The Supreme Court wrapped a bow around the IRS victories in the turn-of-the-century tax shelter wars by unanimously ruling that the 40% “gross valuation misstatement” penalty applied to a tax understatement caused by the “COBRA” tax shelter.
COBRA relied on contributing long and short currency options to a partnership, but claiming basis for the long position, and ignoring the liability caused by the short position. The shelter was cooked up in Paul Daugerdas’ tax shelter lab at now-defunct Jenkens & Gilchrist and marketed by Ernst & Young. The shelter was designed to generate $43.7 million in tax losses for a cash investment of $3.2 million.
COBRA, like so many other shelters of the era, was ruled a sham and the losses disallowed, but the Fifth Circuit Court of Appeals ruled that the 40% penalty did not apply. Other circuits ruled that it did, so the Supreme Court took the case to settle the issue.
Writing for a unanimous court, Justice Scalia disposed of the Fifth Circuit’s position (citations omitted, my emphasis):
In the alternative, Woods argues that any underpayment of tax in this case would be “attributable,” not to the misstatements of outside basis, but rather to the determination that the partnerships were shams — which he describes as an “independent legal ground.” That is the rationale that the Fifth and Ninth Circuits have adopted for refusing to apply the valuation-misstatement penalty in cases like this, although both courts have voiced doubts about it.
We reject the argument’s premise: The economic substance determination and the basis misstatement are not “independent” of one another. This is not a case where a valuation misstatement is a mere side effect of a sham transaction. Rather, the overstatement of outside basis was the linchpin of the COBRA tax shelter and the mechanism by which Woods and McCombs sought to reduce their taxable income. As Judge Prado observed, in this type of tax shelter, “the basis misstatement and the transaction’s lack of economic substance are inextricably inter twined,” so “attributing the tax underpayment only to the artificiality of the transaction and not to the basis over valuation is making a false distinction.” In short, the partners underpaid their taxes because they overstated their outside basis, and they overstated their outside basis because the partnerships were shams. We therefore have no difficulty concluding that any underpayment resulting from the COBRA tax shelter is attributable to the partners’ misrepresentation of outside basis (a valuation misstatement).
I see the basis-shifting shelters of the 1990s as elaborate incantations designed to to get the Tax Fairy to magically wish away tax liabilities. Like any good witch doctor, the shelter designers relied on lots of elaborate hand-waving and dark magic to do their work, and they collected a lot of cash for their work. But there is no Tax Fairy. Justice Scalia has let Tax Fairy believers know that pursuing her is not just futile, but potentially very expensive.
Blue Book Blues. One digression by Justice Scalia in Woods is worth a little extra attention. From the opinion (citations omitted, my emphasis):
Woods contends, however, that a document known as the “Blue Book” compels a different result…Blue Books are prepared by the staff of the Joint Committee on Taxation as commentaries on recently passed tax laws. They are “written after passage of the legislation and therefore d[o] not inform the decisions of the members of Congress who vot[e] in favor of the [law].” While we have relied on similar documents in the past, …our more recent precedents disapprove of that practice. Of course the Blue Book, like a law review article, may be relevant to the extent it is persuasive.
Back in the early national firm days of my career, one of my bosses was a former national firm lobbyist who was exiled to The Field when a merger with another firm left room in Washington for only one lobbyist in the combined firm. I remember him telling clients that he could get around unpleasantness in the tax code by arranging for helpful language in the Blue Book. From what Justice Scalia says, he would have done as well by writing a law review article.
Jack Townsend also noticed this.
A new tax credit for the IRS to administer. What could possibly go wrong? A lot, as the IRS’s experience with the fraud-ridden refundable credits and ID-theft fraud has shown. Now a new Treasury Inspector General’s report warns that IRS systems aren’t yet prepared to stop premium tax credit fraud under Obamacare, reports Tax Analysts ($link):
While the IRS has existing practices to address ACA-related fraud, the agency’s approach is not part of an established fraud mitigation strategy for ACA systems, the report says. The IRS has two systems under development to lessen ACA tax refund fraud risk, but until those systems are completed and tested, “TIGTA remains concerned that the IRS’s existing fraud detection system may not be capable of identifying ACA refund fraud or schemes prior to the issuance of tax return refunds,” it says.
IRS Chief Technology Officer Terence Milholland said in a response included in the report that fraud prevention plans will be put in place as ACA systems are released.
The IRS loses $10 billion annually to Earned Income Tax Credit Fraud alone. This isn’t reassuring.
Paul Neiffer, Losses Can Offset Investment Income:
- If you have a net capital loss for the year, the regular tax laws limit this loss to $3,000. The final regulations allow this up to $3,000 loss to offset other investment income.
- If you have a passive loss such as Section 1231 losses, as long as that loss is allowed for regular income tax purposes, you will be allowed to offset that against other investment income.
- Finally, if you have a net operating loss carry forward that contains some amount of net investment losses, you will be allowed to use that portion of the NOL to offset other investment income.
A big improvement over the propsed regulations.
Jason Dinesen, Same-Sex Marriage, IRAs and After-Tax Basis:
It’s clear that for 2013 and going forward, couples in same-sex marriage will only need to apply “married person” rules to IRAs (and to everything else relating to their taxes).
What’s less clear is what happens with differences between federal and state basis for prior years.
Robert D. Flach, A YEAR END TIP FOR MUTUAL FUND INVESTMENTS. “If you want to purchase shares in a mutual fund during the fourth quarter of the year, wait until after the capital gain dividend has been issued, and the NAV has dropped, before purchasing the shares.”
David Brunori, Indexing the State Income Tax Brackets Makes Sense (Tax Analysts Blog)
Missouri Rep Paul Curtman (R) wants to index his state’s income tax brackets to inflation. Of all the tax ideas presented this year, this is among the best. Missouri imposes its top rate of 6 percent on all incomes over $9,000. Nine grand was a lot of money in 1931 – and the top tax rate was aimed at the very wealthiest Missourians. But that threshold hasn’t changed since Herbert Hoover was president.
Or they could just go with one flat rate.
TaxProf, The IRS Scandal, Day 209
William McBride, Summary of Baucus Discussion Draft to Reform International Business Taxation (Tax Policy Blog)
Howard Gleckman, The Supreme Court Opens The Door to Sales Tax Collections by Online Sellers (TaxVox)
They were too busy fighting the shelter wars to notice. The Cold War Is Over, but No One Told the IRS (Joseph Thorndike, Tax Analysts Blog)
Career Corner: A Friendly Reminder to Slobbering Drunks: Be Less Slobbery and Drunk at Your Company Holiday Party (Going Concern)
Tags: tax shelters, Kay Bell, David Brunori, Paul Daugerdas, Jenkens & Gilchrist, Ernst & Young, Joseph Thorndike, Going Concern, Obamacare, TIGTA, Jack Townsend, William McBride, Supreme Court, ACA, Net Investment Income Tax, Section 1411, Clint Stretch, Stephen Olsen, Career Corner, Justice Scalia, Blue Book