Does a 40% gross valuation misstatement penalty apply when the penalty is assessed on a loss that was completely disallowed?
Taxpayer Says: The penalty does not apply because the partnership agreed the underlying transaction was a sham, and the partnership was not entitled to the resulting capital loss deduction. Since the loss was not allowed, the related tax underpayment was attributable to an incorrect deduction, not a valuation misstatement.
Internal Revenue Service Says: The partnership owes the penalty because the underpayment was based on a gross misstatement of basis. The basis claimed on the tax return for the asset that caused the capital loss was 400% higher than the correct basis of zero.
From Internal Revenue Code Section 6662(a), (b)(3): Imposes a penalty on an underpayment of tax “attributable to” a substantial valuation misstatement.
From Internal Revenue Code Section 6662(h) and 6662(h)(2)(A): A taxpayer may be liable for a 40% penalty on any portion of an underpayment of tax attributable to a gross valuation misstatement. A gross valuation misstatement exists if the value or adjusted basis of any property claimed on a tax return is 400% or more of the amount determined to be the correct amount of such value or adjusted basis.
From Federal Tax Regulation 1.6662-5(g): The value or adjusted basis claimed on a [tax] return of any property with a correct value or adjusted basis of zero is considered to be 400 percent or more of the correct amount. There is a gross valuation misstatement with respect to such property, therefore, and the applicable penalty rate is 40 percent.
From Federal Tax Regulation 1.6662-5(h)(1): Whether there is a gross valuation misstatement in the partnership context is determined at the partnership level.
From McCrary v. Commissioner, 92 T.C. 827, 851-856 (1989): When the Commissioner asserts a ground unrelated to value or basis of property for totally disallowing a deduction or credit and a taxpayer concedes the deduction or credit on that unrelated ground, any underpayment resulting from the concession is not attributable to a gross valuation misstatement.
From Petaluma FX Partners, LLC v. Commissioner, 131 T.C. 84, 104-105 (2008), aff’d in pertinent part, rev’d in part and remanded, 591 F.3d 649 (D.C. Cir. 2010): It has long been the Court’s view that the gross valuation misstatement penalty does apply when the Court determines that an underpayment stems from deductions or credits that are disallowed because a transaction lacks economic substance or a participant is a sham.
THE CAUSE OF THE DISPUTE
When you underpay the tax you owe, you’re generally subject to penalties based on the amount of the underpayment. When the underpayment occurs because you report an incorrect basis, a “substantial” valuation or “gross” valuation penalty of 20% or 40% may apply. The valuation penalties were enacted to discourage taxpayers from inflating basis in order to claim losses.
As an example, say you report on your tax return that you have a basis of $95,000 in an asset, and you sold it for much less, leading to a loss. If the value of the asset (your basis) is actually $5,000, you have made an overstatement. If your loss is attributable to the overstatement, the IRS can assess a valuation penalty.
Disputes arise over valuation penalties when the IRS completely disallows the loss deduction. In that situation, the question becomes one of how much of the penalty is attributable to the valuation. The reason: When a deduction is inappropriate and disallowed, the valuation of the property supposedly generating the deduction has no impact on the amount of tax actually owed.
More plainly, the argument is this: If you claim a deduction that is later completely disallowed, the underpayment is attributable to the invalid deduction, not the overvaluation of the asset.
In this case, the taxpayer was a general partnership that engaged in a tax avoidance scheme involving the sale of borrowed Treasury notes. As part of the scheme, the individual partners sold their interests in the partnership, using a higher basis than was actually correct, and claimed losses in excess of $5 million on their personal tax returns in 2001 and 2002.
The IRS disallowed the losses, saying the partnership was a sham, and was formed to create artificial losses for tax purposes.
The partnership agreed with the IRS determination. In addition, the partnership agreed a 20% accuracy-related penalty on the underpaid tax.
The IRS says the higher 40% gross valuation penalty applies, because the correct value of the partners’ interests in the partnership was zero, and the basis claimed on their individual tax returns exceeded zero by more than 400% (the percentage in effect for the year in question).
The partnership says the 40% penalty does not apply, because the underpayment of tax was not attributable to a valuation misstatement. Instead, the underpayment was caused by the fact that the partnership was a tax sham, which made the deduction invalid. Since the underpayment arose because the IRS disallowed the claimed loss on the grounds it was a tax scam, the loss was not related to any property in the transaction and there could be no misstatement of basis on which to assess the penalty.
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
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