Tax · Primary-source case analysis

Woods: A Sham Partnership’s Inflated Basis Triggered the Valuation-Misstatement Penalty

By Aneeta Mishra and Timothy Chan

Published August 10, 2026

United States v. Woods involved offsetting currency-option transactions contributed to partnerships to create claimed bases far exceeding the participants’ net economic investment and losses of more than $45 million from about $3.2 million of contributions.

The option structure generated artificial basis

The participants bought long options and sold nearly offsetting short options, but counted only the long-option premiums when calculating partnership basis. The partnerships then disposed of assets and reported enormous paper losses.

The partnerships were disregarded for lack of economic substance

The IRS determined that the partnerships were tax-avoidance shams and that the partners could not claim bases above zero. The district court agreed that the entities lacked economic substance.

The partnership court could address penalty applicability

Under the then-governing TEFRA framework, a partnership-level court could determine whether a penalty related to an adjustment of partnership items, while partner-specific defenses remained for later proceedings.

Zero basis made the misstatement gross

The Court held that the valuation-misstatement penalty covered basis errors resulting from a sham transaction and reversed the Fifth Circuit. Current partnership audit procedures differ, but economic-substance, basis, penalty, and partner-defense issues still require separate analysis.

Key takeaways

• Reconcile claimed basis with the taxpayer’s net economic investment and every offsetting obligation.
• Document a genuine business purpose and non-tax economic effect before using partnership losses.
• Separate entity-level penalty applicability from partner-specific defenses.
• Apply current centralized partnership-audit and penalty statutes rather than former TEFRA mechanically.