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

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IN THE UNITED STATES COURT OF FEDERAL CLAIMS No.06-407T (into which have been consolidated Nos. 06-408T, 06-409T, 06-410T, 06-411T, 06-810T, 06-811T) Judge Emily C. Hewitt (E-Filed July 5, 2007) __________________________________________ ) ALPHA I, L.P., BY AND THROUGH ROBERT ) SANDS, A NOTICE PARTNER ) ) Plaintiff, ) ) v. ) No. 06-407T ) THE UNITED STATES, ) Defendant. ) __________________________________________) ) BETA PARTNERS, L.L.C, BY AND THROUGH ) ALPHA I, L.P., A NOTICE PARTNER ) ) Plaintiff, ) ) v. ) No. 06-408T ) 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. ) No. 06-409T ) THE UNITED STATES, ) Defendant. ) __________________________________________)

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________________________________________ 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 ) ) ) ) ) ) ) ) ) )

No. 06-410T

) ) ) ) ) ) Plaintiff, ) ) v. ) ) THE UNITED STATES, ) ) Defendant. ) ) __________________________________________) ) MICKEY MANAGEMENT, L.P., BY AND ) THROUGH MARILYN SANDS, A NOTICE ) PARTNER, ) Plaintiff, ) ) v. ) ) UNITED STATES OF AMERICA, ) Defendant. ) __________________________________________)

No. 06-411T

No. 06-810T

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

No. 06-811T

PLAINTIFFS' RESPONSE TO UNITED STATES' MOTION FOR SUMMARY JUDGMENT IN CAUSE NOS. 06-407T, 06-408T, 06-411T, 06-810T, AND 06-811T AND BRIEF IN SUPPORT AND PLAINTIFFS' CROSS MOTION FOR SUMMARY JUDGMENT AND BRIEF IN SUPPORT

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TABLE OF CONTENTS

PAGE(S)

ISSUES PRESENTED . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 STATEMENT OF THE CASE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 I. II. Introduction. . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Defendant's Motion for Summary Judgment and Plaintiffs' Cross Motion for Summary Judgment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Factual Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4

III.

ARGUMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 I. THE REQUIREMENT TO COVER A SHORT SALE IS NOT A LIABILITY WITHIN THE MEANING OF SECTION 752 . . . . . . . . . . . . . . . . . . . . . . .8 A. B. The Interplay of Section 705 and Section 752 . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 The Requirement to Cover a Short Sale Is Not a Liability for Purposes of Section 752 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 The Authorities Cited by Defendant Do Not Alter the Legal Principle that Contingent Obligations are not liabilities under section 752 . . . . . . . . . . . . . . . . 22 1. 2. 3. II. Rev. Rul. 95-26 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22 Salina Partnership LP v. Commissioner . . . . . . . . . . . . . . . . . . . . . . . . . .26 Colm Producer, Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

C.

NO ACCURACY-RELATED PENALTIES SHOULD APPLY IN THIS CASE . . . . . 32 A. The Penalties Do Not Apply By Their Own Terms . . . . . . . . . . . . . . . . . . . . . . 33 1. There was not a "substantial understatement" of tax . . . . . . . . . . . . . . . . 33 a. Defendant's motion for summary judgment on the substantial understatement penalty should be denied. . . . . . . . . . 34 Plaintiffs' cross-motion for summary judgment on the substantial understatement penalty should be granted . . . . . . . . .34

b.

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2.

Plaintiffs were not negligent. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 a. Defendant's motion for summary judgment on the negligence penalty should be denied . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37

b.

Plaintiffs' cross-motion for summary judgment on the negligence penalty should be granted. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

3.

Neither the "substantial valuation misstatement" penalty nor the "gross valuation misstatement" penalty can apply . . . . . . . . . . . . . . . . . . . . . . . .38 a. There was no misstatement on any return of the tax imposed by chapter 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39 Any Underpayment of Tax Is Not Attributable to a Misstatement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .42

b.

B.

The Penalty Provisions of Section 6662(a) Are Inapplicable Where, as Here, a Taxpayer Relied Reasonably and in Good Faith Upon Professional Tax Advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48

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TABLE OF AUTHORITIES CASES PAGE(S)

Bowen v. Georgetown Univ. Hosp., 488 U.S. 204 (1988) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Brown v. Helvering, 291 U.S. 193 (1934) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Bursten v. United States, 395 F.2d 976, 981 (5th Cir. 1968) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Chamberlain v. Comm'r, 66 F.3d 729, 733 (5th Cir. 1995) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 Chock Full O'Nuts Corp. v. United States, 453 F.2d 300 (2d Cir.1971) . . . . . . . . . . . . . . . . . . . 41 Cinema '84 v. Comm'r, 412 F.3d 366 (2d Cir. 2005) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 Commissioner v. Acker, 361 U.S. 87 (1959) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .48 Colm Producer, Inc. v. United States, 460 F.Supp.2d 713 (N.D. Tex. 2006 5th Cir.) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .30-32 Deluxe Corp. v. United States, 885 F.2d 848 (Fed. Cir. 1989) . . . . . . . . . . . . . . . . . . . . . . . . . .42 Deputy v. du Pont, 308 U.S. 488 (1940) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19-20 E.C. Allen v. A.G. Edwards & Sons, Inc., 606 F.2d 84 (5th Cir. 1979) . . . . . . . . . . . . . . . . . . . . 8 Estate of Monroe v. Comm'r, 124 F.3d 699, 714-15 (5th Cir. 1997) . . . . . . . . . . . . . . . . . . . . . 45 Foxman v. Comm'r, 41 T.C. 535, 551, n.9, aff'd, 352 F.2d 466 (2d Cir. 1965) . . . . . . ........ . . 47 Helmer v. Comm'r, 34 T.C.M. (CCH) 727 (1975) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .passim Helvering v. Credit Alliance Corp., 316 U.S. 107 (1942) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 Hendricks v. Comm'r, 423 F.2d 485 (4th Cir. 1970) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9, 28 Henry v. Comm'r, 170 F.3d 1217, 1220-1221 (9th Cir. 1999) . . . . . . . . . . . . . . . . . . . . . . . . . . .45 Klamath Strategic Investment Fund, LLC v. United States, 440 F. Supp. 2d 608 (E.D. Tex. 2006) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2, 27, 36 Koshland v. Helvering, 298 U.S. 441 (1936) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 La Rue v. Comm'r, 90 T.C. 465 (1988) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .passim Long v. Comm'r, 71 T.C. 1 (1978) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . passim

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Mauerman v. Comm'r, 22 F.3d 1001, 1006 (10th Cir. 1994) . . . . . . . . . . . . . . . . . . . . . . . . . . . .46 Neonatology Assoc., P.A. v. Comm'r, 299 F.3d 221(3d Cir. 2002) . . . . . . . . . . . . . . . . . . . . . . ..44 Nico v. Comm'r, 67 T.C. 647 (1977) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Olson v. United States, 172 F.3d 1311 (Fed. Cir. 1999) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40 Reser v. Comm'r, 112 F.3d 1258, 1268 (5th Cir. 1997) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .46 Richardson v. Comm'r, 121 F.2d 1 (2d Cir. 1941) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9, 11 Rite Aid Corp. v. United States, 255 F.3d 1357 (Fed. Cir. 2001) . . . . . . . . . . . . . . . . . . . . . . . . .41 Salina Partnership v. Comm'r, 80 T.C.M. (CCH) 686 (2000) . . . . . . . . . . . . . . . . . . . . . . . . 26-30 Srivastava v. Comm'r, 220 F.3d 353, 367 (5th Cir. 2000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .46 Stephenson Trust v. Comm'r, 81 T.C. 283 (1983) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14-41 Stratmore v. Comm'r, 48 T.C.M. (CCH) 1369 (1984) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26 USA Choice Internet Service, LLC v. United States, 73 Fed. Cl. 780 (2006) . . . . . . . . . . . . . . . .23 Nalle v. Comm'r, 997 F.2d 1134 (5th Cir. 1993) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 Stanford v. Comm'r, 152 F.3d 450 (5th Cir. 1998) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43-45 United States v. Boyle, 469 U.S. 241, 251 (1985) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 Weiner v. United States, 389 F.3d 152 (5th Cir. 2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .43

CODE SECTIONS 701. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 705. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .passim 722. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 731. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 733. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 752. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .passim

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1233. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . .passim 6662. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . .passim 6664. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . .passim REVENUE RULINGS Rev. Rul. 57-29, 1957-1 C.B. 519 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . 16 Rev. Rul. 73-301, 1973-2 C.B. 215. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 Rev. Rul. 79-294, 1979-2 C.B. 305. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17 TREASURY REGULATIONS Treas. Reg. § 1.6662-4(g)(4)(i)(B). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .passim Treas. Reg. § 1.6664-4(b)(1). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . passim Treas. Reg. § 1.1233-1(a)(1) . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . .passim MISCELLANEOUS S. REP. NO. 81-2375. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 I.R.S. G.C.M. 37,332 (Nov. 25, 1977) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16 I.R.S. G.C.M. 37,971 (June 1, 1979) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . .17 I.R.S. G.C.M. 37,860 (Feb. 16, 1979) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 I.R.S. G.C.M. 38,237 (Feb. 15, 1980) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 I.R.S. G.C.M. 35,328 (May 4, 1973) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 ALICE WELT CUNNINGHAM, SHORT-SALE OBLIGATIONS AND BASIS IN PARTNERSHIP INTERESTS, 72 TAX NOTES 1663 (1996) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 1 WILLIAM S. MCKEE ET AL., FEDERAL TAXATION OF PARTNERSHIPS AND PARTNERS ¶7.01[1] (3d ed. 1997) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . .2, 26

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ISSUES PRESENTED 1. Whether contingent obligations assumed by Alpha I, L.P. and then Beta Partners, LLC to cover short sales of United States Treasury notes are "liabilities" within the meaning of 26 U.S.C. § 752? 2. Whether the accuracy-related penalties prescribed in 26 U.S.C. § 6662 apply with respect to any underpayment of tax that would result if Alpha and Beta and their partners were required to treat the contingent obligations as "liabilities"? 3. Whether plaintiffs acted reasonably and in good faith in taking the tax positions at issue, such that the accuracy-related penalties enumerated in 26 U.S.C. § 6662 can not apply by virtue of 26 U.S.C. § 6664(c)? STATEMENT OF THE CASE I. Introduction These consolidated cases involve a series of partnerships used by members of the Sands family to facilitate gifts to various charities and to invest family wealth in a tax-efficient manner. Defendant's motion for summary judgment, and plaintiffs' cross-motion for summary judgment, pertain to only certain of these partnerships: Alpha I, L.P. ("Alpha"), Beta Partners, LLC ("Beta"), Mickey Management, L.P., M,L,R&R, and CWC Partnership I. 1 Plaintiffs filed suit with respect to each of these partnerships to contest adjustments that defendant made to the partnerships' tax returns. Defendant premised these adjustments on the extraordinary position that Alpha and Beta and their partners should have treated obligations to "cover" several short sales of United States Treasury notes as "liabilities" for purposes of section 752. 2 The taxpayers did not treat the obligations to close the short sale positions as liabilities for

The cross-motions should be treated as cross-motions for partial summary judgment with respect to CWC Partnership I because it also was a partner in R,R,M&C Group, L.P., which is not at issue in these cross-motions. 2 Unless otherwise noted, all references to the "Code" or to sections cited herein refer to the Internal Revenue Code of 1986, as amended and as in effect during the years in question.

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the simple reason that those obligations were contingent, in that the future cost to acquire the replacement Treasury notes that would be needed to close the short sales was unknown until the short sales were actually closed. It is black-letter law that contingent obligations are not to be treated as "liabilities" for purposes of section 752. The Court should reject defendant's effort to disavow the settled legal principle that an obligation that is contingent either in effect or in amount is not a "liability" under section 752. Defendant has consistently relied on this settled principle when it works to its benefit (to increase taxes owed), and the Court should fairly and consistently apply it when it works to the benefit of taxpayers (to decrease taxes owed). A single word in a statute (i.e., "liability") cannot vary in meaning simply based on whose ox is being gored. 3 See Klamath Strategic Investment Fund, LLC v. United States, 440 F. Supp. 2d 608, 619 (E.D. Tex. 2006) (holding that section 752 did not apply to contingent obligations arising in another case that defendant called "Son of Boss", based on the settled law and defendant's prior interpretation of the term "liability"). II. Defendant's Motion for Summary Judgment and Plaintiffs' Cross Motion for Summary Judgment The premise of defendant's motion is that Alpha and Beta and their partners should have treated contingent obligations to "cover" several short sale positions of United States Treasury notes (hereinafter "the contingent cover obligations") as liabilities for purposes of section 752. The contingent cover obligations were assumed by Alpha from its limited partners, and then by Beta from Alpha. If defendant is correct, plaintiffs' failure to treat the contingent cover obligations as liabilities ultimately resulted in Alpha incorrectly determining its tax basis in Yahoo and Corning stock, and in Alpha's partners incorrectly determining their tax bases in

As one well-respect treatise on partnership taxation has observed, "[o]ver the years, the Service has consistently attempted to maximize the fiscal by being inconsistent in its view of what constitutes a liability for 752 purposes . . . ." 1 WILLIAM S. MCKEE ET AL., FEDERAL TAXATION OF PARTNERSHIPS AND PARTNERS ¶ 7.03 at 7-3 (3d ed.1997). (Reproduced in Appendix A).

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Alpha. 4 Even if defendant's theory were correct, however, for the reasons discussed below, plaintiffs strongly disagree with defendant's assertions that this resulted in plaintiffs or any of their partners avoiding tax on $44 million of income. While defendant has styled its motion as a motion for summary judgment, in fact it is a motion for partial summary judgment, because its resolution, even if favorable to defendant, will not dispose of all of the issues in the Alpha, Beta, M,L,R&R or Mickey Management, L.P. cases. If defendant's motion were granted, it would resolve only the substantive tax issues raised by defendant in the Notices of Final Partnership Administrative Adjustment ("FPAAs") that it issued to those partnerships. However, defendant also has asserted accuracy-related penalties with respect to any underpayment of tax that results from those adjustments. While defendant seeks summary judgment for those penalties pursuant to 26 U.S.C. § 6662(a) (Def.'s Mot. Summ. J. 17-18), defendant's motion does not address plaintiffs' defenses to these penalties which will remain for resolution regardless of how the Court might decide defendant's motion on the substantive legal issue in this case. Plaintiffs are cross-moving for summary judgment on the appropriate treatment of the contingent obligation to cover a short sale under section 752. Plaintiffs agree with defendant that, aside from penalties, this is the only contested issue in the Alpha, Beta, M,L,R&R and Mickey Management, L.P. cases. (Def.'s Mot. Summ. J. 8, 13.) Plaintiffs also are cross-moving for summary judgment on the penalties asserted by defendant on any underpayment of tax that might result from resolution of the substantive section 752 issue, as the accuracy related penalties under 26 U.S.C. § 6662 do not apply and even if they could otherwise be applicable, those penalties cannot apply in this case because plaintiffs acted reasonably and in good faith in taking the tax positions at issue.
4

Alpha distributed some of the Yahoo and Corning stock to its partners, who in turn contributed it to two other partnerships, M,L,R&R and Mickey Management, L.P. MLR&R sold some of the stock in 2001 and 2002. Mickey Management, L.P. and Alpha also sold some of the stock in 2002.

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III.

Factual Background In its motion for summary judgment, defendant goes to great lengths in its effort to bias

the Court against the Alpha partnership, which defendant alleges (without citation to any supporting evidence) was a "tax shelter" used by members of the Sands' family to avoid tax on $44 million in income. (Def.'s Mot. Summ. J. 4, 5). The clear record, however, shows that plaintiffs have used only $7,811,557 in "excess" losses from the sales of Yahoo and Corning stock; far less than the $44 million alleged by defendant. (Pls. PFUF ¶ 37.) In addition, the allegation that Alpha was created to avoid tax is belied by the undisputed evidence that the Sands used, and continue to use, Alpha to pool family wealth in a variety of investments, and that Alpha has generated approximately $21 million in income and currently holds approximately $61,000,000 of assets. (Pls. PFUF ¶ 13.) 5 Plaintiffs have filed a separate document (titled Plaintiffs' Response to Defendant's Proposed Findings of Uncontroverted Fact) to respond to these and other baseless assertions made by defendant, as required by Ct. Fed. Cl. R. 56(h)(2). Plaintiffs also have filed their Proposed Findings of Uncontroverted Fact ("Pls. PFUF") as a separate document in support of their cross-motion for summary judgment, in accordance with Ct. Fed. Cl. R. 56(h)(1). The facts critical to plaintiffs' response to defendant's motion and plaintiffs' cross-motion are as follows: 1. In March 2001, a representative of The Heritage Organization (Heritage) contacted the Sands family regarding possible strategies the family could implement to transfer wealth between generations and diversify their assets in a tax-efficient manner. (Pls. PFUF ¶ 1.) Based in part on discussions with Heritage, the Sands family members implemented a financial plan, a

This case has become a "high profile" case in the Sands' hometown of Rochester, New York, and filings are under constant review by the local press. Thus, defendant's repeated misrepresentation or mischaracterization of material facts such as these is particularly prejudicial to plaintiffs. Plaintiffs are uncertain of the appropriate remedy for these misstatements, but believe some rebuke is in order given their materiality.

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part of which included formation of and investment by the family members in Alpha. (Pls. PFUF ¶ 5.) 2. Alpha was formed in late 2001 as a limited partnership under the laws of the state of Missouri. (Pls. PFUF ¶ 7.) The purpose of the partnership was to provide an investment vehicle for the family members to pool assets and to enhance the privacy of the family's financial information. (Pls. PFUF ¶ 6.) The six limited partners in Alpha were Robert Sands, Richard Sands, Marilyn Sands, Andrew Stern, the Marvin Sands Master Trust, and CWC Partnership I ("CWC"), collectively the "Alpha limited partners." (Pls. PFUF ¶ 8.) The general partner of Alpha was R, R, M & C Management Corporation, which was owned 50% by Richard Sands and 50% by Robert Sands. (Pls. PFUF ¶¶ 10, 12.) The Sands family has used Alpha to make many investments over the years, and, during this period, Alpha has generated more than $21 million of profits. (Pls. PFUF ¶ 13.) Alpha presently holds approximately $61,000,000 in assets. (Id.) 3. On December 11, 2001, each of the Alpha limited partners executed short sales of Treasury Notes through UBS PaineWebber ("PaineWebber") accounts. 6 (Pls. PFUF ¶ 14.) On December 17, 2001, the Alpha limited partners all contributed their respective PaineWebber accounts and various amounts of cash to Alpha for limited partner interests in the partnership. (Pls. PFUF ¶ 18). Their respective partnership interests were as follows: · · · · · · Robert Sands Richard Sands Marilyn Sands CWC Andrew Stern Marvin Sands Trust 21.401% limited partner interest 18.022% limited partner interest 14.641% limited partner interest 12.949% limited partner interest 5.857% limited partner interest 27.030% limited partner interest.

The principle partners in CWC Partnership I ("CWC") are Trust FBO Abigail Stern U/W Laurie Sands ("Abigail Trust") and Trust FBO Zachary Stern U/W Laurie Sands ("Zachary Trust"). The Abigail Trust and the Zachary Trust also executed short sales of Treasury notes in brokerage accounts at PaineWebber, and then contributed their PaineWebber accounts and cash to CWC.

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RRM&C Management Corp. also contributed $2,582 to Alpha for a .1% general partner interest. (Pls. PFUF ¶ 18.) 4. The short sales were just one of the many investments made by the Sands family associated with Alpha over the years. (Pls. PFUF ¶ 13). They made these specific investments for a number of reasons including: 1) to hedge against the impact of movements in interests rates on their stock holdings in Constellation Brands; 2) to profit from movements in interest rates; 3) to potentially obtain tax benefits; and 4) to increase diversification and liquidity in their investment portfolios. (Pls. PFUF ¶ 15.) As defendant notes, the Alpha limited partners computed their tax bases in Alpha by reference to the cash that they contributed to Alpha unreduced by the contingent obligation to cover the short sale positions, because contingent obligations are not "liabilities" within the meaning of section 752. (Pls. PFUF ¶¶ 55, 58, and 61). On December 17, 2001, Alpha also purchased 67,525 shares of Corning stock and 33,400 shares of Yahoo stock. (Pls. PFUF ¶ 20.) 5. Beta Partners LLC (Beta) was formed on December 10, 2001, also under the laws of the state of Missouri. (Pls. PFUF ¶ 21.) Its initial members were Alpha and Gloria Robinson. (Pls. PFUF ¶ 22.) Beta was formed to provide individual investors outside the family an opportunity to invest with the family members. (Pls. PFUF ¶ 21.) On December 20, 2001, Alpha contributed the Yahoo and Corning shares and the remaining cash it had received from the Alpha limited partners (and the requirement to "cover" the short sales) to Beta for the majority membership interest. (Pls. PFUF ¶ 23.) Also on December 20, Ms. Robinson contributed cash to Beta in exchange for her minority membership interest. (Pls. PFUF ¶ 24.) As defendant also notes, Alpha computed its tax basis in Beta by reference to the cash that it contributed to Beta unreduced by the contingent obligation to cover the short sale positions, because contingent

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obligations are not "liabilities" within the meaning of section 752, which was consistent with the position taken by Alpha's partners. (Pls. PFUF ¶¶ 55, 58, and 61). 6. On December 26, 2001, Beta used most of its cash to acquire Treasury notes which it used to close the short sales. Beta recognized a profit of $90,018 upon closing the short sales. (Pls. PFUF ¶ 25.) 7. On December 27, 2001, Gloria Robinson and Alpha entered an agreement whereby Alpha agreed to purchase Gloria Robinson's membership interest in Beta, which had the effect of terminating Beta pursuant to section 708(b)(1)(B). (Pls. PFUF ¶ 26.) Alpha then took possession of Beta's assets, which principally consisted of the shares of Yahoo and Corning stock. (Pls. PFUF ¶ 27.) 8. During 2001 and 2002, Alpha transferred most of the Yahoo and Corning stock to its partners in varying amounts. (Pls. PFUF ¶ 28.) The partners then contributed some of that stock to M,L,R&R, and some to Mickey Management, L.P. (Id.) Alpha, M,L,R&R and Mickey Management, L.P. each sold some of the Yahoo and Corning stock during 2002. (Pls. PFUF ¶ 32.) The total losses claimed by these partnerships on the sales of the Yahoo and Corning stock was $15,647,272. (Pls. PFUF ¶ 36.) However, the Alpha limited partners could "use" only $7,811,557 of these losses to offset their taxable income because they had losses from other ventures. (Pls. PFUF ¶ 37.) 7 9. In deciding to engage in the above transactions, the Alpha limited partners (none of whom are tax practitioners) relied on the advice they received from their personal advisors at their long-time accounting firm Bernard Robinson & Company ("Bernard Robinson") and at the law firm of Milbank, Tweed, Hadley & McCloy LLP ("Milbank Tweed") who reviewed the

Some of the other losses were derived from transactions involving RRM&C Group, which is also at issue in these consolidated cases but is not at issue in these cross-motions. However, even if those losses were disallowed, plaintiffs would still will have "used" less than one-third of the $44 million in losses from sales of Yahoo and Corning stock alleged by defendant.

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financial plan presented by Heritage. (Pls. PFUF ¶¶ 39-41.) In implementing the transactions described above and in determining the correct tax treatment of the transactions, the Alpha limited partners engaged Lewis, Rice & Fingersh, L.C. ("Lewis Rice") to provide legal services and tax opinions relating to the transactions. (Pls. PFUF ¶ 48.) Lewis Rice personnel spent some 549 hours in their representation of the partners of plaintiffs. (Pls. PFUF ¶ 52.) Lewis Rice extensively researched and analyzed the applicable law, conducted due diligence and requested and received from the Alpha limited partners the information necessary for evaluating the tax consequences of the transactions. (Pls. PFUF ¶¶ 53-54.) The opinions issued by Lewis Rice were based both on their research and analysis of the applicable law and authorities and on the experience, professional judgment, and assessment of the probable outcome of litigation or other adversarial proceedings by Lewis Rice. (Pls. PFUF ¶ 56.) Lewis Rice concluded that the position that the contingent obligations to cover the short sale positions were not liabilities for purposes of section 752 was more likely than not correct. (Pls. PFUF ¶ 55.) The Alpha limited partners relied on the opinions issued by Lewis Rice in determining the proper tax treatment of the transactions described above. (Pls. PFUF ¶ 58.) That treatment is reflected in the tax returns prepared by Bernard Robinson for plaintiffs and their partners. (Pls. PFUF ¶ 61.) ARGUMENT I. THE REQUIREMENT TO COVER A SHORT SALE IS NOT A LIABILITY WITHIN THE MEANING OF SECTION 752. When an investor borrows securities such as United States Treasury notes and then sells the borrowed securities (i.e., a "short sale"), his investment is based on the economic assessment that the fair market value of the securities will fall before he has to acquire replacement securities and deliver them to the lender. See, e.g., E.C. Allen v. A.G. Edwards & Sons, Inc., 606 F.2d 84, 85 (5th Cir. 1979). If the value does fall, the cost of the securities to cover the short sale will then be less than the amount for which the borrowed securities were sold, and the investor will

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have a profit. For tax purposes, the investor will recognize as gain (or loss, if the cost to cover increases) the difference between the proceeds received upon selling the borrowed securities and the cost, or "basis," of the replacement securities. However, the investor obviously cannot know whether he will have a gain or a loss on the short sale until the date that he acquires the replacement securities to be delivered to the lender, because he cannot know in advance how much the replacement securities will cost. For that reason, under Treas. Reg. § 1.1233-1(a) and the "open transaction" doctrine, the investor does not recognize income or loss for tax purposes until he acquires and delivers the replacement securities to the lender, even though he earlier received proceeds upon the disposition of the borrowed securities. 8 The short sale is not closed until the replacement property is actually delivered to the lender, even if the borrower acquires and holds the replacement property in a separate account, because until delivery the borrower is free to use the replacement as he sees fit. Richardson v. Comm'r, 121 F.2d 1 (2d Cir. 1941). Section 1233 and the open transaction doctrine reflect a broad, consistent theme in the Code that defers the recognition of contingencies until they become certain. While contingencies may have significant economic value or cost, the tax law generally does not allow taxpayers to take into account as certainties things that are actually unknown, regardless of their economic value or cost. This principle particularly permeates the provisions of the Code that control a partner's basis in his partnership interest. Applying this principle, the IRS and the courts have

This rule often benefits the Service, because it prevents taxpayers from deducting losses until the transaction is complete. For example, in Hendricks v. Comm'r, 51 T.C. 235, 241-43 (1968), aff'd, 423 F.2d 485 (4th Cir. 1970), the taxpayer's broker purchased securities in December to cover a series of short sales, but such purchase was not settled until the following January. The taxpayer claimed a loss on his short sale positions in December because, in part, the cost of covering the short sale position was irrevocably fixed. The Commissioner nevertheless argued that the taxpayer could not deduct the loss until the following year (which began with January) because his purchase of the covering securities was not settled until that time. The Tax Court agreed with the Service finding that section 1233 and Treas. Reg. § 1.1233-1(a)(1) controlled the issue.

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long held that taxpayers may not adjust their bases in partnerships to account for contingencies, just as they may not take into account gain or loss on transactions that are still open. A. The Interplay of Section 705 and Section 752

The Code provides specific rules for how partners in partnerships are to account for income and loss from investments such as short sales, and it establishes a "pass through" regime under which a partnership acts as a conduit through which items of income and loss are passed to its partners. The partnership does not pay any tax on its income; rather, it is the partners who report their shares of the partnership income or loss on their own tax returns and pay tax or deduct losses accordingly. See Section 701. Section 705 plays a critical role in making adjustments to the partners' tax basis in their partnership interests (known as their "outside bases"), to reflect the results of partnership operations. It provides, in relevant part: (a) General rule.--The adjusted basis of a partner's interest in a partnership shall . . . be the basis of such interest determined under section 722 (relating to contributions to a partnership) or section 742 (relating to transfers of partnership interests)-(1) increased by the sum of his distributive share for the taxable year and prior taxable years of-(A) taxable income of the partnership as determined under section 703(a), ... (2) decreased (but not below zero) by distributions by the partnership as provided in section 733 and by the sum of his distributive share for the taxable year and prior taxable years of-(A) losses of the partnership . . . . For example, assume a partnership has two partners, each with a 50% interest, and the partnership holds only an asset in which it has a basis of $100. If the partnership sells the asset for $160, the partnership will have a $60 gain (and $160 of cash), and it will report $30 of income to each of the two partners, which they must report on their tax returns, paying any resulting tax. Section 705 then requires each partner to increase her basis in the partnership by that $30 to avoid the double taxation that would otherwise result when she ultimately sells her

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partnership interest (her 50% share is now worth $80) or the partnership distributes cash. 9 The mirror image is also true ­ section 705(a) also requires a partner to decrease his outside basis by his share of distributions from the partnership or his share of partnership losses (so he can deduct a loss only once). Under section 705(a), a partner's outside basis in a partnership is thus adjusted at the end of each year during which the partnership recognizes gain or loss. Partnerships, like other taxpayers, do not recognize gain or loss on a short sale until replacement securities are acquired and delivered to the lender, and section 1233 accordingly defers the recognition of gain or loss until that time. See Treas. Reg. § 1.1233-1(a)(1) ("For income tax purposes, a short sale is not deemed to be consummated until delivery of property to close the short sale."); see also Richardson, 121 F.2d at 4 (stating that gain or loss on a short sale was "only realized when the borrowed stock was delivered, or at least not before the lender acquired an equitable interest in specific shares."). Thus, a partner's outside basis in a partnership that holds an open short sale position will be adjusted under section 705 to reflect the gain or loss on the short sale when the partnership acquires and delivers the securities to cover the short sale. The Service used this very rule in Rev. Rul. 73-301, 1973-2 C.B. 215, where it held that section 705 governs when a partner's basis in a partnership is to be adjusted to account for "contingent" obligations, like the obligation to cover a short sale. The issue involved in that ruling -- whether interim payments received by a partnership in connection with a long-term contract constituted liabilities for purposes of section 752 -- is similar to the question here. In concluding that the interim payments were not "liabilities" within the meaning of section 752, the ruling stated that "[t]he income or loss from performance of the contract will affect the basis

9

A partner must recognize gain to the extent the proceeds from a sale of her interest exceed her outside basis. See sections 741, 1001. A partner also must recognize gain on any distribution of money that she receives from a partnership in excess of her outside basis. See section 731(a)(1).

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of the partnership interests of the partners, as provided in section 705(a), when such income or loss is recognized for Federal income tax purposes." Id. at 216 (emphasis added). Defendant's position in this case, on the other hand, inconsistently treats the requirement to cover a short sale as a "liability" for purposes of section 752 before the partnership acquires and delivers the securities to cover the short sale, i.e., while the transaction is still open. Section 752, which governs the treatment of liabilities by partners and partnerships, provides: (a) Increase in partner's liabilities.--Any increase in a partner's share of the liabilities of a partnership, or any increase in a partner's individual liabilities by reason of the assumption by such partner of partnership liabilities, shall be considered as a contribution of money by such partner to the partnership. (b) Decrease in partner's liabilities.--Any decrease in a partner's share of the liabilities of a partnership, or any decrease in a partner's individual liabilities by reason of the assumption by the partnership of such individual liabilities, shall be considered as a distribution of money to the partner by the partnership. (c) Liability to which property is subject.--For purposes of this section, a liability to which property is subject shall, to the extent of the fair market value of such property, be considered as a liability of the owner of the property. (d) Sale or exchange of an interest.--In the case of a sale or exchange of an interest in a partnership, liabilities shall be treated in the same manner as liabilities in connection with the sale or exchange of property not associated with partnerships. Under section 752(b), a partner must decrease his basis in the partnership to the extent that the partnership assumes the partner's individual "liabilities." 10 In turn, under section 752(a), all partners are then to increase their bases in their partnership interests for their share of the new "partnership" liability. 11 In the next section of this brief, plaintiffs will show that the contingent cover obligations are not "liabilities' within the meaning of section 752, as that term has long been interpreted and applied by defendant and the courts. For now, however, it is important to understand the incongruity that defendant's position would create between sections 705 and 752. By treating a
Section 752(b) treats a decrease in a partner's liabilities as a distribution of money to him from the partnership. The distribution of money from the partnership reduces basis dollar-for-dollar. See section 733. 11 Section 752(a) treats an increase in a partner's share of partnership liabilities as a contribution of property to the partnership. The contribution increases the partner's basis in the partnership on a dollar-for-dollar basis. See section 722.
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contingent cover obligation as a "liability" subject to section 752, the Service would require an estimated adjustment to the partners' bases in the partnership for the amount of the section 752 liability when the "liability" is assumed by the partnership, even though the Code precludes recognition of gain or loss on the transaction precisely because the cost to cover that is reflected in that "liability" cannot be anticipated. Thus, the amount of the section 752 liability cannot be quantified without prematurely treating the short sale as a closed transaction to derive a fixed and determinable liability in direct violation of Treas. Reg. § 1.1233-1(a)(1) and the open transaction doctrine. By focusing on section 752 ­ and avoiding discussion of sections 705, 1233, and the open transaction doctrine ­ defendant's brief incorrectly describes only part of the story. Indeed, defendant's brief noticeably lacks any explanation of how taxpayers are to estimate the amount of a "liability" that is contingent for purposes of calculating their initial cost basis in a partnership. In the case of a short sale of Treasury notes, the cost to cover will depend on movements in interest rates, which will drive the cost to acquire covering securities up or down. No taxpayer, including plaintiffs, can estimate with any certainty the cost to cover such a short sale for purposes of calculating the "liability". Defendant's position cannot be reconciled with Treas. Reg. § 1.1233-1(a)(1), which provides (emphasis added): "For income tax purposes a short sale is not deemed to be consummated until delivery of property to close the short sale." There is nothing in section 1233 or Treas. Reg. § 1.1233-1(a)(1) that indicates that open transaction treatment under this regulation "for income tax purposes" meant to say "for income tax purposes except under Code 752," which is the limitation that defendant now advocates. Defendant may not unilaterally add this restriction to the statute in disregard of its own regulations. An administrative agency "may not usurp the authority of Congress by adding restrictions to a statute which are not there."

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Stephenson Trust v. Comm'r, 81 T.C. 283, 288 (1983) (quoting Estate of Boeshore v. Comm'r, 78 T.C. 523, 527 (1982)). B. The Requirement to Cover a Short Sale Is Not a Liability for Purposes of Section 752.

Defendant's position not only ignores sections 1233 and 705, it is also in direct conflict with well-settled precedent holding that the requirement to cover a short sale position is not a "liability" within the meaning of section 752. In 1975 the Internal Revenue Service won a case in the United States Tax Court that governs this issue and that is directly on point. Helmer v. Comm'r, 34 T.C.M. (CCH) 727 (1975) involved two partners in a partnership that sold an option to acquire property owned by the partnership to a development corporation. The development corporation paid upfront consideration for the option and also made annual payments that were to be applied to the purchase price of the property if the option were exercised. The partnership treated these payments as "liabilities" that increased the Helmers' basis in their partnership interests under sections 752(a) and 722 on the theory that the partnership would have to credit these payments against the purchase price if the development corporation decided to exercise the option. The Service, however, argued that the amount that the partnership received for giving the option was not a "liability" within the meaning of section 752. The resolution of this issue was important to the Helmers because the partnership distributed the option proceeds to them and, under section 731(a), the Helmers would have taxable gain to the extent the distributions exceeded their partnership bases (so they wanted to count the option payments as a liability to increase their bases). As is the case with short sales, the partnership could not, under the open transaction doctrine, recognize income on the option contract (which also would have increased outside basis) until the option either expired or was exercised. The court agreed with the Service and held that the option proceeds were not a liability for purposes of section 752 because the

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obligation of the partnership to credit the payments to the development corporation was contingent upon the option being exercised. The Helmers were therefore not allowed to increase their bases in the partnership and, as a result, they had taxable gain on the distributions from the partnership. The Service again successfully argued that "contingent" obligations are not "liabilities" within the meaning of section 752 in Long v. Comm'r, 71 T.C. 1 (1978), motion for reconsideration, 71 T.C. 724 (1979), aff'd and remanded, 660 F.2d 416 (10th Cir. 1981). In that case, the courts held that contingent or contested obligations are not "liabilities" for purposes of increasing partnership basis until the obligations become fixed or liquidated. The taxpayer in Long was the beneficiary of the estate of his deceased father. The decedent was a partner in a partnership that constructed buildings, and upon his death the estate took his place as a partner in the partnership. Two lawsuits, which sought millions of dollars in damages for constructionrelated claims, were pending against the partnership when the father died. Shortly thereafter, the partnership was liquidated and the taxpayer, as beneficiary of the estate, claimed a loss on the liquidation. The estate treated the construction claims against the partnership as "liabilities" for purposes of section 752, which would have increased its basis in the partnership allowing it to deduct the losses. But the Service refused to allow the taxpayer to include the estate's share of such "liabilities" in its outside basis because such liabilities were contingent. The court agreed: The treatment of the other claims is not so clear, however the generic sense of the term, contingent or contested liabilities such as the Kansas City Life-TWA and USF&G claims are not "liabilities" for partnership basis purposes at least until they have become fixed or liquidated. This Court has held on a number of occasions that contingent and indefinite liabilities assumed by the purchaser of an asset are not part of the cost basis of the asset. We think that partnership liabilities should be treated in the same manner. We see no logical reason for distinguishing the above cases solely because the asset involved is an interest in a partnership, and neither party suggests such a distinction. Those liabilities are fixed or paid.

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The Kansas City Life-TWA and USF&G claims were too contingent at the death of the decedent to be included in the estate's initial computation of its basis in the decedent's partnership interest. Liability for those claims had not been established and was in fact contested. Moreover, the amounts of damages sought were by no means definite or fixed. Id. at 7-8 (emphasis added) (citations omitted). The court in Long gave two independent reasons for holding that the claims were not liabilities for purposes of section 752: the obligations were contingent, and they were also indefinite in amount. The Service has on many occasions ruled that contingent or executory obligations do not constitute liabilities under section 752. Most on point, in Rev. Rul. 57-29, 1957-1 C.B. 519, the taxpayer entered into a "when-issued" securities contract that gave the taxpayer the future right to receive a fixed payment in return for its contractual obligation to deliver specific securities to the buyer when and if such securities were issued. The Service ruled that: In computing the cost basis of assets for any purpose, the Internal Revenue Service does not recognize an obligation of a taxpayer reflected in an executory contract prior to the performance of the contract. Such an executory contract to buy or sell securities which has cost the taxpayer nothing has a basis of zero to him, for Federal income tax purposes, in computing his gain or loss on a subsequent sale or disposition thereof prior to performance on the contract. Id. at 519-20. The "when-issued" security purchase agreements addressed in this Ruling are treated as short sales for tax purposes. See section 1233(e)(2)(A); Treas. Reg. §§ 1.1233-1(c)(1), 1.1233-1(c)(6) Ex. 6 (applying short sale rules to "when issued" securities); S. REP. NO. 81-2375, at 87 (1950) (providing that the entry into a contract to sell stocks or securities "when issued" shall be considered as a short sale and the performance of such contract or the assignment thereof for value shall be considered as a closing of such short sale) (reproduced in Appendix A); I.R.S. G.C.M. 37,332 (Nov. 25, 1977) ("when issued" sales contracts are treated as short sales subject to section 1233). Thus, in flat contrast to the position that defendant is taking in this case, the Service has already ruled that an executory obligation such as the obligation to cover a short sale is not to be treated as a liability for purposes of section 752.

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The position adopted by the Service in Rev. Rul. 57-29 was reaffirmed in Rev. Rul. 79294, 1979-2 C.B. 305. In Rev. Rul. 79-294, the Service stated that a commodity futures contract (including a short position under a commodity futures contract) is merely an executory contract and not a liability under section 752. Id. See also I.R.S. G.C.M. 37,971 (June 1, 1979) ("The Internal Revenue Service does not recognize an obligation of a taxpayer reflected in an executory contract prior to the performance of the contract."); I.R.S. G.C.M. 37,860 (Feb. 16, 1979) ("[I]n computing the cost basis of an executory contract for any purpose the Service does not recognize an obligation of a taxpayer reflected in an executory contract prior to performance of the contract.") (emphasis added); I.R.S. G.C.M. 38,237 (Feb. 15, 1980) ("[T]he Service does not recognize the obligation of a taxpayer reflected in an executory contract prior to performance of the contract."). Helmer and Long and the cited IRS pronouncements all stand for the same fundamental proposition: contingent obligations (i.e., those where the obligation itself is unmatured, executory, or speculative) are not "liabilities" for purposes of section 752. Obligations that are contingent in amount also are not "liabilities" for purposes of section 752, even if such obligations are "definite" in the sense that it is certain that the obligor will have to transfer at least some property to satisfy the obligation. In La Rue v. Comm'r, 90 T.C. 465 (1988), the Service argued, and the Court agreed, that obligations that are fixed in the sense that it is known that some amount will be paid, but that remain contingent in amount, do not constitute "liabilities" for purposes of section 752. The court stated the meaning of "liability" for purposes of section 752 was established in Long and that, even though a contract may create a definite obligation to replace securities, that obligation does not represent a "liability" under section 752 until the cost of that obligation becomes fixed in amount: Once the `back office' failures occurred, Goodbody incurred an obligation. The partnership was contractually obligated to its customers under the

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NYSE rules. Goodbody was under an obligation to replace any missing securities or money. Essentially, Goodbody's books were in error because of the back office problems and the Haskins report reflected estimated liability figures. All of petitioners' witnesses testified that these were transactions for which the partnership was liable. There was, however, a contingency or speculative quality concerning the amount of Goodbody's liability. Until any missing securities were purchased or excess securities sold, at market price, there was no way of determining the amount of loss, or in some circumstances, gain. Petitioners have not shown that these amounts were determinable with reasonable accuracy. As a result of the Haskins audit, Goodbody (and Merrill Lynch) knew which particular securities would have to be sold or purchased and how much money was missing from customer accounts. However, it was not certain upon which of these claims Goodbody would ultimately be liable, because the smaller the amount of the transaction the less likely the customer would be to claim it. In addition, the exact amount of loss or gain was not determinable until actual purchase or sale. Valuation of the claims may be a purely ministerial matter because of the ready market for securities, but is not readily determinable until purchase or sale occurs. The additional reserves reflected potential liabilities of the partnership, valued by reference to listed stock prices but before actual sale or purchase and, accordingly, represented estimates. Accrual accounting requires that the amount be determinable with `reasonable accuracy.' A loss is not determinable until the securities are actually purchased or sold, and the transaction closed. We accordingly hold that because the reserves were not a fixed obligation of the partnership sufficiently determinable in amount in 1970, they cannot be included in the partners' bases in that year. LaRue, 90 T.C. at 479-80 (footnotes omitted) (emphasis added). See also Long, 71 T.C. at 8 (holding that the obligation was not a section 752 liability because, in part, "the amounts of damages sought were by no means definite or fixed"). The obligation at issue in LaRue ­ to replace identified missing securities and money ­ was an obligation substantially similar to plaintiffs' obligation to cover a short sale of Treasury notes and, in LaRue, the Tax Court clearly held that, despite the ready market from which the securities could be obtained, the amount of the obligation was contingent and speculative and therefore such obligation could not represent a "liability" under section 752. The requirement to cover the short sale that is involved in the present case is contingent in the same manner as the obligations addressed in Helmer, Long, and La Rue. Although the

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borrower in a short sale must eventually purchase like securities (in this case, Treasury notes) to cover the short sale, that obligation is open, executory and not fixed in amount. Even if the cover requirement matures, the taxpayer can not know how much it will cost to acquire the covering securities until they are actually acquired, and the obligation therefore remains contingent in amount until that time. For these reasons, the executory cover requirement can not be treated as a liability for purposes of section 752 under the settled precedents. The conclusion that an obligation that is contingent in amount is not a "liability" also draws support from the ruling of the Supreme Court, again at the urging of the Service, that the obligation to cover a short sale is not an "indebtedness" because it does not require the repayment of money. In Deputy v. du Pont, 308 U.S. 488 (1940), the taxpayer borrowed stock and agreed to return it within ten years, and also agreed in the interim to pay the lender all dividends that he received on the borrowed shares. The taxpayer then sold the stock to nine du Pont executives (i.e., he sold it short). In 1931, the taxpayer paid the lender $567,648 in dividends that had been paid on the stock, and he deducted that amount as "interest paid or accrued . . . on indebtedness" under former section 23(b) (the predecessor to current section 163). The Service contended that an obligation to cover a short sale was not "indebtedness" and disallowed the deduction. The Supreme Court decided the issue under a plain meaning approach. It determined that "indebtedness" meant "borrowed money" and "interest on indebtedness" meant "compensation for the use or forbearance of money." The Court held that while the requirement to cover the short sale was an "obligation," it was not "borrowed money," and could not therefore be "indebtedness." Id. at 497-98. The ruling in du Pont is that a short sale involves the borrowing of property, not money, and that an obligation to return property does not qualify as "debt" for tax purposes. The Court's decision in du Pont illustrates that there are two independent components to a short sale that may

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not be collapsed for tax purposes: the borrowing of a security and the sale of a security. The taxpayer in du Pont was not allowed to deduct his "interest" expense because he had not borrowed any money and incurred any "indebtedness" under the plain meaning of that term ­ he had instead only borrowed property. The cash received in a short sale is thus attributable to the sale of the borrowed property and is not attributed to any borrowing of funds. The Service may not disregard the holding it advocated in du Pont to suit its different purposes in this case. Either the obligation to return property in a short sale is a "debt" for tax purposes or it is not. The Supreme Court, and Congress through legislative enactments, 12 have determined that the obligation to return property in a short sale is not a "debt" or a "borrowing" for tax purposes. An executory promise to return property in a short sale cannot be a "liability" for the same reason. The terms "liability," "debt" and "indebtedness" are synonymous. See THE NEW ROGET'S THESAURUS IN DICTIONARY FORM 126-27 (Norman Lewis, ed., Berkley Books rev. ed 1978) (1961). (Debt: "liability . . . indebtedness") (reproduced in Appendix A). Indeed, at one time defendant proposed a definition of "liability" for purposes of section 752 which would only apply to "debt", which under du Pont would not include obligations to cover a short sale. 13 Because there is no valid reason for defining a "liability" differently than "debt,"

Congress has also recognized that the requirement to cover a short sale is not a "debt" for tax purposes. Several provisions of the Code have been enacted to treat a short sale position as debt only for specific purposes. See, e.g., sections 163(d)(3)(C), 246A(d)(3)(B), 263(g)(2), 265(a)(5). These provisions make clear that, but for their existence, the requirement to cover a short sale would not otherwise constitute "debt" for tax purposes. The "bluebook" explanation of the legislative changes to sections 163, 246A, 263, and 265 also indicates that "a short sale was not treated as a borrowing" prior to these changes. Staff of the Joint Committee on Taxation, 98th Cong., GENERAL EXPLANATION OF THE REVENUE PROVISIONS OF THE DEFICIT REDUCTION ACT OF 1984 at 156-57 (Comm. Print 1985) (emphasis added) (reproduced in Appendix A). 13 Temp. Treas. Reg. § 1.752-1T(k) (since withdrawn by the IRS but reproduced in Appendix A) provided (emphasis added): (k) Examples. The following examples illustrate the application of the rules of this section. Except as otherwise provided, these examples assume that . . . (2) partnership indebtedness constitutes debt for federal income tax purposes . . . . Example 2(ii) . . . As provided by paragraph (g) of this section [the definition of liability], an obligation that constitutes a debt for federal income tax purposes is a liability of the obligor 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 . . . .

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defendant is bound by that result until Congress amends the statute to provide for a different rule. See Brown v. Helvering, 291 U.S. 193, 200 (1934) ("Except as otherwise specifically provided by statute, a liability does not accrue as long as it remains contingent."). Defendant failed to offer any explanation of why the contingent obligations to cover are to be treated as liabilities for purposes of section 752. Instead, in a "declare victory and walk away" moment, defendant in a footnote without any explanation merely states that the "liabilities in issue here . . . are not contingent." (Def.'s Mot. Summ. J. 15, n.17.) This is directly contrary to section 1233 and defendant's longstanding position that obligations to cover short sales are contingent. See, e.g., I.R.S. G.C.M. 35,328 (May 4, 1973) (describing a short sale as "involving [an] obligation which would vary with changes in market values while the proceeds of the transaction remained fixed from the time it was entered"). The cost to cover the short sale is either contingent or it is not: defendant should not be allowed to treat the obligation to cover a short sale as open and contingent for purposes of deferring gain or loss, but as immediately closed and fixed and determinable for purposes of recognizing and quantifying a "liability." Defendant is necessarily bound by the same legal standards for computing basis that it has long imposed on taxpayers, both with respect to how basis is calculated under section 752 and for application of the open transaction doctrine. The impracticality of defendant's position is also apparent. There is no provision in the Code or the Treasury regulations that speaks to how the amount of a short sale obligation is to be measured before it is closed. This should be expected, because the Code and regulations otherwise treat a short sale as an open position until the covering securities are delivered to the lender. See Treas. Reg. § 1.1233-1(a)(1) ("For income tax purposes, a short sale is not deemed to be consummated until delivery of property to close the short sale."). There is no realistic

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method for determining the amount of the obligation until the cover transaction is concluded ­ for it is not possible to know today what the cost to cover will be tomorrow. The lack of any meaningful method for estimating the amount of these contingencies is well-demonstrated by defendant's own motion. At first, defendant indicates that the amount of the "liability" at issue for purposes of section 752 is $44,000,000, which is the actual amount of cash that the Alpha limited partners received in the short sales (excluding accrued interest). (Def.'s Mot. S