Supreme Court In U.S. V. Woods, 134 S.Ct. 557 (2013) Determines That Partnership Level TEFRA Judicial Proceedings Can Include The Imposition Of A Gross Valuation Understatement Penalty

The case involved an abusive tax shelter resulting in the purchase offsetting options by the taxpayer, Gary Woods, and his employer, Mc Combs. The tax shelter transaction was promoted to the taxpayer as one which would generate substantial tax losses to reduce anticipated taxable income. The taxpayers, pursuant to the tax strategy, purchased from Deutsche Bank a series of currency-option spreads. Each spread had a long-leg, for which the parties paid a premium, and a short option, which Woods and McCombs sold to the Bank and for which they received a premium. The tax shelter program was promoted by members of the firm of Jenkins&Gilchrist under the name "Current Options Bring Reward Alternatives," or COBRA. Since the premium paid for the long option was largely offset by the premium received for the short option, the net cost to Woods and McCombs was substantially less than the cost of the long option alone. Woods and McCombs contributed the options, along with cash, to two partnerships, which used the cash to purchase stock and currency.

In calculating basis under Section 752, Woods and McCombs considered only the long component of the spreads and disregarded the nearly offsetting short component. As a result, when the partnerships' assets were disposed of for modest gains, Woods and McCombs claimed huge losses. Although they had contributed roughly $3.2 million in cash and spreads to the partnerships, they claimed losses of more than $45 million.

The tax shelter, like other variants of son-of-boss basis strategies, drew the attention of the Internal Revenue Service. After auditing the partnerships that were created under the transaction, the Internal Revenue Service sent a Notice of Final Partnership Administrative Adjustment (FPAA) to each partnership contending that the partnership level losses should be disallowed and that the partnerships were to be ignored. As to this latter point, the Service argued that the partnerships lacked "economic substance," i.e., they were shams. As there were no valid partnerships for tax purposes, the Service determined that the partners could not claim a basis for their partnership interests greater than zero and that any resulting tax underpayments would be subject to a 40% penalty for gross valuation misstatements.

After filing suit in the federal district court, the trial court held that the partnerships were properly disregarded as shams but that the valuation-misstatement penalty did not apply. The Fifth Circuit Court of Appeals affirmed the lower court's decision. It held that the District Court had jurisdiction to determine whether the partnerships' lack of economic substance could justify imposing a 40% gross...