Thompson v. Comm'r

148 T.C. No. 3

UNITED STATES TAX COURT

DOUGLAS M. THOMPSON AND LISA MAE THOMPSON, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 6613-13. Filed February 2, 2017.

This case arose out of Ps’ participation in a distressed asset

debt tax shelter. Ps conceded substantive issues related to this case

but contest the issue of liability for penalties under I.R.C. secs.

6662(h) and 6662A. Ps filed a motion to disqualify the Judge based

on Ps’ belief that they cannot get a fair trial because the President of

the United States has the power under I.R.C. sec. 7443(f) to remove

the Judges of the Tax Court for cause. Ps also filed a motion to

declare the penalty under I.R.C. sec. 6662A unconstitutional as

violating the Excessive Fines Clause of the Eighth Amendment.

Held: I.R.C. sec. 7443(f) does not violate the Constitution and

we do not need to recuse ourselves on that basis.

Held, further, accuracy-related penalties under I.R.C. sec.

6662A do not violate the Eighth Amendment.

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Joseph A. DiRuzzo III and Jeffrey J. Molinaro, for petitioners.

Nicole M. Connelly, Julia Ann Cannarozzi, Craig Connell, and Clare W.

Darcy, for respondent.

OPINION

WHERRY, Judge: Pending before the Court are petitioners’ motion to

disqualify the Judge and declare section 7443(f)1 unconstitutional and petitioners’

motion for judgment on the pleadings under Rule 120 and to declare section

6662A unconstitutional.

Background

The information below is based upon examination of the pleadings, moving

papers, responses, and attachments submitted in connection with this case.

Factual recitations are meant to provide context for our analysis of petitioners’

motions and to set forth matters that appear undisputed. They do not, however,

constitute findings of fact in the event of a subsequent trial or trials. Rule 1(b);

Fed. R. Civ. P. 52(a).

1

Unless otherwise indicated, section references are to the Internal Revenue

Code (Code) in effect at all relevant times. Rule references are to the Tax Court

Rules of Practice and Procedure.

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Petitioners, Douglas and Lisa Mae Thompson, were married during the

taxable years 2003-07 and filed their personal income tax returns jointly.

Respondent determined the following Federal income tax deficiencies and

penalties for tax years 2003-07 in a notice of deficiency issued on December 18,

2012:

Penalties

Year Deficiency Sec. 6662(h) Sec. 6662A

2003 $90,822 --- ---

2004 17,459 --- ---

2005 116,124 $46,450 $67,228

2006 19,525 --- ---

2007 11,575 --- (1 )

1

Respondent also determined, in the alternative, a sec. 6662A penalty for

2005 of $4,816 and sec. 6662(h) penalties for 2003, 2004, 2005, 2006, and 2007

of $36,329, $6,984, $46,450, $7,810, and $4,630, respectively.

The deficiencies in petitioners’ Federal income tax arose out of an alleged

loss from a flow-through distressed asset debt transaction that petitioners reported

on their Federal income tax return for the tax year 2005.2 The loss was partially

carried back to the 2003 and 2004 tax years and carried forward to the 2006 and

2007 tax years to shield petitioners’ income from taxation. The source of the loss

2

See generally Kenna Trading LLC v. Commissioner, 143 T.C. 322 (2014);

Superior Trading LLC v. Commissioner, 137 T.C. 70 (2011), aff’d, 728 F.3d 676

(7th Cir. 2013).

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was a listed transaction described in Notice 2008-34, 2008-1 C.B. 645. Because

petitioners failed to disclose the relevant facts relating to the transaction,

respondent determined they are subject to a 30% penalty under sections 6662A(c)

and 6664(d)(2) (now section 6664(d)(3)).

Petitioners resided in California when they timely filed the petition.3 On

March 24, 2015, petitioners conceded that they were not entitled to the bad debt

deduction, which respondent disallowed, but they continue to contest the

determined penalties and interest.

Discussion

I. Disqualification of a Judge and Constitutionality of Section 7443(f)

In their motion to disqualify the Judge and to declare section 7443(f)

unconstitutional, petitioners argue that we should recuse ourselves from

3

Note 2 of petitioners’ motion for recusal of Judge filed on January 5, 2015,

indicates that any appeal of this case would be to the Court of Appeals for the

Eleventh Circuit, absent stipulation of the parties to the contrary as petitioners’

residence is now in the State of Florida. However, a review of the pleadings and

documents in the record together with a later filed correction to petitioners’

motion for recusal of Judge, establishes that petitioners’ residence when the

petition was filed was in California. Therefore, any appeal would be to the Court

of Appeals for the Ninth Circuit, absent stipulation of the parties to the contrary.

See paragraph 2 of respondent’s answer, petitioners’ report filed on January 5,

2015, and sec. 7482(b)(1).

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consideration of this case until the alleged constitutional infirmity of section

7443(f) is cured.

Section 7443(f) authorizes the President to remove Judges of the Tax Court

“after notice and opportunity for public hearing, for inefficiency, neglect of duty,

or malfeasance in office, but for no other cause.” Petitioners contend that this

section violates basic principles of separation of powers. In a recently released

Opinion of this Court, however, we held that the Presidential authority to remove

Tax Court Judges for cause under section 7443(f) is constitutional and that we

need not recuse ourselves. Battat v. Commissioner, 148 T.C. __, __ (slip op. at

43) (Feb. 2, 2017); accord Kuretski v. Commissioner, 755 F.3d 929 (D.C. Cir.

2014), aff’g T.C. Memo. 2012-262, cert. denied, 135 S. Ct. 2309 (2015).

Petitioners did not advance in their motion any arguments that we have not

addressed in Battat. Thus, we do not need to discuss this issue further. We

decline to recuse ourselves in this case or declare section 7443(f) unconstitutional.

II. Constitutionality of Section 6662A

A. Legal Standard for Motion for Judgment on the Pleadings

“A judgment on the pleadings is a judgment based solely on the allegations

and information contained in the pleadings and not on any outside matters.” See

Nis Family Trust v. Commissioner, 115 T.C. 523, 537 (2000) (citing Rule 120(a)

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and (b)). The movant has the burden of showing entitlement to judgment on the

pleadings, including “that the pleadings do not raise a genuine issue of material

fact and that he is entitled to a judgment as a matter of law.” Id.

Because petitioners argue that section 6662A is unconstitutional on its face

and do not raise any issues as to its application to their particular situation,

deciding this issue on a motion for a judgment on the pleadings is appropriate.

B. Application of the Eighth Amendment to Section 6662A

Section 6662A(a) imposes a penalty on any reportable transaction under-

statement. If a taxpayer fails to adequately disclose a reportable transaction giving

rise to an understatement under section 6662A, the penalty is imposed at a rate of

30%, and there are no available defenses. Secs. 6662A(c), 6664(d)(2). However,

if a taxpayer sufficiently discloses the details of the transaction, the penalty rate is

20% of the amount of the reportable transaction understatement. Sec. 6662A(a).

In this latter instance, a taxpayer may be able to avoid the penalty under section

6662A if he or she shows reasonable cause and good faith, as well as that there is

or was substantial authority for a position he or she took on a tax return, and the

taxpayer reasonably believed that such treatment was more likely than not the

proper treatment of the transaction in question. Sec. 6664(d)(1) and (2).

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The Eighth Amendment to the United States Constitution provides:

“Excessive bail shall not be required, nor excessive fines imposed, nor cruel and

unusual punishments inflicted.” “The Excessive Fines Clause limits the

government’s power to extract payments, whether in cash or in kind, ‘as

punishment for some offense.’” Austin v. United States, 509 U.S. 602, 609-610

(1993) (emphasis in Austin) (quoting Browning-Ferris Indus. of Vt., Inc. v. Kelco

Disposal, Inc., 492 U.S. 257, 265 (1989)).

In a case discussing application of the Double Jeopardy Clause to a State tax

on possession of illegal drugs, the Supreme Court stated: “Criminal fines, civil

penalties, civil forfeitures, and taxes all share certain features: They generate

government revenues, impose fiscal burdens on individuals, and deter certain

behavior. All of these sanctions are subject to constitutional constraints.” Dep’t

of Revenue of Mont. v. Kurth Ranch, 511 U.S. 767, 778 (1994). At the same time,

the Supreme Court recognized that taxes are typically motivated by revenue

raising rather than punitive purposes. Id. at 779-780. “[N]either a high rate of

taxation nor an obvious deterrent purpose automatically marks * * * [a] tax as a

form of punishment.” Id. at 780. Nevertheless, “at some point, an exaction

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labeled as a tax approaches punishment, and our task is to determine * * * [when

it] crosses that line.” Id.4

To pass the constitutional proportionality inquiry under the Excessive Fines

Clause, the amount of the forfeiture or fine must bear some relationship to the

gravity of the offense that it is designed to punish. See United States v.

Bajakajian, 524 U.S. 321, 334 (1998). The Court in Bajakajian noted that

judgments about the appropriate punishment for an offense belong in the first

instance to the legislature. Id. at 336. The Court then came up with the following

test to be used by the trial courts: “If the amount of the forfeiture is grossly

disproportional to the gravity of the defendant’s offense, it is unconstitutional.”

Id. at 337. Thus, to answer the question whether section 6662A violates the

Eighth Amendment, we need to answer two questions: (1) whether section 6662A

constitutes punishment for an offense; and (2) whether the punishment is grossly

disproportional to the gravity of the offense.

4

We note that since the Supreme Court ruling in Dep’t of Revenue of Mont.

v. Kurth Ranch, 511 U.S. 767 (1994), this Court has held that a 75% addition to

tax for fraud does not violate the Double Jeopardy Clause because it is “a civil

sanction, imposed as a safeguard for the protection of the revenue and to

reimburse the Government for the heavy expense of investigation and the loss

resulting from the taxpayer’s fraud.” Ward v. Commissioner, T.C. Memo. 1995-

286, aff’d sub nom. I&O Pub. Co. v. Commissioner, 131 F.3d 1314 (9th Cir.

1997).

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This Court has stated before that “[t]he purpose of civil tax penalties is to

encourage voluntary compliance.” See Gorra v. Commissioner, T.C. Memo. 2013-

254, at *63. On many occasions, different courts have ruled that Federal civil tax

penalties are remedial, not punitive. In Helvering v. Mitchell, 303 U.S. 391, 401

(1938), the Supreme Court held that a civil fraud penalty under the Revenue Act

of 1928 was remedial because it was primarily provided “as a safeguard for the

protection of the revenue and to reimburse the [g]overnment for the heavy expense

of investigation and the loss resulting from the taxpayer’s fraud.” In Little v.

Commissioner, 106 F.3d 1445, 1454 (9th Cir. 1997), aff’g T.C. Memo. 1993-281,

the Court of Appeals for the Ninth Circuit declined to extend the reasoning of

Austin to the negligence and substantial understatement additions to tax of former

sections 6653(a) and 6661. The court in Little reasoned that “[t]he additions to tax

at issue * * * are purely revenue raising because they serve only to deter

noncompliance with the tax laws by imposing a financial risk on those who fail to

do so”. Id. As such, the additions to tax in Little were not “punishment” and did

not violate the Eighth Amendment.

Similarly, this Court has found contentions that civil tax penalties violate

the Excessive Fines Clause to be meritless in numerous other cases. See, e.g.,

Acker v. Commissioner, 26 T.C. 107, 114 (1956) (stating that “additions to tax are

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remedial in character, not penal or punitive”, and therefore do not violate the

Eighth Amendment); Gorra v. Commissioner, T.C. Memo. 2013-254 (holding that

the 40% penalty under section 6662(h) does not violate the Excessive Fines

Clause); Wilson v. Commissioner, T.C. Memo. 2002-234 (reiterating the principle

that additions to tax, including the 75% civil fraud penalty under section 6663, are

remedial rather than punitive); Louis v. Commissioner, T.C. Memo. 1996-257

(holding that 50% addition to tax for fraud imposed by former section 6653(b) did

not violate the Eighth Amendment because it was remedial), aff’d, 170 F.3d 1232

(9th Cir. 1999).

Petitioners argue that because Congress intended section 6662A to deter

taxpayers from entering into tax avoidance transactions, it is not purely remedial

and is subject to review under the Eighth Amendment as a form of punishment.

We are not persuaded by this argument. As the Supreme Court noted in Kurth

Ranch, 511 U.S. at 780, “neither a high rate of taxation nor an obvious deterrent

purpose automatically marks this tax as a form of punishment.”

Discussion of the tax penalties with respect to listed or reportable

transactions dates back to the end of 1990s. The Secretary of the Treasury stated

that tax shelters represented the most significant compliance problem confronting

the U.S. system of taxation. Lawrence H. Summers, U.S. Sec’y of the Treasury,

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Remarks to the Federal Bar Association: Tackling the Growth of Corporate Tax

Shelters (Feb. 28, 2000). Besides reducing tax base, tax shelters “breed disrespect

for the system by participants and observers, and waste valuable public and private

sector resources.” S. Comm. on Finance, 107th Cong., Technical Explanation of

Tax Shelter Transparency Act (News Release May 10, 2002). In response to that

challenge, the Department of the Treasury issued regulations requiring disclosure

of certain transactions and maintenance of customer lists by promoters of tax

shelters. Secs. 301.6111-2, 301.6112-1, Proced. & Admin. Regs. However, the

initial results were underwhelming. As a result, Congress enacted a number of

penalties related to disclosure of certain transactions and failure to report them

properly on tax returns as a part of the American Jobs Creation Act of 2004, Pub.

L. No. 108-357, secs. 811(a), 812(a) 118 Stat. at 1575, 1577.

In that regard, it is instructive to consider the reasons for enacting a “sister”

section of 6662A, section 6707A, which provides a penalty for failure to disclose

reportable transactions:

The Committee believes that the best way to combat tax

shelters is to be aware of them. The Treasury Department, using

the tools available, issued regulations requiring disclosure of

certain transactions and requiring organizers and promoters of tax-

engineered transactions to maintain customer lists and make these

lists available to the IRS. Nevertheless, the Committee believes

that additional legislation is needed to provide the Treasury

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Department with additional tools to assist its efforts to curtail

abusive transactions. * * *

H.R. Rept. No. 108-548 (Part I), at 261 (2004). In explaining the reasons for

enacting section 6662A, the House of Representatives Committee on Ways and

Means stated:

Because disclosure is so vital to combating abusive tax

avoidance transactions, the Committee believes that taxpayers

should be subject to a strict liability penalty on an understatement of

tax that is attributable to non-disclosed listed transactions or non-

disclosed reportable transactions that have a significant purpose of

tax avoidance. Furthermore, in order to deter taxpayers from

entering into tax avoidance transactions, the Committee believes

that a more meaningful (but not a strict liability) accuracy-related

penalty should apply to such transactions even when disclosed.

H.R. Rept. No. 108-548 (Part I), supra at 263. This explanation makes it clear that

the primary goal for enacting section 6662A was to reinforce voluntary

compliance with the existing disclosure requirements and deter taxpayers from

using tax shelters. The penalty under section 6662A imposes a financial risk on

those who fail to comply and serves a revenue-raising purpose. Thus, the penalty

under section 6662A is no different from penalties upheld in the cases discussed

above and does not violate the Eighth Amendment.

Assuming arguendo that the Excessive Fines Clause is implicated in this

case, the penalty under section 6662A is not so grossly disproportionate as to fail

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the Bajakajian test. Petitioners argue that because of the way the penalty is

calculated, it may be imposed even if there is no actual tax deficiency for the year

in question. Moreover, the penalty is calculated at the highest applicable rate of

tax. In petitioners’ view, this makes the section 6662A penalty excessive and

grossly disproportionate.

We disagree. The penalty under section 6662A applies only to listed

transactions--which are considered per se abusive--and to reportable transactions

if a significant purpose is avoidance or evasion of Federal income tax. See sec.

6662A(b)(2). The penalty is then imposed only if there is a “reportable transaction

understatement” as defined in section 6662A(b). In many cases, tax shelters

represent transactions generating tax losses without corresponding economic

losses to investors. These tax losses can be carried back or forward to shield

income from taxation over several years. Ironically, the facts of this case illustrate

this concept very well. Petitioners entered into a listed transaction in 2005 and

attempted to partially offset their income with fictitious losses over a span of five

years, from 2003 to 2007. As a result, the potential harm to the fisc was spread

over several years. Calculation of the section 6662A penalty is designed to

quantify this harm by taking into account the full tax benefit a taxpayer may have

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obtained as a result of engaging in a listed or reportable transaction. Thus, it is

proportional to the harm caused and does not violate the Bajakajian test.

Finally, petitioners argue that the section 6662A 30% penalty for

undisclosed transactions violates the Excessive Fines Clause because section

6662A imposes a higher penalty rate on undisclosed reportable transactions and

takes away defenses that would be available for disclosed transactions. Again, we

disagree. Legislative history makes it clear that Congress saw voluntary

disclosure as a key element in curbing the abuse of tax shelters. By imposing a

strict liability penalty at a higher rate on undisclosed transactions, Congress

wanted to take away taxpayers’ ability to ignore or manipulate the existing rules.

Tax shelters are notoriously difficult to detect and hard to prosecute. Some

promoters and taxpayers, aware of low tax return audit rates, consciously engage

in attempts to game the tax system and get away with questionable transactions.

The higher penalty may not even make up for the lost revenue and prosecution

expenses related to detecting, prosecuting, and resolving these transactions. In

any event, it serves as an important deterrent that alters taxpayers’ cost-benefit

analysis when they consider participating in reportable or listed transactions.

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C. Conclusion

Both petitioners’ motion to disqualify the Judge and motion for judgment on

the pleadings will be denied. Section 7443(f) and penalties under section 6662A

do not violate the United States Constitution.

An appropriate order will be issued.