Yesterday the Supreme Court held that the 40% gross valuation misstatement penalty under I.R.C. § 6662(h) is applicable in cases where the IRS determines that a partnership is a sham or lacks economic substance. United States v. Woods, No. 12-562 (U.S. Dec. 3, 2013). The Court's opinion in Woods provides two main holdings: (1) that the District Court had jurisdiction under TEFRA to determine whether the partnerships' lack of economic substance could justify the application of a valuation misstatement penalty on the partners; and (2) that the gross valuation misstatement penalty applied to the disallowed partnership losses.
This case resolved a circuit split with respect to the second holding. Here in the Ninth Circuit, the courts (including the Tax Court, pursuant to the Golsen rule) were bound by the precedent set forth in Gainer v. Commissioner, 893 F.2d 225 (9th Cir. 1990). Gainer involved the purchase and claimed depreciation deduction of a partial interest in a refrigerated shipping container. Because the container was not placed in service during the year at issue, no deduction was allowable. However, the court refused to impose the valuation misstatement penalty because the taxpayer would not have been entitled to a deduction regardless of the stated value, and that therefore the underpayment was not "attributable to" any valuation misstatement. This rationale was based in large part on the precedent of the Fifth Circuit.
Subsequently, in Keller v. Commissioner, 556 F.3d 1056 (9th Cir. 2009), a case involving the disallowance of deductions related to the Hoyt sheep and cattle investment shams, the Ninth Circuit noted the circuit split. The court even found that the application of the overvaluation penalty in cases involving tax avoidance schemes that lack economic substance in the many other circuits that did so was a "sensible approach." However, the Ninth Circuit nonetheless found that it was constrained by Gainer and refused to apply the gross valuation misstatement penalty in Keller.
After Woods, courts in the Ninth Circuit will now be obliged to apply the valuation misstatement penalties in cases involving partnership losses that are disallowed due to a lack of economic substance.
The Woods opinion can be found at http://www.supremecourt.gov/opinions/13pdf/12-562_k5fl.pdf.