Tax Penalties Alert: Tax Court Refuses to Impose Accuracy-Related Penalty Despite Lack of Economic Substance

Tax Controversy Alert
02.23.06

On February 15, 2006, the U.S. Tax Court refused to impose an accuracy-related penalty on a group of taxpayers even though the court found that the transactions in issue lacked economic substance. In Melnik v. Commissioner, T.C. Memo 2006-25, the court held that the taxpayers’ sale of stock to a foreign company owned by two foreign trusts in exchange for private annuities was a sham transaction. Nonetheless, because the taxpayers reasonably relied on the advice of an experienced tax professional in entering into the transaction, the court concluded that the reasonable cause and good faith exception to the accuracy-related penalty applied.

The Melnik case involves a group of taxpayers (a husband, his wife, and his brother) who decided to sell their scrap metal business (a U.S. corporation) and engaged tax counsel to assist them in disposing of the business in the most tax-efficient manner. After receiving an offer for the business, the taxpayers met with their attorney and an accountant to discuss “various planning scenarios.” The taxpayers chose a transaction in which they sold part of their stock to a foreign holding company owned by two foreign trusts in exchange for annuities.

The taxpayers sold 75% of the outstanding shares of stock in the scrap metal business to the foreign holding company. The taxpayers and the foreign holding company then sold all of the stock in the scrap metal business to an unrelated party. Based on advice from their tax lawyer, the taxpayers took into account for U.S. tax purposes only the sale of the 25% of the shares which they personally owned on the date of the sale. As a result, the taxpayers recognized as capital gain only a portion of the total gain realized on the sale.

The IRS assessed a deficiency for the tax attributable to the gain on the stock transferred to the foreign holding company on the ground that the sale of stock to the foreign holding company was a sham transaction lacking economic substance. The IRS also determined that the taxpayers were liable for an accuracy-related penalty under section 6662 due to negligence or disregard of rules or regulations or due to a substantial understatement of tax.

The Tax Court sustained the IRS’s determination that the transaction lacked economic substance. The court determined that the taxpayers had “de facto control” over the assets “ostensibly owned” by the foreign holding company and the foreign trusts and that the record was “lacking in credible evidence that the annuity transactions had economic substance independent of tax considerations.” Because the foreign company was “a conduit,” the court concluded that the taxpayers should be subject to U.S. income tax on the entire gain from the sale of the scrap metal business.

Notwithstanding the court’s analysis of the merits of the transaction, the court held that the taxpayers were not liable for an accuracy-related penalty. While observing that a taxpayer’s adoption of a “flagrant tax avoidance scheme” is “patently negligent,” the court noted that private annuity transactions using foreign entities had not been “consistently rejected” by the courts. For that reason, the court determined that the taxpayers’ transaction was not “per se negligent.”

Additionally, in the court’s view, the record established that the taxpayers’ attorney “was the driving force behind the planning of the annuity transactions” and had assured the taxpayers that there was a “reasonable basis for the income tax reporting of the private annuity transactions” and the stock sale. The court concluded that the taxpayers had reasonably relied on their attorney in good faith and thus satisfied the section 6664 reasonable cause and good faith exception to the accuracy-related penalty under section 6662.

Although Melnik is not the first case in which the IRS prevailed with respect to the underlying issue but did not succeed in imposing an accuracy-related penalty, the decision sends a clear message to the IRS. Even in cases where the courts find transactions to be aggressive, the courts will not summarily ignore taxpayers’ reasonable reliance on expert tax counsel in determining whether to impose accuracy-related penalties. While a single case will not change the IRS practice of asserting accuracy-related penalties regardless of taxpayers’ reliance on counsel, taxpayers may be able to use Melnik to support their “reasonable reliance” arguments under section 6664 to obtain a more favorable settlement with respect to accuracy-related penalties.

For additional information, please contact the following lawyer:

Patricia Sweeney, psweeney@milchev.com, 202-626-5926

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