Opinion ID: 821217
Heading Depth: 3
Heading Rank: 1

Heading: Applicability of the Valuation

Text: Misstatement Penalty Section 6662 of the Internal Revenue Code imposes a 20 percent penalty with respect to underpayment that results from a “substantial valuation misstatement,” which includes a misstatement of “basis” if “the adjusted basis of any property[] claimed on any return of tax imposed by chapter 1 is 200 percent or more of the amount determined to be the correct amount of such . . . adjusted basis.”17 I.R.C. 17 With exceptions not relevant in this case, “[t]he basis of property shall be the cost of such property ... .” I.R.C. § 1012(a). Typically, the “cost” of an asset “is equal to the cost to the taxpayer of acquiring the asset.” Muserlain v. Comm’r, 932 F.2d 109, 114 (2d Cir. 1991); see also Parsons v. United States, 227 F.2d 437, 438 (3d Cir. 1955) (noting that “cost to the taxpayer [is] represented by the taxpayer‟s 18 § 6662(b)(1)-(3), (e)(1)(A). That section goes on to increase the penalty to 40 percent if the taxpayer claims an adjusted basis in the property that is 400 percent or more of the correct amount; this is known as a “gross valuation misstatement.” Id. § 6662(h). We have held that, “where a claimed tax benefit is disallowed because it is an integral part of a transaction lacking economic substance, the imposition of the valuation overstatement penalty is properly imposed ... .” Merino v. Comm’r, 196 F.3d 147, 159 (3d Cir. 1999).18 outlay” (internal quotation marks omitted)); supra note 3 (recognizing that the taxpayer‟s acquisition cost can under certain circumstances include the seller‟s liabilities). 18 Our sister circuits are divided as to whether the valuation misstatement penalty applies to tax deductions that have been totally disallowed under the economic substance doctrine. Compare Fidelity Int’l Currency Advisor A Fund, LLC v. United States, 661 F.3d 667, 671-75 (1st Cir. 2011) (holding that the penalty is applicable), Zfass v. Comm’r, 118 F.3d 184, 190 (4th Cir. 1997) (same), Gilman v. Comm’r, 933 F.2d 143, 151 (2d Cir. 1991) (same), and Massengill v. Comm’r, 876 F.2d 616, 619-20 (8th Cir. 1989) (same), with Heasley v. Comm’r, 902 F.2d 380, 383 (5th Cir. 1990) (holding that when the IRS totally disallows a deduction, the underpayment is “not attributable to a valuation overstatement” but rather to claiming an improper deduction), Gainer v. Comm’r, 893 F.2d 225, 228 (9th Cir. 1990) (same), and Todd v. Comm’r, 862 F.2d 540, 543 (5th Cir. 1988) (holding that the penalty was inapplicable when the deficiency was not due to overstated basis but to a failure to place property into service). However, Crispin‟s reliance on Todd and Gainer is misplaced because they do not state the 19 law of this Circuit. See Merino v. Comm’r, 196 F.3d 147, 157-159 (3d Cir. 1999) (holding that the valuation misstatement penalty applies to property acquired in a transaction found to lack economic substance and expressly declining to follow Todd and Heasley). Our reasoning as to the applicability of the valuation misstatement penalty finds support in the recent decision of the United States Court of Appeals for the Eleventh Circuit in Gustashaw, supra. In that case, the taxpayer conceded the tax deficiency that the Commissioner had assessed as a result of the disallowance of a CARDS Loan loss, so the economic substance issue was not before the Court, but the taxpayer contested the penalties. Applying the “majority rule,” the Eleventh Circuit held that the 40 percent penalty applies “even if the deduction is totally disallowed because the underlying transaction, which is intertwined with the overvaluation misstatement, lacked economic substance.” 696 F.3d at 1136. Also, the Fifth and Ninth Circuits “have questioned the wisdom of their positions” in Todd, Heasley, and Gainer because those positions create the “anomalous result” of relieving a taxpayer of the penalty when a deduction is disallowed because it is so egregious that it is improper for a reason other than valuation, such as a lack of economic substance, See Bemont Investments, L.L.C. ex rel. Tax Matters Partner v. United States, 679 F.3d 339, 355 (5th Cir. 2012) (Prado, J., concurring) (noting that the “Todd/Heasley rule,” by “[a]mplifying the egregiousness of the scheme – to the point where the transaction is an utter sham – could ... , perversely, shield the taxpayer from liability for overvaluation”); Keller v. Comm’r., 556 F.3d 1056, 1061 (9th Cir. 2009) (recognizing that the rule as expressed in most Circuits, including Merino, is a “sensible method of resolving 20 In this case, it is not entirely clear how the Tax Court determined the correct basis of the “asset” at issue, namely the “loan assumption proceeds” (App. at 27), even though it did conclude that Crispin made a gross valuation misstatement when he claimed $9.4 million in adjusted basis for that asset on his 2001 tax return. There are two ways one might think about a basis determination and the consequent amount of a valuation overstatement in a CARDS transaction, both of which provide grounds for affirmance. Cf. ACM P’ship, 157 F.3d at 249 n.33 (noting that a court of appeals may affirm a decision of the Tax Court on any grounds supported by the record, regardless of the Tax Court‟s rationale). One way is to take the entire CARDS Loan for which the taxpayer agreed to be jointly and severally liable ($9.4 million in Crispin‟s case) and ask what it cost the taxpayer to enter into that loan. That cost, which may be viewed as representing the taxpayer‟s basis, see supra note 17, can rightly be seen in the CARDS context as limited to the value of the foreign currency actually purchased by the taxpayer and exchanged for U.S. dollars ($1.8 million here).19 The overvaluation cases” because it “cuts off at the pass what might seem to be an anomalous result – allowing a party to avoid tax penalties by engaging in behavior one might suppose would implicate more tax penalties, not fewer[,]” but acknowledging that, “[n]onetheless, in this circuit we are constrained by Gainer”). 19 The $1.8 million also represents the fair market value of the asset (i.e., the foreign currency) that Crispin actually purchased in his CARDS transaction. The basis in 21 amount of the valuation misstatement is thus the difference between the basis that Murus claimed on its 2001 tax return and that cost. (The difference is the $7.6 million deduction claimed by Murus and disallowed by the Commissioner, resulting in an equivalent upward adjustment in Crispin‟s taxable income.) Cf. Merino, 196 F.3d at 151 (noting that the parties had stipulated that the fair market value of the asset (which the Court appears to have used as a proxy for cost basis) was less than $50,000). Another way to consider a CARDS loan is not as one transaction but as two closely related transactions: first, the purchase and exchange of the foreign currency (for which the taxpayer actually assumed liability, see supra note 8) and second, the agreement to be jointly and severally liable for the amount of the CARDS Loan in excess of that purchase. Focusing only on the second CARDS-related transaction, the basis is zero because that part of the transaction plainly lacks economic substance. Therefore, the overstatement is the full amount of the basis attributable to that second transaction (again, in this case, the $7.6 million deduction disallowed by the Commissioner.) Cf. Gustashaw, 696 F.3d at 1133 (noting that “a basis of zero ... is the correct amount when a transaction lacks economic substance”). property may be limited to its fair market value, rather than to the taxpayer‟s outlay, “where a transaction is not conducted on at arm‟s-length by two economically self-interested parties or where a transaction is based upon „peculiar circumstances‟ which influence the purchaser to agree to a price in excess of the property‟s fair market value.” Lemmen v. Comm’r, 77 T.C. 1326, 1348 (1981) (quoting Bixby v. Comm’r, 58 T.C. 757, 776 (1972)) (internal quotation marks omitted). 22 The amount of the valuation misstatement and of the deduction disallowed in this case are the same under either approach, and the explanation of the tax deficiency that the Commissioner sent to Murus alludes to both approaches. (See Supplemental App. at 135 (disallowing the $7.6 million deduction because the “transaction as a whole lacks economic substance”); id. at 125 (concluding that “the taxpayer‟s basis should be limited to the fair market value of the assets received rather than the full loan amount”)). But the calculation of the percentage overstatement is not the same – $9.4 million divided by $1.8 million under the first approach, and $7.6 million divided by $0 under the second. The latter calculation, of course, results in an undefined percentage overstatement which the Commissioner treats as meeting the 400 percent threshold. See Treas. Reg. § 1.6662-5(g) (providing that the “adjusted basis claimed on a return of any property with a correct ... adjusted basis of zero is considered to be 400 percent or more of the correct amount[] ... and the applicable penalty rate is 40 percent”). For purposes of this case, then, either calculation yields an overstatement of more than 400 percent, so that the 40 percent penalty under I.R.C. § 6662 applies. Consequently, we need not, and do not, decide which is the correct or better approach, though we urge the Commissioner to clarify his interpretation of the law on this point. In either case, because the underpayment in Crispin‟s taxes is directly traceable to the inflated basis in the loan assumption proceeds, that underpayment is “attributable to” a valuation misstatement of over 400 percent, and the 40 percent penalty is applicable to Crispin‟s underpayment of his 2001 taxes. 23