Fifth Circuit: Penalties upheld in sham partnerships | KPMG | GLOBAL

Fifth Circuit: Penalties upheld in “sham partnerships” case

Fifth Circuit: Penalties upheld in sham partnerships

The U.S. Court of Appeals for the Fifth Circuit affirmed penalty determinations made by a federal district court with regard to “sham partnerships,” including the imposition of the gross-valuation misstatement penalty under section 6662.


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The case is: Chemtech Royalty Associates, L.P. v. United States, No. 15-30577 (5th Cir. May 17, 2016). Read the Fifth Circuit’s decision [PDF 162 KB]


In a prior appeal, the Fifth Circuit affirmed the federal district court’s decision to disregard the partnership form of two partnerships held to be “sham partnerships” for tax purposes, but vacated and remanded the case back to the district court as to the penalty issues in order to consider the application of the section 6662 penalties—in particular the substantial-valuation and gross-valuation penalties in light of the intervening decision in United States v. Woods, 134 S. Ct. 557, 564 (2013).

On remand, the federal district court re-instated the vacated penalty award and further held that a tax penalty for gross-valuation misstatement applied. The district court held that the gross-valuation misstatement penalty applied with respect to one of the partnerships, and that the substantial-understatement and negligence penalties applied to both partnerships for different tax years. As a result and because section 6662 penalties do not “stack,” the 20% penalty applied for tax years 1997 to mid-1998 and a 40% penalty applied for tax years mid-1998 to 2006.

In affirming the district court’s decision, the Fifth Circuit:

  • Refused to require the district court to consider whether the taxpayer had a reasonable basis and substantial authority specifically regarding the “sham partnership” issue
  • Rejected the government’s claim that the substantial authority defense to section 6662 penalties attributable to tax shelters—i.e., that a taxpayer reasonably believed that the tax treatment of the items involved was more likely than not the proper treatment of that item—was unavailable to the taxpayer
  • Found the taxpayer lacked substantial authority for its position, providing a clear explanation of the applicable standard and the reasons behind its conclusion

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