TaxNewsFlash-United States

February 26, 2009
No. 2009-102

PRINTABLE VERSION

Ninth Circuit: 40% Penalty Does Not Apply When Depreciation Deduction Is Disallowed in Total

The U.S. Court of Appeals for the Ninth Circuit today held that in determining whether the enhanced 40% penalty for gross valuation misstatements applies, the validity of the deductions must be determined first and that the overvaluation penalty can only be imposed on any remaining inflated value. Keller v. Commissioner, No. 06-75441 (9th Cir. February 26, 2009).

Relying on Ninth Circuit precedence (Gainer v. Commissioner, 893 F.2d 225 (9th Cir. 1990)), the appeals court reversed the imposition of the 40% gross valuation misstatement penalty, affirmed the imposition of the 20% negligence penalty, and remanded the case to the Tax Court for calculation of the 20% negligence penalty.

For an electronic version of the 12-page decision: Keller

Summary

The taxpayer was a solo investor in “sheep and cattle investment shams directed by Walter J. Hoyt, III.” There was some evidence that the taxpayer may not have acquired any cattle at all under this scheme. The taxpayer’s returns for 1994 and 1995 reported losses relating to his investment.

In 2001, the IRS issued a notice of deficiency asserting deficiencies for 1994 and 1995 as well as accuracy related penalties of 40% of the underpayment. The deficiency was based on the IRS conclusion that the cattle were not actually being used in a trade or business or to generate income, and the 40% penalty was applied due to alleged gross valuation misstatements in the claimed value of the cattle. The statutory language under section 6662(h)(1) provides that the 40% penalty applies to situations when the tax underpayment “is attributable to one or more gross valuation misstatements.”

Before the Tax Court, the taxpayer conceded the deficiencies but contested the 40% penalty assessment. The taxpayer asserted that his tax underpayment was not “attributable to” a valuation overstatement because he was entitled to no deduction at all, rather than simply a reduced deduction. In other words, the taxpayer claimed that the underpayment was “attributable to” taking an illegitimate deduction—not overvaluing an asset.

The Tax Court upheld the deficiencies—and imposition of the 40% penalty for a gross valuation misstatement—finding that even if the taxpayer had not in fact acquired any cattle, his basis in the cattle would be $0, thus supporting the imposition of the 40% penalty for gross valuation misstatement.

On appeal, the Ninth Circuit affirmed imposition of the 20% penalty but reversed imposition of the 40% penalty, finding that an overvaluation penalty can only apply on any lingering inflated value.

Relying on Gainer and the Joint Committee on Taxation’s “Blue Book” explanation of the Economic Recovery Tax Act of 1981, the Ninth Circuit held that when a depreciation deduction is disallowed in total, any overvaluation is subsumed in that disallowance, and an associated underpayment is “attributable to” an invalid deduction—not the overvaluation of the asset—thereby precluding an associated penalty for overvaluing an asset. The case was remanded to the Tax Court for a determination of the amount of the 20% negligence penalty.

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