- Does a district court have jurisdiction to determine whether an overstatement penalty should be applied in a partnership-level proceeding?
- Does the overstatement penalty apply to an underpayment in federal income tax where the transaction lacks economic substance because the sole purpose of the transaction was to inflate the taxpayer’s basis in property?
In November 1999, two business partners claimed a significant overstatement of adjusted basis in assets that allowed them to overstate financial losses by nearly $43 million. The partners claimed tax deductions on those losses, thereby significantly underpaying federal income taxes. After conducting an audit, the Internal Revenue Service filed a notice of Final Partnership Administrative Adjustment to the Respondent, Gary Woods. Woods then filed a petition with the court for a readjustment of the partnership items. The district court concluded, and the court of appeals affirmed, that the overstatement penalty was inapplicable in this case because there was a lack of economic substance. The Supreme Court will decide whether the district court had jurisdiction to consider the penalty and whether the overstatement penalty applies to a transaction that lacks economic substance. This case implicates the use of tax shelters and the possible penalties faced by alleged tax dodgers; it will decide what issues are appropriate in partner-level litigation; and it will determine the fate of billions of dollars hanging in the balance.
Questions as Framed for the Court by the Parties
Section 6662 of the Internal Revenue Code prescribes a penalty for an underpayment of federal income tax that is "attributable to" an overstatement of basis in property. 26 U.S.C. 6662(a), (b)(3), (e)(l)(A) and (h)(l).
The question presented is as follows:
Whether the overstatement penalty applies to an underpayment of tax resulting from a determination that a transaction lacks economic substance because the sole purpose of the transaction was to generate a tax loss by artificially inflating the taxpayer’s basis in property.
In addition to the question presented by the petition, the parties are directed to brief and argue the following question: whether the district court had jurisdiction in this case under 26 U.S.C. § 6226 to consider the substantial valuation misstatement penalty.
In November 1999, Gary Woods and his business partner, Texas billionaire Billy “Red” McCombs, collaborated in a series of investments through the creation of partnerships that engaged in transactions through a tax shelter called Current Options Bring Reward Alternatives (“COBRA”). See Woods v. United States, 794 F. Supp. 2d 714, 717. The purpose of COBRA was to enable taxpayers to claim a large tax loss by artificially inflating their basis in a particular asset. See id. Through COBRA, taxpayers would claim on their tax returns that their outside basis in a partnership—or their capital stake in a partnership—was much higher than it really was. See id.at718. This inflation would allow the taxpayers to report more losses than they actually suffered and thereby claim more tax deductions than they are entitled to. See id.at719.
Woods and McCombs together engaged in two COBRA transactions involving two partnerships, one to generate ordinary losses and one to generate capital losses. See id.at 717.Woods and McCombs bought and sold options on foreign currencies and Sun Microsystems stock in order to generate large paper losses used to offset gains. See Brief for Petitioners, United States at 33. The Internal Revenue Service (“IRS”) found that Woods and McCombs together incurred only $1.37 million in losses on the transactions, but that Woods and McCombs claimed more than $45 million in losses on the partnership’s tax return. See id.at 34. After conducting a partnership-level audit, the IRS issued Final Partnership Administrative Adjustments (“FPAAs”) and (1) denied the existence of the partnerships, and (2) concluded that the partnership transactions were for the sole purpose of tax avoidance and constituted an economic sham for federal income tax purposes. See Brief for Respondent, Gary Woods at 31. The IRS imposed a 40% penalty under 26 U.S.C § 6226 for gross valuation misstatement on the unpaid taxes that were owed. See id.
In 2005, Woods sued the United States on behalf of the partnership in the Western District of Texas, challenging the FPAAs and alleging that the penalties imposed were not applicable. See Brief for Respondent, at 31. The district court, asserting jurisdiction under the Tax Equity and Fiscal Responsibility Act (“TEFRA”), 26 U.S.C § 6226(a), upheld the IRS’s determination that the transactions lacked economic substance and held that the losses reported and passed through to Woods and McCombs should not be allowed for tax purposes. See Woods 794 F. Supp. 2d at 717. The court explained that the use of the partnerships was for the sole purpose of generating a paper loss to avoid paying a large amount in taxes. See id.at718. However, the district court held that the valuation-misstatement penalty did not apply because the IRS may not penalize the taxpayer for a valuation overstatement in a deduction that the IRS completely disallows. See id.at717. Finally, the district court held that the underpayment at issue here was not attributable to a valuation overstatement, but rather attributable to claiming an improper deduction. See id.
The United States appealed the denial of the gross valuation-misstatement penalty, arguing that the penalty applied because the transactions that were deemed to lack economic substance had the effect of improperly inflating basis. See Brief for Respondent, at 33. While the government appealed the district court’s penalty ruling, the Fifth Circuit Court of Appeals in Bemont Investment LLC v. United States, reached the same result as the district court. See Woods v. United States, 471 Fed. Appx. 320 (5th Cir. 2012). Relying on Heasley and the Fifth Circuit court’s prior decision in Todd v. Commissioner, the court in Bemont held that the overstatement penalty cannot apply when the IRS completely disallows all tax attributes flowing from a transaction in full. See Brief for Petitioners at 38. The Fifth Circuit affirmed the district court’s decision in Woods, holding that issue was decided by Bemont. See id.at 39-40.
This case presents the Supreme Court with the opportunity to settle a circuit split over whether an overstatement penalty imposed by the IRS applies to an underpayment that resulted when the taxpayer had no business purpose for entering into the transaction. See Brief for Petitioners, United States at 1. The IRS and the United States argue that the courts erred in holding that the basis-overstatement penalty is inapplicable when a basis-inflating transaction is found to lack economic substance, stating that the plain text of § 6662 refutes the decision of the Fifth Circuit. See Brief for Petitioners at 67. Woods contends that the district court lacked jurisdiction to decide the overstatement valuation penalty and that the penalty is inapplicable because the tax underpayment is not “attributable to” any valuation misstatement. See Brief for Respondent, Gary Woods at 39-57. The Court’s resolution of the case will have wide-ranging implications for alleged tax dodgers engaging in transactions that may be found lacking in economic substance and will determine what issues are appropriate for resolution in a partner-level litigation—all while billions of dollars hang on the decision. See id.at 22.
THE INTENT AND IMPACT OF THE VALUATION-MISSTATEMENT PENALTY
The United States argues that the valuation-misstatement penalty should apply because the court of appeals’ interpretation of the penalty would frustrate the penalty’s purpose of deterring large basis overstatements. See Brief for Petitioners at 48. Furthermore, according to the United States, the court’s decision would foster the inequity that taxpayers who make simple mistakes on their returns are subject to the penalty, while those who engage in far more egregious misconduct are not. See id. The United States also contends that the new “non-economic substance transaction penalty” passed in 2010, would not apply to the thousands of taxpayers who engaged in abusive tax-shelter schemes before 2010. See Reply Brief for Petitioners, United States at 3.
Woods and supporting amici counter that the valuation-misstatement penalty should only apply when it can be attributable to a valuation misstatement. See Brief for Respondents at 56; Brief for David J. Shakow in Support of Respondents at 7. Several partnerships, including New Millenium Trading, LLC, argue that Congress enacted the valuation-misstatement penalty in order to address the “run of the mill case” in which a taxpayer simply overstates the purchase price value of an asset, and not for cases like this one. See Brief of Amici Curiae New Millenium Trading, LLC, AHG Investements, LLC, NPR Investments, LLC, Alpha I, L.P., And West Ventures, L.P. in Support of Respondents at 35. Additionally, Woods argues that if the Court adopts the government’s version of the penalty, the IRS may seek to impose penalties on myriad other legal errors that have nothing to do with valuation misstatements. See Brief for Respondents at72. Finally, Woods contends that because the addition of the “non-economic substance transaction penalty” in 2010 addresses these types of cases, a win for the proponents would render the 2010 amendment superfluous and this decision “won’t have much of an impact on the future.” See id.at 36.
THE STATUTE'S JURISDICTIONAL LIMITATION
The Court will also decide whether the district court had jurisdiction under 26 U.S.C § 6226 to consider the misstatement penalty. The United States argues that granting jurisdiction to these types of cases best effectuates Congress’s objectives in the Tax Relief Act (“TRA”) because it would decrease the administrative burden of the IRS. See Brief for Petitioners at 67. The government further argues that granting jurisdiction would also avoid inconsistent treatment of different partners with respect to the same penalty, reducing the amount of litigation and the possibility of inconsistent rulings. See id.
Woods argues that granting jurisdiction would render meaningless the statute’s limitation that penalties must “relate to an adjustment to partnership items.” See Brief for Respondents at 41. Woods’ supporters argue that if the attenuated connection the government demands were enough for jurisdiction, the result would be to rewrite 26 U.S.C § 6226 (f) to create jurisdiction that Congress withheld. See Brief of Amici Curiae Gordon W. Bush et al in Support of Respondents. Furthermore, Woods argues that the government’s view has an “Alice-in-Wonderland feel to it,” resulting in “penalty first, verdict afterwards.” See Brief for Respondents at 45.
In sum, this case presents the Supreme Court with the opportunity to decide a circuit split and determine whether the 26 U.S.C § 6226 overstatement penalty applies to understatements of tax when the basis has been totally disallowed because the transaction lacked economic substance. The court’s ruling will implicate alleged tax dodgers, decide what issues are appropriate in partner-level litigation, and determine the fate of billions of dollars hanging in the balance.
The Court must first determine if the district court had jurisdiction to consider the substantial overstatement penalty. See Brief for Petitioner at 37 (citing 26 U.S.C. § 6226). The United States argues that the courts below had jurisdiction to evaluate the applicable penalty when considering the petition for judicial review of a notice of Final Partnership and Administrative Adjustment (“FPAA”). See id. at 37. Woods contends that the partnership-level proceeding was mismatched with a partner-level issue, and thus that the district court lacked jurisdiction. See Brief for Respondent at 20.
If the Court finds that there was jurisdiction, it must then determine if the overstatement penalty can be triggered by transactions that lack economic substance. The government argues that the language of 26 U.S.C. § 6662 does not prevent the penalty from applying to transactions that lack economic substance when the underpayment of tax is attributable to an overstatement of basis in property. See Brief for Petitioner at 39-40. Woods asserts that Congress did not intend for the penalty to apply “when the underpayment results from a legal determination that a transaction lacks economic substance.” Brief for Respondent at 19.
DID THE DISTRICT COURT HAVE JURISDICTION TO CONSIDER THE PENALTY?
The Tax Equity and Fiscal Responsibility Act (“TEFRA”) separates partnership tax issues into two groups: (1) combined partnership-level proceeding and (2) individual partner-level proceedings. Woods contends that the Court does not have jurisdiction over this issue because Congress did not grant the Court power to make a partner-level determination in a partnership-level proceeding, such as this one. See Brief for Respondent at 40-41.
The United States asserts that the courts were authorized by 26 U.S.C. § 6226(f) to determine the applicability of any penalty that relates to the adjustment to a partnership in the partnership proceedings. See Brief for Petitioner at 49. Furthermore, the government contends that an overstatement penalty relates to the adjustment because the ultimate penalties will consider the partners’ positions in inflating basis figures for the partnership for tax purposes. See id. at 57. The government notes that the D.C. and Federal Circuits have highlighted that overstatement penalties in cases like this will require additional partner-level proceedings at the termination of the partnership-level proceedings. See id. at 36. Additionally, the United States reasons that any penalty found in the partnership proceeding will later be determined in the partner-level proceeding. See id. at 38. According to the United States, Congress’s purpose in creating the TRA was to reduce the burden on the IRS See id. at 38. The government argues that allowing the partner to ultimately contest the issue will place the burden on the partner to challenge the assessment of the penalty in a refund proceeding if he disagrees with the penalties. See id. at 38. Lastly, the United States notes that there is a greater risk of inconsistent rulings if the TRA were inapplicable to any penalty that required partner-level determinations because the Tax Court would have to litigate the question against individual partners. See id. at 38.
Woods responds that a partnership proceeding is the incorrect proceeding to determine the overstatement basis because overstatement basis is a partner-level issue. See Brief for Respondent at 21. Woods contends that courts would have to assume jurisdiction to decide the merits of this case without jurisdiction, thus creating a form of hypothetical jurisdiction, which is not allowed. See id. at 22 (citing Steel Co.v. Citizens for Better Environment, 523 U.S. 83, 94 (1998)). Generally, Woods notes, nonpartnership items must be determined in partner-level proceedings after the termination of partnership-level proceedings. See id. at 25 (citing 26 U.S.C. § 6230(a)(2)(A)(i)). Both parties agree that the outside basis, an “affected item,” is a nonpartnership item. See id. at 24 (citing Brief of Petitioner at 32). Woods states that it is unreasonable for the government to try to claim that the TRA made an exception that allows outside basis to be determined in a partnership level proceeding. See id. at 28. Woods quotes the D.C. Circuit’s holding in Petaluma FX Partners LLC v. Commissioner that there is “no jurisdiction to determine that penalties apply with respect to outside basis because those penalties do not relate to an adjustment to a partnership item.” See id. at 26 (citing Petaluma FX Partners LLC v. Commissioner, 591 F.3d 649, 655 (D.C. Cir. 2010)). Woods asserts that if a penalty has an outside basis, then it must be determined at a partner-level proceeding, even if there is a close connection to a partnership item. See id. at 26-27. Lastly, Woods contends that the IRS, like the district court, lacked authority to decide the penalty in the FPAAs that resulted from the partnership level audits because they must have used partner-level audits for affected items. See id. at 30-31.
DOES THE OVERSTATEMENT PENALTY APPLY?
The valuation-misstatement (overstatement) penalty applies when a taxpayer overstates the value or purchase price of property. Woods urges that the penalty applies to factual conclusions, not legal conclusions, such as the courts finding of a lack of economic substance in the transaction. See Brief for Respondent at 32. Accordingly, Woods contends that there was no overstatement and thus that the penalty should not apply. See id. at 32-33.
The United States disputes Woods’s interpretation of 26 U.S.C. § 6662, noting that none of the courts of appeals have interpreted the statute as applying the penalty to only factual conclusions. See Reply Brief for Petitioners at 2. The basis of Woods’s argument is that the statute, amended in 2010, makes use of the term “or” in a parenthesis, when stating that “the statute imposes a penalty where ‘the value of any property (or the adjusted basis of any property) claimed” is overvalued by 200 percent or more. See id. at 10. The United States explains that the “or” points to an alternative way to trigger the penalty. See id.Further, the United States claims that the court of appeals misread an illustrative passage in the General Explanation of the Economic Recovery Tax Act of 1981 about the overstatement penalty which conflicts with the plain text of 26 U.S.C. § 6662 and could potentially create a way to avoid penalties even when partnerships use sham transactions to overstate basis. See Brief for Petitioners at 25-26, 39, 43-44. The United States argues that the statute does not reflect Woods’s proposal that the penalty should not apply because the transaction lacked any economic substance, thus having an actual basis of zero.See id. at 73-74 (citing Gustashaw v. Commissioner, 696 F.3d 1124, 1136 (11th Cir. 2012)). Rather, the government asserts that § 6662 applies to transactions even where there is a lack of economic substance. See id.
Woods argues that valuation misstatements in court are a matter of fact, not legal determinations for jurists to make. See Brief for Respondents 35-36. Woods rejects the government’s argument that Congress adopted the basis overstatement penalty in connection with the valuation-misstatement penalty. See id. at 36-37. Woods contends that basis overstatements due to factual misrepresentations of a property’s value may also be penalized with the valuation-misstatement penalty, but that in this case the court determined that there was a basis overstatement in the legal proceeding. See id. at 37. Woods uses the government’s acknowledgment that the partnership never made any “factual misrepresentations about a particular purchase price,” to argue that lack of economic substance is the only grounds for disregarding the tax consequences. See id. at 39-40. Lastly, Woods declares that the power of taxation should diminish the government’s ability to penalize taxpayers if a statute may be easily misconstrued. See id. at 51-52. Therefore, Woods states that taxpayers should only be subject to a penalty when “the words of the statute plainly impose it,” but that here the statute is unclear.See id. at 52 (citing Commissioner v. Acker, 361 U.S. 87, 91 (1959)).
In this case, the Supreme Court will decide whether the district court had jurisdiction to determine overstatement basis in a partnership-level proceeding, and if so, whether the overstatement penalty applies to a transaction that lacks economic substance. The Court’s resolution of the case will have wide-ranging implications for alleged tax dodgers engaging in transactions that may be found lacking in economic substance and will determine which issues are appropriate for resolution in a partner-level litigation—all while billions of dollars hang in the balance.
- Patrick Temple-West, Supreme Court To Weigh IRS Penalties On Alleged Tax Dodgers, Huffington Post, March 26, 2013.
- Alan Horowitz, Supreme Court Poised To Consider Penalty Issue In Woods, Tax Appellate Blog, March 13, 2013.