United States: Supreme Court Hears Oral Arguments In United States v. Woods

On October 9, 2013, the Supreme Court heard oral arguments in United States v. Woods.¹ Woods involves the question of whether the section 6662 overstatement penalty applies to an underpayment of tax resulting from a determination that a transaction lacked economic substance because the sole purpose of the transaction was to generate a tax loss by artificially inflating the taxpayer's basis in property. The Supreme Court, sua sponte, directed the parties to additionally brief and argue the question of whether the federal district court had jurisdiction to consider the section 6662 penalty.²

Oral arguments focused on whether the district court had jurisdiction to consider the section 6662 penalty. Under section 6662(f), a district court in a partnership-level proceeding has authority to apply any penalty "which relates to an adjustment of a partnership item." Counsel for the government contended that a district court has authority to impose such a penalty if it makes a threshold determination that the type of error the IRS identified on a partnership return typically will trigger a penalty on an individual partner when that partner prepares his or her return consistent with the partnership return.

Counsel for taxpayer contended that the government's position was an overly broad interpretation of the Code and instead focused on the argument that outside basis was not a partnership item. Counsel for the government countered this by arguing that the transaction giving rise to the penalty—the sham transaction which artificially inflated basis—was a partnership item. Justice Kagan noted that both parties agreed that the sham transaction was a partnership item, but that they disagreed as to whether the section 6662 penalty may relate to an item that is indirectly related to a partnership item.

Lower courts have disagreed as to the proper treatment of this issue. Both the D.C. Circuit³ and the Federal Circuit⁴ have concluded that penalties relating to outside basis cannot be determined in a partnership-level proceeding. The Tax Court in TigersEye Trading, LLC v. Commissioner, disagreed with the conclusion reached by the D.C. Circuit in Petaluma FX Partners, LLC.⁵ Woods is being closely watched as it is expected to resolve the split among lower courts and will affect many cases in which the IRS is attempting to collect section 6662 penalties from taxpayers involved in transactions involving an overstatement of basis. A decision in this case is expected by June 2014.

Footnote

1 United States v. Gary Woods, No. 12-562.

2 See Transcript of Oral Argument, United States v. Woods (Oct. 9, 2013) (No. 12-562); see also Madara and Velarde, "TEFRA Jurisdiction Dominates Woods Oral Arguments," Tax Notes Today (Oct. 10, 1013).

3 Petaluma FX Partners, LLC v. Commissioner, 591 F.3d 649 (D.C. Cir. 2010), aff'g in part, rev'g in part 131 T.C. 84 (2008).

4 Jade Trading, LLC, v. United States, 598 F.3d 1372 (Fed. Cir. 2010), aff'g in part, rev'g in part and remanding on penalty issues 80 Fed. Cl. 11 (2007).

5 Tigers Eye Trading, LLC v. Commissioner, 138 T.C. 67 (2012).

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