Fifth Circuit Upholds Penalties in NPR

The Fifth Circuit has finally issued its opinion in NPR (as reflected in our prior coverage, this case was argued almost two years ago), a case involving a Son-of-BOSS tax shelter in which the district court absolved the taxpayers of penalties.  The taxpayers were not as fortunate on appeal, as the Fifth Circuit handed the government a complete victory.

The court’s consideration of the two issues before the court of broadest applicability were overtaken by events — specifically, the Supreme Court’s December 2013 decision in United States v. Woods.  See our report here.  In line with that decision, the NPR court held that the penalty issue could be determined at the partnership level and that the 40% penalty was applicable because the economic substance holding meant that the basis in the partnership was overstated.  This latter holding reversed the district court, which had relied on the Fifth Circuit precedents that were rejected in Woods.

The other issues resolved by the Court were mostly of lesser precedential value.  First, the court affirmed the district court’s conclusion that a second FPAA issued by the IRS was valid because NPR had made a “misrepresentation of a material fact” on its partnership return.

Second, the court rejected the district court’s holding that the taxpayers could avoid penalties on the ground that there was “substantial authority” for their position.  It criticized the district court for basing its “substantial authority” finding in part on the existence of a favorable tax opinion from a law firm (authored by R.J. Ruble who eventually went to prison as a result of his activities in promoting tax shelters).  The court explained that a legal opinion cannot provide “substantial authority”; that can be found only in the legal authorities cited in the opinion.  Here, the legal opinion had relied on the “Helmer line of cases,” which establish that contingent obligations generally do not effect a change in a partner’s basis.  The court of appeals held that Helmer did not constitute substantial authority in a situation in which the transactions lack economic substance and in which the partnership lacked a profit motive.  The court also observed that the IRS was correct in arguing that its Notice 2000-44 should be considered as adverse “authority” for purposes of the “substantial authority” analysis — albeit entitled to less weight than a statute or regulation.

Finally, the court overturned the district court’s finding that the taxpayers had demonstrated “reasonable cause” for the underpayment of tax.  With respect to the partnership, the court stated flatly that “the evidence is conclusive that NPR did not have reasonable cause.”  With respect to the individual partners, the court left a glimmer of hope, ruling that an individual partner’s reasonable cause can be determined only in a partner-level proceeding.  Thus, the court merely vacated the district court’s finding of reasonable cause and left the individual partners the option of raising their own individual reasonable cause defenses (whatever those might be) in a partner-level proceeding.

NPR Investments – Fifth Circuit Opinion

Supreme Court Rules for Government on Both Issues in Woods

The Supreme Court this morning ruled 9-0 in favor of the government on both issues in Woods, holding that:  (1) there is partnership-level TEFRA jurisdiction to consider the appropriateness of a penalty when the partnership is invalidated for lack of economic substance; and (2) the 40% valuation overstatement penalty can apply in that setting on the theory that the basis of a sham partnership is zero and therefore the taxpayers overstated their basis.  See our prior coverage here.  The opinion, authored by Justice Scalia, is concise and appears to resolve definitively both issues that had previously divided the lower courts.

On the jurisdictional issue, the Court began by pointing to Code section 6226(f), which establishes partnership-level jurisdiction for “the applicability of any penalty . . . which relates to an adjustment to a partnership item.”  Accordingly, the Court found, the question “boils down to whether the valuation-misstatement penalty ‘relates to’ the determination” that the partnerships were shams.  On that point, the Court agreed with the government’s “straightforward” argument that “the penalty flows logically and inevitably from the economic-substance determination” because the trigger for the valuation overstatement calculation is the conclusion that a sham partnership has zero basis.

The Court rejected the taxpayer’s argument (previous adopted by the Federal and D.C. Circuits) that there can be no partnership-level determination regarding “outside basis” because some partner-level determinations are necessarily required to conclude that outside basis has been overstated.  The Court found that this approach is inconsistent with TEFRA’s provision that the applicability of some penalties must be determined at the partnership level.  If the taxpayer’s position were correct, the Court stated, it “would render TEFRA’s authorization to consider some penalties at the partnership level meaningless.”  The Court stressed that the partnership-level applicability determination is “provisional,” meaning that individual partners can still raise partner-level defenses, but the partnership-level proceeding can determine an overarching issue such as whether the economic-substance determination was categorically incapable of triggering the penalty.  In the Court’s view, “deferring consideration of those arguments until partner-level proceedings would replicate the precise evil that TEFRA sets out to remedy:  duplicative proceedings, potentially leading to inconsistent results, on a question that applies equally to all of the partners.”

With respect to the merits issue of the applicability of the 40% penalty, the Court relied on what it regarded as the “plain meaning” of the statute.  The text applies the penalty to tax underpayments attributable to overstatements of “value . . . (or the adjusted basis)” of property.  Finding that the parentheses did not diminish or narrow the import of the latter phrase, the Court concluded that a substantial overstatement of basis must trigger the 40% penalty and that such an overstatement occurred in this case.  Because the term “adjusted basis” “plainly incorporates legal inquiries,” the Court was unpersuaded by the taxpayer’s argument that the penalty applies only to factual misrepresentations of an asset’s value or basis.  As we have previously noted (see here and here), both the taxpayer and an amicus brief filed by Prof. David Shakow set forth considerable evidence that the intent of Congress in enacting the 40% penalty was to address factual overstatements, not overstatements that flow from legal errors.  The Court, however, stated that it would not consider this evidence, which is found in legislative history and in the IRS’s prior administrative practice, because “the statutory text is unambiguous.”

In addition, the Court rejected the reasoning of the Fifth Circuit that the underpayment of tax was “attributable to” a holding that the partnership was a sham, not to an overstatement of basis.  The Court instead adopted the reasoning of Judge Prado’s opinion in the Fifth Circuit (which had questioned the correctness of binding circuit precedent) that, “in this type of tax shelter, ‘the basis understatement and the transaction’s lack of economic substance are inextricably intertwined.'”

At the end of the opinion, the Court addressed an issue of statutory interpretation that has broader implications beyond the specific context of Woods.  The taxpayer had relied on language in the Blue Book, and the Court stated in no uncertain terms that the Blue Book is not a relevant source for determining Congressional intent.  Rather, it is “post-enactment legislative history (a contradiction in terms)” that “is not a legitimate tool of statutory interpretation.”  The Court acknowledged that it had relied on similar documents in the past, but suggested that such reliance was a mistake, stating that more recent precedents disapprove of that practice.  Instead, the Blue Book should be treated “like a law review article”— relevant only if it is persuasive, but carrying no special authority because it is a product of the Joint Committee on Taxation.

Woods – Supreme Court Opinion

 

Supreme Court Struggles to Unravel TEFRA Jurisdiction in Woods Oral Argument

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.

NPR Court Asks Parties for Additional Information on Jurisdictional Questions

It has been almost two years since the Fifth Circuit heard oral argument in the NPR Investments case, which involves a “son-of-BOSS” tax shelter and associated questions regarding penalties and jurisdiction under TEFRA.  See our previous reports on the oral argument and describing the issues.  Last week, the court issued an order directing the parties to file short “letter briefs,” answering some specific questions involving TEFRA jurisdiction over penalties.  In particular, the court asked the parties to address how NPR compares to the Petaluma (D.C. Cir.) and Jade Trading (Fed. Cir.) cases in which the courts found a lack of jurisdiction in partnership-level proceedings to impose a valuation misstatement penalty where a basis-inflating transaction was found to lack economic substance.  As we have reported, the Supreme Court is preparing to hear argument in U.S. v. Woods, which involves the validity of such a penalty and the same jurisdictional issue addressed in Petaluma and Jade Trading.

It is not clear whether the Fifth Circuit panel considering NPR was aware that the Supreme Court is poised to decide these questions in Woods (though Woods is a case that comes from the Fifth Circuit), but it certainly is aware of it now.  The government’s response to the court’s order points the court to the government’s brief in Woods and explicitly states that “the issue whether Petaluma and Jade Trading were correctly decided is at the heart of the jurisdictional issue before the Supreme Court in Woods, scheduled for argument on October 9.”  Given that a Supreme Court decision will be coming down in the next several months that, at a minimum, will bear closely on the issues in NPR Investments and quite possibly resolve them definitively, it is hard to see why the Fifth Circuit would press ahead to decide the NPR case.  Most likely, it will continue to sit on the case until Woods is decided.  But that is not certain.  The responses to the court’s request for supplemental briefs demonstrated some level of agreement between the government and the taxpayer.  If the Fifth Circuit has an opinion almost ready to go, but for a couple of areas of uncertainty that have now been cleared up by the supplemental briefs, it might go ahead and issue its opinion.  If it does, however, the ultimate result in the case likely will still remain in play until the Supreme Court speaks in Woods.

NPR Investments – Court Request for Supplemental Briefs

NPR Investments – Government’s Supplemental Brief

NPR Investments – Taxpayer’s Supplemental Brief

Briefing Complete in Woods

The government has filed its reply brief in the Supreme Court in Woods.  See our reports on the opening briefs here and here.  The discussion of the jurisdictional issue focuses less on the textual analysis set forth in the government’s opening brief and more on the policy implications of adopting the taxpayers’ position.  The government asserts that the taxpayers’ reading of the statute would effectively “negate Congress’s grant of authority to courts in partnership-level proceedings to determine the applicability of penalties.”

On the merits, the reply brief devotes most of its attention to responding to the taxpayers’ threshold argument that the penalty is inapplicable because there was no valuation misstatement to begin with, which was not the rationale of the court of appeals’ opinion.  The government relies heavily on the statutory reference to “adjusted basis,” noting that it is stated in the disjunctive and therefore should be read to apply to basis overstatements that have nothing to do with “fact-based” valuation misstatements.  The merits discussion also adverts to policy, stating that there is nothing “objectionable about the fact that basis overstatements arising from sham transactions will nearly always trigger the 40% penalty for gross misstatements.”  That is because “the most egregious misconduct–engaging in phony transactions to create an artificial basis–warrants the most severe sanction.”

We also link to an amicus brief inadvertently omitted from our previous report.  This brief, filed by Penn Law School Professor David Shakow because the issue is one “in which he has a special interest and about which he has been engaged for some time in writing,” supports the taxpayers’ primary argument on the merits.  The brief analyzes the statutory language in context, and examines the history of the statute — both the legislative history and its application before tax shelters became rampant — and concludes that the valuation misstatement penalty should not apply in the absence of an actual valuation misstatement.  According to Professor Shakow, the IRS, with the acquiescence of many courts, is improperly “using the valuation misstatement penalty as a surrogate for a ‘tax shelter’ penalty that Congress has not authorized.”

Oral argument is scheduled for October 9.

Woods – Government Reply Brief

Woods – Amicus Brief of Prof. Shakow

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

Supreme Court Briefing Underway in Woods on Penalty and TEFRA Issues

The government has filed its opening brief in the Supreme Court in the Woods case, which involves whether the 40% gross valuation overstatement penalty applies in the context of a basis-inflating transaction held not to have economic substance.  See our earlier report here.

The government’s arguments on the question whether the penalty can be applied in these circumstances are similar to those discussed here previously and addressed in several court of appeals decisions.  It relies on the “plain text” of the statute, arguing that “[t]he word ‘attributable’ means ‘capable of being attributed’” and therefore a finding of lack of economic substance does not defeat the conclusion that the tax underpayment is “attributable” to a basis overstatement.  And the brief responds at length to the Fifth Circuit’s reliance on the “Blue Book” to justify a narrower interpretation of the statute.  The government characterizes the court’s approach as reflecting “a misinterpretation of the relevant passage” in the Blue Book and goes on to say that, “[i]n any event, the Blue Book, a post-enactment legislative report, could not trump the plain text of Section 6662.”  Finally, the government asserts that a contrary rule “would frustrate the penalty’s purpose of deterring large basis overstatements.”

The brief also addresses a question not presented in the petition for certiorari, but instead added to the case by the Supreme Court – namely, whether the district court had jurisdiction under Code section 6226 to decide the penalty issue.  This issue concerns the two-level structure established by TEFRA for judicial proceedings involving partnerships.  Partnerships are not taxable entities themselves; tax attributes from the partnership flow through to the tax returns of the individual partners.  Accordingly, before 1982, tax issues raised by a partnership tax return could be resolved only through litigation with individual partners, leading to duplicative proceedings and often inconsistent results.  The TEFRA scheme calls for proceedings at the partnership level to address “the treatment of any partnership item,” which would be issues common to all the individual partners.  Adjustments that result from those proceedings flow down to the individual partners, and the IRS can make assessments on the individual partners based on those partnership-level determinations without having to issue a notice of deficiency or otherwise initiate a new proceeding.  Issues that depend on the particular circumstances of individual partners, however, are determined in separate partner-level proceedings.

In this case, the penalty determination was made at the partnership level.  That seems logical in one sense because the conclusion that the transaction lacked economic substance – and therefore did not have the effect on basis claimed by the taxpayer – was a partnership-level determination that would not depend on an individual partner’s circumstances.  The Tax Court agrees with that approach, but the D.C. Circuit and the Federal Circuit have stated that such determinations do not involve “partnership items” within the meaning of TEFRA and hence a penalty determination like the one in this case should  be made at the individual partner level.  See Jade Trading, LLC v. United States, 598 F.3d 1372 (Fed. Cir. 2010); Petaluma FX Partners, LLC v. Commissioner, 591 F.2d 649 (D.C. Cir. 2010).  The reason is that the basis at issue here is an “outside basis,” that is, the partner’s basis in his or her partnership interest.  A partner’s outside basis is not a tax attribute of the partnership entity (unlike, for example, the basis of an asset held by the partnership).  These courts did not dispute the assertion that outside basis is an “affected item” (that is, an item affected by a partnership item) and that the conclusion underlying the penalties obviously follows from the partnership item determination; it is obvious that there is zero outside basis in a partnership that must be disregarded on economic substance grounds.  But these courts ruled that obviousness is not a good enough reason to get around the jurisdictional limitations of the statutory text; “affected items” must be determined in a partner-level proceeding.

In its brief in Woods, the government argues that the statutory text allows the penalty determination to be made at the partnership level because the text affords jurisdiction over a penalty that “relates to an adjustment to a partnership item.”  I.R.C. § 6226(f) (emphasis added).  According to the government, “[w]hen a partnership item is adjusted in a way that requires an adjustment to an affected item and triggers a penalty, the penalty ‘relates to’ the adjustment to the partnership item.”  The statute thus should be understood as providing that “the court [considering the partnership-level issues] should decide whether an error with respect to a partnership item, if reflected in a partner’s own return, could trigger the penalty.”  The government’s brief then argues forcefully that its interpretation “best effectuates the objectives” of TEFRA because requiring this kind of penalty determination – involving “a pure question of law whose resolution does not depend on factors specific to any individual partner” – to be made at the partner level “would restore the inefficient scheme that Congress intended to do away with.”

The taxpayer’s brief is due July 22.

Woods – Government’s Opening Brief

Government Brief in Woods Due on May 30

We previously reported on the Court’s grant of certiorari in Woods, noting that the government’s opening brief would be due on May 9.  If you are looking for the brief, be advised that the Court has extended the filing date until May 30.  The taxpayer’s brief will be due July 22.

Supreme Court Agrees to Hear Penalty Issue in Woods

The Court this morning granted the government’s petition for certiorari in United States v. Woods, No. 12-562.  As we recently reported, the issue presented in the petition concerns the applicability of the valuation overstatement penalty — specifically, whether tax underpayments are “attributable to” overstatements of basis when the inflated basis claim has been disallowed based on a finding that the underlying transactions lacked economic substance.

The Court also added a second question for the parties to brief — “Whether the district court had jurisdiction in this case under 26 U.S.C. section 6226 to consider the substantial valuation misstatement penalty.”  This issue involves the general question under TEFRA of which issues are to be resolved in a partner-level proceeding and which should be resolved at the partnership level.  See Petaluma FX Partners, LLC v. Commissioner, 591 F.3d 649, 655-56 (D.C. Cir. 2010).

The government’s opening brief is due May 9.  Oral argument will likely be scheduled for late 2013, with a decision expected by June 2014.

Supreme Court Denies Certiorari in Union Carbide

The Court this morning denied Union Carbide’s petition for certiorari that sought review of the Second Circuit’s denial of claimed research and experimentation credits for the costs of certain supplies used in production process experiments.  The petition had also asked the Court to consider the court of appeals’ application of Auer deference principles.  See our prior reports here.

The Court also entered an order denying a motion by the National Association for Manufacturers to file an untimely brief as amicus curiae in support of the petition.  Although the Court routinely grants motions for leave to file timely amicus briefs, it does take its time limits seriously.  In this case, the amicus brief was due January 3 and the brief was actually filed (with an accompanying motion for leave to file out of time) on January 15.

The Court took no action on the government’s petition for certiorari in Woods, a penalty case.  See our prior report here.  It was scheduled to consider the case at last Friday’s conference, but apparently decided that it needed more time to decide what to do.  The case will be rescheduled to be considered again at a future conference, possibly this Friday.  So there could be an order in the case next Monday.

Supreme Court Poised to Consider Penalty Issue in Woods

The government has asked the Supreme Court to resolve a longstanding conflict in the circuits on the applicability of the penalty for valuation misstatements in United States v. Woods, No. 12-562.

The Code contains a variety of civil penalty provisions for conduct connected with underreporting of tax.  The basic penalty is found in section 6662, which imposes an accuracy-related penalty for underpayments of tax “attributable to” different kinds of conduct, including negligence, substantial understatements of tax, and substantial overvaluations.  The penalty is 20% of the portion of the underpayment “attributable to” the misconduct.  I.R.C. § 6662(a), (b).  Section 6662(e) applies the 20% penalty in the case of a “substantial valuation misstatement,” which is defined as occurring when “the value of any property (or the adjusted basis of any property) claimed on any [tax return] is 150 percent or more of the amount determined to be the correct amount of such valuation or adjusted basis.”  I.R.C. § 6662(e)(1)(A).  That 20% penalty is doubled, however, to 40% in the case of a “gross valuation misstatement,” which is defined in the same way, except that the overvaluation is 200% or more of the correct amount.  I.R.C. § 6662(h)(2)(A)(i).  (Prior to 2006, the relevant percentages were 200% for a substantial valuation misstatement and 400% for a gross valuation misstatement.)

Congress’s focus in originally enacting this penalty was to address a specific problem of overvaluation.  It found that many taxpayers were severely overvaluing difficult-to-value assets like artwork, anticipating that the dispute would ultimately be resolved by “dividing the difference.”  Thus, the severe penalties were enacted as a deterrent to these overvaluations.  See generally H.R. Rep. No. 97-201, at 243 (1981).

In the last decade or so, however, the government has most frequently invoked this penalty regime in its efforts to combat tax shelters.  Oversimplifying a bit, many tax shelters work by using a series of transactions that have the effect of creating a high basis in some particular asset.  Disposal of that asset then generates a large tax loss.  The IRS often argues in these cases that the high basis is artificially inflated because the transactions lack economic substance.  If that argument succeeds, the high basis and attendant tax loss goes away.  In such cases, the government also frequently argues that the 40% gross valuation overstatement penalty applies on the theory that the taxpayer claimed a high basis in an asset ultimately found to have a much lower basis; hence, the adjusted basis “claimed on” the return exceeded by more than 200% or 400% “the amount determined to be the correct amount of” the adjusted basis.  I.R.C. § 6662(h)(2)(A)(i).  The government has not been able to apply this approach in a uniform way across the country, however, because of a persistent disagreement in the circuits over how to construe the penalty statute.

The crux of the dispute centers on the “attributable to” language in the statute.  More than 25 years ago, the IRS contested certain taxpayers’ deductions and credits claimed as a result of transactions involving the purchase of refrigerated containers.  It argued both that the taxpayers had overstated their bases in the property and that the containers had not been placed in service in the years in which the deductions had been taken.  The court ruled for the IRS based on the latter argument.  The Fifth Circuit held that, in these circumstances, the valuation overstatement penalty did not apply because the tax underpayment was not “attributable to” the valuation overstatement; even if there were such an overstatement, the deductions were completely disallowed for a reason independent of the overstatement.  Todd v. Commissioner, 862 F.2d 540, 541-45 (5th Cir. 1988).  Two years later, the Fifth Circuit applied Todd to a case where the two grounds for disallowance were more closely connected, the IRS having contended that the units were overvalued and that the taxpayers did not have a profit motive for the transactions.  Heasley v. Commissioner, 902 F.2d 380, 383 (5th Cir. 1990).

The Fifth Circuit has continued to apply Heasley in tax shelter cases, holding that when an asset is found to have an artificially inflated basis because transactions lack economic substance, the tax underpayment is “attributable to” the economic substance conclusion, not to an overvaluation.  Last year, it reaffirmed its adherence to that approach in Bemont Invs. L.L.C. v. United States, 679 F.3d 339 (5th Cir. 2012), although the judges indicated that they thought the Fifth Circuit precedent was probably wrong.  Shortly thereafter, a different panel rejected the government’s position in a one-paragraph per curiam opinion in Woods v. Commissioner, No. 11-50487 (June 6, 2012), that describes Todd, Heasley, and Bemont as “well-settled,” and the court denied a petition for rehearing en banc.  As a result, the 40% penalty is unavailable in the Fifth Circuit in the typical tax shelter case, although a 20% penalty usually will still apply because of negligence or a substantial understatement of tax (I.R.C. §§ 6662(c), (d)(1)).

The government asks the Court to grant certiorari in Woods, contending in its petition that “[t]here is a lopsided but intractable division among the circuits over whether a taxpayer’s underpayment of tax can be ‘attributable to’ a misstatement of basis where the transaction that created an inflated basis is disregarded in its entirety as lacking economic substance.”  Although the Ninth Circuit has followed the Fifth Circuit’s approach, the petition states that eight other circuits have gone the other way.  Several of those decisions have expressly disagreed with the Fifth Circuit precedent.  The petition says the circuit conflict is “ripe for resolution” given that the Fifth and Ninth Circuit have recently denied petitions for rehearing en banc asking them to reconsider their minority view on this issue.

The case is a strong candidate for Supreme Court review, unless the Court concludes that the issue is “overripe.”  In 2010, Congress passed section 6662(i), which imposes a 40% penalty on any underpayment of tax attributable to a “nondisclosed noneconomic substance transaction” entered into after March 30, 2010.  That new section would make the penalty applicable in such economic substance situations even in the Fifth and Ninth Circuits, and thus makes resolution of the conflict less important for future years.  The cert petition addresses this concern, stating that the new statute “has no application to the thousands of taxpayers who engaged in abusive, basis-inflating tax shelters before the provision’s effective date.”  In addition, the government argues that the new provision will not affect cases “where value- or basis-related deductions are disallowed in full on a ground other than lack of economic substance.”

In its brief in opposition, the taxpayer does not deny the existence of the circuit conflict.  He argues, however, that the issue does not warrant the Court’s attention, largely because the 2010 legislation has resolved the issue presented for future years.  In addition, the taxpayer argues that “the imposition of the 40% penalty in cases where the 20% penalty applies is not an important matter” and expresses skepticism about the government’s “sensationalized claim” that “hundreds of millions of dollars” in penalties are riding on this issue.  In response, the government identifies a group of eight cases docketed within the Fifth Circuit that involve aggregate basis misstatements of approximately $4 billion.

The Court is expected to announce whether it will hear the case on March 18.

Woods – Petition for Certiorari

Woods – Brief in Opposition

Woods – Reply Brief in Support of Certiorari

Fifth Circuit decision in Bemont