When the government filed its petition for certiorari in United States v. Woods, it hoped that the US Supreme Court would reverse the US Court of Appeals for the Fifth Circuit after that court held the "basis overstatement" tax penalty does not apply to certain tax shelters. Although the Supreme Court granted the government's petition, the oral arguments in the case suggest that the court is much more interested in another issue—whether the district court enjoyed jurisdiction to consider the penalty in the first instance. However, the court and the parties overlooked a key issue that could be dispositive of that jurisdictional question.
In Woods, the taxpayers engaged in so-called COBRA tax shelters, engineered to create massive tax losses. As part of the shelters, the taxpayers contributed property to two partnerships, and the partnerships also assumed some of their liabilities. Under their reading of the case law, the taxpayers believed that their transactions created more than $45 million of basis in their partnership interests, even though their economic outlay was only around $1 million. That $45 million of basis was then eventually used by the taxpayers to generate deductible losses on their returns. (Basis is the measuring stick for determining whether a taxpayer has a gain or loss on the sale of property, so if a taxpayer inflates his basis in property, he can create a tax loss.)
The government believed that the COBRA shelters violated the judge-made economic substance doctrine, under which courts will disregard transactions that are solely motivated by tax benefits or which accomplish nothing other than the creation of tax benefits. At trial, the district court accepted the government's arguments and denied the taxpayers' claimed losses. Because their transactions were disregarded, the taxpayers actually had $0 of basis in their partnership interests, and they could not claim losses using the $45 million basis figure.
Aside from the denial of their claimed losses, the taxpayers also faced the government's imposition of the basis overstatement penalty. Section 6662 imposes a 20 percent penalty on any understatement of a tax liability "attributable to" a basis overstatement. The penalty increases to 40 percent for particularly egregious overstatements (that is, when the claimed basis is 400 percent or more of the property's true basis). At trial, the government argued that the 40 percent penalty applied, because the taxpayers claimed a $45 million and their true basis was $0.
But following Fifth Circuit precedent, the district court rejected the government's position. In Woods, the taxpayers ultimately understated their tax liabilities because the transactions they undertook lacked economic substance, not because they inflated their basis. Thus, their understatement was not "attributable to" a basis overstatement, as required to trigger the Section 6662 penalty.
A majority of circuits, however, have found that the overstatement penalty can apply to COBRA and similar transactions lacking economic substance. In light of this circuit split, and with the hope that the Supreme Court would adopt the majority position, the government filed a petition for certiorari.
The Supreme Court agreed not only to address the question presented in the government's petition, but also directed the parties to address whether the district court, in a TEFRA proceeding, actually enjoyed jurisdiction to consider whether the basis overstatement applies.
Generally speaking, a TEFRA proceeding applies to disputes over partnership items. If, for example, 100 persons form a partnership and there is an issue about whether the partnership reported its income correctly, the Internal Revenue Service (IRS) would not have to litigate the issue against every single partner individually. The TEFRA procedures allow for a unified litigation proceeding, in which a court's holding on the partnership item (the determination of the partnership's income) would bind all the partners.
However, if a tax issue relates to a nonpartnership item—essentially, something specific to each partner—then litigation must proceed through separate, partner-level lawsuits, or "non-TEFRA proceedings."
Section 6226(f) specifically grants jurisdiction to consider penalties in a TEFRA proceeding when that penalty "relates to" a partnership item. Thus, TEFRA proceedings involve not only the determination of partnership items, but penalties that relate to those items. However, when the applicability of a penalty is determined in a TEFRA proceeding, that may impose hardships on individual partners, because they enjoy no immediate opportunity to present individual defenses to the penalty. Instead, they must pay the penalty first and then seek a refund of the penalty paid. In other words, when penalties relate to a partnership item, the TEFRA proceedings establish a "pay first, fight later" rule.
If, however, the applicability of a penalty does not relate to a partnership item, a court in a TEFRA proceeding cannot determine whether that penalty applies. Thus, penalties related to nonpartnership items must be determined through multiple non-TEFRA proceedings against individual partners.
In Woods, all parties agreed that the district court enjoyed jurisdiction to determine whether the partnership must be disregarded under the economic substance doctrine. But whether the basis overstatement penalty relates to that determination—such that jurisdiction was proper—reflected a source of disagreement.
Usually, a partner's basis in his partnership interest (his "outside basis") is not a partnership item, and disputes over his outside basis, or penalties related to the inflation of that basis, would be examined in a non-TEFRA proceeding. For example, if Adam bought a partnership interest, his outside basis would generally be equal to the amount he paid for that interest. If the basis overstatement penalty potentially applied to Adam (perhaps because when he sold his interest he inflated his outside basis), a determination of his true basis and the applicability of any penalty would be addressed in a non-TEFRA proceeding. The taxpayers in Woods argue that penalties related to the inflation of their outside bases should similarly be determined in non-TEFRA proceedings.
Under the government's view, however, the basis overstatement penalty potentially applies only because the partners' outside bases were reduced from $45 million to $0, and that reduction naturally follows from the finding that the partnership did not exist. Viewed this way, the applicability of the basis overstatement penalty "relates to" a partnership item (the existence of the partnership), and was properly considered in the district court's TEFRA proceeding. Although this view seems faithful to the statute's "relate to" language, the only two circuit courts to have considered the issue have rejected the government's arguments.
Oral argument in Woods did not provide any strong indication of the justices' views on either the jurisdictional or merits issues. Rather, the justices spent almost all of the time at oral argument simply trying to understand the statutory framework. Justice Breyer admitted that the jurisdictional question left him "genuinely confused," a feeling that anyone grappling with the TEFRA provisions is prone to experience. Justice Scalia, showing his affinity for statutory interpretation questions of even the most painful sort, repeatedly emphasized that the wording of the statute seemed to support the government's position and seemed skeptical of the taxpayers' arguments. Little time was left for either the government or the taxpayers to argue the merits question.
The confusion seen in the Woods oral arguments leaves one wondering whether the court's consideration of the jurisdictional question may have been premature. That question continues to be relevant in various ongoing proceedings, and the court might have benefited from further judicial analysis of the issues or some scholarly commentary on the subject. In fact, in Woods, neither the government nor the taxpayers addressed an issue that could be dispositive of the jurisdictional question.
Under the tax code, TEFRA proceedings generally apply only to real partnerships. Fake partnerships, like those created by the Woods taxpayers, are generally not subject to TEFRA. However, under Section 6233, if a fake partnership files a partnership tax return, the TEFRA procedures will apply "to the extent provided in regulations." That is, TEFRA proceedings can apply to fake partnerships only if the US Department of the Treasury (Treasury) issues regulations under Section 6233 extending that treatment.
Although Congress enacted Section 6233 in 1984, no final regulations actually existed in 1999, when the taxpayers in Woods engaged in the COBRA shelters. That is, the extension of TEFRA to fake partnerships turns on the existence of legitimate regulations, but the Treasury did not actually issue final regulations until 2001, and those regulations apply only prospectively.
Before 2001, the Treasury issued had proposed regulations under Section 6233 and solicited comment on those regulations. However, although the public submitted comments on those regulations, in 1987 the Treasury decided to issue "temporary" regulations that did not respond to comments. Instead, the Treasury stated that its proposed regulations would "be finalized in due course with any changes that may be made as a result of comments received," and the temporary regulations were issued simply to provide "immediate guidance to partners and partnership."
Unfortunately, the Treasury did not heed its promise to promptly incorporate public comments, and the 1987 temporary regulations lingered on the books until 2001. By 1999, these temporary regulations were likely invalid and could not extend TEFRA jurisdiction to fake partnerships. As the US Court of Appeals for the Ninth Circuit observed in Tedori v. United States, the government can offer "[n]o explanation ... as to why such a 'temporary regulation,' issued in 1987 shortly after enactment of the Tax Reform Act of 1986, should remain 'temporary' well over a decade later."
Although the Ninth Circuit did not squarely hold that a "temporary" regulation lacks force after sitting on the shelf for more than a decade, that conclusion seems inevitable after the Supreme Court's decision in Mayo Foundation for Medical Research v. United States. In Mayo, the court announced that the tax law is subject to the same administrative law doctrines and standards that apply to any other area of federal law. And in every other area of law, it is quite clear that a federal agency cannot ignore notice and comment requirements, issue a regulation in "temporary" form, and then adversely invoke that regulation against the public a decade later.
The taxpayers in Woods thus might have been expected to, but did not, raise the argument that the procedural irregularities regarding the Section 6233 temporary regulations defeated the government's jurisdictional argument. Instead, the taxpayers accepted that validity of those regulations, even though a large body of scholarly commentary and some case law casts serious doubt on the temporary regulations. If the court accepts the assumptions of the parties, its holding could extend far beyond TEFRA matters and could scale back Mayo's rejection of tax exceptionalism. This would give the Treasury significant leeway to skirt the notice and comment procedures that other federal agencies must dutifully observe.
Andy Grewal is a Professor of Law at the University of Iowa College of Law. His teaching and research interests relate to federal income taxation. His writing focuses primarily on issues relating to the intersection between tax law, administrative law and statutory interpretation theory.
Suggested Citation: Andy Grewal, US v. Woods and the Missing Jurisdictional Argument, JURIST - Forum, Nov. 9, 2013, http://jurist.org/forum/2013/11/andy-grewal-woods-jurisdiction.php.
This article was prepared for publication by Michael Kalis, an associate editor for JURIST's academic commentary service. Please direct any questions or comments to him at firstname.lastname@example.org