Earlier this week, the Supreme Court heard oral argument in United States v Woods. (The court will post audio of the argument here). As many tax procedure buffs know, the case presents an opportunity for the Court to decide whether the 40% gross valuation misstatement penalty applies in a variety of tax shelter transactions when a court has found that a transaction lacked economic substance or there is a concession on the underlying liability on grounds that do not directly relate to property valuation misstatements. Those concessions include the at-risk rules or the economic substance doctrine. Most courts, except for the Fifth and Ninth Circuits have found that taxpayers cannot avoid the heightened penalty through a finding or such concessions, though later decisions in those circuits have also expressed reservations in their prior holdings. Woods presents an opportunity for the Court to step in and resolve the circuit split on the penalty issue.
The Pain of TEFRA
Before getting to the merits, however, there is a preliminary question that the Court will consider. These cases typically arise in the context of TEFRA partnership proceedings, and, in order to get to the penalty issue, the Court must find that the lower courts properly exercised jurisdiction over the matter.
Tax procedure is a byzantine area of the law, and the TEFRA rules are among the most complicated. We recently rewrote the entire TEFRA provisions in Chapter 8 of the Saltzman and Book treatise. It was some of the most challenging content, both because of the statutory complexity and the fact-intensive nature of many of the cases.
To deal with the TEFRA issue, the Supreme Court asked the parties in Woods to brief the following issue:
Whether the district court had jurisdiction in this case under 26 U. S. C. 6226 to consider the substantial valuation misstatement penalty.
For those who wish to understand the TEFRA context, the following is a brief summary of the issue, including the government’s argument, and language from two cases (Jade Trading and Petaluma), where the DC and Federal Circuits suggested that the courts do not have jurisdiction over the issue. My description of the government argument liberally borrows from the government’s opening brief.
Under TEFRA, “the applicability of any penalty…which relates to an adjustment to a partnership item [must] be determined at the partnership level” through the IRS’s issuance of a Final Partnership Administrative Adjustment (FPAA). Under Section 6226(f), If a timely petition for review of the FPAA is filed, the reviewing court has “jurisdiction to determine… the applicability of any penalty … which relates to an adjustment to a partnership item.”
Two separate requirements under 6226 are implicated. A court has jurisdiction in a partnership-level proceeding to determine whether a particular tax penalty is applicable whenever (i) the court has made or upheld an “adjustment to a partnership item,” and (ii) the penalty “relates to” that adjustment to the partnership item.
The “relates to” requirement is the one that has given some courts pause, and is what the Woods jurisdictional issue turns on.
Not surprisingly, the parties have a different view as to what relates to means. The taxpayer states that the overstatement penalty does not “relate to” the determination that a partnership is a sham. Looking to cases like Petaluma and Jade Trading, counsel for the taxpayer in oral argument this week emphasized that in shelters the basis overstated is the partners’ outside basis in the partnership, which attaches to the assets the partnership distributes on liquidation. Under TEFRA, a partner’s outside basis is ordinarily an affected item rather than a partnership item. The D.C. and Federal Circuits have reasoned that “the [overstatement] penalty * * * relates to an adjustment of an affected item, not a partnership item” as required by Section 6226(f).
The government disagrees. It points out that the statute defines a “partnership item” as “any item required to be taken into account for the partnership’s taxable year under any [income tax] provision” that, as provided in the pertinent Treasury regulations, “is more appropriately determined at the partnership level than at the partner level.” 6231(a)(3)
Regulation define a “partnership item” to include “[t]he partnership aggregate and each partner’s share of * * * [i]tems of income, gain, loss, deduction, or credit of the partner-ship,” as well as “[c]ontributions to the partnership” by the partners, including “the partner’s basis in the contributed property,” and certain “[d]istributions from the partnerships.” Regulations expand and state that partnership items “are defined to include legal and factual determinations that underlie the determination of the amount, timing, and characterization” of those items. Treas reg. 301.6231(a)(3)- 1(b).
In light of the statutory and regulatory definitions, the government notes then that the intermediate step of outside basis adjustment (which is normally an affected item) does not change the underlying point that the penalty has a relationship with the shamming determination, which is a partnership level item, under the applicable regulations, because it is a legal and factual determination that underlies the amount and characterization of other partnership items.
The exchange between Justice Kagan and counsel for the taxpayer seems to narrow the dispute to the “relate to” language, an issue that is at the heart of the difference between the government and taxpayer views:
JUSTICE KAGAN: And in that sense, Mr. Garre, it strikes me as wrong to say the words in dispute are “partnership item.” Actually, everybody agrees what “partnership item” means, what it includes, and what it doesn’t include. It doesn’t include outside basis. The government is perfectly happy to concede that.
It seems as though the words in dispute are what does “relate to” mean and does “relate to” have to be “relate to” in this very direct way that excludes this intermediate step of adjusting outside basis.
MR. GARRE: Right. And the reason why — and I think that gets back to partnership item, because if you read “relates to” in the broad sense that the government is asking you to read it, then in essence you are adding — you’re taking away the limitation of “partnership item” and you are adding words that says “or affected item.” Because what they’re saying is, look, anytime you have a partnership item that is in any way related to the imposition of a penalty down the road, then you can do it.
But another way of saying that, and the way that Congress would have said if it meant it was: Courts, you can determine the applicability of any penalty that relates to a partnership item or an affected item. But Congress didn’t say that.
The government’s response to this argument is best illustrated in its opening brief:
Far from demonstrating that the penalty does not “relate to” an adjustment to a partnership item, however, the link between the penalty and an affected item confirms that the requisite “relationship]” exists. An “affected item” is “any item to the extent such item is affected by a partnership item.” 26 U.S.C. 6231(a)(5). Thus, an adjustment to a partnership item will typically require an associated adjustment to the affected item. When a penalty is triggered by an inaccurate affected item, and the affected item is rendered inaccurate because of an adjustment to a partnership item, the penalty logically “relates to” the adjustment to the partnership item.
What Else is at Stake?
The government also framed the procedural stakes in Woods as one as “simply whether the Court in the partnership level proceeding can make the threshold determination whether the sort of error that the IRS identifies on the partnership return can trigger a penalty down the road if the individual partner prepares his or her return in a manner consistent with the partnership return.” Under TEFRA, generally, if the threshold determination is answered the way the government urges, partners would only be allowed to raise individual defenses (such as a reasonable cause defense) in individual refund level actions.
If the threshold question is answered the way the taxpayer urges in Woods, individual partners would be entitled to litigate the merits of the issue relating to whether the penalty should apply to a shammed partnership, a result that gave some of the justices pause when considering one purpose of TEFRA was to limit the possibility of inconsistent treatment among partners.
The issue is somewhat blunted by Congress’ 2010 passage of a new penalty, Section 6662(b)(6), which disallows claimed tax benefits by reason of a transaction lacking economic substance. There seems to be no dispute that (b)(6) is a partnership item, and IRS could use that penalty to attack similar arrangements.
It appears that in Woods the Court will squarely address the TEFRA jurisdictional issue. Depending on how the Supreme Court resolves the TEFRA issue, we may not get clarity on the split in the circuits as to whether the underlying substantial valuation penalty applies when the partnership itself is shammed or disregarded.