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I. INCREASE TO BASIS IN JF INC. INTEREST DUE TO CONTRIUTION
Code §358(a)(1) provides that in a nontaxable Code §351 exchange, the tranferor's basis
in his stock received is determed by reference to his basis in the transferred proper. Therefore,
more liely
than not, your basis in your corporate stock was increased by your adjusted basis in your
Parership interest contrbuted to JFW InC.61
61 Code §358(a)(1).
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J. THE TRASFER OF AN INTEREST IN THE PARTNERSIDP SHOULD RESULT
IN AN ADJUSTMENT TO THE P ARTNERSIDP'S BASIS IN ITS ASSETS BECAUSE OF TH ELECTION MAE UNER CODE SECTION 754
You transferred, your interest in JFWLLC, which wil be treated for federal income tax
puroses as a tranfer ofJFWLLC's interestin the Parership, to JF INC. on April 30, 2000. Ths
transfer constituted an "exchange" under the provisions of Code section 721. (See Section H.
above.) Because of such transfer, the Parership intends to make, or already has made and has in
effect,
with respect to the taxable period in which such tranfer occured and thereafer, an election
under section 754 of
the Code. Pusuant to such election, in the case of a transfer of a parership
interest by sale or exchange, Code section 743 requies the increase in the adjusted basis of
parership propert by the excess of the basis to the transferee parer of its interest in the
parership over its proportonate share of the adjusted basis of the parership propert. Code
section 743(b)(1); Treas. Reg. sec. 1.743-l(b)(1)(i). An adjustment of ths tye is made to
parership propert
with respect to the transferee parer only. Code section 7 43(b); Treas. Reg. sec.
1.743-1
(b).
Your transfer of your interest in the Parership to JFW INC. will therefore result in an
adjustment to the basis of the Parership's propert
Under Code section 743. Code section 743(c)
provides that the alocation of
the basis adjustment is made in accordance with the rules set fort in
Code section 755. In general, Code section 755 requires that the allocation be made in a maner
which has the effect of reducing the difference between the fair market value and the adjusted basis
of parership propert, subject to certain characterization rules. Since the cash in the Parership
has a tax basis equal to its fai market value, while the fai market value of the Shares held by the
Parership signficantly exceeds the adjusted basis of such stock, the basis adjustment should be
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entiely allocated to such stock. Such adjusted basis should more liely than not be used to
determine the Parership's share of any gai or loss realized upon any subsequent sale or other
disposition of such stock.
The transfer of a greater than 50% interest in the Parership also caused a termation of
the
Parership for federa income tax puroses under the provisions of Code section 708(b)(1 )(B).
Under the applicable reguations, the effect of such termnation is that "the followig is deemed to
occur: The parership contrbutes al of its assets and liabilities to a new parership in exchange
for an interest in the new parership; and, imediately thereafer, the termated parership
distrbutes interests in the new parership to the purchasing parer and the other
remaig parers
the termated
in proportion to their
respective interest in the ternated parership in liquidation of
p~ership, either for the contiuation of the business by the new parership or for its dissolution
and widing up." Treas. Reg. sec. 1.708-1(b)(I)(iv). Such deemed ç:ontrbutions and distrbutions
do not themselves effect the adjusted tax basis of propertes, or the capital accounts of parers, nor
is a new taxpayer identification numberrequied for the "new" parership. Id. Additionally, a Code
section 754 election (includig a Code section 754 election made by
the terated parership on
the parership in which the sale or exchange
its fial retu) that is in effect for the taable year of
occurs, applies with resect to the incomig
parer. Treas. Reg. sec. 1.708-1(b)(I)(v).
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K. NON-APPLICABILITY OF CERTAIN DOCTRINES
In reachig our conclusions herein, we have determed that it is more likely than not that
neither the sham transaction doctrne nor the step tranaction doctre should apply.
Non-Aoplicability of
the Sham Transaction Doctrine
It is axiomatic that taxpayers may strctue their business transactions as they please, even
though motivated by tax-beneficial considerations. Gregory v. Helvering. 293 U.S. 465 (1935);
Fran Lyon Co. v. United States, 435 U.S. 561, 581 (1978); Rice's Toyota World. Inc. v.
Commissioner. 752 F.2d 89 (4th Cir. 1985) affg. and revg. 81 T.C. 184 (1983); Baker v.
Commssioner, T .C. Memo 1991-331. However, a tranaction must have economic substance to be
respected for federa tax puroses. Fran Lyon Co., 435 U.S~ at 583-584. A traction which,
though it may be proper in form, lacks economic substance beyond the creation of
tax benefits and
is not imbued with ta-independent considerations is an economic sham without effect for federal
income tax puroses.62 Kar v. Commssioner, 924 F.2d 1018 (11th Cir. 1991), afg. Smith v.
Commssioner, 91 T.C. 733 (1988); Rice's Toyota World. Inc. v. Commissioner, 752 F.2d 89 (4th
Cir. 1985), afg. and revg. 81 T.C. 184 (1983).
Generally, cours focus on two factors to determne whether a transaction would be deemed
an economic sham for feder tax puroses:
62 The cour have distigushed "sham in fact," in which the alleged trsactions never actuy took place,
from "sham in substace," in which tractpns actualy toak place and are genuie for general private law puroses, but for federa ta puroses nonetheless lack the substace their form repreents. See Lerm v. Commsioner, 939 F.2d 44, 48 at n.6 (3d Crr. 1991); Kirchm v. Commssioner. 862 F.2d 1486, 1492 (11th Cir. 1989); Horn v. noted Commssioner, 968 F.2d 1229, n.8 (D.C. Cir. 1992); Brown v. Commssioner, T.C. Memo 1992-379, n.8 (cour
that the investment in a horse breedig ta shelter were not factu sham, since they (did) not deal with phantom horses fictitiousness;" however, the cour found the tractions to be economic sham). The "sham in fact" or other indices of
analysis is not addressed in ths opinon because the transctions entered into by you, JFWLLC, the Parership, and
JFW INC. were indisputably rea and genuine.
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1) whether the transaction has no economic substance, which involves
the objective analysis of whether there is any realstic potential for profit or
practicable economic effect, exclusive oftax benefits, and
2) whether the taxpayer was motivated by no business puroses other
_ than obtaing tax benefits in enterig into the transaction, which involves a
subjective analysis of
the taxpayer's intent.
See, e.g., Kar v. Commssioner. 924 F.2d 1018 (11th Cir. 1991); Bryt v. Commssioner,
928 F.2d 745 (6th Cir. 1990); Rice's Tovota World. Inc. v. Commssioner, 752 F.2d 89,91 (4th Cir.
1985), Levv v. Commssioner, 91 T.C. 838, 853-54 (1988). The two factors must be examined in
light of the facts and circumstances existig as of the time of
the subject tranaction, not in hidsight.
The
cours have not been unform as to the weight they assign to these factors. In Rice's
Toyota World. Inc., the Four Circuit established that a transaction is not a sham for tax puroses
if the taxpayer satisfies either factor of
ths inqui. Other cours, such as the Eleventh Circuit, apply
a more flexible anysis, assignng neither factor special consideration. K. v. Commssioner, 924
F.2d 1018 (11th Cir. 1991). The Tax Cour considers the economic substance factor virally determtive in the analysis and business purose merely relevant. Cher v. Commissioner, 89
T.C. 986 (1987). Accordig to the Tax Cour, "A tranaction imbued with economic'substance will
be recognzed for tax puroses even in the absence of a business purose. On the other hand, the
existence of a subjective business purose does not mandate the recogntion of a trsaction lacking
economic substance." Dixon v. Commssioner, T.C. Memo 1991-614. il other cases, parcularly
older ones, the taxpayer's intent has been disregarded entiely. See Knetsch v. United States, 364
u.s. 361 (1960).
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Finally, there is a narow line of sham cases involving interest deductions which contiue to
arculate the test as it was stated in 1960 in Knetsch--whether the arangements "have purose,
substance, or utility apar from their anticipated tax consequences." Goldstein v. Commssioner, 364
F.2d 734 (2d CIr. 1966), afg. 44 T.C. 284 (1965); Sheldon v. Commssioner. 94 T.C. 738 (1990)
(noting that profit potential and profit objective were of little signficance in determining the
substance of the subject debt instrents, since those factors were not relevant for puioses of
Code
section 163).
The genesis ofthe distinct doctre of
economic shams is Knetsch v. United States, 364 U.S.
361 (1960).63 In Knetsch, the taxpayer purchased from an inurance company in 1953 30-year
matuty 22% deferred anuity savigs bonds with a total face value of $4 millon. The taxpayer
paid for the bonds with $4,000 in cash and $4,000,000 of 32% nonrecourse anuity loan notes,
secured by the bonds. Interest on the notes of$140,000 was due and paid in advance. The cash or
loan value of the bonds at the end of the fist contract year
was to be $4,100,000, and the contract
terms permitted the taxpayer to borrow the excess of ths value above his indebtedness without
waiting until the end of the fist year. The taxpayer took advantage of ths provision with days
after the purchase, whereby he received from the company $99,000 of
the $100,000 excess over his
$4,000,000 indebtedness, for which he signed 32% notes and prepaid the fist year's interest of
$3,465. On their joint retu for 1953, the taxpayer and his spouse claied interest deductions for
the sum ofthe two interest payments--$143,465. These "borrowigs" and "interest" payments were
repeated durg the following two tax year. In 1956, the bonds were surndered and the
63 Knetsch was predicated on Gregory v. Helverg. 293 U.S. 465 (1935), which was the fist ladmk case
under federa ta law applyig the substce over form doctre.
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indebtedness was canceled. The IRS disallowed the interest deductions on the ground that the
purorted debts were shams.
The tral cour in Knetsch found that there was no "commercial economic substance" to
the
tranaction, that the pares did not intend the taxpayer to become indebted to the company, that no
indebtedness of the taxpayer was created by any of
the transactions, and that no economic gai could
be achieved from the purchase of these bonds without regard to the tax consequences. The cour
concluded that the transactions were shams and upheld the IRS determation. 58-2 U.S.T.C. iI9935
(S.D. CaL. 1958). The Ninth Circuit affied the decision.
, The Supreme Cour majority arculated the issue in Knetsch in terms of
whether ''what was
done," apar from tax motive, comported with the intent of the relevant statute. Accordigly, the
Cour fist "put aside" a fidig by the tral cour that the taxpayer's sole motive in purchasing the
bonds was to secure an interest deduction. The majority anwered the issue in the negative.
"Ths (form), as we have seen, was a fiction, because each year Knetsch's anua
borrowing kept the net cash value, on which any anuity or inurance payments
would depend, at the relative pittance of $1,000. Plaiy, therefore, Knetsch's
transaction with the insurance company did "not appreciably afect his beneficial
interest except to reduce his tax . .. For it is patent tht there was nothing of
substance to be realized by Knetsch from this transaction beyond a tax deduction.
What he was ostensibly "lent" back was in realty only the rebate of a substatial par
of the so-called "interest" payments. The $91,570 difference retaied by the . company was its fee for providing the facade of "loan" whereby the petitioners sought to reduce their 1953 and 1954 taes in the total sum of $233,297.68. There
may well be single-premium anuity arangements with nonta substance which
create an "indebtedess" for the puroses of (Code section 163(a)). But ths one is
a sham." (Emphasis provided.)
364 U.S. at 365-366.
In Goldstein v. Commssioner, 364 F.2d 734 (2d Cir. 1966), the Second Circuit reinorced
that a tranaction need not be fictitious to be an economic sham. That case involved a wier of
the
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Irsh Sweepstaes who adopted a pIan to generate interest deductions to reduce the ta burden on
the wigs. The plan was to purchase relativ~ly large amounts of Treasur notes bearg 12%
interest by means of fuds borrowed at 4%. The 4% interest on the borrowed fuds was to be
prepaid and deducted in the taxable year of
the sweepstakes wigs. The loans were secured by
the Treaur notes and it was contemplated that the overall transactions would result in economic
losses, but that the net result would be ta benefits.
The Second Circuit in Goldstein disagreed with
the Tax Cour that both loan transactions
created "no genuie indebtedness," and instead remarked that those transactions were "reguar and
...indistguishable from any other legitiate loan tranaction contracted for the purchase of
Governent securties." 364 F.2d at 737. The cour went on to hold that Code section 163 "does
not permt a deduction for interest paid or accrued in loan arangements ... that can not with reason
be said to have purose, substance or utility apar from their anticipated tax consequences." 364
F.2d at 740. The cour added that Congress intended though the broad language of
Code section
163 to permit an interest deduction to encourage--
"purosive activity to be financed though borrowing ....In other words, the interest
deduction should be permitted whenever it can be said that the taxayer's desire to , secure an interest deduct~on is only one of mixed motives that prompts the taxpayer
to borrow funds; or, put a thid way, the deduction is proper if there is some
substance to the loan arangement beyond the taxpayer's desire to secure the
deduction." (Emphasis provided.)
364 F.2d at 741.
The Supreme Cour revisited the sham transaction doctre in United States v. Consumer Life
Insurance Co.. 430 U.S. 725 (1977). Specifically, the Cour addressed whether by vie of
two sets
of reinurce agreements, or "treaties," the taxpayers maintained a suffcient proporton of life
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inurance reserves vis-à-vis nonlife reserves to quaify for the favorable federal income ta treatment
aforded "life insurance companes" under Code section 801. The governent argued, among other
theories, that the treaties, which allocated uneared premium reserves between the tapayers and
other unelated inurance companes, were sham transactions without substace.
The Cour rejected ths arguent on the ground that the treaties, which were negotiated at
ar's lengt, served valid business puroses for the respective paries in addition to ta benefits.
Under the fist set of treaties, the taxpayers were the reinurers, and
the ceding companes were
requied to hold the premiums until eared. The ters of those treaties permitted the ceding
companes to invest the fuds and keep all resultig investment income. The second set of
treaties,
the basic business puroses
under which the taxpayers were the cedig companes, "served most of
commonly claied for reinsurance treaties," and in effect enabled each taxpayer to expand its
business. Moreover, each taxayer associated itself though the second treaty with a reinurance
company more experienced in the field and, under the terms, were shielded agaist certain
catastrophic losses. According to the Cour "tax considerations well may have had a good deal to
do with the specific term of
the treaties, but even a 'major motive' to reduce taxes wil not vitiate
an otherwise substantial transaction." 430 U.S. at 738. (Emphasis provided.)
In 1978, the Supreme Cour decided Fran Lyon Co. v. United States, 435 U.s. 561 (1978)
which is the most recent landmark decision on the sham tranaction doctre.64 In Fra Lvon Co.,
Worten Ban & Trust (''Worten'') planed the constrction of a multistory ban and offce
64 Fra Lvon Co. is distigushable from nwnerous sham cases in that the IR conceded the subject
trsactons had substace beyond the creation of ta benefits, but, in the IR's view, their form did not comport with
their substace. Nevereless, cours have consistently relied on Fran Lvon Co. in the anaysis of sham in cases where ta benefits. the subject trsaction was the generation of the only substace of
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building to replace its existig facilty. Worten's banng competitor also planed to constrct a
new building in which to relocate its operations, which placed pressure on Worten to follow
though with its constrction plans. Worten intially hoped to fiance, build and own the proposed
facility by sellg debentues and contrbutig the proceeds to a wholly-owned real estate subsidiar.
As planed, the subsidiar would hold formal title and would raise the remaig $5 millon by a
conventional mortgage loan on the new premises. Worten abandoned the plan for two reasons.
, First, Worten legally could not pay more interest on any debentues it might issue than that
specified under Arkanas banng law, which would rènder the proposed-obligation unarketable.
Second, the Federal Resere refused to grant Worten the necessar
perssion to invest in bang
premises in the planed amount. Worten was thus forced to seek an alternative solution that would
provide it with the use of the buildig, satisfy the stte and federal regulators, and attact the
necessar capital.
Consequently, afer negotiations with varous prospective investors, Worten negotiated and
consumated a sale-leaseback arangement with the taxpayer, whereby
the taxpayer took title to the
Worten building
under constrction, fianced the acquisition through unelated thd pares, and
leased the building back to Worten. The lease
was a net lease; the rental payments were identical
to the taxpayer's mortgage payments; and the lease granted Worten a option to purchase the
building afer the priar lease and on other futue dates at predetermined amounts that would
represent a 6% compound retu on the taxpayer's equity. The IR maitaied that the tapayer's
transactions in their entiety were shams for tax puroses and that all deductions, such as interest
expenses and depreciation, should be disallowed. Accordig to the IR, the taxpayer was in
- substance merely a conduit between W orten and the lenders in an elaborate financing arangement.
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The Supreme Court rejected the governent's position. The Cour found a host of
business
the tranaction.
and regulatory puroses, rather than mere ta benefits, underlyig the strctue of
the notes and the
The Cour regarded the taxpayer's exposure to the "real and substantial" risk of
presence of a thrd par--a finance agency--in the transaction as evidence that the transaction as
strctued had substance. The Cour conc1uded-
"In short, we hold tht where, as here, there is a genuine multiple-par transaction
with economic substace which is compelled or encouraged by business or regulatory
realities, is imbued wíth ta-independent considerations, and is not shaped solely by
tax -avoidance featues that have meanngless labels attached, the Governent should
honor the allocation of rights and duties effectuated by the paries."
435 U.s. at 583-584. .
Smith v.Commssioner, 78 T.C. 350 (1982), involved the analysis of
the sham transaCtion
doctre in the context of "commodity tax straddles." The taxpayer acquied on August 7, 1973,
long
positions in March and December 1974 silver futues contracts and short positions in July 1974
silver futues contracts puruant to simultaneously placed "straddle"65 trades complying with the
rules of the Commodity Exchange, Inc. ("COMEX"). Two days later, the taxpayers acquied
additional
long and short positions in silver futues contracts and applied the short positions to close
out the long positions acquied on Augut 7. The goal ofthese straddles was to "move" short-term
capital gai into a futue year and possibly convert it into
a long-ter capital gai. 78 T.C. at 364.
The taxpayers liquidated their strddles in Februar 1974 by acquiring additional positions. The
taxpayers claimed deductible losses for 1973 of over $95,000 on the August 9 close of the long
t..
6S A "straddle" wa dermed as the simultaeous holding in a long position in one deliver month and a short
position in another delivery month. Under the COMEX rues in effect in 1973, strddles could be bought and sold as a unt 78 T.C. at 355. "Butterfy straddles," which involve two separate strddles havig one common intermediate
l.
delivery month, are designed to create less economic risk. 78 T.e. at 365. Smith involved buttery strddles.
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positions.66 The IRS challenged the 10sses under varous theories, including the sham transaction
doctre, the step transaction doctre and the profit objective requiement for losses of individuals
under Code section 165( c )(2).
The cour fist addressed what unts of propert were intialy acquired.. Accordig to the
cour,
"(the taxpayer) did not merely acquire a long or short position on Augut 7; rather,
petitioners claim to have acquied equal
long and short positions that day. Did these
positions cancel each other out such that no propert was acquired for ta puroses
on August 7? We th not."
78 T.C. at 372.
After makg adjustments to the basis of
the acquied positions and the amounts realzed in
closingthem out to reflect fair market value rather than the arficial prices asserted by the taxpayers,
the cour concluded the "losses were real, not shams."
"They were the product of commodity trading actually engaged in puruant to COMEX rules durg the straddle trdig sessions on August 7 and 9. The contracts traded were legally binding on the paries under the rules of the COMEX; if petitioners had not, through later independent trades, closed out their August 7
the underlyig commodity, silver, would have ensued. Such losses may not be disalowed on the grounds of sham."
positions, delivery rights and obligations respectig
78 T.C. at 385.
The cour then addressed whether the fist-year losses in a commodity ta straddle should be
integrated with second-year gais and recognzed, if at all, only in the second year. The cour
indicated that it might have been more sympathetic with the ms' s arguent to integrate the losses
66 Subsequent to the ta year in question, Congrss enacted ta legislation goverg such strddles. See 78
T.C. at 362-363.
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and gais if
the tapayers were "guanteed" to have an exact offetting unealized gain; however,
in that case the tapayers were not so assured. As explaied by the Tax Cour
"Contrcts indifferent delivery month could, and in fact, did, show varg relative
prices durg the coure of petitioner" straddles trades. Whle the actual pricing
differences may have been small considerig the size of petitioners" investments, we
. are not prepared to say such differences were de mis. For us to draw a line, here,
by sayig that investments in these different assets must be integrated for tax
puroses because their prices travel too much in tandem, simply begs the question:
How nearly parlel is too nearly parallel? If platium and gold futues prices travel roughy in tandem, are we to integrate a straddle in opposing platium and gold
futues?"
After rejectig the IR's step transaction arguent, the Tax Cour in Smith held for the IRS
on the ground that the taxpayer had no profit objective in enterig into the transactions in violation
of Code section 165(c)(2) goverg losses of
individuals.
Rice's Toyota World. Inc. v. Commssioner, 752 F.2d 89 (4th Cir. 1985), afg. and revg. 81
T.C. 184 (1983) was the first major case to constre Fran Lvon Co. as requirg the two factor
analysis under the sham transaction doctre. In Rice's TovoY! the taxayer entered into a computer
sale and leaseback tranaction, which the sellerllessee (''Finalco'') had marketed as a ta shelter, and
fianced the investment with a 3-year recourse and two 8-year nonrecoure notes. The taxpayer's
purchase price was over 10 percent more than the price Finco had recently paid for the used
computer, which was subleased to an end-user at the time of
the taxpayer's transaction. Under the
lease, rental payments exceeded the taxpayer's obligations on the nonrecourse debt by $10,000
anually. Finalco, which was responsible for remarketig the computer followig the expiration of
the sublease, was entitled to 30 percent of
the re-lease or sale proceeds. The taxpayer paid off
the
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recourse note with interest as scheduled. The IRS determed the entie arangement to be a sham
and disallowed the depreciation and interest deductions associated with the transaction.
The Tax Cour noted that the presence of a genuine indebtedness supported by an actual
investment is strong evidence of economic substance. 81 T.C. at 202. However, the Tax Cour
found that the taxpayer lacked any business purose for enterig into the sale-leaseback transaction,
that the transaction was devoid of economic substance, and thus that the entire arangement,
including the recoUrse note, was a sham for tax puroses.
The Four Circuit agreed that the taxpayer satisfied neither factor of
the sham transaction
analysis with respect to the computer sale-leaseback and thus affed the disallowance of the
depreciation deductions and nonrecourse interest deductions. hi determng the business purose
inquir -- specifically, whether
the taxpayer entered into the tranaction with a profit objective -- the
Four Circuit looked to three facts. First, the taxpayer did not seriously evaluate whether the
computer would have sufficient residual value at the end of
the existig lease to enable it to ear a
profit on its purchase and leaseback. According to
the cour,
the computer (either in sellig or releasing) should therefore have been the crucial point of inquir for a person with a business purose of makg a
"Residual value of profit on ths tranaction. However, Rice's principal officer lmew virlly
nothg
about computers, and relied alost exclusively.on the representations of a Finalco
salesperson regardig expected residual value. Desite the Finalco representative's fran concession that he was not an expert in predictig residual values, Rice did not
purue the representative's offer to provide an expert appraisal of likely residual
value. Rice's accountant advised that the transaction appeared to be profitable, but the record does not reveal that the accountat's opinion reflects anytng more than the fact that the transaction, if successful, would generate large tax deductions.
t"
Although Rice had in its possession a report containing a char that showed a possibility tht the computer would have suffcient residual value to ear Rice a
1..
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profit, the report wared of great risk in predicting residual values, and also showed
a large possibilty oflosses on
the transaction."67
Second, the sales literatue of
the transaction emphasized the large tax deductions associated
with the transaction, rather than the profit potential. Thid, and most criticaly accordig to the cour,
the taxpayer willingly paid an inated purchase pnce for the computer. Accordig to the cour,
"Considenng that Finalco had a nght to 30 percent of re-leasing or sale proceeds after five years, Rice can more accurately be said to have purchased only 70 percent of a computer, then wort less than $1,000,000. Because Rice paid so obviously inflated a purchase pnce for the computer and fianced the purchase maiy with nonrecourse
debt, it was properly inerable by the tax cour that Rice intended to abandon the walg away from the nonrecourse note balance before tranaction down the road by
the transaction ran its stated course. ,,68
The economic substce inqui, according to the Four Circuit, requies an objective
determation of whether a reasonable possibility of profit from the tranaction existed apar from
tax benefits. The cour accepted the Tax Cour's fiding that the sale-leaseback cared no hope of
earing a profit because the computer's residual value was not sufcient to recoup the interest and
principal paid to the seller on the recourse note less the $10,000 anual return under the lease. In
substance, the taxpayer did not purchase or lease a computer, but rather, paid a fee to Finalco in
exchange for clais for tax benefits. The cour found the nonrecourse note associated with the sham
investment similarly without economic substance.
The Four Circuit revèrsed, however, the Tax Cour on the disallowance of the interest
deductions based on the recourse note, which it held was genuie and had independent economic
67 752 F.2d at 92-93.
68 752 F.2d at 93.
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substance. Citig Fran Lvon Co.. the cour reasoned that a transaction that has economic substance
mus be respected for tax puroses even ifthe motive for the transaction is to avoid taxes.
The case of Sheldon v. Commssioner, 94 T.C. 738 (1990), seems to be the only case in
which deductions under a Code provision that does not requie a profit motive were denied for a
tranaction that produced some profit. Sheldon was a pre-1984
leveraged Treasur Bil transaction
in which the tapayer deducted interest in one year and reported income on the Treasur Bil in the
subsequent year. The 9-judge majority denied the interest deduction under Goldstein v.
Commssioner. 364F.2d 734 (2d Cir. 1966), cer. denied, 385 U.S. 1005 (1967) stating that the
potential for gai was not the sole standard by which the substace of a trsaction is judged, "and
in any event, (the potential for gai in the case sub judice) is infnitesimally nomial and vastly
inignficant when considered in comparson with the claied deductions." The majority also stated,
"In sumar, the timing of the trsactions here was critical and of overding
importance. The transactions were intentionally and cleverly strctued to be and are
real, but are without substace with the meang of established case precedent. The transactions occured at year-end to create deferral for tax puroses irespective of
whether they resulted in gain or loss, which, as strctued, were destied to be de
mins in amount."69
Seven judges dissented in the case, wrting:
"To date the only instances I can :fd in which we have compared potential profit
with expected ta benefit are those in which we have evaluated a tranaction for
profit objective ..,
The majority. . . sets fort a new "de miis" test for economic substance. ... Such a new test could require us to substitute our business judgment for that of tapayers
and disregard, for Federal income tax puroses, those transactions lackig sufcient
potential profit in light of expected tax benefits. For example, applying such a test to sale and leaseback transactions, will we have to deterine ... whether the potential profit from residual values is de mis when compared to expected tax benefits?
69 94 T.e. at 769.
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Assumg an inquir into whether a transaction offers enough profit is appropriate
. (and ... I believe it is not), then the proper analysis should be to compare the potential
profit with the invesbnent, rather than to compare the potential profit with the expected tax benefits, heretofore a section 183 inquir."
It is possible that the Sheldon case can be read to stand for the proposition that more than a
de minis business purose/profit motive must exist, but that once the theshold has been met, no
fuer weighg.of tax versus non-tax factors is necessar.70
InPeatOil&GasAssociatesv. Commissioner. ioOT.C. 271 (1993), the Tax Cour, in
Judge
Swift's concurng opinon, discussed the judicial authorities surounding the notion of a weighng
oftax versus non-tax motives in the context of
the sham transaction doctrne. Judge Swift declined
which follows:
to weigh tax versus non-tax benefits in a compellg legal analysis, a porton of
"I believe a 'priar' profit-objective test, as suggested by Judge Ruwe in his
concurg opinon-that is not found in the relevant statutory or regulatory scheme, that is in my opinon contrar to commercial and fiancial reality, and that has been
utilzed by the Supreme Cour only in the context of evaluating whether an activity
is in the nature of a hobby
activity as distigushed from a trade or business
activity--is too strct.
Over the years, in the context of analyzing passive, ta-sheltered invesbnents, the
cour have not been consistent in the languge used to describe the quantity or level of profit objective that must be established: (1) under section 183; (2) under the
profi-objective aspect of the sha-transaction doctrne; and (3) under the
profit-objective aspect of the economic-substance doctre. The inconsistent
profit-objective languge that has been used has included, among other language, the
following: 'Basic', 'dominant', 'priar', 'predomiant', 'substatial', 'reasonable',
'bona fide', and 'actual and honest.' As one cour commented we have been glutted
with tests. Many such tests proliferate because they give the comforting ilusion of
consistency and precision. They often obscure rather than clarfy. Collis v.
70 Generay, the fidig of a profit motive has been sufficient for the cour to hold in favor of
without fuer analysis. It is interestig to note that none of the cases wher the cour have arguably employed a test tht weighs tax and non-tax motivations have involved a question involvig the interpretation and application of
Subchapter K. The provisions of Subchapter K are mostly mechacal in natu, and do not conta the "for profit"
the tapayer
restrction that has provided some cour in some cases the basis to asser that business purose mut exceed ta
purse.
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Commssioner. 857 F.2d 1383,1386 (9th Cir. 1988), affg. Disterv. Commssioner. T.e. Memo 1987-217.
Some cours have used different, inconsistent language in the same opinon. For example, one recent opinion suggested that investors have to establish tht they had
a 'dominant' profit objective, but also that 'the determtion crucial to the intant case (was) whether the taxpayers had an actu and honest profit objective.' Nickson v. Commissioner. 962 F.2d 973, 976 (10th Cir. 1992), afg. Brock v. Commssioner.
T.e. Memo 1989-641. Another opinon suggested that investors must show a
'priar' profit objective, but then suggested that the test for sha-trsaction
. puroses was whether 'the transaction has any practicable economic effects other than' ta benefits. Bryant v. Commssioner, 928 F.2d 745,758 (6th Cir. 1991), afg. par, and remandig T.C. Memo 1989-527. in par, revg., in
The Tax Cour, however, in the last 5 year and with few exceptions--in evaluatig
passive, tax -sheltered investments and in an attempt to brig some unformity to the profit objective-has language and the analysis associated with the determation of consistently stated the test relatig to profit objective to be whether the investors had an actual and honest profit objective (or whether the investors had a 'bona fide', 'good faith', or 'any' profit objective-language, in my opinon, synonymous with
'actual and honest'). Generally, no parcular attempt has been made by the Tax
the amount of profit objective requied (i.e., to disallow claied ta benefits where the investors' profit objective was actu and honest but not primar).
Cour to quantify
Accordig to my research, in over 123 of the 131 Tax Cour division and
memorandum opinions issued since 1987 in which profit objective as at issue in the
context of passive, tax-sheltered investments, we applied the 'actual and honest'
profi-objective test, or a synonymous test, in evaluating whether passive investors had the requisite profit objective. See, e.g., Krause v. Commssioner. 99 T.C. 132
(1992); Mare v. Commssioner, 92 T.C. 958 (1989), afd. without published
opinon
921 F.2d280(9th Cir. 1991; McCrarv. Commssioner, 92 T.C. 827 (1989);
Antonidesv. Commssioner, 91 T.C. 686
Levyv. Commssioner, 91 T.C. 838 (1988);
(1988), affd 893 F.2d 656 (4th Cir. 1990); Soriano v. Commssioner, 90 T.C. 44 (1988); Fielding v. Commssioner, T.C. Memo 1992-553; Univeral Research and
Development Parership No. I v. Commssioner. T.C. Memo 1991-437; Schwar
v. Commssioner, T.C. Memo 1991-380; Berr v. Commssioner. T.e. Memo
199-145; Charlton v. Commssioner. T.C. Memo 1990-402; Bukove v.
Commssioner. T.C. Memo, 1989-588; Golden v. Commssioner, T.C. Memo Brownv. Commssioner, Keenv. Commssioner. T.C.Memo 1989-300; 1989-514; T.C. Memo 1988-527.
I submit that the "primary" profit obj ective test suggested by Judge Ruwe ignores the
commercial and business reality that the ta laws afect the shape of most business
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transactions. Fra
Lyon v. United States. 435 U.S. 561,580 (1978). Theunderlying
activity on which a passive, tax -sheltered investment is tyically strctued generally
constitutes an activity that cares with it (assumg it is not a sham) signficant tax
benefits. The availabilty of the tax benefits, or tax shelter, is often the reason the that ,in preference to an activity paricular activity (e.g., equipment leasing) is selected
does not car with it signficant ta benefits (e.g., undeveloped land). The presence,
therefore, of signficant tax benefits (that may even represent the investors' priar
objective for enterig into the trsaction) should not result in the loss of the associated tax benefits if the investor, in fact, has an actual and honest profit
objective apar from the tax benefits (and assuming the traction is not a sham).
Judge Ruwe's concurg opinion cites the Supreme Cour's opinon in
Commssioner v. Groetzng;er, 480 U.S. 23 (1987), as support for his suggestion
that
we should require taxpayers to prove a "priary" profit objective in analyzng the
allowableness of
ta benefits associated with passive, tax-sheltered investments. In
Commssioner v. Groetzinger. supra'at 35, the Supreme Cour utilized a priar
profit-objective test to ascertain whether a taxpayerw3. engaged in the active conduct
of a gamblig trade or business activity or whether the tapayer's gamblig activity
was merely a hobby. As stated by the Supreme Cour, "the tapayer's priar
purose for engagig in the activity must be for income or for profit. A sporac
activity, a
hobby, or an amusement diversion does not qualfy." (Footnote omitted).
The hobby-loss issue in Groetzinger is distigushable from issues arsing in the
context of ta-sheltered investments, and as suggested in Snyder
v . Dnited States, 674
F.2d 1359, 1363 (10th Cir. 1982), the priar
profit-objective test should only apply
when distigushing between a hobby and a trade or business activity. See also
Carkhufv. Commssioner. 425 F.2d 1400, 1404
(6th Cir. 1970), afg. T.C. Memo 1969-66; Schley v. Commssioner. supra at 750. As noted in Johnson v. United
States, 11 CLCt. 17,27,58 AFTR 2d 86-5893, at 86-5901,86-2 D.S.T.C. par. 9705
at 85,705 (1986), "the predomiant profit motive cases under section 162 have
importance only in the 'hobby loss' context, and do not control in a business sitution
and a priar profit-objective test is not supported by relevant statutory language or
legislative history."
Recently, in ACM Parership v. Commssioner, 73 TCM 2189 (1997), affd. in par and rev' d
in par 157 F.3d231 (3rd Cir., 1998), cert. dened, 119 S. Ct. 1251 (1999), the Tax Cour
was faced
with assessing whether a series of complex financial trsactions had the requisite economic
substance to be respected for U.S. federal income tax puroses. ACM Parership involved a foreign
parershp that engaged in contigent installment sales transactions of certai notes that shifted
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income to a foreign parer and generated a
capita loss to its U.S. parer, Colgate-Palolive, which
incured all the costs. The Tax Cour found, in a memorandum decision, that at the tie
Colgate-Palolive entered into the parership, its only opportty to ea a profit was though
either an increase in the credit qualty of the issuers of the notes or a 400-500 basis point increase
in the 3-month LIBOR interest rate.
The Tàx Cour found it 'was impossible for the issuers' credit quality to increae by the
necessar amount because it was so highly rated at the tie of
the transaction. Moreover, a 6-year
review of the 3-month LIBOR rate by the Tax Cour failed to find an increase of even 300 bass
points with that tie frame. Thus, the Tax Cour concluded that there was no reasonable
expectation of profit frm the investment strategy undertaken by the taxpayer, without regard to tax
benefits, and that engagig in such stategy was not "consistent with rational profit-motivated
behavior in the absence of expected tax benefits." il explaig its rationale, the Tax Cour held "in
ths case...the taxpayer desired to tae advantage of a loss that was not economically inerent in the
object of
the sale, but which the tapayer created arificially though the manpulation and abuse of
the ta laws. A taxpayer is not entitled to recognize a phantom loss from a transaction that lacks
economic substance."
The Tax Cour also determed tht, on the basis of
the evidence presented, the investment
strategy did not achieve the stated hedging effects and other non-tax commerciài goals as the
taxayer had contended. Thus, the Tax Cour concluded that the strtegy served no usefu non-tax
business purose and held for the Servce.
On ACM's appea to the Thd Ciruit Cour of Appeals, the appellate cour applied an
economic substance aIalysis in its paral afation of the Tax Cour's holding, fiding
that ACM's
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tranactions had no effect on ACM's net economic position or non-tax business interests and thus
did not constitute an economically substantive transaction that may be respected for tax puroses.
The Thd Circuit did acknowledge tht it is "well established that whère a transaction objectively
affects that taxpayer's net economic position, legal relations, or non-ta business interests, it will not
be disregarded merely because it was motivatedby tax considerations." The Thrd Circuit did allow
ACM to deduct the economic losses it incured in the transaction.
The ACM case appears to be an afation of
the well developed case law regardig sham
transactions by vie of the fact that the Tax Cour cited and applied the two-par "sham" test of
Rice's Toyota Wodd. Whle the Tax Cour analyzed other business alteratives the tapayer could
have pursued, it does not appear the cour meant to imply that a taxpayer must always purue the
most efficient and profitable means of accomplishig the taxpayer's goals in order to avoid havig
the transaction labeled a "sham." Rather, the cour appear to have been assessing alternative
business transactions as a means of gaugig the validity of the taxpayer's assertons regarding
business purose.
These principles have been recently reafed in a
number of cases. See Winn-Dixie Stores.
Inc. v. Commssioner. 113 T.C. No. 21 (1999) (findig the
taxpayer's leveraged corporate-owned
life insurce ("COLr') progr lacked economic substace and constituted a "sham" for tax
puroses since "( t)he only 'expense' that was reduced by the COLI plan was petitioner's income tax
liability); Compaq Computer Corp. v. Commssioner, 113 T.C. No. 13 (1999) (disallowig as
lackig economic substace the captue of foreign tax credits though an American depository
receipts ("ADR") arangement where petitioner's treasurer failed to separtely analyze the
transactions or consut outside advisors, shredded the spreadsheet the ADR advisor provided, and
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failed to discuss with the ADR advisor such basic information as the price of
the ADRs); Saba
Parership v. Commissioner, T.C. Memo. 1999-359 (disallowig similar ACM-tye traction);
United Parcel Servce of America. Inc. v. Commssioner; T.C. Memo. 1999-268 (disalowig
distrbution of newly formed reinance subsidiar as a taable dividend because such restrctug
was a "sham" that had "neither business purose nor economic substace, other than ta
avoidance"). Furer, the IRS, in Notice 99-59 (December 27, 1999),71 used simlar arguents
concerng the lack of economic substance in voicing its disapproval of an arangement commonly
referred to as a bond and option sales strtegy ("BOSS") (involvig a borrowing and encumbrance
and the corporate distrbution
of assets subject to the encumbrance). As explaied below, the
analysis used in the above-described matters is inapplicable to the tranactions at issue here.
Economic Substance .
The critical issue in determg whether the investments made by
you in the foreign curency
options positions had economic substance is whether the investments had "realistic potential for
profit"
or some other practicable economic effect without regard to tax consequences. According
to the Tax Cour, _
"The phrase "realstic potential for profit" does not mean that the tranaction must make a profit or even that simar tranactions generaly are profitable. As we fouId in Abramson v. Commssioner, only an average of 1 film in 10 is successful; in wells drlled may be wildcat oil drllng, the success rate based upon the number of
low. Realistic potential for conceived and
profit is found, however, when the transaction is carefuy
planed in accordance with standards applicable to the parcular
industr, so that judged by those stdards the hypothetical reaonablè businessman
would make the investment."
71 Although notices do not have the force of law, they are indicative of the position of the IR, and
provided by
"(t)axayers are entitled to rely on and the (IR) states tht it wi be bound by substative and procedur gudance Rev. Rul. 90-91, 1990-2 notices or anouncements." Hall v. Commssioner, T.e. Memo. 1998-336 (citig C.B. 262).
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Cheri v. Commssioner, 89 T.C. 986, 993-994 (1987).
In Salina Parership LP. FPL Group. Inc. v. Commssioner.72 the Tax Cour rued tht a
short sale transaction providing a 4 to 7 percent retu on investent over the yield on Treasur bils
and potentially $119 millon in additional tax benefits was not a sham in substance. Sala
Parership was formed on December 16, 1992 and entered into a short sale of
U.S. Treasur bils
with a face value of $350 milion on December 17. On December 28, 1992, FPL acquied a 98
percent parership interest in Salina. On December 30, 1992, Salina closed its short position in the
Treasur bils and the proceeds were reinvested pursumt to
an alterative ta strategy. The Salna
Parership contiued its existence until November of 1994. For the short 1992 taxable year, Sala
Parership reported a capital gai of$344 millon; FPL offset its distbutive share ($337 millon)
with its significant capita loss carover resultig from an unelated sale. FPL increased its outside
basis in its interest in the limted parership by the $337 milion gai it had reported in 1992, and
claied large ordiar losses attbutable to its interest in the lited parership for the
taxable years
1994 though 1997.
The IRS in Salina argued that FPL's investment in Salina durg the period December 28
though 31, should be disregarded for tax puroses as a sham in substance. The IR contended that
Goldman Sachs, fuly aware that FPL had incured a large capital
loss in 1992, orchestrated Salina's
$350 million short position in Treasur bills so that, followig FPL's investment in the parership
and the imediate liquidation of
the parership's investments, Salina would realze a substantial
capital gai and a subsequent built-in loss in its Salina parership interest -- a loss that FPL would
be able to realize at wil though its control of Salina.
72 T.e. Memo 2000-352 (Novemer 14,2000).
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However, the Tax Cour held that FPL's investment in Salina was not a sham in substace
because FPL invested in Salina in order to achieve legitiate business objectives independent of
the
purorted tax benefits and FPL's investment produced objective economic consequences.
Although we agree with respondent that Goldman Sachs strctued FPL's purchase of the Salina parership interest to provide FPL with a perceived tax benefit, this
factor, standing alone, is insufcient to render the tranaction a sham in substance.
Considerig al the facts and circumstances, we conclude that FPL entered into the
Sala transaction to achieve a valid business purose independent of tax benefits.
The record demonstrates that FPL entered into the Salina parership for the primar
purose of enhancing the retu on its short-term investments. . .
Weare convinced that FPL' s investment in Salina provided a reasonable opportty
for FPL to ear profits independent of ta benefits. As previoùsly discussed, FPL
carefuly evaluated the potential risks and rewards of the . . . strategy. . . we are satisfied that the potential profits associated with the investment were not de mis
relative to the perceived tax bene;ft. As shown below, there is ample evidence that the investments made had profit potential.
Business Purpose
You have indicated that you, JFWLLC, the Parership and JF INC. each had the business
purose of a profit objective with respect to your respective investments and activities. Although
a reasonable expectation of profit is not required, the activity must be entered into in good faith with
the objective of
makg a profit. Taube v. Commssioner. 88 T.C. 464, 478-479 (1987).
the trsaction, however, which may be perceived to demonstrate
There are several aspects of
a substantial tax motive in connection with the tranactions. Those facts, however, should not render
the tranactions shams. The general standard under the sham trsaction doctre is whether the
transaction was entered into for the sole motive of obtainig tax benefits. As long as a bona fide
non-tax business purose exists, the cour do not weigh the motives. See, e.g., Knetsch v. United
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States, 364 U.S. 361 (1960); United States v. Consumer Life Inurance Co., 430 U.S. 725 (1977);
Fran
Lvon v. United States, 435 U.S. 561 (1978); Rice's Tovota World. Inc. v. Commssioner. 752
F.2d 89 (4th Cir. 1985), afg. and revg. 81 T.C. 184 (1983); Goldstein v. Commssioner, 364 F.2d
734 (2d eir. 1966); Peat Oil & Gas Associates v. Commssioner, 100 T.C. 271 (1993).
The recogntion and magntude of any tax benefits from the investent to you may be
relevant to the subjective intent anysis but must be viewed in light of all of
the facts suroundig
the tranactions. The business purose and substance of
the Long and Short Options positions are
addressed subsequently in ths Section.
The Options Investments of JFWLLC
You engaged in the following Options trsactions: you, though JFWLC, bought (1) a
digital option on the EurofU.S. Dollar exchange rate at a stre price of
0.9912 U.S. Dollar per 1.00
Euro with an expirtion date of April 17, 2000, a settlement date of April 19,2000, and a payoff
amount of $19,325,000, and paid a premium of
$9,662,500 and (2) a digital option on the Swiss
FracfU.S. Dollar exchange rate at a stre price of 1.7027 Swiss Francs per 1.00 U.S. Dollar with
an expiration date of April 17,2000, a settlement date of April
19, 2000, and a payoff amount of
$19,325,000 and paid a premium of
$9,662,500. Additionally, you sold (1) a digital option on the
EurofU.S. Dollar exchange rate at a strke price of 0.9914 U.S. Dollàr per 1.00 Euro and received
a premium of$9,565,875, with an expiration date of April
17, 2000, a settlement date of April 19,
2000, and a payoff
amount of$19,131,750 and (2) a digital option on the Swiss FrancfU.S. Dollar
exchange rate at a stre price of 1.7029 Swiss Fracs per 1.00 U.S. Dollar and received a premium
of $9,565,875, with an expirtion date of April 17,2000, a settlement date of April
19, 2000, and
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