United States v. Woods

Gary Woods (plaintiff) utilized a tax shelter involving the use of partnerships that generated paper losses upon the disposition of partnership assets to their partners, including Woods. The shelter worked by inflating the partners’ outside basis (the amount used in calculating partner tax losses or gains). After conducting partnership-level audits pursuant to the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), the Internal Revenue Service (IRS) disregarded the partnerships as shams that lacked economic substance. The IRS further determined that the partners’ adjusted basis in their respective partnership interests was zero and that any resultant tax understatements were subject to a penalty for significant valuation misstatements pursuant to 26 U.S.C. § 6662. Woods sued the United States (defendant), challenging the IRS’s determinations. The district court ruled that the IRS properly disregarded the partnerships but that the penalty was inapplicable. The court of appeals affirmed the penalty decision. The United States Supreme Court granted the United States’ petition for a writ of certiorari and also requested briefing regarding whether the district court had jurisdiction to consider valuation-misstatement penalties in a partnership-level proceeding. The United States argued that there was jurisdiction because the penalty related to the adjustment of partnership items. Per the United States, disregarding a partnership as a sham logically and inevitably triggered a valuation-misstatement penalty because a partner could not have an outside basis greater than zero in a disregarded partnership. Woods responded that there was no jurisdiction because outside basis was unrelated to a partnership-level adjustment due to the need for a partner-level proceeding to finally determine whether to impose a penalty. Regarding the penalty’s applicability, the United States argued that under § 6662’s plain language, a taxpayer substantially understated a valuation or adjusted basis if the value or adjusted basis of property claimed on a tax return was at least 200 percent more than the property’s correct value or adjusted basis. Woods countered that valuation under § 6662 related only to factual value, not legal value as affected by disregarding a partnership.