Ninth Circuit holds that the gross valuation mistatement penalty does not apply when a deduction is completely disallowed
By Vince Nardone, Tax Attorney, Columbus Ohio | Email Me
Guest Author: M. Pilar Honer, Esq., Columbus, Ohio
In Keller v. C.I.R., 556 F.3d 1056 (9th Cir. 2009), the Ninth Circuit held that Internal Revenue Code’s § 6662(h) gross valuation misstatement penalty did not apply where a taxpayer’s deduction was completely disallowed. Although the taxpayer had overvalued the item for which the deduction was taken, the court held that since the taxpayer was not entitled to the deduction at all, the taxpayer’s underpayment of tax was not attributable to the overstatement but rather to the improper tax deduction. Therefore, at the end of the day, the taxpayer was only assessed the negligence penalty of 20 percent.
This case involved a taxpayer who was one of hundreds of individuals duped into participating in a sheep and cattle tax shelter scheme. The tax shelter was structured so that the taxpayer signed a 15-year promissory note to the promoter in exchange for 146 heifers that were still in the embryonic stage. The taxpayer made no initial payments other than a $50.00 application fee, and promised to reinvest 75% of the tax benefits back into the scheme.
As it turned out, the whole investment was a sham. During the criminal investigation of the promoter, the government found that although there was a severe and pervasive shortage of cows, these non-existent cows continued to be sold to investors. Further, the promoter sold the same cows to more than one investor. Regardless of these facts and although the taxpayer allegedly did not purchase the cattle until 1995, the taxpayer’s 1994 return showed substantial losses from the cattle operation. These losses eliminated all of the taxpayer’s 1994 income tax, and income taxes from 1991, 1992, and 1993. Further and most importantly, the depreciation schedules reflected the value of the cattle to be more than 200 percent greater than their actual value.
Eventually the Service examined the taxpayer’s returns, disallowed the deductions, and assessed penalties. The Service found that since none of the cattle were being used in a trade or business or to generate income, the entire value of the deductions were improper and assessed a 40 percent penalty due to the gross valuation misstatements of the cattle. Under I.R.C. § 6662, there are a variety of accuracy related penalties that the Service may impose upon a taxpayer for an underpayment of tax, these include negligence and substantial understatement of income penalties. Generally, the penalty is 20 percent of the portion of that underpayment. When there is a gross valuation misstatement, however, the penalty is increased to 40 percent.
The taxpayer conceded to the imposition of a 20 percent negligence penalty, but petitioned to the tax court the imposition of a 40 percent gross valuation misstatement penalty. The tax court held for the government reasoning that if the taxpayer had in fact not acquired any cattle his basis in the cattle would have been zero. That basis of zero would have been far below the claimed basis; therefore, the 40 percent gross valuation misstatement did apply. The taxpayer then appealed to the Ninth Circuit, which reversed the tax court’s holding.
The Ninth Circuit’s decision was supported by its strict construction of Internal Revenue Code § 6662(h), which states that the gross valuation misstatement penalty applies when the tax underpayment “is attributable to one or more gross valuation misstatements.” The court held that since the taxpayer’s deficiency was not due to a misstatement of the value of the item for which the deduction was taken, but rather, due to the disallowance of the entire item of the deduction, the gross valuation misstatement penalty did not apply. In its ruling, the court was also greatly guided and constricted by its prior decision in Gainer v. Commissioner, 893 F. 2d at 227 (9th Cir. 1990) where it held that the gross overvaluation misstatement penalty would not apply when there is some other ground for disallowing the entire portion of the deduction. In this case, the entire deduction was disallowed on the grounds that the cattle were not being used in a trade or business; therefore, there was already another ground for disallowing the entire portion of the deduction and the gross overvaluation misstatement penalty did not apply.
The Ninth Circuit, however, did recognize that other circuits have held that when overvaluation is intertwined with a tax avoidance scheme that lacks economic substance, an overvaluation penalty can apply. See Merino v. Comm'r, 196 F.3d 147, 155 (3d Cir. 1999); Zfass v. Comm'r, 118 F.3d 184, 190–91 (4th Cir. 1997); Illes v. Comm'r, 982 F.2d 163, 166–67 (6th Cir. 1992); Gilman v. Comm'r, 933 F.2d 143, 149–52 (2d Cir. 1991); Massengill v. Comm'r, 876 F.2d 616, 619–20 (8th Cir. 1989). Further, the court found that the other circuits’ approach seemed sensible because it allowed the imposition of a higher rather than a lower tax penalty on a party that participates in a tax shelter scheme. Nevertheless, the court was constrained by Gainer and held that even though these deductions were in connection with a tax shelter scheme, the higher 40 percent penalty did not apply.
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