DC CIRCUIT APPLIES SUPREME COURT'S HOLDING ON PARTNERSHIP ITEM & OUTSIDE
BASIS
Tigers Eye Trading, LLC, et al. v. Comm (CA DC 6/26/2015) 115 AFTR 2d ¶ 2015-862
Based on the Supreme Court's recent holding in Woods, the Court of Appeals for the District of Columbia Circuit (DC Circuit)
has affirmed the Tax Court's decision that the Code Sec. 6662(h) gross valuation misstatement penalty applied to a partner
in a Son-of-BOSS tax shelter which was designed to create artificial losses. However, the DC Circuit reversed the Tax
Court's holding that the partner had no outside basis in the partnership (i.e., the basis of the individual partner in the
partnership).
Background. Under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA, PL 97-248) partnership audit rules, the tax
treatment of any partnership item (see below), and the applicability of any penalty, addition to tax, or additional amount that
relates to an adjustment to a partnership item, generally is determined at the partnership level. (Code Sec. 6221) A partner
whose tax liability might be affected by the outcome of the litigation of partnership items may participate in the proceeding.
(Code Sec. 6224) IRS may assess additional tax liability against individual partners within one year of the final conclusion of
the partnership's tax determination. (Code Sec. 6229(d))
A partnership item is any item required to be taken into account for the entity's tax year under the Code's income tax
provisions, to the extent IRS regs provide that the item is more appropriately determined at the partnership level than at the
partner level. (Code Sec. 6231(a)(3)) Reg. § 301.6231(a)(3)-1 provides a list of such items. A nonpartnership item is an item
that is (or is treated as) not a partnership item. (Code Sec. 6231(a)(4)) An affected item is any item to the extent the item is
affected by a partnership item. (Code Sec. 6231(a)(5))
Taxpayers are subject to a 20% accuracy-related penalty for an underpayment of tax required to be shown on a return that
is attributable to a substantial valuation misstatement. (Code Sec. 6662(a), Code Sec. 6662(b)(3)) The penalty is 40% of the
portion of an underpayment of tax attributable to one or more substantial valuation misstatements that meet the
requirements for a gross valuation misstatement. (Code Sec. 6662(h)) A gross valuation misstatement exists if the value or
adjusted basis of any property claimed on a tax return is 200% (400% under a prior, pre-amended version of this provision
that was applicable to this taxpayer's case) or more of the amount determined to be the correct amount of such value or
adjusted basis. (Code Sec. 6662(h)(2)(A)) Whether there is a gross valuation misstatement in the partnership context is
determined at the partnership level. (Reg. § 1.6662-5(h)(1)) Under Reg. § 1.6662-5(g), the gross valuation misstatement
penalty is automatically triggered if a partner claimed on his tax return that an asset worth zero was worth anything at all.
Facts. To offset the tax that he would otherwise owe on $27 million in capital gains, A. Scott Logan participated in a Son of
BOSS (bond option sales strategy) tax shelter, Tigers Eye Trading, LLC, and engaged in a series of transactions that
created close to $27 million of artificial financial losses. Logan joined Tigers Eye through three trusts he had formed. The
trusts were the true partners in Tigers Eye. Logan claimed losses based on the three trusts' outside basis. (For simplicity's
sake, however, in its description of the transaction, the Court and this article referred to Logan himself and not his trust as
the partner.)
On audit, IRS determined Tigers Eye was a sham entity that lacked economic substance and was created solely so that its
participants could avoid taxes. IRS issued a deficiency notice that disregarded the partnership's existence and any
contributions made to the sham enterprise, adjusted the outside basis of each of its partners, including Logan, to zero, and
determined that any partner who underpaid his taxes as a result of reporting his outside basis in Tigers Eye faced a gross
valuation misstatement penalty.
The partnership and Logan challenged the notice in the Tax Court. After Logan's motions for summary judgment were
denied, the partnership settled with IRS and entered into a stipulated decision that accepted IRS's findings and bound all
parties.
Shortly after the stipulated decision was entered, the DC Circuit held in Petaluma FX Partners LLC, (CA DC 6/26/2015) 115
AFTR 2d ¶ 2015-863 (see Weekly Alert ¶ 37 07/02/2015) that the Tax Court lacked jurisdiction to do what it had just done in
Logan's case: determine a partner's outside basis in a proceeding that was adjudicating the tax treatment of the partnership.
The DC Circuit remanded the case to the Tax Court to decide if it could determine the applicability of penalties to be
imposed on individual partners without adjusting any partner's outside basis. Logan moved to revise the stipulated decision,
arguing that under Petaluma the Tax Court not only lacked jurisdiction to adjust his outside basis to zero, but also to apply
the penalty to him. The Tax Court disagreed with Logan's reading of Petaluma and left the stipulated decision intact. Logan
appealed to the DC Circuit. While Logan's appeal was pending, the Supreme Court resolved the jurisdictional questions
related to outside basis and penalties in Woods (see below). As a result, the DC Circuit ordered a new briefing and held oral
argument on the matter.
Supreme Court's Woods decision. In U.S. v. Woods, (S Ct 2013) 112 AFTR 2d 2013-6974112 AFTR 2d 2013-6974 (see
Weekly Alert ¶ 29 09/18/2014), the Supreme Court concluded that the penalty for tax underpayments attributable to
valuation misstatements was applicable to an underpayment as the result of a basis-inflating transaction that was later
disregarded for lack of economic substance. The Court reasoned that the penalty's plain language made it applicable in
such a situation. The transactions at issue were designed to generate losses by enabling the partners to claim a high
outside basis in the partnerships. But once the partnerships were deemed not to exist for tax purposes because they were
formed solely for tax avoidance purposes (and had no business purpose other than that), no partner could legitimately claim
an outside basis greater than zero..
Further, the Supreme Court held that the unified partnership audit rules give courts in partnership-level proceedings
jurisdiction to determine the applicability of any penalty that could result from an adjustment to a partnership item, even if
imposing the penalty also requires determining affected or non-partnership items (such as outside basis). The partnershiplevel applicability determination is provisional—the court may decide only whether adjustments properly made at the
partnership level have the potential to trigger the penalty. Each partner remains free to raise in subsequent partner-level
proceedings any reasons why the penalty should not be imposed on him.
Appellate Court decision. The DC Circuit affirmed the Tax Court's decision that the gross valuation misstatement penalty
applied to a partner in a Son-of-BOSS tax shelter which was designed to create artificial losses. However, the DC Circuit
reversed the Tax Court's holding that the partners had no outside basis in the partnership.
Because the parties to the case agreed on how the issues they once disputed should be resolved under Woods, the DC
Circuit noted that its analysis was brief. The taxpayer and IRS recognized that Woods answered their questions on the Tax
Court's jurisdiction over penalties and outside basis. Logan conceded that the Tax Court properly applied his penalty when
that Court conducted its review of the partnership and its items. In turn, IRS acknowledged that the Tax Court lacked
jurisdiction to determine that the Tigers Eye partners had no basis in the partnership.
The DC Circuit reasoned that Woods made it clear that a court adjudicating partnership matters has jurisdiction to apply any
penalty that could result from an adjustment to a partnership item. This includes situations where the partnership is a mere
tax shelter—a determination that should be made in the course of adjudicating partnership issues. In such a case, the
partnership never existed, and no partner could have any outside basis in the entity. Accordingly, it followed that any partner
who claimed his outside basis as a loss on his tax return faces a potential gross valuation misstatement penalty for doing so.
That penalty related to and flowed directly from an "adjustment to a partnership item" (i.e., the determination that the
partnership lacked economic substance).
Thus, in the course of adjudicating matters related to the partnership, a court could announce that any member of the tax
shelter partnership who IRS later found shirked his taxes by claiming a basis greater than zero, was subject to a gross
valuation misstatement penalty. This was a penalty that IRS could impose directly on the partner, requiring him to pay it
before bringing a refund action.
The DC Circuit also reasoned that Woods made it clear that outside basis is not a partnership item that a court has
jurisdiction to adjust when reviewing matters involving only the partnership. That adjustment must be formally conducted in
proceedings with each partner, although the reviewing court can determine whether the adjustments it does make, including
the economic substance determination, have the potential to trigger a penalty. In doing so, it's not required to shut its eyes to
the legal impossibility of any partner's possessing an outside basis greater than zero in a partnership that, for tax purposes,
doesn't exist.
Thus, although a court in a proceeding involving a partnership may announce that a penalty has been triggered based on
the presumption that outside basis in a sham partnership is zero, that court cannot formally adjust a partner's outside basis
at that time.
The DC Circuit also noted that other issues raised by Logan had, in effect, resolved themselves. Logan had argued that
certain language in the Tax Court's summary judgment ruling, and in the notice that the Tax Court approved in its stipulated
decision, was legally erroneous and could preclude him from raising his reliance on his law firm's advice as a defense to
penalties in a future refund action. However, in its brief and at oral argument, IRS explained that the Tax Court issued no
binding ruling on Logan's defense based on his firm's advice, leaving all issues regarding its availability and application to be
litigated in a future refund action. In IRS's view, nothing would prevent Logan from asserting this defense.
References: For the unified audit rules for partnerships, see FTC 2d/FIN ¶ T-2100 ; United States Tax Reporter ¶ 62,214 ;
TaxDesk ¶ 825,000 ; TG ¶ 70400 .