Stobie Creek Investments LLC v. United States

United States Court of Appeals
for the Federal Circuit
__________________________
STOBIE CREEK INVESTMENTS LLC,
JFW ENTERPRISES, INC.,
TAX MATTERS AND NOTICE PARTNERS; AND
STOBIE CREEK INVESTMENTS LLC,
BY AND THROUGH
JFW INVESTMENTS, LLC,
TAX MATTERS AND NOTICE PARTNER,
Plaintiffs-Appellants,
v.
UNITED STATES,
Defendant-Appellee.
__________________________
2008-5190
__________________________
Appeal from the United States Court of Federal
Claims in 05-CV-748 and 07-CV-520, Judge Christine
O.C. Miller.
__________________________
Decided: June 11, 2010
__________________________
ROBERT E. KOLEK, Schiff Hardin LLP, of Chicago, Illi-
nois, argued for plaintiffs-appellants. With him on the
brief were NEIL LLOYD and THOMAS R. WECHTER. Of
counsel was COLLEEN FEENEY ROMERO.
STOBIE CREEK INVESTMENTS v. US 2
JUDITH A. HAGLEY, Attorney, Appellate Section, Tax
Division, United States Department of Justice, of Wash-
ington, DC, argued for defendant-appellee. With her on
the brief were JOHN A. DICICCO, Acting Assistant Attorney
General, GILBERT S. ROTHENBERG, Acting Deputy Assis-
tant Attorney General, and RICHARD FARBER, Attorney.
__________________________
Before BRYSON, PROST, and MOORE, Circuit Judges.
PROST, Circuit Judge.
This tax refund suit concerns a series of transactions
exemplifying the Son of BOSS 1 tax shelter, marketed here
as the Jenkens & Gilchrist (“J & G”) strategy. The shel-
ter took advantage of the fact that assets and contingent
liabilities were treated differently for tax purposes when
contributed to a partnership, thus enabling the taxpayer
to generate an artificial loss. See 26 U.S.C. §§ 722, 733,
752, 754; see also IRS Notice No. 2000-44, 2000-2 C.B.
255, 2000 WL 1138430. This artificial loss is then used to
offset income from other transactions.
In this case, the taxpayers used the J & G strategy to
inflate the basis of their stock in the Therma-Tru family
business, thereby eliminating more than $200 million in
capital gains (and avoiding $4 million in taxes) resulting
from the sale of that stock. The Internal Revenue Service
(“IRS”) subsequently determined that the partnership
used to implement the J & G strategy, Stobie Creek
Investments LLC (“Stobie Creek”), was a sham. Based on
1 “BOSS” is an acronym for “Bond and Option Sales
Strategy.” Son of BOSS is a variation on the BOSS tax
shelter. Kornman & Assocs. v. United States, 527 F.3d
443, 446 n.2 (5th Cir. 2008).
3 STOBIE CREEK INVESTMENTS v. US
this determination, the IRS disallowed the partnership’s
stated basis in the stock, increased the partnership’s
capital gain from the sale of that stock, and assessed
additional taxes.
Stobie Creek, JFW Enterprises, Inc., and JFW In-
vestments, LLC (collectively, “plaintiffs”) then filed this
refund suit in the United States Court of Federal Claims,
contesting the Notices of Final Partnership Administra-
tive Adjustment (“FPAAs”) in which these determinations
were made. Following a bench trial, the Court of Federal
Claims upheld the FPAAs and associated penalties,
concluding that the basis-inflating transactions were
properly disregarded under the economic substance
doctrine. Stobie Creek Invs., LLC v. United States, 82
Fed. Cl. 636, 701-02, 721 (2008). Plaintiffs now appeal
the application of the economic substance doctrine, accu-
racy-related penalties, and an evidentiary ruling made
during trial. We affirm.
This case turns on whether a series of transactions
was properly disregarded under the economic substance
doctrine, despite complying with the literal terms of the
tax code. We conclude that the answer is yes. The trial
court properly disregarded the transactions as lacking an
objective economic reality; the taxpayers failed to show
that the transactions were undertaken for any business
purpose beyond obtaining a tax benefit. Accordingly,
Stobie Creek, acting through Jeffrey Welles, was properly
subject to accuracy-related penalties pursuant to 26
U.S.C. § 6662. Because it was not reasonable for Stobie
Creek to rely on advice of professionals involved in pro-
moting and implementing the tax shelter, the narrow
reasonable-cause defense in 26 U.S.C. § 6664(c)(1) does
not apply.
STOBIE CREEK INVESTMENTS v. US 4
BACKGROUND
The taxpayers in this case are six members of the
Welles family and the Welles trust (collectively the
“Welleses”). This case arises out of a series of events
beginning in 1999, when the Welles family agreed to sell a
controlling interest in the family business, Therma-Tru
Corporation (“Therma-Tru”) to Kenner and Company
(“Kenner”). Stobie Creek, 82 Fed. Cl. at 642. Patriarch
and taxpayer David Welles Sr. (“David Welles”) started
what became Therma-Tru in 1962, when attorneys from
the law firm of Shumaker, Loop & Kendrick, LLP (“SLK”)
helped him purchase a lumberyard. Therma-Tru subse-
quently grew into one of the leading manufacturers and
sellers of residential entry doors. Id. at 641.
Over the years, the Welles family retained SLK for a
variety of legal matters, including the Therma-Tru deal
with Kenner. David Waterman (“Waterman”) was the
principal SLK attorney representing the Welleses in the
transaction. The deal called for Kenner to infuse Therma-
Tru with cash equal to a 50% equity position. At the
same time, Therma-Tru shareholders would redeem 50%
of their stock for cash. Because the deal involved Kenner
paying cash for stock, the Therma-Tru shareholders
would be taxed on their redemption of stock for cash. The
Welles family planned to redeem 50% of their stock for
approximately $215 million in cash. Because of their low
basis in the stock, the redemption was expected to pro-
duce more than $200 million in capital gains.
Before the sale to Kenner was finalized, Jeffrey
Welles asked Waterman whether there were any strate-
gies for reducing the taxes the Welles family would oth-
erwise owe on the planned sale. Id. at 643. Jeffery
Welles is the son of Therma-Tru founder David Welles
5 STOBIE CREEK INVESTMENTS v. US
and the primary investment adviser to Therma-Tru and
the Welles family. Prior to assuming this role, Jeffrey
Welles worked in investment banking with Goldman
Sachs and Lazard Freres. Id. at 641. In response to
Jeffrey Welles’s request, SLK contacted the law firm
Jenkens & Gilchrist, P.C. (“J & G”). Waterman had
previously referred other SLK clients with similar re-
quests to J & G. In those cases, as here, Waterman and
SLK then helped the clients implement a strategy 2 devel-
oped and marketed by J & G.
To learn the details of the J & G strategy, the Welles
family signed confidentiality agreements prepared by
Donna Guerin, a partner at J & G. Id. at 643. In Janu-
ary 2000, the Welles family met in Vero Beach, Florida, to
discuss various matters related to the pending Therma-
Tru deal with Kenner (the “Vero Beach meeting”). During
the two-day meeting, Waterman gave a presentation on
the J & G strategy. Id. at 645. Among the materials
Waterman distributed and discussed was an executive
summary prepared by J & G, which gave a detailed
overview of the J & G strategy. When asked whether he
would engage in the J & G strategy if he were in the
Welleses’ situation, Waterman said he would. Id. at 646.
The goal of the J & G strategy was to reduce the capi-
tal gain resulting from the sale of assets. The strategy
reduced a taxpayer’s capital gain by increasing, or “step-
ping up,” the basis in the asset the taxpayer wanted to
sell. Because a partnership does not pay taxes, the result-
ing stepped-up basis passes through to the partners,
2 J & G called its strategy the “Basis Enhancing
Derivatives Structure,” or BEDS. 82 Fed. Cl. at 643 n.6.
We refer to it simply as the “J & G strategy.”
STOBIE CREEK INVESTMENTS v. US 6
thereby reducing the partner’s capital gain and attendant
capital gains tax when the asset is sold. Id. at 645.
To create a stepped-up basis in the asset, the J & G
strategy called for contributions to a partnership, followed
by distribution of the partnership’s assets to the taxpay-
ers. This goal was accomplished through a sequence of
six steps, carried out in a particular order to ensure the
taxpayers received the desired tax benefit: (1) investment
in foreign currency options through a single-member LLC;
(2) formation of a partnership with a third party or
wholly-owned S corporation; (3) contribution of the foreign
currency options to the partnership; (4) recognition of an
economic gain or loss by the partnership when the options
expired or were exercised; (5) termination and liquidation
of the partnership through contribution of the taxpayer’s
partnership interest to an S corporation; (6) sale of the
partnership’s assets by the S corporation or taxpayer. Id.
Because of their importance to this appeal, steps 1, 3,
and 5 warrant additional discussion here. Step 1 of the J
& G strategy called for a particular type of investment in
foreign currency: option spreads. To create an option
spread, or “collar,” the taxpayer sells a short option and
purchases a long option on the same currency.
When the options are contributed to the partnership
(here, Stobie Creek) during step 3, the taxpayer’s basis in
his partnership interest is increased by the cost of the
long option, but not decreased by the short option obliga-
tion. Under the J & G strategy, the short option’s contri-
bution has no effect on the taxpayer’s basis because it is
not treated as a “liability” under 26 U.S.C. § 752 when
calculating the taxpayer’s basis in his partnership inter-
est. When the partnership is liquidated during step 5, the
tax basis in the partnership’s assets is “stepped up” to
7 STOBIE CREEK INVESTMENTS v. US
match the partner’s outside basis. This stepped-up basis
allows the taxpayer to recognize less capital gain when
the asset is sold during step 6.
The Welles family decided to pursue the J & G strat-
egy. To obtain help implementing the strategy, the
Welleses agreed to pay a fixed fee to J & G and SLK.
J & G received a fee equal to 2% of the total gain to be
sheltered, or $4,091,500. SLK’s fee was 1% of the total
gain to be sheltered, or $2,045,750. Id. at 651.
On March 3, 2000, the Stobie Creek partnership was
formed. Single-member limited liability companies
(“LLCs”) were also formed for each family member, as
well as the David Welles Qualified Annuity Trust (“Welles
Trust”). To allow the LLCs to join Stobie Creek as part-
ners, SLK attorneys prepared the corresponding paper-
work, originally dated March 3, 2000. SLK asked Jeffrey
Welles to review drafts of various documents, including
the Stobie Creek company agreement and authorization
for Stobie Creek to receive all cash proceeds from the
Therma-Tru sale.
Three days later, Waterman sent a letter to each of
the Welleses. The letter “confirm[ed] and correct[ed]
certain information [SLK] provided to” the Welleses at the
Vero Beach meeting. Waterman stated that J & G would
be issuing a tax opinion for the Welleses similar to the
one attached to the letter, which would opine that it was
“more likely than not” that the transactions would be
respected for federal income tax purposes. Id. at 647.
Waterman also opined that recently issued federal regula-
tions “did not appear to apply” to the Welles family, since
the J & G strategy reduced only individual income tax
liability, not corporate tax liability.
STOBIE CREEK INVESTMENTS v. US 8
Contrary to his prior recommendation, Waterman’s
letter made a point of not recommending the J & G strat-
egy: “I believe we [SLK] have been clear that we are not
recommending that you pursue [J & G’s] proposal. In
fact, we have advised you that our knowledge of J & G’s
proposal was obtained in confidence under a confidential-
ity agreement . . . [and] we are therefore unable to issue
the opinion being offered by J & G.” While noting that
the letter tried to distance Waterman and SLK from their
prior promotion of the J & G strategy, the trial court
nonetheless found that the legal advice of Waterman or
SLK was tainted by self-interest. Id. at 648. The trial
court concluded that SLK was a broker for J & G’s strat-
egy. Id.Two weeks later, on March 20, 2000, SLK sent an
email to J & G. Per the email’s request, J & G instructed
Deutsche Bank to open accounts for each of the Welleses’
single-member LLCs. SLK provided J & G and Deutsche
Bank with a list showing the amount of capital gain each
of the Welleses expected to realize upon redemption of
their Therma-Tru stock. Id. at 648. Deutsche Bank used
this list to determine the stated premiums for the options
the Welleses would be purchasing as part of the J & G
strategy. Deutsche Bank subsequently sent Jeffrey
Welles sample confirmations for the type of digital options
the Welleses were planning to acquire.
On March 28, 2000, $2,045,750 was wired from the
Welles trust to Deutsche Bank. Jeffrey Welles authorized
the transfer, which paid for the options the LLCs were to
acquire through step 1 of the J & G strategy. The amount
corresponded to the difference between the stated premi-
ums on the long and short options. Three days later, on
March 31, each of the LLCs entered into two pairs of
option contracts (collectively, the Foreign Exchange
9 STOBIE CREEK INVESTMENTS v. US
Digital Options Transactions or “FXDOTS”). The first
pair was an option collar on the value of the Swiss franc
(“CHF”) versus the United States dollar. The second pair
was an option collar on the value of the United States
dollar versus the euro. Both pairs of options were to close
on April 17, 2000. Each option was digital, meaning the
payoff was a fixed amount if the option expired “in the
money” or nothing at all if the option expired “out of the
money.” A long (call) option expires “out of the money” if
the asset’s price is lower at the option’s expiration than
the price of exercising the option to buy the asset. A short
(put) option expires “out of the money” if the asset’s price
is higher at the option’s expiration than the price of
exercising the option to sell the asset. Id. at 649 & n.9.
On April 3, 2000, the LLCs transferred their option
contracts to the Stobie Creek partnership.
The option collar on the euro consisted of a purchased
long option with a strike price of $0.9912 per euro and a
sold short option with a strike price of $0.9914 per euro.
The two-pip (two-thousands of a unit) spread between the
two options, $0.9912 - $0.9914 per euro, was referred to as
that option collar’s “sweet spot.” Using the LLC belonging
to Jeffrey Welles as an example, if the euro traded at less
than $0.9912 per euro on the option’s close date, the LLC
(Jeffrey Welles) would lose $96,625. If the euro traded at
more than $0.9914 per euro, he would gain $96,625. If
the euro traded in the collar’s sweet spot (above $0.9912
but below $0.9914), Jeffrey Welles would gain
$19,228,357.
Analogously, the option collar on the Swiss franc con-
sisted of a purchased long option with a strike price of
CHF 1.7027 per dollar and a sold short option with a
strike price of CHF 1.7029 per dollar. The sweet spot for
STOBIE CREEK INVESTMENTS v. US 10
the Swiss franc option collar was again a two-pip spread,
CHF 1.7027 – CHF 1.7029 per dollar. 3
As shown in the table below, there were nine possible
outcomes for Stobie Creek’s investments in the euro and
Swiss franc digital options. The returns from these
possible outcomes varied from a gain of $407 million
(hitting both collars’ sweet spots) to a loss of $2 million
(all options finishing out of the money).
As the table shows, six of the nine possible outcomes yield
a positive return. However, as the experts explained at
trial, the outcomes were not all equally likely to occur.
3 Again taking the LLC belonging to Jeffrey Welles
as an example, if the Swiss franc traded at less than CHF
1.7027 per dollar, the LLC (Jeffrey Welles) would lose
$96,625. If the Swiss franc traded at more than CHF
1.7029 per dollar, he would gain $96,625. If the euro
traded in the collar’s sweet spot (above CHF 1.7027 but
below CHF 1.7029), Jeffrey Welles would gain $19,228,357.
11 STOBIE CREEK INVESTMENTS v. US
On April 17, 2000, all of the options expired out of the
money. Stobie Creek consequently lost its entire invest-
ment of $2,045,750. On May 9, 2000, the Therma-Tru
deal with Keener closed. Id. at 650.
After the close of the Therma-Tru deal (and long after
the options expired), a series of emails and faxes passed
among the Welleses, SLK, and J & G regarding the
proper dates for documents related to the formation and
transfer of partnership interests among the different
corporate entities. SLK was responsible for preparing
undated versions of some forms, which it then sent to J &
G for review. At trial, the government introduced several
copies of the assignment and joinder agreements transfer-
ring the Stobie Creek partnership interests from the
LLCs to the S corporations. Some were signed, others
were not; some were undated, others bore various (con-
flicting) dates. Upon learning that the Therma-Tru stock
certificates had to be dated April 14, 2000, an attorney at
SLK asked Guerin at J & G whether this posed a “timing
issue,” though he believed the April 14th date “pose[d] no
threat.” Id. The trial court found that the “threat” re-
ferred to the proper ordering of the transactions, which
was necessary to achieve the strategy’s beneficial tax
treatment. The “threat” was ultimately addressed by
replacing the March 24, 2000 documents assigning each
LLC’s interest in the Therma-Tru stock with documents
dated April 14, 2000. Another series of emails between
SLK and J & G concerned the date on which to “docu-
ment” the shift of the partnership interests from the LLCs
to the S corporations. SLK and J & G ultimately settled
on April 30, 2000 because it enabled them to file a tax
return for a short year. Other emails and faxes between
SLK and J & G show that confusion (and re-dating) of
documents continued through December 2000. Id. at 651.
STOBIE CREEK INVESTMENTS v. US 12
In February 2001, Stobie Creek filed its federal in-
come tax return for the tax period beginning on Stobie
Creek’s formation date, March 3, 2000, and ending on
April 30, 2000, the date when the partnership interests
were documented as passing from the LLCs to the S
corporations (the “2000 tax year”). Id. at 657. In Febru-
ary 2002, Stobie Creek filed its return for the tax period
beginning May 1, 2000 and ending December 31, 2000
(the “2000 stub year”).
The IRS issued a FPAA for Stobie Creek’s 2000 tax
year in March 2005. The IRS issued a FPAA for Stobie
Creek’s 2000 stub year in February 2007. The FPAAs
disregarded Stobie Creek for tax purposes as a sham and
disallowed the partnership’s stated basis in the Therma-
Tru stock, finding it attributable to transactions entered
into for the purpose of tax avoidance. As a result, the
FPAAs increased Stobie Creek’s capital gain income from
the sale of the Therma-Tru stock and assessed over $4.2
million in additional taxes. The FPAAs also imposed
accuracy-related penalties pursuant to 26 U.S.C. § 6662.
Id. at 702.
Stobie Creek and the other plaintiffs filed this action
in the Court of Federal Claims in July 2005. Id. at 657.
The complaint sought readjustment of partnership items
for the 2000 tax year and 2000 stub year, as well as a tax
refund of the $4.2 million assessed in the FPAAs.
During a two week bench trial, the Court of Federal
Claims heard testimony from several fact witnesses,
including Waterman and Jeffrey Welles. Plaintiffs also
presented three expert witnesses, Dr. Robert Kolb, Dr.
Richard Levich, and Dr. Jeffrey Frankel. The government
offered the testimony of one expert witness, Dr. David
DeRosa. Id. at 639-40 n.3. The trial court found that
13 STOBIE CREEK INVESTMENTS v. US
Stobie Creek’s basis calculations complied with the literal
requirements of the tax code. Id. at 670-71. In so finding,
the trial court declined to apply Treasury Regulation §
1.752-6 retroactively. 4 The trial court nonetheless disre-
garded the transactions implementing the J & G strategy
under the economic substance, step transaction, and end
result doctrines. Id. at 671-702. In doing so, the court
found that the plaintiffs failed to show the FXDOTs had a
business purpose beyond creating a tax advantage. Id. at
696. This finding was largely based on the nature of the
investments: the trial court found that for the FXDOTs to
make any profit, two historically correlated currencies—
the Swiss franc and the euro—had to decouple and move
in opposite directions. If the currencies moved in the
same direction relative to the dollar, the most favorable
outcome the Welleses could hope for was breaking even,
or zero profit. Id. at 690.
The trial court further found that Stobie Creek, acting
through Jeffrey Welles, the manager of the tax matters
partner for Stobie Creek, was liable for accuracy-related
penalties under 26 U.S.C. § 6662. In so holding, the trial
court rejected plaintiffs’ argument that the reasonable
cause defense in 26 U.S.C. § 6664(c)(1) applied. The trial
4 Had the trial court applied Treasury Regulation
§ 1.752-6 retroactively, plaintiff’s refund action would fail
under the literal application of the tax code and treasury
regulations because the short options would constitute
liabilities for the purpose of 26 U.S.C. § 752, reducing the
LLCs’ basis in their partnership interests.
The government has not appealed the trial court’s
holding on the retroactivity of Treasury Regulation §
1.752-6. Accordingly, we do not decide whether Treasury
Regulation § 1.752-6 applies retroactively because, even if
it does not, the J & G strategy was properly disregarded
under the economic substance doctrine.
STOBIE CREEK INVESTMENTS v. US 14
court found that Jeffrey Welles’s reliance on the profes-
sional advice of J & G and SLK was not reasonable or in
good faith, given that both firms had a clear conflict of
interest and Jeffrey Welles’s own investment experience
meant he would have recognized that the J & G strategy
was “too good to be true.” Id. at 707-21.
The plaintiffs now appeal. We have jurisdiction under
28 U.S.C. § 1295(a)(3).
ANALYSIS
This case is governed by certain provisions of the Tax
Equity and Fiscal Responsibility Act of 1982 (“TEFRA”),
26 U.S.C. §§ 6221-6234. TEFRA created a unified part-
nership-level procedure for auditing and litigating “part-
nership items,” thus addressing concerns about
inconsistent treatment of the same partnership items
across partners. See Schell v. United States, 589 F.3d
1378, 1381 (Fed. Cir. 2009). Penalties related to adjust-
ments of partnership items are also determined during
the partnership-level proceeding. 26 U.S.C. §§ 6221,
6226(f).
I. Economic Substance Doctrine
The primary question before this court is whether the
transactions implementing the J & G strategy were
properly disregarded under the economic substance
doctrine. We conclude that they were.
How a transaction is characterized is a question of
law we review de novo. Accordingly, we review the trial
court’s application of the economic substance doctrine
without deference. Coltec, 454 F.3d at 1357. The trial
court’s underlying factual findings are reviewed for clear
15 STOBIE CREEK INVESTMENTS v. US
error. Jade Trading, LLC ex rel. Ervin v. United States,
598 F.3d 1372, 1376 (Fed. Cir. 2010). Because deductions
are a matter of legislative grace, the taxpayer has the
burden of proving that a transaction had economic sub-
stance by a preponderance of evidence. Id.The economic substance doctrine seeks to distinguish
between structuring a real transaction in a particular way
to obtain a tax benefit, which is legitimate, and creating a
transaction to generate a tax benefit, which is illegiti-
mate. Coltec, 454 F.3d at 1357; see also Klamath Strate-
gic Invest. Fund ex. rel St. Croix v. United States, 568
F.3d 537, 543-44 (5th Cir. 2009). Under this doctrine, we
disregard the tax consequences of transactions that
comply with the literal terms of the tax code, but nonethe-
less lack “economic reality.” Coltec, 454 F.3d at 1355-56;
see also Frank Lyon Co. v. United States, 435 U.S. 561,
583-84 (1978); Klamath, 568 F.3d at 544; United Parcel
Serv. of Am., Inc. v. Comm’r, 254 F.3d 1014, 1018 (11th
Cir. 2001); ACM P’ship v. Comm’r, 157 F.3d 231, 247 (3d
Cir. 1998); James v. Comm’r, 899 F.2d 905, 908-09 (10th
Cir. 1990). Such transactions include those that have no
business purpose beyond reducing or avoiding taxes,
regardless of whether the taxpayer’s subjective motiva-
tion was tax avoidance. Coltec, 454 F.3d at 1355 (citing
Higgins v. Smith, 308 U.S. 473, 476 (1940)); Ballagh v.
United States, 331 F.2d 874, 877-78 (Ct. Cl. 1964); see also
Frank Lyon, 435 U.S. at 583-84; Klamath, 568 F.3d at
544. We also disregard transactions shaped solely by tax-
avoidance features. Frank Lyon, 435 U.S. at 583-84; see
also Coltec, 454 F.3d at 1355; Gregory v. Helvering, 293
U.S. 465, 469-70 (1935); Klamath, 568 F.3d at 544.
Whether a transaction lacks “economic reality,” has no
bona fide “business purpose” or was shaped solely by tax-
avoidance features is an objective inquiry, evaluated
prospectively. Coltec, 454 F.3d at 1356. In other words,
STOBIE CREEK INVESTMENTS v. US 16
the transaction is evaluated based on the information
available to a prudent investor at the time the taxpayer
entered into the transaction, not what may (or may not)
have happened later.
As they did at trial, the parties on appeal primarily
focus on whether the FXDOTs should be disregarded
under the economic substance doctrine. The plaintiffs
argue that the FXDOTs should not be disregarded be-
cause they were entered into with a bona fide business
purpose: namely, profit from investing in foreign curren-
cies.
In a careful, well-reasoned opinion, the Court of Fed-
eral Claims rejected plaintiffs’ argument. It then disre-
garded the FXDOTs as lacking economic substance. In
doing so, the trial court properly gave greater weight to
the testimony of government expert Dr. DeRosa. The
trial court did not clearly err in finding that Dr. DeRosa’s
testimony provided the more convincing and complete
methodology for determining how a “reasonable investor”
would judge the profit potential of the FXDOTs. This
analysis examined the probability of each outcome, the
expected rate of return, and the price of the options,
which are all factors a prudent investor might consider
when deciding whether to invest. Stobie Creek, 82 Fed.
Cl. at 685-89. The factors Dr. DeRosa considered were
thus highly relevant to evaluating the central question
about the FXDOTs: whether a prudent investor would
have had a reasonable expectation of earning a profit
from the transaction. See Coltec, 454 F.3d at 1357.
Similarly, the trial court did not clearly err in finding
that the selective and incomplete analysis of the plaintiffs’
experts undermined their opinions that the FXDOTs had
a “very substantial profit potential” (Dr. Kolb) or at least
17 STOBIE CREEK INVESTMENTS v. US
a modest profit potential (Dr. Levich). Stobie Creek, 82
Fed. Cl. at 677-80. For example, although plaintiffs’
expert Dr. Kolb testified that the nine possible outcomes
were not equally probable, he did not calculate the prob-
abilities of the different outcomes—even though these
probabilities were essential to evaluating whether a profit
potential existed. As the trial court correctly observed, no
reasonable person would make an investment, no matter
what the stated return, if the probability of achieving that
return were zero. Id. at 691. The analysis of plaintiffs’
second expert, Dr. Levich, was similarly incomplete. Dr.
Levich estimated that the probability of obtaining a 2-to-1
payoff on the FXDOTS was 9-21% on the dollar/euro
options and 15-27% on the Swiss franc/dollar options; as
for either or both options hitting the sweet spot (5 of the 9
outcomes), Dr. Levich simply stated it would be a “rela-
tively rare occurrence.” Id. at 680. The trial court prop-
erly accorded Dr. Levich’s testimony little weight for two
reasons. First, the trial court found Dr. Levich’s opinion
was based on estimates of high volatility in the exchange
rate, which the market data did not support. Second, the
trial court found Dr. Levich’s opinion was undermined by
the nature of the trades themselves: to return any profit-
able outcome, the FXDOTs required two historically
correlated currencies to decouple and move in opposite
directions. So long as the currencies moved in the same
direction (as they had historically), the most the Welleses
could hope for was breaking even, or zero profit. 82 Fed.
Cl. at 690. In light of the record, neither of these findings
is clearly erroneous.
Based on its evaluation of the expert testimony and
supporting documentation, the trial court disregarded the
FXDOTs under the economic substance doctrine. It
concluded that the transactions did not reflect economic
STOBIE CREEK INVESTMENTS v. US 18
reality, nor were they motivated by a business purpose.
Id. at 672-98, 701-02.
We reach the same conclusion. Measured either by
their economic reality or their purported business pur-
pose, the FXDOTs were properly disregarded under the
economic substance doctrine.
A. Economic Reality
A transaction lacks “economic reality” when the tax
result (gain or loss) is “purely fictional.” See, e.g., Jade
Trading, 598 F.3d at 1377. This inquiry often focuses on
whether there was a reasonable possibility of making a
profit from the transaction. See, e.g., Coltec, 454 F.3d at
1356 (quoting Black & Decker Corp. v. United States, 436
F.3d 431, 441 (4th Cir. 2006)); see also Gilman v. Comm’r,
933 F.2d 143, 146-47 (2d Cir. 1991) (asking whether a
prudent investor would have found that a “realistic poten-
tial for economic profit” existed). Thus, in Jade Trading,
we held that the taxpayers were not entitled to a basis of
over $15 million in their Jade partnership interests (and
an attendant tax loss of $14.9 million) because they had
not contributed $15 million to the partnership, nor had
they lost $14.9 million on exiting the partnership. 598
F.3d at 1377. In so holding, we explained that the “[op-
tion] transaction's fictional loss, inability to realize a
profit, lack of investment character, meaningless inclu-
sion in a partnership, and disproportionate tax advantage
as compared to the amount invested and potential return,
compel a conclusion that the spread transaction objec-
tively lacked economic substance.” Id.In this case, the FXDOTs lacked economic reality for
at least two reasons: (1) the tax result flowing from the
FXDOTs was purely fictional; and (2) there was no rea-
19 STOBIE CREEK INVESTMENTS v. US
sonable possibility that the FXDOTs would return a
profit. We discuss each of these reasons in turn.
First, as in Jade Trading, the $204,575,000 stepped-
up basis in the Therma-Tru stock 5 was purely fictional:
although the taxpayers only paid (and lost) about $2
million for the FXDOTs, they claimed a basis of over $200
million in their partnership interests, based on the con-
tribution of those FXDOTs to Stobie Creek. See 598 F.3d
at 1377. It is true that the taxpayers did purchase and
contribute long options with a stated premium of
$204,575,000 to Stobie Creek. However, they also sold
and contributed short options with a stated premium of
$202,529,250. Even though a literal application of the tax
code at that time 6 may have permitted the taxpayers to
treat these transactions separately, what matters under
the economic substance doctrine is whether the tax
treatment accords with economic reality.
In our analysis, the FXDOTs are properly treated as a
single, unified transaction. Such treatment is more
consistent with what was actually paid for the FXDOTs
and how Deutsche Bank, the broker for the options,
treated the transaction. Because Deutsche Bank is a
third party and the one that stood to lose if the invest-
ments were not properly hedged, Deutsche Bank’s treat-
ment is particularly probative. The evidence shows that
Deutsche Bank netted the premiums of the long and short
5 When the partnership interests were transferred
from the LLCs to the S corporations, the basis in the
Therma-Tru stock was stepped up to match the taxpayers’
outside basis in the partnership, $204,575,000.
6 The applicable regulations have since been
amended. See Treas. Reg. §§ 1.752-6, 1.752-7 (2009).
STOBIE CREEK INVESTMENTS v. US 20
options against each other, rather than require full pay-
ment of the option premiums and deposits against the
margin, as is typically required when such options are
entered into separately. The netting of the premiums and
absence of a margin requirement are strong evidence
Deutsche Bank did not view the long and short options as
separate (or separable) transactions. Indeed, because
Deutsche Bank treated the FXDOTs as one transaction,
the taxpayers only paid the difference between the pre-
miums, $2,045,750, rather than the long option’s stated
premium of $204,575,000. Thus, when the FXDOTs
expired out of the money, the taxpayers lost only
$2,045,750, not $204,575,000.
Because the economic reality is that the long and
short options were not separate, under the economic
substance doctrine they similarly should not be separate
for the purpose of calculating the taxpayers’ basis in
Stobie Creek. Accordingly, the taxpayers’ claimed basis of
$204,575,000 is properly disregarded as lacking economic
reality; it does not reflect what the taxpayers paid
Deutsche Bank for the FXDOTs ($2,045,757), or what
they lost when the FXDOTs expired out of the money.
The FXDOTs also lack economic reality because there
was no reasonable possibility the FXDOTs would return a
profit, due to a combination of factors. These factors
included the nature of the market (i.e., the high positive
correlation between the movement of the euro and Swiss
franc), the overpricing of the option premiums, and the
structure of the investment (i.e., the necessity of the
currencies decoupling, the effectively nonexistent “sweet
spot,” and the narrow range of the strike price). Cf.
Klamath, 568 F.3d at 545 (noting that the taxpayers
designed the transactions and investment strategy “so
there was no reasonable possibility of a profit”).
21 STOBIE CREEK INVESTMENTS v. US
The evidence presented at trial shows that for the
FXDOTs to have made any profit, the historically corre-
lated euro and Swiss franc would have had to decouple
and move in opposite directions. Stobie Creek, 82 Fed. Cl.
at 690. Taking probabilities into account reveals that five
of the nine possible outcomes would never occur, because
the sweet spots would never be hit. Government expert
Dr. DeRosa explained that the sweet spots could never be
hit because of the strike price’s narrow range (two pips)
and Deutsche Bank’s wide latitude in deciding whether
the FXDOTs were “in the money.” Id. at 686. In deciding
whether a sweet spot had hit, Deutsche Bank could
choose a quote’s bid price, ask price, or something in
between. Nor was Deutsche Bank limited to a specific
bank’s quote; it could solicit quotes from as many banks
as it wanted and could choose among them. Further, the
quotes Deutsche Bank received were three pips wide, and
thus always greater than the two-pip spreads for the
FXDOTs’ sweet spots. The unattainable nature of the
sweet spots is supported by the way Deutsche Bank
internally hedged the FXDOTs. The evidence shows
Deutsche Bank manually changed the short component’s
strike price for each option pair, eliminating the need for
Deutsche Bank to internally hedge against the risk of
hitting the sweet spot. Because there was effectively no
sweet spot, the probability of any positive return was only
11.43% for the dollar/euro options and 19.95% for the
Swiss franc/dollar options. Id. at 688.
The expected rates-of-return similarly show there was
no reasonable possibility the FXDOTs would earn a profit.
Expected rates of return are revealing, particularly if they
account for costs and fees associated with implementing
the transaction; a reasonable investor would consider
such expenses when evaluating an investment’s likely
profitability. Dr. DeRosa testified that the expected rate
STOBIE CREEK INVESTMENTS v. US 22
of return was -77.14% for the dollar/euro options and -
60.10% for the Swiss franc/dollar options. Id. at 688.
With J & G’s and SLK’s fees for implementing the trans-
action included in the analysis, these rates were even
more negative.
Finally, the price the Welleses paid for FXDOTs
strongly suggests the transaction lacked economic reality.
The trial court sensibly reasoned that a prudent investor
would not want to overpay for an investment, and would
thus avoid a transaction in which the premiums were
greater than the investment’s expected value. By this
rubric, the FXDOTs were precisely the type of transaction
a reasonable investor would seek to avoid: Although the
theoretical value of the euro/dollar long options was only
about $23.3 million, the premiums valued the options at
$102.3 million, more than four times that amount. The
Swiss franc/dollar options were similarly overpriced; the
stated premiums valued the options at more than three
times the options’ theoretical value. This disparity is far
greater than the marginal variation Dr. DeRosa testified
could occur, and there is no evidence of a market-related
reason for the significant pricing difference.
B. Business Purpose
Asking whether a transaction has a bona fide busi-
ness purpose is another way to differentiate between real
transactions, structured in a particular way to obtain a
tax benefit (legitimate), and transactions created to gen-
erate a tax benefit (illegitimate). Coltec, 454 F.3d at 1357.
We conclude that the FXDOTs fall in the category of
“illegitimate” transactions identified in Coltec. See id.
The evidence shows that the FXDOTs were part of a
prepackaged strategy marketed to shelter taxable gain.
23 STOBIE CREEK INVESTMENTS v. US
Stobie Creek, 82 Fed. Cl. at 693-94. The Welleses sought
out the J & G strategy not because they wanted to profit
from investments in foreign currency (a legitimate pur-
pose), but only because they wanted to lower their tax
liability on the Therma-Tru deal, an unrelated transac-
tion (an illegitimate purpose). Here the tax-avoidance
motive preceded the “investment” strategy and any
evaluation of profit potential; the FXDOTs (and the J & G
strategy more generally) were simply a means to the
desired end of creating a tax benefit.
It is true that the Welleses implemented the J & G
strategy for the purpose of minimizing the tax conse-
quences of the Therma-Tru deal, a real transaction with
economic substance. That connection in itself, however,
does not legitimize the FXDOTs or the J & G strategy.
Although the Welleses were unquestionably free to struc-
ture the Therma-Tru deal to minimize their tax liability,
the J & G strategy was not a way of structuring the
Therma-Tru deal. Cf. Coltec, 454 F.3d at 1357. Rather,
the J & G strategy was a separate, independent set of
transactions that had no purpose besides creating a tax
benefit. Id.; cf. Ballagh, 331 F.2d at 878.
The Welleses’ claim of a profit motive behind the
FXDOTs is belied by ample evidence that the tax advan-
tages could not have been achieved had the transaction
taken another form and that, absent the tax advantages,
the transaction never would have occurred. See Frank
Lyon, 435 U.S. at 583 n.18; Gregory, 293 U.S. at 469-70.
This court’s decision in Jade Trading held that the
“meaningless inclusion in the partnership” of options was
evidence the transaction lacked economic substance. Cf.
598 F.3d at 1377. In this case, the Welleses similarly
used unnecessary corporate entities to invest in the
FXDOTs. Although the LLCs, S corporations, and part-
STOBIE CREEK INVESTMENTS v. US 24
nership (Stobie Creek) were not necessary to the transac-
tion and did not enhance its potential profitability, the
taxpayers nevertheless went to great lengths to create
these entities and transfer the FXDOTs among them. See
id.; cf. Gregory, 293 U.S. at 469-70.
Taxpayers’ focus on generating tax benefits, rather
than pursuing a legitimate business purpose, is also
evidenced by the backdating of different transactions,
including the FXDOTs, to conform to the J & G strategy.
Stobie Creek, 82 Fed. Cl. at 695. The trial court found
this backdating did nothing to enhance the transactions’
investment potential, but was absolutely critical to
achieving the desired basis enhancement and associated
tax benefits. Id. at 695-96. Indeed, the FXDOTs could
have been, and in fact were, carried out in a different
order than J & G’s prescribed strategy. We agree with
the trial court that the redating of different transactions
reveals an emphasis on generating tax benefits; conform-
ing to the J & G strategy mattered only if the purpose was
tax avoidance, not economic profit from the FXDOTs. Cf.
Neonatology Assocs. v. Comm’r, 299 F.3d 221, 230 n.12 (3d
Cir. 2002); Rogers v. United States, 281 F.3d 1108, 1114-
15 (10th Cir. 2002).
Finally, the fee structure undermines plaintiffs’ con-
tention that the J & G strategy had a business purpose
(besides generating tax benefits, which does not count).
See Coltec, 454 F.3d at 1358-59. The fees paid to SLK, J
& G, and Deutsche Bank were all computed based on the
amount of gain to be sheltered by the J & G strategy,
without reference to typical economic considerations, such
as the amount of risk on the investment. Stobie Creek, 82
Fed. Cl. at 693-94. Plaintiffs have offered no explanation
for why the taxpayers paid such high fees, particularly to
Deutsche Bank. Deutsche Bank’s fee exceeded not only
25 STOBIE CREEK INVESTMENTS v. US
the normal fees for foreign currency options, but the value
of the FXDOTs themselves.
Thus, because the FXDOTs lacked economic reality
and had no business purpose, they were properly disre-
garded under the economic substance doctrine.
II. Penalties
A. Jurisdiction
A threshold question is whether we have jurisdiction
to review the accuracy-related penalties imposed under 26
U.S.C. § 6662. See Special Devices, Inc. v. OEA, Inc., 269
F.3d 1340, 1342-43 (Fed. Cir. 2001). Because plaintiffs
challenge the “applicability of a[] penalty . . . which re-
lates to an adjustment to a partnership item” and do not
raise a partner-level defense, we conclude that the answer
is yes. 26 U.S.C. §§ 6226(f), 6230.
The penalties challenged on appeal relate to Stobie
Creek’s misstatement of its inside basis in Therma-Tru
stock, as well as to adjustments of its basis in that stock
pursuant to 26 U.S.C. § 754. The partnership’s basis in
contributed property is a partnership item. Treas. Reg. §
301.6231(a)(3)-1(a)(vi), (c)(2); see also Am. Boat Co. v.
United States, 583 F.3d 471 (7th Cir. 2009). Adjustments
made pursuant to a § 754 election are also partnership
items. Treas. Reg. § 301.6231(a)(3)-1(a)(3). Accordingly,
the penalties “relate[] to an adjustment to a partnership
item,” i.e., Stobie Creek’s basis in the Therma-Tru stock.
26 U.S.C. § 6226(f).
Further, the defense at issue on appeal is a partner-
ship-level defense, not a partner-level defense. In a
partnership-level proceeding such as this, we lack juris-
STOBIE CREEK INVESTMENTS v. US 26
diction to consider partner-level defenses. See 26 U.S.C.
§§ 7422(h), 6230(c); Schell, 589 F.3d at 1382; Am. Boat,
583 F.3d at 478-79. Stobie Creek argues it had reason-
able cause for stepping up the basis in the Therma-Tru
stock. A reasonable-cause defense under 26 U.S.C.
§ 6664(c) may be a partner- or partnership-level defense,
depending on who is asserting it. See Temp. Treas. Reg. §
301.6221-1T(d); Klamath, 568 F.3d at 548; Whitehouse
Hotel Ltd. v. Comm’r, 131 T.C. 112, 173 (2008). We have
jurisdiction because here the partnership (Stobie Creek)
is claiming it had reasonable cause based on the actions of
its managing partner, Jeffrey Welles. 7 See Am. Boat, 583
F.3d at 479-80.
B. Reasonable-Cause Defense
On the merits, the only question is whether Stobie
Creek, acting through Jeffrey Welles, had reasonable
cause for its tax position. Stobie Creek argues reasonable
cause and good faith are demonstrated by Jeffrey Welles’s
reliance on advice from SLK and J & G. Stobie Creek, 82
Fed. Cl. at 718. The answer turns on whether such
reliance was reasonable under the circumstances. We
conclude that it was not.
Mandatory, accuracy-related penalties apply to cer-
tain underpayments of tax that meet the statutory re-
quirements. 26 U.S.C. § 6662(a), (h). Section 6664(c)(1)
provides a narrow defense to § 6662 penalties if the
taxpayer proves it had (1) reasonable cause for the under-
payment and (2) acted in good faith. See also Treas. Reg.
§ 1.6664-4(c)(1). The taxpayer bears the burden of show-
7 Jeffrey Welles was the manager of North Chan-
nel, the tax-matters partner of Stobie Creek.
27 STOBIE CREEK INVESTMENTS v. US
ing this exception applies. See Conway v. United States,
326 F.3d 1268, 1278 (Fed. Cir. 2003). Whether a taxpayer
had reasonable cause is a question of fact decided on a
case-by-case basis. Id.; Treas. Reg. § 1.6664-4(b)(1). We
review this determination and the findings underlying it
for clear error. See Am. Boat, 583 F.3d at 483; Barrett v.
United States, 561 F.3d 1140, 1148 (10th Cir. 2009). In
doing so, we take into account all the pertinent facts and
circumstances. Treas. Reg. § 1.6664-4(b)(1). The most
important of these factors is “the extent of the taxpayer’s
effort to assess the taxpayer’s proper tax liability,” judged
in light of the taxpayer’s “experience, knowledge, and
education.” Treas. Reg. § 1.6664-4(b)(1).
One way to show reasonable cause is to show reason-
able reliance on the advice of a competent and independ-
ent professional adviser. Treas. Reg. § 1.6664-4(b)(1);
United States v. Boyle, 469 U.S. 241, 251 (1985). This
advice must meet several requirements. First, the tax-
payer must show that the advice was based on “all perti-
nent facts and circumstances and the law as it relates to
those facts and circumstances.” Treas. Reg. § 1.6664-
4(c)(1)(i). Second, the advice relied upon must not be
based on any “unreasonable factual or legal assumptions,”
and must not “unreasonably rely on the representations,
statements, findings, or agreements of the taxpayer or
any other person.” Id. § 1.6664-4(c)(1)(ii). Third, the
taxpayer’s reliance on the advice must itself be objectively
reasonable. The reasonableness of any reliance turns on
the quality and objectivity of the advice. See Klamath,
568 F.3d at 548; Chamberlain v. Comm’r, 66 F.3d 729 (5th
Cir. 1995); Swayze v. United States, 785 F.2d 715, 719
(9th Cir. 1986). Reliance is not reasonable, for example, if
the adviser has an inherent conflict of interest about
which the taxpayer knew or should have known. Treas.
Reg. § 1.6664-4(c); Am. Boat, 583 F.3d at 481-82; Hansen
STOBIE CREEK INVESTMENTS v. US 28
v. Comm’r, 471 F.3d 1021, 1031-32 (9th Cir. 2006); Neona-
tology, 299 F.3d at 234; Pasternak v. Comm’r, 990 F.2d
893, 903 (6th Cir. 1993). Nor is it reasonable if the tax-
payer knew or should have known that the transaction
was “too good to be true,” based on all the circumstances,
including the taxpayer’s education, sophistication, busi-
ness experience, and purposes for entering into the trans-
action. Treas. Reg. § 1.6664-4(c); Hansen, 471 F.3d at
1032.
The trial court concluded that Stobie Creek was not
entitled to the reasonable-cause defense because it was
not reasonable for Jeffrey Welles to rely on the advice of
SLK or J & G. Stobie Creek, 82 Fed. Cl. at 720-21. The
court found that both firms had an inherent conflict of
interest, which Jeffrey Welles knew or should have known
about. This conflict of interest arose from the role of SLK
and J & G in promoting, implementing, and receiving fees
from the J & G strategy. Accordingly, the trial court
found that the firms could hardly qualify as independent
professionals, since neither was disinterested in the
outcome of the strategy they were evaluating.
We agree that the reasonable-cause defense does not
apply to Stobie Creek. The trial court did not clearly err
in finding it objectively unreasonable for Jeffrey Welles to
rely on the advice of J & G and SLK because J & G was a
promoter of the shelter and SLK was an agent of the
promoter, making them anything but independent. Cf.
Pasternak, 990 F.2d at 903. Advice hardly qualifies as
disinterested or objective if it comes from parties who
actively promote or implement the transactions in ques-
tion. See, e.g., id.; Mortensen v. Comm’r, 440 F.3d 375(6th Cir. 2006); Van Scoten v. Comm’r, 439 F.3d 1243,
1253 (10th Cir. 2006); Goldman v. Comm’r, 39 F.3d 402,
408 (2d Cir. 1994).
29 STOBIE CREEK INVESTMENTS v. US
Further, the trial court did not clearly err in finding
that Jeffrey Welles knew or should have known about this
conflict of interest. At trial, the government presented
extensive circumstantial evidence that Jeffrey Welles
authorized, reviewed, or at minimum received updates on
the strategy’s progress, and thus knew about both firms’
roles.
For example, J & G’s role as a promoter of the strat-
egy was evident from the initial confidentiality agree-
ment, which stated that the “proprietary” strategy had
been “developed by J & G.” This role was again apparent
in J & G’s fee agreement, which tied the firm’s compensa-
tion to the gain sheltered by the strategy. Jeffrey Welles
received, reviewed, and signed these documents. J & G’s
role was similarly evidenced by its efforts to implement
the shelter. For example, J & G helped set up the
FXDOTs, draft the formation and transfer agreements for
Stobie Creek, and assure that the transactions adhered to
the strategy’s chronology.
Similarly, the evidence supports the trial court’s con-
clusion that Jeffrey Welles knew or should have known
that SLK was an agent of J & G, and thus could not
reasonably rely on SLK’s advice. SLK’s agency relation-
ship was apparent from the beginning. Waterman re-
ferred the Welleses to J & G, presented the strategy at
the Vero Beach meeting, and recommended the strategy.
As was true for J & G, SLK’s fee agreement made clear
that SLK had a financial stake in the outcome, again
tying compensation to the sheltered gain. SLK also
helped implement the strategy by drafting and backdat-
ing documents for the different corporate entities. In-
deed, SLK openly acknowledged its role in a letter to the
Welleses. The letter stated that the lower taxable gain
that would be reported on Stobie Creek’s return was
STOBIE CREEK INVESTMENTS v. US 30
“produced by the tax strategy that was developed by [J &
G] and implemented with our [SLK’s] help earlier this
year.” The trial court found that Jeffrey Welles received
this letter. Based on that and other evidence presented at
trial, it was reasonable for the trial court to infer that
Jeffrey Welles (and thus Stobie Creek) knew or should
have known about the conflicts of interest for J & G and
SLK. It was not objectively reasonable for Jeffrey Welles
to ignore evidence of these conflicts and continue to rely
on the advice, regardless of the Welleses’ longstanding
relationship with SLK or the reputations of both firms.
Even if Jeffrey Welles had not known about the con-
flicts of interest, his reliance on the advice of SLK and J &
G was still unreasonable. Based on Jeffrey Welles’s
education and experience, as well as the reason the
Welleses pursued the J & G strategy, the trial court found
that Jeffrey Welles should have known that the J & G
strategy was “too good to be true.” Cf. Neonatology, 299
F.3d at 234. This determination is not clearly erroneous.
Jeffrey Welles was a highly educated professional with
extensive experience in finance, having worked as an
investment banker and as the manager of his family’s
complex finances. Stobie Creek, 82 Fed. Cl. at 715. In
that managerial role, he had helped implement a number
of sophisticated tax-planning strategies, giving him
sufficient knowledge and experience to know when a tax-
planning strategy was likely “too good to be true.” Jeffrey
Welles knew that the J & G strategy was marketed as a
“Basis Enhancing Derivatives Structure” and that the
purpose of the strategy was to boost the basis in capital
assets, “generating a reduced gain for tax purposes.”
Moreover, Jeffrey Welles sought out and selected the J &
G strategy because of a desire to avoid taxes that would
otherwise be owed on the Therma-Tru deal, not because
he wanted to structure the deal itself to minimize taxes.
31 STOBIE CREEK INVESTMENTS v. US
Accordingly, Stobie Creek had no reasonable-cause
defense for its tax position.
III. Evidentiary Ruling
Plaintiffs argue that they are entitled to a new trial
because the trial court erroneously excluded the testi-
mony of their expert, Stuart Smith. We disagree.
A trial court’s evidentiary rulings are reviewed for
abuse of discretion. Pac. Gas & Elec. Co. v. United States,
536 F.3d 1282, 1285 (Fed. Cir. 2008). In this case, Smith
sought to testify about the tax laws “as they existed in
2000” and whether the J & G tax opinion letter complied
with the standards set out in Treasury Circular 230. The
trial court excluded Smith’s expert report and testimony
under Federal Rule of Evidence 702, concluding that
Smith’s opinion would not “assist” the court because the
opinion concerned a question of law, not fact. Stobie
Creek Invs., LLC v. United States, 81 Fed. Cl. 358, 359-61
(2008).
Plaintiffs are not entitled to a new trial because the
trial court properly excluded Smith’s expert testimony.
Under Rule 702, expert testimony must “assist the trier of
fact to understand the evidence or to determine a fact in
issue.” Fed. R. Evid. 702 (emphases added). Because
proper interpretation of the tax laws and Treasury Circu-
lar 230 are issues of law, it was not an abuse of discretion
to exclude expert testimony related to those questions.
See Mola Dev. Corp. v. United States, 516 F.3d 1370, 1379
n.6 (Fed. Cir. 2008). To the extent Smith sought to testify
about whether the J & G tax opinion letter met the stan-
dards of Treasury Circular 230, that opinion similarly
would not have “assist[ed]” the trial court because Smith’s
proposed testimony consisted of a lengthy legal analysis of
STOBIE CREEK INVESTMENTS v. US 32
past precedent and assumed key factual representations
underlying the J & G opinion were accurate, when in
actuality they were false (and known to be so by the
Welleses). Stobie Creek, 81 Fed. Cl. at 362; see Stobie
Creek, 82 Fed. Cl. at 706-07, 720-21. Excluding Smith’s
report and testimony was thus within the trial court’s
discretion.
CONCLUSION
We affirm the application of the economic substance
doctrine to the J & G strategy and accuracy-related
penalties imposed on Stobie Creek. Stobie Creek was not
entitled to a reasonable-cause defense under § 6664(c)(1)
and the testimony of plaintiff’s expert Smith was properly
excluded under Federal Rule of Evidence 702.
AFFIRMED