The U.S. Supreme Court agreed with the Internal Revenue Service and sustained the assessment of a 40% penalty against the taxpayer who invested in a 1990s tax shelter.

The decision, U.S. v. Woods, reversed a 5^th Circuit opinion which held that the 40% penalty did not apply in sham partnership cases and declared the issue “well settled.”

 The Woods’ case got to the Supreme Court to resolve a split between two circuits that found for the taxpayers in these type of case and other circuits that found for the IRS.  The issue involves the maximum income tax penalty that can be imposed on a tax shelter investor. More specifically, this decision resolved the issue concerning whether the penalty for tax underpayments attributable to valuation misstatements applies to an underpayment resulting from a basis-inflating transaction that is subsequently disregarded for lack of economic substance.

This decision may may be an unwelcome surprise to high income taxpayers who were sold on so-called Son of Boss tax shelters by the likes of KPMG, Deutsche Bank and Ernst & Young.

The Department of Justice is going back into cases in the wake of the U.S. Supreme Court's decision in U.S. v. Woods that the 40 percent gross valuation misstatement penalty applies to overstated basis when the entire transaction is disallowed, “We've gone back into cases on both the jurisdictional issue and the penalty issue in the wake of Woods,” Kathryn Keneally, the assistant attorney general of the tax division, said. 

Justice Scalia, writing for the court in a unanimous decision, said that the district court had jurisdiction under the Tax Equity and Fiscal Responsibility Act (TEFRA) to provisionally determine the applicability of the valuation misstatement penalty at the partnership level, because the penalty resulted from an adjustment to a partnership item “even though imposing the penalty requires a subsequent, partner-level proceeding.” 

The Court stated that the plain language of the statutory provision made it applicable to a situation, whereby, the taxpayer’s basis was disallowed based upon grounds such as a lack of economic substance. The Court explained that once the taxpayers’ partnerships were deemed not to exist for tax purposes, no partner could legitimately claim a basis in their partnership interest greater than zero.
 
 

Sources:

Forbes

U.S. v. Woods