03 December 2013

Law in Plan English: United States v. Woods

This is one in a series of posts designed to describe court decisions in plain English. For more detail and background on the legal issues, see the link to the case below. For similar posts, click here.

SCOTUSblogUnited States v. Woods

Argument: Oct 9 2013 (Aud.)

Why did the Supreme Court take this case? The Fifth and Ninth Circuits have held that whenever the IRS totally disallows a deduction, it may not penalize the taxpayer for a valuation overstatement included in that deduction. On the other hand, the First, Second, Third, Fourth, Sixth and Eighth Circuits have held the opposite. So-called "circuit splits" are perhaps the most common way cases make it to the Supreme Court.

Background: On behalf of two general partnerships, Woods participated in an aggressive tax shelter which effectively liquidated the assets of the partnerships and claimed the results as losses. The Internal Revenue Service (IRS) disallowed these losses, and imposed penalties. At issue in this case is Section 6662 of the Internal Revenue Code, which prescribes a penalty for an underpayment of federal income tax that is “attributable to” an overstatement of basis in property. 26 U.S.C. 6662(a), (b)(3), (e)(1)(A) and (h)(1). Woods filed a petition for review with the District Court, which affirmed the finding of the IRS disallowing the losses, but reversed the penalty. It relied on prior Fifth Circuit precedent1 in holding that whenever the IRS totally disallows a deduction, it may not penalize the taxpayer for a valuation overstatement included in that deduction. In a brief, per curiam opinion, the Fifth Circuit affirmed.


Issue: The question before the Court are (1) whether Section 6662 of the Internal Revenue Code, which prescribes a penalty for an underpayment of federal income tax that is “attributable to” an overstatement of basis in property, 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; and (2) whether the district court had jurisdiction in this case under 26 U.S.C. §6226 to consider the substantial valuation misstatement penalty.

Holding: In a unanimous decision, the Supreme Court ruled that the District Court had jurisdiction to determine whether the partnerships’ lack of economic substance could justify imposing a valuation-misstatement penalty on the partners. Furthermore, the Court ruled that the valuation-misstatement penalty applied in this case. The practical impact of this decision is that whenever the IRS totally disallows a deduction, it may penalize the taxpayer for a valuation overstatement included in that deduction.

1 Heasley v. Commissioner of Internal Revenue, 902 F.2d 380, 383 (5th Cir.1990).
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