United States v. Woods

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Woods and McCombs participated in a tax shelter to generate paper losses to reduce their taxable income. They purchased currency-option spread packages consisting of a long option, for which they paid a premium, and a short option, which they sold and for which they collected a premium. Because the premium paid was largely offset by that received, the net cost of the packages was substantially less than the cost of the long option alone. Woods and McCombs contributed the spreads, plus cash, to partnerships, which used the cash to purchase stock and currency. In calculating their basis in the partnership interests, they considered only the long component of the spreads and disregarded the nearly offsetting short component. When the partnerships’ assets were disposed of for modest gains, they claimed huge losses. Although they had contributed $3.2 million in cash and spreads to the partnerships, they claimed losses of more than $45 million. The IRS sent notices, finding that the partnerships lacked “economic substance,” disallowing related losses, and concluding that the partners could not claim a basis greater than zero for their partnership interests and that tax underpayments would be subject to a 40-percent penalty for gross valuation misstatements. The district court held that the partnerships were properly disregarded as shams but that the penalty did not apply. The Fifth Circuit affirmed. The Supreme Court reversed, first holding that the district court had jurisdiction to make the determination. The Tax Equity and Fiscal Responsibility Act authorizes courts in partnership-level proceedings to provisionally determine the applicability of any penalty that could result from an adjustment to a partnership item, even though imposing the penalty requires a subsequent, partner-level proceeding. In the later proceeding, a partner may raise reasons why the penalty may not be imposed on him personally. However, the valuation-misstatement penalty applies in this case. Once the partnerships were deemed shams, no partner could legitimately claim a basis greater than zero. Any underpayment resulting from use of a non-zero basis would be attributable to a partner having claimed an adjusted basis that exceeded the correct amount. When an asset’s adjusted basis is zero, a valuation misstatement is automatically deemed gross. The valuation¬misstatement penalty encompasses misstatements that rest on both legal and factual errors, so it is applicable to misstatements that rest on use of a sham partnership. View "United States v. Woods" on Justia Law