The Tax Court has held that an inexperienced investor was not liable for the Code Sec. 6662(a) substantial underpayment penalty for not reporting gain on a purported loan transaction program that was in fact a disguised sale. She acted in good faith on an honest misunderstanding of the law, had legitimate, non-tax reasons for trying to structure the transaction as a loan and consistently treated the transaction as a loan.
The new decision dealt with a transaction widely characterized as Ponzi scheme, one that the Tax Court previously held to be a disguised sale (Callloway, (2010) 135 TC No. 3. There, however, the Tax Court held that the taxpayer was liable for the accuracy related penalty under Code Sec. 6662 .
Background. Under Code Sec. 6662(a) and Code Sec. 6662(b)(2) , a 20% penalty applies for any substantial underpayment of income tax. A substantial understatement of income tax exists for an individual if the amount of the understatement exceeds the greater of 10% of the tax required to be shown on the return, or $5,000. ( Code Sec. 6662(d)(1) ) The accuracy-related penalty under Code Sec. 6662(a) doesn’t apply, however, to any portion of an underpayment if a taxpayer shows that there was reasonable cause for it, and that the taxpayer acted in good faith with respect to that portion. ( Code Sec. 6664(c)(1) , Reg. § 1.6664-4(a) ) In determining reasonable cause, pertinent facts and circumstances include the taxpayer’s efforts to assess his proper tax liability, the taxpayer’s knowledge and experience and the reliance on the advice of a professional in determining whether the taxpayer acted with reasonable cause and in good faith. ( Reg. § 1.6664-4(b)(1) )
Facts. Cecelia Shao joined a software company called Veritas at the height of the dot-com boom and received shares in the company after each merit increase. Lacking experience with stocks, she opened an account with E*trade to administer her stock grants. Shao accumulated a large number of Veritas shares and saw them as a source of retirement funds, but she needed cash for immediate needs and began looking for ways to unlock the shares’ value without selling. Her certified financial planner suggested a margin loan with E*trade, but she wanted other options to raise cash to buy a home. Shao’s planner suggested that she enter into a loan program with a company called Derivium. The terms of the 2001 agreement characterized the transaction as a 3-year loan of 90% of the value of the stock pledged as collateral. The terms of the agreement allowed Derivium to sell the stock, which it did immediately upon receipt The loan’s terms were as follows: nonrecourse as to borrower (recourse against collateral only); dividends to be received as cash payments against interest due, with balance of interest owed to accrue until maturity date; noncallable before maturity; no prepayment allowed before maturity; interest at 10.5% compounded annually; balloon payment at loan maturity equal to the loan principal plus accrued interest. Derivium, which engaged in some 1,700 similar transactions involving approximately $1 billion, boasted to its potential clients that it could make the loans because it had a sophisticated hedging strategy.
Shao believe the only difference between Derivium’s deal and her E*trade margin account was that she wasn’t subject to margin calls with Derivium. Consistent with Shao’s understanding of the transaction, her planner prepared Shao’s 2001 tax return without reporting a sale of the Veritas stock. Shao never received a Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, for the sale of the securities, nor a Form 1099-C, Cancellation of Debt, and didn’t withhold any information from her planner.
After a wave of lawsuits against it, and IRS’s investigation of it as an abusive tax shelter, Derivium filed for bankruptcy in 2005. As the bankruptcy went forward, the trustee uncovered what he deemed a Ponzi scheme.
In 2005, IRS contested Shao’s characterization of the Derivium transaction as a loan and also hit her with a 20% substantial underpayment penalty under Code Sec. 6662 .
Earlier this year, the Tax Court held that a substantially similar Derivium transaction was a sale rather than a loan (Callloway, (2010) 135 TC No. 3. In that case, the Tax Court said the taxpayer was liable for the accuracy related penalty under Code Sec. 6662 because he didn’t act with reasonable cause and in good faith because he didn’t report the transaction on his returns consistent with his characterization of it. He couldn’t avoid liability for the penalty by showing reliance on a competent professional adviser (i.e., his financial adviser) because he made no effort to establish that adviser’s credentials or qualifications nor did he establish whether the adviser had any connection to Derivium. He also should not have relied on a memo about another transaction written by a person claiming to be a certified public accountant to Derivium’s president.
Tax Court’s decision. The Tax Court held that Shao did sell her Veritas stock in 2001, triggering capital gain she should have reported. However, the Court said he wasn’t liable for the Code Sec. 6662(a) accuracy-related penalty for not reporting the sale on her 2001 tax return.
In deciding whether Shao acted with reasonable cause and in good faith under Reg. § 1.6664-4(a) , the Tax Court said it had to consider all the facts and circumstances, including the experience, knowledge, and education of the taxpayer. Although Shao had a college degree, it was in cultural anthropology and she didn’t have any investing experience before being hired at Veritas. When she entered into both of her stock transactions (the E*trade margin loan and the Derivium transaction) she did so only after consulting a certified financial planner. Shao herself began hiring tax professionals to prepare her returns as soon as she started getting stock options. When she entered the Derivium transaction the only stock loan she had ever entered into was her E*trade margin loan, which she believed was similar to the Derivium transaction and whose legitimacy had never been questioned.
Under Reg. § 1.6664-4(a) , to find good faith and reasonable cause “the most important factor is the extent of the taxpayer’s effort to assess the taxpayer’s proper tax liability.” Shao sought financial advice from a trusted certified financial planner before entering the deal and also hired her to prepare the related tax returns. The returns were consistent with Shao’s understanding of the transaction and consistent with the information returns she received from third parties because she didn’t get a Form 1099-B or 1099-C showing a sale of the stock or cancellation of debt. The Tax Court also said it was inappropriate to penalize taxpayers where a mistake of law was in a complicated subject area without clear guidance.
The Tax Court held Shao had legitimate, nontax motivations for wanting to structure her deal as a loan instead of a sale—she wanted to reduce risk and use some of the stocks’ value without selling her nest egg. In essence, the Court said she may have been naïve, but not negligent. Unlike the taxpayer in Calloway, Shao treated her transaction like a loan throughout its existence, proving her good faith. As a result, the Tax Court held that Shao acted in good faith on an honest misunderstanding of the law that was reasonable in her circumstances.