The opinion
T.C. Memo. 2014-47
UNITED STATES TAX COURT
HUMBOLDT SHELBY HOLDING CORPORATION AND SUBSIDIARIES,
Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 25936-07. Filed March 18, 2014.
P purchased H Corp. and S Corp., two corporations that had
recently realized large capital gains. To avoid paying taxes on the
gains it inherited, P executed a common tax avoidance scheme to
generate capital losses. Under the scheme, P contributed largely
offsetting short-term options to two LLCs it had formed. P increased
its bases in the LLCs by the cost of the purchased options but did not
reduce its bases by the cost of the sold options. This accounting
treatment allowed P to increase its bases in the partnerships by
approximately $75 million while spending only $320,000.
After the options expired, P resigned from the LLCs and
received stock with nominal fair market value but very high bases. P
sold the stock and recognized capital losses of almost $75 million,
which completely offset the gains P had inherited from H Corp. and S
Corp. R issued a notice of deficiency disallowing P’s claimed
deductions from the stock sales and professional fee deductions P had
also claimed. R further determined that P was liable for the accuracy-
related penalty under I.R.C. sec. 6662.
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[*2] Held: P improperly deducted capital losses on stock whose
basis was artificially inflated with a transaction that lacked economic
substance.
Held, further, P was not entitled to deduct professional fees
under I.R.C. sec. 162.
Held, further, P is liable for the accuracy-related penalty under
I.R.C. sec. 6662.
Jasper George Taylor III and Susan Virginia Sample, for petitioner.
Elaine Harris, Veronica L. Trevino, and Julie Ann P. Gasper, for
respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GOEKE, Judge: James Haber is a tax professional who has promoted tax
shelters to third parties through a company called the Diversified Group, Inc.
(DGI). This case involves a tax scheme Mr. Haber carried out for his personal
benefit. Mr. Haber is petitioner’s sole shareholder, and his scheme would have
allowed petitioner to avoid approximately $25 million of Federal income tax while
incurring costs of only $320,000.
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[*3] To carry out the tax scheme at issue, petitioner contributed paired options to
a partnership to generate an artificially high basis in property the partnership later
distributed. Petitioner recognized large capital losses when it sold the stock and
reported those losses on its 2003 return to offset capital gains. Respondent
disallowed the capital loss deductions and related section 1621 business deductions
and determined that petitioner was liable for a section 6662 accuracy-related
penalty. The issues for decision are:
1) whether petitioner improperly claimed short-term capital loss deductions
of $74,093,688 for its 2003 taxable year. We hold that it did;
2) whether petitioner improperly claimed section 162 business deductions of
$1,249,925 for professional fees it incurred during its 2003 taxable year. We hold
that it did; and
3) whether petitioner is liable for the accuracy-related penalty under section
6662. We hold that it is.
1
Unless otherwise indicated, all section references are to the Internal
Revenue Code (Code) in effect for the year at issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure.
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[*4] FINDINGS OF FACT
Petitioner is a Delaware corporation with principal offices in New York.
Petitioner claimed capital loss deductions of $74,093,688 and deducted
$1,249,925 for professional fees on its consolidated Federal income tax return for
the taxable year ended November 30, 2003. Respondent determined a deficiency
of $25,617,887 in petitioner’s Federal income tax for the taxable year ended
November 30, 2003, and a penalty under section 6662 of $10,247,155. Petitioner
generated the disputed losses with a common tax avoidance scheme we will
describe below.
1. The General Scheme
To carry out the scheme, a taxpayer first creates a partnership. Next, the
taxpayer buys and sells offsetting contingent assets and liabilities and contributes
them to the partnership. The taxpayer increases its basis in the partnership by its
basis in the contingent asset but does not decrease its basis for the contingent
liability.2 After the contingency period for the assets and liabilities expires,
2
Under sec. 722 when a party contributes property to a partnership in
exchange for a partnership interest, the party takes a basis in the partnership
interest equal to his or her basis in the contributed property. Under sec. 752 a
partner’s basis in its partnership interest decreases when the partnership assumes a
liability of the partner. Perpetrators of this scheme have argued that in Helmer v.
Commissioner, T.C. Memo. 1975-160, we held that partners should not decrease
(continued...)
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[*5] usually with little or no economic consequence, the taxpayer liquidates the
partnership interest and receives property. The property has a very high basis but
minimal actual value. The taxpayer sells the high-basis property at its actual value
and recognizes a capital loss.
2. Digital Options
Taxpayers have often used digital options as the offsetting contingent assets
and liabilities in the avoidance scheme. A digital option is an investment that
provides for a return if a designated event occurs at a designated time. For
example, a digital option might provide that X will receive $20 if the S&P 500 is
trading above 450 (the “strike price”) on January 1, 20XX. If the S&P 500 were
trading below 450 on the expiration date, X would receive nothing.
Investors can both buy and sell digital options. If X had sold the option in
our example above, X would have had to pay $20 if the S&P 500 were trading
above 450 on January 1, 20XX. If the S&P 500 were trading below 450 on the
expiration date, X would not have to pay anything.
If an investor buys and sells options with exactly the same terms, he or she
will make exactly zero on the investment. Any payment the investor would owe
2
(...continued)
their partnership bases when they contribute sold options.
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[*6] would be offset by the receipt of an identical payment. For example, if X
both bought and sold the options described above and the S&P 500 were trading
above 450 on the expiration date, X would both pay and receive $20. If the index
were trading below 450 on the expiration date, it would neither owe nor receive a
payment. In either scenario, the return on investment would be zero.
A party that intends to use digital options to generate tax losses usually will
not purchase and sell options that offset completely, because a transaction that
could not produce a gain or loss would too obviously lack economic substance.
Instead, the party will usually purchase and sell options that ostensibly provide an
opportunity for gain or loss. To accomplish this, the party will purchase options
that only mostly offset. For instance, using our previous example, X would
purchase an option with a strike price of 450 and sell an option with a strike price
of 450.03. This arrangement would provide for a result called “hitting the sweet
spot”. The sweet spot is the range of prices between the strike price for the
purchased option and the strike price for the sold option. In our example, if the
S&P 500 were trading at 450.01 on the expiration date, X would receive payment
on its purchased option and avoid payment on its sold option. Hitting the sweet
spot can result in a very large windfall for an investor, but the probability of
hitting it is usually very low.
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[*7] 3. The HSHC Transaction
Mr. Haber created Humboldt Shelby Holding Corp. (HSHC) to acquire
Humboldt Corp. (Humboldt) and Shelby Corp. (Shelby), two corporations with
large built-in gains. Combined, the two corporations had assets worth
approximately $90 million, but they expected to pay $25 million in Federal
income tax on their 2003 capital gains. Consequently, the corporations’ combined
net asset value was only about $65 million. HSHC purchased the two corporations
for $86 million and then engaged in a strategy to avoid paying taxes on the built-in
gains.
Mr. Haber created HBS Investments, LLC (HBS Investments).3 Humboldt
and Shelby each purchased largely offsetting digital options and contributed them
3
We have simplified the facts here for readability. Mr. Haber did not
himself create HBS Investments, LLC. Mr. Haber was the president of JSB
Investments. JSB Investments had two subsidiaries: Brenview Holdings and
Cumberdale Holdings. Brenview and Cumberdale formed HBS Investments with
initial contributions of $20,000 each. The HBS Investments operating agreement
vested all management and control in JSB Investments.
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[*8] to HBS Investments.4 Refco Capital Markets Ltd. (Refco), a commodities
dealer, arranged the option trades.
Humboldt purchased an option for $70 million and sold a largely offsetting
option for $69.7 million. When Humboldt contributed the options to HBS
Investments, it took a basis of $70 million in the partnership interest it received.
Shelby purchased an option for $4.4 million and sold a largely offsetting option
for $4.38 million. When Shelby contributed the options to HBS Investments, it
took a basis of $4.4 million in its resulting partnership interest. Refco agreed to
allow Humboldt and Shelby to pay only the $320,000 difference between the
premiums of the purchased and sold options.
The options expired three months later with no payment on either side.
Humboldt and Shelby liquidated their partnership interests in HBS Investments
and received common stock of various publicly traded companies. Their bases in
the stock matched their bases in their partnership interests (approximately $75
million). Subsequently, they sold the distributed stock at its fair market value and
4
We have again simplified the facts here for readability. Humboldt and
Shelby did not purchase the options directly. Rather, each formed a corresponding
LLC--Humboldt created Humboldt Trading, LLC, and Shelby created SHEL
Trading, LLC. The LLCs purchased the options and contributed them to HBS
Investments. When HBS Investments later liquidated, the LLCs recognized the
tax losses, which then flowed to Humboldt and Shelby.
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[*9] recognized losses of nearly $75 million. HSHC used the losses to offset the
built-in gains it inherited when it purchased Humboldt and Shelby and avoided
paying any tax on the gains.
4. Features of the Options at Issue
The Humboldt options were linked to the S&P 500 Index. Humboldt
expected to receive approximately $800,000 if the index price was less than or
equal to 816.93 on the expiration date and nothing if the price exceeded 816.96.
Humboldt expected to receive approximately $234 million if the price fell within
the sweet spot on the expiration date.
Shelby’s options were linked to the NASDAQ 100 Index. Shelby expected
to receive approximately $30,000 if the index price was less than or equal to
891.13 on the expiration date and nothing if the index price exceeded 891.16.
Shelby expected to receive approximately $15 million if the index price fell within
the sweet spot.
The option contracts gave Refco a 15-minute window on the expiration date
to select the price that would control the options’ outcomes. Refco could have
chosen as the controlling price any value at which the indexes traded within that
window. This contract provision removed any practical possibility that the
options would expire within the sweet spot. The relatively long window ensured
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[*10] that Refco could set a price outside of the sweet spot, and Refco had
significant financial incentives to do so. Consequently, although each set of
options ostensibly provided for three potential outcomes, only two were possible:
(1) the options could have finished “in the money”, generating $800,000 and
$30,000 respectively or (2) the options could have finished “out of the money” and
generated no return.
5. Fees
Petitioner deducted $1,249,925 for “professional fees” it paid in connection
with the acquisition of Humboldt and Shelby and the subsequent paired-option
transaction. The components of this deduction are (1) a $1,020,000 finder’s fee
related to the acquisition; (2) a $50,155 legal fee petitioner paid to obtain a tax
opinion concerning the paired option arrangement; and (3) unsubstantiated fees
totaling $179,770.
6. Criminal Investigation Involving Mr. Haber
Mr. Haber is petitioner’s sole owner and the architect of its tax avoidance
plan. Mr. Haber is a witness in criminal proceedings in the Southern District of
New York involving a former DGI client. The U. S. attorney for that district
denied Mr. Haber’s request for immunity. Consequently, Mr. Haber has invoked
his Fifth Amendment privilege against self-incrimination and declined to testify in
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[*11] these proceedings. Petitioner moved to stay the case until the criminal
prosecution’s conclusion. We denied the motion after finding that the interests of
justice did not support further delaying the trial.
OPINION
I. Burden of Proof
The taxpayer bears the burden of proving by a preponderance of the
evidence that the Commissioner’s determinations are incorrect. Rule 142(a);
Welch v. Helvering, 290 U.S. 111, 115 (1933). Deductions are a matter of
legislative grace, and a taxpayer bears the burden of proving entitlement to any
claimed deductions. Rule 142(a)(1); INDOPCO, Inc. v. Commissioner, 503 U.S.
79, 84 (1992). The term “burden of proof” includes two distinct concepts: (1) the
burden of persuasion, “i.e., which party loses if the evidence is closely balanced”,
and (2) the burden of production, “i.e., which party bears the obligation to come
forward with the evidence at different points in the proceeding”. Schaffer v.
Weast, 546 U.S. 49, 56 (2005). Before trial we considered shifting the burden of
proof to respondent in the light of Mr. Haber’s decision to invoke his Fifth
Amendment privilege and our decision to move forward with the trial in his
absence. We ultimately decided against shifting the burden of persuasion because
doing so would have effectively sanctioned the Commissioner for the Federal
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[*12] prosecutor’s refusal to grant Mr. Haber immunity. We did shift the burden
of production to respondent and requested petitioner to provide an offer of proof
regarding the testimony Mr. Haber would have provided if he had been granted
immunity.
Immunity is a statutory creation whose administration Congress bestowed
on the executive branch. 18 U.S.C. secs. 6002 and 6003 (2012). Congress has
given the Attorney General the authority to exchange the protection of immunity
for otherwise incriminating testimony when, in his judgment, a witness’ testimony
may be in the public’s interest. United States v. Quinn, 728 F.3d 243 (3d Cir.
2013). “There is * * * overwhelming judicial and legislative authority for the
proposition that review on the merits of a Federal prosecutor’s decision to grant
immunity is barred by statute.” United States v. Herman, 589 F.2d 1191, 1201 (3d
Cir. 1978). This bar extends to judicial review on the merits of a prosecutor’s
decision to withhold immunity. Id.
Rule 142 permits the Court to shift the burden of proof in its discretion
under certain circumstances. Given the prosecutor’s broad authority to make
immunity decisions without judicial interference, we exercised this discretion
cautiously here. After careful consideration of Mr. Haber’s circumstances, we
determined that he could invoke his Fifth Amendment right to avoid testifying, but
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[*13] we declined to shift the burden of persuasion. After trial it is apparent that
the burden of persuasion has no bearing on the resolution of this case. The
evidence in the record would support our conclusion even if we had shifted the
burden and even if Mr. Haber had testified as petitioner claimed in its offer of
proof. Considering the significant objective evidence of his intent here, we would
have given little weight to his self-serving testimony. See Faulconer v.
Commissioner, 748 F.2d 890, 894 (4th Cir. 1984) (“A taxpayer’s mere statement
of intent is given less weight than objective facts.”), rev’g T.C. Memo. 1983-165.
II. Economic Substance Doctrine
A. Overview
“The legal right of a taxpayer to decrease the amount of what otherwise
would be his taxes, or altogether avoid them, by means which the law permits,
cannot be doubted.” Gregory v. Helvering, 293 U.S. 465, 469 (1935). However,
we will disregard transactions that lack economic substance, even when they
formally comply with the requirements of the Code. See, e.g., Knetsch v. United
States, 364 U.S. 361 (1960). Whether a transaction has economic substance is a
factual determination. United States v. Cumberland Pub. Serv. Co., 338 U.S. 451,
456 (1950). We will respect a transaction when it constitutes a genuine,
multiple-party transaction, compelled by business or regulatory realities, with
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[*14] tax-independent considerations that are not shaped solely by tax avoidance
features. Frank Lyon Co. v. United States, 435 U.S. 561, 583-584 (1978).
Courts have used different, though related, approaches in determining
whether a transaction has economic substance. An appeal in this case would lie to
the Court of Appeals for the Second Circuit, and accordingly we follow the law of
that circuit. See Golsen v. Commissioner, 54 T.C. 742 (1970), aff’d, 445 F.2d 985
(10th Cir. 1971). The Court of Appeals for the Second Circuit has endorsed a
flexible approach in assessing economic substance. Gilman v. Commissioner, 933
F.2d 143 (2d Cir. 1991), aff’g T.C. Memo. 1989-684. Under that approach, we
evaluate both the transaction’s objective economic substance and the taxpayer’s
subjective business purpose for engaging in the transaction. Id. at 148. These
distinct aspects of the economic substance inquiry do not, however, constitute
discrete prongs of a rigid two-step analysis. Long Term Capital Holdings v.
United States, 330 F. Supp. 2d 122, 171 n.68 (D. Conn. 2004), aff’d, 150 Fed.
Appx. 40 (2d Cir. 2005). They are instead simply more precise factors to consider
in the overall inquiry of whether the transaction had any practical economic effect
other than the creation of tax losses. Altria Grp. Inc. v. United States, 694 F.
Supp. 2d 259, 282 (S.D.N.Y. 2010), aff’d, 658 F.3d 276 (2d Cir. 2011). Courts
have consistently considered the pertinent objective factors to be those relating to
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[*15] the profit potential of a given transaction and the subjective factors to be
those relating to the purpose of the transaction. See, e.g., Crispin v.
Commissioner, 708 F.3d 507 (3d Cir. 2013), aff’g T.C. Memo. 2012-70; Klamath
Strategic Inv. Fund v. United States, 568 F.3d 537 (5th Cir. 2009); Coltec Indus.,
Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006).
B. Application
Under the objective prong of the analysis, we consider whether the
transaction had any profit potential. If both sets of options had finished in the
money, the transaction would have generated a $510,000 profit independent of tax
considerations.5 However, “the existence of some potential for profit does not
foreclose a finding of no economic substance”. Keeler v. Commissioner, 243 F.3d
1212, 1219 (10th Cir. 2001), aff’g T.C. Memo. 1999-18. The profit potential
should be evaluated in the light of the guaranteed tax benefit the transaction
provides. See Sala v. United States, 613 F.3d 1249, 1254 (10th Cir. 2010)
(finding that a $24 million tax benefit “dwarfed” a potential profit of $550,000
such that the “‘the economic realities of [the] transaction * * * [were] insignificant
5
HBS Investments would have received $800,000 on the Humboldt paired
options and $30,000 on the Shelby paired options, resulting in a $510,000 profit
net of the options’ $320,000 cost.
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[*16] in relation to the tax benefits of the transaction’” (quoting Rogers v. United
States, 281 F.3d 1108, 1116 (10th Cir. 2002))).
The existence of a relatively minor business purpose will not validate a
transaction if “the business purpose is no more than a facade.” ASA Investerings
P’ship v. Commissioner, 201 F.3d 505, 513 (D.C. Cir. 2000), aff’g T.C. Memo.
1998-305. Any seeming business purpose that existed here was merely a facade.
The options could have resulted in a $320,000 loss or a $510,000 profit. These
economic effects are inconsequential compared to the $25 million tax benefit the
options were guaranteed to generate. Although the transaction had some profit
potential, that potential was not significant enough to persuade us that petitioner
engaged in the transaction for any nontax business reason.
Under the subjective prong, we determine the transaction’s purpose by
considering objective evidence of the taxpayer’s intent. See Hines v. United
States, 912 F.2d 736, 740 (4th Cir. 1990). Petitioner purchased Humboldt and
Shelby for $86 million. If petitioner had paid tax on the built-in gains it inherited,
it would have lost about $20 million on the purchase. Because petitioner
generated artificial losses to offset the built-in gains, HSHC made a $3 million
profit on the deal. Petitioner could offer $86 million only because it had devised a
scheme to avoid paying the tax. After the purchase, petitioner carried out a
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[*17] specific and targeted scheme to generate capital losses almost exactly
offsetting the capital gains it inherited. Mr. Haber had promoted similar
transactions to DGI clients as a way to avoid paying tax on their capital gains, and
we have no reason to believe he engaged in this transaction for a different purpose.
Under certain circumstances, an investor may use paired options as a
legitimate means of generating gains. However, the facts here demonstrate that
petitioner entered the transaction solely to generate tax losses. Petitioner claims
that if Mr. Haber had been available to testify, it could have established that it had
nontax reasons for engaging in the option transaction. We find this unlikely. In
determining the purpose of a transaction, we rely on objective evidence of intent.
Mr. Haber’s self-interested testimony would have done little to offset the objective
evidence that tax-avoidance alone motivated the transaction.
C. Petitioner’s Attempt To Distinguish Its Transaction
Petitioner admits that courts have consistently found similar tax avoidance
schemes lacking in economic substance. However, petitioner attempts to
distinguish its transaction. First it attempts to differentiate the economics of its
transaction. Petitioner argues that its options could have generated a profit
without hitting the sweet spot whereas the options in other cases had to hit the
sweet spot to generate a profit. This argument does not persuade us that the
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[*18] options had economic substance. As we discussed earlier, the transaction’s
profit potential was insignificant compared to the guaranteed tax benefits it
produced. We do not find it significant that petitioner’s options were more likely
to generate a profit than those in other cases. The potential profit was not
significant enough to suggest that nontax business reasons motivated the
transaction.
Petitioner also attempts to distinguish its transaction on the basis that it did
not initiate the scheme on the advice of a tax shelter promoter. Courts have often
found that a taxpayer’s involvement with a tax shelter promoter indicated that tax
avoidance primarily motivated a disputed transaction. See, e.g., Palm Canyon X
Invs., LLC v. Commissioner, T.C. Memo. 2009-288; Stobie Creek Invs., LLC v.
United States, 82 Fed. Cl. 636, 693 (2008), aff’d, 608 F.3d 1366 (Fed. Cir. 2010);
Jade Trading, LLC v. United States, 80 Fed. Cl. 11, 50 (2007), aff’d in part, rev’d
in part and remanded, 598 F.3d 1372 (Fed. Cir. 2010); Maguire Partners-Master
Invs., LLC v. United States, 2009 WL 4907033 at *11-*12 (C.D. Cal. 2004), aff’d
sub nom. Thomas Inv. Partners, Ltd. v. United States, 444 Fed. Appx. 190 (9th
Cir. 2011). Petitioner argues that the absence of a promoter in this case
demonstrates that its transaction represented legitimate tax planning. We disagree.
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[*19] Mr. Haber is a tax shelter promoter. He did not need to consult a third-party
promoter, because he knew the scheme well enough to execute it himself.
The subjective economic substance inquiry is whether tax avoidance solely
motivated the transaction at issue. The absence of a third-party promoter does not
necessarily indicate that nontax reasons motivated a transaction, especially when
the taxpayer is himself an expert on the shelter at issue. We find petitioner’s
attempts to distinguish its case unavailing, and we accordingly reach the same
result as the many courts who have considered similar transactions.
D. Conclusion
Petitioner attempted to generate nearly $75 million of capital losses with a
cash outlay of only $320,000. The options could have produced a $510,000 profit
independent of any tax benefit. But “the existence of some potential profit is
insufficient to impute substance into an otherwise sham transaction where a
common-sense examination of the evidence as a whole indicates the transaction
lacked economic substance.” Sala, 613 F.3d at 1254 (quoting Keeler v.
Commissioner, 243 F.3d at 1219). A commonsense review of the record here
reveals that tax avoidance alone motivated the transaction. Petitioner knew the
transaction would produce guaranteed tax benefits of $25 million and would at
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[*20] most cost $320,000. The tax benefits alone prompted the transaction.
Accordingly, we find the transaction lacked economic substance.
III. Professional Fees
Respondent denied a $1,249,925 deduction petitioner had claimed for
professional fees for the year at issue. Petitioner has provided canceled checks
and bank statements to substantiate its payment of the fees in question. The fees
include $1,020,000 petitioner paid to K&Z Partners LLC to facilitate petitioner’s
purchases of Humboldt and Shelby and $50,155 petitioner paid to obtain a legal
opinion letter concerning the tax consequences of the paired-option contributions.
Petitioner has not explained the purpose of the remaining fees.
Under section 162, a taxpayer may deduct ordinary and necessary expenses
it incurs in carrying on a trade or business. Petitioner has provided documents
demonstrating that it paid all amounts associated with its professional fees
deduction. However, petitioner has provided no evidence to demonstrate a
business purpose for $179,770 of the deduction. Petitioner bears the burden of
proving not only that it incurred the expenses, but also that the expenses were
ordinary and necessary in carrying on its trade or business. Petitioner has failed to
carry its burden, and we accordingly sustain respondent’s denial of this portion of
the professional fees deduction.
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[*21] Costs associated with a transaction that lacks economic substance are not
deductible as business expenses under section 162. See Winn-Dixie Stores, Inc. v.
Commissioner, 113 T.C. 254, 294 (1999), aff’d, 254 F.3d 1313 (11th Cir. 2001).
We have determined that the paired-option transaction lacked economic substance.
Petitioner incurred $50,155 in legal fees to obtain a tax opinion concerning that
transaction. Accordingly, petitioner was not entitled to deduct those fees under
section 162. We sustain respondent’s denial of this portion of the professional
fees deduction.
“It has long been recognized, as a general matter, that costs incurred in the
acquisition or disposition of a capital asset are to be treated as capital
expenditures.” Woodward v. Commissioner, 397 U.S. 572, 575 (1970). Petitioner
incurred the consulting fee in connection with its acquisition of the Humboldt and
Shelby stock. Stock is a capital asset, and a taxpayer must capitalize expenses
related to its acquisition. Petitioner should have increased its bases in its
Humboldt and Shelby stock by the amount of the consulting fee. Instead,
petitioner improperly deducted the expense. We sustain respondent’s denial of the
deduction.
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[*22] IV. Penalty
Section 6662 provides that a taxpayer may be liable for a penalty of 20% of
the portion of an underpayment of tax attributable to (1) a substantial
understatement of income tax, (2) negligence or disregard of rules or regulations,
or (3) any substantial valuation misstatement. Sec. 6662(a) and (b)(1), (2), and
(3). A “substantial valuation misstatement” occurs if the value of any property or
the adjusted basis of any property claimed on an income tax return is 200% or
more of the correct amount. Sec. 6662(e)(1)(A); sec. 1.6662-5(e)(1), Income Tax
Regs. If the valuation misstatement is 400% or more of the correct amount, the
misstatement is considered a “gross valuation [misstatement]”, and the 20%
penalty increases to 40%.6 Sec. 6662(h). The section 6662 penalties do not apply
if taxpayers demonstrate they acted with reasonable cause and in good faith. Sec.
6664(c)(1).
The IRS may impose only one accuracy-related penalty on any portion of an
underpayment, even if that portion resulted from more than one of the types of
6
For returns filed after August 17, 2006, the applicable percentage in sec.
6662(h)(2)(A)(i) was changed from 400% to 200%. See Pension Protection Act of
2006 (PPA), Pub. L. No. 109-280, sec. 1219(a)(2)(A), 120 Stat. at 1083.
Similarly, for returns filed after August 17, 2006, the applicable percentage with
respect to the substantial valuation misstatement penalty of sec. 6662(e)(1)(A) was
changed from 200% to 150%. See PPA sec. 1219(a)(1)(A), 120 Stat. at 1083.
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[*23] misconduct described in section 6662. Sec. 1.6662-2(c), Income Tax Regs.
In the notice of deficiency, respondent determined that petitioner is liable for the
accuracy-related penalty under section 6662(c) for negligence, section 6662(d) for
a substantial understatement of income tax, section 6662(e) for a substantial
valuation misstatement, and section 6662(h) for a gross valuation misstatement.
Section 1.6662-2(c), Income Tax Regs., prevents respondent from stacking these
penalties to impose a penalty greater than 20% on any portion of the
underpayment (or 40% if that portion is attributable to a gross valuation
misstatement).
Petitioner owed Federal income tax of over $25 million for its 2003 taxable
year but reported and paid nothing. The underpayment resulted from a valuation
misstatement. Petitioner drastically overstated its bases in securities it received
upon resigning from HBS Investments. Petitioner claimed bases totaling almost
$75 million, but its actual bases totaled $320,000. This valuation misstatement
qualifies as “gross” under section 6662(h), and petitioner is liable for a 40%
penalty on the portion of the underpayment attributable to the misstatement. See
United States v. Woods, 571 U.S. ___, 134 S. Ct. 557 (2013) (holding that the
gross valuation misstatement penalty applies when a transaction lacking economic
substance results in a valuation misstatement).
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[*24] Petitioner reported a loss of about $1.8 million on its 2003 return. A portion
of the loss was attributable to its improper deduction of professional fees. Even
without the professional fees deduction, petitioner would have reported a net loss.
Therefore, although a portion of the understatement of income did not result from
a gross valuation misstatement, the entire tax underpayment did. Therefore, we
find that respondent correctly calculated the penalty as 40% of the entire
underpayment.
Petitioner argues that it is not liable for the accuracy-related penalty,
because it had reasonable cause for understating its income tax. In their briefs,
both parties apply the special reasonable cause rules for substantial
understatements of income tax resulting from tax shelter items. See sec. 1.6664-
4(f), Income Tax Regs. However, because we determine that the accuracy-related
penalty applies on account of a gross valuation misstatement, we apply the
reasonable cause rules associated with the application of the penalty on that
ground. See Gustashaw v. Commissioner, T.C. Memo. 2011-195; sec. 1.6664-
4(b)(1), Income Tax Regs. We determine whether a taxpayer acted with
reasonable cause and in good faith on a case-by-case basis, taking into account all
pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. The
most important factor is generally the extent of the taxpayer’s effort to assess the
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[*25] proper tax liability. Id. Circumstances that may indicate reasonable cause
and good faith include an honest misunderstanding of fact or law that is
reasonable in the light of all the facts and circumstances, including the experience,
knowledge, and education of the taxpayer. Id.
Petitioner’s underpayment did not result from an honest misunderstanding
of the law. Mr. Haber is a sophisticated tax planner who deliberately exploited a
perceived loophole in the law. Petitioner did not make a reasonable effort to
assess its proper tax liability. Petitioner should have known that reporting $75
million in losses from a transaction that cost $320,000 would result in a significant
tax underpayment.
Petitioner claims that a straightforward interpretation of the Code and
caselaw supported its tax position when it filed its return. We disagree.
Petitioner’s scheme depended on Mr. Haber’s unreasonable interpretation of
Helmer v. Commissioner, T.C. Memo. 1975-160, and its progeny. In Helmer a
partnership granted a development company an option to purchase the
partnership’s land at a fixed price. The agreement required the development
company to make annual payments to the partnership while the option remained
unexercised. The annual payments were to count toward the purchase price if the
development company exercised the option. The partners argued that the
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[*26] payments increased the partnership’s liabilities and thus increased their
bases.7 We disagreed because “no liability arose upon receipt of the option
payments”.
Petitioner relied on Helmer for the proposition that a sold option is not a
liability, and thus partners should not decrease their bases when they contribute
sold options. This interpretation was not reasonable, especially given the abusive
result it achieved in this case. The options at issue here did not resemble the
option we addressed in Helmer and did not command the same treatment. We find
that petitioner has failed to establish reasonable cause and is liable for the
accuracy-related penalty.
Decision will be entered
for respondent.
7
Sec. 752 provides that “[a]ny increase in a partner’s share of the liabilities
of a partnership * * *shall be considered as a contribution of money by such
partner to the partnership.” Under sec. 722, partners increase their bases for
money contributions.