Federal Imposition of Accuracy-Related Penalties on Son of BOSS Tax Shelters in Stobie Creek Investments
On June 11, 2010, the Federal Circuit Court affirmed the application of the judicial economic substance doctrine (as compared with newly enacted section 7701(o) version of the economic substance doctrine) to a Son of BOSS tax shelter that was marketed as the Jenkins & Gilchrist law firm strategy and affirmed the imposition of accuracy related penalties in Stobie Creek Investments LLC v. U.S., Fed. Cir., No. 2008-5190 (6/11/2010).
The Son of BOSS (Bond and Option Sales Strategy) shelter attempted to take advantage that assets and contingent liabilities were treated differently for tax purposes when contributed to a partnership, thus facilitating, it was thought or planned, to permit the investor to benefit from an artificial tax loss to offset substantial realized gains of the same taxpayer. The "artificial loss" was the tax product so to speak used to offset the large gains. The government has been highly successful in defeating the Son of BOSS strategy in various lawsuits and as part of an overall national policy for inviting taxpayer concessions.
The facts involved members of a family that had a highly successful family owned business that they were in the process of selling (assets) and realizing a substantial capital gain. They approached a lawyer with Jenkins & Gilchrist in January 200. The goal of the J & G strategy was to reduce the capital gain resulting from the sale of assets.
The strategy reduced a taxpayer's capital gain by increasing, or "stepping up," the basis in the asset the taxpayer wanted to sell. Because a partnership does not pay taxes, the resulting stepped-up basis passes through to the partners, thereby reducing the partner's capital gain and attendant capital gains tax when the asset is sold. To create a stepped-up basis in the assets, the J & G strategy required the contribution of assets to a partnership followed by the distribution of the partnership's assets to the taxpayers. The goal of realized a large capital loss was to be achieved through a six step process: (i) investment in foreign currency options through a single-member LLC; (ii) formation of a partnership with a third party or wholly-owned S corporation; (iii) contribution of the foreign currency options to the partnership; (iv) recognition of an economic gain or loss by the partnership when the options expired or were exercised; (v) termination and liquidation of the partnership through contribution of the taxpayer's partnership interest to an S corporation; and the (vi) sale of the partnership's assets by the S corporation or taxpayer.
Among the various steps, step 3 is important for the success of the tax strategy. The idea was to make a substantial investment in foreign currency option spreads, whereby the LLC sells a short option and purchases a long option in the same currency. As contributed (i.e., the options) to the tax partnership, i.e., Stobie Creek, the partners basis in his partnership interest is increased by the cost (or adjusted basis) of the purchase made in the long option, but not decreased by the short option obligation. Under the J & G strategy, the short option's contribution has no effect on the taxpayer's basis because it is not treated as a "liability" section 752 when calculating the taxpayer's basis in his partnership interest. When the partnership is liquidated during step 5, the tax basis in the partnership's assets is "stepped up" to 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 family involved agreed to embark on the J&G strategy, including a fee to J&G of 2% of the gain to be sheltered or approximately $4.1M. Another promoter’s fee was $2M yielding total fees of in excess of $6M. The Welles family decided to pursue the J & G strategy. To obtain help implementing the strategy,
Then, with the formation of the LLC and execution of the plan, J & G stated it 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.
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 closely held 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 closely held stock and assessed over $4.2 million in additional taxes. The FPAAs also imposed accuracy-related penalties per § 6662.
Stobie Creek and the other plaintiffs filed this action in the Court of Federal Claims in July 2005. 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.
In this case, Stobie Creek Investments LLC, JFW Enterprises Inc., and JFW Investments LLC used the Son of BOSS strategy to inflate the basis of their stock in a family business, thereby eliminating over $200 million in capital gains realized from the sale of that stock. Upon audit, the IRS disallowed the losses in their entirety charging that the Stobie Creek Investments LLC strategy was a sham. Based on this determination, the IRS disallowed the partnership's stated basis in the stock, increased the partnership's capital gain from the sale of the stock, and assessed additional taxes.
In March, 2005 a notice of final partnership administrative adjustmentFPAA Issued a Notice of Final Partnership Administrative Adjustment (FPAA) for Stobie Creek's 2000 tax year was issued in March 2005. A second FPAA for the 2000 stub year was issued in February 2007.
The FPAAs disregarded Stobie Creek as a sham and disallowed the partnership's stated basis in the stock, finding it attributable to transactions entered into for the purpose of tax avoidance. The Service increased the entity’s capital gain from the sale of stock and assessed over $4.2M in additional taxes as well as accuracy related penalties per section 6662.
Tax Refund Suit Filed by Taxpayers in the Court of Federal Claims
The plaintiffs filed an action in the Court of Federal Claims in July 2005, seeking a refund of the increased taxes and penalties. The trial court found that the plaintiffs failed to show the underlying foreign exchange digital options transactions, which were the economic investments that would facilitate and leverage the amount of the loss realized to the U.S. transferors, had no business purpose beyond creating a tax advantage. It further lacked economic substance. The trial court also found that Stobie Creek was liable for the accuracy-related penalties.
[As an aside, under the entity level audit procedures, the IRS must mail an FPAA to the designated "tax matters partner", all notice partners, and representatives of notice groups. The primary mailing of the FPAA, which is used for notice of deficiency purposes, is the mailing to the TMP. The mailing to the other partners must occur within 60 days after the mailing to the TMP. An FPAA is equivalent to a notice of deficiency (90-day letter) in regular audits. A deficiency attributable to a partnership item cannot be assessed until the notice of an FPAA has been mailed and 150 days have elapsed after the mailing. Where a Tax Court petition is filed within 150 days after the FPAA notice, no deficiency attributable to a partnership item may be assessed until the Tax Court's decision on the matter becomes final.]
At the trial, the court found that Stobie Creek's basis calculations complied with the literal requirements of the tax code. It declined, therefore, to retroactively apply Treas. Reg. §1.752-6. The trial court nonetheless disregarded the transactions implementing the J & G strategy under the economic substance, step transaction, and end result doctrines. 4 Had the trial court applied Treas. Reg. § 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 § 752, reducing the LLCs’ basis in their partnership interests. The government did not appeal the trial court’s determination not to apply Treas. Reg. §1.752-6 retroactively. It simply ruled against the taxpayers under the economic substance doctrine.
The trial court further held that the accuracy penalty was appropriate and that reasonable cause was not present through the argued reliance on the opinion of the J&G law firm. See §6664(c)(1). Reliance on the law firm’s opinion was not reasonable due to their clear conflict of interest.
On appeal to the Federal Circuit, the Court examined the economic substance doctrine as applied by the trial court. The court of appeals noted that the purpose of this rule is to separate a transaction that should be respected as legitimate and a transaction principally designed to generate a tax benefit, which is a sham. In this case, the appellants argued that the foreign exchange digital options should not be treated as shams or lacking in economic substance since there were bona fide business transactions, designed to generate an economic profit from investing in foreign currencies. See section 988.
Such argument was rejected at the trial court and by the Federal Circuit based on the facts related to the investments and through the introduction of expert testimony.
The economic substance doctrine distinguishes between 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 illegitimate. A transaction could meet the literal terms of the Code but still lack "economic reality". See, e.g., Frank Lyon Co. v. U.S., 435 U.S. 561, 583-84 (1978). Such transactions include those that have no business purpose beyond reducing or avoiding taxes, regardless of whether the taxpayer's subjective motivation was tax avoidance. Transactions shaped solely by tax-avoidance are also disregarded. Under an "objective" test, the Federal Circuit stated that 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 Industries Inc v. U.S., 454 F3d 1340 (Fed. Cir. 2006), vacg & remg 62 Fed. Cl. 716 (Ct. Fed. Cl. 2004). The objective test of economic substance requires that the transaction be evaluated based on information available to a prudent investor at the time the taxpayer entered into the transaction, not what may (or may not) have happened later. If this test is failed, then the transaction fails as well, as to its designed tax benefits, regardless of the taxpayer’s subjective motivation was (or was not) tax avoidance.
The Appeals Court, after evaluating the transcript of the proceedings below, reached the same conclusion as the trial court that the transactions did not reflect economic reality and were not motivated by a business purpose. The Court stated that the trial court properly treated the options as part of a separate, unified transaction, that were part of determining the taxpayer’s basis in Stobie Creek LLC. The options were also found to have lacked economic substance since there was not reasonable possibility that the options would return a profit. There also was no bona fide business purpose other than to generate tax benefits. This was evidenced, in part, by the fee structure. All the fees were computed by the amount of the gain to be shelter by the tax strategy.
Reasonable Cause Defense to Accuracy Related Penalties Rejected
As to the partnership level assertion of reasonable cause, to avoid the accuracy related penalty on partnership level determinations (i.e., for stepping up the basis in the closely held stock), the Court reviewed and affirmed the lower court’s determination that the penalties were to be imposed. See §6664(c). Temp. Treas. Reg. § 301.6221-1T(d). The taxpayers claimed that the TMP, Jeffrey Welles, had reasonable cause, reliance on advice from the promoter and J&G law firm, on the merits of its reporting position. Section 6664(c)(1) provides a narrow defense to § 6662 penalties if the taxpayer proves it had (1) reasonable cause for the underpayment and (2) acted in good faith. See also Treas. Reg. § 1.6664-4(c)(1). The taxpayer bears the burden of showing this exception applies. The most important of these factors contained in the regulations 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).
Reliance is not reasonable, however, where, as was the case here, the adviser has an inherent conflict of interest about which the taxpayer knew or should have known. Treas. Reg. § 1.6664-4(c). This was a finding made by the trial court and the Appeals Court affirmed.Circuit Court of Appeals Affirms
Evaluation on Appeal of the Economic Substance Doctrine
Taxpayers Appeal to the Federal Circuit After Losing on Economic Substance; Penalties Imposed
