On February 2, 2017, the United States Tax Court upheld accuracy-related penalties under Section 6662A against a taxpayer who participated in a distressed asset/debt tax shelter transaction in Thompson v. Commissioner. The taxpayer moved to declare Section 6662A unconstitutional as violating the Eighth Amendment’s Excessive Fines Clause. The Tax Court concluded that the penalty wasn’t so grossly disproportionate as to violate the Eighth Amendment.
The taxpayers reported a loss on a flow-through distressed asset debt transaction (“DAD”) on their joint tax return for tax year 2005. The IRS audited the 2005 return and concluded that the source of the loss was a listed transaction described in Notice 2008-34. Because the taxpayers failed to disclose the relevant facts relating to the transaction, the Service asserted a 30 percent penalty under Sections 6662A(c) and 6664(d)(2) (now Section 6664(d)(3)). The taxpayers conceded that they were not entitled to the bad debt deduction, but contested the determined penalties and interest. The taxpayer argued that Section 6662A is unconstitutional on its face.
Application of the Eighth Amendment
Section 6662A(a) imposes a penalty on any reportable transaction understatement. If a taxpayer fails to adequately disclose a reportable transaction giving rise to an understatement under Section 6662A, the penalty is 30 percent, and there are no available defenses. The Eighth Amendment to the United States Constitution provides: “Excessive bail shall not be required, nor excessive fines imposed, nor cruel nor unusual punishments inflicted.” In Austin v. United States, the Supreme Court held that “[t]he Excessive Fines Clause limits the government’s power to extract payments, whether in cash or in kind, as punishment for some offense.”
In deciding whether Section 6662A violated the Excessive Fines Clause, the Tax Court looked to United States v. Bajakajian, where the Supreme Court stated, to pass constitutional proportionality, the amount of the forfeiture or fine must bear some relationship to the gravity of the offense that it is designed to punish. Thus, “if the amount of the forfeiture is grossly disproportional to the gravity of the defendant’s offense, it is unconstitutional.” Thus, to answer the question of whether Section 6662A violates the Eighth Amendment, the Tax Court addressed two questions: (1) whether Section 6662A constitutes punishment for an offense, and (2) whether the punishment is grossly disproportional to the gravity of the offense. The Tax Court answered both questions in the negative.
As to the first question, the Tax Court concluded that “the primary goal for enacting Section 6662A was to reinforce voluntary compliance with existing disclosure requirements and deter taxpayers from using tax shelters.” In explaining the reasons for enacting Section 6662A, the Tax Court cited to the House of Representatives Committee on Ways and Means:
Because disclosure is so vital to combating abusive tax avoidance transactions, the Committee believes that taxpayers should be subject to a strict liability penalty on an understatement of tax that is attributable to non-disclosed listed transactions or non-disclosed reportable transactions that have a significant purpose of tax avoidance. Furthermore, in order to deter taxpayers from entering into tax avoidance transactions, the Committee believes that more meaningful (but not a strict liability) accuracy-related penalty should apply to such transactions even when disclosed.
The Tax Court considered these comments and concluded that “the primary goal for enacting Section 6662A was to reinforce voluntary compliance with the existing disclosure requirements and deter taxpayers from using tax shelters.” Accordingly, the Tax Court found that the Section 6662A penalty imposes a financial risk to taxpayers who fail to comply, and serves a revenue-raising purpose. Thus, the court concluded that the penalty under Section 6662A is no different from penalties upheld on other cases.
Finally, the Tax Court concluded that even assuming that Section 6662A implicated the Excessive Fines Clause, the penalty imposed is not so grossly disproportionate as to fail the Bajakajian test.