6694 - Substantial authority - Klunder caser

Everyone needs to understand the concept of "substantial authority" now that the term was hijacked for used in section 6694(a)(2)(A), as specified in the Emergency Economic Stabilization Act (October 3, 2008) retroactive to May 25, 2007.
That means that you will be hit with a $1,000 per position (or the higher of 50% of your fee) for each undisclosed position in a tax return unless you have "substantial authority" to support the position taken but not disclosed to the IRS.

The proposed regulations reference the regulations under section 6662 for the "analysis" of the relevant "authorities" and, therefore, there is zero doubt that the final regulations will also reference the 6662 regulations.

The Kluener case, below, makes some interesting observations about "substantial authority."


98-2 USTC ¶50,712] Kluener v. Commissioner U.S. Court of Appeals, 6th Circuit, 97-1201, 9/9/98, 154 F3d 630, 154 F3d 630. Affirming and reversing in part the Tax Court, 72 TCM 1326, Dec. 51,663(M) , TC Memo. 1996-519


The Internal Revenue Code imposes a twenty percent tax on the portion of an underpayment attributable to substantial understatement of income taxes. I.R.C. §6662(b)(2). This penalty deters taxpayers from playing the "audit lottery." Caulfield v. Commissioner [94-2 USTC ¶50,444], 33 F.3d 991, 994 (8th Cir. 1994). A taxpayer may reduce or eliminate this penalty by establishing that "substantial authority" supported his tax treatment of an item. I.R.C. §6662(d)(2)(B)(i); Norgaard v. Commissioner [91-2 USTC ¶50,378], 939 F.2d 874, 880 (9th Cir. 1991). Here, the Tax Court penalized the taxpayers $56,093 for substantial understatement of taxes. The taxpayers contest the penalty only on the ground that substantial authority supported Kluener's tax treatment.

The substantial authority standard is an objective standard involving an analysis of the law and application of the law to relevant facts. 26 C.F.R. §1.6662-4(d)(2) (1997. In contrast, the regulations interpreting the former §6661 do not emphasize the standard's objective nature. Cf. id. at §1.6661-3(a)(2). An objective standard accompanies a legal issue, not a factual issue, with no need to defer to a lower court. Norgaard [91-2 USTC ¶50,378], 939 F.2d at 877-78. Therefore, we review de novo a lower court's decision regarding substantial understatement penalties. We review de novo its evaluation of the law and its application of the law to the relevant facts. We review its underlying factual findings only for clear error.


Substantial authority exists only if the weight of the taxpayer's authorities is substantial in relation to the contrary authorities. 26 C.F.R. §1.6662-4(d)(3) (1997). "Substantial" means something less than a preponderance, but more than a mere reasonable basis. Id. at §1.6662-4(d)(2). "Authority" includes several sources of law, such as statutes, court cases, legislative history, and regulations, although none of these is particularly relevant if "materially distinguishable" on its facts. See id. at §1.6662-4(d)(3)(ii). The taxpayer's subjective belief that there is substantial authority is irrelevant. Id. at §1.6662-4(d)(3)(i).

The Sixth Circuit has not yet considered two issues regarding substantial authority. We must consider the precise meaning of "substantial," and whether "authority" includes factual evidence as well as legal sources. A §6661 case addressed both issues. See Osteen v. Commissioner [95-2 USTC ¶50,465], 62 F.3d 356, 359 (11th Cir. 1995). In Osteen, the taxpayers consistently lost money on their horse breeding operation. The deficiency issue turned on the taxpayers' intent. The Tax Court upheld the deficiency after finding that the taxpayers never intended to earn a profit, and upheld a tax penalty after finding that they lacked substantial authority for their position.

On appeal, the Eleventh Circuit criticized the substantial authority standard:
The application of a substantial authority test is confusing in a case of this kind. If the horse breeding enterprise was carried on for profit, all of the deductions . . . would be allowed. There is no authority to the contrary. If the enterprise was not for profit, none of the deductions would be allowed. There is no authority to the contrary. Nobody argues, however, not even the Government, that because the taxpayers lose on the factual issue, they also must lose on what would seem to be a legal issue.
Id. at 359.

In other words, the court criticized the substantial authority test for ignoring factual evidence. Without the facts, the taxpayers could present no authority to support their position, much less substantial authority.

The court then considered the penalty issue from both factual and legal standpoints. It held that substantial factual authority supported the taxpayers' position:

If the Tax Court was deciding that there was no substantial authority because of the weakness of the taxpayers' evidence to establish a profit motive, we reverse because a review of the record reveals there was evidence both ways. In our judgment, under the clearly erroneous standard of review, the Tax Court would be due to be affirmed [on the deficiency] even if it had decided this case for the taxpayers. With that state of the record, there is substantial authority from a factual standpoint for the taxpayer's position. Only if there was a record upon which the Government could obtain a reversal under the clearly erroneous standard could it be argued that from an evidentiary standpoint, there was not substantial authority for the taxpayer's position.Id.

The court also held that substantial legal authority supported their position:
If the Tax Court was deciding there was not substantial legal authority for the deductions, we reverse because of the plethora of cases in which the Tax Court has found a profit motive in the horse breeding activities of taxpayers that were similar to those at hand.Id.

Therefore, under Osteen, "authority" encompasses factual evidence, particularly in a case that turns on intent; "substantial" authority exists if the taxpayers present sufficient facts to support a judgment in their favor under the clearly erroneous standard of review, looking at the case as if they had won on the deficiency. Id. See also Streber v. Commissioner [98-1 USTC ¶50,333], 138 F.3d 216, 223 (5th Cir. 1998) (in a §6661 case that turned on the date of a gift, following Osteen and holding that authority includes factual evidence).

Osteen's analysis applies to §6662. Under §6662, "authority" encompasses factual evidence as well as legal sources. Section 6662's regulations direct us to examine relevant facts: "[t]he substantial authority standard . . . involv[es] an analysis of the law and application of the law to relevant facts." 26 C.F.R. §1.6662-4(d)(2) (1997). Indeed, the regulations demand that we examine the facts: "[t]he weight of authorities is determined in light of the pertinent facts and circumstances." Id. at §1.6662-4(d)(3)(i).

On the other hand, another provision seems to imply that authority consists only of legal sources. After stating that "only the following are authority," the regulations list numerous legal sources of authority, but never refer to factual evidence. Id. at §1.6662-4(d)(3)(iii). Nonetheless, we interpret this provision as excluding only certain types of legal sources, not any factual evidence. For example, this provision states that "authority" does not include overruled decisions or the opinions of tax advisors. In any event, to the extent that the regulations may conflict, we reconcile them by noting that two provisions command us to examine relevant facts, whereas nothing explicitly precludes us from examining them.
Moreover, policy concerns indicate that "authority" should include factual evidence. In this case, for example, to ignore the facts is to assess a penalty. Cf. Osteen, supra. Nothing in the regulations supports such a result. Finally, practical jurisprudential factors force courts to examine the facts. A court must examine the facts to evaluate a legal source's relevance. In this sense, a legal source can constitute substantial authority only if its facts resemble those in the current case.

We disagree, however, with Osteen's analysis of "substantial." Under the regulations, "substantial" means more than a reasonable basis. 26 C.F.R. §1.6662-4(d)(2) (1997). Therefore, "substantial authority" requires a taxpayer to present considerable or ample authority, whereas Osteen requires him to present only some evidence. See Streber v. Commissioner [98-1 USTC ¶50,333], 138 F.3d 216, 228 (5th Cir. 1998) (King, J., dissenting). 2

Here, the Tax Court found that substantial authority did not support Kluener's position. The court did not examine the factual evidence. In a footnote, it distinguished the taxpayers' legal authority, Caruth and Smalley, on the ground that the corporations in those cases used the transferred proceeds, whereas APECO never used the proceeds. This cursory footnote represented the court's entire discussion of an issue that cost the taxpayers $56,093. Cf. Osteen [95-2 USTC ¶50,465], 62 F.3d at 359 (criticizing the Tax Court for failing to discuss the penalty at length).
We hold that substantial authority supported Kluener's tax treatment of the horse proceeds. Considerable factual evidence indicates that he transferred the horses for a valid, non-tax business purpose. This evidence includes his reference notes, the lack of prior research, his lack of tax expertise, and APECO's genuine need for funds. This evidence is substantial in relation to the contrary evidence. There are two very strong contrary facts: APECO never used the proceeds, and Kluener actively hid APECO Equine. Neither of these facts, alone or combined with others, overwhelms the taxpayers' evidence. The two unexpected financial developments explain, at least in part, APECO's forbearance. Similarly, Kluener's deceit does not necessarily mean that he never intended to benefit APECO. As APECO's sole shareholder and CEO, Kluener could have controlled the proceeds without deceiving anyone. The taxpayers argue that he wanted APECO personnel to focus on the new sprayers; in light of his total control, this rationale carries at least some weight.

With this factual background, substantial legal authority supported Kluener's tax treatment. In this type of case, the distinctions between valid and invalid transfers are "shadowy and artificial." E.g., United States v. Cumberland Public Serv. Co. [50-1 USTC ¶9129], 338 U.S. 451, 454-55 (1950). Cf. Norgaard [91-2 USTC ¶50,378], 939 F.2d at 880-81. Several cases support Kluener's tax treatment. In both Caruth and Smalley, for example, a shareholder transferred property to improve the finances of a legitimate corporation, not a shell. See Caruth v. United States [88-2 USTC ¶9514], 688 F. Supp. 1129 (N.D. Tex. 1987), aff'd on another issue [89-1 USTC ¶9172], 865 F.2d 644 (5th Cir. 1989); Smalley v. Commissioner [CCH Dec. 31,929(M)], 32 T.C.M. (CCH) 373 (1973). In neither case was the transfer essential, and in neither case did the transferee use the funds immediately. Although those transferees ultimately used the funds, those taxpayers never faced an unexpected financial squeeze. As a result, when Kluener prepared his tax returns, Caruth and Smalley provided substantial authority supporting his tax treatment.

Moreover, the contrary legal authority does not overwhelm these cases. While the IRS relies heavily on Stewart and Hallowell, both cases differ in important respects. See Stewart v. Commissioner [83-2 USTC ¶9573], 714 F.2d 977 (9th Cir. 1983); Hallowell v. Commissioner [CCH Dec. 30,847], 56 T.C. 600 (1971). In Stewart, no evidence indicated that the transferee needed funds, and in Hallowell, the taxpayers repeatedly transferred property over a three-year period. Neither case involved unexpected events. Because of these distinctions, and considering all the relevant facts, Caruth and Smalley represent substantial authority in relation to Stewart and Hallowell. Therefore, we reverse the imposition of an accuracy-related penalty. 3
AFFIRMED in part, REVERSED in part.
CONCURRING IN PART, DISSENTING IN PART

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I like this case for a few reasons. First, the comment in the 6662 regulations that "substantial authority" is an objective standard is simply not true, and it does conflict with the "facts & circumstances" standard in the same regulations.
"Substantial authority" is clearly a "subjective standard." Indeed, I have read a number of 6662 cases that have concluded that there is "no substantial authority" without a discussion of the facts. The final 6694 regulations should make it clear that "substantial authority" is not an objective standard to avoid confusing the courts, as indicated in this case.

I also like the comment of the Court that one has to look at conflicting authority. All of the technical authority on a position taken in a return will be and should be considered by tax return preparers. This case is helpful because the court noted that there were a few cases that supported taxpayer's position.

This Court indicated that the authority must be ample and considerable. This is another way or restating the regulations under section 1-6662-4(d)(3) in stating that the weight of authhorities supporting the treatment is substantial in relation to the weight of authority supporting contrary treatment.

The necessary premise for "substantial authority" is that the return preparer will be held to have researched all of the tax law and then make a justment that there ampley authhority to support the position even if there is contrary authority.

If I did not know that the "more likely than not" standard involved having 51% or more to support a position, I would have conclued that the authhority contemplated under 1.6662-4(d)(3) implies more authority for the position versus the contrary authority. But let's assume that "substantial authority" is quantified by having at least 40% of the authority to support a position. How can any human determine the difference between 51% and 41%? That decision is clearly a subjective decision.

In short, the legislative change from "more likely than not" to "substantial authority" was, in my personal and humble opinion, worthwhile but at the same time technically meaningless.

If you want to avoid the $1,000 (or 50% income) penalty (per position), the return preparers need to provide compelling technical support. More technical support is better than less technical suppor, an obvious point. You also have to understgand that the return preparer industry must deal with an aggressive IRS examiner. IRS examiners are indeed aggressive on discretionar factual and legal issues. They are even difficult when the law is clear because you cannot expect them to know the applicable law.

Finally, you have to expect that understatements of tax have a stong likelihood of being perceived to be viewed as "reckless" by the IRS, because they will be motivated to hit return preparers with the $5,000 penalty under section 6694(b).

The Klunder case is an example of how the courts will struggle with the "substantial authority" standard.

Given this complexity with the "substanaitl authority" standard, I believe the best way to deal with problematical decisions is to disclose the positions taken with the use of "substantial authority" even though the standard is "reasonable basis." There is clearly less authority for the "reasonable basis" standard, but that is the only way to play it safe to avoid the draconian $5,000 penalties per position taken in a return.

Another safety net is to geta written opinion on the technical authority from a tax attorney or some other tax expert and also make the disclosure. That by far is the safest strategy to avoid the large draconian penalties. That conclusion is reflected by the flow of opinion requests we have been receiving from those who agree with this conclusion. The best time to deal with problematical issues for the 2008 tax year is now before the tax returns are filed in 2009. It will be much more expensive to defend a position after the IRS has selected a tax return for examination. These matters are client matters: 1) we want to prevent clients from being hit with a negligence penalty, and an attorney opinion will give him "reasonable cause" within the meaning of section 6664; 2) you need to get your client to pay for the extra time needed for positions taken or for the opinion of a tax attorney or other tax expert.