Eleventh Circuit directs Tax Court to develop test for substantial understatement penalty.

• Author: Barton, Peter C.

In Osteen, 62 F3d 356 (1995), the Eleventh Circuit reversed the Tax Court's assessment of the substantial understatement penalty in a Sec. 183 case. The Court of Appeals held that the Tax Court did not adequately explain why the taxpayers did not have substantial authority for their position. Also, the Appeals Court directed the Tax Court to develop a "consistent and workable test" for substantial authority for provisions such as Sec. 183, in which the regulations apply several factors to determine whether the taxpayer engaged in an activity for profit. Finally, the Court of Appeals' comparison of Osteen with other cases appears to have weakened the regulations' test for substantial authority.

Background

Sec. 183 specifies that if an activity is not engaged in for profit, deductions generally are not allowed in excess of gross income. An activity is for profit if the taxpayer has an actual and honest, even though unreasonable, profit objective. The burden of proof is on the taxpayer unless the activity was profitable in three out of five consecutive tax years, ending with the current tax year. If the activity involves horses, the activity must be profitable in two out of seven consecutive tax years (ending with the current tax year).

In determining whether an activity is engaged in for profit, Regs. Sec. 1.183-2(b) specifies nine nonexclusive factors:

1. Whether the activity is operated in a businesslike manner.

2. The expertise of the taxpayer or his advisers.

3. The time and effort spent by the taxpayer.

4. The expectation that the activity's assets may appreciate.

5. The taxpayer's record in other activities.

6. The taxpayer's history of income or loss in the activity.

7. The amount of any profits earned.

8. The taxpayer's financial status.

9. Elements of pleasure or recreation in the activity.

No one or group of these factors is conclusive; instead, they must be applied on a case-by-case basis.

Sec. 6661, which applied to tax returns due (without extensions) before 1990, imposed a 25% penalty for any underpayment due to a substantial understatement of income tax. An understatement is substantial if it exceeds the greater of 10% of the correct tax or $5,000 ($10,000 generally for C corporations). For any item not involving a tax shelter, an understatement shall be reduced (under Sec. 6661 (b) (2) (B) if the taxpayer's treatment of the item was either based on substantial authority or the taxpayer provided adequate disclosure with his return.

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