Undervaluation can be costly
The recent U.S. Supreme Court case, U.S. v. Woods, overturned legal precedent and signaled that accuracy-related penalties can be imposed in more instances. This broad interpretation exposes clients and practitioners to substantial penalties. In this article, three recent cases are summarized on how, when, and why accuracy-related penalties are applied.
The Pension Protection Act of 2006 added Internal Revenue Code Section 6695A, which provides penalties that are aimed directly at appraisers who provide appraisals for income (as well as transfer) tax purposes. Several requirements must be met for the penalties to be triggered. First, an appraisal must have been prepared in connection with a return or a claim for a refund. Second, the person preparing the appraisal, i.e., the appraiser, needs to know or have reason to know that the appraisal will be used for such purpose. Finally, the appraisal must result in a ‚Äúsubstantial valuation misstatement under Chapter 1‚ÄĚ of the Code (within the meaning of Code Section 6662[e]) or a ‚Äúgross valuation misstatement‚ÄĚ1 Penalties also apply in other contexts and these deserve attention too, especially in connection with tax returns.
U.S. Code ¬ß 6662 (Section 6662) of the Internal Revenue Code applies a 40 percent penalty to the amount of tax attributable to a ‚Äė‚Äėgross valuation misstatement,‚Äô‚Äô or a 20 percent penalty to a ‚Äė‚Äėsubstantial valuation misstatement.‚Äô‚Äô The accuracy related penalties are triggered by ‚Äúmisstatement of valuation.‚ÄĚ A quick highlight of court cases involving gross valuation misstatement penalties underscores the importance of substance over form and the context in which the penalties are being assessed.
U.S. v. Gary Woods
This is the leading case. It is a 2013 U.S. Supreme Court case, decided on December 3, 2013. Here, Mr. Woods and his employer created an offsetting-option tax shelter partnership for the purpose of reducing their taxable income. The District Court and Fifth Circuit found that the partnerships were properly disregarded as shams, but that the valuation-misstatement penalty did not apply. The U.S. Supreme Court granted certiorari to resolve a circuit split over whether the valuation-misstatement penalty was applicable in these circumstances. It was settled that a taxpayer who underpays their taxes due to a valuation misstatement may incur an accuracy-related penalty. A 20-percent penalty applies to ‚Äúthe portion of any underpayment which is attributable to any substantial valuation misstatement under chapter 1.‚ÄĚ 26 U.S.C. ¬ß6662(a), (b)(3).
If the reported value or adjusted basis exceeds the correct amount by at least 400 percent, the valuation misstatement is considered not merely substantial, but ‚Äúgross,‚ÄĚ and the penalty increases to 40 percent. ¬ß6662(h). An IRS regulation provides that when an asset‚Äôs true value or adjusted basis is zero, ‚Äúthe value or adjusted basis is claimed‚Ä¶is considered to be 400 or more of the correct amount,‚ÄĚ so that the resulting valuation misstatement is automatically deemed gross and subject to the 40-percent penalty. Treas. Reg. ¬ß1.6662-5(g), 26 CFR ¬ß1.6662-5(g)(2013).
Significantly, for tax preparers and their clients, the court added ‚Äú[o]ur holding that the valuation misstatement penalty encompasses legal as well as factual misstatements of adjusted basis does not make superfluous the new penalty that Congress enacted in 2010 for transactions lacking in economic substance‚Ä¶the fact that both penalties are potentially applicable to sham transactions resulting in valuation misstatement penalty is not problematic.‚ÄĚ The court rejected Woods‚Äô argument that any underpayment of tax in the case was ‚Äúattributable,‚ÄĚ not to the misstatement of outside basis, but rather to the determination that the partnerships were shams (described as an independent legal ground).
In rejecting this argument, the court added that ‚Äúthe economic-substance determination and the basis for misstatement are not ‚Äėindependent‚Äô of one another‚Ä¶the overstatement of outside basis was the linchpin of the COBRA tax shelter and the mechanism by which Woods and McCombs sought to reduce their taxable income‚Ä¶We therefore have no difficulty concluding that any underpayment resulting from the COBRA tax shelter is attributable to the partners‚Äô misrepresentation of outside basis (a valuation misstatement).‚ÄĚ
Salem Financial v. United States
The federal court concluded that proper tax treatment for a complex financial transaction known as transaction Structured Trust Advantages Repackaged Securities‚ÄĚ (STARTS) was an economically meaningless tax shelter. The court applied accuracy related penalty and determined that the transaction disregarded.
Estate of Helen P. Richmond, TC Memo 2014-26 (Tax Court)
The U.S. Tax court ruling emphasized the importance of using a qualified appraiser and imposed a 20 percent accuracy-related penalties for the estate under Section 6662(c). In so holding, the court observed that the 20 percent penalty is imposed on ‚Äúany portion of an underpayment of tax required to be shown on a return where the underpayment is attributable to a substantial estate tax valuation understatement. Sec. 6662(a), (b)(5). An estate tax valuation understatement is treated as ‚Äėsubstantial‚Äô where the value of any property required to be reported on an estate tax return is reported at 65 percent or less of the correct value.‚ÄĚ Here, the estate reported the sale of the decedent‚Äôs interest in the personal holding company to be $3,149,767 on the state tax return; the U.S. Tax Court determined that the proper value was $6,503,804, the amount reported on the estate tax return was less than 65 percent of the proper value, and a substantial valuation understatement.‚ÄĚ
The court also did not find a basis to waive the penalty; that is, it did not find ‚Äúreasonable cause‚ÄĚ or ‚Äúgood faith‚ÄĚ. Sec. 6664(c)(1). The court faulted the estate for using an unsigned draft report prepared by its accountant as its basis for reporting the value of decedent‚Äôs interest in the personal holding company in the return. It emphasized that the accountant, Mr. Winnington, ‚Äúis not a certified appraiser.‚ÄĚ
The court determined the valuation as improper valuation of a decedent‚Äôs interest in a holding company. Further, it rejected the capitalization of dividends method used by the tax payer‚Äôs expert in valuing the holding company and deemed it inappropriate. The IRS countered that an adjusted net asset value is more appropriate due to most of the investment holding companies assets consisting of marketable securities. As for why it (the estate) should be excused from the penalty, ‚Äúthe estate failed to make such a showing.‚ÄĚ
Baria Jaroudi, CPA/ABV, CBA, CVA, is a supervisor at Briggs & Veselka Co., a Houston-area independent public accounting that provides business advisory and audit services (http://www.bvccpa.com). Baria Jaroudi can be reached at (713) 667-9147 and at email@example.com.
1Shannon Pratt-Valuing a Business- the Analysis and Appraisal of Closely-Held Businesses