In AHG Investments LLC v. Commissioner of Internal Revenue, 140 T.C. No. 7 (3/14/2013), the U.S. Tax Court reversed its previously established position in holding that a taxpayer may not avoid application of the gross valuation misstatement penalty, imposed under Section 6662 of the Internal Revenue Code, merely by conceding the Internal Revenue Service asserted adjustments to income on alternative grounds unrelated to valuation. By holding that the gross valuation misstatement penalty may not be so easily avoided, the Tax Court adopted what has become the majority position of those circuit courts that have considered this issue.
The facts in AHG are relatively straightforward. With respect to taxable years 2001 and 2002, the IRS disallowed about $10.1 million of the taxpayer’s allocable share of partnership losses. In its final partnership administrative adjustment, the IRS enumerated 14 alternative grounds in support of the disallowance of the partnership’s losses and asserted a 40 percent accuracy-related penalty under Code §6662(a) for that portion of the underpayments of tax that could be attributed to a gross misstatement of value. In its Tax Court petition in response to the IRS disallowance, the taxpayer conceded that the adjustment was correct on several grounds, including the concession that the taxpayer was not at risk under Code §465 and that the transaction at issue did not have substantial economic effect as required under Treasury Regulation §1.704-1(b). The taxpayer then filed a motion for partial summary judgment with the Tax Court, arguing that the 40 percent gross valuation misstatement penalty does not apply as a matter of law because the taxpayer had conceded the correctness of the IRS adjustments on grounds unrelated to valuation.
Under Code §6662(h), a taxpayer may be liable for a 40 percent 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 the tax return is 400 percent or more of the amount determined to be the correct amount of such value or adjusted basis. In its decision in AHG, the Tax Court acknowledged that it had previously held that when the IRS asserts a basis for disallowing a deduction or credit that is unrelated to valuation and the taxpayer concedes the loss of the deduction or credit on that unrelated basis, any underpayment resulting from the concession will not be attributed to a gross valuation misstatement.
In McCrary v. Commissioner, 92 T.C. 827 (1989), the Tax Court held that, in effect, taxpayers could selectively concede the basis for disallowing a loss, deduction or credit in order to avoid the determination that the disallowance was based upon a valuation misstatement. By such a selective concession, the taxpayer would avoid the imposition of the misstatement penalty. Similarly, in Todd v. Commissioner, 89 T.C. 912 (1987), the Tax Court held that the valuation misstatement penalty was not applicable where there had been a judicial determination that the disallowance of claimed deductions and credits was on grounds unrelated to a valuation misstatement even though a valuation misstatement had been asserted by the IRS. On appeal, the U.S. Court of Appeals for the Fifth Circuit upheld the Tax Court’s determination in Todd v. Commissioner, 862 F.2d 540 (5th Cir. 1988). In its decision, the Fifth Circuit relied on the Joint Committee on Taxation staff report, which explains the application of the valuation misstatement penalty as follows:
"The 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. Thus, the underpayment resulting from the valuation overstatement will be determined by comparing the taxpayer’s (i) actual tax liability (i.e., the tax liability that results from a proper valuation and which takes into account any other proper adjustments); with (ii) the actual tax liability as reduced by taking into account the valuation overstatement. The difference between these two amounts will be the underpayment that is attributable to the valuation overstatement."
In interpreting the above formula, the Tax Court in McCrary and Todd,as well as the Fifth Circuit in Todd, were essentially stating that the valuation misstatement penalty would not apply in any situation where the issue of valuation would not alter the amount of the tax adjustment because one or more other grounds existed that resulted in the same adjustment. For example, in AHG, by conceding the correctness of the disallowance of losses by the IRS on the basis of a failure to comply with the at-risk rules and the substantial economic effect rule, the maximum disallowance of tax losses was attained and no further tax liability would result from the misstatement of value.
Subsequent to McCrary and Todd, a number of other circuit courts have examined this issue and have come to a contrary conclusion. For example, in Fidelity International Currency Advisor A Fund LLC v. United States, 661 F.3d 667 (1st Cir. 2011), the First Circuit held that the valuation misstatement penalty can be imposed when the tax adjustment can be based on a multitude of reasons including a valuation misstatement. The First Circuit was critical of the Fifth Circuit’s interpretation of the Joint Committee’s explanation that as long as there was some other basis for a disallowance, the valuation misstatement penalty was inapplicable. In Fidelity International, the First Circuit asserted that the proper interpretation of the Joint Committee’s explanation of the penalty is that the penalty does not apply where there is an upward adjustment of tax that is unrelated to a valuation misstatement and is due solely to some other erroneous tax position. The holding of the First Circuit was followed by the Federal Circuit in Alpha I LP v. United States, 682 F.3d 1009 (Fed.Cir. 2012), and the Eleventh Circuit in Gustashaw v. Commissioner, 696 F.3d 1124 (11th Cir. 2012).
In Alpha, the Federal Circuit observed that "the [Joint Committee explanation], in sum, offers the unremarkable proposition that, when the IRS disallows two different deductions, but only one disallowance is based on a valuation misstatement, the valuation misstatement penalty should apply only to the deduction taken on the valuation misstatement, not the other deduction, which is unrelated to valuation misstatement. The court in Todd mistakenly applied that simple rule to a situation in which the same deduction is disallowed based on both valuation misstatement and nonvaluation misstatement theories." In essence, the interpretation of the Joint Committee staff’s explanation adopted in Alpha and followed by the Federal and Eleventh circuits is that the valuation misstatement penalty cannot be avoided merely because there may be multiple grounds, including a valuation misstatement, that give rise to a disallowance. Conversely, the penalty is not applicable to any adjustment where a valuation misstatement is not asserted.
Having convinced itself that its earlier decisions in McCrary and Todd were in error, the Tax Court next had to tackle the issue of stare decisis so that it could reverse direction on this issue. The Tax Court noted that stare decisis generally requires courts to follow the holding of a previously decided case, absent special justification. The Tax Court concluded that the IRS had met its burden to persuade the Tax Court to overrule its precedent established by McCrary and Todd. In adopting its new position on the applicability of the valuation misstatement penalty under Code §6662, the Tax Court acknowledged that its prior interpretation of the Joint Committee’s explanation was erroneous. The Tax Court also examined several secondary factors involving "judicial economy." Specifically, the court stated that one reason for its decision in McCrary was the belief that by allowing the valuation misstatement penalty to be avoided by conceding an upward tax adjustment on other grounds, taxpayers would be encouraged to settle cases involving the valuation misstatement penalty and thus avoid time-consuming trials. Although the Tax Court noted that its previous position may have furthered "judicial economy" by encouraging settlements, such a position also had the adverse consequence of encouraging taxpayers to engage in more complex and aggressive tax schemes, the elements of which could be selectively conceded to avoid the valuation misstatement penalty.
The decision of the Tax Court in AHG and the position of the majority of circuit courts that have considered this issue have made taxpayers more exposed to the applicability of the valuation misstatement penalty contained in Code §6662. When the IRS asserts alternative grounds for disallowing a deduction, loss or credit, in addition to asserting a valuation misstatement, taxpayers will no longer be allowed to avoid this penalty merely by selectively conceding the upward tax adjustment on the alternative grounds. •
Mark L. Silow is the firmwide managing partner of Fox Rothschild. He formerly was chairman of the firm’s tax and estates department. His work involves a broad range of commercial and tax matters, including business and tax planning, corporate acquisitions and dispositions, real estate transactions, estate planning and employee benefits.