Free Response to Motion - District Court of Federal Claims - federal

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apayoffamountof$19,131,750. On

April

3, 2000, you

contrbuted the above

referenced

positions

to the Parership. On April

17, 2000, the Parership's Option positions terated.

For puroses of analyzing whether the above described options transactions were shams, it
is possible that either

the two-factor test or the Knetsch/Goldstein test could be applied. Under either

test, those transactions should be respected as strctued for tax puroses.
The foreign curency options transactions must be respected for tax puroses because they
were economicaly substative transactions. Unlike the investments in Knetsch, Goldstein. and

Sheldon. the foreign curency options positions did not lock in economic losses; rather, they created
substatial risk and potential profit.
We have been informed that an objective investment analysis of

the instant option positions

at the tie of

your investment in such option positions, using generally accepted models employig

standard option pricing theories and methodologies, indicated a substantial probabilty tht the long

option stre price level would be reached and that profitability would be achieved. With a payoff
amountas a multiple of

the investment amount of2.0 with respect to the Swiss Franc options, and

2.0 with respect to the Euro options, it is objectively demonstrable that a realstic possibilty of

economic profit existed.

Given tht the foreign curency options positions were imbued with economic substace and
were not entered into and held solely for ta puroses, you were free to strctue such an option

investment however you desired. Fra Lyon Co. v. United States. 435 U.S. 561 (1978). This

priciple was generally reflected in a relatively recent Tax Cour case Richard Hansen Land. Inc. v.
Commssioner, T.C. Memo 1993-249. In

that casethe IRS urged the cour to recast for ta puroses

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a closely-held taxpayer's acquisition of an amortable estate for years in far land on
substace-oyer-form grounds. The Tax Cour rejected the IR's arguent and stated,
"Weare not impressed with respondent's search for a business purose to justifY the

form of the transaction. It is obvious that respondent's attack is not directed at the fact that petitioners ended up with an estate for years. Rather, respondent is sayig tht however valid the reasons for acquiring an estate for years may be, one must , have a reason other than a tax reason for the form used. The effect of such a position is to., suggest that if tax advantages are the motivating force, one must choose a

strctue for the transaction which wil mize and even eliate those
advantages, at least where related paries are involved. Under ths thesis, the fact that the transaction has substace would be irelevant. We were not prepared to go ths
far in Gordon v. Commssioner. supra, and we are notprepared to extend our holding in tht caSe to a situation such as it involved herein. The question in ths "'ase is not

one of purose but whether the acquisitions of the estates for year and the remainders "were in fact what they appear to be in form." C£ Hobby v. 2 T.C. 980, 985 (1943). We th that the circumstances herein
Commssioner.

satisfy that test. The fact that the tractions might have been strctued another way, more advantageous to the revenue, does not, in and of itself, justifY recasting their form.

In sumar, there is substantial evidence and authority for concludig that the Options

transactions at issue had economic substance and were entered into for business puroses.
Non-ADDlicabilitv of the SteD Transaction Doctrine
The "step tranaction" doctre represents a judicially imposed requirement to amalgamate

formally separte tranactions as a single integrated trsaction "if such steps are in substace

integrated, interdependent, and focused toward a parcular result." Penod v. Commssioner. 88
T.C. 1416 at 1428 (1987).

Application of the step transaction doctre may cause cer interedate steps in a
transaction to be ignored for federal income tax puroses. As stated by the Tax Cour in Smith v.

Commssioner. 78 T.C. 350,389 (1982):

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"The step tranaction doctre generally applies in cases where a tapayer seeks to

get from point A to point D and does so stopping in between at points B and C. The

the unecessar stops is to achieve tax consequences diffeng frm 'those which a diect path from A to D would have produced. In such a sitution, cours are not bound by the twisted path taen by the tapayer, and the intereng stops may be disregarded or rearanged.'m
whole puiose of

Typically, the Cours have invoked the step trsaction doctre as the result of severa

alternative tests.

Under the "binding commtment" test, steps will be collapsed if, at the tie of the fist step,
there was binding commtment to undertake the later steps. Under the "mutual interdependence"
test, steps wil be collapsed if

they are so interdependent that the legal relations created by one step

would have been economically meangless without a completion of al of

the steps. Under the "end
formally separte steps if they are really

result" test, the Cours will collapse a seres of

prearged

pars of a single transaction intended from the outset to reach a paricular result. Whle ths test has

potentially broad application, it has been somewhat limted by interpretations which would require,
(regarless of the test employed), that the step transaction doctre

only be invoked where

meangless or unecessar steps are underen without independent legal signficance.

73 The cour in Smith rejected the IR's arguent under the step tranction doctre on the following basis:

"Respondent has not pointed us to any cour decision which to ths date has held. that the step
traction doctre requies tht ga. and losses in a ta shelterg investment spang the coure

of more than i taable year mut be integrted and recogned only at the termation of such an investment 2, 5, or 20 years down the road. Indeed, such an arguent would go far toward
widerming the ver sysem of iiua ta accountig.
Respondent's arguent also fai to reogne that there is some rik that the futue offsettg ga

might never occu (a conceivable, though not probable, result in the instat case). Accordingly, we view petitioners' strddle trsactions as being distigushable from the situtions where cour have
previously

applied the step traction doctre, most notably in the taation of trsactions between

corporations and stockholders."
78 T.e. at 389-390.
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More recently, in True v. United States, 190 F.3d 1165 (10th Cir. 1999), the cour affied

sumar judgment in favor of

the IRS regardig the integration of one series of

transactions under

the "end result" formulation of the step transaction. There, the cour found the evidence clearly
showed that, from the beginng,

the end result was the sole outcome intended to be achieved by

enterig into the tranactions. The cour also concluded that integration of the transactions would

be appropriate under the "mutul interdependence" formulation, because each of the steps would

have been fritless without the others. The cour did, however, reverse the distrct court's sumar
,judgment integratig another series of

transactions. The cour concluded that with respect to those

transactions, there was a factual issue under the "end result" formulation whether the evidence

created a genuie factu issue that the end result achieved was the sole intended result from the
outset. Simlarly, the cour found a factual issue under the "mutual interdependence" formulation,

because it appeared that each of

the steps might have economic signficance on its own. The True

decision appears to stand for the proposition that if the facts demonstrate that at the time of enterig

into a series of transactions an investor has in mind only one fial outcome, and no other plausible
outcome exists, a cour can apply the "end-result" formulation of the step transaction doctre to

disregard intermediate steps. Ths is parcularly tre if those intermediate steps had so little
economic signficance on their own as to also be covered by the "mutual interdependence"

formulation.

It should be noted that under any of these specifc tests, you should be viewed as the

tranferor of the Options positions, not cash, to the Parership, i.e., you never had a "bindig
commitment" to transfer the Options positions to the Parership, or to subsequently trsfer in the

Parership to JFW INC. The "steps" were not ''mutually interdependent" because each phase of

the

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transaction was economically

viable regardless of

whether the next "step" was underten; and you

were wiling from an economic viewpoint to enter into the options trsaction and the contrbution
traction regardless of whether there was any subsequent tranfer to the thd par

which occured

as the "end result" of

the transaction. In the case ofWeIkel v. Commssioner. 51 TCM 432 (1986),

the cour indicated that the end result test will not apply where the taxpayer completes a fit step
expectig to undertake

a later step but lmowing that the later step may not occur.

The step transaction doctrne canot be used to ignore ta-motivated trsactions uness they
are shams; nor can it be invoked to create steps tht did not occur. See Grove v. Commssioner. 490

F.2d 241 (2d eir. 1973) in which the cour refused to recast a tax-motivated transaction as a
redemption followed by a gift rather than a gift followed by a redemption because there is no basis
for "generat(ing) events which never took place jus so an additional ta liabilty

might be asserted";

see also Esmark. Inc. v. Commssioner, 90 T.e. 171 (1988), afd per curam, 886 F.2d 1318 (7th
Cir. 1989), Techncal Advice Memorada 8735006 and 8735007 (May 18, 1987), Techncal Advice

Memorandum 8815003 (December 11, 1987) and Techncal Advice Memoradum 8948001

(November 27, 1989). For example, iii one case the Tax Cour found that for puroses of
determg the year in which investment tax credit recaptue is realized, the step tranaction
doctre is ineffective to treat the second step of a ta-free "spin-off' (the distrbution of stock) as

occurg in the year the first step of the transaction (the drop down of assets into the spun-off
companes) was underaken, sttig:
''None of

the steps in ths tranction were meangless or unecessar. . . just as the step transaction doctre is inappropriate to generåte events neither may it rearange events so as to cause a signficant step . . . which actually takes place in one year to

be treated for ta puroses as havig taken place in a diferent year. Where a

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paricular step has an independent tax consequence, as is the case here, that step is given its tax consequence in the parcular year in which it takes place."

Tandyv. Commssioner. 92 T.C. 1165, 1172-1173 (1989).
Ths rationale is equally applicable to cases involving timing issues. As the cour stated in
Walt Disnev. Inc. v. Commssioner, 97 T.C. 221, 236 (1991). ''Te Tandy reasonig is no less
appropriate here merely because a change in taxable years did not intervene," and ". . . overall plans
and integrated trsactions do not, without more, justif application of

the step transaction doctrne."

None of

the transactions engaged in by

you or the Parership was meanngless. Rather, you,

though JFWLLC, entered into the Options with a realistic hope of

profit (as well as a risk ofloss)

regardless of

whether any subsequent contrbution to another entity in which you held an interest

occured. The same is tre for the Parership's investment in the Shares. In addition, the
Parership was entitled to any profit (as well as risk ofloss) on the Options and other investments
(including the Shares) regardless of whether any subsequent transaction occured. Thus, none of

the

trsactions were ilusory, but rather were imbued with economic substace.

The decision of the Tax Cour in Esmark precisely ilustrates that the IRS canot invent

fictitious transactions merely because the transactions the taxayer actually undertook consisted of
tax-savig, but meangful steps, aied at a parcular conclusion. In that case, Esmark Corporation

("Esmark"), for valid business reasons, wanted to dispose of its enerw segment and redeem a
substantial portion of its stock. To accomplish these goals, Esmark solicited thd paries to
undertake a public tender offer to purchase approximately 50% of

its stock. Esark intended to then
holding company

distbute the stock ofits wholly-owned subsidiar, Vickers (which fuctioned as a

for TransOcean, an energy subsidiar), in exchange for the recently-purchased Esmark stock held

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by

the acquier. Esmark wanted to strctue the disposition of

its energy business and the contrction

of its capita strctue in ths maner priarly because it believed it would not be taxed on ths

traction under the literallanguage of Code section 3 i 1 as then in effect.
Mobil Oil Corp. ("Mobil'') agreed to the tender offer-redemption format suggested by Esmark

in the offer it submitted, and emerged as the highest bidder. Mobil and Esmark negotiated additional
terms and entered into a bindig agreement providing for the tender offer/redemption traction.

A Mobil subsidiar completed a successful tender offer for approximately 54% of

Esmark's stock

and on the same day exchanged.its newly acquied EsIIark stock for the Vickers stock. The IRS

rejected Esmark's chaacteriatinu of the exchange as a ta-free distrbution of Vickers stock in
redemption of Esmark stock held by Mobil, and attempted to recast the tranaction as if

Esmark had

sold Vickers stock to Mobil for cash and then distrbuted the cash to its shareholders in redemption
of their Esmark stock.

The Tax Cour found no merit in any of the theories that the IRS advanced to requie
recharacterization of the traction as a sale of

Vickers followed by a self-tender. Specifically,

while the Tax Cour found that the transaction could have been accomplished differently, the Tax
Cour also held that Mobil's ownership of

Esmark's stock could not be disregarded under the step

transaction doctrne, even though Esmark clearly chose to strctue a transaction resultig in the least

tax. The Tax Cour stated:

"(The IR) proposes to recharactere the tender offer/redemption as a sale of the
Vickers shares to Mobil followed by a self-tender. Ths recharacteriation does not

simply combine steps; it invents new ones. Cour have refused to apply the step
trsaction doctrne in ths maner. In Grove v. Commssioner, 490 F.2d 241 (2d

ths Cour, the Commssionerrelied Memoraidum Opinion of Cir. 1973), afg a on the step transaction doctre to recharacterze a donor's gift of stockí followed by

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a redemption of that stock from the donee as a redemption of the donor's shares followed by a gift of cash to the donee. The Cour of Appeals stated:
'. . . (W)e can discover no basis for elevatig the Commssioner's 'form' over that
employed by the taxpayer in good faith. 'Usefu as the step transaction doctre may

be in the interpretation of equivocal contracts and ambiguous events, it canot generate events which never took place just so additional tax liability might be
asserted. ",

90T.C. at 196-197 (citations omitted).

Simlarly, the step transaction doctre should not be available to inert fictitious steps so as
to maximze a taxpayer's tax liability. Hypothetically, a transaction could have been stctued that
would leave you in nearly the same ultiate position as the described trsactions (disregarding the

effect oftaxes). However, you did not choose to undertake ths hypothetical trsaction. Just as the

step transaction doctrne did not apply to treat Esmark as redeemig its stock for cash followig
Mobil's purorted purchae of

Vickers, it should also not apply to treat you or the Parership as

having engaged in a transaction which did not actually occur.

Authorities under Code section 351 fuer support respecting the independent transactions

undertaken by you and the Parership. Under Code section 351, transferors of propert to a
corporation in exchange for the corporation's stock must be in "control" of the corporation

"imediately after"

the exchange in order to obtain tax-free treatment. The IRS has sometimes

assered that the trsferor is not in control "imediately afer" the exchange when a trferor of
propert disposes of

the corporation's stock shorty after receipt.

Thus, in American Bantam Car Co. v. Commssioner. 11 T.C. 397 (1948), afd per curam,

177 F.2d 513 (3rd Cir. 1949), the step transaction doctre did not defeat an otherse qualfyg
Section 351 tranaction despite the existence of a prearanged plan to dispose of stock representig

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control. In that case, shareholders transferred assets to a corporation in exchange for common stock

representig control in the corporation. Five days later, pursuant to a previous intent, the corporation
and shareholders contractually agreed with underwters that the shareholders would tranfer their

newly acquired common stock to the underwters as and if

the underters sold shares of preferred

stock in the corporation. The underwters successfuy marketed the ,preferred stock, and the
shareholders tranferred stock representig "control" of

the corporation to the underwters pursuant

to their agreement. Neverteless, the Tax Cour found that the subsequent loss of control was not
an integral par of

the intial Code section 351 trsaction, and thus the shareholders' common stock

ownership was respected for purses of determg whether Code section 351 was satisfied.. See
also Harder v. Commssioner, 17 TCM 494 (1958) (Code section 351 was satisfied even though thd
pares had the option, but not the obligation, to purchase the stock received by the trsferor

shareholders as of

the date of

the Code section 351 exchange); and Rev. RuL. 78-294, 1978-2 C.B.

141 (a firm commtment underter who intends to sell to the public the stock he receives from a

corporation is in "control" of the corporation for puroses of Code section 351 because the
underwter would be required to keep the shares of stock he could not sell and therefore assmned

the risks of marketig the stock).

Several ruings issued by the IR also illustrate that the step transaction doctre is not
available as a mean to recharacterie a tax-motivated transaction consisting of economically
meangful events. Examples of such ruligs focus on "debt-for-equity swaps" and "debt-for-debt

swaps."

In a tyical debt-for-equity swap, a corporate issuer ("Issuet') and an underwter
("Underwter") enter into a binding exchange agreement ("Exchange Agreement") pursuant to
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which the Issuer would agree to reacquie its outstanding debentues from the Underter in
exchange for newly issued shares of its stock. Generaly, the Underwter would purchase the
corporation's outstanding debentues in varous acquisition transactions prior to enterig into a
formal Exchange Agreement, but after discussing the terms of

the transaction and preparg wrtten
the pares to the transaction. A

proposal

letters settg forth the expected rights and obligations of

tyical Exchage Agreement would then provide that the Underter would register its newly
acquied stock for resale with

the Securties and Exchange Commission ("SEC"), although the

Underwter would not be legally commtted to the Issuer to sell such stock. In actu practice and
in accordace with the pares' intent, however, the Underwter would sell its newly acuied stock

imediately after the swap, sometimes pursuant to binding agreements with brokers entered into at
the same tie as

the Exchange Agreement. Under Code section 1 08 (as in effect durg the years
the

involved), the Issuer did not report cancellation of indebtedness income even though the value of

stock was less than the face amount of the canceled debt. Code section 108 was subsequently

amended in 1984 to treat a debtor corporation that uses its stock to cancel debt as satisfyg the debt

with an amount of money equal to the fai market value of the stock. Thus, i~ the stock was issued

in exchange for debt tradig at a discount after the amendient to Code section 108, the debtor
corporation would recognize cancellation of indebtedness income. A tyical debt-for-debt swap
followed essentially the same form as a debt-for-equity swap, except that the pares intended to

avoid cancellation of indebtedness income on the basis of an exception for recapitalizations derived
from then existig Code section 1232.

In Techncal Advice Memoranda 8735006 and 8735007 (May 18, 1987) (debt-for-equity
swaps) and in Techncal Advice Memorandum 8815003 (December 1 1, 1987) (debt- for-debt swap),

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the National Offce of

the IR rejected the Distrct Director's contention that the

exchanges should

be recast on the grounds of

"substace over form" as diect retiements by the Issuer of its debt for

cash (resulting in cancellation of indebtedness income). In al thee rulings, the National Offce also
rej ected the Distrct Director's attempt to recast the swaps under the theory that the Underter was

the Issuer's agent, which would have attbuted the Underwter's activities to the Issuer. The
National Offce found in these rulings that therecharacterizations proposed by the field agents would

requie a conclusion that in substance the Underwter had firs paricipated in an underwting of
new stock or debt on behalf of the Issuer, and that the Issuer had then used the proceeds of the

underwtig to repurchase its existing debt.

The National Offce noted that it found this recharacteriation ''problematic because it
requires a reversal of the order of the transactions, which the Cours and IR have generally been
reluctat to do in applyig the step-transaction doctrne." (Citations omitted). Moreover, the

National Offce stated that it found "no merit to the arguent tht application of

the step-transaction

doctre here and the resultig recharcterization of

the form of

these tranactions better portays the

substance of these tractions. Contrarly, its application would ignore salient economic realities."

It should be noted that in these rulings the Nationa Offce found that several meangful
factors precluded the Distrct Director from recharcterig the tranaction. Specifically, the

Underwter acquied at least some of

the existing debt for its own account prior to the execution of

the Exchange Agreement, and the Issuer did not provide fuds for the acquisition of such debt or act

as guarantor for any financing arangement with respect to such acquisition, so that "(t)he

Underwter ran the risk, however minimal, that the (Issuer) would not execute (the Exchange
Agreement), and acquied whatever benefit" ownership of

the existig debt provided. The IRS
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found such risk even though, in Techncal Advice Memoradum 8735007, an SEC filing was made
with respect to the newly issued stock and a group of

brokers agreed to buy the stock received by the

Underwter on the same day that the Exchange Agreement was executed between the Underwter
and Issuer, and, in Techncal Advice Memorandum 8815003, thd-par underwters were, as of
the date of the exèhange, "previously commtted" to acquing the newly issued debt of

Underwter.

Additionally, the Underter, not the Issuer, stood to profit from the sale of the stock or debt
received from the Issuer and the Underwter, not the Issuer, bore the risk ofloss on the subsequent

sales of the newly issued stock or debt and the Issuer generly did notprovide any indemnfication
to

the Underwter agaist ths loss. In Techncal Advice Memorandum 8735007, however, the

Issuer did agree to indemnfy the Underter in the event that reguatory impedients prevented
the Issuer from entertg the Underwter's offer to consumate the exchange. The National

Offce noted that such an indemnty

is not uncommon and did not reduce the Underwter's risk with

resect to sellig the newly acquired stock. In Techncal Advice Memorandum 8815003, the

National Offce also noted that the Issuer at one point refused to renegotiate the pricing ters when

the Underwter suggested revising the exchange ratio to reflect the increased risks from an
unexpected delay in closing. Furer, the Issuer did not redeem any of the newly issued stock or

debt, indicatig that the Underwter was not merely a faciltator of a tritory issuance of new
securties.
The National Office concluded in each Techncal Advice Memorandum that application of
the step tranaction doctre would distort the economic substance of

the transactions. In Techncal

Advice Memoranda 8735006 and 8753007, the National Offce found:

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"Recasng the form. . . would not better reflect (the) substance than the form in

which the transactions were cast. Whle it would result in a greater tax liability. . .
there is nothg in the tax law that requires a tapayer to strctue his tranactions in

a form that wil result in a greater ta liability, 'so long as there is substace to the form that is chosen."

Similarly, the National Offce rejected application of the step transaction doctre in
Techncal Advice Memorandum 8815003, stating:
"The application of a step transaction approach to the facts presented would distort

the economic substance of the transactions involved. Moreover, none of the alternative step trsaction formulations apply. Certly neither par was under a
binding commtment prior to the execution of the Exchange Agreement, nor was the

Underwter under any bindig commtment to (Issuer) to sell the New Debentues to the public. Each of the supposed steps -- acquisition of the Old Debentues for
New Debentues, and sale of

the New Debentues - cared its own independent legal

and economic signficance. The earlier transactions were not "frtless" without the
later tranactions (so) the mutual interdependence test would not result in stepping

the transactions together. Finaly, the end resut test merely states that, when a
taxpayer intends by a series of circuitous tractions to reach a parcular result, the

actual circuitous tranaction underten by the taxayer may be recharacteried for
tax puroses to reach the same result in a more diect maner. Application of

the end

result test would not result in the separate tranactions being stepped together,
because to do so would not only ignore the substance of each tranaction, but would

also presuppose an end result which never took place -- that is, (Issuer) never
received cash for its New Debentues. Thus, recastig the trsaction would not the debt-for-debt exchange the economic realities of result in a better reflection of
than the form

chosen by the pares, and therefore the end result test does not require

that the transaction be stepped together."

In a like maner, the step trsaction doctre should not be applied to treat the Parership
as the intial investor in the options positions. Such a recasting of

the trsaction would requie a

reversal of steps, which the National Offce has acIaowledged is problematic.
In addition, an anysis of

the factors the National Offce found signficant in the swap rugs
the described transactions has economic substace and must be

supports the view that the form of

respected. First, you invested in the Long Option and sold the Short Option for your own account

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using your own fuds as investment capitaL. Those positions had independent economic profit

potential. You expected to profit from your options positions even if there was no subsequent
transfer of

the securties positions to the Parership.
As the IR stated in Rev. RuL. 79-250, 1979-2 C.B. 156:

"The Internal Revenue Servce has indicated on several occasions that theshold steps
will not be disregarded under a step tranaction analysis if such preliar activity

results in a permanent alteration of a previous bona fide business relationship. Thus, the substance of each of a series of steps will be recognzed and the step transaction
doctre wil not apply, if each such step demonstrtes independent economic

signficance, is not subject to attack as a sham, and was undertaken for valid business puroses and not mere avoidance oftaxes."
Each of the tranactions of

you, JFWLC, the Parership and JFW INC. was meangfl and

imbued with non-tax considerations. Each created risk and left the pares involved in distinctly
different legal and economic positions.

In sumar, recasting any of the transactions addressed in ths opinion would distort, not
better reflect, the economic and legal reaities. Therefore none of those transactions should be
stepped together. Where there are two or more paths to the same end result, the taxpayer is not

required to take the more expensive route. See, e.g., Glacier State Elec. Supply Co. v.
Commissioner, 80 T.C. 1047 (1983).

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L. TREASURY REGULATION SECTION 1.701-2
Treasur Reguation section 1.701':2 (sometimes referred to herein as the "Regulation") was
proposed by the Treasur

on May 12, 1994, to be effective on or after May 12, 1994, and was revised

and re-issued in fial form with retention of the origial effective date, except for cert aggregate

versus entity issues, on December 29, 1994, notwthtandig substantial criticism and adverse
commentar by tax practitioners, trade and professiona organzations, clais of the,

House Ways

and Means and Senate Finance commttees, and at least one federal agency. As modified, the
regulation was effective for any transaction "involving a parership" occurg on or afer May 12,
1994.
Under the Reguation, if a parership is formed or availed ofin connection with a transaction
with a pricipal purose of substatially reducing the present value of

the parers' aggegate federal

tax liability in a maner that is inconsistent with the intent of subchapter K of the Code (the
parership rules), the IRS can disregard the form of the transaction. Ii such a case, even if

the

taxpayer complies with the literal language of one or more of the provisions of the Code or
regulations thereunder, the IR can recast the transaction for federal tax puroses as it deems
appropriate. The pricipal purose for strctug a tranaction involvig a parership wil be

determined based on all of the facts and circumstances, includig a number of ilustrative factors
arculated in the final Regulation.
, There is no clear guidance as to how ths Regulation will be applied by the

IRS and there can

be no assurances that the IRS will not attempt to apply the Regulation to you, JFLC, the
Parership and/or JFW INC.

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Provisions of

the Rerulation

The requiement ofTreas. Reg. sec. 1.701-2 of a purose to achieve a result inconsistent with
the purose of

Subchapter K is diffcult to analyze. Treas. Reg. sec. 1.701-2(a) purorts to defie

the intent of Subchapter K:

"Subchapter K is intended to pent taxpayers to conduct joint business
(including investment) activities though a flexible economic argement without incurng an entity-level tax."
However, implicit in the intent of subchapter 1( accordig to the IR and the Treasur, are

the following requiements:

(1) the parership must be bona fide and each parerhip transaction or series of related transactions (individualy or collectively) must be entered into for a substantial
business purose;74
(2) the form of each parerhip trsaction must be respected under substance over form

principles; and
(3) generally, the tax consequences under subchapter K to each parer of the

parership

operations and of transactions between the parer and the parership must accurtely reflect the parer's economic agreement and clearly reflect the parer's
income (collectively, the "proper reflection of

income'').

The Regulation.

notes that cer subchapter K provisions and the regulations thereunder

were adopted to promote admstrative convenience or other

policy objectives, with the recogntion

74 The defmition of "substatial" is not provided in Tre. Reg. sec. 1.701 -2. Ordi, "substatial" mea
"real" or more than de mis." See, e.g., Black's Law Dictiona 1428 (6th ed. 1990); Tre. Reg. sec. 25.2703-

l(c)(l) ("Any discretiona modification. . . tht results in other th a de mis chage. . . is a substatial
modification."); Valmont Industres. Inc. v. Coimssioner. 73 T.C. 1059, 1074 (activity was "substatial," not "de'

mi"); McNemiv v. Coissioner. 54 T.C. 1057, 106 (1970) ("different is substatial, not de minimis"). For puroses of the reguation, both meags are consistent with unoffcial statements ofTreasui and IR official. See
Sheppard, Lee, "Fin Parerhip Antibuse Rule: Grdgig Acceptace," 66 Tax Notes 776, 777-778 (Feb. 6, 1995):

"There was no conscious effort to incorporate the stadads of section 355; we meant tht business purose has to be

real, not ,an aftertought." (Statement of Monte Jackel, IR Actig Associate Chef Counel (Domestic).) (Treasui)
could just say ''business purose," because people would read that to be de mis, and asser any old purose. ...

A trendous ta savigs requies more th a pepercorn ofbusiness purose." (Statement ofJohn Rooney, Attorney-

Advisor, Treasui Office of Tax Legislative Counsel.) 'In any event, the "substantial" stadad clearly represents a
lower theshold than the "pri or "pricipal" standads.

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present value of the parers' federal tax liability is substantially less than would be the case if
purortedly separate trsactions that are designed to achieve a parcular end result are integrated

in a single traction; (3) one or more parers who are necessar to achieve the claied tax results
either have a nomial interest in the parership, are substantially protected from any risk of loss

from the parership's activities, or have little or no paricipation in the parership's profits other
than a preferred retu in the natue of a payment for the use of capital; (4) substantially all of the

parers are related (diectly or indirectly) to one another; (5) parership items are allocated in

compliance with the literalanguge of Treas. Reg. sections 1.704-1 and 1.704-2, but with results
, that are inconsistent with the purose of Code section 704(b) and those reguations; (6) the benefits
and burdens of ownership of propert

nominally contrbuted to the parership are in substantial par

retained (diectly or indirectly) by the contrbutig parer (or a related par); or (7) the benefits and

burdens of ownership of parership propert are in substantial par shied (diectly or indiectly)
to the distrbutee parer before or afer the propert is actually distrbuted to the distrbutee parer
(or a related par). The weight to be given these factors is also dependent on the facts and
circumstances of

the situtions.

The requirement ofTreas. Reg. sec. 1.701-2 tht the parership be utilized for "a" pricipal

purose oftax avoidace as opposed to havig tax reduction be "the" pricipal purose of

utilizing

the parership suggests an interpretation by the IRS that would proscrbe "an important" purose
of

tax avoidance. However, Webster's Ninth New Collegiate Dictionar (Merram-Webster Inc.,

1975) defies "pricipal" as "most important," and the Cour in Malat v. Riddell. 383 U.S. 569

(1966) defied ''priarly'' as meang "of

first importce" or "pricipally." (Emphasis added).

Thus, a reasonable regulatory interpretation would requie a tax avoidance motivation to ran at least
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co-equally ("a" versus "the") with some other first order purose or constitute. itself the highest
purose before the Regulation could be invoked. The existence of any non-tax purose of

higher

magntude would presumably render the tax purose of secondar, and thus non-principal,
importance.

The fial Reguation intially provided sixteen examples of parership tranactions which

discussed the application of the anti-abuse rule. Two of these examples (Examples 5 and 6)

concered the application of the anti-abuse rule to transfers of interests in famly parerships.
However, on Januar 3, 1995, only five days after publishig the Regulation in fial form after eight
months of reconsideration, heargs and commentar, the IR anounced in Anouncement 95-8,

1995-7 IR 56, that the Regulation would be amended as of its effective date to provide that it
applies solely with respect to income taxes, and that because the Regulation will not apply

to trsfer

. taxes, Examples 5 and 6 would be deleted.

The Regulation specifically provides that the IR can contiue to asser and rely upon

applicable nonstatutory priciples and other statutory and regulatory authorities to challenge
tranctions, and that the Reguation is not intended to limt the applicabilty of such priciples and

authorities.

Analvsis
1. Do the Transactions at Issue Violate the Regulation?

The Parership was a bona fide parership (see discussion in Section C relatig to the tax
. classification of

the Parership). Taxpayers will presumably fie retu in a maner consistent with

applicable statutes and valdly adopted regulations; in fact, they would appear to have no choice but
to do so. For example, the Supreme Cour in Commissioner v. Culbertson, 337 U.S. 733 (1949), a

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case dealing with using parerships to achieve income splittg to avoid high margial ta brackets,

upheld the tax classification of a famly parerhip. Congress followed shortly thereafer with the

enctment of the predecessor of Code section 704(e), which specifically permts the use of
parership to achieve rate splitting despite bc;ing clearly tax motivated. See S. Rep. No. 781, 82d
Congress, 1 st Session 38 (1951) wherein it is stated: "If the ownership is real, it does not matter

what .

motivated the transfer to hi or whether the business benefited from the entrance of the new
parer." il fact, the equivalent of the curent preamble to the regulations subsequently

promulgated

under the predecessor of Code section 704( e) expressly disavows

the relevance of a tax -avoidance

motive to the classification issue.

The IR frequently cites Merran v. Commssioner, 55 T.C.M. 191 (CCH) (1988), afd
873 F.2d 897

(5th Cir. 1989) as a cáse that support the IR when it attempts to disregard a

parership entity (and th:iS disaow the tax benefits that flowed though it) when in the view of the

IRS the parership lacks economic purose and profit motive. The facts of the Merran case

make it clear that the decision as applied to those facts was correct. In Merran, a parerhip was
formed to acquire a drlling rig from a corporation controlled by the parers of the parership.

Even though the parerhip executed a note for purchase of the assets, payments of pricipal and

interest were not timely made and mangement of the rig was continued by the corporation. In
essence, the Tax Cour held that the risks and burdens of ownership were not trsfered from the
selling corporation to the parership. The Tax Cour opinon and the CoUr of Appeals opinon

made it clear that had the form of the business transaction been followed -- as is the case of the

transaction at issue -- the parership would have been respected.

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