IRS Negligence – Gross Undervaluation Penalties

Understanding the difference between the IRS Negligence Penalty Versus the Gross Undervaluation Penalty

Keller v. C.I.R., 2009 (9th Cir. Feb 26, 2009) (NO. 06-75441) Under 26 U.S.C. § 6662(b)(1) the IRS may asses a 20 percent penalty for negligence.

Under § 6662(h) a 40 percent penalty may be assessed for gross valuation misstatements.

Keller is one of hundreds of individuals who obtained illegitimate tax benefits through the sheep and cattle investment shams directed by Walter J. Hoyt, III.

Keller purchased the cattle through a $956,980 promissory note and made no initial payments, other than a $50 application fee, to Hoyt to finance his investment. Instead, he agreed to allocate 75 percent of the tax savings he enjoyed from the investment back to Hoyt. Later he began making payments on the promissory note of a little over $1,000 each month.

As it turns out, Keller may not have acquired any cattle in the first instance. During Hoyt and his co-conspirators’ criminal trial, the government described the cow shortage as “severe and pervasive.” The shortage was growing, and yet nonexistent “phantom” cows continued to be sold to new investors. Additionally, the same cows-as identified by name and ear tag number-were often sold to more than one investor.

IRS Negligence – Gross Undervaluation Penalties

After a tax assessment by the IRS, Keller petitioned the tax court for a redetermination of the deficiency. However, prior to trial, Keller and the Commissioner stipulated that Keller should not have been entitled to any Hoyt-related deductions. The issue at trial was thus reduced to the imposition of accuracy-related penalties. The tax court determined that if Keller had in fact not acquired any cattle, his basis in the cattle would be zero for the relevant tax years, far below the claimed bases, and thus supported the 40 percent penalty for gross valuation misstatements. The court also found the 20 percent penalty for negligence applicable and rejected Keller’s other defenses. It upheld the deficiency and penalty amounts in full.

The appeal turned on whether or not the underpayment of taxes was “attributable to” the overvaluation of the cattle.

The Ninth Circuit had previously considered the words “attributable to” in a similar context. Gainer v. Commissioner, 893 F.2d 225, 226 (9th Cir.1990) interpreted “attributable to” in § 6659, now repealed, which also imposed a penalty on taxpayers who underpaid their taxes by overvaluing an asset. In Gainer, the taxpayer purchased a 10 percent interest in a refrigerated shipping container for $26,000 (thus, the shipping container’s total value was $260,000) by paying $4,500 up front and executing a non-recourse promissory note for the balance. The actual fair market value of the container was somewhere between $52,000 and $60,000, leaving the taxpayer’s interest truly valued between $5,200 and $6,000. Nonetheless, in the 1981 tax year, a depreciation deduction was taken based on the $26,000 purchase price. Prior to trial before the tax court, the parties agreed the deduction was improper in the first instance because the container was not placed in service during the 1981 tax year. The Commissioner nonetheless sought to impose a penalty for overvaluing the container. The tax court refused, reasoning that the taxpayer was not entitled to any deduction regardless of the stated value and thus any underpayment was attributable to taking an unwarranted deduction, not overvaluing the containers. The court rejected the Commissioner’s argument that “attributable to” actually means “capable of being attributed.”

Prior to trial, Keller and the Commissioner stipulated that all of the Hoyt-related deductions he took were unlawful. Once the totality of the deduction was disallowed, the fact that the cattle purportedly acquired by Keller had a claimed basis far in excess of their true value became irrelevant. Keller’s tax deficiency was “attributable to” taking a depreciation deduction to which he was not entitled (at all) rather than “attributable to” overvaluation.

The Commissioner argued that Keller’s concession of invalid deductions was “opportunistic” and should therefore be rejected. The Ninth Circuit pointed out the concession allowed Keller to avoid an overvaluation penalty, it also confirmed, without any opportunity in court to argue otherwise, that he owed over $28,000 plus interest in back taxes. In any event, the Commissioner agreed to the stipulation at the time and must live with the consequences of that agreement.

Submit a Comment