Yesterday (December 3, 2013) the Supreme Court issued two decisions, described below, of interest to the business community.

  • Taxation—Penalties for Overstating Basis—District Court Jurisdiction
  • Forum-Selection Clauses—Proper Venue—Transfer Between Districts

Taxation—Penalties for Overstating Basis—District Court Jurisdiction

United States v. Woods, No. 12-562 (previously discussed in the March 25, 2013, Docket Report)

Section 6662(e) of the Internal Revenue Code imposes a penalty for an underpayment of income tax that is "attributable to" an overstatement of the value or basis of property. Today, the Supreme Court, in a unanimous opinion by Justice Scalia, held that the overstatement penalty is applicable to an underpayment resulting from a basis-inflating transaction subsequently disregarded for lack of economic substance. The Court also decided that district courts have jurisdiction to consider the applicability of tax penalties in partnership-level proceedings.

Woods arose from an IRS determination that two partnerships involving the same two individuals had engaged in a sham transaction—the COBRA tax shelter promoted during the 1990s—for the sole purpose of generating tax losses. The district court upheld the IRS determination disregarding the partnerships as shams. But the court overturned the assessment of a valuation-misstatement penalty, based on Fifth Circuit precedent excepting the total disallowance of a deduction from the penalty for valuation overstatements. Woods v. United States, 794 F. Supp. 2d 714, 717 (W.D. Tex. 2011). The IRS appealed, and the Fifth Circuit affirmed in a per curiam opinion, holding that the issue was "well settled" in the circuit.

The Supreme Court reversed. As an initial matter, the Supreme Court held that the district court had jurisdiction to determine the applicability of the tax penalty even though the proceeding was at the partnership level rather than the partner level. (Partnerships file tax returns but do not pay taxes or penalties.) The Court held that Section 6224(f) of the Internal Revenue Code gives courts in partnership-level proceedings "jurisdiction to determine the applicability of any penalty that could result from an adjustment to a partnership item, even if imposing the penalty would also require determining affected or non-partnership items such as outside basis." The Court emphasized, however, that "such a partnership-level applicability determination is provisional: the court may decide only whether adjustments properly made at the partnership level have the potential to trigger the penalty." Individual partners remain free to dispute the imposition of any penalty on them specifically in subsequent partner-level proceedings.

Turning to the merits of the case, the Court determined that, where an asset's true value or adjusted basis is zero, any claim of a positive basis is automatically a gross-valuation misstatement, so that the penalty under Section 6662(e) applies. Woods had argued that the penalty applies only to factual misrepresentations about an asset's worth—not to misrepresentations that rest on legal errors (such as what properly constituted the asset's basis). The Court rejected this argument, noting that Section 6662(e) also applies to an overstatement of "adjusted basis," which clearly incorporates legal considerations. The Court also rejected Woods' argument that any underpayment of tax in this case would be "attributable" not to a basis misstatement, but rather to the determination that the partnerships were shams—a supposedly "independent legal ground." Contrary to this view (which reflected the approach of the Fifth and Ninth Circuits), the Court held that the "economic-substance determination and the basis misstatement are not 'independent' of one another." Rather, the Court observed, the basis overstatement at issue was the "linchpin of the tax shelter," and the mechanism by which Woods sought to reduce his taxable income. Therefore, the valuation-misstatement penalty applied.

The Court's decision is important to all taxpayers engaging in basis-increasing transactions that may be challenged by the IRS as lacking economic substance. Additionally, the Court's jurisdictional decision is relevant to any partnerships or individual partners that may contest the applicability of tax penalties based on the partnership's treatment of tax items.

Forum-Selection Clauses—Proper Venue—Transfer Between Districts

Atlantic Marine Construction Co. v. United States District Court for the Western District of Texas, No. 12-929 (previously discussed in the April 1, 2013, Docket Report)

What procedure should a defendant use to enforce a forum-selection clause when the defendant is sued in a court that is not the contractually selected forum?

The Supreme Court today held in Atlantic Marine Construction Co. v. United States District Court for the Western District of Texas, No. 12-929, that if the case is filed in a federal district court that is authorized by statute (but not the forum that the parties selected), the defendant should invoke 28 U.S.C. § 1404(a), which permits the court to transfer the case it to another proper venue "[f]or the convenience of the parties and witnesses, in the interest of justice." The defendant may invoke 28 U.S.C. § 1406(a), which authorizes a district court to dismiss or transfer a case, only if the action is filed in a venue not authorized by statute.

Importantly, the Court held both that the party resisting the forum-selection clause has the burden of establishing that public interests disfavoring transfer outweigh the parties' contractual choice of forum, and that the parties' choice should control except in the most unusual cases.

Atlantic Marine is significant for the business community because it provides greater certainty regarding the enforceability of forum-selection clauses, giving businesses that employ such clauses in their contracts greater predictability about where they will face future litigation. The Court reinforced the strong policy favoring the enforcement of such clauses, and clarified the mechanism for their enforcement.

In this case, Atlantic Marine Construction had entered into a contract with J-Crew Management that called for all disputes to be resolved in the state or federal court in Norfolk, Virginia. After J-Crew sued Atlantic Marine in federal court in Texas, Atlantic Marine invoked the forum-selection clause and sought to dismiss or transfer under § 1406(a), or else to transfer under § 1404(a). The district court declined to transfer, concluding that § 1406(a) did not apply because venue in Texas was proper despite the forum-selection clause, and that the balance of public and private interests weighed against a discretionary transfer under § 1404(a). The Fifth Circuit denied Atlantic Marine's petition for a writ of mandamus, concluding that Stewart Organization, Inc. v. Ricoh Corp., 487 U.S. 22 (1988), implicitly held that a forum-selection clause is a nondispositive factor favoring transfer under § 1404(a), and is irrelevant under § 1406(a). Over a dissent that noted the presumptive enforceability of forum-selection clauses, the panel majority concluded that the district court did not clearly abuse its discretion in weighing public and private interests under § 1404(a).

In a unanimous opinion by Justice Alito, the Supreme Court reversed and remanded. The Court first reasoned that a forum-selection clause does not render venue in an unselected forum "wrong" or "improper," because the venue statute (28 U.S.C. § 1391) does not address forum-selection clauses. Slip op. 4-8. Accordingly, when a case is filed in a district in which venue is proper under § 1391, a party may not enforce the clause using mechanisms for dismissal or transfer that are predicated on the wrongfulness or impropriety of venue, such as 28 U.S.C. § 1406(a) for clauses selecting federal forums, or Fed. R. Civ. P. 12(b)(3) for clauses selecting state forums. Rather, a clause selecting a federal forum may be enforced using § 1404(a), and a clause selecting a state forum may be enforced under the forum non conveniens doctrine.

The Court then described the appropriate standard for transfer. In ordinary cases not involving forum-selection clauses, courts must balance "the convenience of the parties and various public-interest considerations" to determine whether transfer would promote "the interest of justice." 28 U.S.C. § 1404(a). But that analysis shifts in three important ways, the Court explained, in cases involving forum-selection clauses. First, in balancing interests the court may not consider "the plaintiff's choice of forum," because the plaintiff had already agreed by contract that another forum is more appropriate. Slip op. 13. Second, because forum-selection clauses "waive" the parties' "right to challenge the preselected forum as inconvenient," the courts must "consider arguments about public-interest factors only." Id. The parties' contractual choice of forum will outweigh public-interest factors "in all but the most exceptional cases." Id. at 12 (quoting Stewart, 487 U.S. at 33 (Kennedy, J., concurring)). Finally, in order to avoid privileging a party that "flouts its contractual obligation and files suit in a different forum," the transferee court will apply the choice-of-law rules of the contractually selected forum, as if the case had been filed there in the first instance. Id. at 14-15. (The same revised analysis would apply in determining whether dismissal on forum non conveniens grounds is appropriate in a case in which a state or foreign forum is selected by the contract.) The Court remanded to allow the lower courts to consider in the first instance whether any other public-interest factors preclude enforcement of the clause in this case.

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