Defeating the Purpose of the Tax Penalty – An Exercise in Underdeterrence

I. Introduction

The IRS has, in the opinion of this
author, a (not so) popular reputation for coming down on taxpayers
hard,inconsistently and infrequently.  Given this perception and
perhaps this reality of relative infrequence of consequence on
taxpayers engaging in funny business, it makes sense that the Internal
Revene Code be given some other teeth to guard against such
shenanigans.  In general, the tooth of choice is the threat of heavy
monetary penalties.  Unfortunately, a recent tax decision coming out of
a Texas federal district court could mark the beginnings of a shift
against the imposition of penalties on tax evaders — a shift that
could embolden an already scarily bold nation of tax-shirkers.

II. Analysis

The case, Klamath Strategic Investment Fund, LLC v. U.S.,
reads for the most part like your run of the mill tax shelter case.[1] 
Two attorneys, faced with the receipt of some substantial income (and
therefore some substantial income tax) created a Bond Linked Issue
Premium Strategy Shelter (or BLIPs), which system of initially
overvalued and rapidly depreciating assets generated losses as the
attorneys, partners in a variety of linked entities, gradually
relinquished their shares in the flailing enterprises.[2]  The court
came to the (predictable) conclusion that these series of transactions
lacked economic substance.  No substance was found because the facts
suggested that the web of contracts/entities existed for the sole
purpose of avoiding the incidence of tax, which has been squarely
rejected as a business purpose having economic substance.[3] 
Consequently, the court held that the taxpayers were responsible for
the taxes they had failed to pay.[4] 

However, on the issue of penalties, they adopted the
plaintiff's argument as to all three areas of penalties proposed by the
IRS.  The first penalty offered by the IRS dealt with the overvaluation
of assets by the taxpayers.[5]  On this issue the court held that "as a
matter of law, an overvaluation penalty cannot apply when the IRS
totally disallows a deduction or credit."[6]  In so holding, the court
relied on earlier 5th Circuit decisions (in conflict with 4th Circuit
holding [7]) which held that in any instance where the IRS totally
disallows a deduction or credit, the IRS may not penalize the taxpayer
for overvaluation.[8]  Essentially, this premise appears to disprove
the age-old adage that two wrongs don't make a right.  In this case,
two wrongs (one being the creation of tax shelters lacking independent
economic substance, two being overvaluation of the assets in those
shelters), make a right (no penalty under the overvaluation statute). 

The next penalty proposed by the IRS addressed the substantial
understatement of the taxpayers' income taxes.[9]  In this instance,
the court held that the taxpayers had reasonably relied on "substantial
authority" as produced by their creative lawyers, which authority
purportedly validated their series of entities and transactions.  This
author's question is this — how can the same court that states that a
"tax shelter" possesses as a definitional element the aim of avoiding
or evading Federal income tax, a court that also says that this shelter
existed for no other legitimate business purpose, accept that
the taxpayers reasonably relied on substantial authority in their
enterprise?  Admitting that the three thoughts are not inherently
inconsistent, the author questions the court's very sparse analysis of
what could have constituted substantial authority authorizing the
transaction relative to "the weight of authorities supporting contrary
treatment."[10]

Finally, the court addresses the final proposed penalty to be
exacted for the taxpayers' negligent disregard for the rules and
regulations of the tax code.[11]  Similar in exception to the
susbtantial understatement penalty, the court wriggles its way out of
this one in finding that the taxpayers acted in good faith and with
reasonable cause in underpaying.[12]  Once again, the court very
generally speaks to the expertise of the counsel sought in
demonstrating the necessary diligence.[13]  Given that it is not
necessary, however, under this test (in contrast to the "substantial
authority" test) to evaluate the quality of the opinion sought, but
only the reasonableness in reliance on the opinion sought, this
declination to penalize is a bit easier to swallow than the other two.

 IV. Conclusion

 What is the importance of this decision?  On its own, not a
whole lot.  It isn't groundbreaking law.  What it potentially
represents, however, is the success of some crafty, tax-fearing
individuals in avoiding any actual repercussions for their behavior. 
It gives a nation full of people already chomping at the bit for tax
freedom a little more rein and breathing room to explore the world of
tax evasion where the carrot is possibly huge, and at smallest, about
the size of the time value of money.

[1]  Klamath Strategic Investment Fund, LLC v. U.S., 2007 WL 283790 (E.D. Tex 2007).

[2] Id.

[3] Id. at 9.

[4]  Id. at 9-12.

[5] Id. at 12, see also 26 U.S.C.A. § 6662(b)(3),(h) (West 2007).

[6]  Supra note 1 at 12.

[7]  See Zfass v. Comm., 118 F.3d 184, 190 (4th Cir. 1997).

[8]  Supra note 1 at 12-13, citing Heasley v. Comm., 902 F.2d 380, 383 (5th Cir. 1990); Weiner v. U.S., 389 F.3d 152, 161-62 (5th Cir. 2004).

[9]  Supra note 1 at 13, see also U.S.C.A. § 6662(b)(2), (d) (West 2007).

[10]  Supra note 1 at 14.

[11]  Supra note 1 at 15, see also 26 U.S.C.A. § 6662(b)(1) (West 2007).

[12]  Supra note 1 at 18-19.

[13]  See supra note 1 at 18-19.