The taxpayer, of course, got into a bullshit tax shelter. I won't go into it, but suffice it to say that it was bad at many levels and, of course, lacked economic substance (and was therefore bullshit in lay terms). Bullshit shelters usually go by acronyms or initialisms; this was was called CARDS (I won't tell you what that stands for). Here is the guts of the holding (footnotes omitted):
A. Gross Valuation Misstatement Penalty in I.R.C. § 6662
Gustashaw argues that the Tax Court erred in upholding the IRS's imposition of the 40% gross valuation misstatement penalties for 2000 through 2002. See I.R.C. § 6662(a)—(h). Specifically, Gustashaw contends that because the CARDS transaction lacked economic substance, there was no value or basis to misstate as to trigger the valuation misstatement penalties, and the penalties should not apply as a matter of law. Gustashaw also argues that Congress has penalized lack-of-economic-substance transactions by enacting I.R.C. §§ 6662A and 6663, and therefore, he should not be subject to gross valuation misstatement penalties under § 6662.
The Internal Revenue Code establishes penalties for underpayment of tax. Section 6662(a) of the Code imposes an accuracy-related penalty of 20% of the portion of an underpayment of tax "attributable to," inter alia, negligence, any substantial understatement of income tax, or any substantial valuation misstatement. I.R.C. § 6662(a), (b)(1)—(3). Under the applicable regulations, only one penalty may apply to a particular underpayment of tax, even if the IRS determines accuracy-related penalties on multiple grounds. Treas. Reg. § 1.6662-2(c).
The 20% penalty increases to 40% if there is a gross valuation misstatement. I.R.C. § 6662(h)(1). A gross valuation misstatement exists if "the value of any property (or the adjusted basis of any property) claimed on any return of tax . . . is  percent or more of the amount determined to be the correct amount of such valuation or adjusted basis (as the case may be)." I.R.C. § 6662(e)(1)(A), (h)(2)(A)(i). By contrast, a "substantial valuation misstatement," which receives only the 20% penalty, occurs when the "value of any property (or the adjusted basis of any property) claimed on any return of tax . . . is 200 percent or more of the amount determined to be the correct amount of such valuation or adjusted basis (as the case may be)." Id. § 6662(e)(1)(A). Treasury Regulations further provide that a gross valuation misstatement exists when the correct or adjusted basis of property is zero. Treas. Reg. § 1.6662-5(g). However, unless the portion of the underpayment attributable to the valuation misstatement exceeds $5,000, no substantial valuation misstatement penalty may be imposed. I.R.C. § 6662(e)(2).
The Internal Revenue Code provides a narrow exception to the imposition of accuracy-related penalties for an underpayment if the taxpayer shows that he acted with reasonable cause and in good faith. I.R.C. § 6664(c)(1). This exception is detailed in section E, below.
B. Majority Rule: The Penalty Applies When the Deduction is Totally Disallowed for Lack of Economic Substance
There is no question that the CARDS transaction lacked economic substance. Indeed, Gustashaw admitted as much at trial, and concedes this on appeal. The correct basis of the foreign currency, then, was not $11,739,258, as Gustashaw reported on his 2000 tax return, but zero. This reduction of basis to zero in turn eliminated the $9,938,324 loss that Gustashaw had claimed on his 2000 return. With the loss eliminated, the IRS properly determined Gustashaw's underpayments in tax, and Gustashaw conceded the deficiencies.
The question we now confront, for the first time in this Circuit, is whether Gustashaw is liable for the assessed gross valuation misstatement penalties when the IRS disregarded the CARDS transaction in its entirety because it lacked economic substance. It seems the obvious and sensible conclusion is that Gustashaw's tax underpayments were "attributable to" a gross valuation misstatement within the meaning of § 6662. That is, the underpayments resulted from Gustashaw's reporting an artificially inflated basis in currency, which was not $11,739,258, but zero. And, pursuant to the regulations, the basis claimed by Gustashaw ($11,739,258) was 400% more than the correct basis of the property (zero), making Gustashaw liable for the 40% gross valuation misstatement penalty. See Treas. Reg. § 1.6662-5(g).
The statute speaks in mandatory terms—the valuation misstatement penalty "shall be added" "to any portion of an underpayment of tax required to be shown on a return . . . which is attributable to . . . [a]ny substantial valuation misstatement" or "gross valuation misstatement." I.R.C. § 6662(a), (b)(3), (h)(1). We can discern no exception for when the valuation or basis misstatements are so egregious that the entire tax benefit is disallowed, and no suggestion that the penalty should not apply when the correct basis or value is determined to be zero because the transaction is completely lacking in economic substance.
Our interpretation is in accord with the majority of circuits to have considered the question. See, e.g., Alpha I, L.P., ex rel. Sands v. United States, 682 F.3d 1009, 1026-31 (Fed. Cir. 2012); Fidelity Int'l Currency Advisor A Fund, LLC, ex rel. Tax Matters Partner v. United States, 661 F.3d 667, 671-75 (1st Cir. 2011); Merino v. Comm'r, 196 F.3d 147, 155, 157-59 (3d Cir. 1999); Zfass v. Comm'r, 118 F.3d 184, 190-91 (4th Cir. 1997); Illes v. Comm'r, 982 F.2d 163, 167 (6th Cir. 1992); Gilman v. Comm'r, 933 F.2d 143, 149, 151 (2d Cir. 1991); Massengill v. Comm'r, 876 F.2d 616, 619-20 (8th Cir. 1989). Only two circuits, the Fifth and the Ninth, have gone the other way. See Gainer v. Comm'r, 893 F.2d 225 (9th Cir. 1990); Todd v. Comm'r, 862 F.2d 540 (5th Cir. 1988). Notably, both circuits have since questioned the soundness of their interpretation. See Bemont Invs., L.L.C. ex rel. Tax Matters Partner v. United States, 679 F.3d 339, 351 (5th Cir. 2012) (panel specially concurring); Keller v. Comm'r, 556 F.3d 1056, 1061 (9th Cir. 2009).
Here, we find the majority rule to be the better interpretation and will apply it in this case. That rule holds that the penalty applies even if the deduction is totally disallowed because the underlying transaction, which is intertwined with the overvaluation misstatement, lacked economic substance. See, e.g., Fidelity, 661 F.3d at 673-74. This rule rests upon the fact that the abusive tax shelter is built upon the basis misstatement, and the transaction's lack of economic substance is directly attributable to that misstatement. As Judge Boudin stated in Fidelity, that "alternative grounds with lower or no penalties existed for disallowing the same claimed losses hardly detracts from the need to penalize and discourage the gross value misstatements." Id. at 673.
C. Minority Rule
As for the minority rule, we think it important to note that the Fifth and the Ninth Circuits have questioned the wisdom of their positions. The Fifth Circuit has stated that, under its rule,
by crafting a more extreme scheme and generating a deduction that is improper not only due to a basis misstatement, but also for some other reason (e.g., a lack of economic substance), the taxpayer increases his chance of avoiding the valuation-misstatement penalty—because, per the Todd/Heasley hierarchy whereby the overvaluation penalty is subordinated to any other proper adjustment, disallowing the deduction on the other ground could block the penalty.Amplifying the egregiousness of the scheme—to the point where the transaction is an utter sham—could thus, perversely, shield the taxpayer from liability for overvaluation. . . . By creating this perverse incentive structure, the Todd/Heasley rule frustrates the purpose of the valuation-misstatement penalty, which is to deter taxpayers from inflating values and bases to generate large, improper tax benefits. . . .
Bemont, 679 F.3d at 355 (panel specially concurring) (citing Heasley v. Comm'r, 902 F.2d 380, 383 (5th Cir. 1990); Todd, 862 F.2d at 542-45). The Ninth Circuit also has recognized that its decision in Gainer, which rested in large part on the Fifth Circuit's reasoning in Todd, leads to the same anomalous result, and thus encourages a taxpayer to engage "in behavior one might suppose would implicate more tax penalties, not fewer." Keller, 556 F.3d at 1061.
The Fifth Circuit has further questioned the soundness of its reasoning in Todd, insofar as the reasoning was based on a misinterpretation of the legislative history surrounding I.R.C. § 6659 (repealed 1989), the predecessor to § 6662. See Bemont, 679 F.3d at 351-53 (panel specially concurring); see also Alpha I, 682 F.3d at 1028-30 (discussing this issue and declining to adopt the Fifth Circuit's approach); Fidelity, 661 F.3d at 673-74 (same). The concurring panel in Bemont noted that the Todd Court had relied on and interpreted the 1981 "Blue Book," a post-enactment summary of tax legislation prepared by the staff of the Joint Committee on Taxation, in analyzing § 6659's penalties assessed against tax underpayments that were "attributable to" a valuation misstatement. Bemont, 679 F.3d at 351 (citing Todd, 862 F.3d at 542-43; Staff of the Joint Comm. on Taxation, 97th Cong., General Explanation of the Economic Recovery Tax Act of 1981 333 (Comm. Print 1981) ("Blue Book")). In relevant part, the Blue Book states that
[t]he portion of a tax underpayment that is attributable to a valuation overstatement will be determined after taking into account any other proper adjustments to tax liability. Thus, the underpayment resulting from a valuation overstatement will be determined by comparing the taxpayer's (1) actual tax liability (i.e., the tax liability that results from a proper valuation and which takes into account any other proper adjustments) with (2) actual tax liability as reduced by taking into account the valuation overstatement. The difference between these two amounts will be the underpayment that is attributable to the valuation overstatement.
Fidelity, 661 F.3d at 673-74 (quoting Blue Book at 333). Through the use of further examples, the Blue Book concludes that when the IRS disallows two different deductions, but only one disallowance is based on a valuation misstatement, the valuation misstatement penalty should apply only to the deduction taken on the valuation misstatement, and not to the other deduction that is unrelated to valuation misstatement. See Bemont, 679 F.3d at 351-52 (panel specially concurring) (quoting Blue Book at 333 & n.2).
In Todd, however, the Fifth Circuit misapplied this guidance to a situation in which the IRS disallowed a single deduction on several grounds, only one of which related to a valuation misstatement. Todd, 862 F.2d at 543-44. The Bemont Court correctly recognized that the reasoning contained in the Blue Book does not extend to a scenario in which "overvaluation is one of two possible grounds for denying the same deduction and the ground explicitly chosen is not overvaluation," but that it was nevertheless bound to follow Todd as the rule of decision. Bemont, 679 F.3d at 352, 355 (panel specially concurring). As other courts have noted in addressing this situation, the Blue Book's guidance is designed to avoid attributing to a basis or value misstatement an upward adjustment of taxes that is unrelated to the overstatement, and is instead due solely to some other, independent tax reporting error. See Alpha I, 682 F.3d at 1029-30; Fidelity, 661 F.3d at 674. This is entirely different from excusing an overstatement because it is one of two independent, rather than the sole, cause of the same underpayment error. We therefore agree with the majority of the other Circuits that have addressed this issue, and decline to adopt the reasoning of the Fifth and Ninth Circuits with regard to the application of valuation misstatement penalties in the present case.I have nothing to add on the key split in the circuits. It seems obvious that critical mass has already formed around the "majority rule" and that, even without Supreme Court review, the split will resolve itself in the two "minority" circuits.
I do want to address the problem that this court and others have noted with respect to the Fifth Circuit's initial reliance -- indeed misreliance -- on the Blue Book. You will recall that some courts simply reject the idea that the Blue Book can be authority one way or the other. I have discussed this in a previous blog, Second Circuit's Statutory Interpretation for Taxpayer Victory on Retrospective Interest Netting (Federal Tax Procedure Blog 8/9/12), here. Here, the Fifth Circuit did rely on the Blue Book (which I think a majority of the courts would to some degree), but apparently just misread it. Note that the Eleventh Circuit appears to have no problem with the Blue Book when it is properly interpreted to interpret the statute.
Finally, I note that perhaps the Ninth Circuit will have an opportunity to not only see the light, but correct the error of its ways. The Tax Court just this week decided Blak Investments v. Commissioner, T.C. Memo. 2012-273, here, which is appealable to the Ninth Circuit, a minority rule court. Applying its Golsen rule, the Tax Court held for the taxpayer on this issue. Maybe the IRS will make one more run at the Ninth Circuit which seems ripe for plucking on this issue.