Prudent taxpayers analyze the relevant tax law while structuring and implementing transactions. The most obvious reason to do so is to ensure that the taxpayer’s proposed tax treatment is accepted by the Internal Revenue Service (IRS). Another reason is to ensure that, if such treatment is not accepted, the taxpayer will not be subjected to penalties.

The most common penalty asserted by the IRS in this regard is the accuracy-related penalty under IRC Section 6662. Among the many defenses to this penalty is the “substantial authority” defense, which looks at whether the weight of authorities supporting the return position is substantial in relation to the weight of authority supporting contrary treatment. The types of authorities that may be considered is broad, and includes the Internal Revenue Code, Treasury Regulations (proposed, temporary and final), other IRS published guidance, case law, tax treaties, legislative materials and certain IRS private guidance.

The U.S. Court of Appeals for the Fifth Circuit’s recent decision in Chemtech Royalty Associates, L.P. provides some guidance on how courts view the substantial authority defense. In Chemtech, the taxpayer argued that it had substantial authority for its position based on two U.S. Tax Court cases, a published Tax Court opinion from 1949 and an unpublished memorandum opinion from 1990. The Fifth Circuit found that both cases, even if not materially distinguishable, were not substantial authority because a 1989 Fifth Circuit opinion was more apposite than the two Tax Court opinions. The court also noted that the published Tax Court opinion was “old” and the memorandum opinion was “unpublished.”

The Fifth Circuit’s opinion illustrates the difficulties that taxpayers may face when relying on the substantial authority defense. Although the applicable Treasury Regulations on the substantial authority defense do not distinguish between published and unpublished cases or the age of the authorities, the court’s approach indicates that these are relevant factors to consider. Taxpayers that intend to rely on the substantial authority defense should review the Fifth Circuit’s opinion in Chemtech, as well as the applicable authority in their relevant circuit.