U.S. Supreme Court Holds Penalty Applies When Transaction Lacks Economic Substance

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On December 3, 2013, the United States Supreme Court in U.S. v. Woods, 112 AFTR 2d 2013-6974, resolved a split in the circuits when it held that the § 6662(h) valuation misstatement penalty applies when deductions are denied because a transaction lacked economic substance. 

Taxpayers are subject to a 40% accuracy-related penalty for an underpayment of tax that is attributable to a gross valuation misstatement. A gross valuation misstatement exists if the value or adjusted basis of any property reported on a return is 400% or more of the correct amount.  The First, Second, Third, Fourth, Sixth, Eighth, and Eleventh Circuits, the Tax Court, and the Court of Federal Claims have held that the 40% penalty could be imposed in cases where deductions are disallowed because the underlying transaction lacked economic substance. 

The Fifth and Ninth Circuits, however, have held that when the Internal Revenue Service totally disallows a deduction, the underpayment in tax is due to an improper deduction and not to a valuation misstatement.  Thus, these Courts have held that the 40% penalty does not apply when a deduction is disallowed because the underlying transaction lacked economic substance.

In Woods, the taxpayer participated in a tax shelter that generated substantial paper losses.  The district court and Fifth Circuit applied controlling precedent and held that the 40% penalty did not apply.  The Supreme Court reversed the Fifth Circuit and unanimously held that the 40% penalty applies to underpayments of tax attributable to both factual misrepresentations (e.g., basis of an asset) and legal errors (e.g., economic substance transactions).  Thus, the penalty may apply to a transaction involving inflated basis that is later disregarded for lack of economic substance.