No valuation misstatement penalties for transaction disregarded as lacking economic substance

A U.S. District Court recently held that IRC Section 6662(h) penalties for gross valuation misstatement do not apply in a tax shelter case in which the Internal Revenue Service ("IRS") determined that the transaction lacked economic substance and the taxpayer conceded that it did not enter into the transaction with a profit motive. NPR Investments LLC v. United States, No. 05-219 (E.D. Tex. Feb. 24, 2010).


Factual background

This case involved a Son of BOSS tax shelter. In December of 2005, the IRS proposed an adjustment to NPR Investments LLC's (the "taxpayer's") partnership return for the calendar year ended December 31, 2001. The partnership was subject to the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA"), which simplifies the treatment of partnership items via a single partnership-level audit and litigation procedure, the results of which are binding on all partners. The IRS, in the Final Partnership Administrative Adjustment ("FPAA"), determined that the transaction in question lacked economic substance and proposed various adjustments, as well as the following penalties: (i) the 40% gross valuation misstatement penalty, (ii) the 20% substantial valuation misstatement penalty, (iii) the 20% negligence penalty, and (iv) the 20% substantial understatement penalty.

The taxpayer, in an Amended Petition for Readjustment of Partnership Items, conceded that the transaction in question lacked economic substance. The taxpayer subsequently filed two motions for summary judgment, one related to the valuation penalties imposed by the IRS and the other related to the negligence and substantial understatement penalties. The taxpayer argued that Section 6662 valuation misstatement penalties apply only to underpayments that are "attributable to" valuation overstatements. Since the taxpayer conceded the merits of the case on grounds unrelated to basis or value, it argued that Section 6662 valuation misstatement penalties cannot apply as a matter of law.


Valuation misstatement penalties inapplicable as a matter of law

The District Court relied on Weiner v. Commissioner, 389 F.3d 152 (5th Cir. 2004), and Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990), which held that "[w]henever the IRS totally disallows a deduction or credit, the IRS may not penalize the taxpayer for a valuation overstatement included in that deduction or credit." The Court rejected the IRS's position that valuation misstatement penalties cannot be avoided by the taxpayer's concession on one of the multiple grounds for an adjustment. In holding that the penalties for valuation misstatement are inapplicable as a matter of law in a situation when IRS totally disregards a transaction as lacking economic substance, the Court stressed that it was bound by the legal precedent in the Fifth Circuit.


Negligence and substantial understatement penalties may apply

On the issue of whether negligence and substantial understatement penalties should apply, the Court found that genuine issue of material fact existed and denied the taxpayer's motion for summary judgment on this issue.