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

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 1 of 48

IN THE UNITED STATES COURT OF FEDERAL CLAIMS Nos. 06-245T, 06-246T, and 06-247T
(Consolidated)

MURFAM FARMS, LLC, By and Through Wendell H. Murphy, Jr., a Partner Other Than Tax Matters Partner, PSM FARMS, LLC, By and Through Stratton K. Murphy, a Partner Other Than Tax Matters Partner, MURPHY PORK PARTNERS, LLC By and Through Wendell H. Murphy, Jr. a Partner Other Than Tax Matters Partner, Plaintiffs, v. UNITED STATES OF AMERICA, Defendant.

§ § § § § § § § § § § § § § § § § § §

____________
UNITED STATES' MEMORANDUM OF LAW IN OPPOSITION TO PLAINTIFFS' MOTION FOR PARTIAL SUMMARY JUDGMENT AS TO THE VALIDITY OF TREASURY REGULATION § 1.752-6

___________

DENNIS M. DONOHUE Chief Senior Litigation Counsel U.S. Department of Justice, Tax Division Post Office Box 403 Ben Franklin Station Washington, D.C. 20044 (202) 307-6492

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 2 of 48

TABLE OF CONTENTS Page(s) TABLE OF CONTENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ii TABLE OF AUTHORITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iv- vii APPENDIX.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . viii BACKGROUND. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 STATEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 A. B. The COBRA Transaction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 The Transaction At Issue.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

ARGUMENT. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 THE RETROACTIVE APPLICATION OF TREASURY REGULATION § 1.752-6 IS VALID . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 A. B. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Treas. Reg. § 1.752-6 Is A Legislative Regulation And Has The Force And Effect Of Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 The Retroactivity Of Treas. Reg. § 1.752-6 Is Valid . . . . . . . . . . . . . . . . . . . . . 21 Congress Was Clearly Aware Of Abusive Partnership Contingent Liability Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Plaintiffs' Assertion That The Real Purpose Of Treas. Reg. §1.752-6 Was To Buttress The Government's Litigation In Notice 2000-44 Transactions Is Belied By The Mandate In Section 309(c) Of The 2000 Act. . . . . . . . . . . . . . . . . . . . . . 26 COBRA Taxpayers Could Not Rely On Helmer And Similar Cases. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

C. D.

E.

F.

-ii-

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 3 of 48

G.

Plaintiffs' Argument That Section 309 Is Limited To Corporate Transactions Is Contrary To The Plain Wording Of The Statute . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 The Regulation's Rules Are Comparable To I.R.C § 358 . . . . . . . . . . . . . . . . . . 31 Plaintiff's Argument That The Regulation Fails The Chevron Test Is Meritless. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Adoption Of The Regulation Is Constitutional And Does Not Violate Due Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 Plaintiffs' Contention That The IRS Violated The Notice And Comment Requirements Of The Administrative Procedure Act (the "APA") Lacks Merit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

H. I.

J.

K.

CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

-iii-

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 4 of 48

TABLE OF AUTHORITIES FEDERAL CASES

ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998)...............................................................................................23 Anderson, Clayton & Co. v. United States, 562 F.2d 972 (5th Cir. 1977)............................................................................................ 34 Cemco Investors, LLC v. United States, 515 F.3d 749 (7th Cir. Feb. 7, 2008)......................................... 3, 22, 23, 27, 29, 33, 37, 38 Cemco Investors, LLC v. United States, 2007 WL 951944 (N.D. Ill.2007), aff'd 515 F.3d 749 (7th Cir. 2008).......................................................................................4 Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S.837 (1984)........................................................................................... . 20, 21, 32 Coltec Industrial, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006), cert. denied, 127 S. Ct. 1261 (2007)............................. 19 Doe v. Wachovia, 268 F. Supp. 2d 627 (W.D.N.C. 2003)................................................................................ 6 Fransen v. United States, 191 F.3d 599 (5th Cir. 1999)............................................................................................. 20 Gilman v, Commissioner, 933 F.2d 143 (2nd Cir. 1991).............................................................................................18 Helmer v. Commissioner, 34 T.C.M. (CCH) 727 (1975).......................................................................................... 29 27, 28, Jade Trading LLC v. United States, 80 Fed. Cl. 11 (2007)............................................................................................. . . . . 28

-iv-

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 5 of 48

Kandi v. United States, 2006 WL 83463 (W.D. Wash. 2006), appeal docketed, No. 06-35209 (9th Cir. March 14, 2006)...........................................................................34 Klamath Strategic Inv. Fund, LLC v. United States, 440 F. Supp. 2d 608 (E.D. Tex. 2006), cross-appeals docketed, Nos. 07-40861, 07-40915 (5th Cir. Sept. 7, 2007, Sept. 19, 2007).....3, 4, 21, 22, 33, 34 38 Klamath Strategic Inv. Fund, LLC v. United States, 472 F.Supp.2d 885, 896-98 (E.D. Tex 2007), cross-appeals docketed, Nos. 07-40861, 07-40915 (5th Cir. Sept. 7, 2007, Sept. 19, 2007)....................................23 Kligfield Holdings v. Commissioner, 128 T.C. 192 (2007)............................................................................................................ 2 La Rue v. Commissioner, 90 T.C. 465 (1988).......................................................................................................27, 28 Long Island Care at Home, Ltd. v. Coke, 127 S. Ct. 2339 (2007)...................................................................................................... 27 Long v. Commissioner, 71 T.C. 1 (1978), rev'd in part on other grounds, 660 F.2d 416 (10th Cir. 1981)........................................................................................... 27 Stobie Creek Investments, LLC v. United States, 2008 WL 852821 (Fed.Cl. March 10, 2008).......................................................................3 Snap-Drape, Inc. v. Commissioner, 98 F.3d 194 (5th Cir. 1996)............................................................................................... 34 The Diversifed Group, Incorporated v. Daugerdas, 139 F. Supp. 2d 445 (S.D.N.Y. 2001)............................................................................. 4, 5 United States v. Jenkens & Gilchrist, 03-5693 (N.D. Ill. March 10, 2005). ..................................................................................6

-v-

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 6 of 48

FEDERAL STATUTES 5 U.S.C. § 553(b)(B)..........................................................................................................36 5 U.S.C. § 553(b) & (c)......................................................................................................35 5 U.S.C. § 553 (b)(A).........................................................................................................35 5 U.S.C. § 553(d)(1) and (3)...............................................................................................36 I.R.C. § 357(b)............................................................................................................. 24, 25 I.R.C. § 358.........................................................................................................................25 I.R.C. § 358(h).................................................................................19, 21, 26, 30, 31, 32, 35 I.R.C. § 358(h)(3)..................................................................... 18, 19, 24, 25, 26, 30, 31, 32 I.R.C. § 362(a)......................................................................................................................8 I.R.C. § 752 ................................................................................................................. 20, 33 I.R.C. §§ 752(a) and (b)...............................................................................................17, 20 I.R.C. § 7805(b)..................................................................................................... 21, 33, 34 I.R.C. § 7805(b)(1)).................................................................................................... 21, 34 I.R.C. § 7805(b)(2)............................................................................................................ 34 I.R.C. § 7805(b)(3)................................................................................................ 23, 33, 34 I.R.C. § 7805(b)(6).............................................................................................................26 I.R.C. § 7805(b)(7).............................................................................................................34 I.R.C. § 362(a)......................................................................................................................8 I.R.C. § 357(b)...................................................................................................................25

FEDERAL REGULATIONS

70 Fed. Reg. 30,334, 30,336-30,337 (2005)...................................................................... 36 68 Fed. Reg. 37,414 (2003)................................................................................................35 68 Fed. Reg. at 37,416.......................................................................................................36 68 Fed. Reg. 37,434 (2003)................................................................................................36 68 Fed. Reg. 37,434, 37,436-37,437 (2003)...................................................................... 35 68 Fed. Reg. 37,438........................................................................................................... 36 Treas. Reg. § 1.752-7.....................................................................................3, 27, 35, 36, 37 Temp. Treas. Reg. § 1.752- 6T..........................................................................................36 Treas. Reg. § 1.358-7.........................................................................................................21 Treas. Reg. 1.752-1............................................................................................................38 Treas. Reg. § 1.752-6........1, 2, 3,4,17, 18, 19, 20, 21, 22, 23, 26, 27, 30, 32, 34, 35,36, 37 Treas. Reg. § 1.752-6(a).....................................................................................................32 Treas. Reg. § 1.752-6(d)(1)................................................................................................18 Treas. Reg. § 1.752-6T...........................................................................................35, 36, 37 . Temp. Treas. Reg. § 1.752-6T...........................................................................27, 35, 36, 37

-vi-

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 7 of 48

OTHER AUTHORITIES S. Rep. No. 106-120 at 1 (1999)..........................................................................................24 S. Rep. No. 106-201 at 47 (1999)........................................................................................25 T.D. 9062, 2003-2 C.B. at 61........................................................................................19, 20 T.D. 9207, 2005-1 C.B. at 1347..........................................................................................23 Title V of the Ticket to Work and Work Incentives Improvement Act of 1999, Pub. L. No. 106-170, 113 Stat. 1860 (1999)...................................................... 25, 26 § 309(c) of the Community Renewal Tax Relief Act of 2000, Pub. L. No. 106-554, 114 Stat. 2763A-638,Appendix A1. T.D. 9062, 2003-2 C.B. 46, 67 (the "2000 Act")...................................................................................................... 19 . 145 Cong. Rec. 27,547, 27,553-27,554 (1999)..................................................................25 2000-2 C.B. at 255 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 1999-2 C.B. at 761 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 H.R. 2488, 106th Cong. (1999) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 H.R. Conf. Rep. No. 106-1033 at 1017 (2000), reprinted in 2000-3 C.B. 304, 347. Treas. Reg. § 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20, 31

-vii-

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 8 of 48

IN THE UNITED STATES COURT OF FEDERAL CLAIMS Nos. 06-245T, 06-246T, and 06-247T
(Consolidated)

MURFAM FARMS, LLC, By and Through Wendell H. Murphy, Jr., a Partner Other Than Tax Matters Partner, PSM FARMS, LLC, By and Through Stratton K. Murphy, a Partner Other Than Tax Matters Partner, MURPHY PORK PARTNERS, LLC By and Through Wendell H. Murphy, Jr. a Partner Other Than Tax Matters Partner, Plaintiffs, v. UNITED STATES OF AMERICA, Defendant.

§ § § § § § § § § § § § § § § § § § §

____________

APPENDIX OF ADDITIONAL LEGISLATIVE AUTHORITIES CITED IN UNITED STATES' MEMORANDUM OF LAW IN OPPOSITION TO PLAINTIFFS' MOTION FOR PARTIAL SUMMARY JUDGMENT AS TO THE VALIDITY OF TREASURY REGULATION § 1.752-6 ______________________________________________

-viii-

3212853.1

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 9 of 48

# A1

Description § 309(c) of the Community Renewal Tax Relief Act of 2000, Pub. L. No. 106-554, 114 Stat. 2763A-587. T.D. 9062, 2003-2 C.B. 46, 67 (the "2000 Act"). H.R. 2488, 106th Cong. (1999), pp. 537-538 H.R. Conf. Rep. No. 106-1033 (2000), reprinted in 2000-3 C.B. 304, 347, pp.1017-1020 H.R. Rep. No. 106-1036 (2000), pp. 5-7 S. 1792, the Tax Relief Extension Act of 1999 S. 1429, 106th Cong. (1999), pp.214-215 S. Rep. No. 106-201 (1999), pp. 46-48 Staff of the Joint Comm. on Taxation, 106th Cong., General Explanation of Tax Legislation Enacted in the 106th Congress (Comm. Print 2001) (JCS-2-01), reprinted in 2000-3 C.B. 565, 651, pp.153-156.

Pages 001-002

A2 A3 A4 A5 A6 A7 A8

003-005 006-010 011-014 015-017 018-020 021-024 025-029

-ix-

3212853.1

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 10 of 48

IN THE UNITED STATES COURT OF FEDERAL CLAIMS Nos. 06-245T, 06-246T, and 06-247T
(Consolidated)

MURFAM FARMS, LLC, By and Through Wendell H. Murphy, Jr., a Partner Other Than Tax Matters Partner,

§ § § § PSM FARMS, LLC, § By and Through Stratton K. Murphy, § a Partner Other Than Tax Matters Partner, § § MURPHY PORK PARTNERS, LLC § By and Through Wendell H. Murphy, Jr. § a Partner Other Than Tax Matters Partner, § § Plaintiffs, § § v. § § UNITED STATES OF AMERICA, § § Defendant. § ___________ UNITED STATES' MEMORANDUM OF LAW IN OPPOSITION TO PLAINTIFFS' MOTION FOR PARTIAL SUMMARY JUDGMENT AS TO THE VALIDITY OF TREASURY REGULATION § 1.752-6 ___________

Plaintiffs move for partial summary judgment in this case involving offsetting option transactions known as COBRA. Specifically, plaintiff requests the Court to issue an order holding Treas. Reg. § 1.752-6 (the "Regulation") to be invalid. This regulation applies retroactively to the COBRA transaction at issue and requires the taxpayers to reduce their basis in their purported partnership interest (outside basis) by the amount of the premium credited to them -1-

3218494.1

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 11 of 48

on the purported short option liability that their "partnership" assumed. The Regulation was designed to prevent the abusive practice of taxpayers, such as the transactions engaged in by various members of the Murphy family here, claiming huge noneconomic losses generated from artificially-inflated bases in partnership interests or assets whose bases are derived from such inflated outside bases. Contrary to plaintiffs' arguments, the Regulation is valid, is manifestly consistent with its authorizing statute and was properly issued. BACKGROUND Treas. Reg. § 1.752-6 is designed to combat so-called Son of Boss transactions. There are a number of different types of Son-of-BOSS transactions, but what they all have in common is the transfer of assets along with significant liabilities to a partnership, with the goal of artificially inflating the taxpayer's basis in the partnership. See, Kligfield Holdings v. Commissioner, 128 T.C. 192, 194 (2007). These liabilities may be varied and may not be completely fixed at the time of transfer. The promoters of these tax shelters claim that because these liabilities may be uncertain, they are contingent liabilities and can be ignored in computing a taxpayer's outside basis in the partnership. The result is that the taxpayers will have a basis in the partnership that can be used to generate enormous tax losses, even though the taxpayer has incurred no corresponding economic loss. On December 27, 1999, the IRS issued Notice 99-59 advising taxpayers that to be deductible for federal income tax purposes, a loss must be bona fide and reflect actual economic consequences. 1999-2 C.B. at 761. On August 11, 2000, the IRS issued Notice 2000-44 informing taxpayers and tax practitioners that noneconomic tax losses generated from artificiallyinflated partnership bases are not allowable deductions and warning taxpayers that claiming such

-2-

3218494.1

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 12 of 48

fictitious losses may result in penalties. 2000-2 C.B. at 255. Following up on these warnings, on June 24, 2003, the Treasury Department issued Treas. Reg. § 1.752-6, in temporary form, which sets forth a basis reduction rule applicable to partnership assumptions of certain obligations (whether fixed or contingent) occurring after October 18, 1999, and before June 24, 2003.1 To support its position that the Regulation is invalid, plaintiffs rely heavily on Klamath Strategic Inv. Fund, LLC v. United States, 440 F. Supp. 2d 608 (E.D. Tex. 2006), cross-appeals
2 docketed, Nos. 07-40861, 07-40915 (5th Cir. Sept. 7, 2007, Sept. 19, 2007). The transaction at

issue in Klamath also sought to inflate artificially a partner's basis in his partnership interest. The Klamath court held that the retroactive application of Treas. Reg. § 1.752-6 to conduct occurring prior to August 11, 2000 (the date on which the IRS issued Notice 2000-44) was invalid. Incredibly, however, plaintiffs fail to inform the Court that the Seventh Circuit recently issued a "withering rejection"3 of Klamath in Cemco Investors, LLC v. United States, 515 F.3d 749 (7th Cir. Feb. 7, 2008). In Cemco, the Seventh Circuit held, in the strongest possible terms, that Klamath was incorrect and that Treas. Reg. § 1.752-6 is valid. Plaintiffs' failure to even note in passing the Seventh Circuit's holding in Cemco, which was decided a month before plaintiffs filed the instant motion, is particularly egregious because plaintiffs twice cite the District Court

A much more detailed set of rules applies to assumptions of such obligations occurring on or after June 24, 2003. See Treas. Reg. § 1.752-7.
2

1

Plaintiff fails to note that this holding is on appeal.

See Stobie Creek Investments, LLC v. United States, 2008 WL 852821 (Fed.Cl. March 10, 2008). -33218494.1

3

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 13 of 48

opinion in Cemco.4 Moreover, although citing the lower court decision, plaintiffs never even mention that the District Court also implicitly found Treas. Reg. § 1.752-6 to be valid or alert the Court that the Seventh Circuit, in affirming the District Court's decision, found Klamath's reasoning devoid of logic.5 STATEMENT A. The COBRA Transaction. COBRA is an acronym for Currency Options Bring Reward Alternatives.6 The COBRA transaction was designed in the months of September and October of 1999 by the national accounting firm Ernst & Young, LLP ("E&Y"), with the assistance of the Chicago law firm of Jenkens & Gilchrist ("J&G") and Deutsche Bank A.G. ("DB"),7 which were already marketing a similar product known as the Option Partnership Strategy ("OPS").8 The OPS strategy and its genesis are described in The Diversifed Group, Incorporated v. Daugerdas, 139 F.Supp.2d 445 (S.D.N.Y. 2001), in which The Diversified Group, alleged that Paul Daugerdas, the newly-

Plaintiffs' Memorandum in Support of its (sic) Motion for Partial Summary Judgment as to the Validity of Treasury Regulation § 1.752-6 ("P. Brief.") at 21 n.72 and 24 n.81. Cemco Investors, LLC v. United States, 2007 WL 951944 (N.D. Ill.2007), aff'd 515 F.3d 749 (7 Cir. 2008).
th 5

4

United States' Additional Proposed Findings of Uncontroverted Facts in Opposition to Plaintiff's Motion for Partial Summary Judgment as to the Validity of Treasury Regulation § 1.752-6 ("Proposed Findings") ¶ 1.
7

6

Proposed Findings ¶ 2. Proposed Findings ¶ 3. -43218494.1

8

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 14 of 48

appointed head of J&G's recently- formed Chicago office, had stolen its tax shelter product.9 The COBRA and OPS transactions are both predicated upon the use of nearly off-setting digital option contracts.10 In the late fall of 1999, J&G and DB implemented 105 OPS transactions.11 Concurrently, they also implemented 15 COBRA transactions for E&Y.12 The 15 COBRA transactions generated noneconomic tax losses totaling $834 million.13 The OPS and COBRA transactions were designed to accomplish the same tax-driven objective and differed only slightly in their terms. The engine driving both transactions was offsetting foreign currency digital options: a purchased (or long) option and a sold (or short) option.14 As structured, the offsetting digital options of both OPS and COBRA provided a net payoff at a pre-agreed upon multiple of the net premium.15 In the instance of the OPS transactions, the net premium was equal to 1% of the desired loss, with the possibility of a 2:1

Proposed Findings ¶ 5. In its suit against J&G, DGI broadly defined its stolen OPS product as follows: "The option partnership strategy is a tax-saving strategy wherein a taxpayer purchases and writes options and transfers these option positions to a partnership so as to create substantial increased basis in the partnership interest. As a result of these trades and transfer, the taxpayer claims that the basis of the taxpayer's partnership interest is increased by the cost of purchased call options, but is not reduced as a result of the partnership's assumption of the taxpayer's obligation with respect to the written call options." The Diversifed Group, Incorporated v. Daugerdas, 139 F.Supp.2d at 449. Proposed Findings ¶ 5.

9

10

Proposed Findings ¶ 6. Proposed Findings ¶ 7. Proposed Findings ¶ 8. Proposed Findings ¶ 9. Proposed Findings ¶ 10. Proposed Findings ¶ 11. -53218494.1

11

12

13

14

15

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 15 of 48

payoff.16 In the case of COBRA, the net premium for the structure implemented with J&G was equal to 5% of the desired loss, with a possibility of a 2.5:1 net payoff.17 For the 2000 COBRA structure implemented without J&G the net premium was equal to 5% of the desired loss, with a possibility of a 2.25:1 net payoff. At the end of 1999, E&Y decided to implement its COBRA product in 2000 without J&G. Notwithstanding these cosmetic changes, these offsetting option transactions were both designed to generate an artificially-inflated basis of a taxpayer's partnership interest, which, in turn, could be used to generate massive tax losses, and thereby eliminate a wealthy taxpayer's unrelated taxable income.18 E&Y began marketing the COBRA transaction in the fall of 1999.19 Both E&Y and J&G required so-called "targets" (potential COBRA purchasers) to sign a non-disclosure agreement ("NDAs").20 The J&G NDA expressly disclosed J&G's role as a promoter and disclaimed any fiduciary relationship with the target.21 See, e.g., Doe v. Wachovia, 268 F. Supp. 2d 627, 634 (W.D.N.C. 2003) (holding that the terms of J&G's NDA vitiated any attorney-client relationship with taxpayers). See also, United States v. Jenkens & Gilchrist, 03-5693 (N.D. Ill. March 10, 2005) (same). In addition to being required to sign NDAs, targets were not allowed to retain any

16

Proposed Findings ¶ 12. Proposed Findings ¶ 13. Proposed Findings ¶ 14. Proposed Findings ¶ 15. Proposed Findings ¶ 16. Proposed Findings ¶ 17. -63218494.1

17

18

19

20

21

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 16 of 48

of the marketing materials.22 Both of these limitations appear to have been imposed upon potential clients in order to minimize the possibility that the COBRA transactions might be disclosed to the IRS.23 In the marketing of the program, targets were typically shown a template J&G draft legal opinion blessing the transaction for federal income tax purposes.24 To assist in choreographing the intricately sequenced steps of this transaction, the promoters not only developed a COBRA power point, but a COBRA Client Questionnaire and a COBRA Action Workplan.25 The COBRA Power Point was used to market the product to potential clients and generally details the overall steps, with particular focus on the planned tax benefits.26 The COBRA Client Questionnaire was designed to provide J&G the necessary information to implement the transaction, detailing both the amount and the character of the desired tax loss.27 The COBRA Checklist was then to be used by E&Y to monitor the planned choreography.28 The COBRA Power Point provides a good overview of the transaction, which slides can be briefly summarized as follows:29 Step One: Purchase/Sale of Offsetting Option Contracts. Each individual simultaneously

22

Proposed Findings ¶ 18. Proposed Findings ¶ 19. Proposed Findings ¶ 20. Proposed Findings ¶ 21. Proposed Findings ¶ 22. Proposed Findings ¶ 23. Proposed Findings ¶ 24. Proposed Findings ¶ 25. -73218494.1

23

24

25

26

27

28

29

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 17 of 48

buys (goes long) and sells (goes short) digital foreign currency options at nearly identical strike prices, creating a position consisting of two offsetting options. Step Two: Transfer of Offsetting Options to Partnership. The individuals transfer the offsetting foreign currency option positions to a "newly formed general partnership." In calculating their basis in the partnership, the taxpayers take into account the stated premium of the long option and ignore the offsetting stated premium received for the short option. In addition, the individuals contribute cash equal to two per cent of the "desired loss" (i.e., the stated premium on the long option) to the partnership. Step Three: Termination of Options and Acquisition of Assets. The digital foreign currency options expire either in or out of the money, resulting in a gain or loss. The COBRA Presentation then states, "[i]f ordinary loss is desired, spot foreign currency will be purchased by the partnership. If capital loss is desired, capital assets will be purchased." Step Four: Transfer of Partnership Interests to S Corp. The individuals transfer their entire interest in the partnership to a newly formed S corporation, which results in the technical termination of the partnership for federal income tax purposes. Step Five: Distribution of Partnership Assets to S Corp and Their Sale. The partnership liquidates and distributes its assets to the S corporation. Under I.R.C. § 362(a), the taxpayers' artificially-inflated outside basis in the now-dissolved partnership carries over and becomes the basis of the distributed stock and/or foreign currency distributed to the S corporation. The S corporation then "sells the stepped-up assets [i.e. the foreign currency or securities] to an unrelated third party, generating a loss for tax purposes." Although not specified on the COBRA Powerpoint, the final step of the transaction was

-8-

3218494.1

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 18 of 48

the payment of fees and preparation and issuance to the taxpayers in the following tax year of two separate legal opinions to support COBRA's claimed tax benefits. For its 1999 COBRA product E&Y charged a fee of 1.5.% of the taxpayers' desired loss and J&G charged a fee of 3% of the taxpayers' desired loss, net of the fee charged by the firm of Brown & Wood, LLP ("B&W).30 For its 2000 COBRA product E&Y charged a fee of 2% of the taxpayers' desired tax loss and substituted the law firm of Proskauer Rose ("PR") for the law firms of J&G and B&W at a substantially reduced fee equal to .5% of the taxpayers' desired tax loss. Just as with the J&G and B&W opinions, the PR opinions were boilerplate opinions containing virtually the same formulaic language except for the required change in the taxpayers' names and the names of their respective entities.31 B. The Transaction at Issue. The three COBRA transactions in these consolidated cases involve a series of entities and steps described. However, there are certain differences: 1. The transactions at issue employed multiple-member LLCs instead of partnerships. However, plaintiffs refer to these entities as partnerships. The fees charged in these transactions are lower than those described in the COBRA presentation. Specifically, the fees here were 2.5% of the long options, not 4.5% as described in the COBRA Presentation. The net option premium paid in these cases was only 3% of the "desired loss," not 5% as described in the COBRA Presentation. The time to expiration of the options in these cases was 60 days, not the 30 days discussed in the COBRA Presentation.

2.

3.

4.

30

Proposed Findings ¶ 26. Proposed Findings ¶ 28. -93218494.1

31

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 19 of 48

5.

The net potential payout in these cases is only 2.25:1 of the net premium, not the 2.5:1 discussed in the COBRA Presentation. It appears that neither J&G nor B&W were involved in these transactions. Instead, E&Y recruited the law firm of Proskauer Rose.

6.

The three COBRA transactions involve eight individuals. Each individual was the sole owner of a single-member LLC, all of which were formed in Delaware on April 6, 2000. The LLCs involved in this case were: WHM Ventures LLC ("WHM LLC"), wholly owned by Wendell H. Murphy WHMJ LLC, wholly owned by Wendell H. Murphy, Jr. JMN Ventures LLC ("JMN LLC"), wholly owned by Joyce Murphy Norman WMC LLC, wholly owned by Wendy M. Crumpler ANB LLC, wholly owned by Angela N. Brown HDM LLC, wholly owned by Harry D. Murphy MDM Ventures LLC ("MDM LLC"), wholly owned by Marc D. Murphy SKM Ventures LLC ("SKM LLC"), wholly owned by Stratton K. Murphy

On April 4, 2000, three multi-member LLCs were formed for these transactions. The ownership of these entities was as follows: A. MURFAM Farms LLC ("MURFAM Farms"): WHM LLC (42.79%) WHMJ LLC (28.04%) JMN LLC (15.72%) WMC LLC (8.59%) ANB LLC (4.86%) PSM Farms LLC ("PSM Farms") HDM LLC (48.78%) SKM LLC (25.61%) MDM LLC (25.61) Murphy Pork Partners WHM LLC (57.1428%) WHMJ LLC (28.5715%) HDM LLC (14.2857%)

B.

C.

-10-

3218494.1

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 20 of 48

On June 22, 2000, three Subchapter S Corporations were formed for these transactions. Ownership was as follows: A. MURFAM Inc.: Wendell H. Murphy (42.79%) Wendell H. Murphy, Jr. (28.04%) Joyce Murphy Norman (15.72%) Wendy M. Crumpler (8.59%) Angela N. Brown (4.86%) PSM Inc.: Harry D. Murphy (48.78%) Stratton K. Murphy (25.61%) Marc D. Murphy (25.61%) Murphy Pork Inc.: Wendell H. Murphy (57.1428) Wendell H. Murphy, Jr. (28.5715%) Harry D. Murphy (14.2857%)

B.

C.

Step One: On April 12, 2000, the eight individuals wired funds to their respective wholly owned LLCs. On April 14, 2000, the LLCs purchased and sold their offsetting positions to Deutsche Bank. All the option pairs had an exercise date of June 13, 2000. The options were as follows: A. MURFAM Farms: WHM LLC purchased a put option on the Euro with a premium of $26,400,000 and a strike price of .92070, with a payout of $52, 800,000. At the same time, WHM LLC sold a put option on the Euro with a premium of $25,608,000 and a strike price of .92050, with a payout of $51,018,000. Therefore, the WHM LLC only paid $792,000, the difference of the premiums, to DB for the option pair. This amount was equal to 3% of premium for the long option. WHMJ LLC purchased a put option on the Swiss Franc with a premium of $17,300,000

-11-

3218494.1

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 21 of 48

and a strike price of 1.5839, with a payout of $34,600,000. At the same time, WHM LLC sold a put option on the Swiss Franc with a premium of $16,781,000 and a strike price of 1.5837, with a payout of $33,432,250. Therefore, the WHMJ LLC only paid $519,000, the difference of the premiums, to DB for the option pair. This amount was equal to 3% of premium for the long option. JMN LLC purchased a put option on the Swiss Franc with a premium of $9,700,000 and a strike price of 1.5839, with a payout of $19,400,000. At the same time, JMN LLC sold a put option on the Swiss Franc with a premium of $9,409,000 and a strike price of 1.5837, with a payout of $18,745,250. Therefore, the JMN LLC only paid $291,000, the difference of the premiums, to DB for the option pair. This amount was equal to 3% of premium for the long option. WMC LLC purchased a put option on the Euro with a premium of $5,300,000 and a strike price of .92070, with a payout of $10,600,000. At the same time, WMC LLC sold a put option on the Euro with a premium of $5,141,000 and a strike price of .92050, with a payout of $10,242,250. Therefore, WMC LLC only paid $159,000, the difference of the premiums, to DB for the option pair. This amount was equal to 3% of premium for the long option. ANB LLC purchased a put option on the Swiss Franc with a premium of $3,000,000 and a strike price of 1.5839, with a payout of $6,000,000. At the same time, ANB LLC sold a put option on the Swiss Franc with a premium of $2,910,000 and a strike price of 1.5837, with a payout of $5,797,500. Therefore, ANB LLC only paid $90,000, the difference of the premiums, to DB for the option pair. This amount was equal to 3% of premium for the long option. B. PSM Farms:

-12-

3218494.1

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 22 of 48

HDM LLC purchased a put option on the Euro with a premium of $12,000,000 and a strike price of .92070, with a payout of $24,000,000. At the same time, HDM LLC sold a put option on the Euro with a premium of $11,640,000 and a strike price of .92050, with a payout of $23,190,000. Therefore, HDM LLC only paid $360,000, the difference of the premiums, to DB for the option pair. This amount was equal to 3% of premium for the long option. SKM LLC purchased a put option on the Swiss Franc with a premium of $6,300,000 and a strike price of 1.5839, with a payout of $12,600,000. At the same time, SKM LLC sold a put option on the Swiss Franc with a premium of $6,111,000 and a strike price of 1.5837, with a payout of $12,174,750. Therefore, SKM LLC only paid $189,000, the difference of the premiums, to DB for the option pair. This amount was equal to 3% of premium for the long option. MDM LLC purchased a put option on the Swiss Franc with a premium of $6,300,000 and a strike price of 1.5839, with a payout of $12,600,000. At the same time, MDM LLC sold a put option on the Swiss Franc with a premium of $6,111,000 and a strike price of 1.5837, with a payout of $12,174,750. Therefore, SKM LLC only paid $189,000, the difference of the premiums, to DB for the option pair. This amount was equal to 3% of premium for the long option. C. Murphy Pork: WMC LLC purchased a put option on the Euro with a premium of $8,000,000 and a strike price of .92070, with a payout of $16,000,000. At the same time, WMC LLC sold a put option on the Euro with a premium of $7,760,000 and a strike price of .92050, with a payout of $15,460,000. Therefore, WMC LLC only paid $240,000, the difference of the premiums, to DB

-13-

3218494.1

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 23 of 48

for the option pair. This amount was equal to 3% of premium for the long option. WHMJ LLC purchased a put option on the Swiss Franc with a premium of $4,000,000 and a strike price of 1.5839, with a payout of $8,000,000. At the same time, WHM LLC sold a put option on the Swiss Franc with a premium of $3,880,000 and a strike price of 1.5837, with a payout of $7,730,00. Therefore, WHMJ LLC only paid $120,000, the difference of the premiums, to DB for the option pair. This amount was equal to 3% of premium for the long option. HDM LLC purchased a put option on the Swiss Franc with a premium of $2,000,000 and a strike price of 1.5839, with a payout of $4,000,000. At the same time, HDM LLC sold a put option on the Swiss Franc with a premium of $1,940,000 and a strike price of 1.5837, with a payout of $3,865,000. Therefore, HDM LLC only paid $60,000, the difference of the premiums, to DB for the option pair. This amount was equal to 3% of premium for the long option. Step Two: Apparently, on April 17, 2000, the individual LLCs transferred their option pairs and cash to the multi-member LLCs, although these transactions were not recorded until May 19, 2000. The apparent transfers were as follows: A. MURFAM Farms: WHM LLC transfers $567,873.06 and one Euro option pair (with the $26,400,000 long option premium). WHMJ LLC transfers $370,661.34 and one Swiss Franc option pair (with the $17,300,00 long option premium) JMN LLC transfers $204,160.60 and one Swiss Franc option pair WMC LLC transfers $111,497.30 and one Euro option pair ANB LLC transfers $63,059.57 and one Swiss Franc option pair

B.

PSM Farms: -143218494.1

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 24 of 48

HDM LLC transfers $255,790.39 and one Euro option pair SKM LLC transfers $132,457.10 and one Swiss Franc option pair MDM LLC transfers $132,457.10 and one Swiss Franc option pair C. Murphy Pork: WHM LLC transfers $172,082.74 and one Euro option pair (with the $8,000,000 long option premium) WHMJ LLC transfers $85,702.05 and one Swiss Franc option pair (with the $4,000,000 long option premium) HDM LLC transfers $42,631.73 and one Swiss Franc option pair

The amount of cash transferred to the "partnerships" over and above the amount paid as fees is equal to approximately 2% of the long option premiums, as called for in the COBRA Presentation. Step Three: Between November 2, 2000, and November 9, 2000, the individual LLCs acquired varying quantities of North Carolina State municipal debt with a value of approximately $180,000. The LLCs transferred these bonds to MURFAM and PSM on December 5, 2000. On December 19, 2000, Murphy Pork purchased $300,000 worth of Euros at a rate of 0.8936. Step Four: On December 27, 2000, the individual LLCs assigned their interests in the multi-member LLCs to the S Corps. This caused a technical termination of the multi-member LLCs for tax purposes.

Step Five: Also on December 27, 200, the multi-member LLCs were liquidated and their assets were distributed to the S Corps. On December 28, 2000, MURFAM, Inc. and PSM, Inc. sold their North Carolina State municipal bonds. On the same day, Murphy Pork, Inc. sold all of -153218494.1

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 25 of 48

its Euros at 0.9235. The proceeds on the foreign currency sale were $310,039.05 Payment of fees: On April 26, 2000, the individual LLCs wired a total sum of $2,006,000 to E&Y. On May 17, 2000, the LLCs wired a total sum of $200,000 to Proskauer Rose. On October 2, 2000, MURFAM and PSM paid a total sum of $207,500 to Proskauer Rose. On December 29, 2000, the S Corps paid a total sum of $94,000 to E&Y. The participants paid a combined total of $2,507,500 in fees to E&Y and Proskauer Rose. The total amount of the fees in these cases amount to 2.5% of the amount charged by DB for the long options. Claimed Tax Losses: The aggregate tax basis that the S Corporations claimed that the stockholders had had in the Partnership Interests at the time that those Partnership interests were transferred to the S Corporation consisted of a basis inflated by the purported price of the long options unreduced by the amount of the short options, reduced by cash distributed by the Partnership to the S Corporation, and increased by the capitalized fees paid to E&Y and Proskauer Rose. Taxpayers claimed a combined outside basis in PSM Farms of $24,455,162 at the time that they contributed their interests to PSM, Inc. This consisted almost entirely of the $24,600,000 in claimed long option premiums, undreduced by the amount of the short options. Taxpayers claimed a basis of $25,070,161 in the assets of PSM, Inc., which included capitalization of fees paid to Proskauer Rose and E&Y. On PSM, Inc.'s 1999 Form 1120S, PSM, Inc. Reported $24,531,884 in net long-term capital loss from the December 29, 2000, sale of municipal bonds, with a reported sales price of $51,321. Taxpayers claimed a combined outside basis in Murphy Pork Partners of $13,892,097 at the tine that they contributed their interests to Murphy Pork, Inc. This consisted almost entirely

-16-

3218494.1

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 26 of 48

of the $14,000,000 in claimed long option premiums, unreduced by the amount of the short options. Taxpayers claimed a basis of $14,242,098 in the assets of Murphy Pork, Inc., which included capitalization of fees paid to Proskauer Rose and E&Y. On Murphy Pork, Inc.'s 1999 Form 1120S, the S Corporation reported an ordinary loss of $13,919,961 from the sale of currency with a sales price of $310,039. Taxpayers claimed a combined outside basis in MURFAM Farms of $61,344,543 at the tine that they contributed their interests to MURFAM, Inc. This consisted almost entirely of the $61,700,000 in claimed long option premiums, unreduced by the amount of the short options. Taxpayers claimed a basis of $62,887,044. in the assets of MURFAM, Inc., which included capitalization of fees paid to Proskauer Rose and E&Y. On its 1999 Form 1120S, MURFAM, Inc. Reported $61,543,012 in net long-term capital loss from the sale of its bonds with a sales price of $127,803. The individuals took advantage of these inflated losses on their 1999 Form 1040s. ARGUMENT THE RETROACTIVE APPLICATION OF TREASURY REGULATION § 1.752-6 IS VALID 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 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 -173218494.1

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 27 of 48

liability. This Regulation thus requires a partner, in a transaction described in § 721(a), to reduce his basis in his partnership interest (outside basis) 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. § 1.7526, 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). Under the Regulation, the participants are required to reduce their outside basis in PSM Farms, MURFAM Farms, and Murphy Pork Partners by the premiums credited to them on the purported short option liabilities assumed by their alleged partnership. The Regulation, as it was intended to do, thus eliminates the artificially-inflated basis that lies at the heart of the COBRA tax shelter.32

B.

Treas. Reg. § 1.752-6 is a legislative regulation and has the force and effect of law.

Treas. Reg. § 1.752-6 was promulgated pursuant to § 309(c) of the Community Renewal

As the United States will show at trial, however, the taxpayers' COBRA transaction was completely bereft of economic substance, thereby requiring their actual basis in their partnership interests to be zero. See, Gilman v, Comm'r, 933 F2nd 143, 150-51 (2nd Cir. 1991). -183218494.1

32

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 28 of 48

Tax Relief Act of 2000, Pub. L. No. 106-554, 114 Stat. 2763A-638.33 T.D. 9062, 2003-2 C.B. 46, 67 (the "2000 Act").34 In the 2000 Act, Congress enacted I.R.C. § 358(h) to address certain situations in which property is transferred to a corporation in exchange for both stock and the corporation's assumption of certain obligations of the transferor. In transactions involving socalled contingent liability tax shelters, transferors took the position that the assumed obligations were not liabilities within the meaning of § 357(c) or that they were described in § 357(c)(3), and, therefore, the obligations did not reduce the basis of the stock received by the transferor in the transferee corporation. See Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1350-51 (Fed. Cir. 2006), cert. denied, 127 S. Ct. 1261 (2007). These assumed obligations, however, meant that the actual market value of the corporation's stock was worth significantly less than the transferor's claimed basis in the corporation's stock. The transferors, as was the plan all along, then sold the stock and reported enormous, but wholly artificial losses, on the sales. Id. Congress responded to these shelters by enacting § 358(h), which provides that, after the application of § 358(d), the basis in stock received in certain exchanges must be reduced by the amount of any liability assumed in the exchange. T.D. 9062, 2003-2 C.B. at 61. "Liability" was defined to "include any fixed or contingent obligation to make payment. . . ." I.R.C. § 358(h)(3). When it enacted § 358(h), Congress also "recognized that taxpayers were attempting to use partnerships . . . to carry out the same types of abuses that section 358(h) was designed to deter." T.D. 9062, 2003-2 C.B. at 61. Congress therefore directed the Secretary of the Treasury

33

Appendix A1.

-19-

3218494.1

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 29 of 48

to "prescribe rules which provide appropriate adjustments under subchapter K of chapter 1 of the Internal Revenue Code of 1986 to prevent the acceleration or duplication of losses through the assumption of (or transfer of assets subject to) liabilities described in section 358(h)(3) of such Code . . . in transactions involving partnerships." 2000 Act, § 309(c)(1). Treas. Reg. § 1.752-6 was enacted pursuant to this statutory directive and is, therefore, a legislative regulation. Legislative regulations have controlling weight unless they are arbitrary, capricious, or manifestly contrary to the underlying statute. Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 843-44 (1984); Fransen v. United States, 191 F.3d 599, 600 (5th Cir. 1999). Contrary to plaintiffs' assertion,35 Treas. Reg. § 1.752-6 is fully consistent with the underlying statute -- § 309(c)(1) of the 2000 Act. Indeed, it implements the Congressional intent to put an end to tax shelters designed to inflate the basis in assets through the use of assumed liabilities and then to generate large, but wholly artificial, losses on the sale of the inflated-basis assets. See H.R. Conf. Rep. No. 106-1033 at 1017 (2000), reprinted in 2000-3 C.B. 304, 347. Treas. Reg. § 1.752-6 prevents tax abuse caused by the creation of artificial losses by requiring the reduction of a partner's basis by the amount of the liability that his partnership assumed.36 Moreover, the wording of Treas. Reg. § 1.752-6 closely tracks § 358(h), which requires a reduction in a shareholder's basis in stock by the amount of any liability, fixed or contingent,

35

P. Brief at 13-19.

Treas. Reg. § 1.752-6 applies only when I.R.C. § 752 is inapplicable. Thus, a taxpayer to whom the Regulation applies is required to decrease his basis in his partnership interest by the amount of any liability, fixed or contingent, assumed by the partnership ­ but cannot increase his basis by his proportionate share of the partnership liabilities as is otherwise permitted by I.R.C. § 752(a). -203218494.1

36

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 30 of 48

assumed by the corporation in certain exchanges. Because Treas. Reg. § 1.752-6 is consistent with the underlying statute, it is controlling here.37 See Chevron, 467 U.S. at 844 ("a court may not substitute its own construction of a statutory provision for a reasonable interpretation made by the administrator of an agency") (footnote omitted). C. The retroactivity of Treas. Reg. § 1.752-6 is valid

Plaintiffs, relying on Klamath, argue that the Regulation fails to satisfy I.R.C. § 7805(b) criteria for retroactive effect of Treasury regulations. Although regulations generally are not retroactive (I.R.C. § 7805(b)(1)), there are exceptions to that rule. Section 7805(b)(6) provides that the statutory presumption against retroactive regulations "may be superseded by a legislative grant from Congress authorizing the Secretary to prescribe the effective date with respect to any regulation." Moreover, Section 7805(b)(3) authorizes Treasury to "provide that any regulation may take effect or apply retroactively to prevent abuse." These two exceptions apply here and validate the retroactivity of Treas. Reg. § 1.752-6. First, Section 7805(b)(6) expressly authorizes the retroactivity because the Community Renewal

In Klamath, the District Court held that Treasury exceeded the Congressional grant of authority in adopting Treas. Reg. § 1.752-6 and that the regulation was, therefore, an interpretive regulation, rather than a legislative regulation. Id. at 621-622. The court relied on the lack of reference to § 752 in either the Community Renewal Tax Relief Act or its legislative history and on Treasury's promulgation of Treas. Reg. § 1.358-7 under the authority granted to it by § 309 of the 2000 Act. The court erred in so holding. In § 309 of the 2000 Act, Congress directed Treasury to prescribe rules to provide "adjustments under subchapter K of chapter 1 of the Code to prevent the acceleration or duplication of losses through the assumption of (or transfer of assets subject to) liabilities described in Section 358(h)(3) . . . in transactions involving partnerships." Because § 752 is in subchapter K, Treas. Reg. § 1.752-6 is a direct fulfillment of the explicit mandate from Congress in the 2000 Act.

37

-21-

3218494.1

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 31 of 48

Relief Tax Act expressly provides that regulations adopted pursuant to § 309(c) "shall apply to assumption of liabilities after October 18, 1999, or such later date as may be prescribed in such rules." 2000 Act, § 309(d)(2). Although the District Court in Klamath held that the Commissioner abused his discretion in making Treas. Reg. § 1.752-6 retroactive, the Seventh Circuit held otherwise in Cemco, and in no uncertain terms. As the Seventh Circuit stated, Section 309(c): enacts basis reduction rules for many transactions and authorizes the IRS to adopt regulations prescribing similar rules for partnerships and S corporations. Section 309(d)(2) of the 2000 Act adds that these regulations may be retroactive to October 18, 1999. That's the power the Commissioner used when promulgating Treas. Reg. § 1.752-6. Cemco, 515 F.3d at 752. Klamath's holding that the retroactive Regulation lacked Congressional authority baffled the Seventh Circuit: The district court in Klamath did not doubt that retroactivity could rest on the 2000 Act; Treas. Reg. § 1.752-6 applies to partnerships (and LLCs treated as partnerships) a rule "similar" to the approach that Congress adopted for other business entities. Klamath held, however, that when promulgating Treas. Reg. § 1.752-6 the IRS had not availed itself of that power. But if the IRS was not using that authority, why in the world does the regulation reach back to October 18, 1999? Retroactivity requires justification; to make a rule retroactive is to invoke one of the justifications; and the choice of date tells us that the justification is the one supplied by the 2000 Act (in conjunction with § 7805(b)(6)). A regulation's legal effect does not depend on reiterating the obvious. Cemco, 515 F.3d at 752. Even if § 7805(b)(6) did not authorize retroactive application, however, § 7805(b)(3), which authorizes retroactive application to prevent abuse, would so authorize. In adopting Treas. Reg. § 1.752-6, the Treasury made clear that it "has determined that a retroactive effective date is -223218494.1

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 32 of 48

appropriate to prevent abuse." T.D. 9207, 2005-1 C.B. at 1347. Abuse is patent in tax shelters as here that attempt to generate artificially-inflated bases in partnership interests, which inflated bases are designed to generate paper tax losses where no comparable economic losses have occurred. The present case is a perfect illustration of that abuse. Under I.R.C. § 7805(b)(3), the Secretary was clearly authorized to prevent such abuse by making Treas. Reg. § 1.752-6 retroactive. Indeed, as the District Court itself later confirmed in its decision on the merits in Klamath, the BLIPS shelter there at issue sought to generate an entirely artificial, noneconomic loss, and, as such, lacked economic substance.38 And as the Seventh Circuit noted in Cemco, "all [§ 1.752-6] does is instantiate the pre-existing norm that transactions with no economic substance don't reduce people's taxes." Cemco, 515 F.3d at 752.39 Accordingly, the Treasury's promulgation of retroactive regulations to combat abusive transactions, such as the COBRA shelter involved here, was authorized by § 7805(b)(3), as well as by § 7805(b)(6). D. Congress Was Clearly Aware of Abusive Partnership Contingent Liability Transactions.

Plaintiffs also asserts that when it added I.R.C § 358(h) to the Code, Congress focused exclusively on specific corporate transactions, and that Notice 2000-44 likely played no role in Congress' deliberations. P. Brief at 18. But the legislative history shows that Congress knew of

Klamath Strategic Inv. Fund, LLC v. United States, 472 F.Supp.2d 885, 896-98 (E.D. Tex 2007), cross-appeals docketed, Nos. 07-40861, 07-40915 (5th Cir. Sept. 7, 2007, Sept. 19, 2007). See generally, ACM P'ship v. Comm'r, 157 F.3d 231, 252 (3d Cir. 1998). ("Tax losses such as these, which are purely an artifact of tax accounting methods and which do not correspond to any actual economic losses, do not constitute the type of bona fide losses that are deductible under the Internal Revenue Code and regulations.") -233218494.1
39

38

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 33 of 48

the potential for abuse in partnerships' assumptions of liabilities in transactions having nothing to do with corporate transactions. In the summer of 1999, Congress began considering legislation pertaining to the tax treatment of assumptions of liabilities in connection with transfers to controlled corporations. On July 21, 1999, the Senate Committee on Finance favorably reported S. 1429, 106th Cong. (1999), the Taxpayer Refund Act of 1999. S. Rep. No. 106-120 at 1 (1999). S. 1429 included a provision (§ 1318) broadening the scope of I.R.C. § 357(b), the anti-abuse rule related to assumptions of liabilities in connection with transfers to controlled corporations, effective July 15, 1999. Id. at 214-15.40 The Committee explained (id.): As one example of a transaction that concerns the Committee, a transferor corporation may transfer assets with a fair market value basis . . . in exchange for preferred stock of the transferee corporation, plus the transferee's assumption of a contingent liability. . . . The transferor claims a high basis for the stock of the transferee held with respect to this transfer, because the basis of the assets is taken into account, while the taxpayer contends that the assumed liability does not reduce stock basis under current law. However, the value of the transferee stock in the hands of the transferor is nominal, because of the liability that offsets virtually all the value of the assets. Section 1318 of S. 1429 survived the reconciliation with H.R. 2488, 106th Cong. (1999) (as passed by the House, the Financial Freedom Act of 1999), to become § 1512 of the conference version of H.R. 2488, the Taxpayer Refund and Relief Act of 1999. H.R. Conf. Rep. No. 106-289 at 537 (1999).41 The Conference Committee added (id. at 538): It is also expected that the Treasury Department will promptly examine the use of partnerships and apply similar rules (for example, with respect to adjustments to the basis of a partnership interest with respect to certain contingent liabilities) where there is a principal purpose of

40

Appendix A6. Appendix A2. -243218494.1

41

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 34 of 48

avoiding Federal income tax through the use of a transaction that includes the assumption of liabilities by a partnership. The conferees note that pursuant to section 7805(b)(3), if necessary to prevent abuse, the Secretary could determine that any regulations applying such rules should be effective on the same date as this provision, i.e., July 15, 1999.42 Thus, less than three months before the introduction of S. 1792, the Conference Committee urged Treasury to "promptly examine the use of partnerships and apply similar rules (for example, with respect to adjustments to the basis of a partnership interest with respect to certain contingent liabilities) where there is a principal purpose of avoiding Federal income tax through the use of a transaction that includes the assumption of liabilities by a partnership." Id. That Congress decided to draft the subsequent grants of authority in S. 1792 and the 2000 Act as broadly as

Congress passed the legislation on August 5, 1999, but the President vetoed it on September 23, 1999. H.R. Rep. No. 106-1036, at 5 (2000). What is now § 309 of the 2000 Act originated on October 19, 1999, when the Chairman of the Senate Committee on Finance released his mark of a bill that would be introduced a week later as S. 1792, the Tax Relief Extension Act of 1999. Staff of the Joint Comm. on Taxation, 106th Cong., General Explanation of Tax Legislation Enacted in the 106th Congress 153 n.174 (Comm. Print 2001) (JCS-2-01), reprinted in 2000-3 C.B. 565, 651. Appendix A8. Instead of altering the general anti-abuse provision of I.R.C. § 357(b), S. 1792 contained a provision (§ 213) aimed at arrangements whereby a taxpayer transfers assets to a corporation in connection with the corporation's assumption of the transferor's contingent liability. 145 Cong. Rec. 27,547, 27,55327,554 (1999). Appendix A5. The Finance Committee again recognized the potential for abuse: "The transferor claims a basis for the stock equal to the basis of the transferred assets [without reduction for the liability assumption] . . . [but] the value of the stock is reduced by the amount of the liability, creating a potential loss." S. Rep. No. 106-201 at 47 (1999). Appendix A7. Section 213(a) of S. 1792, supra, would have added a basis reduction rule to I.R.C. § 358 applicable to stock received in contribution/assumption transactions. 145 Cong. Rec. at 27,553. Section 213(b) of the bill directed the IRS to prescribe similar rules for transactions involving partnerships, and § 213(c)(2) of the bill authorized retroactive application of those rules to liability assumptions occurring after October 18, 1999. Id. at 27,554. Although several of the bill's provisions were eventually included in Title V of the Ticket to Work and Work Incentives Improvement Act of 1999, Pub. L. No. 106-170, 113 Stat. 1860 (1999), § 213 was not among them. In December 2000, Congress enacted the basis reduction rule of § 358(h), which is substantially similar to § 213 of S. 1792. -253218494.1

42

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 35 of 48

possible ­ limiting them neither to partnership assumptions of liabilities nor to transactions described in § 358, but instead referring to "transactions involving partnerships" ­ is hardly surprising. 43 In short, in issuing a regulation retroactive to October 18, 1999, to combat tax avoidance resulting from the assumption by partnerships of purportedly contingent liabilities, Treasury did precisely what Congress directed it to do in section 309 of the 2000 Act. It therefore follows that the Regulation's retroactive effective date is valid under I.R.C. § 7805(b)(6). E. Plaintiffs' Assertion That the Real Purpose of Treas. Reg. §1.752-6 Was to Buttress the Government's Litigation in Notice 2000-44 Transactions Is Belied by the Mandate in Section 309(c) of the 2000 Act.

Plaintiffs claim the that the real purpose of the Regulation was not to prevent abuse but to bolster the Government's litigation position in cases involving Notice 2000-44 transactions. P. Brief at 21-22. Other than a series of claims of "highly unusual, and suspect behavior" by the Treasury, plaintiff has no direct evidence of this assertion. P. Brief at 22. This allegation is belied by the Congressional mandate in Section 309(c) of the 2000 Act. As discussed above, the Treasury Department promulgated Treas. Reg. § 1.752-6 to comply with Congress' directive to adopt retroactively rules comparable to I.R.C. § 358(h) for partnerships. 2000 Act, § 309(c)(1). Notice 2000-44 was simply the first step of the process. Mindful of the legislative history of Section 309(c), the IRS first issued a warning to taxpayers regarding claiming tax losses arising from artificially-inflated partnership bases. And, as the Seventh Circuit observed in Cemco, "[g]etting from a warning to a regulation often takes years...and did so here." 515 F.3d at 751.

Notice 2000-44 was released on August 13, 2000, or over four months before the enactment of the 2000 Act. [Pltf. Appendix B, Ex. B.3. at pp.25-27] -263218494.1

43

Case 1:06-cv-00245-EJD

Document 57

Filed 04/21/2008

Page 36 of 48

Furthermore, since Temp. Treas. Reg. § 1.752-6T, promulgated on June 24, 2003, predated the commencement of this litigation, it clearly was not adopted to further the Government's litigating position here. In any event, a regulation that is adopted in the course of litigation can still be valid. See Long Island Care at Home, Ltd. v. Coke, 127 S. Ct. 2339, 2349 (2007) (upholding Department of Labor's most recent interpretation of its regulation even though this interpretation was "written in response to this litigation"). F. COBRA Taxpayers Could Not Rely on Helmer and Similar Cases.

Plaintiff claims that the retroactive application of Treas. Reg. §1.752-6 contravenes 25 years of precedent, which the taxpayers were entitled to rely upon in engaging in their COBRA transaction. P. Br. at 7-10. What plaintiff means by 25 years of precedent are three non-binding Tax Court cases. This line of cases started with Helmer v. Comm'r, 34 T