Did the Tax Court Enforce Retroactive Penalties?

Taxpayers and practitioners alike were unsettled by recent language from a Tax Court opinion suggesting that retroactive penalties may be enforced.  See Soni v. Comm’r, T.C. Memo. 2013-30.   In Soni, the Tax Court summarily stated “[t]his Court has decided previously that taxpayers may be liable for a penalty arising from a transaction entered into before the penalty was enacted.”  Id. at *8.  In support, the Court cited Patin v. Comm’r, 88 T.C. 1086, 1127 n.34 (1987), aff’d without published opinion, 865 F.2d 1264 (5th Cir. 1989), and aff’d without published opinion sub nom. Hatheway v. Comm’r, 865 F.2d 186 (4th Cir. 1988), and aff’d sub nom. Skeen v. Comm’r, 864 F.2d 93 (9th Cir. 1989), and aff’d sub nom. Gomberg v. Comm’r, 868 F.2d 865 (6th Cir. 1989) (all available through major commercial case reporting services); McGehee Family Clinic, P.A. v. Comm’r, T.C. Memo. 2010-202, slip op. at 6.

Retroactive penalties conflict with Congress’ express recognition that taxpayers, as a general matter, should not be penalized if their tax return filing position is successfully challenged by the IRS if—at the time the return was originally filed—the taxpayer took the position reasonably and in good faith.  The primary exception to this fundamental proposition is the new and arguably strict liability penalty for transactions lacking economic substance.  Some would argue, and the IRS routinely does in fact argue, that if a transaction lacked economic substance, it necessarily was not entered into reasonably and in good faith.  Obviously, we disagree with this argument given the ever-shifting and vague economic substance doctrine.  Nonetheless, what to make of Soni and the cases it relied upon?

A close review of the facts and holding of Soni reveals that the Tax Court did not impose retroactive penalties.  In summary, the court enforced penalties arising from transactions entered into before the transaction was subject to penalty—not before the penalty was enacted.  This is a fine, but significant, distinction.

In Soni, the taxpayers engaged in a certain transaction beginning in 2001.  In a revenue ruling issued three years later, the IRS “listed” the transaction as an abusive tax shelter, arguably putting the taxpayer on notice that the transaction could not be entered into in good faith. (Obviously, this line of reasoning ignores the fact that the IRS has “delisted” certain transactions that it previously considered abusive.)  Even after the transaction was listed, the taxpayer continued to engaged in it.  For the taxable year ending after the revenue ruling was effective, the IRS sought to impose a penalty under I.R.C. section 6662A (for understatements with respect to reportable transactions) on the taxpayers for engaging in the listed transaction at issue.

Part of the taxpayers’ defense to the penalty was that they relied upon a favorable IRS determination letter issued in 2002, before the revenue ruling was issued.  In upholding the penalty, the court found that the revenue ruling should have put the taxpayers on notice that they could no longer rely upon such determination letter and that the transaction was now a listed transaction—“[i]gnorance of the law is no excuse for noncompliance with the applicable law.”  Id. at *10.

None of the cases cited by the court in Soni (listed above) actually applied penalties retroactively or stand for the proposition that a penalty can be applied prior to the enactment of the penalty statute.  In fact, in McGehee, the court explicitly stated that the penalty was not being applied retroactively and was applicable only to tax years ended after the date of enactment of the penalty at issue.  See McGehee, T.C. Memo. 2010-202.  So, despite the loose language in Soni, the Tax Court did not open the floodgates to retroactive penalties.

John Harrington

About John Harrington

John Harrington is the co-leader of Dentons' US Tax practice, which was recognized by The Legal 500 in 2020 for outstanding work in international and non-contentious tax. Recognized by Chambers Global as a Notable Practitioner, he advises clients on inbound and outbound transactional and compliance issues; international tax legislative, regulatory and treaty matters; and a variety of domestic tax issues.

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Marc Teitelbaum

About Marc Teitelbaum

Marc Teitelbaum is the former chair of Dentons' Tax practice, which was recognized by The Legal 500 in 2020 for outstanding work in international and non-contentious tax. Marc has been involved in advising public companies, underwriters and investment funds principally in the following areas: acquisition and disposition of domestic and foreign corporations whether taxable or tax-free transactions; the US tax consequences of foreign operations and foreign joint ventures, in particular, multinational manufacturing and sales operations; debt and equity financings; and investment strategies in partnership form, including tax- and accounting-advantaged structured domestic and cross-border financing arrangements.

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