Valuation-misstatement penalty applies to tax shelter transactions.

• Author: Beavers, James A.

The Supreme Court held in a unanimous decision that the Sec. 6662(b)(3) penalty for tax underpayments attributable to valuation misstatements applies to an underpayment resulting from a basis-inflating transaction that is disregarded for a lack of economic substance.

Background

Gary Woods (along with his employer, Billy Joe McCombs) agreed to participate in a COBRA (Current Options Bring Reward Alternatives) tax shelter transaction that was marketed by a large accounting firm. The COBRA transaction was designed to generate large paper losses for the purchasers by giving them an artificially high basis in partnership interests, which enabled them to claim large tax losses on the disposition of the interests.

In the COBRA transaction, Woods and McCombs purchased and sold a series of currency-option spreads from Deutsche Bank. Each spread was a package consisting of a long option that they bought from the bank for a premium and a short option that they sold to the bank for a premium. The premium they paid for the long option was $46 million, and the premium they received for the short option was $43.7 million, making the net cost of the package to Woods and McCombs $2.3 million. They contributed the spreads, along with $900,000 in cash, to two partnerships, which used the cash to purchase stock and Canadian currency. When calculating their bases in their partnership interests, Woods and McCombs took into account only the long component of the spreads and disregarded the nearly offsetting short component, asserting that the liability was too contingent to count. This resulted in Woods and McCombs claiming a combined outside basis in the partnerships of $48 million.

Woods and McCombs then transferred their interests in each partnership to two S corporations they jointly owned, leaving each partnership with only one owner. Because each partnership now only had one owner, it was liquidated by operation of law and its assets were distributed to its owner. Under Sec. 732(b), the S corporations treated the basis in the partnerships' assets distributed to them as equal to Woods's and McCombs's outside bases in their partnership interests. Thus, when the S corporations shortly afterward sold the assets, although they actually made a modest gain on the sale, the S corporations claimed $45 million in losses on the sale for tax purposes; these losses were passed through to Woods and McCombs.

Not surprisingly, the IRS did not agree that the tax losses...