The Supreme Court on Oct. 9 heard arguments in a case that could resolve a split in the circuit courts of appeal, of whether courts can apply an accuracy-related penalty for a tax underpayment that is attributable to a valuation misstatement, when the underlying transaction is disregarded for lacking economic substance.
In United States v. Woods (No. 12-562), the Supreme Court will address the accuracy-related penalty question as well as the issue of whether the lower court properly exercised its jurisdiction under Section 6226(a)(2) to decide the penalty issue in a partnership-level proceeding. The Supreme Court's decision on that issue may have far-reaching consequences on the 1982 Tax Equity and Fiscal Responsibility Act.
In Woods, the taxpayer, Gary Woods, participated in a tax shelter. In a final partnership administrative adjustment, the IRS disallowed losses on the basis that the transaction lacked economic substance and imposed accuracy-related penalties under section 6662. Woods filed a refund suit in the Western District of Texas. The district court sided with him, citing circuit court precedent that when the IRS totally disallows a deduction, the IRS may not then penalize the taxpayer for a valuation overstatement included in the deduction. The Fifth Circuit affirmed.
Section 6662(b)(3) imposes a 20% penalty when an underpayment of tax is "attributable to" any substantial valuation misstatement, which can be an overstatement of basis. Section 6662(h) increases that penalty to 40% when there is a gross valuation misstatement. But circuits are split on whether the penalty should apply if the entire transaction has been found to lack economic substance. The Fifth and Ninth circuits have taken the minority view that the underpayment of tax is not attributable to a valuation misstatement when the transaction lacks economic substance; rather, the underpayment is attributable to the disregarded transaction, and accordingly, the penalty does not apply. Eight other circuits have found the opposite, that the underpayment is attributable to the valuation misstatement.
The Supreme Court may address the penalty issue directly, but it is possible that the Court will limit its decision to the jurisdictional issue at hand, of whether the IRS lacked the authority to impose a penalty in a partnership-level proceeding, as opposed to a partner-level proceeding. Woods argued that the penalty applied to a nonpartnership item — outside basis — and that the statute allows for the imposition of the penalty only to a partnership-level item.
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