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

Case 1:05-cv-00748-CCM
, '.\

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Jenkens & Gilchrst
A PROFESSIONAL CORPORATION

AUSTIN, TEXAS

(512) 499-3800
CALLAS. TeXAS

, 225 WEST WASHINGTON STREET SUITE 2600

(214) 855-4500
HOUSTON, TEXAS

CHICAGO, ILLINOls 60606-3418

(312) 425-3900
FACSIMILE (3'2) 425..3909

(713) 951.3300
LOS ANGELES, CALIFORNIA

(310) 820-8800

www.Jenkens.com

SAN ANTONIO, TEXAS

(210) 246-5000
WASHINGTON, C.C.

(202) 326-1600

Januar 2,2001

CONFENTIA
ATTORNY-CLIENT PRIEGED
. Mr. Jeffey F. Welles

780 Thd Avenue Suite 3400
New York,

NY 10017

Dear Mr. Welles:

You have requested us to review the United States federal income tax consequences of a
number of trsactions in which you have been involved and to provide our opinon regarding

certin material United States federal income ta issues. Such trsactions are described below

under the heading "Facts."
In connec.tion with ths opinon, we have examed such matters of law, and such limited

liability company, corporate, and parership records and such other agreements, certficates,

intrents and documents, and we have made such other inquiries of offcers, owners and
representatives of

the entities involved, as we have deemed necessar to render the opinons set fort

herein. We have without any investigation or independent conftion relied upon and assumed
the accuracy of

the responses to such inquies and such certficates, lited liability company and

parership records and other documents with respect to factul matters.

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Exhibit 9

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J enkens & Gilchrst
A PROFESSIONAL CORPORATION

Mr. Jeffey F. Welles

Januar 2,2001
Page 2

FACTS
In parcular, our opinon is based upon the following facts:

1. On March 24, 2000, you contrbuted shares of Therma- Tru Corporation (the
"Shares") to Stobie Creek Investments LLC, a Delaware limited liability company which is treated

as a pare~hip for Federal income tax puroses1 (the "Parership").
2. On March 31, 2000, you, though a Delaware limted liability company wholly

owned by you, JFW Investments, L.L.C. ("JFWLLC"), entered into certn over-the-counter,
non-publicly traded European style foreign curency option positions on the Euro and the Swiss
Franc (the "Options") with

Deutsche BanAG New Y orkBranch ("Ban"), an unelated substantive

counter par. Specifically, you bought digita options on (I) the EurolU.S. Dollar exchange rate

at a stre price of

0.9912 U.s. Dollars per 1.00 Euro 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 and (2) the Swiss FranclU.S. Dollar exchange rate at a stre price of 1.7027 Swiss

Francs per 1.00 U.S. Dollar with an expiration date of Aprifl 7,2000, a settlement date of April

19,

2000 and a payoff amount of$19,325,000, and paid a premium of$9,662,500 (collectively referred to herein as the "Long Option"). Additionally, you sold (1) a digita option on the EurolU.S. Dollar
exchange rate at a stre price of 0.9914 U.S. Dollars per 1.00 Euro and received a premium of
i Under federa income ta law, a lited liabilty company is a business entity that is eligible to elect its
classification for federal ta puroses. As an eligible entity, a limited liability company with at least two members can

elect to be classifed as either an association (and thus a corporation) or a parership. See Treas. Reg. §30L.7701-3(a).
Unless the entity elects otherwise, a domestic eligible entity is a parership if it ha two or more members. Treas. Reg. §30 1.770 1-3(b )(i). Hence, for puroses of this opinon letter, Stobie Creek Investments LLC wil be referred to as the
"Parership" and its members as "Parers."
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J enkens & Gilchrst
A PROFESSIONAL CORPORATlON

Mr. Jeffey F. Welles
Januar 2, 2001
Page 3

$9,565,875, with an expirtion 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 FraclU.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 expiration date of April 17,2000, a settement date of April

19, 2000, and a payoff

amount

of$19,131,750 (collectively referred to herein as the "Short Option").
3. On April

3, 2000, you contrbuted the Options to the Partership as a contrbution

to capitaL.

4. On April

17, 2000, the Parership's Option positions termated.
30, 2000, you contrbuted your intere~t in JFLC to JF Enterprises, Inc.

5. On April

("JF INC."), a Delaware corporation in which you are the 1 00% shareholder, as a contrbution to
its capita. The Parership made, or intends to make, with respect to its taable year ending April
30, 2000, an election pursuant to section 754 of

the Internal Revenue Code of 1986, as amended (the

"Code").

OPINON
Based on the following discussion and anlysis and subject to the qualifications, limtations
. and assuptions set fort herein we are of

the opinon that under curent U.S. federal income ta

law it is more liely than not that:

A. JFWLLC, as a single member limted liabilty company, should be disregarded as an
entity for federa income ta puroses.

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Jenkens & Gilchrst
A PROFESSIONAL CORPORATION

Mr. Jeffey F. Welles January 2,2001 Page 4

B. Investing in the Options should not be taxable and the Options should be treated as

separate instrents for federal income tax puroses.

C. The Parership should be classified as a parership for federal income ta puroses.
D. Your contributions of

the Options to the Partership should not result in a taxable

gai or loss.
E. The Short Option should not be a liabilty withi the meang of Code section 752.

F. Your basis in your interest in the Parership afer the contrbution of the Options
should include the cost of the Long Option contrbuted, without adjustment for the
Short Option.

G. An adjustment to your adjusted basis in your Parership interest should be required
as a result of the expiration of the Options, due to the recogntion of loss on such
expirtion under Code section 1234.

H. Your contrbution of your interest in JFWLLC to JFW INC. should be treated as a
tranfer of JFWLLC's interest in the Parership and should not be a taable

trsaction and JFW INC.' s basis in'the Parership interest contrbuted by you as

a result of your contrbution of your interest in JFLC should be equal to your'
basis as of the date of sl.ch contrbution.
I. Your basis in your interest in JFW INC. should be increased by an amount equal to

the adjusted basis of your interest in the Parership as of the date of contrbution.

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J enkens & Gilchrst
A PROFESSIONAL CORPORATION

Mr. Jeffey F. Welles

Januar 2,2001
Page 5

J. The effect of

the Code section 754 election should be that the Parership's basis in

its propert should be increased with respect to JFW INC.

K. The step transaction and sham tranaction doctres should not apply to the
tranactions described herein.

L. Treasur Regulation section ("Treas. Reg. sec.") 1.701-2 should not apply to the
tranåctions described herein.

The opinions set fort above are subject to the followig qualifications, limtations and
exceptions:
No opinon is expressed about the ta treatment of

the described transaction for puroses of

any state or local income ta, or any ta other than the United States federal income tax.

Any misstatement of a material fact or omission of any fact that may be matenal or any
change in any of the facts referred to may requie a modification of all or a par of our opinons.

Our opinions are limted to the matters expressly set forth herein and no opinion may be
implied or inerred beyond the matters so stated. The opirons expressed herein are based upon our
interpretation of curent law. The opinons expressed herein are not binding on the Intern Revenue

Servce (the "IR" or the "Service") or the cour, and there can be no assuce that the IR and
the cour wil not tae a position contr to the opinons expressed herein. In fact, on August 11,

2000, the IR issued Notice 2000-4, which describes two tranactions with respect to which the

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Jenkens & Gilchrst
A PROFESSIONAL CORPORATION

Mr. Jeffey F. Welles
Janua 2,2001
Page 6

IR concluded that ta losses generated were "arficial" and not allowable to the tapayer.2 One
of

the described transactions in Notice 2000-44 bears similarties to the trsactions described in our

enclosed opinion. While Notice 2000-4 sets fort the IR position on such loss generation
transactions, the Notice does not chage the existing law which we rely upon herein.3

We do not undertake to advise you of any changes in law which may occur after the date
hereof. The Code, the regulations promulgated thereunder, and the admstrative position of

the

IR are subject to change either prospectively or retroactively. Such changes could render certai
or all of the opinons expressed herein inapplicable.
For puroses of all of the above opinons, we are relyig on the trth of

the representations

of

you and/or parers or representatives of

the Parership or .parers or representatives of JFW

INC.
The opinons expressed herein are fushed by us solely for your benefit and for the benefit
of

the Parership and JFW INC. and they may not be relied upon or delivered to any person other

than you, JFLC,the Parership and JFW INC. and your successors ör assigns without our

express, prior wrtten approval.

2 2000-35 I.R.B. 6700. The IR views Notices as "the equivalent of Revenue Rulings and Revenue
Procedures." Rev. RuL. 87-138, 1987-2 C.B. 287. Revenue Ruligs and other IR admstrtive authority such as

Notices do not have the force and effect oflaw. True Oil Co. v. C.I.R., 170 F.3d 1294 (iOth Cir. 1999), citing, Storm Cir. 1985). CourhaveheldthattheymerlyrepreenttheIR's 770F.2d 148, 154 States, (10th Plastics.Inc_ v. United litigatig position. See e.g., Stubbs Overbeck & Associates v. U.S_. 445 F.2d 1142, 1146-47 (5th Cir. 1971); Neuhoff v. Commssioner. 75 T.C. 36, 46 (1980). "(A)lthough they are entitled to some consideration, they do not control when
contr to statute or the expressed intention of Congress." True Oil Co. v. C.I.R., 170 FJd 1294 (10t Cir. 1999),

citing, Storm Plastics. Inc. v. Unite States. 770 F.2d 148, 154 (iOth Cir. 1985).
J For a more thorough discussion of

Notice 2000-4, see Section M, below.

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J enkens & Gilchrst
A PROFESSIONA~ CORPORATION

Mr. Jeffey F. Welles

Janua 2, 2001
Page 7

REPRESENTATIONS
You and/or parers of the Parership and/or offcers of JFW INC. have represented the

\\ l) .

;followig:
a. You entered into the purchase and sale of

the Options for substatial nontax business
your belief

reasons, including (i) to produce overall eèonomic profits because of

that

the Euro/U.S. Dollar exchange rate and the Swiss Francl.S. Dollar'exchange rate
would change; and (ii) your belief

that the most direct way, with the most leverage,

to realize gain from expected changes in curency prices was the purchase and sale
of the Options.

b. You contrbuted the Options to the Parership for substantial nonta business
reasons, including, but not limted to, potential diversification of the risks of certain

investments, the desire to co-invest as parers with the other members and for your
convenience.
c. Your contrbution of

your interest in JFWLLC to JFW INC. was made f~r substatial

nonta business reasons, inèluding, but not limted to, the ability to engage in estate
plang, shared investment maagement, ownership with other anticipated

shareholders, and asset protection plang.
d. Neither you, JFWLLC, the Parership, nor JFW INC. were obligated to engage in

any transaction to which our opinons herein relate upon the completion of any other
of such tractions.

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Jenkens & Gilchrst
A PROFESSIONAL CORPORATION

Mr. Jeffey F. Welles
Januar 2,2001
Page 8

e. To the best of your knowledge, you have provided to us all the facts and

circumtaces necessary for us to form our opinon.

APPLICABLE LAW

Ou analysis of the applicable United States federal income ta law with respect to the
above-stated facts and in support of each, of the lettered opinons as set fort on pages 3 though 5
hereof is

attached, with each attchment lettered to correspond to each such opinon.

Based on the foregoing and subject to the qualifications, limitations and assumptions set

fort herein, we are of the opinon that the described ta consequences have substatial authority
and that it is more likely than not that you will prevail if chalenged by the IRS.
Very trly yours,

JENKNS & GILCHRST

~lM~

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A. SINGLE. MEMBER LIMITED LIAILITY COMPAN DISREGARED FOR
FEDERA INCOME TAX PUROSES
General
The IR issued revised reguations promulgated under Code section 7701 on December 17,

1996 (the "Classification Reguations"). T.D. 8697. In genera, these regulations provide that,
effective Januar 1, 1997, any domestic business entity which is not a corporation and which has a

single owner will be disregarded as an entity separate from its owner unless the, entity elects
otherwise. Treas. Reg. sec. 301.7701-3(b)(1)(ii).
JFW Investments. L.L. C.
JFWLLC was formed under a Certficate of Formation filed with the State of

Delaware on the

March 17,2000. JFWLLC is a domestic entity which is not a corporation and you own 100% of

membership interest in JFWLLC. Under the rules provided in the Treasur Reguations, JFLC

should be disregarded as a separate entity. Neither you nor JFWLLC elected nor intend to elect to
be classified as a parership or as an association taxable as a corporation. Accordingly, it is more

liely than not that the IRS should regard you as the owner of the assets held in the name of
JFLC. As a result, your transfer of your interest in JFWLLC to JFW INC. will more liely than

not be treated as a trsfer to JFW INC. of JFWLLC's interest in the Parership.

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B. INSTING IN TH OPTIONS IS NOT TAXLE AN tHE OPTONS SHOULD

CONSTITTE SEPARTE TRSACTIONS
You sold the Short Option on March 3 i, 2000. Receivig an option premium is more likely

than not, not a taxable tranaction, as the option wrter canot determe whether the option will be
exercised or will lapse. In Rev. Rul. 58-234,1958-1 C.B. 279, the Serce held that no income, gai,

profits, or eargs are derved from the receipt of either a "put" or "call" option premum unless and

until the option expires without being exercised, or is termated upon payment by the optionor of

an amount less than the premium.
Also, on March 31,2000 you bought the Long Option. Ths is a mere investment transaction,
th,e taxation of

which will more likely than not also be determed upon its exercise or lapse.
than not be govered

Once the Options are exchanged or lapse, their taxation wil more liely

by Code section 1234.
In deterg the tax consequences of

the transactions involvig the Options, a theshold
the Long Option and the Short Option would be regarded as separate

issue concern whether each of

transactions or instead would be somehow integrated into a single transaction.

First, the tiing of income, gains, deduction and losses from a hedgig transaction must
match those of the hedged trsaction. Treas. Reg. sec. 1.446-4. A hedge is a trsaction entered

into in the normal course of a tapayer's trde or business. It does not appear that an entity involved

in the Option transactions will hedge the economic risk with any other entity involved in the
transaction. Specifically, both the Parership and Ban retai real net economic risk which neither

will hedge with the other. Also, since you entered into the Long Option and the Short Option as an

investment activity, and not as a trade or business, it is more likely than not that the hedging
regulations will not be applicable. See Treas. Reg. sec. 1 .445-4( a) and Treas. Reg. sec. 1.1221-2(b).

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Second, even where one transaction may signficantly offset the risk of the other, ths factor
alone is generally not sufcient to integrte otherwse separate transactions that would be given

separate effect. See, e.g., Code section 1 092 (deferrng the loss on one "leg" of a straddle until gai
is recognzed on the other, but not nettg the offsettg positions); Code section 1258

(recharacterzing as ordiar income cerain gain attbutable to the time value of a taxpayer's

investment trsaction, but not recharacterizing it as a borrowig) and Code section 1259 (describing

treatment of a constrctive sale).

Thd, Code section 988 tranactions, which involve foreign curency tranactions, may not
be integrated. Specifically, Treas. Reg. sec. 1.988-1 ( e) provides in relevant par:

(T)he amount of exchage gai or loss from a section 988 transaction shal be
separately computed for each section 988 tranaction, and such amount shall not be
integrated with gai or loss recognzed on another transaction (whether or not such

transaction is economically related to the section 988 transaction).
As discussed below in Section G, the acquisition and disposition of each of

the Long Option

and the Short Option are Code section 988 tranactions.

Four, a critical factor in determng if

two instrents should be treated as one is whether

they can be trsferred or assigned independently of one another. For example, Code section 269B

provides for the special treatment of a stapled entity, which occurs where the stock of one entity
canot be traded without tradig the stock of

the other entity. Here, however, each Option is not a

stapled entity as described under Code section 269B because it can be transfered, assigned, or

liquidated independently of the other. It does not appear that Congress has attempted to treat
non-stapled entities as a single entity.

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Finally, cour have long recognzed that a taxpayer can hold long and short positions in
propert at the same time, and that each position is a separate propert. See Smith v. Commssioner.
78 T.C. 350 (1983), af:ld, 820 F.2d 1220 (4th Cir. 1987) (holdig

that each leg ofa strddle should
whether the legs were acquied at different ties or at

be treated as separate propert, regardless of

the same time); see also, Stoller v. Commssioner, 994 F.2d 855 (DC Cir. 1993), afg in par and
rev'g in par, 60 TCM 1554 (1990) (respectig separate contracts as stand-alone tractions);

Richardson v. Commssioner. 121 F.2d 1 (2d Cir. 1941) (fiding that long and short positions can
be held simultaeously); Rev. Proc. 65-29, 1965-2 CB 1023; Rev. Rul. 78-182, 1978-1 CB 265.

Based on the foregoing, the Options wil be more liely than not treated as separate
instrents for federal income tax puroses.

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C. CLASSIFCATIONOFTHPARTNRSll AS

A

PARTNRSIDPFORFEDERA

INCOME TAX PUROSES
hi determg the tax consequences of

the transactions involvig the Parership, a theshold

issue is its classification for federal tax puroses. Code section 7701(a)(2) defines the ter
"parership" to include a syndicate, group, pool,joint ventue, or other

uncorporated organzation

though or by means of

which any business, fiancial operation, or ventue is cared on, and which
the Code, a trst, estate or corporation. See also Code section 761(a).

is not, with the meang of

The term "paret' includes a member in such a syndicate, group, pool joint ventue or organation.
Code

section 7701(a)(2). The classification of an entity as a parership under state law is not

determative of its classification for federal tax puroses.

Under the Classification Regulations, effective Janua 1, 1997, any business entity which
is not classifed as a corporation for federal tax puroses, and which has two or more owners can

choose to be classified as either a parership or an association taxable as a corporation, and if no
such election is made, will by default be classified as a parership. Treas. Reg. sec. 301.7701-2, -3.

Entities which are classified as corporations for federal ta puroses include (1) a business entity
organed under a Federal or State statute, or under a statute of a federaly recognzed Indian trbe,

if the statute describes or refers to the entity as incorporated or as a corporation, body corporate or

body politic; (2) an entity which elects to be classified as an association; (3) a business entity
organzed under a State statute, if

the statute descrbes orrefers to the entity as ajoint stock company

or joint-stock association; (4) an insurance company; (5) a State-chaered business entity conductig

banng activities; (6) a business entity wholly owned by a state or political subdivision thereof; (7)

a business entity that is taxable as a corporation under a provision of the Code other than section

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~/"

7701(a)(3); and (8) certai foreign entities, as more fuly provided in the Treasur Regulations.
Treas. Reg. sec. 301.7701-2(b).
The Partnership

Stobie Creek Investments LLC, a Delaware lited liability company, was formed under a
Certifcate of

Formation dated March 3,2000, and governed by an Operating Agreement dated

March 3,2000 (the ''Parership Agreement"). More than one person owned an equity interest in
the Parership. Neither the Parership nor any parer has filed an election to treat the Parership

as an association taxable as a corporation. The Parership did not constitute a corporation under
any other provision of

the Treasur Reguations. Accordigly, the IR should regard the Parership

as a parership rather than a corporation for tax puroses.

Potential IRS Arguments
There are thee grounds on which the IRS conceivably could argue that the Parership

should not be treated as a parership for federal tax puroses. First, the IRS might allege that the
Parership lacked a profit motive. To ths end, the IRS perhaps would clai that the parers used
the Parership to serve tax puroses. Second, the IR could allege that np tre parership existed.

For reasons set fort below, you should prevail if the IRS challenges the classification of the
Parership on either of

these grounds. Finally, the IRS might argue that the Parership should be

disregarded pursuant to the Subchapter K anti-abuse regulation. That regulation is analyzed
separately in this opinon.
It is generally understood that to qualify as a parerhip for tax puroses, the organation
must have a profit objective. Hence, a ventu formed to purue a

hobby or aristic interest, instead

of economic profits, has been held not to constitute a parership for income tax puroses. Ewi~
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v. Commssioner, 20 T.C. 216 (1953), affd., 213 F.2d 438 (2d Cir. 1954). However, the Tax Cour
has treated a tax shelter limted parership as a parership for

tax puroses despite its deteration

that

the

entity

lacked

a profit

motive. Branenv. Commssioner, 78 T.C.471, 512n. 16 (1982), afd.

722 F.2d 695 (11 th Cir. 1984). See also National Commodity & Barer Association v. United States,
843 F.Supp. 655 (D. Colo 1993) (memberhip organzation that cared on financial operations and

tax protester activities lacked profit motive but was classified as a parership). In addition, the IRS

has on at least one occasion indicated that the absence of a joint profit motive does not prevent an
arangement from being a parership for tax puroses. In PLR 7903084, the IRS classified an
arangement between co-owners of environmental protection equipment as a parership, even

though the arangement lacked a joint profit motive. In reaching ths conclusion, the IRS stated that
the classification priciples set fort in Treas. Reg. sec. 301.7701-2 ''were developed without

reference to, and do not defitely cover, uncorporated organzations (òther than trsts) that are
engaged in not-for-profit activities." The IR has also rued that an uncorporated organzation
with no profit objective maybe classifed as a parership. PLR 9108025 (November 26,1990).

Assumg that a profit objective is requied of entities classified as parerships for tax
puroses, it has been represented that the Parership possessed that objective. Moreover, as noted

below, objectively the Parership has a realstic ability to profit though chages in values of the
varous options it holds. In any event, the presence of a tax motive in the formation or use of a

parership historically has never prevented a parership from classification as such for tax
puroses. See, e.g., Commssionerv. Culbertson, 337 U.S. 733 (1949); Slifka v. Commssioner, 182

F.2d 345 (2d Cir. 1950).

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The question of whether a parership actually exists was recently addressed in the case of

ASA Investerigs Parership v. Commssioner, T.C. Memo. 1998-305. There, the Tax Cour held
that no parership existed for federal income tax puroses between Alled Signal Inc. and a foreign

commercial ban. In that case, the parership, which was primarly capitalzed with contrbutions
from such foreign parer, invested in high-grade, floatig-rate private placement notes ("PPNs").
The PPNs were. subsequently sold in an installment sale in which the consideration was cash and
LmOR-indexed intalent notes. Due to the strctue of the sale, a large portion of

the PPNs' tax

basis was allocated to the LmOR notes. Additional financial instrents were purchased by the

parership, and later Alled Signal purchased most of the foreign parer's interest in the
parership. The LIOR notes were distrbuted to Allied Signal, which subsequently sold such
notes, generating a large capita110ss. Whle a parership agreement had been entered into by the
paries, other agreements regardig the economics of the series of transactions were also in place.
The result of such other agreements was that the foreign parer was to get a certai specified retu

on its contrbution to the parership. The Cour held that to form a valid parership the pares
must have intended to join together in the present conduct of an enterprise, and found, as a factual

matter, that the purorted parers of ASA had divergent business goals. The Cour found that,
considerg all of

the facts and circumstances, the foreign parer was, in realty, a creditor to Allied

Signal, rather than its parer.
In the case of the Parership, each of

the parers intended to join together in the common

purose of profitig :fom the investment in foreign curency option positions and other fiancial

intrents and investments and sharg the losses and profits therefrm. No parer's share was

guarteed or limted. Also, each parer shared proportionality in the income, gai, loss and
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deductions of

the Parership. Accordigly, the analysis employed by the cour in ASA should be

inapplicable and the parership should be respected.

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D. YOUR CONTRIBUTIONS OF THE OPTIONS TO TH PARTNERSHIP SHOULD

NOT RESULT IN A TAXLE GAIN OR LOSS
General Rule - Nonrecognition
'Code §721(a) provides that:
No gain or loss shall be recogned to a parership or to any of its parers in the

case of a contrbution of propert to the parership in exchange for an interest in the

parership.
As a result of ths general rule, it is more likely than not that your contrbution of the Options to the

Parership should not result in taxable gai or loss. Furter, it is more likely than not that the
exceptions to the general rue listed below, the investment company exception of Code §721 (b), the

Code §1234(b) exception for closing transactions and the Code §1256(c) exception for mid-year
mark to markets, should not apply to your contrbution of

the Options to the Parership.

Investment Companv Exception

It is possible that gai may be recognzed on a transfer to a parership if such transfer
qualifies under Code §351 as a trsfer to an investment company.4 Under

Code §351(e) and Treas.

Reg. § 1.351-1 (c), a transfer of propert qualifies as a transfer to an investment company if:

or indirectly, in diversification of the trsferors' (i) the transfer results, diectly interests, and (ii) the transferee is (a) a regulated investment company (RC),

(b) a real estate investment trst (RIT), or
(c) a company more than 80 percent of the value of

whose assets are held for

investment and are stocks or securties.5
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whether an money;

4 Code §721(b).
5 The Taxpayer Relief Act of 1997 amended Code §3S1(e) to provide that the detertion of entity constutes an investment company is made by includig in the defition of stocks and securties: (i) any

(n) stocks and other equity intests in a corporation, evidences of indebtedness, options, forward or futues contrcts,
notional pricipal contracts and dervatives; (il) any foreign curency; (iv) any interest in a real estate investment trt,

a common trst fud, a reguated investment company, a publicly-trded parership or any other equity interest which
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. Because the Options transfered to the Parership by you were transferred pro rata in .
accordance with your interests in the Parership, there was no diversification of interests.

Therefore, the transfer does not meet the requirement of Treas. Reg. §1.351-1(c)(I)(i), and the
Parership more likely than not should not be classified as an investment company.
Code §1234(b) Exception for Closinc Transactions

Code § 1234(b) provides that gai or loss from any "closing transaction" with respect to an
)
option in propert shal be treated as short-term capital gai or loss. Code § 1234(b )(2)(A) broadly

defines a "closing trsaction" as any

termination of

the taxpayer's obligation under an option, other

than though the exercise or lapse of the option.

According to the legislative history, the purose of enactig ths provision was to elimte
taxpayers' ability to enter into arangements that would allow them to obtain ordinar and capital
gai though the acquisition of offsettg options, treated as "closing transactions," thereby

trggerig
Private Letter Rulings

the recognition ofincome.6 Such arangements were described in a series of

issued to the Chicago Board Options Exchange ("CBOE"), wherein the IRS concluded, among other
thngs, that certain set-off tranactions that the

tapayer elected to be treated as "closing trsactions"

puruant to its ter or any other argement is readiy converble into, or exchangeable for, any asset described in

any precedig clause, ths clause or clause (v) or (viü); (v) except to the extent provided in reguations precnòed by the Secreta, any interest in a precious meta, uness such meta is used or held in the active conduct of a trde or business after the contrbution; (vi) except as otherse provided in regulations prescribed by the Se~eta, interest in

any entity if substatially al of the assets of such entity consist (diectly or indiectly) of any assets described in any
preceding clause or clause (vi); (vi) to the extet provided in reguations prescnbed by the Secreta, any interest in

any entity not descnbed in clause (vi), but only to the extent of the value of such interest that is attbutable to assets listed in clauses (i) though (v) or clause (vii); or (viü) or any other asets specified in the regutions prescribed by the

Secreta. Code §351(e)(1)(A) and (B)(i) though (vi).
6 See H. Rpt. No. 94-1192, 94th Cong., 2d Sess., 5 (May 26, 1976).
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were recogntion events. Consequently, it appears that Code § 1234(b) does not create the recogntion
event itself, but merely detenInes the character of recogned gai or loss.
In any

event, it is more liely than not that Code §1234(b) would not independently cause

gai or loss to be recognzed by you on the tranfer. The Short Option lapsed subsequent to its

trsfer into the Parership,

thereby disqualifyg it from tax treatment under Code § 1234(). As

discussed above, the tranfer of the Options to the Parership was more likely than not a
nonrecogntion event under Code §721; your obligation under the Short Option was not termated

as a result of the assignent. The original option contract was not novated to remove you as a
potential obligor.
Code 81256 Exception

Code § 1256(a) provides that any Code §1256 contract held by the tapayer at the close of

the taxàble year shall be marked to market (basis shal be increased to fai market value). Code
§1256(c) provides that, with respect to a Code §1256 contract, ths rule should also apply to a
termation during the taxable year that occurs as aresult of offsettng, by

takng or makg delivery,

by exercise or being exercised, by assignent or being assigned, by lapse or otherwise. Thus, there

is a risk that the mark to market rules could apply to the tax-free contrbution to the Parership.

However, ths is unikely because the mark to market rules only apply to "Code §1256
contrcts." Code § 1256(b) dermes such contracts as any

reguated futues contracts, foreign curency

contracts, nonequity options, and dealer equity options. Code § 1256(g) furter provides that both
the futues contracts and the options contrcts need to be trded or listed on a board of trade or
exchange, thus excludig the Options at issue from ths defition.

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With respect to foreign curency contracts, Code § 1256(g)(2)(A) provides that the foreign

curency contract must be a contract -1. which requires delivery of, or the settlement of

which depends on the value of, foreign curency which is a curency in which positions are also traded

though regulated futues contracts,
ii. which is traded in the interban market, and
11. whi'ch is entered into at ar's lengt at a price determed by reference to the

price in the interban market.
Based upon these requiements, the Options should not be marked to market upon contrbution to
the Parership. While the Options at issue are contracts for a curency in which positions are also

traded though regulated futues contracts, such digital option contracts are not traded in the

interban market. Furermore, as the legislative history makes clea, a contract between two
persons neither of whom is a futues commission merchant or other similar parcipant in the
interban market is not a foreign curency contract under the provision.7

Conclusion

Oter instances in which income or gai might be requied to be recognzed upon the transfer
to a parership include when debt relief exceeds the basis of propert tranferred under the
priciples of Code §752,8 or if the contrbution were a disgused sale of propert to the entity

under

the principles of Code §707. In your case, such exceptions are more likely than not inapplicable,

7 See House Ways and Mean Commttee Report on P .L. 97-48.
8 As discussed in Section E below, the Short Option trsfered to the Parerhip should not constitute a
"liabilty" for puroses of

Code §752; additionally, such contigent obligations are generlynot taen into account for

federl income ta puroses in ta-free trsactions, such as parership formtions under Code §721, in accordace

with a "step into the shoes" approach. See, e.g., Keyes and Mandao, "Dealg With Contigent Stock and Contigent Liabilties in Tax-Free Traactions," 52 N.Y.U. 24 (1994).
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and the general rue of nonrecogntion of gai should more likely than not apply to the contrbution
by you of

the Long Option and the Short Option to the Parership.

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E. TREATMENT UNDER CODE SECTION 752 OF ASSUMG A SHORT OPTION POSITION

Code §752(b) treats a parership's assuption of a parer's "liabilities" as a deemed
distrbution of

money by the parership to such parer, thus decreasing the parer's basis in the

parership. Code §752, however, does not defie the term "liabilties." Additionaly, no other

section of the Code or the Treasur Regulations defines the term "liabilities." Given the lack of a

statutory' or regulatory defition, the cours have literally interpreted the term "liabilities" for puroses of Code § 752 to mean its plai and ordiar meang,9 even where a literal interretation
may be inconsistent with the purorted policy of Code § 7 52 to equate parerhip outside and inside
basis. lO

Cours look to dictionar defitions to determine the plai and ordiar meang of
undefined terms used in the Code. In the recent Salina case, the Tax Cour relied on the Black's Law
Dictionar defition of

"liabilities" to mean "being legally obligated." Another standard dictionar

defines a "liability" as "a debt; an amount which is owed," and a "contigent liability" as "an amount
resulting from past transactions which may become a liabilty in the futue under cert defied

circumstances."l1 Clearly, under these and other dictionar defitions, for there to be a "liabilty,"
there must be an "amount," and for the liability to be other than "contigent," ths amount must be

"owed" or "legally obligated" to be paid.

9 See, e.g., Salia Parership LP. FPL Group. Inc. v. Commssioner. T.C. Mem 2000-352 (Novemer 14,
2000). 10 See, e.g., Helmer v. Commssioner. 34 T.C.M. 727 (1975).
i i Merram-Webster International Dictionar of the Englsh Laguage, Second Edition.
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There is curntly

nothg owed and no curnt legal obligation to make payment with respect

to the Short Option. Instead, the legal obligation with respect to the Short Option comes into being
if, and only if, a payment is due with respect to the Short Option purant to its term as a result of

the exchange rates on the date the Short Option expires. Ths potential contractual duty under the

Short Option fails to meet the plain and ordiar meanng of a "liability," especially takng into
account that the Short Option is a European-style, out-of-the-money' option when assumed by the
Parership. Thus, it is more liely than not that the Short Option should not be treated as an

assumption of a liability by the Parership for puroses of Code §752(b). This conclusion is
consistent with the tax treatment of options in general and is supported by

the authorities interpreting

the term "liabilty" under Code §752.
Tax Treatment of Options In General

Based upon case law, the ruings, and the statutes, when issuig a put or call option, the
premium should be held in suspense under an open tranaction theory

until the option expires, lapses,

or the wrter's potential contractual duty under the option terinates. Additionally, upon the
termination of an option on stock. securities or commodities (including foreign curency), the wrter
recognzes "gai or loss," not "income" (and not cancellation of

indebtedness income).

The Tax Consequences of Issuinf an Option

~ 58-234," the IR held th the preum received by the wrter (iss or
optionor) of a "put" or "call" option which is not exercised constituted ordiar income under §61
of

the 1954 Code, which should be included in his grss income only for the taxable year in which

121958-1 C.B. 279.

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the failure to exercise the option became final. The IRS based its holdig on an "open transaction"
approach:
An optionor, by the mere grantig of an option to sell ("put") or buy ("cal"), cert

propert, may not have pared with any physical or tagible assets; but, just as the
optionee thereby acquies a right to sell, or buy, cer propert at a fixed price

durg a specified futue period or on or before a specified futue date, so does the optionor become obligated to accept, or deliver, such proper at that price, if the
option is exercised. Since the optionor assumes such obligation, which may be

burdensome and is continuing unti the option is terminated. without exercise, or otherwse, there is no closed transaction nor ascerable income or gain realized by an optionor upon mere receipt of a premium for granting such an option. The open, rather than closed, statu of an unexercised and otherwise untermated option to buy (in effect a "call") was recognzed. for Federal income ta puroses, in A.E. Hollingsworth v. Commssioner,27B. T. A. 621, acquiescence, C.B. XI-I, 6 (1933). "put" or "call" option premiums It is manfest, from the natue and consequences of
and obligations, that there is no Federa income tax incidence on accouIt of either the receipt or the payment of such option premiums, i e., from the standpoint of either the optionor or the optionee, uness and until the options have been termated, by
failure to exercise, or otherwise, with resutant gain or loss. The optionor seekig to his option obligation, might pay the minimze or conclude the eventual burden of
optionee, as consideration for cancellation of the option, an amount

equal to or

greater than the premium. Hence, no income, gai, profits, or eargs are derived

from the receipt of either a "put" or "cal" option premium uness and until the option expires without being exercised, or is termnated upon payment by the optionor of an amount less t:an the premium. Therefore, it is considered that the priciple of the

decision in Nort American Oil Consolidated v. Buret, 286 U.S. 417, Ct. D. 499, "eargs," is not applicable to C.B. XI- l, 293 (1932), which involved the recèipt of
receipts of premiums on outstandig options.

In Rev. RU~2, 13 dealg with options listed on the Chicago Board Options Exchange,
the Serce followed Rev. RuL. 58-234 in holding, inter alia, that as to the wrter of a put or call,

''tere is no Federal income ta incident on account of either the receipt or the payment of such
option premium, that is, from the standpoint of either the optionor or the optionee, unless and until

the options have been termnated, by failure to exercise, or otherwse, with resultant gai or loss."

131978-1 C.B. 265, citing, 1958-1 C.B. 279. Because ofa 1976 amendment to Code §1234, as noted below,
the rug adds that ths ga or loss is now short-term capita gain or loss.
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In 1. T. 3835,14 the IRS rued that the premium received by a wrter of a "put" or "call" option

which is not exercised constitutes a short-term capital gai, to be taken into account in computig
his gross income for Federal income tax puroses, onlyfor the taxable

year in which thefailure to

exercise the option becomes finaL.

In the case of Virgia Iron Coal & Coke Co. v. Commssioner, the taxpayer granted a
counter par a four-year option to buy the stock of a subsidiar in exchange for a payment of

$300,000 in 1930 and anua payments of $125,000, applied to the purchase price if the counter
15 Afer par exercised the option. payig $300,000 in 1930 and $125,000 in 1931, the counter

par

notified the tapayer in 1933 that it was abandonig the option. The taxpayer, who had not intially
reported the receipt of

the option premiums, thereupon filed amended retus for 1930 and 1931 and

reported the premiums as income for the appropriate year. The Commssioner asserted that the
premiums were income in the year the option was abandoned, and the cour agreed adopting an
"open tranaction" approach: 16

It was impossible to tell in 1930 and 1931, when the payments were received,
whether they would ultiately represent income to the petitioner or a retu of
capital. They were to be applied agaist the purchase price in case of

the exercise of

the option. Had the option been exercised, they would have represented a retu of

capital, that is, a recovery of a par of the basis for gain or loss which the propert had in the hands of the seller. In that event they would not have been income and
141947-1 c.B. 53.

IS 37 B.T.A. 195 (1938).
1637 B.T.A. 197-199. A disent argued that the tapayer recognd income in the year of had unfetterd control of

receipt because it

the premium at tht ti. The dissent added that the income could be included in the year the

option was abandoned under only one of two theories, both of which the dissent felt were untenable. The firt theory is that the counter par "forfeited" the premum only in 193 3. That theory was untenable because the taayer had absolute control of the fuds since 1930, so there was nothg to "forfeit." The second theory wa that the value of the abandonment was income. However, if that were the case, the only income would be the difference between the value
of the optioned proper at the tie of the abandonment and the price at which the tapayer was obligated to convey

it.
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their retu as income when received would have been improper... But in case of

termation of the option and abandonment by the Texas Co. of its right to have the the purchase price, it would be apparent for the fist payments applied as a par of time that the payments represented clear gai to the petitioner. il that case, since no
proper would be sold, there would be no reason to reduce the basis of

that retaied.

Thus it was impossible for either the taxpayer or the Commssioner to determne in

1930 and 1931 whether or not the payments would eventually represent income and

how they should be reported. Obviously those years could not be held open for income tax puroses to await the fial outcome of such contracts. The taxpayer in
ths case, after the option to purchase had been surendered, filed amended retus reporting the payments as income for the years in which received. But retus must

be filed in the light of facts known at the tie the retus are due. Some other
taxpayer might not choose to file amended retus. Then the statute of litations

would foreclose the Commissioner and prevent the collection of taes lawfully due. If the Commissioner is to make an orderly and unform collection of taxes in such cases, the ta liability for those earlier years must be determed and closed by collection, without waitig to see whether or not the option is exercised.
Thus it is necessar to exclude such payments from the income of the year in which
received and to include them for the later year when, for the fist tie, a satsfactory

deteration of their character for income tax puroses can be made. The other

par to the contract in the taxable year for the fist tie released and abandoned its
right under the agreements to have the payments applied agaist the purchase price, and chaged off its loss. The recipient then knew for the first time that it could retain

the payments without any obligation to apply them against the purchase price. Its the option. It had lost nothg, but had retained everyg was then free of propert with which it stared and had acquired $425,000 in addition. The $425,000 was then mcome.

The taxpayer argues that, since the fuds were received.in 1930 and 1931 with the
right to retai them forever and to use them without restrction, they should have

been accrued as income for those year. Although they were received without any

obligation to retu them, there was one condition attached to their receipt. That is, they had to be applied against the purchase price in case the option was exercised. That one condition is the determinig factor in ths case. Until it was removed in the liability of 1933, the question of the recipient for income tax upon the payments had to be held in abeyance.

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Based upon ths case law, more likely than not, the Short Option position should be treated as an
open transaction until the option expires, lapses, or the

wrter' s potential contractual duty under the

option terminates.

The Tax Consequences Upon Termination of

the Option

Code § 1234(a)(I) curently

provides the followig rue: "Gai or loss attbutable to the sale

or exchange of, or loss attbutable to failure to exercise, an option to buy

or sell proper shall be

considered gai or loss from the sale or exchange of propert which has the same character as the
propert to which the option relates has in the hands of the taxpayer (or would have in the hands of

the tapayer if acquired by hi)." Rev. Rul 78-182 provides that if a holder sells a put or call option
on a capita asset before matuty, any gain or loss recognzed at that tie is capital gai.11 As

provided in Section D, Code § 1234(b) provides that "gai or loss" from any "closing tranaction"

with respect to an option in proper shall be treated as a gai or loss from the sale or exchange of
a capital asset held not more than 1 year. IS Code § 1234(b )(2)(A) defies a "closing transaction" as
"any termation of

the taxayer's obligation under an option in propert other than though the'
the option." As described in Section D, the contrbution of

exercise or lapse of

the Options to the

Parership was more likely

than not, not a closing transaction which trggered Code § l234(b). The
17 , 2000, subsequent to their transfer into the Parership. Because of the

Options lapsed on April

lapse, the Options are disquafied from Code § 1234(b) tax treatment, and thus fall under the general
rule of

Code §1234(a).

17 1978-1 C.B. 265.

18 Rev. Rul. 58-234, 1958-1 C.B. 279.

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