The Supreme Court held Tuesday that the 40 percent gross valuation misstatement penalty applies to overstated basis where partnerships were shams, so no partner could legitimately claim a basis in the partnership interest greater than zero.

Gary Woods and Billy Joe McCombs participated in an offsetting option tax shelter (Current Options Bring Reward Alternatives, or COBRA) to reduce their taxable income in 1999, according to the court. They purchased a series of currency option spreads from Deutsche Bank, consisting of a long option, for which they paid a premium, and a short option, which they sold to Deutsche Bank and for which they received a premium.

Because the premium paid for the long option was largely offset by the premium they received for the short option, the net cost to the Woods and McCombs was less than the cost of the long option alone. Respondents contributed the spreads, along with cash, to two partnerships that used the cash to purchase stock and currency. When calculating their basis, they considered only the long component of the spreads and disregarded the offsetting short component, generating huge losses when the partnerships were sold.

The IRS determined that Woods and McCombs could not claim a basis for their partnership interests greater than zero and that any resulting tax underpayments would be subject to a 40 percent penalty for gross valuation. Both the district court and the Fifth Circuit held that the partnerships were shams, but that the valuation misstatement penalty did not apply. The decision in this case resolves a circuit split, as both the Fifth and Ninth Circuits have held that only the 20 percent penalty for substantial understatement applies.

The Supreme Court agreed that the 40 percent gross valuation misstatement penalty applies. Once the partnerships were deemed to not exist and the entire transaction was disallowed, no partner could legitimately claim a basis in his partnership interest greater than zero.