reasonable cause and substantial authority

NPR INVESTMENTS, LLC v. U.S., Cite as 106 AFTR 2d 2010-XXXX, 08/10/2010
Code Sec(s):
Court Name: IN THE UNITED STATES DISTRICT COURT FOR THE EASTERN DISTRICT OF TEXAS TEXARKANA DIVISION,
Docket No.: CV 5:05-CV-219-TJW,
Date Decided: 08/10/2010.
Disposition:
B. The Accuracy Related Penalties
There are two accuracy-related penalties asserted by the Government that are still in dispute in this case: 9 a 20% penalty for substantial understatement of income tax under Section 6662(b)(2) and (d) and a 20% penalty for negligence or disregard of rules and regulations under Section 6662(b)(1). The Court now addresses the applicability of the penalties.
1. Substantial Understatement of Income Tax
In the August 15, 2005 FPAA, the IRS imposed a penalty for substantial understatement of income tax. The Court now turns to this penalty.
a. Legal Principles
Section 6662(b) imposes a 20% penalty to “[a]ny substantial understatement of income tax.” 26 U.S.C. § 6662(a), (b)(2). “For purposes of this section, there is a substantial understatement of income tax for any taxable year if the amount of the understatement for the taxable year exceeds the greater of (i) 10 percent of the tax required to be shown on the return for the taxable year, or (ii) $5,000.” 26 U.S.C. § 6662(d)(1)(A). The amount of the substantial understatement used to compute the penalty does not include any item for which there was substantial supporting authority. 26 U.S.C. § 6662(d)(2)(B)(i); Treas. Reg. § 16662-4(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 (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.” Treas. Reg. § 1.6662-4(d)(2). For substantial authority to exist, “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). Opinions rendered by tax professionals are not authority. Treas. Reg. § 1.6662-4(d)(3)(iii). The authorities underlying such opinions, if applicable to the facts of a particular case, may give rise to substantial authority for the tax treatment of an item.Id. In addition, in a case involving a tax shelter, the “substantial authority” exception does not apply unless the “taxpayer reasonably believed that the tax treatment of such item by the taxpayer was more likely than not the proper treatment.” 26 U.S.C. § 6662(d)(2)(C)(i)(II). 10 A “tax shelter” includes, among other things, a partnership or an investment plan “if a significant purpose of such ... is the avoidance or evasion of Federal income tax.” 26 U.S.C. § 6662(d)(2)(C)(iii).
c. Analysis
This Court may assume, arguendo, that the NPR partnership was a tax shelter within the definition. The record, however, supports a finding that substantial authority existed. The Taxpayers obtained comprehensive opinions of counsel before they filed their returns. The Sidley Austin opinions relied on the relevant authority at the time. Cohen went over the opinions with the Taxpayers and confirmed that they were reasonable. Further, Mr. Stuart Smith (“Smith”) provided expert opinion and testimony that substantial authority supported the tax treatment at issue in this case. Smith's experience includes over 40 years as a tax lawyer, both as Tax Assistant to the Solicitor General in the Department of Justice and now in private practice. (Tr. II at 60–61.) After examining the material issues identified in the opinions, Smith concluded that the opinions provided “objectively reasonable tax advice” because they “discussed all of the authorities in an even-handed balanced way, taking into account all possible challenges in a thorough and complete manner.” (Tr. II at 77.) He further concluded that the opinions were the “quality and character upon which a taxpayer could rely in good faith.” (Id.) The Court agrees with Smith's opinions and concludes that the Sidley Austin opinions provided “substantial authority” for the Taxpayers' treatment of their basis in their respective partnerships. The record also supports a finding that the Taxpayers reasonably believed that the tax treatment applied to the transactions was “more likely than not” the proper treatment. Although they are experienced attorneys, the Taxpayers are not tax lawyers. Based on all of the record evidence, the Court finds that the Taxpayers were not aware of any financial agreements between Cohen and DGI when they decided to enter the transactions and when they filed their returns. (Tr. II at 8–9.) The Taxpayers believed that Cohen was properly discharging his duties as their fiduciary. The Taxpayers sought advice from Cohen before deciding to enter these transactions and relied heavily upon his advice. The Taxpayers sought to make a profit from the investment plan when they entered the pertinent transactions, even if NPR did not. Accordingly, the Court finds that the substantial understatement penalty does not apply.
2. Negligence
In the August 15, 2005 FPAA, the IRS also imposed a penalty for negligence. The Court now turns to this penalty.
a. Legal Principles
The 20% negligence penalty applies to the extent that an understatement of the tax was attributable to the taxpayer's “negligence or disregard of rules or regulations.” 26 U.S.C. § 6662(b)(1). “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” of the tax laws. 26 U.S.C. § 6662(c). Negligence includes the “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.” Treas. Reg. § 1.6662-3(b)(1). “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 which would seem to a reasonable and prudent person to be “too good to be true” under the circumstances.” Treas. Reg. § 1.6662-3(b)(1)(ii). Disregard for the “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.” Treas. Reg. § 1.6662-3(b)(2). The Fifth Circuit defines negligence as “any failure to reasonably attempt to comply with the tax code, including the lack of due care or the failure to do what a reasonable or ordinarily prudent person would do under the circumstances.” Heasley v. Comm'r, 902 F.2d 380, 383 [66 AFTR 2d 90-5068] (5th Cir. 1990).
A taxpayer is not negligent where there is a reasonable basis for the position taken. Treas. Reg. § 1.6662-3(b)(1). “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.” Treas. Reg. § 1.6662-3(b)(3). Reasonable basis requires reliance on legal authorities and not on opinions rendered by tax professionals. Id.; Treas. Reg. § 1.6662-4(d)(3)(iii). The Court may, however, examine the authorities relied upon in a tax opinion to determine if a reasonable basis exists. See Treas. Reg. § 1.6662-4(d)(3)(iii). “If a return position is reasonably based on one or more of the authorities set forth in [the substantial authority section] ... 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).” Treas. Reg. § 1.6662-3(b)(3).
c. Analysis
The reasonable basis standard is less stringent than the substantial authority standard; if the substantial authority defense is applicable to the substantial understatement penalty, the reasonable cause defense will also be applicable.See Treas. Reg. § 1.6662-4(d)(2); Treas. Reg. § 1.6662-3(b)(3). As discussed above, the Court finds that there was “substantial authority” to rely on the Sidley Austin opinions. Id. Therefore, the “reasonable basis” standard has also been met. Accordingly, a penalty for negligence is not applicable in this case.
C. Reasonable Cause and Good Faith Defense
Finally, the Court turns to the reasonable cause and good faith issues. Notwithstanding the specific requirements of the penalties discussed above, a taxpayer may defeat the imposition of any of those penalties if he demonstrates reasonable cause.
1. Legal Principles
Section 6664(c)(1) provides an absolute defense to any accuracy-related penalty. A taxpayer that would otherwise be subject to a twenty-percent accuracy-related penalty under § 6662(b) is not liable if the taxpayer can demonstrate that the underpayment was made with reasonable cause and the taxpayer acted in good faith. 26 U.S.C. 6664(c)(1); Treas. Reg. § 1.6664-4(a). The plaintiffs bear the burden of production and proof on their reasonable cause defenses. Klamath Strategic Investment Fund v. U.S., 568 F.3d 537, 548 [103 AFTR 2d 2009-2220] (5th Cir. 2009); see Montgomery v. Commissioner, 127 T.C. 43, 66 (2006). Although each instance requires a case-by-case determination of all pertinent facts and circumstances, generally the most important factor in assessing the applicability of the exception is the amount of effort the taxpayer spent to determine the proper tax liability in light of all the circumstances. Treas. Reg. § 1.6664-4(b). When considering the taxpayer's effort to determine the proper tax liability, the taxpayer's reliance on the advice of a professional tax adviser may not be sufficient to demonstrate reasonable cause and good faith. Treas. Reg. § 1.6664-4(b)(1). Rather, the validity of the reliance turns on “the quality and objectivity of the professional advice which they obtained.” Klamath, 568 F.3d at 548, citing Swayze v. U.S., 785 F.2d 715, 719 [57 AFTR 2d 86-1050] (9th Cir. 1986). “Reliance on ... professional advice, or other facts, however, constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith.” Treas. Reg. § 1.6664-4(b)(1). To determine if reliance on a tax professional's advice was reasonable and in good faith, all facts and circumstances must be taken into account. Treas. Reg. § 1.6664-4(c). “For example, the taxpayer's education, sophistication and business experience will be relevant in determining whether the taxpayer's reliance on tax advice was reasonable and made in good faith.” Id. “Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of all the facts and circumstances, including the experience, knowledge, and education of the taxpayer.” Treas. Reg. § 1.6664-4(b)(1). A taxpayer is not required to challenge the advisor's conclusions, seek a second opinion, or check the advice himself. U.S. v. Boyle, 469 U.S. 241, 250–51 [55 AFTR 2d 85-1535] (1985). “To require the taxpayer to challenge the attorney, to seek a “second opinion,” or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place.” Id. at 251.
In order to establish reasonable reliance in good faith on the advice of a tax professional, a taxpayer must establish that all facts and circumstances were considered, and no unreasonable assumptions were made. Treas. Reg. § 1.6664-4(c)(1)(i)–(ii). For the advice to be based on “[a]ll the facts and circumstances,” it must include all pertinent facts and circumstances, including “the taxpayer's purposes (and the relative weight of such purposes) for entering into a transaction and for structuring a transaction in a particular manner.” Treas. Reg. § 1.6664-4(c)(1)(i). Additionally, “[t]he advice must not be based on unreasonable factual or legal assumptions (including assumptions as to future events) and must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person.” Treas. Reg. § 1.6664-4(c)(1)(ii). “The fact that these requirements are satisfied, however, will not necessarily establish that the taxpayer reasonably relied on the advice (including the opinion of a tax advisor) in good faith.” Treas. Reg. § 1.6664-4(c)(1).
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In short, the Taxpayers acted reasonably and in good faith in relying on their tax advisors' advice with respect to their investments in the underlying transactions. As aptly stated by Mr. Nix at trial, “at every step, we followed the advice of people we relied on, people who were supposed to have known what they were doing and did know what they were doing. And what else could we have done except follow their advice?” (Tr. II at 32–33.) The Court finds that the Taxpayers have proven, by a preponderance of the evidence, their good faith in relying on the advice of qualified tax accountants and tax lawyers. Accordingly, the criteria under the reasonable cause exception of 26 U.S.C. § 6664(c) is satisfied, and the Taxpayers are not liable for accuracy-related penalties.