Supreme Court Overturns 5th Circuit Tax-Shelter Decision

By Brett Snider, Esq. on December 05, 2013 | Last updated on March 21, 2019

The Supreme Court reversed a Fifth Circuit decision on Tuesday, ruling unanimously that billionaire Billy Joe "Red" McCombs owed the IRS for his tax-shelter shenanigans.

McCombs had attempted to argue that despite him and partner Gary Woods setting up a tax shelter to create financial losses for the Texan pair, neither should be eligible for the 40% penalty leveled at them by the Internal Revenue Service (IRS), reports Reuters.

So why did SCOTUS think otherwise?

Sham Partnership = Penalty

Basically the tax shelter allowed McCombs and Woods to claim their losses from the tax shelter were approximately $45 million, despite the fact that the pair's investment in the tax shelter was only $3.2 million. Once the IRS had caught on to McCombs and Woods' little ol' scheme, they ordered the pair to pay the valuation misstatement penalty for essentially trying to cheat the IRS out of more than $40 million in taxes.

The fight was essentially over whether McCombs and Woods partnership had any "economic substance" -- another way of saying that the partnership was formed for actual economic gain and not just as a tax dodge. Under the relevant valuation penalty statute, either a 20% or 40% penalty based on the error is assessed based on either substantial or "gross" valuation misstatement, respectively.

When the IRS determines a partnership to have no economic value, the value of the partnership is ... $0. So valuing the partnership at around $43 million (as compared to $0) is certainly a "gross" error. Pulling a fast one, Woods argues that there is room for interpretation in the statutory language of "value."

What is "Value" Anyway?

It's somewhat surprising that the Fifth Circuit essentially ratified this reasoning, but Woods argued before SCOTUS that the penalty statute only intended to punish "factual" value and not "legal" valuation errors.

Basically, Woods was asking the Court to believe that the penalty shouldn't apply to him because the sham partnership was "factually" worth $43 million, it was only the "legal" determination of the IRS that made it worth nothing.

As they say in Texas, that dog won't hunt. Justice Scalia and the other eight were "not convinced" by this narrow reading of the statute, noting that calculating value in just about every other facet of tax law calls for legal inquiries.

Bottom Line

This is one of two Fifth Circuit cases flatly reversed by SCOTUS on Tuesday -- the other being a forum selection clause case. Buck up guys, it's almost Christmas!

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