United States: US Supreme Court Imposes Valuation-Misstatement Penalty In TEFRA Proceeding

On December 3, 2013, the United States 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.


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).

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