## Facts

- Taxpayers participated in an offsetting-option tax shelter intended to create large paper losses to reduce taxable income.
- They acquired currency-option “spreads” consisting of a long option (purchased) and a nearly offsetting short option (sold), making the net economic cost far smaller than the long-option premium alone.
- They contributed the spreads and cash to two partnerships that used the cash to purchase stock and currency.
- In computing outside basis, they treated only the long-option component as relevant and disregarded the offsetting short-option liability, inflating claimed basis.
- After modest gains on asset dispositions, they claimed losses exceeding $45 million despite contributing roughly $3.2 million in cash and spreads.
- The IRS issued FPAAs disallowing the losses, determining the partnerships lacked economic substance and should be disregarded for tax purposes.
- Treating the partnerships as shams, the IRS concluded partners’ correct outside basis was zero and asserted a 40% gross valuation-misstatement penalty for resulting underpayments.
- The tax matters partner sought judicial review under TEFRA partnership-level procedures.

## Issues

1. In a TEFRA partnership-level proceeding, does the court have jurisdiction to determine the applicability of a valuation-misstatement penalty arising from adjustments that treat the partnership as lacking economic substance?
2. Does the 40% gross valuation-misstatement penalty apply when the underpayment results from a transaction disregarded for lack of economic substance, making the correct outside basis zero?

## Decision

- The Supreme Court unanimously reversed and remanded.
- The Court held the district court had jurisdiction in the TEFRA partnership-level proceeding to determine, on a provisional basis, whether the valuation-misstatement penalty could apply.
- The Court held the 40% gross valuation-misstatement penalty applies where the partnership is disregarded as a sham and the correct outside basis is zero, but the taxpayer claimed a positive basis that generated the underpayment.

## Legal Principles

- Under TEFRA, a court in a partnership-level proceeding may determine the applicability of any penalty that could result from an adjustment to a partnership item, even though final assessment and partner-specific defenses are addressed in later partner-level proceedings.
- When a partnership is disregarded for lack of economic substance, partners’ correct outside basis may be treated as zero; an underpayment attributable to claiming a non-zero basis is attributable to a valuation misstatement.
- The valuation-misstatement penalty reaches basis misstatements arising from legal as well as factual error, including misstatements produced by using a sham transaction.
- If the correct adjusted basis is zero, a valuation misstatement is treated as “gross” for purposes of the 40% penalty.

## Conclusion

The Court held that TEFRA authorizes partnership-level courts to determine whether penalties could apply and that a gross valuation-misstatement penalty may be imposed when sham partnerships produce a zero basis and taxpayers claim inflated basis to generate large losses.


United States v. Woods, 571 U.S. 31 (2013)