United States: Focus On Tax Controversy And Litigation - April 2014

In addition to a discussion of the Supreme Court's decision in Woods v. Commissioner, this month's issue features articles about a pair of recent decisions from the Southern District of New York regarding waiver of attorney client communications by disclosure to the SEC, two directives recently issued by the Internal Revenue Service's Large Business & International Division regarding Information Document Requests, new John Doe summonses issued to US banks for the production of records about US taxpayers with offshore accounts, Notice 2013 69, which provides guidance on the implementation of FATCA for Foreign Financial Institutions, and an urge by Congress to seek extradition of Swiss residents charged with tax evasion offenses.

US Supreme Court Imposes Valuation-Misstatement Penalty in TEFRA Proceeding

By Richard A. Nessler

On December 3, 2013, the United State Supreme Court, in a unanimous decision written by Justice Scalia, ruled that San Antonio entrepreneur and former owner of the Minnesota Vikings, Red McCombs, and his business partner, Gary Woods, were liable for the 40 percent gross valuation-misstatement penalty under IRC § 6662.1 The Supreme Court granted certiorari to address the question whether the federal district courts have jurisdiction in a TEFRA partnership level proceeding to determine whether a partnership's lack of economic substance could justify imposing a valuation-misstatement penalty on the partners. The Supreme Court reversed the Fifth Circuit, and found that the District Court had jurisdiction in the TEFRA proceeding to determine the applicability of the valuation-misstatement penalty.

The jurisdictional penalty issue arose in connection with an offsetting-option tax shelter known as COBRA. The taxpayers entered into the COBRA transaction to reduce their tax liability for 1999. To do so, the taxpayers created two general partnerships, one that would produce an ordinary loss, and the other, capital losses. They used wholly owned LLCs to execute a series of long and short currency option transactions, with a net cost of about $2.3 million. Woods and his employer later contributed the currency spreads to the partnerships along with about $900,000 of cash. The cash was used to purchase foreign currency and stock. The partnerships terminated the spreads in exchange for a lump sum payment from the bank. At the end of the tax year, they transferred their interests in these partnerships to two S corporations, leaving each partnership with a single partner (the relevant S corporation). The partnerships were then liquidated by operation of law and their assets, the currency and stock, were deemed distributed to the S corporations. Upon the sale of the currency and stock the S corporations reported a huge loss, which flowed to the taxpayers. The loss was reported because the taxpayers calculated the tax basis of their interests in the partnerships by disregarding the short option, on the theory that it was "too contingent" to count as a liability. As a result, the taxpayers claimed a total adjusted outside basis (the partner's tax basis as opposed to the "inside basis", which is the partnership's basis) of more than $48 million.

The Service did not agree with the taxpayers and issued a Final Partnership Administrative Adjustment ("FPAA") to deny the COBRA losses. The Service determined that the partnerships had been formed solely for purposes of tax avoidance by artificially overstating basis in the partnership interests. Woods sought judicial review of the FPAA under TEFRA's procedural rules (i.e., IRC Section 6226(a)). The District Court held that the partnerships were properly disregarded as shams, but that the valuation-misstatement penalty under section 6662 did not apply. The Government appealed the decision on the penalty only, to the Fifth Circuit Court of Appeal. The Court of Appeals held that the valuation-misstatement penalty did not apply, citing to Bemont Invs, LLC v. United States, 679 F.3d 339 (5th Cir. 2012), when the relevant transaction is disregarded for lacking economic substance. Two other courts, in the Federal Circuit and DC Circuit, held that the federal court lacked jurisdiction to impose the valuation-misstatement penalty under section 6662 in similar circumstances, which prompted the Supreme Court to take the issue.

The Supreme Court first reviewed the jurisdictional issue, finding that the Federal district court has jurisdiction under Section 6226(f), which provides that the court in a TEFRA partnership level proceeding has jurisdiction to determine "the applicability of any penalty . . . which relates to an adjustment to a partnership item"2 even if the item (e.g., overstated outside basis) is an affected item, and not a partnership item. Simply stated, the issue considered by the Supreme Court was whether the valuation-misstatement penalty "relates to" the determination that the partnerships were shams. The Supreme Court held that the term "relates to" is "essentially indeterminate" and any attempt to narrow jurisdiction goes against the purposes of TEFRA. As the Court put it, "[b]arring partnership-level courts from considering the applicability of penalties that cannot be imposed without partner-level inquiries would render TEFRA's authorization to consider some penalties at the partnership level meaningless."3 The Supreme Court rejected taxpayer's argument that the outside basis was not a partnership item, but an affected item because it required a partner-level determination, regardless of whether or not the penalty had a connection to a partnership item.

As to the application of the valuation-misstatement penalty, the Court found that the plain language under IRC Section 6662(a), (b)(3) required application of the penalty. The COBRA transactions generated losses by enabling the partners to claim a high outside basis in the partnerships. But if disregarded as shams the Supreme Court found that no partner could legitimately claim an outside partnership basis greater than zero. If a partner attempts to do so, to claim losses on his return, and the deduction of losses caused the partner to underpay his taxes, then the resulting underpayment of tax would be "attributable to" the partner having claimed an "adjusted basis" in the partnership that exceeded the correct amount of such adjusted basis. The Supreme Court noted that the statute refers to either "value" or "adjusted basis" and it is this latter term that requires the "application of a host of legal rule" and the statute "contains no indication that the misapplication of one of those legal rules cannot trigger the penalty."4 The Court was not influenced by the fact that the term "adjusted basis" appears in a parentheses, finding that this does not justify "robbing the term of its independent and ordinary significance."5

The Supreme Court rejected Woods' other argument that the underpayment of tax would be attributable to the determination that the partnerships were shams, and not to the misstatement of outside basis. This was the rationale used by the Fifth and Ninth Circuits who refused to permit application of the penalty. However, the Supreme Court had no difficulty concluding that the underpayment for the COBRA tax shelter was attributable to the partners' misrepresentation of outside bases. Based on the Supreme Court's analysis, federal courts may exercise jurisdiction to determine the applicability of the valuation-misstatement penalty under Section 6662 to determine whether the partnerships' lack of economic substance could justify imposing a valuation-misstatement penalty on the partners.

To read this Newsletter, Focus on Tax Controversy and Litigation, in full please click here.


1 United States v. Gary Woods, 571 US __ No. 12-562 (Dec. 3, 2013).

2 Slip Op. at 7.

3 Id. at 9.

4 Id. at 13.

5 Id. at 14, quoting Reiter v. Sonotone Corp., 442 US 330, 339 (1979).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Similar Articles
Relevancy Powered by MondaqAI
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions