On Tuesday, the U.S. Supreme Court held that the 40% penalty for a gross valuation misstatement applied when the partnerships at issue had been determined to be shams that lacked economic substance, and, as a result, the partners’ outside basis in the partnerships was zero ( Woods, No. 12-562 (U.S. 12/3/13), rev’g 471 Fed. Appx. 320 (5th Cir. 2012)).
The decision resolved a split among the circuit courts, with most courts holding that the penalty applied. The Fifth Circuit, in which this case originated, and the Ninth Circuit have held that the penalty does not apply when the entire transaction had been disregarded on economic substance grounds. It also addressed a disagreement among the courts over whether district courts have jurisdiction to determine whether the penalty applies in a partner-level proceeding.
The taxpayer in this case had invested in a basis-inflating tax shelter called COBRA. The tax shelter generated large paper losses that the taxpayer sought to use to offset taxable income. The losses stemmed from artificially inflated outside bases in partnerships, which allowed the taxpayer to claim a large tax loss when the partnership interests were disposed of.
In a unanimous opinion written by Justice Antonin Scalia, the Court explained that a substantial valuation misstatement penalty of 20% applies under Sec. 6662 to any portion of an underpayment attributable to any substantial valuation misstatement. Under the version of Sec. 6662 then in effect, if the reported value or adjusted basis of a property exceeded the correct amount by at least 400%, the 20% penalty increased to 40%. Under Regs. Sec. 1.6662-5(g), if property was found to have a basis of $0, the value or adjusted basis of the property was deemed to be 400% or more of the correct amount and the 40% penalty applied.
The taxpayer primarily argued against the penalty on the grounds that value and valuation are factual, rather than legal issues, and that the penalty applies to factual misrepresentations of an asset’s worth or cost, not to legal determinations of whether a partnership existed. The Court, however, concluded that determining “value” involved legal issues as well as factual issues. The Court further noted that the penalty also refers to adjusted basis, which “plainly incorporates legal inquiries.” Therefore, the Court held that the valuation-misstatement penalty encompasses legal as well as factual issues.
The taxpayer in the alternative argued, as the Fifth and Ninth Circuit had held in prior cases, 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 was an independent legal ground. In rejecting this argument, Scalia quoted a concurring opinion in a Fifth Circuit decision, stating that, with the type of tax shelter at issue, “the basis misstatement and the transaction’s lack of economic substance are inextricably intertwined, so attributing the tax underpayment only to the artificiality of the transaction and not to the basis valuation is making a false distinction” (slip op. at 15–16, quoting Bemont Investments LLC, 679 F.3d 339, 354 (5th Cir. 2012)).
The final issue the Court addressed was whether the district court had jurisdiction to determine whether the penalty applied in the partnership-level proceeding. The taxpayer argued that the issue of the partners’ outside basis in their partnership interests was not a partnership-level item that fell under the partnerships’ unified audit provisions in the Tax Equity and Fiscal Responsibility Act (TEFRA). But the Court agreed with the IRS that the TEFRA partnership rules would be undermined if penalties could be determined only at the partner level rather than at the partnership level during a partnership audit.