Bemont Investments, L.L.C. Ex Rel. Tax Matters Partner v. United States

Case: 10-41132 Document: 00511836971 Page: 1 Date Filed: 04/26/2012

IN THE UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT United States Court of Appeals

Fifth Circuit

FILED

April 26, 2012

No. 10-41132

Lyle W. Cayce

Clerk

BEMONT INVESTMENTS, L.L.C.,

by and through its Tax Matters Partner,

Plaintiff-Appellee - Cross-Appellant,

v.

UNITED STATES OF AMERICA,

Defendant-Appellant - Cross-Appellee,

BPB INVESTMENTS, L.C.,

by and through its Tax Matters Partner,

DANIEL BEAL, BPB Investments, L.L.C.

Tax Matters Partner,

Plaintiffs-Appellees - Cross-Appellants,

v.

UNITED STATES OF AMERICA,

Defendant-Appellant - Cross-Appellee.

Appeals from the United States District Court

for the Eastern District of Texas

Before REAVLEY, DAVIS, and PRADO, Circuit Judges.

W. EUGENE DAVIS, Circuit Judge:

Case: 10-41132 Document: 00511836971 Page: 2 Date Filed: 04/26/2012

No. 10-41132

These consolidated cases sought judicial review of notices of final

partnership administrative adjustment (FPAA) issued to Bemont Investments,

L.L.C. (Bemont) and BPB Investments, L.C.(BPB). Following that review in the

district court, the government appeals two aspects of the district court’s

judgment: (1) the ruling on the partnerships’ motion for partial summary

judgment disallowing the 40% valuation misstatement penalty, and (2) the

ruling post trial holding that the FPAA issued to Bemont for the 2001 tax year

was time-barred. The partnerships appeal the district court’s judgment

upholding the imposition of the 20% substantial understatement and negligence

penalties. We affirm in part and reverse in part.

I.

On October 13, 2006, the Commissioner of the Internal Revenue issued

FPAAs to Bemont and BPB for tax years 2001 and 2002. An FPAA is the

partnership equivalent of a statutory notice of deficiency to an individual or non-

partnership entity. The FPAAs disallowed losses from a foreign currency

hedging transaction claimed on Bemont’s 2001 partnership return and BPB’s

2002 return. Both FPAAs also imposed four, alternative, non-cumulative

penalties: (1) a 40% penalty for underpayment attributable to a gross valuation

misstatement, (2) a 20% penalty for underpayment attributable to negligence,

(3) a 20% penalty for underpayment attributable to a substantial

understatement of income tax, and (4) a 20% penalty for underpayment

attributable to a substantial valuation misstatement, all under 26 U.S.C. § 6662.

The partnerships timely commenced actions for readjustment of partnership

items by filing petitions in the district court. The actions were consolidated and

referred by consent to a magistrate judge for all purposes.

Before trial, the court granted the partnerships’ motion for partial

summary judgment, holding that the government was foreclosed from imposing

the valuation misstatement penalties (items (1) and (4) above). The remainder

2

Case: 10-41132 Document: 00511836971 Page: 3 Date Filed: 04/26/2012

No. 10-41132

of the case proceeded to trial. After a bench trial, the court determined that the

FPAA issued to Bemont for 2001 was time-barred, precluding the tax

assessment and penalties related to that tax year. The court upheld the

disallowance of losses reported by the partnerships and the imposition of

penalties against them (items (2) and (3) above) for 2002. Both sides appeal.

The transaction underlying this dispute is described by the IRS as a classic

Son of BOSS tax shelter. This type of shelter creates tax benefits in the form

of deductible losses or reduced gains by creating an artificially high basis in

partnership interests. Ordinarily under the Internal Revenue Code, when a

partner contributes property to a partnership, the partner’s basis in his

partnership interest increases. 26 U.S.C. § 722. When a partnership assumes

a partner’s liability, the partner’s basis decreases. 26 U.S.C. §§ 722, 752. A Son

of BOSS shelter recognizes the increased basis resulting from the partnership’s

acquisition of the partner’s asset, but ignores the effect on that basis created by

the partnership’s assumption of the partner’s liability. A higher basis can lead

to the recognition of a loss or a reduced amount of gain when the asset is sold.

The IRS classified such schemes as abusive tax shelters. Notice 2000-44, 2000-2

C.B. 255. The notice designated such shelters as “listed transactions” for

purposes of Treasury Regulation §§ 1.6011-4T(b)(2) and 301.6111-2T(b)(2). A

listed transaction is one the IRS has determined to be a tax avoidance

transaction. Treas. Reg. § 1.6011-4T, as amended by T.D. 92000, 2002-2 C.B. 87.

Taxpayers who purchase and entities who promote listed transactions

have certain disclosure requirements to the IRS. In general, the taxpayer must

file a disclosure statement with any tax return that includes gains or losses from

a listed transaction. 26 U.S.C. § 6011. Promoters of listed transactions, who are

also called material advisors, must keep lists identifying persons who engage in

such transactions and report that information to the IRS upon request. 26 U.S.C.

§ 6112.

3

Case: 10-41132 Document: 00511836971 Page: 4 Date Filed: 04/26/2012

No. 10-41132

To combat the problem of taxpayers and promoters who fail to comply with

the disclosure requirements, Congress extended the usual three-year statute of

limitations for issuance of a deficiency notice or FPAA in cases involving

undisclosed listed transactions until one year after the taxpayer or his tax-

shelter advisor has complied with the notice requirements. 26 U.S.C. §

6501(c)(10).

The particular shelter in this case took the following form. Andrew Beal

formed BPB and contributed to BPB $5 million in cash and stock with a cost

basis of $4 million in Solution 6, an Australian company. Beal’s purported plan

was to takeover Solution 6 in a transaction requiring substantial sums of

Australian dollars. To hedge the risk that the Australian dollar would

appreciate (relative to the U.S. dollar) prior to closing on a takeover bid for

Solution 6, BPB entered into a digital currency swap transaction with Deutsche

Bank. The swaps included two long positions that required BPB to pay

Deutsche Bank a fee of $202.5 million. Two short positions required Deutsche

Bank to pay BPB a fee of $197.5 million. BPB only paid Deutsche Bank the net

difference between the long and short positions, i.e. $5 million. In addition, the

swaps required BPB and Deutsche Bank to make offsetting fixed payments to

each other - under which term Deutsche Bank paid BPB approximately $2.5

million. Thus, BPB’s net cost of these transactions was $2.5 million.

Shortly after Beal formed BPB, BPB formed a partnership called Bemont

with Montgomery. BPB contributed the swaps contracts and Solution 6 stock

to Bemont. The partnerships reported that the tax basis of the swaps

contributed was $202.5 million, ignoring the $197.5 million offset represented

by the short swaps.

After the swaps terminated in November 2001, Montgomery left the

Bemont partnership with BPB, causing Bemont to terminate for tax purposes.

Once Montgomery exited, Bemont’s only asset was the Australian currency,

4

Case: 10-41132 Document: 00511836971 Page: 5 Date Filed: 04/26/2012

No. 10-41132

which was deemed distributed to BPB. In late 2001, Beal and Montgomery

decided not to pursue the takeover of Solution 6 and BPB sold most of the

Australian currency at its fair market value. Using the inflated basis of $202.5

million, Bemont reported a $151 million foreign-currency loss on its 2001 return,

which was allocated to Beal. In 2002, after the deemed distribution from

Bemont, BPB sold the remainder of the Australian currency and reported a $46

million foreign-currency loss on its 2002 return, which was allocated to Beal.

In adopting this tax treatment, Beal and Montgomery relied on the advice

of tax accountant, Matt Coscia, that the tax treatment using the inflated tax

bases was likely correct. Neither Beal nor the partnerships filed the disclosure

statements required by Notice 2000-44 and 26 U.S.C. § 6011 with their tax

returns affected by participation in the transactions.

In April 2005, the IRS audited Beal’s 2002 tax return and inquired about

the $46 million loss allocated from BPB. Beth Montgomery, the accountant who

had prepared Beal’s return, gave the IRS agent a copy of the agreement

assigning BPB’s rights under the swaps to Bemont. The agreement listed all

four swaps - two long and two short. She also provided copies of the

confirmation letters for the long swaps but did not provide further detail on the

short swaps. No adjustments were made by the IRS to Beal’s return for that

year.

On October 13, 2006, after the ordinary three-year statute of limitations

for examining Beal’s and the partnerships’ 2001 returns had expired, the IRS

issued FPAAs to BPB and Bemont. The FPAA the IRS issued to Bemont covered

the 2001 tax year, disallowing the losses from the swaps and determining that

Bemont’s partners had no basis in the partnership. The FPAA the IRS issued

to BPB dealt with the 2002 tax year, and disallowed the losses from the swaps

and determined that the BPB partners had no basis. Thus this case deals with

the 2001 losses reported by Bemont and the 2002 losses reported by BPB.

5

Case: 10-41132 Document: 00511836971 Page: 6 Date Filed: 04/26/2012

No. 10-41132

II.

The district court’s findings of fact are reviewed for clear error and legal

conclusions are reviewed de novo. Klamath Strategic Inc. Fund v. United States,

568 F.3d 537, 543 (5th Cir. 2009).

III.

Ordinarily, the IRS must assess taxes within three years after a taxpayer

files his return. 26 U.S.C. § 6501. Because the IRS issued the FPAA for

Bemont’s 2001 tax year more than three years after the return was filed, the

district court had to determine whether the statute of limitations had run as to

Bemont’s 2001 return. The Internal Revenue Code allows an exception to the

three year limitations period in 26 U.S.C. § 6501(c)(10) “with respect to a listed

transaction as defined in 26 U.S.C. § 6707(c)(2)” when the taxpayer fails to make

the required disclosure under 26 U.S.C. § 6011. The partnerships do not

challenge the fact that the transactions in this case are listed transactions or

that the required disclosures were not made in conjunction with the partnership

returns. Rather, they rely on a separate provision of § 6501 which provides that

as to listed transactions, the statute of limitations “shall not expire before the

date which is 1 year after the earlier of (A) “the date on which the Secretary is

furnished with the information so required,” or (B) “the date that a material

advisor meets the requirements of Section 6112 with respect to a request by the

Secretary under that section 6112(b) relating to such transaction with respect

to such taxpayer.” 26 U.S.C. § 6501(c)(10).

The district court found that subpart (A) of § 6501(c)(10) did not apply

because neither the partnerships nor Beal provided the required disclosure with

their respective returns and because Montgomery did not furnish complete

information about the swaps during the audit of Beal’s 2002 tax return. Beth

Montgomery provided full disclosure regarding the long swaps, but did not

disclose the offsetting short swaps.

6

Case: 10-41132 Document: 00511836971 Page: 7 Date Filed: 04/26/2012

No. 10-41132

The district court therefore focused on subsection (B), which by its terms,

commences the limitations period when a material advisor, in response to a

request from the secretary, satisfies the disclosure requirement in § 6112. That

provision requires material advisors to keep lists of persons engaging in listed

transactions in a form and containing such information as the secretary may

require by regulation.1

The regulation promulgated under the authority granted in § 6112 is

structured in a series of questions and answers “relating to the requirement to

maintain a list of investors in potential abusive tax shelters (temporary).” Treas.

Reg. § 301.6112-1T (2002). Question 16 asks “In what manner must an

organizer or a seller maintain a list?” Answer A-16 states:

A list may be maintained on paper, card file, magnetic media, or in

any other form, provided the method of maintaining the list enables

the Internal Revenue Service to determine without undue delay or

difficulty the information required by A-17 of this section.

Question 17 asks what information must be included on the list. The

requirement provided in Answer A-17 is quoted in the margin.2

1

26 U.S.C. § 6112 reads as follows:

Material advisors of reportable transactions must keep lists of advisees, etc.

(a) In general. Each material advisor (as defined in section 6111) with respect

to any reportable transaction (as defined in section 6707A(c)) shall (whether or

not required to file a return under section 6111 with respect to such

transaction) maintain (in such manner as the Secretary may by regulations

prescribe) a list–

(1) identifying each person with respect to whom such advisor acted as a

material advisor with respect to such transaction, and

(2) containing such other information as the Secretary may by regulations

require.

26 U.S.C. § 6112.

2

Answer A-17 states:

(a) A list must include the following information -

(1) The name of the tax shelter and the registration number, if any, obtained

under section 6111;

(2) The TIN (as defined in section 7701(a)(41)), if any, of the tax shelter;

7

Case: 10-41132 Document: 00511836971 Page: 8 Date Filed: 04/26/2012

No. 10-41132

The district court found that pursuant to an IRS summons Deutsche Bank

(a material advisor to the partnerships) provided information to the IRS no later

than July 2005 which identified Bemont and BPB as participating in Son of Boss

/ Digital Options and that the information provided substantially complied with

the statute and applicable regulations issued by the IRS as set forth in 26 C.F.R.

§ 301.6112-1T. Specifically, the district court found that by July 2005, the IRS

had information that identified BPB and Bemont, and as to these entities, the

account number for the buy and sell, the foreign exchange amount, the foreign

exchange rate, the amount of U.S. dollars involved, the trade and sell dates, and

the percentage sold. Accordingly, it held that the FPAA issued to Bemont in

(3) The name, address, and TIN (as defined in section 7701(a)(41)) of each

person who is required to be included on the list under A-8 or A-10 of this

section and, in the case of a tax shelter that is a transaction described in section

6111(d)(1)(A) and § 301.611-2T(b) whether or not the direct or indirect

participant is a corporation, the name, address and TIN of each investor and

any indirect corporate participant in the shelter if known to the organizer or

seller;

(4) If applicable, the number of units (i.e., percentage of profits, number of

shares, etc.) acquired by each person who is required to be included on the list;

(5) The date on which each interest was acquired;

(6) The amount of money invested in the tax shelter by each person required to

be included on the list under A-7 or A-10 of this section;

(7) A detailed description of the tax shelter that describes both the structure of

the tax shelter and the intended tax benefits for participants in the tax shelter;

(8) A summary or schedule of the tax benefits that each person is intended or

expected to derive from participation in the tax shelter, if known by the

organizer or seller;

(9) Copies of any additional written materials, including tax analyses or

opinions, relating to the tax shelter that have been given to any potential

participants in the tax shelter or to any representatives, tax advisors or agents

of such potential participants by the organizer or seller or by any other person

who has participated in the offering of the tax shelter ( including any written

materials that the organizer or seller has possessed);

(10) If the interest was not acquired from the person maintaining the list, the

name of the person from whom the interest was acquired;

(11) the name and address of each agent of the person maintaining the list who

is described in paragraph (b) of A-6 of this section.

Treas. Reg. § 301.6112-1T (2002).

8

Case: 10-41132 Document: 00511836971 Page: 9 Date Filed: 04/26/2012

No. 10-41132

October 2006 was too late and the IRS was time barred from assessing

additional taxes or related penalties for the 2001 tax year.3

Although the parties present arguments addressing whether the

information was provided to the IRS as a § 6112 list and whether the

information includes sufficient details to satisfy the regulatory requirements of

such a list, we conclude that we need not reach these issues because the

disclosure did not satisfy the regulation’s requirement in A-16 – that the

information be provided in a form that enables the IRS to determine the

information required by A-17 without undue delay or difficulty. Resolving the

issue requires us to focus on the facts surrounding Deutsche Bank’s disclosure.

In 2004, the IRS issued a series of summons to Deutsche Bank. The

summonses were never disclosed in this litigation. However, Deutsche Bank’s

cover letters and responses to the IRS provide insight into what the IRS

requested. A May 2005 letter states that the disclosure relates to “In re Matter

of the Liability of Taurus Corporation and Deutsche Bank, AG for Penalties

under I.R.C. Section 6707/6708, Summonses dated October 20, 2004.”4 The

letter discloses that the bank had made previous productions of documents in

January, March and April of 2005. Those submissions included 123 CDs that

captured approximately 1,100,000 pages of documents. The May 2005

submission included an additional 103 CDs that captured approximately

1,090,000 pages of documents. The information on Bemont and BPB was

included on 21 CDs labeled “Transaction: FX Digital Options” responsive to the

3

With respect to the 2002 partnership return of BPB, there is no dispute that the FPAA

issued to BPB on the same date was timely because it was issued within three years of the

date the partnership filed its 2002 return.

4

I.R.C. Section 6707 and 6708 deal respectively with “Failure to furnish information

regarding reportable transactions” and “Failure to maintain lists of advisees with respect to

reportable transactions.”

9

Case: 10-41132 Document: 00511836971 Page: 10 Date Filed: 04/26/2012

No. 10-41132

IRS’s summons headed “Son of Boss / Digital Options.” The letter also indicates

that Deutsche Bank expected to make an additional submission of documents.

The partnerships at issue in this case are identified on three of those pages

in charts attached to internal Deutsche Bank emails. One email has the subject

line “September Commissions” with a one page attachment that includes a list

of clients and commissions due. The list includes BPB for a transaction labeled

“SWAP.” The second email has a subject line reading “Sell cad please” and has

a 15 page chart attached. One page of the chart includes a reference to Beal and

BM Investments LLC (the entity referred to as Bemont in this opinion), related

account numbers, a reference to Australian dollars and an “FX Amount” of

$4,849,660. Another page contains a reference to BM Investments with an

account number.

Regardless of whether the information on the three discrete pages meets

or does not meet the requirements of Question and Answer A-17 of the

regulation, we find that the disclosure as a whole does not meet the regulations

requirement in A-16 that the information be provided in a form that enables the

IRS to determine the information required by A-17 without undue delay or

difficulty. First, the references to BPB and Bemont were on three pages buried

in over 2 million pages of documents. Second, the references were in charts

attached to internal Deutsche Bank emails. Neither the emails or the chart

titles give any hint that the attachments contained lists of advisees engaging in

tax shelter transactions. Rather BPB and Bemont were listed in emails

containing calculations of commissions due and in a list of sales orders. The

taxpayer does not explain and it is not apparent to us how the IRS would be

expected to locate these references within the volume of documents or how the

IRS could easily determine from this information that any of the listed entities

participated in abusive tax shelter transactions.

10

Case: 10-41132 Document: 00511836971 Page: 11 Date Filed: 04/26/2012

No. 10-41132

Accordingly, we conclude that the 2005 disclosures by Deutsche Bank did

not trigger the one year limitations period in 26 U.S.C. § 6501(c)(10) and the

district court’s ruling to the contrary that the IRS’s assessment against Bemont

for the 2001 tax year was untimely is reversed.

IV.

Section 6662 of the Internal Revenue Code imposes a penalty of 20% of any

underpayment of tax that is attributable to a number of causes, including

negligence, substantial understatement of income tax, and substantial valuation

misstatement under chapter 1 (income tax). This provision increases the

valuation misstatement penalty to 40% in the case of a gross valuation

misstatement. 26 U.S.C. § 6662(h)(1). The taxpayer is allowed a defense to the

substantial understatement penalty “if there is or was substantial authority for

such treatment.” 26 U.S.C. § 6662(d)(2)(B). The code also allows the taxpayer

a complete defense to both the negligence and understatement penalties in 26

U.S.C. § 6664(c)(1) if the taxpayer acted “in good faith” and with “reasonable

cause.” The district court found that the negligence penalty was properly

imposed and that the good faith / reasonable cause defense did not apply.

However, in a ruling on the partnerships’ motion for partial summary judgment,

the district court found that the 40% penalty for gross valuation misstatements

did not apply. Because only one penalty can apply and because the district court

had already confirmed the application of the negligence penalty, it did not

consider the substantial understatement penalty or the taxpayer’s defense of

substantial authority for the treatment it took on the return.

The government appeals the disallowance of the 40% gross valuation

misstatement penalty. The taxpayer cross appeals the negligence penalty and

also argues that the substantial understatement penalty should not apply.

A.

11

Case: 10-41132 Document: 00511836971 Page: 12 Date Filed: 04/26/2012

No. 10-41132

The government argues that the district court erred in holding that the

40% penalty for basis valuation misstatements in 26 U.S.C. § 6662 does not

apply when the IRS totally disallows the taxpayer’s claimed loss or deduction.

Section 6662's graduated penalty for valuation misstatements applies if a

taxpayer’s understatement is “attributable to” a “valuation misstatement”. 26

U.S.C. § 6662(b). A “valuation misstatement” exists if the “value of any property

(or the adjusted basis of any property) claimed on any return [on any income tax

return] is 200 [or for gross misstatements 400] percent or more of the amount

determined to be the correct amount of such valuation or adjusted basis.” 26

U.S.C. § 6662(e)(1)(A), (h). The district court held that this penalty did not apply

based on several Fifth Circuit cases dealing with the meaning of “attributable

to” in similar contexts.

First, in Todd v. Comm’r, 862 F.2d 540 (5th Cir. 1988), this court

construed 26 U.S.C. § 6659(a), which calls for an addition to the tax if the

taxpayer had an underpayment of income tax “which is attributable to a

valuation overstatement.” The Tax Court had denied the taxpayer’s depreciation

deductions for the tax years in question because the asset with the arguably

inflated valuation had not been placed in service during those years (which is a

requirement for taking a depreciation deduction). Id. at 541. Applying a formula

found in an explanation of the underlying statute in the General Explanation of

the Economic Recovery Tax Act of 1981 or “blue book” prepared by the staff of the

Joint Committee on Taxation, the Tax Court compared (1) the actual tax liability

after adjusting for the failure to place the assets in question into service in the

applicable tax years and (2) the actual tax liability adjusted for the valuation

overstatements. Id. at 542-43. Because there was no difference between the two

amounts, the Tax Court determined that no part of the underpayment of tax was

attributable to the valuation overstatement. Id. at 543.

12

Case: 10-41132 Document: 00511836971 Page: 13 Date Filed: 04/26/2012

No. 10-41132

In other words, where the deductions and credits for these [assets]

were inappropriate altogether, the Todds’ valuation of the property

supposedly generating the tax benefits had no impact whatsoever on

the amount of tax actually owed.

Id. This court was persuaded that the Tax Court’s approach was proper.

In Heasley v. Comm’r, 902 F.2d 380 (5th Cir. 1990), this court addressed

again a valuation overstatement penalty in 26 U.S.C. § 6659(a). As in Todd, the

IRS completely disallowed a deduction claimed for $10,000 in advance rental

payments and a $20,000 investment tax credit that related to the taxpayer’s

investment in equipment for an energy conservation program. Id. at 382. The

Heasleys had overvalued each of two units by $95,000. Id. However, applying

the same rationale as in Todd, this court stated

Whenever the I.R.S. totally disallows a deduction or credit, the

I.R.S. may not penalize the taxpayer for a valuation overstatement

included in that deduction or credit. . . . In this case, the Heasleys’

actual tax liability does not differ one cent from their tax liability

without the valuation overstatement included. In other words, the

Heasleys’ valuation overstatement does not change the amount of

tax actually owed.

Id. at 383. Consistent with Todd, we found that the valuation overstatement

penalty did not apply.

In this case, the IRS gave a number of reasons to disallow the losses

reported by the partnerships. As described by the district court, the deductions

were not disallowed because of a substantial valuation misstatement. Rather

the IRS determined that the transactions which generated the purported losses

were created for no business purpose other than tax avoidance, lacked economic

substance and were an economic sham. Accordingly, the IRS disregarded the

transactions in full. Because the IRS treated the transactions as a sham, and

disallowed all tax attributes flowing from the transactions in full, any valuation

13

Case: 10-41132 Document: 00511836971 Page: 14 Date Filed: 04/26/2012

No. 10-41132

misstatement was irrelevant to the calculation of the tax and, under the

precedent cited above, the 40% penalty cannot apply.5

The district court properly disallowed the 40% penalty for basis valuation

misstatements.

B.

In its cross-appeal, the partnerships argue that the district court erred in

imposing the 20% negligence penalty and also argue that the 20% substantial

understatement penalty should not apply. As outlined above, 26 U.S.C. §

6662(b)(2) imposes a 20% penalty on “the portion of any underpayment which is

attributable to . . . (1) Negligence or disregard of rules or regulations. [and] (2)

Any substantial understatement of income tax.” The substantial

understatement penalty does not apply “if there is or was substantial authority”

for the treatment proposed by the taxpayer. 26 U.S.C. § 6662(d)(2)(B). Both

penalties are also excused if the taxpayer acted “in good faith” and with

“reasonable cause.” 26 U.S.C. § 6664(c)(1). Resolution of this issue narrows to

whether either defense applies.

Section 6662 defines the conduct that justifies the imposition of the 20%

negligence or disregard penalty as follows: “‘[n]egligence’ 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.” 26

U.S.C. § 6662(c). Negligence is strongly indicated if a taxpayer fails to make a

reasonable attempt to ascertain the correctness of a deduction or credit which

5

The government attempts to avoid the application of the above cases by pointing to

Treas. Reg., § 1.6662-5(g), which it argues mandates a finding that, when basis is reduced to

zero, the deemed valuation misstatement is considered to be a gross valuation misstatement.

However, we agree with the district court that the regulation does not purport to negate the

holdings in the cases discussed above – that the valuation misstatement penalty does not

apply when the IRS completely disallows a deduction on other grounds. It only helps

determine whether a valuation misstatement is a gross misstatement. In particular it

specifies how to characterize a valuation misstatement when the true basis is determined to

be zero.

14

Case: 10-41132 Document: 00511836971 Page: 15 Date Filed: 04/26/2012

No. 10-41132

would seem “too good to be true” to a reasonable and prudent person. Treas.

Reg. § 1.6662-3(b)(l); 26 C.F.R. § 1.6662-3(b)(1). A taxpayer can avoid this

penalty if he can show a “reasonable basis” for his position.6 Id. In addition, the

reasonable cause and good faith defense may also provide relief from the

negligence penalty, even if a return does not meet the reasonable basis standard.

The partnerships argue that the district court erred by ignoring their

alleged defense of reasonable cause and good faith to the negligence penalty.

The taxpayer bears the burden of proof on these defenses. Klamath Strategic

Investment Fund v. United States, 568 F.3d 537, 548 (5th Cir. 2009).

The most important factor is the extent of the taxpayer's effort to

assess his proper liability in light of all the circumstances. Treas.

Reg. § 1.6664-4(b). Reliance on the advice of a professional tax

adviser does not necessarily demonstrate reasonable cause and good

faith; rather, the validity of this reliance turns on "the quality and

objectivity of the professional advice which they obtained." Swayze

v. United States, 785 F.2d 715, 719 (9th Cir. 1986).

Id. In Klamath, the district court found that the taxpayers had

sought legal advice from qualified accountants and tax attorneys

concerning the legal implications of their investments and the

6

Reasonable basis is defined in (b)(3) of the regulations as follows:

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. If a return position is reasonably based on one

or more of the authorities set forth in § 1.6662-4(d)(3)(iii) (taking into account

the relevance and persuasiveness of the authorities, and subsequent

developments), 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). (See § 1.6662-4(d)(3)(ii) for rules with respect to

relevance, persuasiveness, subsequent developments, and use of a well-reasoned

construction of an applicable statutory provision for purposes of the substantial

understatement penalty.) In addition, the reasonable cause and good faith

exception in § 1.6664-4 may provide relief from the penalty for negligence or

disregard of rules or regulations, even if a return position does not satisfy the

reasonable basis standard.

26 CFR 1.6662-3.

15

Case: 10-41132 Document: 00511836971 Page: 16 Date Filed: 04/26/2012

No. 10-41132

resulting tax deductions. They hired attorneys to write a detailed

tax opinion, providing the attorneys with access to all relevant

transactional documents. This tax opinion concluded that the tax

treatment at issue complied with reasonable interpretations of the

tax laws. At trial, the Partnerships' tax expert concluded that the

opinion complied with standards established by Treasury Circular

230, which addresses conduct of practitioners who provide tax

opinions. Overall, the district court found that the Partnerships

proved by a preponderance of the evidence that they relied in good

faith on the advice of qualified accountants and tax lawyers.

Id. In contrast, in this case, the district court concluded that the taxpayers’

professional advisor Coscia “was no more than a ‘puppet’” for them and

“rendered no real independent or objective advice. Coscia said what he was paid

to say.” Accordingly the district court found that “the reasonable cause defense

and defense to negligence” were not available to the taxpayers. Based on our

review of the record, these fact findings are not clearly erroneous and support

the district court’s conclusion that the 20% negligence penalty was properly

assessed.

The IRS also imposed a 20% penalty for a substantial understatement of

income tax. This penalty may be avoided if the taxpayer can show that he had

“substantial authority” for the tax treatment of an item. 26 CFR 1.6662-4(d)(2).

The standard for the substantial authority defense is more stringent than that

for the reasonable basis defense that precludes imposition of the negligence or

disregard penalty.7 Relying on Streber v. Comm’r, 138 F.3d 216 (5th Cir. 1998),

7

The regulations set forth the definition of “substantial authority” as follows:

Substantial authority standard. 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 as defined in §

1.6662-3(b)(3). The possibility that a return will not be audited or, if audited,

that an item will not be raised on audit, is not relevant in determining whether

16

Case: 10-41132 Document: 00511836971 Page: 17 Date Filed: 04/26/2012

No. 10-41132

the partnerships argue that the substantial authority defense should apply and

that because the standard for the substantial authority defense is more stringent

than the reasonable basis standard, neither penalty is proper. Presumably

because the district court found that the negligence penalty should be upheld,

it did not address the substantial underpayment penalty because only one

penalty may be imposed.

The taxpayer’s reliance on Streber is misplaced. In Streber, two sisters in

their twenties received over a million dollars each and hired an attorney to

advise them on their potential tax liability. Id. at 217. The IRS charged them

with negligence and substantial understatement penalties (under statutes that

are very similar to the ones applicable to this case) for treating the funds as a

gift. Id. at 218. As in this case, the taxpayers appealed only the penalties. Id.

at 218-19.

Addressing the substantial authority defense, this court stated that

substantial authority could rest on factual matters.

In a recent decision, the Eleventh Circuit explained that where the

substantial authority issue turns on evidence going both ways,

"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 . . . ." Osteen v. Commissioner, 62

F.3d 356, 359 (11th Cir. 1995). Apart from trying to confine Osteen

to its facts, an untenable position, I.R.S. does not demonstrate how

its principle is inapt here. The government makes no effort to assert

that the only rational tax treatment of the transaction was as a gift

made before 1985.

Id. at 223 (emphasis added). The taxpayers argue that their factual defenses

(that the swaps had profit potential and the takeover bid for Solution 6 was not

the substantial authority standard (or the reasonable basis standard) is

satisfied.

26 CFR 1.6662-4(d)(2) (emphasis added).

17

Case: 10-41132 Document: 00511836971 Page: 18 Date Filed: 04/26/2012

No. 10-41132

abandoned prior to the swaps) were supported by credible evidence. Thus the

taxpayers in this case assert that the district court’s fact findings against them

do not preclude their reliance on the rejected factual assertions for purposes of

the substantial authority defense. They argue that this is true even though the

district court rejected their factual assertions.

We conclude that Streber is inapplicable to this case for several reasons.

First, in Streber, the facts “were complex, largely undisputed, and not materially

affected by the Tax Court’s assessment of the sisters’ lack of credibility.” Id. The

facts in this case were greatly disputed, particularly on the critical issue of

whether the underlying transaction was a sham. Second, in Streber, neither the

IRS or the Tax Court argued “that ‘substantial authority’ means only legal, not

factual authority.” Id. n.14. In this case, the government points to Treas. Reg.

§ 1.6662-4(d)(3)(iii), which clearly limits the relevant substantial authority to

legal authorities.8

8

The application part of the regulation reads as follows:

(iii) Types of authority. Except in cases described in paragraph (d)(3)(iv) of this

section concerning written determinations, only the following are authority for

purposes of determining whether there is substantial authority for the tax

treatment of an item: Applicable provisions of the Internal Revenue Code and

other statutory provisions; proposed, temporary and final regulations

construing such statues; revenue rulings and revenue procedures; tax treaties

and regulations thereunder, and Treasury Department and other official

explanations of such treaties; court cases; congressional intent as reflected in

committee reports, joint explanatory statements of managers included in

conference committee reports, and floor statements made prior to enactment by

one of a bill's managers; General Explanations of tax legislation prepared by the

Joint Committee on Taxation (the Blue Book); private letter rulings and

technical advice memoranda issued after October 31, 1976; actions on decisions

and general counsel memoranda issued after March 12, 1981 (as well as general

counsel memoranda published in pre-1955 volumes of the Cumulative Bulletin);

Internal Revenue Service information or press releases; and notices,

announcements and other administrative pronouncements published by the

Service in the Internal Revenue Bulletin. Conclusions reached in treatises, legal

periodicals, legal opinions or opinions rendered by tax professionals are not

authority. The authorities underlying such expressions of opinion where

applicable to the facts of a particular case, however, may give rise to substantial

authority for the tax treatment of an item. Notwithstanding the preceding list

18

Case: 10-41132 Document: 00511836971 Page: 19 Date Filed: 04/26/2012

No. 10-41132

Streber is factually and legally distinguishable from the facts of this case

and we decline to apply it.

V.

For the above reasons, we reverse the judgment of the district court that

the FPAA as to the 2001 tax year was untimely; we affirm the judgment of the

district court in all other respects including disallowing the 40% valuation

misstatement penalty and upholding the 20% negligence penalty for both 2001

and 2002. We remand this case to the district court for entry of judgment

consistent with this opinion.

REVERSED in part; AFFIRMED in part; REMANDED.

of authorities, an authority does not continue to be an authority to the extent

it is overruled or modified, implicitly or explicitly, by a body with the power to

overrule or modify the earlier authority. In the case of court decisions, for

example, a district court opinion on an issue is not an authority if overruled or

reversed by the United States Court of Appeals for such district. However, a

Tax Court opinion is not considered to be overruled or modified by a court of

appeals to which a taxpayer does not have a right of appeal, unless the Tax

Court adopts the holding of the court of appeals. Similarly, a private letter

ruling is not authority if revoked or if inconsistent with a subsequent proposed

regulation, revenue ruling or other administrative pronouncement published in

the Internal Revenue Bulletin.

26 CFR 1.6662-4 (d)(3)(iii).

19

Case: 10-41132 Document: 00511836971 Page: 20 Date Filed: 04/26/2012

No. 10-41132

EDWARD C. PRADO, Circuit Judge, concurring:

Under this circuit’s precedent, the 40% penalty for a tax underpayment

attributable to a substantial valuation misstatement does not apply when the

relevant deduction has been totally disregarded because the underlying

transaction lacked economic substance. See Todd v. Comm’r, 862 F.2d 540,

542–45 (5th Cir. 1988); Heasley v. Comm’r, 902 F.2d 380, 383 (5th Cir. 1990); see

also I.R.C. § 6662. Because we are precedent-bound to follow the Todd/Heasley

rule, I concur in the majority opinion, including Part IV.A. I write separately,

however, to note that the Todd/Heasley rule may be misguided.

I.

In Todd, we relied on the 1981 “Blue Book”—the name for a post-

enactment summary of a major tax law prepared by the staff of the Joint

Committee on Taxation—to interpret I.R.C. § 6659 (repealed 1989), the

predecessor to § 6662, which penalized a tax underpayment “attributable to” a

valuation overstatement. See Todd, 862 F.2d at 542–43 (interpreting Staff of the

Joint Committee on Taxation, General Explanation of the Economic Recovery

Tax Act of 1981, at 333 (Comm. Print 1981) (“Blue Book”)). The Blue Book

stated that “‘[t]he portion of a tax underpayment that is attributable to a

valuation overstatement will be determined after taking into account any other

proper adjustments to tax liability,’” and offered a formula: the tax

underpayment attributable to the valuation overstatement equals the difference

between (i) “‘actual tax liability (i.e., the tax liability that results from a proper

valuation and which takes into account any other proper adjustments)’” and (ii)

“‘actual tax liability as reduced by taking into account the valuation

overstatement.’” Id. at 542–43 (quoting Blue Book at 333). The Blue Book also

offered an example: If an improper $20,000 deduction “was claimed by the

taxpayer as a result of a valuation overstatement,” and “another deduction of

$20,000 is disallowed totally for reasons apart from the valuation

20

Case: 10-41132 Document: 00511836971 Page: 21 Date Filed: 04/26/2012

No. 10-41132

overstatement,” then the overvaluation penalty should apply only to the former

valuation-related deduction, not to the latter unrelated deduction. Id. at 543

(quoting Blue Book at 333 n.2). Thus, if the taxpayer’s filing reflected a taxable

income of $40,000, but the actual taxable income after adjusting for each

improper deduction was $80,000, and the taxable income reduced by counting

the valuation overstatement was $60,000, then the tax underpayment

attributable to the valuation overstatement is $80,000(r) minus $60,000(r),

where r is the tax rate. See id.

This example makes sense of the Blue Book’s statement that the portion

of tax underpayment attributable to a valuation overstatement will be

determined “after taking into account any other proper adjustments to tax

liability.” According to the Blue Book, if a filing suffers from two unrelated

sources of deficiency—e.g., one improper deduction stemming from a valuation

overstatement of a particular asset, and another improper deduction stemming

from a false charitable contribution—one should isolate the effect of the

valuation-related deduction by (i) calculating the actual tax liability after

correcting each improper deduction, (ii) calculating the tax liability reduced by

counting the valuation-related deduction, and (iii) taking the difference. The

Blue Book’s formula and example are expressing a straightforward principle in

mathematical terms: Do not apply the valuation overstatement penalty to a tax

infraction, such as an improper charitable deduction, that is unrelated to (i.e.,

incapable of being attributed to) the valuation overstatement.

Yet, the Todd court misread the Blue Book’s elementary guidance. In

Todd, the defendant-investors overvalued their property and consequently

claimed improper deductions and credits, which the Tax Court totally denied

because the property had not been placed in service—a requirement for those

deductions and credits. Id. at 540–41. We found support in the Blue Book to

hold that the valuation overstatement penalty should not apply, because there

21

Case: 10-41132 Document: 00511836971 Page: 22 Date Filed: 04/26/2012

No. 10-41132

was no difference between the investors’ actual tax liability (which excluded the

overvaluation-generated tax benefit that was conditioned on placing the property

in service) and their tax liability reduced by taking into account the

overvaluation (which, we concluded, would still not have included the tax

benefit, as the deduction was denied because the property had not been placed

in service). Id. at 542–43. As noted, however, the Blue Book only explains that

the overvaluation penalty should not apply to an improper tax benefit that is

unrelated to the valuation overstatement. The Blue Book only covers the case

of two unrelated deductions, one of which is caused by overvaluation.

Accordingly, the Blue Book does not suggest that the overvaluation penalty

should not apply if overvaluation is one of two possible grounds for denying the

same deduction and the ground explicitly chosen is not overvaluation. No

language in the Blue Book counsels against applying the penalty in such a case;

the tax underpayment could still be “attributable to” the overvaluation. But we

inferred otherwise, despite the Blue Book’s silence, and begged the question.

What is more, we exacerbated Todd’s misinterpretation in Heasley,

holding that “[w]henever the IRS totally disallows a deduction or credit, the

I.R.S. may not penalize the taxpayer for a valuation overstatement included in

that deduction or credit.” Heasley, 902 F.3d at 383. Our misreading of the Blue

Book thereby calcified in the form of the Todd/Heasley rule. Now, under our

precedent, the overvaluation penalty is inapplicable even if the possible grounds

for denying the same deduction—overvaluation and a lack of economic

substance, for example—emerge from the same factual nucleus.

To be sure, a routine application of the Todd/Heasley rule decides this

case. If an overvaluation generates an improper deduction, and the deduction

is totally disallowed on the ground that the underlying transaction is a sham, we

are bound to hold that the tax underpayment is not “attributable to” the

valuation overstatement. In so reasoning, however, we have strayed from the

22

Case: 10-41132 Document: 00511836971 Page: 23 Date Filed: 04/26/2012

No. 10-41132

Blue Book’s text.1 Penalizing Defendants for the valuation misstatement would

not flout the Blue Book’s warning not to apply the valuation-misstatement

penalty to a tax infraction that is unrelated to the overvaluation.2

II.

Arguably, if the Todd/Heasley rule did not bind us, tax underpayment in

this case would be “attributable to” a valuation overstatement. Defendants

made a valuation misstatement when they asserted that the basis in the

Australian currency was $202.5 million. In reality, the basis in the Australian

currency was about $5 million. To create this anomaly, Defendants engaged in

two sham, offsetting transactions; they moved the “long” and “short” swaps into

the partnership; they recognized the $202.5 million increase in basis from the

“long” swap assets, but ignored the $197.5 million decrease in basis from the

“short” swap liabilities; and they dissolved the partnership, leaving behind a

fake basis of about $202.5 million in the Australian currency. Defendants then

sold the Australian currency, which was actually worth about $5 million, in the

marketplace for its fair market value—presumably close to $5 million. They

should not have reported much loss, if any. As we know, however, Defendants

1

We have not only strayed from the Blue Book, but we have also strayed from Todd.

In Todd, the possible grounds for denying the same deduction were independent: the

overvaluation was unrelated to the failure to place the property in service. In our case,

however, the possible grounds for denying the deduction overlap: the overvaluation and the

transaction’s lack of economic substance are factually interrelated.

2

I am not suggesting that the Blue Book is high-quality legislative history. It is not

available to members of Congress when they vote on the corresponding tax bill, and it is not

approved by committee members. Still, although the Blue Book does not reflect congressional

intent as reliably as a concurrent committee report does, according interpretive weight to the

Blue Book could be appropriate, depending on the case. See Michael Livingston, What’s Blue

and White and Not Quite as Good as a Committee Report: General Explanations and the Role

of ‘Subsequent’ Tax Legislative History, 11 Am. J. Tax Pol’y 91 (1994) (arguing that the Blue

Book’s interpretive weight should depend on the case and the role it is performing in the

court’s reasoning). Nonetheless, the problem here is that we found authority for the

Todd/Heasley rule in the 1981 Blue Book, even though the Blue Book was, at best, silent on

whether the overvaluation penalty should have applied in either Todd or Heasley.

23

Case: 10-41132 Document: 00511836971 Page: 24 Date Filed: 04/26/2012

No. 10-41132

made a valuation misstatement. They asserted that the Australian currency

had a basis of $202.5 million. Thus, Defendants claimed a loss of about $200

million from the sale, because they had sold an item worth $202.5 million for

much less. Consequently, when Defendants paid their taxes, they did not pay

tax on about $200 million. But as we know, the loss was artificial. As a result

of their valuation misstatement, Defendants paid less tax than they should have.

After analyzing the anatomy of Defendants’ scheme, it becomes clear that

the basis misstatement and the transaction’s lack of economic substance are

inextricably intertwined. The basis misstatement was the engine of, the vehicle

behind the sham transaction. By misstating the basis in Australian currency,

Defendants claimed an artificial loss when they sold the currency; by claiming

the artificial loss, Defendants underpaid their tax. Misstating the basis thereby

generated an improper tax benefit in direct proportion to the amount of the

misstatement. Although that deduction was disregarded because the

transaction lacked economic substance, attributing the tax underpayment only

to the artificiality of the transaction and not to the basis overvaluation is making

a false distinction. The basis misstatement is an essential element of the

transaction’s artificiality; in fact, disregarding the deduction for a lack of

economic substance pulls the correct basis to zero, which eliminates the claimed

loss, and renders the tax underpaid. Therefore, disregarding the transaction for

a lack of economic substance does not alter the reality that the tax

underpayment was ultimately “attributable to” the basis misstatement—or so

one could argue, in a world without Todd/Heasley.

III.

The near-unanimous opposition to the Todd/Heasley rule is worth

highlighting. Except for the Ninth Circuit, every sister circuit that has

considered the issue has concluded that the valuation misstatement penalty may

apply even if the deduction is totally disallowed because the underlying

24

Case: 10-41132 Document: 00511836971 Page: 25 Date Filed: 04/26/2012

No. 10-41132

transaction lacked economic substance. See Fidelity Int’l Currency Advisor A

Fund, LLC v. United States, 661 F.3d 667, 673–74 (1st Cir. 2011) (rejecting

Todd/Heasley rule for “misreading” the Blue Book and following “without

hesitation the dominant view of the circuits”); Merino v. Comm’r, 196 F.3d 147,

158 (3d Cir. 1999) (declining to apply Todd/Heasley and affirming valuation

overstatement penalty because overvaluation was “an essential component of the

tax avoidance scheme”); Zfass v. Comm’r, 118 F.3d 184, 191 (4th Cir. 1997)

(rejecting Todd/Heasley and affirming valuation overstatement penalty because

value overstatement was “primary reason” for disallowance due to lack of

economic substance); Illes v. Comm’r, 982 F.2d 163, 167 (6th Cir. 1992) (“The tax

benefit . . . was directly dependent upon the valuation overstatement, and the

amount of the tax benefit was actually determined by the amount of the

overvaluation. The entire artifice of the [tax] shelter was constructed on the

foundation of the overvaluation of its assets. Plainly, then, [the tax]

underpayment was attributable to [the] valuation overstatement.”); Gilman v.

Comm’r, 933 F.2d 143, 151 (2d Cir. 1991) (“The lack of economic substance was

due in part to the overvaluation, and thus the underpayment was attributable

to the valuation overstatement.”); Massengill v. Comm’r, 876 F.2d 616, 619–20

(8th Cir. 1989) (“When an underpayment stems from disallowed depreciation

deductions or investment credit due to lack of economic substance, the deficiency

is attributable to overstatement of value, and subject to penalty [for valuation

overstatement].”).

In addition, the Federal Court of Claims and the Tax Court, when not

bound by corresponding circuit precedent, have sided with the majority. See

Clearmeadow Invs., LLC v. United States, 87 Fed. Cl. 509, 535–36 (Fed. Cl.

2009) (siding with majority and criticizing Todd/Heasley rule); Petaluma FX

Partners, LLC v. Comm’r, 131 T.C. 84, 104–05 (2008) (siding with majority and

applying valuation misstatement penalty despite lack of economic substance,

25

Case: 10-41132 Document: 00511836971 Page: 26 Date Filed: 04/26/2012

No. 10-41132

where D.C. Circuit had not yet spoken on the issue), rev’d on other grounds, 591

F.3d 649 (D.C. Cir. 2010).

Although the Ninth Circuit has not joined the majority because it is bound

by its own precedent to follow the Todd/Heasley rule, it has questioned the

rule’s wisdom. Keller v. Comm’r, 556 F.3d 1056, 1060–61 (9th Cir. 2009)

(holding that the Ninth Circuit is “constrained by” Gainer v. Comm’r, 893 F.2d

225 (1990), which “rested in large part” on Todd, but recognizing the “sensible”

approach of “many other circuits”). Only we remain completely out of step.

IV.

As a policy matter, the Todd/Heasley rule could incentivize improper tax

behavior. If a taxpayer claims a benefit that is improper only due to a basis

misstatement, then the valuation-misstatement penalty may apply. But by

crafting a more extreme scheme and generating a deduction that is improper not

only due to a basis misstatement, but also for some other reason (e.g., a lack of

economic substance), the taxpayer increases his chance of avoiding the

valuation-misstatement penalty—because, per the Todd/Heasley hierarchy

whereby the overvaluation penalty is subordinated to any other proper

adjustment, disallowing the deduction on the other ground could block the

penalty. Amplifying the egregiousness of the scheme—to the point where the

transaction is an utter sham—could thus, perversely, shield the taxpayer from

liability for overvaluation. See Fidelity, 661 F.3d at 673 (recognizing this

perverse policy result); Gilman, 933 F.2d at 150 (same); see also Keller, 556 F.3d

at 1061 (same, though following circuit precedent not to apply penalty). A

taxpayer could generate an enormous improper tax benefit by overstating an

asset’s basis, but then could escape the overvaluation penalty by strategically

conceding a deficiency on the ground of economic substance. See Clearmedaow,

87 Fed. Cl. at 536 (recognizing the risk of such “gamesmanship”). By creating

this perverse incentive structure, the Todd/Heasley rule frustrates the purpose

26

Case: 10-41132 Document: 00511836971 Page: 27 Date Filed: 04/26/2012

No. 10-41132

of the valuation-misstatement penalty, which is to deter taxpayers from inflating

values and bases to generate large, improper tax benefits—such as a deduction

to the tune of $200 million.

V.

Still, I understand that our hands are tied. Additionally, I am not

convinced that Treasury Regulation § 1.662-5(g) frees us from the grip of

Todd/Heasley. I therefore concur.

Judges Reavley and Davis concur in Judge Prado’s special concurrence.

27