More on the Supreme Court's Opinion in Woods on TEFRA and the 40% Basis Overstatement Penalty (12/4/13)

I offer more detailed comments on United States v. Woods, ___ U.S. ___ (2013), here.  This blog entry is primarily for students.

1.  The opinion has a good summary of the state of the law leading to the original enactment of the TEFRA partnership provisions.  Slip Op. 6 & 7.  This context is important to understand the general nature of the TEFRA partnership provisions and its policy choices.  The context is useful far beyond the context of the immediate issue.

2.  The immediate threshold question was the court's jurisdiction to determine penalty issues in the unified TEFRA proceeding.  The penalty in question was one of the accuracy related penalties.  In 1997, the TEFRA provisions were amended to have such penalties determined at the partnership level with respect to partnership items despite the fact that at least one critical component of the Section 6662 penalty has a defense of reasonable cause and good faith -- see Section 6664(c)(1), here -- that must be asserted by a partner at the partner level and not in the partnership level proceeding.  The statutory solution to this problem is to permit the partner to assert the defense at the partner level but in a separate refund proceeding (rather than in a Tax Court proceeding pursuant to a notice of deficiency).  Justice Scalia said pithily:  "Barring partnership-level courts from considering the applicability of penalties that cannot be imposed without partner-level inquiries would render TEFRA’s authorization to consider some penalties at the partnership level meaningless."  (Slip Op. 9.) Justice Scalia then reasons (Slip Op. 10):

Applying the foregoing principles to this case, we conclude that the District Court had jurisdiction to determine the applicability of the valuation-misstatement penalty — to determine, that is, whether the partnerships’ lack of economic substance (which all agree was properly decided at the partnership level) could justify imposing a valuation-misstatement penalty on the partners. When making that determination, the District Court was obliged to consider Woods’ arguments that the economic-substance determination was categorically incapable of triggering the penalty. Deferring consideration of those arguments until partner-level proceedings would replicate the precise  [*20] evil that TEFRA sets out to remedy: duplicative proceedings, potentially leading to inconsistent results, on a question that applies equally to all of the partners.
To be sure, the District Court could not make a formal adjustment of any partner’s outside basis in this partnership-level proceeding. See Petaluma, 591 F. 3d, at 655. But it nonetheless could determine whether the adjustments it did make, including the economic-substance determination, had the potential to trigger a penalty; and in doing so, it was 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, did not exist. Each partner’s outside basis still must be adjusted at the partner level before the penalty can be imposed, but that poses no obstacle to a partnership-level court’s provisional consideration of whether the economic-substance determination is legally capable of triggering the penalty.  n2
   n2 Some amici warn that our holding bodes an odd procedural result: The IRS will be able to assess the 40-percent penalty directly, but it will have to use deficiency proceedings to assess the tax underpayment upon which the penalty is imposed. See Brief for New Millennium Trading, LLC, et al. as Amici Curiae 12-13. That criticism assumes that the underpayment would not be exempt from deficiency proceedings because it would rest on outside basis, an “affected ite[m] . . . other than [a] penalt[y],” 26 U. S. C. § 6230(a)(2)(A)(i). We need not resolve that question today, but we do not think amici’s answer necessarily follows. Even an underpayment attributable to an affected item is exempt so long as the affected item does not “require partner level determinations,” ibid.; see Bush v. United States, 655 F. 3d 1323, 1330, 1333-1334 (CA Fed. 2011) (en banc); and it is not readily apparent why additional partner-level determinations would be required before adjusting outside basis in a sham partnership. Cf. Petaluma FX Partners, LLC v. Commissioner, 591 F. 3d 649, 655, 389 U.S. App. D.C. 64 (CADC 2010) (“If disregarding a partnership leads ineluctably to the conclusion that its partners have no outside basis, that should be just as obvious in partner-level proceedings as it is in partnership-level proceedings”).

3.  Turning to the more interesting issue of whether the valuation/basis misstatement penalty can be avoided because of some threshold defect in the tax benefit actually claimed on the return through the misstatement, Justice Scalia invokes his "plain" meaning textual analysis to hold that the penalty cannot be avoided.  Basically, the taxpayer attempted to equate the terms basis and value, so that basis means value which, the taxpayer urged, is a factual inquiry rather than the type of legal inquiry that sunk the tax gambit here.  The notion is that if the shelter fails because of a pure legal inquiry such as value (and by taxpayer's equation, basis), then the penalty just cannot apply according to its text.  But, reasoned Justice Scalia, the statute does not equate basis and value and, even if value could be construed to require a factual reason for disallowance (as opposed to the sham or lack of economic substance reason applied), then basis is an inherently legal construct and does not have any connotation of a purely factual inquiry.  (Slip Op. 11-16.)

4.  In reaching the foregoing conclusion, Justice Scalia found the text plain and unambigous analysis, rendering legislative history or any other source of interpretation irrelevant.  (See particularly Slip Op. 15 n. 5.) Of course Justice Scalia is no fan of such sources, and is a particular critic of legislative history.  But, by finding the statutory text plain and unambiguous, he defers holding in the case that legislative history is always irrelevant.  That is his sometimes belief of course (even though he is not alwas consistent on that issue), but he was writing an opinion for a unanimous court and likely would have drawn some concurring opinions on that issue had he been compelled to deal with that issue.

5.  On Justice Scalia's plain meaning preference for statutory analysis, it is interesting that, in resolving the threshold jurisdictional issue, history and context rather than plain meaning were critical. I offer the following from my text (footnotes omitted):

Still, the polar extremes of textualism and intentionalism offer a convenient model for analysis of how the various courts approach the interpretation of tax statutes specifically.  I cite two recent studies on the use of legislative history.  The first is a study of Supreme Court opinions over a very long period (1953-2006) using statistical techniques and analysis to draw conclusions.  The authors’ findings include: use of legislative history is driven by a combination of legal and ideological factors, with legal factors (e.g., length and complexity of the statute, frequency of amendment, age of the statute (new and old statutes prompting reference to legislative history), etc.) having the most influence.  Still ideological factors do have some influence: (i) “liberal Justices are generally more likely than conservative Justices to cite legislative history;” (ii) “Justices are more likely to consult legislative history when they are ideologically sympathetic to the purposes of the enacting Congress;” and (iii)  as to ideological influence: 

[T]he propensity of Justices to cite legislative history is significantly correlated with the ideology of the Justices themselves: liberal Justices are more likely than conservative Justices to use it. In addition, the fact that a Justice is of the same ideological bent as the legislators who enacted the statute increases the likelihood that he or she will turn to legislative history. At the same time, however, the fact that a liberal Justice cites legislative history in a particular opinion does not render it more likely that the opinion in question will arrive at a liberal outcome. 

Finally, we reject the oft-expressed hypothesis that Justice Scalia's vocal criticism of legislative history helps to explain the overall decline in legislative history usage since the Burger Court.  The decline is more likely attributable to the overall rightward shift in the composition of the Court, for which no single Justice can be assigned either credit or blame.  Liberal Justices who were inherently predisposed to use legislative history have, on the whole, been replaced by conservative Justices who are not. Controlling for such factors as the ideology of each Justice, we found no evidence that Justice Scalia has influenced the legislative history usage of other members of the Court. 

I should caution that this study analyzes interpretation of the gamut of statutes and is not limited to tax statutes (although tax statutes were a significant component of the data set).  It is often felt that use of legislative history for interpreting tax statutes may not fit within mainstream analyses simply because, Justice Scalia aside, there is a long tradition of using  legislative history for interpreting tax statutes.  The notion may be that tax statutes are more bipartisan (perhaps in earlier years) and expertise driven, so as to make the legislative history are more reliable guide to what the text means (or should mean). 

The other recent study focuses on interpreting tax statutes by the lower courts.  This study draws broad conclusions from a study of 10 cases where the literal meaning of the text of the statute was demonstrably at odds with the intentions of the drafters.  The study determined that, with surprising consistency, the Tax Court adopted an intentionalist approach but the courts of appeals adopted a textualist or plain meaning approach.  A general tendency of the Tax Court to adopt an intentionalist approach is perhaps not surprising, since it is a tax specialty court more attuned to the nuances and needs of a comprehensive tax system governing a complex economy.  Courts of appeals and the Supreme Court for that matter tend to lack that tax background and approach and often focus more narrowly on the text in order to apply some plain meaning, perhaps justified in part on the notion that the public at large must deal with the statute in a generalist sort of way and structure transactions without the detailed nuances that might be available by going beyond the text of the statute.

The two cited studies are David S. Law and David Zaring, Law Versus Ideology: The Supreme Court and the Use of Legislative History, 51 Wm. and Mary L. Rev. 1653 (2010); and David E. Shores, Textualism and Intentionalism in Tax Litigation, 61 Tax Law. 53 (2007).

6.  For the same reason, as noted yesterday in the original blog on the case, Justice Scalia takes straight aim at the Blue Book for not even being legislative history.  The question is whether this unanimous opinion sound sthe death knell of the Blue Book as a statutory interpretive tool?  I am not so sure.  First, what Justice Scalia says forcefully and obviously is that the Blue Book is not legislative history and, thererfore, one cannot infer that the Blue Book is a statement by Congress or some component thereof of its intent in the way the Committee Reports and real legislative history are.  Second, the Blue Book often just parrots the legislative history, in which case there is no independent significance to the legislative history.  Third, the Blue Book extensions (or spins, as Justice Scalia might call them) sometimes find their way into the Regulations, in which case the Blue Book may be the source for the independently authoritative Regulations under Chevron.  Fourth, Justice Scalia does reason that the Blue Book may persuade, relegating it to the a comparable authority of a law review article.  I suspect that, in terms of its "persuasiveness," the Blue Book might be higher (whether or not the person persuaded acknowledges it). Fifth, the Blue Book is considered some level of authority under Section 6664(c)(1)'s good faith defense.  See Regs. § 1.6662-4(d)(3)(iii), here.  So, I think that the Blue Book will continue to inform the discussion for scholars, practitioners and courts, although perhaps in a lesser way because of the Woods opinion.

7.  As an aside, Justice Scalia, unlike Judge Posner, does employ footnotes for various purposes and did so in this case (see paragraph 4 above, probably to hold unanimity).  However, I like to quote the following from the transcript of the oral argument in Cuno v. DaimlerChrysler, Inc., 545 U.S. 1165 (2006):

Mr. Enrich:  In a footnote in Flast [v. Cohen], the Court specifically says, “Having now decided that there's Establishment Clause standing, we can also reach the free-exercise question without discussing whether there would be independent standing.” 

Justice Scalia:  I had not recollected that footnote. I will -- I will find it. I don't read footnotes, normally.

I don't think that "normally" ignoring footnotes is a good strategy for us ordinary observers and practitioners of the law.  Still, I suppose, it might be Justice Scalia's signal that his footnotes might not "normally" be important.  I doubt that he would express it that way, though.  And then, of course, one would have to read the footnote to determine whether it  was important and therefore should be read in the first instance.

Addendum 12/4/13 4:0 pm:

I add the following to address certain portions of Andrew Velarde, Supreme Court Holds Valuation Misstatement Penalty Applies in Tax Shelter Case, 2013 TNT 233-1 (12/3/13).

8.  The article reports a practitioner lamenting as follows:

The Court's "dismissiveness of the taxpayer's arguments does not readily reflect the difficulty of the issues," Allison told Tax Analysts. "The Court's upholding of jurisdiction of penalties in a partnership-level proceeding sets up potential confusion as to when and how to introduce evidence to defend against those penalties, and to what extent principles of res judicata and collateral estoppel could adversely impact defenses in subsequent partner-level proceedings," he said.

With due respect to a very good lawyerI am not sure what this comment means.  The law is very clear on what the partner needs to do at his level to assert any defenses to the penalty determinations at the partnership level. See § 6230(c)(1)(C), (c)(3) & (c)(4), here, and Regs. 301.6221-1(d), here.

9.  Jasper L. Cummings, Jr. is quoted:

"However, the opinion left an exception to this dislike of legislative history big enough to drive a truck through," Cummings said, citing Scalia's comment that the blue book "may be relevant to the extent it is persuasive."

I agree but think that many others read the opinions as to legislative history and the blue book more narrowly.

10.  Allison is again quoted:

Allison likewise noted the Court's dismissal of blue book commentary, expressing disappointment in its decision. "The Court's rejection of the blue book as a means of interpreting the application of the valuation misstatement penalty where multiple legal grounds for a determination exists is ultimately unsatisfying, given how much of the debate in the lower courts had centered around the blue book's language," Allison said.

That is Justice Scalia's point.  The Blue Book does not answer the question because the plain language of the statute did answer the question.  No reason to do anything with the Blue Book except to say, as Justice Scalia did, (i) it is not relevant to the plain language analysis, (ii) it is not legislative history in any event, and (iii) it is suspect of any authority except as persuasive.  Obviously, it was not persuasive in light of the plain meaning of the statute.

11.  Another practitioner is quoted (emphasis supplied by JAT):

Probasco argued that one part of the Court's penalty analysis was oversimplified and could create problems in the future. "The decision seems to assume that if a partnership is a sham and doesn't exist, the partners have no basis. But that's not always the case," he said. "Sometimes it merely means that the partners must report the transactions as though the partners engaged in the transactions directly. That would mean the partners still had a basis, although much lower. . . . Treating 'partnership was a sham' as 'partners had zero basis' could result in applying the gross valuation misstatement penalty inappropriately in other cases."

Again, I don't see the problem.  The holding that the partnership is a sham means that there is no partnership interest and hence no basis in the partnership interest.  This is true whether the claimed partnership interest basis was the effect of the bullshit / sham leverage or from the portion representing the taxpayer's actual cash investment.  Neither gives basis in a sham partnership interest in a sham partnership.  Other than that, Probasco does not spell out his unspecified horrors that might result.

12.  Again, Mr. Cummings is quoted:

Cummings noted that the Court did not express an opinion on the economic substance doctrine itself but rather followed, without endorsing, the IRS and the Fifth Circuit's determination that the economic substance doctrine made the partnership a sham. He did say it was notable that the opinion did not go so far as to call the COBRA transaction an "illegal tax shelter," as some courts of appeals had.

Mr. Cummings does not tell us what he means by "illegal tax shelter" but the holding is entirely consistent with that description.  Might not use those words, but the tax shelter and its structure were shams, nothing, vapor, etc.  Yet from those shams, nothings, vapors taxpayers claimed tax benefits there were not entitled to.  That sounds like they were illegal to me.  Now, if Mr. Cummings says that the Justice Scalia did not pronounce them criminal tax shelters, well that was not the issue in the case, although I think the criminal prosecutions of the various promoters for this ilk of shelter certainly establishes that there were criminality that at least reached the promoters.

13.  My final comment to all  of this is that these bullshit tax shelter taxpayers should count  themselves lucky.  They got the 40% penalty (plus, of course, interest on the penalty since the due dates of their 1040s).  A good argument can be made that the 75% civil fraud penalty was more appropriate.  They all signed statements at the inception of these shelters representing that they had legitimate nontax profit motives when, in fact, the cases establish where it has been litigated that they did not have that profit motive.  Readers might want to consider in this regard that the jury was instructed in Daugerdas that the "relevant taxpayers" -- the ones mentioned in the tax evasion counts -- did not have the subjective intent required under the  dual economic substance test, treated as conjunctive rather than disjunctive.  see Daugerdas Retrial Jury Instructions - Part 07 Tax Evasion Instructions Part 3 Economic Substance (Federal Tax Crimes Blog 11/27/13; 11/29/13), here.  If indeed they told  the big lie as the sine qua non for anyone participating in the structure ab inition, where are the consequences of the big lie -- both in terms of the civil fraud penalty and perhaps even criminal prosecution.  Shouldn't they consider themselves lucky with just a 40% hit to their pocket books and whatever hit they took to their prides and egos.

14.  We here is my next final comment but it relates to the foregoing final comment.  What if these partners are so bold as to try to raise the partner level defenses in the partner level proceeding discussed above in paragraph 8?  Can the Government come back with an assertion of a partner level personal civil fraud penalty assertion?  This might  require the issue of a notice of deficiency, but keep in mind that the statute is always open for such a notice of deficiency at the partner level as to the partner's own fraud.  And this is true even if some event has occurred which might otherwise close out the year on res judicata or any other basis.  Probably be best if they just let sleeping dogs lie and count their blessings.  (The blessings are, of course, that  they are still rich even after paying the penalty and they are paying lesser penalties than they probably should have.)