1. A 20% penalty for tax due that is attributable to return reporting positions based on negligence or substantial understatement.
2. a 40% penalty applies to tax due that is attributable to return reporting positions based on gross valuation or basis misstatements. Gross valuation or basis misstatements are those that exceed 200%.
A split among the courts has developed as to whether, if the tax is disallowed in a judicial proceeding for some threshold reason (such as lack of economic substance or simply failing to meet some other requirement of the code), the 40% gross valuation or basis misstatement penalty can apply. In holding that the 40% penalty cannot apply, courts reason that the tax due is attributable to the threshold disqualifier and not to the gross valuation or basis misstatement. See e.g., Keller v. Commissioner, ___ F.3d ___ (9th Cir. 2009). Other courts reject that if the gross valuation or basis misstatement was an essential ingredient of the originally claimed reporting position. See e.g., Long Term Capital Holdings, Inc. v. United States, 338 F.Supp.2d 122 (D. Conn. 2004), aff’d by unpublished order (2nd Cir. 9/27/05).
A decision reported just yesterday shows how a taxpayer skillfully exploited this split in authority. Alpha I, L.P., v. United States, ___ Fed. Cl. ___ (3/16/2009), denying the Government's motion for reconsideration in Alpha I, L.P., v. United States, 84 Fed. Cl. 622, 634 (2008). Basically, in this TEFRA proceeding, the partnership conceded a threshold legal disqualifier to the tax benefits in issue and then moved for summary judgment on the gross valuation misstatement issue because the valuation was no longer relevant and hence the tax due (conceded for other reasons) was not attributable to the gross valuation misstatement. The Government opposed the motion. The Court granted the motion. Alpha I, L.P., v. United States, 84 Fed. Cl. 622, 634 (2008). The Government then moved for reconsideration. The Court rejected the motion for reconsideration essentially because it did not raise any matters not previously considered as to the proper interpretation and application of the penalty. The Court reasoned (such as it is) in this regard (which I quote in its entirety because I don't understand it),
According to plaintiffs, however, "Defendant has lost sight of the different policy underlying the valuation misstatement penalty from other penalties designed to punish and deter taxpayers from taking negligent, aggressive, or fraudulent positions." Pls.' Resp. to Def.'s Mot. for Recons. 16. The court addressed the policy behind the § 6662(e) penalties in its Opinion of November 25, 2008. See Alpha I, 84 Fed. Cl. at 632-33. The court concluded that "forcing a 'trial on alternative grounds for adjustments plaintiffs have already conceded violates the purpose and policy behind the valuation misstatement penalties and is simply a waste of the Court's and the parties' resources.'" Id. at 632 (quoting Plaintiffs' Reply in Support of Plaintiffs' Motion for Partial Summary Judgment 5).Apparently, the Court thought that was the end of it from a legal analysis perspective.
But the Court proceeded to dispatch a Government policy consideration not relevant to the interpretation and application of the penalty. This policy related to how the Government induces taxpayers into settlement without trial by holding out the prospects of a worse result at trial. The Government argues that the partners of the Alpha I partnership making this strategic maneuver would be better off than other similarly situated taxpayers who settled. Adopting Alpha I's position on this matter, the Court held that whether or not the taxpayer partners in Alpha I were better off is not relevant and in any event not certain. And that was the end of that.
The bottom line takeaway for practitioners whose clients may be subject to the gross valuation misstatement penalty in an overly aggressive shelter or other return reporting position is to find some threshold disqualifier and go to a jurisdiction (such as the Fifth, Ninth, or Court of Federal Claims) and concede the tax on the basis of the disqualifier.