SCOTUS Reports

Tag: Substantial Understatement

  • Graev v. Commissioner, 147 T.C. No. 16 (2016): Procedural Requirements for Penalty Assessments

    Graev v. Commissioner, 147 T. C. No. 16, 2016 U. S. Tax Ct. LEXIS 33 (U. S. Tax Ct. 2016) (including reporter, court, and year)

    In Graev v. Commissioner, the U. S. Tax Court ruled that the IRS’s inclusion of a 20% accuracy-related penalty in a notice of deficiency complied with statutory requirements, despite the absence of written supervisory approval for the initial determination of the penalty. The court held that the penalty’s assessment would be premature to consider without an actual assessment, and affirmed the penalty on grounds of substantial understatement of income tax, while reversing the 40% valuation misstatement penalty. This case underscores the importance of procedural compliance in tax penalty assessments and impacts the IRS’s practices in asserting penalties.

    Parties

    Lawrence G. Graev and Lorna Graev, the petitioners, were the taxpayers who challenged the IRS’s determination of tax deficiencies and penalties. The respondent was the Commissioner of Internal Revenue, representing the IRS. The Graevs filed their petition in the U. S. Tax Court, contesting the IRS’s notice of deficiency issued on September 22, 2008, which determined deficiencies in their 2004 and 2005 tax returns.

    Facts

    In 2004, Lawrence Graev purchased property in New York City and donated a facade conservation easement to the National Architectural Trust (NAT). The Graevs claimed charitable contribution deductions on their 2004 and 2005 tax returns for this donation. The IRS, after examining the returns, determined deficiencies and assessed both a 40% gross valuation misstatement penalty under section 6662(h) and an alternative 20% accuracy-related penalty under section 6662(a). The IRS’s examining agent obtained approval for the 40% penalty but not the 20% penalty, which was later suggested by a Chief Counsel attorney and included in the notice of deficiency without further approval. The Graevs challenged the penalties, asserting that the IRS failed to comply with the supervisory approval requirement under section 6751(b).

    Procedural History

    The IRS issued a notice of deficiency to the Graevs on September 22, 2008, which included both the 40% and 20% penalties. The Graevs timely filed a petition with the U. S. Tax Court on December 19, 2008. The IRS later conceded the 40% penalty but maintained the alternative 20% penalty. The Tax Court issued an opinion in Graev I, sustaining the disallowance of the charitable contribution deductions. The court then addressed the procedural requirements for the 20% penalty in the current case, focusing on compliance with sections 6751(a) and 6751(b).

    Issue(s)

    Whether the IRS’s notice of deficiency complied with the requirement under section 6751(a) to include a computation of the 20% penalty?

    Whether the IRS’s failure to obtain written supervisory approval for the initial determination of the 20% penalty under section 6751(b) barred its assessment?

    Whether the Graevs were liable for the 20% accuracy-related penalty under section 6662(a) due to a substantial understatement of income tax?

    Rule(s) of Law

    Section 6751(a) requires the IRS to include with each notice of penalty information with respect to the name of the penalty, the section of the Code under which the penalty is imposed, and a computation of the penalty.

    Section 6751(b)(1) prohibits the assessment of any penalty unless the initial determination of such assessment is personally approved in writing by the immediate supervisor of the individual making such determination or a higher level official designated by the Secretary.

    Section 6662(a) imposes a 20% accuracy-related penalty on any portion of an underpayment of tax due to negligence or substantial understatement of income tax.

    Holding

    The Tax Court held that the IRS’s notice of deficiency complied with section 6751(a) by including the 20% penalty as an alternative with a computation, albeit reduced to zero to avoid stacking with the 40% penalty. The court also held that the issue of compliance with section 6751(b)(1) was premature since no penalty had yet been assessed. Finally, the court sustained the 20% accuracy-related penalty under section 6662(a) on the basis of the Graevs’ substantial understatement of income tax.

    Reasoning

    The court reasoned that the notice of deficiency clearly informed the Graevs of the 20% penalty and its computation, satisfying section 6751(a). Regarding section 6751(b)(1), the court found that the statute requires written supervisory approval before the assessment is made, which had not occurred at the time of the case. The court rejected the Graevs’ argument that the lack of approval invalidated the penalty, citing that the statute does not specify a consequence for noncompliance and that the Graevs were not prejudiced by the lack of approval. On the merits of the 20% penalty, the court found that the Graevs had a substantial understatement of income tax due to disallowed charitable contribution deductions and that they failed to establish reasonable cause, substantial authority, or adequate disclosure to avoid the penalty.

    Disposition

    The court sustained the 20% accuracy-related penalty under section 6662(a) and entered a decision under Rule 155, reflecting the holdings in both Graev I and the current case.

    Significance/Impact

    This case is significant for clarifying the procedural requirements for penalty assessments under sections 6751(a) and 6751(b). It impacts IRS practices by emphasizing the necessity of written supervisory approval before assessment and the importance of including penalty computations in notices of deficiency. The decision also underscores the importance of taxpayers’ compliance with disclosure and substantiation requirements to avoid accuracy-related penalties. The case has been influential in subsequent litigation concerning the IRS’s procedural compliance with penalty assessments.

  • Cameron v. Commissioner, 98 T.C. 123 (1992): Inclusion of Self-Employment Tax in Substantial Understatement Penalty Calculation

    Cameron v. Commissioner, 98 T. C. 123 (1992)

    The self-employment tax must be included in calculating the substantial understatement penalty under Section 6661.

    Summary

    In Cameron v. Commissioner, the U. S. Tax Court upheld the validity of a regulation that included self-employment tax in the calculation of a substantial understatement of income tax under Section 6661. The taxpayers, George and Susan Cameron, argued against the inclusion, claiming it broadened the scope of the penalty beyond what Congress intended. The court, however, found that the regulation was a reasonable interpretation of the law, citing legislative history indicating that self-employment taxes should be treated as part of the income tax for most purposes. This decision has significant implications for how penalties for substantial understatements are calculated, particularly for self-employed individuals.

    Facts

    George and Susan Cameron filed their federal income tax returns for 1984, which included both income and self-employment taxes. The Commissioner determined deficiencies in their income and self-employment taxes for that year and assessed an addition to tax under Section 6661 for a substantial understatement of income tax. The Camerons contested the inclusion of the self-employment tax in the calculation of the penalty, arguing it was not intended by Congress.

    Procedural History

    The case was brought before the United States Tax Court after the Commissioner determined deficiencies and assessed penalties against the Camerons. The Tax Court was tasked with deciding the validity of the regulation that included self-employment tax in the calculation of the Section 6661 penalty.

    Issue(s)

    1. Whether the regulation under Section 1. 6661-2(d)(1), Income Tax Regs. , which includes self-employment tax in the calculation of a substantial understatement of income tax under Section 6661, is a valid interpretation of the statute.

    Holding

    1. Yes, because the regulation is a reasonable interpretation of Section 6661, supported by legislative history indicating that self-employment taxes should be treated similarly to income taxes for penalty purposes.

    Court’s Reasoning

    The Tax Court upheld the regulation, reasoning that it was a reasonable interpretation of Section 6661. The court noted that the term “income tax” is not defined in the Code, and while Section 6661 does not explicitly mention self-employment tax, the legislative history of the self-employment tax provisions (Sections 1401-1403) indicates Congress’s intent for these taxes to be treated as part of the income tax for most purposes. The court cited a conference committee report from 1950, which stated that self-employment tax should be included with the income tax in computing any overpayment or deficiency, and any related interest or additions. This legislative history supported the court’s conclusion that the regulation was valid and that the Camerons were liable for the Section 6661 penalty.

    Practical Implications

    This decision clarifies that self-employment tax must be included when calculating the substantial understatement penalty under Section 6661. For legal practitioners and self-employed individuals, this means that any understatement of income tax that includes self-employment tax must be considered when determining potential penalties. The ruling impacts how tax professionals advise clients on tax reporting and planning, especially for self-employed individuals or those with significant self-employment income. It also influences the IRS’s approach to assessing penalties for understatements. Subsequent cases have followed this precedent, affirming the inclusion of self-employment tax in similar penalty calculations.

  • Estate of McClanahan v. Commissioner, 95 T.C. 98 (1990): When Additions to Tax Apply for Negligent or Late Filing

    Estate of Herbert J. McClanahan, Deceased, Arleen McClanahan, Executrix, and Arleen McClanahan v. Commissioner of Internal Revenue, 95 T. C. 98 (1990)

    Additions to tax under sections 6653(a) and 6661 apply to taxpayers who negligently fail to file returns on time or file after IRS contact, even if the taxpayer is in poor health.

    Summary

    Herbert McClanahan, a certified public accountant, failed to file his tax returns from 1977 to 1983 despite being aware of his obligation. After IRS contact in 1984, he filed the delinquent returns. The Tax Court upheld the IRS’s imposition of additions to tax under sections 6653(a) for negligence and 6661 for substantial understatements in 1982 and 1983. The court rejected McClanahan’s health as an excuse for non-filing, noting his continued professional activity. The decision also clarified that multiple penalties can be applied and upheld the 25% rate for section 6661 penalties assessed after October 21, 1986.

    Facts

    Herbert J. McClanahan, a certified public accountant, did not file his federal income tax returns for the years 1977 through 1983. Despite suffering from health issues, including heart problems and later cancer, McClanahan continued to operate his accounting and tax practice. His wife, Arleen McClanahan, became aware of the non-filing in 1978 but was repeatedly assured by her husband that he would handle it. In April 1984, after an IRS special agent contacted McClanahan, he filed the delinquent returns on June 1, 1984, and paid the due taxes and additions on July 23, 1984. McClanahan died in February 1986.

    Procedural History

    The IRS assessed additions to tax under sections 6651(a)(1), 6653(a), and 6661. The McClanahans filed a petition in the Tax Court contesting the additions under sections 6653(a) and 6661. The court heard the case and issued its decision on July 24, 1990, upholding the IRS’s determination.

    Issue(s)

    1. Whether petitioners are liable for additions to tax under section 6653(a) for negligence or intentional disregard of rules or regulations.
    2. Whether petitioners are liable for additions to tax under section 6661 for substantial understatements of tax in 1982 and 1983, and if so, whether the additions should be computed using a 25-percent rate.

    Holding

    1. Yes, because the court found that McClanahan’s failure to file timely returns over seven years, despite his continued professional activity, constituted negligence.
    2. Yes, because the court determined that section 6661 applies to delinquent returns filed after IRS contact, and the 25% rate applies to additions assessed after October 21, 1986.

    Court’s Reasoning

    The court applied the legal rule that negligence is the lack of due care or failure to act as a reasonable person would under the circumstances. It rejected McClanahan’s health as an excuse for non-filing, noting his continued professional activity and the quick preparation of delinquent returns after IRS contact. The court cited cases like Emmons v. Commissioner to support the imposition of section 6653(a) additions for negligence. For section 6661, the court interpreted the statute and regulations to include delinquent returns filed after IRS contact as part of the “audit lottery” that the law aimed to deter. The court also upheld the 25% rate for section 6661 additions assessed after October 21, 1986, based on the Omnibus Budget Reconciliation Act of 1986, rejecting due process challenges by citing cases like United States v. Darusmont.

    Practical Implications

    This decision emphasizes that taxpayers cannot escape tax penalties by citing health issues if they remain professionally active. It clarifies that multiple tax penalties can be imposed for the same conduct, reinforcing the IRS’s ability to enforce compliance. For practitioners, the case highlights the importance of timely filing, even in difficult circumstances, and the potential consequences of delinquent filing. The decision also impacts how attorneys should analyze cases involving late-filed returns and substantial understatements, considering the potential application of section 6661 penalties. Subsequent cases have cited Estate of McClanahan to support the imposition of multiple penalties and the application of section 6661 to late-filed returns.

  • Accardo v. Commissioner, 94 T.C. 96 (1990): Deductibility of Legal Fees for Criminal Defense Not Tied to Income-Producing Assets

    Accardo v. Commissioner, 94 T. C. 96 (1990)

    Legal expenses incurred in defending against criminal charges are not deductible under IRC section 212(2) even if a potential forfeiture of income-producing assets is at stake.

    Summary

    In Accardo v. Commissioner, the Tax Court ruled that legal fees incurred by Anthony Accardo in successfully defending against RICO charges were not deductible. Accardo argued that the fees were deductible under IRC section 212(2) as they were incurred to protect his certificates of deposit from forfeiture. The court, however, held that the legal fees were not deductible because the criminal charges arose from Accardo’s alleged racketeering activities, not from the management or conservation of the certificates of deposit. The decision reinforced the principle that deductibility of legal fees depends on the origin of the claim, not its potential consequences on income-producing property.

    Facts

    Anthony Accardo and 15 others were indicted for violating RICO by conspiring to control the Laborers Union’s insurance business through a kickback scheme. The indictment included a forfeiture provision for any proceeds from the alleged racketeering activities. Accardo was acquitted but sought to deduct the legal fees incurred in his defense, claiming they were necessary to protect his certificates of deposit from forfeiture. These certificates were his only assets potentially subject to forfeiture, though the indictment did not specifically identify them. The funds used to purchase these assets were not obtained from the alleged racketeering activities.

    Procedural History

    The Commissioner of Internal Revenue determined deficiencies in Accardo’s federal income taxes for 1981 and 1982, including additions for negligence and substantial understatements. Accardo petitioned the Tax Court for a redetermination, arguing that his legal fees were deductible under IRC section 212(2). The case was submitted fully stipulated under Rule 122 of the Tax Court Rules of Practice and Procedure.

    Issue(s)

    1. Whether legal expenses incurred in the successful defense of RICO charges are deductible under IRC section 212(2) as expenses paid for the management, conservation, or maintenance of property held for the production of income.

    2. Whether the taxpayers are liable for additions to tax under IRC sections 6653(a)(1) and (2) for negligence.

    3. Whether the taxpayers are liable for an addition to tax under IRC section 6661 for substantial understatement of income tax.

    Holding

    1. No, because the legal fees were incurred to defend against criminal charges arising from Accardo’s alleged racketeering activities, not from the management or conservation of his certificates of deposit.

    2. Yes, because the taxpayers failed to carry their burden of proof to show they were not negligent in claiming the deductions.

    3. Yes, because the taxpayers’ understatement of income tax was substantial and they did not establish any exception to the addition to tax under IRC section 6661.

    Court’s Reasoning

    The court applied the principle established in United States v. Gilmore that the deductibility of legal expenses depends on whether the claim arises in connection with the taxpayer’s profit-seeking activities, not on the consequences that might result to the taxpayer’s income-producing property. The court distinguished Accardo’s case from situations where legal fees might be deductible, noting that the RICO charges arose from his alleged criminal activities, not from the management or conservation of his certificates of deposit. The court also relied on Lykes v. United States, which rejected the argument that legal expenses incurred to protect income-producing assets from a tax deficiency were deductible. The court emphasized that allowing such a deduction would lead to capricious results, as the deductibility would depend on the character of the taxpayer’s assets rather than the nature of the claim. The court found no evidence that Accardo made any effort to determine the propriety of his claimed deductions or to establish any plausible arguments in support of them, leading to the conclusion that he was negligent under IRC section 6653(a). The court also found that Accardo’s understatement of income tax was substantial and that he did not establish any exception to the addition to tax under IRC section 6661.

    Practical Implications

    This decision clarifies that legal fees incurred in defending against criminal charges are not deductible under IRC section 212(2), even if the defense is necessary to protect income-producing assets from forfeiture. Taxpayers and their attorneys should carefully consider the origin of the claim when determining the deductibility of legal expenses. The decision also underscores the importance of taxpayers making a good faith effort to determine the propriety of their claimed deductions and adequately disclosing relevant facts on their tax returns to avoid additions to tax for negligence and substantial understatement. This case may be cited in future cases involving the deductibility of legal fees and the application of additions to tax for negligence and substantial understatement.

  • Woods v. Commissioner, 91 T.C. 88 (1988): Calculating Underpayment for Substantial Understatement Penalty

    William A. Woods II, Petitioner v. Commissioner of Internal Revenue, Respondent, 91 T. C. 88 (1988)

    The term ‘underpayment’ for the substantial understatement penalty under section 6661 includes withholding credits, unlike other penalty sections.

    Summary

    William A. Woods II challenged the IRS’s imposition of a 25% penalty under section 6661 for a substantial understatement of his 1983 income tax, which he did not file. The IRS calculated the penalty on the total tax deficiency of $7,152, ignoring Woods’s withholding credits of $3,813. 77. The Tax Court ruled that ‘underpayment’ in section 6661 should account for withholding credits, reducing the penalty base. The court rejected Woods’s other ‘tax protester’ arguments and upheld other penalties, but invalidated the regulation that equated ‘underpayment’ with ‘understatement’ for section 6661 purposes.

    Facts

    In 1983, William A. Woods II earned $32,844 in wages and $53 in interest income but did not file a federal income tax return. The IRS determined a deficiency of $7,152 and imposed various penalties. Woods contested the penalties, arguing that his wages were not taxable income, that filing was voluntary, and that withholding credits should reduce the section 6661 penalty. The IRS had not disputed the $3,813. 77 in withholding credits claimed by Woods.

    Procedural History

    The IRS issued a notice of deficiency on September 13, 1985, assessing a 25% penalty under section 6661 based on the full deficiency. Woods timely filed a petition with the Tax Court. The court considered the IRS’s motion for judgment on the pleadings and supplemental motion to increase the section 6661 penalty to 25% under the Omnibus Budget Reconciliation Act of 1986. The court ultimately issued its decision on July 25, 1988, as amended on August 2, 1988.

    Issue(s)

    1. Whether the term ‘underpayment’ in section 6661(a) includes withholding credits in calculating the penalty for a substantial understatement of income tax.
    2. Whether the regulation at section 1. 6661-2(a), Income Tax Regs. , equating ‘underpayment’ with ‘understatement’ for section 6661 purposes is valid.

    Holding

    1. Yes, because the plain meaning of ‘underpayment’ suggests it accounts for payments made, including withholding credits, thus reducing the penalty base to the actual unpaid amount.
    2. No, because the regulation conflicts with the statutory language of section 6661 and the ordinary meaning of ‘underpayment’, rendering it invalid.

    Court’s Reasoning

    The court analyzed the statutory language of section 6661, focusing on the terms ‘understatement’ and ‘underpayment’. It determined that ‘understatement’ is defined as the difference between the tax required and the tax shown on the return, which in Woods’s case was the full deficiency since he filed no return. However, ‘underpayment’ was not defined in section 6661, and the court interpreted it according to its ordinary meaning as the amount by which the payment was insufficient, which includes withholding credits. The court rejected the IRS’s argument to use the definition from sections 6653 and 6659, which exclude withholding credits, noting that those sections specifically modify the term ‘underpayment’, whereas section 6661 does not. The court also found that the regulation at section 1. 6661-2(a) was invalid because it ignored the statutory language and rendered parts of it superfluous. The court emphasized the need to give effect to every part of the statute and noted that Congress’s omission of a specific definition for ‘underpayment’ in section 6661 was significant.

    Practical Implications

    This decision clarifies that withholding credits must be considered when calculating the ‘underpayment’ for the section 6661 penalty, potentially reducing the penalty amount for taxpayers who have had taxes withheld. It invalidates the regulation that treated ‘underpayment’ and ‘understatement’ as equivalent, requiring the IRS to revise its approach to this penalty. Practitioners should ensure that clients’ withholding credits are properly accounted for in penalty calculations. The ruling also underscores the importance of statutory interpretation and the need to consider the plain meaning of terms, which may affect how other tax provisions are analyzed. Subsequent cases, such as Pallottini v. Commissioner, have applied this ruling, confirming the 25% rate for section 6661 penalties post-1986.

  • Pallottini v. Commissioner, 90 T.C. 498 (1988): Determining the Applicable Rate of Addition to Tax Under Conflicting Statutes

    Pallottini v. Commissioner, 90 T. C. 498 (1988)

    When conflicting statutes are enacted, the court will look to the text of the statutes and their effective dates to determine the applicable rate of addition to tax.

    Summary

    In Pallottini v. Commissioner, the U. S. Tax Court resolved a conflict between two 1986 statutes, the Tax Reform Act (TRA) and the Omnibus Budget Reconciliation Act (OBRA), which proposed different rates for the addition to tax under Section 6661 for substantial understatements of tax. The court held that the 25% rate specified in OBRA, which was enacted before TRA, applied to penalties assessed after OBRA’s enactment date. The decision hinged on the effective date provisions and the explicit repeal of TRA’s amendment by OBRA. This case underscores the importance of statutory language and effective dates in resolving conflicts between laws.

    Facts

    The Commissioner assessed a deficiency and addition to tax against Guido John Pallottini and Joan M. Pallottini for the tax years 1981 and 1982. The parties settled all issues except the correct rate of the addition to tax under Section 6661 for 1982. The Tax Equity and Fiscal Responsibility Act of 1982 initially set the rate at 10%. However, in 1986, both TRA and OBRA amended Section 6661, with TRA increasing the rate to 20% for returns due after December 31, 1986, and OBRA increasing it to 25% for penalties assessed after October 21, 1986. OBRA was enacted one day before TRA and explicitly repealed TRA’s amendment.

    Procedural History

    The case was filed in the U. S. Tax Court. After settling all other issues, the court focused solely on the rate of the addition to tax under Section 6661. The Commissioner sought to apply the higher rate established by OBRA without amending the pleadings, which the court allowed under Section 6214(a) and Rule 41(b)(1) of the Tax Court Rules of Practice and Procedure, given the parties’ consent and agreement on the issue.

    Issue(s)

    1. Whether the rate of the addition to tax under Section 6661 for 1982 is 10%, 20%, or 25% given the conflicting amendments by TRA and OBRA.

    Holding

    1. Yes, the rate of the addition to tax under Section 6661 for 1982 is 25% because OBRA, which was enacted before TRA and explicitly repealed TRA’s amendment, applies to penalties assessed after October 21, 1986.

    Court’s Reasoning

    The court relied on the principle that when statutes conflict, the text of the statutes and their effective dates are paramount. OBRA’s amendment to Section 6661, setting the rate at 25%, was effective for penalties assessed after October 21, 1986, whereas TRA’s amendment to 20% applied to returns due after December 31, 1986. OBRA also explicitly repealed TRA’s amendment. The court found no legislative history contradicting the statutory language, thus adhering to OBRA’s 25% rate. The court cited Watt v. Alaska for the approach to resolving statutory conflicts and noted that OBRA’s repeal of TRA’s amendment was clear and direct. A concurring opinion by Judge Korner argued that the court should have also considered the principle that the last act passed by the legislature during the same session controls, though this was not necessary to the decision.

    Practical Implications

    This decision highlights the importance of statutory language and effective dates in resolving conflicts between laws. Practitioners should closely examine the text of conflicting statutes and their effective dates to determine the applicable law. The ruling reaffirms that the Tax Court can consider unpleaded issues with the parties’ consent, as seen in the application of OBRA’s rate without amending the pleadings. For taxpayers and tax professionals, understanding the applicable penalty rates under Section 6661 is crucial, especially in cases of substantial understatements of tax. Subsequent cases should apply this ruling when determining the appropriate rate of addition to tax under similar circumstances.