Taxpayers’ Brief Filed in Woods

The taxpayers have filed their response brief in the Supreme Court in the Woods case, contending first that the courts lacked jurisdiction to impose the penalties requested by the IRS and, second, that, if jurisdiction exists, the Fifth Circuit correctly held that the valuation misstatement penalty could not be imposed.

On the jurisdictional point, the brief emphasizes the same basic point made by the courts that have questioned jurisdiction in similar partnership cases (see our previous report here) – namely, that the statute allows for partnership-level jurisdiction in a TEFRA proceeding only over a penalty that relates to adjustment of a “partnership item.”  It is undisputed that outside basis is not a partnership item, and the taxpayers contend that the “penalty at issue in this case undeniably relates to the adjustment of a nonpartnership item—outside basis—not to a partnership item.” The taxpayers’ brief dismisses the government’s argument on this point as having “an Alice-in-Wonderland feel to it” and, at any rate, as proving too much.  The taxpayers concede that the outside basis determination does relate to the adjustment of a partnership item, specifically, whether the partnership transaction should be disregarded for lack of economic substance.  But the brief maintains that, if that attenuated connection were enough for jurisdictional purposes, then the statute’s jurisdictional limitation “would be rendered essentially meaningless and could be readily circumvented.”  The result would be to “rewrite Section 6226(f) to create precisely the jurisdiction that Congress withheld.”

On the merits of the penalty, the brief begins with a different argument from the one relied upon by the Fifth Circuit – maintaining that “there was no ‘valuation misstatement’ to begin with.”  Pointing to the common meaning of the word “valuation” in the statutory text, and to the legislative history, the taxpayers argue that “Congress meant the penalty to address misstatements about valuation—an inherently factual concept concerning the worth or cost of property.”  Therefore, the penalty should not be “triggered by transactions that are accurately reported but deemed not to exist based on a legal conclusion that they lack economic substance,” even if the result of that legal conclusion is to restate the basis claimed by the taxpayer.

The government argues, of course, that the text of the penalty provision is not limited strictly to classic “valuation” misstatements, because the statute defines those misstatements as occurring when “the value of any property (or the adjusted basis of any property)” is overstated on the return.  The taxpayers argue, however, that the government is overreading the parenthetical “adjusted basis” reference and, read in context, it should apply “only when basis is incorrectly reported due to a factual misrepresentation of a property’s worth or cost.”  For the government to read this language as authorizing application of the valuation overstatement penalty to cases where there is a “basis overstatement that is in no way dependent on a valuation error” – that is, one that is traceable to a legal conclusion that the transaction creating the basis was devoid of economic substance – is in the taxpayers’ view “essentially blowing [the penalty provision] up and transforming it into a penalty scarcely recognizable to the one Congress intended.”

The taxpayers also point to the penalty provision added in Congress’s recent enactment of an economic substance provision.  They argue that the penalty associated with that provision (see Code section 6662(b)(6) and (i)) could impose a 40% penalty for the reporting in this case and therefore its enactment indicates that the existing valuation misstatement penalty should not be construed to cover economic substance cases.

As a fallback argument, the taxpayers argue for adopting the rationale of the Fifth Circuit – namely, that the underpayment of tax is “attributable to” a finding of no economic substance and hence is not attributable to a basis overstatement.  Finally, the taxpayers rely on language from Supreme Court decisions in the 1930s to argue that doubts about the meaning of ambiguous tax statutes should be resolved in favor of the taxpayer.

An amicus brief in support of neither party was filed by Professor Andy Grewal.  That brief discusses the state of the law in the courts of appeals regarding the substance of the economic substance doctrine, but urges the Court to “reserve its opinion on the broader economic substance issues implicated in this case.”  Four amicus briefs were filed in support of the taxpayers, on either one or both issues, by other taxpayers involved in pending litigation that would potentially be affected by the Court’s holding.  See here, here, here, and here.

The government’s reply brief is due August 18.  Oral argument has been scheduled for October 9.

Woods – Taxpayers’ Response Brief