In United States v. Woods (December 3, 2013), the Supreme Court resolved a split among different circuits of the United States Court of Appeals on the application of the valuation and tax basis overstatement penalty. IRC Section 6662(b) imposes a penalty on any tax deficiency that results from a taxpayer’s overstatement of either the value or the tax basis of an asset. In Woods, as well as in prior cases, the Fifth Circuit held that where the IRS disallowed a deduction because the transaction that gave rise to it lacked economic substance, it could not also impose the penalty for overstating a tax basis, even if it was the overstated tax basis that gave rise to the deduction.
In these cases, the taxpayer used an artificially inflated asset tax basis to generate a tax loss when the asset was sold. The IRS disallowed the loss on the basis that the transaction giving rise to the loss lacked any economic substance apart from the creation of tax benefits. The reasoning of the Fifth Circuit was that once the IRS determines the transaction lacked economic substance, any loss would be disallowed, whether or not it resulted from an overstatement of the tax basis of the asset. Therefore the tax basis overstatement penalty could not be applied.
Several other circuits had addressed this issue and they concluded that the tax basis overstatement penalty could be applied. These courts found that since the loss resulted from an overstated tax basis, the lack of economic substance and the tax basis overstatement were inextricably linked. The Supreme Court agreed and held the tax basis overstatement penalty could be applied even where the reason for denying a deduction was that the underlying transaction lacked economic substance.