In the widely reported case Klamath Strategic Investment Fund (see “Tax Matters,” JofA, March 07, page 72), the district court disallowed claimed losses on a finding that the transactions were shams and lacked economic substance. An important but less widely known aspect of the case was the court’s refusal to apply any of the assessed penalties. The decision points out what penalties can be assessed and how a taxpayer can defend against them.
The transaction in question is the tax shelter known as Bond Linked Issue Premium Structure (BLIPS), which used foreign bank loans to create basis and loss on disposition. After disallowing a loss deduction, the court considered and declined to apply four penalties: 40% for gross valuation misstatement, 20% for substantial valuation misstatement, 20% for substantial understatement of tax and the 20% penalty for negligence or disregard of rules and regulations.
The 40% gross valuation penalty applies if one or more valuation misstatements exceed the actual valuation by 400% or more. Based on the decision in Heasley v. Commissioner (66 AFTR2d 90-5068), the court ruled the penalty applies only to valuation errors and not to inappropriate deductions or credits. Since Treasury was arguing that the loan should be ignored as a sham and not that assets were overvalued, the penalty could not apply. It is important to note that while the Fifth Circuit Court of Appeals applied this rule, others uphold the penalty if the denied deduction is the result of overvaluation. Given this split, it is likely a future case will go to the Supreme Court to determine the interaction of the valuation penalty with the denial of a deduction.
The 20% substantial-valuation penalty was not applied for the same reason. The taxpayer argued the 20% penalty for substantial understatement of income tax did not apply because there was substantial authority for the claimed position, supported by an opinion letter of the law firms Klamath consulted. The court agreed that there was substantial authority, based on the numerous authorities cited in the opinion letters.
The penalty for negligence or disregard of rules does not apply if there is a reasonable basis for the position claimed, a lower standard than substantial authority. The court noted that Klamath entered the transaction before it was announced as abusive, obtained advice from qualified professionals and responded to all IRS inquiries in a timely fashion. It also said Klamath hired an outside law firm to investigate the foreign-currency transaction, and also hired two well-known and highly respected tax lawyers who were unrelated to the transaction. Therefore, the taxpayer was not negligent and the penalty did not apply.
The taxpayer’s approach could be regarded as a road map for avoiding penalties. Still unanswered, however, is the interaction of valuation penalties and denied deductions.
Klamath Strategic Investment Fund LLC v. U.S., 99 AFTR2d 2007-850.
Prepared by Edward J. Schnee , CPA, Ph.D., Hugh Culverhouse Professor of Accountancy and director, MTA Program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.