United States v. Woods

Citation134 S.Ct. 557,187 L.Ed.2d 472,571 U.S. 31
Decision Date03 December 2013
Docket NumberNo. 12–562.,12–562.
Parties UNITED STATES, Petitioner v. Gary WOODS.
CourtUnited States Supreme Court

571 U.S. 31
134 S.Ct. 557
187 L.Ed.2d 472


No. 12–562.

Supreme Court of the United States

Argued Oct. 9, 2013.
Decided Dec. 3, 2013.

Malcolm L. Stewart, Washington, DC, for Petitioner.

Gregory G. Garre, Washington, DC, for Respondent.

Joel N. Crouch, Meadows, Collier, Reed, Cousins, Crouch & Ungerman LLP, Dallas, TX, Gregory G. Garre, Counsel of

134 S.Ct. 560

Record, Brian D. Schmalzbach, Katya S. Cronin, Latham & Watkins LLP, Washington, DC, for Respondent.

Donald B. Verrilli, Jr., Solicitor General, Kathryn Keneally, Assistant Attorney General, Malcolm L. Stewart, Deputy Solicitor General, John F. Bash, Assistant to the Solicitor General, Gilbert S. Rothenberg, Richard Farber, Arthur T. Catterall, Attorneys, Department of Justice, Washington, DC, for Petitioner.

Justice SCALIA delivered the opinion of the Court.

571 U.S. 33

We decide whether the penalty for tax underpayments attributable to valuation misstatements, 26 U.S.C. § 6662(b)(3), is applicable to an underpayment resulting from a basis-inflating transaction subsequently disregarded for lack of economic substance.

I. The Facts


This case involves an offsetting-option tax shelter, variants of which were marketed to high-income taxpayers in the late 1990's. Tax shelters of this type sought to generate large paper losses that a taxpayer could use to reduce taxable income. They did so by attempting to give the taxpayer an artificially high basis in a partnership interest,

571 U.S. 34

which enabled the taxpayer to claim a significant tax loss upon disposition of the interest. See IRS Notice 2000–44, 2000–2 Cum. Bull. 255 (describing offsetting-option tax shelters).

The particular tax shelter at issue in this case was developed by the now-defunct law firm Jenkens & Gilchrist and marketed by the accounting firm Ernst & Young under the name "Current Options Bring Reward Alternatives," or COBRA. Respondent Gary Woods and his employer, Billy Joe McCombs, agreed to participate in COBRA to reduce their tax liability for 1999. To that end, in November 1999 they created two general partnerships: one, Tesoro Drive Partners, to produce ordinary losses, and the other, SA Tesoro Investment Partners, to produce capital losses.

Over the next two months, acting through their respective wholly owned, limited liability companies, Woods and McCombs executed a series of transactions. First, they purchased from Deutsche Bank five 30–day currency-option spreads. Each of these option spreads was a package consisting of a so-called long option, which entitled Woods and McCombs to receive a sum of money from Deutsche Bank if a certain currency exchange rate exceeded a certain figure on a certain date, and a so-called short option, which entitled Deutsche Bank to receive a sum of money from Woods and McCombs if the exchange rate for the same currency on the same date exceeded a certain figure so close to the figure triggering the long option that both were likely to be triggered (or not to be triggered) on the fated date. Because the premium paid to Deutsche Bank for purchase of the long option was largely offset by the premium received from Deutsche Bank for sale of the short option, the net cost of the package to Woods and McCombs was substantially less than the cost of the long option alone. Specifically, the premiums paid for all five of the spreads' long options totaled $46 million, and the premiums received for the five spreads' short options totaled $43.7 million, so the net cost of the

571 U.S. 35

spreads was just $2.3 million. Woods and McCombs contributed the spreads to the partnerships along with about $900,000 in cash. The partnerships used the cash to purchase assets—Canadian dollars for the

134 S.Ct. 561

partnership that sought to produce ordinary losses, and Sun Microsystems stock for the partnership that sought to produce capital losses. The partnerships then terminated the five option spreads in exchange for a lump-sum payment from Deutsche Bank.

As the tax year drew to a close, Woods and McCombs transferred their interests in the partnerships to two S corporations. One corporation, Tesoro Drive Investors, Inc., received both partners' interests in Tesoro Drive Partners; the other corporation, SA Tesoro Drive Investors, Inc., received both partners' interests in SA Tesoro Investment Partners. Since this left each partnership with only a single partner (the relevant S corporation), the partnerships were liquidated by operation of law, and their assets—the Canadian dollars and Sun Microsystems stock, plus the remaining cash—were deemed distributed to the corporations. The corporations then sold those assets for modest gains of about $2,000 on the Canadian dollars and about $57,000 on the stock. But instead of gains, the corporations reported huge losses: an ordinary loss of more than $13 million on the sale of the Canadian dollars and a capital loss of more than $32 million on the sale of the stock. The losses were allocated between Woods and McCombs as the corporations' co-owners.

The reason the corporations were able to claim such vast losses—the alchemy at the heart of an offsetting-options tax shelter—lay in how Woods and McCombs calculated the tax basis of their interests in the partnerships. Tax basis is the amount used as the cost of an asset when computing how much its owner gained or lost for tax purposes when disposing of it. See J. Downes & J. Goodman, Dictionary of Finance and Investment Terms 736 (2010). A partner's tax

571 U.S. 36

basis in a partnership interest—called "outside basis" to distinguish it from "inside basis," the partnership's basis in its own assets—is tied to the value of any assets the partner contributed to acquire the interest. See 26 U.S.C. § 722. Collectively, Woods and McCombs contributed roughly $3.2 million in option spreads and cash to acquire their interests in the two partnerships. But for purposes of computing outside basis, Woods and McCombs considered only the long component of the spreads and disregarded the nearly offsetting short component on the theory that it was "too contingent" to count. Brief for Respondent 14. As a result, they claimed a total adjusted outside basis of more than $48 million. Since the basis of property distributed to a partner by a liquidating partnership is equal to the adjusted basis of the partner's interest in the partnership (reduced by any cash distributed with the property), see § 732(b), the inflated outside basis figure was carried over to the S corporations' basis in the Canadian dollars and the stock, enabling the corporations to report enormous losses when those assets were sold. At the end of the day, Woods' and McCombs' $3.2 million investment generated tax losses that, if treated as valid, could have shielded more than $45 million of income from taxation.


The Internal Revenue Service, however, did not treat the COBRA-generated losses as valid. Instead, after auditing the partnerships' tax returns, it issued to each partnership a Notice of Final Partnership Administrative Adjustment, or "FPAA." In the FPAAs, the IRS determined that the partnerships had been "formed and availed of solely for purposes of tax avoidance by artificially overstating basis in the partnership interests of [the] purported partners." App. 92, 146. Because the partnerships had "no business purpose other than tax avoidance," the IRS said, they "lacked economic

134 S.Ct. 562

substance"—or, put more starkly, they were "sham[s]"—so the IRS would disregard them for tax

571 U.S. 37

purposes and disallow the related losses. Ibid. And because there were no valid partnerships for tax purposes, the IRS determined that the partners had "not established adjusted bases in their respective partnership interests in an amount greater than zero," id., at 95, ¶ 7, 149,¶ 7 so that any resulting tax underpayments would be subject to a 40–percent penalty for gross valuation misstatements, see 26 U.S.C. § 6662 (b)(3).

Woods, as the tax-matters partner for both partnerships, sought judicial review of the FPAAs pursuant to § 6226(a). The District Court held that the partnerships were properly disregarded as shams but that the valuation-misstatement penalty did not apply. The Government appealed the decision on the penalty to the Court of Appeals for the Fifth Circuit. While the appeal was pending, the Fifth Circuit held in a similar case that, under Circuit precedent, the valuation-misstatement penalty does not apply when the relevant transaction is disregarded for lacking economic substance. Bemont Invs., LLC v. United States, 679 F.3d 339, 347–348 (2012). In a concurrence joined by the other members of the panel, Judge Prado acknowledged that this rule was binding Circuit law but suggested that it was mistaken. See id., at 351–355. A different panel subsequently affirmed the District Court's decision in this case in a one-paragraph opinion, declaring...

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