Blum v. Comm'r , 103 T.C.M. 1099 ( 2012 )

T.C. Memo. 2012-16
UNITED STATES TAX COURT
SCOTT A. AND AUDREY R. BLUM, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 2679-06. Filed January 17, 2012.
Ps, through a grantor trust, entered into an
Offshore Portfolio Investment Strategy (OPIS)
transaction through KPMG, an accounting firm. Through
direct and indirect interests in UBS stock, they
created a $45 million loss. Ps claimed the loss for
tax purposes but did not, in fact or substance, incur a
$45 million loss. Ps were pursued by KPMG when KPMG
became aware that Ps would have a substantial capital
gain. KPMG issued an opinion, after the fact, that the
$45 million capital loss would “more likely than not”
be upheld.
1. Held: the OPIS transaction is disregarded
under the economic substance doctrine.
2. Held, further, Ps are liable for accuracy-
related penalties for gross valuation misstatements and
negligence under sec. 6662(a), I.R.C.
-2-
Nancy Louise Iredale, Jeffrey Gabriel Varga, and Stephen J.
Turanchik, for petitioners.
Henry C. Bonney, Jr., Kevin G. Croke, and Elizabeth S.
Martini, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
KROUPA, Judge: Respondent determined deficiencies in and
penalties with respect to petitioners’ Federal income taxes for
1998, 1999 and 2002 (years at issue) as follows:
Penalties
Year Deficiency Sec. 6662(b) Sec. 6662(h)
1998 $9,414,861 $1,948 $3,762,048
1999 16,298,672 2,954 6,513,560
2002 18,737 3,747 -0-
The parties have resolved a number of issues in their stipulation
of settled issues. In addition, the Court dismissed for lack of
jurisdiction those portions of the deficiencies and penalties
pertaining to petitioners’ Bond Leveraged Investment Portfolio
Strategy (BLIPS) transaction. Accordingly, the parties will need
to prepare a Rule 1551 computation.
This Court has not previously considered an Offshore
Portfolio Investment Strategy (OPIS) transaction. The question
1
All section references are to the Internal Revenue Code
(Code) for the years at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure, unless otherwise
indicated. All monetary amounts are rounded to the nearest
dollar.
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before us is whether petitioners are entitled to deduct certain
capital losses claimed from their participation in the OPIS
transaction. We hold that they are not because the transaction
lacks economic substance. We must also decide whether
petitioners are liable for gross valuation misstatement penalties
and negligence penalties under section 6662(a). We hold they are
liable for the penalties.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. We
incorporate the stipulation of facts and documents, the second
stipulation of facts and documents, the third stipulation of
documents and the accompanying exhibits by this reference.
Petitioners resided in Jackson, Wyoming when they filed the
petition.
I. Petitioners’ Background
Scott Blum (Mr. Blum) and Audrey Blum (Mrs. Blum) were
married in the mid-1990s and have twin children. Mr. Blum, the
only adopted child of an engineer and a secretary, was an
entrepreneurial child and prone to selling his toys. After
parking cars for a hotel and selling women’s shoes, he started
his first company when he was 19 years old to sell computer
memory products. He sold that company two years later for over
$2 million. During the same year, at the age of 21, Mr. Blum
started Pinnacle Micro, Inc. (Pinnacle) with his parents. Mr.
Blum and his parents ran Pinnacle for nine years, including when
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it was a public company. Mr. Blum entered into an Internet-based
business after leaving Pinnacle.
Mr. Blum founded Buy.com, an online retailer, in 1997, and
it set a record for being the fastest growing company in United
States history during its first year of operation. In 1998 Mr.
Blum sold a minority interest in Buy.com stock for a total of $45
million. The sales comprised a $5 million stock sale in August
and a $40 million stock sale at the end of September. His basis
in the stock was zero, and in response to the potential gain Mr.
Blum entered into a $45 million OPIS transaction during 1998,
creating a capital loss of approximately $45 million. The OPIS
transaction was created, managed and promoted by Mr. Blum’s
accounting firm.
Mr. Blum, a savvy businessman, has relied on advisers
including accountants, attorneys and investment counselors. He
never prepared his own tax return. We will introduce the
participants in the OPIS transaction and the entities used to set
up the transaction before describing the arrangement.
II. The Participants
A. The Blum Trust
Mr. Blum created the Scott A. Blum Separate Property Trust
(Blum Trust) in 1995 as a grantor trust. A grantor trust is
disregarded as an entity for Federal income tax purposes. The
Blum Trust was established near the time of Mr. Blum’s marriage
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for family financial planning purposes to address the possibility
of a divorce and its effect upon his corporate businesses. The
Blum Trust normally held stock in Mr. Blum’s start-up companies
and has held other investments through stock brokerage firms.
B. KPMG
Petitioners’ accountant, KPMG Peat Marwick LLP (KPMG),2 a
“Big Four” tax and accounting firm, prepared their individual tax
returns. KPMG also represented petitioners in a Federal income
tax audit, and Mr. Blum hired KPMG employees to work for him as
his business employees.
KPMG is a member firm of KPMG International, a Swiss
cooperative, of which all KPMG firms worldwide are members. At
all relevant times, KPMG was one of the largest accounting firms
in the world, providing services to many of the largest
corporations worldwide. KPMG provided tax services to corporate
and individual clients, including preparing tax returns,
providing tax planning and tax advice and representing clients
before the Internal Revenue Service and the U.S. Tax Court.
In 1998 KPMG was promoting a transaction commonly referred
to as OPIS. KPMG’s capital transaction group sought clients with
large capital gains (above a certain dollar threshold) for the
OPIS transaction. Brent Law (Mr. Law) referred petitioners to
2
The firm’s name was later reduced by removing “Peat
Marwick.”
-6-
KPMG's capital transaction group. Mr. Law had represented
petitioners in their audit and had prepared their tax returns.
Mr. Law knew that Mr. Blum had potential capital gains from sales
of Buy.com stock. He therefore suggested to Mr. Blum’s financial
adviser (Mr. Williams) that they contact KPMG’s capital
transaction group to structure Mr. Blum’s stock sales. Days
later, Mr. Blum or Mr. Williams contacted Mr. Law and asked to be
introduced to Carl Hasting (Mr. Hasting) of KPMG’s capital
transaction group.
Mr. Hasting explained the OPIS transaction to Mr. Blum
without providing any written materials. Despite the magnitude
of the investment, Mr. Blum did not personally perform an
economic analysis of the transaction or consult with his
investment advisers about the transaction. He simply inquired
into KPMG’s reputation. On the basis of two hour-long meetings
with Mr. Hasting and without a written prospectus or other
documentation, Mr. Blum decided to participate in the OPIS
transaction.
Mr. Blum, on his own behalf and on behalf of the Blum Trust,
signed an engagement letter in September 1998 (KPMG engagement
letter). Mr. Blum signed the KPMG engagement letter only four
days before he signed a stock purchase agreement to sell $40
million of Buy.com shares. Pursuant to the KPMG engagement
letter, Mr. Blum and the Blum Trust retained KPMG to provide
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advice on the OPIS transaction. KPMG agreed to provide a tax
opinion letter to Mr. Blum for the OPIS transaction, but only if
requested. Upon such request, the opinion letter would rely on
“appropriate” facts and representations, and state that the tax
treatment described in the opinion would “more likely than not”
be upheld. KPMG specified, in the KPMG engagement letter, that
its fees were based on the complexity of its role and the value
of the services provided, rather than time spent. KPMG’s minimum
fee was to be $687,500, with an additional amount to be agreed on
by the parties.
Except for a call from Mr. Hasting to Mr. Blum about a month
into the OPIS transaction, Mr. Blum did not track or monitor the
transaction. He was generally unfamiliar with the entities
involved in his OPIS transaction, other than KPMG and UBS AG
(UBS), and lacked even a generalized knowledge about the assets
involved in the deal.
C. Foreign Special Purpose Entities
Three foreign entities were formed to implement Mr. Blum’s
OPIS transaction, although he was not familiar with them.
Alfaside Limited (Alfaside) was incorporated in the Isle of Mann
on September 28, 1998. Four days later, Benzinger GP, Inc.
(Benzinger GP) was incorporated as a Cayman Islands exempted
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company.3 The following day, Alfaside acquired 100-percent
ownership of Benzinger GP and formed a Cayman Islands limited
partnership with Benzinger GP called Benzinger Investors, L.P.
(Benzinger LP).4 Petitioners and KPMG intended that Benzinger GP
and Benzinger LP would both be corporations for U.S. Federal
income tax purposes.5 The following diagram illustrates the
ownership structure of the three foreign entities:
3
A Cayman Islands exempted company is a common choice for
U.S. practitioners creating a foreign entity. An exempted
company’s operation is conducted mainly outside the Cayman
Islands. A 20-year exemption from taxation in the Cayman Islands
is typically applied for.
4
Benzinger LP filed a Form SS-4, Application for Employer
Identification Number. It received a notification of its U.S.
Federal tax identification number on Dec. 22, 1998.
5
Petitioners and KPMG took the position that Benzinger GP
defaulted to corporate treatment but also filed a protective
check-the-box election on Form 8832, Entity Classification
Election, electing corporate treatment. See sec.
301.7701–3(b)(2), (c)(1)(i), Proced. & Admin. Regs. Benzinger LP
did not default to corporate treatment, but petitioners and KPMG
took the position that it was eligible to elect its
classification and also filed a Form 8832 electing corporate
treatment for Benzinger LP. See sec. 301.7701–3(a), (b)(2),
(c)(1)(i), Proced. & Admin. Regs.
-9-
D. QA Investments
A few days later, the Blum Trust retained QA Investments,
LLC (QA) to serve as its investment adviser for the OPIS
transaction.6 Mr. Blum was not familiar with QA and had never
spoken with anyone at QA when his grantor trust retained QA’s
services. Nevertheless, the investment advisory agreement (Blum
Trust advisory agreement) between the Blum Trust and QA gave QA
substantial discretionary authority with respect to specified
funds owned by the Blum Trust, subject to the investment
objectives. The Blum Trust’s investment objectives specified an
6
Quadra Capital Management, L.P., d.b.a. QA Investments, was
a financial boutique providing asset management, financial
advice, brokerage activities and tax planning services.
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intent to acquire approximately $2,250,000 of UBS common stock
and the right to instruct QA to purchase or sell put or call
options on UBS common stock. The stated investment objectives
also included an International Swaps and Derivatives Association
(ISDA) swap agreement with respect to UBS and a privately
negotiated call option related to the UBS stock price.7 The Blum
Trust agreed to pay QA a $135,000 fee within 30 days of the
execution of the Blum Trust advisory agreement. The Blum Trust
paid the fee in October 1998.
Benzinger LP also retained QA to serve as its investment
adviser regarding the OPIS transaction pursuant to an investment
advisory agreement (Benzinger LP advisory agreement). The
Benzinger LP advisory agreement gave QA certain discretionary
authority to implement an investment strategy based on certain
expectations about UBS stock. The initial account value to be
invested was $3,015,000 and the strategy contemplated a $45
million notional account value.8 QA was to hedge the notional
7
ISDA is a trade organization of participants in the market
for over-the-counter derivatives. ISDA has created a
standardized contract, the ISDA master agreement, which functions
as an umbrella agreement and governs all swaps between the
parties to the ISDA master agreement. See generally K3C Inc. v.
Bank of Am., N.A., 204 Fed. Appx. 455, 459 (5th Cir. 2006).
8
In this context, notional account value refers to the total
value of a leveraged position. The investment strategy was to be
initiated through the purchase of UBS securities with a $45
million market value by securing financing or leverage through a
variety of possible means including borrowing, margin,
(continued...)
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account value by writing in-the-money covered call options or
purchasing long significantly out-of-the-money put options.9 QA
billed Benzinger LP $562,500, calculated as a percentage of the
notional account value, in December 1998.
E. UBS
Union Bank of Switzerland merged with Swiss Bank Corporation
(SBC) in mid-1998, a year at issue, to form the entity now known
as UBS. QA first introduced UBS’ Global Equity Derivatives group
to the OPIS transaction. KPMG subsequently provided additional
information about the transaction to UBS. A UBS officer
estimated that UBS’ profit for each OPIS transaction would be 2.5
percent to 3 percent of the notional amount of the transaction.
The price of UBS stock rose over 48 percent during the
course of petitioners’ OPIS transaction.
8
(...continued)
derivatives and other investment techniques.
9
Options are often referred to as being “at-the-money,” “in-
the-money,” or “out-of-the-money.” An option that is “at-the-
money” has its strike price equal to the market price of the
underlying asset. An option is “in-the-money” when the option’s
strike price is less than the current market price of the
underlying asset. If the value of the underlying asset is
greater than the exercise price for a call option or less than
the exercise price for a put option, that option is said to be
“in-the-money.” In this case, it is advantageous to the owner of
the option to exercise his or her right under the option as
opposed to acquiring or selling such assets in the stock market.
An option is “out-of-the-money” when it would be disadvantageous
to exercise the option, as opposed to acquiring or selling the
assets in the stock market.
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III. The Transaction
Having introduced the participants, we now delve into the
operation of petitioners’ OPIS transaction. We explain the
different transactions and steps that make up the larger whole.
A. Step 1: The Blum Trust Purchases UBS Stock and GP Call
Option; Enters into Equity Swap
Mr. Blum wired $2,250,000 to the Blum Trust’s Pali Capital
LLC (Pali) brokerage account (Pali account) on October 2, 1998,
as contemplated in the Blum Trust advisory agreement. The same
day, the Blum Trust used nearly all of those funds to purchase
10,469 shares of UBS stock.
Mr. Blum also wired $3,015,000 to SBC as payment from the
Blum Trust to Alfaside for (1) the first two fixed payments under
an equity swap agreement (equity swap) and (2) the premium under
a call option (GP call option). The equity swap was an agreement
between the Blum Trust and Alfaside. Under the equity swap, the
Blum Trust would pay Alfaside two fixed payments on specified
payment dates. After the termination date, Alfaside was to pay
the Blum Trust an amount in Swiss francs (CHF) to be calculated
based on the price of UBS common stock as of that date.
Petitioners and KPMG theorized that the parties were not required
to withhold U.S. tax under the equity swap.10
10
KPMG opined that the equity swap would most appropriately
be characterized for tax purposes as a notional principal
contract. If that were the case, payments would be sourced by
(continued...)
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The Blum Trust purchased the GP call option from Alfaside
for $112,500. Pursuant to the GP call option, the Blum Trust
could require Alfaside to either (1) sell its half of the stock
of Benzinger GP for $229,500 or (2) pay a cash settlement price
calculated from Benzinger GP’s net asset value. The Blum Trust
had a period of less than two months in which it could exercise
its option.
B. Step 2: Benzinger LP Purchases UBS Stock; Constructs
Collar
In the second step, Benzinger LP entered into a delayed
settlement agreement with UBS on October 16, 1998 to purchase
163,980 shares of UBS stock for $45 million. Benzinger LP
treated the transaction for tax purposes as a stock purchase as
of that date. It was, however, not required to pay for the stock
and UBS was not required to deliver the stock until November 27,
1998. Benzinger LP’s purported $45 million basis in the 163,980
shares would allegedly shift to the Blum Trust and therefore to
petitioners on November 27 under step 3 below.
Also on October 16, Benzinger LP and UBS used put and call
options to construct a collar on the 163,980 UBS shares.11
10
(...continued)
the residence of the taxpayer and therefore exempt from
withholding. See sec. 1441; sec. 1.863-7(b), Income Tax Regs.
11
A collar is an option strategy that limits the possible
positive or negative returns on an underlying investment to a
specific range. Generally, in an option collar transaction, an
(continued...)
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Benzinger LP purchased 163,980 put options12 from UBS and sold
147,58213 call options14 to UBS. Pursuant to their terms, the
options could be exercised only on their November 27, 1998
expiration date, and any options that were in-the-money on that
expiration date would be automatically exercised.
The call options had a range option feature that required
UBS to pay Benzinger LP certain amounts if the price of UBS stock
achieved certain levels on specified days (RECAP feature). On
the same day Benzinger LP and UBS entered into the options,
however, the price of the UBS stock closed below the specified
level. The stock’s closing below the specified level eliminated
or terminated the RECAP feature before any payments came due
under it. The share price drop also reset the strike price on
the call options to 90 percent, the same as the strike price on
the put options.
The cost of the UBS call options was almost CHF 3 million
more than the cost of the Benzinger LP put options. Benzinger LP
11
(...continued)
investor purchases a put option and sells a call option.
12
In industry parlance, these put options are plain-vanilla
90-percent put options.
13
These options represent 90 percent of the total number of
options.
14
In industry parlance and as partially described below,
these call options could be considered 95-percent call options
with barrier and reset and embedded range options.
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was required to deposit that difference with UBS as part of the
security for the stock purchase. The remainder of the security
posted with UBS consisted of the $3,015,000 that the Blum Trust
paid for the equity swap and the GP call option, converted into
CHF.15
In sum, Benzinger LP purported to purchase $45 million worth
of UBS stock on October 16, 1998, but paid no money, received no
stock and entered into transactions that would cause it to never
receive at least 90 percent of the stock.
QA subsequently sent UBS a document denominated “trade
ticket” that ensured Benzinger LP would not receive the other 10
percent of the stock. The trade ticket ordered UBS to
simultaneously redeem any UBS shares held by Benzinger LP on
November 27, 1998 after the call or put options were exercised.
C. Step 3: UBS Redeems the 163,980 Shares While the Blum
Trust Purchases 163,980 Call Options
In the third step, UBS redeemed the 163,980 shares that
Benzinger LP had acquired that day pursuant to the delayed
settlement. This was primarily completed through automatic
exercise of the call options, which were in-the-money on November
27, 1998.16
15
CHF 6,880,935 was deposited with UBS, composed of CHF
2,913,195 net amount from the put and call options and CHF
3,967,740 (exchanged from $3,015,000).
16
The put options were out-of-the money on that date and
(continued...)
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Pursuant to the trade ticket, UBS redeemed the remaining
16,398 shares that were not included in the call options on the
same day. The cumulative result of these transactions was as
follows:
Transaction Information CHF
Step 2 transactions 163,980 shares -4,622,760
(delayed settlement,
collar) and UBS
redemption
Deposit from the Blum $3,105,000 converted to 3,967,740
Trust CHF
Interest on collateral 6,984
Net premium due 2,913,195
Benzinger LP on
collar
Total Due to Benzinger LP from 2,265,159
UBS
The total due from UBS to Benzinger LP, CHF 2,265,159, was
converted to $1,660,065 and paid on December 8, 1998.
At the same time that UBS redeemed the 163,980 shares, the
Blum Trust purportedly purchased 163,980 out-of-the-money call
options on UBS stock (OTM call options). The OTM call options
were 16.5 percent out-of-the-money. They cost $675,000 and
expired a month later on December 28, 1998.
16
(...continued)
therefore expired worthless. See supra note 9 for an explanation
of in-the-money and out-of-the-money options. See infra note 17
for an explanation of expiring worthless.
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D. Step 4: Closing Out
Mr. Blum then closed out the OPIS transaction. The Blum
Trust’s 163,980 call options were left to expire worthless on
December 28, 1998.17 On the same day, the Blum Trust also sold
10,469 shares of UBS stock that had been purchased less than
three months before. In early January 1999 the Blum Trust
purportedly received from Alfaside (1) $368,694 for cash settling
the GP call option and (2) approximately $1.6 million pursuant to
the equity swap.
E. The Net Result
At the conclusion of this convoluted and contrived series of
transactions, the net cost of the OPIS transaction to Mr. Blum
was approximately $1.5 million. For that cost, the OPIS
transaction yielded over $45 million in capital losses to offset
capital gains on tax returns petitioners filed. The following
diagram depicts the cumulative transaction:
17
Options have an exercise period or date(s) and an
expiration date, and therefore generally lose value as time
passes. If an option expires out-of-the-money (below the
exercise price for a call option and above the exercise price for
a put option), then the option will be said to expire worthless.
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IV. Tax Returns
KPMG prepared petitioners’ tax returns, on which they
claimed over $45 million in capital losses for 1998 from the OPIS
transaction. Mr. Blum reported these losses on the Blum Trust’s
tax return for 1998, the only tax return the Blum Trust has ever
filed. The Blum Trust’s alleged losses were reported in a chart
that included the following:
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Date Gross Cost or
Item Acquired Date Sales Other Gain / Loss
Sold Price Basis
UBS 10/2/98 12/28/98 $3,257,593 $39,681,91 -$36,424,324
stock 7
UBS 11/27/98 12/27/98 -0- 8,629,508 -8,829,509
options
Buy.com 7/30/97 10/20/98 500,000 -0- 500,000
Buy.com 7/30/97 10/29/98 20,000,000 -0- 20,000,000
Buy.com 7/30/97 10/30/98 20,000,000 -0- 20,000,000
Buy.com 7/30/97 8/17/98 5,000,000 -0- 5,000,000
The loss of over $36 million was reported on the Blum Trust’s
sale of the 10,469 shares of UBS stock purchased at step 1. The
nearly $9 million loss was reported on the 163,860 call options
purchased at step 3, which expired worthless. The capital gains
from the sales of Buy.com shares were essentially eliminated by
the losses claimed from the OPIS transaction. Petitioners
reported this net difference, as adjusted by a few other
unrelated sales, on the income tax return they filed for 1998.
Petitioners also claimed a $1,754,670 capital loss from the
equity swap on the income tax return they filed for 1999.
V. Tax Opinion
The KPMG engagement letter stated that KPMG would provide a
tax opinion letter regarding the OPIS transaction, if requested.
KPMG sent to Mr. Blum a letter, dated after petitioners filed an
income tax return for 1998, asking Mr. Blum to represent certain
information about the OPIS transaction. KPMG agreed to finalize
and issue its tax opinion after receiving the signed
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representation letter. Mr. Blum signed the representation letter
in May 1999. In that letter, Mr. Blum represented that he had
independently reviewed the economics underlying the investment
strategy and believed it had a reasonable opportunity to earn a
reasonable pre-tax profit. He made this representation even
though he had not performed an economic analysis of the
transaction or consulted with his investment advisers about the
transaction.
At some point after mid-May 1999 KPMG executed a tax opinion
letter (tax opinion) dated as of December 31, 1998. The 99-page
tax opinion stated that it relied on representations from Mr.
Blum, Benzinger GP and QA. KPMG opined that it was more likely
than not that (1) Benzinger LP and Benzinger GP would be treated
as corporations for U.S. Federal income tax purposes, (2) the
amount paid by UBS in redemption of Benzinger LP’s UBS shares
would be treated as a dividend, (3) Benzinger LP’s tax basis in
the redeemed UBS shares would be attributed and allocated to the
Blum Trust’s separately purchased UBS shares and potentially to
the Blum Trust’s UBS call options, (4) the Blum Trust would not
be subject to U.S. tax on the dividend received by Benzinger LP
for redeeming its UBS shares and (5) payments made by the Blum
Trust to Alfaside under the swap contract would not be subject to
U.S. withholding tax. The record does not indicate when or if
petitioners received the tax opinion.
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VI. Aftermath
KPMG’s tax-focused transactions, including OPIS, soon became
a topic of governmental and popular interest.
A. Commissioner’s Position on OPIS
The Commissioner disagreed with the positions taken in
KPMG’s “more likely than not” tax opinion and challenged the
validity of basis-shifting transactions such as OPIS in July
2001, nearly three years after Mr. Blum entered into the OPIS
transaction. The Commissioner rejected the foundations of these
transactions and noted that reasons for disallowance could
include (1) the redemption does not result in a dividend, (2) the
basis shift is improper and (3) there is no stock attribution or
basis shift because the transaction serves no purpose other than
tax avoidance. Notice 2001-45, 2001-2 C.B. 129.
The next year, the Commissioner issued a settlement
initiative for basis-shifting tax shelters, such as OPIS.
Announcement 2002–97, 2002-2 C.B. 757. The Commissioner
permitted settling taxpayers to claim 20 percent of the claimed
losses and waived penalties in certain cases if the settling
taxpayers conceded 80 percent of the claimed losses. Id. Later
that year, the Commissioner also issued a coordinated issue paper
presenting in greater detail his rejection of OPIS transactions.
Industry Specialization Program Coordinated Issue Paper, “Basis
Shifting” Tax Shelter, 2002 WL 32351285 (Dec. 3, 2002).
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B. KPMG’s Indictment
Around the same time, KPMG’s legal opinions became the focus
of the United States Senate Permanent Subcommittee on
Investigations’ (committee) inquiry into the development and
marketing of abusive tax shelters. The committee eventually
focused on four transactions designed and promoted by KPMG, one
of which was OPIS.
Facing the possibility of grand jury indictment, KPMG
entered into a deferred prosecution agreement (DPA) with the
Government in August 2005. KPMG agreed to the filing of a
one-count information charging KPMG with participating in a
conspiracy to defraud the United States, commit tax evasion and
make and subscribe false and fraudulent tax returns. It admitted
and accepted that it helped high-net-worth individuals evade tax
by developing, promoting and implementing unregistered and
fraudulent tax shelters. It further admitted that KPMG tax
partners engaged in unlawful and fraudulent conduct, including
issuing opinions they knew relied on false facts and
representations. KPMG agreed to pay the Government $456 million,
to limit its tax practice to comply with certain guidelines and
to cooperate with any investigation about which KPMG had
knowledge or information.
Later, during 2005, Federal prosecutors obtained numerous
indictments against current and former KPMG employees and
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partners. The indicted individuals were charged with conspiracy
and tax evasion for designing, marketing and implementing tax
shelters, including OPIS.
C. Blum v. KPMG
Despite the DPA, KPMG’s legal battles continued. Mr. Blum
was one of many clients who sued KPMG in the aftermath of its
indictment and the related IRS scrutiny. He filed a complaint
against KPMG in Los Angeles Superior Court at the end of 2009 in
connection with the OPIS transaction.
Mr. Blum refers to OPIS and BLIPS in his lawsuit as the “Tax
Strategies.” Mr. Blum alleges in his suit that KPMG breached its
fiduciary duty to him and induced him to pursue a course of
action that he would not have otherwise pursed. In particular,
Mr. Blum alleges that he was induced to invest millions of
dollars in the Tax Strategies and to conduct his business to
realize taxable income that would be offset by the losses the Tax
Strategies generated. He further claims that, in reliance on
KPMG, he did not adopt other strategies to defer or minimize tax
liability or make different decisions regarding share sales. He
seeks damages of over $100 million.
VII. Deficiency
As previously mentioned, respondent determined deficiencies
in, and penalties regarding, petitioners’ Federal income taxes
for the years at issue. Petitioners timely filed a petition with
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this Court for redetermination of the positions respondent set
forth in the deficiency notice. As previously mentioned, the
parties resolved certain issues in their stipulation of settled
issues and the Court dismissed those portions of the deficiencies
and penalties pertaining to petitioners’ BLIPS transaction.
OPINION
The subject transaction presents a case of first impression
in this Court. We are asked to decide whether petitioners are
entitled to deduct losses from their OPIS transaction. We must
also decide whether petitioners are liable for any accuracy-
related penalties for underpayments resulting from the OPIS
transaction. We begin with the parties’ arguments regarding this
complicated OPIS transaction.
Petitioners argue that their claimed benefits from the OPIS
transaction were taken according to the letter of the tax laws.
In support of that position, petitioners argue that OPIS yielded
the claimed losses pursuant to the following analysis:
(1) UBS’ exercise of the call options and Benzinger LP’s
sale of the remaining shares to UBS was a redemption of stock
under section 317(b).
(2) To determine whether a redemption qualifies as a sale or
exchange or as a distribution, the stock attribution rules apply.
Secs. 302(c), 318(a). Petitioners argue that, under the stock
attribution rules, the Blum Trust was treated as owning the
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163,980 shares that are the subject of its call options, in
addition to the 10,469 shares that it directly held. See sec.
318(a)(4). Also under these rules, the Blum Trust was treated as
owning 50 percent of Benzinger GP, and therefore Benzinger LP was
treated as owning the 10,469 shares directly held by the Blum
Trust and the 163,980 shares constructively owned by the Blum
Trust. See sec. 318(a)(3)(C), (4), (5)(A).
(3) Because of Benzinger LP’s constructive ownership of the
Blum Trust’s UBS shares (both direct and constructive), the UBS
redemption of Benzinger LP’s shares did not completely terminate
Benzinger LP’s interest in the corporation. See sec. 302(b)(3).
Moreover, petitioners argue that it was not a substantially
disproportionate redemption because Benzinger LP was deemed to
own the same number of shares before and after step 3 of the
transaction under the attribution rules. See sec. 302(b)(2).
Petitioners theorize that the UBS redemption is essentially
equivalent to a dividend. See United States v. Davis, 397 U.S.
301 (1970). Accordingly, petitioners conclude that the
redemption would not be treated as a sale or exchange but would
instead be treated as a distribution of property. See sec.
302(a), (d).
(4) UBS had sufficient earnings and profits in 1998, so the
distribution pursuant to the UBS redemption would be treated as a
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dividend and would not reduce Benzinger LP’s tax basis in the
redeemed UBS shares. See sec. 301(c)(1).
(5) Benzinger LP thus retained its tax basis in the UBS
shares but did not own any shares directly. Petitioners took the
position and argue that Benzinger LP’s basis in the UBS shares
therefore could be allocated to the Blum Trust’s UBS shares and
options because the attribution of shares from the Blum Trust
caused the redemption to be treated as a dividend. See Levin v.
Commissioner, 385 F.2d 521 (2d Cir. 1967), affg. 47 T.C. 258(1966); sec. 1.302-2(c) and Example (2), Income Tax Regs.18
Petitioners further posit that the OPIS transaction has
economic substance because Mr. Blum entered into it for
investment purposes and had a reasonable possibility of profiting
from the transaction. They also urge the Court that they
reasonably relied on their long-time tax adviser, so they should
not be liable for penalties in case of deficiencies.
Respondent argues petitioners are not entitled to deduct
losses from the OPIS transaction because they incorrectly
reported their Federal income tax treatment of certain steps.
Specifically, respondent alleges that petitioners’ tax treatment
18
Petitioners took the position that UBS’ redemption of
Benzinger LP’s shares was not taxable to the Blum Trust because
(a) the equity swap did not, in substance, transfer to the Blum
Trust an equity interest in Benzinger LP and (b) the GP call
option did not implicate the controlled foreign corporation,
foreign personal holding company and passive foreign investment
company provisions of the Code.
-27-
of the OPIS transaction is incorrect because Benzinger LP never
owned the 163,980 UBS shares for Federal income tax purposes and
therefore did not have a $45 million basis that could be shifted.
Respondent also takes the position that Benzinger LP could not
shift its alleged basis to the Blum Trust because UBS’ redemption
of Benzinger LP’s UBS stock was a distribution in a sale or
exchange of that stock, and not a dividend. Respondent further
argues that petitioners’ losses are disallowed because the
transaction lacks economic substance.19
We agree with respondent that the OPIS transaction lacked
economic substance. We admit KPMG painstakingly structured an
elaborate transaction with extensive citations to complex Federal
tax provisions. The entire series of steps, however, was a
subterfuge to orchestrate a capital loss. A taxpayer may not
deduct losses resulting from a transaction that lacks economic
substance, even if that transaction complies with the literal
terms of the Code. See Coltec Indus., Inc. v. United States, 454
F.3d 1340, 1352–1355 (Fed. Cir. 2006); Keeler v. Commissioner,
243 F.3d 1212, 1217 (10th Cir. 2001), affg. Leema Enters., Inc.
v. Commissioner, T.C. Memo. 1999-18. Accordingly, we do not
address the parties’ arguments regarding the merits of
19
Respondent also argues that petitioners’ losses are
disallowed under sec. 165 because they were not incurred in a
transaction entered into for profit and that they are limited by
the at-risk rules in sec. 465. We need not reach these arguments
because of our other holdings.
-28-
petitioners’ treatment of each step within the OPIS transaction.
Instead, we begin our analysis with the general principles of the
economic substance doctrine.20
I. Merits of OPIS Under the Economic Substance Doctrine
A court may disregard a transaction for Federal income tax
purposes under the economic substance doctrine if it finds that
the taxpayer failed to enter into the transaction for a valid
business purpose but rather sought to claim tax benefits not
contemplated by a reasonable application of the language and
purpose of the Code or its regulations.21 See, e.g., New Phoenix
Sunrise Corp. & Subs. v. Commissioner, 132 T.C. 161 (2009), affd.
408 Fed. Appx. 908 (6th Cir. 2010); Palm Canyon X Invs., LLC v.
Commissioner, T.C. Memo. 2009-288. There is, however, a split
among the Courts of Appeals as to the application of the economic
20
The taxpayer generally bears the burden of proving the
Commissioner’s determinations are erroneous. Rule 142(a). The
burden of proof may shift to the Commissioner if the taxpayer
satisfies certain conditions. Sec. 7491(a). Our resolution is
based on a preponderance of the evidence, not on an allocation of
the burden of proof. Therefore, we need not consider whether
sec. 7491(a) would apply. See Estate of Bongard v. Commissioner,
124 T.C. 95, 111 (2005).
21
Congress codified the economic substance doctrine mostly
as articulated by the Court of Appeals for the Third Circuit in
ACM Pship. v. Commissioner, 157 F.3d 231, 247–248 (3d Cir. 1998),
affg. in part and revg. in part on an issue not relevant here
T.C. Memo. 1997–115. See sec. 7701(o), as added to the Code by
the Health Care and Education Reconciliation Act of 2010, Pub. L.
111–152, sec. 1409, 124 Stat. 1067; see also H. Rept. 111–443(I),
at 291–299 (2010). The codified doctrine does not apply here
pursuant to its effective date.
-29-
substance doctrine. An appeal in this case would lie to the
Court of Appeals for the Tenth Circuit absent stipulation to the
contrary and, accordingly, we follow the law of that circuit.
See Golsen v. Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d
985 (10th Cir. 1971).
The Court of Appeals for the Tenth Circuit applies a so-
called unitary analysis in which it considers both the taxpayer’s
subjective business motivation and the objective economic
substance of the transactions. See Sala v. United States, 613
F.3d 1249 (10th Cir. 2010); Jackson v. Commissioner, 966 F.2d
598, 601 (10th Cir. 1992), affg. T.C. Memo. 1991-250. The
presence of some profit potential does not necessitate a finding
that the transaction has economic substance. Keeler v.
Commissioner, supra at 1219. Instead, that Court of Appeals
requires that tax advantages be linked to actual losses. See
Sala v. United States, supra at 1253; Keeler v. Commissioner,
supra at 1218-1219. It has further reasoned that “correlation of
losses to tax needs coupled with a general indifference to, or
absence of, economic profits may reflect a lack of economic
substance.” Keeler v. Commissioner, supra at 1218. Applying
those standards, we hold that petitioners’ OPIS transaction lacks
economic substance and we now discuss our underlying reasoning
and conclusions for our holding.
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A. Prearranged Steps Designed To Generate Loss
Petitioners’ OPIS transaction was a structured deal with
several components, some straight-forward and some complex. The
components of this deal were carefully pieced together to
generate, preserve and shift a substantial tax basis so as to
obviate petitioners’ $45 million capital gain. We conclude,
based on the record and the entirety of the transactions, that
petitioners’ OPIS transaction was designed to create a tax loss
that would offset their capital gains from sales of Buy.com
shares.
KPMG designed OPIS’ prearranged steps to generate a
significant, artificial loss. KPMG sought clients with
substantial capital gains for the OPIS transaction. Investors
were targeted based on their potential capital gains and not
their investment profiles. Indeed, KPMG had a minimum capital
gains requirement for clients participating in the transaction.
Mr. Blum contends that he had no interest in a tax shelter
when he met with Mr. Hasting. The record conflicts, however,
with his contention. Mr. Law suggested that Mr. Blum contact
KPMG’s capital transaction group because he knew that Mr. Blum
had potential capital gains from stock sales. Mr. Blum retained
KPMG for the OPIS transaction just days before selling $40
million of Buy.com shares. Mr. Blum retained KPMG as his tax
adviser, not as his investment adviser.
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KPMG intended OPIS as a loss-generating transaction. The
OPIS transaction was a prearranged set of steps that, from the
outset, was designed and intended to generate a loss. Those
circumstances are indicative of transactions lacking economic
substance. See Sala v. United States, supra at 1253.
B. Mr. Blum Did Not Approach the Transaction as an Investor
Mr. Blum contends that he did not view the prearranged OPIS
steps as a loss-generating transaction, but that he intended to
make a potentially high-yielding investment. Petitioners’
reliance on this subjective prong of the economic substance
analysis is not supported by the facts. We do not accept Mr.
Blum’s claim that he subjectively believed the OPIS transaction
would be profitable because his actions during or after the
transaction conflict with his contention.
Mr. Blum’s contention concerning his intent on entering into
the transaction conflicts, for example, with the KPMG engagement
letter for tax consultation services that provides for a tax
opinion about losses from the transaction. Mr. Blum’s asserted
focus on investment does not comport with his retention of QA as
an investment adviser when he knew little about and never spoke
to anyone at QA. He hired an investment adviser that he did not
know and he did so through a tax adviser, which suggests that
tax, not investment, was the primary consideration.
-32-
Mr. Blum testified that $5 million was a relatively sizable
amount of money to him. The record indicates that Mr. Blum
essentially entrusted this sizable amount of money to an unknown
investment adviser based on two hour-long presentations from his
tax adviser. Mr. Blum did not perform an economic analysis of
the OPIS transaction, nor did he ask his existing investment
advisers to review it. He had no general knowledge of the
participants (except for KPMG and UBS) and no understanding of
the transaction. Furthermore, Mr. Blum did not track his
investment, except to the extent that he received a call from
KPMG a month into the deal.
Mr. Blum’s actions belie his testimony. His lack of due
diligence in researching the OPIS transaction indicates that he
knew he was purchasing a tax loss rather than entering into a
legitimate investment. See Pasternak v. Commissioner, 990 F.2d
893, 901 (6th Cir. 1993), affg. Donahue v. Commissioner, T.C.
Memo. 1991-181; Country Pine Fin., LLC v. Commissioner, T.C.
Memo. 2009-251.
Mr. Blum’s statements in his subsequent suit against KPMG
confirm his lack of subjective profit motive. In his suit, Mr.
Blum alleges that he was induced to invest millions of dollars in
a tax strategy and to conduct his business so as to realize
taxable income that would be offset by losses generated by OPIS.
He further claims that, in reliance on KPMG, he did not adopt
-33-
other strategies to defer or minimize his tax liability or make
different decisions regarding share sales. Mr. Blum’s actions
during and after the OPIS transaction do not indicate a profit
motive.
C. Loss Had No Economic Reality
Petitioners’ significant capital losses from the OPIS
transaction were not only intentional, but they were also
artificial. Indeed, the claimed losses created by the OPIS
transaction were prearranged and intended to be artificial. Mr.
Blum invested approximately $6 million into the OPIS transaction
and lost approximately $1.5 million, yet the transaction
generated over $45 million in capital losses. Petitioners’
disproportionate losses violated the principle that tax
advantages must be linked to actual losses. See Keeler v.
Commissioner, 243 F.3d at 1218.
Benzinger LP was able to create an artificial basis in UBS
shares, which it otherwise would not have, through Benzinger LP’s
delayed settlement stock purchase of UBS shares and the collar on
those shares. Benzinger LP treated the UBS share redemption as a
dividend through its application of the attribution rules and the
rules governing redemptions. This treatment had no tax
consequences to Benzinger LP, but allowed it to retain its
alleged basis in the shares for Federal income tax purposes.
Retaining this $45 million basis was crucial. As Benzinger LP no
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longer held any interests in UBS shares, its basis allegedly
transferred to petitioners’ UBS shares and options. Petitioners
therefore claimed a substantial capital loss upon selling their
UBS shares and expiration of their options.
Petitioners’ claimed capital losses far exceeded their
investments in the shares and options. Petitioners’ claimed loss
on their sale of directly-held UBS shares acquired in step 1 of
the transaction is particularly significant to the planned tax
strategy. In reality, the UBS shares appreciated substantially
during this period. Petitioners’ earned approximately $1 million
(before fees) on their direct investment in UBS shares, yet they
claimed a capital loss of over $36 million on the sale.
In other words, petitioners claimed a substantial capital
loss because they received a tax-exempt foreign entity’s
carefully constructed and carefully retained basis in shares that
it never actually received. Petitioners incurred no such
economic loss of the stated magnitude. Indeed, petitioners do
not contest that their loss is fictional. The absence of
economic reality is the hallmark of a transaction lacking
economic substance. Sala v. United States, 613 F.3d at 1254; see
also Coltec Indus., Inc. v. United States, 454 F.3d at 1352;
Keeler v. Commissioner, supra at 1218–1219; K2 Trading Ventures,
LLC v. United States, ___ Fed. Cl. ___, 2011 WL 5998957 (Nov. 30,
2011).
-35-
D. Loss Dwarfs Profit Potential
Petitioners’ artificial $45 million loss has no meaningful
relevance to the minuscule potential for profit from OPIS.
Petitioners’ expert, Dr. James Hodder (Dr. Hodder), concluded
that petitioners had a 76.3-percent chance of losing money.
Despite the high risk, Dr. Hodder concluded that OPIS had
potential for high yields that could make the deal an appropriate
investment for the right investor. Dr. Hodder calculated that
OPIS had a 19.1-percent chance of realizing a $600,000 profit.
He further concluded that petitioners had a 7.6-percent chance of
realizing a $3 million profit. These amounts are de minimis when
compared to petitioners’ capital losses of over $45 million from
OPIS. The expected tax benefit dwarfs any potential gain such
that the economic realities of OPIS are meaningless in relation
to the tax benefits. See Sala v. United States, supra at 1254;
Rogers v. United States, 281 F.3d 1108, 1116 (10th Cir. 2002).
The mere presence of a profit potential does not automatically
impute substance where a common-sense examination of the
transaction and the record in toto reflects a lack of economic
substance. Sala v. United States, supra at 1254; Keeler v.
Commissioner, supra at 1219.
E. The Numbers Do Not Add Up
Despite the presence of some profit potential in OPIS, we
find that profit was not a primary purpose of the transaction.
-36-
The expert testimony presented in this case, while not central to
our determination, loosely supports the notion that OPIS was
intended to generate a loss.
Petitioners and respondent both provided the Court with
expert reports that sought to quantify the profitability of
petitioners’ OPIS transaction. Petitioners’ expert, Dr. Hodder,
performed simulations to calculate the expected probability that
the Blum Trust would realize a profit when it entered into the
OPIS transactions. Dr. Hodder concluded that the deal had a
23.7-percent chance of breaking even before taxes, a 19.1-percent
chance of realizing a 10-percent return ($600,000 profit) and a
7.6-percent chance of realizing a 50-percent return ($3 million
profit). The greatest chance for profit was in the Blum Trust’s
direct investment in UBS shares, which was more than twice as
likely as the GP call option and the equity swap to yield a
profit. Dr. Hodder concluded that the OTM call options were the
least likely to yield a profit, with a mere 11.3-percent chance
of breaking even.
Dr. Hodder focused on the high volatility in UBS stock
prices at the time. Based on his volatility estimates, Dr.
Hodder ultimately concluded that OPIS presented a high-risk
opportunity that had potential for high rewards. He stated that
“[i]t is kind of a long shot gamble, but it is a long shot gamble
-37-
with a huge upside, and I don’t think that is unreasonable, but
it is not something that I would have done.”
Dr. Hodder’s calculations are helpful, but his conclusion
that there is some profit potential does not require us to find
that the transaction has economic substance. See Keeler v.
Commissioner, 243 F.3d at 1219; see also K2 Trading Ventures, LLC
v. United States, ___ Fed. Cl. at ___, 2011 WL 5998957 at *19
(“potential for profit does not in and of itself establish
economic substance--especially where the profit potential is
dwarfed by tax benefits”). His calculations assume a transaction
that was not pre-ordained to create a loss intended specifically
to offset a particular gain.
Respondent’s expert witness, Dr. A. Lawrence Kolbe (Dr.
Kolbe), did not address the question of whether petitioners’ OPIS
transaction had profit potential. Instead, Dr. Kolbe looked at
the net present value and the expected rate of return relative to
the cost of capital. He concluded that the OPIS transaction, as
a whole, was extremely unprofitable. Dr. Kolbe determined that
petitioners’ entry into OPIS resulted in an immediate loss of 36
percent of the invested amount because the securities were priced
far above their value.
A bad deal or a mispriced asset need not tarnish a
legitimate deal’s economic substance. A finding of grossly
mispriced assets or negative cashflow can, however, contribute to
-38-
the overall picture of an economic sham. See, e.g., Country Pine
Fin., LLC v. Commissioner, T.C. Memo. 2009-251.
We note that both experts agreed that the equity swap and
the OTM call options were highly overpriced, and neither was able
to replicate the final payment from the GP call option based on
the record. We also note that the price of UBS stock rose over
48 percent during the course of petitioners’ OPIS transaction,
yet petitioners lost hundreds of thousands of dollars from the
transaction (without even considering fees) and then claimed
millions and millions in losses. The numbers do not add up.
In sum, the OPIS transaction lacked economic substance. It
was intended to create a significant capital loss and worked
exactly as intended. Accordingly, the OPIS transaction is
disregarded for tax purposes and petitioners’ claimed losses are
disallowed.22
22
Respondent alleges that petitioners failed to report
$35,311 of income in 1999 in connection with the settlement of
the GP call option. Petitioners claim they were entitled to
allocate $35,311 of fees paid to KPMG and QA to the basis of the
GP call option and to recover those amounts when the Blum Trust
settled the GP call option. Because we find that the OPIS
transaction lacked economic substance and related losses are
disallowed without regard to the value or basis of the assets,
this issue is now moot. See Leema Enters., Inc. v. Commissioner,
T.C. Memo. 1999–18, affd. sub nom. Keeler v. Commissioner, 243
F.3d 1212 (10th Cir. 2001).
-39-
II. Accuracy-Related Penalties
We now turn to respondent’s determination that petitioners
are liable for accuracy-related penalties. A taxpayer may be
liable for a 20-percent accuracy-related penalty on the portion
of an underpayment of income tax attributable to, among other
things, negligence or disregard of rules or regulations. Sec.
6662(a) and (b)(1). The penalty increases to a 40–percent rate
to the extent that the underpayment is attributable to a gross
valuation misstatement. Sec. 6662(h)(1). An accuracy-related
penalty under section 6662 does not apply to any portion of an
underpayment of tax for which a taxpayer had reasonable cause and
acted in good faith. Sec. 6664(c)(1).
Respondent determined that the 40-percent accuracy-related
penalty applies to petitioners’ underpayment resulting from the
disallowed losses reported for 1998. Respondent determined that
a 20–percent accuracy-related penalty applies on account of a
disallowed loss and omitted income for 1999. Petitioners deny
that they were negligent with respect to 1999 and assert that
they meet the reasonable cause exception to the accuracy-related
penalties.
A. Gross Valuation Misstatement
Respondent determined an accuracy-related penalty of 40
percent for a gross valuation misstatement with respect to losses
reported from the OPIS transaction for 1998. A taxpayer may be
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liable for a 40–percent penalty on that portion of an
underpayment of tax that is attributable to one or more gross
valuation misstatements. Sec. 6662(h). A gross valuation
misstatement exists if the value or adjusted basis of any
property claimed on a tax return is 400 percent or more of the
amount determined to be the correct amount of such value or
adjusted basis. Sec. 6662(h)(2)(A)(i). The value or adjusted
basis of any property claimed on a tax return that is determined
to have a correct value or adjusted basis of zero is considered
to be 400 percent or more of the correct amount. Sec.
1.6662–5(g), Income Tax Regs.
Our holding that the OPIS transaction lacks economic
substance results in the total disallowance of the losses at
issue without regard to the value or basis of the property used
in the OPIS transaction. See Leema Enters., Inc. v.
Commissioner, T.C. Memo. 1999-18. We have held that the gross
valuation penalty applies when an underpayment stems from
deductions or credits that are disallowed because of lack of
economic substance. See Petaluma FX Partners, LLC v.
Commissioner, 131 T.C. 84, 104-105 (2008), affd. in pertinent
part, revd. in part and remanded 591 F.3d 649 (D.C. Cir. 2010).
In the absence of a decision of the Court of Appeals for the
Tenth Circuit squarely on point, we follow our precedent.
Consequently, a gross valuation misstatement accuracy-related
-41-
penalty applies to petitioners’ underpayment for 1998 absent a
showing of reasonable cause or some other defense.
B. Negligence
Respondent also determined that petitioners are liable for
the 20-percent accuracy-related penalty because the 1999
underpayment resulting from a disallowed loss and omitted income
was due to negligence. Sec. 6662(a) and (b)(1). Negligence is
defined as a “lack of due care or the failure to do what a
reasonable and ordinarily prudent person would do under the
circumstances.” Viralam v. Commissioner, 136 T.C. 151, 173
(2011). Negligence is strongly indicated where “[a] taxpayer
fails to make a reasonable attempt to ascertain the correctness
of a deduction, credit or exclusion on a return which would seem
to a reasonable and prudent person to be ‘too good to be true’
under the circumstances.” Sec. 1.6662–3(b)(1)(ii), Income Tax
Regs. The deficiency determined by respondent with respect to
petitioners’ tax return for 1999 is linked to OPIS, a “too good
to be true” transaction.
An underpayment is not attributable to negligence, however,
to the extent that the taxpayer shows that the underpayment is
due to the taxpayer’s reasonable cause and good faith. See secs.
1.6662–3(a), 1.6664–4(a), Income Tax Regs. The burden is upon
the taxpayer to prove reasonable cause. See Higbee v.
Commissioner, 116 T.C. 438, 447-449 (2001). We determine whether
-42-
a taxpayer acted with reasonable cause and in good faith by
considering the pertinent facts and circumstances, including the
taxpayer’s efforts to assess his or her proper tax liability, the
taxpayer’s knowledge and experience and the reliance on the
advice of a professional. Sec. 1.6664-4(b)(1), Income Tax Regs.
Generally, the most important factor is the extent of the
taxpayer’s effort to assess the proper tax liability. Id.
C. Reasonable Cause and Good Faith
Petitioners seek to defend against both accuracy-related
penalties by asserting that they relied on KPMG to prepare the
tax returns and to assure them that the deductions from the OPIS
transaction were claimed legally. The good-faith reliance on the
advice of an independent, competent professional as to the tax
treatment of an item may negate an accuracy-related penalty. See
sec. 1.6664–4(b), Income Tax Regs. A taxpayer may rely on the
advice of any tax adviser, lawyer or accountant. United States
v. Boyle, 469 U.S. 241, 251 (1985); Canal Corp. & Subs. v.
Commissioner, 135 T.C. 199, 218 (2010).
We look to the facts and circumstances of the case and the
law that applies to those facts and circumstances to determine
whether a taxpayer reasonably relied on advice. See sec.
1.6664–4(c)(1)(i), Income Tax Regs. We have used a three-prong
test to guide that review. Namely, the taxpayer must prove by a
preponderance of the evidence that (1) the adviser was a
-43-
competent professional who had sufficient expertise to justify
reliance, (2) the taxpayer provided necessary and accurate
information to the adviser and (3) the taxpayer actually relied
in good faith on the adviser’s judgment. 106 Ltd. v.
Commissioner, 136 T.C. 67, 77 (2011); Neonatology Associates,
P.A. v. Commissioner, 115 T.C. 43, 99 (2000), affd. 299 F.3d 221(3d Cir. 2002). We review petitioners’ situation in light of
these factors.
First, KPMG was a well-known international “Big Four”
accounting firm. It had not yet faced the legal and public
scrutiny that ultimately resulted from its structured tax
activities. Mr. Law, who had prepared petitioners’ tax returns
and helped them through the audits of four tax years, referred
Mr. Blum to Mr. Hasting. Accordingly, KPMG and its principals
had sufficient relevant expertise and properly appeared competent
to petitioners.
Petitioners failed, however, to satisfy the second factor.
Initially, we observe that petitioners provided KPMG and its
principals with all the relevant financial data needed to assess
the correct level of income tax. See sec. 1.6664–4(c)(1)(i),
Income Tax Regs. Accordingly, KPMG had the necessary and
accurate information. Nevertheless, petitioners failed to
satisfy the second factor because KPMG’s opinion relied upon
false representations from Mr. Blum.
-44-
The most crucial of these representations was that Mr. Blum
independently reviewed the economics underlying the investment
strategy and believed it had a reasonable opportunity to earn a
reasonable pretax profit. Mr. Blum knew this representation was
false, or would have known it if he had read it. The record, as
a whole, reflects that the OPIS transaction was structured to
fabricate a loss. This loss creation was KPMG’s reason for
seeking out Mr. Blum and Mr. Blum’s reason for engaging in the
transaction. Mr. Blum’s representations to KPMG are contrary to
this fact and are part of the guise that was used to fabricate
the intended loss. Petitioners thus failed to satisfy the second
factor because Mr. Blum made false representations to KPMG.
KPMG’s promotion and facilitation of OPIS concerns the last
factor and the heart of the issue. Petitioners certainly relied
on KPMG, and KPMG’s failures toward its client during and after
the years at issue are well-documented. Nevertheless, we do not
find that petitioners actually relied on KPMG in good faith for
purposes of the reasonable cause and good faith defense to
accuracy-related penalties.
Petitioners point to KPMG’s 99-page tax opinion on the OPIS
transaction, but petitioners did not actually rely on this
opinion. The record does not show when the opinion was
finalized, but we know that it was finalized after petitioners
filed the tax return for 1998. As previously mentioned, KPMG’s
-45-
opinion also relied upon false representations from Mr. Blum.
The opinion on which petitioners allegedly relied was thus
belated and based on a false representation.
Petitioners also argue that they received oral advice from
KPMG regarding OPIS. KPMG did not, however, describe the tax
opinion to Mr. Blum when he was entering into the transaction.23
Mr. Blum also did not recount any oral advice that would have
supported his argument of reasonable reliance. Petitioners have
failed to satisfy their burden of showing that they reasonably
relied on oral advice.
Finally, we hold that petitioners could not have reasonably
relied on KPMG because of its role as a promoter. Reliance is
unreasonable if the adviser is a promoter of the transaction or
suffers from an inherent conflict of interest of which the
taxpayer knew or should have known. Neonatology Associates, P.A.
v. Commissioner, supra at 98. We have held that, when the
transaction involved is the same tax shelter offered to numerous
parties, we adopt the following definition of promoter: “‘an
adviser who participated in structuring the transaction or is
23
The engagement letter also did not provide a description
of the opinion letter that would be provided upon request. The
engagement letter stated that the opinion letter would rely on
“appropriate” facts and representations and would provide that
the tax treatment described in the opinion would “more likely
than not” be upheld. It provided no details regarding the tax
treatment to be described in the opinion or the facts and
representations that would be required before the opinion could
be issued.
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otherwise related to, has an interest in, or profits from the
transaction.’” 106 Ltd. v. Commissioner, supra at 79-80 (quoting
Tigers Eye Trading, LLC v. Commissioner, T.C. Memo. 2009–121).
KPMG sought clients with significant capital gains and structured
the OPIS deal for petitioners and numerous other clients. KPMG
was a promoter of OPIS and its obvious conflict makes
petitioners’ reliance unreasonable.
Petitioners claimed an artificial loss of over $45 million.
This is exactly the type of “too good to be true” transaction
that should cause a savvy, experienced businessman to seek
independent advice. See Neonatology Associates, P.A. v.
Commissioner, 299 F.3d at 234 (“When, as here, a taxpayer is
presented with what would appear to be a fabulous opportunity to
avoid tax obligations, he should recognize that he proceeds at
his own peril.”); New Phoenix Sunrise Corp. & Subs. v.
Commissioner, 132 T.C. at 195. Petitioners’ decision to rely
exclusively on KPMG in structuring, facilitating and reporting
their OPIS transaction was therefore not reasonable. Petitioners
did not take their position in good faith and thus lacked
reasonable cause for that position. Accordingly, we sustain
respondent’s determination that petitioners are liable for
accuracy-related penalties for 1998 and 1999.
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We have considered all remaining arguments the parties made
and, to the extent not addressed, we find them to be irrelevant,
moot, or meritless.
To reflect the foregoing and due to the parties’
concessions,
Decision will be entered
under Rule 155.