Tax Shown on Original Return, Not Amount Computed on Amended Return, Used to Compute Limitation on §6707A Disclosure Penalty

How to calculate the penalty for failing to disclose a listed transaction under IRC §6707A when the taxpayer erroneously overreported other income on the return is the issue the Tax Court was asked to decide in the case of Yari v. Commissioner, 143 TC No. 7.  And the Tax Court’s answer (sustained on appeal by the Ninth Circuit) was not the one the taxpayer liked.

The case in question involved a Roth IRA “stuffing” transaction where the taxpayer had a Roth IRA acquire 100% of the interest in a management S corporation.  That corporation then charged management fees to the taxpayer’s controlled business (a disregarded entity LLC), receiving $1,221,778 in such fees over the years from 2002 to 2007.

In Notice 2004-8 the IRS identified this sort of transaction as an abusive Roth IRA transaction.  The IRS went to identify the transaction described in this notice as a listed transaction.

On October 17, 2005 the taxpayers signed their 2004 return and did not enclose a disclosure form related to this transaction as required under IRC §6707A.

The IRS examined the return and determined that $482,912 should have been included in the taxpayer’s income due to the management fee transaction, increasing the taxpayer’s liability by $135,215.

Originally IRC§ 6707A imposed a mandatory $100,000 penalty for the failure to attach a disclosure of a listed transaction to the tax return and the IRS initially assessed such a penalty on the return.  While the taxpayer had a request for a collection due process hearing pending Congress retroactively modified the law to reduce the penalty to the greater of $5,000 or 75% of the decrease in tax shown on the return due to participation in that activity, with the penalty still capped at no more than $100,000.

The taxpayers had, in the interim, discovered errors on their returns as filed and prepared amended tax returns which served, even with the additional $482,912 in income from the management fee transaction reflected on the return, to reduce their tax to zero for the year in question.  The taxpayers therefore asked the IRS to recalculate the penalty.

The IRS took this into consideration, but decided that the $100,000 amount was the correct penalty under the revised law.  The IRS position was that the penalty was calculated based on the reduction in tax claimed on the return the taxpayer actually filed at the time, and not based on a recalculated tax based on other adjustments.  Since 75% of $482,912 being more than $100,000, the IRS concluded that the penalty remained unchanged.

The taxpayers argued that the penalty should be computed based on the tax that would have been shown on the return after these adjustments.  In that case the tax actually would not have changed, so the penalty would have been capped at $5,000.

The Tax Court agreed with the IRS.  The court pointed out that §6707A refers to the reduction in tax claimed on the return where the failure to disclose took place.  In the Court’s view was that, under the plain language of the statute, this meant that the key issue was the claimed benefit at the point when the disclosure should have taken place (the original return).

The opinion contrasted the language in §6707A with a provision found in §6651(a)(2) which also imposes a penalty on the tax shown on the return, which would lead to the same result.  There, the Court noted, Congress added IRC §6651(c)(2) which grants explicit relief if the actual required to be shown on the return was less than that reported on the return.  The lack of any similar relief provision in §6707A indicates that Congress did wish the claimed benefits to be the basis for the penalty since, as the Court noted, Congress knows how to write a provision to base a calculation on the tax actually due.

The taxpayer appealed this decision to the Ninth Circuit Court of Appeals—but in a very short unpublished opinion the panel hearing the appeal determined that the Tax Court had correctly decided the matter, stating:

We agree with the Tax Court that the Commissioner properly based his calculation of the penalty upon the return signed by Yari on October 17, 2005, rather than upon amendments to that return, which were prepared years later. See Yari, 143 T.C. at 163-69. We, therefore, affirm the Tax Court for the reasons stated in its comprehensive decision. Id. at 157-69.