On December 3, 2013, the U.S. Supreme Court unanimously reversed the U.S. Court of Appeals for the Fifth Circuit and held that (1) a federal district court in a partnership-level proceeding had jurisdiction to determine the provisional applicability of section 6662 valuation misstatement penalties assessed against individual partners when the partnership lacked economic substance, and (2) the valuation misstatement penalties applied when a partner’s underpayment of taxes was attributable to the partner having claimed an adjusted basis that exceeded the correct amount of that adjusted basis and the resulting “overstatement” of basis was due to the partnership’s lack of economic substance. United States v. Woods, No. 12-562 (Dec. 3, 2013). In making these determinations, the Court resolved a split among federal appellate courts on the second question and effectively reversed two federal appellate courts on the first question.
The Woods opinion establishes that in all federal circuits, valuation misstatement penalties are now in play for any underpayment that is attributable to an adjusted basis overstated by the statutory thresholds, even if the overstatement is not due to a “valuation” issue but instead due to differences of opinion (between taxpayers and the Internal Revenue Service (IRS)) about the legal ramifications of agreed facts.
The taxpayers participated in what the Supreme Court labeled an “offsetting-option tax shelter."1 As the Court described the facts, the taxpayers purchased offsetting currency option spreads and contributed the spreads, along with some cash, to two partnerships. The total of the net cost of the spreads and the amount of the cash was about $3.2 million. But when calculating their bases in the partnership interests, the taxpayers considered only the “long” component of the spreads and disregarded the nearly offsetting “short” component. As a result, the taxpayers claimed a total adjusted basis in their respective partnership interests (or “outside basis”) of more than $48 million. The partnerships disposed of these assets after a few weeks (and before the end of the tax year) for modest gains, but the taxpayers claimed losses of more than $45 million attributable to their increased outside bases in the partnerships.
The IRS disallowed the losses on the ground that the partnerships lacked economic substance, or were “shams,” because they had no business purpose other than tax avoidance. The IRS thus disregarded the partnerships for tax purposes and disallowed the related losses. The IRS also determined that because the partnerships were “shams,” the amount of the partners’ outside bases in their partnership interests was not greater than zero. Then the IRS applied the 40% gross valuation misstatement penalty (I.R.C. § 6662(b)(3)) on the partners’ tax underpayments resulting from the disallowed losses.
The taxpayers challenged the IRS determinations in the United States District Court for the Western District of Texas. That court upheld the IRS’s determinations that the partnerships were shams and that the resulting losses should be disallowed. But citing Fifth Circuit precedent, the court refused to uphold the IRS’s application of the valuation misstatement penalty on the ground that the IRS cannot penalize a taxpayer for a valuation overstatement included in a deduction that the IRS has totally disallowed. Because the valuation misstatement in this case related to the partners’ outside bases in the partnerships disregarded by the IRS, the IRS could not impose, on the partners, the valuation misstatement penalty on the resulting underpayments attributable to the disregarded partnerships. Woods v. United States, 794 F. Supp. 2d 714, 717 (W.D. Tx. 2011), citing Heasley v. Commissioner, 902 F.2d 380, 383 (5th Cir. 1990). The Fifth Circuit affirmed the district court without a published opinion. United States v. Woods, 471 Fed. Appx. 320 (5th Cir 2012).
The Supreme Court granted certiorari because the Fifth Circuit’s application of the valuation misstatement penalty in this context had been followed by the Ninth Circuit only, while the First, Third, Seventh, and Eleventh Circuits had rejected the Fifth Circuit’s approach.2 Additionally, both the Federal Circuit and the District of Columbia Circuit had determined that federal district courts in partnership-level proceedings lacked jurisdiction to consider whether the valuation misstatement penalty may be applicable to individual partners when the IRS had disregarded a partnership due to lack of economic substance. The Court also took up that question and answered it first.3
District Court Has Jurisdiction to Determine Applicability of Valuation Misstatement Penalty to a Partner’s Underpayment When Partnership Lacked Economic Substance
Under Title IV of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), partnership-related tax matters are addressed in two stages. First, the IRS initiates proceedings at the partnership level to adjust “partnership items” – those relevant to the partnership as a whole. The IRS then issues a Notice of Final Partnership Administrative Adjustments (FPAA) that notifies partners of adjustments to the partnership items, and the partners may seek judicial review of the IRS’s adjustments. After the adjustments to the partnership items are final, the IRS may initiate further proceedings at the partner level to make any resulting “computational adjustments” to the tax liability of the individual partners. Most adjustments of this type may be directly assessed against the partners, bypassing deficiency proceedings and allowing the partners to challenge the assessments in post-payment refund actions only. But deficiency proceedings are required for a deficiency attributable to “affected items which require partner level determinations (other than penalties . . . that relate to adjustments of partnership items).” I.R.C. § 6230(a)(2)(A)(i).
Section 6226(f), enacted as part of TEFRA, provides that a court in a partnership proceeding has jurisdiction to determine both partnership items and “the applicability of any penalty . . . which relates to an adjustment to a partnership item.” (Emphasis added). Both parties agreed that a determination that a partnership lacks economic substance is an adjustment to a partnership item. But the taxpayers argued that because outside basis is not a partnership item, but an “affected item,” a penalty that would originate because of a misstatement of outside basis cannot be considered at the partnership level. In other words, a penalty does not “relate to” a partnership item adjustment if it requires a partner-level determination, regardless of whether or not the penalty has some connection to a partnership item.
The Supreme Court rejected the taxpayers’ argument. The Court determined that under TEFRA’s “structure” a court has jurisdiction in a partnership-level proceeding to provisionally determine the applicability of any penalty that could result from an adjustment to a partnership item, even though the actual imposition of the penalty would require a subsequent, partner-level proceeding. In other words, under TEFRA’s two-stage structure, penalties for a tax underpayment must be imposed at the partner level because the partnerships themselves do not pay taxes. But TEFRA provides that the applicability of some penalties must be determined at the partnership level. The Court said determination of whether or not the penalty is applicable is always provisional, or contingent upon determinations a court in a partnership-level proceeding does not have jurisdiction to make. Thus, the Supreme Court concluded that TEFRA’s authorization allowing courts to consider certain penalties at the partnership level would be meaningless if courts were prohibited from considering, in a partnership level proceeding, whether certain penalties may be applicable to individual partners.
The Court was unwilling to read these TEFRA provisions as meaningless and held that courts in partnership-level proceedings have jurisdiction to determine the applicability of any penalty that could result from an adjustment to a partnership item, even if the actual imposition of the penalty would also require determining affected or non-partnership items such as outside basis. Thus, the district court in Woods did have jurisdiction to determine the applicability of the valuation misstatement penalty with respect to whether the partnerships’ lack of economic substance could justify imposing a valuation misstatement penalty on the taxpayers.
The Valuation Misstatement Penalty Applies to Underpayments Attributable to a Partner’s Increased Outside Basis in a Partnership Lacking Economic Substance
Section 6662 imposes a penalty on any underpayment that is “attributable to” a “substantial” or “gross” “valuation misstatement” that exists where “the value of any property (or the adjusted basis of any property) claimed” on a tax return exceeds by a specified percentage “the amount determined to be the correct amount of such valuation or adjusted basis.” §§ 6662(a), (b)(3), (e)(1)(A), (h). The “substantial” valuation misstatement penalty is 20% and the “gross” valuation misstatement penalty is 40%. The statute in effect at the time of the transactions in Woods imposed the “substantial” valuation misstatement penalty when the claimed value or adjusted basis of a property exceeded the correct value or basis by at least 200%. And the “gross” valuation misstatement penalty applied when the claimed number exceeded the actual number by at least 400%. The IRS applied the “gross” valuation misstatement penalty of 40% to the underpayments attributable to the “sham” partnership transaction because the taxpayers’ reported adjusted outside bases were, under applicable regulations, deemed to exceed the correct amount of such bases (zero) by at least 400%. See Treas. Reg. § 1.6662-5(g).
Congress amended section 6662 in 2006 to significantly lower the thresholds for substantial and gross misstatements to 150% and 200%, respectively.
The taxpayers advanced two arguments against the IRS’s application of the gross valuation misstatement penalty. First, the taxpayers argued that the IRS’s determination that the partnerships were shams did not result in a “valuation misstatement” because the determination of a “valuation” or a “value” is a factual, rather than a legal, concept. Thus, the valuation misstatement penalty can apply only to factual misrepresentations about an asset’s worth or cost but not to misrepresentations based on legal errors. Because the IRS determined that the valuation misstatement was attributable to the IRS’s legal position that the partnerships lacked economic substance and should therefore be disregarded for tax purposes, the taxpayers argued that the valuation misstatement penalty, which is limited to factual errors, did not apply. The taxpayers’ second argument was that the penalty did not apply because any underpayment of tax was not “attributable to” a valuation misstatement. According to the taxpayers, when the IRS renders a deduction of any size improper based on an independent legal ground (in this case disregarding the partnerships for lack of economic substance), a valuation misstatement becomes irrelevant to a taxpayer’s tax liability. The Court noted that the taxpayers’ second argument was also the rationale adopted by the Fifth and Ninth Circuits “for refusing to apply the valuation-misstatement penalty in cases like this.” (Slip Op. at 15).
The Court rejected both taxpayer arguments and held that the penalty was applicable here based on the plain language of section 6662. Once the partnerships were disregarded for tax purposes, “no partner could legitimately claim an outside basis greater than zero.” (Slip Op. at 12). Because the taxpayers then used outside bases of more than zero to claim losses and to underpay their taxes, the resulting underpayments were “attributable to” the taxpayers having claimed an “adjusted basis” in the partnership that exceeded “the correct amount of such . . . adjusted basis.” I.R.C. § 6662(e)(1)(A).
The Court rejected the taxpayers’ first argument on the grounds that (1) “value” is not limited solely to factual issues, and (2) even if the term “value” were so limited, section 6662 refers to value or adjusted basis, and the term “adjusted basis” clearly incorporates legal inquiries. The Court rejected the taxpayers’ second argument by determining that “the economic substance determination and the basis measurement are not ‘independent’ of one another” but instead are “inextricably intertwined.” (Slip Op. at 15). The Court observed that “this is not a case where a valuation misstatement is a mere side effect of a sham transaction. Rather, the overstatement of outside basis was the linchpin of the . . . tax shelter [in this case] and the mechanism by which [the taxpayers] sought to reduce their taxable income.” (Id.)
Notably, in rejecting the taxpayers’ second argument, the Court refused to consider material from the Joint Committee on Taxation’s “Blue Book” explanation of section 6662 that provided support for the taxpayer’s position. The Court justified its refusal to consider material from the Blue Book on the ground that the Blue Book contains only commentaries on recently passed tax laws that are “written after the passage of the legislation and therefore do not inform the decisions of the members of Congress who vote in favor of the law.” (Slip Op. at 16, citing Flood v. United States, 33 F.3d 1174, 1178 (9th Cir. 1994)). Thus, the Court did not consider the Blue Book to be a “legitimate tool of statutory interpretation” in this case. (Id.) The Court did note, however, that “the Blue Book, like a law review article, may be relevant to the extent that it is persuasive.” (Id.)
The Woods opinion injects uncertainty into whether the Blue Book will be considered relevant in interpreting a tax statute. The Court in Woods characterizes the Blue Book as so-called “post-enactment legislative history,” which, because it was not written pre-enactment, could not have been considered by Congress during the enactment process. Under prior precedents, “post-enactment legislative history” is not a “legitimate tool of statutory interpretation” as pre-enactment legislative history would be. Rather, such post-enactment documents are given weight similar to a law review article, i.e., they may be relevant to the extent they are persuasive. See, e.g., Bruesewitz v. Wyeth LLC, 131 S.Ct. 1068, 1081 (2011), (rejecting reliance on committee reports from a later Congress). The Court in Woodsexplicitly disapproved of an earlier decision, Federal Power Commission v. Memphis Light, Gas & Water Division, 411 U.S. 458, 472 (1973), which had stated that the Blue Book “provides a compelling contemporary indication” of the meaning of the statute. After Woods, to the extent that the Blue Book supports the pre-enactment legislative history, it should be treated as additional persuasive evidence of the meaning of the statute. If the pre-enactment legislative history is silent, however, a court can choose either to disregard the Blue Book completely or to consider it to the extent it is independently persuasive.