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Supreme Court Reverses Fifth Circuit and held that the Valuation Misstatement Penalty Applies to Sham Partnerships. (Parker Tax Publishing January 2014)

The Supreme Court was recently asked to decide whether the 40 percent valuation-misstatement penalty applied in the case of partnerships deemed to be shams. Two lower courts held that the penalty did not apply. Unfortunately for the taxpayer in Comm'r v. Woods, 2013 PTC 374 (S. Ct. 12/3/13), the Supreme Court reversed the lower courts' decisions and held that, once the partnerships were deemed not to exist for tax purposes because they were shams, no partner could legitimately claim a basis in his partnership interest greater than zero.

Any underpayment resulting from use of a non-zero basis was therefore "attributable to" the partner's having claimed an adjusted basis in the partnerships that exceeded the correct amount of such adjusted basis. The Supreme Court concluded that, under the relevant regulations, when an asset's adjusted basis is zero, a valuation misstatement is automatically deemed "gross" for purposes of applying the 40 percent underpayment penalty.


Taxpayers are subject to a 20 percent accuracy-related penalty with respect to any portion of an underpayment of tax that is attributable to a substantial valuation misstatement. The penalty is increased to 40 percent in the case of a gross valuation misstatement.

In 2010, the Code was amended to add Code Sec. 6662(b)(6), effective for underpayments attributable to transactions entered into after March 30, 2010. That penalty applies specifically to transactions lacking in economic substance. The new penalty covers all sham transactions, including those that do not cause the taxpayer to misrepresent value or basis; thus, it can apply in situations where the valuation misstatement penalty cannot.

OBSERVATION: According to the Supreme Court, the fact that both penalties may potentially apply to sham transactions resulting in valuation misstatements is not problematic because, while penalties might overlap in a given case, a taxpayer generally cannot receive more than one accuracy-related penalty for the same underpayment.


Gary Woods and his employer, Billy Joe McCombs, participated in an offsetting-option tax shelter designed to generate large paper losses that they could use to reduce their taxable income. To that end, they purchased from Deutsche Bank a series of currency option spreads. Each spread was a package consisting of a long option, which Woods and McCombs purchased from Deutsche Bank and for which they paid a premium, and a short option, which Woods and McCombs sold to Deutsche Bank and for which they received a premium. Because the premium paid for the long option was largely offset by the premium received for the short option, the net cost of the package to Woods and McCombs was substantially less than the cost of the long option alone.

Woods and McCombs contributed the spreads, along with cash, to two partnerships, which used the cash to purchase stock and currency. When calculating their basis in the partnership interests, Woods and McCombs considered only the long component of the spreads and disregarded the nearly offsetting short component. As a result, when the partnerships' assets were disposed of for modest gains, Woods and McCombs claimed huge losses.

Although they had contributed roughly $3.2 million in cash and spreads to the partnerships, they claimed losses of more than $45 million. The IRS sent each partnership a Notice of Final Partnership Administrative Adjustment, disregarding the partnerships for tax purposes and disallowing the related losses. It concluded that the partnerships were formed for the purpose of tax avoidance and thus lacked "economic substance"-i.e., they were shams. As there were no valid partnerships for tax purposes, the IRS determined that the partners could not claim a basis for their partnership interests greater than zero and that any resulting tax underpayments would be subject to a 40-percent penalty for gross valuation misstatements.

Woods took his case to court, and a Texas district court held that the partnerships were properly disregarded as shams but that the valuation-misstatement penalty did not apply. The IRS appealed, and the Fifth Circuit affirmed the lower court's decision.

Applicability of Valuation-Misstatement Penalty

Taxpayers who underpay their taxes due to a "valuation misstatement" may incur an accuracy-related penalty. A 20-percent penalty applies to the portion of any underpayment that is attributable to any substantial valuation misstatement. There is substantial valuation misstatement if the value of any property (or the adjusted basis of any property) claimed on any income tax return is 200 percent or more of the amount determined to be the correct amount of such valuation or adjusted basis.

Under Code Sec. 6662(h), if the reported value or adjusted basis exceeds the correct amount by at least 400 percent, the valuation misstatement is considered not merely substantial, but "gross," and the penalty increases to 40 percent.

Under Reg. Sec. 1.6662-5(g), when an asset's true value or adjusted basis is zero, the value or adjusted basis claimed is considered to be 400 percent or more of the correct amount, so that the resulting valuation misstatement is automatically deemed "gross" and subject to the 40-percent penalty.

Taxpayer's Argument

Woods primarily argued that the economic-substance determination did not result in a valuation misstatement because the statutory terms "value" and "valuation" connote "a factual - rather than legal - concept." Thus, Woods said, the penalty applies only to factual misrepresentations about an asset's worth or cost, not to misrepresentations that rest on legal errors (like the use of a sham partnership).

In the alternative, Woods argued that any underpayment of tax in this case would be "attributable," not to the misstatements of outside basis, but rather to the determination that the partnerships were shams-which he described as an "independent legal ground."

Supreme Court's Analysis

The Supreme Court rejected Woods' primary argument, saying it doubted that the term "value" would be limited to factual issues and exclude threshold legal determinations. But even if the term "value" were limited to factual matters, the Supreme Court said, the statute refers to "value" or "adjusted basis." The Court said there was no justification for extending any limitation on the term "value" to the term "adjusted basis," which plainly incorporates legal inquiries. An asset's basis is simply its cost; but calculating its adjusted basis requires the application of a host of legal rules, the Court noted, including specialized rules for calculating the adjusted basis of a partner's interest in a partnership. The statute contains no indication that the misapplication of one of those legal rules cannot trigger the penalty.

The Court observed that, to overcome the plain meaning of "adjusted basis," Woods was asking the Court to interpret the parentheses in the statutory phrase "the value of any property (or the adjusted basis of any property)" as a signal that "adjusted basis" is merely explanatory or illustrative and has no meaning independent of the term "value."

According to the Court, given the compelling textual evidence to the contrary, the parentheses cannot bear that much weight. For one thing, the terms reappear later in the same sentence without the parentheses-in the phrase "such valuation or adjusted basis." Moreover, the Court noted, the operative terms are connected by the conjunction "or." In its ordinary use, the Court said, the term "or" is almost always disjunctive; that is, the words it connects are to be given separate meanings. There is no way, the Court stated, that the term "adjusted basis" can be regarded as synonymous with the term "value." Finally, the Court observed, the term's second disjunctive appearance is followed by "as the case may be," which eliminates any lingering doubt that the terms "value" and "adjusted basis" are alternatives.

With respect to Woods' alternative argument, the Court noted that his argument was the rationale that the Fifth and Ninth Circuits have adopted for refusing to apply the valuation-misstatement penalty in cases similar to Woods. The Court rejected the argument's premise: The economic substance determination and the basis misstatement are not "independent" of one another. This is not a case where a valuation misstatement is a mere side effect of a sham transaction, the Court observed. Rather, the overstatement of outside basis was the linchpin of the tax shelter at issue and the mechanism by which Woods and McCombs sought to reduce their taxable income. In this type of tax shelter, the Court noted, the basis misstatement and the transaction's lack of economic substance are inextricably intertwined, so attributing the tax underpayment only to the artificiality of the transaction and not to the basis over valuation was making a false distinction. In short, the partners underpaid their taxes because they overstated their outside basis, and they overstated their outside basis because the partnerships were shams. The Court thus had no difficulty concluding that any underpayment resulting from the tax shelter was attributable to the partners' misrepresentation of outside basis (i.e., a valuation misstatement).

As a result, the Supreme Court reversed the Fifth Circuit and held that the district court had jurisdiction to determine whether the partnerships' lack of economic substance could justify imposing a valuation-misstatement penalty on the partners. Under TEFRA's framework, a court in a partnership-level proceeding has jurisdiction to determine the applicability of any penalty that relates to an adjustment to a partnership item, the Court said. A determination that a partnership lacks economic substance, the Court held, is such an adjustment.

TEFRA authorizes courts in partnership-level proceedings to provisionally determine the applicability of any penalty that could result from an adjustment to a partnership item, even though imposing the penalty requires a subsequent, partner-level proceeding. In that later proceeding, the Court stated, each partner may raise any reasons why the penalty may not be imposed on him specifically. Applying those principles to the Woods case, the district court had jurisdiction to determine the applicability of the valuation-misstatement penalty and, the Court concluded, the valuation-misstatement penalty applies in this case. (Staff Editor Parker Tax Publishing)

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