Gassoway v. Comm’r: Disallowed Refundable Credits Aren’t Part of “Substantial Understatement”, Either

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Frequent guest blogger Carl Smith discusses the recent Gassoway case and the Tax Court’s discussion of how to calculate an understatement in the face of disallowed refundable credits.

In Rand v. Commissioner, 141 T.C. 376 (2013), on which we have blogged before, the Tax Court grappled with the question of how, if at all, disallowed refundable tax credits go into the computation of the “underpayment” under section 6664(a) upon which a section 6662 accuracy-related penalty may be imposed.  In that case, the taxpayers conceded that they were liable for a penalty to the extent there was such an underpayment.  In Rand, the court held that disallowed refundable credits don’t count toward the underpayment, except to the extent that the credits were used to bring tax down to zero on the return (and not below zero).  In Rand, improper credits were used to offset $144 of self-employment taxes (the correct income taxes were zero in any event), so the 20% penalty was imposed on the $144 “underpayment”.

But, what if a taxpayer doesn’t stipulate to liability for a penalty under section 6662, and the IRS only argues for a penalty on account of a “substantial understatement of income tax”, within the meaning of section 6662(b)(2) and (d) and not, in the alternative, on the grounds of negligence or disregard of rules or regulations under section 6662(b)(1) and (c)?  Those were the exact facts of Gassoway v. Commissioner, T.C. Memo. 2015-203 (Oct. 15, 2015), and the IRS lost again — even though by the time of its brief the IRS had already reduced the “underpayment” to reflect the holding in Rand.  The problem was that the IRS confused the “understatement” with the “deficiency” — a similar error to the one it made in Rand.  In Gassoway, the court held that the “understatement” was only $2,856, though an understatement couldn’t be considered “substantial” unless it at least exceeded $5,000.  So, not even the penalty recalculated to reflect Rand could be imposed.

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Rand

Section 6664(a) defines the “underpayment” on which a section 6662 penalty may be imposed, but the IRS must establish one of several violations of the rules of section 6662 for any penalty to be imposed.  In Rand, the taxpayers stipulated that they violated at least one of the rules of section 6662, so that any “underpayment” was subject to a 20% penalty.  In Rand, the non-penalty issues were the correctness of dependency exemptions, additional child tax credits (ACTCs), earned income tax credits (EITCs), and the 2008-only recovery rebate credit.  All three of the credits involved were refundable.  Section 6664(a) defined the “underpayment” as

the amount by which any tax imposed by this title exceeds the excess of —

(1) the sum of (A) the amount shown as the tax by the taxpayer on his return, plus (B) amounts not so shown previously assessed (or collected without assessment), over

(2) the amount of rebates made.

Leaving out any discussion of previous assessments, collections, or rebates made (which were not involved in either Rand or Gassoway), “underpayment” is essentially defined as the amount of the correct tax (i.e., the tax imposed) over “the amount shown as the tax by the taxpayer on his return.”  In Rand, the parties all agreed that the correct tax was merely the $144 of self-employment tax and there were no credits against the tax that were properly allowable.  The issue was what had been “the amount shown as the tax by the taxpayer on his return.”  The taxpayers had claimed over $7,000 of improper ACTCs, EITCs, and recovery rebate credits on their return.  The IRS argued that to the extent the credits generated refunds, the amount of the refunded credits should be treated as a negative number, so the tax shown on the return should be somewhere around negative $7,000.

The Tax Court disagreed with the IRS, noting that, under section 6211(b)(4), disallowed refundable credits that generate refunds are specifically treated as negative amounts of tax for purposes of the similar calculation of a “deficiency” under section 6211, but there is no parallel provision about negative amounts from refundable credits in section 6664(a)’s definition of “underpayment”.  Thus, “the amount shown as the tax by the taxpayer on his return” can never go below zero.  So, the underpayment was the $144 of correct tax minus $0 — or $144.  The IRS has since conceded the correctness of the Tax Court’s ruling in Rand.

Gassoway Facts

 

In Gassoway, the taxpayer claimed at least three children as dependents, claimed head of household status, and claimed non-refundable child tax credits (CTCs).  Apparently, these deductions and credits brought the tax down to zero.  But, in the payments section of the return, the taxpayer also claimed an ACTC of $3,691 and an EITC of $2,658, and the IRS sent him a refund check that included these two credits.

The IRS audited the return and changed the taxpayer’s filing status to single and denied the dependency exemptions and the claimed credits for the three children.  In a notice of deficiency, the IRS sought a deficiency of $9,205 — which is the sum of corrected tax of $2,856, disallowed ACTC of $3,691, and disallowed EITC of $2,658.  The notice of deficiency, prepared before the IRS lost Rand, calculated an accuracy-related penalty — based only on a substantial understatement of income tax — equal to 20% of the deficiency, or $1,841.  By the time of trial, the IRS had recalculated the penalty to be $571.20, which is 20% of the corrected tax of $2,856 and which excludes from the underpayment the disallowed refundable credits, since none of those credits was used to bring the tax down to zero on the original return.

Gassoway Holdings

In her opinion, Judge Chiechi made quick work of the underlying adjustments and credits.  She sustained all of the IRS adjustments because the taxpayer failed to provide credible evidence that the three children lived with him for most of the taxable year.

But, she took a lot longer discussing the penalty.  Initially, she noted that, under section 6662(d)(1)(A), there is a “substantial understatement of income tax” only if “the understatement . . . exceeds the greater of– (I) 10 percent of the tax required to be shown on the return for the taxable year, or (ii) $5,000.”  Even though the IRS now conceded that the “underpayment” under section 6664(a) was only $2,856, it argued that the “understatement” was the full deficiency, $9,205.  Since $9,205 exceeded both 10% of the $2,856 required to be shown as tax on the return and $5,000, the IRS argued that there was a “substantial understatement” for purposes of section 6662(d)(1)(A).

Judge Chiechi rejected the IRS’ argument on how to calculate the “understatement.”  Surprisingly not even citing Rand, she noted that, under section 6662(d)(2)(A), the term “understatement” for purposes of this section “means the excess of– (i) the amount of the tax required to be shown on the return for the taxable year, over (ii) the amount of the tax imposed which is shown on the return, reduced by any rebate (within the meaning of section 6211(b)(2)).”  She noted that regulations under this “understatement” provision refer to the regulations under section 6664(a) for “underpayment” for the meaning of the terms “tax required to be shown on the return” and “tax imposed which is shown on the return”.  Reg. secs. 1.6662-4(b)(3) and (4), citing Reg. secs. 1.6664-2(b) and (c).  Moreover, she noted (as the Tax Court had in Rand) that the definition of “understatement” does not contain a provision like that at section 6211(b)(4) (relating to the definition of “deficiency”) that treats excess refundable credits that generate overpayments as negative amounts of tax.  Accordingly, she calculated that the “tax required to be shown on the return” was $2,856 and the “tax imposed which is shown on the return” was $0.  The difference between those two figures, she held, was the “understatement”.  Since the understatement, properly computed, was not over $5,000, the penalty for substantial understatement of income tax liabilities could not apply.  She noted that the IRS had not argued that an alternative reason for imposing the penalty (read, negligence) applied, so she declined to impose any section 6662 penalty — even though there was an “underpayment” of $2,856.

Quintero S Case Opinion

The penalty calculation holding by Judge Chiechi in Gassoway is the first such holding in a precedential opinion.  However, it is not a novel holding.  The exact same issue was raised, apparently sua sponte, by Special Trial Judge Carluzzo 13 years earlier in Quintero v. Commissioner, T.C. Summary Op. 2002-47, where he wrote:

Section 6662(a) imposes an accuracy-related penalty of 20 percent of any portion of an underpayment of tax that is attributable to a substantial understatement of income tax. Sec. 6662(b)(2), (d). An understatement of income tax is a substantial understatement of income tax if it exceeds the greater of $ 5,000 or 10 percent of the tax required to be shown on the taxpayer’s return. Sec. 6662(d)(1).  Ignoring conditions not relevant here, for purposes of section 6662, an understatement is defined as the excess of the amount of the tax required to shown on the taxpayer’s return over the amount of the tax which is shown on the return. Sec. 6662(d)(2)(A). In this case, for purpose of section 6662, the amount of tax required to be shown on petitioners’ 1997 return is $ 1,796. 2/ The amount of tax shown on the return is zero. 3/ Because the difference between these two amounts is less than $ 5,000, the underpayment of tax required to be shown on their 1997 return is not a substantial understatement of income tax. Consequently, they are not liable for the accuracy-related penalty imposed by section 6662(a).

  1. This is the sec. 1 income tax that results from including in petitioners’ 1997 income the compensation that petitioner received from AAA that year.

 

  1. Unlike the computation of a deficiency under sec. 6211 or the computation of an understatement for purposes of sec. 6694, the earned income tax credit claimed on petitioners’ 1997 return (and disallowed in the notice of deficiency) is not taken into account in the computation of the underpayment (sic; should be “understatement”) of income tax for purposes of sec. 6662.

 

Id. at *10-*11 (emphasis added).

In Gassoway, Judge Chiechi did not cite Quintero.

Final Observation

Ironically, most people are also not aware that the issue and holding in Rand — the calculation of the “underpayment” under section 6664(a) — was also presaged in two Summary Opinions, where the issue was also apparently raised, sua sponte, by two other Special Trial Judges.  See Akhter v. Commissioner, T.C. Summary Op. 2001-20 at *8 (Special Trial Judge Dinan); Solomon v. Commissioner, T.C. Summary Op. 2008-95 (Chief Special Trial Judge Panuthos).  Indeed, the holding in Solomon was discussed and much disputed by the IRS in PMTA 2010-01 (Nov. 20, 2009).  And the lawyers who brought the Rand case for the taxpayers knew all about these three earlier Summary Opinion holdings.  Accordingly there is a reason for tax lawyers to at least skim Summary Opinions for novel legal issues.  As the Tax Court said only just a few days ago, when discussing a Summary Opinion in Reifler v. Commissioner, T.C. Memo. 2015-199 (Oct. 13, 2015) at 16 n. 10, “Sec. 7463 precludes Summary Opinions from being treated as precedent in other cases, but this Court’s rules do not prohibit citations of Summary Opinions to the extent they are persuasive.”

About Carlton Smith

Carlton M. Smith worked (as an associate and partner) at Roberts & Holland LLP in Manhattan from 1983-1999. From 2003 to 2013, he was the Director of the Cardozo School of Law tax clinic. In his retirement, he volunteers with the tax clinic at Harvard, where he was Acting Director from January to June 2019.

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