Argument preview: Court to resolve circuit split about tax penalties
on Oct 2, 2013 at 12:19 pm
You could be forgiven if your reaction to the (lengthy) question presented in No. 12-562, United States v. Woods, led you to write this case off as a piece of painful boredom through which the Justices will sit to start the third day of October Term 2013. Loosely speaking, the issue is whether an “overstatement” penalty in the tax code (penalizing taxpayers who substantially misstate items on their tax returns) applies to abusive tax shelters. A look at the briefs, however, suggests that things will be a bit livelier. The most obvious reason is that respondents have retained former Solicitor General Gregory Garre – fresh from his victory in another tax shelter case last year (United States v. Home Concrete), to say nothing of his remarkable victory in Maples v. Thomas. So you have to know this will not be another routine walkover by the Solicitor General’s office. And the spirited discussion in the briefs does not disappoint.
The case comes to the Court because of an eight-to-two circuit split on the meaning of Section 6662 of the Internal Revenue Code, which imposes a penalty for any underpayment of federal income tax that is “attributable to” an overstatement of basis in property. The problem involves application of that penalty when the taxpayer’s return relies on transactions that the IRS disregards as lacking economic substance (a common outcome for tax shelters). Those transactions often are designed to justify taxpayer claims of a high basis that has no economic foundation in out-of-pocket dollars; the high basis produces a phantom loss that offsets other income. Most courts have held that the resulting underpayments are “attributable to” an overstatement of basis. Thus, the dominant rule in the courts of appeals allows assessment of the penalties in these cases. The Fifth and Ninth Circuits, however, generally have rejected that reasoning, holding that when the transactions are disregarded as lacking economic substance, the underpayment is attributable to the disregarded transactions, not to the basis overstatement.
This case arises out of a type of tax shelter commonly marketed ten to fifteen years ago, in which the taxpayer purchases and sells offsetting short-term options on a foreign currency. Relying on technical tax rules that create special rules for recognizing options as liabilities, taxpayers had a barely colorable basis for claiming that the transactions resulted in large losses, far exceeding cash outlays. In this case, for example, entities owned by the taxpayers spent about three million dollars to purchase a pair of offsetting thirty-day options, which they contributed to partnerships. After the options terminated, the partnerships distributed their assets to a different set of entities owned by the taxpayers, who ultimately claimed losses on their personal returns of more than forty-five million dollars. [Side note of trivia: Although the named defendant is Woods, the other participant in the scheme is “Red” McCombs, former owner of the Minnesota Vikings and namesake of the business school at the University of Texas.]
All agree that the transactions lack economic substance. But when the Fifth Circuit refused to allow an overstatement penalty, the Solicitor General – doubtless emboldened by the eight-to-two circuit split in his favor – sought and obtained review. To complicate matters, the Court’s order granting review asked for briefing on a separate question with a less-settled circuit conflict – whether the district court (and thus the court of appeals) had jurisdiction to consider the penalty problem at all. The proceedings in this case were at the “partnership” level – invalidating the insubstantial transactions of the partnerships. Two courts of appeals have indicated that the overstatement penalty can be addressed only in separate (later) proceedings at the “partner” level. The Court asked for briefing not only on the applicability of the penalty, but also on the jurisdictional question – whether the court can consider the partner-level penalty in these proceedings reviewing the IRS’s partnership-level determinations.
The Solicitor General’s brief reiterates the positions that have succeeded in the lower courts. On the jurisdictional question, the statute permits district courts to consider any penalty that “relates to an adjustment to a partnership item.” All agree that the penalty in this case flows from an overstatement of the partner’s bases in the partnership’s assets. In the language of the tax code, that is an “affected item,” an item affected by the adjustment to the partnership’s return, but not itself a partnership item. The Solicitor General cogently argues that the penalty “relates to” the adjustment to the partnership item because there would have been no adjustment to the affected item without the adjustment to the partnership item.
On the merits, the Solicitor General argues that the relevant penalty is “attributable to” an overstatement of basis. The brief explains that once the IRS disregards the transactions the partners had no basis at all in the partnership. Because the partners would have paid the appropriate tax if they had reported the appropriate basis in the partnership (zero), the underpayment is, from this perspective, “attributable to” an overstatement of basis. The Solicitor General emphasizes the oddity of a garden-variety basis error (claiming a donated painting was worth $1 million instead of $100,000) bearing the penalty when a wholly abusive tax shelter (like this one) would bear no penalty at all.
Entering the case for the first time at the merits stage, Garre’s added value is obvious – he completely recasts the taxpayer’s argument. Thus, on the merits, his principal argument is not the “two causes” argument that persuaded the Fifth Circuit. The court of appeals reasoned that underpayment is not “attributable to” overstatement of basis when there are two distinct causes of the underpayment; if the underpayment is overdetermined, it would have occurred without regard to basis overstatement.
Although Garre presents that argument in passing, he emphasizes a novel and much more persuasive argument: that the penalty simply doesn’t apply to tax shelters. Persuasively recounting the history that led to enactment of the penalty, Garre shows that the abuse that motivated the statute was false factual assertions of the value of particular assets. Because that problem does not ordinarily appear in “no-economic-substance” cases, the penalty does not apply.
Here, Garre sharply emphasizes a gap between the statute and the Solicitor General’s description of it. The statute refers repeatedly to “valuation overstatements,” but the Solicitor General’s brief frequently – on dozens of occasions – describes it as a “basis-overstatement” penalty. Garre argues that the subtle terminology shift implicitly underscores the difficulty of applying the actual words of the statute to the “no-economic-substance” context. Most tellingly, Garre points out that Congress recently enacted an explicit “no-economic-substance” penalty. This case arises only because that penalty was not retroactive; Garre can argue with great force that Congress’s willingness to attend to the matter explicitly shows that the older valuation misstatement penalty does not apply; the argument pretty completely deflates the Solicitor General’s argument about the oddity of leaving this highly abusive conduct unpenalized.
Garre also presents an elegant punctuation argument – reminiscent of Justice Blackmun’s opinion in United States v. Ron Pair, resting the Court’s holding on the placement of a single comma. Here, Garre notes that the statute refers to a misstatement of “the value of any property (or the adjusted basis of any property).” The government’s reading puts a great deal of weight on the reference to “the adjusted basis,” because in tax shelter cases there typically is an overstatement of basis, but not an overstatement of property valuation. Garre’s argument that the placement of the words inside the parenthetical shows that they should have a subsidiary meaning to the words outside the parenthetical is devastating.
The briefs battle on several other issues of text and tax practice. But the summary above should be enough to show that the government will have its hands full at the oral argument the first week of October.