Valuation-Misstatement Penalty Applies to Tax Shelter Transactions

By James A. Beavers, J.D., LL.M., CPA, CGMA

Procedure & Administration

The Supreme Court held in a unanimous decision that the Sec. 6662(b)(3) penalty for tax underpayments attributable to valuation misstatements applies to an underpayment resulting from a basis-inflating transaction that is disregarded for a lack of economic substance.


Gary Woods (along with his employer, Billy Joe McCombs) agreed to participate in a COBRA (Current Options Bring Reward Alternatives) tax shelter transaction that was marketed by a large accounting firm. The COBRA transaction was designed to generate large paper losses for the purchasers by giving them an artificially high basis in partnership interests, which enabled them to claim large tax losses on the disposition of the interests.

In the COBRA transaction, Woods and McCombs purchased and sold a series of currency-option spreads from Deutsche Bank. Each spread was a package consisting of a long option that they bought from the bank for a premium and a short option that they sold to the bank for a premium. The premium they paid for the long option was $46 million, and the premium they received for the short option was $43.7 million, making the net cost of the package to Woods and McCombs $2.3 million. They contributed the spreads, along with $900,000 in cash, to two partnerships, which used the cash to purchase stock and Canadian currency. When calculating their bases in their partnership interests, Woods and McCombs took into account only the long component of the spreads and disregarded the nearly offsetting short component, asserting that the liability was too contingent to count. This resulted in Woods and McCombs claiming a combined outside basis in the partnerships of $48 million.

Woods and McCombs then transferred their interests in each partnership to two S corporations they jointly owned, leaving each partnership with only one owner. Because each partnership now only had one owner, it was liquidated by operation of law and its assets were distributed to its owner. Under Sec. 732(b), the S corporations treated the basis in the partnerships’ assets distributed to them as equal to Woods’s and McCombs’s outside bases in their partnership interests. Thus, when the S corporations shortly afterward sold the assets, although they actually made a modest gain on the sale, the S corporations claimed $45 million in losses on the sale for tax purposes; these losses were passed through to Woods and McCombs.

Not surprisingly, the IRS did not agree that the tax losses generated by the COBRA transactions were valid. After audit, the IRS sent each partnership a Notice of Final Partnership Administrative Adjustment (FPAA), disregarding the partnerships for tax purposes and disallowing the related losses. The IRS concluded that Woods and McCombs formed the partnerships for the purpose of tax avoidance and thus they lacked “economic substance,” i.e., they were shams. Because there were 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 under Secs. 6662(b)(3) and 6662(h).

Woods, who was the tax matters partner of both partnerships, sought judicial review of the FPAAs. A district court held that the IRS had properly disregarded the partnerships as shams but that the valuation-misstatement penalty did not apply. The Fifth Circuit affirmed (Woods, 471 Fed. Appx. 320 (5th Cir. 2012), aff’g 794 F. Supp. 2d 714 (W.D. Tex. 2011)). The IRS petitioned the Supreme Court, and the Supreme Court agreed to hear the case to resolve a split in opinion among the circuits on the issue.

Sec. 6662

Under Sec. 6662, an accuracy-related penalty of 20% applies to “the portion of any underpayment which is attributable to . . . [a]ny substantial valuation misstatement under chapter 1.” The version of Sec. 6662(e) in effect at the time of the transaction provided

there is a substantial valuation misstatement under chapter 1 if . . . the value of any property (or the adjusted basis of any property) claimed on any return of tax imposed by chapter 1 is 200 percent or more of the amount determined to be the correct amount of such valuation or adjusted basis (as the case may be).

Under Sec. 6662(h), if the reported value or adjusted basis exceeds the correct amount by at least 400%, the valuation misstatement is considered not merely substantial but “gross,” and the penalty increases to 40%.

The Supreme Court’s Decision

In a unanimous decision, the Supreme Court held that the Sec. 6662(b)(3) valuation-misstatement penalty applied to the COBRA transaction. The Court found that under the plain language of Sec. 6662, Woods’s and McCombs’s underpayments of tax related to the COBRA transactions were attributable to their claiming an adjusted basis in the partnerships that exceeded the correct amount of the basis. Because Regs. Sec. 1.6662-5(g) provides that when an asset’s true value or adjusted basis is zero, any misstatement is considered to be 400% or more of the correct amount and is automatically deemed to be a gross valuation misstatement, and Woods’s and McCombs’s misstatements of their partnership bases were thus gross valuation misstatements subject to a 40% penalty.

To avoid this plain-language interpretation of the statute, Woods made two arguments. First, he argued that the economic substance determination did not result in a “valuation misstatement.” He asserted that the statutory terms “value” and “valuation” connote “a factual—rather than legal—concept,” and that the penalty therefore applies only to factual misrepresentations about an asset’s worth or cost, not to misrepresentations that rest on legal errors (like the use of a sham partnership). The Court, however, did not believe, based on its own precedent and Tax Court precedent, that a determination of value was purely a factual issue. It also found that the statute refers to value or adjusted basis and that a determination of adjusted basis clearly required legal inquiries. Therefore, because the valuation-misstatement penalty encompasses misstatements that rest on legal as well as factual errors, it is applicable to misstatements that rest on the use of a sham partnership.

In an attempt to avoid the plain meaning of “adjusted basis” applied by the Court, Woods argued that the structure of the language of Sec. 6662 essentially made adjusted basis synonymous with value for these purposes. The Court stated outright that the two items could not be regarded as synonymous, and, after parsing the language of the statute, the Court concluded the statute did not indicate the two items were intended to be considered the same.

In the alternative, Woods argued that any underpayment of tax in this case would be “attributable” not to the misstatements of outside basis, but rather to the determination that the partnerships were shams, which he described as an “independent legal ground.” The Fifth and Ninth Circuits had taken this position in refusing to apply the valuation-misstatement penalty in similar cases (see Bemont Investments LLC, 679 F.3d 339 (5th Cir. 2012), and Keller, 556 F.3d 1056 (9th Cir. 2009)).

The Court rejected the argument, finding that in this case the economic substance determination and the basis misstatement were not “independent” of one another. According to the Court, this was not a case where a valuation misstatement was a mere side effect of a sham transaction. Rather, the overstatement of outside basis was the linchpin of the COBRA tax shelter and the mechanism by which Woods and McCombs sought to reduce their taxable income. Woods had relied largely on a passage from the “Blue Book,” or General Explanation of the Economic Recovery Act of 1981 (JCS-71-81) (written by the Joint Committee on Taxation staff), in support of his position, but the Court explained that the Blue Book was, as a postenactment explanation, not a legitimate tool of statutory interpretation and, like a law review article, was relevant only to the extent it was persuasive. The Court stated that the cited passage was not persuasive because it considered a situation quite different from the one at hand.


The Supreme Court’s decision resolves a split in the circuit courts in favor of the majority of circuits. Only the Fifth and Ninth Circuits adhered to the rule that an adjustment to tax liability due to the disallowance of a credit or deduction on grounds other than a valuation misstatement meant, for purposes of determining the gross-valuation-misstatement penalty, there would be no underpayment attributable to a valuation misstatement on which to assess a penalty. Every other circuit that considered the issue has held that the valuation misstatement penalty may apply even if the deduction is totally disallowed because the underlying transaction lacked economic substance.

Woods, No. 12-562 (U.S. 12/3/13)

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