We previously posted on what we called the “issue of first impression” defense to penalties and the recent application of this defense by the United States Tax Court (Tax Court) in Peterson v. Commissioner, a TC Opinion. We noted that taxpayers may want to consider raising this defense in cases where the substantive issue is one for which there is no clear guidance from the courts or the Internal Revenue Service. Yesterday’s Memorandum Opinion by the Tax Court in Curtis Investment Co., LLC v. Commissioner, addressed the issue of first impression defense in the context of the taxpayer’s argument that it acted with reasonable cause and good faith in its tax reporting position related to certain Custom Adjustable Rate Debt Structure (CARDS) transactions. For the difference between TC and Memorandum Opinions, see here.

The Tax Court (and some appellate courts) has addressed the tax consequences of CARDS transactions in several cases, each time siding with the Internal Revenue Service (IRS). In its opinions in those other cases, the Tax Court has found that the CARDS transaction lacks economic substance. The court in Curtis Investment concluded that the CARDS transactions before it was essentially the same as the CARDS transactions in the other cases with only immaterial differences. Applying an economic substance analysis, the Tax Court held the taxpayer issue lacked a genuine profit motive and did not have a business purpose for entering into the CARDS transactions.

The Tax Court was then faced with determining whether to sustain the IRS’s determination that the 40 percent penalty under Internal Revenue Code Section 6662(h)(1) for an underpayment attributable to a gross valuation misstatement applied. The taxpayer “contend[ed] that the issues raised by the CARDS transactions … are novel issues” and therefore no penalty should be imposed. The court acknowledged that at the time the relevant returns were filed, no CARDS transactions had been litigated and that it had “previously found that a taxpayer acted with reasonable cause and good faith when a deficiency is the result of an issue of first impression and the taxpayer’s position is reasonably debatable.” However, the court noted that, regardless of whether the legal issue is novel, the court considers all of the facts and circumstances in determining whether to impose penalties. It further noted that the requirement that a transaction have economic substance is a longstanding principle of tax law and that the IRS had previously announced in a published notice its position prior to the filings of the relevant tax returns that was unfavorable to CARDS transactions. Thus, the court rejected the “issue of first impression” defense on the ground that the taxpayer’s position was not reasonably debatable and, based on the facts and circumstances of the case, the taxpayer’s failed to prove reasonable cause and good faith.

Practice Point: The Tax Court’s opinion provides useful guidance on the extent to which the “issue of first impression” defense provides a valid means of defeating a penalty asserted by the IRS. Taxpayers and their advisors should continue to consider the applicability of this defense based on their specific facts and circumstances, as well as the prevailing law at the time a tax return is filed.