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CPA Incorrectly Claimed Basis Step-Up for Shares Transferred to Nonresident Alien Wife.

(Parker Tax Publishing June 4, 2015)

The Tax Court held that because a taxpayer had incorrectly claimed a basis step-up for shares with zero basis he had gifted to his nonresident alien wife and was subject to a gross valuation misstatement penalty. The court found he could not avoid the penalty by claiming he relied on professional advice, because given his extensive experience as a CPA, the reliance was not reasonable. Hughes v. Comm'r, T.C. Memo. 2015-89.

Background

Ian Hughes obtained a CPA license in Texas in 1979, took a job with KPMG LLP that same year, became a partner in 1986 and moved to the London office in 1994. Hughes' career at KPMG focused almost entirely on the tax aspects of corporate transactions. Hughes divorced his first wife in September 2000, and in October 2000 he married Vanessa, a U.K. citizen and his current wife.

In 1999 KPMG spun off its consulting business to a newly formed corporation, KCI, and allocated its shares among the KPMG partners in two classes reported as "founder's shares" and "K-1 shares" (collectively, KCI shares) . Hughes did not contribute funds in connection with KCI's formation. As there was no public market for the KCI shares and no plans for a public offering, there was no fair market value and the basis in the KCI shares was zero.

In late 2000, Hughes began to fear that if the KCI shares were sold, thereby establishing a fair market value, his first wife would seek a portion of the proceeds. After consulting with his U.K. divorce lawyer, Hughes prepared a gift deed and transferred his interest in the KCI shares in trust to Vanessa. Hughes made an additional gift to Vanessa in 2001. Hughes did not advise KPMG of his transfer of the KCI shares to Vanessa either in 2000 or 2001, report the transfer of shares to the U.K. for either year or file the required U.S. gift tax return.

In 2001 KPMG sold the founder's shares and a portion of the K-1 shares. Hughes received $326,990 and $857,270 for the founder's and K-1 shares, respectively. On his 2001 income tax return, Hughes treated the amounts he received from the sale of founder's and K-1 shares as long-term capital gains, claiming zero bases for the KCI shares.

In 2005, Hughes filed an amended return for 2001, revising his bases in the founder's and K-1 shares to reflect a stepped-up basis that he claimed should have resulted from what he believed were income taxable gifts of the KCI shares to Vanessa. The amended return reported zero capital gain attributable to sale of the founder's shares, claiming the bases matched the amount of the sale proceeds, and a lower amount of long-term capital gain from the sale of the K-1 shares.

Hughes represented to the IRS that he had arrived at the newly claimed bases after consulting with his U.K. divorce lawyer and informal talks with colleagues at KPMG as to the U.S. and U.K. tax consequences of his gift of the shares. As a result of these discussions and his own research, Hughes believed that Code Sec. 1041(d) rendered the stock gifts taxable to him, but that pursuant to a tax treaty between the U.S. and the U.K., he was taxable on capital gain only in the U. K., his country of residence at the time of the transfers.

In 2011 the IRS issued a notice of income tax deficiency in the amount of $364,006 with respect to the amended bases for the KCI shares and imposed a 40 percent gross valuation misstatement penalty.

Rejection of Basis Step-Up

When property is acquired in a taxable exchange, its basis is generally the cost of such property (Code Sec. 1012(a)). When property was acquired by gift, by contrast, its basis is the same as it would be in the hands of the donor (Code Sec. 1015(a)).

The IRS argued Hughes' basis in the shares, which it found to be zero, transferred to Vanessa under Code Sec. 1015(a). Hughes countered that, under Code Sec. 1041 (which provides that gain or loss is generally not recognized on a transfer of property from an individual to a spouse, but makes an exception for transfers to nonresident alien spouses), the gifts resulted in taxable income to himself. Since the transfer was taxable, Hughes claimed that under U.S. v. Davis, 370 U.S. 65 (1962), Vanessa took a fair market value basis in the KCI shares. According to Hughes this income was capital gains taxable to him only in the U.K., his country of residence at the time of the gifts, pursuant to a tax treaty.

The Tax Court noted that Code Sec. 1041only applies where gain or loss has been realized and would otherwise be recognized under the Code. The court determined that since gifts are not income taxable events under Code Sec. 102, neither the donor nor donee of a gift realizes gain and thus there is no gain to be recognized, meaning that Code Sec. 1041 would not apply to spousal gift transfers. Because the gifts were not income taxable exchanges, nothing in the Code or the regulations allowed Vanessa to take stepped-up bases in the shares, and the court determined she took transferred bases of zero from Hughes under Code Sec. 1015(a).

The tax court pointed out that since the gifts were not taxable, Davis was inapplicable to Hughes' situation. In Davis, the taxpayer agreed, pursuant to divorce, to transfer shares to his wife in exchange for a release from any future property claims against him, which was deemed a taxable transaction with the wife receiving basis in the shares equal to the value of her extinguished property rights. The tax court determined that even if it were to treat Hughes' gifts of KCI shares to Vanessa as taxable transactions under Davis, Hughes' amount realized and Vanessa's basis in the KCI shares would be the fair market value of what she transferred to Hughes in exchange for the KCI shares; since Vanessa transferred nothing, the fair market value would be zero, and she still would have had zero basis in the shares.

The court noted that Hughes, in concluding that he was not subject U.S. capital gains tax on the transfer, had misread the effective date and relied on a treaty not in effect at the time of his gifts to Vanessa. Since the gifts did not generate income to Hughes, the court stated it was irrelevant whether, under the applicable tax treaty, the U.S. could tax a U.S. citizen resident in U.K. on capital gain, but did note that U.S. income tax treaties regularly include a saving clause that allows the U.S. to tax its citizens' income as if the treaty were not in effect, and the relevant treaty had such a clause.

Gross Valuation Misstatement Penalty

Because Hughes had reported basis when none existed, the Tax Court determined he was subject to the 40 percent gross valuation misstatement penalty.

A 40 percent accuracy-related penalty generally applies to any portion of an underpayment of tax that is attributable to a gross valuation misstatement, defined as an overstatement of 400 percent or more of the actual value or basis claimed on a return (Code Sec. 6662(h)(1)). If the correct value or basis is zero, an amount claimed on a return is considered to be 400 percent or more of the correct amount, triggering the 40 percent gross valuation misstatement penalty (Reg. Sec. 1.6662-2(c)).

A taxpayer can avoid the penalty by showing there was a reasonable cause for the misstatement and the taxpayer acted in good faith (Code Sec. 6664(c)). Taxpayers may argue that he or she had reasonable cause and showed good faith by relying on professional advice (Reg. Sec. 1.6664-4(c)). Reasonable cause and good faith may also be shown by an honest misunderstanding of fact or law that is reasonable in light of the experience, knowledge, and education of the taxpayer (Reg. Sec. 1.6664-4(b)(1)).

Hughes claimed that because he relied reasonably and in good faith on his divorce lawyer and his colleagues at KPMG, he was not liable for the penalty. The Tax Court disagreed, noting that Hughes' divorce lawyer was not familiar with U.S. tax law and thus plainly lacked sufficient expertise to justify reliance on such matters. As to his KPMG colleagues, the court noted the discussions were highly informal, and Hughes had asked about the taxability of the gifts, not about what basis his wife would receive in the shares.

Hughes also argued he was excused from the penalty because he honestly misunderstood the applicable law. The court agreed that Hughes clearly misunderstood the law applicable to the gifts, but considering his experience, knowledge, and education, the misunderstanding was not reasonable. The court noted that Hughes had been a partner at KPMG for over 20 years, yet failed to notice that the treaty he relied on was not in effect when he transferred the shares. Even though he was not an expert in individual income taxes, the court stated he should have learned, or at least been aware of, basic income tax principles relating to gifts while studying for his CPA licensing exam, and if he did not, the fundamentals should not reasonably have eluded him throughout his KPMG career.

Because the shares had zero basis when transferred to Vanessa, the Tax Court determined that her basis was zero, and because Hughes had reported non-zero basis in those shares on his amended return, the court sustained the IRS's deficiency determination, and upheld the 40 percent gross valuation misstatement penalty.

For a discussion on spousal property transfers, see Parker Tax ¶14,250. For a discussion of tax penalties, see Parker Tax ¶262,100. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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