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Superior Trading can’t shake superior penalty as 7th Circuit sides with majority of other Circuits on eve of SCOTUS oral argument on imposition of gross valuation penalty when underlying transaction lacks economic substance

Posted on Aug. 31, 2013

In Superior Trading  LLC v. Comm’r, the Seventh Circuit has joined eight other Circuits in holding that the 40% gross valuation misstatement penalty under Section 6662(h) can be imposed when the transaction is disallowed completely because it lacked economic substance.  Professor Paul Caron at the TaxProfBlog has posted a block quote of the salient language here.

There is currently a split on this issue, with the vast majority of Circuits agreeing with the Seventh Circuit.  The Fifth and Ninth Circuits, however, have held that a complete disallowance is not a valuation misstatement, but instead an improper deduction, and the higher 40% penalty for substantial valuation misstatement cannot be imposed.  The Supreme Court expects to hear oral argument on the matter on October 9th.  A decision should be issued by June at the latest.

For a review of the prior holdings, along with the often repeated but great description of the taxpayer transactions as what they are, “bull$#*! tax shelters”, see Jack Townsend’s Tax Procedure blog here, here, and here.  This is also covered in great detail in Saltzman Chapter 7B.03[2][c].

The Seventh Circuit opinion was not terribly interesting as regard the 6661(h) issue.  Only about four paragraphs are devoted to the issue, and the opinion is very much in line with the other majority Circuit statements.  A more interesting summary of the differing views of the “Blue Book” that may have given rise to the split can be found in a recent Tax Court case, AHG Investments, LLC v. Comm’r, where the Court switched its prior holding to be in line with the majority of the Circuits.  This case also highlights how the Fifth and Ninth Circuit are wavering in their positions on the matter.

The result “feels” right, as you would not expect a transaction lacking economic substance to be less penalized than one that merely undervalued something.  I suspect SCOTUS will find a well-reasoned way to follow the majority, but taxpayers currently facing this unfortunate issue should probably preserve appeal rights in case SCOTUS follows the rationale of the Fifth and Ninth Circuit.

There is a TEFRA jurisdictional issue, which could possibly result in SCOTUS deciding it lacks jurisdiction to hear the case. The Miller & Chevalier blog has a brief summary of the taxpayer’s position here and here.  The argument is that the penalty at issue relates to the outside basis in the entity, which is a partner item and not a partnership item, making the review by the lower court in a partnership proceeding under Section 6226 inappropriate.  Although this penalty does related to outside basis which is a partner item, the government has responded by arguing the individual partner’s situation is inapplicable to the inflation of all the outside basis in a transaction by the partnership that lacks economic substance.  Further, requiring this type of review at the partner level would reinstate inefficiencies that Congress had tried to remove by have partnership proceedings.  So, there may be a tax procedure issue before SCOTUS, a holding on which gets thwarted by a tax procedure issue.

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