T. JOHN WARD, District Judge.
This case is a Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA") partnership proceeding under Section 6226 of the Internal Revenue Code.
Harold W. Nix ("Nix"), Charles C. Patterson ("Patterson"), and Nelson J. Roach
In 2001, the Taxpayers expressed to Mr. Sid Cohen ("Cohen"), their personal CPA at Pollans & Cohen, an interest in investing in foreign currencies because investments in foreign currency carried the possibility of returns not achievable in traditional investments. (Tr. I at 143.)
At the Taxpayers' direction, Cohen set up a meeting with DGI and R.J. Ruble ("Ruble"), a lawyer with the law firm Sidley, Austin, Brown & Wood LLP ("Sidley Austin"), in New York in October of 2001. (Tr. I at 145.) The meeting in New York was attended by Cohen, Patterson, Mr. James Haber ("Haber"), and Ruble, among others. (Id.) Haber explained investments
The same day in New York, Ruble also met with Patterson and Cohen at DGI's office. (Tr. I at 146-48, 177.) Ruble brought with him a draft, template tax opinion letter describing a similar transaction to the one proposed to Taxpayers. (Tr. 1 at 148.) Ruble went through the opinion with Patterson and Cohen to explain the tax benefits or losses from the transaction and his "legal analysis" of the correct treatment of such benefits. (Tr. I at 147-48.) Ruble confirmed that hitting the sweet spot was "a high risk long shot" and that if the options pairs did not "hit all the way" or did not hit the sweet spot, there would be tax losses. (Tr. I at 61-64.)
By October 25, 2001, Roach decided to join the investment scheme, formed his own SMLLC, and funded it with $375,000. (P-Exh. 28 at NPR002020.) Like Nix's and Patterson's SMLLCs, Roach's SMLLC was also managed by DGI. (Id.) On October 30, 2001, each Taxpayer purchased two pairs of offsetting foreign currency options, with each paired option being in the same foreign currency with identical expiration dates and almost identical strike prices, through their respective SMLLCs. (P-Exh. 26 at PC 06319; P-Exh. 27 at NPR02188, P-Exh. 28 at NPR002020.) The strike prices of the long and short components of each option pair were set apart by only three pips, "a razor thin" margin.
Nix and Patterson each paid DGI an "advisory fee" of $750,000 and Roach paid DGI a fee of $450,000. (Id.; Tr. I at 117; Tr. II at 14, 38.) In addition, Nix and Patterson paid Cohen a fee of $250,000 and Roach paid Cohen a fee of $150,000. (Id.) DGI also directly paid Cohen a fee of $325,000 for referring the Taxpayers as clients, which was unknown to the Taxpayers until after the penalties were assessed. (G-Exh. 141; Tr. I at 211-12; Tr. II at 8-9.) In deciding whether to enter into this transaction, Patterson relied upon the representations of Cohen and DGI. Nix and Roach relied upon the representations of Cohen and Patterson and even appointed Patterson as their agent to investigate the transactions. (Tr. I at 136, 184, 234-235; Tr. II 4-5, 7, 9, 21-22, 42.) All three Taxpayers relied on Cohen as their fiduciary agent to DGI and the transactions. (See id.)
On December 18, 2001, all three Taxpayers withdrew from NPR. (P-Exh. 26 at PC06320; P-Exh. 27 at NPR002189; P-Exh. 28 at NPR002021; Tr. 1 at 71-73, 248-49; Tr. II at 25-26.) In exchange for their partnership interests, they received cash and foreign currencies representing the fair market value of their interests in NPR as of December 18, 2001. (Id.) The Taxpayers then contributed their foreign currencies to a different partnership through which they operated their Law Firm. Inside of the Law Firm, all gains or losses on these foreign currencies were to be specially allocated to their respective contributing partners on the Law Firm's books and tax returns such that the Law Firm's other partners did not receive any gain or loss from these foreign currencies. (Tr. I at 186-190.) The losses from these foreign currency sales were listed in a "Business Risk Division" on the Law Firm's tax returns. (Id.) When the foreign currencies were sold in 2001, 2002, and 2003, the Law Firm offset these losses against the income allocated to each Taxpayer to reduce the earned income shown on Schedules K-1 issued to the Taxpayers by the Law Firm. (See, e.g., P-Exh. 6.) The DGI investment scheme was generally described under IRS Notice 2000-44:
See IRS Notice 2000-44, at 3-4. The Taxpayers engaged in similar transactions and tax reporting as described in IRS Notice 2000-44. As stated previously, when the Taxpayers withdrew from NPR, they received cash and foreign currencies representing the fair market value of their interests in NPR as of December 18, 2001. (P-Exh. 26 at PC06320; P-Exh. 27 at NPR002189; P-Exh. 28 at NPR002021; Tr. 1 at 71-73, 248-49; Tr. II at 25-26.) In their tax returns, the Taxpayers claimed that Section 752 allowed them to increase their tax basis in NPR by the premiums on the contributed long options but did not require them to reduce that basis by the amount they might have to pay on the contributed short options. The foreign currencies received by the Taxpayers upon withdrawal from NPR had a basis materially distinct from their value, and the basis was determined by what the Taxpayers paid for the long option position, while ignoring what the Taxpayers were paid for the short option position. (See, e.g., P-Exh. 6.)
When the Taxpayers resigned from NPR based on Roach's decision to withdraw for personal reasons, the Taxpayers each obtained a thorough, written opinion from Sidley Austin that detailed the proper tax treatment of their investments. (Tr. I at 72-74, 249-250; Tr. II at 25-27.) In drafting those opinions, Sidley Austin relied on representations made by each of the Taxpayers. (P-Exhs. 17, 18, and 19.) Each of the Taxpayers believed these representations to be true at the time they were made, and continued to believe them to be true at the time of trial. (Tr. I at 77-78, 252-53; Tr. II at 29.) Not learned in the area of tax law, the Taxpayers reviewed the Sidley Austin opinions with Cohen. (Tr. I at 81, 250-51; Tr. II at 27.) After reviewing the Sidley Austin opinions, Cohen concluded that the opinions "had cited the important areas where there might be potential controversy and had adequately dealt with them to [his] satisfaction that [the Taxpayers] would be okay." (Tr. I at 160-61.) Accordingly, Cohen advised the Taxpayers that they could rely on the opinions because Sidley Austin was a "very well known firm," because the opinions were "very, very well reasoned," and because Ruble was an "acknowledged partnership tax expert." (Id.)
NPR's 2001 tax return was prepared by Grant Thornton LLP and filed with the IRS on or about April 1, 2002. (P-Exh. 3.) On line 2 of Schedule B, the return indicates that one of NPR's partners was a partnership. (Id. at 2.) However, in the same tax return on line 4 of Schedule B, NPR answered "No" to the following question, "Is this partnership subject to the consolidated audit procedures of Sections 6221 through 6223?" (Id.) Sections 6221 through 6223 refer to TEFRA's audit procedures. In fact, NPR was a partnership subject to the TEFRA audit procedures,
NPR's return was initially examined by Paul Doerr ("Doerr"), who currently is and was an Internal Revenue Service ("IRS") Agent in 2005. (Tr. II at 117; P-Exh. 2.) Doerr and his managers did not initiate the standard TEFRA procedures, but instead they applied the normal deficiency procedures set forth in Sections 6211 through 6216 and issued a standard Letter 2205 for notifying non-TEFRA partnerships and other taxpayers that their returns have been selected for examination. (P-Exh. 49 at 15, 49.) The IRS notified NPR on March 25, 2005 that it had completed its audit and had determined that no adjustments would be made to NPR's 2001 tax year. (P-Exh. 2.) The March 25, 2005 notice stated:
(Id.) Doerr signed the notice on behalf of the IRS. (Id.) Doerr and his managers initially and mistakenly concluded that there was no need to adjust any of the items on NPR's return. (P-Exh. 49 at 35-36, 48-49, 73.) Instead, they intended to deny the losses related to the Taxpayers' participation in NPR by issuing notices of deficiency directly to NPR's partners under the normal audit procedures. (Id. at 35-36.) While under a belief that NPR was not subject to the TEFRA procedures, Doerr issued the March 2005 no-change letter to NPR indicating that no changes were necessary to its return. (Id. at 48-49, 73.)
Doerr also prepared deficiency notices denying losses on Patterson's personal tax returns related to both his participation in NPR and losses related to his participation in a separate BLIPS transaction.
On December 6, 2005, NPR filed suit under Section 6226, seeking the redetermination of adjustments made by the IRS to the Form 1065 federal partnership return filed by NPR for its taxable year ending December 31, 2001. The IRS made these adjustments by issuing a Notice of FPAA to NPR on or about August 15, 2005. In the FPAA, the IRS notified NPR of various adjustments made to the Form 1065 partnership tax return and provided various explanations for the adjustments it made. The IRS also determined that NPR was subject to various penalties, including a(i) 40 percent gross valuation misstatement penalty, (ii) 20 percent substantial valuation misstatement penalty, (iii) 20 percent negligence penalty, and (iv) 20 percent substantial understatement penalty. Prior to trial on motion for summary judgment by NPR, the Court ruled that the 40% penalty for gross valuation misstatement and 20% penalty for substantial valuation misstatement do not apply as a matter of law based on the facts of this case. (Dkt. No. 109.) On August 10, 2009, NPR filed its First Amended Petition for Readjustment of Partnership Items Under Internal Revenue Code Section 6226 (the "Amended Petition"). In the Amended Petition, NPR conceded that, if the August 15, 2005 FPAA is valid, NPR did not enter into the transactions at issue with a profit motive, and thus, conceded the adjustments that the IRS made in the FPAA. Thus, the actual adjustments made by the IRS to the tax returns and whether NPR had profit motive are not materially disputed. Rather, the dispute is whether the penalties applied by the IRS are applicable.
Two primary issues were tried before this Court from March 8 through March 10, 2010. The first issue is whether the notice of final partnership administrative adjustment ("FPAA") issued on August 15, 2005 by the IRS is invalid under Section 6223. The second issue is whether the accuracy-related penalties asserted by the Defendant under Section 6662 are applicable in this case because the Taxpayers allegedly relied reasonably and in good faith on the advice of their tax and legal advisors.
The first issue is whether the notice of FPAA issued by the IRS on August 15, 2005 with respect to the 2001 tax year of NPR is invalid. NPR argues that the FPAA is invalid because it is the second notice of final partnership administrative adjustment the IRS issued to NPR with respect to its 2001 tax year. According to NPR, a second notice violates Section 6223(f).
The Internal Revenue Code contains two different sets of audit procedures. Sections 6211 through 6216 cover general deficiency procedures, while Sections 6221 through 6234 cover the TEFRA audit procedures for certain partnerships. Pursuant to TEFRA, "the tax treatment of any partnership item ... shall be determined at the partnership level." 26 U.S.C. § 6221. When the IRS seeks to adjust partnership items in such a partnership-level administrative proceeding, TEFRA requires that the IRS give "notice of (1) the beginning of an administrative proceeding at the partnership level with respect to a partnership item, and (2) the final partnership administrative adjustment
Neither the Internal Revenue Code nor the regulations promulgated thereunder specify that the required FPAA "notice" take a particular form. Clovis I v. Comm'r, 88 T.C. 980, 982 (1987); see also Sealy Power, Ltd. v. Comm'r, 46 F.3d 382, 386 (5th Cir.1995). "While the Code does not specifically define the FPAA, it is evident from the context, structure and purpose of the applicable Code provisions that an FPAA gives notice of the amount of partnership income properly allocable, in the view of the IRS, to each partner for individual tax purposes." PAA Management, Ltd. v. U.S., 962 F.2d 212, 214 (2d Cir.1992). The critical inquiry in determining whether notice of a FPAA has been given by the IRS is whether the notice indicates that it is the final notice and that a determination has been made. See Clovis, 88 T.C. at 982 ("whatever form a FPAA takes, it must minimally give notice to the taxpayer that respondent has FINALLY DETERMINED adjustments to the partnership return"); see also Chomp Associates v. Comm'r, 91 T.C. 1069, 1073-75 (1988); Sealy, 46 F.3d at 386. The mere fact that the FPAA is a "no change" notice does not preclude it from being a valid FPAA. See University Heights at Hamilton Corp. v. Comm'r, 97 T.C. 278, 282 (1991). "[A]n FPAA is the functional equivalent of a notice of deficiency." Sealy, 46 F.3d at 386. Thus, the Court analyzes the validity of the FPAA in the same way it analyzes the validity of a notice of deficiency. See id.
NPR argues that the March 25, 2005 letter was a "notice of ... the final partnership administrative adjustment" resulting from the IRS's audit of NPR's 2001 tax year. See 26 U.S.C. § 6223(a)(2). NPR argues that the March 25, 2005 notice issued by the IRS to NPR constitutes a notice of final partnership administrative adjustment because (i) it explicitly states, in two different places, that it is the "final notice" that the IRS will send regarding the examination and (ii) the IRS satisfied the minimal notice requirements by sending it to the Tax Matters Partner. NPR argues that the notice is unequivocal in indicating that the IRS had completed its audit of NPR with respect to its activities and that the IRS had determined to make no changes to the NPR return. NPR argues that the fact that the IRS determined to make no adjustments is not unusual and does not make it any less of a determination. NPR argues that the March 25, 2005 notice meets all elements of the term "notice of final partnership administrative adjustment" within the meaning of Section 6223: it is a notice, it indicated that it was the final notice, and it indicated that the IRS had determined not to adjust NPR's partnership items. NPR
The Court finds that the initial FPAA of March 2005 provided adequate or minimal notice to NPR that the IRS had determined adjustments, or the lack thereof, to the partnership return. There is no dispute that the notice met the statutory requirement for a valid notice of FPAA in that it was mailed to the Tax Matters Partner for the partnership. See 26 U.S.C. § 6223(a). Further, the Court finds that the initial letter provided notice, indicated that it was the final notice, and indicated that the IRS had determined not to adjust NPR's partnership items. (See P-Exh. 2.) Thus, the Court finds that the March 2005 letter appears to be a valid FPAA notice within the meaning of Section 6223 under the relevant caselaw. See Sealy, 46 F.3d at 386; Clovis, 88 T.C. at 982; Chomp, 91 T.C. at 1073-75. Even the Government does not genuinely dispute that it is a valid notice under this caselaw. Rather, the Government argues that the earlier March 25, 2005 letter was not an FPAA because: (1) FPAAs are issued only after IRS has initiated the TEFRA audit procedures, and the IRS had not initiated TEFRA audit procedures at the time the March 25, 2005 letter was issued; (2) the March 25, 2005 letter was issued by Doerr who did not have authority to issue or sign an FPAA; (3) the March 25, 2005 letter was not intended to be an FPAA; and (4) in the alternative, even if the March 25, 2005 letter is deemed an FPAA, the August 15, 2005 FPAA was allowed under Section 6223(f) because NPR misrepresented that it was not subject to the TEFRA audit procedures on its 2001 partnership return.
The Court rejects the Government's first three arguments. The Court finds no requirement, either by statute or by caselaw, that the validity of a FPAA notice is affected by whether the IRS followed proper internal procedures in issuing the notice or the intent of the agent that provided the notice. See, e.g., Greenberg's Express, Inc. v. Comm'r, 62 T.C. 324, 327 (1974) ("As a general rule, this Court will not look behind a notice of deficiency to examine the evidence used or the propriety of respondent's motives or of the administrative policy or procedure involved in making his determinations."); Riland v. Comm'r, 79 T.C. 185, 200-01 (1982) (determining that notice was valid even if the revenue agents violated internal procedures as set out in the Internal Revenue Manual); Selgas v. Comm'r, 475 F.3d 697, 699-700 (5th Cir.2007) ("As a general matter, IRS internal operating procedures confer no rights on individual taxpayers...."). Therefore, even assuming without deciding that the IRS failed to follow its internal procedures in issuing the March 2005 notice, this does not affect the validity of the March 2005 notice. Likewise, the Court rejects the Government's argument that because Doerr did not have express authority to issue an FPAA that the March 2005 notice is invalid as a FPAA notice.
The Government's fourth argument has merit, however. As such, the FPAA issued on August 15, 2005 is valid. Section 6223(f) allows the IRS to send a second FPAA if there is a showing of either "fraud or malfeasance or misrepresentation of a material fact." There appears to be no cases that have construed the term "misrepresentation" within the specific context of Section 6223(f). Both parties cite decisions that construe "misrepresentation" in other statutory contexts, but these decisions are unpersuasive as to this specific statute. The term "misrepresentation" is defined as "the act of making a false or misleading assertion about something, usually with the intent to deceive" and as "an assertion that does not accord with the facts." See Black's Law Dictionary 1091 (9th ed. 2009). Black's Law Dictionary additionally provides definitions for the terms "fraudulent misrepresentation," "innocent misrepresentation," "material misrepresentation," and "negligent misrepresentation," implying that a "misrepresentation," by itself, necessarily need not be fraudulent or intentional. See id. In other words, the term "misrepresentation" is broad enough to describe a fraudulent as well as a negligent or innocent statement. The statutory language is written in the disjunctive, meaning that if there is "fraud" or "malfeasance" or a "misrepresentation of a material fact," then a second FPAA can be mailed. In other words, if the taxpayers submitted a material fact that was false, then this exception applies. The Court finds that there is no evidence indicating that the inconsistent answers on NPR's tax return were intentional or fraudulent. However, the misrepresentation in this case was material and it related directly to the proper audit procedures that should have been originally applied to the tax return. As such, the Court concludes that the IRS is entitled to invoke this exception and send a second FPAA. To hold otherwise would prevent the IRS from relying upon submitted information in tax returns in preparing notices and would place an impermissible burden on the IRS to verify the accuracy of the submitted information and the intent with which it was submitted.
There is no dispute that, and the Court finds that, the tax return filed by NPR erroneously failed to check a box that indicated that NPR was subject to the TEFRA provisions. The Court finds that Doerr mistakenly took actions as though NPR was a non-TEFRA partnership, applied the normal deficiency procedures set forth in Sections 6211 through 6216, and issued a standard non-TEFRA closing letter. The Court finds that Doerr was under the mistaken impression that NPR was not subject to the TEFRA audit procedures at the time he issued the March 25, 2005 no-change letter and that there was no need to adjust any of the items on NPR's return. The Court finds that had NPR correctly checked the box indicating that the tax return was subject to the
This Court has jurisdiction to determine the applicability of any penalty which relates to an adjustment to a partnership issue pursuant to 26 U.S.C. § 6226(f). There are two accuracy-related penalties asserted by the Government that are still in dispute in this case:
In the August 15, 2005 FPAA, the IRS imposed a penalty for substantial understatement of income tax. The Court now turns to this penalty.
Section 6662(b) imposes a 20% penalty to "[a]ny substantial understatement of income tax." 26 U.S.C. § 6662(a), (b)(2). "For purposes of this section, there is a substantial understatement of income tax for any taxable year if the amount of the understatement for the taxable year exceeds the greater of (i) 10 percent of the tax required to be shown on the return for the taxable year, or (ii) $5,000." 26 U.S.C. § 6662(d)(1)(A). The amount of the substantial understatement used to compute the penalty does not include any item for which there was substantial supporting authority. 26 U.S.C. § 6662(d)(2)(B)(i); Treas. Reg. § 16662-4(a).
"The substantial authority standard is an objective standard involving an analysis of the law and application of the law to relevant facts. The substantial authority standard is less stringent than the more likely than not standard (the standard that is met when there is a greater than 50-percent likelihood of the position being upheld), but more stringent than the reasonable basis standard." Treas. Reg. § 1.6662-4(d)(2). For substantial authority to exist, "the weight of the authorities supporting the treatment is substantial in relation to the weight of authorities supporting contrary treatment." Treas. Reg. § 1.6662-4(d)(3)(i). Opinions rendered by tax professionals are not authority. Treas. Reg. § 1.6662-4(d)(3)(iii). The authorities underlying such opinions, if applicable to the facts of a particular case, may give rise to substantial authority for the tax treatment of an item. Id. In addition, in a case involving a tax shelter, the "substantial
The Government argues that the facts satisfy the mathematical test for the penalties because the amount of understatement was greater than 10 percent of the required tax. See 26 U.S.C. § 6662(d)(1)(A). As a result, the Government urges that the penalty applies in this case. The Government argues that the Taxpayers' reliance on the caselaw is misplaced. The Government argues that the Taxpayers knew this was a tax shelter listed in Notice 2000-44, yet decided to enter into the transactions nonetheless. NPR argues that the 20% substantial understatement of income tax penalty does not apply in this instance. NPR argues that there was "substantial authority" for the treatment of the Taxpayers' tax positions. NPR contends that the input and advice of Cohen and Sidley Austin provide substantial authority for the tax treatment at issue. NPR argues that it is not a tax shelter, but even if it were, the substantial-authority exception would still apply. NPR argues that the advice given to the Taxpayers by Cohen and Sidley Austin justifiability relied on the existing case law and strongly supported NPR's position that their tax position was, more likely than not, correct.
This Court may assume, arguendo, that the NPR partnership was a tax shelter within the definition. The record, however, supports a finding that substantial authority existed. The Taxpayers obtained comprehensive opinions of counsel before they filed their returns. The Sidley Austin opinions relied on the relevant authority at the time. Cohen went over the opinions with the Taxpayers and confirmed that they were reasonable. Further, Mr. Stuart Smith ("Smith") provided expert opinion and testimony that substantial authority supported the tax treatment at issue in this case. Smith's experience includes over 40 years as a tax lawyer, both as Tax Assistant to the Solicitor General in the Department of Justice and now in private practice. (Tr. II at 60-61.) After examining the material issues identified in the opinions, Smith concluded that the opinions provided "objectively reasonable tax advice" because they "discussed all of the authorities in an even-handed balanced way, taking into account all possible challenges in a thorough and complete manner." (Tr. II at 77.) He further concluded that the opinions were the "quality and character upon which a taxpayer could rely in good faith." (Id.) The Court agrees with Smith's opinions and concludes that the Sidley Austin opinions provided "substantial authority" for the Taxpayers' treatment of their basis in their respective partnerships. The record also supports a finding that the Taxpayers reasonably believed that the tax treatment applied to the transactions was "more likely than not" the proper treatment. Although they are experienced attorneys, the Taxpayers are not tax lawyers. Based on all of the record evidence, the Court finds that the Taxpayers were not aware of any financial agreements between Cohen and DGI when they decided to enter the transactions and
In the August 15, 2005 FPAA, the IRS also imposed a penalty for negligence. The Court now turns to this penalty.
The 20% negligence penalty applies to the extent that an understatement of the tax was attributable to the taxpayer's "negligence or disregard of rules or regulations." 26 U.S.C. § 6662(b)(1). "For purposes of this section, the term `negligence' includes any failure to make a reasonable attempt to comply with the provisions of this title, and the term disregard' includes any careless, reckless, or intentional disregard" of the tax laws. 26 U.S.C. § 6662(c). Negligence includes the "failure to make a reasonable attempt to comply with the provisions of the internal revenue laws or to exercise ordinary and reasonable care in the preparation of a tax return." Treas. Reg. § 1.6662-3(b)(1). "Negligence is strongly indicated where... [a] taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction, credit or exclusion on a return which would seem to a reasonable and prudent person to be too good to be true' under the circumstances." Treas. Reg. § 1.6662-3(b)(1)(ii). Disregard for the "rules or regulations is careless' if the taxpayer does not exercise reasonable diligence to determine the correctness of a return position that is contrary to the rule or regulation." Treas. Reg. § 1.6662-3(b)(2). The Fifth Circuit defines negligence as "any failure to reasonably attempt to comply with the tax code, including the lack of due care or the failure to do what a reasonable or ordinarily prudent person would do under the circumstances." Heasley v. Comm'r, 902 F.2d 380, 383 (5th Cir.1990).
A taxpayer is not negligent where there is a reasonable basis for the position taken. Treas. Reg. § 1.6662-3(b)(1). "Reasonable basis is a relatively high standard of tax reporting, that is, significantly higher than not frivolous or not patently improper. The reasonable basis standard is not satisfied by a return position that is merely arguable or that is merely a colorable claim." Treas. Reg. § 1.6662-3(b)(3). Reasonable basis requires reliance on legal authorities and not on opinions rendered by tax professionals. Id.; Treas. Reg. § 1.6662-4(d)(3)(iii). The Court may, however, examine the authorities relied upon in a tax opinion to determine if a reasonable basis exists. See Treas. Reg. § 1.6662-4(d)(3)(iii). "If a return position is reasonably based on one or more of the authorities set forth in [the substantial authority section] ... the return position will generally satisfy the reasonable basis standard even though it may not satisfy the substantial authority standard as defined in § 1.6662-4(d)(2)." Treas. Reg. § 1.6662-3(b)(3).
The Government argues that entering into a transaction that is "too good to be true" is careless and not what a reasonable person would do. The Government argues that the Taxpayers had full knowledge of their advisors' conflicts of interest. The Government argues that a reasonable, prudent person would not proceed with a transaction that was the subject of an IRS penalty warning without obtaining completely
The reasonable basis standard is less stringent than the substantial authority standard; if the substantial authority defense is applicable to the substantial understatement penalty, the reasonable cause defense will also be applicable. See Treas. Reg. § 1.6662-4(d)(2); Treas. Reg. § 1.6662-3(b)(3). As discussed above, the Court finds that there was "substantial authority" to rely on the Sidley Austin opinions. Id. Therefore, the "reasonable basis" standard has also been met. Accordingly, a penalty for negligence is not applicable in this case.
Finally, the Court turns to the reasonable cause and good faith issues. Notwithstanding the specific requirements of the penalties discussed above, a taxpayer may defeat the imposition of any of those penalties if he demonstrates reasonable cause.
Section 6664(c)(1) provides an absolute defense to any accuracy-related penalty. A taxpayer that would otherwise be subject to a twenty-percent accuracy-related penalty under § 6662(b) is not liable if the taxpayer can demonstrate that the underpayment was made with reasonable cause and the taxpayer acted in good faith. 26 U.S.C. 6664(c)(1); Treas. Reg. § 1.6664-4(a). The plaintiffs bear the burden of production and proof on their reasonable cause defenses. Klamath Strategic Investment Fund v. U.S., 568 F.3d 537, 548 (5th Cir.2009); see Montgomery v. Commissioner, 127 T.C. 43, 66 (2006). Although each instance requires a case-by-case determination of all pertinent facts and circumstances, generally the most important factor in assessing the applicability of the exception is the amount of effort the taxpayer spent to determine the proper tax liability in light of all the circumstances. Treas. Reg. § 1.6664-4(b). When considering the taxpayer's effort to determine the proper tax liability, the taxpayer's reliance on the advice of a professional tax adviser may not be sufficient to demonstrate reasonable cause and good faith. Treas. Reg. § 1.6664-4(b)(1). Rather, the validity of the reliance turns on "the quality and objectivity of the professional advice which they obtained." Klamath, 568 F.3d at 548, citing Swayze v. U.S., 785 F.2d 715, 719 (9th Cir.1986). "Reliance on ... professional advice, or other facts, however, constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith." Treas. Reg. § 1.6664-4(b)(1). To determine if reliance on a tax professional's advice was reasonable and in good faith, all facts and circumstances must be taken into account. Treas. Reg. § 1.6664-4(c). "For example, the taxpayer's education, sophistication and business experience will be relevant in determining whether the taxpayer's reliance on tax advice was reasonable and made in good faith." Id. "Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of all the facts and circumstances, including the experience, knowledge, and education of the taxpayer." Treas. Reg. § 1.6664-4(b)(1). A taxpayer is not required to challenge the advisor's conclusions, seek a second opinion, or check the advice himself. U.S. v. Boyle, 469 U.S. 241,
In order to establish reasonable reliance in good faith on the advice of a tax professional, a taxpayer must establish that all facts and circumstances were considered, and no unreasonable assumptions were made. Treas. Reg. § 1.6664-4(c)(1)(i)-(ii). For the advice to be based on "[a]ll the facts and circumstances," it must include all pertinent facts and circumstances, including "the taxpayer's purposes (and the relative weight of such purposes) for entering into a transaction and for structuring a transaction in a particular manner." Treas. Reg. § 1.6664-4(c)(1)(i). Additionally, "[t]he advice must not be based on unreasonable factual or legal assumptions (including assumptions as to future events) and must not unreasonably rely on the representations, statements, findings, or agreements of the taxpayer or any other person." Treas. Reg. § 1.6664-4(c)(1)(ii). "The fact that these requirements are satisfied, however, will not necessarily establish that the taxpayer reasonably relied on the advice (including the opinion of a tax advisor) in good faith." Treas. Reg. § 1.6664-4(c)(1).
The Government argues that the Taxpayers' clear objective from the outset was to report these tax shelter transactions in a manner so as to conceal the tax losses and avoid their detection by the IRS. The Government argues that NPR's, the Law Firm's, and the Taxpayer's individual tax returns were replete with false and misleading reporting. The Government argues that the Taxpayers did not exercise reasonable care with these transactions. The Government argues that the Taxpayers sought penalty protection, not independent legal advice, where it was apparent that the advisors were tainted by conflicts of interest. The Government also argues that the Taxpayers were unreasonable in relying upon the obtained advice and opinions. The Government argues that there is no evidence that supports a reasonable belief of a reasonable chance of making a profit with the transactions. The Taxpayers argue that they did not hide the transactions, that they reasonably relied upon their advisors, that any potential conflicts of interest did not make their reliance unreasonable, and that they reasonably believed that they could earn a profit in the transactions.
Messrs. Nix, Patterson, and Roach are not tax lawyers, and they have no expertise in tax matters. Instead, they rely on qualified, professional advisors for tax advice. Because of the complexity of the tax treatment, it was necessary for the Taxpayers to seek advice from qualified tax attorneys concerning the applicable law to the facts of their investment and the resulting tax effects. The Taxpayers initially relied upon Cohen, their personal CPA at Pollans & Cohen. Cohen introduced them to Ruble, who was a tax expert on partnership matters with the law firm Sidley Austin. Patterson asked Ruble whether there was a conflict of interest and, after a series of questions to Ruble, became assured that there was not a conflict of interest. (Tr. I at 60-61.) Based on all of the record evidence, the Court finds that the Taxpayers were not aware of any financial agreements between Cohen and DGI when they decided to enter the transactions and when they filed their returns. (Tr. II at 8-9.) The Taxpayers believed that Cohen was properly discharging his duties as their fiduciary.
In short, the Taxpayers acted reasonably and in good faith in relying on their tax advisors' advice with respect to their investments in the underlying transactions. As aptly stated by Mr. Nix at trial, "at every step, we followed the advice of people we relied on, people who were supposed to have known what they were doing and did know what they were doing. And what else could we have done except follow their advice?" (Tr. II at 32-33.) The Court finds that the Taxpayers have proven, by a preponderance of the evidence, their good faith in relying on the advice of qualified tax accountants and tax lawyers. Accordingly, the criteria under the reasonable cause exception of 26 U.S.C. § 6664(c) is satisfied, and the Taxpayers are not liable for accuracy-related penalties.
The Court finds that the August 15, 2005 notice of FPAA is valid. The Court also finds that no penalties are applicable. The parties are directed to confer and submit, within 15 days, a proposed form of judgment (agreed if possible) consistent with this opinion.
IT IS SO ORDERED.
