By Ken Berry
In a new case decided by the US Supreme Court, the remnants of a tax shelter partially constructed by wily Texas billionaire Billy Joe McCombs - known informally as "Red" - collapsed like a house of cards (US v. Gary Woods, S. Ct. No. 12-562, December 3, 2013).
The highest court in the land unanimously ruled that San Antonio–based McCombs, former owner of the Minnesota Vikings NFL franchise, and his business partner Gary Woods, owe a whopping tax penalty to the IRS. The duo set up a partnership designed to shield an expected influx of income from tax. Based on court papers, McCombs and Woods sank $32 million into the deal.
This tax shelter is known as a "current options bring reward alternatives", or COBRA. Here's how the COBRA shelter reduced the tax bite: When calculating their basis in the partnership interests, McCombs and Woods considered only the "long" component of various currency-option spreads and disregarded the nearly offsetting "short" component. Subsequently, when the assets were disposed of for modest gains, the two moguls claimed they were entitled to losses of more than $45 million.
The partnership was found to be a sham by the lower courts, but McCombs didn't meekly accept his fate. He and Woods argued that they shouldn't be on the hook for a 40 percent penalty in addition to the regular tax liability.
According to Justice Antonin Scalia, who wrote the opinion, the taxpayers failed to impress the top court. "At the end of the day, Woods' and McCombs' $3.2 million investment generated tax losses that, if treated as valid, could have shielded more than $45 million of income from taxation", he said.
Because there were no valid partnerships for tax purposes, the IRS determined that the partners could not claim a basis for their partnership interests greater than zero and that any resulting tax underpayments are subject to a 40 percent penalty for gross valuation misstatements. In the final analysis, the Supreme Court reversed the lower court and upheld the extra assessment. "The penalty is applicable to tax underpayments resulting from the partners' participation in the COBRA tax shelter", wrote Scalia.
It isn't yet clear how much the penalty will amount to, but it's expected to run well into the millions. The IRS still has to figure out the interest calculation.
As of this writing, neither McCombs nor Woods has responded publicly to the ruling. However, experts are calling the decision a clear win for the IRS and a severe blow to taxpayers. Fighting the 40 percent penalty will likely be an uphill battle in future cases.