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Eleventh Circuit directs Tax Court to develop test for substantial understatement penalty.

In Osteen, 62 F3d 356 (1995), the Eleventh Circuit reversed the Tax Court's assessment of the substantial understatement penalty in a Sec. 183 case. The Court of Appeals held that the Tax Court did not adequately explain why the taxpayers did not have substantial authority for their position. Also, the Appeals Court directed the Tax Court to develop a "consistent and workable test" for substantial authority for provisions such as Sec. 183, in which the regulations apply several factors to determine whether the taxpayer engaged in an activity for profit. Finally, the Court of Appeals' comparison of Osteen with other cases appears to have weakened the regulations' test for substantial authority.


Sec. 183 specifies that if an activity is not engaged in for profit, deductions generally are not allowed in excess of gross income. An activity is for profit if the taxpayer has an actual and honest, even though unreasonable, profit objective. The burden of proof is on the taxpayer unless the activity was profitable in three out of five consecutive tax years, ending with the current tax year. If the activity involves horses, the activity must be profitable in two out of seven consecutive tax years (ending with the current tax year).

In determining whether an activity is engaged in for profit, Regs. Sec. 1.183-2(b) specifies nine nonexclusive factors:

1. Whether the activity is operated in a businesslike manner.

2. The expertise of the taxpayer or his advisers.

3. The time and effort spent by the taxpayer.

4. The expectation that the activity's assets may appreciate.

5. The taxpayer's record in other activities.

6. The taxpayer's history of income or loss in the activity.

7. The amount of any profits earned.

8. The taxpayer's financial status.

9. Elements of pleasure or recreation in the activity.

No one or group of these factors is conclusive; instead, they must be applied on a case-by-case basis.

Sec. 6661, which applied to tax returns due (without extensions) before 1990, imposed a 25% penalty for any underpayment due to a substantial understatement of income tax. An understatement is substantial if it exceeds the greater of 10% of the correct tax or $5,000 ($10,000 generally for C corporations). For any item not involving a tax shelter, an understatement shall be reduced (under Sec. 6661 (b) (2) (B) if the taxpayer's treatment of the item was either based on substantial authority or the taxpayer provided adequate disclosure with his return.

For returns due (without extensions) after 1989, Congress repealed Sec. 6661 and replaced it with Sec. 6662, imposing a 20% penalty for any underpayment of tax due to one or more of the following:

* Negligence.

* Substantial understatement of income tax.

* Substantial valuation misstatement.

* Substantial overstatement of pension liabilities.

* Substantial estate or gift tax valuation understatement.

The substantial authority and the adequate disclosure exceptions to the substantial income tax understatement component of the accuracy-related penalty continue to apply, as does the 10% or $5,000 rule.

Neither the repealed Sec. 6661 nor the current Sec. 6662 defines substantial authority, but the regulations, which are virtually the same for both statutory provisions, explain this term. Sec. 6661 applied to the years at issue in Osteen.

Substantial authority is an objective standard that involves applying the law to the facts of the taxpayer's situation. Regs. Sec. 1.6661-3 specified that there is substantial authority for the tax treatment of an item only if the weight of authorities supporting the taxpayer's position is substantial in relation to the weight of authorities supporting contrary treatment of the item in question. "Substantial authority" lies between "reasonable basis" and the stricter standard of "more likely than not." A position that is "arguable, but fairly unlikely to prevail in court" satisfies the reasonable basis standard, but not the substantial authority standard. There can be substantial authority for more than one position with respect to the same item.

Regs. Sec. 1.6661-3(b) (3) also indicated that

...the weight of authorities depends on their persuasiveness and relevance as well as their source. For example, a case or revenue ruling having some facts in common with the tax treatment at issue would not be considered particularly relevant if the authority is materially distinguishable on its facts, or is otherwise inapplicable to the tax treatment at issue.

Authorities include statutes, regulations, revenue rulings and procedures, tax treaties, court cases and congressional committee reports. Substantial authority must exist either on the last day of the tax year or when the return is filed, and the burden of proof is on the taxpayer to prove that he has substantial authority.

The Osteen Case

In Osteen, Harry Osteen operated a horse breeding and selling activity. From 1983-1989, this activity generated minimal revenues and losses ranging between $8,000-$20,000 per year. For 1987-1988, the years at issue, the Osteens were employed full-time--Harry as a bank president, his wife as a nurse. The IRS disallowed $38,432 of these losses and assessed $3,161 in substantial understatement penalties.

Applying the regulations' factors, the Tax Court held that the Osteens lacked a profit motive. The court relied on their inexperience in breeding horses, their failure to hire experienced advisers, the lack of a profitability assessment for breeding horses in Florida, the limited time spent managing the operation, the string of consistent losses and the significant income Osteen earned as a bank executive. Turning to the penalty, the Tax Court simply stated that, based on its discussion of the profit motive factors as applied to the Osteens' situation, there was not substantial authority for their position.

The Court of Appeals first distinguished between using the correct law and applying it to the facts of the case. The court stated that it would reverse the Tax Court's application of the law to the facts only if the Tax Court's ruling was "clearly erroneous." (This term was not defined.) The Court of Appeals then held that the Tax Court's factual finding that the Osteens did not have a profit motive was not clearly erroneous. Thus, the appellate court affirmed the Tax Court on the Sec. 183 issue.

Turning to the substantial understatement penalty, the Court of Appeals began its analysis with the following statement: "The application of a substantial authority test is confusing in a case of this kind." The court then explained that if the horse breeding activity were carried on for profit, all of the deductions claimed by the Osteens would be allowed. If it were not carried on for profit, no deductions would be allowed. Next, the court stated that in most cases involving substantial authority, the Tax Court " little explanation as to why there is substantial authority in one case, but not in another." The court concluded both that there were no court decisions that provided guidance on substantial authority and the test in the regulations was unhelpful in "an all or nothing case of this kind." (Presumably, the court was referring to the "weighing of authorities" test in the regulations.)

The Appeals Court then decided that the Osteens had substantial authority for a profit motive based on their evidence and previous cases. The court held that there was sufficient evidence for a profit motive because there was evidence both for and against a profit motive. Moreover, there would not be substantial authority only if the taxpayer had won in the Tax Court on the profit motive issue and the IRS was able to obtain a reversal on that issue under the "clearly erroneous" standard of review. Thus, the Court of Appeals concluded that, from an evidence viewpoint, the taxpayer had substantial authority unless the evidence was so weak that it would be clearly erroneous for the taxpayer to prevail on the merits.

The court also determined that there was substantial legal authority for the Osteens' position because of the many cases " which the Tax Court has found a profit motive in the horse breeding activities of taxpayers that were similar to those at hand." The Eleventh Circuit then cited 15 horse breeding cases in which the taxpayers won in the Tax Court, along with the determining factors. The court recognized that these 15 cases were distinguishable from Osteen because, unlike those taxpayers, the Osteens lost on the profit motive issue. Nevertheless, these cases were "not so dissimilar that they must be discarded as providing no substantial authority for the tax returns filed in this case."

Also, the Appeals Court cited another horse breeding Sec. 183 case, Harston, TC Memo 1990-538. In Harston, even though the taxpayers did not have a profit motive, they were not liable for the substantial understatement penalty because "...petitioners have convinced us they had substantial authority for their position." The Court of Appeals found "little distinction" between Harston and Osteen even though in Harston the Tax Court found that the taxpayers had maintained a good cost accounting system, cut costs, hired professional trainers and spent significant time in carrying on the business. (The Harstons lost on the profit issue because of their lack of consistent breeding of the horses and their substantial losses.)


Osteen has made it easier for CPAs to contest the Service's imposition of the substantial understatement penalty against their clients. The Tax Court will have to provide a test to clarify when the taxpayer has substantial authority in cases similar to Sec. 183 cases. Equally important, the Court of Appeals appears to have weakened the regulations' requirement that "...the tax treatment at issue would not be considered particularly relevant if the authority is materially distinguishable on its facts...." (This same language is contained in Regs. Sec. 1.6662-4 (d) (3) (ii).) Finally, the court appears to have weakened the substantial authority standard by stating:

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 for the taxpayer's position.

Two additional points should be noted. First, Osteen is binding only in the Eleventh Circuit states of Florida, Georgia and Alabama. If the Tax Court develops a substantial authority test, it should apply to the entire country. Second, the scope of Osteen is uncertain because the meaning of "an all or nothing case of this kind" is unclear. The Court of Appeals apparently meant cases in which several deductions were allowed or disallowed based on a single judicial ruling. However, it arguably applies in any situation in which the court's ruling is based on a multi-factor test, such as is present in Sec. 183 cases. If so, it will probably be difficult to develop a substantial authority test for these types of cases because the taxpayer will usually have some evidence in favor of his position on some of the factors.
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Author:Sager, Clayton R.
Publication:The Tax Adviser
Date:May 1, 1996
Previous Article:AICPA should revise SRTP No. 6 to reflect authority on amended returns.
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