxattorney.com.

6694 and negligence

this blog was amended and expanded in the next blog

a case dealing with "substantial authority"

John R. Hernandez v. CommissionerDocket No. 17244-96., TC Memo. 1998-46, 75 TCM 1714, Filed February 5, 1998

One of the issues in this case is whether petitioner, a CPA, was liable for accuracy-related penalties under section 6662(d) for substantial understatements of income tax. The purpose of presenting an excerpt from this case is to illusrate how the Tax Court will apply the "substnatial authority" standard which is presently the standard for determining the return preparer penalty under section 6694(a)(2)(A) as legislated under the Emergency Economic Stabilization Act of 2008. The IRS proposed regulations require an analysis of the relevant authority under section 1.6662-(4)(d)(3). This is the reason cases like the present Hernandez case provides guidance for the 6694(a) issues.


OPINION

Issue 5. Petitioner Is Liable for the Accuracy-Related Penalty Under Section 6662(d) for Substantial Understatements of Income Tax



Respondent is foreclosed from imposing the accuracy-related penalty if a taxpayer has substantial authority for the treatment of the items at issue or if the taxpayer adequately disclosed such items. Sec. 6662(d)(2)(B)(i) and (ii). Petitioner has the burden of showing either that he had substantial authority for the tax treatment of the tax certificate interest or that he adequately disclosed his treatment on the returns for each year in issue. Rule 142(a).


The substantial authority standard is "an objective standard involving an analysis of the law and application of the law to relevant facts. The substantial authority standard is less stringent than the 'more likely than not' standard, * * * but more stringent than the reasonable basis standard". Sec. 1.6662-4(d)(2) , Income Tax Regs.


Section 1.6662-4(d)(3)(i) , Income Tax Regs., states that substantial authority for a taxpayer's treatment of an item exists "only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment."


With respect to the issue of whether petitioner may exclude tax certificate interest under section 103(a) , petitioner did not have substantial authority to support such an exclusion. This Court had issued a Memorandum Opinion directly on point, Barrow v. Commissioner [Dec. 39,947(M) ], T.C. Memo. 1983-123, long before petitioner filed his income tax return for any of the tax years in question. That Memorandum Opinion is substantial authority that directly contradicts petitioner's position. Sec. 1.6662-4(d)(3) (iii), Income Tax Regs.


Petitioner stated in open court that he would show that our opinion in Barrow v. Commissioner, supra, is wrong. He has failed to do so. Indeed, he has cited no authority at all to support his position, nor has he provided any persuasive reasoning to support his assertions so as to invoke section 1.6662-4(d)(3) (ii), Income Tax Regs.

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The return preparer industry has been generally passive about the need to provide technical support for the positions taken (i.e.,the need to provide "substantial authority" for undisclosed positions). For the 2008 tax year, you better be certain that the positions taken are supported by the applicable statute, regulations, and (as in the present case) the applicable case law. That means, guys & gals, that you can no longer be content to just plug in numbers into return preparation software. You are going to be expected to be a technical expert on the position taken in the tax return. In the John R. Hernandez case, it is apparent that this CPA did not do the necessary research on the interest issue. If this were a 6694 case, the CPA would be hit with the 6694(a)penalty and be at risk that he was sufficiently "reckless" that he might also be subject to the 6694(b) much higher $5,000 penalty. The IRS coud easily take the position that the CPA was "reckless" for his failure to check out an apparent case that woulod have negated the position taken. I have been taken aback by the failure of the return preparer professional organizations to issue a "wake up" call to all return preparers that they must be prepared to provide complete technical support for the positions taken. What you need to think about is whether you have the technical resources to research the relevant tax law. How are you going to handle the difficult issues? Those decisions should be made before the tax returns are filed for the 2008 tax year.


Continue to send comment to ab@irstaxattorney.com if you want to see more examples of how the "substantial authority" standard will be applied. If you are wrong on any position that is not disclosed to the IRS, can you handle a $5,000 penalty if you cannot justify that you were not "reckless" to the IRS? Suppose you make a careless mistake; will you be able to justify that you were not "reckless?" The return preparation industry is presently passive when they should be making all return preparers aware of the need to support all factual and legal issues with relevant analysis and technical support.

6694 reasonable cause undercut by regulations.

1.6694-2(d) of Proposed Regulations - Exception for reasonable cause and good faith. .

I have previously commented on the "reasonable cause" exception for the 6694(a) penalty. In this blog, my focus is limited to a focus on 1.6694-2(d)(5) below dealing with one of the factors that will be considered: Reliance on advice of others. and in that categoy, you can rely in good faith on the advice of another advisor UNLESS (i) The advice or information is unreasonable on its face;(ii) The tax return preparer knew or should have known that the other party providing the advice or information was not aware of all relevant facts; or (iii) The tax return preparer knew or should have known (given the nature of the tax return preparer's practice), at the time the return or claim for refund was prepared, that the advice or information was no longer reliable due to developments in the law since the time the advice was given.

What I find strange in the extreme is that even if you met all of the complex provisions for good faith and reasonable cause, that exception will not apply unless the return preparer is an expert on the tax law who would know that the technical position taken by the other tax advisor, who might be a tax attorney,was invalidated by new developments or new law that would make the opinion of the tax attorney incorrect. Why rely on a "tax advisor" if you still have the technical responsibility of to know that the tax advosor is incorrect? The proposed regulations expect you to be a tax expert and do the necessary tax research to make sure that there are no new developments that would invalidate the opinion of the tax advisor who has offered a legal opinion that was represented to be a valid analysis of the relevant tax authorities. In short, this proposed regulation requires you to be a reviewer of the technical opinion of the tax advisor. Curiously the AICPA comment on this part of the proposed regulations found no fault with this high standard of technical expertise mandated for all return preparers. Obviously, the AICPA expects all CPA's to have tax research services and that CPAs are being compensated by their clients to have researched the available law before you can rely on a tax advisor. If you are that good, why would you need a tax advisor? As I indicated in a prior blog, the "reasonable cause" exception in the Proposed Regulations is levels more difficult than the regulations under section 6664(d)reasonable cause provisions to abate a negligence penalty. I see no reason for the IRS to draft high threshold standards for the reasonable cause exception for the 6694(a) pwnalty. Is it because return preparers hold themselves out to be tax experts? In the real world, return prepares merely hold themselves out to be competent to prepare tax returns. Apparently, the IRS, with the approval of the AICPA, have created a very high standard of professional expertise on all tax positions for all tax return preparers, whether or not they are CPAs or tax attorneys.

We can all agree that return preparers should strive to improve their knowledge of tax law. It is a different standard when the IRS serves to punish return preparers with the draconian $1,000 or 50% of fees by taking away "reasonable cause" provided by law for all tax return preparers who are not tax experts even when they rely on the opinion of a tax attorney. I believe this high threshold is not consistent with the intent of Congress when they drafted a "reasonable cause" exception to the 6694 statute before and after the current amendment to section 6694. Since there has been no opposition to this section, I expect it to survive into the Final Regulations. However, I expect that this regulation will not stand as a legislative regulation if challanged in the courts because it is clearly inconsistent with the 6694 statute that provides for this exception. If redrafted, the IRS should track the precedent of the regulations and the case law under section 6664(d). Note the following extract from the proposed regulations.

The penalty under section 6694(a) will not be imposed if, considering all the facts and circumstances, it is determined that the understatement was due to reasonable cause and that the tax return preparer acted in good faith. Factors to consider include:

(1) Nature of the error causing the understatement. The error resulted from a provision that was complex, uncommon, or highly technical and a competent tax return preparer of tax returns or claims for refund of the type at issue reasonably could have made the error. The reasonable cause and good faith exception, however, does not apply to an error that would have been apparent from a general review of the return or claim for refund by the tax return preparer.

(2) Frequency of errors. The understatement was the result of an isolated error (such as an inadvertent mathematical or clerical error) rather than a number of errors. Although the reasonable cause and good faith exception generally applies to an isolated error, it does not apply if the isolated error is so obvious, flagrant, or material that it should have been discovered during a review of the return or claim for refund. Furthermore, the reasonable cause and good faith exception does not apply if there is a pattern of errors on a return or claim for refund even though any one error, in isolation, would have qualified for the reasonable cause and good faith exception.

(3) Materiality of errors. The understatement was not material in relation to the correct tax liability. The reasonable cause and good faith exception generally applies if the understatement is of a relatively immaterial amount. Nevertheless, even an immaterial understatement may not qualify for the reasonable cause and good faith exception if the error or errors creating the understatement are sufficiently obvious or numerous.

(4) Tax return preparer's normal office practice. The tax return preparer's normal office practice, when considered together with other facts and circumstances, such as the knowledge of the tax return preparer, indicates that the error in question would rarely occur and the normal office practice was followed in preparing the return or claim for refund in question. Such a normal office practice must be a system for promoting accuracy and consistency in the preparation of returns or claims for refund and generally would include, in the case of a signing tax return preparer, checklists, methods for obtaining necessary information from the taxpayer, a review of the prior year's return, and review procedures. Notwithstanding these rules, the reasonable cause and good faith exception does not apply if there is a flagrant error on a return or claim for refund, a pattern of errors on a return or claim for refund, or a repetition of the same or similar errors on numerous returns or claims for refund.

(5) Reliance on advice of others. For purposes of demonstrating reasonable cause and good faith, a tax return preparer may rely without verification upon advice and information furnished by the taxpayer or other party, as provided in §1.6694-1(e). The tax return preparer may reasonably rely in good faith on the advice of, or schedules or other documents prepared by, the taxpayer, another advisor, another tax return preparer, or other party (including another advisor or tax return preparer at the tax return preparer's firm), and who the tax return preparer had reason to believe was competent to render the advice or other information. The advice or information may be written or oral, but in either case the burden of establishing that the advice or information was received is on the tax return preparer. A tax return preparer is not considered to have relied in good faith if --

(i) The advice or information is unreasonable on its face;

(ii) The tax return preparer knew or should have known that the other party providing the advice or information was not aware of all relevant facts; or

(iii) The tax return preparer knew or should have known (given the nature of the tax return preparer's practice), at the time the return or claim for refund was prepared, that the advice or information was no longer reliable due to developments in the law since the time the advice was given.

(6) Reliance on generally accepted administrative or industry practice. The tax return preparer reasonably relied in good faith on generally accepted administrative or industry practice in taking the position that resulted in the understatement. A tax return preparer is not considered to have relied in good faith if the tax return preparer knew or should have known (given the nature of the tax return preparer's practice), at the time the return or claim for refund was prepared, that the administrative or industry practice was no longer reliable due to developments in the law or IRS administrative practice since the time the practice was developed.

6694 and request for rulings

Section 1.6694-2(b)(5) of the Proposed Regulations provides that written determinations. The tax return preparer may avoid the section 6694(a) penalty by taking the position that the tax return preparer reasonably believed that the taxpayer's position satisfies the "more likely than not" standard if the taxpayer is the subject of a "written determination" as provided in §1.6662-4(d)(3)(iv)(A).

The final regulations will substitute the “substantial authority” standard for the “more likely than not” standard, but that will not change this exception for the imposition of the 6694(a) penalty.

Section 1.6662-4(d)(3)(iv)(A) provides that there is substantial authority for the tax treatment of an item by a taxpayer if the treatment is supported by the conclusion of a ruling or a determination letter (as defined in §301.6110-2(d) and (e)) issued to the taxpayer, by the conclusion of a technical advice memorandum in which the taxpayer is named, or by an affirmative statement in a revenue agent's report with respect to a prior taxable year of the taxpayer ("written determinations"). The preceding sentence does not apply, however, if --

(1) There was a misstatement or omission of a material fact or the facts that subsequently develop are materially different from the facts on which the written determination was based, or
(2) The written determination was modified or revoked after the date of issuance by
(i) A notice to the taxpayer to whom the written determination was issued,
(ii) The enactment of legislation or ratification of a tax treaty,
(iii) A decision of the United States Supreme Court,
(iv) The issuance of temporary or final regulations, or
(v) The issuance of a revenue ruling, revenue procedure, or other statement published in the Internal Revenue Bulletin.
Except in the case of a written determination that is modified or revoked on account of §1.6662-4(d)(3)(iv)(A)(1), a written determination that is modified or revoked as described in §1.6662-4(d)(3)(iv)(A)(2) ceases to be authority on the date, and to the extent, it is so modified or revoked. See section 6404(f) for rules which require the Secretary to abate a penalty that is attributable to erroneous written advice furnished to a taxpayer by an officer or employee of the Internal Revenue Service.

The procedures for requesting technical advice is found in Rev. Proc. 2008-2 and the procedures for requesting rulings is found in Rev. Proc. 2008-1. There revenue procedures are updated at the beginning of each calendar year.

In summary, if you are concerned about the section 6694(a) penalty, you can request technical advice or request a ruling from the IRS on the position you may take. As a practical matter, the request for technical advice must come from an IRS examiner or manager. The IRS examiners do not like to request technical advice; it is a rare accomodation for taxpayers. The request for rulings is cumbersome, but you can rely on a favorable determination. I see no reason why this procedure is not also available to prevent the application of the section 6694(b) penalty.

If you have any questions about this procedure to prevent the imposition of the section 6694 penalties, contact ab@irstaxattorney.com.

The substantial authority standard

Below are the "substantial authority" regulations referenced in the 6694 regulations. There is nothing new in the changes to 6694(a) on August 3, 2008 in the Emergency Bill that will impact on the reference to the technical standards referenced in the current Temporary 6694 regulations, as replicated below. The "conduct" required of a tax return preparer from the "more likely than not" standard to the "substantial authority" standard retains the "substantial authority" standard. The difference is the nuance from requiring "analysis" and relevant "authority" of going from more than 50% accuracy to perhaps something that is more than 40% accurate. But in cases where the IRS is assessing the statutory negligence penalty against your client, you can expect to be hit with the $1,000 or $5,000 (or the higher of 50% of your fees) penalty. Bet on it! We are dealing with IRS examiners who are largely aggressive. Worse, there is a lareg body of IRS examiners who lack the education and training to make decisions that are reasonable.




The taxpayer bears the burden of proving substantial authority. Norgaard v. Comm'r [ 91-2 USTC ¶50,378], 939 F.2d 874, 877-78 (9th Cir. 1999). Substantial authority for tax treatment exists "only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment." Treas. Reg. §1.6662-4(d)(3)(i). Substantial authority is an "objective standard involving an analysis of the law and application of the law to relevant facts." Treas. Reg. §1.6662-4(d)(2). "[T]he taxpayer's belief that there is substantial authority for the tax treatment of an item is not relevant in determining whether there is substantial authority for that treatment." Treas. Reg. §1.6662-4(d)(3)(i) (1998). Pertinent authorities for a substantial authority analysis include the Internal Revenue Code, other statutory provisions, regulations, revenue rulings, and court decisions, but not opinions rendered by tax professionals. Treas. Reg. §1.6662- 4(d)(3)(iii).

Reg. §1.6662-4 (d) Substantial authority

(1) Effect of having substantial authority. --If there is substantial authority for the tax treatment of an item, the item is treated as if it were shown properly on the return for the taxable year in computing the amount of the tax shown on the return. Thus, for purposes of section 6662(d), the tax attributable to the item is not included in the understatement for that year. (For special rules relating to tax shelter items see §1.6662-4(g).)
(2) Substantial authority standard. --The substantial authority standard is an objective standard involving an analysis of the law and application of the law to relevant facts. The substantial authority standard is less stringent than the more likely than not standard (the standard that is met when there is a greater than 50-percent likelihood of the position being upheld), but more stringent than the reasonable basis standard as defined in §1.6662-3(b)(3). The possibility that a return will not be audited or, if audited, that an item will not be raised on audit, is not relevant in determining whether the substantial authority standard (or the reasonable basis standard) is satisfied.

(3) Determination of whether substantial authority is present
(i) Evaluation of authorities. --There is substantial authority for the tax treatment of an item only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment. All authorities relevant to the tax treatment of an item, including the authorities contrary to the treatment, are taken into account in determining whether substantial authority exists. The weight of authorities is determined in light of the pertinent facts and circumstances in the manner prescribed by paragraph (d)(3)(ii) of this section. There may be substantial authority for more than one position with respect to the same item. Because the substantial authority standard is an objective standard, the taxpayer's belief that there is substantial authority for the tax treatment of an item is not relevant in determining whether there is substantial authority for that treatment.

(ii) Nature of analysis. --The weight accorded an authority depends on its relevance and persuasiveness, and the type of document providing the authority. For example, a case or revenue ruling having some facts in common with the tax treatment at issue is not particularly relevant if the authority is materially distinguishable on its facts, or is otherwise inapplicable to the tax treatment at issue. An authority that merely states a conclusion ordinarily is less persuasive than one that reaches its conclusion by cogently relating the applicable law to pertinent facts. The weight of an authority from which information has been deleted, such as a private letter ruling, is diminished to the extent that the deleted information may have affected the authority's conclusions. The types of document also must be considered. For example, a revenue ruling is accorded greater weight than a private letter ruling addressing the same issue. An older private letter ruling, technical advice memorandum, general counsel memorandum or action on decision generally must be accorded less weight than a more recent one. Any document described in the preceding sentence that is more than 10 years old generally is accorded very little weight. However, the persuasiveness and relevance of a document, viewed in light of subsequent developments, should be taken into account along with the age of the document. There may be substantial authority for the tax treatment of an item despite the absence of certain types of authority. Thus, a taxpayer may have substantial authority for a position that is supported only by a well-reasoned construction of the applicable statutory provision.

(iii) Types of authority. --Except in cases described in paragraph (d)(3)(iv) of this section concerning written determinations, only the following are authority for purposes of determining whether there is substantial authority for the tax treatment of an item: applicable provisions of the Internal Revenue Code and other statutory provisions; proposed, temporary and final regulations construing such statutes; revenue rulings and revenue procedures; tax treaties and regulations thereunder, and Treasury Department and other official explanations of such treaties; court cases; congressional intent as reflected in committee reports, joint explanatory statements of managers included in conference committee reports, and floor statements made prior to enactment by one of a bill's managers; General Explanations of tax legislation prepared by the Joint Committee on Taxation (the Blue Book); private letter rulings and technical advice memoranda issued after October 31, 1976; actions on decisions and general counsel memoranda issued after March 12, 1981 (as well as general counsel memoranda published in pre-1955 volumes of the Cumulative Bulletin); Internal Revenue Service information or press releases; and notices, announcements and other administrative pronouncements published by the Service in the Internal Revenue Bulletin. Conclusions reached in treatises, legal periodicals, legal opinions or opinions rendered by tax professionals are not authority. The authorities underlying such expressions of opinion where applicable to the facts of a particular case, however, may give rise to substantial authority for the tax treatment of an item. Notwithstanding the preceding list of authorities, an authority does not continue to be an authority to the extent it is overruled or modified, implicitly or explicitly, by a body with the power to overrule or modify the earlier authority. In the case of court decisions, for example, a district court opinion on an issue is not an authority if overruled or reversed by the United States Court of Appeals for such district. However, a Tax Court opinion is not considered to be overruled or modified by a court of appeals to which a taxpayer does not have a right of appeal, unless the Tax Court adopts the holding of the court of appeals. Similarly, a private letter ruling is not authority if revoked or if inconsistent with a subsequent proposed regulation, revenue ruling or other administrative pronouncement published in the Internal Revenue Bulletin.
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I will say repeatedly that you need to focus on your 2008 factual and legal positions before your 2008 returns are filed in 2009 in order to minimize your risk of the draconian 6694 penalties for each position taken.

If you have any questions on any of the above or on any client issue, call 888 712-7690 or e-mail me at ab@irstaxattorney.com

6694(c)(2)(A) as amended

Emergency Economic Stabilization Act of 2008, as Amended and Passed by the Senate on October 1 (legislative day, September 17), 2008, signed by the President October 3, 2008, includes the following as it pertains to “unreasonable positions” under section 6694(a):


6694(a)(2)(C) TAX SHELTERS AND REPORTABLE TRANSACTIONS- If the position is with respect to a tax shelter (as defined in section 6662(d)(2)(C)(ii)) or a reportable transaction to which section 6662A applies, the position is described in this paragraph unless it is reasonable to believe that the position would more likely than not be sustained on its merits.


Section 6662A is described below. The 6662A penalty applies to the clients of tax return preparers. The $1,000/50% penalty will apply to 6662A transactions as expressly noted under section 6694(a)(2)(C). However, it could be argued that IRS published positions on “reportable transactions” should be known by all return preparers, and the failure to know of the reportable transaction could be viewed as “reckless” under section 6662(b) and therefore result in the $5,000 penalty.

It is also the responsibility of return preparers to be aware of “reportable transactions” to assist their clients in avoiding that penalty. There is no defense for not knowing about a reportable transaction. For that reason the “more than likely” language in 6694(a)(3)(C) is arguably an understatement of the conduct expected of return preparers.

The problem with "reportable transactions" is that there is a huge penalty for not reporting a "reportable transaction" under section 6111. Section 6111 is listed as follows:

DISCLOSURE OF REPORTABLE TRANSACTIONS



6111(a) IN GENERAL. --Each material advisor with respect to any reportable transaction shall make a return (in such form as the Secretary may prescribe) setting forth --



6111(a)(1) information identifying and describing the transaction,



6111(a)(2) information describing any potential tax benefits expected to result from the transaction, and



6111(a)(3) such other information as the Secretary may prescribe.



Such return shall be filed not later than the date specified by the Secretary.



6111(b) DEFINITIONS. --For purposes of this section --



6111(b)(1) MATERIAL ADVISOR. --



6111(b)(1)(A) IN GENERAL. --The term "material advisor" means any person --



6111(b)(1)(A)(i) who provides any material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, insuring, or carrying out any reportable transaction, and



6111(b)(1)(A)(ii) who directly or indirectly derives gross income in excess of the threshold amount (or such other amount as may be prescribed by the Secretary) for such aid, assistance, or advice.



6111(b)(1)(B) THRESHOLD AMOUNT. --For purposes of subparagraph (A), the threshold amount is --



6111(b)(1)(B)(i) $50,000 in the case of a reportable transaction substantially all of the tax benefits from which are provided to natural persons, and



6111(b)(1)(B)(ii) $250,000 in any other case.



6111(b)(2) REPORTABLE TRANSACTION. --The term "reportable transaction" has the meaning given to such term by section 6707A(c).



6111(c) REGULATIONS. --The Secretary may prescribe regulations which provide --



6111(c)(1) that only 1 person shall be required to meet the requirements of subsection (a) in cases in which 2 or more persons would otherwise be required to meet such requirements,



6111(c)(2) exemptions from the requirements of this section, and



6111(c)(3) such rules as may be necessary or appropriate to carry out the purposes of this section.




If you need assistance in identifying a “reportable transaction,” you can contact us at ab@irstaxattorney.com.

Attached below is also an example of a “reportable transaction”
and the 6662A statute:

6662A(a) IMPOSITION OF PENALTY. --If a taxpayer has a reportable transaction understatement for any taxable year, there shall be added to the tax an amount equal to 20 percent of the amount of such understatement.

6662A(b) REPORTABLE TRANSACTION UNDERSTATEMENT. --For purposes of this section --

6662A(b)(1) IN GENERAL. --The term "reportable transaction understatement" means the sum of --

6662A(b)(1)(A) the product of --
6662A(b)(1)(A)(i) the amount of the increase (if any) in taxable income which results from a difference between the proper tax treatment of an item to which this section applies and the taxpayer's treatment of such item (as shown on the taxpayer's return of tax), and

6662A(b)(1)(A)(ii) the highest rate of tax imposed by section 1 (section 11 in the case of a taxpayer which is a corporation), and

6662A(b)(1)(B) the amount of the decrease (if any) in the aggregate amount of credits determined under subtitle A which results from a difference between the taxpayer's treatment of an item to which this section applies (as shown on the taxpayer's return of tax) and the proper tax treatment of such item.

For purposes of subparagraph (A), any reduction of the excess of deductions allowed for the taxable year over gross income for such year, and any reduction in the amount of capital losses which would (without regard to section 1211) be allowed for such year, shall be treated as an increase in taxable income.

6662A(b)(2) ITEMS TO WHICH SECTION APPLIES. --This section shall apply to any item which is attributable to --

6662A(b)(2)(A) any listed transaction, and

6662A(b)(2)(B) any reportable transaction (other than a listed transaction) if a significant purpose of such transaction is the avoidance or evasion of Federal income tax.

6662A(c) HIGHER PENALTY FOR NONDISCLOSED LISTED AND OTHER AVOIDANCE TRANSACTIONS. --Subsection (a) shall be applied by substituting "30 percent" for "20 percent" with respect to the portion of any reportable transaction understatement with respect to which the requirement of section 6664(d)(2)(A) is not met.

6662A(d) DEFINITIONS OF REPORTABLE AND LISTED TRANSACTIONS. --For purposes of this section, the terms "reportable transaction" and "listed transaction" have the respective meanings given to such terms by section 6707A(c).

6662A(e) SPECIAL RULES. --

6662A(e)(1) COORDINATION WITH PENALTIES, ETC., ON OTHER UNDERSTATEMENTS. --In the case of an understatement (as defined in section 6662(d)(2)) --

6662A(e)(1)(A) the amount of such understatement (determined without regard to this paragraph) shall be increased by the aggregate amount of reportable transaction understatements for purposes of determining whether such understatement is a substantial understatement under section 6662(d)(1), and

6662A(e)(1)(B) the addition to tax under section 6662(a) shall apply only to the excess of the amount of the substantial understatement (if any) after the application of subparagraph (A) over the aggregate amount of reportable transaction understatements.
6662A(e)(2) COORDINATION WITH OTHER PENALTIES. --

6662A(e)(2)(A) COORDINATION WITH FRAUD PENALTY. --This section shall not apply to any portion of an understatement on which a penalty is imposed under section 6663.

6662A(e)(2)(B) COORDINATION WITH GROSS VALUATION MISSTATEMENT PENALTY. --This section shall not apply to any portion of an understatement on which a penalty is imposed under section 6662 if the rate of the penalty is determined under section 6662(h).

6662A(e)(3) SPECIAL RULE FOR AMENDED RETURNS. --Except as provided in regulations, in no event shall any tax treatment included with an amendment or supplement to a return of tax be taken into account in determining the amount of any reportable transaction understatement if the amendment or supplement is filed after the earlier of the date the taxpayer is first contacted by the Secretary regarding the examination of the return or such other date as is specified by the Secretary.

Notice 2007-72 , I.R.B. 2007-36, August 14, 2007, is an example of a reportable transaction, as follows:



The Internal Revenue Service and the Treasury Department are aware of a type of transaction, described below, in which a taxpayer directly or indirectly acquires certain rights in real property or in an entity that directly or indirectly holds real property, transfers the rights more than one year after the acquisition to an organization described in §170(c) of the Internal Revenue Code, and claims a charitable contribution deduction under §170 that is significantly higher than the amount that the taxpayer paid to acquire the rights. The IRS and the Treasury Department believe this transaction has the potential for tax avoidance or evasion, but lack sufficient information to determine whether the transaction should be identified specifically as a tax avoidance transaction. This notice identifies this transaction, and substantially similar transactions, as transactions of interest for purposes of §1.6011-4(b)(6) of the Income Tax Regulations and §§6111 and 6112. This notice also alerts persons involved with these transactions to certain responsibilities that may arise from their involvement with these transactions.



FACTS

In a typical transaction, Advisor owns all of the membership interests in a limited liability company (LLC) that directly or indirectly owns real property (other than a personal residence as defined in §1.170A-7(b)(3)) that may be subject to a long-term lease. Advisor and Taxpayer enter into an agreement under the terms of which Advisor continues to own the membership interests in LLC for a term of years (the Initial Member Interest), and Taxpayer purchases the successor member interest in LLC (the Successor Member Interest), which entitles Taxpayer to own all of the membership interests in LLC upon the expiration of the term of years. In some variations of this transaction, Taxpayer may hold the Successor Member Interest through another entity, such as a single member limited liability company. Further, the agreement may refer to the Successor Member Interest as a remainder interest.

After holding the Successor Member Interest for more than one year (in order to treat the interest as long-term capital gain property), Taxpayer transfers the Successor Member Interest to an organization described in §170(c) (Charity).

Taxpayer claims the value of the Successor Member Interest to be an amount that is significantly higher than Taxpayer's purchase price (for example, an amount that is a multiple of Taxpayer's purchase price and exceeds normal appreciation). Taxpayer claims a charitable contribution deduction under §170 based on this higher amount. Taxpayer reaches this value by taking into account an appraisal obtained by or on behalf of Advisor or Taxpayer of the fee interest in the underlying real property and the §7520 valuation tables.

The Internal Revenue Service and the Treasury Department are concerned about apparent irregularities in this transaction. Specifically, the IRS and the Treasury Department are concerned with the large discrepancy between (1) the amount Taxpayer paid for the Successor Member Interest, and (2) the amount claimed by Taxpayer as a charitable contribution. The IRS and the Treasury Department also have the following additional concerns, which may be present in some variations of this transaction: (1) any mischaracterization of the ownership interests in LLC; (2) a Charity's agreement not to transfer the Successor Member Interest for a period of time (which may coincide with the expiration of the applicable period in §6050L(a)(1)); and (3) any sale by Charity of the Successor Member Interest to a party selected by or related to Advisor or Taxpayer.



TRANSACTION OF INTEREST



Effective Date

Transactions that are the same as, or substantially similar to, the transactions described in this notice are identified as transactions of interest for purposes of §1.6011-4(b)(6) and §§6111 and 6112 effective August 14, 2007, the date this notice was released to the public. Persons entering into these transactions on or after November 2, 2006, must disclose the transaction as described in §1.6011-4. Material advisors who make a tax statement on or after November 2, 2006, with respect to transactions entered into on or after November 2, 2006, have disclosure and list maintenance obligations under §§6111 and 6112. See §1.6011-4(h) and §§301.6111-3(i) and 301.6112-1(g) of the Procedure and Administration Regulations.

Independent of their classification as transactions of interest, transactions that are the same as, or substantially similar to, the transaction described in this notice already may be subject to the requirements of §6011, 6111, or 6112, or the regulations thereunder. When the IRS and the Treasury Department have gathered enough information to make an informed decision as to whether this transaction is a tax avoidance type of transaction, the IRS and the Treasury Department may take one or more actions, including removing the transaction from the transactions of interest category in published guidance, designating the transaction as a listed transaction, or providing a new category of reportable transaction.



Participation

Under §1.6011-4(c)(3)(i)(E), Advisor, LLC or any entity used in place of LLC, Taxpayer, and any members of Taxpayer if Taxpayer is a flow-through entity, are participants in this transaction for each year in which their respective tax returns reflect tax consequences or the tax strategy described in this notice.

Charity is not a participant if it received the Successor Member Interest described in this notice on or prior to August 14, 2007. For Successor Member Interests received after August 14, 2007, under §1.6011-4(c)(3)(i)(E) Charity is a participant in this transaction for the first year for which Charity's tax return reflects the Successor Member Interest described in this notice. In general, Charity is required to report the receipt of the Successor Member Interest described in this notice on its return for the year in which it is received. See §6033. Therefore, in general, Charity will be a participant for the year in which Charity received the Successor Member Interest.



Time for Disclosure

See §1.6011-4(e) and §301.6111-3(e).



Material Advisor Threshold Amount

The threshold amounts are the same as those for listed transactions. See §301.6111-3(b)(3)(i)(B).



Penalties

Persons required to disclose these transactions under §1.6011-4 who fail to do so may be subject to the penalty under §6707A. Persons required to disclose these transactions under §6111 who fail to do so may be subject to the penalty under §6707(a). Persons required to maintain lists of advisees under §6112 who fail to do so (or who fail to provide such lists when requested by the Service) may be subject to the penalty under §6708(a). In addition, the Service may impose other penalties on persons involved in these transactions or substantially similar transactions, including the accuracy-related penalty under §6662 or 6662A.



DRAFTING INFORMATION

The principal authors of this notice are Patricia M. Zweibel of the Office of Associate Chief Counsel (Income Tax and Accounting) and Leslie H. Finlow of the Office of Associate Chief Counsel (Passthroughs and Special Industries). For further information concerning this notice generally, contact Ms. Zweibel at (202) 622-7900 (not a toll-free call). For further information concerning the sections of this notice under the heading TRANSACTIONS OF INTEREST, contact Ms. Finlow at (202) 622-3070 (not a toll-free call).


Notice 2008-20 , I.R.B. 2008-6, January 17, 2008.




Listed transactions: Intermediary transaction tax shelter: Components and participants. --
The IRS has identified the four components identifying an intermediary transaction tax shelter (ITTS), which is a listed transaction under Reg. §1.6011-4(b)(2).





SECTION 1. PURPOSE

Notice 2001-16, 2001-1 C.B. 730, identified the Intermediary Transaction Tax Shelter as a listed transaction under §1.6011-4(b)(2) of the Income Tax Regulations. Since that notice was published, the Internal Revenue Service (Service) has received disclosure statements with respect to Notice 2001-16 transactions pursuant to §1.6011-4 and other information pursuant to §§6111 and 6112 of the Internal Revenue Code and through promoter audits. After reviewing the disclosure statements and other information, the Service and Treasury Department have decided to identify the components of an Intermediary Transaction Tax Shelter. A transaction that does not have all of the components identified herein is not the same as or substantially similar to the listed transaction described in Notice 2001-16. The Service and Treasury Department also are identifying the persons who are treated as participants in an Intermediary Transaction Tax Shelter under §1.6011-4(c)(3)(i)(A). This notice should not otherwise be construed as limiting the scope or application of Notice 2001-16 and should not otherwise create any inference as to whether or not a transaction was required to be disclosed or registered under §6011 or §6111 prior to January 17, 2008.



SECTION 2. BACKGROUND

An Intermediary Transaction Tax Shelter attempts to avoid the corporate income tax from a sale of assets. Generally it involves transactions in which shareholders of a corporation dispose of their shares of stock of the corporation, one or more persons purchase the corporation's assets in one or more taxable transactions, and all or a portion of the gain or tax that would otherwise result to the corporation from a sale of the assets is avoided.



SECTION 3. DISCUSSION

.01 Components of an Intermediary Transaction Tax Shelter

An Intermediary Transaction Tax Shelter involves the use of an intermediary (M) (which can be one or more persons) in facilitating the transaction. However, the Service has received information and comments from taxpayers suggesting that identifying the transaction based on the role of an entity that appears to be an intermediary may result in over-disclosure or under-disclosure of the transaction depending on the circumstances of the transaction. To address these concerns, this notice identifies the four necessary components in an Intermediary Transaction Tax Shelter from the perspective of the target corporation, its shareholders, and the purchasers of the target corporation's assets.

1. A corporation (T) directly or indirectly (e.g., through a pass-through entity or a member of a consolidated group of which T is a member) owns assets the sale of which would result in taxable gain and, as of the time of the stock disposition described in component two, T (or the consolidated group of which T is a member) has insufficient tax benefits to eliminate or offset such taxable gain (or the tax) in whole or in part. The tax that would result from such sale is hereinafter referred to as T's Built-in Tax. In determining whether T's (or the consolidated group's) tax benefits are insufficient for purposes of the first sentence, the following tax benefits shall be excluded: (i) any tax benefits attributable to a listed transaction under §1.6011-4(b)(2), and (ii) any tax benefits attributable to built-in loss property acquired within 12 months before the stock disposition described in component two, to the extent such built-in losses exceed built-in gains in property acquired in the same transaction(s). All references to T in this notice include successors to T.

2. At least 50 percent of the T stock (by vote or value) is disposed of by T's shareholder(s) (X), other than in liquidation of T, in one or more related transactions within a 12 month period.

3. Either within 12 months before, simultaneously, or within 12 months after the date on whichhas disposed of at least 50 percent of the T stock (by vote or value) (excluding any time T is protected or hedged against price fluctuations), all or most of T's assets are disposed of (Sold T Assets) to one or more buyers (Y) in one or more transactions in which gain is recognized with respect to the Sold T Assets. Where a disposition of Sold T Assets is an intercompany transaction between members of a consolidated group, the disposition will not be a "transaction in which gain is recognized with respect to the Sold T Assets" for purposes of the preceding sentence until such gain must be taken into account under the rules of §1.1502-13.

4. All or most of T's Built-in Tax described in component one that would otherwise result from the disposition of the Sold T Assets described in component three is purportedly offset or avoided or not paid.

.02 Participation in the Listed Transaction

A transaction must have all four of the components identified herein to be the same as or substantially similar to the listed transaction identified in Notice 2001-16 as the Intermediary Transaction Tax Shelter. In determining whether a person is a participant in a transaction identified in Notice 2001-16, the general rule in §1.6011-4(c)(3)(i)(A) applies, except the following rules apply with respect to persons in the position ofor Y as described below:
 In no event will anybe treated as a participant under §1.6011-4(c)(3)(i)(A) if the only T stockdisposes of is traded on an established securities market (within the meaning of §1.453-3(d)(4)) and prior to the disposition(including related persons described in section 267(b) or 707(b)) did not hold five percent (or more) by vote or value of any class of T stock disposed of by X.

 In no event will any Y be treated as a participant under §1.6011-4(c)(3)(i)(A) if the only Sold T Assets acquired by Y are either (i) securities (as defined in section 475(c)(2)) that are traded on an established securities market (within the meaning of §1.453-3(d)(4)) and represent a less-than-five-percent interest in that class of security, or (ii) assets that are not securities and do not include a trade or business as described in §1.1060-1(b)(2).

.03 Disclosure, List Maintenance, and Registration Requirements; Penalties; Other Considerations

Independent of their classification as "listed transactions," transactions that are the same as, or substantially similar to, the transaction described in Notice 2001-16 may already be subject to the requirements of §6011, §6111, or §6112, or the regulations thereunder.

Persons involved with these transactions are alerted to certain responsibilities that may arise from their involvement with these transactions. Persons required to disclose these transactions under §1.6011-4 and who fail to do so may be subject to the penalty under §6707A. Persons required to disclose or register these transactions under §6111 who have failed to do so may be subject to the penalty under §6707(a). Persons required to maintain lists of investors under §6112 who fail to provide such lists when requested by the Service may be subject to the penalty under §6708(a). A person that is a tax-exempt entity within the meaning of §4965(c), or an entity manager within the meaning of §4965(d), may be subject to excise tax, disclosure, filing or payment obligations under §4965, §6033(a)(2), §6011, and §6071. Some taxable entities may be subject to disclosure obligations under §6011(g) that apply to "prohibited tax shelter transactions" as defined by §4965(e) (including listed transactions).

In addition, the Service may impose other penalties on persons involved in this transaction or substantially similar transactions (including an accuracy-related penalty under §6662 or 6662A) and, as applicable, on persons who participate in the promotion or reporting of this transaction or substantially similar transactions (including the return preparer penalty under §6694, the promoter penalty under §6700, and the aiding and abetting penalty under §6701).

Further, under §6501(c)(10), the period of limitations on assessment may be extended beyond the general three-year period of limitations for persons required to disclose transactions under §1.6011-4 who fail to do so. See Rev. Proc. 2005-26, 2005-1 C.B. 965.

The Service and the Treasury Department recognize that some taxpayers may have filed tax returns taking the position that they were entitled to the purported tax benefits of the types of transactions described in Notice 2001-16. These taxpayers should consult with a tax advisor to ensure that their transactions are disclosed properly and to take appropriate corrective action.



SECTION 4. EFFECTIVE DATE

This notice is effective as of January 17, 2008. This notice is applicable to returns and statements due under §6011 or §6111 after January 17, 2008.



SECTION 5. EFFECT ON OTHER DOCUMENTS

Notice 2001-16 is modified with respect to the types of persons who may be treated as participants in an Intermediary Transaction Tax Shelter under §1.6011-4(c)(3)(i)(A).

AICPA comment on Proposed 6694 Regulations

I have attached comment provided by the AICPA on the proposed regulations for your review. For today's blog, I will comment on their #11 below the AICPA draft.


AICPA Comments on Proposed Rules (REG-129243-07) Regarding Tax Return Preparer Penalties

August 19, 2008

Tax return preparer penalties : Proposed regulations : IRS hearing : AICPA comments



AICPA Comments on Proposed Rules (REG-129243-07) Regarding Tax Return Preparer Penalties



August 7, 2008

The Honorable Eric Solomon

Assistant Secretary (Tax Policy)

Department of the Treasury

1500 Pennsylvania Avenue, NW

Room 3120

Washington, DC 20220

The Honorable Douglas H. Shulman

Commissioner

Internal Revenue Service

1111 Constitution Avenue, N.W.

Washington, D.C. 20224

RE: Comments on Proposed Regulations, REG-129243-07, Regarding Tax Return Preparer Penalties

Dear Assistant Secretary Solomon and Commissioner Shulman:

Enclosed for your consideration are the American Institute of Certified Public Accountants' comments on the above-referenced proposed regulations. The comments were developed by the AICPA's Preparer Penalty Task Force and approved by the Tax Practice Responsibilities Committee and the Tax Executive Committee.

The AICPA wishes to thank the Treasury Department and the Internal Revenue Service for your prompt and thoughtful guidance addressing the challenges posed to taxpayers, tax practitioners, and our tax system by the May 2007 changes to the tax return preparer penalty provisions in the Internal Revenue Code. The transitional relief (Notice 2007-54) you provided within approximately two weeks of the date of enactment was critical for many practitioners, particularly those working on returns due a few weeks after the legislation was enacted.

Further, the notices issued on December 31, 2007 (Notices 2008-11, 2008-12, 2008-13) provided practical guidance that enabled the 2008 tax filing season to proceed without any serious disruption caused by the changes to the preparer penalty. Issuance of the proposed regulations in just over one year after the legislative changes, with the declared intent to issue final regulations by year end, also helped to further meaningful discussion of the potentially broader impact of the legislative changes on the preparer penalty regime.

We also thank you for working with the practitioner community while you developed the interim guidance and proposed regulations. In particular, we believe your efforts to understand the practical problems created by the statutory changes have contributed to guidance that generally strikes an appropriate balance between the obligations of those persons striving to comply with the tax laws and those responsible for administering these laws.

The AICPA is generally highly supportive of the proposed regulations. We offer a few recommendations not as criticisms but rather as suggestions to enhance the guidance available to the tax community and facilitate administration of the proposed regulations.

Included in our comments are recommendations that the final regulations:

Clarify when a tax return preparer is required to sign a return;

Define a "return" in a manner consistent with the definition of "return" for income tax purposes, as established by case law;

Clarify that, subject to the same limitations that apply in determining reasonable cause, a tax return preparer may rely on advice furnished by the taxpayer, an advisor, another tax return preparer, or other party in determining if the reasonable belief/more likely than not and the reasonable basis standards are satisfied;

Permit a tax return preparer to rely on a taxpayer's legal conclusions regarding Federal tax issues that the tax return preparer had reason to believe the taxpayer was competent to provide;

Permit a tax return preparer to rely on estimates, under rules similar to those contained in the AICPA Statements on Standards for Tax Services No. 4, Use of Estimates;

Permit a tax return preparer to rely on generally accepted administrative or industry practice not just with respect to establishing reasonable cause, but also with respect to determining if the reasonable belief/more likely than not standard is satisfied;

Permit the amount of an item or position relative to the amount of other items or positions on the return to be a factor considered in assessing the appropriate level of due diligence; and

Provide a transition rule for the effective date of the final regulations that will allow tax return preparers a reasonable opportunity to adapt to the changes between Notice 2008-13 and the final regulations.

The AICPA is the national professional organization of certified public accountants comprised of approximately 350,000 members. Our members advise clients on federal, state and international tax matters, and prepare income and other tax returns for millions of Americans. Our members provide services to individuals, not-for-profit organizations, small and medium-sized business, as well as America's largest businesses.

We would be pleased to discuss the attached comments with Treasury and the IRS at any time. If you have any questions, please feel free to contact me at (212) 773-2858 or jeffrey.hoops@ey.com; Alan Einhorn, Co-Chair of the Task Force, at (202) 879-4966 or aeinhorn@deloitte.com; Ed Swails, Co-Chair of the Task Force, at (202) 327-8721 or ed.swails@ey.com; or Jean Trompeter, AICPA Technical Manager, at (202) 434-9219 or jtrompeter@aicpa.org.

Sincerely,

Jeffrey R. Hoops

Chair, AICPA Tax Executive Committee

Enclosure

cc: Hon. Donald L. Korb, Chief Counsel, Internal Revenue Service Karen Gilbreath Sowell, Deputy Assistant Secretary (Tax Policy), Department of Treasury

Anita C. Soucy, Attorney-Advisor, Office of Tax Legislative Counsel, Department of Treasury, Deborah Butler, Associate Chief Counsel, Internal Revenue Service



AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

Comments on Proposed Regulations, REG-129243-07

Regarding Tax Return Preparer PenaltiesDeveloped by:

Preparer Penalty Task Force

Alan R. Einhorn, Co-Chair

J. Edward Swails, Co-Chair

Stephen R. Buschel

Conrad M. Davis

Walter B. Doggett III

Eve Elgin

John A. Galotto

Rochelle L. Hodes

James W. Sansone

Peter S. Wilson

Jean E. Trompeter, Technical Manager

Approved by:

Tax Practice Responsibilities Committee

Tax Executive Committee

Submitted to the Internal Revenue Service

August 7, 2008



AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

Comments on Proposed Regulations, REG-129243-07

Regarding Tax Return Preparer Penalties

General Comments

The American Institute of Certified Public Accountants wishes to thank the Treasury Department and the Internal Revenue Service for your prompt and thoughtful guidance addressing the challenges posed to taxpayers, tax practitioners, and our tax system by the May 2007 changes to the tax return preparer penalty provisions in the Internal Revenue Code. The transitional relief (Notice 2007-54) provided within approximately two weeks of the date of enactment was critical for many practitioners, particularly those working on returns due a few weeks after the legislation was enacted.

Further, the notices issued on December 31, 2007 (Notices 2008-11, 2008-12, 2008-13) provided practical guidance that enabled the 2008 tax filing season to proceed without any serious disruption caused by the changes to the preparer penalty. Issuance of the proposed regulations in just over one year after the legislative changes, with the declared intent to issue final regulations by year end, also helped to further meaningful discussion of the potentially broader impact of the legislative changes on the preparer penalty regime.

We also thank you for working with the practitioner community while you developed the interim guidance and proposed regulations. In particular, we believe your efforts to understand the practical problems created by the statutory changes have contributed to guidance that generally strikes an appropriate balance between the obligations of those persons striving to comply with the tax laws and those responsible for administering these laws.

Although we generally are highly supportive of the proposed regulations, we have concerns with some provisions and suggestions as to how the guidance may be clarified in certain areas. Our suggestions, categorized as policy recommendations and technical recommendations, are set forth below with our reasons for proposing the modifications. If you have any questions regarding these recommendations, we would be happy to discuss them with you.



Policy Recommendations



1. Prop. Reg. section 301.7701-15(b)(1): "Signing Tax Return Preparer"



A. Define in a Single Section

The term "signing tax return preparer" is described in multiple sections of the proposed regulations --section 301.7701-15(b)(1), section 1.6694-1(b)(2), section 1.6695-1(b)(1) and section 1.6695-1(b)(3). In addition, although the definition of the term "signing tax return preparer" is purported to be provided in section 301.7701-15(b)(1), in fact that section merely provides a cross-reference to section 1.6695-1(b) for the definition of signing tax return preparer. We recommend that the term "signing tax return preparer" be defined in section 301.7701-15(b)(1), rather than in section 1.6695-1(b). Other sections that rely on a definition of "signing tax return preparer" should cross reference to section 301.7701-15(b)(1).



B. Provide a Clear Definition

Although there are a number of sections in the proposed regulations that refer to "signing tax return preparer," none of them provides a clear definition of the term. For example:

Section 301.7701-15(b)(1) provides that a signing preparer is "any tax return preparer who signs or who is required to sign a return or claim for refund as a tax return preparer pursuant to section 1.6695-1(b)."

Section 1.6695-1(b)(1) merely states that a preparer must sign a return after it is completed and before it is provided to the taxpayer for signature. This section also provides rules for another signer if the preparer is unavailable at the time a signature is required.

Section 1.6695-1(b)(3) provides rules for deciding who is required to sign a return if there are multiple preparers associated with the return. That section provides in the case of multiple preparers, "the individual tax return preparer who has primary responsibility as between or among the tax return preparers for the overall substantive accuracy of the preparation of such return or claim for refund shall be considered to be the signing tax return preparer." This language provides a rule to determine who is required to sign when there are multiple preparers. However, it does not define the term "signing tax return preparer."

Section 1.6694-1(b)(2) states that the signing tax return preparer "will generally be considered the person who is primarily responsible for all of the positions on the return or claim for refund giving rise to an understatement." But this statement appears to be more of a presumption that the IRS will use to determine who is responsible for the understatement, rather than a definition of the term "signing tax return preparer."

Accordingly, we strongly recommend that Treasury and the IRS provide a clear and concise definition of the term "signing tax return preparer" that does not, in a circular manner, define the signing tax return preparer as the person who signs the return. Rather the definition should clarify who is required to sign a tax return.



C. Clarify When a Preparer Is Required To Sign a Return

The current regulations address two kinds of services provided by a section 7701 tax return preparer: (1) the situation where the preparer, or someone at the preparer's direction, actually completes the return, claim, or schedule ("preparation"); and (2) the situation where the preparer provides advice with respect to the determination of the existence, characterization, or amount of an entry on a return or claim for refund ("advice"). However, there is another type of service that is commonly performed by a section 7701 tax return preparer: (3) the situation where a taxpayer engages a preparer to review all or part of a tax return or claim for refund that has already been prepared by the taxpayer (including the taxpayer's employees or the general partner in the case of a partnership) or another preparer ("review").

The main difference between preparation and the other two situations is that in preparation, the preparer actually fills in the return, claim or schedule and determines the appropriate presentation of the information on the return, claim, or schedule. Even if the preparer uses computer software, professional judgment is required to determine the information to be collected from the taxpayer, necessary due diligence, how the taxpayer's information should be analyzed under the tax law, and the appropriate placement of the information on the return, claim, or schedule.

In contrast, individuals who provide advice or who review a return, claim, or schedule do so with respect to select items or particular transactions. In addition, individuals who provide advice or who review a return, claim or schedule generally do not take responsibility for placement or presentation on the return, claim, or schedule of the item or transaction on which they provided advice. With respect to both advice and review, the preparer will not generally fill in or complete a return, claim, or schedule.

While some tax advice may be provided before the preparation of the return, claim, or schedule has even begun, review of a tax return or claim occurs after it has been prepared (either by the taxpayer or by another preparer). As with any tax advice, the tax system benefits when a competent tax return preparer reviews the taxpayer's return or claim and advises the taxpayer about the proper tax treatment of an item or transaction.

As noted above, the proposed regulations do not clearly define the term "signing tax return preparer" and the rules are unclear regarding who is required to sign a return or claim for refund. However, the following premises are generally understood and should be the foundation for guidance in this area:

In the case of a single tax return preparer who collects the taxpayer's information and prepares or oversees preparation of the entire tax return (including all schedules), that individual is the preparer and should be required to sign the return. The current and proposed regulations provide that even if another preparer prepares a single schedule that is included in the overall return, the first preparer is required to sign the return because this is the individual with primary responsibility for the overall substantive accuracy of the preparation of the return.

A tax return preparer who provides oral or written tax advice and who takes primary responsibility for the overall substantive accuracy of the preparation of the return will be required to sign the return or claim for refund.

In our experience, there is significant confusion and uncertainty regarding whether a preparer who reviews a return or claim for refund is required to sign it. Compare PLR 7902033 (holding that the reviewing CPA is a nonsigning preparer) with Rev. Rul. 84-3, 1984-1 C.B. 264 (holding that the reviewing CPA is a signing preparer). 1 The lack of a definition of the term "signing tax return preparer," including who is required to sign a return, makes it very difficult for the preparer to determine how to comply with the law. Given the uncertainty regarding the issue, we recommend that the final regulations specifically address this point. It is incumbent on the government to clearly define who is required to sign a return or claim for refund.

We recommend the regulations provide that the determination of whether a preparer who reviews a tax return or claim for refund is required to sign the return or claim should be based on all of the facts and circumstances including the scope of services to be provided and the reviewer's relative responsibility for the overall substantive accuracy of the return in relation to the taxpayer or the other preparer who completed the return.

We further recommend that there be a presumption in the regulations that a preparer who reviews a return or claim for refund is not primarily responsible for the overall substantive accuracy of that return or claim, and therefore not required to sign it, unless:

there is a written agreement stating that the reviewer will sign the return or claim; or

facts and circumstances otherwise demonstrate that the reviewer has taken primary responsibility for the overall substantive accuracy of the preparation of the return or claim for refund.

Given the fact that reviewing a return is essentially the same as providing advice, a preparer who reviews a return should be regarded as the nonsigning preparer of those positions he or she in fact reviews, and the regulations should clearly state that conclusion. Any concerns regarding what some have referred to as the "shadow preparer" phenomenon are unfounded. First, taxpayers who engage a preparer to review a return will readily identify the preparer who reviewed the return. Second, even without signing the return, if an individual received compensation to review a substantial portion of the return or claim for refund, the individual will be a preparer subject to the penalty under section 6694.



2. Prop. Reg. section 1.6694-1(b)(3): Responsibility of Nonsigning Preparers

The preamble to the proposed regulations specifically requests comments on the approach taken in Prop. Reg. section 1.6694-1(b)(3). That provision generally provides that the individual nonsigning preparer within a firm with overall supervisory responsibility for the position(s) at issue is the preparer with respect to those positions for section 6694 purposes in the following circumstances: (1) there is no signing preparer in the firm; (2) there is a signing preparer, but the IRS concludes he or she is not primarily responsible for the position(s); or (3) "the IRS cannot conclude which individual (as between the signing tax return preparer and other persons within the firm) is primarily responsible for the position. . ."

We are concerned that the default situation described in (3) above (that is, imposing the penalty on the individual with overall supervisory responsibility, but not necessarily primary responsibility, for a position when the IRS cannot reach a conclusion as to who is primarily responsible) will lead to more harm than good and should not be adopted. We do not believe that a serious penalty, such as a section 6694 penalty, should be imposed on a person merely because the IRS is not able to reach a conclusion as to who is primarily responsible for the conduct giving rise to the penalty. For example, a section 6694 penalty not only may seriously compromise a professional's career, but also may result in a referral to the IRS Office of Professional Responsibility with the ensuing sanctions under Circular 230. In addition, such an approach would indirectly undercut the general rule that the signing preparer is responsible. That is, the default rule inevitably will tip towards penalizing the supervisory individual, as opposed to the signing preparer, assuming the signing preparer has some information indicating he or she was not primarily responsible. While we support the approach in the proposed regulations that the signing preparer should not always be the individual responsible for the penalty, we believe the default rule goes too far in the other direction by making it more likely that the individual with overall supervisory responsibility will be the individual who is penalized.

We appreciate the Service and Treasury were trying to balance fairness with administrability in arriving at the default rule. We do not believe, however, that the potential administrative hurdles are likely to be so high as to justify a default rule with so many negatives, particularly if preparer penalties are not to be imposed routinely, but only when clearly warranted. Accordingly, we recommend that the following phrase be stricken from Prop. Reg. section 1.6694-1(b)(3): "or the IRS cannot conclude which individual (as between the signing tax return preparer and other persons within the firm) is primarily responsible for the position."



3. Prop. Reg. section 1.6694-1(f)(4): No Preparer Liable for the Section 6694 Penalty

Prop. Reg. section 1.6694-1(f)(4), Example 3, describes a situation where there is an understatement, multiple practitioners involved, yet no one is liable for a section 6694 penalty (the tax advisor is not liable for a section 6694 penalty because the events had not occurred when the advice was given, and the signing preparer is not liable because he or she reasonably relied on the advice of the tax advisor). We agree with the example and the need to provide guidance that makes it clear that even if there is an understatement of tax, the section 6694 penalty may not apply. To reinforce this message within the IRS, we recommend that guidance to IRS personnel, including the Internal Revenue Manual, specifically set forth a statement consistent with Example 3 that there may be instances where there is an understatement of tax, and yet no section 6694 penalty may be asserted because no preparer is responsible for the position resulting in the understatement.



4. Prop. Reg. section 301.7701-15(b)(4): Definition of "Return"



A. Definition of "Return"

Section 301.7701-15(b)(4) of the proposed regulations defines a return as any return (including amended or adjusted return) reporting the taxpayer's tax liability. Also included in the definition of return is "any information return or other document identified in published guidance . . . that reports information that is or may be reported on another taxpayer's return under the Code if the information reported on the information return or other document constitutes a substantial portion of the taxpayer's return . . . "For the reasons described below, we believe the proposed regulations have exceeded the authority provided by Congress and should limit the definition of return to exclude documents that do not report a tax liability.



1. Consistency with Sections 7701 and 6696

Code section 7701(36) provides that a tax return preparer means "any person who prepares . . . any return of tax imposed by this title or any claim for refund of tax imposed by this title." (Emphasis added.) Section 6696(e)(1) provides that for purposes of section 6694, section 6695, and section 6695A, the term "return" means any return of any tax imposed by the Internal Revenue Code. These provisions of the Code are clear that not every document created and prescribed for use by the IRS is a return. Rather, only documents that are returns of tax imposed are treated as "returns" for purposes of the preparer penalties. In order to give this language meaning, Prop. Reg. section 301.7701-15(b)(4) should be revised so that only documents reporting a tax liability are treated as returns subject to preparer penalties.



2. Unaltered Definition of "Return"

Although the Small Business and Work Opportunity Act of 2007 generally extended the preparer penalty regime to apply not just to income tax, but to all types of tax, Congress did not amend the long-established definition of return for purposes of income taxes. Because Congress did not change the law in this area, longstanding and generally accepted rules relating to what is a return of income tax should continue to apply. The language in the proposed regulations defining a return, and the inclusion of many of the documents in the list of "returns" published in Notice 2008-11 and supplemented in Notice 2008-46, are contrary to established law regarding what is a return of income tax. The final regulations should limit the documents treated as a return to be consistent with IRS's authority under existing law.



3. Definition of "Return" as Developed in Case Law

The Supreme Court defined a return of income tax for purposes of the statute of limitations in the seminal case of Beard v. Commissioner, 82 T.C. 766, 777 (1984), affd. per curiam 793 F.2d 139 (6th Cir. 1986). That Court cited Badaracco v. Commissioner, 464 U.S. 386, 78 L. Ed. 2d 549, 104 S. Ct. 756 (1983) and its predecessors, including Germantown Trust Co. v. Commissioner, 309 U.S. 304, 84 L. Ed. 770, 60 S. Ct. 566, 1940-1 C.B. 178 (1940); Zellerbach Paper Co. v. Helvering, 293 U.S. 172, 79 L. Ed. 264, 55 S. Ct. 127, 1934-2 C.B. 341 (1934); Florsheim Bros. Drygoods Co. v. United States, 280 U.S. 453, 74 L. Ed. 542, 50 S. Ct. 215, 1930-1 C.B. 260 (1930), to establish a four-part test for what constitutes a return of income tax. Under this test, for a document to be treated as a return it must: (1) calculate tax liability, (2) purport to be a return, (3) represent an honest and reasonable attempt to satisfy the requirements of the tax law, and (4) be executed by the taxpayer under penalties of perjury. Beard v. Commissioner, supra at 777.

We recommend that the regulations adopt the four-part Beard test to define a return. With respect to income taxes, the law is clear that this is the test of a return. We urge that the Beard test also be adopted for all types of tax, with the recognition that there may need to be some flexibility regarding the jurat requirement (some non-income tax forms would need to be modified to include a jurat, or the jurat requirement would have to be waived for non-income tax forms that do not include a jurat). Regardless of whether the specific language in the Beard test is adopted, the language in the proposed regulations stating that any document identified by IRS as a return will be treated as a return must be modified to be consistent with the limitations set forth in case law.



4. IRS Published Guidance

IRS published guidance specifically excludes the Form W-2 from being a return covered by section 6694 and section 6695 before those provisions were amended to include non-income tax returns. 2 The government's rationale for now proposing to include a Form W-2 in the list of "returns" covered by these provisions is that the information on the form will be used to compute the income tax liability of the employee. As stated above, there has been no change to the definition of return for purposes of income taxes. Thus, a Form W-2 should be excluded from the definition of return under the final regulations.

Similarly, section 301.7701-15(c)(1)(ii) of the current regulations provides that certain forms that relate to income tax, such as estimated tax declarations (since eliminated, but comparable to the Form 2210 and Form 2220 today), extensions of time to file, Form 1099, or any similar form, are not treated as returns. Again, nothing in the 2007 Act changed the definition of return for purposes of income tax. Accordingly, these forms should also be excluded from the definition of return under the final regulations.



5. Treatment of Information Returns under OBRA'89

As part of the comprehensive penalty reform last undertaken in 1989, Congress structured the civil penalty regime to avoid stacking. Rules were created around different categories of penalties, including accuracy-related penalties such as section 6662 and section 6663, delinquency penalties such as section 6651, information return penalties such as those under section 6721 through section 6724, and preparer and promoter penalties such as those under section 6694, section 6695, section 6700, and section 6701. Each penalty was intended to address particular behavior.

If information returns are included in the category of returns covered by the preparer penalties, the penalty structure established by Congress in 1989 will have been altered. The amendments made by the Small Business and Work Opportunity Act of 2007 and its legislative history do not reflect an intent by Congress to alter the structure put in place in 1989. Therefore, information returns that are covered by separate information reporting penalties should not be included in the category of returns covered by section 6694 and section 6695. Accordingly, Form 1099 and similar returns should be excluded from the definition of return in the final regulations.



6. Form 5500

Similarly, we recommend that the Form 5500 be eliminated from the scope of the section 6694 preparer penalties regime. No taxes are paid with Form 5500, and information reported on Form 5500 generally is not used in preparing any tax return. If the Form 5500 is not eliminated, we suggest (1) that the IRS identify the specific line items on the Form 5500 to which the preparer penalties apply, and (2) that welfare plans, which are required to file a Form 5500 only by ERISA and not by the Internal Revenue Code, be completely exempt from section 6694.



B. Publication of the List of Returns

The preamble of the proposed regulations states that the list of returns subject to section 6694 and section 6695 will be published simultaneously with the final regulations. We believe that a list of the forms designated as returns is crucial to the preparer's understanding of when the preparer's conduct can be penalized. Accordingly, we believe that the list of returns should be published in a regulation subject to notice and comment. At a minimum, the list should first be published in proposed form to allow the public to provide comments. In addition, the list should provide sufficient lead time within a prospective effective date to permit preparers sufficient time to develop and implement processes and procedures to comply with the requirements of section 6107, section 6109, section 6694, and section 6695. Any additions to the list should have an effective date that does not impose new requirements in the middle of a filing season and should take into account fiscal-year returns.



5. Prop. Reg. section 1.6694-2(b): Definition of "Reasonable Belief"

The preamble to the proposed regulations states that a tax return preparer may meet the reasonable belief/more likely than not standard if "the tax return preparer relies on information or advice furnished by a taxpayer, advisor, another tax return preparer, or other party . . . as provided in proposed §1.6694-1(e)." 73 Fed. Reg. 34565 (June 17, 2008). (Emphasis added.) However, the definition of the reasonable belief standard in the text of the regulations omits the word "advice," and provides merely that a tax return preparer "may rely in good faith without verification upon information furnished by the taxpayer, advisor, other tax return preparer, or other party . . . as provided in §1.6694-1(e)." Prop. Reg. section 1.6694-2(b)(1). We believe that the omission of the word "advice" in the text of the proposed regulations was unintentional, and that the drafters' intent was to include reliance upon advice as a means to satisfy the reasonable belief standard, as stated in the preamble. As recognized in the preamble, the heightened standards imposed on tax return preparers and the increased complexity of the tax law "often requires signing and nonsigning tax return preparers to rely on the work of others in ensuring compliance." 73 Fed. Reg. 34564 (June 17, 2008). Indeed, tax return preparers routinely rely on the advice of other preparers and advisors in forming a belief as to the likelihood of a particular tax position being sustained on its merits, and this type of reliance is clearly relevant in assessing the reasonableness of a preparer's belief regarding the position. However, as the proposed regulation is currently drafted, the only way a tax return preparer can satisfy the reasonable belief standard is to personally engage in the analysis prescribed by Reg. section 1.6662-4(d)(3)(ii). While reliance on advice is specifically identified as a factor to be considered in the reasonable cause provision, see Prop. Reg. section 1.6694-2(d)(5), the availability of this defense does not cure the problem for diligent tax return preparers who wish to have clear rules of conduct they can comply with to avoid exposure to section 6694 liability in the first place.

In order to address the above concern, we recommend adding the word "advice" to the text of the reasonable belief definition, in the same manner that it appears in the preamble, or otherwise adding a reliance upon advice clause to the reasonable belief provision. We also recommend the following conforming changes to the regulations:

l In the reasonable belief provision (Prop. Reg. section 1.6694-2(b)), in order to establish the proper standards for advice that a tax return preparer may rely upon, insert either the text of, or a cross-reference to, the requirements for advice provided in the reasonable cause provision (e.g., the tax return preparer had reason to believe the advisor was competent to render the advice, the advice was not unreasonable on its face, etc.). See Prop. Reg. section 1.6694-2(d)(5).

If reliance on advice language is not added to section 1.6694-1(e) as recommended below, revise the text of the reasonable cause provision to ensure that the term "as provided in §1.6694-1(e)" modifies the word "information" and not "advice."



6. Prop. Reg. section 1.6694-2(c)(2): Definition of "Reasonable Basis"

For the same reasons that we recommended adding reliance on advice to the definition of reasonable belief (see above), we also recommend adding reliance on advice to the definition of reasonable basis. In determining "whether the tax return preparer has a reasonable basis for a position" as stated in the proposed regulations, see Prop. Reg. section 1.6694-2(c)(2), it is necessary, as it is in determining reasonable belief, to consider whether the tax return preparer reasonably relied upon advice from another advisor or party who was competent to provide the advice. To make this modification, the words "and advice" could be added to the second sentence of the provision, such that it reads "a tax return preparer may rely in good faith without verification upon information and advice furnished by the taxpayer, advisor, other tax return preparer or other party (including another advisor or tax return preparer at the tax return preparer's firm), as provided in §1.6694-1(e)."



7. Prop. Reg. section 1.6694-1(e)(1): Reliance on Advice

Consistent with the changes recommended above regarding the definitions of reasonable belief and reasonable basis, we recommend Prop. Reg. section 1.6694-1(e)(1) be amended to refer specifically to reliance on advice from others. We recommend adding the words "and advice" in the third sentence of the provision, such that it reads that a "tax return preparer may also rely in good faith and without verification upon information and advice provided by another advisor, another tax return preparer or other party (including another advisor or tax return preparer at the tax return preparer's firm)."



8. Prop. Reg. section 1.6694-1(e)(1): Reliance on Legal Conclusions

Prop Link Reg section 1.6694-1(e)(1) provides: "A tax return preparer, however, may not rely on information provided by a taxpayer with respect to legal conclusions on Federal tax issues." We are concerned that this sentence could be interpreted to change the longstanding interpretation of the verification provision in the section 6694 regulations that permits a tax return preparer to rely on information provided by the taxpayer that involves both law and fact. For example, preparers have long been permitted to rely on information from the taxpayer regarding information about basis, earnings and profits, depreciation, inventory, and similar items if the preparer does not have a reason to believe such information is inaccurate or incomplete.

In addition, many large entity taxpayers have in-house tax departments staffed by experienced tax professionals, including CPAs and attorneys who are qualified to perform the research and analysis necessary to address Federal tax issues. The provision in Prop. Reg. section 1.6694-1(e)(1) that states a preparer cannot rely on a client's legal conclusions on Federal tax issues could effectively require preparers to re-perform the research and analysis conducted by these in-house tax professionals.

To address these concerns, we recommend preparers be permitted to rely on research and analyses performed, and legal conclusions reached by taxpayers regarding Federal tax issues provided the preparer has reason to believe the taxpayer is competent to perform such services. To effect this recommendation, we suggest that the following language be inserted in Prop. Reg. section 1.6694-1(e):

A preparer may rely without verification on a taxpayer's legal conclusions regarding Federal tax issues that the tax return preparer had reason to believe the taxpayer was competent to provide.



9. Prop. Reg. section 1.6694-1(e)(1): Reliance on Estimates

The nature of accounting, upon which calculations of taxable income are based, requires the use of estimates. The use of estimates is specifically contemplated in the Treasury Regulations, for example Reg. sections 1.448-2(d), 1.451-1(a), and 1.451-5. The AICPA has established standards for the use of the taxpayer's estimates, in Statement on Standard for Tax Services ("SSTS") No. 4 , Use of Estimates, which permits reliance on estimates of the taxpayer if it is not practical to obtain the exact information and if the preparer determines that the estimates are reasonable based on facts and circumstances known to him or her at the time the return is prepared. A copy of SSTS No. 4 is attached as Appendix A to these comments.

In our previous comments, we recommended that the regulations addressing a preparer's reliance on taxpayer and third-party information address the use of estimates, with that reliance on estimates limited in a manner similar to SSTS No. 4. In view of the important role of estimates in tax compliance, we urge Treasury and IRS to reconsider this issue and to include a specific reference to the use of estimates in the final regulations.

Accordingly, we recommend that the following language be inserted in Prop. Reg. section 1.6694-1(e)(1) before the third sentence thereof (as originally proposed):

A preparer may rely on the taxpayer's estimates if (1) it is not practical to obtain the exact information, (2) the preparer determines that the estimates are reasonable based on facts and circumstances known to the preparer at the time the return is prepared, (3) the estimates are not presented in a manner that would imply greater accuracy than exists; and (4) the use of or reliance on estimates is not otherwise prohibited by the Code, the Treasury Regulations, or any Revenue Procedure, Revenue Ruling, or Notice published by the Internal Revenue Service.



10. Prop. Reg. sections 1.6694-2(b)(1) and (d)(6): Reliance on Generally Accepted Administrative or Industry Practice

We commend Treasury and the Service for recognizing the importance of generally accepted administrative and industry practice in the work of return preparers, and for including a provision in the proposed regulations that would permit return preparers to rely upon generally accepted administrative or industry practice in establishing reasonable cause relief from penalties. Prop. Reg. section 1.6694-2(d)(6). However, we believe that reliance on generally accepted administrative or industry practice also should be recognized as a relevant factor in determining whether the reasonable belief/more likely than not standard is satisfied. Clearly articulating relevant criteria on the front end (before a penalty is asserted) helps professionals in understanding their obligations and in complying with the tax laws, notwithstanding that relief ultimately may be available on the back end (through reasonable cause). Taking generally accepted administrative or industry practice into account up front also would further more consistent application of the penalty rules in that the role of this practice would not be fleshed out only on a case-by-case basis through individual reasonable cause determinations.

Certainly, based on public statements, Treasury and IRS believe that tax administration is best served by preventing a flood of disclosures that report positions consistent with generally accepted administrative or industry practice that are recognized by the government as sound. Preparers will more readily forgo disclosures in these situations if the regulations affirmatively state that the penalty will not apply in the first instance (such that reasonable belief/more likely than not is satisfied) if the position is consistent with generally accepted administrative or industry practice. Therefore, we urge the government to provide for reliance on generally accepted administrative or industry practice in both section 1.6694-2(b) with respect to reasonable belief and in section 1.6694-2(d)(6) with respect to reasonable cause. This change could be effectuated simply by adding a cross reference to Prop. Reg. section 1.6694-2(d)(6) in the definition of reasonable belief.

The AICPA would be happy to facilitate an ongoing dialog between Treasury and the IRS industry groups and AICPA members with specialized industry experience, to assist with the development of additional guidance in this area after the proposed regulations have been finalized.



11. Prop. Reg. section 1.6694-2(b)(1): Consideration of Item's Relative Size and Complexity in Establishing Reasonable Belief

Prop. Reg. section 1.6694-2(b)(1) provides that:

A tax return preparer may "reasonably believe that a position would more likely than not be sustained on its merits" if the tax return preparer analyzes the pertinent facts and authorities, and in reliance upon that analysis, reasonably concludes in good faith that the position has a greater than 50 percent likelihood of being sustained on its merits. . . Whether a tax return preparer meets this standard will be determined based upon all facts and circumstances, including the tax return preparer's diligence. In determining the level of diligence in a particular situation, the tax return preparer's experience with the area of Federal tax law and familiarity with the taxpayer's affairs, as well as the complexity of the issues and facts, will be taken into account.

Each tax return contains a multitude of positions. Some of these issues are extremely complex, although the impact of any particular issue on the taxpayer's overall tax liability could be relatively small. This is particularly true with respect to accounting methods where issues include revenue recognition, inventory, capitalization and depreciation, allocation of costs, and valuation.

There are economic constraints on any taxpayer's expenditures for tax return preparation. Signing tax return preparers operating within these constraints should not be expected to address every tax return position in the same manner, regardless of its relative size or complexity in relation to the taxpayer's overall return. Rather, tax administration is benefited if preparers devote a greater degree of scrutiny to those items having a greater impact on the taxpayer's overall tax liability.

Accordingly, we recommend that the proposed regulations expressly provide that the amount of an item or position relative to the amount of the other items or positions shown on the return is a factor to be considered in assessing the appropriate level of due diligence with respect that item or position. We recommend that the last sentence of Prop. Reg. section 1.6694-2(b)(1), quoted above, be revised to read:

Factors that will be taken into account in determining the level of diligence in a particular situation include the tax return preparer's experience with the area of Federal tax law and familiarity with the taxpayer's affairs, the complexity of the issues and facts, and the amount of the item or position relative to the amount of the other items or positions on the return.

In making this recommendation, we are not suggesting that the relative size of an item prevent the application of the section 6694 penalty in the case of smaller items, only that it be an express consideration in evaluating the sufficiency of the preparer's due diligence. A preparer of a return knowingly reporting a position that is unsupportable should be subject to the section 6694 penalty, regardless of the amount of the item in relation to the resulting understatement.



12. Prop. Reg. section 1.6694-2(b)(4): Effect of Conflict Between Circuits

In defining reasonable belief, Prop. Reg. section 1.6694-2(b)(4), Example 4, posits a situation involving a split of authority between federal circuits. However, this Example does not specifically address whether a preparer is bound by a decision of the federal Circuit Court of Appeals to which an appeal would lie in the event of such a conflict. We note that in applying the accuracy-related penalty for substantial understatements, Reg. section 1.6662-4(d)(3)(iv)(B) provides that "[t]he applicability of court cases to the taxpayer by reason of the taxpayer's residence in a particular jurisdiction is not taken into account in determining whether there is substantial authority for the tax treatment of an item. Notwithstanding the preceding sentence, there is substantial authority for the tax treatment of an item if the treatment is supported by controlling precedent of a United States Court of Appeals to which the taxpayer has a right of appeal with respect to the item."

We believe that the proposed regulations should adopt the same rule as Reg. section 1.6662-4(d)(3)(iv)(B), so that the application of the reasonable belief/more likely than not standard and the determination of when a position must be disclosed do not vary based upon the taxpayer's residence. This approach supports uniform disclosure by return preparers (and taxpayers) of similar positions across the country. In addition, incorporating the accuracy-related penalty principles regarding jurisdiction into the preparer penalty regulations will prevent conflicts between taxpayers and preparers in complying with the tax laws.



13. Prop. Reg. section 1.6694-3(c)(2): Definition of "Contrary to" a Regulation or Rule

Prop. Reg. section 1.6694-3(c)(2) addresses whether a preparer will be deemed to have acted recklessly or intentionally with respect to positions "contrary to" a regulation that are disclosed on Form 8275-R. Prop. Reg. section 1.6694-3(c)(2) further states that such a position must be a good faith challenge to the validity of a regulation. Neither Prop. Reg. section 1.6694-3(c)(2) nor Prop. Reg. section 1.6662-4(f) defines the term "contrary to" a regulation.

Because the regulations mandate the filing of the Form 8275-R, as opposed to Form 8275, to satisfy the adequate disclosure obligations of the taxpayer and the tax return preparer in certain situations, we recommend that the instructions to Form 8275-R be expanded to explain when the Form 8275-R must be used by taxpayers and preparers. This will help ensure that positions "contrary to" a regulation are appropriately identified, while avoiding situations where the Form 8275 is filed but the Form 8275-R should have been used.

Similarly, we recommend that the IRS also clarify in the instructions to Form 8275 when a position is considered to be "contrary to" a rule (i.e., a statute, revenue ruling or notice) to assist taxpayers and preparers in determining whether disclosure of a position on a Form 8275 is necessary to avoid a disregard-of-a-rule penalty.



14. Prop. Reg. section 1.6694-3(c)(3): Standard for Positions Contrary to Revenue Rulings or Notices

The proposed regulations tighten the provision in the current regulations for positions contrary to revenue rulings or notices (other than notices of proposed rulemaking) to provide that a preparer is not considered to have recklessly or intentionally disregarded a revenue ruling or notice if the preparer reasonably believes the position satisfies the more likely than not standard. Prop. Reg. section 1.6694-3(c)(3). In such a case, a preparer would not have to disclose the position to avoid violating section 6694(b), even if the preparer knew or was reckless in not knowing that the position was contrary to a revenue ruling or notice. Under current regulations, a preparer is not considered to have disregarded a revenue ruling or notice if the position satisfies the realistic possibility standard. Thus, the proposed change would increase the situations in which a preparer must disclose a position contrary to a revenue ruling or notice to avoid a section 6694(b) penalty. The proposed change also would create a standard for preparers in this context that would be stricter than the standard for taxpayers. Under the current regulations, a taxpayer is not considered to have recklessly or intentionally disregarded a revenue ruling or notice if a position (other than with respect to a reportable transaction) is contrary to the ruling or notice, as long as the position satisfies the realistic possibility standard. See Reg. section 1.6662-3(b)(2).

The original carve-outs from the sections 6662 and 6694 "disregard penalties" for positions contrary to revenue rulings or notices were made because revenue rulings and notices typically receive less rigorous internal review before publication and less weight by courts than regulations. Requiring disclosure of all positions contrary to revenue rulings or notices to avoid a disregard penalty also could pose a trap for the unwary and burden the government with too many disclosures of routine return positions or positions potentially covered by outdated guidance.

We continue to believe that the original balance struck in the existing regulations makes sense from the standpoint of the government, as well as the taxpayer and practitioner communities, although we appreciate the more recent focus on reportable transactions. Accordingly, we recommend that the carve-out for preparers in the case of positions contrary to revenue rulings or notices be revised to conform to the standard for taxpayers. Under this approach, a preparer (like a taxpayer) would not be considered to have intentionally or recklessly disregarded a revenue ruling or notice if the contrary position did not involve a reportable transaction and satisfied the realistic possibility standard. This approach also would conform the preparer standard to the taxpayer standard in this context and avoid problems associated with a discontinuity in taxpayer and preparer standards. Finally, this approach would reduce the circumstances in which a preparer may inadvertently be subject to a section 6694(b) penalty (with the heightened prospect of referral to OPR).



15. Effective Date

The proposed regulations indicate that the final regulations will be applicable to returns and claims for refund filed, and advice provided, after the date that final regulations are published in the Federal Register. This would result in a mid-year revision to the standards for tax return preparers, and does not allow return preparers the opportunity to review the final regulations, train their employees, and revise forms and practice aids to promote compliance before they become effective.

We recognize that the proposed regulations, and ultimately the final regulations, are more comprehensive than the interim guidance and address issues that were not addressed in Notice 2008-13. It is appropriate that the final regulations become effective as soon as possible to provide preparers with guidance in these areas. To allow preparers a reasonable opportunity to adapt to any changes between Notice 2008-13 and the final regulations, we recommend that Treasury adopt a transition rule providing that a preparer who complies with the requirements of Notice 2008-13 for any return filed or any advice given within the 60 days following publication of the final regulations will be deemed to have satisfied his or her obligations under the final regulations.



Technical Recommendations



16. Prop. Reg. section 1.6107-1(b)(1): Record Retention by Signing Preparers

Link Internal Revenue Code section 6107 requires that tax return preparers furnish copies of returns to the taxpayer, retain copies of returns for a period of three years, and make these copies of returns available upon the request of the Secretary.

Proposed Reg. section 1.6107-1(c) appears to provide that, if a signing preparer is employed by, or a partner in, a corporation or partnership, the organization will be treated as the signing preparer for purposes of the section 6107 requirements. While we agree with this approach, some of the wording of Prop. Reg. section 1.6107-1(c) is confusing. We recommend that Proposed Reg. section 1.6107-1(c)(1) and (2) be replaced by the following language:

(c) Tax return preparer. For the definition of "signing tax return preparer," see section 7701(a)(36) and 301.7701-15(b)(1) of this chapter. For purposes of applying this section, a corporation, partnership or other organization that employs a signing tax return preparer to prepare for compensation (or in which a signing tax return preparer is compensated as a partner or member to prepare) a return of tax or claim for refund shall be treated as the sole signing preparer.



17. Prop. Reg. section 1.6694-1(b)(1) and Sec. 301.7701-15(b)(3): "Tax Return Preparer"

Prop. Reg. section 1.6694-1(b)(1) references Code section 7701(a)(36) and Prop. Reg. sec. 301.7701-15 for the definition of a "tax return preparer" and notes that a person is a tax return preparer subject to section 6694 "if the individual is primarily responsible for the position(s) on the return or claim for refund giving rise to an understatement." It would be helpful if there were a cross-reference in this section to the language in Sec. 301.7701-15(b)(3) which states: "A person who renders tax advice on a position that is directly relevant to the determination of the existence, characterization, or amount of an entry on a return or claim for refund will be regarded as having prepared that entry."



18. Prop. Reg. section 1.6694-1(b)(2): Responsibility of Signing Tax Return Preparer

Prop. Reg. section 1.6694-1(b)(2) states that: "The signing tax return preparer within the meaning of §301.7701-15(b)(1) of this chapter will generally be considered the person who is primarily responsible for all of the positions on the return or claim for refund giving rise to the understatement." We believe, based upon the context in which this provision appears, that the intent of this provision was to describe the responsibility of the signing tax return preparer relative to other preparers within the signing preparer's firm.

Accordingly, we recommend that the language quoted above be clarified by inserting the phrase "within a firm" after "will generally be considered the person," so that the provision reads: "The signing tax return preparer within the meaning of §301.7701-15(b)(1) of this chapter will generally be considered the person within the firm who is primarily responsible for all of the positions on the return or claim for refund giving rise to the understatement."



19. Prop. Reg. section 1.6694-2(c)(3)(i): Adequate Disclosure by Signing Preparers



A. Prop. Reg. section 1.6694-2(c)(3)(i)(C)

Prop. Reg. section 1.6694-2(c)(3)(i) describes the means by which a signing preparer satisfies the obligation to make adequate disclosure with respect to a position for which the preparer does not have a reasonable belief that the position is more likely than not correct. Prop. Reg. section 1.6694-2(c)(3)(i)(A) states unconditionally that disclosure is adequate if a position is disclosed on the Form 8275 or Form 8275-R, as appropriate, or in accordance with the annual revenue procedure (actual disclosure). Prop. Reg. section 1.6694-2(c)(3)(i)(B) states that if a position does not have substantial authority but has a reasonable basis, a signing preparer may satisfy adequate disclosure by providing the taxpayer with a return that includes the disclosure in accordance with Reg. section 1.6662-4(f). Under this rule, disclosure is adequate even if the taxpayer removes the Form 8275 or Form 8275-R from the return before it is filed. Prop. Reg. section 1.6694-2(c)(3)(i)(C) states that in cases where the position has substantial authority, the only way to satisfy adequate disclosure is to advise the taxpayer of the penalty standards applicable to the taxpayer under section 6662 and document this advice in the file.

Reading these sections together, it becomes apparent that one variation of what should be treated as adequate disclosure is not covered. If a position has substantial authority and a preparer delivers to the taxpayer a return with an appropriately completed Form 8275 or Form 8275-R attached, but the taxpayer removes the Form 8275 or Form 8275-R prior to filing the return, the preparer also should be viewed as having satisfied the adequate disclosure requirements.

To remedy this, we recommend that Prop. Reg. section 1.6694-2(c)(3)(i)(C) be revised to read as follows:

(C) For income tax returns, if the position would otherwise meet the standard for nondisclosure under section 6662(d)(2)(B)(i) (substantial authority), either the tax return preparer provides the taxpayer with the prepared tax return that includes the disclosure in accordance with §1.6662-4(f), or the preparer advises the taxpayer of all the penalty standards applicable to the taxpayer under section 6662. The tax return preparer must also contemporaneously document any advice in the tax return preparer's files.



B. Prop. Reg. section 1.6694-2(c)(3)(i)(D)

Prop. Reg. section 1.6694-2(c)(3)(i)(D) requires that the preparer advise the taxpayer that "disclosure will not protect the taxpayer from assessment of an accuracy-related penalty if either section 6662(d)(2)(C) or 6662A applies to the position." We recommend adding after the word "disclosure" the words "in accordance with Reg. section 1.6662-4(f)," since appropriate Form 8886 disclosure is relevant both in determining the penalty rate under section 6662A(c) and in the availability of a reasonable cause defense to the section 6662A penalty under section 6664(d).



20. Prop. Reg. section 1.6694-2(c)(3)(ii): Adequate Disclosure by Nonsigning Preparers



A. Prop. Reg. section 1.6694-2(c)(3)(ii)(A): Adequate Disclosure - Advice to Taxpayer

In Prop. Reg. section 1.6694-2(c)(3)(ii)(A) with respect to a nonsigning preparer's advice to a taxpayer, if the firm is advising the taxpayer, the contemporaneous documentation should confirm that the affected taxpayer has been advised by a preparer in the firm of the potential penalties and the opportunity to avoid penalty through disclosure.



B. Prop. Reg. section 1.6694-2(c)(3)(ii)(B): Adequate Disclosure - Advice to Another Tax Return Preparer

In Prop. Reg. section 1.6694-2(c)(3)(ii)(B) with respect to a nonsigning preparer's advice to another tax return preparer, if providing nonsigning preparer advice to another preparer in the same firm, contemporaneous documentation should be satisfied if there is a single instance of contemporaneous documentation within the firm.

If the firm is advising another preparer outside of the firm, this documentation should confirm that the preparer outside the firm has been advised that disclosure under section 6694(a) may be required.



21. Prop. Reg. section 1.6694-3(c)(2): Cross-references

Prop. Reg. section 1.6694-3(c)(2) provides that a preparer is not considered to have recklessly or intentionally disregarded a rule or regulation if the position contrary to the rule or regulation has a reasonable basis and is disclosed in accordance with Prop. Reg. section 1.6694-2(c)(3) - except that disclosure in accordance with an annual revenue procedure would not be adequate for purposes of section 6694(b). (In the case of a position contrary to a regulation, the position also must represent a good faith challenge to the validity of the regulation and the regulation must be identified.)

We believe that the cross-reference to Prop. Reg. section 1.6694-2(c)(3) in Prop. Reg. section 1.6694-3(c)(2) is confusing and either should be revised or replaced with a separate set of disclosure rules for purposes of section 6694(b) along the lines of the current regulations. See Reg. section 1.6694-3(c)(3). At a minimum, the cross-reference should be altered to make clear that the advice a nonsigning preparer gives to another preparer to avoid a section 6694(b) penalty is that disclosure may be necessary in order for the other preparer to avoid a section 6694(b) (instead of a section 6694(a)) penalty. See Prop. Reg. section 1.6694-2(c)(3)(ii)(B), which is caught by the cross-reference.

The cross-reference is confusing, because the disclosure rules in Prop. Reg. sections 1.6694-2(c)(3)(i)-(iii) specifically address situations in which the relevant return position has a reasonable basis, but does not satisfy the reasonable belief/more likely than not standard. Putting aside the carve-out for positions contrary to revenue rulings or notices, the section 6694(b) penalty potentially applies, however, regardless of whether the reasonable belief/more likely than not standard is met.

Moreover, in the case of signing preparers under Prop. Reg. section 1.6694-2(c)(3)(i), the cross-reference should be to Prop. Reg. section 1.6694-2(c)(3)(i)(A) and, if the proposed change addressing positions contrary to revenue rulings or notices is adopted, to Prop. Reg. section 1.6694-2(c)(3)(i)(E) as well. The provisions in Prop. Reg. sections 1.6694-2(c)(3)(i)(B)-(D) are irrelevant for purposes of the disregard penalty. A cross-reference to Prop. Reg. section 1.6694-2(c)(3)(i)(A) is necessary to encompass disclosure on a Form 8275-R. The cross-reference to Prop. Reg. section 1.6694-2(c)(3)(i)(E) would be necessary to address the situation in which the preparer may be subject to a section 6694(b) penalty, but the taxpayer is not otherwise subjected to a penalty. As explained previously, this would happen under the proposed change if a position contrary to a revenue ruling or notice not involving a reportable transaction satisfied the realistic possibility, but not the reasonable belief/more likely than not, standard.



22. Prop. Reg. section 1.6694-3(d), Example 3: Example - Section 6694(b) Penalty

Clarification is needed regarding the facts in Example 3, at Prop. Reg. section 1.6694-3(d). The facts should be further refined to make it clear that (1) there are no cases that ruled favorably with respect to the validity of that portion of the regulations, (2) that no other facts would justify a reasonable belief that it is more likely than not that the regulations are valid (e.g., explicit legislative history) and (3) that the U.S. Tax Court case was decided and published before the tax return preparer prepared the return (this could be done by stating the date on which the return was prepared and the year of the case).



23. Prop. Reg. section 1.6694-3(f): Offsetting Section 6694(a) and Section 6694(b) Penalties

Prop. Reg. section 1.6694-3(f) offsets the amount of any section 6694(a) penalty against the amount of any section 6694(b) penalty "for the same return or claim for refund." Given that the penalty is assessed and is effectively calculated on a position-by-position basis, any offset should also be addressed on a position-by-position basis.



24. Prop. Reg. section 1.6695-1(f)(2)(ii): Deposit of Refund Checks in the Taxpayer's Account

Prop. Reg. section 1.6695-1(f)(1) prohibits a tax return preparer from endorsing or negotiating a refund check relating to a return for which he or she is a preparer. Many tax return preparers also perform bookkeeping services for the same taxpayers for whom they prepare returns. These bookkeeping services sometimes include arranging for deposits into a taxpayer's account.

The proposed regulation should be clarified to specifically state that a preparer is not prohibited from affixing the taxpayer's name on a refund check (typically accomplished via a mechanical stamp) for the purpose of depositing the check into an account in the name of the taxpayer. For some preparers, it is very common to provide general assistance with general business matters of the client and depositing the refund check into the taxpayer's account may be required as part of this assistance. We believe that this activity would not constitute endorsement or negotiation of a check, but a clarification in the regulations would be helpful to avoid potential confusion among those not familiar with these issues.

Accordingly, we suggest that the regulation be clarified by adding the following language at the end of Prop. Reg. section 1.6695-1(f)(1):

A tax return preparer will not be considered to have endorsed or otherwise negotiated a check for purposes of this paragraph (f)(1) solely as a result of having affixed the taxpayer's name to a refund check for the purpose of depositing the check into an account in the name of the taxpayer or in the joint names of the taxpayer and one or more other persons (excluding the tax return preparer).



Conclusion

As we stated in our opening comments, we greatly appreciate the efforts and approach taken by Treasury and the IRS in providing timely guidance on the revised return preparer penalty provisions. Both the interim guidance and the proposed regulations reasonably balance the interests of taxpayers, tax practitioners, and the government in complying with and administering the new provisions. We offer our recommendations not as criticisms of the proposed regulations, but rather as suggestions to enhance the guidance available to the tax community and facilitate administration of the new provisions. We would be happy to discuss these recommendations or any other aspects of the proposed regulations with you at any time.



Appendix A



AICPA Statement on Standards for Tax Services No. 4, Use of Estimates



Introduction

1. This Statement sets forth the applicable standards for members when using the taxpayer's estimates in the preparation of a tax return. A member may advise on estimates used in the preparation of a tax return, but the taxpayer has the responsibility to provide the estimated data. Appraisals or valuations are not considered estimates for purposes of this Statement.



Statement

2. Unless prohibited by statute or by rule, a member may use the taxpayer's estimates in the preparation of a tax return if it is not practical to obtain exact data and if the member determines that the estimates are reasonable based on the facts and circumstances known to the member. If the taxpayer's estimates are used, they should be presented in a manner that does not imply greater accuracy than exists.



Explanation

3. Accounting requires the exercise of professional judgment and, in many instances, the use of approximations based on judgment. The application of such accounting judgments, as long as not in conflict with methods set forth by a taxing authority, is acceptable. These judgments are not estimates within the purview of this Statement. For example, a federal income tax regulation provides that if all other conditions for accrual are met, the exact amount of income or expense need not be known or ascertained at year end if the amount can be determined with reasonable accuracy.

4. When the taxpayer's records do not accurately reflect information related to small expenditures, accuracy in recording some data may be difficult to achieve. Therefore, the use of estimates by a taxpayer in determining the amount to be deducted for such items may be appropriate.

5. When records are missing or precise information about a transaction is not available at the time the return must be filed, a member may prepare a tax return using a taxpayer's estimates of the missing data.

6. Estimated amounts should not be presented in a manner that provides a misleading impression about the degree of factual accuracy.

7. Specific disclosure that an estimate is used for an item in the return is not generally required; however, such disclosure should be made in unusual circumstances where nondisclosure might mislead the taxing authority regarding the degree of accuracy of the return as a whole. Some examples of unusual circumstances include the following:

a. A taxpayer has died or is ill at the time the return must be filed.

b. A taxpayer has not received a Schedule K-1 for a pass-through entity at the time the tax return is to be filed.

c. There is litigation pending (for example, a bankruptcy proceeding) that bears on the return.

d. Fire or computer failure has destroyed the relevant records.


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11. Prop. Reg. section 1.6694-2(b)(1): Consideration of Item's Relative Size and Complexity in Establishing Reasonable Belief

Prop. Reg. section 1.6694-2(b)(1) provides that:

A tax return preparer may "reasonably believe that a position would more likely than not be sustained on its merits" if the tax return preparer analyzes the pertinent facts and authorities, and in reliance upon that analysis, reasonably concludes in good faith that the position has a greater than 50 percent likelihood of being sustained on its merits. . . Whether a tax return preparer meets this standard will be determined based upon all facts and circumstances, including the tax return preparer's diligence. In determining the level of diligence in a particular situation, the tax return preparer's experience with the area of Federal tax law and familiarity with the taxpayer's affairs, as well as the complexity of the issues and facts, will be taken into account.

Each tax return contains a multitude of positions. Some of these issues are extremely complex, although the impact of any particular issue on the taxpayer's overall tax liability could be relatively small. This is particularly true with respect to accounting methods where issues include revenue recognition, inventory, capitalization and depreciation, allocation of costs, and valuation.

There are economic constraints on any taxpayer's expenditures for tax return preparation. Signing tax return preparers operating within these constraints should not be expected to address every tax return position in the same manner, regardless of its relative size or complexity in relation to the taxpayer's overall return. Rather, tax administration is benefited if preparers devote a greater degree of scrutiny to those items having a greater impact on the taxpayer's overall tax liability.

Accordingly, we recommend that the proposed regulations expressly provide that the amount of an item or position relative to the amount of the other items or positions shown on the return is a factor to be considered in assessing the appropriate level of due diligence with respect that item or position. We recommend that the last sentence of Prop. Reg. section 1.6694-2(b)(1), quoted above, be revised to read:

Factors that will be taken into account in determining the level of diligence in a particular situation include the tax return preparer's experience with the area of Federal tax law and familiarity with the taxpayer's affairs, the complexity of the issues and facts, and the amount of the item or position relative to the amount of the other items or positions on the return.

In making this recommendation, we are not suggesting that the relative size of an item prevent the application of the section 6694 penalty in the case of smaller items, only that it be an express consideration in evaluating the sufficiency of the preparer's due diligence. A preparer of a return knowingly reporting a position that is unsupportable should be subject to the section 6694 penalty, regardless of the amount of the item in relation to the resulting understatement.

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COMMENT FOR THIS BLOG

The emphasis on "analyzing the pertinent facts and authorities" is mine as well as ghe other emphasis. It is my experience with return preparers, including CPAs, is that a large percent do not subscribe to a tax research service that would give them the research needed to support the positions taken. Even if they have that research capability, the same large percent do not have the analytical skill to support the position taken with the relevant "authorities." Even if they have access to the tax research and have the necessary analytical skill to discearn the relevant authorities, the same large percent do not have the writing skill when those positions are disclosed to the IRS. And for positions not disclosed, I would also venture to say that the same large percent do not keep the technical records in the client file. Therefore, it both surprises me and disappoints me that the only comment made by the AICPA on this most important part of the regulations is that they want these standards to be based on the complexity of the issues in determining the amount of "due dilligence" needed to apply to a position taken.

It is obvious to me that the AICPA misses the entire importance of 1.6694-2(b)(1) and the reference to "dilligence." The AICPA assumes that all CPAs have the skill set and capability to fully support the position taken with the necessary analysis of the relevant authorities. The AICPA assumption of the technical capabilities of all CPAs is wrong! To make the matter worse, the AICPA focuses on the term "diligence" as the key term in that regulation. Wrong again! The term "diligence" is merely one element of all of the facts and circumstances that the IRS will take into account.

The AICPA leadership misreads the regulation and misapplies the regulation. The facts and circumstances obviously take complexity into account because complexity is a "fact and circumstance" in addition to their failure to understand the reference to "diligence."

Unfortunatly for the CPA world and other tax return preparers, the AICPA has not alerted the industry to the technical requirements of this important regulation. In addition the AICPA does not understand the aggressiveness of IRS examiners who will lust after the very large 6694 penalties. It is as if the AICPA is "in denial" that the standards for "analysis" and "authorities" in section 1.6662-4(d)(3) do not exist! If you disagree with my criticism, post it in a reply to this blog or contact me at ab@irstaxattorney.com.

Do not rely on the "reasonable basis" standard

6694(a)(2)(B), as recently amended, provides that the penalty under 6694(a)(1)(B), as amended, ($1,000 or 50% of the income derived) will not apply to positions properly disclosed to the IRS.

Section 1.6694-2(c)(2) of the regulations defines “reasonable basis” as the standard for disclosed positions and provides: “For purposes of this section, “reasonable basis” has the same meaning as in §1.6662-3(b)(3) or any successor provision of the accuracy-related penalty regulations. For purposes of determining whether the tax return preparer has a reasonable basis for a position, a tax return preparer may rely in good faith without verification upon information furnished by the taxpayer, advisor, other tax return preparer, or other party (including another advisor or tax return preparer at the tax return preparer’s firm), as provided in §1.6694-1(e).

§1.6662-3(b)(3) of the regulations defines Reasonable basis.

--Reasonable basis is a relatively high standard of tax reporting, that is, significantly higher than not frivolous or not patently improper. The reasonable basis standard is not satisfied by a return position that is merely arguable or that is merely a colorable claim. If a return position is reasonably based on one or more of the authorities set forth in §1.6662-4(d)(3)(iii) (taking into account the relevance and persuasiveness of the authorities, and subsequent developments), the return position will generally satisfy the reasonable basis standard even though it may not satisfy the substantial authority standard as defined in §1.6662-4(d)(2). (See §1.6662-4(d)(3)(ii) for rules with respect to relevance, persuasiveness, subsequent developments, and use of a well-reasoned construction of an applicable statutory provision for purposes of the substantial understatement penalty.) In addition, the reasonable cause and good faith exception in §1.6664-4 may provide relief from the penalty for negligence or disregard of rules or regulations, even if a return position does not satisfy the reasonable basis standard.

The 6694 regulations are based on 6662(d)(2)(B) law that the negligence penalty will be reduced when the relevant facts affecting the item's tax treatment are adequately disclosed in the return or in a statement attached to the return, and there is a reasonable basis for the tax treatment of the item by the taxpayer. Note also:

Section 301.7430-5(c) (1) providing the general rule that the position of the Internal Revenue Service is substantially justified if it has a reasonable basis in both fact and law. A significant factor in determining whether the position of the Internal Revenue Service is substantially justified as of a given date is whether, on or before that date, the taxpayer has presented all relevant information under the taxpayer's control and relevant legal arguments supporting the taxpayer's position to the appropriate Internal Revenue Service personnel.

Under the authority of §301.7430-5(c) (1), “reasonable basis” is a position that is substantially justified in both fact and law. Curiously, this regulation places “reasonable basis” relatively close to “substantial authority.” I find it impossible to find a difference between “substantial justification” for a position and “substantial authority” for a position. In addition "reasonable basis" is a subjective term and can mean anything to any IRS examiner. The fact is that the return prepares have as much risk with a disclosed position as an undisclosed position because the term "reasonable basis" is entirely subjective, and if the IRS references "substantial justification" then I see no difference with that term and the "substantial authority" standard for undisclosed positions.

You also have to take into account the incompetence and aggressiveness of IRS examiners. I had an office conference yesterday representing a client who got caught up in a tax shelter promoted by a CPA who has been indicted for tax fraud by the DOJ. My client was a compliant taxpayer who, with others, got sucked into a bad tax shelter. Her underpayment of tax triggered the 6662 20% statutory penalty. The examiner never heard of "reasonable cause" and would not allow it because her reviewer will never accept it. She only had two years of experience and she brought in a new IRS examiner to observe her. He has been with the IRS for only 29 days. He is around 40 years old and has had a career in sales. Understand that you have to take into account the low level of knowledge of the IRS examiners and their lack of training and tendancy to be aggressive.

Notwithstanding the difficulties with the ambiguity in the "reasonable basis" standard for disclosed position, it would be foolish to not take advantage of the stipulation in the regulations that it is lower than the substantial authority standard. If you need to deal with the IRS, go for the disclosed "reasonable basis" standard.

All disclosed postions should be accompanied by a legal memorandum to discuss the facts and the law and even argue the benefits of the lower threshold for the reasonable basis standard.

The calls to my office and e-mails to me indicate that there is still a great deal of confusion on how to deal with the complex factual and legal issues and how to support a disclosure that meets the "reasonable basis" standard." My advice is that "more authority" and analysis is better than less authority and analysis. My solution to the subjective nature of the reasonable basis standard is to assume that I need to meet the highest level of analysis and authority in order to reduce the possibility of an examination and the penalty.

Let me know if you have any questions on any of the above. ab@irstaxattorney.com or 703 425-1400.

Be prepared for $5,000 6694 penalties

6694(b)(1) IN GENERAL . --Any tax return preparer who prepares any return or claim for refund with respect to which any part of an understatement of liability is due to a conduct described in paragraph (2) shall pay a penalty with respect to each such return or claim in an amount equal to the greater of --

6694(b)(1)(A) $5,000, or

6694(b)(1)(B) 50 percent of the income derived (or to be derived) by the tax return preparer with respect to the return or claim.

6694(b)(2)(B) a reckless or intentional disregard of rules or regulations.

To emphacize the point, 6694(b)(2)(B) will impose the $5,000/50% penalty if a return preparer is merely "reckless." But the term "reckless" is defined by statute as "negligence."


6662(c) NEGLIGENCE. --For purposes of this section, the term "negligence" includes any failure to make a reasonable attempt to comply with the provisions of this title, and the term "disregard" includes any careless, reckless, or intentional disregard.

§1.6662-3(b) Definitions and rules

(1) Negligence. --The term "negligence" includes any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws or to exercise ordinary and reasonable care in the preparation of a tax return. "Negligence" also includes any failure by the taxpayer to keep adequate books and records or to substantiate items properly. A return position that has a reasonable basis as defined in paragraph (b)(3) of this section is not attributable to negligence. Negligence is strongly indicated where --

(i) A taxpayer fails to include on an income tax return an amount of income shown on an information return, as defined in section 6724(d)(1);

(ii) A taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction, credit or exclusion on a return which would seem to a reasonable and prudent person to be "too good to be true" under the circumstances.


(2) Disregard of rules or regulations. --The term "disregard" includes any careless, reckless or intentional disregard of rules or regulations. The term "rules or regulations" includes the provisions of the Internal Revenue Code, temporary or final Treasury regulations issued under the Code, and revenue rulings or notices (other than notices of proposed rulemaking) issued by the Internal Revenue Service and published in the Internal Revenue Bulletin. A disregard of rules or regulations is "careless" if the taxpayer does not exercise reasonable diligence to determine the correctness of a return position that is contrary to the rule or regulation. A disregard is "reckless" if the taxpayer makes little or no effort to determine whether a rule or regulation exists, under circumstances which demonstrate a substantial deviation from the standard of conduct that a reasonable person would observe.


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The above language comes only from the Internal Revenue Code and tax regulations. The language quoted is not ambiguous. After May 25, 2007, all return preparers will be jubject to the $5,000/50% penalty if:

1. The position taken is contrary to a "rule or regulation" if a reasonable person would have known or that rule or regulation and relevant IRS notices or rulings. Following the Internal Revenue Code includes, for example, section 6001 record and substantiation regulations. There is little doubt that the failure to comply with the §1.6662-3(b)(1)substantiation mandate can be viewed as "reckless" within the meaning of section 6694(b)
2. A return preparer has not researched the position taken in the tax return and the position is onctrary to any IRS notice.
3. A return preparer misapplies a rule or regulation. "Substantial deviation" is a term that means that the position taken was wrong.
4. §1.6662-3(b)is the provision of the regulations which also defines "reasonable basis." If you play that out to its logical conclusion, 6694(b) can be defined to be equal to 6694(a) wihich provides the "reasonable basis" standard for disclosed positions from extrapolations from the word "reckless."

I have identified a large loophole for IRS examiners to equate 6694(a) with 6694(b), a result that would be clearly contrary to Congressional intent. For this reason, the final 6694 regulations should find a way to limit the definition of "reckless" to something stronger than the definition under section 6662(c).

T

6694(c) appealing the penalty

The IRS has the absolute right to assess as 6694(a)or(b) penalty in their total discretion on every position taken in every tax return. There does not have to be an IRS warning. There is no appeal to a Manager. And you do not have the normal appeal rights to the IRS Office of Appeals. Read the remedy below under 6694(c). The only appeal right is to pay the 15% and then file a claim for a refund. With an aggressive IRS, one has to assume that they will go for the $5,000 6694(b) penalty and assess the $5,000 (or the higher of 50% of the fee) for multiple "positons" taken in the return.

This is a hold-over from pre-5/25/2007 law when the penalty was only $250 and the 15% was not a big deal.

This appeal procedure means you have to be out-of-pocket even when the penalty is capricious and arbitrary. I have already been called by return preparers when the penalty is being assessed capriciously WITHOUT EXPLANATION! And that is under the pre-Small Business Act law. As the expression goes: "Let the games begin!" The assessment of the penalty is presumed to be correct. Will you be prepared to deal with the penalty with an "analysis" of the relevant "authorities" to negate the penalty?

The claim for refund is a simple procedure but it should be accompanied by a technical memorandum on the facts and on the law for each penalty.

Although not mentioned in the statute or proposed regulations, you can also request abatement of the penalties by asserting "no liability" on Form 656 (the offer in compromise form dealing with "no liability"). I believe you can also file a request for audit reconsideration. Indeed, you should or could use all of these appeal procedures because there are parts of the IRS that are "black holes" (they often claim they did not receive it or they do not react). Remember we are dealing with a large organization with employees who are not necessarily well trained or well educated. And they tend to sit on requests that they do not understand. They get paid regardless of the quality or lack of quality of what they do. Always send important applications to the IRS in any manner that you can prove that the claim was filed.

The "reasonable cause" exception only applies to 6694(a) penalties and not to 6694(b) penalties. It appears that the only way to can argue "reasonable cause" would be after the penalty is assessed or if the penalty is discussed with you prior to the assessment of the penalty.

The proposed regulations can resolve this issue by writing a rule that the penalty cannot be assessed without first giving the return preparer the opportunity to argue "reasonable cause." Under present rules, one can only argue "reasonable cause" during the 15% refund procedure.

I have been dealing with the 6677 penalty which also has a "reasonable cause" exception. But the IRS is famous for not allowing the "reasonable cause" before the penalty is assessed.







6694(c) EXTENSION OF PERIOD OF COLLECTION, WHERE PREPARER PAYS 15 PERCENT OF PENALTY. --

6694(c)(1) IN GENERAL . --If, within 30 days after the day on which notice and demand of any penalty under subsection (a) or (b) is made against any person who is an income tax return preparer, such person pays an amount which is not less than 15 percent of the amount of such penalty and files a claim for refund of the amount so paid, no levy or proceeding in court for the collection of the remainder of such penalty shall be made, begun, or prosecuted until the final resolution of a proceeding begun as provided in paragraph (2). Notwithstanding the provisions of section 7421(a), the beginning of such proceeding or levy during the time such prohibition is in force may be enjoined by a proceeding in the proper court. Nothing in this paragraph shall be construed to prohibit any counterclaim for the remainder of such penalty in a proceeding begun as provided in paragraph (2).

6694(c)(1) IN GENERAL . --If, within 30 days after the day on which notice and demand of any penalty under subsection (a) or (b) is made against any person who is a tax return preparer, such person pays an amount which is not less than 15 percent of the amount of such penalty and files a claim for refund of the amount so paid, no levy or proceeding in court for the collection of the remainder of such penalty shall be made, begun, or prosecuted until the final resolution of a proceeding begun as provided in paragraph (2). Notwithstanding the provisions of section 7421(a), the beginning of such proceeding or levy during the time such prohibition is in force may be enjoined by a proceeding in the proper court. Nothing in this paragraph shall be construed to prohibit any counterclaim for the remainder of such penalty in a proceeding begun as provided in paragraph (2).
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Everyone should be prepared for the IRS penalties for the tax returns filed for the 2008 tax year. Now is the time to prepare for the possibility that penalties will be assessed after the 2008 tax returns are filed. For any questions on positions taken or to be taken for the 2008 tax year, contact ab@irstaxattorney.com

Economic Stabilization Act of 2008 (P.L. 110-343)

The amendment to section 6694(a) revised the definition of "unreasonable position" and modified the standards for imposition of the tax return preparer penalty.

THE BACKGROUND

The Small Business and Work Opportunity Tax Act of 2007 (P.L. 110-28) expanded the scope of return preparer penalties to include all tax return preparers for returns prepared after May 25, 2007 (Code Sec. 6694). The phrase "tax return preparer" covers preparers of not only income tax returns but also estate and gift tax, employment tax, excise tax, and exempt organization returns.

Under the Small Business Tax Act an "unreasonable position" penalty applies to tax return preparers if the preparer knew (or reasonably should have known) of the position, did not have a reasonable belief that the position would more likely than not be sustained on its merits, and either did not disclose the position as provided in Code Sec. 6662(d)(2)(B)(ii) or did not have a reasonable basis for the position. The more likely than not standard adopted by the Small Business Tax Act replaced the previous realistic possibility standard.

Interim guidance concerning application of the more likely than not standard was subsequently provided (Notice 2008-13, IRB 2008-3, 282). The interim guidance explains that a tax return preparer may rely in good faith without verification upon information furnished by the taxpayer, as well as information furnished by another advisor, tax return preparer or other third party. Thus, a tax return preparer is not required to independently verify or review the items reported on tax returns, schedules or other third party documents to determine if the items meet the standard, but the preparer may not ignore the implications of information furnished to or actually known to the preparer. The tax return preparer must make reasonable inquiries if the information furnished by another tax return preparer or a third party appears to be incorrect or incomplete.

For disclosed positions, Code Sec. 6694(a) requires that there be a reasonable basis for the tax treatment of the position. One way to disclose a position is to use Form 8275, Disclosure Statement, which is attached to the taxpayer's return. The interim guidance also permits a tax return preparer to advise the taxpayer of the difference between the penalty standards applicable to the taxpayer and the penalty standards applicable to the preparer along with contemporaneously documenting that the advice was provided (Notice 2008-13, IRB 2008-3, 282).

Proposed regulations were subsequently issued addressing the return preparer penalty standards, and providing that a tax return preparer may reasonably believe that a position would more likely than not be sustained on its merits if, after analyzing the pertinent facts and authorities and, in reliance upon that analysis, the tax return preparer reasonably concludes in good faith that the position has a greater than 50-percent likelihood of being sustained on its merits (Prop. Reg. §1.6694-2(b)(1), NPRM REG-129243-07).

The amount of the return preparer penalty for the understatement of a tax liability is the greater of $1,000 or 50 percent of the income derived (or to be derived) by the preparer with respect to the return or refund claim (Code Sec. 6694(a)(1)). The return preparer penalty for an understatement of a tax liability due to willful or reckless conduct is the greater of $5,000 or 50 percent of the income derived (or to be derived) by the preparer with respect to the return or refund claim (Code Sec. 6694(b)(1)).

NEW LAW EXPLAINED

Penalty on understatement of taxpayer's liability by tax return preparer modified. --

For tax returns prepared after May 25, 2007, the definition of "unreasonable position" is revised, and the standards for imposition of the tax return preparer penalty are modified. The definition of unreasonable position is divided into three categories --a general category, a disclosed positions category, and a tax shelters and reportable transactions category --each with its own standard to determine whether such position is an unreasonable position (Code Sec. 6694(a)(2), as amended by the Emergency Economic Stabilization Act of 2008 (P.L. 110-343)).


"Substantial authority" is the nondisclosure standard retroactive to May 26, 2007 replacing the requirement that a preparer was required to have a reasonable belief that a tax position would "more likely than not"(MLTN) be sustained on its merits if challenged by the IRS. Substantial authority for a tax position is analogous to the exception to the accuracy-related penalty for taxpayers under Code Sec. 6662.

Division C, Act Sec. 506 of the Emergency Economic Stabilization Act of 2008 (P.L. 110-343) requires that the MLTN remain applicable in determining the tax preparer penalty to a reportable transaction under Code Sec. 6662A, or if a significant purpose of an entity, plan or arrangement is the avoidance of income tax described as a tax shelter in Code Sec. 6662(d)(2)(C)(ii).Tax return preparers need to evaluate tax positions for "significant purpose" potential. This is a very subsjective standard that may be a trap for the unwary tax return preparer. Obviously, all transactions that appear to are motivated by tax savings should be examined as "tax shelters." Tax reduction is not "tax avoidance" but it may appear to be "tax avoidance."

For undisclosed positions, which fall into the general category, the penalty applies unless there is or was substantial authority for the position (Code Sec. 6694(a)(2)(A), as amended by the Emergency Economic Act of 2008).

Sec. 6694(a)(3), as amended, retains the good faith reasonable cause exception to imposition of the penalty. A preparer is not considered to have relied in good faith if: (i) the advice is unreasonable on its face; (ii) the preparer knew or should have known that the third party advisor was not aware of all relevant facts; or (iii) the preparer knew or should have known (given the nature of the tax return preparer's practice), at the time the tax return or claim for refund was prepared, that the advice was no longer reliable due to developments in the law since the time the advice was given (Proposed Reg. §1.6694-2(d)(5)).

The reasonable cause exception to the Code Sec. 6694(a)penalty requires a review of all applicable facts and circumstances with reference to the nature of the error, the frequency and materiality of the errors, the preparer's normal office practice, reliance on another preparer's advice, and reliance on generally accepted administrative or industry practice. The most relevant Code Sec. 6694(a) penalty issue remains the reasonableness of the preparers belief in the reported position, not the likelihood it will prevail.

It is almost difficult to to distinguish between "more likely than not" and "substantial authority" when facing an aggressive IRS examiner. For that reason it is my opinion that the lobbying efforts of the ABA, the ABA, and other professional organizations was mostly a waste of time and effort. The lobbying effor should have been focused on the draconian lare size of the penalties. Without question, IRS examiners and IRS software will raise 6694(a) and (b) penalty issues whenever there is an underpayment of tax that triggers the negligence penalty under section 6662. Amended 6694(a)conforms the tax return preparer penalty standard for positions falling within the general category to the Code Sec. 6662(d)(2)(B)(i) taxpayer standard for imposition of the accuracy-related penalty (Joint Committee on Taxation, Technical Explanation of H.R. 7060, the "Renewable Energy and Job Creation Tax Act of 2008" (JCX-75-08)). By reducing the standard from more likely than not to substantial authority, and conforming the tax return preparer standard to the taxpayer standard, not much has been accomplished because the Final Regulations are expected to retain the most critical requirements for tax return preparers: the need to provide an "analysis" of the relevant tax "authorities" to negate penalties for either disclosed on nondisclosed positions. In short, the 6694 regulations require tax return preparers to be experts on the tax law and provide technical support for "unreasonable positions" which are negated by "substantial authority" for undisclosed positions and "reasonable basis" for disclosed positions. I find it quite strange that the return preparation industry is slow to realize the high standards preseantly required to support any complex factual or legal tax issue.

Although the preparer does not have to examine or verify supporting information, they should make sure that the support data meets the substantiation requirements of the tax regulations.

As a tax attorney, I document controversial positions with a legal memorandum. Disclosed positions are best supported with a legal memorandum to support the positions taken in order to prevent the return from being selected for examination and also to negate a possible section 6662 negligence penalty for your client.

Retained positions equire documentation of any tax related research (including authorities both for and against the tax position), the reasoning behind the conclusion, and relevant authorities supporting the conclusion. Reality check: return prepared can only avoid the 6694(a)and (b) penalties with an analysis of the relevant authorities when the nondisclosed positions are examined by the IRS. The section 6694(b) penalty will apply if the return preparer is perceived as "reckless" - the same term used in section 6662(c). I have little doubt that aggressive IRS examiners will term any lack of knowledge of a technical position as "reckless" where the issues are clearly covered by tax regulations (e.g., substantiation requirements), revenue rulings, IRS notices, reportable transactions, applicable case law and other authority that should have been known by the tax return preparer.

-- Division C, Act Sec. 506(a) of the Emergency Economic Stabilization Act of 2008 (P.L. 110-343), amending Code Sec. 6694(a);



-- Division C, Act Sec. 506(b), providing the effective date.

"substantial authority" and state law

George S. Mauerman v. Commissioner , TC Memo. 1993-23, 65 TCM 1772, Filed January 19, 1993


In its discussion of a "substantial authorit" issue, this case made the following comment relative to state law:

Although State law creates legal interests and rights, the Federal revenue acts designate how the interests or rights so created shall be taxed. United States v. Mitchell [71-1 USTC ¶9451 ], 403 U.S. 190, 197 (1971), and cases there cited. Once rights are obtained under State law, whatever they are called, these rights are subject to the Federal definition of taxability. Helvering v. Stuart [42-2 USTC ¶9750 ], 317 U.S. 154, 162 (1942). If an interest or right created by State law is intended by the Congress to be taxed, then the Federal law prevails no matter what name is given to the interest or right by State law. Morgan v. Commissioner [40-1 USTC ¶9210 ], 309 U.S. 78, 81 (1940).

In interpreting the words used in a Federal revenue act, State law is not controlling unless the Federal statute "by express language or necessary implication, makes its own operation dependent upon state law." Heiner v. Mellon, 304 U.S. 271, 279 (1938); Burnet v. Harmel [2 USTC ¶710 ], 287 U.S. 103, 110 (1932). -----------------------------


The above cited case involved a "substantial authority" issue in which state law was examined. The above language outlines how or when state law is used. For example, the issue of whether or not there has been a "fraudulent transfer" (an issue that could trigger a 6694 penalty), depends on an analysis of state law.

The Temporary regulations do not describe state law in its guidance on an "analysis" of the relevant "authorities." I believe that is a correctable omission in the Temporary Regulations. As another example, the existance or validity of a trust depends on state law and there are tax conseqences that depend on whether or not there is a valid trust.

This is simply a "heads up" that there are many tax issues that require one to be able to apply state law. The requirment that an undisclosed position be supported by an analysis of the relevant authority necessarily includes state law in some cases.

Given the complexity of applying state law, the Final Regulations could create a safe harbor for state law issues. On the other hand, the complexity of the law would be a "reasonable cause" consideration.

The substantial authority standard of conduct

Tax return preparers bear the burden of proving substantial authority. Norgaard v. Commissioner, 939 F.2d 874, 877-78 (9th Cir. 1999);Custom Chrome, Inc. v. Commissioner, 217 F.3d 1117, 1127-28 (9th Cir. 2000). Substantial authority for tax treatment exists "only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment." Reg. §1.6662-4(d)(3)(i). Pertinent authorities for a substantial authority analysis include the Internal Revenue Code, other statutory provisions, regulations, revenue rulings, and court decisions, but not opinions rendered by tax professionals. Treas. Reg. §1.6662- 4(d)(3)(iii).

That is your standard of conduct for undisclosed positions. There has to be more authority and better quality authority than an opposing position. Frankly, guys & gals, I see not difference from the "substantial authority" standard than the more likely than not standard.

Reg. §1.6662-4(d)(2) states that substantial authority is an "objective standard involving an analysis of the law and application of the law to relevant facts."
That statement, although in the regulations is incorrect. Can anyone reading this blog tell me how "substantial authority" is objective? I think the final 6694 regulations should eliminate this SUBJECTIVE guidance. This regulation is wrong based on all elements of semantics. I do not think it would help if the final regulations conclude that the standard is met if the return preparer is 40% correct. It is still a subjective standard and the 40% or some other percent is meaningless.

Although you have this "victory" in eliminating the more likely than not standaqrd, it was a waste of time by the AICPA, the ABA and the NAEA associations. The court cases that I have read on the application of "substantial authority" have not attempted to quantify this standard based on any objective measures. I find the new standard at a high level of technical authority. It means that return prepares are required to :

1. Have the ability to do tax research and be on top of current changes in all of the tax law.
2. Be competent to "analyze" tax law, including the case law.
3. Be competent to select relevant "authority" to support the position taken, as selected from all of the applicable tax law.
4. You have to have technical writing skills.
5. Any it means that you have to have been paid sufficiently to put the time needed into this technical research, analysis and writing.

You do not understand your vulnerability to $1,000 or $5,000 penalties or the higher of 50% of your fees, unless you realize that the IRS is holding you to the standards of an experienced tax attorney.

I believe that you have little choice but to make full disclosures of the complex factual and legal issues to the IRS to take avantage of the "reasonable basis" standard and also attach a written support memorandum from a competent tax attorney. The "reasonable basis" standard is still subjective, but the points 1 - 5 above are still applicable. You need to suppy more technical support than required by the "reasonable basis" standard to minimize the risk of an audit examination. You need to educate your clients now that the complex positions will have to be disclosed.

Comment on any of these blogs can be sent to ab@irstaxattorney.com

The "substantial authority" standard

Now that the "more likely than not" standard has been legislated out of existance under section 6694(a), tax return preparers can avoid or abate a section 6694(a) penalty based on "substantial authority." The following regulation is relevant to define that term>


Reg. §1.6662-4(d)(3):

(3) Determination of whether substantial authority is present


(i) Evaluation of authorities. --There is substantial authority for the tax treatment of an item only if the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment. All authorities relevant to the tax treatment of an item, including the authorities contrary to the treatment, are taken into account in determining whether substantial authority exists. The weight of authorities is determined in light of the pertinent facts and circumstances in the manner prescribed by paragraph (d)(3)(ii) of this section. There may be substantial authority for more than one position with respect to the same item. Because the substantial authority standard is an objective standard, the taxpayer's belief that there is substantial authority for the tax treatment of an item is not relevant in determining whether there is substantial authority for that treatment.

(ii) Nature of analysis. --The weight accorded an authority depends on its relevance and persuasiveness, and the type of document providing the authority. For example, a case or revenue ruling having some facts in common with the tax treatment at issue is not particularly relevant if the authority is materially distinguishable on its facts, or is otherwise inapplicable to the tax treatment at issue. An authority that merely states a conclusion ordinarily is less persuasive than one that reaches its conclusion by cogently relating the applicable law to pertinent facts. The weight of an authority from which information has been deleted, such as a private letter ruling, is diminished to the extent that the deleted information may have affected the authority's conclusions. The types of document also must be considered. For example, a revenue ruling is accorded greater weight than a private letter ruling addressing the same issue. An older private letter ruling, technical advice memorandum, general counsel memorandum or action on decision generally must be accorded less weight than a more recent one. Any document described in the preceding sentence that is more than 10 years old generally is accorded very little weight. However, the persuasiveness and relevance of a document, viewed in light of subsequent developments, should be taken into account along with the age of the document. There may be substantial authority for the tax treatment of an item despite the absence of certain types of authority. Thus, a taxpayer may have substantial authority for a position that is supported only by a well-reasoned construction of the applicable statutory provision.

(iii) Types of authority. --Except in cases described in paragraph (d)(3)(iv) of this section concerning written determinations, only the following are authority for purposes of determining whether there is substantial authority for the tax treatment of an item: applicable provisions of the Internal Revenue Code and other statutory provisions; proposed, temporary and final regulations construing such statutes; revenue rulings and revenue procedures; tax treaties and regulations thereunder, and Treasury Department and other official explanations of such treaties; court cases; congressional intent as reflected in committee reports, joint explanatory statements of managers included in conference committee reports, and floor statements made prior to enactment by one of a bill's managers; General Explanations of tax legislation prepared by the Joint Committee on Taxation (the Blue Book); private letter rulings and technical advice memoranda issued after October 31, 1976; actions on decisions and general counsel memoranda issued after March 12, 1981 (as well as general counsel memoranda published in pre-1955 volumes of the Cumulative Bulletin); Internal Revenue Service information or press releases; and notices, announcements and other administrative pronouncements published by the Service in the Internal Revenue Bulletin. Conclusions reached in treatises, legal periodicals, legal opinions or opinions rendered by tax professionals are not authority. The authorities underlying such expressions of opinion where applicable to the facts of a particular case, however, may give rise to substantial authority for the tax treatment of an item. Notwithstanding the preceding list of authorities, an authority does not continue to be an authority to the extent it is overruled or modified, implicitly or explicitly, by a body with the power to overrule or modify the earlier authority. In the case of court decisions, for example, a district court opinion on an issue is not an authority if overruled or reversed by the United States Court of Appeals for such district. However, a Tax Court opinion is not considered to be overruled or modified by a court of appeals to which a taxpayer does not have a right of appeal, unless the Tax Court adopts the holding of the court of appeals. Similarly, a private letter ruling is not authority if revoked or if inconsistent with a subsequent proposed regulation, revenue ruling or other administrative pronouncement published in the Internal Revenue Bulletin.

(iv) Special rules

(A) Written determinations. --There is substantial authority for the tax treatment of an item by a taxpayer if the treatment is supported by the conclusion of a ruling or a determination letter (as defined in §301.6110-2(d) and (e)) issued to the taxpayer, by the conclusion of a technical advice memorandum in which the taxpayer is named, or by an affirmative statement in a revenue agent's report with respect to a prior taxable year of the taxpayer ("written determinations"). The preceding sentence does not apply, however, if --

(1) There was a misstatement or omission of a material fact or the facts that subsequently develop are materially different from the facts on which the written determination was based, or

(2) The written determination was modified or revoked after the date of issuance by --

(i) A notice to the taxpayer to whom the written determination was issued,

(ii) The enactment of legislation or ratification of a tax treaty,

(iii) A decision of the United States Supreme Court,

(iv) The issuance of temporary or final regulations, or

(v) The issuance of a revenue ruling, revenue procedure, or other statement published in the Internal Revenue Bulletin.

Except in the case of a written determination that is modified or revoked on account of §1.6662-4(d)(3)(iv)(A)(1), a written determination that is modified or revoked as described in §1.6662-4(d)(3)(iv)(A)(2) ceases to be authority on the date, and to the extent, it is so modified or revoked. See section 6404(f) for rules which require the Secretary to abate a penalty that is attributable to erroneous written advice furnished to a taxpayer by an officer or employee of the Internal Revenue Service.

--------------

COMMENT:

The practical effect of the "substantial authority" standard is to require tax return preparers to be as competent on tax law at a tax attorney who has access to tax law services and who is competent to research the available tax law on any tax issue. If the return preparer is capable of research all of the available tax law, the return preparer must have the ability to "analyze" the law applicable to the relevant tax issue and support the position taken based on the relevant tax "authority."

If y have any questions about this regulation and how to determine whether you have "substantial authority" for any position you will be taking for the2008 tax year, contact ab@irstaxattorney.com.

more likely than not standars is ELIMINATED

Emergency Economic Stabilization Act of 2008, as Amended and Passed by the Senate on October 1 (legislative day, September 17), 2008, , (October 3, 2008) - signed by gthe President 10-3-2008

N



SEC. 506. MODIFICATION OF PENALTY ON UNDERSTATEMENT OF TAXPAYER'S LIABILITY BY TAX RETURN PREPARER.

(a) In General- Subsection (a) of section 6694 is amended to read as follows:

`(a) Understatement Due to Unreasonable Positions-

`(1) IN GENERAL- If a tax return preparer --

`(A) prepares any return or claim of refund with respect to which any part of an understatement of liability is due to a position described in paragraph (2), and

`(B) knew (or reasonably should have known) of the position,

such tax return preparer shall pay a penalty with respect to each such return or claim in an amount equal to the greater of $1,000 or 50 percent of the income derived (or to be derived) by the tax return preparer with respect to the return or claim.

`(2) UNREASONABLE POSITION-

`(A) IN GENERAL- Except as otherwise provided in this paragraph, a position is described in this paragraph unless there is or was substantial authority for the position.

`(B) DISCLOSED POSITIONS- If the position was disclosed as provided in section 6662(d)(2)(B)(ii)(I) and is not a position to which subparagraph (C) applies, the position is described in this paragraph unless there is a reasonable basis for the position.

`(C) TAX SHELTERS AND REPORTABLE TRANSACTIONS- If the position is with respect to a tax shelter (as defined in section 6662(d)(2)(C)(ii)) or a reportable transaction to which section 6662A applies, the position is described in this paragraph unless it is reasonable to believe that the position would more likely than not be sustained on its merits.

`(3) REASONABLE CAUSE EXCEPTION- No penalty shall be imposed under this subsection if it is shown that there is reasonable cause for the understatement and the tax return preparer acted in good faith.'.

(b) Effective Date- The amendment made by this section shall apply --

(1) in the case of a position other than a position described in subparagraph (C) of section 6694(a)(2) of the Internal Revenue Code of 1986 (as amended by this section), to returns prepared after May 25, 2007, and

(2) in the case of a position described in such subparagraph (C), to returns prepared for taxable years ending after the date of the enactment of this Act.

-----------

The Bill signed by the President is retroactive to May 25, 2007. So now that you have the "substantial authority" standard, do you think you will duck the penalty?
"Substantial authority" equates to being more than 40% correct instead of more than 50% correct. But note the following:

1. You still have to have the resources to do tax research
2. You still have to support positions not disclosed to the IRS with an "analysis" of the relevant "authorities" as required by the current proposed regulations.
3. The term "substantial authority" is subjective. Reasonable people can disagree on what is or is not "substantial authority."
6. You still have the risk that if you, as a return preparer, are "reckless," you can be subject to the $5,000 penalty.
7. The proposed regulations expect you to be knowledgeable about current changes in the tax law.
8. The IRS is aggressive on examination issues, and you can bet your sweet "bippie" that they will be encouraged to go after the very large penalties of $1,000 or $5,000 and the higher of 50% of your fee for preparing the tax retun.

The professional organizations that lobbied effectively for this change goofed in a "big time" way. They should have lobbied the size of the penalty. Prior to May 25, 2007, the size of the penalty was $250. Minimal revenue was collected from this penalty under prior law. The size of the current penalty is draconian. You can expect the IRS to vigorously go after the $1,000 and $5,000 penalties.

Frankly, I believe it will be easier for the IRS to go after the 6694(b) $5,000 penalty than the 6694(a) $1,000 penalty because all they need to do is establish that a return preparer was "reckless" - the same term used to determine "negligence" under 6662(c). In short, mere negligence will be sufficient for the IRS to justify the $5,000 penalty.

Without question, your best strategy would be to make a "disclosure" to the IRS of the position taken in order to take advantage of the lower "reasonable basis" standard, and at the same time have that position justified by a tax expert who can write a quality written memorandum on the facts and the applicable law. That way you have a better chance of preveting the tax return from being selected for examination and you have a better shot of comining under the "reasonable cause" exception to the penalty.

For those who want advice on any technical issue that may be subject to the disclosure rules, send us an e-mail at ab@irstaxattorney.com.

Section 6694(b) penalty easy to apply by IRS

The $5,000 penalty will apply under §6694(b)and §1.6694-3(c) for "reckless" disregard of the relevant authority.

The term "reckless" is also used in section 6662(c) in connection with the definition of "negligence." Section 1.6694-3(c) does not clearly define the term "reckless." Note that section 6662(c) uses the term "careless" along with the word "reckless" is a way that equalizes the two terms.

6662(c) NEGLIGENCE. --

For purposes of this section, the term "negligence" includes any failure to make a reasonable attempt to comply with the provisions of this title, and the term "disregard" includes any careless, reckless, or intentional disregard.

§1.6662-3(b)(2) of the regulations states that the term "disregard" includes any careless, reckless or intentional disregard of rules or regulations. The term "rules or regulations" includes the provisions of the Internal Revenue Code, temporary or final Treasury regulations issued under the Code, and revenue rulings or notices (other than notices of proposed rulemaking) issued by the Internal Revenue Service and published in the Internal Revenue Bulletin. A disregard of rules or regulations is "careless" if the taxpayer does not exercise reasonable diligence to determine the correctness of a return position that is contrary to the rule or regulation. A disregard is "reckless" if the taxpayer makes little or no effort to determine whether a rule or regulation exists, under circumstances which demonstrate a substantial deviation from the standard of conduct that a reasonable person would observe.

As I read these rules, if a return preparer is careless in research of an authoritative position, that person is careless or reckless and subject to the $5,000 penalty if the return preparer not not find a relevant IRS "rule" (which could be a position in the Internal Revenue Manual.

If the return preparer is "careless" or "reckless" by missing a position that should have been disclosed by a "reasonable person," the "reasonable basis" standard of 6694(a) DOES NOT APPLY. When dealing with 6694(b) the key issue is a very low threshold of conduct. Any missed technical authority can be viewed as "careless" or "reckless." Another way to make this point is that 6694(b) trumps 6694(a), an obvious point. But the point of this blog is that it will be easier for the IRS to apply the $5,000 penalty than the $1,000 penalty because it is easier for the IRS to find a return preparer is careless or releckess than challange the reasonabl basis standard used under 6694(a) for disclosed posiitons.

It will be easier for an IRS examiner to go after the $5,000 penalty under section 6694(b) than the $1,000 penalty under 6694(a) because "careless" and "reckless" is a low threshold. The proposed regulations cannot resolve this problem. The 6694(b) statute uses the word "reckless" and only a change to the statute can cure this statutory loophole for the IRS that makes it easier to trigger the 6694(b) penalty over the 6694(a) penalty. When dealing with 6694(a), one can cite any relevant authority are then argue they have met the "reasonable basis" standard. This is not the case with 6694(b) where one can miss some authority and be viewed as "careless" or "reckless" by missing some authority.

For example, one circuit court case in your circuit might be more relevant than a case in another circuit. A reasonable person would have been able to find the more relevant case. In this situation the return preparer can easily be accused of being reckless or careless under 6694(b) but also meet the 6694(a) reasonable basis standard. I do not believe the drafters of the proposed regulations have addressed this conflict nuance between the two subsections of 6694.

The other important point is that the 6694(b) statute requires FULL RESEARCH AND ANALYSIS OF THE RELEVANT AUTHORITY in order to avoid being accused of being careless or reckless. Any incomplete disclosure of the relevant auhority can easily be challanged as careless or reckless using the "reasonable person" standard.

How does one determine what a "reaonable person" would do? It is a facts and circumstnaces test. This is a subjecttive test rather than an objective test in measuring whether the conduct of the return preparer has been careless or reckless.

This issue is likely to be a nightmare for the return preparer industry because of inherent "careless" or "reckless" conduct ambiguties in all disclosed positions.

If anyone wants to challange the above, open up a discussion on this issue in the reply to this blog or e-mail me at ab@irstaxattorney.com.

fraud, negligence and 6694

Below is a case published yesterday that considers the civil fraud penalty, negligence resulting from an IRS examination. It is a taste of the real world and the world that I inhabit representing taxpayers before the IRS. The taxpayer won on the 75% civil fraud penalty because the IRS did not prove civil fraud by "clear and convincing" evidence. The point is not that she won on that issue - the point is that the IRS is aggressive and raises those issues. The negligenc penalty was imposed because she did not and could not support her claim for a credit. Whenever the negligence penalty is imposed - due to lack of substantiation, a common issue - then section 6694 would be an issue for any tax return preparer. This case is an example of what goes on in examination cases. The IRS can be expected to be aggressive. In many cases, they look for fraud. They obviously check substantiation. If the substantiation is inadeqate as it is in a high percent of cases, then the 6662 and 6694 issues will be in play. This case is documented just for the "reality check" that it will be quite easy for the IRS to raise 6694 issues in every case where there is a potential negligence penalty. The 6694 regulations that say you can rely on data from a client will not help you if the IRS accuses you of being aware that the substantiation was inadequate. What did you know and when did you know it? Should you have asked about substantiation on a credit issue? Probvably so. I have been getting good feedback on this blog. Let me know if you want to see more cases as they occur. I think they are helpful to force you to think about how you would have handled the same client and whether you want to represent her before the IRS during an IRS examination. The issue is not whether 6694 was an issue in this case, the issue is whether the 6694 penalty could be raised for any tax return preparer in this type of a case.
T
Cynthia G. Wilcox v. Commissioner.

Dkt. Nos. 9907-02 ; 22015-03 ; 22590-04 , TC Memo. 2008-222, October 1, 2008.

[Code Sec. 901]


An individual was not entitled to claim the foreign tax credit for amounts paid to the Russian Federation. The taxpayer failed to establish that the taxes were withheld by her Russian employer and then paid over to the Russian taxing authority. No receipts of payments were provided and neither the Russian employer or tax authority provided testimony. The only documents provided by the taxpayer were letters from her Russian employer listing amounts she was paid and Forms 3, the equivalent of Form W-2, for some of the years at issue.


[Code Sec. 6662]


An individual was not entitled to claim the foreign tax credit for amounts paid to the Russian Federation because she failed to failed to establish that the taxes were withheld by her Russian employer and then paid over to the Russian taxing authority was liable for the negligence penalty. No receipts of payments were provided and neither the Russian employer or tax authority provided testimony. Thus, the penalty was imposed based on the taxpayer's failure keep adequate books and records of her employment relationship and entitlement to foreign tax credits.


[Code Sec. 6663]


The fraud penalty was not imposed on an individual who failed to substantiate foreign tax credits for amounts paid to the Russian Federation. The IRS's assertion of fraud, which was based on the theory that the taxpayer never worked for the Russian employer and provided forged documents to support her foreign tax credit claim, was not supported by clear and convincing evidence. The IRS failed to provide testimony by an employee of the Russian Ministry of Taxation or a document expert to prove that the letters and Forms 3, the equivalent of Form W-2, were forgeries.



MEMORANDUM FINDINGS OF FACT AND OPINION



WELLS, Judge: Respondent determined the following deficiencies in income tax and penalties for petitioner's respective taxable years:





Penalty

Year Deficiency Sec. 6663

1997 $320,441 $240,330.75

1998 400,372 300,279.00

1999 334,303 250,727.25

2000 153,165 114,874.00





The issues we must decide are: (1) Whether petitioner has substantiated the existence or amounts of any foreign tax credits for the taxable years 1997, 1998, 1999, and 2000; (2) whether respondent has established that petitioner is liable for the fraud penalty pursuant to section 66631 for taxable years 1997, 1998, 1999, and 2000; and (3) whether petitioner has established that she is not liable, in the alternative, for a penalty pursuant to section 6662(a).





FINDINGS OF FACT



Some of the facts and certain exhibits have been stipulated. The parties' stipulations of fact are incorporated herein by reference and are found as facts. Petitioner resided in Washington, D.C., at the times the petitions were filed.



Petitioner earned a marketing degree from the College of William & Mary. She operated her own advertising and consulting business, Wilcox Advertising, Inc., before the taxable years in issue. She closed it down in 1992 or 1993.



Petitioner filed income tax returns for taxable years 1997, 1998, 1999, and 2000, claiming foreign tax credits for taxes paid to the Russian Federation. Petitioner's tax returns for the taxable years in issue each list her occupation as "Public Relations". On March 29, 2002, respondent issued a notice of deficiency to petitioner determining deficiencies in her income tax for taxable years 1997 and 1998 as set forth above. On October 2, 2003, respondent issued a notice of deficiency to petitioner determining a deficiency in her income tax for taxable year 1999 as set forth above. On August 24, 2004, respondent issued a notice of deficiency to petitioner determining a deficiency in her income tax for taxable year 2000 as set forth above. In each of the notices respondent disallowed petitioner's claimed foreign tax credits for lack of substantiation.



For the taxable years in issue, the record does not contain any receipts showing the payment of taxes by petitioner to the Russian Ministry of Taxation or any record of payment from petitioner's Russian employer, Multifunctional Cooperative Energia, also known as Diversified Cooperative Energia (Energia). The Russian Government informed the U.S. Internal Revenue Service (IRS) that petitioner was not registered as a taxpayer in the Moscow tax office and that petitioner did not file income tax returns in Russia for any of the taxable years in issue. The Russian Ministry of Taxation informed the IRS that it had no record of petitioner on their tax rolls and that she did not pay any income taxes to the Russian Government during the taxable years in issue. Energia had not filed tax returns or paid any taxes in Russia since either 1993 or 1995.



Petitioner's accountants, Kirkland, Russ, Murphy & Tapp (KRMT), prepared petitioner's income tax returns from information she furnished. KRMT made no attempt to verify the information petitioner provided.



Petitioner did not maintain any foreign bank accounts or interests in foreign trusts. There are no bank statements, deposit slips, or wire transfer records from any of petitioner's bank accounts during the taxable years in issue evidencing a deposit from Energia or a payment to the Russian Government or the Moscow city government.



There are no deposits into any of petitioner's accounts during 1997 which match in amount any of the monthly salary or housing allowance amounts detailed in the letters purporting to be from Energia that petitioner presented to the IRS, nor in an amount matching a 1997 bonus which she alleges to have received from Energia.



During 1997 there were no deposits into any of petitioner's accounts of $9,612, $9,802, $9,900, or $9,960, which are the amounts of monthly salary payments net of Russian withholding taxes which petitioner alleges to have paid to the Russian Government for that taxable year. Additionally, there was no deposit into any of petitioner's accounts during 1997 of $468,520, which is the bonus payment net of Russian withholding tax petitioner alleges she was paid from Energia.



During 1998 there was no deposit into any of petitioner's accounts of $64,513, which is the total of the 1998 monthly salary payment net of Russian withholding tax petitioner alleges she was paid from Energia.



Petitioner did not offer any written evidence of a contract for her services indicating the manner in which her bonus or commissions that she alleges were to be paid by Energia were to be calculated. Petitioner did not offer any pay stubs or other written evidence reflecting payments of salary, bonuses, or commissions from Energia. Petitioner did not offer records of the manner in which her bonus or commission amounts to be paid by Energia were accruing or the amount and/or value of diamond sales from which such bonuses or commissions would be computed.



During 1997 petitioner twice traveled to Russia. On the first trip petitioner entered February 4 and departed February 10. On the second trip petitioner entered March 7 and departed on an unknown date.



On May 5, 1998, petitioner gave birth to a son, DK.2 DK lived with petitioner from the time he was born throughout the taxable years in issue. After giving birth to DK, petitioner did not work for several months. Petitioner did not travel to Russia during the last 4 months of 1997 or during 1998.



Petitioner rented an apartment and lived "on and off very often" in Belgium between 1994 and 1997 and again during 1999, particularly while her son Bradford Hamilton Wilcox, who was born on March 3, 1979 (Bradley), was going to school in Switzerland. On May 5, 1997, petitioner married Menachem Josef Kaszirer (Mendy Kaszirer) and remained married to him throughout the taxable years in issue. Mendy Kaszirer is a Belgian citizen. However, Mendy Kaszirer's mother is Russian, and he was born in Russia. Petitioner continues to share a house in Belgium with her husband Mendy Kaszirer.



Petitioner traveled to Russia three times during 1999, the first entering March 29 and departing April 12, the second entering April 23 and departing on an unintelligible date, and the third entering May 31 and departing June 2. Petitioner was pregnant during 1999. Petitioner did not travel to Russia during 2000. Petitioner's Russian travel visa was revoked in 2001.



Mendy Kaszirer and his father, Ignatie Kaszirer, started Kaszirer Diamonds, N.V., a diamond company which became one of the largest in the world. Kaszirer Diamonds declared bankruptcy during 1996 or thereabouts.



Mendy Kaszirer had been doing business in Russia for 30 years before 1993. Mendy Kaszirer spoke Russian fluently. Petitioner was not fluent in Russian during the taxable years in issue.



Mendy Kaszirer had great knowledge of the diamond business. Petitioner knew nothing about the diamond business before meeting him. Mendy Kaszirer's knowledge of the diamond business remained substantially greater than petitioner's during the years in issue.



Kaszirer Diamonds had business interests in Russia, including joint ventures, and the company purchased diamonds in Russia. Kaszirer Diamonds was one of the major partners in the "Intertrade" joint venture. Mendy Kaszirer was one of the contacts for Kaszirer Diamonds with whom petitioner worked on the "Intertrade" joint venture.



Kaszirer Diamonds was one of the partners in the "Victoria" joint venture. At trial, petitioner recalled that Kaszirer Diamonds was a partner in the Victoria joint venture, but she could not remember with whom she dealt from Star Diamond or the factory. Mendy Kaszirer was the party from Kaszirer Diamonds with whom she dealt on the "Victoria" joint venture.



Petitioner's job with Energia was to bring foreign investment to the Russian diamond trade, primarily through joint ventures. Petitioner helped facilitate the following joint ventures: Almaz Juvelier Export, which dealt with diamond polishing and made jewelry; Octoprom, a diamond polishing operation; Anastasia, which opened a location selling jewelry and polishing diamonds on Red Square; Imperial Trading, a diamond polishing operation; and Rosshtern and Ornament Trading, diamond polishing.



Petitioner could not recall the names of the partners involved in Almaz Juvelier Export, Imperial Trading, or Rosshtern and Ornament Trading. Mendy Kaszirer knew better than petitioner the principals of the unnamed diamond company from Belgium owned by an Indian who was a party to the Rosshtern joint venture. Mendy Kaszirer met with Gary Harrod in Moscow when Gary Harrod went there.



Kaszirer Diamonds owned Quantex Diamonds, Inc., a servicing agent. David Josowitz (Mr. Josowitz) was the President of Quantex Diamonds, Inc. (Quantex), during the taxable years in issue. As of December 3, 1998, Mr. Josowitz had worked for Quantex for at least 20 years. Mr. Josowitz worked at the office of Quantex in New York, New York, during the years in issue. Mr. Josowitz first met petitioner through Mendy Kaszirer during 1993. Petitioner worked with Mendy Kaszirer during that time. Petitioner received wages of $300,000 during 1995 and $395,000 during 1996 from Kaszirer Diamonds.



Petitioner occasionally visited the offices of Quantex in New York during the taxable years in issue. Petitioner had no assigned duties at Quantex during the years in issue. While visiting the Quantex offices in New York during 1997, petitioner worked on designing a line of jewelry as a personal project. Petitioner sold some jewelry on her own behalf during the taxable years in issue. On August 16, 1999, petitioner sold a 5-carat diamond ring to Cora Diamond Co. for $20,000. During 1999 petitioner sold a ring for $28,941 through Diacor International.



Petitioner represented to U.S. Trust Co. of New York that she had personal property, including jewelry, worth $700,000 as of November 19, 1998. Petitioner told U.S. Trust Co. of New York that she did not accrue any salary during 1997.



Petitioner owned and operated Millennium Penthouse, Inc. (Millennium), an S corporation, during all of the taxable years in issue. Millennium held title to a condominium at 1965 Broadway, Unit PH1E, New York, New York (1965 Broadway). The mortgage on 1965 Broadway called for a monthly payment of $11,775.80 and monthly maintenance fees of $1,300. A lease between Millennium and Quantex for 1965 Broadway called for a payment of $15,000 per month. Quantex did not use 1965 Broadway for any business purpose. Millennium also held title to a Miami, Florida, rental property, similar to a strip mall, that had tenants.



Only the Forms 1120S, U.S. Income Tax Return for an S Corporation, filed on behalf of Millennium for 1997 and 1998 report any rental income from Quantex and not of $15,000 per month. Only the Forms 1120S filed on behalf of Millennium for 1999 and 2000 report rental income from the tenants of the strip mall in Miami. Millennium reported a net loss in each of the taxable years in issue.



Petitioner owned all of the outstanding shares of Harbour Group, Inc. During 1996 petitioner purchased all of the shares of Harbour Group, Inc., from Harbour Group, Ltd., a British Virgin Islands company, for $900,000, a price later decreased to $700,000. Harbour Group, Inc., was incorporated as a C corporation, and effective January 1, 1997, became an S corporation. Harbour Group, Inc., owned petitioner's residence at 917 Anchorage Road in Tampa, Florida. Harbour Group, Inc., also owned two boats valued at $350,000. Mendy Kaszirer was an agent for Harbour Group, Inc., and one of three individuals petitioner knew were involved with Harbour Group, Inc.



With the assistance of an attorney, petitioner applied for and received an exemption certificate so that Harbour Group, Inc., would not be required to withhold any tax under sections 897 and 1445 upon the payment of the purchase price of the home at 917 Anchorage Road in Tampa, to Harbour Group, Ltd., B.V.I.



Petitioner's plans were for Blue Diamond Trading, Inc. (Blue Diamond), to be a wholesale diamond business in Miami, Florida. Mendy Kaszirer was involved in operating Blue Diamond. Mendy Kaszirer helped procure and sell diamonds for Blue Diamond. Petitioner was the president and secretary of Blue Diamond. The monthly statements for Blue Diamond's corporate checking account at Mellon National Bank were mailed to petitioner and retained by her accountant. Petitioner wrote most, if not all, of the checks on Blue Diamond's corporate checking account. Petitioner acted on behalf of Blue Diamond in directing an accountant to prepare and file tax returns on Blue Diamond's behalf. Blue Diamond paid petitioner $50,000 on December 23, 1998, and $25,000 on April 6, 1999. Blue Diamond had ceased operations by August 1999. In August 1999 petitioner, as president of Blue Diamond, entered into a wire transfer agreement with United National Bank. During June and July of 2000 petitioner paid herself travel expenses out of Blue Diamond's corporate checking account. Blue Diamond paid insurance premiums on behalf of petitioner, which Blue Diamond treated as salary payments.



Mendy Kaszirer acted as the trustee and was a beneficiary of several trusts. Mendy Kaszirer acted as trustee on behalf of the K Trust and the J & O Trust (Kaszirer family trusts). Mendy Kaszirer's three sisters were other beneficiaries of the Kaszirer family trusts. The Kaszirer family trusts held real property worth approximately $100 million. Mendy Kaszirer was accused by several Kaszirer family members of stealing the Kaszirer family fortune, including stealing diamonds from the family business and embezzling funds from a Kaszirer Diamonds, N.V. bank account. During 1997 Ignatie Kaszirer, Orlie Kaszirer Rechdiner, Anita Kaszirer Rosenberg, and Henri Rosenberg filed two lawsuits, Index Nos. 122134/97 and 401578/97, in the Supreme Court of the State of New York against Mendy Kaszirer. The purpose of the lawsuits was to forcibly remove Mendy Kaszirer as a trustee of various family trusts of which they were beneficiaries. The trust lawsuits against Mendy Kaszirer settled without trials.3



During 1999 Mendy Kaszirer was accused of breaking Belgian laws. Mendy Kaszirer was arrested in the United States during 1999 and extradited to Belgium.



During 1999 while petitioner's audit was assigned to Revenue Agent Theodore Curtis (Agent Curtis), KRMT provided three letters to the IRS dated January 29, 1998. Petitioner represented those letters to be from Energia (Energia letters).



On February 24, 2000, petitioner informed KRMT that she did not have documentation for taxes paid to Russia. On June 4, 2001, petitioner provided to the IRS several Forms 3 allegedly issued by Energia relating to her taxable years 1997 and 1998. Form 3 is the Russian equivalent of a Form W-2, Wage and Tax Statement. The Energia letters and Forms 3 that petitioner's representatives provided to the IRS during the audit did not contain a KRMT Bates stamp number.



The Energia letters each contain a stamp or seal purporting to be the corporate seal of Energia. The purported stamp or seal on the Forms 3 differed from the seal registered by Energia with the Russian Government. The letterhead on the Energia letters did not include a mailing address, telephone number, facsimile number, or electronic mail address for Energia.



U.S. Trust Co. of New York provided only personal loans to its clients, not commercial loans. Petitioner led Diane Katz, a loan officer at U.S. Trust Co. of New York, to believe that petitioner was moving back to New York to live at 1965 Broadway, which petitioner was purchasing, and that petitioner would be working in New York City.



Petitioner represented to U.S. Trust Co. of New York that her monthly living expenses were $35,000. U.S. Trust Co. of New York determined that petitioner's living expenses were more accurately $100,000 per month.



Petitioner produced letters for loan companies indicating she was employed during 1998 by Quantex and Blue Diamond. Petitioner produced letters for loan companies indicating she was employed during 1999 by Anchor Diamond Importers, Inc. (Anchor Diamond).



Anchor Diamond paid for health insurance for petitioner. The amounts reflected on the Form W-2 issued by Anchor Diamond with respect to petitioner were not money paid directly to her but were for amounts paid to a health insurance company for petitioner's insurance.



Petitioner received Forms W-2 from Quantex for 1997 and 1998 reflecting wages of $10,200 and $3,600, respectively. Those amounts were not salary paid directly to petitioner but were amounts paid to a health insurance company for petitioner's insurance.



Petitioner asked Mr. Josowitz to write a letter asserting that she had an accrued bonus of $422,648 from Quantex as of March 25, 1998. Petitioner did not have an accrued bonus from Quantex, and Quantex never made a payment of $422,648 to petitioner or one of her corporations.



Petitioner asked Mr. Josowitz to write a letter asserting that her expected income from Quantex would be $450,000 for 1997, plus a $12,000 monthly housing allowance. As president, Mr. Josowitz received a salary of $60,000 annually from Quantex. He did not receive a living allowance.



Petitioner asked Mr. Josowitz to write a letter asserting that she had requested that Quantex transfer $450,000 in funds it was holding for her in 1997.



Quantum Diamonds, Inc. (Quantum), was incorporated in the United States. Mr. Josowitz was the vice president of Quantum. Mr. Josowitz was the only person authorized to write checks on the bank account of Quantum. Petitioner did not work for Quantum. Quantum did not pay petitioner a salary during 1997. Quantum did pay for petitioner's health insurance during 1997. The stock of Quantum was owned by some or all of the following members of the Kaszirer family: Ignatie Kaszirer, Mendy Kaszirer, and Bruno Goldberger.



Petitioner asked Mr. Josowitz to write a letter asserting that she received a salary from both Quantex and Quantum Diamonds.



Petitioner asked Mr. Josowitz to write a letter asserting that her living allowance was $15,000 per month for 1998.



Quantex made payments to Millennium at petitioner's request. Quantex did not use 1965 Broadway (owned by Millennium) for any business purpose.



Quantex lacked any relationship with petitioner or Energia by which it could obtain credit for any amounts it owed Energia for paying petitioner. Quantex had no relationship with any joint venture from Russia by which Quantex could obtain credit for any amount it owed the Russian joint venture for paying a third party, such as petitioner.



Heinrich and Cecilia Kremer (the Kremers) were Belgian citizens. Petitioner met the Kremers in Belgium. The Kremers and petitioner developed a relationship, and petitioner became "like a goddaughter" to them.



The Kremers did not have green cards which would have allowed them to reside in the United States for more than 90 days at a time. U.S. banks would not grant loans or sell mortgages to nonresidents who lack green cards. Petitioner allowed the Kremers to purchase in petitioner's name a house in which to live. The Kremers reimbursed petitioner for construction draws on the house.



Blue Diamond paid for health insurance for both of the Kremers. Blue Diamond also paid for health insurance for petitioner. Diane Katz at U.S. Trust Co. of New York received a letter from Heinrich Kremer, as president of Blue Diamond, saying that petitioner was due a bonus of $432,640.



In addition to her minor son DK and her son Bradley, petitioner has a daughter whose married name is Stacey Gaulding. Many of the personal expenses of petitioner and her three children, such as car payments, pool service payments, cellular telephone bills, automotive insurance, college and law school tuition, health insurance, and medical expenses, were paid out of the corporate bank accounts of Harbour Group, Inc., and Blue Diamond. KRMT did not advise her to pay personal living expenses or those of her children out of the corporate bank account of Harbour Group, Inc.



The IRS audited petitioner's returns for taxable years 1997 through 2000. Agent Curtis was assigned to the audit for petitioner's 1997 taxable year. On May 28, 1999, as part of that audit Agent Curtis requested all documents used to determine the amount of gross income of $966,000 reflected on the Form 1116, Foreign Tax Credit, attached to petitioner's 1997 income tax return. The only documents petitioner and her representatives provided were the Energia letters listing amounts paid to petitioner and amounts of tax withheld during taxable year 1997 and the Forms 3 relating to taxable years 1997 and 1998. Agent Curtis questioned the validity of the Energia letters submitted by petitioner's representatives.



Petitioner never provided the IRS with a calculation showing how her bonus or commission amounts from Energia were derived. Petitioner did not submit any data from either her financial accounts for taxable years 1997 through 2000 or the accounts of Energia showing actual payments to petitioner by Energia or deductions of income tax by Energia. Neither petitioner nor her representatives ever provided to the IRS: Documentation of the payment of income tax to the Russian Government by or on behalf of petitioner for any of taxable years 1997 through 2000; documentation from the Russian Government confirming receipt of alleged tax payments made on petitioner's behalf for taxable years 1997 through 2000; or documentation of the payments from Energia to petitioner during any of taxable years 1997 through 2000 inclusive showing where petitioner's alleged compensation from Energia was deposited or deposit slips showing the deposits of the alleged income into petitioner's accounts.



The IRS representative in Bonn, Germany, needed the address of Energia to assist Agent Curtis in his efforts to obtain information from the Russian tax authorities. On or about October 18, 1999, Agent Curtis requested the address from petitioner's representatives. Gary Hardie (Mr. Hardie) of KRMT was a representative of petitioner during the audit of petitioner's income tax returns for years 1997 through 2000. On December 29, 1999, Mr. Hardie told Agent Curtis that Energia was out of business and no longer existed.



Before completing the audit for petitioner's taxable year 1997, Agent Curtis was assigned to a management detail. The IRS assigned the audit of petitioner's taxable year 1997 to Revenue Agent Susan Miradakis (Agent Miradakis). Agent Miradakis asked petitioner's representatives, both orally and in writing, to provide proof of petitioner's alleged income from Energia during the years in issue.



Agent Miradakis requested the address of Energia from petitioner's representatives. Petitioner later admitted that the claim that Energia was out of business was not true, and, on July 18, 2000, represented that "City of Moscow, Lubjanka Str. 22/24" was the current address of Energia in Moscow. Petitioner claimed that Energia had been at the address provided on July 18, 2000, "for the last several years." The address provided did not match a street address for Energia petitioner provided to Popular Mortgage Co. on April 9, 1999, only 1-1/2 years earlier.



The Unified Residential Loan Application that petitioner submitted to Popular Mortgage Co. during 1999 included a telephone number for Energia. Petitioner never provided a telephone number for Energia to the IRS. During the audit petitioner never provided addresses or phone numbers of her managers or coworkers at Energia.



Agent Miradakis asked petitioner's representatives, both orally and in writing, to provide information as to petitioner's foreign travel for taxable years 1997, 1998, and 1999. Petitioner's representative sent copies of pages from petitioner's passport to Agent Miradakis. The copies were largely illegible, a fact acknowledged by petitioner's representative at the time. In the light of the poor quality of the copies, the IRS examiner asked petitioner's representatives to set forth in writing the dates of petitioner's travel to Russia during the taxable years in issue.



Petitioner's representatives refused to provide a written schedule of petitioner's travel, stating that: (1) The information was "apparent in the passport we provided you"; (2) the entries and departures from Russia were in the back of her passport, starting on page 36; and (3) they did not believe the information was material to any issue concerning petitioner's income tax liabilities. Petitioner refused to provide documents relating to her foreign travels aside from a copy of her passport unless the IRS promised that her matters were solely civil in nature.



During the audit Agent Miradakis requested information concerning Millennium and Harbour Group, Inc. Specifically, Agent Miradakis requested that petitioner produce the Form 1120S filed on behalf of the two corporations for taxable years 1997 and 1998.



During the audit Agent Miradakis asked petitioner to produce the general ledgers and proof of "Additional Paid-in Capital" for Harbour Group, Inc., for taxable years 1996, 1997, and 1998, and Millennium for taxable years 1997 and 1998. For each company, Agent Miradakis also requested a 1998 schedule of the Accumulated Adjustments Accounts and documentation showing that distributions made to petitioner during taxable year 1998 were nontaxable distributions. Additionally, if additions to Additional Paid-in Capital had been made, then Agent Miradakis requested petitioner to produce documentation of any additions which were from petitioner's own funds. Petitioner's representatives responded that information relating to petitioner's S corporations was almost completed and should be available within a few days of May 1, 2001. Neither the Forms 1120S nor any of the other requested information was ever produced to Agent Miradakis during the audit.



On or about October 30, 2001, through her representative, petitioner told Agent Miradakis that there would be no further cooperation in the audit unless the IRS would guarantee in writing that her matters were solely civil in nature. At some point during 2001, petitioner and her representatives did cease all cooperation in the audit. All the documentary evidence relating to financial institutions was procured by the IRS through summonses issued by Special Agent Coffman to the respective financial institutions or to KRMT.



Special Agent Coffman issued a summons to KRMT during early 2002, requesting all documents KRMT had received from petitioner regarding the preparation of income tax returns for 1997 through 2000. KRMT promptly sent Special Agent Coffman two or three banker's boxes. KRMT did not withhold any documents from its file relating to petitioner on any grounds (including privilege) and represented that the boxes were the complete file. All documents in the files were stamped with a KRMT Bates stamp number, and there are no missing Bates stamp numbers in the documents provided.



Petitioner initially told accountant Jack Kirkland of KRMT that the amount of Russian tax withheld from petitioner's alleged pay from Energia was 52 percent of her gross wages for taxable year 1997. Petitioner told Mr. Hardie of KRMT that the withholding rate on her wages from Energia during taxable year 1998 had been 52 percent. On February 24, 2000, petitioner told KRMT that the withholding rate on her income from Energia was 51 percent during taxable year 1999 and that she thought it had been 51 percent during taxable year 1998. The withholding percentages were revised downward before the preparation of petitioner's 1997, 1998, and 1999 income tax returns. The percentages of alleged gross income claimed to have been withheld reported on the respective tax returns were 31.3 percent for taxable year 1996, 39.9 percent for taxable year 1997, 33.5 percent for taxable years 1998 and 1999, and 28.9 percent for taxable year 2000.



Petitioner, through her representative, indicated to the IRS that the Energia letters submitted previously to the IRS bore the official stamp of the Russian Ministry of Taxation and were "substantially similar to a Form W-2". The Energia letters submitted to the IRS did not purport to bear the stamp of the Russian Ministry of Taxation but purported to bear the stamps of Energia and of the notary who certified the authenticity of the translator's signature.



On February 12, 2001, petitioner's representative communicated to Agent Miradakis that the withholding form used by the Russian Ministry of Taxation was a new form in taxable year 2000 and had not been in existence during the years in issue. Agent Miradakis learned from the Russian Ministry of Taxation that the Form 3 had been in use during the taxable years in issue. Agent Miradakis informed petitioner's representative that she had learned that Form 3 had been in use during the taxable years in issue. Agent Miradakis obtained a copy of a blank Form 3 from the Russian Ministry of Taxation and gave one to petitioner's representative. Later in the audit, petitioner retracted her statement that Form 3 had not been in use during the taxable years in issue, blaming confusion. After receiving a blank Form 3 from Agent Miradakis, petitioner presented to the IRS the Forms 3 relating to taxable years 1997 and 1998.



Petitioner claimed during the audit that an agent from the Russian Ministry of Taxation visited the Energia office every 2 weeks to collect her withholding tax. Agent Miradakis later learned that such a visit was impossible; taxes were withheld by the Russian payor and then paid over to a special account. Petitioner, through her representative, told Agent Miradakis that petitioner's Russian income taxes were collected every 2 weeks by an agent at the place of business. Agent Miradakis directed that the IRS make inquiries of accountants from Russia as to how Russians paid their taxes. As a result of the inquiries, Agent Miradakis was informed that Russian withholding taxes were deposited by the withholder to a special bank account, not collected personally.



Petitioner questioned the authenticity of documents provided to the IRS from the Russian Ministry of Taxation, claiming that they lacked the Ministry's official seal. Petitioner claimed that, on the basis of her experience, an official Government seal should appear to the left of the signature block on documents from the Russian Ministry of Taxation. Agent Miradakis investigated petitioner's claim regarding the placement of seals on Russian Ministry of Taxation correspondence. Agent Miradakis was informed that the Russian Ministry of Taxation did not typically place seals on their correspondence. Agent Miradakis viewed other letters from the Russian Ministry of Taxation, none of which had an official seal of the Ministry.



The Energia letters state that taxes were withheld pursuant to Russian law. The letters do not make any mention of the use of third-party conduits to pay petitioner her salary or her bonuses during the taxable years in issue.



Petitioner told KRMT that Alex Cohen Consulting, Inc., had no operations during 1999. Alex Cohen Consulting, Inc., had a corporate checking account and paid fees to the Florida Department of State as late as September 10, 2000. Alex Cohen Consulting, Inc., paid petitioner $9,500 on December 14, 1998. Federal income tax returns (Forms 1120S) were filed on behalf of Alex Cohen Consulting, Inc., for all of the taxable years in issue reporting gross receipts of $40,000 for 1997. Petitioner deposited money into and wrote checks on an account in the name of Alex Cohen Consulting, Inc., throughout all of the taxable years in issue.



The files KRMT provided to Special Agent Coffman contained no evidence of any payments by a Russian entity to petitioner.



At trial, petitioner claimed to have received a diploma from the Wharton Business School. Petitioner misspelled Wharton as "Wartan" on the Uniform Residential Application she submitted to Popular Mortgage Co.



For taxable year 1997 petitioner reported adjusted gross income of $947,385 and had $360.57 withheld from her income and paid over to the IRS. Petitioner claimed estimated tax payments of $11,880 for taxable year 1997, stemming from either her 1996 tax return or estimated payments made during taxable year 1997.



For taxable year 1998 petitioner reported adjusted gross income of $1,251,394 and had $352.56 withheld from her income and paid over to the IRS. Petitioner claimed estimated tax payments of $25,560 for taxable year 1998.



For taxable year 1999 petitioner reported adjusted gross income of $1,073,450 and had zero withheld from her income. Petitioner claimed estimated tax payments of $24,450 for taxable year 1999.



For taxable year 2000 petitioner reported adjusted gross income of $721,694 and had zero withheld from her income. Petitioner claimed estimated tax payments of $26,173 during taxable year 2000, including $13,373 applied from her claimed overpayment from taxable year 1999.



Petitioner did not call her husband, Mendy Kaszirer, to testify at trial. Petitioner did not call any witnesses from Energia or any of the entities which participated in the joint ventures on which she worked to testify at the trial. Petitioner did not call a witness from the City of Moscow government or the Russian Government to testify at trial. Petitioner claims to have spent many days with the mayor of Moscow.





OPINION



Payment of taxes to a foreign Government may give rise to either a deduction or a credit. See secs. 164, 901.4 Section 164(a)(3) provides that a deduction is allowed for foreign income taxes. In lieu of the section 164 deduction, section 901(a) and (b)(1) permits a taxpayer to elect a credit for foreign income tax which meets the requirements set forth in the statute and the regulations promulgated thereunder.



Petitioner claims foreign tax credits during the taxable years in issue on account of foreign income tax she contends was withheld on her behalf by Energia and paid to the Russian Federation. Petitioner has the burden of proving that she is entitled to the foreign tax credits she claims.



The purpose of the foreign tax credit is the reduction of international double taxation. See Am. Chicle Co. v. United States, 316 U.S. 450, 452 (1942); Nissho Iwai Am. Corp. v. Commissioner, 89 T.C. 765, 776 (1987). Nonetheless, permitting a credit for foreign income taxes "paid or accrued" is "an act of grace on the part of Congress", and a taxpayer seeking to benefit from such a credit must prove that all the conditions upon which its allowance depends have been fulfilled. Irving Air Chute Co. v. Commissioner, 143 F.2d 256, 259 (2d Cir. 1944), affg. 1 T.C. 880 (1943). With respect to income tax withheld at the source, such conditions include establishing that the foreign income tax for which credit is claimed was not only withheld, but paid over to the foreign taxing authority. Cont. Ill. Corp. v. Commissioner, 998 F.2d 513, 516-517 (7th Cir. 1993), affg. on this point T.C. Memo. 1991-66; Norwest Corp. v. Commissioner, T.C. Memo. 1995-453. Regulations require the taxpayer to submit "the receipt for each such tax payment". Sec. 1.905-2(a)(2), Income Tax Regs.



The legislative history of the Tax Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2085, clearly states that a foreign tax credit will be allowed only when the taxpayer is able to document not only that the foreign taxes have been withheld, but also that they have been paid. H. Conf. Rept. 99-841 (Vol. II), at II-594 (1986), 1986-3 C.B. (Vol. 4) 1, 594. The conference report states:



The conferees intend that the amount of any withholding tax paid be positively established through documentation provided in accordance with the requirements of Code section 905(b) and Treas. reg. sec. 1.905-2. In this regard, the conferees emphasize that the mere fact that withholding took place does not necessarily constitute adequate proof of the amount of tax paid.



The conference report specifically addresses prior caselaw, stating that the rule set forth in Lederman v. Commissioner, 6 T.C. 991 (1946), which suggested that payment is proved ipso facto by the act of withholding, is subject to abuse.



Petitioner failed to produce any credible evidence of tax paid to the Russian Government. She did not produce a receipt as contemplated in the regulations. Petitioner provided no testimony by anyone involved in payment of the alleged foreign taxes in issue from either Energia or the Russian tax authorities. Petitioner relies solely on the Energia letters and the Forms 3.



The Russian Government informed the IRS that petitioner was not a taxpayer and had not filed with them, although petitioner asserts that she was not required to file in Russia since she claimed no deductions or refunds. Also, Energia had not filed tax returns since either 1993 or 1995. On the basis of the record, we hold that petitioner has not met her burden of proving that the tax she claims was paid to the Government of Russia was in fact paid. Consequently, we hold that petitioner is not entitled to foreign tax credits under section 901 for the taxable years in issue.




Section 6663 Penalty


The Commissioner has the burden of proving fraud by clear and convincing evidence. Sec. 7454(a); Rule 142(b). To satisfy this burden, the Commissioner must show: (1) An underpayment exists; and (2) the taxpayer intended to evade taxes known to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of taxes. Parks v. Commissioner, 94 T.C. 654, 660-661 (1990). The Commissioner must meet that burden through affirmative evidence because fraud is never imputed or presumed. Petzoldt v. Commissioner, 92 T.C. 661, 699 (1989). If the Commissioner establishes that any portion of an underpayment in a particular year is attributable to fraud, the entire underpayment is treated as attributable to fraud, except with respect to any portion of the underpayment which the taxpayer establishes (by a preponderance of the evidence) is not attributable to fraud. Sec. 6663(b).



Section 6663(a) imposes a penalty equal to 75 percent of the portion of any underpayment which is attributable to fraud. The penalty in the case of fraud is a civil sanction imposed primarily as a safeguard for the protection of the revenue and to reimburse the Government for the heavy expense of investigation and the loss resulting from a taxpayer's fraud. Helvering v. Mitchell, 303 U.S. 391, 401 (1938). Fraud is an intentional wrongdoing on the part of the taxpayer with the specific purpose to evade a tax believed to be owing. McGee v. Commissioner, 61 T.C. 249, 256 (1973), affd. 519 F.2d 1121 (5th Cir. 1975). The existence of fraud is a question of fact to be resolved from the entire record. Gajewski v. Commissioner, 67 T.C. 181, 199 (1976), affd. without published opinion 578 F.2d 1383 (8th Cir. 1978).



However, fraud need not be established by direct evidence, which is rarely available, but may be proved by surveying the taxpayer's entire course of conduct and drawing reasonable inferences therefrom. Spies v. United States, 317 U.S. 492, 499 (1943). Courts have relied on a number of indicia or badges of fraud in deciding whether to sustain the Commissioner's determinations with respect to the additions to tax for fraud. Although no single factor may be sufficient to establish fraud, the existence of several indicia may be persuasive circumstantial evidence of fraud. Solomon v. Commissioner, 732 F.2d 1459, 1461 (6th Cir. 1984), affg. per curiam T.C. Memo. 1982-603; Beaver v. Commissioner, 55 T.C. 85, 93 (1970).



Circumstantial evidence that may give rise to a finding of fraudulent intent includes: Understatement of income, inadequate records, failure to file tax returns, concealment of assets, failure to cooperate with tax authorities, filing false documents, failure to make estimated tax payments, engaging in illegal activity, attempting to conceal illegal activity, dealing in cash, implausible or inconsistent explanations of behavior, an intent to mislead which may be inferred from a pattern of conduct, and lack of credibility of the taxpayer's testimony. Spies v. United States, supra at 499. The taxpayer's background and the context of the events in question may be considered circumstantial evidence of fraud. Spies v. United States, supra at 497; Bradford v. Commissioner, 796 F.2d 303, 307 (9th Cir. 1986), affg. T.C. Memo. 1984-601; Niedringhaus v. Commissioner, 99 T.C. 202, 211 (1992).



Respondent's assertion of fraud primarily relies on a theory that petitioner never worked for Energia and provided forged documents to support her claim that she did work for Energia. Respondent alleges that petitioner's income actually comes from working for Kaszirer Diamonds or is simply money embezzled from Kaszirer Diamonds or Kaszirer family trusts with the help of her husband. Petitioner responds that she is the victim of slander on the part of her brother-in-law and that she worked for Energia and had taxes withheld and any failure to pay taxes to the Russian Ministry of Taxation is due to fraud on the part of Energia.



Respondent makes much of petitioner's inability to prove conclusively that she actually worked for Energia and of her implausible explanation of how she was paid by Energia. Respondent contends that adequate proof was presented showing that petitioner did not work for Energia. Respondent argues that since petitioner did not work for Energia, any documents from Energia must be forgeries and petitioner's income tax deficiencies for the taxable years in issue must be a product of fraud. However, we conclude on the basis of the record that respondent has not proved by clear and convincing evidence that petitioner did not work for Energia. Consequently, respondent's contentions, which largely flow from respondent's proposition that petitioner was never employed by Energia, while they raise suspicions, remain unproved by clear and convincing evidence.



Respondent also contends that the Forms 3 provided by petitioner are forgeries since petitioner claimed the Form 3 was not in use during taxable years 1997 and 1998 and the documents were not provided until after respondent furnished petitioner with a blank sample. Similarly, respondent takes the absence of Bates stamp numbers on the Energia letters to mean they were not a part of KRMT's files at the time of preparing petitioner's tax returns. Respondent contends that petitioner forged the letters or persuaded someone in Russia to produce them to support her claimed employment and foreign tax credits. However, respondent did not provide any testimony by an employee of the Russian Ministry of Taxation or a document expert or provide any other clear and convincing evidence to prove any of the letters or forms are in fact forgeries.



While the circumstances do arouse substantial suspicion, we are mindful that it is respondent's burden to prove fraud by clear and convincing evidence. We find respondent's contentions without clear and convincing support in the record. While much of the evidence upon which respondent relies contributed to our holding on the deficiency issues, the evidence is not sufficiently persuasive, on a clear and convincing basis, to prove that petitioner's contentions are actually false. Accordingly, we hold that respondent has failed to carry respondent's burden of proof on a clear and convincing basis. Consequently, we hold that petitioner is not liable for the fraud penalty under section 6663.




Section 6662 Penalty


Respondent argues, in the alterative to the fraud penalty, that petitioner is liable for the accuracy-related penalty under section 6662. Respondent bears the burden of production under section 7491(c) and must come forward with sufficient evidence that it was appropriate to impose the penalty. See Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001).



A taxpayer may be liable for a 20-percent penalty on any underpayment of tax attributable to negligence or disregard of rules or regulations. Sec. 6662(a) and (b)(1). "Negligence" is any failure to make a reasonable attempt to comply with the provisions of the Internal Revenue Code, and "disregard" means any careless, reckless or intentional disregard. Sec. 6662(c). Negligence also includes any failure by a taxpayer to keep adequate books and records to substantiate items properly. See sec. 1.6662-3(b)(1), Income Tax Regs.



As to the issue of negligence, we conclude that respondent has met the burden of production. The evidence shows that petitioner failed to keep adequate books and records of her unique employment relationship and entitlement to foreign tax credits. Accordingly, we sustain respondent's determination that petitioner is liable for the accuracy-related penalty.



We have considered all of petitioner's contentions, and to the extent they are not addressed herein, they are irrelevant, moot, or without merit.



To reflect the foregoing,



Decisions will be entered under Rule 155.


1 Unless otherwise indicated, all Rule references are to the Tax Court Rules of Practice and Procedure, and all section references are to the Internal Revenue Code, as amended.

2 The Court generally refers to minor children by their initials. See Rule 27(a)(3).

3 Petitioner moved that the settlement documents be admitted into evidence under seal. We granted petitioner's motion and the documents are admitted solely for the purpose of proving the existence of settlements, not for the terms of the settlements.

4 SEC. 164. TAXES.

(a) General Rule. --Except as otherwise provided in this section, the following taxes shall be allowed as a deduction for the taxable year within which paid or accrued:

* * * * * * *

(3) State and local, and foreign, income, war profits, and excess profits taxes.

SEC. 901. TAXES OF FOREIGN COUNTRIES AND OF POSSESSIONS OF UNITED STATES.

(b) Amount allowed. --Subject to the limitation of section 904, the following amounts shall be allowed as the credit under subsection (a):

(1) Citizens and domestic corporations. --In the case of a citizen of the United States and of a domestic corporation, the amount of any income, war profits, and excess profits taxes paid or accrued during the taxable year to any foreign country or to any possession of the United States; * * *

Frivolous positions can cost you $10,000 or more

We know that the 6694(a) penalty will automatically apply if a position is determined to be "frivolous." But any frivolous position (there can be more than one in each return) will also be "reckless" and be subject to the $5,000 6694(b) penalty. At the same time, the $5,000 penalty for "frivolous tax returns" and $5,000 penalty for "specified frivolous submissions" may also apply under section 6702.
Below is Notice 2008-14 with identified frivolouse positions that will likely trigger the 6694(b) and 6702 $5,000 penalties. For these reasons, all return preparers need to be on notice of all IRS published and identified frivolous positions. The 6702 statute is also listed below.

Notice 2008-14, I.R.B. 2008-4, January 14, 2008.


The IRS has identified 43 frivolous positions that have been deemed frivolous by courts or have no basis for validity in existing law. These positions are frivolous for purposes of the Code Sec. 6702(a) penalty for filing frivolous tax returns and the Code Sec. 6702(b) penalty for filing specified frivolous submissions, such as requests for Collection Due Process (CDP) hearings, applications for installment agreements, offers in compromise, and taxpayer assistance orders. Included in the list are four new positions that relate to a misinterpretation of the Ninth Amendment regarding objections to military spending, erroneous claims that taxes are owed only by persons with a fiduciary relationship to the U.S. or IRS, a nonexistent "Mariner's Tax Deduction," or something similar, related to invalid deductions for meals and misuse or excessive use of the credit for fuels under Code Sec. 6421. Notice 2007-30, I.R.B. 2007-14, 883, is modified and superseded.


PURPOSE

Positions that are the same as or similar to the positions listed in this Notice are identified as frivolous for purposes of the penalty for a "frivolous tax return" under section 6702(a) of the Internal Revenue Code and the penalty for a "specified frivolous submission" under section 6702(b). Persons who file a purported return of tax, including an original or amended return, based on one or more of these positions are subject to a penalty of $5,000 if the purported return of tax does not contain information on which the substantial correctness of the self-assessed determination of tax may be judged or contains information that on its face indicates the self-assessed determination of tax is substantially incorrect. Likewise, persons who submit a "specified submission" (namely, a request for a collection due process hearing or an application for an installment agreement, offer-in-compromise, or taxpayer assistance order) based on one or more of the positions listed in this Notice are subject to a penalty of $5,000. The penalty may also be applied if the purported return or any portion of the specified submission is not based on a position set forth in this Notice, yet reflects a desire to delay or impede the administration of Federal tax laws for purposes of section 6702(a)(2)(B) or 6702(b)(2)(A)(ii).



BACKGROUND

Section 407 of Tax Relief and Health Care Act of 2006, Pub. L. No. 109-432, 120 Stat. 2922, 2960-62 (2006), amended section 6702 to increase the amount of the penalty for frivolous tax returns from $500 to $5,000 and to impose a penalty of $5,000 on any person who submits a "specified frivolous submission." A submission is a "specified frivolous submission" if it is a "specified submission" (defined in section 6702(b)(2)(B) as a request for a hearing under section 6320 or 6330 or an application under section 6159, 7122 or 7811) and any portion of the submission (i) is based on a position identified by the Secretary as frivolous or (ii) reflects a desire to delay or impede administration of the Federal tax laws. Section 6702 was further amended to add a new subsection (c) requiring the Secretary to prescribe, and periodically revise, a list of positions identified as frivolous. Notice 2007-30, 2007-14 I.R.B. 883, contained the prescribed list. This Notice revises the list to add more positions identified as frivolous. The positions that have been added are found in paragraphs 9(g), 11, 14 and 25.



DISCUSSION

Frivolous Positions. Positions that are the same as or similar to the following are frivolous.
(1) Compliance with the internal revenue laws is voluntary or optional and not required by law, including arguments that:

a. Filing a Federal tax or information return or paying tax is purely voluntary under the law, or similar arguments described as frivolous in Rev. Rul. 2007-20, 2007-14 I.R.B. 863.

b. Nothing in the Internal Revenue Code imposes a requirement to file a return or pay tax, or that a person is not required to file a tax return or pay a tax unless the Internal Revenue Service responds to the person's questions, correspondence, or a request to identify a provision in the Code requiring the filing of a return or the payment of tax.

c. There is no legal requirement to file a Federal income tax return because the instructions to Forms 1040, 1040A, or 1040EZ or the Treasury regulations associated with the filing of the forms do not display an OMB control number as required by the Paperwork Reduction Act of 1980, 44 U.S.C. §3501 et seq., or similar arguments described as frivolous in Rev. Rul. 2006-21, 2006-1 C.B. 745.

d. Because filing a tax return is not required by law, the Service must prepare a return for a taxpayer who does not file one in order to assess and collect tax.

e. A taxpayer has an option under the law to file a document or set of documents in lieu of a return or elect to file a tax return reporting zero taxable income and zero tax liability even if the taxpayer received taxable income during the taxable period for which the return is filed, or similar arguments described as frivolous in Rev. Rul. 2004-34, 2004-1. C.B. 619.

f. An employer is not legally obligated to withhold income or employment taxes on employees' wages.

g. Only persons who have contracted with the government by applying for a governmental privilege or benefit, such as holding a Social Security number, are subject to tax, and those who have contracted with the government may choose to revoke the contract at will.

h. A taxpayer may lawfully decline to pay taxes if the taxpayer disagrees with the government's use of tax revenues, or similar arguments described as frivolous in Rev. Rul. 2005-20, 2005-1 C.B. 821.

i. An administrative summons issued by the Service is per se invalid and compliance with a summons is not legally required.

(2) The Internal Revenue Code is not law (or "positive law") or its provisions are ineffective or inoperative, including the sections imposing an income tax or requiring the filing of tax returns, because the provisions have not been implemented by regulations even though the provisions in question either (a) do not expressly require the Secretary to issue implementing regulations to become effective or (b) expressly require implementing regulations which have been issued.

(3) A taxpayer's income is excluded from taxation when the taxpayer rejects or renounces United States citizenship because the taxpayer is a citizen exclusively of a State (sometimes characterized as a "natural-born citizen" of a "sovereign state"), that is claimed to be a separate country or otherwise not subject to the laws of the United States. This position includes the argument that the United States does not include all or a part of the physical territory of the 50 States and instead consists of only places such as the District of Columbia, Commonwealths and Territories (e.g., Puerto Rico), and Federal enclaves (e.g., Native American reservations and military installations), or similar arguments described as frivolous in Rev. Rul. 2004-28, 2004-1 C.B. 624, or Rev. Rul. 2007-22, 2007-14 I.R.B. 866.

(4) Wages, tips, and other compensation received for the performance of personal services are not taxable income or are offset by an equivalent deduction for the personal services rendered, including an argument that a taxpayer has a "claim of right" to exclude the cost or value of the taxpayer's labor from income or that taxpayers have a basis in their labor equal to the fair market value of the wages they receive, or similar arguments described as frivolous in Rev. Rul. 2004-29, 2004-1 C.B. 627, or Rev. Rul. 2007-19, 2007-14 I.R.B. 843.

(5) United States citizens and residents are not subject to tax on their wages or other income derived from sources within the United States, as only foreign-based income or income received by nonresident aliens and foreign corporations from sources within the United States is taxable, and similar arguments described as frivolous in Rev. Rul. 2004-30, 2004-1 C.B. 622.

(6) A taxpayer has been untaxed, detaxed, or removed or redeemed from the Federal tax system though the taxpayer remains a United States citizen or resident, or similar arguments described as frivolous in Rev. Rul. 2004-31, 2004-1 C.B. 617.

(7) Only certain types of taxpayers are subject to income and employment taxes, such as employees of the Federal government, corporations, nonresident aliens, or residents of the District of Columbia or the Federal territories, or similar arguments described as frivolous in Rev. Rul. 2006-18, 2006-1 C.B. 743.

(8) Only certain types of income are taxable, for example, income that results from the sale of alcohol, tobacco, or firearms or from transactions or activities that take place in interstate commerce.

(9) Federal income taxes are unconstitutional or a taxpayer has a constitutional right not to comply with the Federal tax laws for one of the following reasons:

a. The First Amendment permits a taxpayer to refuse to pay taxes based on religious or moral beliefs.

b. A taxpayer may withhold payment of taxes or the filing of a tax return until the Service or other government entity responds to a First Amendment petition for redress of grievances.

c. Mandatory compliance with, or enforcement of, the tax laws invades a taxpayer's right to privacy under the Fourth Amendment.

d. The requirement to file a tax return is an unreasonable search and seizure contrary to the Fourth Amendment.

e. Income taxation, tax withholding, or the assessment or collection of tax is a "taking" of property without due process of law or just compensation in violation of the Fifth Amendment.

f. The Fifth Amendment privilege against self-incrimination grants taxpayers the right not to file returns or the right to withhold all financial information from the Service.

g. The Ninth Amendment exempts those with religious or other objections to military spending from paying taxes to the extent the taxes will be used for military spending.

h. Mandatory or compelled compliance with the internal revenue laws is a form of involuntary servitude prohibited by the Thirteenth Amendment.

i. Individuals may not be taxed unless they are "citizens" within the meaning of the Fourteenth Amendment.

j. The Sixteenth Amendment was not ratified, has no effect, contradicts the Constitution as originally ratified, lacks an enabling clause, or does not authorize a non-apportioned, direct income tax.

k. Taxation of income attributed to a trust, which is a form of contract, violates the constitutional prohibition against impairment of contracts.

l. Similar constitutional arguments described as frivolous in Rev. Rul.