Tax Legal Services · Primary-source case analysis

United States v. Woods: Sham Partnerships Can Trigger the Valuation-Misstatement Penalty

By Aneeta Mishra and Timothy Chan

Published April 17, 2026 · Updated October 18, 2026

Decision: United States v. Woods, 571 U.S. 31 (2013).

Woods connects partnership-level economic-substance findings to partner-level basis consequences and the gross valuation-misstatement penalty under the former TEFRA framework.

Offsetting options produced paper losses

Gary Woods and Billy Joe McCombs bought offsetting currency-option spreads, contributed them to partnerships, and counted the long options while disregarding nearly offsetting short options in computing outside basis. On roughly $3.2 million contributed, they claimed losses exceeding $45 million.

The partnerships were disregarded

The IRS concluded that the partnerships were tax-avoidance shams lacking economic substance, disallowed the losses, treated outside basis as zero, and asserted a 40-percent gross valuation-misstatement penalty. The district court upheld the sham determination but rejected the penalty; the Fifth Circuit affirmed. The governing zero-basis regulation treated any positive claimed basis as a gross misstatement. The Supreme Court assumed that regulation’s validity because Woods did not challenge it; it did not resolve an amicus’s objection about division by zero. Woods, 571 U.S. at 43–44 &n.4.

Partnership-level jurisdiction was sufficient

The Supreme Court held that the partnership-level court could decide whether an adjustment to a partnership item had the potential to trigger the penalty even though partner-level determinations would be required before collection. Individual partners remained able to raise personal defenses later.

Basis overstatement and sham status were intertwined

Woods argued that a valuation penalty reaches factual appraisal errors, not a legal conclusion that a partnership does not exist for tax purposes. The Court rejected that distinction because the statute separately names value and adjusted basis. Basis incorporates legal rules; treating the parenthetical reference to basis as merely another word for market value would read that independent term out of the statute. Woods, 571 U.S. at 44–46. The overstatement was the loss-generating mechanism here, not an unrelated side effect of the sham finding.

Key takeaways

• Penalty applicability may be determined at the partnership level even when later partner issues remain.
• Disregarding a partnership can reduce outside basis to zero.
• Adjusted basis is a legal calculation, not just an appraisal of market value.
• Economic-substance and basis theories may be inseparable when inflated basis drives the claimed loss.