Supreme Court Action: TERFA, Undervaluation of Basis in Partner Taxes, And Penalties

The Supreme Court’s other opinion from yesterday concerns taxation in the context of partnerships designed to generate large tax losses that offset a partner’s income.  The case is United States v. Woods (12-562).  Gary Woods and his employer, Billy Joe McCombs, bought offsetting currency options from Deutsche Bank.  They paid a premium for the long option and sold back a short option to the Bank which substantially reduced the cost of the long option alone.  Woods and McCombs contributed the spreads to two partnerships along with some $3.2 million in cash that was used to purchase stock and currency.  They ultimately disposed of their interests and claimed losses of $45 million.  They attributed this to calculations that accounted for the long option and ignored the offsetting short option.

The IRS treated the partnerships as shams designed for tax avoidance.  As such, the IRS viewed them as not valid for tax purposes.  The Service sent each partnership a Notice of Final Partnership Administrative Adjustment and assessed a 40% penalty on the tax underpayment.  Woods filed suit in federal District Court which held that the partnerships were properly disregarded as shams.  The Court also held that the penalty did not apply.  This was affirmed by the Fifth Circuit.

The Supreme Court reversed.  The Court agreed that the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) applied, allowing the IRS to initiate partnership-related tax proceedings at the partnership level.  The Court noted that there were multiple forums and procedures followed, some of which gave inconsistent results, before TEFRA.  The District Court had the power under the Act to determine whether the partnership was a sham (an adjustment under the Act) and whether a penalty relating to the adjustment applied.  The language of TERFA makes it clear that the penalty assessed by the IRS applied in this case.  In that respect, the holdings of the lower courts were reversed.  Justice Scalia delivered the opinion for a unanimous Court.

Mark

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