RESPONDENT:Gary Woods et al.
LOCATION: United States District Court for the Western District of Texas
DOCKET NO.: 12-562
DECIDED BY: Roberts Court (2010-2016)
CITATION: 571 US (2013)
GRANTED: Mar 25, 2013
ARGUED: Oct 09, 2013
DECIDED: Dec 03, 2013
Gregory G. Garre – for the respondents
Malcolm L. Stewart – Deputy Solicitor General, Department of Justice, for the petitioner
Facts of the case
In 1999, Gary Woods and Billy McCombs became investors in two partnerships. Those partnerships then transferred their assets to a corporation that was jointly owned by Woods and McCombs, which caused the partnerships to be considered liquidated for tax purposes. Because the value of a liquidated asset is equal to the partner’s basis in the investment, the partnerships reported their losses on their tax reports as equal to the purchased options Woods’ and McCombs’ separate companies originally contributed to the partnerships. After conducting an audit, the Internal Revenue Service (IRS) determined that the partnership transactions served no business purpose and were solely for the purpose of tax avoidance. Therefore they had no legal basis and the IRS did not consider the partnerships valid. The IRS imposed accuracy-related penalties for understatements of income and gross valuation misstatements.
In 2005, Woods (as the tax matters representative for the partnership) brought the matter before a district court and argued that penalties were inappropriate because the tax consequences of the transactions were accurately reported. The district court held that the transactions “lacked economic substance” and that their reported losses should be disregarded. The court also held that, because the transactions had no economic substance, the valuation misstatement penalties did not apply. The United States appealed the decision with regard to the valuation misstatement penalties, and the U.S. Court of Appeals for the Fifth Circuit affirmed the lower court’s ruling.
Did the district court have jurisdiction to consider the applicability of the valuation misstatement penalty under the Internal Revenue Service Code?
(1) Does the penalty for overstatement apply to situations in which the tax underpayment resulted from a transaction that was determined to lack economic substance?
Media for United States v. Woods
Audio Transcription for Opinion Announcement – December 03, 2013 in United States v. Woods
Justice Scalia has our opinion this morning in case 12-562, United States versus Woods.
This is case here on writ of certiorari to the United States Court of Appeals for the Fifth Circuit.
The case involves a type of tax shelter that was marketed to high income taxpayers in the late 1990s.
The mechanics of the shelter were complex, but its aim was simple, to artificially inflate a taxpayer’s basis in a partnership so that the taxpayer could claim huge losses when the partnership’s assets were disposed of.
In this case, respondent Gary Woods and his employer, Billy Joe McCombs contributed roughly $3.2 million in cash and financial instruments to two partnerships which used the cash to purchase stock and currency.
When those assets were later sold for modest gains, Woods and McCombs claimed that their extremely high tax basis in the two partnerships gave them losses of more than $45 million.
How the tax shelter produced that high tax basis is too tedious to recite. [Laughter]
The IRS ruled that the partnerships had no genuine business purpose, but were shams that could be disregarded for tax purposes.As a result, the IRS concluded that to the extent Woods and McCombs underpaid their taxes by claiming a basis in the partnerships greater than zero, they would be subject to the statutory 40% penalty for gross valuation misstatements.
Woods sought judicial review on behalf of the partnerships.
The District Court held that the partnerships were properly disregarded as shams, but that the valuation misstatement penalty did not apply.
The Fifth Circuit affirmed.
We granted certiorari to consider the applicability of the penalty and we reverse.
At the onset, we hold the District Court had jurisdiction to consider the valuation misstatement penalty.
Congress has enacted a two-stage structure for adjudicating tax matters related to partnerships.
Partnerships themselves are not taxed, it’s only the partners who are taxed when the partnership distributes money or property to them.
In the first stage, items applicable to the partnership as a whole and penalties related to those items are determined in unified proceedings at the partnership level.
In the second stage, those partnership level determinations are used to adjust the tax liability of the individual partners.
This case involves a proceeding at the partnership level.
No one disputes that the District Court had jurisdiction to determine that the partnerships were shams.
Accordingly, the District Court also had jurisdiction to provisionally determine the applicability of any penalty that could result from the ruling that the partnerships were shams regardless of whether imposing the penalty would require additional determinations at the individual partner level which it always does.
Turning to the merits, we hold that the valuation misstatement penalty is applicable.
The penalty applies to the portion of any tax underpayment that is attributable to a substantial or gross valuation misstatement which exists where the value or the adjusted basis of any property claimed on a tax return exceeds the correct amount of that value or adjusted basis by a specified percentage.
The penalty’s plain language makes it applicable here.
Once the partnerships were deemed not to exist for tax purposes, no partner could legitimately claim a basis in the partnerships greater than zero.
Any underpayment resulting from the use of a non-zero outside basis would therefore be attributable to the taxpayer’s having claimed an adjusted basis that exceeded the correct amount of that adjusted basis.
And under the relevant treasury regulation which is not challenged here, when an asset’s true adjusted basis is zero, the valuation misstatement is automatically deemed gross and is therefore subject to a 40% penalty.
The judgment of the Court of the Appeals for the Fifth Circuit is reversed.
The Court’s decision is unanimous.