Free Memorandum - District Court of Federal Claims - federal

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No. 05-1223 T (Judge Allegra) ______________________________________________________________________________ ______________________________________________________________________________

IN THE UNITED STATES COURT OF FEDERAL CLAIMS _____________________

CLEARMEADOW INVESTMENTS, LLC, CLEARMEADOW CAPITAL CORP., Tax Matters Partner, Plaintiff, v. THE UNITED STATES, Defendant. _____________________ BRIEF IN SUPPORT OF DEFENDANT'S MOTION FOR SUMMARY JUDGMENT _____________________

RICHARD T. MORRISON Acting Assistant Attorney General DAVID GUSTAFSON ROBERT STODDART Attorneys United States Department of Justice Tax Division Court of Federal Claims Section Post Office Box 26 Ben Franklin Station Washington, DC 20044 TEL: (202) 307-6445 FAX: (202) 514-9440 ______________________________________________________________________________ ______________________________________________________________________________

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TABLE OF CONTENTS Page Questions Presented. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Statement of the Case.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 A. B. Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 The transaction before the Court is one of many such deals devised and marketed by Cantley & Sedacca, Deutsche Bank, and other promoters. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 When Hutton entered the MLD he had no reasonable belief that he would earn a profit in excess of his costs apart from the promised tax benefits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Through Clearmeadow, Hutton pretended to spend 27.5 million for long and short positions in the MLD transaction. . . . . . . . . . . . . . . . . . . . . . . . . . 8 Following Cantley & Sedacca's plan, Hutton contributed his MLD positions to a corporation, which joined Daniel Brooks in a purported partnership. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Before the end of the taxable year, Hutton liquidated the Clearmeadow partnership and had Clearmeadow Capital sell a portion of a partnership asset to generate exactly the amount of tax loss Hutton needed for the year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 The IRS offered Hutton the chance to settle his tax liabilities, but he refused; the IRS then adjusted Clearmeadow's partnership return, and Hutton brought suit here.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Like other investors in this tax shelter, Hutton sued the promoters, claiming that the MLD transaction was a sham. . . . . . . . . . . . . . . . . . . . . . . . . . 16

C.

D.

E.

F.

G.

H.

Jurisdiction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 A. B. Both the plaintiff's complaint and the FPAA are timely. . . . . . . . . . . . . . . . . . . . 17 This Court has jurisdiction to determine the partnership items that will affect the plaintiff's basis in its partnership interest. . . . . . . . . . . . . . . . . . . 19

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[Table of Contents, continued] Page Argument. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 I. The partnership assumed Clearmeadow Capital's $2,769,200 liability in a transaction described in Notice 2000-44. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 A. In this proceeding the Court can determine the character of Clearmeadow Capital's contribution, although the reduction in the basis of Clearmeadow Capital's partnership interest will occur later. . . . . . . . . . . . . . . . . . . . . . . . . . . 22 The Secretary had the authority to apply Treas. Reg. § 1.752-6 to transactions that occurred before it was issued. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Treas. Reg. § 1.752-6 governs Clearmeadow's transaction, which occurred after Notice 2000-44.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

B.

C.

II.

The 40% gross valuation misstatement penalty applies to the transactions and tax reporting of Clearmeadow LLC.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 A. For purposes of this motion, the Court need not consider the other penalties in the FPAA. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 In this case, the gross valuation misstatement is "applicable" as a matter of mere arithmetic. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 The Clearmeadow partnership has no defense against the penalty; it could not reasonably have relied on Cantley & Sedacca's opinion. . . . . . . . . . . . . . . . . . . 31 Hutton must raise his personal defenses against the penalty in a partner-level proceeding after assessment and payment of the penalty. . . . . . . . . . . . . . . . . . . 34

B.

C.

D.

III.

Clearmeadow's transaction lacked business purpose and economic substance. . . . . . . . 38

Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Appendix A: Internal Revenue Code of 1986 (26 U.S.C.). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 Community Renewal Tax Relief Act of 2000 (part of the Consolidated Appropriations Act, 2001), Pub. L. No. 106-554, 114 Stat. 2763. . . . . . . . . . . . . 50 - ii -

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[Table of Contents, Appendix A, continued] Page Treasury Regulations (26 C.F.R.). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 Miscellaneous: Rev. Rul. 58-234, 1958-1 C.B. 279. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66 Modifications and Additions to the Unified Partnership Audit Procedures, 64 Fed. Reg. 3886-01 (Jan. 26, 1999). . . . . . . . . . . . . . . . . . . . . . . . 68 Notice 2000-44, 68 Fed. Reg. 37,434-01 (June 24, 2003).. . . . . . . . . . . . . . . . . . 71 Assumption of Partner Liabilities, 68 Fed. Reg. 37,434-01 (June 24, 2003). . . . 74 T.D. 9062, 68 Fed. Reg. 37,414-01 (June 24, 2003). . . . . . . . . . . . . . . . . . . . . . . 75 Chief Counsel Notice CC-2003-020, 2003 WL 24016805 (June 25, 2003).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82

Appendix B (separately bound): Declaration of Robert Stoddart. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Exhibit Number 1 Description Letter from Cantley & Sedacca, LLP, to Mark Hutton (Oct. 5, 2001). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Certificate of Formation of Clearmeadow Investments, LLC. . . . . . . . . . . 8 Operating Agreement of Clearmeadow Investments, LLC. . . . . . . . . . . . 10 Certificate of Incorporation of Clearmeadow Capital Corp.. . . . . . . . . . . 19 IRS Form 2553, Election by a Small Business Corporation. . . . . . . . . . . 21 Certificate of Filing for Certificate of Incorporation of Clearmeadow Capital Corp... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Deutsche Bank Alex Brown Client Statement (Oct. 31, 2001). . . . . . . . . 24 Deutsche Bank Alex Brown Client Statement (Nov. 30, 2001). . . . . . . . 30 Deutsche Bank Alex Brown Client Statement (Dec. 31, 2001).. . . . . . . . 34

2 3 4 5 6

7 8 9

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[Table of Contents, Appendix B, Declaration of Robert Stoddart, continued] Page Exhibit Number Description

10

Deutsche Bank Alex Brown Client Statement, Canadian Dollars (Dec. 31, 2001). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Deutsche Bank Alex Brown Confirmation Statement, US Dollars (Dec. 14, 2001). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42 Deutsche Bank Alex Brown Confirmation Statement, Canadian Dollars (Dec. 14, 2001). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 Deutsche Bank Alex Brown Confirmation Statement, Canadian Dollars (Dec. 27, 2001). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 Deutsche Bank Alex Brown Confirmation Statement, US Dollars (Dec. 27, 2001). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 Cover letter from Clarion Capital, LLC, to Mark Hutton. . . . . . . . . . . . . 46 Clarion Capital Statement of Account for Clearmeadow Investments, LLC, as of 12/29/01. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 Societe Generale, Confirmation for Currency Linked Deposit Swap, Clearmeadow Investments, LLC (Oct. 15, 2001). . . . . . . . . . . . . . 49 Societe Generale, Confirmation for Currency Linked Deposit Swap, Clearmeadow Investments, LLC (Oct. 15, 2001). . . . . . . . . . . . . . 54 Letter from Clearmeadow Investments, LLC, to Craig Brubaker (Oct. 15, 2001). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 Letter from Clearmeadow Investments, LLC, to Craig Brubaker (Oct. 10, 2001). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 Letter from Clearmeadow Investments, LLC, to Craig Brubaker (Dec. 18, 2001). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 Assignment of Limited Liability Company Units and Joinder Agreement (Oct. 19, 2001). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61

11

12

13

14

15A 15B

16

17

18

19

20

21

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[Table of Contents, Appendix B, Declaration of Robert Stoddart, continued] Page Exhibit Number 22 Description Amended and Restated Operating Agreement of Clearmeadow Investments, LLC (Oct. 19, 2001). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 Assignment of Limited Liability Company Units and Joinder Agreement (Dec. 18, 2001). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88 Letter from Clearmeadow Investments, LLC, to Craig Brubaker (Dec. 18, 2001). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91 Cover letter from Clearmeadow Investments, LLC, to Craig Brubaker, referencing a "Schedule A" (Oct. 10, 2001). . . . . . . . . . . . . . . 92 Schedule A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93 Certificate of Assessments and Payments for Clearmeadow Investments, LLC.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94 Form 1065, 2001 U.S. Return of Partnership Income of Clearmeadow Investments, LLC. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 Form 1120S, 2001 U.S. Income Tax Return for an S Corporation, Clearmeadow Capital Corp... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111 Excerpts from Form 1040, 2001 U.S. Individual Income Tax Return of Mark E. Hutton and Mary S. Hutton. . . . . . . . . . . . . . . . . . . . 126 Excerpts of a letter from Cantley & Sedacca, LLP, to Mark Hutton (Jan. 22, 2002). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135 Letter from Cantley & Sedacca to Mark Hutton (Jan. 23, 2002). . . . . 146A Excerpts from the transcript of the deposition of Mark Hutton (May 8, 2007).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147 Hutton Deposition Exhibit 1: Investor representations.. . . . . . . . . . . . . 187 Huttton Deposition Exhibit 2: Letter from Clearmeadow Investments, LLC, to Craig Brubaker (Oct. 15, 2001).. . . . . . . . . . . . . . 191

23

24

25A

25B 26

27

28

29

30

30A 31

31A 31B

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[Table of Contents, Appendix B, Declaration of Robert Stoddart, continued] Page Exhibit Number 32 Description Excerpts from the transcript of the deposition of Bryan Hanning (May 8, 2007).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192 Hanning Deposition Exhibit 1: Affidavit (Sept. 19, 2006).. . . . . . . . . . 217 Hanning Deposition Exhibit 2: Intake Summary. . . . . . . . . . . . . . . . . . 218 Hanning Deposition Exhibit 3: Letter from Cantley & Sedacca, LLP, to Mark Hutton (Oct. 4, 2001). . . . . . . . . . . . . . . . . . . . . . . . . . . . 221 Hanning Deposition Exhibit 4: Printout of e-mails to and from Mark Hutton, Bryan Hanning, and Jeremy Nerenberg (Nov. 30Dec. 6, 2001). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224 Excerpts from the transcript of the deposition of Scott Hewitt (May 8, 2007). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225 Hewitt Deposition Exhibit 2: Letter from Cantley & Sedacca, LLP, to Amy Klupny (March 1, 2002). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253 Excerpt from Hewitt Deposition Exhibit 3: Draft Form 1065, 2001 U.S. Return of Partnership Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254 Excerpts from the transcript of the deposition of Daniel Brooks taken in NHB X, LLC, Norman H. Bevan, Tax Matters Partner v. Commissioner, No 17453-05 (Tax Ct. Nov. 30, 2006). . . . . . . . . . . . . . 257 Excerpts from the statement under oath of Edward Sedacca, taken in NHB X, LLC, Norman H. Bevan, Tax Matters Partner v. Commissioner, No 17453-05 (Tax Ct. Jan. 26, 2007). . . . . . . . . . . . . . . 323 Civil Docket for Hutton et al. v. Deutsche Bank AG et al., No. 072041 (D. Kan.). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353 Excerpts from the complaint filed in Hutton et al. v. Deutsche Bank AG et al., No. 07-2041 (D. Kan.).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360 Excerpts from an order and opinion filed in Michael Ling et al. v. Deutsche Bank, AG, et al, No. 04 CV 4566 (S.D.N.Y.). . . . . . . . . . . 369A - vi -

32A 32B 32C

32D

33

33A

33B

34

35

36

37

38

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[Table of Contents, Appendix B, Declaration of Robert Stoddart, continued] Page Exhibit Number 39 Description Order approving proposed notice and proof of claim, Michael Ling et al. v. Deutsche Bank, AG, et al, No. 04 CV 4566 (S.D.N.Y.) (Feb. 2, 2007).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369D Representative Exchange Rates for Selected Currencies for December 2001 (data archived by the International Monetary Fund). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369I Final Partnership Administrative Adjustment Letter. . . . . . . . . . . . . . 369K

40

41

Declaration of Martha TenEyck.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370 Exhibit Number 1 2 Description Letter from the IRS to Mark E. and Mary S. Hutton (May 20, 2004). . . 374 Form 15382, Notice of Election to Participate in Announcement 2004-46 Settlement Initiative.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375 Letter from the IRS to Mark E. and Mary S. Hutton (July 21, 2004). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 378 Extract from Form 9984, Examining Officer's Activity Record. . . . . 378A Letter from the IRS to Anthony S. Gasaway (July 21, 2004). . . . . . . . . 379 Letter from the IRS to Mark E. and Mary S. Hutton (Dec. 22, 2004). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380 Letter from the IRS to Mark E. and Mary S. Hutton (Jan. 21, 2005). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381 Letter from the IRS to Mark E. and Mary S. Hutton (Feb. 7, 2005). . . . 384 Letter from the IRS to Mark E. and Mary S. Hutton (March 24, 2005). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385 Letter from the IRS to Anthony S. Gasaway (March 24, 2005, 2005). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 388 - vii -

3

3A 4 5

6

7 8

9

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[Table of Contents, Appendix B, Declaration of Martha TenEyck, continued] Page Exhibit Number Description

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Letter from the IRS to Mark E. and Mary S. Hutton (March 29, 2005). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389 Letter from the IRS to Anthony S. Gasaway (March 24, 2005).. . . . . . . 390 Letter faxed by Anthony S. Gasaway to Martie TenEyck, IRS (April 11, 2005). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 391 Letter from the IRS to Anthony S. Gasaway (April 12, 2005). . . . . . . . 394 Form 2848, Power of Attorney and Declaration of Representative.. . . . 397 Letter faxed by Anthony S. Gasaway to Martie TenEyck, IRS (June 8, 2005). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 399

11 12

13 14 15

TABLE OF AUTHORITIES Cases: Agro Science Co. v. Comm'r, 934 F.2d 573, (5th Cir. 1991) .. . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 Avon Products, Inc. v. United States, 97 F.3d 1435 (Fed. Cir. 1996). . . . . . . . . . . . . . . . . . . . . . 36 Celotex Corp. v. Catrett, 477 U.S. 317 (1986). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 CEMCO Investors, LLC, v. United States, No. 04 C 8211, 2007 WL 951944 (N.D. Ill. March 27, 2007) . . . . . . . . . . . . . . . . . . . . . 30 Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984). . . . . . . 37 Coltec Indus., Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006). . . . . . . . . . . . . . . . . . . . . . 39 Crown Operations Int'l, Ltd. v. Solutia, Inc., 289 F.3d 1367 (Fed. Cir. 2002). . . . . . . . . . . . 38-39 Domulewicz v. Comm'r, 129 T.C. No. 3, 2007 WL 2262884 (Aug. 8, 2007). . . . . . . . . . . . . 19, 35 Drobny v. Comm'r, 86 T.C. 1326 (1986). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 Gilman v. Comm'r, 933 F.2d 143 (2d Cir. 1991). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Gindes v. United States, 661 F.2d 194, (Ct. Cl. 1981).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 Heasley v. Comm'r, 902 F.2d 380 (5th Cir. 1990). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Helmer v. Commissioner, 34 T.C.M. (CCH) 727 (1975). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Hutton et al. v. Deutsche Bank AG et al., No. 07-2041 (D. Kan.).. . . . . . . . . . . . . . . . . . . . . . . . 16 Illes v. Comm'r, 982 F.2d 163 (6th Cir. 1992). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Katz v. Commissioner, 335 F.3d 1121 (10th Cir. 2003). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Keener v. United States, 76 Fed. Cl. 455 (2007) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20, 37 - viii -

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[Table of Authorities, Cases, continued] Page Klamath Strategic Investment Fund, LLC, v. United States, 440 F. Supp. 2d 608 (E.D. Tex. 2006).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 Klamath Strategic Investment Fund, LLC, v. United States, 472 F. Supp. 2d 885 (E.D. Tex. 2007).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35, 36, 37, 38 Ling et al. v. Deutsche Bank, AG, et al, No. 04 CV 4566 (S.D.N.Y.). . . . . . . . . . . . . . . . . . . . . . 17 Long Island Care at Home, Ltd. v. Coke, 127 S. Ct. 2339 (2007).. . . . . . . . . . . . . . . . . . . . . . . . 37 Massengill v. Comm'r, 876 F.2d 616 (8th Cir. 1989). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Mayrath v. Comm'r, 357 F.2d 209 (5th Cir.1966).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 McKeever v. Comm'r, T.C. Memo. 2000-288, 2000 WL 1297710 (2000). . . . . . . . . . . . . . . 33-34 Merino v. Comm'r, 196 F.3d 147 (3d Cir. 1999).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Nussdorf v. Comm'r, 129 T.C. No. 5, 2007 WL 2330800 (Aug. 16, 2007) . . . . . . . . . . . . . . . . . 23 Santa Monica Pictures v. Commissioner, 89 T.C.M. (CCH) 1157, 2005 WL 1111792 (2005). . . . . . . . . . . . . . . . . . . . . . . . . . 35, 38 Sealy Power, Ltd. v. Comm'r, 46 F.3d 382 (5th Cir. 1995). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 Transpac Drilling Venture 1983-63 v. United States, 16 F.3d 383 (Fed. Cir. 1994). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 United States v. Mead Corp., 533 U.S. 218 (2001). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 Zfass v. Comm'r, 118 F.3d 184 (4th Cir. 1997). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 Statutes: Internal Revenue Code of 1986: § 162.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 § 165.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 § 212.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 § 358.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26, 27 § 705.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 § 722.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 § 732.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 § 733.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 § 752.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22, 24, 25, 26, 29 § 754.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 § 6226.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17, 18, 20, 30 § 6229.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 § 6231.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18, 20, 37 § 6659.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 § 6662.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29, 30, 31 § 6663.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 § 6664.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31, 34 § 7805.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27, 28 - ix -

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[Table of Authorities, Statutes, continued] Page Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Pub. L. No. 97-248, 96 Stat. 324, codified as 26 U.S.C. §§ 6221-6233.. . . . . . . . . . . . . . . . . . . . . . . . 20 Omnibus Budget Reconciliation Act of 1989, Pub. L. No. 101-239, 103 Stat. 2106. . . . 39 Community Renewal Tax Relief Act of 2000, Pub. L. No. 106-554, 114 Stat. 2763. . . . 27 Treasury Regulations (26 C.F.R.): § 1.752-6T. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15, 25, 27 § 1.752-6. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26, 28 § 1.183-2. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 § 1.6031(a)-1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 § 1.6662-2. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 § 1.6664-4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 § 301.6221-1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31, 35, 36 § 301.6226(e)-1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 § 301.6231(a)(3)-1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 § 301.6231(a)(5)-1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21, 30 § 301.6231(a)(7)-2. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 § 301.7701-3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8, 11 Miscellaneous: Rev. Rul. 58-234, 1958-1 C.B. 279. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Modifications and Additions to the Unified Partnership Audit Procedures, 64 Fed. Reg. 3886-01 (Jan. 26, 1999). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 Notice 2000-44, 2000-2 C.B. 255 .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . passim T.D. 8965, 66 Fed. Reg. 50,541 (Oct. 4, 2001). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 Assumption of Partner Liabilities, 68 Fed. Reg. 37,434-01 (June 24, 2003). . . . . . . 25, 27 T.D. 9062, 68 Fed. Reg. 37,414-01 (June 24, 2003). . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Announcement 2004-46.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 T.D. 9207, 70 Fed. Reg. 30334-01 (May 26, 2005).. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Chief Counsel Notice CC-2003-020, 2003 WL 24016805 (June 25, 2003). . . . . . . . . . . . 2 Rule 56, Rules of the U.S. Court of Federal Claims (RCFC). . . . . . . . . . . . . . . . . . . . . . 39

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IN THE UNITED STATES COURT OF FEDERAL CLAIMS ______________ No. 05-1223 T (Judge Allegra) CLEARMEADOW INVESTMENTS, LLC, CLEARMEADOW CAPITAL CORP., Tax Matters Partner, Plaintiff, v. THE UNITED STATES, Defendant. ______________ BRIEF IN SUPPORT OF DEFENDANT'S MOTION FOR SUMMARY JUDGMENT ______________ The defendant, the United States, presents the following brief in support of its motion for summary judgment. All relevant statutes, regulations, and other non-case authorities are set out in Appendix A, infra. QUESTIONS PRESENTED I. Did the Clearmeadow partnership assume a liability to pay $2,769,200 in a

transaction described in Notice 2000-44 when the plaintiff contributed to the partnership an option under which the plaintiff may have had to pay $2,769,200 on the closing date? II. Does the penalty for a gross valuation misstatement apply as a result of the

Clearmeadow partnership's transactions and tax reporting? III. Did the Clearmeadow partnership's transactions lack economic substance and

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STATEMENT OF THE CASE A taxpayer, Mark Hutton, claims benefits arising from a tax shelter he bought from promoters whom he has sued elsewhere for promoting a sham. Here and for the moment, however, Hutton argues that the sham was a legitimate investment. The shelter at issue is a Son of Boss transaction, which the IRS has defined as follows (Chief Counsel Notice CC-2003-020, 2003 WL 24016805 (June 25, 2003)): The Son of Boss transaction involves the contribution of a purchased option to a partnership and the assumption by the partnership of a separate written option which the taxpayer incurred. A taxpayer engaged in a Son of Boss transaction claims that the basis in the taxpayer's partnership interest is increased by the cost of the purchased call option but is not reduced under Internal Revenue Code § 752 for the assumption of the obligation under the written call option. Subsequently, taxpayer claims a loss on the disposition of the partnership interest even though taxpayer has incurred no corresponding economic loss. The defendant will now describe how Hutton bought, exploited, and defended the tax shelter he is now willing­elsewhere­to recognize as a sham. A. Summary

On October 15, 2001, through an entity called Clearmeadow Investments, LLC, Hutton pretended to deposit $25,000,000 with the New York branch of Societe Generale; and Societe Generale pretended to deposit $25,000,000 with Hutton; each party promised to pay to the other on December 14, 2001, both the nonexistent deposit and offsetting amounts of interest that each nonexistent deposit was supposed to earn at the rate of 3.6650% per annum. As part of the same transaction, Hutton pretended to pay Societe Generale $2,500,000 for a foreign-currency option under which Hutton could collect $2,800,000 from Societe Generale if certain conditions were met on the expiration date, December 14, 2001; and Societe Generale pretended to pay Hutton

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$2,472,500 for a nearly identical option under which Societe Generale could collect $2,769,200 from Hutton if certain conditions were met on the expiration date, December 14, 2001. (See Defendant's Proposed Findings of Uncontroverted Fact (hereinafter DPF) 38-42, 44.) Actually, Hutton transferred to Societe Generale only the excess of his purported payment over his purported receipt­$27,500. Not another penny changed hands. Clearmeadow never had more than $287,500 in its account. (See DPF 45-46.) As a result of these offsetting transfers, Hutton claims to have increased his basis in a partnership by $2,500,000 when he contributed to it the option he purported to buy from Societe Generale. When the partnership liquidated, he attached part of that inflated basis to a partnership asset that had a nominal value, sold the asset, and claimed a tax loss of $1,004,040. (See DPF 97, 98, 104, 105, 110.) But Hutton had also transferred to the partnership the option he sold to Societe Generale, and the partnership accordingly assumed Hutton's potential $2,769,200 liability. Nevertheless, Hutton did not reduce his basis in the partnership by the amount of the transferred liability. Hutton entered this tax shelter more than a year after the IRS announced that such transactions abuse the law. See Notice 2000-44, 2000-2 C.B. 255 (released on August 13, 2000). Because the potential $2,769,200 liability Hutton transferred was just as real as the $2,500,000 he pretended to pay Societe Generale (and for other reasons), the IRS adjusted the partnership's return to reflect both sides of his bargain. (See DPF 129.) Hutton now challenges the adjustments: he wants this Court to give him the tax benefits he claimed for the $2,500,000 he is supposed to have paid for the contributed option; and he invites the Court to join him in

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ignoring the $2,769,200 liability of which the partnership relieved him. The law, common sense, and elementary fairness all stand in his way. B. The transaction before the Court is one of many such deals devised and marketed by Cantley & Sedacca, Deutsche Bank, and other promoters.

Mark Hutton, a resident of Wichita, Kansas (DPF 1), is the sole shareholder of Clearmeadow Capital Corp. (DPF 104), the plaintiff and the tax-matters partner of Clearmeadow Investments, LLC, through which Hutton entered these transactions. Hutton is a general contractor. During 2001, he noticed that his income was increasing over earlier years (DPF 1, 3); and when the year ended, he found that he had earned $921,885 of non-passive income through one of his S-corporations, Hutton Construction Corp. (DPF 2). A business acquaintance of Hutton, Bryan Hanning, approached him with an "investment" in foreign-currency transactions that was offered through the law firm of Cantley & Sedacca. (DPF 5.) Hanning had found Cantley & Sedacca listed in a binder of information under the caption "resources for investment opportunities and tax strategies." (DPF 6.) Hanning is employed with Massachusetts Mutual Life Insurance Company and is a member of AGH Wealth Advisors. (DPF 4.) Before 2001, Hanning had sold Hutton and his business entities only insurance-related products, and all but one of them were products of Massachusetts Mutual. (DPF 12.) Hanning was now proposing a transaction much different from any other business he had ever done with Hutton. (DPF 13.) Beckett Cantley and Edward Sedacca formed Cantley & Sedacca some time during the second quarter of 2001. (DPF 7.) A very high proportion of the firm's clients entered marketlinked deposit transactions (MLDs) like Hutton's, and all of the transactions relied upon a similar

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legal theory. (DPF 8.) An MLD is a combination of (1) a deposit with a fixed yield, like a CD or a bank account; and (2) a variable component that is linked to some market­for example, currencies or equities. (DPF 63.) Edward Sedacca understood that MLDs were a product of Deutsche Bank, and Cantley & Sedacca's MLDs were executed by a former employee of Deutsche Bank, Daniel Brooks. (See DPF 9.) After earning an MBA in investment and finance from Duke University's Fuqua School of Business, Brooks spent several years trading foreign currencies and currency options for various employers, including Bankers Trust. When Deutsche Bank bought Bankers Trust in 1999, Brooks joined Deutsche Bank Alex Brown (hereinafter DB Alex Brown), where he worked as a vice-president at the currency desk in foreign exchange sales. (DPF 60.) DB Alex Brown is a member of the New York Stock Exchange and is a brokerage. (DPF 37.) Brooks met Edward Sedacca through Craig Brubaker, who worked as a broker with DB Alex Brown. (DPF 62.) In April of 2001 (the second quarter of the year, when Cantley & Sedacca was formed), Brooks left DB Alex Brown and founded an entity called Clarion Capital to do currency trading and advising. (DPF 61.) Brooks had not been involved with MLD transactions when he worked with DB Alex Brown; it was Cantley & Sedacca who introduced him to MLDs, because that was the structure they were planning to use. (DPF 63.) Brooks discussed with Cantley & Sedacca the "risk" he would put into the MLD transaction­that is, the options embedded in the MLD and the possibility that they would be profitable. (DPF 76.) His only role was to arrange the currency option; he had no role in the "deposit" portion. (DPF 65.) The currency options in Brooks's MLDs were European digital options. A European option is exercisable only at a specific date and time. A digital option is a combination of a -5-

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purchased "long" position and a sold "short" position. In the long position, the investor purchases a potential profit­up to a certain point­and in the short position the investor sells away the remaining potential profit. Brooks sees two advantages to trading currencies using digital options: (1) the investor can lose no more than the price he paid for the long position; and (2) the premium is low because the short position limits the investor's potential profit. According to Brooks, digital options are the most commonly used derivatives in currency trading. (DPF 66.) Brooks arranged most of the options through Deutsche Bank, but for about 30 clients, including Hutton, he arranged the options through Societe Generale. (See DPF 78.) Though Cantley & Sedacca had developed the structure of the MLDs, the investors all held accounts with DB Alex Brown before contacting Brooks, and Brooks received his instructions through DB Alex Brown. (DPF 67.) Between June and December of 2001, Brooks engaged in MLD transactions with 150 different customers. To carry out the transactions, he always joined an LLC with the customer. Cantley & Sedacca formed the LLCs, which were all basically the same. Through Clarion Capital, Brooks owned 1% of each LLC for the life of the MLD transaction, but he held no interest in any of the LLCs after December 31, 2001. (DPF 64.) By then, all of the investors had terminated his interest in their LLCs and his investment authority over their accounts with DB Alex Brown. (See DPF 90.) C. When Hutton entered the MLD he had no reasonable belief that he would earn a profit in excess of his costs apart from the promised tax benefits.

Following their usual procedure (see DPF 10), Cantley & Sedacca held a conference call with Hutton and his advisors­Hanning, Mark Kaplan (a CPA with Hanning's firm), and Scott Hewitt. Hewitt is a CPA who performs accounting and tax services for Hutton and his entities.

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(DPF 14.) To gather necessary information about Hutton, Cantley & Sedacca sent Hanning a form captioned "Intake Summary," which Hanning helped Hutton complete. He then returned it to Cantley & Sedacca. (DPF 11.) Hanning also forwarded to Hutton a document from Cantley & Sedacca captioned "Agreement for Your Legal Services." (DPF 17.) Cantley & Sedacca paid Hanning a referral fee, which Hanning disclosed to Hutton. (DPF 15-16.) On October 5, 2001, Hutton signed a document identical to the agreement for legal services that Hanning had given him. (DPF 34.) The document informed Hutton that Cantley & Sedacca charged a flat fee of $150,000 (considered earned on the date of the document). It also put Hutton on notice that the IRS might challenge the tax benefits generated by the transaction he contemplated, and it warned him that the $150,000 fee would cover neither an audit defense nor the cost of any consequent litigation. (See DPF 33.) By signing the October 5 agreement Hutton represented: (1) that he had relied solely upon his (and his financial advisor's) independent investigation of all matters or concerns regarding the MLD transaction; and (2) that he (or his financial advisor) possessed knowledge and experience in financial and business matters sufficient to ensure his (or his financial advisor's) capability to evaluate the merits and risks of the MLD transaction. (DPF 18.) Hutton's representation was false: neither he nor any of his advisors had independently investigated the MLD transaction, and neither he nor any of his advisors even claimed to have knowledge and experience in financial and business matters sufficient to ensure their capability to evaluate the merits and risks of the MLD transaction. (See DPF 20-32.) Despite his personal inability to evaluate the transaction (DPF 22), Hutton never asked anyone whether it had a reasonable possibility of producing an economic profit in excess of tax benefits and out-of-pocket costs -7-

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(DPF 30). According to Hutton, when he was deciding to enter the MLD transaction only Cantley & Sedacca led him to believe that it offered a reasonable opportunity to make a profit. (DPF 31.) But in the agreement Hutton signed on October 5, Cantley & Sedacca stated that they were not financial advisors themselves, and that they stressed that they had expressed no opinion about the MLD transaction. (DPF 18.) D. Through Clearmeadow, Hutton pretended to spend 27.5 million for long and short positions in the MLD transaction.

On October 9, 2001, Edward Sedacca signed a certificate of formation for Clearmeadow Investments, LLC, a Delaware limited liability company. The Delaware Secretary of State filed the certificate on October 10, 2001. (DPF 35.) The initial operating agreement of Clearmeadow Investments, LLC, dated October 10, 2001, named Hutton as the sole Member and provided that the Member would have no liability for the debts of the company except to the extent of his capital contribution, which was $287,500. (DPF 36.) Because Clearmeadow had only a single owner and was not a corporation, it was to be "[d]isregarded as an entity separate from its owner" for federal tax purposes. See Treas. Reg. § 301.7701-3(b)(1)(ii). On October 15, 2001, Clearmeadow deposited $287,500 into an account with DB Alex Brown. (DPF 37.) On the same day, Clearmeadow executed two agreements with Societe Generale, New York Branch, captioned "Confirmation for Currency Linked Deposit Swap." Both agreements were sent to the attention of Mr. Jason Saffran, Cantley & Sedacca. (DPF 38, 40.) With one agreement, Clearmeadow purported to purchase what Cantley & Sedacca later called the "long MLD position," which it summarized as follows: Clearmeadow deposited EUR

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(euros) 27,427,520 with Societe Generale on October 15, 2001. On December 14, 2001, Societe Generale was to repay this amount, plus 3.67% annual interest. Societe Generale would also pay Clearmeadow an additional amount, the "Long Bonus Yield," if on December 14, 2001, the "JPY [Japanese yen]/USD [US dollar] spot market exchange rate is at least 124.65." Clearmeadow paid a premium of EUR 2,747,252 for the long MLD position. (DPF 39.) The Court will find the details of the agreement at DPF 38. With the other document, Clearmeadow purported to sell what Cantley & Sedacca later the "short MLD position," which it summarized as follows: Societe Generale deposited EUR 27,427,520 with Clearmeadow on October 15, 2001. On December 14, 2001, Clearmeadow was to repay this amount, plus 3.67% annual interest. Clearmeadow would also pay Societe Generale an additional amount, the "Short Bonus Yield," if on December 14, 2001, the "spot market JPY/USD exchange rate is at least equal to 124.67." Societe Generale paid a premium of EUR 2,717,033 for the short MLD position. (DPF 41.) The Court will find the details of the agreement at DPF 40. These agreements denominate the parties' obligations in euros, but Hutton made his purported payment and claimed his tax benefits in dollars. Accordingly, the defendant will refer to the amounts in dollars, using the information that Daniel Brooks and Clarion Capital reported to Clearmeadow on a statement of account. One entry on that statement, dated October 15, 2001, is captioned "Long Market Linked Deposit (MLD)" and reads as follows (DPF 42): Fixed Interest (3.665% annualized actual/360) Deposit Amount EUR 27,472,520 Premium Paid EUR 2,747,252 Bonus Coupon (Variable Interest Income) USD 150,163 USD 25,000,000 USD 2,500,000 USD 2,800,000

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The same statement also contains an entry dated October 15, 2001, for a "Short Market Linked Deposit (MLD)," which reads as follows (DPF 42): Fixed Interest (3.665% annualized actual/360) Deposit Amount EUR 27,472,520 Premium Received EUR 2,717,033 Bonus Coupon (Variable Interest Expense) USD 150,163 USD 25,000,000 USD 2,472,500 USD 2,769,200.

On October 15, 2001, in order to appear to buy the "long MLD position," Hutton sent a letter on Clearmeadow's stationery to Craig Brubaker at DB Alex Brown concerning Clearmeadow's account. The letter states, in part (DPF 44): This letter constitutes your authorization to transfer the necessary funds to complete the purchase of the market linked deposits in the notional amount of US $25,000,000 and also to pay premiums totaling US $2,500,000 associated therewith from the above-referenced account to Societe Generale, New York ABA. At the time, however, Clearmeadow's account contained no more than $287,500 (DPF 45) and throughout 2001 it never contained more than $287,500 (DPF 46). Hutton's longtime accountant, Scott Hewitt, is generally familiar with Hutton's holdings and assets; Hewitt was not aware that Hutton had $27.5 million to invest. (DPF 47.) Hutton did not borrow the $27.5 million from Deutsche Bank, and he had no reason to imagine that Deutsche Bank was lending it to him. (See DPF 48.) Simply put, on October 15, 2001, DB Alex Brown did not transfer the sums of $25,000,000 and $2,500,000 from Clearmeadow to Societe Generale. (DPF 49.) Instead, on October 16, 2001, DB Alex Brown wired $27,500 from Clearmeadow's account to Societe Generale in New York. That amount is the excess of the premium Clearmeadow purported to pay for the long MLD position, $2,500,000, over the premium it purported to receive on the short MLD position, $2,472,500. It is also 1.1% (110 basis points) of

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$2,500,000, the premium for the long MLD position, which is the amount the bank charged to set up the option. (DPF 50.) E. Following Cantley & Sedacca's plan, Hutton contributed his MLD positions to a corporation, which joined Daniel Brooks in a purported partnership.

On October 12, 2001, a Cantley & Sedacca attorney signed a certificate of incorporation for Clearmeadow Capital Corporation, which Hutton had already elected to treat as an Scorporation with the help of another Cantley & Sedacca attorney. (See DPF 51, 52.) On October 19, 2001, Hutton transferred his entire membership interest in Clearmeadow Investments, LLC, to Clearmeadow Capital Corporation as a contribution to its capital. He accepted the transfer as president of Clearmeadow Capital Corporation. (DPF 54.) In the rest of this brief the defendant will generally refer to the corporation as "Clearmeadow Capital" and to the LLC as "the Clearmeadow partnership," "Clearmeadow LLC," or "the LLC." On October 19, 2001, Mark E. Hutton, president of Clearmeadow Capital, and Daniel J. Brooks, president of CF Advisors XXXVII, LLC, executed an amended and restated operating agreement for Clearmeadow Investments, LLC. Clearmeadow Capital contributed $287,500 to the LLC in exchange for 99,000 Class A Units and became the Class A Member. CF Advisors contributed $2,500 "out of its service fees" for 1,000 Class B Units and became the Class B Member. The amended and restated operating agreement limited the members' liability to the amount of their contributions. (DPF 55.) (The defendant will refer to CF Advisors/Brooks as "Brooks" unless more description seems needed.) When Brooks joined Clearmeadow LLC, it at least appeared to become a partnership for federal tax purposes. See Treas. Reg. § 301.77013(b)(1)(i).

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According to the new operating agreement of Clearmeadow LLC, Clearmeadow Capital had solicited Brooks to obtain his services as an investment advisor and specialist in foreign currency and foreign currency derivative investments. The parties agreed to pay Brooks an immediate front-end fee of $10,000 for his services, plus 2% of the company's net asset value as of the end of the fiscal year and 20% of all income and gains realized during the fiscal year. (DPF 56.) Even before signing this agreement, Hutton had asked DB Alex Brown to transfer $10,000 from Clearmeadow's account to two accounts held by CF Advisors in Baltimore Maryland. On October 23, 2001, DB Alex Brown transferred the money­$7,500 to an account with DB Alex Brown and $2,500 to an account with "Bankers Trust Company Deutsche Bk London/F." (DPF 58-59). Clearmeadow Capital reserved the right to terminate Brooks's services at any time after December 16, 2001, and­upon delivery of notice­to require him to sell all of his Class B units to Clearmeadow Capital for book value. Brooks had no similar rights against Clearmeadow Capital. (DPF 57.) While Brooks managed Clearmeadow, it made several small option trades; Brooks arranged three to five such currency-option trades for each of the LLCs that entered such MLD transactions. (See DPF 100.) And on December 13, 2001, Clearmeadow Investments paid $1,000 in US funds for $1,487.51 of Canadian currency. The settlement date was December 14, 2001. (DPF 86.) Other persons who bought MLDs through Cantley & Sedacca also purchased Canadian currency. Daniel Brooks bought the currency at the investors' instructions, but he does not know the reason for the purchases or what became of the currency. In particular, he does not know if there was any tax reason for the purchases. (DPF 87.) - 12 -

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F.

Before the end of the taxable year, Hutton liquidated the Clearmeadow partnership and had Clearmeadow Capital sell a portion of a partnership asset to generate exactly the amount of tax loss Hutton needed for the year.

Soon after Brooks bought the Canadian currency, Hutton ended the partnership. On December 18, 2001, Clearmeadow Capital bought Brooks's partnership interest (DPF 88) and ended Brooks's investment authority over the DB Alex Brown account maintained by Clearmeadow Investments, LLC (DPF 89). The former partnership then distributed its assets to Clearmeadow Capital; those assets were $284,315 in cash and 1,487.51 units of Canadian currency. (See DPF 97.) Generally (ignoring adjustments for distributed cash), when a partnership liquidates and distributes property other than money, a partner's basis in the property is the partner's basis in the partnership. See Code § 732(a)(1). Clearmeadow Capital asserts that the 1,487.51 Canadian dollars had a "cost basis" of $2,501,000 (see DPF 97), which is the $2,500,000 cost of the long MLD position Clearmeadow Capital had contributed to Clearmeadow LLC plus $1,000. The partnership had served Hutton's purpose: it had transformed a net investment of $27,500 into a potential loss of over $2,000,000. Hutton betrayed his intentions on November 30, 2001, when he sent the following e-mail to Hanning and to Jeremy Nerenberg, an attorney with Cantley & Sedacca (DPF 84): Scott [Hewitt] and I met today and figured this out. We would like to take down $1,005,000 of the loss for year 2001. I would think the balance for next year but if possible I would like to wait until later in 2002 to decide on this. Is that possible? With the phrase "loss for the year 2001," Hutton was referring to the tax loss that would be generated by the MLD transaction. (Ibid.) Nerenberg replied, in part, as follows (DPF 85): I spoke too soon in my prior e-mail. Apparently, the entire remaining balance would have to be triggered next year (e.g., no amount can be carried over into - 13 -

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2003). Please contact Ed Sedacca at 972-361-0090 should you have any questions regarding this matter. I will assume that you would still like to take down $1,005,000 of the loss for year 2001, and thus take the entire remaining balance for year 2002 ­ is this correct? The promoters delivered the tax loss Hutton ordered, almost to the dollar. On December 24, 2001, on Hutton's instructions, DB Alex Brown sold $597.98 of Clearmeadow Capital's Canadian currency (40.2% of the total amount) for $323.08 in US funds. (DPF 91, 92.) Clearmeadow Capital reported the results of this sale as a "portfolio loss" on its 2001 federal income tax return, and it computed the loss as follows (DPF 104): Date Acquired CAD Currency 12/14/2001 Date Sold 12/24/2001 Cost Proceeds Net Gain (Loss) ($1,005,079)

$1,005,402

$323

The $1,005,402 "cost" was 40.2% of the $2,501,000 tax basis that Clearmeadow Capital claimed in the Clearmeadow LLC partnership. (See DPF 105.) Clearmeadow Capital passed this loss (reduced by $1,039 of profits) and other tax attributes to its sole shareholder, Mark Hutton, who reported them on his 2001 income tax return. (DPF 109, 110.) The net Clearmeadow loss of $1,004,040 neatly offset the $921,885 of income Hutton received from Hutton Construction Corporation. (DPF 110.) Hutton kept the rest of the potential loss for another day: Clearmeadow Capital listed its remaining partnership "basis," $1,495,598, as a current asset on the balance sheet of its 2001 return. (DPF 106.) At DPF 97-110 the Court will find all of Clearmeadow LLC's tax attributes tracked from the partnership return through Clearmeadow Capital's S-corporation return to Mark Hutton's individual return.

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G.

The IRS offered Hutton the chance to settle his tax liabilities, but he refused; the IRS then adjusted Clearmeadow's partnership return, and Hutton brought suit here.

On August 29, 2002, Clearmeadow LLC filed its 2001 federal partnership return (DPF 94), and Clearmeadow Capital filed its 2001 federal S-corporation income-tax return (DPF 103). Hutton and his wife filed a joint federal income-tax return on August 28, 2002. (DPF 110.) In a letter dated May 20, 2004, the IRS informed Hutton that it had issued Announcement 2004-46, which grants taxpayers an opportunity to resolve tax liabilities associated with transactions described in Notice 2000-44 (Son of Boss transactions); the letter enclosed a Notice of Election to participate in the settlement initiative. (See DPF 111.) Hutton signed the Notice of Election and returned it to the IRS (DPF 113), but he and his representative failed to provide the information the IRS requested within the time allowed (see DPF 114-122). Finally, the IRS served summonses upon Hutton and his wife, requiring them to appear and produce requested documents. (DPF 123.) Hutton refused to produce more documents (DPF 124), and neither the Huttons nor their representative appeared in response to the summonses (DPF 125). Using the information in its possession (DPF 126), the IRS mailed a Notice of Final Partnership Administrative Adjustment (FPAA) to Clearmeadow Capital Corp., the tax matters partner of Clearmeadow Investments, LLC, on August 24, 2005 (DPF 128). The FPAA reverses all the items that Clearmeadow Investments, LLC, reported to its partners on forms K-1 and corrects them to zero. The FPAA finds, among other things, that (1) the obligations assumed by the partnership when it received the MLD short position constitute liabilities for purposes of Treas. Reg. § 1.752-6T, and the partnership's assumption of the liabilities should reduce the partners' basis in their partnership interests; (2) the purchase and contribution of the MLD - 15 -

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positions, the formation of the partnership, and its liquidation had neither business purpose nor economic substance, and as a consequence the transactions should be disregarded and all claimed losses and increases in basis should be denied; and (3) understatements of tax resulting from the partnership items are attributable to substantial understatement of income tax, gross valuation misstatements, and negligence or disregard of rules and regulations. The FPAA also proposes penalties. (DPF 129.) Through Clearmeadow Capital, Hutton filed a complaint with this Court on November 21, 2005, demanding a determination of the partnership items set forth in the FPAA and a determination of partnership-level defenses to the proposed penalties. (See Compl. ¶ 2.) Among other allegations, the complaint asserts that "Clearmeadow engaged in business activity." (Id. ¶ 12ii.) H. Like other investors in this tax shelter, Hutton sued the promoters, claiming that the MLD transaction was a sham.

On January 23, 2007, Hutton and the Clearmeadow entities filed a class-action RICO suit against the promoters of the MLD transaction; it is captioned Hutton et al. v. Deutsche Bank AG et al., No. 07-2041 (D. Kan.). (DPF 131.) In his RICO suit, Hutton demands from the promoters some of the relief he demands from the defendant here. (See DPF 132.) Hutton's RICO complaint asserts that the promoters marketed and implemented a "fraudulent and illegal" Son of Boss tax shelter designed to give the false impression that a complex series of financial transactions were legitimate business transactions with economic substance, though they were not. (DPF 133.) In his deposition in the present case, Hutton reaffirmed that assertion to be an "accurate representation." (DPF 134.) Hutton's RICO complaint also admits that his MLD

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transaction fell within the scope of Notice 2000-44.1 (DPF 135.) In fact, Hutton's RICO complaint makes many of the arguments the defendant will raise in this brief (see DPF 139) and it generally demonstrates that his suit here is untenable (see DPF 131-44). Hutton is not the only investor in this MLD Son of Boss shelter who realized that it was a fraud. The promoters recently settled another class-action suit for $4,599,000.00; the case is captioned Ling et al. v. Deutsche Bank, AG, et al, No. 04 CV 4566 (S.D.N.Y.). The district court approved the Ling settlement on February 2, 2007. By its terms, the settlement applies to the Clearmeadow entities and to Hutton. (DPF 145.) Hutton cannot prove his case here without contradicting himself and disproving his case against the promoters of the shelter. JURISDICTION Before discussing the substance of the case, the defendant must address jurisdictional issues raised in Hutton's complaint. A. Both the plaintiff's complaint and the FPAA are timely.

The plaintiff asks this Court to redetermine Clearmeadow's partnership items under Code § 6226(a), which permits a tax matters partner to file a petition in this Court within 90 days after

As the defendant explains at page 26, infra, when a partnership assumes a liability in a transaction like those described in Notice 2000-44, the assumption results in a reduction of the partner's basis in his partnership interest even if the partnership also assumes substantially all of the assets with which the liability is associated. Accordingly the defendant will ask the Court to determine that Clearmeadow's transaction is similar to ones described in Notice 2000-44. - 17 -

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the FPAA is mailed. Because Clearmeadow Capital had continuing exclusive authority to make necessary management decisions for the LLC (DPF 57), Clearmeadow Capital is the tax matters partner. See Treas. Reg. § 301.6231(a)(7)-2. The FPAA was mailed on August 24, 2005, and Clearmeadow Capital filed its complaint on November 21, 2005, within the time allowed. As Code § 6226(e) requires, Clearmeadow Capital deposited with the IRS the amount by which Hutton's tax liability would be increased if he adjusted his personal return to reflect the changes the FPAA made to the return of Clearmeadow LLC.2 (See Compl. ¶ 10.) The Court has jurisdiction of Hutton's petition. Despite Hutton's assertions to the contrary, however, the Court also has jurisdiction to uphold the FPAA. In paragraph 20 of his complaint, he insists: "The 2001 tax return of Clearmeadow was due March 15, 2002 for [sic] which the defendant had three years to perform an examination and make adjustments. The FPAA was issued on August 25, 2001 [sic] and hence the statute of limitations prevents any adjustments to be made." These assertions lack any merit. First, Hutton has misstated the facts: the FPAA was mailed on August 24, 2005. (DPF 128.) Second, Hutton has misstated the date on which Clearmeadow's return was due: under Treas. Reg. § 1.6031(a)-1(e)(2), "The return of a partnership must be filed on or before the fifteenth day of the fourth month following the close of the taxable year of the partnership"­in this case April 15, not March 15. Third, Hutton has

As an S corporation, Clearmeadow Capital is a "pass-thru partner." See Code § 6231(a)(9). Hutton was an "indirect partner" in Clearmeadow LLC because he held an interest in the partnership "through 1 or more pass-thru partners." § 6231(a)(10). When a pass-thru partner files a complaint, as Clearmeadow Capital did in this cases, § 6226(e)(1) requires a deposit equal to the increase in the tax liability of "each indirect partner holding an interest through the pass-thru partner." Treas. Reg. § 301.6226(e)-1(a)(1). - 18 -

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ignored the applicable statute, Code § 6229(a)(1), under which the IRS may assess tax attributable to partnership items within 3 years of the date the partnership return was filed. Clearmeadow LLC filed its 2001 partnership return on August 29, 2002. (DPF 94.) The IRS had until August 29, 2005, to issue the FPAA. The FPAA is valid. B. This Court has jurisdiction to determine the partnership items that will affect the plaintiff's basis in its partnership interest.

As the defendant will explain, it is entitled to judgment as a matter of law that Hutton's S-corporation contributed a $2,769,200 liability to the Clearmeadow partnership in a transaction similar to ones described in Notice 2000-44. When applied to the partner, this partnership-level determination will eliminate the portfolio loss Hutton claimed on his return and will also make him liable for a penalty. These results, however, will occur on the partner level after this TEFRA partnership case has ended. See Domulewicz v. Comm'r, 129 T.C. No. 3, 2007 WL 2262884 at *7-*8 (Aug. 8, 2007). Hutton misunderstands the distinction between the TEFRA proceedings and a subsequent assessment, apparently reasoning that this Court's decision cannot affect his basis in the partnership (his "outside basis"3) because the Court can consider only "partnership items." According to him, however, the FPAA purports to adjust "non-partnership items"­in particular, the basis of Clearmeadow Capital's partnership interest in the LLC. (See Compl. ¶ 15.) Hutton is partially correct about this Court's jurisdiction. After receiving the FPAA, Clearmeadow Capital filed a "petition for a readjustment of the partnership items of

The partnership's basis in its assets is sometimes called the "inside basis," and the partners' basis in their partnership interests is the "outside basis." See generally, e.g., Gindes v. United States, 661 F.2d 194, 197 n.9 (Ct. Cl. 1981) (discussing the distinction). - 19 -

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[Clearmeadow LLC] for [the 2001] taxable year" under Code § 6226(a), which is part of the Tax Treatment of Partnership Items Act of 1982. Congress enacted these provisions as Title IV of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Pub. L. No. 97-248, 96 Stat. 324, codified as 26 U.S.C. §§ 6221-6233. The Act sets out ways to determine the tax treatment of partnership items on the partnership level and to obtain a single judicial review of adjustments. See generally Transpac Drilling Venture 1983-63 v. United States, 16 F.3d 383, 387 (Fed. Cir. 1994); Keener v. United States, 76 Fed. Cl. 455, 457-59 (2007) (discussing the history, purpose, and application of the TEFRA partnership provisions). Section 6226(f) describes the jurisdiction this Court can exercise in a TEFRA proceeding as follows: A court with which a petition is filed in accordance with this section shall have jurisdiction to determine all partnership items of the partnership for the partnership taxable year to which the notice of final partnership administrative adjustment relates, the proper allocation of such items among the partners, and the applicability of any penalty, addition to tax, or additional amount which relates to an