New Phoenix Sunrise Corporation and Subsidiaries v. Commissioner

132 T.C. No. 9UNITED STATES TAX COURT
NEW PHOENIX SUNRISE CORPORATION AND SUBSIDIARIES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 23096-05. Filed April 9, 2009.
P is the parent of a consolidated group of corporations
and a wholly owned subsidiary S. During 2001 S sold
substantially all of its assets, realizing a gain of about
$10 million. Also during 2001, S entered into a transaction
whereby: (1) S purchased from and sold to a foreign bank
respectively a long and a short option in foreign currency,
paying only the net premium to the foreign bank; (2) S and
W, a part owner of P, formed partnership O; and (3) S
contributed the long and short options to O, increasing its
basis in O by the amount of the premium on the purchased
long option but not reducing its basis by the amount of the
premium on the sold short option. The long and short
options expired worthless. Shortly thereafter the
partnership dissolved and distributed shares of stock in
Cisco Systems, Inc., to S in redemption of its partnership
interest. S sold the stock for a small economic loss. On
its consolidated return P claimed a loss of about $10
million on S’ sale of the stock. P calculated the amount of
the loss by claiming an inflated basis of about $10 million
in the Cisco Systems, Inc. stock distributed by O. The
- 2 -
claimed $10 million loss was used to offset the $10 million
gain on the sale of S’ assets. O filed an information
return showing a loss on the expiration of the long and
short options and allocating that loss to S and W.
Because O qualified as a small partnership under sec.
6231(a)(1)(B)(i), I.R.C., the unified audit and litigation
procedures of the Tax Equity and Fiscal Responsibility Act
of 1982, Pub. L. 97-248, sec. 401, 96 Stat. 648, do not
apply. R issued a notice of deficiency to S, and P
petitioned upon a consolidated return which included S. The
notice of deficiency disallowed the claimed loss on the sale
of the stock, the claimed flowthrough loss from O, and
claimed deductions for legal fees. The notice was based in
part on R’s belief that the transaction entered into by P
lacked economic substance and should be disregarded for
Federal tax purposes. The notice also imposed the penalty
under sec. 6662, I.R.C.
Held: The transaction S entered into lacked economic
substance and is disregarded.
Held, further, the legal fees are not deductible by P.
Held, further, S is liable for sec. 6662, I.R.C.,
penalty.
John P. Tyler, Anthony J. Rollins, and Willard N. Timm, for
petitioner.
R. Scott Shieldes and Kathryn F. Patterson, for respondent.
GOEKE, Judge: Respondent determined a deficiency of
$3,355,906 in petitioner’s Federal income tax for 2001 and
imposed a penalty under section 6662 of $1,298,284.1 For the
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code (Code).
- 3 -
reasons stated herein, we uphold the determinations in the notice
of deficiency and find the section 6662 penalty applicable.
FINDINGS OF FACT
Some of the facts have been stipulated, and the stipulations
of fact and the accompanying exhibits are incorporated herein by
this reference.
On April 30, 1973, the Pruett-Wray Cattle Co. was
incorporated pursuant to the laws of the State of Arizona. In
1990 it changed its name to New Phoenix Sunrise Corp. (New
Phoenix).
1. Mr. Wray
Timothy Wray (Mr. Wray) became president and CEO of New
Phoenix in 1996. Mr. Wray graduated from Princeton University
with a bachelor of arts degree and then obtained a master’s
degree in business administration from Stanford University. Mr.
Wray was a member of the U.S. Rowing Team from 1990 through 1995.
After graduating from college, but while still a member of the
rowing team, Mr. Wray worked for Vanguard, a securities firm.
After retiring from rowing, Mr. Wray began to examine the
family business, New Phoenix. At that time New Phoenix was
managed by nonfamily members and experiencing financial
difficulties. Mr. Wray worked to refinance the company’s debt by
securing a new lender and as part of the arrangement took over as
president and CEO until New Phoenix’s dissolution in 2001. In
- 4 -
addition to serving as New Phoenix’s president and CEO, Mr. Wray
worked from 1996 until 2001 as a research analyst for Questor
Management Co., a private equity firm.
2. Capital Poly Bag
Capital Poly Bag, Inc. (Capital), was incorporated in 1972
under the laws of the State of Ohio. Capital manufactured
plastic bags for sale to large institutions and had manufacturing
facilities in Columbus, Ohio, and Atlanta, Georgia. New Phoenix
purchased the stock of Capital in 1986. At all relevant times
thereafter, Capital was a subsidiary of New Phoenix and filed
consolidated income tax returns with the New Phoenix group of
corporations.
3. Elsea, Collins & Co.
Elsea, Collins & Co. (Elsea Collins) was an accounting firm
in Columbus, Ohio. Elsea Collins provided financial accounting
and performed State and local tax work for Capital starting in
the 1980s. During 2001 and 2002 James Hunter (Mr. Hunter) was a
C.P.A. and a partner at Elsea Collins.
4. Bricker & Eckler, L.L.P.
Bricker & Eckler, L.L.P. (Bricker & Eckler), is a law firm
based in Columbus, Ohio. Bricker & Eckler provided legal
services for Capital from the 1970s until the company’s
dissolution. During 2001 and 2002 Gordon F. Litt (Mr. Litt) was
an attorney and a partner at Bricker & Eckler.
- 5 -
5. Joseph W. Roskos & Co.
In 2001 and 2002 Joseph W. Roskos & Co. (Roskos & Co.) was a
subsidiary of Bryn Mawr Bank Corp. in Bryn Mawr, Pennsylvania.
Roskos & Co. provided office services, including accounting,
consulting, tax services, and fiduciary support for high-net-
worth individuals. Elsea Collins prepared New Phoenix’s
financial statements, upon which Roskos & Co. relied in providing
services to New Phoenix.
In 2001 and 2002 Robert M. Fedoris (Mr. Fedoris) was Roskos
& Co.’s president, and Andrew King (Mr. King) was an employee.
Mr. Fedoris prepared New Phoenix’s consolidated Form 1120, U.S.
Corporation Income Tax Return, as well as Form 1065, U.S. Return
of Partnership Income, for Olentangy Partners, discussed below.
6. Jenkins & Gilchrist
During 2001 and 2002 Jenkens & Gilchrist, P.C. (Jenkens &
Gilchrist), was a law firm based in Dallas, Texas, with offices
in Chicago, Houston, Austin, San Antonio, Los Angeles, and
Washington, D.C.
7. Sale of Capital
In November 2000 negotiations commenced regarding the sale
of substantially all of Capital’s assets to Pitt Plastics, Inc.,
an unrelated third party (the asset sale). At the time, Capital
was the only operating company within the New Phoenix
consolidated group of corporations.
- 6 -
On April 24, 2001, the shareholders of New Phoenix approved
the sale of substantially all of Capital’s assets to Pitt
Plastics, Inc. On April 30, 2001, the asset sale was
consummated. Capital sold substantially all of its assets to
Pitt Plastics, Inc., for $15,292,767. Mr. Litt represented New
Phoenix in connection with the asset sale and also advised New
Phoenix regarding the tax consequences of the asset sale and the
contemplated liquidation of the New Phoenix group.
After the asset sale Mr. Wray became Capital’s president,
treasurer, and sole director. Capital realized a gain of
$10,338,071 from the asset sale. After the asset sale Capital’s
only real asset consisted of approximately $11 million in cash.
In July 2001 New Phoenix estimated that its gain from the asset
sale was approximately $10.3 million.
8. Mr. Wray Meets Attorneys of Jenkens & Gilchrist
In the fall of 2001 Mr. Litt introduced Mr. Wray to Paul
Daugerdas (Mr. Daugerdas) and John Beery (Mr. Beery) of Jenkens &
Gilchrist. Messrs. Daugerdas and Beery were promoting a tax
strategy called “Basis Leveraged Investment Swap Spread” (the
BLISS transaction or the transaction at issue). A one-page
executive summary of the BLISS transaction provided the following
steps:
1. Taxpayer, through a single-member limited liability
company treated as a disregarded entity for tax purposes,
enters into two swaps (notional principal contracts) paying
an upfront payment (yield adjustment fee) to acquire one
- 7 -
swap, and receiving an upfront payment with respect to the
other. Such transaction is a nontaxable event,
notwithstanding the receipt of cash proceeds as an upfront
payment, however such amount (and the amount paid for the
other swap) must be amortized into income and expense over
the life of the swap. A business and/or investment reason
for this investment strategy must exist (e.g., the position
should hedge an investment, or currency prices will increase
or decrease, etc.).
2. Taxpayer and another partner or his wholly owned S
Corporation (“S Corp.”) form a partnership or limited
liability company designed to be taxed as a partnership
(referred to herein as “Partnership”), in which Taxpayer is
99% partner, and S Corp. (or other party) is a 1% partner.
3. Taxpayer contributes the purchased swap entered
into to the Partnership, together with the short swap. This
contribution should result in Taxpayer’s tax basis in his
partnership or membership interest being equal to the cost
of the swap contributed. The short swap is, more likely
than not, not treated as a liability for tax purposes,
achieving this result.
4. Throughout the duration of the swap, the
Partnership makes or receives payments pursuant to the swap
terms and conditions, and recognizes economic gain or loss
on the transaction. At maturity, the swap terminates.
5. Partnership purchases foreign currency or
marketable securities for investment. Alternatively, the
Partnership may receive a capital asset as a contribution
from its partners.
6. Taxpayer (and, other partner) contributes his
stepped-up Partnership interest to S. Corp. This results in
the Partnership only having one partner, and therefore it
liquidates. This results in a step-up in the basis of the
assets formerly held by Partnership to the stepped-up
outside basis of the S. Corp. partner.
7. S Corp. sells the stepped-up assets, generating an
ordinary or capital loss, as the case may be.
On November 15, 2001, Mr. Daugerdas sent Mr. Litt a blank
information questionnaire pertaining to Mr. Wray and Capital.
- 8 -
Mr. Litt completed the questionnaire and returned it to Mr.
Daugerdas the following day. Jenkens & Gilchrist prepared
documents and correspondence used to implement the BLISS
transaction.
9. Olentangy Partners
On or before November 19, 2001, Mr. Wray authorized Jenkens
& Gilchrist to form Olentangy Partners. Olentangy Partners was
organized as a general partnership on November 19, 2001, pursuant
to the laws of the State of Ohio. The partnership agreement was
signed by Mr. Wray, both in his individual capacity and as
president of Capital. The partnership agreement identifies
Capital as having a 99-percent interest and Mr. Wray as having a
1-percent interest in Olentangy Partners. Jenkens & Gilchrist
prepared all documents related to the formation of Olentangy
Partners and filed all documents for Olentangy Partners with the
appropriate government agencies. Olentangy Partners did not
contemplate or engage in any activities other than the BLISS
transaction.
10. Deutsche Bank AG
Deutsche Bank AG (Deutsche Bank) is an international bank
headquartered in Germany with a branch office in London, England.
The London branch does business as Deutsche Bank AG London
Branch. Deutsche Banc Alex. Brown (DBA Brown) is a licensed
broker-dealer engaged in the securities brokerage business in the
- 9 -
United States. DBA Brown is a division of Deutsche Bank
Subsidiaries, Inc., and Deutsche Bank Alex. Brown, L.L.C., which
are indirect subsidiaries of Deutsche Bank.
11. Options in General
An option is a contract that gives the buyer the right, but
not the obligation, to buy or sell an asset at a predetermined
price (the strike price). In exchange for selling an option, the
seller receives from the purchaser a premium which reflects the
value of the option. The risk to a purchaser of an option is
limited to the premium. The risk to the seller of an option can
be unlimited; it is the difference between the strike price and
the market price of the asset at expiration less the premium. A
European option is one that can be exercised only on its
expiration date. A digital option is one in which the payout is
a fixed amount agreed to by the buyer and the seller at the time
of the option’s inception.
An option to purchase property such as foreign currency is
“in the money” if at expiration the strike price is at or below
the price at which the referenced currency is trading in the
foreign currency market (the spot rate). An option to purchase
such property is “out of the money” if at expiration the strike
price is above the spot rate.
A European digital option on foreign currency typically
expires at 10 a.m. New York time on the termination date
- 10 -
referenced in the option contract. The buyer of a European
digital option on foreign currency typically pays an upfront
premium in exchange for a predetermined payout if the option is
in the money. This premium is typically expressed as a
percentage of the payout and delineates the odds that the option
will be in the money at the time of expiration.
An option spread trade involves the simultaneous purchase
and sale of linked options. The purchase of one option is either
partially or completely financed by the sale of another option at
a different strike price. An option spread trade limits the gain
the purchaser can realize on the options because the option sold
puts a ceiling on the total profit. Similarly, the seller of the
option spread has limited its potential loss to the amount of the
spread purchaser’s potential gain.
12. The Digital Option Spread
On or about November 30, 2001, Mr. Wray simultaneously
opened two separate brokerage accounts with DBA Brown–-one on
behalf of Olentangy Partners (the Olentangy Partners account) and
the other on behalf of Capital (the Capital account).
Capital purchased a digital option spread on the U.S.
dollar/Japanese yen (USD/JPY) exchange rate from DBA Brown. On
December 12, 2001, DBA Brown sent Mr. Berry letter agreements
between Capital and Deutsche Bank AG London Branch for use in the
- 11 -
transaction. The letter agreements included incorrect notional
amounts.
On December 14, 2001, DBA Brown issued corrected letter
agreements identifying each as a “Digital Swap Transaction” and
describing purported transactions entered into between Deutsche
Bank AG London Branch and Capital. The letter agreements, Letter
Agreement 533865-1/ODET 59299 (the long contract) and Letter
Agreement 533866-1/ODET 59299 (the short contract), were dated
December 14, 2001, identified the trade date as December 7, 2001,
and had a corrected notional amount of $105 million.
Deutsche Bank gave Mr. Wray a choice of one of three
currencies to use for the digital option spread: The Japanese
yen, the British pound, or the euro. Mr. Wray chose the Japanese
yen. The long contract required Capital to pay: (1) A premium
of $10,631,250 on December 11, 2001, and (2) two other fixed
payments of $63 million each, the first on December 14, 2001, and
the second on December 20, 2001. In exchange the long contract
called for Deutsche Bank AG London Branch to make the following
contingent payments: (1) $73,631,250 on December 14, 2001, but
only if the spot rate on the USD/JPY exchange rate at 10 a.m. on
December 12, 2001, as determined by the calculation agent, was
greater than or equal to ¥ 127.75; and (2) $73,631,250 on
December 20, 2001, but only if the spot rate at 10 a.m. on
- 12 -
December 18, 2001, as determined by the calculation agent, was
greater than or equal to ¥ 128.75.
The short contract called for Deutsche Bank AG London branch
to pay: (1) A premium of $10,368,750 on December 11, 2001, and
(2) two other fixed payments of $63,065,625 each, one on December
14, 2001, and the other on December 20, 2001. In exchange, the
short contract called for Capital to make the following
contingent payments: (1) $73,500,000 on December 14, 2001, but
only if the spot rate at 10 a.m. on December 12, 2001, as
determined by the calculation agent, was greater than or equal to
¥ 127.77; and (2) $73,500,000 on December 20, 2001, but only if
the spot rate at 10 a.m. on December 18, 2001, as determined by
the calculation agent, was greater than or equal to ¥ 128.77.
Capital and Deutsche Bank did not pay the full amounts of
their respective premiums under the digital option spread.
Instead, Capital paid the net difference of $262,500 (the
$10,631,250 premium on the long contract minus the $10,368,750
premium on the short contract) on December 21, 2001.2
The short contract’s strike prices (¥ 127.77 and ¥ 128.77)
exceeded the long contract’s strike prices (¥ 127.75 and ¥
128.75) by only 2 pips. A pip is one ten-thousandth of a quoted
price in foreign exchange. In USD/JPY terms, a pip is worth
2
After Capital paid Deutsche Bank $262,500, Deutsche Bank
returned $131,250, leaving Capital at risk for the remaining
$131,250.
- 13 -
$0.0008. Both contracts listed Deutsche Bank as the calculation
agent. As discussed more fully below, Deutsche Bank’s role as
calculation agent limited the profit potential of the
transaction.
On December 17, 2001, Jenkens & Gilchrist forwarded to Mr.
Wray the remaining documents necessary to implement the BLISS
transaction. The package consisted of: (1) Letter agreements
memorializing the digital option spread; (2) an agreement
assigning the digital option spread to Olentangy Partners; (3) an
agreement liquidating Olentangy Partners; and (4) correspondence
authorizing DBA Brown to transfer the digital option spread to
Olentangy Partners, to purchase and sell securities, and to make
certain deposits to and withdrawals from the Capital and
Olentangy Partners accounts. Many of the documents were not
dated, and Jenkens & Gilchrist advised Mr. Wray not to date the
documents.
On December 18, 2001, the digital option spread expired
worthless. On December 20, 2001, Mr. Wray signed and returned
the above-referenced documents to Jenkens & Gilchrist. Mr. Wray
also sent copies to Mr. Litt. That same day Jenkens & Gilchrist
forwarded to DBA Brown the assignment agreement and the letter
signed by Mr. Wray authorizing the assignment of the digital
option spread to Olentangy Partners. The assignment agreement
and the letter were both dated December 7, 2001. They were among
- 14 -
the documents that Mr. Wray signed on December 20, 2001, but was
told not to date.
Pursuant to the assignment agreement and Mr. Wray’s letter,
DBA Brown transferred the digital option spread from the Capital
account to the Olentangy Partners account. In contributing the
digital option spread to Olentangy Partners, Capital stepped up
its outside basis in Olentangy Partners by the amount of the long
position’s premium but did not reduce its outside basis by the
amount of the transferred short position’s premium. On December
24, 2001, DBA Brown transferred the amount of $393,740 from the
Capital account to the Olentangy Partners account as a capital
contribution. Also on that same day, Olentangy Partners
purchased 8,110 shares of Cisco Systems, Inc. stock for $149,958
(the Cisco stock).
Pursuant to the liquidation agreement signed by Mr. Wray,
Olentangy Partners was liquidated effective December 26, 2001,
and as of that date DBA Brown liquidated the Olentangy Partners
account and transferred the Cisco stock and $304,839 from that
account to the Capital account.
On December 28, 2001, Capital sold the 8,110 shares of the
Cisco stock for $148,467, realizing an economic loss of $1,491
from the sale.
- 15 -
13. The IRS Response to Alleged Abusive Tax Shelters
On February 28, 2000, the Department of the Treasury
(Treasury Department) issued temporary regulations requiring
corporate taxpayers to disclose listed and other reportable
transactions. Sec. 301.6111-2T, Temporary Income Tax Regs., 65
Fed. Reg. 11218 (Mar. 2, 2000). Notice 2000-44, 2000-2 C.B. 255,
was issued on August 11, 2000, and published in the Internal
Revenue Bulletin on September 5, 2000. Notice 2000-44, 2000-36
I.R.B. 255. The notice warned taxpayers of transactions calling
for the simultaneous purchase and sale of offsetting options
which were then transferred to a partnership. The notice
determined that the purported losses from such offsetting option
transactions did not represent bona fide losses reflecting actual
economic consequences and that the purported losses were not
allowable for Federal tax purposes. See Jade Trading, LLC v.
United States, 80 Fed. Cl. 11 (2007).
14. Reporting of the Transaction
On February 20, 2002, Mr. Hunter calculated Capital’s gain
from the asset sale. Of the total, he attributed $1,115,967 to
ordinary gain and $9,222,104 to capital gain.
On April 18, 2002, Mr. Litt emailed Mr. Daugerdas to inform
him that he felt incapable of advising New Phoenix’s accountants
regarding the proper reporting of the BLISS transaction. Mr.
Litt anticipated questions from Roskos & Co. concerning whether
- 16 -
the BLISS transaction had to be reported as a listed transaction
or as a confidential corporate tax shelter.
On May 29, 2002, Mr. Litt emailed Mr. Wray, attaching a copy
of a news article about the Treasury Department’s action
regarding abusive tax shelters. In the email Mr. Litt suggests
that in view of the news article and possible Treasury Department
action, it was important to prepare and file the New Phoenix tax
returns as soon as possible.
The Treasury Department amended its temporary regulations
regarding disclosure requirements, effective June 14, 2002, to
include noncorporate taxpayers who directly or indirectly entered
into listed transactions on or after January 1, 2000. 67 Fed.
Reg. 41324-01 (June 18, 2002).
On June 25, 2002, Mr. Litt and Mr. Daugerdas spoke, and they
discussed the June 14, 2002, Treasury Department amendments as
well as the section 6662 accuracy-related penalty. Mr. Daugerdas
indicated that the June 14, 2002, amendments applied to the BLISS
transaction and that not disclosing it was an aggressive position
to take.
On June 26, 2002, Jenkens & Gilchrist issued a written tax
opinion to Capital concerning treatment of the BLISS transaction.
The opinion concluded that Capital would more likely than not
prevail if the Internal Revenue Service (IRS) challenged
Capital’s Federal income tax reporting of the BLISS transactions.
- 17 -
Mr. Wray instructed New Phoenix’s advisers and return preparers
to prepare New Phoenix’s Federal income tax returns in accordance
with the Jenkens & Gilchrist opinion letter.
On July 1, 2002, Mr. Litt discussed the June 14, 2002,
amendments with Mr. Wray and informed him that not disclosing the
BLISS transaction was an aggressive position requiring approval
of New Phoenix’s tax return preparer.
On July 8, 2002, Mr. Wray sent Mr. Litt an email indicating
his intention of taking as aggressive a position as possible in
filing the return. On July 11, 2002, Mr. Daugerdas and Mr. Litt
discussed the possibility that the BLISS transaction was
substantially similar to those transactions discussed in Notice
2000-44, supra; the section 6662 accuracy-related penalty; and
the potential of being audited if New Phoenix disclosed the BLISS
transaction.
On July 26, 2002, Roskos & Co. sent draft copies of Federal
tax returns for 2001 for Capital and New Phoenix to Mr. Daugerdas
and Mr. Hunter. A letter enclosed with the drafts indicated that
Mr. Wray wanted to file the returns as soon as possible in view
of the new regulations. A second set of draft returns was sent
on August 29, 2002. The second set included two different
versions of Capital’s Schedules M-1, Reconciliation of Income
(Loss) per Books With Income per Return, and Schedules M-2,
Analysis of Unappropriated Retained Earnings per Books, and
- 18 -
attached statements. The difference between the two versions was
in how the BLISS transaction was reported. The first version
included a Schedule M-1 adjustment on line 8, Deductions on this
return not charged against book income this year, of $10,588,013,
to show the book to tax difference of the sale of the Cisco
stock. The second version did not include any adjustment
regarding the sale of the Cisco stock.
On September 19, 2002, New Phoenix filed a consolidated Form
1120 for the taxable year ending December 31, 2001. The Form
1120 was signed on behalf of New Phoenix by Mr. Wray as president
and Mr. Fedoris as paid tax return preparer. The return reported
a Federal income tax liability of $261,977. New Phoenix reported
a net capital gain of $9,222,104 and an ordinary gain of
$1,115,967 from the asset sale. On Schedule D, Capital Gains and
Losses, New Phoenix reported a $10,504,462 loss on the sale of
the Cisco stock by Capital. To arrive at this amount New Phoenix
reported a sale price of $148,474 and an adjusted basis in the
Cisco stock of $10,652,936. New Phoenix derived this adjusted
basis from Capital’s stepped-up basis in Olentangy Partners less
cash distributions. New Phoenix also reported $129,897 as
Capital’s distributive share of loss from Olentangy Partners and
claimed a deduction of $500,000 for payments to Jenkens &
Gilchrist.
- 19 -
The New Phoenix consolidated return Schedule M-1 did not
include an adjustment to account for the difference between book
and tax treatment of the sale of the Cisco stock. The attached
statement showing Schedule M-1 adjustments for New Phoenix
subsidiaries also did not contain a Schedule M-1 adjustment for
Capital to account for the difference in treatment.
On or about November 6, 2002, Olentangy Partners filed an
information return reporting a loss of $131,250 from the digital
option spread’s expiring worthless. Of this loss, Olentangy
Partners reported Capital’s distributive share as $129,938 and
Mr. Wray’s distributive share as $1,312. On Capital’s Schedule
K-1, Partner’s Share of Income, Credits, Deductions, etc.,
Olentangy Partners reported capital contributions of $11,018,428
and distributions of $10,888,531. On Mr. Wray’s Schedule K-1,
Olentangy Partners reported capital contributions of $6,562 and
distributions of $5,250. On or about October 22, 2002, Mr. Wray
filed his Federal income tax return for tax year 2001. In
reporting the BLISS transaction for Federal income tax purposes,
New Phoenix and its officers and advisers relied solely on the
advice of Jenkens & Gilchrist.
On September 14, 2005, respondent issued a timely notice of
deficiency (the notice) to petitioner.3 The notice determined a
3
The unified audit and litigation procedures of the Tax
Equity and Fiscal Responsibility Act of 1982 (TEFRA), Pub. L. 97-
(continued...)
- 20 -
deficiency in income tax of $3,355,906 and imposed a penalty of
$1,298,284 pursuant to section 6662. Attached to the notice was
an explanation of items which provided various grounds for the
disallowance of the claimed $10,504,462 loss on the sale of the
Cisco stock and for the imposition of the section 6662 penalty.
On December 8, 2005, a petition was filed on behalf of New
Phoenix. A trial was held on January 22 and 23, 2008, during the
Court’s Atlanta, Georgia, session. Petitioner produced three
fact witnesses and one expert witness. Respondent produced two
expert witnesses. Pursuant to section 7482(b)(2), the parties
stipulated that the decision in this case will be appealable to
the Court of Appeals for the Sixth Circuit.
OPINION
I. Introduction
Respondent makes arguments in support of the notice of
deficiency including that the digital option spread is a sham
lacking economic substance; that Olentangy Partners was a sham
and should be ignored for Federal income tax purposes; and,
should we find economic substance in the digital option spread
3
(...continued)
248, sec. 401, 96 Stat. 648, do not apply to Olentangy Partners.
Olentangy Partners qualifies as a small partnership under sec.
6231(a)(1)(B)(i) and did not elect pursuant to sec.
6231(a)(1)(B)(ii) to have TEFRA apply. See Wadsworth v.
Commissioner, T.C. Memo. 2007-46 (“The small partnership
exception permits this Court to review in a deficiency suit items
that otherwise would be subject to partnership-level
proceedings.”).
- 21 -
and respect Olentangy Partners as a partnership, that petitioner
treated the digital option spread incorrectly on its return.
Separately, respondent argues that because the transaction
lacks economic substance, New Phoenix is not entitled to deduct
the $500,000 paid to Jenkens & Gilchrist.
Lastly, respondent argues that should we uphold his
determinations, New Phoenix is liable for an accuracy-related
penalty based upon the resulting underpayment. The notice
determined a variety of section 6662 penalties. Respondent
argues that a section 6662(h) 40-percent gross valuation penalty
applies because New Phoenix made a gross valuation misstatement
by overstating its basis in the Cisco stock. Should we find that
New Phoenix did not make a gross valuation misstatement,
respondent argues that a 20-percent penalty should be imposed
because New Phoenix made a substantial understatement of income
tax on its return and acted negligently by disregarding Notice
2000-44, supra. Anticipating petitioner’s claimed reasonable
cause and good faith defense, respondent argues that New Phoenix
was not reasonable in relying on the Jenkens & Gilchrist opinion
letter because it was issued by a promoter of the transaction.
II. Burden of Proof
In general, the burden of proof with regard to factual
matters rests with the taxpayer. Under section 7491(a), if the
taxpayer produces credible evidence with respect to any factual
- 22 -
issue relevant to ascertaining the taxpayer’s liability and meets
other requirements, the burden of proof shifts from the taxpayer
to the Commissioner as to that factual issue. Because we decide
this case on the basis of the preponderance of the evidence, we
need not decide upon which party the burden rests.
III. Sham Transaction Doctrine
As stated above, the parties have stipulated that an appeal
in this case would lie in the Court of Appeals for the Sixth
Circuit. Pursuant to Golsen v. Commissioner, 54 T.C. 742 (1970),
affd. 445 F.2d 985 (10th Cir. 1971), we follow the law of that
Court of Appeals as it applies to this case.
“The legal right of a taxpayer to decrease the amount of
what otherwise would be his taxes, or altogether avoid them, by
means which the law permits, cannot be doubted.” Gregory v.
Helvering, 293 U.S. 465, 469 (1935). However, even if a
transaction is in formal compliance with Code provisions, a
deduction will be disallowed if the transaction is an economic
sham. Am. Elec. Power Co. v. United States, 326 F.3d 737, 741
(6th Cir. 2003).
The Court of Appeals for the Sixth Circuit has stated that
“‘The proper standard in determining if a transaction is a sham
is whether the transaction has any practicable economic effects
other than the creation of income tax losses.’” Dow Chem. Co. v.
United States, 435 F.3d 594, 599 (6th Cir. 2006) (quoting Rose v.
- 23 -
Commissioner, 868 F.2d 851, 853 (6th Cir. 1989), affg. 88 T.C.
386 (1987)). “If the transaction has economic substance, ‘the
question becomes whether the taxpayer was motivated by profit to
participate in the transaction.’” Id. (quoting Illes v.
Commissioner, 982 F.2d 163, 165 (6th Cir. 1992), affg. T.C. Memo.
1991-449). “‘If, however, the court determines that the
transaction is a sham, the entire transaction is disallowed for
federal tax purposes’,” id., and no subjective inquiry into the
taxpayer’s motivation is made, id. A court “will not inquire
into whether a transaction’s primary objective was for the
production of income or to make a profit, until it determines
that the transaction is bona fide and not a sham.” Rose v.
Commissioner, supra at 853.
Accordingly, we must first determine whether the BLISS
transaction had any practical economic effect. Dow Chem. Co. v.
United States, supra at 599. The presence or lack of economic
substance for Federal tax purposes is determined by a fact-
specific inquiry on a case-by-case basis. Frank Lyon Co. v.
United States, 435 U.S. 561, 584 (1978). If we find that the
BLISS transaction did in fact have a practical economic effect,
we will then look to Mr. Wray’s and New Phoenix’s motives in
entering into the transaction at issue.
- 24 -
IV. Economic Effect
A. Respondent’s Arguments
Respondent argues that the transaction lacked economic
substance and should therefore be disregarded. Respondent
premises this argument on two factors: (1) That the digital
option spread had no practical economic effect, and (2) that the
transaction served no business purpose and was developed as a tax
avoidance mechanism and not an investment strategy.
1. Practical Economic Effect
Respondent argues that a prudent investor would not have
engaged in the digital option spread because there was no
reasonable possibility, after taking into account transaction
costs, of making a profit. Respondent contends that Capital paid
Deutsche Bank a net amount of $131,250 in exchange for four
possible outcomes:
(1) If the contracts were “out of the money” on both
expiration dates, Capital would lose its $131,250 net
investment;
(2) If the contracts were “in the money” on only one
expiration date, Capital would break even;
(3) If the contracts were “in the money” on both expiration
dates, Capital would earn a maximum net profit of $131,250;
(4) If the long contract was “in the money” and the short
contract was “out of the money” on one or both of the two
expiration dates, Capital could earn either $73 million or
$147 million, referred to as hitting the “sweet spot.”
Although it appears that respondent is conceding economic
substance on the basis of the third and fourth possible outcomes,
- 25 -
respondent argues that any profits in scenario 3 were dwarfed by
the transactions fees, while hitting the “sweet spot” was not
possible.
Concerning the third possible outcome, respondent argues
that although a profit potential existed if both contracts
expired in the money, it would not be a true economic profit
because the fees Capital paid to enter into the transaction,
including fees paid to Deutsche Bank and the $500,000 paid to
Jenkens & Gilchrist, would exceed any amount Capital earned.
Regarding the fourth possible outcome, respondent relies on
expert testimony concerning two factors that in his view prevent
Capital from ever hitting the “sweet spot”. Respondent produced
two expert witnesses--Steven Pomerantz (Dr. Pomerantz) and Thomas
P. Murphy (Mr. Murphy). Dr. Pomerantz holds a Ph.D. in
mathematics from the University of California at Berkeley and has
taught classes in statistics, probability, operations research,
and finance at both the undergraduate and graduate level. Dr.
Pomerantz has also worked in the investment community for more
than 20 years, holding positions in research and management for
fixed income, equities, derivatives, and alternative investments
at several major firms.
Mr. Murphy received a B.A. in psychology and economics from
the University of Pennsylvania and an M.B.A. in finance and
accounting from Columbia Business School. Mr. Murphy has worked
- 26 -
in the foreign exchange markets for about 25 years, as a market
maker providing quotes to customers, a buy-side user seeking
quotes from market makers, and as a manager of both.
The crux of respondent’s argument is that although there was
a very small theoretical possibility of hitting the “sweet spot”,
the structure of the transaction and industry practice lowered
that theoretical possibility to zero.
Dr. Pomerantz testified about the probabilities of the
following outcomes: (1) There was a 95.8-percent chance that
neither option would pay, and Capital would lose its $131,250
investment; (2) there was a 3.4-percent chance that one option
would pay, and Capital would break even; (3) there was a 0.6-
percent chance that both options would pay, earning Capital a
$131,250 profit; and (4) there was a 0.2-percent chance that
Capital would hit at least one “sweet spot”, earning at least $73
million. Dr. Pomerantz further testified that taking into
account the costs associated with entering into the BLISS
transaction, Capital would lose money in the first three
scenarios.
Mr. Murphy also testified about Capital’s chances of hitting
either “sweet spot”. Mr. Murphy testified that the probability
of the long option’s hitting the “sweet spot” was 0.182 percent,
and the probability of the short option’s hitting the “sweet
spot” was 0.115 percent. Mr. Murphy also testified that during
- 27 -
his currency trading career he had never entered into a spread
trade where the strike prices were so narrow.
Respondent argues further that even if we find the small
percentage chance of hitting the “sweet spot” to be sufficient to
satisfy the first prong of Dow Chemical, the digital option
spread, and accordingly the BLISS transaction, ultimately lacked
economic substance because Deutsche Bank could in effect prevent
hitting the “sweet spot” either by virtue of its being the
calculation agent or by taking advantage of its large trading
position to move the market and the strike price itself.
Mr. Murphy testified that pursuant to industry practice
hitting the “sweet spot” was impossible. Mr. Murphy’s conclusion
centered on Deutsche Bank’s role as calculation agent, which made
this result impossible. Mr. Murphy’s expert report defined the
calculation agent as the entity, normally the seller of the
digital option structure, that determined whether the payout
event occurred at expiration on the termination date. Mr. Murphy
explained that to make this determination in 2001, the
calculation agent would contact four other banks for a spot
price. The other banks would then provide a range within which
they would be willing to buy and sell the particular currency
pair. Mr. Murphy testified that in 2001 industry practice was
such that the counterparty banks contacted always gave a spread
that was at least 3 pips wide. Mr. Murphy further explained that
- 28 -
the calculation agent would then choose any rate within the range
provided by the four banks.
In Mr. Murphy’s view, hitting the “sweet spot” was
impossible because Deutsche Bank was the calculation agent for
the digital option spread and, facing the prospects of making a
large payout to Capital if the “sweet spot” was hit, could simply
choose a rate from those provided by the four other banks that
was most beneficial to Deutsche Bank. Respondent, relying on Mr.
Murphy’s testimony, argues that hitting the “sweet spot” was
impossible because the option spreads were 2 pips wide and the
market spread was 3 pips wide in accordance with industry
practice. Respondent contends that Deutsche Bank would never use
the “sweet spot” as the calculation rate, thereby allowing itself
to avoid making the large payments required.
Mr. Murphy provided the following example in his report:
Example: On the day of expiration at 10:00 AM, the spot FX
market is trading around the strike prices of the USD/JPY
option. CPD is long USD/JPY Digital Call with a strike
price at 127.75 and short a USD/JPY Digital Call with a
strike price at 127.77. DB calls 4 banks for prices in
USD/JPY and receives the following quotes:
i. Bank A: USD/JPY 127.75 - 127.78
ii. Bank B: USD/JPY 127.74 - 127.77
iii. Bank C: USD/JPY 127.73 - 127.76
iv. Bank D: USD/JPY 127.72 - 127.75
DB has complete discretion as to where the 10:00 AM rate
should be. DB can determine that all the options are out of
the money by setting the rate at 127.72, 127.73 or 127.74
and no payout is made. Alternatively, and less likely, DB
could set the calculation rate at 127.77 or 127.78 and thus
both options would have paid out for a small profit to CPB.
- 29 -
The sweet spot would have occurred only if the fixing were
either 127.75 or 127.76 and DB would have complete
discretion not to set it at those rates. * * * This shows
that there was no way the sweet spot was going to be paid
out.
In addition to the above arguments, respondent argues that
Deutsche Bank, on account of its ability to make large-volume
trades, would be able to manipulate the market in such a way as
to make sure that the “sweet spot” was unattainable.
2. Lack of Business Purpose
In addition to the digital option spread’s alleged inherent
lack of profitability, respondent argues that the BLISS
transaction served no business purpose because it was developed
as a tax avoidance mechanism and not as an investment strategy.
Respondent contends that the true purpose behind Capital’s
entering into the BLISS transaction was to reduce the
consolidated tax liability of the New Phoenix group of
corporations. Respondent points to memorandums produced by Mr.
Wray and sent to New Phoenix shareholders, documents related to
the promotion and implementation of the transaction, and Deutsche
Bank’s control over the terms of the contracts.
Respondent points to memorandums prepared by Mr. Wray and
sent to New Phoenix shareholders on July 31 and December 20,
2001, to support respondent’s contention that the transaction was
entered into for tax avoidance purposes. The July 31, 2001,
memorandum states in part that New Phoenix planned to take steps
- 30 -
to “reduce the potential tax burden by approximately $2 million”.
The December 20, 2001, memorandum states in part:
[New Phoenix] has determined, subject to receipt of written
confirmation of such opinion of tax counsel, to take an
aggressive tax position which will permit a significantly
greater proceeds amount * * * from the sale of CPB to be
distributed to the shareholders.
Respondent also points to Deutsche Bank’s control over the
terms of the digital option spread contracts, including setting
the possible currencies, the strike prices, the expiration dates,
and the premiums. Respondent argues that Deutsche Bank’s
limiting of Capital’s potential profit and its own risk shows the
fictional character of the BLISS transaction.
Lastly respondent argues that the assignment of the options
to Olentangy Partners is evidence of the tax avoidance nature of
the transaction because there was no reason to contribute the
options other than to claim tax benefits.
B. Petitioner’s Arguments
1. Economic Effect
Petitioner argues that the digital option spread and the
BLISS transaction did in fact have economic effect. Petitioner
argues that similar trades were done for purely economic reasons
outside of the potential tax benefits present in the instant
case.
Petitioner points to testimony by its expert witness, Scott
Hakala, Ph.D. (Dr. Hakala), in support of its argument. Dr.
- 31 -
Hakala earned a Ph.D. in economics, focusing on monetary and
financial theory and international finance from the University of
Minnesota in 1989. From 1982 to 1992 Dr. Hakala taught courses
in international finance at both the undergraduate and master’s
level at Southern Methodist University. For the past 15 years
Dr. Hakala has served as a consultant on international finance.
Dr. Hakala concluded that (1) the commercial terms of the digital
option spread were priced consistently with market conditions and
prices, and (2) the digital option spread provided a prospect of
economic gain for Capital. Dr. Hakala’s conclusions were based
on extensive study of market conditions, trends, and pricing of
the USD/JPY exchange rate for the year before the trade date.
Dr. Hakala testified that this data supported Mr. Wray’s belief
that the U.S. dollar would increase in value relative to the
Japanese yen.
Petitioner disputes respondent’s contention that Deutsche
Bank had total control over the outcome of the digital option
spread and would never allow Capital to profit because Deutsche
Bank could manipulate the spot rate or manipulate the market to
affect the spot rate.
Disputing respondent’s expert testimony concerning industry
practices in 2001, petitioner contends that the spot rate was
determined by the Federal Reserve Board and could not be altered
by Deutsche Bank as respondent argues. Petitioner contends that
- 32 -
the confirmation documents and all included terms are governed by
the International Swaps and Derivatives Association, Inc. (ISDA),
and assorted ISDA documents and policies.
Petitioner further contends that Deutsche Bank had neither
the motivation nor the ability to manipulate the market.
Petitioner argues that Deutsche Bank simply served as a broker-
dealer in this transaction and, acting in accordance with
standard broker-dealer practice, would enter into an offsetting
transaction to the digital option spread. This offsetting
transaction, petitioner argues, would remove any risk to Deutsche
Bank and any conflict of interest that would cause Deutsche Bank
to selectively choose the market rate. Petitioner also points to
the size of the foreign exchange market as proof of Deutsche
Bank’s inability to manipulate the market by virtue of its large
trading position, arguing that Deutsche Bank would not attempt to
make large trades in order to move the market because that would
open Deutsche Bank to risk on other contracts with other parties.
2. Lack of Business Purpose
Petitioner disputes respondent’s contention that the digital
option spreads were assigned to Olentangy Partners simply to
produce tax benefits. Petitioner argues that the digital option
spread was transferred to Olentangy Partners in order to
compensate Mr. Wray. Mr. Wray testified that over the course of
his time with New Phoenix he was not compensated on a day-to-day
- 33 -
basis but instead would receive equity in New Phoenix according
to the type of work he did for the company. Mr. Wray further
testified that because he was not compensated on a day-to-day
basis, he would not be able to share any profits that New Phoenix
received on account of the BLISS transaction. Mr. Wray stated
that transferring the digital option spreads to Olentangy
Partners would allow him, as a partner in the partnership, to
receive a share of any profits in a way that his normal
compensation from New Phoenix would not.
C. Conclusion
We agree with respondent that the BLISS transaction lacks
economic substance and fails the first prong of Dow Chem. Co. v.
United States, 435 F.3d 594 (6th Cir. 2006).
1. Economic Loss
We note at the outset that neither Mr. Wray, New Phoenix,
nor Capital actually suffered a $10 million economic loss during
2001. The loss claimed as a result of the stepped-up basis in
the Cisco stock was purely fictional. Although Capital purchased
and sold the long option to Deutsche Bank for a premium, it paid
only the difference between the long and short options. See Jade
Trading, LLC v. United States, 80 Fed. Cl. at 45; Maguire
Partners-Master Invs., LLC v. United States, 103 AFTR 2d 763,
772, 2009-1 USTC par. 50,215, at 87,444 (C.D. Cal. 2009) (“First,
the claimed basis is fictional, because * * * [the taxpayers]
- 34 -
paid only $1.5 million and $675,000, * * * but gained an
increased basis of $101,500,000 and $45,675,000, respectively.”);
see also Kornman & Associates, Inc. v. United States, 527 F.3d
443, 456 (5th Cir. 2008) (“The Trust acknowledges that it only
suffered a $200,000 economic loss in connection with these
transactions, yet it claimed a $102.6 Million tax loss on its
return.”); Cemco Investors, L.L.C. v. United States, 515 F.3d
749, 750-751 (7th Cir. 2008); Klamath Strategic Inv. Fund, L.L.C.
v. United States, 472 F. Supp. 2d 885, 894 (E.D. Tex. 2007).
2. Deutsche Bank Controlled the Market Rate
Petitioner points to Mr. Wray’s testimony concerning his
background and research into currency markets before entering
into the BLISS transaction as evidence that a reasonable investor
would enter into this type of transaction. While we do not
discount and respondent does not disregard Mr. Wray’s education
and experience in the field of finance, documents prepared by
Jenkens & Gilchrist to promote the BLISS transaction cast doubt
on Mr. Wray’s proffered reasons for entering into the
transaction. The one-page executive summary discussed above
provided in part that “A business and/or investment reason for
this investment strategy must exist (e.g., the position should
hedge an investment, or currency prices will increase or
decrease, etc.).” Mr. Wray’s testimony that he decided to enter
into the transaction after researching currency markets served
- 35 -
only as an attempt to make an illegitimate transaction appear to
have a legitimate basis.
Respondent’s experts credibly testified that on the basis of
industry practice the BLISS transaction had no realistic
probability of earning a profit. As respondent argues, the
documents memorializing the digital option spread list Deutsche
Bank as the calculation agent. Although petitioner argues that
Deutsche Bank would not intentionally choose a market rate to
avoid making a payment, it is important to note that the
contracts specifically state that neither party owes a fiduciary
duty to the other. Because Deutsche Bank acted as calculation
agent, and because the strike price of the options was only 2
pips, Deutsche Bank would always be able to choose a market rate
outside that range. Capital never had a true opportunity to earn
a profit because Deutsche Bank would never let that happen. To
do so would be to voluntarily make itself liable for payments of
more than $70 million. See Stobie Creek Invs., LLC v. United
States, 82 Fed. Cl. 636, 693 (2008).
The digital option spread was a closed transaction and
Olentangy Partners soon disappeared. There could be no chance of
future profits, much less future profits “consistent with the
taxpayer’s actual past conduct.” Dow Chem. Co. v. United States,
supra at 602 n.14. A prudent investor would not have entered
into the BLISS transaction.
- 36 -
3. Contribution to Partnership
Respondent argues that Capital and Mr. Wray’s formation of
Olentangy Partners was necessary so that Capital could assign its
inflated interest in Olentangy Partners to another asset--the
Cisco stock. Respondent further contends that this was done for
one reason: to claim a noneconomic tax loss of more than $10
million when that stock was finally sold. Respondent concludes
by arguing that this lends support to his argument that the BLISS
transaction lacked economic substance.
Petitioner argues that the digital option spread was
contributed to Olentangy Partners in order to allow Mr. Wray to
participate in any profits that might be earned. Mr. Wray also
testified that the digital option spread was contributed in order
to allow him to take part in any profits earned by the
transaction.
We do not find Mr. Wray credible on this point. The
contribution of the options to Olentangy Partners was required in
order to claim the tax benefits of the BLISS transaction. Jade
Trading, LLC v. United States, supra at 46 (“Funneling the trades
through the partnership * * * was crucial for tax purposes to
have the individual partners contribute the spreads to Jade and
redeem the unexercised spreads from Jade in order to generate the
inflated bases.”); Maguire Partners-Master Invs., LLC v. United
States, supra at 772, 2009-1 USTC par. 50,215, at 87,444 (“there
- 37 -
is no evidence that the contribution to the partnerships, which
was part of the design of the prepackaged transactions, had any
effect ‘on the investment’s value, quality, or profitability.’
However, the contribution was required for the creation of an
increased basis.”); Stobie Creek Invs., LLC v. United States,
supra at 694 (“This series of routings through the various
investment vehicles * * * nevertheless, were an integral
requirement for achieving the basis-enhancing effects of the J &
G strategy, demonstrating the primary structure and function of
these FXDOT as tax-planning instruments over their nominal
structure and function as investments.”). By contributing the
digital option spread to Olentangy Partners, Capital was able to
increase its basis in the partnership by the value of the
purchased long option, while ignoring the sold short option under
Helmer v. Commissioner, T.C. Memo. 1975-160, and its progeny.4
The BLISS transaction executive summary discussed above
sheds light on the decision to contribute the digital option
spread to Olentangy Partners and lends support to respondent’s
argument that the transaction as a whole lacked economic
substance. Step 3 of the summary provided that
4
We do not decide whether Helmer v. Commissioner, T.C. Memo.
1975-160, requires or allows this treatment of the contributed
short option. Because we find the BLISS transaction lacked
economic substance, we do not consider respondent’s alternative
arguments in support of the notice.
- 38 -
Taxpayer contributes the purchased swap entered into to the
partnership, together with the short swap. This
contribution should result in taxpayer’s tax basis in his
partnership or membership interest being equal to the cost
of the swap contributed. The short sale swap is, more
likely than not, not treated as a liability for tax
purposes, achieving this result.
Absent the benefit of the claimed tax loss, there was
nothing but a cashflow that was negative for all relevant
periods--the “‘hallmark[] of an economic sham’” as the Court of
Appeals for the Sixth Circuit has held. Dow Chem. Co. v. United
States, 435 F.3d at 602 (quoting Am. Elec. Power Co. v. United
States, 326 F.3d 737, 742 (6th Cir. 2003). Such a deal lacks
economic substance. Id. Because we find that the transaction at
issue lacked economic substance, we do not consider Mr. Wray’s
and Capital’s profit motive in entering into the transaction.
Id. at 605; Illes v. Commissioner, 982 F.2d at 165; Rose v.
Commissioner, 868 F.2d at 853. Pursuant to the aforementioned
cases, the BLISS transaction must be ignored for Federal income
tax purposes. Accordingly, the overstated loss claimed as a
result of the sale of the CISCO stock is disregarded, as is the
flowthrough loss from Olentangy Partners.
Because we find that the BLISS transaction lacked economic
substance, we do not consider respondent’s alternative arguments
in support of the notice.
- 39 -
V. Fees
We next consider fees related to the BLISS transaction. On
its Federal income tax return New Phoenix claimed a deduction of
$500,000 for fees paid to Jenkens & Gilchrist to implement the
BLISS transaction and to provide the written tax opinion.
Petitioner alleges that respondent erred by disallowing the
claimed deduction.
Respondent argues that petitioner is not entitled to deduct
the legal fees because the transaction at issue lacked economic
substance. Respondent relies on Winn-Dixie Stores, Inc. & Subs.
v. Commissioner, 113 T.C. 254, 294 (1999), affd. 254 F.3d 1313(11th Cir. 2001), and Brown v. Commissioner, 85 T.C. 968, 1000
(1985), affd. sub nom. Sochin v. Commissioner, 843 F.2d 351 (9th
Cir. 1988). Respondent argues that petitioner cannot deduct the
fees because those expenses relate to a transaction that lacks
economic substance.
Petitioner contends that respondent’s reliance on Winn-Dixie
Stores, Inc. & Subs. and Brown is inappropriate. Petitioner
argues that the fees at issue in those cases were administrative
fees connected with a disregarded corporate-owned life insurance
plan. Petitioner, however, argues that the fees paid to Jenkens
& Gilchrist were not administrative fees and are deductible under
Saba Pship. v. Commissioner, T.C. Memo. 1999-359, vacated and
remanded 273 F.3d 1135 (D.C. Cir. 2001).
- 40 -
Petitioner’s reading of Saba Pship. is overly broad. The
Court in Saba Pship. did not impose a broad rule that all
nonadministrative fees paid in connection with a disregarded
transaction are allowed as deductions. In Saba Pship., we held
that where the taxpayer’s purchases of private placement notes
(PPNs) and certificates of deposit (CDs) were disregarded for
lack of economic substance, and because the taxpayer was not
required to include in income payments received pursuant to the
purchase and sale of those PPNs and CDs, the taxpayer was not
entitled to deduct fees related to those transactions. Id.Where the taxpayer was required to include in income payments
received from their participation in the purchases and sales, it
was allowed to deduct related fees.
Jenkens & Gilchrist was paid $500,000. However, the invoice
does not provide any detail concerning what the fees were for; it
simply states that the $500,000 was for legal services rendered.
Jenkens & Gilchrist was intimately involved in the development,
promotion, sale, and implementation of the BLISS transaction and
provided a tax opinion meant to shield the purchaser from
penalties should the transaction be challenged. A finding that
the BLISS transaction lacks economic substance does not trigger
an inclusion of the type of income to petitioner that justified
the deduction of related fees in Saba Pship. v. Commissioner,
supra. Capital paid Jenkens & Gilchrist to implement a
- 41 -
transaction that we have held lacks economic substance.
Accordingly, petitioner is not entitled to a $500,000 deduction
for legal fees paid to Jenkens & Gilchrist. See Winn-Dixie
Stores, Inc. & Subs. v. Commissioner, supra at 294; Brown v.
Commissioner, supra at 1000-1001.
VI. Penalties
Section 6662 imposes an accuracy-related penalty on certain
underpayments of tax, and the amount of the penalty is computed
as a percentage of the underpayment. The explanation of items
attached to the notice imposed alternative section 6662
penalties, including penalties for a gross valuation
misstatement, negligence, and a substantial understatement of
income tax. Section 1.6662-2(c), Income Tax Regs., provides that
only one accuracy-related penalty may be imposed with respect to
any given portion of an underpayment, even if that portion is
attributable to more than one of the types of conduct listed in
section 6662(b). See also Jaroff v. Commissioner, T.C. Memo.
2004-276.
We will take each penalty in turn and determine whether the
individual penalty applies to petitioner’s underpayment. Should
we determine that a penalty applies, we will then determine
whether petitioner satisfies the reasonable cause exception in
section 6664(c). Lastly, should we find that petitioner is
liable for a penalty on one or more grounds, and that petitioner
- 42 -
did not satisfy the reasonable cause exception, we will apply the
antistacking provisions to determine how each penalty applies to
the different portions of the underpayment.
A. Valuation Misstatement Penalty
Respondent argues that petitioner is liable for either a
substantial or gross valuation penalty pursuant to section
6662(b)(3) and (e) or (h). Section 6662(b)(3) imposes a 20-
percent penalty on that portion of an underpayment which results
from a substantial valuation misstatement. There is a
substantial valuation misstatement if the value of any property
claimed on the return is 200 percent or more of the amount
determined to be the correct amount. Sec. 6662(e)(1)(A).
Section 6662(h) increases the penalty to 40 percent in the case
of a gross valuation misstatement. There is a gross valuation
misstatement if the value is 400 percent or more of the value
determined to be the correct amount. Sec. 6662(h)(2)(A)(i).
Respondent argues that the gross valuation misstatement
penalty applies because petitioner reported an adjusted basis of
$10,652,936 in the Cisco stock when the stock had a true basis of
$148,474. Accordingly, respondent contends petitioner’s reported
basis is more than 400 percent of the correct amount and the
gross valuation misstatement penalty applies.
Petitioner argues that the gross valuation misstatement
penalty does not apply as a matter of law because should we
- 43 -
disallow the claimed loss, a basis adjustment would not be
required. Petitioner argues that should we disallow the loss on
the Cisco stock as a result of a finding that the BLISS
transaction lacked economic substance, the underpayment of tax
would stem from a lack of economic substance, not a valuation
misstatement. Petitioner points to Heasley v. Commissioner, 902
F.2d 380 (5th Cir. 1990), revg. T.C. Memo. 1988-408, Gainer v.
Commissioner, 893 F.2d 225 (9th Cir. 1990), affg. T.C. Memo.
1988-416, and Todd v. Commissioner, 89 T.C. 912 (1987), affd. 862
F.2d 540 (5th Cir. 1988), in support of this argument. In
Heasley, the Court of Appeals for the Fifth Circuit held that
Whenever the I.R.S. totally disallows a deduction or credit,
the I.R.S. may not penalize the taxpayer for a valuation
overstatement included in that deduction or credit. In such
a case, the underpayment is not attributable to a valuation
overstatement. Instead, it is attributable to claiming an
improper deduction or credit. * * * [Id. at 383.]
We begin by noting that Heasley is distinguishable. In
Heasley, the Court of Appeals reasoned that a valuation penalty
should not apply where a deduction is disallowed in full because
the amount of the taxpayer’s liability does not depend on a
misvaluation; the taxpayer’s liability is based upon the
disallowance of the entire deduction. Id. at 383 (“In this case,
the Heasleys’ actual tax liability does not differ one cent from
their tax liability with the valuation overstatement included.
In other words, the Heasleys’ valuation overstatement does not
change the amount of tax actually owed.”). Petitioner had some
- 44 -
basis in the Cisco stock apart from the basis claimed as a result
of entering into the BLISS transaction. Heasley does not apply
because by disallowing overvalued basis we are not disallowing
the entire deduction claimed as a result of the sale of the Cisco
stock.
Respondent also points to Illes v. Commissioner, 982 F.2d
163 (6th Cir. 1992), and argues that the Court of Appeals for the
Sixth Circuit does not follow the Heasley line of cases. In
Illes v. Commissioner, supra at 167, the court held that a
valuation misstatement penalty applies in situations in which an
underpayment stems from disallowed deductions or credits due to
lack of economic substance. In the instant proceeding, the
deficiency resulted directly from the incorrect basis in the
Cisco stock. New Phoenix reported a basis of $10,652,936 in the
Cisco stock. The correct basis was $149,958. The reported basis
is more than 400 percent of the correct basis, and the
underpayment results directly from this overstatement.
Accordingly, petitioner is liable for a 40-percent gross
valuation misstatement penalty. See id.; see also Pasternak v.
Commissioner, 990 F.2d 893, 903-904 (6th Cir. 1993), affg.
Donahue v. Commissioner, T.C. Memo. 1991-181; cf. Keller v.
Commissioner, 556 F.3d 1056 (9th Cir. 2009), affg. in part and
revg. in part T.C. Memo. 2006-131.
- 45 -
B. Substantial Understatement of Income Tax
Respondent argues that petitioner is liable for the 20-
percent accuracy-related penalty for a substantial understatement
of income tax pursuant to section 6662(d). The 20-percent
accuracy-related penalty will apply where the 40-percent gross
valuation penalty does not. For corporate taxpayers, there is a
substantial understatement of income tax if the understatement
exceeds the greater of 10 percent of the tax required to be shown
on the return or $10,000. Sec. 6662(d)(1); sec. 1.6662-4(b)(1),
Income Tax Regs. Section 6662(d)(2)(B)(i), however, provides
that the amount of an understatement is reduced for any item that
is supported by substantial authority. Section 1.6662-4(d)(2),
Income Tax Regs., provides that the substantial authority
standard
is an objective standard involving an analysis of the law
and application of the law to relevant facts. The
substantial authority standard is less stringent than the
more likely than not standard (the standard that is met when
there is a greater than 50-percent likelihood of the
position being upheld), but more stringent than the
reasonable basis standard as defined in § 1.6662-3(b)(3)
[Income Tax Regs.]. * * *
Section 6662(d)(2)(C)(i) provides that the reduction for
substantial authority does not apply to tax shelters. Section
6662(d)(2)(C)(ii) defines the term “tax shelter” as “a
partnership or other entity, * * * any investment plan or
arrangement, or * * * any other plan or arrangement, if a
- 46 -
significant purpose of such partnership, entity, plan, or
arrangement is the avoidance or evasion of Federal income tax.”
Respondent argues that New Phoenix was required to show a
tax of $3,617,883 on its return. Because New Phoenix reported a
tax of only $261,977, respondent contends New Phoenix understated
its tax liability by $3,355,906, which exceeds both $10,000 and
10 percent of the tax required to be shown on the return.
Petitioner argues that it did not substantially understate
its income tax because it had substantial authority for the
position taken on its tax return. Respondent argues that
petitioner should not be able to avail itself of the substantial
authority safe harbor because (1) New Phoenix did not have
substantial authority for its position, and (2) the transaction
was a tax shelter. Respondent argues that the BLISS transaction,
regardless of outcome, was guaranteed to provide Capital with a
$10 million tax loss and tax avoidance was a significant purpose
of the transaction.
We find that petitioner lacked substantial authority for the
position taken on its return. Although petitioner claims to have
relied on caselaw in taking the position that the sold short
option was contingent and not required to be taken into account
when calculating Capital’s basis in Olentangy Partners,
petitioner’s advisers were aware of Government efforts to combat
abusive tax shelters that called that conclusion into question.
- 47 -
Before New Phoenix filed its tax returns, Mr. Wray, Mr. Litt, and
Mr. Daugerdas all knew that the Government was investigating
transactions substantially similar to the transaction at issue.
Mr. Litt voiced his concerns to Mr. Wray and spoke with Mr.
Daugerdas on numerous occasions, specifically about section 6662
penalties and how similar the BLISS transaction was to those
transactions described in Notice 2000-44, supra, and subsequent
IRS releases. These releases cast doubt on any claimed reliance
on Helmer v. Commissioner, T.C. Memo. 1975-160, and its progeny,
and petitioner cannot claim to have had substantial authority for
its return position. See Jade Trading, LLC v. United States, 80
Fed. Cl. at 58 (“At bottom, the fictional nature of the
transaction and its lack of economic reality outweigh Helmer in
the substantial authority assessment.”); cf. Klamath Strategic
Inv. Fund, L.L.C. v. United States, 440 F. Supp. 2d 608 (E.D.
Tex. 2006).
Accordingly, petitioner substantially understated its income
tax liability and is liable for a 20-percent accuracy-related
penalty.
C. Negligence and Disregard of Rules
Lastly respondent argues that petitioner is liable for a 20-
percent accuracy-related penalty for negligence and disregard of
rules or regulations. Section 6662(c) provides that “the term
‘negligence’ includes any failure to make a reasonable attempt to
- 48 -
comply with the provisions of this title, and the term
‘disregard’ includes any careless, reckless, or intentional
disregard.” Section 1.6662-3(b)(1)(ii), Income Tax Regs.,
provides that 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.”
Respondent argues that the tax benefits from the BLISS
transaction were too good to be true, that petitioner was
negligent, and that petitioner disregarded rules and regulations
in its reporting of the transaction at issue. Respondent points
to Mr. Wray’s lack of investigation and argues that Mr. Wray
failed to apply his financial background to the digital option
spread. Respondent contends that Mr. Wray had the financial
acumen to correctly evaluate the profit potential of the digital
option spread and to properly value it. Respondent further
contends that the disparity between the out-of-pocket costs of
the BLISS transaction and the expected tax benefits would have
alerted a reasonable and prudent person that the benefits were
too good to be true. Respondent disputes Mr. Wray’s testimony
concerning his research and argues that any research Mr. Wray
eventually did was only meant to serve as a pretext and was done
after deciding to enter into the BLISS transaction.
- 49 -
Lastly respondent argues that petitioner acted negligently
because at the time it reported the BLISS transaction, New
Phoenix and its advisers were aware of the IRS investigation and
position concerning transactions similar to the one at issue, yet
relied on Jenkens & Gilchirst and improperly reported the BLISS
transaction.
Petitioner argues that it was not negligent because at the
time it entered into the transaction caselaw supported the
position taken on its return. Petitioner again points to Helmer
v. Commissioner, supra, and other cases holding that assumption
of a contingent liability by a partnership does not reduce a
partner’s basis in that partnership.
We agree with respondent. At the time petitioner reported
the BLISS transaction on its return, New Phoenix and its advisers
knew that reliance on Helmer was misplaced. New Phoenix filed
its return well after the IRS issued Notice 2000-44, supra, was
aware of recent developments in this area of tax law, and did not
seek independent advice to guarantee proper reporting of the
BLISS transaction. See Neonatology Associates, P.A. v.
Commissioner, 299 F.3d 221, 234 (3d Cir. 2002) (“As highly
educated professionals, the individual taxpayers should have
recognized that it was not likely that by complex manipulation
they could obtain large deductions for their corporations and tax
free income for themselves.”), affg. 115 T.C. 43 (2000).
- 50 -
Accordingly, the negligence penalty applies. See Pasternak v.
Commissioner, 990 F.2d at 903; Stobie Creek Invs., LLC v. United
States, 82 Fed. Cl. at 721; Jade Trading, LLC v. United States,
82 Fed. Cl. at 57; Maguire Partners-Master Invs., LLC v. United
States, 103 AFTR 2d at 778, 2009-1 USTC par. 50,215, at 87,450.
D. Reasonable Cause and Good Faith
Separate from its arguments that it had substantial
authority for its position and did not act negligently,
petitioner argues that it acted with reasonable cause and in good
faith in its reporting of the BLISS transaction because
petitioner obtained a “written tax opinion from a nationally
recognized and well respected law firm”. Section 6664(c)(1)
provides that “No penalty shall be imposed under section 6662 * *
* with respect to any portion of an underpayment if it is shown
that there was a reasonable cause for such portion and that the
taxpayer acted in good faith with respect to such portion.” If
petitioner is able to show reasonable cause for the position
taken on its return, the penalties discussed above will not
apply. The decision as to whether the taxpayer acted with
reasonable cause and good faith depends upon all the facts and
circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. Relevant
factors include the taxpayer’s efforts to assess his proper tax
liability, including the taxpayer’s reasonable and good faith
- 51 -
reliance on the advice of a professional such as an accountant or
attorney.
Petitioner draws support for its reasonable cause and good
faith argument from United States v. Boyle, 469 U.S. 241, 251
(1985), in which the Supreme Court stated that “When an
accountant or attorney advises a taxpayer on a matter of tax law,
such as whether a liability exists, it is reasonable for the
taxpayer to rely on that advice.”
Respondent concedes that under Boyle taxpayers need not
second-guess their independent, professional advisers, but argues
that Jenkens & Gilchrist was not independent, but rather was a
promoter of the BLISS transaction. Accordingly, respondent
argues, it was not reasonable for petitioner to rely on an
opinion written by Jenkens & Gilchrist. Respondent points to
Pasternak v. Commissioner, supra, in support of his position. In
Pasternak, the Court of Appeals for the Sixth Circuit rejected a
taxpayer’s argument that negligence penalties under section 6653
should not be imposed because the taxpayer relied “on the advice
of ‘financial advisors, industry experts, and professionals’”.
Id. at 903. The court stated that “the purported experts were
either the promoters themselves or agents of the promoters.
Advice of such persons can hardly be described as that of
‘independent professionals.’” Id. In Mortensen v. Commissioner,
440 F.3d 375, 387 (6th Cir. 2006), affg. T.C. Memo. 2004-279, the
- 52 -
court further stated that “In order for reliance on professional
tax advice to be reasonable * * * the advice must generally be
from a competent and independent advisor unburdened with a
conflict of interest and not from promoters of the investment.”
We find petitioner’s reliance on Jenkens & Gilchrist and the
tax opinion to be unreasonable rather than reasonable. Jenkens &
Gilchrist actively participated in the development, structuring,
promotion, sale, and implementation of the BLISS transaction.
Petitioner was not reasonable in relying on the tax opinion in
the face of such a conflict of interest. See Neonatology
Associates, P.A. v. Commissioner, supra at 234; Pasternak v.
Commissioner, supra at 903; Illes v. Commissioner, 982 F.2d at
166; Maguire Partners-Master Invs., LLC v. United States, supra
at 778, 2009-1 USTC par. 50,215, at 87,450 (“Furthermore, the
partnerships have failed to demonstrate that they * * * sought
and received disinterested and objective tax advice because the
tax advice that they did receive came from Arthur Andersen, which
also arranged the transactions resulting in the increased basis
that is at issue in this case.”); Stobie Creek Invs., LLC v.
United States, supra at 715 (“The evidence nonetheless
unequivocally establishes that both J & G and SLK were tainted by
conflict-of-interest.”).
As discussed above, Mr. Litt had concerns about the
reporting of the BLISS transaction. Mr. Litt informed Mr. Wray
- 53 -
of these concerns and had numerous discussions with Mr. Daugerdas
centered on the applicability of section 6662 penalties and
recent IRS developments. Mr. Litt also sent Mr. Wray copies of
tax publication articles detailing the Treasury Department and
the IRS’ actions concerning alleged abusive tax shelters. See
Maguire Partners-Master Invs., LLC v. United States, supra at
778, 2009-1 USTC par. 50,215, at 87,450.
These documents show that at the time New Phoenix and its
advisers were considering the proper reporting of the
transaction, Mr. Litt and Mr. Wray were aware that the Government
was investigating transactions similar to the transaction at
issue. These concerns should have put New Phoenix on notice that
the reporting of the BLISS transaction as recommended by Jenkens
& Gilchrist was unacceptable. Petitioner should have also known
that Jenkens & Gilchrist had a personal stake in the BLISS
transaction and could not be relied upon to provide independent
advice. That petitioner’s independent advisers had significant
questions about the BLISS transaction should have caused Mr. Wray
to question Jenkens & Gilchrist’s assurances that the transaction
was reported properly. These factors should have put petitioner
on notice that reliance on Jenkens & Gilchrist was unreasonable
and that petitioner would have to consult with independent
counsel in order to determine the propriety of New Phoenix’s
reporting. See Pasternak v. Commissioner, 990 F.2d at 903; Illes
- 54 -
v. Commissioner, supra at 166; see also Watson v. Commissioner,
T.C. Memo. 2008-276; Ghose v. Commissioner, T.C. Memo. 2008-80.
It was unreasonable for petitioner and Mr. Wray to rely on
Jenkens & Gilchrist in view of the surrounding facts.
In summary, Jenkens & Gilchrist’s conflict of interest and
petitioner’s knowledge of recent developments in tax law should
have convinced petitioner of the need for further investigation
into the proper reporting of the BLISS transaction. Petitioner
claimed a fictional loss of nearly $11 million. This is exactly
the type of “too good to be true” transaction that should cause
taxpayers to seek out competent advice from independent advisers.
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.”); Stobie Creek
Invs., LLC v. United States, supra at 716 (relying on Neonatology
Associates, P.A., holding that the Jenkens & Gilchrist strategy
is the type that should appear to be too good to be true).
Petitioner’s decision to rely exclusively on Jenkens & Gilchrist
in reporting the BLISS transaction was therefore not reasonable.
Petitioner did not have reasonable cause for its position and did
not take that position in good faith. Accordingly, petitioner
remains liable for the section 6662 penalties.
- 55 -
E. Conclusion
Only one accuracy-related penalty may be applied with
respect to any given portion of an underpayment, even if that
portion is characterized by more than one of the types of conduct
described in section 6662(b). Sec. 1.6662-2(c), Income Tax Regs.
As discussed above, petitioner is liable for an accuracy-related
penalty because of a gross valuation misstatement, a substantial
understatement of income tax, and negligence. Section 1.6662-
2(c), Income Tax Regs., prevents the Commissioner from stacking
these amounts to impose a penalty greater than the maximum
penalty of 20 percent on any given portion of an underpayment (or
40 percent if such portion is attributable to a gross valuation
misstatement). See Jaroff v. Commissioner, T.C. Memo. 2004-276.
Accordingly, petitioner is liable for the 40-percent
accuracy-related penalty on that portion of the underpayment
stemming from its overvaluation of the Cisco stock, and a 20-
percent accuracy-related penalty on the remainder of the
underpayment stemming from the disallowed flowthrough loss from
Olentangy Partners and from the disallowed deduction for payments
made to Jenkens & Gilchrist.
- 56 -
VII. Conclusion
Respondent’s determinations in the notice are upheld, and
petitioner is liable for the section 6662 accuracy-related
penalty.
Accordingly,
Decision will be entered
for respondent.