substantial authority defense

The Internal Revenue Code (Code) contains various provisions regarding the imposition of penalties and additions to tax. The accuracy-related penalty under section 6662(a), which imposes a penalty equal to 20 percent of the amount of any understatement of tax, is commonly asserted on the grounds that the taxpayer was negligent, disregarded rules or regulations, or had a substantial understatement of tax. Over the years, the Internal Revenue Service (IRS) has become increasingly aggressive in asserting penalties and generally requires that taxpayers affirmatively demonstrate why penalties should not apply, as opposed to the IRS first developing the necessary facts to support the imposition of penalties.

There are many different defenses available to taxpayers depending on the type and grounds upon which the penalty is asserted. These defenses include the reasonable basis and adequate disclosure defense, the substantial authority defense, and the reasonable cause defense.

Another defense available to taxpayers is what we will refer to as the “issue of first impression” defense. The Tax Court’s recent opinion in Peterson v. Commissioner, 148 T.C. No. 22, reconfirms the availability of this defense. In that case, the substantive issue was the application of section 267(a) to employers and employee stock ownership plan (ESOP) participants. The court, in a published T.C. opinion (see here for our prior discussion of the types of Tax Court opinions) held in the IRS’s favor on the substantive issue but rejected the IRS’s assertion of an accuracy-related penalty for a substantial understatement of tax on the ground that it had previously declined to impose a penalty in situations where the issue was one not previously considered by the Tax Court and the statutory language was not entirely clear.

The Tax Court’s opinion in Peterson is consistent with prior opinions by the court in situations involving the assertion of penalties in cases of first impression. In Williams v. Commissioner, 123 T.C. 144 (2004), for instance, the substantive issue was whether filing bankruptcy alters the normal Subchapter S rules for allocating and deducting certain losses. The Tax Court agreed with the IRS’s position, but it declined to impose the accuracy-related penalty because the case was an issue of first impression with no clear authority to guide the taxpayer. The court found that the taxpayer made a reasonable attempt to comply with the code and that the position was reasonably debatable.

Similarly, in Hitchens v. Commissioner, 103 T.C. 711 (1994), the court addressed, for the first time, an issue related to the computation of a taxpayer’s basis in an entity. Despite holding for the IRS, the court rejected the accuracy-related penalty. It stated “[w]e have specifically refused to impose additions to tax for negligence, etc., where it appeared that the issue was one not previously considered by the Court and the statutory language was not entirely clear.” Other cases are in accord. See Braddock v. Commissioner, 95 T.C. 639, 645 (1990) (“as we have previously noted, this issue has never before, as far as we can ascertain, been considered by any court, and the answer is not entirely clear from the statutory language”); Wofford v. Commissioner, 5 T.C. 1152, 1166-67 (1945) (“If the petitioner was mistaken, as he evidently was, as to the controversial question of what the legal effect of the assignment for income tax purposes was, that is not a sufficient reason for holding that he was negligent.”).

Practice Point: As noted above, the IRS is more frequently asserting penalties against taxpayers. To the extent the substantive issue is one for which there is no clear guidance from the courts or the IRS, taxpayers may want to consider using the “issue of first impression” defense. This defense may avoid the potential pitfalls associated with the waiver of privilege when other penalty defenses are raised.

Prudent taxpayers analyze the relevant tax law while structuring and implementing transactions.  The most obvious reason to do so is to ensure that the taxpayer’s proposed tax treatment is accepted by the Internal Revenue Service (IRS).  Another reason is to ensure that, if such treatment is not accepted, the taxpayer will not be subjected to penalties.

The most common penalty asserted by the IRS in this regard is the accuracy-related penalty under IRC Section 6662.  Among the many defenses to this penalty is the “substantial authority” defense, which looks at whether the weight of authorities supporting the return position is substantial in relation to the weight of authority supporting contrary treatment.  The types of authorities that may be considered is broad, and includes the Internal Revenue Code, Treasury Regulations (proposed, temporary and final), other IRS published guidance, case law, tax treaties, legislative materials and certain IRS private guidance.

The U.S. Court of Appeals for the Fifth Circuit’s recent decision in Chemtech Royalty Associates, L.P. provides some guidance on how courts view the substantial authority defense.  In Chemtech, the taxpayer argued that it had substantial authority for its position based on two U.S. Tax Court cases, a published Tax Court opinion from 1949 and an unpublished memorandum opinion from 1990.  The Fifth Circuit found that both cases, even if not materially distinguishable, were not substantial authority because a 1989 Fifth Circuit opinion was more apposite than the two Tax Court opinions.  The court also noted that the published Tax Court opinion was “old” and the memorandum opinion was “unpublished.”

The Fifth Circuit’s opinion illustrates the difficulties that taxpayers may face when relying on the substantial authority defense.  Although the applicable Treasury Regulations on the substantial authority defense do not distinguish between published and unpublished cases or the age of the authorities, the court’s approach indicates that these are relevant factors to consider.  Taxpayers that intend to rely on the substantial authority defense should review the Fifth Circuit’s opinion in Chemtech, as well as the applicable authority in their relevant circuit.