Son of BOSS Case Highlights Ongoing Dispute Over Application Of The Valuation Misstatement Penalty

By Phil Karter

The recent decision in Bemont Investments, LLC v. United States, USDC E.D. Tex., No. 4:07-cv-00009 (March 9, 2010) is another burr in the IRS’s saddle when it comes to enforcement of the substantial valuation and gross valuation misstatement penalties.  These two penalties, particularly the 40% gross valuation misstatement penalty, are powerful weapons in the IRS’s arsenal to deter taxpayers from entering into transactions the IRS considers abusive.  Bemont, out of the District Court for the Eastern District of Texas, was a Son of BOSS case that the IRS characterized as a sham transaction.

The taxpayer contended that under “well settled Fifth Circuit law,” a transaction characterized as a sham cannot involve a valuation misstatement resulting in a 20 percent or 40 percent penalty because under Fifth Circuit precedent, specifically Todd v. Comm’r, 862 F.2d 540, 541-42 (5th Cir. 1988), and Heasley v. Comm’r, 902 F.2d 380, 382-83 (5th Cir. 1990), these penalties are not applicable if the IRS’s disallowance of tax benefits is not “attributable to” a valuation misstatement.  Thus, the argument goes, the disallowance of the deduction is not an overstatement but a complete eradication of value.  The Ninth Circuit held similarly in Keller v. Comm’r, 556 F.3d 1056 (2009).

Unfortunately, the story doesn’t end there, particularly if the applicable jurisdiction for a dispute on this issue lies within the Second, Fourth, Sixth and Eighth Circuits.  In those circuits, the courts have held that the deficiency is attributable to an overstatement and that the penalty therefore applies.  (The Court of Federal Claims in Jade Trading held to the same effect, but that case is currently up on appeal).

Needless to say, this sets up a classic split among multiple circuits on an issue the IRS considers vitally important to its enforcement efforts.  Why then no petitions for certiorari to the Supreme Court?  Word has it that the government is looking for the best litigating vehicle.  The loss in Keller, for example, was never followed by a government appeal to the Supreme Court, which was not surprising considering the somewhat taxpayer-sympathetic circumstances of that case.  Will the Bemont case finally present that litigating vehicle the government believes can lead it to victory with the Supremes?  Certainly the perception of Son of BOSS cases is that they present a considerably less taxpayer-friendly set of circumstances than the Fifth and Ninth Circuit cases that have been decided in the taxpayers’ favor on the penalty issue.  In any event, any decision by the government to take the valuation misstatement penalty issue in Bemont all the way to the top will have to wait a good long while.  The decision by the District Judge dismissing the government’s penalty claim was only on a motion for partial summary judgment.  Therefore the matter must first work its way through the District Court and the Fifth Circuit, which is likely to take several years.  Nonetheless, the split by the courts over the valuation misstatement penalty it is a bona fide hot button issue with the government, so stay tuned. Undoubtedly, the final chapter to this story has yet to be written.

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