In an important opinion the 8th Circuit in Wells Fargo v US held that the reasonable basis defense to the negligence penalty requires a taxpayer to prove that they actually relied on relevant legal authority rather than just show that objectively the authority supported the taxpayer’s position. Wells Fargo is the first appellate opinion to hold that reasonable basis for penalty defense purposes is based on a subjective rather than objective standard. The earlier district court opinion had attracted significant interest, and as I discuss below, the court’s holding may force taxpayers to waive attorney client privilege if they want to use the defense to the negligence penalty.
Before getting to the 8th Circuit opinion I will give some context.
The transaction at issue involved interest deductions and a complex foreign tax credit generating transaction. At the district court, the government lost in its effort to use the economic substance doctrine to disallow interest expense deductions for a transaction that lacked a non tax business purpose but won on its use of the doctrine to disallow the foreign tax credits arising from a trust structure. The district court also sustained the negligence penalty attributable to the tax due from the disallowed foreign tax credits.
There are a couple of tangential issues that that I need to address before I get to the main parts of this post. I am not analyzing Wells Fargo’s economic substance issue; for readers looking for more background see Stu Bassin’s post Wells Fargo Decision Answers Economic Substance Question that followed the district court opinion. In addition, the negligence penalty in this case was not asserted on audit but arose as part of the government’s offset defense in the district court litigation. That is important for purposes of a separate Section 6751(b) managerial approval/Graev issue that I do not analyze in this post. Essentially the 8th Circuit in this opinion held that supervisory approval is not required when the government asserts a penalty as an affirmative defense in refund litigation, as done in this case. For readers wanting more on 6751(b), I direct you to many posts on the issue or newly revised ¶ 7B.24 in Saltzman and Book.
To the negligence penalty and reasonable basis.
Section 6662 imposes a 20 percent penalty on any underpayment of tax that is attributable to the taxpayer’s “negligence or disregard of rules or regulations.” Treasury regulations under Section 6662 provide a defense to the negligence penalty if the taxpayer’s “return position” was “reasonably based on one or more of the authorities set forth in § 1.6662-4(d)(3)(iii) (taking into account the relevance and persuasiveness of the authorities, and subsequent developments).” The Wells Fargo opinion cross references regs under Section 6114 (addressing treaty based return positions) which provide that a “taxpayer is considered to adopt a ‘return position’ when the taxpayer determines its tax liability with respect to a particular item of income, deduction or credit.”
As I discussed following the district court opinion in Wells Fargo and The Negligence Penalty for A Transaction Lacking Reasonable Basis, the penalty issue was “teed up for the district court in a somewhat odd manner, with Wells Fargo stipulating that if the foreign credit generating transaction was a sham, it should not be subject to the penalty because ‘there was an objectively reasonable basis for Wells Fargo’s return position under the authorities referenced in § 1.6662–3(b)(3).’ In finding that the transaction was a sham, the district court also held that Wells Fargo was subject to the penalty because it had to prove that it in fact consulted with the authorities before adopting its position on the return.
In my 2017 post I noted that the penalty aspect of the opinion was controversial:
At or around the time of the opinion, Jim Malone of Post & Schell wrote a terrific blog post critiquing the district court opinion, suggesting that perhaps Wells Fargo deserved to be penalized but that the court’s approach to the issue was “troubling”. There was also a piece in Bloomberg that quoted Jim and former PT guest poster Andy Grewal, with Andy saying that “it would be more sensible to apply Section 1.6662-3(b)(1) in accordance with its plain meaning and examining all relevant authorities supporting the treatment of a position, whether or not the taxpayer was aware of them.”
Practitioners have been closely following the case. For example, a February 2020 article in Tax Notes co-written by my old Davis Polk colleague Mario Verdolini and Christopher Baratta The Objectivity of the Reasonable Basis Defense to Tax Penalties (subscription needed) criticized the district court opinion and urged the 8th Circuit to adopt an objective approach in applying reasonable basis.
The 8th Circuit Majority Opinion on Reasonable Basis
The 8th Circuit, in affirming the district court, disagreed, finding that reasonable basis requires evidence that a taxpayer actually relied on relevant legal authority in support of its positions taken on tax returns. In so doing the 8th Circuit sidestepped the possible thorny administrative law issue concerning whether IRS is entitled to deference regarding an interpretation of its own regulations because it concluded that the regs were not ambiguous. (Aside: Deference to an agency’s interpretation of its own ambiguous regulations is the so-called Auer issue I discussed in my earlier post on the case. Last year the Supreme Court addressed Auer in Kisor v. Wilkie, where it tightened the standard under which courts are to defer to agency interpretations of their own regulations. For those wanting more on this, see Saltzman and Book IRS Practice & Procedure ¶ 3.6, where Greg Armstrong and I recently added a revised discussion of the importance of Auer deference in light of Kisor; I discuss this a bit more below in reviewing the dissent. See also an earlier post discussing Kisor.)
Citing Black’s Law Dictionary, the opinion stressed that the “plain or common usage of the word “base” suggests that one is relying on particular information in order to form an opinion or a position about something.”
As the district court noted, “[i]t is difficult to know how a taxpayer could ‘base’ a return position on a set of authorities without actually consulting those authorities, just as it is difficult to know how someone could ‘base’ an opinion about the best restaurant in town on Zagat ratings without actually consulting any Zagat ratings.” Indeed, the regulation does not require the taxpayer’s position to be simply “consistent with” or “supported by” the relevant legal authority. If it did, then it might be sufficient that the relevant authorities supported the taxpayer’s position, regardless of whether the taxpayer relied upon them. But in order for a taxpayer to “base” its position on relevant authority, it must have actually known about those authorities and actually relied upon them when forming its return position. (emphasis added though citations omitted, including cites to some district court opinions taking a contrary view of the issue)
In addition to its use of a plain language analysis, the opinion also notes that the subjective approach to the reasonable basis defense is “sensible in light of the broader context of the statute and accompanying regulatory definition.” In reaching that conclusion, the opinion looks to the underlying issue relating to a penalty, and how that suggests some foundation in actual taxpayer behavior:
Again, the government is seeking to impose a “negligence penalty,” which suggests that the focus of the inquiry must be, at least in part, on the taxpayer’s actual conduct—whether it met the requisite standard of care in preparing its tax return and considering its return position—rather than simply determining whether its legal position finds support in the relevant legal authority. See 26 U.S.C. § 6662(c) (defining “negligence” as “any failure to make a reasonable attempt to comply with the provisions of this title”).
In support of its view that considering actual conduct is at least part of the inquiry, the opinion notes that in a 1996 case, Chakales v Comm’r, the 8th Circuit stressed that “the burden is on the taxpayer to prove that he did not fail to exercise due care or do what a reasonable and prudent person would do under similar circumstances.”
The opinion does spend time directly addressing the arguments that Wells Fargo offered, including that other regulations directly require taxpayers or third parties to analyze authorities or facts and circumstances (recall that the reasonable basis regs employ the passive voice “is based” approach rather than directly requiring that the taxpayer base its position on authorities):
That other statutory provisions or regulations use different language in creating an actual reliance requirement does not mean that the provision at issue in this case requires only that the taxpayer’s position be objectively reasonable with respect to the relevant legal authorities.
While it brushed that away the passive voice argument, the opinion noted that Wells Fargo’s concern that a subjective standard “would likely require a taxpayer to waive attorney-client privilege in order to prove that it actually relied on the relevant legal authority” had more “appeal.” Despite that appeal, the opinion noted that other defenses (like actual reliance) trigger similar concerns and that this argument “standing alone” was insufficient to carry the day.
As a final matter, Wells Fargo argued that policy issues supported its view of the regulations and that it should not matter if a taxpayer gets to a reasonable position by luck or design. The opinion disagreed:
[T]here is a sound policy reason underlying a subjective or actual reliance requirement—it incentivizes taxpayers to actually conform to the requisite standard of care rather than simply taking the chance that there may be a reasonable basis for their underpayment of tax. It also reflects the understanding that a taxpayer who carefully studies the relevant legal authorities but arrives at an incorrect conclusion of law, albeit with a reasonable basis for its position, is perhaps less blameworthy or culpable than a taxpayer which simply ignored the existing authorities in forming its tax position and attempts to generate a reasonable basis as a post-hoc justification for its underpayment.
There is a brief but powerful dissenting opinion by Judge Grasz. The dissent disagrees with the majority opinion’s finding that the regulation was unambiguous. In so doing, the dissent is persuaded by Wells Fargo’s argument that the reasonable basis regulations on their face do not impose a reliance argument, and is cast in “objective terms”, unlike the reasonable belief defense, which directly requires that taxpayers “analyze the pertinent authorities.”
The Supreme Court has explained that when “Congress includes particular language in one section of a statute but omits it in another section of the same Act, it is generally presumed that Congress acts intentionally and purposely in the disparate inclusion or exclusion.” Russello v. United States, 464 U.S. 16, 23 (1983) (quotation omitted). I see no reason why the same canon of statutory construction would not apply when interpreting the regulation here. See Black & Decker Corp. v. C.I.R., 986 F.2d 60, 65 (4th Cir. 1993) (“Regulations, like statutes, are interpreted according to canons of construction.”). If the IRS wanted to require actual reliance on the specified authorities to satisfy the reasonable-basis defense, it could have expressly said so, as it did in setting forth eligibility for the reasonable-belief defense. Its failure to do so indicates actual reliance is not required.
Judge Grasz also returns to the Zagat’s restaurant review analogy (i.e., it is difficult to know how someone could ‘base’ an opinion about the restaurant in town on Zagat ratings without actually consulting any Zagat ratings) in the original district court opinion that the majority also used. While Judge Grasz notes that the analogy is “incisive and colorful” it in his view is based on the faulty premise that the consulting has to be done before the taxpayer takes a position on the return:
It assumes the taxpayer must base its position on the specified authorities before the return is filed. The regulation makes no such demand. Instead, 26 C.F.R. § 1.6662-3(b)(3) simply provides that a return position will generally be considered — presumably by the agency or the courts — to have a reasonable basis if it is based on one of the authorities designated in 26 C.F.R. § 1.6662-4(d)(3)(iii). And § 1.6662- 4(d)(3)(iii) further indicates that the agency or courts should consider only such designated authority to make its determination. Reading these regulations together, I believe the agency and/or the courts — not the taxpayer — are to make the determination whether there was a reasonable basis for a return position based on the specified authorities.
The dissent extends the analogy to show why he believes that the majority’s view strays from the regulations:
To illustrate this distinction [that is that the agency or the courts and not the taxpayer are to make the determination under the regs], let us alter the district court’s restaurant analogy. Suppose three friends try to decide where to go for dinner. Two of the friends, Friend A and Friend B, offer differing suggestions, each claiming his suggestion is the best restaurant in town. Tasked with resolving the dispute, Friend C consults Zagat to see which of the two recommended restaurants is indeed “the best,” and, after doing so, sides with Friend A. Friend C’s decision was indeed based on the Zagat ratings. But Friend A did not rely on the Zagat ratings when taking his position. In other words, Friend C’s determination was based on Zagat, regardless of whether Friend A ever relied on the service.
Once establishing that there is at least ambiguity in the regs, that tees up the Auer/Kisor issue. Kisor essentially looks to see if five additional factors are present before a court is to give an agency’s view greater deference. Here, according to Judge Grasz, three of those factors were absent, that the interpretation must be the agency’s authoritative or official position; the interpretation must in some way implicate the agency’s substantive expertise; and the interpretation must reflect fair and considered judgment.
In light of his view that the regulations did not require a subjective standard and in light of Kisor, Judge Grasz felt that the court effectively improperly gave deference to the IRS’s own view of the regulation. That did not mean necessarily mean that Wells Fargo established that it had reasonable basis. He would have remanded it to the district court to see if in the court’s view Wells Fargo’s foreign tax credit had a reasonable basis in the authorities. (Those few readers still with me might wonder what exactly is reasonable basis? Well that is for another day but most observers peg a position as having a reasonable basis if it has a 20% or more probability of winning).
This case is sure to attract attention and is a powerful tool in the government’s arsenal to penalize aggressive tax positions, or at least put taxpayers in a bind of waiving privilege claims to successfully assert a reasonable basis defense.
I do believe that the majority opinion perhaps overstates its position that the broader context of the statute and regulations support the conclusion that the regs require a taxpayer to show that it actually relied on the authorities. For example, as the Verdolini & Baratta article in Tax Notes earlier this year notes, the reasonable basis regulations take into account subsequent developments. If, as Verdolini and Baratta note, “a taxpayer had to rely on the authorities when filing a return, it would be impossible for the taxpayer to rely on any developments after the filing of the return.”
I anticipate that this will not be the last appellate word on this issue.