September 1998 Issue

TAX COURT RULING ON PENALTY CALCULATIONS FAVORS IRS

By Peter Barton, MBA, CPA, JD, professor of accounting, and Clay Sager, associate professor of accounting, University of Wisconsin-Whitewater

The Tax Court ruled, in Lemishow v. Commissioner, that, when the court sustains the accuracy-related penalty on one of two IRS adjustments, the penalty should be based on the difference between the tax on the taxpayer's total corrected taxable income and the tax on the taxpayer's taxable income without the penalized item. This calculation produced a larger penalty than the calculation proposed by the taxpayer. Lemishow is the first Tax Court case to consider this issue, which occurs frequently due to the progressive income tax rates and the various penalties to which Lemishow applies.

The IRC section 6662 accuracy-related penalty applies to the portion of any underpayment of tax attributable to one or more of the following infractions: 1) negligence, 2) substantial understatement of income tax,
3) substantial valuation misstatement affecting income tax, 4) substantial overstatement of pension liabilities, or 5) substantial estate or gift tax valuation understatement. Under section 6662(a), the penalty is calculated by adding to the tax "an amount equal to 20% of the portion of the underpayment." For infractions #3­#5, if the infraction is "gross" [as defined in section 6662(h)(2)] rather than "substantial," the rate is 40%. Finally, for any portion of an underpayment due to fraud, the rate is 75% under section 6663(a).

Regulations section 1.6664-3 provides ordering rules to determine the amount of the penalties under sections 6662 and 6663. They apply where 1) There is at least one adjustment on which no penalty is imposed and at least one adjustment on which a penalty is imposed, or
2) There are at least two adjustments on which penalties are imposed at different rates. Adjustments to the return are considered made in the following order: 1) adjustments on which no penalties are imposed; 2) adjustments on which 20% penalties are imposed; 3) adjustments on which 40% penalties are imposed; and 4) adjustments on which 75% penalties are imposed.

In the first Lemishow case on the underlying issues, 110 TC No. 11 (1998), the Tax Court sustained the IRS's adjustments of $480,414 to Lemishow's income. Of this amount, $102,519 was subject to the accuracy-related penalty. The IRS and Lemishow calculated the underpayment of tax for penalty purposes differently. Following the regulations' ordering rules #1 and #2, the IRS calculated the tax on Lemishow's total corrected income less the tax on his total income without the $102,519 adjustment. This resulted in an underpayment of tax of $40,595 at a tax rate of 39.6%, and a penalty of $8,119. Lemishow calculated the tax on his reported income plus the $102,519 adjustment. Then he subtracted the tax on his reported income. This resulted in an underpayment of tax of $26,490 at a tax rate of 25.8%, and a penalty of $5,298.

The Tax Court ruled that the IRS was correct in calculating Lemishow's penalty by following the regulations. Finding the penalty statute to be unclear and the regulations to be reasonable, the Tax Court followed the Supreme Court rule that regulations which provide a reasonable interpretation of an unclear statute should be followed. The regulations need not be the best interpretation of the statute.

Cite: Lemishow v. Commissioner, 110 TC No. 26 (June 2, 1998). *

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