The recent opinion in Wells Fargo & Co. v. United States, No. 09-CV-2764 (PJS/TNL), 2017 U.S. Dist. LEXIS 80401 (D. Minn. May 24, 2017) provided a thoughtful application of the economic substance doctrine.
In the same opinion, the court also addressed the applicability of a negligence penalty for the underpayments associated with the aspects of the STARS transaction that lacked economic substance; the penalty potentially applied to its claims for foreign tax credits derived from the trust component of the transaction. Wells Fargo, 2017 U.S. Dist. LEXIS 80401 at *13. The question was what a taxpayer must establish to avoid a negligence penalty under section 6662(b)(1) of the Internal Revenue Code; Wells Fargo argued that it should not be penalized if the position it took on its tax return was objectively reasonable under relevant authority. The court, however, adopted the government’s position, holding that Wells Fargo had to demonstrate that it actually analyzed the relevant authorities: “[T]he Court concludes that Wells Fargo must prove that it actually consulted the authorities that purportedly provided a reasonable basis for the position taken in its return.” 2017 U.S. Dist. LEXIS 80401 at *15. The potential ramifications of this holding are quite broad.
The Code contains a plethora of penalties for non-compliant taxpayers. These include penalties for failure to file a return on time, penalties for failure to pay taxes when due, and penalties for submitting a fraudulent return. See I.R.C. §§ 6651(a)(1), (2); 6663. And for honest taxpayers who file on time, section 6662 of the Code offers eight different accuracy-related penalties that could apply if they understate their tax liability:
This section shall apply to the portion of any underpayment which is attributable to 1 or more of the following:
(1) Negligence or disregard of rules or regulations.
(2) Any substantial understatement of income tax.
(3) Any substantial valuation misstatement under chapter 1.
(4) Any substantial overstatement of pension liabilities.
(5) Any substantial estate or gift tax valuation understatement.
(6) Any disallowance of claimed tax benefits by reason of a transaction lacking economic substance (within the meaning of section 7701(o)) or failing to meet the requirements of any similar rule of law.
(7) Any undisclosed foreign financial asset understatement.
(8) Any inconsistent estate basis.
I.R.C. § 6663(b). The negligence penalty is one of the most commonly imposed of these accuracy-related penalties.
The Code defines negligence as follows: “For purposes of this section, the term ‘negligence’ includes any failure to make a reasonable attempt to comply with the provisions of this title, and the term ‘disregard’ includes any careless, reckless, or intentional disregard.” I.R.C. § 6663(c). A Treasury Regulation elaborates on this standard in several ways:
- First, it observes that “[t]he term negligence includes any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws or to exercise ordinary and reasonable care in the preparation of a tax return.” Treas. Reg. § 1.6662-3(b)(1). This can include a taxpayer’s failure to maintain adequate books and records. Id.
- Second, it notes that “[a] return position that has a reasonable basis as defined in paragraph (b)(3) of this section is not attributable to negligence.” Id.
- Third, it provides examples of negligence that include “[a] taxpayer [who] fails to make a reasonable attempt to ascertain the correctness of a deduction, credit or exclusion on a return which would seem to a reasonable and prudent person to be ‘too good to be true’ under the circumstances.” Treas. Reg. § 1.6662-3(b)(1)(ii).
Then in defining what constitutes a “reasonable basis” for a tax position, the regulation provides as follows:
If a return position is reasonably based on one or more of the authorities set forth in §1.6662-4(d)(3)(iii) (taking into account the relevance and persuasiveness of the authorities, and subsequent developments), the return position will generally satisfy the reasonable basis standard even though it may not satisfy the substantial authority standard as defined in §1.6662-4(d)(2). . . .
Treas. Reg. § 1.6662-3(b)(3).
In Wells Fargo, the court initially focused on the ordinary meaning of the term “negligence,” noting that a negligence standard normally calls for a focus on due care. 2017 U.S. Dist. LEXIS 80401 at *15. Next, the court considered the statutory definition contained in section 6662(c), indicating that the Code’s language “comports with this view.” Id. The court then commented that “[c]ase law likewise confirms that, in determining whether the negligence penalty applies, the focus is on the taxpayer’s conduct.” Id. (citing Chakales v. Comm’r, 79 F.3d 726, 729 (8th Cir. 1996); Goldman v. Comm’r, 39 F.3d 402, 407 (2d Cir. 1994); Pasternak v. Comm’r, 990 F.2d 893, 902 (6th Cir. 1993); Zmuda v. Comm’r, 791 F.2d 1417, 1422-03 (9th Cir. 1984)).
Then the court addressed Wells Fargo’s argument that the reasonable basis standard “provides a purely objective legal defense to the negligence penalty.” 2017 U.S. Dist. LEXIS 80401 at *16. While acknowledging that the regulation did speak in objective terms to a degree, the Wells Fargo Court concluded that it was “ambiguous concerning whether a taxpayer must have actually relied on the authorities” that purport to provide a reasonable basis for the position on the return. Id. In the court’s view, this ambiguity was created by a clause in the regulation providing “that the reasonable-basis standard is generally satisfied ‘[i]f a return position is reasonably based on one or more’ of a set of authorities. Id. (quoting Treas. Reg. § 1.6662-3(b)(3)). In light of the ambiguity, the court elected to defer to the government’s position on how the regulation should be interpreted, noting that the reasonable basis test was not supposed to measure “the probability of the return position prevailing in litigation.” Id. at *18 (quoting Definition of Reasonable Basis, 63 Fed. Reg. 69433, 69433 (Dec. 2, 1998)).
Perhaps the court correctly determined that Wells Fargo should be penalized, but its approach to the issue is troubling. First, negligence generally involves conduct that deviates from what a reasonably prudent person would do under the circumstances, a standard that suggests the penalty should only apply to a taxpayer who fails to conduct whatever investigation was reasonable under the circumstances. The text of the regulation supports this by indicating that “[n]egligence is strongly indicated” in various situations, including where “[a] taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction, credit or exclusion on a return which would seem to a reasonable and prudent person to be ‘too good to be true’ under the circumstances.” Treas. Reg. § 1.6662-3(b)(1), (b)(1)(ii). While Wells Fargo lost at trial after years of litigation, that fact alone does not mean that STARS was “too good to be true” at the time it filed its returns.
The four cases that the Wells Fargo Court relied upon reinforce the conclusion that investigation and analysis are required in situations where the return position does not appear to be objectively reasonable:
- In Chakales, the court opined that “the burden is on the taxpayer to prove that he did not fail to exercise due care or do what a reasonable and prudent person would do under similar circumstances.” 79 F.3d at 729 (citation omitted). The taxpayer there acknowledged that he did not understand the relevant transactions, leading the court to conclude that “further investigation was clearly mandated.” Moreover, the court also concluded that further investigation would have revealed that the position adopted was not reasonable. Id.
- In Goldman, “[t]he offering memorandum indicated that the principal benefit a limited partner would receive was a tax deduction four times greater than the original amount invested, and advised that there was a high probability that such deductions would be questioned by the IRS.” 39 F.3d at 407. In the face of that warning, the taxpayer did not seek independent advice.
- In Pasternak, “the Tax Court found that petitioners were aware that they were buying a program that consisted primarily of ‘window dressings’ for tax benefits and either negligently or intentionally disregarded the law.” 990 F.2d at 902. The Tax Court had also found that a reasonably prudent person would have asked whether the tax benefits were too good to be true. Id. at 903.
- While the court in Zmuda did focus on the taxpayers’ failure to investigate, that was in a specific context where they were on notice that the return position was implausible: “The accountant preparing the Zmudas’ 1977 forms warned of possible tax consequences from the transfer of property to the trusts. The Zmudas ignored that advice and proceeded without seeking further counsel.” 791 F.2d at 1422. The court also noted that their failure to seek independent advice came in the context of “extensive continuing press coverage of questionable tax shelter plans.” Id.
Similarly, the surrounding statutory context also suggests that there has to be something to put a taxpayer on notice that a return position may be questionable before a duty to investigate is triggered: “The maxim noscitur a sociis, that a word is known by the company it keeps . . . is often wisely applied where a word is capable of many meanings in order to avoid the giving of unintended breadth to the Acts of Congress.” Jarecki v. G.D. Searle & Co., 367 U.S. 303, 307 (1961) (citations omitted). The penalty is not for negligence, it is for “[n]egligence or disregard of rules or regulations.” I.R.C. § 6662(b)(1). Coupling negligence with the phrase “disregard of rules or regulations” suggests that Congress intended to penalize taxpayers whose position is lacked a factual basis or because existing “rules or regulations” said that it was improper.
The idea that a taxpayer can be penalized for adopting a return position that has plausible legal support is troubling for practical reasons, as it suggests that different taxpayers who enter into the same transaction could be treated differently based upon the extent of their investigation. It is one thing to treat the two taxpayers differently if there was some reason to investigate, as the Second Circuit indicated in Goldman, where the offering document affirmatively warned investors that the tax benefits provided by the transaction were likely to be challenged by the IRS. 39 F.3d at 407 (distinguishing Wright v. Commissioner, T.C. Memo. 1994-288, 1994 WL 276907 (June 23, 1994)). After all, if taxpayers are on notice that they should investigate, it is certainly fair to differentiate between those who investigate and those who do not.
It is quite another thing to treat taxpayers differently when the circumstances either do not suggest that investigation is in order, or where further analysis by the taxpayer would not have revealed that its position was unreasonable. For example, a return position could be rejected in litigation when an appellate court overturns prior precedent; in that situation, it does not seem appropriate to differentiate between taxpayers based on the extent of the analysis that went into the decision to adopt that position on the return. To the extent that Wells Fargo suggests that such an outcome is appropriate, it is quite troubling.
In fairness to the court, its penalty ruling came in strange context: In a stipulation designed to limit the scope of discovery, Wells Fargo had limited its penalty defense so that it would only argue that its return position was objectively reasonable. 2017 U.S. Dist. LEXIS 80401 at *15. The truncated record may have led the court to analyze the negligence penalty in relatively simplistic terms. Nonetheless, the court appears to have ruled in a fashion that gives the penalty a disturbing breadth.