REVISED, April 16, 1998
UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT
_________________________
96-60443
__________________________
TRACY P. STREBER,
TERESA P. DELONEY,
STEPHEN J. DAVIS,
Defendant-Appellants,
versus
COMMISSIONER OF INTERNAL REVENUE,
Plaintiff-Appellee.
_________________________________________________________________
Appeals from the United States Tax Court
_________________________________________________________________
April 15, 1998
Before KING, JONES, Circuit Judges, and KENDALL,1 District Judge.
JONES, Circuit Judge:
Two sisters were about 20 and 25 years old when they
received over a million dollars each, and they hired a lawyer to
advise them on potential tax liability. The Commissioner charged
them with negligence and substantial understatement penalties2 for
1
District Judge of the Northern District of Texas, sitting by
designation.
2
I.R.C. § 6653(a), which has been amended following the
commencement of this action, provided for additions to tax on
account of negligence or intentional disregard of rules or
regulations. I.R.C. § 6661(a), which has since been repealed,
provided, during the years at issue, for an addition to tax in the
case of an underpayment due to a substantial understatement.
treating the money as a gift even though they followed one
alternative course recommended by the tax lawyer and even though
the Commissioner herself relied on their theory in asserting tax
liability of the girls’ father.3 Under these circumstances, the
Tax Court’s imposition of the penalties was clearly erroneous. The
Tax Court also erred in holding that Teresa’s ex-husband
procedurally defaulted his case. We REVERSE.
I. BACKGROUND
The underlying facts are simplified for present purposes.
In 1979, Larry Parker, the girls’ father, acquired an interest in
440 acres of undeveloped land known as Northgate Forest Property.
At least part of Parker’s interest in this joint venture was held
on behalf of his daughters, Teresa Deloney and Tracy Streber, who
were then aged nineteen and fourteen. On March 4, 1981, two
promissory notes in the amount of $2,000,000 each for sale of the
land were endorsed, one to Teresa and the other one to Teresa as
custodian for Tracy who was still a minor. Both notes were due and
payable on March 4, 1985. Neither Teresa nor Tracy was involved in
negotiating the terms of the agreement.
At some point, Parker and his then-wife, the sisters’
mother, divorced.
When the notes were not paid on the due date, Parker,
Teresa, Tracy, and other interested parties filed a suit against
3
On appeal, the daughters do not, however, contest liability
for the base amount of tax.
2
the makers of the notes. On April 23, 1985, the suit was settled,
and Teresa and Tracy received eighty-five percent of the face value
of the notes, i.e., $1,700,000 apiece.
Within a few weeks, Teresa and Tracy met with attorney
Edwin Hunter to discuss the tax consequences of their income from
the joint venture. Hunter provided Teresa and Tracy with two basic
alternatives: (1) pay capital gains tax on the income they
received; or (2) treat the income as a gift from Parker, who would
then be liable for any taxes due on receipt of the money.
Teresa and Tracy chose the latter option. Neither
Teresa, who filed a joint return with her then-husband Stephen
Davis, nor Tracy reported receipt of the joint venture income on
their 1985 tax returns. Parker did not report the receipt of the
income either.
On October 22, 1991, the Commissioner issued statutory
notices of deficiency to Tracy, Teresa, and Stephen for 1985,
stating that Tracy and Teresa should have included the joint
venture income they received in their 1985 income. All three filed
petitions for redetermination of the deficiency in the Tax Court.
Contemporaneously, the Commissioner, in order to avoid a
“whipsaw” situation, also issued a statutory notice of deficiency
against Parker and his wife for 1985. The notice of deficiency was
based on the determination that the Parkers should have included in
their 1985 income tax return the joint venture income that was paid
3
to Teresa and Tracy. Parker and his wife filed a petition for
redetermination of the deficiency in the Tax Court.
Upon a motion by the Commissioner, the Tax Court
consolidated all three cases for trial. The Commissioner averred
that either the Parkers or Teresa and Tracy were liable for the
tax, but not both.
The Tax Court found no deficiency in Parker’s 1985
income. Instead, the court found that Parker made a gift to his
daughters in 1980, and, therefore, Tracy and Teresa were liable for
the taxes on the joint venture income received in 1985. The court
also sustained the Commissioner’s determination of additions to tax
for negligence and substantial understatement against Tracy and
Teresa. Finally, the Tax Court found that Davis had failed to
prosecute his case and held him in default.
Teresa and Tracy filed a motion for reconsideration of
the decisions concerning only the additions to tax. They argued
that their actions were based on substantial authority and were
reasonable and in good faith. Moreover, they maintained that their
decision to treat the money as a gift from Parker was based on the
advice they had received from counsel. Davis moved for
reconsideration, claiming it was wrong for the court to have held
him in default. The Tax Court vacated its decision in order to
consider these motions.
Upon reconsideration, the Tax Court held that the
sisters’ assertion that there was substantial legal and factual
4
justification for their failure to report the joint venture income
was not sufficient to convince the court to change its
determination that the addition to tax should apply. The Court did
not believe that Tracy and Teresa “relied on an expert’s advice.”
The Tax Court found:
Movants met with an attorney, Edwin K. Hunter
(Hunter), who, based on the facts as he knew
them, explained to movants alternative tax
reporting positions. However, we do not find
that Hunter advised movants that they did not
have to report the gains in question. The
testimony on that point is ambiguous. Hunter,
however, was one of the movant’s attorneys and
was present throughout the trial. Hunter no
doubt could have resolved any ambiguity as to
what he advised movants. Nevertheless,
movants did not call Hunter as a witness. Our
rules do not preclude Hunter from testifying.
We infer from Hunter’s failure to testify that
his testimony would have been adverse to
movants. Movants cannot claim that, based on
expert advice, they acted with due care, or as
a reasonable and ordinarily prudent person
would act, in the circumstances.
The Tax Court also rejected Davis’s claim, holding that
Davis had a full opportunity to participate at the trial and did
not do so on his own account, although he participated in the
proceedings as a witness.
Tracy and Teresa now appeal. They contend that the Tax
Court erred in sustaining the Commissioner’s assessment of the
negligence and substantial understatement penalties. They argue
that they reasonably relied on the advice they received from their
attorney, and that reliance is not nullified under the factual
circumstances of this case where the taxpayers choose one of the
5
alternatives their advisor recommends.4 Davis filed a separate
appeal making the same claim and also arguing that the Tax Court
abused its discretion in holding him in default.
II. ANALYSIS
A. NEGLIGENCE PENALTY
This court reviews the tax court’s findings of negligence
under the clearly erroneous rule. See Sandvall v. Commissioner,
898 F.2d 455, 459 (5th Cir. 1990). Clear error exists when this
court is left with the definite and firm conviction that a mistake
has been made. See Chamberlain v. Commissioner, 66 F.3d 729, 732
(5th Cir. 1995).
“The IRS may penalize taxpayers for an underpayment due
to negligence or disregard of rules and regulations. Negligence
includes any failure to reasonably attempt to comply with the tax
code, including the lack of due care or the failure to do what a
reasonable or ordinarily prudent person would do under the
circumstances. ‘Disregard’ includes careless, reckless, or
intentional conduct.” Heasley v. Commissioner, 902 F.2d 380, 383
(5th Cir. 1990) (citations omitted).
The relevant inquiry for the imposition of a negligence
penalty is whether the taxpayer acted reasonably. See Reser v.
Commissioner, 112 F.3d 1258, 1271 (5th Cir. 1995). “Taxpayers may
not rely on someone with a conflict of interest or someone with no
4
Edwin K. Hunter, appellant’s counsel of record before the tax
court, filed an amicus curiae brief.
6
knowledge concerning the matter upon which the advice is given.”
Chamberlain, 66 F.3d at 732. “Good faith reliance on professional
advice concerning tax laws is a defense.” Durrett v. Commissioner,
71 F.3d 515, 518 (5th Cir. 1996).
In this case we find that the Tax Court clearly erred
when it sustained the Commissioner’s assessment of a negligence
penalty, because appellants reasonably relied on the advice they
received from their attorney, Edwin Hunter.
Due care does not require young, unsophisticated
individuals to independently examine their tax liabilities after
taking the reasonably prudent step of securing advice from a tax
attorney.5 At relatively tender ages, the appellants received
large sums of money. Tracy Streber testified that she and her
sister came to the conclusion that they had to seek advice from an
attorney to make sure they did “the legal thing.” As she
explained:
It was just known that when you get money like
that, some kind of tax had to be paid and we
didn’t know what it was, so we went to get
counseled.
. . . .
I knew that is why you had to go to a tax
person.
5
Cf. Heasley v. Commissioner, 902 F.2d 380, 383 (5th Cir.
1990) (“[D]ue care does not require moderate-income investors . .
. to independently investigate their investments. They may rely on
the expertise of their financial advisors and accountants . . .
.”).
7
Given their level of understanding in these matters, the appellants
took the appropriate steps to secure legal advice from attorney
Edwin Hunter to ensure that their tax returns for the upcoming year
complied with the law. Not only Tracy Streber, but also Davis and
Betty Berwick (Tracy and Teresa’s mother, and Larry Parker’s first
wife) testified that the purpose of seeking legal advice was to
understand the tax consequences of their income from the joint
venture and to ensure that any position they took was on sound
legal footing.
Hunter advised appellants that they could either treat
the joint venture income as a capital gain or as a gift from
Parker. Relying on Hunter’s opinion, the appellants chose to treat
the joint venture income as a gift. Due care does not require that
the appellants challenge their attorney’s opinion or independently
investigate the propriety of his advice. See Chamberlain, 66 F.3d
at 733. As the Supreme Court held:
When an accountant or attorney advises a
taxpayer on a matter of tax law, such as
whether liability exists, it is reasonable for
the taxpayer to rely on that advice. Most
taxpayers are not competent to discern error
in the substantive advice of an accountant or
attorney. To require the taxpayer to
challenge an attorney, to seek a “second
opinion,” or to try to monitor counsel on the
provisions of the Code himself would nullify
the very purpose of seeking the advice of a
presumed expert in the first place. “Ordinary
business care and prudence” do not demand such
actions.
United States v. Boyle, 469 U.S. 241, 251, 105 S. Ct. 687, 692-93
(1985) (citation omitted). Having done no less than reasonable
8
prudence demands, the appellants should not be held negligent in
their treatment of the joint venture income.
The I.R.S. asserts that the Tax Court found that Hunter
never advised them “that they did not have to report the gains in
question.” This conclusion, however, is contrary to the
overwhelming weight of the evidence, which supports the proposition
Hunter did in fact tell the appellants that they should treat the
joint venture income as a gift from Parker.
First, according to the witnesses, Hunter advised his
clients to select the alternative that would result in more tax
revenue for the government and would, therefore, be less likely to
receive an I.R.S. challenge. Although the position the sisters
ultimately adopted meant that they would not be personally liable
for tax on their joint venture income, when Hunter was rendering
his advice, the appellants were concerned over the way in which the
I.R.S. might have viewed a decision that would have resulted in
less tax liability for their father than other positions would have
required. The appellants were worried that Parker’s own rather
questionable practices might make them more susceptible to a
government audit and possible penalties if they took anything less
than a careful tax position in this case. Tracy Streber testified
about the appellants’ choice to treat the joint venture income as
a gift: “We didn’t want to defraud the government. We didn’t want
them to think we were in cahoots or whatever with my father, to
defraud them.” Because the gift tax rate was higher than the
9
capital gains tax rate, Hunter stated that the I.R.S. might view
the appellants’ decision to treat the joint venture income as a
capital gain as an attempt to conspire with Parker to limit his tax
liability and the tax liability for all the family members.6
Second, the evidence shows that Hunter actively supported
his clients’ position to treat the joint venture income as a gift.
In June 1986, for example, Parker’s attorney wrote to Hunter
encouraging him to reconsider Hunter’s filing of the appellants’
amended tax returns, which “reflect[ed] their receipt of certain
income as a gift from their father.”7 A month earlier, Hunter
participated in his clients’ efforts to notify the I.R.S. of the
possible deficiencies in Parker’s 1985 tax return.8 Given the
substantial risks associated with voluntarily reporting to the
I.R.S. in this case, it is hard to understand how the Tax Court
could have concluded that Hunter would have advised the appellants
to take any position other than the one they adopted in this
matter. Although the appellants understood that by informing the
agency they might receive a financial reward from the government if
the information proved useful, they must also have understood that
6
Davis testified that Hunter explained that if they were to
choose to treat the joint venture income as a capital gain, it was
very likely that the I.R.S. would maintain that they “still have a
liability as far as owing tax on the money.”
7
Letter from David S. Gamble, Attorney to Larry Parker, to
Edwin K. Hunter 1 (June 25, 1986).
8
See Memorandum of Interview, Internal Revenue Service (May 9,
1986) (noting the presence of Edward K. Hunter, Attorney for
Informants, Teresa Davis and Stephen Davis).
10
this action would highlight their own tax returns for scrutiny.9
The decision to inform on Parker to the I.R.S. not only placed the
appellants at personal risk of a government audit, but it also
placed Hunter’s professional judgment and reputation under review.
In the face of this risk, Hunter actively promoted his clients’ tax
position. It is impossible to reconcile Hunter’s later actions
with the Tax Court finding that his initial tax advice to the
sisters was “ambiguous” or that he did not actually recommend
treating the joint venture income as a gift.10
The I.R.S. also contends that Tracy and Teresa did not in
fact rely on Hunter’s advice, propounded in alternatives, because
they made the “ultimate decision” not to report the income from the
joint venture on their tax returns. I.R.S. does not dispute that
the legal advisor here offered several possibilities and discussed
the tax ramifications of each.11 IRS contends, however, that
9
The Evaluation Report on Claim for Reward makes clear that
the information provided to the I.R.S. had substantial value,
because otherwise Parker’s 1985 tax return would not have been
audited.
10
The dissent does not even mention the correspondence between
Hunter and Parker’s attorney, which has to be premised on Hunter’s
advice that the income the girls received was a gift. The dissent,
like the Tax Court, casts no doubt on the veracity of Berwick’s and
Davis’s testimony about Hunter’s advice. Finally, the dissent
unnecessarily flays Hunter over a subsequent legal malpractice
action the girls have pending against him. The lawsuit is
irrelevant to the question of their lack of negligence and due
diligence, at least in a case such as this, where the advice he
gave -- that there was a gift -- was sound enough to be the basis
of one of I.R.S.’s alternative positions.
11
The dissent goes even further than the Tax Court did in
implying that Tracy and Teresa decided on their own not to report
11
because the Tax Court found he did not affirmatively recommend a
preferred course of action, which the taxpayers followed, the
reliance on counsel defense is unavailable. We need not reach this
conclusion because, overruling the Tax Court’s erroneous findings,
we find that Hunter did in fact affirmatively advise and vigorously
assist taxpayers’ chosen course of action. But even if the Tax
Court’s findings here are accurate, unless circumstances show that
a tax advisor discussed and discounted alternative tax strategies,
the taxpayers should ordinarily not be held negligent for following
any of the bona fide alternatives developed by an advisor
acquainted with the relevant facts. To find otherwise adds a new
requirement to the reliance on counsel defense: not only must the
taxpayer show that his advisor discussed how to treat a tax-related
transaction, he must also show that the advisor ranked any
alternatives hierarchically, and he (the taxpayer) adopted
whichever alternative was at the top of the list. Otherwise, the
advisor’s recommendation in a situation where bona fide alternative
tax strategies exist will be found “ambiguous” and cannot furnish
the basis for a taxpayer’s reasonable reliance. If this proffered
method of analysis is not simply a semantical quibble designed to
determine the outcome of this case, it drives a mischievous wedge
the income from the notes. First, the dissent does not concede, as
IRS does, that Hunter advised the girls of alternative tax
treatments of the income. Second, the dissent accuses the girls of
not furnishing Hunter with appropriate documentation, but neither
IRS nor the Tax Court mentioned this sort of problem, which is not
inferable from any of the Tax Court’s findings.
12
between advisors and taxpayers. Advisors will be deterred from
recommending alternative tax strategies, and clients will be
discouraged from seeking any but the most tax-advantageous advice.
The I.R.S. finally emphasizes that the Tax Court ruled
against the appellants because the court did not find Tracy Streber
and Teresa Deloney to be credible. The Tax Court gave their
testimony and answers “little weight.” Moreover, in its opinion on
reconsideration, the Tax Court noted that Hunter could have
testified on behalf of the appellants to clear up any ambiguity
that might have existed over whether he, in fact, advised them to
treat the joint venture income as a gift from Parker. Because the
appellants chose not to call him as a witness, the court inferred,
his testimony would have been adverse to their position. This
reasoning is unpersuasive.
In general, a court may draw a negative inference from a
party’s failure to produce a witness “whose testimony would
elucidate the transaction.” Graves v. United States, 150 U.S. 118,
121, 14 S. Ct. 40, 41 (1893). The strength of the inference “is
rooted in notions of common sense[,] . . . will vary with the facts
of each case,” United States v. Tucker, 552 F.2d 202, 210 (7th
Cir. 1977), and may be drawn only where a witness has information
“peculiarly within his knowledge,” McKay v. Commissioner, 886 F.2d
1237, 1238 (9th Cir. 1989) (citing Wichita Terminal Elevator Co. v.
Commissioner, 6 T.C. 1158, 1165 (1946)). Thus, a party need not
call a witness whose testimony would be cumulative “without any
13
apprehension” that a court will draw a negative inference.” 2 John
Henry Wigmore, Evidence § 287, at 202-03 (Chadbourne rev. 1979).12
In this case, the tax court examined the evidence of four
witnesses who were privy to Hunter’s conversation with his clients.
These witnesses, Teresa, Tracy, Davis, and Berwick, all testified
that Hunter advised his clients that they could either pay capital
gains tax on the income they received or treat the income as a gift
from Parker. Even assuming that Teresa and Tracy were not
credible, the Tax Court never referred to the testimony of Davis
and Berwick, who each confirmed that Hunter did advise his clients
to treat the joint venture income as a gift from Parker. Davis
said that Hunter “felt from . . . hearing the case and the
documents -- he felt that it was a gift.” When Berwick was asked
why the appellants chose to treat the income as a gift, she
answered: “Because Mr. Hunter told them that in his opinion, that
was the correct one.” Contrary to this testimony, which the Tax
Court neither questioned nor commented upon, the court still held
that it could not find that “Hunter advised [appellants] that they
did not have to report the gains in question.” Once again, even
12
“In general, put somewhat more strongly, there is a general
limitation . . . that the inference cannot fairly be drawn except
from the nonproduction of witnesses whose testimony would be
superior in respect to the fact to be proved.” 2 Wigmore § 287, at
203. Two witnesses -- Berwick and Davis -- whose credibility went
unchallenged by the I.R.S. were present during the meeting in which
Hunter rendered his advice. Under these circumstances, Hunter’s
hypothetical testimony could not fairly be characterized as
superior to that of these other witnesses. Their testimony of what
they heard Hunter say is not a priori inferior to Hunter’s possible
testimony of what he remembers advising to his clients.
14
assuming Tracy Streber and Teresa Deloney were not credible, at
least two other witnesses independently supported the position that
Hunter had advised his clients to treat the joint venture income as
a gift from Parker. This testimony was uncontradicted. Moreover,
because Hunter’s testimony would have been cumulative, and maybe
counterproductive -- focusing attention away from the primary issue
of whether his clients were liable in the first place -- and
because the subject of Hunter’s advice was not peculiarly within
his knowledge, see McKay, 886 F.2d at 1238, the tax court erred
when it drew an inference adverse to the appellants. To hold
otherwise would in essence require the attorney to testify in all
cases involving an advice of counsel defense.
After reviewing the record, “we are left with the
definite and firm conviction that a mistake has been made.”
Chamberlain, 66 F.3d at 732. The appellants did rely on their
attorney’s advice when they elected to treat the joint venture
income as a gift from Parker. Furthermore, given the appellants’
relative youth and inexperience in business matters, they acted
with all the care a reasonably prudent person would exercise under
similar circumstances. See Reser, 112 F.3d at 1271. Our laws
demand nothing more. Thus, we hold that the Tax Court clearly
erred when it sustained the imposition of negligence penalties
against the appellants.
15
B. SUBSTANTIAL UNDERSTATEMENT PENALTY
The second issue before this court is whether the Tax
Court abused its discretion when it held appellants liable for the
addition to tax for substantial understatement, pursuant to I.R.C.
§ 6661(a). See Heasley v. Commissioner, 902 F.2d 380, 385 (5th
Cir. 1990). Section 6661 provides for an addition to tax equal to
twenty-five percent of the amount of any underpayment attributable
to a substantial understatement of tax. If a taxpayer is able to
show that there was a reasonable cause for the understatement and
good faith, which may stem from reasonable reliance on the advice
of professional, the I.R.S. may waive the understatement penalty.
See Heasley, 902 F.2d 384-85; see also Reser v. Commissioner, 112
F.3d 1258, 1271-72 (5th Cir. 1997).
First, as has been noted, the appellants reasonably
relied on the advice they received from their attorney. I.R.S.
acknowledges that “the extent of the taxpayer’s effort to assess
her proper tax liability under the law is the most important
factor” in determining reasonable cause and good faith. Heasley,
905 F.2d at 385. Because of appellants’ youth and inexperience in
business, reliance on counsel, and proof of “good faith” in their
position by reporting the transaction to the Service as to their
father’s potential liability, the conclusions this court reached in
Heasley are controlling:
Applying the I.R.S.’s own regulatory
standards, we find that the I.R.S. abused its
discretion by failing to waive the penalty in
this case. We are at a loss to determine just
16
what the I.R.S. would find to be a reasonable
cause given the Heasleys’ experience,
knowledge, and education. First, the Heasleys
attempted to assess their proper tax liability
by taking their taxes to a C.P.A., something
they never did before. The accountant found
no problem with the plan. While Danner
suggested that the Heasleys use Smith, nothing
else in the record connects the two.
Therefore, considering this “most important
factor,” the Heasleys showed reasonable cause
and good faith. Second, the Heasleys read the
portions of the prospectus and other O.E.C.
materials and relied on Danner to explain the
rest. If neither Danner nor their C.P.A.
found anything wrong with the investment, how
could the Heasleys? Certainly, their failure
to out-guess their financial advisor and
accountant is not negligence. Finally, the
Heasleys believed that they legitimately
claimed the deduction and investment tax
credit. Given the Heasleys’ inexperience and
limited knowledge about investing, and their
level of education, their misunderstanding is
reasonable. The I.R.S. abused its discretion
by failing to waive the penalty and the tax
court erred by upholding the I.R.S.’s
decision.
Id.
Second, I.R.S. too narrowly interprets the meaning of the
substantial authority defense on which appellants rely to defeat
this penalty.13 This case turned on one factual issue: when Parker
made the gift to his daughters. If the gift was made before 1985,
Tracy and Teresa are liable for the income they received in 1985;
if it was effectively made in 1985, Parker is liable. The
subsidiary facts relating to this transaction were complex, largely
13
I.R.C. § 6661(b)(2)(B)(i) provided that any “substantial”
understatement of tax “shall be” reduced “by that portion of the
understatement which is attributable to []the tax treatment of any
item . . . if there is or was substantial authority for such
treatment . . . .”
17
undisputed, and not materially affected by the Tax Court’s
assessment of the sisters’ lack of credibility. In a recent
decision, the Eleventh Circuit explained that where the substantial
authority issue turns on evidence going both ways, “there is
substantial authority from a factual standpoint for the taxpayer’s
position. Only if there was a record upon which the Government
could obtain a reversal under the clearly erroneous standard could
it be argued that from an evidentiary standpoint, there was not
substantial authority . . . .” Osteen v. Commissioner, 62 F.3d
356, 359 (11th Cir. 1995). Apart from trying to confine Osteen to
its facts, an untenable position, I.R.S. does not demonstrate how
its principle is inapt here. The government makes no effort to
assert that the only rational tax treatment of the transaction was
as a gift made before 1985.14
For these reasons, the I.R.S. abused its discretion in
failing to waive the penalty and the Tax Court erred in upholding
the I.R.S.’s decision. See Heasley, 902 F.2d at 385. It is clear
upon review of the record that the appellants had substantial
factual authority for the tax position they asserted and reasonably
relied on the advice of their attorney.
14
The dissent ignores Osteen and makes a legal argument that
neither I.R.S. nor the Tax Court did, namely, that “substantial
authority” means only legal, not factual authority.
18
C. FAILURE TO PROSECUTE
Because we have held that the sisters are not liable for
negligence and substantial understatement penalties, we need not
reach the merits of the dispute over Davis’s possible failure to
prosecute. Davis’s derivative liability for his ex-wife’s income
vitiates a default judgment. The Tax Court decision holding the
appellant in default for failure to prosecute his case is reversed.
CONCLUSION
These appellants are not liable for negligence and
substantial understatement penalties from their decision to treat
the joint venture income as a gift. The decision of the Tax Court
is REVERSED.
ENDRECORD
19
KING, Circuit Judge, dissenting:
In reversing the judgment of the tax court, the majority errs
on two levels. First, under the guise of a review only for clear
error, the majority rejects the tax court’s determination that the
appellants were liable for an addition to tax based upon their
negligence pursuant to former § 6653 of the Internal Revenue Code.
In so doing, the majority exceeds its authority as an appellate
court by usurping the fact-finding function properly relegated to
the tax court. Second, the majority concludes that the tax court
erred in holding the appellants liable for an addition to tax based
upon a substantial understatement of their tax liability because
substantial authority within the meaning of former § 6661 of the
Internal Revenue Code existed for the tax position taken by the
appellants. In order to justify this conclusion, the majority
adopts a construction of the substantial authority standard that
fails to comport with the treasury regulations interpreting § 6661
and that strips the statute of much of its force as a deterrent of
taxpayer misconduct. I respectfully dissent.
I. Addition to Tax for Negligence
The majority improperly holds that the tax court clearly erred
in finding that the appellants acted negligently in declining to
report the joint venture income as a capital gain and that the
appellants were therefore liable for negligence penalties pursuant
to former § 6653(a) of the Internal Revenue Code. See 26 U.S.C.A.
§ 6653(a) (West 1989) (amended in 1989). Because the majority
makes no mention of the burden of proof applicable to the parties’
dispute over the negligence penalty, it is worth noting here that
the Commissioner’s determination of negligence is presumed correct
and that the taxpayer therefore bears the burden of proving the
absence of negligence. See Westbrook v. Commissioner, 68 F.3d 868,
880 (5th Cir. 1995); Sandvall v. Commissioner, 898 F.2d 455, 459
(5th Cir. 1990).
The majority concludes that the tax court erred in declining
to accept the appellants’ contention that their failure to report
the income from the joint venture on their 1985 tax returns did not
constitute negligence because they made the decision based on the
advice of counsel. In reaching this conclusion, the majority pays
lip service to the fact that, as an appellate court, our review of
the tax court’s finding of negligence is limited to a review for
clear error. See Streber v. Commissioner, ___ F.3d at ___ (5th
Cir. 1998), Majority op. at 6 (citing Sandvall, 898 F.2d at 459).
It then proceeds to conduct a thinly veiled de novo review of the
facts, reversing the tax court’s judgment regarding the negligence
penalty merely because it reaches a different factual conclusion
than that reached by the tax court. The majority’s conclusion that
“the overwhelming weight of the evidence . . . supports the
proposition [Edwin] Hunter did in fact tell the appellants that
they should treat the joint venture income as a gift from Parker,”
Streber, ___ F.3d at ___, Majority op. at 9, simply cannot
withstand scrutiny.
21
First, the majority points to the testimony of Tracy Streber,
Teresa Deloney (by affidavit and deposition), Betty Berwick, and
Steve Davis as establishing that Hunter told the appellants that
they should treat the joint venture income as a gift. Credibility
assessments regarding this testimony were exclusively within the
province of the tax court, as it was the trier of fact. See
Durrett v. Commissioner, 71 F.3d 515, 517 (5th Cir. 1996). The tax
court explicitly concluded that it “did not find [Tracy and Teresa]
to be credible witnesses” and therefore accorded their testimony
“little weight.” While it is not our place as an appellate court
to strictly scrutinize the tax court’s credibility determinations,
it is worth noting that the court had every reason to make the
credibility assessments that it did in this case.
Tracy’s testimony at trial was exceptionally vague and riddled
with lapses of memory. For example, when asked by the court what
advice Hunter had given Tracy and her sister, Tracy replied as
follows: “I don’t--well, there was this chalk talk thing, and
there was--and ultimately it was, well it was a gift. And we--you
know, that is--so your dad owes the tax.” When answering a number
of related questions posed by the court regarding the sisters’
meeting with Hunter, Tracy responded that she could not remember or
did not know. The tax court could properly decline to credit
Tracy’s testimony. See id.; see also MacGuire v. Commissioner, 450
F.2d 1239, 1244 (5th Cir. 1971) (“‘The Tax Court not only may, but
should, base its findings on the testimony it believes to be true,
22
rejecting after due consideration that which it believes is
false.’” (quoting Boyett v. Commissioner, 204 F.2d 205, 208 (5th
Cir. 1953))).
The tax court concluded that Teresa, whose affidavit and
deposition were entered into evidence, had “failed to tell the
truth” in “various important respects.” The court specifically
concluded that Teresa had previously misrepresented her involvement
in reporting her father’s alleged understatement of his tax
liability to the IRS. In response to interrogatories sent to her
in the discovery phase of the trial, Teresa made the following
statement:
I never gave advice to the Internal Revenue Service about
shortcomings in the income tax returns filed by Larry and
Martha [Parker] for 1985, nor do I have personal
knowledge that any relative or counsel did so.
When later asked in deposition whether she provided the IRS with
any communication regarding her father’s tax liability, she stated
that she did not remember making such a communication. When asked
if she had heard of anyone else making such a communication, she
stated that she “ha[d] heard” during the pretrial proceedings
“[t]hat it was done.” When asked by whom, she responded “by myself
and my husband through our attorney.” When asked in a later
deposition session what this earlier statement meant, Teresa
responded, “It means that all I have heard in these proceedings is
that--that Steve and I were supposedly the informants, but I have
no knowledge of who informed, when it was done. I did not do it.
He did not do it.” A reward application bearing Teresa’s signature
23
and containing information regarding her father’s tax liability was
filed with the IRS and entered into evidence. Additionally, an IRS
memorandum reciting that Teresa was in attendance at a meeting with
an IRS special agent in 1986 at which she provided information
relating to her father’s 1985 tax return was also entered into
evidence. Based on its conclusion that Teresa had testified
falsely about her involvement in informing on her father to the
IRS, the tax court had every right to infer that Teresa had also
testified falsely about the advice that she received from Hunter
and her reliance on it. See Toussaint v. Commissioner, 743 F.2d
309, 312 (5th Cir. 1984) (concluding that the tax court could
properly infer that the taxpayer had testified falsely about a
particular matter based on the taxpayer’s false testimony regarding
a related matter).
The majority also notes that two other witnesses--Berwick and
Davis--indicated that Hunter felt that Tracy and Teresa could
legally treat the joint venture income as a gift from their father
and decline to report it as a capital gain. As noted earlier, the
tax court had the exclusive authority to make credibility
assessments regarding this testimony. More importantly, however,
none of the witnesses established that Tracy and Teresa provided
Hunter with all of the information relevant to an informed
determination of the appropriate tax treatment of the joint venture
income.
24
In order to take advantage of the defense to negligence
penalties provided by good-faith reliance on the advice of counsel,
a taxpayer must prove that the advice of counsel allegedly relied
upon was “based on knowledge of all the facts” relevant to the
advice given. See Leonhart v. Commissioner, 414 F.2d 749, 750 (4th
Cir. 1969), cited with approval in Heasley v. Commissioner, 902
F.2d 380, 383-84 n.8 (5th Cir. 1990). The taxpayers did not meet
this burden here.
Tracy testified at trial that she did not provide Hunter with
any documents relating to the joint venture and that she could not
remember whether anyone else provided Hunter with any such
documents. Teresa’s affidavit states that she and Davis “provided
Mr. Hunter numerous documents [they] believed relevant to this
situation and other legal matters [they] were discussing with him,”
but does not specify the exact nature of those documents. Davis
testified that Teresa provided Hunter with some documents, but was
vague as to their contents. When asked what kind of documents
Teresa provided to Hunter, Davis stated, “She had, you know,
documents how the deal--you know, wasn’t a lot of documents, but
she did have some as far as the deal--land deal . . . .” As to
what Hunter was told at the meeting with the sisters, Tracy
testified that she “[could] only speculate” about what she had told
Hunter and that she “[could not] speak for [her] sister.” Such
testimony fails to establish that Hunter knew all of the facts
relevant to a determination of whether the joint venture income
25
constituted a gift and therefore fails to establish that Tracy and
Teresa did not act negligently.
The majority next concludes that, in light of the fact that
Hunter assisted the appellants in reporting on Parker to the IRS,
thereby subjecting them to heightened scrutiny regarding their
treatment of the joint venture income, “it is hard to understand
how the Tax Court could have concluded that Hunter would have
advised the appellants to take any position other than the one they
adopted in this matter.” Streber, ___ F.3d at ___, Majority op. at
10. This analysis is problematic on two levels. First, the
majority takes it upon itself to theorize about the cost-benefit
analysis that the appellants conducted in weighing the cost of
reporting to the IRS and thereby increasing their risks of an audit
against the benefit of a potential cash reward for providing the
IRS with what the majority acknowledges was information of
“substantial value.” Id. at ___, Majority op. at 11 n.9. Second,
based on an assumption that Hunter provided the appellants with
sound advice regarding the risks of heightened IRS scrutiny that
would flow from reporting on Parker, the majority concludes that
Hunter must have provided advice regarding the appropriate
treatment of the joint venture income that, at least in the view of
the appellants, was so unsound that it constituted legal
malpractice.15
15
The appellants have filed a legal malpractice action
against Hunter, the law firm where he is employed, and other
attorneys related to Hunter’s alleged advice that they treat the
26
The majority also concludes that the tax court erred in
drawing a negative inference from the fact that Hunter did not
testify at the trial. In support of this conclusion, the majority
states that, unless a potential witness has information “peculiarly
within his knowledge,” a party should feel free not to produce the
potential witness “‘without any apprehension’ that a court will
draw a negative inference.” Streber, ___ F.3d at ___, Majority op.
at 13-14. (quoting McKay v. Commissioner, 886 F.2d 1237, 1238 (9th
Cir. 1989), and JOHN HENRY WIGMORE, EVIDENCE § 287, at 202-03 (Chadbourn
rev. 1979)). The legal authority that the majority cites for this
proposition fails to bear it out.
First, McKay does not stand for the proposition that the trier
of fact may draw a negative inference from a party’s failure to
produce a witness only when that witness possesses information
peculiarly within his knowledge. The sentence containing the
passage quoted by the majority states the following: “Moreover,
petitioner declined to testify and since the fact at issue was
peculiarly within his knowledge, the court properly concluded his
testimony would be unfavorable to him . . . .” McKay, 886 F.2d at
1238. The most that one can glean from this passage is that the
Ninth Circuit has concluded that a scenario in which a party
declines to produce a witness to present testimony peculiarly
within the witness’s knowledge constitutes one circumstance in
which the fact-finder may properly infer that the witness’s
joint venture income as a gift for tax purposes.
27
testimony would be unfavorable to the party. In no sense does the
Ninth Circuit’s language preclude the existence of other such
circumstances.
Second, Wigmore does not support the evidentiary rule
advocated by the majority. In the passage cited by the majority,
Wigmore states the general rule regarding when the trier of fact
may draw negative inferences from a party’s failure to produce a
witness within his control as follows:
[T]here is a general limitation (depending for its
application on the facts of each case) that the inference
[that a witness would testify in a manner unfavorable to
the party that declines to produce him] cannot fairly be
drawn except from the nonproduction of witnesses whose
testimony would be superior in respect to the fact to be
proved.
WIGMORE, supra, § 287, at 203. One can hardly doubt that the
testimony of Hunter--the purveyor of the legal advice at issue
here--regarding the substance of that advice would have been in
some sense superior to that of the witnesses who testified
regarding the matter. Indeed, given the vague and conclusory
nature of the testimony of the witnesses at trial regarding
Hunter’s advice and Tracy’s substantial lapse of memory as to its
substance, one might even conclude that the details of that advice
were peculiarly within Hunter’s knowledge.
More importantly, however, in the same paragraph quoted by the
majority, Wigmore goes on to say that the general limitation on the
fact-finder’s authority to draw negative inferences from a party’s
failure to produce a witness rests on “grounds of expense and
28
inconvenience” and “should not be enforced with any strictness;
otherwise it would become practically objectionable.” Id. In this
case, the expense and inconvenience of placing Hunter on the
witness stand would have been negligible. Not only was he
available to the appellants, he was in the court room throughout
the trial. Furthermore, the tax court found--and the appellants do
not dispute--that the Tax Court Rules of Practice and Procedure
would have allowed Hunter to testify without disqualification. See
26 U.S.C. foll. § 7453 R. 24(f).
The majority also contends that a conclusion that the tax
court could properly draw a negative inference from Hunter’s
failure to testify “would in essence require the attorney to
testify in all cases involving an advice of counsel defense.”
Streber, ___ F.3d at ___, Majority op. at 15. This is simply not
true. Allowing the tax court to draw such an inference does not
imply that the testimony of counsel is necessary to establish a
viable advice of counsel defense. It does not imply that the court
must draw such an inference or that, when the court does draw such
an inference, it is foreclosed from concluding that the other
evidence in the record nonetheless establishes that the taxpayer
reasonably relied on the advice of counsel.
In sum, given (1) the tax court’s exclusive power to make
credibility assessments regarding the witnesses at trial, (2) the
paucity of evidence regarding what information Hunter had when he
gave the advice at issue here, and (3) the tax court’s discretion
29
to draw a negative inference from Hunter’s failure to testify, the
tax court had ample basis on this factual record for concluding
that the appellants did not bear their burden of proving that they
were shielded from liability for negligence by good-faith reliance
on the advice of counsel. As an appellate court, our inquiry
properly ends there.
II. Substantial Understatement
The majority next errs in concluding that the tax court abused
its discretion in holding the appellants liable for a substantial
understatement penalty pursuant to former § 6661 of the Internal
Revenue Code. Section 6661, repealed after the tax years at issue
in this case, provided for the imposition of a penalty based on a
taxpayer’s substantial understatement of tax liability for a
taxable year. See 26 U.S.C.A. § 6661(a) (West 1989) (repealed in
1989). The section provided that, for purposes of computing the
penalty, the amount of the taxpayer’s understatement of tax
liability is “reduced by that portion of the understatement which
is attributable to . . . the tax treatment of any item by the
taxpayer if there is or was substantial authority for such
treatment.” Id. § 6661(b)(2)(B)(i). The taxpayer bears the burden
of proving the existence of substantial authority. See Westbrook,
68 F.3d at 882.
The majority concludes that, from a factual standpoint,
substantial authority for a taxpayer’s position within the meaning
of § 6661 exists unless “‘there was a record upon which the
30
Government could obtain a reversal under the clearly erroneous
standard’” had the tax court accepted the taxpayer’s position.
Streber, ___ F.3d at ___, Majority op. at 18 (quoting Osteen v.
Commissioner, 62 F.3d 356, 359 (11th Cir. 1995)). This
construction of the substantial authority standard contravenes
§ 6661's interpretive regulations. Section 1.6661-3 of the
Treasury Regulations indicates that § 6661's substantial authority
standard does not contemplate substantial evidentiary authority.
Rather, the regulation provides an exclusive list of potential
sources of authority, all of which are legal sources, which
indicates that § 6661 contemplates only substantial legal
authority. Section 1.6661-3 provides in relevant part as follows:
Types of authority. In determining whether there is
substantial authority . . . , only the following will be
considered authority. Applicable provisions of the
Internal Revenue Code and other statutory provisions;
temporary and final regulations construing such statutes;
court cases; administrative pronouncements (including
revenue rulings and revenue procedures); tax treaties and
regulations thereunder, and Treasury Department and other
official explanations of such treaties; and Congressional
intent as reflected in committee reports, joint
explanatory statements of managers included in conference
committee reports, and floor statements made prior to
enactment by one of a bill's managers.
26 C.F.R. § 1.6661-3(b)(2) (1997) (emphasis added). Noticeably
absent from this list of potential sources of authority is any
mention of factual evidence favorable to the taxpayer’s position.
Furthermore, the majority’s construction of the substantial
authority standard implies that, in many circumstances, if a
taxpayer is able to survive summary judgment, he is shielded from
31
liability for substantial understatement penalties because
substantial authority--in the form of some evidence--supports his
tax position.16 Moreover, when a taxpayer’s entitlement to a
particular tax benefit hinges upon facts that will be elucidated by
witness testimony, the taxpayer need only lie about the facts that
would entitle him to the benefit in order to shield himself from
liability for a substantial understatement penalty resulting from
his improperly claiming the benefit. In such a circumstance, the
taxpayer’s testimony would constitute some evidence indicating his
entitlement to the benefit, and, the majority opinion in this case
notwithstanding, it is doubtful that we would be in a position on
appeal to conclude that the trial court would have clearly erred
had it credited the taxpayer’s testimony. Surely Congress did not
intend to impose such a toothless penalty for substantial
understatement of tax liability.17
16
It is true that “[a] finding is clearly erroneous when,
although some evidence supports the decision, we are ‘left with the
definite and firm conviction that a mistake has been committed.’”
United States v. Tello, 9 F.3d 1119, 1122 (5th Cir. 1993) (quoting
United States v. United States Gypsum Co., 333 U.S. 364, 395
(1948)). However, on numerous occasions, we have concluded that a
factual finding is not clearly erroneous based on an inquiry that
appears to begin and end with a determination that the record
contains some evidence supporting the factual finding. See, e.g.,
United States v. Jobe, 101 F.3d 1046, 1066 (5th Cir. 1996); Lewis
v. NLRB, 750 F.2d 1266, 1278-79 (5th Cir. 1985).
17
It is worth noting that the majority’s construction of the
substantial authority standard also provides a disincentive for
taxpayers to settle with the IRS in situations in which they are
potentially liable for substantial understatement penalties. If
the taxpayer is able to create a fact issue about which reasonable
minds could differ regarding his entitlement to a particular tax
benefit, he can avoid liability for substantial understatement
32
The majority’s erroneous construction of the substantial
authority standard is rendered even more unfortunate by the fact
that it is entirely gratuitous. The majority independently
concludes that the IRS abused its discretion by declining to waive
the substantial understatement penalty pursuant to § 6661(c)
because the appellants relied in good faith on the advice of
counsel in choosing to treat the joint venture income as a gift.
As I indicated above in my discussion of the majority’s treatment
of the tax court’s imposition of negligence penalties, the majority
errs in this regard by making an independent assessment of the
factual issue of whether the appellants truly acted in good-faith
reliance on the advice of counsel. However, the majority’s
conclusion that the appellants were entitled to waiver of the
penalty provides an independent, albeit legally unsound, basis for
its decision to reverse the tax court’s imposition of the
substantial understatement penalty. Nevertheless, the majority
proceeds to heap one legal error onto another by promulgating in
dicta a construction of the substantial authority standard that
fails to comport with the treasury regulations interpreting § 6661
and that robs the statute of much of its value as a deterrent of
taxpayer misconduct. I therefore respectfully dissent.
penalties. In some circumstances, this heightened incentive may be
sufficiently strong that it convinces the taxpayer to proceed to
trial rather than settle the dispute.
33