In Uncategorized on 09/25/2012 at 17:43

And That’s An Understatement–Not!

Connoisseurs of the anfractuosities of, and travelers through the Byzantine labyrinth that is, Title 26 of the United States Code will appreciate BLAK Investments, Kyle W. Manroe Trust, Robert Manroe and Lori Manroe, Trustees, Tax Matters Partner, 2012 T. C. Memo. 273, filed 9/25/12. Judge Vasquez is our guide for this journey into the unexpected and counterintuitive.

To paraphrase Charles Dickens, the deal was dead to begin with. It was agreed by the parties, and “stipulated that ‘BLAK Investments was a sham, lacked economic substance, and was formed and/or availed of to claim deductions of artificial losses solely for tax purposes’ and conceded that a 20% accuracy-related penalty under section 6662(a) applies to the entire underpayment of tax resulting from the transaction. The sole issue remaining for decision is whether petitioner is liable for the higher 40% penalty rate for a gross valuation misstatement under section 6662(h).” 2012 T. C. Memo. 273, at p. 2.

Slam dunk for the IRS, no? BLAK is a son-of-BOSS, a mix-and-match of short sale of U. S. treasuries with an unliquidated liability to cover, using the old Section 752 dodge, pre-amendment. See my blogpost “Woodshedding Your Experts–Stobie Creek Part Deux”, 1/10/11. So a phony basis builder gets blown up, and a thumping capital gain gets laid on the Manroes.

Now what about the 40%? Judge Vasquez: “We have held that when the Commissioner asserts a ground unrelated to value or basis of property for totally disallowing a deduction or credit and a taxpayer concedes the deduction or credit on that unrelated ground, any underpayment resulting from the concession is not attributable to a gross valuation misstatement. See McCrary v. Commissioner, 92 T.C. 827, 851-856 (1989). Petitioner conceded the deductions on the grounds that BLAK Investments is a sham and lacks economic substance–grounds unrelated to the value or basis of the Treasury notes, foreign currency, or any other property in the transaction.” 2012 T. C. Memo. 273, at p. 6.

Game over for IRS? Not quite. “Nonetheless, it has long been the Court’s view that the gross valuation misstatement penalty does apply when the Court determines that an underpayment stems from deductions or credits that are disallowed because a transaction lacks economic substance or a participant is a sham.” 2012 T. C. Memo. 273, at p. 7 (Citations omitted, but one of them is the celebrated Petaluma case; see my blogposts “The Great Dissenter – Part Deux”, 2/15/12, and “Judge, He Didn’t Mean It”, 9/17/12).

So which is it, 20% or 40%? The answer is ambiguous. The Courts of Appeal are all over the lot. Ninth Circuit, where these California taxpayers could appeal, felt constrained by stare decisis to follow an earlier decision that said that a sham is not an understatement (cf. Home Concrete v. US , and my blogpost “Colony Lives”, 4/26/12).

Judge Vasquez: “We have similarly stated that stare decisis ‘generally requires that we follow the holding of a previously decided case, absent special justification. This doctrine is of particular importance when the antecedent case involves statutory construction’. Therefore, respondent bears the heavy burden of persuading us that we should overrule our established precedent.” 2012 T. C. Memo. 273, at p. 10 (Citations omitted).

IRS doesn’t bear the heavy burden, so stare decisis carries the day.

But IRS has one last round in its magazine. IRS claims its amended regulation under Section 6662(h) deserves Mayo Clinic deference (see my blogpost “Carpenter, Colony, Chevron and Mayo”, 4/26/11).

Judge Vasquez nails that one: “The Court of Appeals was well aware of the regulation when it decided Keller. We believe the Court of Appeals saw no need to address the regulation as the taxpayer there did not contest the amount of the overvaluation; he instead argued that section 6662(h) is not ‘applicable in the first instance’ because ‘his tax underpayment is not “attributable to” the valuation overstatement’. Keller v. Commissioner, 556 F.3d at 1059.

“The Court of Appeals agreed with the taxpayer and held that ‘When a depreciation deduction is disallowed in total, any overvaluation is subsumed in that disallowance, and an associated tax underpayment is “attributable to” the invalid deduction, not the  overvaluation of the asset.’ Id. at 1061. Because the Court of Appeals found that section 6662(h) was inapplicable, the regulation interpreting section 6662(h) would have been equally inapplicable.” 2012 T. C. Memo. 273, at p. 12 (Footnote omitted).

So the taxpayer’s sham transaction draws only a 20% penalty. At least in California, it’s better to create phony basis when you’re doing a completely phony deal, rather than creating phony basis in an economically substantial but nevertheless phony deal.

Don’t you just love this stuff?

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