Free Notice (Other) - District Court of Federal Claims - federal

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 1 of 44

COBRA STRIKES BACK: ANATOMY OF A TAX SHELTER Karen C. Burke Grayson M.P. McCouch
"Like sellers of treasure maps, promoters of tax shelters promise that for a large fee one can navigate a secret route. What clinches these deals is not the chart itself but [an opinion letter] that appears to warrant that the map is as good as gold. ... Written by tax lawyers using the embossed stationery of their firms, the letters typically cost $50,000, $75,000 or more, and require a signed promise to keep the contents secret, like the treasure map, lest the Internal Revenue Service discover where untaxed fortunes lie. But ... opinion letters may not be worth the paper they are written on."*

Introduction Paul M. Daugerdas has gained notoriety for himself and his erstwhile firm, Jenkens & Gilchrist, as the designer of a tax shelter technique that uses contingent liabilities to generate artificial tax losses on a grand scale.1 For all its surface complexity and sophistication, the basic shelter transaction is surprisingly simple in concept. In essence, it uses offsetting options to inflate the basis of property that is distributed by a partnership and then contributed to and sold by another partnership, resulting in a large tax loss without any corresponding economic loss. In principle, this type of shelter could be replicated indefinitely and generate unlimited tax losses.



W arren Distinguished Professor, University of San Diego School of Law. Professor, University of San Diego School of Law.



W e are grateful for superb research assistance provided by Judith Lihosit and for generous research support from the University of San Diego School of Law. David Cay Johnston, Costly Questions Arise on Legal Opinions for Tax Shelters, N.Y. Times, Feb. 9, 2003, at 25. Contingent-liability shelters represent "a majority of all abusive tax-shelter cases in litigation now." Tom Herman, Tax-Shelter Users Get Some Rare Good News, W all St. J., June 4, 2008, at D1 (quoting an I.R.S. spokesman). A tax shelter might be loosely defined as "a deal done by very smart people that, absent tax consideratons, would be very stupid." Id. (quoting Professor Michael Graetz); see also Joseph Bankman, The New Market in Corporate Tax Shelters, 83 Tax Notes 1775, 1777 (1999) (describing a tax shelter as "a product whose useful life is apt to end soon after it is disovered by the Treasury").
1 *

1

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 2 of 44

Mr. Daugerdas is by no means unique. The transactions that he approved as shelter counsel on behalf of Jenkens & Gilchrist differ only in trivial details from myriad other transactions peddled by other lawyers and accountants.2 Contingent-liability tax shelters, however, are a highly risky business. Mr. Daugerdas and others like him have reaped enormous rewards for themselves and their clients, but some of the tax shelters they designed for credulous and wealthy clients have backfired spectacularly. Congress and the Treasury have taken remedial action to shut down abusive tax shelters, and several courts have invoked the longstanding judicial doctrines to strike down transactions that lack economic substance and have no real business or investment purpose, despite purported compliance with the literal terms of the tax laws. The proliferation of abusive tax shelters could never have gotten off the ground without the active participation of high-priced counsel ­ some of them at highly reputable firms ­ who issued reassuring legal opinions concerning the tax consequences of shelter transactions.3 Upon discovering that the anticipated tax benefits failed to materialize, disgruntled clients have rushed to sue the lawyers, accountants, investment advisers, and banks that created and marketed defective shelters. Mr. Daugerdas is the target of a criminal

In November 2003, the Senate held committee hearings on the tax shelter industry, focusing on "generic abusive tax shelters sold to multiple clients." The Role of Professional Firms in the U.S. Tax Shelter Industry, Report of Permanent Subcommittee on Investigations, Senate Committee on Homeland Security and Governmental Affairs, S. Rep. 109-54, at 1 (2005) [hereinafter Tax Shelter Industry]. For insightful discussions of the market for tax shelters, see generally Joseph Bankman, The Tax Shelter Problem, 57 Nat'l Tax J. 925 (2004); Bankman, supra note 1, at 1780-82 (noting that the tax shelter industry relies heavily on maintaining "secrecy in product design and sales" and escaping detection through the "audit lottery"). During the 1990's, several law firms began to compete directly in the shelter market, helping to develop and market "tax products" and charging fees based on the size of the expected tax loss. See Tax Shelter Industry, supra note 2, at 96-100 (discussing role of Brown & W ood). Tax-shelter practice has long been viewed as fundamentally different from legitimate tax planning, although the line may have become blurred. See Peter C. Canellos, A Tax Practitioner's Perspective on Substance, Form and Business Purpose in Structuring Business Transactions and in Tax Shelters, 54 SMU L. Rev. 47, 56 (2001) ("The tax shelter professional is a different breed, by experience, temperament, reputation, and calling.").
3

2

2

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 3 of 44

investigation, and Jenkens & Gilchrist has been disbanded.4 And they are only the tip of the iceberg. This article offers a preliminary assessment of several challenges faced by Congress, the Treasury, and the courts in dealing with contingent-liability tax shelters. The article unfolds in four parts. Part I examines the role of Daugerdas and his firm in creating and marketing contingent-liability shelters, against the broader background of the tax shelter industry. Part II explains the basic structure of the offsetting option transaction and its attempt to manipulate the partnership tax provisions ­ in essence, the transaction turns on a simple question of whether (and in what amount) contingent liabilities must be taken into account in determining the basis of an investment for tax purposes.5 Part III analyzes the contrasting rationales of two recent judicial decisions involving defective tax shelters. Part IV argues in favor of applying Treasury regulations retroactively to shut down contingent-liability tax shelters and avoid unnecessary and wasteful litigation. I. Contingent-Liability Tax Shelters Background. In late 1998, Jenkens & Gilchrist, a fast-growing Texas firm, brought Mr. Daugerdas on board as a tax partner in charge of the firm's newly-opened Chicago office.6 Mr.

See Lynnley Browning, 3 Lawyers Face Scrutiny in Tax Inquiry, N.Y. Times, Jan. 25, 2006, at C1; Lynnley Browning, Texas Law Firm W ill Close and Settle Tax Shelter Case, N.Y. Times, Mar. 30, 2007, at C3. One hallmark of tax shelters is reliance on "a literal reading of some relevant legal authority" to produce artificial tax losses in a manner "inconsistent with legislative intent or purpose." Bankman, supra note 2, at 925; see also Mark P. Gergen, The Common Knowledge of Tax Abuse, 54 SM U L. Rev. 131 (2001). Before joining Jenkens & Gilchrist, Mr. Daugerdas was a tax partner at Altheimer & Gray, a Chicago law firm; before that he was the head of futures and options trading in the Chicago office of Arthur Andersen. In the late 1990's, Jenkens & Gilchrist was expanding rapidly. Despite some concerns about Mr. Daugerdas's aggressive tax opinions and his demands for unconventional compensation and indemnification arrangements, the firm viewed him as a promising and "not ... terribly risky" source of additional revenue. Nathan Koppel, Fatal Vision: How a Bid to Boost Profits Led to a Law Firm's Demise, W all St. J., May 17, 2007, at A1 ("That risk assessment proved
6 5

4

3

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 4 of 44

Daugerdas brought with him a lucrative specialty in tax shelters and a close working relationship with several accounting firms (including Ernst & Young and KPMG) and the securities arm of Deutsche Bank.7 During the next five years, he sold at least 600 generic shelters which generated hundreds of millions of dollars in fees for the firm ­ he personally netted $93 million ­ and billions of dollars of artificial tax losses for clients.8 The financial incentives for crossing the line between shelter promoter and shelter counsel were clearly powerful, and Mr. Daugerdas placed himself and his firm in an ethically equivocal position by rendering favorable tax opinions concerning tax shelters that he helped to design and market.9 Worse still, the shelters were highly risky. If detected, they would inevitably be challenged by the Internal Revenue Service and might

catastrophically wrong."). Mr. Daugerdas's activities leading to the collapse of Jenkens & Gilchrist have received extensive news coverage. Except as otherwise indicated, the factual background summarized in notes 6-26 and accompanying text is drawn from Paul Braverman, Helter Shelter, 25 Am. Law. 65 (Dec. 2003); Brenda Sapino Jeffreys, Bitten by a COBRA?, 19 Tex. Law. _ (Mar. 10, 2003); Nathan Koppel, supra; and Sheryl Stratton, Jenkens Settlement Info Reveals "W ealth" of Shelter Advisers, 105 Tax Notes 273 (2004). Deutsche Bank allegedly played a major role in creating and marketing COBRA and related tax shelters. See Lynnley Browning, W ider Look at Tax Shelters Offered by Deutsche Bank, N.Y. Times, May 18, 2006, at C4. Deutsche Bank recently settled suits with hundreds of shelter investors for undisclosed amounts but continues to face potential criminal charges. See Lynnley Browning, Bank Settles Shelter Suits By Investors, N.Y. Times, Feb. 8, 2007, at C1. Mr. Daugerdas created the shelters and issued opinion letters. For each opinion letter, Jenkens & Gilchrist charged the client a fee equal to 3 percent of the expected tax losses. Ernst & Young's role was to target clients and market the shelters; Ernst & Young charged an additional fee equal to 1.5 percent of the expected tax losses. See Braverman, supra note 6, at 68. See Bankman, supra note 1, at 1783 ("However profitable it is to write opinions, ... there is more to be made in developing and promoting the shelters."); see also Braverman, supra note 6, at 66-67. To market shelters, promoters prepare a "selling memorandum" which sets forth technical arguments in support of the shelter. See Canellos, supra note 3, at 57 ("No one really believes the selling memorandum."). For purposes of penalty protection, shelter investors require an opinion letter from a law firm; although purportedly "independent," the firm is in fact often identified by the shelter promoter as willing to render a favorable opinion. See id. ("The firms rendering such opinions bridge the gap between real practice and shelter practice, with inevitable adverse reputational consequences, given their role as facilitators of often abusive transactions.").
9 8 7

4

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 5 of 44

well be held invalid in court.10 The Service became aware of the scope of shelter promoters' activities in the course of an investigation of accounting firms, and in 2002 began serving summonses on promoters and auditing the tax returns of individual investors. One of those investors, Henry Camferdam, and his business partners had purchased a shelter designed by Mr. Daugerdas and known as COBRA (an acronym for "Currency Options Bring Reward Alternatives").11 Mr. Camferdam soon emerged as a poster-boy for disgruntled shelter investors.12 Appearing in 2003 before the Senate Finance Committee at a hearing on abusive tax shelters, he recalled being approached by Ernst & Young with a high-pressure sales pitch about "a tax strategy that could virtually eliminate our capital gains taxes."13 Although he received assuances that the shelter was "completely legal," he was offered two separate tax opinions from purportedly "independent" counsel as "insurance" against the risk of audit by the Service; in addition, he was required to sign a confidentiality

Disgruntled investors eventually brought a class action against Jenkens & Gilchrist, Mr. Daugerdas, and others, claiming that the defendants knew that the tax shelters lacked economic substance and would be held invalid if litigated. See Denney v. Jenkens & Gilchrist, 230 F.R.D. 317, 322 (2005). In 1999, Mr. Camferdam and his three business partners paid more than $6 million in fees ­ $1 million to Ernst & Young, $2 million to Jenkens & Gilchrist, $75,000 to Brown & W ood (for a second tax opinion), and $3 million to Deutsche Bank ­ to avoid $14 million of taxes on $70 million of gain from sale of their business. See Tax Shelters: W ho's Buying, W ho's Selling, and W hat's the Government Doing About It?, Hearing Before the Senate Committee on Finance, S. Hrg. 108-371, at 15, 87 (2004) (statement of Henry Camferdam, Jr.) [hereinafter W ho's Buying]. Following Ernst & Young's disclosure of their names and the ensuing audit, they eventually ended up owing $14 million in taxes plus an additional $11 million in interest and penalties. See Sheldon D. Pollack & Jay A. Soled, Tax Professionals Behaving Badly, 105 Tax Notes 201, 205 n.31 (2004). Mr. Camferdam portrayed himself as an innocent investor who "fully intended to pay the taxes [he] owed on the gain from the sale" but was lured by his "trusted legal and tax advisors" into "a tax savings strategy that they represented was completely legal." W ho's Buying, supra note 11, at 88. He inquired, with no apparent sense of irony, "[w]hat can be done to protect future taxpayers" from being placed in a similar position. Id. at 89.
13 Id. at 15. Mr. Camferdam was initially unaware of "the actual relationships and roles of E&Y, Jenkens & Gilchrist, and Deutsche Bank"; specifically, Ernst & Young told him that the shelter was "an E&Y strategy" and that Jenkens & Gilchrist was "an `independent' law firm." Id. at 88. Although Jenkens & Gilchrist collected a fee of more than $2 million for an opinion letter, Mr. Camferdam "never talked to anyone" at the firm. Id. at 87. 12 11

10

5

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 6 of 44

agreement and was not allowed to discuss the shelter with outside counsel.14 Mr. Camferdam and his business partners sued Jenkens & Gilchrist, Mr. Daugerdas, and others, claiming that they had been lured into purchasing a defective tax shelter. Despite their efforts to portray themselves as innocent investors, these clients may find it difficult to show that they reasonably relied on legal advice concerning transactions that appeared too good to be true.15 In 2004, the government forced Jenkens & Gilchrist to turn over its client lists; in 2005, the firm agreed to pay $81.5 million to settle a class action brought by more than 1,000 tax shelter investors, including Mr. Camferdam.16 By 2006, Mr. Daugerdas had become "the tax lawyer at the heart of a broadening federal investigation into questionable tax shelters."17 In 2007, Jenkens & Gilchrist was finally forced to close its doors. As part of a landmark settlement, the firm accepted responsibility for criminal wrongdoing in connection with its tax shelter

Id. at 86-88. Ernst & Young was "in a hurry to get the deal done," and Mr. Camferdam viewed it as "like closing a mortgage loan, where it was sign the documents or go to another lender, except that in this case E&Y was the only party we knew of who could eliminate our taxes, in their words, `legally and conservatively.'" Id. at 87. Mr. Camferdam admitted that from the outset "it was obvious there was no business purpose for this shelter other than tax reduction. There was no risk possibility." W ho's Buying, supra note 11, at 15. In investor suits, it is often difficult to prove malpractice on the part of shelter counsel. See Bankman, supra note 1, at 1782-83. For example, Jenkens & Gilchrist argued that its "more likely than not" opinion was no more aggressive than similar opinions rendered by other law and accounting firms. See Denney v. Jenkens & Gilchrist, 230 F.R.D. 317, 338 (2005). The bulk of the settlement (more than $70 million) was paid by Jenkens & Gilchrist's insurance; Jenkens & Gilchrist paid $5.25 million; of the remaining $6.25 million, Mr. Daugerdas paid around $4 million and his two tax partners from the Chicago office paid around $1 million each. See Denney v. Jenkens & Gilchrist, 230 F.R.D. 317, 324 (S.D.N.Y. 2005); Paul Braverman, Jenkens and Several Liability: Can Tax Shelter Victims Pierce the Veil of a Law Firm's Corporate Structure?, 27 Am. Law. _ (Feb. 2005). Jenkens & Gilchrist stripped Mr. Daugerdas of his equity stake in the firm, and in December 2005 finally terminated his contractual arrangement with the firm. See Lynnley Browning, 3 Lawyers Face Scrutiny in Tax Inquiry, N.Y. Times, Jan. 25, 2006, at C1. Lynnley Browning, Inquiry Into Tax Shelters W idens Beyond Audit Firms, N.Y. Times, Feb. 4, 2006, at C3; see also Lynnley Browning, Tax Inquiry Is Moving Past KPMG, N.Y. Times, Sept. 16, 2005, at C1 (describing focus on Jenkens & Gilchrist, Ernst & Young, and Deutsche Bank); Sheldon D. Pollack & Jay A.Soled, Tax Professionals Behaving Badly, 105 Tax Notes 201, 205 n.26 (Oct. 11, 2004) (noting that tax shelter promoters such as Mr. Daugerdas "are denounced as `rogue' partners by their colleagues after they are publicly exposed, but were hailed as `rainmakers' before they got caught").
17 16 15

14

6

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 7 of 44

activities and agreed to pay a $76 million penalty.18 Offsetting-Option Shelters. The COBRA shelter purchased by Mr. Camferdam was part of a family of tax shelters known generically as "Son of BOSS."19 These transactions typically involved a transfer to a partnership of property encumbered by contingent liabilities, resulting in high-basis, low-value partnership interests. By ignoring the effect of the contingent liabilities on outside basis, the transaction purported to create a large artificial capital loss that could be used to offset unrelated capital gains. These shelters were aggressively marketed to individuals who had accumulated substantial wealth during the technology and stock-market boom of the late 1990's.20 The basic concept of an offsetting-option shelter was remarkably simple.21 A taxpayer would sell an option to acquire securities (or foreign currency) to a bank and simultaneously buy a substantially offsetting option from the bank. The cost of the purchased ("long") option would

The combined effect of investor lawsuits and government investigation led to the demise of the Jenkens & Gilchrist. Between 2001 and 2007, the firm lost nearly 400 lawyers. As part of the settlement with the government, Jenkens & Gilchrist admitted that some of its attorneys "developed and marketed fraudulent tax shelters, with fraudulent tax opinions," referring to the Chicago office without naming the individuals involved. Press Release, U.S. Attorney, Southern District of N.Y., Press Release (Mar. 29, 2007) (quoting Jenkens & Gilchrist statement). The government indicated that the decision not to prosecute Jenkens & Gilchrist was based partly on "its inability to continue practicing as a law firm." Id.; see generally Lynnley Browning, Texas Law Firm W ill Close and Settle Tax Shelter Case, N.Y. Times, Mar. 30, 2007, at C3. Variants of COBRA included OPS ("Option Partnership Strategy") and SOS ("Short Option Strategy"). These so-called Son-of-BOSS shelters are variants of an earlier corporate tax shelter known as BOSS ("Bond and Options Sales Strategy"). See Bankman, supra note 2, at 931 ("Many of the new purchasers were individuals, who lacked expertise to judge shelter quality and who had once-in-a-lifetime gains to shelter."). Some shelter investors who sought to avoid tax on their stock options later discovered that they had made a costly mistake when they were assessed with tax on stock that had plummeted in value. See David Cay Johnston, Costly Questions Arise on Legal Opinions for Tax Shelters, N.Y. Times, Feb. 9, 2003, at 25 (noting one executive's lament that he might "lose his entire fortune because all of his Sprint shares are worth millions less than the taxes he avoided on those shares in the shelter").
21 20 19

18

See Notice 2000-44, 2000-2 C.B. 255 (describing offsetting-option shelter).

7

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 8 of 44

be slightly higher than the premium received for the sold ("short") option.22 The taxpayer would then contribute the long option and the liability incurred under the short option to a partnership in exchange for a partnership interest. Upon a sale of the partnership interest, either before or after the expiration of the short option, the taxpayer would report a capital loss. The tax loss was premised on the theory that the short option was not taken into account as a liability under § 752 due to its contingent nature. Accordingly, the premium paid for the long option would increase the taxpayer's outside basis but the contingent liability under the short option would not be included in the amount realized on sale of the partnership interest.23 The offsetting-option transaction was designed to produce a substantial tax loss with no real downside economic risk and minimal cash outlay for the taxpayer. This is the essence of the tax shelter. As long as the purchased and sold options remained bundled together, the taxpayer's potential economic loss and net out-of-pocket cost were limited to the spread between the two positions ­ a trivial amount, since the premium received for the short option offset most of the cost of the long option. With virtually no economic risk and minimal cash outlay, the transaction could be tailored to create any desired amount of loss (equal to the contingent liability that was ignored). Indeed, the taxpayer might even claim to have a profit motive, due to the (infinitesimal) chance of a large gain if the purchased option was "in the money" at the time of exercise. Of

A call option entitles the holder to acquire property (e.g., stock, securities, or currency) at a specified price during a fixed term or at a fixed future date. If the value of the underlying property on the relevant date exceeds the strike price (including the premium paid), the holder exercises the option and realizes a profit; if the value of the underlying property is equal to or less than the strike price, the option is worthless. The grantor ("writer") of a call option is obligated to deliver the underlying property (or any excess value over the strike price) to the holder upon exercise. If the writer of a call option does not actually own the underlying property (a "naked" option), the writer's risk of loss is essentially the same as that of a short seller. Likewise, outside basis would not be decreased to reflect relief of the contingent liability on expiration of the short option prior to sale of the partnership interest.
23

22

8

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 9 of 44

course, any realistic possibility of such a large gain would prompt the bank (a necessary accommodation party) to demand additional compensation.24 As a practical matter, the artificial tax loss generated by the shelter was limited only by the amount of gain that the taxpayer wished to shelter from tax. While there was no shortage of taxpayers willing to pay hefty fees to promoters based on a percentage of the expected tax loss (as well as $100,000 or more to outside counsel for a tax opinion25), there was also fierce competition among designers and promoters for tax shelter business.26 Shelter counsel maintained that each mutation of the basis-shift transaction could be distinguished from the others if it employed a slightly different financial instrument or legal rationale to achieve an artificial tax loss. Thus, the ability to draw minute, highly technical, formalistic distinctions between functionally equivalent transactions commanded a high premium in the tax shelter industry.

In some cases, it is not clear whether the banks involved in tax shelters actually carried out the purported financial transactions. See Lynnley Browning, Deutsche Bank Said to Seek Settlement on Tax Shelters, N.Y. Times, Feb. 24, 2006, at C3 ("W ith Deutsche Bank, a lack of documents would raise questions about whether the transactions were ever executed at all."); Lynnley Browning, Bank Settles Shelter Suits By Investors, N.Y. Times, Feb. 8, 2007, at C1 (noting allegations that shelters "typically involved fake loans and fake trades to generate artificial losses"). Tax opinions were an important "marketing tool" because they purported to provide insurance against penalties in the event the shelter ultimately proved defective. Tax Shelter Industry, supra note 2, at 45. W hile the protection of a "more likely than not" opinion was subject to various limitations (e.g., if it relied on factual assumptions that the taxpayer did not reasonably believe were accurate, or if the transaction lacked a significant business purpose), such an opinion was widely perceived as shielding a taxpayer from the 20% substantialunderstatement penalty (as well as stiffer civil and criminal penalties). See Bankman, supra note 1, at 1778-79. For example, in 2000, Mr. Daugerdas was sued by his former business partner, James Haber of Diversified Group Inc., who accused Mr. Daugerdas of selling tax shelters without sharing the profits pursuant to an agreement with Diversified; the suit was eventually settled. See Braverman, supra note 6, at 65 (noting that Mr. Daugerdas described the offsetting-option transaction as "based on a nonproprietary strategy that anyone familiar with the tax code could figure out"). Although promoters sought to limit misappropriation by imposing confidentiality requirements, "leakage" about shelters ensured "some limited competition, with more than one promoter offering identical or at least similar shelters." Bankman, supra note 1, at 1781.
26 25

24

9

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 10 of 44

Response of Courts, Congress, and the Treasury. The judicial doctrines of economic substance and business purpose pose a formidable obstacle for tax shelter proponents. These doctrines allow courts to disregard or recharacterize a transaction that lacks a business or investment purpose (other than to generate artificial tax losses) and has no real effect on a taxpayer's economic situation.27 When basis-shift shelters began to proliferate on a large scale in the late 1990's, it was not clear whether these judicial doctrines would prove sufficiently robust to withstand the proclivity of some courts for hyper-literalism in interpreting tax statutes.28 At the same time, the emergence of antipathy toward taxes and mistrust of the Internal Revenue Service as a powerful political movement contributed to a widespread acceptance of tax avoidance as a legitimate pursuit. Unsurprisingly, shelter counsel and tax litigators made the most of this apparent shift in judicial and public attitudes and redoubled their efforts to discover and exploit perceived gaps and ambiguities in the the tax laws. In 2000, in response to abusive corporate tax shelters, Congress amended § 358 of the Code to clarify that contingent liabilities, while often difficult to value, are indeed treated as liabilities for purposes of the corporate nonrecognition provisions. Oddly enough, prior law

See, e.g., Gregory v. Helvering, 293 U.S. 465 (1935); ACM Partnership v. Comm'r, 157 F.3d 231 (3d Cir. 1998), cert. denied, 526 U.S. 1017 (1999). In applying these doctrines, courts are not always clear about how the relevant transaction should be defined or what kind or level of business purpose is required. See Bankman, supra note 2, at 928 ("The economic substance doctrine is a blunt instrument that works best on the most egregious shelters."). For example, in a case involving a contingent-liability transaction, one judge mused that the economic substance doctrine might be constitutionally suspect on separation-of-powers grounds. See Coltec Industries, Inc. v. United States, 62 Fed. Cl. 716, 756 (2004), vacated and remanded, 454 F.3d 1340 (Fed. Cir. 2006), cert. denied, 127 S.Ct. 1261 (2007) (Susan Braden, J.) ("[W ]here a taxpayer has satisfied all statutory requirements established by Congress, as Coltec did in this case, the use of the `economic substance' doctrine to trump `mere compliance with the Code' would violate the separation of powers."). Cf. Marvin A. Chirelstein & Lawrence A. Zelenak, Tax Shelters and the Search for a Silver Bullet, 105 Colum. L. Rev. 1939, 1939-40 (2005) ("It is beyond doubt that such [rule] manipulations are contrary to congressional intent, but that perception has not always been conclusive or even probative in the cases that have arisen.").
28

27

10

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 11 of 44

provided no statutory or regulatory definition of "liabilities" as used in the corporate nonrecognition provisions of § 358 or the analogous partnership provisions of § 752.29 In amending § 358, Congress specifically targeted corporate transactions that purported to accelerate or duplicate losses through assumption of contingent liabilities.30 The amended provision shut down these shelters by requiring a shareholder to reduce its basis in stock of a controlled corporation to reflect contingent obligations that otherwise would not be taken into account under the basis provisions.31 In Notice 2000-44, the government signalled its intent to shut down contingent-liability shelters involving partnerships.32 In amending the corporate tax provisions of § 358, Congress directed the Treasury to promulgate rules providing "appropriate adjustments" under Subchapter

Section 358(h)(3) now defines the term "liability" to include "any fixed or contingent obligation to make payment," without regard to whether the obligation constitutes a liability under any other provision of the Code. See Community Renewal Tax Relief Act of 2000, Pub. L. 106-554 (Appendix G), § 309(d)(1), 114 Stat. 2763A-587, 2763A-638 (2001) (effective for assumptions of liability after Oct. 18, 1999); Staff of Joint Comm. on Tax'n, General Explanations of Tax Legislation Enacted in the 106th Congress 153-56 (2001) (JCS-2-01). The contingent-liability shelter used by Black & Decker Corp. (B&D) was a prototypical transaction targeted by § 358(h). See Black & Decker Corp. v. United States, 436 F.3d 431 (4th Cir. 2006). In essence, B&D transferred $561 million cash to a subsidiary in exchange for preferred stock worth $1 million plus assumption by the subsidiary of B&D's contingent employee and healthcare obligations ($560 million estimated present value). B&D claimed a basis of $561 million in the preferred stock (equal to the cash contribution), ignoring the offsetting contingent obligation, and reported a $560 million loss on sale of the stock to an accommodation party for $1 million. Under § 358(h), B&D would have been required to reduce the basis of the preferred stock to $1 million ($561 million less $560 million contingent obligation), eliminating the built-in $560 million loss on sale of the stock. Section 358(h)(1), when applicable, requires that a shareholder's basis in stock of a controlled corporation be reduced (but not below fair market value) if the basis of the stock would otherwise exceed its fair market value because an assumed liability does not give rise to a basis reduction under § 358(d), the corporate analog of § 752(b). As in Black & Decker, such contingent liabilities represent the estimated present value of future expenses which have not yet generated any tax basis or other tax benefit. Notice 2000-44 identified two transactions as abusive: the so-called "premium loan" transaction and the offsetting-option transaction. See Notice 2000-44, 2000-2 C.B. 255. Like the corporate tax-shelter identified in Notice 99-59, 1999-2 C.B. 761, these transactions involved aggressive interpretations of the term "liability." Notice 2000-44 warned that participants in these transactions, as well as those involved in promoting or reporting them, might be subject to appropriate penalties. The Notice also warned that willful concealment of gains and losses through improper netting might give rise to criminal liability.
32 31 30

29

11

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 12 of 44

K to prevent "acceleration or duplication of losses" through assumption of liabilities in "transactions involving partnerships," and specifically authorized the new rules to be applied with retroactive effect to October 19, 1999.33 The Treasury interpreted this directive to authorize rules similar to those of § 358(h) for liabilities assumed by partnerships, and accordingly in 2003 promulgated Temporary Regulations § 1.752-6, which by its terms applies to certain liabilities assumed by partnerships after October 18, 1999.34 Under the retroactive regulations, the contingent-liability transactions described in Notice 2000-44 no longer produce the desired tax loss because outside basis must be reduced (but not below fair market value) to reflect assumption of the contingent liability. The new regulations require a basis reduction only to the extent that the contingent liability was not previously taken into account for purposes of § 752. Section 358(h) operates essentially as a buttress to the judicial doctrine of economic substance. In Coltec Industries, Inc. v. United States, the Court of Appeals for the Federal Circuit held that the assumption of contingent asbestos liabilities by a corporate shell subsidiary "had no meaningful economic purpose, save the tax benefits to Coltec."35 The court focused on the lack

See Community Renewal Tax Relief Act of 2000, Pub. L. 106-554 (Appendix G), § 309(c)(1), 114 Stat. 2763A-587, 2763A-638 (2001) (authorizing regulations); id. § 309(d)(2) (authorizing retroactive effect). See T.D. 9062, 2003-2 C.B. 46 (temporary regulations applicable to partnership's assumption of partner's liabilities occurring after October 18, 1999 and before June 24, 2003); see also REG-106736-00, 2003-2 C.B. 60 (proposed regulations applicable to assumption of liabilities occurring on or after June 24, 2003). The regulations were promulgated in final form in 2005. See T.D. 9207, 2005-1 C.B. 1344. Under the final regulations, the amount of a § 752 liability is equal to the amount of the associated basis increase (or other tax benefit). See Reg. § 1.7521(a)(4). Coltec Industries, Inc. v. United States, 454 F.3d 1340, 1347 (Fed. Cir. 2006); see id. at 1351-54 (rejecting as "untenable" the lower court's rejection of the economic substance doctrine on constitutional grounds, and noting that the lower court "failed to follow binding precedent of the Supreme Court and this court"). The court viewed the economic substance doctrine as "merely a judicial tool for effectuating the underlying Congressional purpose that, despite literal compliance with the statute, tax benefits not be afforded based on transactions lacking in economic substance." Id. at 1354.
35 34

33

12

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 13 of 44

of any business purpose for the transfer and assumption of liabilities that produced an artificial tax loss. Having properly identified the transaction in question, the court had little difficulty in seeing that any purported business purpose was either mere window-dressing or could have been accomplished without the transfer and assumption of liabilities that purportedly generated tax benefits.36 The court also held that contingent obligations were liabilities for purposes of § 358 (prior to the enactment of § 358(h)), relying on case law dating back to 1946 concerning the sale of a business.37 Shortly after the decision in Coltec, the government reached a settlement in another high-profile corporate contingent-liability shelter case, in which the taxpayer apparently agreed to pay a portion of the taxes owed without penalties.38 In the partnership area as well, contingent-liability shelters have given courts an opportunity to address the tension between literal compliance with the Code and the economic substance doctrine.39 As one court noted, however, taxpayers may perceive the tension differently, arguing that "the economic substance doctrine cannot ignore `deliberately adopted rules of law', in particular, [a Tax Court decision holding] that contingent liabilities do not constitute section 752 liabilities for purposes of calculating a partner's basis."40 While the

36

See id. at 1357-1360.

See id. at 1347 ("It is widely recognized that when one party in an exchange assumes a contingent liability of another party, that contingent liability, like all other liabilities, forms an integral part of the purchase price in the exchange."); Black & Decker Corp. v. United States, 436 F.3d 431, 437-38 (4th Cir. 2006) (concluding that contingent liabilities were liabilities under §§ 357 and 358 prior to enactment of § 358(h)). See Black & Decker Announces Settlement in Litigation Over Outstanding Income Taxes, 2007 TNT 243-28 (Dec. 18, 2007).
39 See e.g., Jade Trading, LLC v. United States, 80 Fed. Cl. 11, 13-14 (2007). The court postponed its decision in Jade Trading pending release of the appellate decision in Coltec concerning the viability of the economic substance doctrine. 40 38

37

Id. at 13.

13

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 14 of 44

government may have a strong argument that contingent-liability transactions should fail under existing law based on extant revenue rulings and other authority, there is clearly a risk that a court might not be persuaded by (or might fail to grasp) the specialized definition of a liability for purposes of § 752.41 Although § 358(h) resolved this issue prospectively in the corporate area by defining liabilities broadly to include both fixed and contingent obligations, the perceived need for a statutory amendment might suggest that contingent liabilities could be ignored under prior law.42 Moreover, in extending a similar rule to the partnership area through retroactive regulations, the government left itself open to claims of unfairness and overreaching by disappointed taxpayers. II. The Cemco Transaction The Transaction. In December 2000, Mr. Daugerdas designed a tax shelter for himself and a client, Steven Kaplan, using a variation of the basic COBRA transaction.43 The transaction proceeded as follows. Acting through a grantor trust (Trust),44 Messrs. Daugerdas and Kaplan purchased a "long" option and simultaneously sold an offsetting "short" option, with Deutsche

41

See infra notes 68-73 & accompanying text.

Cf. Coltec Industries, Inc. v. United States, 454 F.3d 1340, 1348 n.7 (Fed. Cir. 2006) (finding § 358(h) "of little utility" in determining whether contingent liabilities were taken into account under prior law). Mr. Kaplan contributed all the cash but received only a 37.5% beneficial interest in Trust; Mr. Daugerdas received the remaining 62.5% interest. After the Service audited the taxpayers and assessed penalties, Mr. Kaplan sued M r. Daugerdas, claiming that Mr. Daugerdas had absconded with investment funds. According to Mr. Kaplan, Mr. Daugerdas portrayed Cemco (an acronym for "Clean Energy Management Company") as "a profit-making partnership" that would invest in third-world energy projects "under the auspices of the United Nations"; appended to a "private placement memorandum" was a copy of the Kyoto Protocol to the U.N. Framework Conventions on Climate Change along with a document entitled "Mandate to the Solar Commission." See Cemco Investors, LLC v. United States (N.D. Ill.), Gov't Exh. No. 19, at 4-5. A grantor trust is transparent for federal income tax purposes, and each separate item of the trust's gains and losses is reportable directly on the grantor's income tax return. See Notice 2000-44, 2000-2 C.B. 255 (warning against use of grantor trusts to conceal gains and losses in contingent-liability transactions).
44 43

42

14

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 15 of 44

Bank (Bank) as the counterparty on both options. The investors' net out-of-pocket outlay for the options was only $6,000, the difference between the $3.6 million premium paid to Bank for the long option and the slightly lower premium received from Bank for the short option.45 Trust contributed both options and $50,000 additional cash to a general partnership (Partnership),46 which used the cash to purchase euros. After the options terminated, Partnership liquidated and distributed the euros to Trust, which took the euros with a substituted basis of $3.65 million (equal to Trust's basis in its partnership interest). Trust then contributed the high-basis euros to another partnership (Cemco), which sold the euros for their $50,000 market value and realized a loss of $3.6 million.47 The entire transaction took place within a four-week period and was undertaken for the purpose of generating an artificial tax loss of $3.6 million for Messrs. Daugerdas and Kaplan. If Messrs. Daugerdas and Kaplan had directly purchased and sold the offsetting options as individuals, they would have realized a gain of nearly $3.6 million on termination of the sold option and a $3.6 million loss on the termination of the purchased option, resulting in a net loss of only $6,000.48 For tax purposes, an option is generally treated as an open transaction as long as

The spread between the two option premiums was $36,000, which Trust initially paid to Bank; however, Bank refunded $30,000 to Trust upon termination of the options two weeks later. The only partners of Partnership were Trust and Mr. Daugerdas's wholly-owned shell corporation (a disregarded entity for federal income tax purposes). W hen Cemco sold the euros, it reported a net ordinary loss of $3.6 million from disposition of nonfunctional currency. See I.R.C. § 988. Apparently, Mr. Daugerdas believed that he could use his tax shelter to avoid tax on the income he earned from selling the same shelter to others.
48 See I.R.C. § 1234(a)(1), (a)(2). Under § 1234(b)(1), the grantor's gain or loss from any "closing transaction" is treated as a short-term capital gain or loss; a closing transaction is "any termination of the taxpayer's obligation under an option . . . other than through the exercise or lapse of the option." See I.R.C. § 1234(b)(1), (b)(2). 47 46

45

15

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 16 of 44

the option remains outstanding and unexercised.49 Specifically, an option-writer does not include the premium received on sale of the option in income until the option expires; only then does the option-writer become entitled to keep the premium with no further obligation to deliver the underlying property to the option-holder. Likewise, an option-holder may not claim a loss for the premium paid to purchase an option until the option expires; only then does the option become worthless. The rule allowing an option-writer to defer inclusion of the option premium in income could also be explained by viewing the option-writer's contingent obligation under the option as an obligation to repay a loan, which would clearly be taken into account as a liability for income tax purposes. Under Crane principles, the option-writer could postpone including the premium in income as long as the obligation remained outstanding, and the expiration of an unexercised option could be viewed as analogous to cancellation of indebtedness under § 61.50 Apart from the character of gain or loss, the overall tax consequences to the option-writer are generally the same, under either an open-transaction or an offsetting-liability analysis.51 For tax purposes, what
49

See Rev. Rul. 78-182, 1978-1 C.B. 265. Open transaction treatment can be traced back to Virginia Iron Coal & Coke Co. v. Commissioner, 37 B.T.A. 195, aff'd, 99 F.2d 919 (4th Cir. 1938), cert. denied, 307 U.S. 630 (1939). See Crane v. Commissioner, 331 U.S. 1 (1947). If a call option is exercised, the option premium is "repaid" by the option-writer's delivery of the underlying property to the option-holder, by analogy to a debtor's repayment of borrowed funds by transferring property other than cash. For purposes of §§ 357, 358, and 752, there may be no "meaningful difference" between a call option and an obligation to repay a loan. See Monte A. Jackel & Jerred G. Blanchard, Jr., Reflections on Liabilities: Extension of New Law to Partnership Formations, 91 Tax Notes 1579, 1591 (2001); id. at 1590-91 (rejecting notion that a call option is too uncertain to constitute a § 752 liability because of the built-in feature that allows the optionee to forgive the obligation by not exercising the call). Other commentators have also recognized the similarity between an option and a loan. See Noël B. Cunningham & Deborah H. Schenk, Taxation W ithout Realization: A "Revolutionary" Approach to Ownership, 47 Tax L. Rev. 725, 781 (1992) (noting that option can be viewed as "a loan without stated interest"); Bruce Kayle, Realization W ithout Taxation? The Not-So-Clear Reflection of Income from an Option to Acquire Property, 48 Tax L. Rev. 233, 251 (1993) (noting "time value of money element" and "presumed equality in value" of grantor's obligation and premium at time of grant).
51 50

16

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 17 of 44

should matter is whether incurring the obligation generated basis or other tax benefits.52 To transmute a real $6,000 economic loss into an artificial $3.6 million tax loss, the taxpayers in Cemco interposed Partnership to exploit potential disparities between inside and outside basis. According to Mr. Daugerdas, the tax consequences of the transaction were as follows. Trust's initial outside basis in its Partnership interest, ignoring the contingent obligation under the short option (as well as the spread between the option premiums) was $3.65 million, equal to the cost of the long option and the additional $50,000 contributed to Partnership. According to Mr. Daugerdas, the contingent obligation of nearly $3.6 million under the short option had no effect on outside basis because it was not treated as a liability under § 752.53 When the options terminated, Partnership realized a gain of nearly $3.6 million (equal to the premium received for the short option) and an offsetting loss of $3.6 million (equal to the premium paid for the worthless long option). Crucially, Mr. Daugerdas argued that the termination of the contingent obligation under the short option had no effect on Trust's outside basis, which remained $3.65 million. On liquidation of Partnership, Trust received the euros with a substituted basis of $3.65 million under § 732. The basis of the euros remained unchanged in Cemco's hands under § 723, and generated a $3.6 million ordinary loss for Messrs. Daugerdas and Kaplan when

See Rev. Rul. 88-77, 1988-2 C.B. 129. Cf. Helmer v. Commissioner, 34 T.C.M. (CCH) 727 (1975) (holding receipt of option payments did not give rise to § 752 liability or increase outside basis because there was no obligation to repay or perform future services). Helmer was arguably distinguishable from Rev. Rul. 73-301, involving deferral of income attributable to the taxpayer's accounting method. See Rev. Rul. 73-301, 1973-2 C.B. 215 (treating progress payments as "unrealized receivables" within the meaning of § 751(c)).
53 Even if the obligation under the short option were treated as a liability, there would be no net change in Trust's initial outside basis, assuming Trust remained obligated to perform under the short option. Under § 752, liabilities assumed and relieved must be netted against each other; in the absence of a net shift of liabilities, Trust would still have an initial outside basis of $3.6 million. See Reg. § 1.752-1(f).

52

17

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 18 of 44

Cemco sold the euros.54 Since the basis of the euros in Cemco's hands was derived from Trust's outside basis in its Partnership interest, a key issue is whether Trust was entitled to ignore the contingent obligation under the sold option in calculating outside basis. Even in 2000, the government could reasonably argue that the contingent obligation should have the same effect on outside basis as other liabilities under § 752. Under § 752(b), a reduction of a partner's share of partnership liabilities produces a corresponding reduction in the partner's outside basis; in mechanical terms, relief of liabilities is treated as a deemed distribution of cash. Under this view, the termination of the short option should have given rise to a deemed distribution of nearly $3.6 million, reducing Trust's outside basis by the same amount and leaving Trust with a basis of only $50,000 in the distributed euros (equal to their pre-distribution basis in Partnership's hands). The rationale for reducing Trust's outside basis by the amount of the terminated contingent liability is reflected in Revenue Ruling 88-77, which treats an obligation as a § 752 liability to the extent it gives rise to basis (i.e., the premium received by Trust on sale of the short option).55 The ruling thus reflects the conceptual equivalence between a liability's "tax amount"

Messrs. Daugerdas and Kaplan could have realized a $3.6 million capital loss if Trust had sold its partnership interest either before or after the options terminated. The liquidation of Partnership, however, allowed Trust to receive the euros with a basis of $3.65 million and realize an ordinary loss on the sale of the euros. See Rev. Rul. 88-77, 1988-2 C.B. 128. The Service issued the ruling in response to a 1984 Congressional directive to harmonize the treatment of accounts payable of cash-method taxpayers for purposes of §§ 752 and 357. See H.R. Conf. Rep. No. 98-861, at 856-57 (1984) (disapproving Rev. Rul. 60-345, 1960-2 C.B. 211). In relevant part, the ruling defines "partnership liabilities" for purposes of § 752 to include "an obligation only if and to the extent that incurring the liability creates or increases the basis to the partnership of any of the partnership's assets (including cash attributable to borrowings)." Thus, the ruling provided a policy-based definition of liabilities for purposes of § 752, but left the term "obligation" undefined.
55

54

18

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 19 of 44

and the basis of assets,56 and maintains symmetry between inside and outside basis.57 The policybased definition of § 752 liabilities has been reaffirmed in subsequent rulings and was eventually embodied in final regulations promulgated in 2005.58 The regulations put to rest the purported "conflict between the plain meaning and the policy-driven definitions" of the term liability that fueled abusive transactions intended to duplicate or accelerate losses by inflating basis.59 In Cemco, the tax amount of the contingent obligation under the short option was nearly $3.6 million, equal to the premium received from Bank on sale of the option. Failure to reduce Trust's outside basis to reflect relief of the contingent obligation would give rise to doublecounting of the basis generated by the obligation. An alternative way to reach the same result would be to view the premiums on the pair of options as a circular flow of funds, in which Trust

The ruling departs from the conventional definition of a liability because it focuses on the amount taken into account for tax purposes, which may differ from the principal or face amount. This concept of liabilities may be interpreted broadly to encompass obligations that fall outside the narrow definition of a liability as an obligation to pay a sum certain or perform future services. See W illiam S. McKee et al., Federal Taxation of Partnerships and Partners, ¶ 7.03[2], at 7-16 (4th ed. 2007). Compare Jackel & Blanchard, supra note 51, at 1588 (broad definition of liability) with Bruce Lemons et al., The New Definition of "Liability" and Its Effect on Prepaid Forward Contracts, 100 Tax Notes 1307, 1315 (2003) (narrow definition of liability). Symmetrical treatment is necessary to preserve equality of inside and outside basis, consistent with the principle that a borrowing transaction does not generate income because of the offsetting repayment obligation. See T.D. 9207, 2005-1 C.B. 1344; Rev. Rul. 95-26, 1995-1 C.B. 131; Rev. Rul. 95-45, 1995-1 C.B. 53. The definition also appeared in temporary regulations promulgated in 1988 but was later omitted from the final version of those regulations "in response to comments that the definition was redundant and therefore unnecessary." REG-106736-00, 2003-2 C.B. 60, 62. The final regulations expressly adopt a broad definition of liabilities for purposes of § 752. See Reg. § 1.752-1(a)(4) (defining § 752 liability to include any "fixed or contingent obligation" that creates or increases basis). The final regulations clarify that obligations, whether fixed or contingent, are taken into account without regard to whether those obligations constitute liabilities under any other provision of the Code. See id. W illiam S. McKee et al., supra note 56, ¶ 7.03[3], at 7-19. The preamble acknowledges that "[t]he definition of a liability contained in these proposed regulations does not follow Helmer." REG-106736-00, 2003-2 C.B. 60, 62. Under one literalist view, the 2005 regulations may be constitutionally infirm because Treasury lacks the authority to expand the definition of liabilities. See Lemons et al., supra note 56, at 1314 ("The argument against a broad definition of the term `liability' is simple ­ it is Congress's responsibility to determine tax policy. It is not within the courts' or the Service's province to disregard the plain meaning of a word to prevent or encourage a benefit to taxpayers.").
59 58 57

56

19

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 20 of 44

paid $3.6 million to Bank for the long option and received nearly the entire purchase price (except for the net out-of-pocket cost of $6,000) from Bank on sale of the offsetting short option. When the short option terminated, the relief of the contingent obligation could be viewed as a purchase-price reduction which should reduce the basis of the long option to $6,000.60 Under this view, Trust's outside basis should have been limited to $56,000 ($6,000 net out-of-pocket cost plus $50,000 additional cash contribution), and then reduced to $50,000 to reflect a $6,000 loss on termination of the long option. As a matter of policy, it makes no sense to allow a taxpayer to conjure $3.6 million of outside basis from thin air and transfer that basis to other property worth $50,000 in order to realize an artificial loss of $3.6 million. Mr. Daugerdas had latched onto (or perhaps stumbled into) a form of "pure" tax arbitrage. Pure tax arbitrage occurs when a taxpayer "buys and sells [or borrows and lends] the same asset."61 In theory, tax losses of any desired magnitude could be "reaped indefinitely" in the absence of "tax law impediments," since there were no real assets on which the pre-tax return would be driven down by market demand.62 Indeed, pure tax arbitrage is the engine that fueled the rapid growth of contingent-liability shelters and prompted the government to shut them down. Although Congress eventually responded by enacting § 358(h) in 2000, arguably no statutory amendment was needed because the transactions were already vulnerable to attack under existing law on the ground that they lacked economic substance and served no purpose

60

See I.R.C. § 108(e).

61 Daniel N. Shaviro, The Story of Knetsch: Judicial Doctrines Combating Tax Avoidance, in Tax Stories: An In-Depth Look at Ten Leading Federal Income Tax Cases 313, 319 (Paul L. Caron ed., 2003) (quoting C. Eugene Steuerle). 62

Id.

20

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 21 of 44

other than to reduce taxes.63 Even if this conclusion were not obvious based on the doctrine of economic substance, the offsetting option scheme concocted by Mr. Daugerdas was clearly vulnerable to challenge under the § 701 partnership anti-abuse regulations; if Partnership was ignored, the $3.6 million artificial loss would evaporate. Yet another line of attack was opened by the retroactive § 752 regulations promulgated in 2003. If the government could show that those regulations applied to Mr. Daugerdas's transaction, there would be no need to litigate the issue of economic substance. III. Judicial Response Cemco. In Cemco, the taxpayers made little or no attempt to defend Mr. Daugerdas's contingent-liability shelter on the merits. Instead, they staked their entire case on a procedural technicality, arguing that the government issued its notice of "final partnership administrative adjustment" (FPAA) to the wrong party. Specifically, they claimed that the government was barred from challenging the artificially-enhanced basis of the euros in Cemco's hands because it failed to challenge Partnership's return in a timely manner. The district court properly rejected this procedural argument, noting that it misapplied the statutory scheme of unified parternship audit and litigation procedures and ignored Cemco's duty to make a correct determination of the basis of the euros contributed by Trust (rather than merely accept whatever fanciful basis Trust might claim).64 The court then granted summary judgment for the government and disallowed the

Except for the interpolation of a partnership, the transaction would not have produced an artificial loss of $3.6 million but rather a real economic loss of $6,000. In effect, Messrs. Daugerdas and Kaplan might just as easily have burned 6,000 one-dollar bills. See I.R.C. §§ 6221-6234. Section 6222 requires partnerships and partners to treat partnership items of the partnership consistently. However, the Service was not required to treat Cemco and Partnership identically merely because they had overlapping partners.
64

63

21

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 22 of 44

artificial loss of nearly $3.6 million under the retroactive § 752 regulations; the court also assessed a penalty for gross valuation misstatement.65 Because the taxpayers in Cemco failed to contest the validity of the retroactive regulations, the court treated them as having conceded the issue.66 As a practical matter, that concession made it unnecessary to determine whether the contingent obligation under the short option actually constituted a § 752 liability. If the obligation were treated as a § 752 liability, in accordance with Revenue Ruling 88-77, Trust would be required to reduce its outside basis in Partnership by the amount of the liability, thereby preventing Trust and Cemco from obtaining an artificially-enhanced basis in the euros or realizing a $3.6 million loss on the sale of the euros. On the other hand, if the contingent obligation did not constitute a § 752 liability, the retroactive regulations would clearly apply to the offsetting-option transaction and produce the same end result. Accordingly, as a matter of litigation strategy, the government had no incentive to clarify the definition of § 752 liabilities for pre-2003 transactions or to challenge the taxpayers' assertion that the contingent obligation in Cemco was technically not a § 752 liability, especially since the prospective regulations unequivocally resolved the issue by restating Revenue Ruling 88-77's policy-based definition of § 752 liabilities for transactions occurring after June 23, 2003.67

65

See Cemco Investors LLC v. United States, 2007-1 U.S. Tax Cas. (CCH) ¶ 50,385 (N.D. Ill. 2007).

This appears to have been a calculated tactical risk. Cf. RJT Investments X v. Commissioner, 491 F.3d 732 (8th Cir. 2007) (upholding deficiency and penalties in Son-of-BOSS case based on finding that partnership was a "sham, lacked economic substance and was formed and/or availed of to overstate ... basis"). See Reg. § 1.752-1(a)(4). To remove any possible doubt about the expansive scope of "obligations," the regulations provide a non-exclusive list of illustrations, including "obligations under derivative financial instruments such as options, forward contracts, futures contracts, and swaps." See Reg. § 1.752-1(a)(4)(ii).
67

66

22

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 23 of 44

The court accepted the taxpayers' view, relying on the Tax Court's 1975 memorandum decision in Helmer v. Commissioner for the proposition that "a contingent obligation, such as a short or sold option, is not a liability under section 752."68 In Helmer, a partnership wrote an option in the ordinary course of business and then made cash distributions (from the option premium) to its partners. The partners argued that their outside bases should be increased by their shares of the contingent obligation, but the Tax Court disagreed and held that the distributions were taxable.69 It is far from clear that Helmer was correctly decided or, more importantly, that the decision carried the persuasive power attributed to it by the taxpayers in Cemco.70 Unlike the tax shelter in Cemco, the distributions in Helmer did not involve the creation of artificial losses through transactions lacking in economic substance. Thus, while the Cemco court's statements about Helmer are pure dicta, it seems unduly simplistic to suggest that "[u]ntil recently, the law respecting whether an option contract should be treated as a liability under section 752 actually supported" the taxpayers' position.71 In portraying Notice 2000-44 as an abrupt "revers[al of the

2007-1 U.S. Tax Cas. (CCH) ¶ 50,385, at _ (N.D. Ill. 2007) (citing Helmer v. Commissioner, 34 T.C.M. (CCH) 727 (1975)). The court cited several additional cases which purported to follow Helmer but were readily distinguishable because they did not involve creation of basis or other tax benefits. See Jackel & Blanchard, supra note 51, at 1583-92 (distinguishing other pre-2000 cases and rulings and concluding that Helmer was the only case that could not be reconciled with the Service's policy-based definition of liabilities). See Helmer v. Commissioner, 34 T.C.M. (CCH) 727, _ (1975) ("The option agreement ... created no liability on the part of the partnership to repay the funds paid nor to perform any services in the future. Therefore we hold that no liability arose under section 752 and the partners' bases cannot be increased by such amounts."). In Helmer, the Tax Court recognized that it faced "a unique situation" and expressed concern that its holding seemed inconsistent with the passthrough nature of partnerships. See id. at _ n.4.
71 Cemco Investors LLC v. United States, 2007-1 U.S. Tax Cas. (CCH) ¶ 50,385, at _ (N.D. Ill. 2007) ("For many years, the Helmer rule served as the definition of liability under section 752. ... Thus, under Helmer and its progeny, it would have been proper for [Partnership] to ignore the short, or sold, option as a liability under section 752."). 70 69

68

23

Case 1:05-cv-00231-EJD

Document 183-2

Filed 07/10/2008

Page 24 of 44

government's] position regarding partnership liabilities under section 752,"72 the Cemco court failed to mention the series of revenue rulings going back to 1988 in which the Service took the position that obligations giving rise to basis were § 752 liabilities. In promulgating proposed regulations under § 752 in 2003, the Treasury clearly acknowledged its refusal to follow Helmer but expressed no view concerning the technical definition of § 752 liabilities for transactions occurring before June 24, 2003.73 On appeal, the Seventh Circuit affirmed the lower court's grant of summary judgment for the government. Writing for a unanimous panel, Judge Easterbrook was plainly skeptical of a transaction that involved "an out-of-pocket cost of $6,000 and no risk beyond that expense, while generating a tax loss of $3.6 million."74 The offsetting options were part of a single, integrated package which was deliberately structured to eliminate virtually all investment risk. The proceeds that Trust received from selling the short option almost completely offset the $3.6 million premium that it nominally paid for the long option. Similarly, the Trust's potential payment obligation of nearly $7.2 million under the short option almost completely offset the $7.2 million potential payoff from the long option, except in the unlikely event that the euro exchange rate fell within a very narrow collar at the end of the two-week option period.75 Since both options were

72

Id. at _.

See REG-106736-00, 2003-2 C.B. 60, 62 (noting that the definition of liabilities under the proposed regulations "does not follow Helmer"); see also id. at 61 ("There is no statutory or regulatory definition of liabilities for purposes of section 752.").
74

73

Cemco Investors LLC v. United States, 515 F.3d 749, 751 (7th Cir. 2008).

Under the long (purchased) option, B