COMMISSIONER OF INTERNAL REVENUE, PETITIONER V. ASPHALT PRODUCTS CO. No. 86-1053 In the Supreme Court of the United States October Term, 1986 Petition for a Writ of Certiorari to the United States Court of Appeals for the Sixth Circuit The Solicitor General, on behalf of the Commissioner of Internal Revenue, petitions for a writ of certiorari to review the judgment of the United States Court of Appeals for the Sixth Circuit in this case. TABLE OF CONTENTS Opinions below Jurisdiction Statute Involved Question presented Statement Reasons for granting the petition Conclusion Appendix A Appendix B Appendix C Appendix D Appendix E Appendix F Appendix G OPINIONS BELOW The opinion of the court of appeals (App., infra, 1a-26a) is reported at 799 F.2d 243. The memorandum opinion of the Tax Court (App., infra, 31a-81a) is reported at 47 T.C.M. (CCH) 1621. JURISDICTION The judgment of the court of appeals (App., infra, 27a-28a) was entered on July 17, 1986. The government's petition for rehearing was denied on September 25, 1986 (App., infra, 29a-30a). The jurisdiction of this Court is invoked under 28 U.S.C. 1254(1). STATUTE INVOLVED Section 6653 of the Internal Revenue Code (26 U.S.C.), as in effect in 1974, is set forth in the Appendix, infra, 90a-91a. QUESTION PRESENTED Section 6653(a)(1) of the Internal Revenue Code provides that "(i)f any part of any underpayment * * * of any tax * * * is due to negligence or intentional disregard of rules or regulations," a penalty shall be imposed in "an amount equal to 5 percent of the underpayment." The question presented is whether the court of appeals erred in holding that, under the circumstances of this particular case, the negligence penalty should be computed, not as 5% of the underpayment, as the statute requires, but rather as 5% of the portion of the underpayment that is attributable to the negligence. STATEMENT Respondent Asphalt Products Company is in the business of manufacturing emulsified asphalt for highways. In 1974, respondent's principal shareholders purchased two trailer-mounted wastewater treatment plants that were temporarily situated in California. The shareholders bought these plants in their individual capacities, for use in a Tennessee development; the plants were completely unrelated to respondent's business as an asphalt manufacturer. At about the same time that the shareholders purchased the trailer-mounted plants, respondent purchased two highway tractors suitable for towing large, heavy trailers. These tractors were used to transport the shareholders' trailer-mounted plants from California to Tennessee. On its income tax return for 1974, respondent claimed a deduction in the amount of $1,103 for the salaries and expenses of the truck drivers who transported the plants across the country. App., infra, 3a-4a, 38a-40a. On audit, the Commissioner determined a deficiency in tax of $154,332 for respondent's 1974 tax year. The bulk of the deficiency was attributable to the Commissioner's determination that respondent had improperly computed its asphalt business income on the cash method of accounting rather than on the accrual method. /1/ Of the balance of the deficiency, approximately $500 was attributable to the Commissioner's disallowance of the $1,103 deduction claimed by respondent for the truck drivers' salaries and expenses, a disallowance predicated on the fact that those costs were not ordinary and necessary expenses incurred in carrying on respondent's business, but rather were incurred for the shareholders' personal benefit. The Commissioner further determined that respondent's claim of a deduction for the truck drivers' salaries and expenses was due to negligence or intentional disregard of IRS rules and regulations. Accordingly, pursuant to Section 6653(a) of the Internal Revenue Code, /2/ the Commissioner asserted an "addition to tax," commonly called a "penalty," in "an amount equal to 5 percent of the underpayment" (I.R.C. Section 6653(a)(1)). Since the underpayment was in the amount of $154,332, the asserted negligence penalty was in the amount of $7,716. App., infra, 3a-4a, 33a. Respondent sought redetermination of the deficiency in the Tax Court. Respondent stipulated that it had erred in deducting the truck drivers' salaries and expenses (App., infra, 34a n.3). But it maintained that it had not been negligent in deducting those expenses and that the negligence penalty therefore should be set aside. The Tax Court rejected that contention, concluded that respondent had indeed been negligent, and upheld the Commissioner's imposition of a penalty (id. at 80a). The Tax Court redetermined a deficiency (reflecting other adjustments) in the amount of $133,249 and thus a negligence penalty in the amount of $6,943 (id. at 82a-83a). /3/ The court of appeals affirmed the Tax Court's finding that respondent had been negligent in deducting the expenses in question. The court ruled, however, that it would be unduly harsh to subject respondent to a penalty equal to 5% of the entire $133,249 underpayment when only $500 of that underpayment was attributable to negligence. App., infra, 13a-15a. Although acknowledging that the Tax Court's computation of the penalty was supported by the language of the statute and the decisions of at least two other circuits (id. at 14a), the court of appeals held that, "(u)nder all the circumstances of the instant case," the 5% negligence penalty should be "applied only to that portion of the deficiency attributable to the disallowed deduction" (id. at 15a (quotation marks omitted)). REASONS FOR GRANTING THE PETITION The decision of the court of appeals is inconsistent with the clear language of Section 6653(a) and with Congress's unequivocal declarations of the intent of that statutory provision. The decision below also conflicts with decisions of other courts of appeals construing Section 6653(a) and the parallel fraud penalty contained in Section 6653(b). If this decision is permitted to stand, it will lead to extensive and burdensome litigation in the Tax Court, to unequal treatment of taxpayers nationwide, and, at least in the Sixth Circuit, to frustation of Congress's intent to deter negligence in the preparation of tax returns. 1. Section 6653(a)(1) of the Code provides that "(i)f any part of any underpayment (as defined in subsection (c)(1) of any tax * * * is due to negligence or intentional disregard of rules and regulations * * *, there shall be added to the tax an amount equal to 5 percent of the underpayment" (empahsis added). Section 6653(c)(1) generally provides that "the term 'underpayment' means * * * a deficiency as defined in (Section 6211)." And Section 6211 defines a "deficiency" as the amount by which the tax actually due exceeds the amount shown as tax on the taxpayer's return. Since the Tax Court determined, and the court of appeals affirmed, a "deficiency" in the amount of $133,249, the statute unambiguously requires that the negligence penalty be computed with reference to that entire amount, as the Tax Court held. Few things in life could be clearer or more certain than this. If any confirmation of the plan meaning of Section 6653(a)(1) were necessary, it is provided by the following subsection, which was added to the statute in 1981. Section 6653(a)(2) imposes an additional penalty in an amount equal to 50% of the interest that is payable "with respect to the portion of the underpayment described in paragraph (1) which is attributable to the negligence" (emphasis added). Thus, Congress quite clearly distinguished between penalties computed on the basis of "the underpayment" and penalties computed on the basis of a "portion of the underpayment." The general 5% negligence penalty lies in the former category, and the court of appeals plainly erred in holding to the contrary. The fact that Section 6653(a)(1) imposes a negligence penalty equal to 5% of the entire underpayment has not heretofore been subject to any doubt. In the 68 years since the negligence penalty was first enacted (Revenue Act of 1918, ch. 18 Section 250(b), 40 Stat. 1057), no court, save the court below, has ever held that the penalty applies only to the portion of the underpayment that is attributable to the taxpayer's negligence. Indeed, even respondent in this case did not have the temerity to suggest that the penalty should be so computed, for it limited its argument to the contention that there was no negligence at all. The court of appeals reached that novel result sua sponte in an apparent attempt to do what it perceived to be "equity" in the case before it. The court did not attempt to explain how the language of the statute could be construed in this fashion, and the court's decision is thus a clear instance of judicial amendment of the statute that Congress enacted. 2. Congress recently reaffirmed the proper construction of Section 6653(a)(1) during its deliberations over the Tax Reform Act of 1986. As described in the Conference Report on that statute (2 H.R. Conf. Rep. 99-841, 99th Cong., 2d Sess. 779-783 (1986), reprinted at App., infra, 84a-89a), Congress gave detailed consideration to whether the scheme for imposing negligence and fraud penalties should be changed -- in particular, the requirement that the penalty be based on the entire amount of the underpayment. Section 6653(b) of the Code has long provided for a fraud penalty essentially parallel to the negligence penalty set forth in Section 6653(a); prior to amendment by the 1986 Act, the fraud penalty was imposed in "an amount equal to 50 percent of the underpayment" if "any part of (the) underpayment * * * is due to fraud." The House Bill proposed increasing the fraud penalty to 75% and limiting it to the portion of the underpayment specifically attributable to the fraud. The Senate Amendment proposed increasing the negligence penalty to 10% and similarly limiting it to that portion of the underpayment attributable to the negligence. Although the fraud penalty was amended in this fashion, the Conference rejected the Senate's proposed amendment of the negligence penalty and decided to "maintain () the 5-percent rate of present law, and the present-law application of that penalty to the entire amount of the underpayment, not just to the portion of the underpayment attributable to negligence" (2 H.R. Conf. Rep. 99-841, supra, at 782; App., infra, 89a (footnote omitted)). The Conference Report went on to address the decision of the court of appeals in the instant case, which had been rendered two months earlier. The Report stated (2 H.R. Conf. Rep. 99-841, supra, at 782 n.3; App., infra, 89a n.3): In a recent case, the Sixth Circuit held that the negligence penalty "should be applied only to that portion of the deficiency attributable to (the negligent action)." (Asphalt Products Co. v. Comm'r, Nos. 84-1841, 84-1822 slip op. (6th Cir. July 27, 1986). The conference agreement provides that the negligence penalty applies (once one element of negligence has been demonstrated) to the entire underpayment, not just to the portion attributabel to negligence. The conference agreement is, with respect to this issue, a continuation of the rule of present law, which also provides that the negligence penalty applies to the entire underpayment, not just to the portion attributable to negligence. The conferees note that this case both inaccurately states present law and is in any event of no effect under the conference agreement. Thus, the Conference Report on the 1986 Act, which apparently was not considered by the court of appeals here, makes it absolutely plain that the court of appeals' decision is in error. /4/ 3. The decision of the court of appeals is at odds with every other decision that has considered this aspect of Section 6653(a). In particular, it directly conflicts with the Second Circuit's decision in Abrams v. United States, 449 F.2d 662 (1971) (per curiam). The court there expressly rejected the taxpayer's contention that the 5% negligence penalty should be applied against only the portion of the underpayment specifically attributable to negligence, holding that the penalty's application to the entire underpayment was "mandated by the relevant statute" (449 F.2d at 663). The court explained (id. at 664 (emphasis in original)). The plain meaning of the Code is that the five percent penalty must be assessed against the 1960 tax deficiency of $39,317.39 and not just against that part of it ($5,748.39) due to negligently unreported income. The statute provides (26 U.S.C. Section 6653(a)) if "any part" of an underpayment is due to negligence, the five percent penalty is to be added to the underpayment. It is evident that it was intended that the five percent was to be assessed not just against that segment of the deficiency due to negligence but against the entire amount. The language is clear and leads to no other interpretation. Accord, e.g., Bianchi v. Commissioner, 66 T.C. 324, 325 (1976), aff'd, 553 F.2d 93 (2d Cir. 1977) (Table); see also Robinson's Dairy, Inc. v. Commissioner, 35 T.C. 601, 609 (1961), aff'd, 302 F.2d 42 (10th Cir. 1962); Lester Lumber Co. v. Commissioner, 14 T.C. 255, 262-263 (1950). /5/ There are also numerous decisions in the Sixth Circuit and in other circuits holding that the 50% fraud penalty, imposed in parallel fashion by Section 6653(b) and its statutory predecessors, is applicable to the entire amount of the underpayment, not just to the portion of the underpayment that is attributable to fraud. See, e.g., Levinson v. United States, 496 F.2d 651, 653-656 (3d Cir.), cert. denied, 419 U.S. 1040 (1974); Romm v. Commissioner, 245 F.2d 730, 736 (4th Cir.), cert. denied, 355 U.S. 862 (1957); Duffin v. Lucas, 55 F.2d 786, 798 (6th Cir. 1932). The court of appeals below made no effort to reconcile this contrary authority. Thus, unless its decision is overturned, taxpayers in the Sixth Circuit will be subjected to substantially smaller negligence penalties than similarly situated taxpayers in other parts of the country, a species of unequal treatment that should not be permitted to stand. 4. The decision of the court below, unless reversed, will have a significant adverse effect on the administration of the tax laws. First, at least in the Sixth Circuit, it will substantially undermine the effectiveness of the negligence penalty. The penalty is not primarily designed as a method of directly increasing revenue. Rather, its principal function is deterence -- to induce taxpayers to comply with the revenue laws in the first instance. As the Second Circuit pointed out in Abrams, 449 F.2d at 664 (emphasis in original): "The five percent penalty for negligence and the fifty percent penalty for fraud are in fact penalties and their imposition on the entire tax deficiency for the year is not only clearly provided for in the statute but serves to act as a deterrent." The possibility that a penalty will be imposed on the entire amount of a deficiency that will be determined at some future time is a substantial disincentive to negligent or intentional underreporting of tax. On the other hand, limiting the penalty to the amount attributable to the negligence, a much smaller sum that can be estimated by the taxpayer, would produce a far less powerful spur to voluntary taxpayer compliance. The taxpayer may well conclude that the possibility that his underpayment will not be discovered justifies the risk of exposure to such a limited penalty, and he may therefore choose to underreport his income and play the "audit lottery." In this case, for example, the negligence penalty, on the court of appeals' theory, would be about $25, approximately the average cost of a parking ticket. Thus, the decision below is likely to lead to reduced voluntary compliance with the tax laws, at least in the Sixth Circuit. /6/ Second, allowing the decision below to remain undisturbed will engender burdensome and unnecessary litigation. Many taxpayers against whom the negligence penalty is asserted are likely to try to bring themselves within the rule created by the court of appeals in this case. Under a proper construction of the statute, which computes the penalty on the entire amount of the underpayment, there is no point in a taxpayer's litigating over whether a particular portion of a deficiency is attributable to negligence. If a taxpayer is shown to have been negligent with respect to one item on his return, he has no reason not to concede his liability for the penalty even if he disagrees with the Commissioner's determination that he was negligent with respect to other items. The decision below, however, would create a strong incentive for contesting the Commissioner's determination of negligence on an item-by-item basis. The trial court would then be forced to take evidence and make specific findings with respect to each contested item, even though under the correct interpretation of Section 6653(a)(1) there should be no need to engage in such a tedious and laborious exercise. See, e.g., Lester Lumber Co. v. Commissioner, 14 T.C. at 263. The court of appeals' error, unless corrected, is likely to result in a considerable waste of administrative and judicial resources because of the frequency with which Section 6653(a) cases arise. Looking at the Tax Court alone, the negligence penalty is addressed in approximately 150 published decisions in a typical year. The IRS informs us, moreover, that as many as 10,000 of the petitions docketed annually in the Tax Court dispute the Commissioner's assertion of a negligence penalty. Many of these cases are ultimately settled and hence do not result in published opinions. However, the Commissioner's ability to settle these cases would be significantly impaired by the decision below, which taxpayers will inevitably seek to use as a "bargaining chip" in the hope of avoiding a portion of the statutorily prescribed negligency penalty. Finally, although the Tax Court will be free to adhere to its (correct) construction of Section 6653(a) in the generality of its decisions concerning the negligence penalty, the rule set forth in Golsen v. Commissioner, 54 T.C. 742, 757 (1970), aff'd, 445 F.2d 985 (10th Cir.), cert. denied, 404 U.S. 940 (1971), requires the Tax Court in a particular case to follow the law of the circuit to which the appeal will lie. Thus, in future cases appealable to the Sixth Circuit, the Tax Court will not be free to ignore the decision below when faced with taxpayer requests for extensive evidentiary proceedings concerning the item-by-item application of the negligence penalty. The Tax Court is already overwhelmed with a docket of some 50,000 pending cases and cannot easily shoulder the additional and unnecessary burden imposed by the Sixth Circuit's erroneous decision in this case. CONCLUSION The petition for a writ of certiorari should be granted. The Court may wish to consider summary reversal. Alternatively the Court may deem it appropriate to vacate the court of appeals' decision and remand the case for reconsideration in light of the Tax Reform Act of 1986 and the accompanying Conference Report (see note 3, supra). Respectfully submitted. CHARLES FRIED Solicitor General ROGER M. OLSEN Assistant Attorney General ALBERT G. LAUBER, JR. Deputy Solicitor General ALAN I. HAROWITZ Assistant to the Solicitor General RICHARD FARBER Attorney DECEMBER 1986 /1/ Respondent challenged this determination in the Tax Court, but the Commissioner's rejection of respondent's use of the cash method of accounting was sustained by the Tax Court (App., infra, 63a-68a). That aspect of the Tax Court's decision was affirmed on appeal (id. at 4a-13a), with one dissent (id. at 17a-26a), and is not involved in this petition. /2/ Unless otherwise noted, all statutory references are to the Internal Revenue Code (26 U.S.C.), as amended (the Code or I.R.C.). /3/ The negligence penalty worked out to slightly more than 5% of the deficiency because of a requirement that the deficiency be adjusted for certain carrybacks (such as net-operating-loss and investment-credit carrybacks) before the penalty is computed. See I.R.C. Section 6653(c)(1); Resp. Computation for Entry of Decision, Schedule 5 (T.C. June 24, 1984). /4/ The decision below was entered on July 19, 1986, and the government's petition for rehearing was filed on August 28, 1986. The petition for rehearing was denied on September 25, 1986, the same day that the House passed the Tax Reform Act, two days before the Senate passed it, and more than two weeks before the President signed it. Pursuant to Rule 28(j) of the Federal Rules of Appellate Procedure, the government mailed a copy of the relevant portions of the Conference Report to the court of appeals on September 22, 1986, but there is no indication that the court considered this additional evidence before denying the Commissioner's petition for rehearing three days later. Because the court of appeals would likely find Congress's comments on the decision below to be relevant, we suggest that it might be appropriate for the Court to vacate the decision below and remand for reconsideration in light of this intervening development. /5/ In an effort to justify its decision, the court of appeals below (App., infra, 14a) seized on the following language in the last paragraph of the Second Circuit's opinion in Abrams (449 F.2d at 664): Appellants argue that a literal application of the statute could lead to absurd results where a comparatively insignificant item of income is negligently omitted. That case is not before us on this appeal and we therefore express no opinion whatever as to its proper disposition if it should ever arise. This passage obviously provides no support for the decision below; the Abrams court simply posited a hypothetical question not before it and expressly declined to suggest an answer. While we see no conceivable basis for avoiding the plain command of the statute in any circumstances, we note that, contrary to the statement of the court below (App., infra, 14a), the hypothetical put forth in Abrams is not presented in this case either. Here, respondent did not negligently omit an insignificant item of income, but affirmatively took a deduction for non-business-related expenses to which it later conceded it was not entitled. /6/ Such reduction in the negligence penalty's deterrent effect would be particularly troublesome in light of the degree to which the problem of noncompliance with the tax laws is increasing. As reflected in the Annual Report of the Commissioner of Internal Revenue, for the years 1978 through 1986 the total amount of negligence penalties asserted by the Commissioner has risen from $10,318,000 to $144,809,00. Congress has responded to the problem of taxpayer non-compliance by enacting several new penalty provisions (see, e.g., I.R.C. Sections 6659, 6661), including, for taxable years after December 31, 1981, an additional time-sensitive penalty for underpayments attributable to negligence or fraud (I.R.C. Sections 6653(a)(2) and (b)(2). And, of course, Congress recently considered and rejected a proposal to limit the 5% negligence penalty to that portion of the underpayment specifically attributable to the negligence. See pages 6-8, supra. APPENDIX