Free Response to Cross Motion [Dispositive] - District Court of Federal Claims - federal

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 1 of 55

IN THE UNITED STATES COURT OF FEDERAL CLAIMS No. 06-407 T (into which have been consolidated Nos. 06-408 T, 06-409 T, 06-410 T, 06-411 T, 06-810 T, 06-811 T) Judge Emily C. Hewitt (E-Filed: August 14, 2007) ALPHA I, L.P., BY AND THROUGH ROBERT SANDS, A NOTICE PARTNER ) ) ) Plaintiff, ) ) v. ) ) THE UNITED STATES, ) ) Defendant. ) __________________________________________) BETA PARTNERS, L.L.C., BY AND THROUGH ) ROBERT SANDS, A NOTICE PARTNER ) ) Plaintiff, ) ) v. ) ) THE UNITED STATES, ) ) Defendant. ) __________________________________________) ) R, R, M & C PARTNERS, L.L.C., BY AND ) THROUGH R, R, M & C GROUP, L.P., A ) NOTICE PARTNER, ) ) Plaintiff, ) ) v. ) ) THE UNITED STATES, ) ) Defendant. ) __________________________________________)

06-407 T

06-408 T

06-409 T

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 2 of 55

) R, R, M & C GROUP, L.P., BY AND THROUGH ) ROBERT SANDS, A NOTICE PARTNER ) ) Plaintiff, ) ) v. ) ) THE UNITED STATES, ) ) Defendant. ) __________________________________________) ) CWC PARTNERSHIP I, BY AND THROUGH ) TRUST FBO ZACHARY STERN U/A FIFTH G. ) ANDREW STERN AND MARILYN SANDS, ) TRUSTEES, A NOTICE PARTNER, ) ) Plaintiff, ) ) v. ) ) THE UNITED STATES, ) ) Defendant. ) __________________________________________) ) MICKEY MANAGEMENT, L.P., BY AND ) THROUGH MARILYN SANDS, A NOTICE ) PARTNER, ) ) Plaintiff, ) ) v. ) ) THE UNITED STATES, ) ) Defendant. ) __________________________________________)

06-410 T

06-411 T

06-810 T

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 3 of 55

) M, L, R & R, BY AND THROUGH RICHARD E. ) SANDS, TAX MATTERS PARTNER, ) ) Plaintiff, ) ) v. ) ) THE UNITED STATES, ) ) Defendant. ) __________________________________________)

06-811 T

UNITED STATES' RESPONSE TO PLAINTIFF' CROSS-MOTION FOR SUMMARY JUDGMENT AND TO PLAINTIFFS' REPLY TO UNITED STATES' MOTION FOR SUMMARY JUDGMENT

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 4 of 55

TABLE OF CONTENTS INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 ISSUES PRESENTED . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 ARGUMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 I. UNDER SECTION 752, THE SHORT SALE OBLIGATIONS MUST BE INCLUDED IN PARTNERSHIP LIABILITIES . . . . . . . . . . . . . . . . . . . . . . . . . 4 A. An obligation to close a short sale is a fixed liability because one who borrows securities in a short sale has a legal obligation to replace the borrowed property with equivalent property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 The IRS's consistent position is that when, as here, an obligation creates or increases the basis of any of the obligor's assets, that obligation is a "liability" under I.R.C. § 752 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Revenue Rulings 88-77 and 95-26, which contain the IRS's interpretation of the term "liability," are entitled to Chevron deference . . . . . . . . . . . . . . . . . . . . 11 The authorities on which appellants rely are inapposite . . . . . . . . . . . . 15 Even if Revenue Ruling 95-26 reflects a change in the IRS's interpretation of § 752, the validity of the ruling would be unaffected . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

B.

C.

D. E.

II.

IN THE ALTERNATIVE, TREAS. REG. § 1.752-6 REQUIRES THE SANDS HEIRS TO REDUCE THEIR BASES IN ALPHA AND ALPHA TO REDUCE ITS BASIS IN BETA BY THE AMOUNT OF THE OBLIGATION TO CLOSE THE SHORT SALE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 A. B. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Treas. Reg. § 1.752-6 is a legislative regulation and has the force and effect of law . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Treas. Reg. § 1.752-6 must be given the retroactive effect for which Congress explicitly provided . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

C.

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 5 of 55

III.

PLAINTIFFS ARE LIABLE FOR THE ACCURACY RELATED PENALTIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 A. 20% Substantial Understatement of Tax Penalty ­ The plaintiffs did not have substantial authority for the positions taken on their returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 20% Negligence Penalty - The Plaintiffs did not have a reasonable basis for the positions taken on their returns . . . . . . . . . . . . . . . . . . . . . . . . . 27 Substantial/Gross Valuation Misstatement Penalty . . . . . . . . . . . . . . . . 29 Plaintiffs' reasonable cause arguments must be rejected . . . . . . . . . . . . 30 1. 2. TEFRA jurisdiction ­ generally . . . . . . . . . . . . . . . . . . . . . . . . . . 30 The Court does not have jurisdiction in this TEFRA proceeding to determine whether the Sands Heirs may be excused from penalties under I.R.C. § 6664(c). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Even if this Court has jurisdiction to review the "reasonable cause" defense, fact issues preclude the Court from granting summary judgment at this time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 Even if this Court has jurisdiction to review the "reasonable cause" defense, the plaintiffs did not have reasonable cause for taking the positions on their returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

B.

C. D.

3.

4.

CONCLUSION. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 6 of 55

TABLE OF AUTHORITIES FEDERAL CASES ACM Partnerhip v. Commissioner, 157 F.3d 231 (3d Cir. 1998) . . . . . . . . . . . . . . . . . . 6 Alexander v. United States, 44 F.3d 328 (5th Cir. 1995) . . . . . . . . . . . . . . . . . . . . . . . . 30 Ammex, Inc. v. United States, 367 F.3d 530 (6th Cir. 2004), cert. denied, 544 U.S. 948 (2005) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Anderson, Clayton & Co. v. United States, 562 F.2d 972 (5th Cir. 1977) . . . . . . . . . . 24 Atlantic Mutual Insurance Co. v. Commissioner, 523 U.S. 382 (1998) . . . . . . . . . . . . 11 Bissell v. Merrill Lynch & Co., 937 F. Supp. 237 (S.D.N.Y. 1996), aff'd, 157 F.3d 138 (2d Cir. 1998) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 COLM Producer, Inc. v. United States, 460 F. Supp. 2d 713 (N.D. Tex. 2006) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2, 4, 10, 40 Chevron USA, Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,12, 21, 22 Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed.Cir.2006) . . . . . . . . . . . 21 Deputy v. du Pont, 308 U.S. 488 (1940) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Fears v. Commissioner, 129 T.C. 2 (2007) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Foil v. Commissioner, 920 F.2d 1196(5th Cir. 1990) . . . . . . . . . . . . . . . . . . . . . . . 12, 13 Fransen v. United States, 191 F.3d 599 (5th Cir. 1999) . . . . . . . . . . . . . . . . . . . . . . . . 21 Harlan v Commissioner, 116 T.C. 31 (2001) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990) . . . . . . . . . . . . . . . . . . . . . . . . 38 Helmer v. Commissioner, 34 T.C.M. (CCH) 727 (1975) . . . . . . . . . . . . . . . . . . . . 10, 15, 16

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 7 of 55

Hendricks v. Commissioner, 423 F.2d 485 (4th Cir. 1970) . . . . . . . . . . . . . . . . . . . . . . . 7 Illes v. Commissioner, 982 F.2d 163 (6th Cir. 1992) . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 Kandi v. United States, 2006 WL 83463 (W.D. Wash. 2006), appeal docketed, No. 06-35209 (9th Cir. March 14, 2006) . . . . . . . . . . . . . . . . . . . . . . . . . 25 Klamath Strategic Investment Fund, LLC v. United States, 440 F. Supp. 2d 608 (E.D. Tex. 2006) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22, 23, 25 La Rue v. Commissioner, 90 T.C. 465 (1988) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Long Island Care at Home, Ltd. v. Coke, 127 S. Ct. 2339 (2007) . . . . . . . . . . . . . . 17, 18 Long Term Capital Holdings v. U.S., 330 F. Supp. 2d 122 (D.Conn 2004) . . . . . . 29, 38 Long v. Commissioner, 71 T.C. 1 (1978), rev'd in part on other grounds, 660 F.2d 416 (10th Cir. 1981) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Marcello v. Commissioner, 380 F.2d 499 (5th Cir. 1967) . . . . . . . . . . . . . . . . . . . . . . . 27 Massengill v. Commissioner, 876 F.2d 616 (8th Cir) . . . . . . . . . . . . . . . . . . . . . . . . . . 38 Merino v. Commissioner, 196 F.3d 147 (3rd Cir. 1999) . . . . . . . . . . . . . . . . . . . . . . . . 38 Neely v. Commissioner, 85 T.C. 934 (1985) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 Neonatology Associates, P.A., v. Commissioner, 299 F.3d 221 (3d Cir. 2002) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 Nicole Rose Corp. v. Commissioner, 320 F.3d 282 (2nd Cir. 2002) . . . . . . . . . . . . . . . . 38 Omohundro v. United States, 300 F.3d 1065 (9th Cir. 2002) . . . . . . . . . . . . . . . . . . . . 12 Salina Partnership, LP v. Commissioner, 80 T.C.M. (CCH) 686 (2000) . . . . . . . . . . 2, 7, 10, 18, 26, 29, 40 Santa Monica Pictures, LLC v. Commissioner, 89 T.C.M. (CCH) 1157 (2005) . . . . . . 29 Schlumberger Technology Corp. v. United States, 55 Fed. Cl. 203 (2003) . . . . . . . . . 11

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 8 of 55

Siddell v. Commissioner, 225 F.3d 103 (1st Cir. 2000) . . . . . . . . . . . . . . . . . . . . . . . . . 16 Snap-Drape, Inc. v. Commissioner, 98 F.3d 194 (5th Cir. 1996) . . . . . . . . . . . . . . . . . 24 United States v. Mead Corp., 533 U.S. 218 (2001) . . . . . . . . . . . . . . . . . . . . . . . . . 11, 12 United States v. Ron Pair Enterprises, Inc., 489 U.S. 235 (1989) . . . . . . . . . . . . . . . . . 4 Weiner v. United States, 389 F.3d 152 (5th Cir. 2004) . . . . . . . . . . . . . . . . . . . . . . 30, 31 Zfass v. Commissioner, 118 F.3d 184 (4th Cir. 1997) . . . . . . . . . . . . . . . . . . . . . . . . . . 38 Zlotnick v. TIE Communications, 836 F.2d 818(3rd Cir. 1988) . . . . . . . . . . . . . . . . . . . 5

FEDERAL STATUTES

12 C.F.R. § 220.12(c)(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 29 U.S.C. § 213(a)(15) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Community Renewal Tax Relief Act of 2000, Pub. L. No. 106-554, 114 Stat. 2763A-587 §309 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Community Renewal Tax Relief Act of 2000, Pub. L. No. 106-554, 114 Stat. 2763A-587 §309(c) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20, 23 Community Renewal Tax Relief Act of 2000, Pub. L. No. 106-554, 114 Stat. 2763A-587 §309(c)(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Community Renewal Tax Relief Act of 2000, Pub. L. No. 106-554, 114 Stat. 2763A-587 §309(d)(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 H.R. Conf. Rep. No. 106-1033 at 1017 (2000), reprinted in 2000-3 C.B. 304, 347 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 H.R. Rep. No. 83-1337 at A236-237 (1954), reprinted in 1954 U.S.C.C.A.N. 4017, 4376-4377 (1954) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 I.R.C. § 357(c) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 I.R.C. § 357(c)(3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 9 of 55

I.R.C. § 358(d) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 I.R.C. § 358(h) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20, 21 22 I.R.C. § 358(h)(3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19, 21, 22 I.R.C. § 465 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

I.R.C. § 705 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 I.R.C. § 705(a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 I.R.C. § 705(a)(1)(A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 I.R.C. § 705(a)(1)(B) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 I.R.C. § 705(a)(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 I.R.C. § 705(a)(2)(B) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 I.R.C. § 721(a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19, 20 I.R.C. § 722 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,8 9 I.R.C. § 731 I.R.C. § 733 I.R.C. § 742 I.R.C. § 752 .......................................................... 8 .......................................................... 8 .......................................................... 7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 - 10, 12 - 16, 18, 20, 22, 27 - 29, 38, 40

I.R.C. §752(a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2, 8, 19, 20 I.R.C. §752(b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2, 8, 19, 20

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 10 of 55

I.R.C. § 1233

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,7, 8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29, 30, 31

I.R.C. § 6221

I.R.C. §6226 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 I.R.C. §6226(e) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 I.R.C. §6226(f) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 I.R.C. § 6230(c)(1)(4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 I.R.C. § 6231(a)(4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 I.R.C.§ 6662 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 I.R.C.§ 6662(a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 I.R.C.§ 6662(b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 I.R.C.§ 6662(c) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27, 29 I.R.C.§ 6662(b)(3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1, 25 I.R.C.§ 6662(d)(1)(A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 I.R.C.§ 6662(d)(2)(C)(i) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 I.R.C.§ 6662(d)(2)(C)(iii) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 I.R.C.§ 6662(h) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1, 25 I.R.C. § 6664(b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 I.R.C. § 6664(c) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30, 32 I.R.C. § 6664(c)(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 I.R.C. § 6664(c)(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 I.R.C. § 7805(a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 11 of 55

I.R.C. § 7805(b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,24, 25 I.R.C. § 7805(b)(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22, 24 I.R.C. § 7805(b)(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 I.R.C. § 7805(b)(3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22, 23 24 I.R.C. § 7805(b)(4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 I.R.C. § 7805(b)(5) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 I.R.C. § 7805(b)(6) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23, 25 I.R.C. § 7805(b)(7) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Notice 200-44 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26, 27 28, 29 33 Rev. Rul. 57-29, 1957-1 C.B. 519 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Rev. Rul. 73-301, 1973-2 C.B. 215 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15, 16 Rev. Rul. 79-294, 1979-2 C.B. 305 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Rev. Rul. 88-77, 1988-2 C.B. 128, 129 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8, 9, 11, 12, 16, 18 Rev. Rul. 95-26 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2, 9 10, 11, 12, 13, 14, 16, 17, 18, 26, 27, 28, 29 Rev. Rul. 95-45 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

Rev. Rul. 95-45, 1995-1 C.B. 53 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10, 14

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 12 of 55

S. Rep. No. 83-1622 at 405 (1954), reprinted in 1954 U.S.C.C.A.N. 4621, 5047 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Taxpayer Bill of Rights 2, Pub. L. No. 104-168, 110 Stat. 1452, I.R.C. . . . . . . . . . . . . 24 T.D. 9062, 2003-2 C.B. 46, 67 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20, 21 T.D. 9207, 2005-1 C.B. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9, 23 Treas. Directive 27-10, 55 Fed. Reg. 42532-02 (1990) . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Treas. Order 111-2, 1981-1 C.B. 698 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Treas. Reg. § 1.358-7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Treas. Reg. § 1.6662-2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 Treas. Reg. § 1.6662-2(c) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25, 27 Treas. Reg. § 1.6662-4(d)(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Treas. Reg. § 1.6662-4(d)(3)(ii) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Treas. Reg. § 1.701-2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Treas. Reg. § 1.752-1(a)(1)(ii) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Treas. Reg. § 1.752-1(a)(4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Treas. Reg. § 1.752-1(a)(4)(i)(A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Treas. Reg. § 1.752-1(a)(4)(ii) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9, 18 Treas. Reg. § 1.752-1(a)(4)(iv) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Treas. Reg. § 1.752-1T(g), 1989-1 C.B. 180, 192 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Treas. Reg. § 1.752-6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2, 3, 19, 20, 21, 22, 23, 25, Treas. Reg. § 1.752-6(d)(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 13 of 55

Treas. Reg. § 301.6221-1(d) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Treas. Reg. § 301.6221-1T . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Treas. Reg. §301.6231(a)(3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Treas. Reg. § 301.6231(a)(4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Treas. Reg. § 301.6226(f)-1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32, 33 Treas. Reg. § 301-7701-15(c)(1)(i) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 Treas. Reg. § 601.601(d)(2)(i)(a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Treas. Reg. § 601.601(d)(2)(v)(d) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

MISCELLANEOUS Black's Law Dictionary 925 (7th ed. 1999) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4, 10 James Christian, Robert Shapiro, and John-Paul Whalen, Naked Short Selling: How Exposed Are Investors, 43 Hous. L. Rev. 1033, 1041 (2006) . . . . . . . 5 Robert Bird & Alan Tucker, Tax Sham or Prudent Investment: Deconstructing the Government's Pyrrhic Victory in Salina Partnership v. Commissioner, 22 Va. Tax. Rev. 231, 253 (2002) . . . . . . . . . . . . . . . . . . . . . . . . . 10 Zachary Knapper, Future-Priced Convertible Securities and the Outlook for "Death Spiral" Securities Fraud Litigation, 26 Whittier L. Rev. 359, 371 & n.79 (2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 14 of 55

INTRODUCTION The United States has moved for summary judgment that, as a matter of law, the obligation to replace borrowed Treasury securities (short sales) is treated as a liability under I.R.C. §752. The United States further moved for summary judgment sustaining the 40% penalty imposed by §6662(b)(3) and (h) because plaintiffs' tax returns show a gross valuation misstatement. Plaintiffs have now cross-moved for summary judgment that the obligation to replace borrowed Treasury securities (short sales) is not a liability under §752. Plaintiffs also maintain that the accuracy related penalties do not apply or that they are excused because plaintiffs relied on tax opinions when they claimed the inflated basis on their tax returns. Plaintiffs are wrong on both counts and summary judgment should be granted sustaining the FPAAs in Cause Nos. 06-407T, 06-408T, 06-411T, 06-810T and 06-811T.1 Plaintiffs' cross-motion for summary judgment contends that the obligation to "to acquire replacement securities and deliver them to the lender" (P. MSJ, p.8) is not a liability for purposes of §752 because the cost to acquire the covering securities cannot be determined until the short positions are actually closed. (P.MSJ, p.19). The plaintiffs are wrong. The ordinary meaning of the term "liability," contained in § 752, encompasses the obligation to close a short sale because one who borrows securities in a short sale has an unconditional legal obligation to replace the borrowed property. This obligation is not

contingent in amount, as plaintiffs erroneously contend. An obligation to close a short sale is an

Cause No. 06-411T involves the participation of CWC Partnership I in two separate tax shelters. At this time, the United States only seeks summary judgment with respect to the tax shelter involving the December 11, 2001 short sales (para. 24 - 27 of the CWC Complaint). Accordingly, a summary judgment ruling that the obligation to replace borrowed Treasury Securities (short sales) is a liability under I.R.C. §752, and sustaining the accuracy related penalties will only partially dispose of the issues raised in that proceeding.

1

1

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 15 of 55

obligation to replace the borrowed property, not to return a sum of money. Thus, the borrower's obligation is fixed at the time the short sale occurs. That the cost of satisfying the obligation may fluctuate with the market does not make the obligation itself contingent. Therefore, the obligation to close a short sale is a "liability" under § 752(a) and (b). Salina Partnership, LP v. Commissioner, 80 T.C.M. (CCH) 686 (2000); COLM Producer, Inc. v. United States, 460 F.Supp. 2d 713, 716 (N.D. Tex. 2006)(appeal pending 5th Circuit, Case No. 06-11422); Rev. Rul. 95-26. In an effort to avoid the imposition of penalties, plaintiffs' brief strongly implies, if not states outright, that the Sands Heirs participated in the subject transactions for legitimate reasons by alluding to vaguely defined investment, estate planning and charitable purposes. The

evidence proves this was not the case at all. In transcripts of taped telephone and in-person conversations with representatives of The Heritage Organization, Richard and Robert Sands frankly admit that their sole motivation from the very beginning was to avoid not just some but ALL of the capital gains taxes that they would otherwise owe on anticipated dispositions of appreciated property. Most disturbing, they well knew that they were not entitled to the tax benefits claimed and took active steps to conceal the true nature of the transactions from the government. For purposes of summary judgment, the United States asserted that the only contested issues in the cases involving the Second Shelter is whether the partnerships' obligation to close the short sales are "liabilities" for purposes of § 752. The United States requested summary judgment solely on § 752 since resolution of the § 752 issue would be the simplest path to resolving these cases. Since the plaintiffs have moved for summary judgment as well, our

2

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 16 of 55

responsive brief now raises the application of Treas. Reg. § 1.752-6 as an alternative basis to deny the tax treatment of the transactions at issue in these cases. If this Court disagrees with the United States regarding the application of § 752 and Treas. Reg. § 1.752-6, unresolved factual and legal issues remain for which a trial would be needed, including, but not limited to: (1) whether the transactions involved should be disregarded because they lacked economic substance and served no business purpose; (2) whether the underlying transactions were a factual sham; (3) whether the partnerships should be disregarded because the parties did not intend to join together as partners to conduct business activity for a purpose other than tax avoidance; (4) whether the transactions should be recharacterized pursuant to the Anti-Abuse rule of Treas. Reg. §1.701-2; (5) whether there was a primary profit motive for entering into the short sale transactions; and (6) the partnership level determination of all factors having an impact on any § 465 partner-level at risk determinations derived from the partnership's books and records. ISSUES PRESENTED 1. Whether the short sale obligations assumed by the partnerships are "liabilities" for purposes of I.R.C. § 752? 2. Alternatively, whether Treas. Reg. § 1.752-6 requires the Sands Heirs to reduce their bases in their partnership interests in Alpha and Alpha to reduce its basis in its partnership interest in Beta by the amount of the obligation to close the short sale.

3

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 17 of 55

3.

If so, whether the accuracy-related penalties under section 6662 apply to the resulting underpayments of tax relating to the Second Shelter?2

4.

Whether the Court has jurisdiction to determine the Plaintiffs' reasonable cause penalty defense in this partnership proceeding, or whether this defense can only be determined in a partner level proceeding?

5.

If the Court can determine reasonable cause, whether fact issues preclude summary judgment on this issue at this time, or alternatively, whether the facts establish that the Plaintiffs are not entitled to be excused from the penalties under a "reasonable cause" exception. ARGUMENT

I.

UNDER SECTION 752, THE SHORT SALE OBLIGATIONS MUST BE INCLUDED IN PARTNERSHIP LIABILITIES. A. An obligation to close a short sale is a fixed liability because one who borrows securities in a short sale has a legal obligation to replace the borrowed property with equivalent property.

It is axiomatic that "[t]he task of resolving [a] dispute over the meaning of . . . [a statute] begins where all such inquiries must begin: with the language of the statute itself." United States v. Ron Pair Enterprises, Inc., 489 U.S. 235, 241 (1989). Section 752, however, does not define the term "liability."3 Thus, in COLM, 460 F.Supp. 2d at 715, the Court relied on the plain

The United States did not address the negligence or substantial understatement of tax penalties in its motion as the penalties are not cumulative. Similarly, the United States did not address the 20 % substantial valuation misstatement penalty because the magnitude of the valuation misstatements are so great that they far exceed the 400% threshold for the application of the 40% gross valuation misstatement penalty. Because plaintiffs place these penalties in issue through their cross-motion for summary judgment, the United States will address them in response to plaintiffs' motion.
3

2

Section 752, as well as the other partnership provisions of Subchapter K of the Internal Revenue Code, was enacted as part of the Internal Revenue Code of 1954. See Act of August 16, 1954, Pub. L. No. 591, 68A Stat. 3, 251. The legislative history does not elucidate the meaning of "liability." It merely explains that § 752 was intended to deal with the effect on a partner of his assumption of partnership liabilities and the partnership's assumption of his

4

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 18 of 55

meaning of "liability," as elucidated in Black's Law Dictionary. See Black's Law Dictionary 925 (7th ed. 1999) (defining "liability" as "the quality or state of being legally obligated or accountable" and as "[a] financial or pecuniary obligation"). Here, the obligation to replace the borrowed Treasuries was a fixed obligation at all times. It was a fixed obligation when the short sale occurred and at all times thereafter. The obligation to replace the borrowed Treasuries was never contingent. The obligation arose at the time the Treasuries were borrowed and continued until the Treasuries were replaced by Beta. This was true when the short sales were made, when the proceeds and obligation to cover were transferred to Alpha and when the proceeds and obligation to cover were transferred to Beta. As we shall demonstrate, below, the critical premise of plaintiffs' argument, i.e., that the obligation to replace borrowed securities with equivalent securities is a contingent obligation entirely outside the scope of § 752 of the Code, is plainly wrong and, accordingly, their entire argument necessarily fails. There can be no doubt that the ordinary meaning of "liability" encompasses an

obligation to close a short sale because one who borrows securities in a short sale has a fixed, legal obligation to return the borrowed property. See Zlotnick v. TIE Communications, 836 F.2d 818, at 820 (3rd Cir. 1988); James Christian, Robert Shapiro, and John-Paul Whalen, Naked Short Selling: How Exposed Are Investors, 43 Hous. L. Rev. 1033, 1041 (2006). Indeed, plaintiffs appear to concede (P.MSJ, p. 8-9) that a short seller has an unconditional obligation to close the short sale by replacing the borrowed property.

liabilities. See S. Rep. No. 83-1622 at 405 (1954), reprinted in 1954 U.S.C.C.A.N. 4621, 5047 (emphasis added). Accord H.R. Rep. No. 83-1337 at A236-237 (1954), reprinted in 1954 U.S.C.C.A.N. 4017, 4376-4377 (1954).

5

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 19 of 55

Plaintiffs contend, however, that, as to Alpha, the obligation to replace the borrowed treasuries was contingent because at the time the brokerage account was contributed to Beta, the short sale remained open and the price and time at which replacement securities would be acquired was unknowable. They therefore contend that Alpha's obligation to close the short sales was a contingent obligation and, consequently, not a "liability" under I.R.C. § 752. Plaintiffs are wrong. The obligation to close a short sale is not analogous to an obligation to pay an unliquidated sum of money, the amount of which may vary with future events. In a short sale, the investor has borrowed securities, not money, from a broker, and it is the securities, that must be returned, not money, as plaintiffs seem to concede (P.MSJ, p.9). The broker does not care whether the borrower keeps the borrowed securities in his account and subsequently returns them, or whether he sells them, as occurred here, and subsequently buys and returns to the broker, similar securities bearing the same face value. Indeed, the broker does not care what it will cost to close the short positions, except to the extent of the protection afforded by the margin account, Because the investor's obligation is to replace the borrowed property with the same or similar property, his obligation is fixed at the time he borrows the property. That the borrower may make a profit or incur a loss with respect to his short sale of the borrowed property, depending on fluctuations in the market, does not make his obligation to the lender to replace the borrowed property a contingent one. On the contrary, regardless of any subsequent change in the market value of the borrowed securities, the borrower's unconditional obligation to replace the borrowed property remains unchanged. Indeed, plaintiffs have cited no authority holding that an unconditional obligation to replace property borrowed from a third party is a contingent liability.

6

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 20 of 55

Moreover, this Court, we respectfully submit, should be loathe to accept the unnatural construction of the term "liability" that plaintiffs have proffered as the centerpiece of their abusive scheme to turn what was in economic terms essentially a wash transaction into a $44 million loss for tax purposes. See ACM Partnerhip v. Commissioner, 157 F.3d 231, 252 (3d Cir. 1998). Plaintiffs' contention (P.MSJ, p. 9) that the tax treatment of short sales as open transactions until the sales are closed (see I.R.C. § 1233) somehow renders the liability of the borrower to replace the property a contingent liability makes no sense. Furthermore, the Tax Court in Salina Partnership, LP v. Commissioner, 80 T.C.M. (CCH) 686 (2000) -- a case on all fours with this case -- rejected it. The court reasoned that I.R.C. §§ 752 and 1233 have disparate policies that warrant different treatment (id. at 698): Petitioner's argument overlooks the disparate policies that sections 1233 and 752 are intended to promote. Section 1233 . . . defers recognition of gain or loss until the short sale is closed, to clarify and simplify the tax treatment of a transaction that is something of hybrid. See Hendricks v. Commissioner, 423 F.2d 485, 486-487 (4th Cir. 1970). . . . In contrast, the basis adjustment provisions in subchapter K, including sections 705 and 752, are intended to avoid distortions in the tax reporting of partnership items by promoting parity between a partnership's aggregate inside basis in its assets and its partners' outside bases in their partnership interests. This reasoning is sound and applies here. The question of whether a transaction is open or closed for purposes of determining when gain or loss on the transaction should be computed has nothing to do with whether an obligation to replace borrowed property with equivalent property is a contingent or fixed obligation. Further, the application of open transaction principles to the determination of bases would

7

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 21 of 55

undermine the comprehensive statutory scheme in the Code that governs matters of basis. Basis is a dynamic concept; a taxpayer's basis in property is adjusted upon the occurrence of various tax events. The statutory provisions pertaining to partnership interests illustrate this concept. Section 705(a) provides the starting point for determining a partner's outside basis and identifies some of the events that cause the adjustment of this basis. A partner's initial outside basis is "the basis of such interest determined under section 722 (relating to contributions to a partnership) or section 742 (relating to transfers of partnership interests)." I.R.C. § 705(a). A partner's basis is subsequently increased, inter alia, by his distributive share of the partnership's taxable and taxexempt income. Id. § 705(a)(1)(A) & (B). His basis is decreased, inter alia, by partnership distributions as provided in I.R.C. § 733 and by his distributive share of partnership losses. Id. § 705(a)(2). Similarly, a partner's outside basis is increased by any increase in his share of partnership liabilities and by any increase in his individual liabilities resulting from his assumption of partnership liabilities. I.R.C. §§ 722, 752(a). A partner's outside basis is

decreased by any decrease in his share of the partnership liabilities and by any decrease in his individual liabilities by reason of the partnership's assumption of them. Id. §§ 731, 752(b). In short, neither the open transaction doctrine nor the provisions of § 1233 (relating to the character of gain or loss realized on short sales) has anything to do with the controlling and correct conclusion in this case that Alpha's fixed obligation to replace the Treasuries borrowed from PaineWebber was a liability under § 752 of the Code.

8

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 22 of 55

B.

The IRS's consistent position is that when, as here, an obligation creates or increases the basis of any of the obligor's assets, that obligation is a "liability" under I.R.C. § 752.

The IRS has consistently maintained that when, as here, an obligation creates or increases the basis of the obligor's assets, that obligation is a "liability" under § 752. The IRS espoused this position as early as 1988. In Rev. Rul. 88-77, 1988-2 C.B. 128, 129, it defined "liability" under § 752 to "include an obligation only if and to the extent that incurring the liability creates or increases the basis to the partnership of any of the partnership's assets (including cash attributable to borrowings), gives rise to any immediate deduction to the partnership, or, under section 705(a)(2)(B), currently decreases a partner's basis in the partner's partnership interest." In 1989, the Treasury Department promulgated a temporary regulation containing a similar definition of "liability" under § 752. Temp. Treas. Reg. § 1.752-1T(g), 1989-1 C.B. 180, 192, provided as follows: [U]nder section 752, an obligation is a liability of the obligor for purposes of section 752 and the regulations thereunder to the extent, but only to the extent, that incurring or holding such obligation gives rise to-(1) The creation of, or an increase in, the basis of any property owned by the obligor (including cash attributable to borrowings); (2) A deduction that is taken into account in computing the taxable income of the obligor; or (3) An expenditure that is not deductible in computing the obligor's taxable income and is not properly chargeable to capital.[4]
4

In 2003, the IRS issued a proposed regulation containing a similar definition, which was adopted in 2005. Prop. Treas. Reg. § 1.752-1(a)(1)(ii), 68 Fed. Reg. 37434, 37436 (2003); Treas. Reg. § 1.752-1(a)(4), T.D. 9207, 20051 C.B. 1344, 1354. Under Treas. Reg. § 1.752-1(a)(4)(i)(A), an obligation is a "liability" under § 752 if, inter alia, incurring the obligation "[c]reates or increases the basis of any of the obligor's assets (including cash)." In addition, an "obligation" is "any fixed or contingent obligation to make payment without regard to whether the obligation is otherwise taken into account for purposes of the Internal Revenue Code" and includes an obligation under a short

9

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 23 of 55

For reasons that are unclear, the final regulations did not contain a definition of "liability." In Rev. Rul. 95-26, 1995-1 C.B. 131, the IRS, relying, in part, on Rev. Rul. 88-77, ruled that a partnership's short sale of securities creates a partnership liability under § 752. The IRS reasoned that a short sale creates an obligation on the part of the seller to return the borrowed property. In addition, the short sale produces cash, and the cash is a partnership asset that increases the partnership's basis in its assets. Therefore, the short sale creates a "liability" under § 752, and the partners' bases in their partnership interests were increased under § 722 to reflect their shares of the liability under § 752.5 Accord Rev. Rul. 95-45, 1995-1 C.B. 53 ("The initial proceeds of an open short sale are . . . an asset of the short seller, increasing the aggregate adjusted basis of its total assets by the amount of the proceeds. Because the obligation on the part of the seller to return the borrowed securities resulted in an increase in the adjusted basis of its assets, the obligation is treated as a liability"). In Salina and COLM, the only reported cases on the question whether an obligation to close a short sale is a "liability" under § 752, the Courts, citing Revenue Ruling 95-26, agreed with the Commissioner that the obligation to close a short sale by replacing the Treasury bills that were borrowed represented a partnership liability within the meaning of section 752. Salina, 80 T.C.M. at 700; COLM, 460 F.Supp. 2d at 717. The courts relied on the "plain and ordinary meaning" of the term "liability," as elucidated in Black's Law Dictionary, and on the partnership's "legally enforceable financial obligation to return the borrowed Treasury bills." Salina, 80 T.C.M. at 700; COLM, 460 F.Supp. 2d at 715. Salina has received critical approval.

sale. Treas. Reg. § 1.752-1(a)(4)(ii). The new definition applies to liabilities incurred or assumed by a partnership on or after June 24, 2003 (id. § 1.752-1(a)(4)(iv)), and, therefore, is inapplicable here. In Rev. Rul. 95-26, the Commissioner correctly cited Deputy v. du Pont, 308 U.S. 488 (1940), for the principle that a short sale creates an obligation. See id. at 497 ("Clearly respondent owed an obligation to the Delaware Company").
5

10

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 24 of 55

See Robert Bird & Alan Tucker, Tax Sham or Prudent Investment:

Deconstructing the

Government's Pyrrhic Victory in Salina Partnership v. Commissioner, 22 Va. Tax Rev. 231, 253 (2002) ("The Court Properly Concluded that Salina's Short Sale Constituted a `Liability' Pursuant to Section 752").6 C. Revenue Rulings 88-77 and 95-26, which contain the IRS's interpretation of the term "liability," are entitled to Chevron deference.

As this Court has recognized, revenue rulings are entitled to some deference because they are the Internal Revenue Services interpretation of its own regulations. Schlumberger

Technology Corp. v. United States, 55 Fed.Cl. 203, 212, fn.5 (2003). We submit, however, that here they should be entitled to the higher level of deference set out in Chevron USA, Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984). Chevron requires a court to follow an agency's interpretation of a statute unless that interpretation is arbitrary, capricious, or manifestly contrary to the statute. 467 U.S. at 844. In United States v. Mead Corp., 533 U.S. 218 (2001), the Court, refining its Chevron analysis, determined that Chevron deference was available to any administrative implementation of a statutory provision "when it appears that Congress delegated authority to the agency generally to make such rules carrying the force of law," and "the agency interpretation claiming deference was promulgated in the exercise of that authority." Id. at 226-227. It is well settled that Treasury Regulations (both legislative and interpretative) are entitled to Chevron deference. Atlantic Mut. Ins. Co. v. Commissioner,

6

Plaintiffs attempt to minimize Salina by urging (P.MSJ, p. 26) that Tax Court memorandum opinions have no precedential value. That memorandum opinions are not precedent in the Tax Court merely means that one Tax Court judge is not bound by another judge's memorandum opinion, just as one circuit court of appeals is not bound by the decision of another circuit court of appeals. But that hardly means that memorandum opinions do not have persuasive value. It is significant to note that plaintiffs themselves rely extensively (Br. 27-29, 31) on a memorandum opinion -- Helmer v. Commissioner, 34 T.C.M. (CCH) 727 (1975) -- notwithstanding their criticism of the Government for doing so.

11

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 25 of 55

523 U.S. 382, 387-89 (1998). We submit that revenue rulings -- like treasury regulations -satisfy the standard for Chevron deference set out in Mead. In terms of deference, revenue rulings and IRS interpretative regulations should be treated the same. Both forms of agency interpretation are issued pursuant to the same

congressional mandate. See I.R.C. § 7805(a) (providing that the "Secretary shall prescribe all needful rules and regulations for the enforcement of this title"). Both are ultimately authorized at the same level of the IRS and the Department of Treasury. See Treas. Order 111-2,

1981-1 C.B. 698, 699 (delegating responsibility for "final determination of the Treasury Department's position" on Treasury Regulations and published revenue rulings from the Secretary to the Assistant Secretary (Tax Policy)); Treas. Directive 27-10, 55 Fed. Reg. 4253202 (1990) (Assistant Secretary (Tax Policy) develops and reviews regulations and rulings; Office of Tax Legislative Counsel assists in the development of regulations and rulings). Both are published. Treas. Reg. § 601.601(d)(2)(i)(a). And both are designed to provide precedent, binding on the IRS, for all taxpayers. Treas. Reg. § 601.601(d)(2)(v)(d). The only material distinction between the Commissioner's interpretive regulations and his revenue rulings is that the latter are not issued pursuant to notice-and-comment procedures. The Supreme Court made clear in Mead, however, that, while notice-and-comment rulemaking and formal adjudication almost always assure Chevron deference, the absence of such formalities in the rulemaking process does not preclude such deference, so long as it appears (as it does with revenue rulings) that Congress intended to grant the agency the power to make binding rules. 533 U.S. at 230-231. But even if this Court were to conclude that revenue rulings are not entitled to Chevron deference, they are certainly highly persuasive precedent that should be followed unless unreasonable. See Foil v. Commissioner, 920 F.2d 1196, at 1202-1203 (5th Cir. 1990); 12

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 26 of 55

Omohundro v. United States, 300 F.3d 1065, 1067-1069 (9th Cir. 2002); Ammex, Inc. v. United States, 367 F.3d 530, 535 (6th Cir. 2004), cert. denied, 544 U.S. 948 (2005). Fully consistent with § 752, Revenue Rulings 88-77 and 95-26 contain a more-thanreasonable interpretation of the term "liability." It makes perfect sense to require a partner who has included an asset in his outside basis to reduce his basis by the obligation that created this asset because the legally-enforceable obligation diminishes the value of his partnership interest. Just as a corporation who borrows money to buy real estate must, on its balance sheet, treat the real estate as an asset and the mortgage as a liability, so too should a partner take into account both the asset and the liability in computing his outside basis. The regulatory realities also support the IRS's treatment of the obligation to close the short sale as a liability under § 752. Regulation T7 requires a short seller to have a margin account and to maintain margin levels exceeding the value of any short-selling activity. See 12 C.F.R. § 220.12(c)(1); Zachary Knapper, Future-Priced Convertible Securities and the Outlook for "Death Spiral" Securities Fraud Litigation, 26 Whittier L. Rev. 359, 371 & n.79 (2004); Bissell v. Merrill Lynch & Co., 937 F. Supp. 237, 240 (S.D.N.Y. 1996), aff'd, 157 F.3d 138 (2d Cir. 1998). Cf. Rev. Rul. 95-26, 1995-1 C.B. at 132 (noting that after the short sale, the investor "leaves the cash proceeds from the sale with the broker-dealer as collateral and deposits additional cash as further collateral with the broker-dealer"). To treat the proceeds of the short sale as if they were unencumbered and freely transferable, as plaintiffs do, flies in the face of reality. These margin requirements prevent the short seller from transferring the proceeds of the short sale until the underlying indebtedness is satisfied or until he substitutes other collateral. Thus, as Fred Luedke (plaintiffs' PaineWebber

7

Regulation T is a Federal Reserve Board regulation governing customer cash accounts and the amount of credit that brokerage firms and dealers may extend to customers to purchase securities.

13

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 27 of 55

broker) testified here, plaintiffs could not have withdrawn the proceeds of the short sale from the brokerage account. (App-B-163) Since Revenue Ruling 95-26 is supported by the economic and regulatory realities, it should be followed. See Foil, 920 F.2d at 1202-1203. Plaintiffs criticize Revenue Ruling 95-26 as nothing more than a one page restatement of the IRS's litigating position. While brief, the rationale espoused in the revenue ruling is as relevant and persuasive today as it was when it was issued more than six years prior to when plaintiffs entered into the tax avoidance scheme now at issue. It makes perfect sense to require a partner who has included an asset in his outside basis to reduce his basis by the obligation that created this asset because the legally-enforceable obligation diminishes the value of his partnership interest. To do otherwise, leads to the obvious distortion of basis now proposed by plaintiffs. Further, it ignores the inescapable reality that the underlying basis flows from the sale of borrowed property. There is also no merit to plaintiffs' further contention that the IRS, by treating the obligation to close the short sale as a "liability" under § 752, unreasonably forces taxpayers to attempt to estimate the amount of the obligation at the time the obligation is contributed to the partnership. Because the investor's obligation to replace the borrowed property is fixed when the short sale has occurred, the IRS has determined that the amount of the liability, for basis purposes, equals the proceeds of the short sale. See Rev. Rul. 95-45, 1995-1 C.B. at 53. Therefore, no estimation of the amount of the obligation to replace the borrowed property is necessary. D. The authorities on which plaintiffs rely are inapposite.

Plaintiffs attempt to minimize the effect of Revenue Ruling 95-26 by arguing that it represents a change in the IRS's long-standing position that a contingent obligation is not considered in determining the basis of a partnership interest. Plaintiffs argument, however, 14

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 28 of 55

assumes the critical matter in dispute, i.e., whether the borrower's obligation to return property is a contingent or fixed obligation. As we have demonstrated, that obligation is a fixed one and, as such, constitutes a liability under § 752. Thus, the purported "change" in position by the IRS alleged by plaintiffs does not exist. As indicated above, the IRS consistently has stated that an obligation that creates or increases the basis of an obligor's asset is a "liability" under I.R.C. § 752. The authorities on which plaintiffs rely are not in point. Some of them pertain to unrelated computation issues. See, e.g., Rev. Rul. 79-294, 1979-2 C.B. 305 (addressing the computation of gross receipts realized by a small business corporation from trading in commodity futures); G.C.M. 37,860 (Feb. 16, 1979) (same). The other authorities on which plaintiffs rely are also distinguishable. Rev. Rul. 57-29, 1957-1 C.B. 519, presented the question of the basis of an "executory contract to buy or sell securities which has cost the taxpayer nothing." Id. at 520. Long v. Commissioner, 71 T.C. 1, 8 (1978), rev'd in part on other grounds, 660 F.2d 416 (10th Cir. 1981), and La Rue v. Commissioner, 90 T.C. 465 (1988), presented the question whether unliquidated claims against a partnership increased a partner's outside basis. The claims in Long arose from structural defects in a building that the partnership had erected. The claims in La Rue arose from a partnership's contractual obligation to replace missing securities or money. Neither of these cases involves obligations that created or increased the basis of the partnership's assets, and they, therefore, furnish no support for plaintiffs' contention that an obligation to close a short sale is not a "liability" under § 752. In both Rev. Rul. 73-301, 1973-2 C.B. 215, and Helmer v. Commissioner, 34 T.C.M. (CCH) 727 (1975), on which plaintiffs also rely, the partnerships had received assets which did not give rise to any partnership obligation. In Rev. Rul. 73-301, the partnership had received progress payments on a contract but had no obligation to return them or perform any additional 15

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 29 of 55

services to retain them. These payments, therefore, were not a "liability" under § 752. In Helmer, the partnership had received option payments pursuant to an agreement giving a corporation the option to purchase certain real estate. Since "[t]he option agreement, however, created no liability on the part of the partnership to repay the funds paid nor to perform any services in the future," the Tax Court "h[e]ld that no liability arose under section 752. . . ." 34 T.C.M. at 731. Here, plaintiffs did have an obligation -- an unconditional obligation to close the short sale by replacing the borrowed Treasuries. Helmer and Revenue Ruling 73-301 are, therefore, distinguishable. Plaintiffs also rely on IRS employee Richard Starke's notes from internal IRS meetings in 1995 in an attempt to show that the Government knew that, under existing rulings, a short sale did not create a liability under § 752. Starke's notes, prepared in conjunction with his work on Revenue Ruling 95-45,8 were for his own purposes only and therefore, should not be considered. See Siddell v. Commissioner, 225 F.3d 103, 111 (1st Cir. 2000) ("Because these internal memoranda represent the personal views of the authors, not the official position of the agency, they do not figure in our decisional calculus"). Moreover, Starke's notes do not bear the weight plaintiffs seek to place upon them. One of the meetings summarized in Starke's notes referred to Revenue Ruling 88-77 in support of the conclusion that a short sale is a "liability" under § 752 : Review of P&SI's briefing memo for 3/7/95 meeting with Brown. Executive summary. Issue: does short sale by partnership create partnership liability under § 752? RR 88-77: § 752 liabilities include an obligation to extent incurring it creates or increases basis of any partnership assets (including cash attributable to borrowings).

8

Revenue Ruling 95-45 addresses short sale obligations assumed by corporations.

16

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 30 of 55

The cash received in the short sale increases the partnership's asset basis. Hence short sale creates a liability. Recommendation: issue the RR.[9] Thus, Starke's notes, to the extent they have any relevance at all, tend to show that the IRS has consistently taken the position that an obligation that creates or increases an obligor's assets is a liability under § 752.

E.

Even if Revenue Ruling 95-26 reflects a change in the IRS's interpretation of § 752, the validity of the ruling would be unaffected. As we have demonstrated, Revenue Ruling 95-26 does not reflect a change in the IRS's position. But even if it did, such a change would have no effect on the validity or applicability of the ruling. See Long Island Care at Home, Ltd. v. Coke, 127 S. Ct. 2339 (2007). In Long Island Care, the Supreme Court unanimously upheld an agency's change in its interpretation of the meaning of the term "domestic service" employment. That case presented the question whether a domestic worker who provided "companionship services" to the elderly and infirm as an employee of a third-party agency was entitled to minimum wages and overtime under the Fair Labor Standards Act ("FLSA"). This Act exempted "any employee employed in domestic service employment to provide companionship services" for the elderly and infirm from minimum wages and maximum hour rules. 29 U.S.C. § 213(a)(15). The Department of Labor had two conflicting regulations. One regulation defined

exempt "domestic service" employment as services performed in and about a private home of the employer. Under the second regulation, at issue in Long Island Care, companionship workers for a third party, i.e., an employer other than the household using their services, were exempt

Starke characterized as "very loose notes" the notes of the meeting at which Chief Counsel Stuart Brown was purportedly "reluctant to say a short sale generates a liability."

9

17

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 31 of 55

from minimum wages and maximum hours. The Court upheld the validity and applicability of the second regulation. 127 S. Ct. at 2348. Noting that in the FLSA, Congress had explicitly left gaps in the scope and definition of "domestic service employment" and "companionship services" for the agency to fill, the Court explained that "[w]hen an agency fills such a `gap' reasonably, and in accordance with other applicable (e.g., procedural) requirements, the courts accept the result as legally binding." Id. at 2345-2346. The Court further held that "as long as interpretive changes create no unfair surprise . . . the change in interpretation alone present[ed] no separate ground for disregarding the Department's present interpretation." 127 S. Ct at 2349. Indeed, the Court gave the Department of Labor's most recent interpretation legal effect even though this interpretation was set forth in the form of internal guidance and was in response to litigation. The Court reasoned that the "agency's course of action indicates that the interpretation . . . reflects its considered views. . . ." Id. In the present case, the IRS's position -- that the obligation to close a short sale is a liability under § 752 -- represents its "considered views."10 The IRS took this position in Rev. Rul. 95-26, in Salina, and in Treas. Reg. § 1.752-1(a)(4)(ii). This interpretation should have created no "unfair surprise"11 to plaintiffs herein. More than ten years before the transactions in issue, the IRS, in Revenue Ruling 88-77, defined "liability" under § 752 to "include an obligation only if and to the extent that incurring the liability creates or increases the basis to the partnership of any of the partnership's assets. . . ." 1988-2 C.B. at 129. More than five years before the transactions in issue, the IRS applied Revenue Ruling 88-77 to short sales and ruled

10

Long Island Care, 127 S. Ct. at 2349. Id.

11

18

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 32 of 55

that short sales of securities by partnerships create partnership liabilities for purposes of I.R.C. § 752. Rev. Rul. 95-26, supra. Accordingly, if any change in interpreting § 752 occurred, "the change in interpretation alone presents no separate ground for disregarding the [IRS's] present interpretation." Long Island Care, 127 S. Ct. at 2349. II. IN THE ALTERNATIVE, TREAS. REG. § 1.752-6 REQUIRES THE SANDS HEIRS TO REDUCE THEIR BASES IN ALPHA AND ALPHA TO REDUCE ITS BASIS IN BETA BY THE AMOUNT OF THE OBLIGATION TO CLOSE THE SHORT SALE. A. Introduction

Treas. Reg. § 1.752-6 applies to a partnership's assumption of a liability occurring after October 18, 1999, and before June 24, 2003, if I.R.C. §§ 752(a) and (b) do not apply to that liability. Treas. Reg. § 1.752-6, Appendix A, infra, provides: If, in a transaction described in section 721(a), a partnership assumes a liability (defined in section 358(h)(3)) of a partner (other than a liability to which section 752(a) and (b) apply) , then, after application of section 752(a) and (b), the partner's basis in the partnership is reduced (but not below the adjusted value of such interest) by the amount . . . of the liability. This Regulation thus requires a partner, in a transaction described in § 721(a), to reduce his basis in his partnership interest by the amount of any liability, as defined in I.R.C. § 358(h)(3), that the partnership assumes. Section 358(h)(3) defines "liability" to "include any fixed or contingent obligation to make payment, without regard to whether the obligation is otherwise taken into account for purposes of this title." Accordingly, under Treas. Reg. § 1.752-6, a partnership's assumption of a contingent liability results in a partner's outside basis being reduced. This regulation is retroactive, applying to assumptions of liabilities occurring after October 18, 1999, and before June 24, 2003. Treas. Reg. § 1.752-6(d)(1).

19

Case 1:06-cv-00407-ECH

Document 51

Filed 08/14/2007

Page 33 of 55

If this Court were to hold that I.R.C. §§ 752(a) and (b) do not apply to an obligation to close the short sale, then Treas. Reg. § 1.752-6 applies. This means that the Sands Heirs' bases in Alpha was reduced by the short sale liability assumed by Alpha, and likewise Alpha's basis in Beta was reduced when the short sale position was transferred to Beta and it assumed the liability. Specifically, Alpha, in a transaction described in § 721(a), assumed the Sands Heirs's obligation to close the short sale and the assumption occurred after October 18, 1999, and before June 24, 2003. In these circumstances, Treas. Reg. § 1.752-6 requires the Sands Heir's bases in Alpha to be reduced by the amount of that liability. Thus, the Sands Heirs' bases in Alpha equaled