Expansion of Sec. 6662 penalty relief.

• Author: Goldberg, Michael J.
• Position: Understatement of income tax penalty - IRC section 6662

A divided Sixth Circuit, reversing the Tax Court, held that factual evidence can be considered "substantial authority" in determining whether to apply the substantial understatement penalty under Sec. 6662 (Estate of Kluener, 9/9/98).While this decision may be little comfort to taxpayers outside the Sixth Circuit (because the Tax Court decision continues to be controlling), Kluener may be persuasive in helping to settle potential penalty assessments.

This was essentially an assignment-of-income case. Kluener made a capital contribution under Sec. 351 of appreciated property to his wholly owned corporation. The assets were sold by the corporation and the gain was offset by net operating losses (NOLs). Eleven months later, the proceeds were distributed tax-free (due to a lack of corporate earnings and profits) to Kluener.

Kluener's tax advisers testified that they advised-him to sell the property through the corporation to use the NOL. However, they denied advising him to subsequently distribute the proceeds to himself and stated that Kluener would not have implemented any tax-planning strategies without their input. Thus, the estate argued that the motive behind the transactions was not tax avoidance and contended that the assets were needed to help with the corporation's cash flow needs and that the proceeds were distributed back to Kluener after unforeseen events alleviated the cash flow shortage.

Sec. 6662 imposes a 20% penalty on the portion of an underpayment attributable to (among other things) a substantial understatement of income tax. A substantial understatement is essentially 10% of the tax required to be shown on the return, subject to certain de minimis rules. The penalty can be reduced or eliminated either by adequately disclosing an item on the return or establishing that there was substantial authority for the taxpayer's treatment of the item.

The Tax Court held, and the Court of Appeals affirmed, the finding that Kluener, and not his corporation, was taxable on the gain. The Tax Court also sustained the assessment of a substantial understatement penalty. On the question of whether Kluener had a nontax motive for the transaction, the Sixth Circuit concluded that, as a question of fact, the Tax Court judgment must be affirmed, because it was not clearly erroneous. However, the Court of Appeals said that a lower standard of judicial review (a de novo review) applies to the question of the existence of substantial authority, a...