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

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.

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

Once the partnerships were treated as nonexistent for tax purposes, no nonzero outside basis was supportable. The overstatement was the mechanism of the shelter, not an unrelated consequence of the economic-substance ruling. The Court reversed and held the valuation-misstatement penalty applicable.

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.
• A legal error can support a valuation misstatement.
• Economic-substance and basis theories may be inseparable when inflated basis drives the claimed loss.