Government Seeks Supreme Court Review in Case Involving Penalty for Basis Overstatement

Whether the overstatement penalty applies to an underpayment resulting from a determination that a transaction lacks economic substance because the sole purpose of the transaction was to generate a tax loss by artificially inflating the taxpayer's basis in property.

                          TABLE OF CONTENTS

1. a. Our federal tax system, "relying as it does upon self-assessment and reporting," United States v. Arthur Young & Co., 465 U.S. 805, 815 (1984), prescribes various penalties for taxpayers who fail to report and pay all of the tax that they owe. As relevant here, the Internal Revenue Code imposes penalties if a taxpayer overstates the value of property, or the taxpayer's basis in property, on a tax return in a way that reduces the total taxes reported and paid. For example, a taxpayer might overstate the value of a painting donated to charity to obtain a larger charitable deduction. Likewise, a taxpayer might overstate her basis in shares of stock that she sold to make it appear that she realized a loss on the transaction.

To deter such overstatements, Section 6662 of the Code provides that "there shall be added to the [income] tax [owed] an amount equal to 20 percent of the portion of the underpayment * * * which is attributable to * * * [a]ny substantial valuation misstatement." 26 U.S.C. 6662(a) and (b)(3). A taxpayer commits a "substantial valuation misstatement" if, inter alia, "the value of any property (or the adjusted basis of any property) claimed on any [tax return] is 200 percent or more of the amount determined to be the correct amount of such valuation or adjusted basis (as the case may be)." 26 U.S.C. 6662(e)(1)(A). No penalty may be imposed, however, unless the underpayment exceeds $5000. 26 U.S.C. 6662(e)(2).

Section 6662 also establishes a greater penalty for a "gross valuation misstatement[ ]," defined to be an overstatement of the value or basis of property that is 400% or more of the correct amount. 26 U.S.C. 6662(h)(2)(A)(i).² "To the extent that a portion of the underpayment [of income tax] is attributable to one or more gross valuation misstatements," a penalty equal to 40% of that portion of the underpayment is imposed on the taxpayer. 26 U.S.C. 6662(h)(1).

b. As the text of Section 6662 implicitly recognizes, cases may arise in which part of a taxpayer's underpayment of tax is "attributable to" an overstatement of value or basis, while the remainder of the underpayment is attributable to other errors (for example, failing to include all taxable income or taking an inapplicable deduction). In those circumstances, it is necessary to identify the "portion" of the underpayment of tax that is "attributable to" the overstatement in order to determine whether the overstatement penalty applies.

After the passage of the Economic Recovery Tax Act of 1981, Pub. L. No. 97-34, 95 Stat. 172, which added the predecessor to the overstatement penalty of Section 6662,³ the staff of Congress's Joint Committee on Taxation produced a summary of the legislation known as the Blue Book. See Staff of the Joint Comm. on Taxation, 97th Cong., General Explanation of the Economic Recovery Tax Act of 1981 (Comm. Print 1981) (Blue Book). The Blue Book stated that "[t]he portion of a tax underpayment that is attributable to a valuation overstatement will be determined after taking into account any other proper adjustments to tax liability." Id. at 333. It then set forth a formula to calculate the appropriate portion:

c. In 1991, the Treasury Department promulgated a regulation addressing various issues with respect to overstatement penalties under Section 6662. See 26 C.F.R. 1.6662-5. Subsection (g) of that regulation provides that where the correct value or basis of property is zero -- and thus the overstatement percentage would technically be infinite or undefined -- any overstatement is a gross valuation misstatement. 26 C.F.R. 1.6662-5(g). The regulation also clarifies that the $5000 minimum underpayment to trigger the penalties applies to both substantial and gross valuation misstatements. See 26 C.F.R. 1.6662-5(b).

2. In November 1999, respondent and another individual, Billy Joe "Red" McCombs, elected to participate in an abusive tax shelter called Current Options Bring Reward Alternatives, or COBRA. App., infra, 4a-5a & n.2. The purpose of COBRA is to generate a large paper loss that can offset real gains that the taxpayer realizes in a given tax year. Id. at 5a. McCombs, at one time the owner of the NBA's San Antonio Spurs and the NFL's Minnesota Vikings, expected to realize significant income in 1999 from the expansion of the NFL to include the resurrected Cleveland Browns franchise. Id. at 16a; 9/15/2010 Trial Tr. (Afternoon Sess.) 76-77. Respondent Woods was a long-time business associate of McCombs. App., infra, 16a.

Like a number of other tax shelters that proliferated during the late 1990s and early 2000s, COBRA was designed to enable a taxpayer to claim an unlawful tax loss by artificially inflating her basis in a particular asset. When the asset is sold for far less than the asserted basis, the taxpayer claims a large loss on that sale that can be used to offset real gains from other transactions. App., infra, 5a.

To execute COBRA, a taxpayer purchases and sells largely offsetting short-term options on a foreign currency. See generally RA Invs. I, LLC v. Deutsche Bank AG, No. 3:04-cv-1565, 2005 WL 1356446, at *1 (N.D. Tex. June 6, 2005) (describing COBRA). For example, the taxpayer might purchase a 30-day option on a foreign currency valued at $100 million while selling a 30-day option on the same currency worth $95 million -- for an out-of-pocket expenditure of $5 million. The taxpayer contributes both of those positions, plus a relatively small amount of cash (e.g., $3 million), to a partnership established with another COBRA participant solely for the purpose of the transaction. The partnership then purchases a relatively small quantity of assets (say, $2 million worth of publicly traded stock or a foreign currency). When the offsetting options expire, the partnership is immediately dissolved and the assets are distributed to the partners. The taxpayer then sells the distributed assets, but claims a basis in them equal to the value of the purchased option plus the cash contributed to the dissolved partnership -- in this example, $103 million, generating a $101 million artificial tax loss.

In order to achieve that large paper loss, the taxpayer includes the cost of the purchased option she contributed to the partnership in calculating her basis in her interest, but she does not reduce the basis by the amount of the nearly offsetting sold option. See App., infra, 19a. A (nonprecedential) Tax Court memorandum opinion from 1975 had held that, for purposes of the partnership basis rules, a sold option is a contingent liability -- i.e., a liability that a partner need not account for in determining her basis in the partnership. See Helmer v. Commissioner, 44 T.C.M. (P-H) ¶ 75,160, at 712 (1975).⁶ Taxpayers who participated in COBRA exploited that opinion to generate an artificially high basis in the assets distributed by the sham partnership upon dissolution. In the example described above, the taxpayer claims on her tax return that her basis in the partnership -- and therefore her basis in the assets distributed by the partnership at dissolution, see 26 U.S.C. 732(b) -- is $103 million, even though she contributed only $8 million to the partnership (the $5 million difference between the prices of the offsetting options, plus the $3 million in cash).

Woods and McCombs together engaged in two COBRA transactions with two sham partnerships -- one to generate ordinary losses and one to generate capital losses. App., infra, 5a-6a, 17a. After limited liability companies owned by Woods and McCombs contributed the requisite offsetting options, the partnerships purchased relatively small amounts of Canadian dollars and Sun Microsystems stock. Id. at 18a. When the partnerships dissolved and their assets were distributed to S corporations owned by Woods and McCombs, those assets were sold for small economic gains. See id. at 5a; Trial Exs. 252, 254. But by counting the cost of the purchased options as part of the bases in those assets, Woods and McCombs claimed huge losses on the 1999 returns of the S corporations (which were then allocated to the taxpayers individually). App., infra, 19a. Taking into account fees paid to other entities to participate in COBRA, Woods and McCombs together lost only $1.37 million on the transactions, but they reported more than $45 million in losses. See ibid.; 9/16/2010 Trial Tr. (Morning Sess.) 25-26.

3. The IRS disallowed the tax treatment of the COBRA transactions on various grounds, including that they lacked economic substance. Under the economic-substance doctrine, a longstanding common-law principle codified by Congress in 2010, "tax benefits * * * with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose." 26 U.S.C. 7701(o)(5)(A) (Supp. V 2011). In this case, the IRS determined that each "purported partnership was formed and availed of solely for purposes of tax avoidance by artificially overstating basis in the partnership interests of its purported partners." Trial Ex. 198, at D0198.0032; Trial Ex. 199, at D0199.0032. The IRS further determined that "a 40 percent penalty shall be imposed on the portion of any underpayment attributable to the gross valuation misstatement[s]." Trial Ex. 198, at D0198.0034; Trial Ex. 199, at D0199.0034.

4. Respondent Woods, as Tax Matters Partner for the two partnerships, sued the United States to challenge both the IRS's conclusion that the COBRA transactions lacked economic substance and the applicability of the penalties imposed.

The district court upheld the IRS's determination that the transactions lacked economic substance. App., infra, 19a-21a. The "central theory of COBRA," the court explained, "was that the basis of each partnership's property was the cost of the 'long' currency options, while the 'short' options could be disregarded for tax purposes." Id. at 19a. The court further explained that the "use of two partnerships with a six-week life span to conduct that trading [was] for the sole purpose of generating a paper loss" via this artificially high basis. Id. at 20a. The court concluded that the COBRA transaction "was totally lacking in economic substance," and that "both the ordinary loss and the capital loss claimed by the respective partnerships should be disregarded for tax purposes." Id. at 21a.

In a subsequent opinion, however, the district court held that the overstatement penalty under Section 6662 was inapplicable. App., infra, 3a-14a. Citing the Fifth Circuit's decision in Heasley v. Commissioner, 902 F.2d 380 (1990), the court stated that "[i]n this Circuit * * * it is clearly established that whenever the Internal Revenue Service totally disallows a deduction, it may not penalize the taxpayer for a valuation overstatement included in that deduction." App., infra, 6a. It explained that "until and unless Heasley is overruled by the Court of Appeals or the Supreme Court, this Court is bound by its holding." Ibid.

5. While the government's appeal of the district court's penalty ruling was pending, the Fifth Circuit issued a decision in Bemont Investments, another case involving a tax shelter designed to "creat[e] an artificially high basis in partnership interests." 679 F.3d at 341. Relying on Heasley, supra, as well as the prior decision in Todd v. Commissioner, 862 F.2d 540 (5th Cir. 1988), the court held that the overstatement penalty cannot apply when the IRS treats "transactions as a sham, and disallow[s] all tax attributes flowing from the transactions in full." Bemont Invs., 679 F.3d at 347-348.

Judge Prado issued a concurring opinion, which was joined by the other two members of the panel. Bemont Invs., 679 F.3d at 351. The concurring opinion explained that, although "a routine application of the Todd/ Heasley rule decides this case," that "rule may be misguided." Id. at 351, 353. Judge Prado explained that "[a]rguably, if the Todd/Heasley rule did not bind us, tax underpayment in this case would be 'attributable to' a valuation overstatement." Id. at 353. The "basis misstatement and the transaction's lack of economic substance," Judge Prado reasoned, "are inextricably intertwined" because "[t]he basis misstatement was the engine of, the vehicle behind the sham transaction." Id. at 354. The concurrence further observed that "disregarding the deduction for a lack of economic substance pulls the correct basis to zero, which eliminates the claimed loss, and renders the tax underpaid." Ibid. As a result, "disregarding the transaction for a lack of economic substance does not alter the reality that the tax underpayment was ultimately 'attributable to' the basis misstatement -- or so one could argue, in a world without Todd/Heasley" Ibid.

In his Bemont Investments concurrence, Judge Prado also noted "[t]he near-unanimous opposition to the Todd/Heasley rule" among other courts of appeals. 679 F.3d at 354. "Except for the Ninth Circuit," he explained, "every sister circuit that has considered the issue has concluded that the valuation misstatement penalty may apply even if the deduction is totally disallowed because the underlying transaction lacked economic substance." Ibid. And although "the Ninth Circuit has not joined the majority because it is bound by its own precedent to follow the Todd/Heasley rule, it has questioned the rule's wisdom." Id. at 355 (citing Keller v. Commissioner, 556 F.3d 1056, 1060-1061 (9th Cir. 2009)).

Judge Prado further observed that "the Todd/Heasley rule could incentivize improper tax behavior" because it rewards taxpayers who do not merely misstate their basis in property but who "craft[ ] a more extreme scheme." Bemont Invs., 679 F.3d at 355. As a result, "[a] taxpayer could generate an enormous improper tax benefit by overstating an asset's basis, but then could escape the overvaluation penalty by strategically conceding a deficiency on the ground of economic substance." Ibid. Despite their misgivings about the Todd/Heasley rule, however, Judge Prado and the other panel members ultimately concluded that, in light of binding circuit precedent, "our hands are tied." Ibid.

6. Citing Bemont Investments, as well as Todd and Heasley, a different panel of the Fifth Circuit affirmed the district court's penalty ruling in this case in a one-paragraph per curiam opinion, App., infra, 1a-2a, stating that "[w]e are convinced this issue is well settled," id. at 2a.

The government filed petitions for rehearing en banc in both Bemont Investments and this case. Bemont Investments became moot when the taxpayer elected to pay the overstatement penalty, see 10-41132 Docket entry (5th Cir. Aug. 2, 2012), and the Fifth Circuit denied rehearing in this case, App., infra, 23a-24a.

A. The Court Of Appeals Erred In Holding That Section 6662 Does Not Impose An Overstatement Penalty Where A Transaction Is Disregarded As Lacking Economic Substance

1. When a transaction designed to generate an artificially high basis in property is disregarded as lacking economic substance, the resulting underpayment of tax is "attributable to" an overstatement of basis within the meaning of Section 6662.

a. Section 6662 provides that the overstatement penalty shall apply to "the portion of any underpayment which is attributable to * * * [a] substantial valuation misstatement." 26 U.S.C. 6662(b)(3); see 26 U.S.C. 6662(h)(1) (applying greater penalty to the "portion of the underpayment * * * attributable to one or more gross valuation misstatements"). The word "attributable" means "capable of being attributed," and to "attribute" is to "explain as caused or brought about by." Webster's Third New International Dictionary of the English Language 141, 142 (1993). As this Court explained in construing the words "gain attributable to such property" in another provision of the Internal Revenue Code, "the phrase 'attributable to' merely confines consideration to that gain caused or generated by the property in question." Braunstein v. Commissioner, 374 U.S. 65, 70 (1963). An underpayment of tax therefore is "attributable to" an overstatement of value or basis if the overstatement caused the underpayment.

Accordingly, when a taxpayer has underpaid income tax as a result of a tax shelter designed to generate tax losses by artificially inflating his basis in property, the underpayment is "attributable to" an overstatement of basis. The COBRA tax-avoidance mechanism employed by respondent provides an apt illustration. As the district court explained, "the whole point of the COBRA strategy" was to create a huge paper loss by claiming that "the basis of each partnership's property was the cost of the 'long' currency options, while the 'short' options could be disregarded for tax purposes." App., infra, 19a. When assets of the two partnerships (stock in Sun Microsystems and Canadian dollars) were sold, the taxpayers, through their S corporations, claimed a basis in those assets equal to the price of the long options (more than $45 million) plus a small amount of cash contributed to the partnerships. The IRS determined, however, that because the transaction had no purpose other than to achieve a tax loss, the transaction must be disregarded in calculating tax liability, and that the correct basis therefore was zero. See ibid.; Trial Ex. 198, at D0198.0014; Trial Ex. 199, at D0198.0014.

For purposes of computing a taxpayer's gain or loss from the sale of property, "the loss shall be the excess of the adjusted basis * * * over the amount realized" from the sale. 26 U.S.C. 1001(a). The impropriety of the deductions that Woods and McCombs claimed did not result from any misrepresentation concerning the amounts they had realized from the sale of the distributed partnership assets. Rather, the deductions were improper because the claimed losses were premised on asserted bases that the IRS subsequently determined to be unfounded.

In its Notice of Final Partnership Administrative Adjustment, the IRS concluded that the taxpayers had "not established adjusted bases in their respective partnership interests in an amount greater than zero." Trial Ex. 198, at D0198.0032; Trial Ex. 199, at D0199.0032. If Woods and McCombs had used that zero figure in calculating their own tax liabilities, they would have paid substantially more tax. It follows that Woods's and McCombs's underpayments of tax were "attributable to" -- that is, were caused by -- the overstatement of their basis in their partnership interests. "Had it not been for the valuation overstatement," Woods and McCombs "would not have underpaid [their] taxes." Illes v. Commissioner, 982 F.2d 163, 167 (6th Cir. 1992) (per curiam), cert. denied, 507 U.S. 984 (1993).

b. The fact that Woods and McCombs were not allowed to take any deduction at all provides no sound reason to treat Section 6662's overstatement penalty as inapplicable. The statute sets forth "no exception for when the valuation or basis misstatements are so egregious that the entire tax benefit is disallowed, and no suggestion that the penalty should not apply when the correct basis or value is determined to be zero because the transaction is completely lacking in economic substance." Gustashaw v. Commissioner, No. 11-15406, 2012 WL 4465190, at *10 (11th Cir. Sept. 28, 2012). Regardless whether an underpayment of tax results from an overstatement of a zero basis or an overstatement of a basis greater than zero, it is "attributable to" an overstatement of basis.

Even if Section 6662 were ambiguous on this question, the issue was resolved in 1991 by Treasury Regulation 1.6662-5(g), which provides that "[t]he value or adjusted basis claimed on a return of any property with a correct value or adjusted basis of zero is considered to be 400 percent or more of the correct amount." 26 C.F.R. 1.6662-5(g). In that circumstance, "[t]here is a gross valuation misstatement with respect to such property." Ibid. That regulation reflects a reasonable interpretation of Section 6662 and is accordingly entitled to judicial deference. See Chevron U.S.A. Inc. v. NRDC, 467 U.S. 837, 842-845 (1984); see also Mayo Found, for Med. Educ. & Research v. United States, 131 S. Ct. 704, 711-714 (2011) ("We see no reason why our review of tax regulations should not be guided by agency expertise pursuant to Chevron to the same extent as our review of other regulations.").

2. In holding that Section 6662's overstatement penalty does not apply where a basis-inflating transaction is entirely disregarded, the Fifth Circuit has "misread the Blue Book's elementary guidance." Bemont Invs., L.L.C. v. United States, 679 F.3d 339, 352 (5th Cir. 2012) (Prado, J., concurring) (discussing Todd v. Commissioner, 862 F.2d 540 (5th Cir. 1988)). As another court of appeals has explained, the Fifth Circuit arrived at its interpretation "not by considering how the 'attributable to' language should be read in light of its purpose * * * but rather because it glossed that requirement by reading language in a congressional tax document." Fidelity Int'l Currency Advisor A Fund, LLC v. United States, 661 F.3d 667, 673 (1st Cir. 2011) (Fidelity).

a. In Todd, the Fifth Circuit considered whether the overstatement penalty could be imposed on taxpayers who had claimed large deductions and tax credits as part of a scheme involving the purchase of refrigerated containers for agricultural products. See 862 F.2d at 540-541. The IRS had concluded that for many participating taxpayers, including the plaintiffs, the deductions and credits were improper in their entirety because the containers had not been placed in service in the years in which the deductions had been taken. See id. at 541. It had also determined that all participating taxpayers had vastly overstated their bases in the property by counting as part of the purchase price of each container not only the cash paid, but also the principal amount of an illusory promissory note. See ibid.

The Fifth Circuit held that the penalty could not be imposed on the plaintiffs because their underpayment of tax was "attributable to" the disallowance of the deduction for failure to place the units in service during the relevant tax years, rather than to the overstatement of basis in the refrigerated units. See Todd, 862 F.2d at 541-545. The court deemed the words "attributable to" ambiguous as applied to a deduction that is disallowed in its entirety for a reason independent of the overstatement of basis. Finding the "formal legislative history" of the Economic Recovery Tax Act of 1981 unhelpful on the question, the court turned to the formula set forth in the Blue Book. Id. at 542-543; see Blue Book 333. The Fifth Circuit reasoned that the plaintiffs' "actual tax liability" was no greater than their "actual tax liability as reduced by taking into account the valuation overstatement," because in either case the plaintiffs' deductions and credits would be completely disallowed for failure to place the refrigerated units in service in the relevant tax years. See Todd, 862 F.2d at 542-543 (citations omitted).

That conclusion rested on a clear misreading of the statute. Under the plain terms of Section 6662, the relevant question is whether the underpayment of tax is "attributable to" an overstatement of value or basis. By overstating their basis in the property, the plaintiffs in Todd claimed a larger deduction -- and thus made a larger underpayment of tax -- than they would have made if their basis in the refrigerated units had been accurately reported. To be sure, even accurate reporting of the plaintiffs' basis in the units would have resulted in some underpayment of tax, given the IRS's determination that no deduction was permissible because the units had not been placed in service. But the difference between that smaller underpayment and the larger underpayment that actually occurred is naturally characterized as "attributable to" the basis overstatement. See Todd v. Commissioner, 89 T.C. 912, 914 (1987) (noting that the government sought the basis-overstatement penalty "only with respect to the difference between the basis claimed on the return * * * and [the plaintiffs'] cash investment"), aff'd, 862 F.2d 540 (5th Cir. 1988). And "a[n] interpretation of the statute that allows imposition of a valuation misstatement penalty even when other grounds are asserted furthers the congressional policy of deterring abusive tax avoidance schemes." Alpha I, L.P. v. United States, 682 F.3d 1009, 1030 (Fed. Cir. 2012), petition for cert. pending, No. 12-550 (filed Nov. 1, 2012); cf. Saudi Arabia v. Nelson, 507 U.S. 349, 375 (1993) (Kennedy, J., concurring in part and dissenting in part) (explaining that "a single injury can arise from multiple causes, each of which constitutes an actionable wrong") (citing Restatement (Second) of Torts §§ 447-449, at 478-482 (1965)).⁷

As numerous judges have observed, the court in Todd simply misapplied the Blue Book's guidance. The Blue Book described a case involving two different improper deductions, one of which is excessive because it is based on a valuation overstatement, and the other of which "is disallowed totally for reasons apart from the valuation overstatement." Blue Book 333 n.2. The question in Todd, by contrast, was how to apply Section 6662 when a single deduction is tainted both by a basis misstatement and by an unrelated legal defect. The Blue Book does not speak directly to that question.

b. In Heasley v. Commissioner, 902 F.2d 380 (1990), the Fifth Circuit "exacerbated Todd's misunderstanding," Bemont Invs., 679 F.3d at 352 (Prado, J., concurring), by holding that Section 6662 is inapplicable to any deduction that is disallowed in full, even when the ground for disallowance is intimately connected to a value or basis overstatement. The Heasleys had claimed an investment tax credit based on a hugely inflated basis in certain energy savings units, each of which they had valued at $100,000, even though they were worth only $4800. See 902 F.2d at 381-382 & nn. 2, 4. The IRS had disallowed the tax credit in its entirety on a number of factually related grounds, including that the taxpayers "did not have a profit objective" and "that the units were overvalued." Heasley v. Commissioner, 57 T.C.M. (P-H) ¶ 88,408, at 2039 (1988).⁸ In imposing the overstatement penalty, the Tax Court had distinguished Todd on the ground that "[i]n the instant case, we made specific findings as to value," which led it to conclude that, "to the extent the underpayment is due to the disallowed credits, the underpayment is attributable to a valuation overstatement." Ibid.

Seeing "no reason to treat this case any differently than Todd," the Fifth Circuit reversed and held that "[w]henever the I.R.S. totally disallows a deduction or credit, the I.R.S. may not penalize the taxpayer for a valuation overstatement included in that deduction or credit." Heasley, 902 F.2d at 383. "In such a case," it concluded, "the underpayment is not attributable to a valuation overstatement. Instead, it is attributable to claiming an improper deduction or credit." Ibid. That was so "even if the possible grounds for denying the same deduction -- overvaluation and lack of economic substance, for example -- emerge from the same factual nucleus." Bemont Invs., 679 F.3d at 353 (Prado, J., concurring). And, as in Todd, the Fifth Circuit in Heasley applied that approach even though it was evident that the taxpayers' overstatement of basis had caused the size of the claimed deduction (and thus the amount of their underpayment) to be greater than it would otherwise have been.

c. In this case, the taxpayers' overstatements of their bases in the purported partnership were integral to their tax-avoidance scheme. As explained above, a taxpayer's "loss" from the sale of property is "the excess of the adjusted basis * * * over the amount realized." 26 U.S.C. 1001(a). The district court ultimately determined that Woods and McCombs each had an adjusted basis of zero in his partnership interests in the two partnerships. If Woods and McCombs had used that zero figure in calculating their own tax liabilities, they would not have claimed a loss on the sale of the distributed partnership assets, and their reported tax liabilities would have been much higher. The underpayments that actually occurred therefore were "attributable to" the basis overstatements under any usual understanding of that term.

d. The Fifth Circuit's interpretation of Section 6662 frustrates the obvious purpose of the overstatement penalty of deterring taxpayers from misrepresenting their bases in property to achieve unwarranted tax reductions. See Fidelity, 661 F.3d at 673-674. It exempts from the penalty taxpayers who engage in transactions specifically designed to inflate the value or basis in property merely because it is determined that they should not have taken any deduction at all. Congress could not have envisioned that outcome. As one court has remarked, "it is particularly dubious that Congress intended to confer * * * largesse upon participants in tax shelters, whose intricate plans for tax avoidance often run afoul of the economic substance doctrine." Clearmeadow Invs., LLC v. United States, 87 Fed. Cl. 509, 534 (2009).

B. Eight Circuits Have Rejected The Fifth Circuit's Interpretation Of Section 6662's Overstatement Penalty, While Only The Ninth Circuit Has Adopted It

There 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. Eight circuits have concluded that "when an underpayment stems from deductions that are disallowed due to a lack of economic substance, the deficiency is attributable to an overstatement of value and is subject to the penalty of [Section 6662]." Merino v. Commissioner, 196 F.3d 147, 155 (3d Cir. 1999) (quoting Zfass v. Commissioner, 118 F.3d 184, 190 (4th Cir. 1997)). Only the Ninth Circuit has adopted the Fifth Circuit's interpretation, although some judges on the Ninth Circuit (like the members of the Bemont Investments panel) have expressed skepticism about that approach. See Keller v. Commissioner, 556 F.3d 1056, 1061 (9th Cir. 2009). In denying rehearing en banc in this case despite Judge Prado's concurrence in Bemont Investments, the Fifth Circuit has now made clear that it has no intention of revisiting its "well settled" precedent. App., infra, 2a. This Court should accordingly resolve the circuit conflict.

1. There is "near-unanimous opposition to the Todd/Heasley rule" among federal courts of appeals. Bemont Invs., 679 F.3d at 354 (Prado, J., concurring). Eight of the ten circuits that have considered the question have held that the overstatement penalty can apply where a transaction is disregarded as lacking economic substance.

a. In Massengill v. Commissioner, 876 F.2d 616 (1989), decided one year before Heasley, the Eighth Circuit upheld the Tax Court's imposition of the overstatement penalty on taxpayers whose depreciation deductions for cattle were disallowed in full because their purchase of the cattle was a sham. See id. at 618. Reasoning that the taxpayers' "correct basis in the cows was zero because no sale had taken place," the court held that "[w]hen an underpayment stems from disallowed depreciation deductions or investment credit[s] due to lack of economic substance, the deficiency is attributable to [an] overstatement of value, and subject to the penalty." Id. at 619-620.⁹

Two years later, the Second Circuit reached the same conclusion in Gilman v. Commissioner, 933 F.2d 143 (1991), cert. denied, 502 U.S. 1031 (1992). The court in Gilman approved the Tax Court's imposition of the overstatement penalty on a taxpayer who had participated in a sham sale-leaseback arrangement that had the effect of assigning an artificially high purchase price to computer equipment, enabling the taxpayer to take large depreciation deductions. See id. at 145. Although the Second Circuit believed that "the application of [the overstatement penalty] to a transaction determined to be without economic substance is not self-evident," the court ultimately "agree[d] with the Tax Court and with the Eighth Circuit" that "[w]here a transaction is not respected for lack of economic substance, the resulting underpayment is attributable to the implicit overvaluation." Id. at 151-152. The Second Circuit expressly rejected that taxpayer's reliance on Todd and Heasley and noted that "application of the [overstatement] penalty" to transactions lacking economic substance "surely reinforces the Congressional objective of lessening tax shelter abuse." Id. at 151.

In Illes, supra, the Sixth Circuit followed Massengill and Gilman in upholding the imposition of the overstatement penalty on a taxpayer who had claimed depreciation deductions and investment tax credits for certain master recordings leased in connection with a sham business enterprise. See Illes, 982 F.2d at 165-166. As part of the scheme, the taxpayer had claimed an interest in the recordings that "exceeded their correct value by more than 250%." Id. at 166. The court rejected the premise of Heasley that "[s]ince [the taxpayer's] underpayment is the result of the [shelter] being an economic sham * * * the underpayment is attributable to his claiming an improper deduction rather than a valuation overstatement," calling that "a false distinction." Id. at 166-167. The taxpayer's underpayment of tax, the Sixth Circuit reasoned, "[p]lainly * * * was attributable to his valuation overstatement" because "[t]he entire artifice of the [tax] shelter was constructed on the foundation of the overvaluation of its assets." Id. at 167. Simply stated, "[h]ad it not been for the valuation overstatement, [the taxpayer] would not have underpaid his taxes." Ibid.¹⁰

The Third and Fourth Circuits subsequently reached the same conclusion. See Merino, 196 F.3d at 155; Zfass, 118 F.3d at 190-191. Those courts have expressly rejected Heasley in favor of the rule adopted by "[t]he Second, Sixth, and Eighth Circuits * * * that when an underpayment stems from deductions that are disallowed due to a lack of economic substance, the deficiency is attributable to an overstatement of value and is subject to penalty." Zfass, 118 F.3d at 190; see Merino, 196 F.3d at 155, 158 (joining the "majority of the Courts of Appeals that have addressed this issue" in upholding the imposition of the overstatement penalty where "the overvaluation of the property in question * * * is an essential component of the tax avoidance scheme" disregarded as lacking economic substance). Both courts also suggested that the decision in Heasley "appear[ed] to have been driven by understandable sympathy for the Heasleys rather than by a technical analysis of the statute." Merino, 196 F.3d at 158; see Zfass, 118 F.3d at 190 n.8.

b. These earlier decisions applying the overstatement penalty to transactions lacking economic substance concerned relatively simple schemes in which the sham transaction was designed to facilitate depreciation deductions or investment credits for overvalued assets. Recent decisions of the First, Federal, and Eleventh Circuits have adopted the majority interpretation and applied it to sophisticated tax shelters similar to COBRA.

In Fidelity, the First Circuit held the overstatement penalty applicable to two tax shelters that, like COBRA, involved the contribution of offsetting option positions to a partnership in order to generate an artificially high basis in a partnership interest. See 661 F.3d at 668-670. The court rejected the taxpayer's argument that, because there were multiple legal grounds for denying the deduction, all "stemming from the same central finding that the transactions lacked economic purpose," the penalty could not apply. Id. at 672-673. "Congress' phrase 'attributable to,'" it explained, "is easily read to cover the role of the misstatements in lowering [the taxpayer's] taxes and that reading serves the underlying policy" of the penalty. Id. at 673. The First Circuit also observed, citing the 5-to-2 circuit conflict that existed at that time, that "[m]ost circuit courts that have confronted variations of [the taxpayer's] argument in the lack of economic substance context have rejected it"; and it concluded that the Fifth Circuit's approach "rests on a misunderstanding of the sources relied on" (e.g., the Blue Book). Ibid.

Shortly after the Fifth Circuit issued its opinion in Bemont Investments, the Federal Circuit also addressed the applicability of the overstatement penalty to a shelter designed to generate an artificially high basis in property contributed to a partnership. See Alpha I, L.P., 682 F.3d at 1013-1014. The Court of Federal Claims had granted summary judgment to the taxpayer on the ground that, under the reasoning of Todd, the penalty did not apply because the taxpayer had conceded that it was not entitled to a deduction on a ground unrelated to the basis misstatement. See id. at 1026-1027. The Federal Circuit reversed that holding. The court stated that it "disagree[d] with the legal analysis employed in Todd[,] * * * finding it flawed in material respects," pointing to the same misapplication of the Blue Book's guidance that Judge Prado had identified. Id. at 1028-1029. It noted that "every circuit court to have addressed the issue, except the Ninth Circuit * * * , has rejected Todd's reasoning." Id. at 1030. The court also made clear that on remand, the Court of Federal Claims was not free to follow Heasley's extension of Todd either, instructing the court to "focus[ ] on the role that any valuation misstatements played in attaining any improper tax benefits" and citing Fidelity, Gilman, and Merino. Id. at 1030-1031.

Most recently, in Gustashaw, the Eleventh Circuit upheld the imposition of the overstatement penalty in the context of another basis-inflating shelter disregarded for lack of economic substance. Finding "no suggestion" in the statute "that the penalty should not apply when the correct basis or value is determined to be zero because the transaction is completely lacking in economic substance," the court noted that Alpha I, Fidelity, Merino, Zfass, Illes, Gilman, and Massengill were all in accord with its view. Gustashaw, 2012 WL 4465190, at *10. It found "the majority rule to be the better interpretation" of Section 6662 because that "rule rests upon the fact that the abusive tax shelter is built upon the basis misstatement, and the transaction's lack of economic substance is directly attributable to that misstatement." Id. at *11.

2. Departing from the approach taken by the majority of circuits, the Ninth Circuit has adopted the holdings of both Todd and Heasley. As a result, the IRS has been prevented from collecting overstatement penalties from taxpayers who employ abusive tax shelters in circuits covering more than 90 million people.

The Ninth Circuit adopted the Todd rule in Gainer v. Commissioner, 893 F.2d 225 (1990), which arose out of the same refrigerated-units scheme involved in Todd.¹¹ The Ninth Circuit agreed with the Fifth Circuit that the phrase "attributable to" is ambiguous and that the "formal legislative history * * * does not discuss how to determine whether a tax underpayment is 'attributable to' an overvaluation of property." Id. at 227. Like the Fifth Circuit, it went on to read the Blue Book's guidance to mean that where there are two independent causes of the same under-reporting error, only one of which is an overstatement of value or basis, the penalty cannot apply. See id. at 227-228.

The Ninth Circuit then adopted Heasley in Keller, supra. Keller involved a shelter designed to generate depreciation deductions by inflating the taxpayer's basis in cattle that he had never truly acquired. See 556 F.3d at 1057-1058. The Tax Court had held that, because the taxpayer "had in fact not acquired any cattle, his basis in the cattle would be zero for the relevant tax years, far below the claimed bases, and thus supported the 40 percent penalty for gross valuation misstatements." Id. at 1058. Reversing, the Ninth Circuit found Gainer "directly on point" and held that "[w]hen a depreciation deduction is disallowed in total, any overvaluation is subsumed in that disallowance, and an associated tax underpayment is 'attributable to' the invalid deduction, not the overvaluation of the asset." Id. at 1060-1061. It concluded that the taxpayer's "tax deficiency was 'attributable to' taking a depreciation deduction to which he was not entitled (at all) rather than 'attributable to' overvaluation." Ibid.

The court in Keller "recognize[d] that many other circuits have concluded that when overvaluation is intertwined with a tax avoidance scheme that lacks economic substance, an overvaluation penalty can apply." 556 F.3d at 1061; see id. at 1061 n.5 (explaining that in Heasley the "Fifth Circuit * * * interpreted its holding in Todd the same way" as the court was interpreting Gainer). The court further acknowledged that "[t]his sensible method of resolving overvaluation cases cuts off at the pass what might seem to be an anomalous result -- allowing a party to avoid tax penalties by engaging in behavior one might suppose would implicate more tax penalties, not fewer." Id. at 1061. But it deemed itself "constrained by Gainer" to adopt the minority rule. Ibid. The Ninth Circuit denied the government's petition for rehearing en banc, even though two panel members favored further review. See 06-75441 Docket entry No. 65 (May 20, 2009).

3. The conflict of authority is ripe for resolution. Every court of appeals except the Seventh, Tenth, and D.C. Circuits has addressed the issue, and eight have adopted the government's reading of the statute. Both the Fifth and Ninth Circuits have denied the government's petitions for rehearing en banc in recent years, and the Fifth Circuit has stated that the issue is "well settled" in that circuit. App., infra, 2a. Absent further review by this Court, taxpayers in different States therefore will continue to be subject to different IRS enforcement regimes.

This case is a suitable vehicle to resolve the issue. The question is squarely presented, and respondent did not appeal the district court's conclusion that COBRA was a transaction lacking economic substance designed to artificially inflate the basis in partnership interests.¹²

C. The Question Presented Is Important To The Efficient And Fair Administration Of The Internal Revenue Code

If left undisturbed, the minority rule of the Fifth and Ninth Circuits will continue to cost the federal fisc hundreds of millions of dollars in forgone penalties from taxpayers who have employed abusive tax shelters. The entrenched position of those circuits has also led to arbitrary and unfair variation in the federal government's enforcement of the Internal Revenue Code.

1. a. In the decade preceding the 2008 financial crisis, there was a substantial increase in high-dollar, basis-inflating tax shelters employed by U.S. taxpayers. See Permanent Subcomm. on Investigations of the Comm. on Homeland Sec. & Governmental Affairs, The Role of Professional Firms in the U.S. Tax Shelter Industry, S. Rep. No. 54, 109th Cong., 1st Sess. 9-11 (2005). Unlike in previous eras, "the U.S. tax shelter industry was no longer focused primarily on providing individualized tax advice to persons who initiate contact with a tax advisor," but rather was "developing a steady supply of generic 'tax products' that [were] aggressively marketed to multiple clients." Id. at 9. Those standardized shelters, with names like COBRA, BOSS, BLIPS, and FLIP, were marketed to wealthy individuals by accounting firms, law firms, investment banks, and others. See id. at 5-7.

As a consequence of this wave of abusive tax shelters, there has been an explosion of litigation in the federal courts involving the IRS's attempts to recoup unpaid taxes and impose penalties on those who participated in and marketed these shelters. Many of the cases appealable to the Fifth or Ninth Circuit involve millions of dollars in potential penalties. See, e.g., Chemtech Royalty Ass'n LLP v. United States, No. 3:05-cv-944 (M.D. La. trial concluded June 27, 2011) ($360 million basis misstatement). If the rule adopted by those circuits is allowed to stand, the federal government will be deprived of substantial revenue that is owed by wealthy individuals or companies that attempted to avoid their tax obligations by participating in abusive tax shelters.

b. In 2010, Congress added to Section 6662 a new subsection that imposes a 40% penalty on any underpayment of tax that is attributable to a "nondisclosed noneconomic substance transaction" entered into after March 30, 2010. 26 U.S.C. 6662(i) (Supp. V 2011). Although this provision may eventually lessen the impact of the Fifth and Ninth Circuit's flawed interpretation of the overstatement penalty, it has no application to the thousands of taxpayers who engaged in abusive, basis-inflating tax shelters before the provision's effective date -- and the millions of dollars in penalties they owe to the federal treasury. Section 6662(i) will have no effect, moreover, on cases where value- or basis-related deductions are disallowed in full on a ground other than lack of economic substance. See, e.g., Derby v. Commissioner, 95 T.C.M. (CCH) 1177, 1194 (2008).

2. Without further review by this Court, the interpretation of Section 6662's overstatement penalty adopted by the Fifth and Ninth Circuits will continue to foster "inequalities in the administration of the revenue laws." Commissioner v. Sunnen, 333 U.S. 591, 599 (1948). Taxpayers who participated in basis-inflating tax shelters and who reside in the Fifth or Ninth Circuit are currently exempt from the overstatement penalty, but taxpayers elsewhere who participated in the same tax shelters are not. See, e.g., Murfam Farms, LLC v. United States, 94 Fed. Cl. 235 (2010) (upholding the overstatement penalty in a case involving COBRA). Such arbitrary differences in treatment threaten the government's ability to enforce the Internal Revenue Code in an even-handed manner.

November 2012

² Section 6662 was amended in 2006 to provide that the threshold for a "substantial valuation misstatement" is 150% (26 U.S.C. 6662(e)(1)(A)) and the threshold for a "gross valuation misstatement[ ]" is 200% (26 U.S.C. 6662(h)(1)). See Pension Protection Act of 2006, Pub. L. No. 109-280, § 1219(a)(1) and (2), 120 Stat. 1083.

³ The predecessor to the overstatement penalty of Section 6662 was located at 26 U.S.C. 6659 and provided a schedule of penalties for "an underpayment of [income tax] for the taxable year which is attributable to a valuation overstatement," defined to exist "if the value of any property, or the adjusted basis of any property, claimed on any return is 150 percent or more of the amount determined to be the correct amount of such valuation or adjusted basis." 26 U.S.C. 6659(a) and (c) (1988). Section 6662 replaced Section 6659 (and other penalty provisions) in 1989. See Improved Penalty Administration and Compliance Tax Act, Pub. L. No. 101-239, Tit. VII, Subtit. G, § 7721(a) and (c)(2), 103 Stat. 2395, 2399. The principal purpose of the change was to "improve the fairness, comprehensibility, and administrability of the[ ] penalties" by consolidating a number of penalty provisions in one section. H.R. Rep. No. 247, 101st Cong., 1st Sess. 1388 (1989).

⁴ An almost identical explanation appears in the legislative history of a similar penalty provision enacted in 1986. See H.R. Rep. No. 426, 99th Cong., 1st Sess. 763 (1985).

⁵ In what appears to have been an inadvertent error, the Blue Book example incorrectly calculated the underpayment attributable to the basis overstatement to be $9800 rather than $10,000 (i.e., $27,505 minus $17,505).

⁶Helmer was superseded by regulations initially proposed in 2003. See 26 C.F.R. 1.752-1(a)(4)(ii).

⁷ The anomalous nature of the Fifth Circuit's approach in Todd is particularly apparent given the treatment of other investors involved in the same Tax Court proceedings. Those other investors had actually placed their refrigerated units in service but (like the Todds) had claimed inflated bases in the assets. The Tax Court held that those taxpayers were liable for penalties for the "portions of their tax deficiencies 'attributable to valuation overstatements.'" Todd, 862 F.2d at 541 (brackets omitted) (discussing Tax Court proceedings). The effect of the Fifth Circuit's approach thus was to treat the additional flaw in the Todds' claimed deduction (ie., their failure to place the units in service) as a ground for avoiding the overstatement penalty.

⁸ In Soriano v. Commissioner, 90 T.C. 44 (1988), the test ease for the transaction at issue in Heasley, the court couched its analysis in terms of economic substance.

⁹ The Eighth Circuit distinguished Todd on the ground that "[t]he taxpayer in Todd had acquired property" -- i.e., the transactions had not been disregarded due to a lack of economic substance, but the deduction had been disallowed for a reason unrelated to the basis overstatement. See Massengill, 876 F.2d at 619.

¹⁰ Although the taxpayer in Illes did not rely on Heasley, the court cited an unpublished opinion in which it had rejected the Heasley analysis in favor of the Second Circuit's approach in Gilman. Illes, 982 F.2d at 167 n.1; see Donahue v. Commissioner, No. 91-1849, 1992 WL 70174, at *4 (6th Cir. Apr. 7, 1992) (959 F.2d 234 (6th Cir. 1992) (Table)). Like the Eighth Circuit in Massengill, the Sixth Circuit distinguished Todd on the ground that, in that case, "the claimed deduction was improper without regard to whether the investors overvalued their interests in the property." Illes, 982 F.2d at 167.

¹¹ As in Todd, the deductions and credits in Gainer had been disallowed because the property had not been placed in service in the relevant tax years.

¹² Respondent filed a notice of appeal from the district court's judgment but later voluntarily withdrew his appeal. See 11-50487 Docket entry (5th Cir. Dec. 13, 2011).