SD NY District Court Rejects Partial Payment § 6707 Penalty Refund Suit (1/2/17)

This is a reposting of the same entry on my Federal Tax Crimes Blog.

In Larson v. United States, 2016 U.S. Dist. LEXIS 179314 (SD NY 2016), here, the Court rejected an attempt by a promoter assessed a very, very large § 6707 penalty to avoid the Flora full payment rule for refund litigation.  The principal holding is that the § 6707 penalty is not a divisible penalty that could benefit under divisible tax exception to Flora's full payment rule.  This aspect of the case is consistent with prior holdings such as Diversified Group Inc. v. United States, 841 F.3d 975, 981 (Fed. Cir. 2016), here.

The full bore application of the Flora full payment exception is troubling on these facts with very, very large § 6707 penalties.  The IRS assessed a $24,745,026 penalty for the FLIP/OPIS shelter and a $135,487,056 penalty for the BLIPS shelter.  The total was thus $160,232,026.  The IRS did reduce the penalty by amounts paid by other co-promoters.  The aggregate amount of that reduction was $96,820,667, leaving Larson liable for $63,411,359.  (Co-promoters also might be liable for the unpaid balance.)

Larson made a partial payment of $1,432,735, hence his refund suit alleging a divisible tax as a basis for not paying all.  The Court's basic analysis as to why the § 6707 penalty is not divisible is fairly straight-forward.  I think the following discussion relating to the claims of hardship because of the amount of the penalty is interesting.

Indeed, at oral argument, Larson did not dispute that the failure to register a tax shelter was "only one act," or "one act per shelter," Tr. at 17:22-23; rather, Larson seeks to limit the applicability of the full-payment rule to his particular circumstances. In a due process challenge to the application of the full-payment rule, Larson argues that the full-payment rule violates "the Fifth Amendment where there is no alternative forum having jurisdiction over pre-payment challenges to such penalties and where an individual does not have the financial means to pay the penalties in full." Opp. Br. at 7. Foreclosed from review in Tax Court, Larson argues that because he cannot pay the penalty, and he cannot seek review for his claim without paying the penalty, the imposition of the full-payment rule violates his Fifth Amendment right to due process. n9
   n9 Larson did not assert a Due Process claim in his Complaint, but he makes arguments based on the Due Process Clause in opposing the Government's motion to dismiss. 

Larson argues that the Supreme Court in Flora I and Flora II never intended for the full-payment rule to apply in circumstances in which Tax Court review is unavailable and the challenged penalty amount is unaffordable to the taxpayer. Larson's reading of Flora I and Flora II strains to find due process arguments where none exists. In reviewing the legislative history of 26 U.S. § 1346(a)(1) and the legislative history that led to the creation of Tax Court, the Supreme Court noted that Congress created the Tax Court as a prepayment forum to ameliorate "the hardship of prelitigation payment." Flora I, 357 U.S. at 74, 75; Flora II, 362 U.S. at 158. But it is clear that Congress created the Tax Court out of legislative grace, not because it was a constitutionally-required response to the full payment rule. See Flora I, 357 U.S. at 75; Flora II, 362 U.S. at 158. Flora I and Flora II held that, in district court, a taxpayer must "pay first and litigate later," and Larson points to no authority that supports his argument that the unavailability of the Tax Court vitiates the full-payment rule in district court. Carving a "when Tax Court is unavailable" exception into the full-payment rule would subvert the full-payment rule's purpose in "promot[ing] the smooth functioning of [the tax litigation] system." See Flora II, 362 U.S. at 647. Although this Court is sympathetic to Larson's circumstances, this Court declines to recognize such an exception to well-settled jurisdictional limits.

IRS Designates Syndications Exploiting Improper Valuations for Conservation Easement Deductions (1/3/17)

This is a reposting of the same entry on my Federal Tax Crimes Blog.

I note at a couple of places in the Federal Tax Procedure Book that some of the most abusive tax shelters do not fail because the legal positions are faulty.  Rather, they fail because the legal positions are all based false facts, often a false valuation of property.  For example, in discussing the substantial and gross valuation misstatement penalties in §§ 6662(e) and (h), here, I state:

Section 6662(e)’s substantial valuation misstatement penalty and § 6662(h)’s gross valuation misstatement penalty are directed to return reporting positions where the law is correctly applied but a critical valuation is grossly erroneous, resulting in the substantial understatement of the tax liability.  In many of the abusive tax shelters over the years, the Achilles heel has been and continues to be inflated valuations.  The legal superstructure had some facial merit, but it was built on a factual house of cards because of gross overvaluation.  A facet of this problem was that, since tax professionals were not valuation experts, they could render their opinions without taking responsibility for the key valuation facts that supported the whole purported tax shelter superstructure.  For example, as to property otherwise qualifying for the old investment tax credit (10 percent of qualifying investment in property), tax shelter promoters would sometimes inflate the value of property to 10 or 20 times its true value and sell it to investment partnerships (where the partners were tax shelter investors) for the inflated value.  Of course, only crazy people would pay the inflated value, so the tax shelter investors paid only a small amount down and “paid” the balance by nonrecourse indebtedness (before the rules related to nonrecourse indebtedness and passive losses).  Assuming that the value was correct, the taxpayers would be entitled to the credit; the problem was in the valuation.  Many, many tax issues, not just tax shelter issues, rely upon valuations.  Thus, for example, estate and gift tax returns rely upon reasonably correct valuations.  The purpose of this penalty is to put some sting in overly aggressive valuations.

I have posted on variations of this theme.  Court Sustains Use of Regular Summons to Appraiser Investigated Even Though Third Party Taxpayers May be Identified (Federal Tax Crimes Blog 1/14/16), here.  See also Prominent and Very Rich Investor Indicted in SDNY (Federal Tax Crimes Blog 5/24/16), here.

Such overvaluations carry risk of criminal prosecution and significant civil penalties.

The IRS strikes again at a valuation shelter in a different package, this one syndications -- promoted "investments" -- offering conservation easement deductions.  Notice 2017-10, 2017-04 IRB, here.  The Notice describes the problem:

The promoters (i) identify a pass-through entity that owns real property, or (ii) form a pass-through entity to acquire real property. Additional tiers of pass-through entities may be formed. The promoters then syndicate ownership interests in the passthrough entity that owns the real property, or in one or more of the tiers of pass-through entities, using promotional materials suggesting to prospective investors that an investor may be entitled to a share of a charitable contribution deduction that equals or exceeds an amount that is two and one-half times the amount of the investor’s investment. The promoters obtain an appraisal that purports to be a qualified appraisal as defined in § 170(f)(11)(E)(i) but that greatly inflates the value of the conservation easement based on unreasonable conclusions about the development potential of the real property. After an investor invests in the pass-through entity, either directly or through one or more tiers of pass-through entities,  the pass-through entity donates a conservation easement encumbering the property to a tax-exempt  entity. Investors who held their direct or indirect interests in the pass-through entity for one year or less may rely on the pass-through entity’s holding period in the underlying real property to treat the donated conservation easement as long-term capital gain property under § 170(e)(1). The promoter receives a fee or other consideration with respect to the promotion, which may be in the form of an interest in the pass-through entity. The IRS intends to challenge the purported tax benefits from this transaction based on the overvaluation of the conservation easement. The IRS may also challenge the purported tax benefits from this transaction based on the partnership anti-abuse rule, economic substance, or other rules or doctrines.