RULING ON MOTION FOR IMPOSITION OF THE NEGLIGENCE PENALTY
Dеfendant, the United States, moves for an order imposing a negligence penalty on plaintiff TIFD III-E Inc. (“TIFD”) for tax years 1997 and 1998. During the 1990s, TIFD’s parent company, General Electric Capital Corporation (“GECC”), joined with a pair of Dutch banks (“the Dutch Banks” or “the Banks”) to form an aircraft leasing company. TIFD considered the Dutch Banks to be its partners in the venture, and did not report any income allocated to the Banks on its own tax returns. During the course of this litigation, I twice found that decision to be more than reasonable; indeed, I found that the compаny correctly deemed the Banks to be equity stakeholders rather than lenders. TIFD III-E v. United States,
Ordinarily, that would have ended the matter. The government, however, later realized that the substantial understatement penalty could not be assessed because the 10% substantial understatement threshold had not been satisfied (presumably because thе payments to the Dutch Banks that the Second Circuit held were interest payments thereby became deductible to the taxpayer, thus reducing its tax liability). See I.R.C. § 6662(d). As a result, the government now seeks to impose the 20% accuracy penalty for different reasons, arguing that TIFD’s underpayment was attributable to negligence. For the reasons set forth below, I find that TIFD’s tax position had a reasonable basis and therefore conclude that the negligence penalty is not applicable.
I. Background
I assume the parties’ familiarity with the facts underlying this case. See Castle Harbour I,
GECC entered the aircraft leasing business to reap tax benefits, but it later sold a stake in its airplanes for a different reason entirely — to mitigate risk in a shaky aircraft-leasing market. Commercial aircraft lose substantial value over time. Companies with sizable income like GECC purchase airplanes and then lease them so that they can take advantage of large, predictable depreciation deductions. But in the early 1990s, GECC started to question the wisdom of its investment; several airlines had fallen into bankruptcy, and
To reduce its exposure, it initiated what it called a “sell-down” effort — it sought a partner that would buy a stake in the airplanes, leaving GECC with cash up front and less risk down the line. In other words, as I explained in my previous opinion, “rather than simply awaiting return in the form of the now-less-eertain-rental income, GECC wanted to lower its risk by raising immediate cash against the future stream of income.” Castle Harbour-I,
With those circumstances in mind, GECC solicited proposals that would allow it to raise cash without incurring any debt. Seven major investment banks responded, but after careful review, GECC rejected each of those bids as inadequate to achieve its purpose. After some back and forth, the investment bank Babcock & Brown submitted a plan acceptable to GECC. Pursuant to the plan, GECC would create a separate entity to which it would contribute aircraft and would then solicit investors to purchase оwnership shares in the new entity. The proposal had an additional lucrative upside — the investors would be foreign tax-neutral entities, and any income allocated to those partners would not be subject to U.S. income tax.
Had the Dutch Banks simply bought a stake in the business, the parties would have been spared more than ten years of litigation. But the deal was more complex; as the Second Circuit described it, “[a]n extraordinarily complex maze of partnership provisions dictate[d] how the revenues, losses, and assets of the pаrtnership would be allocated over the eight-year duration of the partnership.” Castle Harbour II,
II. Discussion
A. Authority to Consider the Application of the Negligence Penalty
As a threshold matter, the government asserts that I lack the authority to decide whether the negligence penalty applies, because the Second Circuit’s decision in Castle Harbour IV automatically became an order of this court, pursuant to Local Rule 77.1(e). That argument is flawed, because the parties jointly moved to alter the judgment (doc. # 145), and I granted that motion (doc. # 146). It was not until a dispute over the substance of the proрosed alterations arose that the government opposed modification of the judgment on the grounds that the Second Circuit reversed without remand. Def.’s Proposal Re Entry of Judgment (doc. # 155).
Substantively, the government’s position is that Castle Harbour IV vacated my decision in Castle Harbour III in its entirety and left intact the FPAA determination made by the IRS before this suit began. Def.’s Mem. Supp. N. Penalty 5 (doc. # 162). That view, however, is not
B. Statutory and Regulatory Framework
Taxpayers who submit inaccurate returns must pay a 20% penalty for “any underpayment which is attributable to ... [n]egligence or disregard of rules or regulations.” I.R.C. § 6662(a) & (b)(1). The statute defines “negligence” as “any failure to make a reasonable attempt to comply with the provisions of this title.” I.R.C. § 6662(c).
The IRS has enacted a regulation that describes when а taxpayer fairly can be said to have been negligent. Treas. Reg. § 1.6662-3. “Negligence” is defined by example, and is “strongly indicated” when the taxpayer “fails to include on an income tax return an amount shown on an information return” or “fails to make a reasonable attempt to ascertain the correctness of a deduction, credit, or exclusion on a return which would seem to a reasonable and prudent person to be ‘too good to be true’ under the circumstances.” Id. § 1.6662-3(b)(l)(i) & (ii). A return position that has a “reasonable basis,” however, “is not attributable to negligence.” Id. § 1.6662-3(b)(l). The “reasonable basis” standard creates a broad limit to negligence penalty liability; a tax position that otherwise might seem “too good to be true” to a reasonable taxpayer, for example, will not be found negligent if the position has a “reasonable basis.” See id.
“Reasonable basis” is a “relatively high standard of tax reporting, that is, significantly higher than not frivolous or not patently improper.” Id. § 1.6662-3(b)(3). “The reasonable basis standard is not satisfied by a return position that is merely arguable or that is merely a colorable claim.” Id. A “reasonable basis” may be found where a return position “is reasonably based” on one or more of the authorities used to determine whether “substantial authority” exists for a tax position. Id. § 1.6662-3(b)(3). Those authorities include regulations, court cases, legislative history, private ruling letters, and technical advice memoranda. Id. § 1.6662-4(d)(3)(iii).
In Castle Harbour IV, the Second Circuit examined the authorities proffered in support of TIFD’s tax position and held that those authorities did not shield TIFD from the substantial understatement penalty. That decision, however, has little impact on the question of TIFD’s negligence. Although both the negligence penalty and the substantial understatement penalty involve an objective analysis of relevant authorities, see, e.g., Neonatology Associates, P.A. v. C.I.R.,
A taxpayer can misinterpret an authority, reach the wrong conclusion, and still behave reasonably. This must be so fоr the “reasonable basis” standard to have meaning; otherwise there would be no such thing as a “reasonable but mistaken” position, and every situation in which litigation leads to tax liability would support imposition of a tax penalty. As the Sixth Circuit has counseled, “[a] taxpayer is not required to be perfect [for] [e]ven tax specialists cannot be perfect.... Reasonable minds can differ over tax reporting [even when] the IRS disallows certain transactions.” Mortensen v. C.I.R.,
C. TIFD’s “Reasonable Basis ”
I have little trouble finding that TIFD had a “reasonable basis” for treating the Dutch Banks’ stake in Castle Harbor as an equity interest rather than debt. GECC never intended to indebt itself to the Dutch Banks. The evidence at trial demonstrated just the opposite: in 1993, it was contractually barred from leveraging its assets to borrow money, and it solicited propоsals from financial professionals with the explicit instruction that the plans raise capital, not incur debt. As TIFD has always maintained, GECC believed that it was offering the Banks a partnership stake akin to “non-participating preferred equity,” a class of financial interest that pays holders dividends at a fixed rate following a pre-determined formula. Pl.’s Mem. Opp. N. Penalty 5 (doc. # 167); PL’s Post Hr’g Mem. 4 (doc. # 176).
In Castle Harbour III, I accepted this analogy, and cited Jewel Tea as providing substantial authority for TIFD’s position.
In Jewel Tea, we ruled that purported preferred shares, unlike the debentures in O.P.P., were properly treated as equity for tax purposes because at no time сould the holders demand their money; “they were at the mercy of the company’s fortunes and payment was merely a way of distributing profits.” In contrast to the holders of the preferred shares in Jewel Tea, the banks in the instant case were effectively promised recovery of their principal investment at a set rate of return, payable on a set schedule. Of course, the banks’ return was not completely divorced from Castle Harbour’s performance. But, as we have explained, because those aspects of the banks’ promised return that depended on Castle Harbour’s performance were so unlikely to result in the banks’ receipt of a return that meaningfully deviated from the Applicable Rate, the banks*149 were in no real sense co-venturers in the partnership’s fortunes.
Castle Harbour IV,
But GECC reasonably could have believed that, tо borrow the Second Circuit’s term, the Dutch Bank’s “narrowly circumscribed risk” would not transform equity into debt. TIFD points to a mountain of authority — all decided or promulgated before TIFD filed its returns — that classified preferred stock as equity even though holders were guaranteed a result and their profits did not depend on corporate growth. Indeed, courts have long treated preferred stock as equity. See, e.g., Staked Plains Trust v. Comm’r,
Provisions of the Internal Revenue Code also classify preferred stock as equity for tax purposes, even when the stock’s value does not depend on corporate growth, is redeemable at the holder’s discretion, and is callable by a corporation at a fixed price. For example, under I.R.C. § 351, a party who controls a company may exchange property for stock in the entity without reporting a gain on his tax return. But the stock cannot be a scrim for a loan; subsection (d) excludes unsecured “indebtedness” from the exеmption. The provision then clarifies that preferred stock should not be considered debt, even though it “is limited and preferred as to dividends and does not participate in corporate growth to any significant extent.” I.R.C. § 351(g); see also I.R.C. § 1504(a)(4) (respecting as equity nonvoting stock that “does not participate in corporate growth to any significant extent”). The IRS has echoed this principle in rulings that distinguish preferred stock from bonds. In 1994, just after GECC and the Dutch Banks struck the Castle Harbour deal, the agency ruled that preferred stock was equity for tax purposes еven though it resembled debt in almost every respect: the interest was debt for corporate law purposes, the stock matured and paid-out a fixed amount on a specific date, and its holders retained the rights of creditors. Rev. Rul. 94-28,1994-
Preferred stock differs from the Castle Harbour deal in some respects, and the Second Circuit discarded the comparison in favor of an analogy to a “secured lender.” But a reasonable person might not have known that it had chosen the wrong comparator — indeed as a government expert testified at trial:
[T]he accounting standards in debt versus equity are complicated. There is no standard that relates to any instrument exactly like this. One has to draw [analogies] to other instruments and as we’ve seen there are many analogies that can be drawn.
Pl.’s Mem. Opp. N. Penalty 9. Given this murkiness, it was entirely reasonable for
TIFD’s view looks especially reasonable in light of this litigation. If it had been clear that the Dutch Banks were lenders, there would have been no need for a two-week trial, two district court opinions, and two appeals. Having presided at the trial of this matter, I twice found not merely that TIFD was reasonable in its tax position, but that it was correct. Although the Second Circuit ultimately disagreed with my interpretation of the law, it did not indicate that my conclusions were “unreasonable.” The Court openly acknowledged that the case was not a slamdunk for the government, because the relevant statute and regulations are ambiguous and “subject to multiple interpretations.” Castle Harbour IV,
Simply put, the objective reasonableness of a tax position becomes virtually unassailable when the taxpayer actually prevails at trial before a district judge who was not compromised by conflict, substance abuse, or senility. The reasonableness of the tax position on which TIFD sustained its burden of proof of correctness after a lengthy bench trial&emdash;even if both taxpayer and judge ultimately were mistaken&emdash;scarcely can be questioned. Indeed, I am aware оf no case in which a negligence penalty has been applied following reversal of a taxpayer’s district court victory.
The government’s position in this case can fairly be described as “mind boggling.” See Holmes,
The IRS regulations do contain a safe harbor provision that examines a taxpayer’s conduct and its subjective belief, allowing the taxpayer to avoid a penalty if it had “reasonable cause ... and acted in good faith.” Treas Reg. § 1.6664-4. In determining whether the reasonable cause and good faith defense applies, the mоst important factor generally is “the extent of the taxpayer’s effort to assess the taxpayer’s proper tax liability.” Id. Under section 1.6664-4, “[rjeliance on an information return, professional advice, or other facts ... constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in goodfaith.” Id. (emphasis added). But section 1.6664-4 is not the provision upon which TIFD relies.
Of course, one way to bolster a case for a reasonable basis could be to show that a taxpayer relied on the independent advice of counsel. Such was the strategy in the case cited by the government, Stobie Creek Investments, LLC v. United States,
III. Conclusion
For the reasons stated above, the government’s motion is DENIED.
It is so ordered.
Notes
. In fact, the government did not even appeal that finding. Br. for Appellant at 35 (May 6, 2005),
. Pursuant to Treas. Reg. § 1.6662-2(c), accuracy-related penalties may not be stacked.
. Its objections notwithstanding, the government fully briefed its position with respect to the substance of the judgment. Initially, the parties' dispute centered on the applicable deductions for interest paid and whether the substantial understatement penalty was subject to partner-level defenses in partnership-level proceedings. Then, the government realized that the substantial understatement penalty would yield no monetary consequence. Consequently, it moved for an order for imposition of the negligence penalty. The parties subsequently settled the interest-rate issue, which means that the applicability of the negligence penalty is the only issue left to be decided.
. The government concedes that there is no case directly on point that supports its position.
. TIFD, correctly or incorrectly, asserts that the reasonable cause and good faith defense found in Treas. Reg. § 1.6664-4 does not apply at the partnership-level; therefore, it understandably has not briefed any issues related to reasonable cause and good faith (including reliance on advice of counsel) at this stage.
. Stobie Creek focused on the potential for "significant overlap ... between the defense to the negligence penalty based on reasonable reliance on the advice of professionals and the reasonable cause and good faith exception to all accuracy-related penalties,” and its discussion did not attempt to distinguish between those defenses.