October 11, 2013
The Supreme Court held oral argument in United States v. Woods on October 9. As we have previously reported, the case presents two distinct questions: (1) a TEFRA jurisdictional question concerning whether the court could determine the applicability of the valuation overstatement penalty in a partnership-level proceeding; and (2) the merits question whether the 40% penalty applied when the partnership was found not to have economic substance and therefore the basis claimed by the taxpayers in the partnership was not recognized.
Most of the argument time for both advocates was spent on the jurisdictional issue, as the Justices often seemed genuinely confused about how TEFRA is generally supposed to work and about the respective positions of the parties on how the statutory provisions should be interpreted in the circumstances of this case. [For example, Justice Sotomayor: “what is this case a fight about?” “Could you give me a concrete example, because I’m not quite sure about what you’re talking about.” Justice Breyer: “I am genuinely confused. I have read this several times.”] Thus, a higher percentage of the Justices’ questions than usual appeared designed simply to elicit information or alleviate confusion, rather than to test the strength of the advocate’s position.
Justice Sotomayor began the questioning by suggesting to government counsel, Deputy Solicitor General Malcolm Stewart, that there was an “incongruity” in its position in that it was acknowledging that there were partner-level issues that precluded a final determination of penalty liability until the partner-level proceeding, yet it was insisting that the penalty could be imposed without a notice of deficiency prior to the partner-level proceedings. Mr. Stewart responded that a taxpayer would have an opportunity before the penalty is imposed to make the kinds of broad objections that are at issue in this case. He would have to file a partner-level refund suit only if he had undeniably partner-specific issues like a good faith reasonable cause defense, and Congress contemplated that there would not be a prepayment forum for those kinds of issues.
Justice Kagan suggested that the government’s position essentially was “what you do at the partnership level is anything that doesn’t require looking at an individual’s tax return”; Mr. Stewart agreed, but he said that he preferred to state the position as “any question that will necessarily have the same answer for all partners should presumptively be resolved at the partnership level.”
Chief Justice Roberts asked Mr. Stewart about the D.C. Circuit’s reasoning in Petaluma that the penalty issue related to outside basis and therefore could not be resolved at the partnership level even if the answer was obvious. Mr. Stewart began his response by agreeing (as the government has throughout the litigation) with the proposition that “outside basis, in and of itself, is not a partnership item,” but this observation triggered some questions looking for clarification. Justice Scalia asked why outside basis would vary from partner to partner, and Justice Kennedy suggested that the government was arguing that “outside basis in this case is necessarily related to inside basis” – a formulation that Mr. Stewart rejected. The result was that the last few minutes of Mr. Stewart’s argument on the jurisdictional point were diverted into explaining that the government was not making certain arguments being suggested by the Court.
When Gregory Garre began his argument for the taxpayers, Justice Kagan zeroed in on the statutory text and asked if the case didn’t just boil down to whether the “related to a partnership item” language in the statute required that the relationship be direct [taxpayers’ view] or could be satisfied if the relationship were indirect [government’s view]. Mr. Garre responded by arguing that the government’s position was more at variance with the statutory text than she had suggested because the statute gives a partnership-level proceeding jurisdiction over “partnership items” and outside basis concededly was not a partnership item. Justice Scalia, and later Justice Kagan, pushed back against that answer by noting that the statute establishes jurisdiction over more than partnership items. Justice Kennedy chimed in to note that penalties are always paid by the partners, not the partnership itself, yet TEFRA contemplates that some penalties are determined at the partnership level.
Mr. Garre then emphasized that this penalty could not be determined at the partnership level because “outside basis isn’t reported anywhere at all on the partnership” return. Justices Scalia and Breyer both blurted out “so what” in response. There followed a long colloquy in which Mr. Garre argued to Justice Breyer that the difference between overstatements of outside basis and inside basis was of jurisdictional significance. Justice Breyer appeared unconvinced, suggesting instead that the partnership itself is a partnership item, and therefore the penalty based on shamming the partnership should also be regarded as a partnership item. Mr. Garre replied that the penalty was for overstating outside basis, which concededly is not a partnership item.
Justice Ginsburg showed great interest in the recently enacted economic substance penalty, asking about it on three different occasions. Although that new penalty is not applicable to the tax years at issue in this case, the taxpayers had argued that its enactment showed that Congress did not agree with the government’s position – namely, that the valuation overstatement penalty already on the books would apply when partnerships are found to lack economic substance. With respect to jurisdiction, Mr. Garre confirmed that the new penalty could be imposed at the partnership level because it is based on shamming the transaction, a partnership-level determination. With respect to the merits, the advocates unsurprisingly responded differently to Justice Ginsburg’s questions. Mr. Stewart stated that, although there was some overlap between the new penalty and the overstatement penalty at issue in this case, the overlap was not total, and it is not anomalous to have some degree of overlap. Therefore, enactment of the new penalty was not inconsistent with the government’s position. Mr. Garre, by contrast, asserted that the new penalty “that Congress passed to cover this situation here solves all the problems,” and thus it would be wrong for the Court “to fit a square peg into a round hole” by applying the valuation overstatement penalty to this situation. Chief Justice Roberts later asked about how the new penalty operates as well.
Mr. Garre then emphasized the “practical consequences” of resolving the penalty issue at the partnership level – specifically, that it would allow the government to impose the penalty without making a prepayment forum available for the taxpayer to contest it. Justice Sotomayor had begun the argument by asking Mr. Stewart about this point, and now she switched sides and asked Mr. Garre why that was inappropriate when it was “obvious” that the partner was going to claim a nonzero basis. Mr. Garre responded that, obvious or not, the court could not create jurisdiction by “assuming a fact necessary to the penalty.”
Justice Scalia had asked Mr. Stewart whether pushing the penalty determination to the partner level would open the door to inconsistent outcomes on the same legal issue. That was a friendly question, and Mr. Stewart happily agreed. When Justice Scalia asked Mr. Garre the same question, it led to a more extended discussion with several Justices. Mr. Garre initially responded that there was no danger of inconsistent outcomes on the merits issue because the Supreme Court’s resolution of that issue would be binding on everyone. Although different outcomes could occur because different partners have different outside basis, that is what Congress intended and is the reason why TEFRA provides for partner-level proceedings. Justice Scalia then asked about the possibility of different results on whether the partnership was a sham, but Mr. Garre pointed out that this determination was properly made at the partnership level and would apply equally to all partners. Chief Justice Roberts, however, questioned whether the asserted need for a partner-level determination of outside basis was mostly theoretical, asking: “does your case hinge on the perhaps unusual situations where you have one of these partners having a fit of conscience and decides to put down the real number or has some other adjustment to it?” Mr. Garre responded “largely, yes,” but added that the statute did not allow these determinations to be made at the partnership level even if they are obvious, and that where individual transactions are shammed (instead of the entire partnership), it will not be obvious that the basis is overstated. Justice Sotomayor remarked that she was confused by the individual transaction point, but she did not press Mr. Garre on the point after he explained it a second time.
The jurisdictional discussions left so little time for the advocates to address the merits that the argument did not shed much light on the Justices’ views on the applicability of the valuation overstatement penalty. During the government’s argument, Justice Ginsburg finally moved the discussion to the merits by asking the question about the new economic substance penalty discussed above. One other question followed from Chief Justice Roberts in which he asked Mr. Stewart to respond to one of the taxpayers’ main arguments – namely, that there is not an overvaluation of an amount here but instead a determination wiping out the entire transaction. Mr. Stewart responded that it was appropriate to apply the valuation overstatement penalty because “the whole point of the avoidance scheme was to create an artificially inflated basis.”
Mr. Garre also moved to the merits issue late in his argument. He began by emphasizing that Congress clearly aimed this penalty at the fundamentally different situation where the taxpayer misstated the amount of the value. Justice Kagan interjected to say that he was describing “the prototypical case,” but that didn’t have to be the only case, and the statute was drafted more broadly. Mr. Garre responded that “context, punctuation, pre-enactment history, post-enactment history and structure” supported the taxpayers’ position, but Justice Kagan rejoined skeptically that “you’re saying they have text, and you have a bunch of other things.” Mr. Garre then expanded on his answer, stating that the reference to “basis” in the statute “comes in a parenthetical, subordinate way” and thus must be related to an overvaluation, not to a situation where “the thing doesn’t exist at all.” He then ended his argument by noting that tax penalties are to be strictly construed in favor of the taxpayer and by inviting the Court to review the amicus brief filed by Prof. David Shakow for examples of other situations that would be mistakenly swept into the valuation overstatement penalty if the government were to prevail.
On rebuttal, Justice Breyer quickly interrupted to ask about his theory that the jurisdictional issue must be resolved in the government’s favor because the existence of the partnership is a “partnership item,” noting his concern that this approach might be too “simple” given that three courts had gone the other way and that he did not “want to say that you are right for the wrong reasons.” Before Mr. Stewart could respond, however, Chief Justice Roberts asked if he could “pose perhaps a less friendly question.” He then asked Mr. Stewart to comment on an analogy drawn by Mr. Garre to a taxpayer who claims a deduction for donating a $1 million painting when in fact he never donated a painting at all. That situation would involve a misstatement, but not a valuation misstatement, and Mr. Garre argued that in both situations the valuation misstatement penalty would be inapplicable. Mr. Stewart, however, sought to distinguish the painting example from this case because the IRS did not determine that the underlying currency transactions did not occur, just that the partnerships were shams. Chief Justice Roberts appeared unpersuaded by this distinction, commenting that calling the partnerships shams was “like saying that there were no partnerships,” so it seemed that the situations were “pretty closely parallel.”
Given the nature of the questioning, it is harder than usual to draw any conclusions from the oral argument, except perhaps that the Court (or at least the Justice who is assigned to write the opinion) is regretting its decision to add the jurisdictional question to the case. Justice Scalia appeared solidly on the side of the government on the jurisdictional question. Justice Breyer appeared to be leaning that way as well, but on a theory not espoused in the briefs that he himself seemed to recognize might not withstand more rigorous analysis. Conversely, Chief Justice Roberts referred several times to the D.C. Circuit’s Petaluma decision, perhaps indicating that he finds its reasoning persuasive. In the end, most of the Justices seem still to be figuring the case out, and we will have to wait to see where they come out.