No substantial understatement penalty in close factual disputes.

• Author: Stein, Ronald A.
• Position: Taxation

Following the lead of the Eleventh Circuit, the Fifth Circuit has significantly curbed the reach of the substantial understatement penalty. In Streber, 138 F3d 216 (1998), rev'g TC Memo 1995-601, the court rejected the Tax Court's sustention of the penalty in a factual contest in which the "substantial authority issue turns on evidence going both ways"

The substantive income tax issue was whether two sisters (or, alternatively, their father) were taxable on settlement proceeds ultimately received by the sisters in a lawsuit to enforce two promissory notes. The sisters argued that their father gave the settlement proceeds to them; therefore, he was liable for the tax on those proceeds. The father countered that he gave his daughters the notes several years prior to the receipt of the proceeds, making the proceeds taxable to them.

The Tax Court sided with the father. In addition, it upheld the IRS's imposition of Sec. 6653 negligence and Sec. 6661 substantial understatement penalties against the sisters. On motion for reconsideration, the sisters argued that the penalties were improper because they had substantial authority for their position and also relied on advice of tax counsel. The Tax Court disagreed and the sisters appealed.

The Fifth Circuit reversed. It concluded that the Tax Court erred in not crediting the sisters' testimony, as well as that of other witnesses, as to reliance on advice of counsel. The court also rejected the Tax Court's approach to the substantial understatement penalty, relying on Osteen, 62 F2d 356 (11th Cir. 1995).

Osteen involved a bank executive who also bred horses. The Service argued that the breeding activity was a hobby, not a business; thus, Sec. 183 limited the taxpayer's allowable breeding losses. At trial, both parties relied upon the analytical factors contained in Sec. 183 regulations to support their respective positions. Applying those regulations, the Tax Court held for the IRS. In addition, it upheld, without critical analysis, the imposition of a Sec. 6661 substantial understatement penalty.

On appeal, the Eleventh Circuit upheld the deficiency but reversed on the penalty. Assuming that the Tax Court's sustention of the penalty rested on the sufficiency of the evidence regarding the taxpayer's...