U.S. Supreme Court - Valuation misstatement penalty issue is resolved 

December 3:  The U.S. Supreme Court today resolved an issue concerning whether the penalty for tax underpayments attributable to valuation misstatements applies to an underpayment resulting from a basis-inflating transaction that is subsequently disregarded for lack of economic substance. United States v. Woods, 12-562 (S. Ct. December 3, 2013)

The Supreme Court held that the federal district courts have jurisdiction in a partnership-level proceeding to determine the applicability of the valuation-misstatement penalty. The Court concluded the penalty is applicable to tax underpayments resulting from the partners’ participation in a tax shelter, and thus reversed the judgment of the Fifth Circuit.


With today’s decision, the Court resolved a split among the federal circuit appeals courts on this valuation misstatement penalty issue.


Read the Supreme Court’s opinion [PDF 116 KB]

Background

The individuals in this case participated in an offsetting-option tax shelter designed to generate large paper losses that they could use to reduce their taxable income. The individuals contributed approximately $3.2 million in cash and spreads to partnerships, but they claimed losses of more than $45 million.


The IRS issued a Notice of Final Partnership Administrative Adjustment, disregarding the partnerships for tax purposes and disallowing the related losses. The IRS concluded that the partnerships were formed for the purpose of tax avoidance and thus lacked “economic substance.” Finding no valid partnerships for tax purposes, the IRS determined that the partners could not claim a basis for their partnership interests greater than zero and that any resulting tax underpayments would be subject to a 40% penalty for gross valuation misstatements.


The federal district court held that the partnerships were properly disregarded as shams but that the valuation-misstatement penalty did not apply. The Fifth Circuit affirmed.

Supreme Court’s decision

Justice Scalia, writing for the unanimous court, concluded:


  • The federal district court had jurisdiction to determine whether the partnerships’ lack of economic substance could justify imposing a valuation-misstatement penalty on the partners.
  • The valuation-misstatement penalty applies in this case, and that the penalty applies pursuant to section 6662 to the portion of any underpayment that is attributable to a “substantial” or “gross” “valuation misstatement,” which exists when “the value of any property (or the adjusted basis of any property) claimed on any return of tax” exceeds by a specified percentage “the amount determined to be the correct amount of such valuation or adjusted basis (as the case may be).”
  • Once the partnerships were deemed not to exist for tax purposes, no partner could legitimately claim a basis in his partnership interest greater than zero. Any underpayment resulting from use of a non-zero basis would therefore be “attributable to” the partner’s having claimed an “adjusted basis” in the partnerships that exceeded “the correct amount of such . . . adjusted basis.”



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