Notice 2002-50 Tax Shelter - 05-09-2005
Revised Date: May 24, 2005
Coordinated Issue Paper
“Notice 2002-50” Tax Shelter
On July 15, 2002, the Service issued Notice 2002-50, 2002-2 C.B. 98, announcing that the Service will challenge transactions in which an investor uses a straddle, a tiered partnership structure, a transitory partner, and the absence of an election under § 754 of the Internal Revenue Code to obtain a permanent noneconomic loss.
Whether the deduction claimed by the Investor upon the termination of the loss leg of the straddle (or alternatively, upon Middle Tier’s sale of its interest in Lower Tier) should be disallowed under the anti-abuse rules contained in § 1.701-2?
Whether the partnership and the partners should be denied the losses under § 165(c)(2)?
Whether, in the circumstances described in this transaction, § 267(d) should be applied using an aggregate approach?
Whether the transaction should be recharacterized under the § 988 antiabuse regulations?
Whether the Investor is insufficiently at risk under § 465 to claim the noneconomic losses as a deduction?
Whether under judicial doctrines (i.e., step transaction, economic substance, and substance over form), the income from the gain leg of Lower Tier’s straddle should be allocated to Investor, or, in the alternative, the benefit of the noneconomic deduction claimed upon the termination of the loss leg of the straddle (or alternatively, upon Middle Tier’s sale of its interest in Lower Tier) should be denied?
Whether legal, promoter fees, and "out of pocket expenses" should be disallowed?
Whether the § 6662 accuracy-related penalty applies to Notice 2002-50 transactions?
Whether the § 6662A accuracy-related penalty provisions apply to Notice 2002-50 transactions?
The deduction claimed by the Investor upon the termination of the loss leg of the straddle (or alternatively, upon Middle Tier’s sale of its interest in Lower Tier) should be disallowed under the anti-abuse rules contained in § 1.701-2.
The partnership and the partners should be denied the losses under § 165(c)(2).
In this situation, § 267(d) should be applied under an aggregate approach.
The transaction should be recharacterized, and the loss accelerated to a time prior to Investor’s participation, under the § 988 anti-abuse regulations.
The Investor is insufficiently at risk under § 465 to claim the noneconomic losses as a deduction.
Under judicial doctrines (i.e., step transaction, economic substance, and substance over form), the income from the gain leg of Lower Tier’s straddle should be allocated to Investor, or, in the alternative, the benefit of the noneconomic deduction claimed upon the termination of the loss leg of the straddle (or alternatively, upon Middle Tier’s sale of its interest in Lower Tier) should be denied. These arguments should be utilized with discretion in appropriate cases and only after detailed development.
Legal, promoter fees, and “out of pocket expenses” should be disallowed.
The § 6662 accuracy-related penalty applies to Notice 2002-50 transactions.
The § 6662A accuracy-related penalty provisions apply to Notice 2002-50 transactions.
Description of transaction
The facts below describe a typical Notice 2002-50 transaction. Accordingly, some of the facts may vary depending on the specific transaction being examined. A Notice 2002-50 transaction involves a number of precisely arranged steps intended to ultimately result in a deductible noneconomic loss for the Investor. The key components of a Notice 2002-50 transaction are (1) the use of a straddle that is not subject to the mark to market rules of § 1256, (2) a tiered partnership structure, (3) a transitory partner, and (4) the absence of an election under § 754.
First, an entity (P1) controlled by the Promoter and a tax indifferent entity (the Accommodating Party) 1 form a limited liability company (Upper Tier) that is classified as a partnership for federal tax purposes. P1 and the Accommodating Party make a capital contribution to Upper Tier in relation to their respective interests. The Accommodating Party contributes $100 for a 99% partnership interest.2 Accommodating Party’s basis in Upper Tier is $100.
Second, Upper Tier contributes $40 for a 99% partnership interest in a subsidiary limited liability company (Middle Tier) that is classified as a partnership for federal tax purposes. Upper Tier’s basis in Middle Tier is $40. The 1% partner (P2) is a promoter-related entity.
Third, Middle Tier contributes $20 in exchange for a 99% interest in a subsidiary limited liability company (Lower Tier) that is classified as a partnership for federal tax purposes. Middle Tier’s basis in Lower Tier is $20. The 1% partner is typically P2.
At no time during the course of the transactions do Upper Tier, Middle Tier, or Lower Tier make a § 754 election.
Fourth, Lower Tier acquires a long and a short position (straddle), in foreign currency forward contracts.3 A straddle involves the use of substantially offsetting positions whereby the value of one position ordinarily varies inversely with the value of the other position, thereby resulting in a substantial diminution of the risk of loss.4 Shortly after acquisition of the straddles, Lower Tier closes the gain leg of the straddle and realizes a $10,000 gain.5 As the gain leg is closed, the loss position is contemporaneously “locked in” by putting on a “switch position” 6 and Lower Tier is left with a net unrealized loss of $10,000.7 The $10,000 unrealized loss leg is held open by Lower Tier. Lower Tier can repeat this step with other straddles until the net unrealized losses approximate the Investor’s tax loss objective.8
The proceeds from the terminated gain leg are invested in an instrument that is a CD equivalent (“CD equivalent”).9 The CD equivalent acts as collateral and will defease the $10,000 unrealized loss position. Accordingly, when the loss leg is terminated (step 8) the CD equivalent will also be terminated, and therefore, generally, no partner will be required to pay additional amounts to cover the loss.10
Fifth, shortly after the gain leg is closed, the Investor purchases Accommodating Party’s interest in Upper Tier for $100 (the amount of Accommodating Party’s initial investment). This purchase causes a technical termination under § 708(b)(1)(B) which causes all the partnerships’ taxable years to close. The $10,000 gain is allocated first to Middle Tier, then to Upper Tier, and finally to the Accommodating Party.11 Moreover, Middle Tier’s basis in Lower Tier is increased to $10,020; Upper Tier’s basis in Middle Tier is increased to $10,040; and the Accommodating Party’s basis in Upper Tier is increased to $10,100.
Accommodating Party may claim a $10,000 tax loss ($10,100 adjusted basis minus $100 amount realized). The Investor’s basis in Upper Tier is $100. Because Upper Tier does not make a § 754 election, Investor’s share of Upper Tier’s basis in its Middle Tier interest remains $10,040.
Sixth, in anticipation of the Investor purchasing Upper Tier’s interest in Middle Tier, Middle Tier engages in a structured loan transaction with Bank. This structured loan transaction is intended to increase Investor’s basis and amount at risk in Middle Tier. The amount of the loan component of the structured loan transaction approximates the amount of the Investor’s desired tax loss. The structured loan transaction consists of (1) Middle Tier borrowing $10,000 denominated in a foreign currency; (2) a simultaneous investment of the $10,000 in an instrument12 (Instrument) (held by the Bank) that is equivalent to a certificate of deposit and which is denominated in a different currency13; and (3) a costless collar14 that hedges the currency exposure implied in the loan and the investment. The investment and the collar will mature on or about the same date that the loan becomes due. The costless collar generally limits Middle Tier’s profit and loss potential on the structured loan transaction to .5% of the loan amount. Further, Bank ensures that Middle Tier will have enough cash on deposit at Bank to cover this potential .5% loss.
In regard to the loan component of the structured loan transaction, Bank retains the right of set off. Middle Tier, however, relinquishes its right of set off. Further, the loan component is guaranteed by the non-managing member of Middle Tier to the extent of the amount of Investor’s desired tax loss.15 The guarantee was not required by Bank, but was part of the structure of the overall transaction. The guarantee does not include a right of set off. The guarantee, as well as the no right of set-off provisions are intended to increase, under § 465, the guarantor’s amount at risk.
The effect of the structured loan transaction is to increase Upper Tier’s basis in Middle Tier to $20,040 under § 752(a).
Seventh, the Investor buys Upper Tier’s 99% interest in Middle Tier for $40. As part of the sale transaction, the Investor guarantees Middle Tier’s loan (undertaken as part of the structured loan transaction), and the Bank releases Upper Tier from its guarantee. This purchase causes a technical termination under § 708(b)(1)(B) which causes Middle Tier’s and Lower Tier’s taxable years to close. Upper Tier’s amount realized on the sale is $10,040 ($40 cash plus $10,000 relief of liability). Upper Tier realizes a capital loss of $10,000 ($10,040 amount realized minus $20,040 adjusted basis) on the sale. Upper Tier claims that this $10,000 loss (which is allocated to the Investor) is disallowed under § 707(b)(1)(A) because Investor and Upper Tier are related parties. After the purchase, Investor’s basis in Middle Tier is $10,040, and the Investor’s basis in Upper Tier is $100.
Eighth, Lower Tier closes the loss leg of the straddle, thereby generating a $10,000 ordinary loss which flows first to Middle Tier and then to Investor. This loss is used by the Investor to offset Investor’s other ordinary income. Investor’s basis in Middle Tier is decreased by $10,000 to $40.
Alternatively, if a capital loss is desired, Middle Tier sells its interest in Lower Tier for $20 to an affiliate of the Promoter.16 This sale causes a technical termination under § 708(b) which causes Lower Tier’s taxable year to close. As a consequence, Middle Tier claims a $10,000 capital loss ($10,020 adjusted basis minus $20 amount realized), which is allocated first to Middle Tier and then to Investor. This loss is used by the Investor to offset gains generated from other transactions. Investor’s basis in Middle Tier is decreased by $10,000 to $40.
Ninth, Investor, typically in the following year, sells his Middle Tier interest to another affiliate of the Promoter (P4) for $40. P4 assumes the Investor’s loan guarantee. The Investor recognizes a $10,000 gain ($10,040 amount realized ($10,000 relief of liability plus $40 cash) minus $40 adjusted basis) from the sale. The Investor takes the position that under § 267(d) the gain is not recognized to the extent of the loss previously disallowed under § 707(b)(1)(A) ($10,000) when Upper Tier sold its interest in Middle Tier.
Generally, the Investor secures a favorable tax opinion from a Co-Promoter. The Co-Promoter rendering the opinion receives compensation in relation to the magnitude of the potential tax benefits to the Investor.
The Investor pays substantial fees to the Promoter and Co-Promoter. Generally, the amount of the fee is based on the amount of the Investor’s tax loss objectives. The fee includes compensation for the design of the transaction and the cost of implementing the transaction, which includes legal fees, accounting fees, and fees charged by the counterparty (the Bank), as well as Accommodating Party fees. In some transactions, the fee is paid directly to Promoter and Co-Promoters by the Investor. In others, the fee is disguised as an investment in a Venture Capital Fund (“VC Fund”), which is a limited liability company classified as a partnership. Generally, the Accommodating Party’s fee is based upon the total amount of Notice 2002-50 transactions in which it
The VC Funds are typically structured in the following manner. The Promoter or the Co-Promoter form limited liability companies (LLCs) which purchase warrants in start-up technology companies. Shortly after the LLCs purchase the warrants, generally, within two weeks, the Promoter or the Co-Promoter secures from an appraisal company a “preliminary” analysis of “the potential pricing” of the warrants. The appraiser’s opinion reflects a “preliminary potential pricing” of the warrants of approximately ten to twenty times the purchase price. No facts have been identified which would account for the substantial increase in valuation during the period between the purchase and the rendering of the pricing opinion.
The Co-Promoter contributes interests in the LLCs to the VC Fund in exchange for a membership interest in the VC Fund.18 Upper Tier then commits to buy an interest in the VC Fund from the Co-Promoter at a price reflecting the inflated values of the warrants. In these instances, the VC Fund makes a § 754 election, and increases Upper Tier’s share of the VC Fund’s basis in the warrants to reflect the sale price of the interests. In other instances, the VC Fund purchases the LLCs from the Co-Promoter at the inflated values, and the VC Fund then sells direct interests in the VC Fund to Upper Tier at a price reflecting the inflated values of the warrants.19 Regardless of which structure is used, the fees are the difference between what the LLCs initially paid for the warrants and the inflated amount paid by Upper Tier. Funding for Upper Tier’s acquisition of its interest in the venture capital funds is generally provided by the Investor upon Investor’s acquisition of Upper Tier. The Investor generally deducts the inflated cost of the warrants, including the disguised fees, as Schedule D capital losses when they become worthless, which generally occurs within the first three years after acquisition of the warrants.20
1. The deduction claimed by the Investor upon the termination of the loss leg of the straddle (or alternatively, upon Middle Tier’s sale of its interest in Lower Tier) should be disallowed under the anti-abuse rules contained in § 1.701-2.
Section 1.701-2, the partnership anti-abuse rule, in pertinent part, provides that subchapter K is intended to permit taxpayers to conduct joint business (including investment) activities through a flexible economic arrangement without incurring an entity-level tax. Implicit in the intent of subchapter K are the following requirements: (1) the partnership must be bona fide and each partnership transaction or series of related transactions (individually or collectively, the transaction) must be entered into for a substantial business purpose; (2) the form of each partnership transaction must be respected under substance over form principles; and (3) except as otherwise provided, the tax consequences under subchapter K to each partner of the partnership operations and of transactions between the partnership and the partner must accurately reflect the partners' economic agreement and clearly reflect the partner's income.
However, certain provisions of subchapter K and the regulations thereunder were adopted to promote administrative convenience and other policy objectives, with the recognition that the application of those provisions to a transaction could, in some circumstances, produce tax results that do not properly reflect income. Thus, the proper reflection of income requirement is treated as satisfied with respect to a transaction that satisfies requirements (1) and (2) to the extent that the application of such a provision to the transaction and the ultimate tax results, taking into account all the relevant facts and circumstances, are clearly contemplated by the provision.
Section 1.701-2(b) provides that if a partnership is formed or availed of in connection with a transaction a principal purpose of which is to reduce substantially the present value of the partners' aggregate federal tax liability in a manner that is inconsistent with the intent of subchapter K, the Commissioner can recast the transaction for federal tax purposes as appropriate to achieve tax results that are consistent with the intent of subchapter K. Thus, even though the transaction may fall within the literal words of a particular statutory or regulatory provision, the Commissioner can determine, based on the particular facts and circumstances, that to achieve tax results that are consistent with the intent of subchapter K: (1) the purported partnership should be disregarded in whole or in part, and the partnership's assets and activities should be considered, in whole or in part, to be owned and conducted, respectively, by one or more of its purported partners; (2) one or more of the purported partners of the partnership should not be treated as a partner; (3) the methods of accounting used by the partnership or a partner should be adjusted to reflect clearly the partnership's or the partner's income; (4) the partnership's items of income, gain, loss, deduction or credit
should be reallocated; or (5) the claimed tax treatment should otherwise be adjusted or modified.
Whether a partnership was formed or availed of with a principal purpose to reduce substantially the present value of the partners' aggregate federal tax liability in a manner inconsistent with the intent of subchapter K is determined based on all of the facts and circumstances, including a comparison of the purported business purpose for a transaction and the claimed tax benefits resulting from the transaction. Section 1.701-2(c). Section 1.701-2(c) lists various factors that may be considered in making the determination.
Section 1.701-2(d), Example 8, provides an example of a plan to duplicate losses through the use of a partnership, lacking a § 754 election, that is not consistent with the intent of subchapter K. In Example 8, A wanted to sell land to B with a basis of $100x and a fair market value of $60x. A and B devised a plan a principal purpose of which was to permit the duplication, for a substantial period of time, of the tax benefit of A's built-in loss in the land. A, C, and W formed a partnership ("PRS"). A contributed the land and C and W each contributed $30x.PRS invested the $60x in an investment asset. In year 3, at a time when the values of the partnership's assets had not materially changed, PRS agreed with A to liquidate A's interest in exchange for the investment asset held by PRS. Under § 732(b), A's basis in the asset was $100x. A sold the investment asset toX, an unrelated party, recognizing a $40x loss.
PRS did not make an election under § 754. Accordingly, PRS's basis in the land contributed by A remained at $100x. PRS sold the land to B for $60x, its fair market value. Thus, PRS recognized a $40x loss that was allocated equally between C and W (which C and W would be able to use to reduce income from other sources), and they each reduced the bases in their partnership interests to $10x. Their respective interests are worth $30x each. Thus, upon liquidation of PRS (or their interests therein), each of C and W would recognize $20x of gain. However, C and W do not liquidate PRS, and PRS's continued existence defers recognition of that gain indefinitely. In § 1.701-2(d), Example 8, PRS was used with a principal purpose of reducing substantially the present value of the partners' aggregate federal tax liability in a manner inconsistent with the intent of subchapter K. Therefore (in addition to possibly challenging the transaction under judicial principles or other statutory authorities, such as the substance over form doctrine or the disguised sale rules under § 707), the Commissioner can recast the transaction as appropriate under § 1.701-2. Compare § 1.701-2(d), Example 9, in which the use of a partnership for which no election under § 754 had been made is consistent with the intent of subchapter K. That is, PRS was a bona fide partnership the purpose of which was to conduct joint business activity through a flexible arrangement, and the ultimate tax results were clearly contemplated by § 754. For these reasons the transaction is treated as satisfying the proper reflection of income standard and will be respected.
The tax benefits of a Notice 2002-50 transaction are only possible by operating in a tiered partnership form and carrying out a series of substantially meaningless steps in a certain order. The transaction’s fundamental tax avoidance device is the use of a straddle that is not subject to the mark to market rules of § 1256, the closing of the gain leg before the loss leg, and the allocation of the gain from the closing of the gain leg to a transitory tax neutral party, while the loss from the closing of the loss leg is allocated to the Investor. If Investor had purchased the straddle directly, both the gain and the loss would be recognized by the Investor. Further, by operating in a tiered partnership form, the relevant parties are able to take advantage of the basis rules relating to § 754 elections. By not making the § 754 elections, there is no downward adjustment in basis, and the sale of interests in both Middle Tier and Lower Tier generates a tax loss.
The tax consequences of the transaction do not clearly reflect the Investor’s income. The Investor’s initial investment is $100 (the amount paid for the Accommodating Party’s interest in Upper Tier), yet Investor has a $10,000 permanent tax loss but no economic loss other that the fees paid to the Promoter. Clearly, the tax loss generated by the transaction does not reflect an underlying economic loss. Accordingly, the § 1.701-2 anti-abuse provisions should be applied to disallow the deduction claimed by the Investor upon the termination of the loss leg or upon the sale of Middle Tier’s interest in Lower Tier.
In the alternative, in certain circumstances, the § 1.701-2 anti-abuse rule should be applied to disregard the Accommodating Party’s interest in Upper Tier, and therefore, the gain from the closing of the gain leg should be allocated to the Investor. The allocation of the gain to Accommodating Party is not consistent with the intent of subchapter K because there is no intent that the proceeds from the closing of the gain leg be distributed to the Accommodating Party. Moreover, the Accommodating Party should be disregarded as a partner under the principles of § 1.701-2.
2. The partnership and the partners should be disallowed the losses under § 165(c)(2).
Section 165(a) allows as a deduction any loss sustained during the year and not compensated by insurance or otherwise. Losses claimed by individuals, other than casualty losses, are limited by § 165(c) to (1) losses incurred in a trade or business and (2) losses incurred in any transaction entered into for profit, though not connected with a trade or business. The requirements of § 165(c)(2) were applied to certain straddle transactions in Fox v. Commissioner, 82 T.C. 1001 (1984). The Tax Court found that § 165(c)(2) requires that the taxpayer enter into the transaction “primarily for profit.” 82 T.C. at 1019-21. See also Dewees v. Commissioner, 870 F.2d 21, 33 (1st Cir. 1989), and the cases cited therein. This "primary profit motive" test (which also applies to other deductions requiring a business or profit motive, such as § 162), has its origins in the Supreme Court decision, Helvering v. National Grocery Co., 304 U.S. 282 (1938), which interpreted a predecessor of § 165(c). See also United States v. Generes, 405 U.S. 93, 105 (1972) ("dominant motive" required).
When partners invest through a partnership, the determination of primary motive, for purposes of § 165(c)(2) and other provisions requiring a business or profit motive, is made at the partnership level.21 See § 703(a) (partnership's taxable income computed in the same manner as an individual's); Brannen v. Commissioner, 78 T.C. 471, 505 (1982), aff'd, 722 F.2d 695 (11th Cir. 1984) ("In order for a partnership to be entitled to a deduction for expenses attributable to a trade or business in computing its taxable income (or loss) under section 703(a), it must be established that the partnership engaged in the activity with the primary purpose and intent of making a profit."). In determining whether the partnership engaged in the activity for profit, all of the relevant facts and circumstances are taken into account, and the burden is on the taxpayer. See Brannen, 78 T.C. at 506. The intent of the partnership for purposes of applying § 165(c)(2) is determined by reference to the collective intent of the general partners, managers, and other controlling individuals, inc luding owners. See Ewing v. Commissioner, 91 T.C. 396, 416-17 (1988), aff'd without published opinion, 940 F.2d 1534 (9th Cir. 1981); Rosenfeld v. Commissioner, 82 T.C. 105, 112 (1984); Seigel v. Commissioner, 78 T.C. 659, 698 (1982); Resnick v. Commissioner, 66 T.C. 74 (1976), aff'd per curiam, 555 F.2d 634 (7th Cir. 1977). In a typical Notice 2002-50 case, the Investor’s lack of a primary profit intent would be attributed to the partnership.
The application of § 165(c) does not require a finding that the transaction lacks economic substance. For example, the Tax Court in Fox found that because the taxpayer did not meet the requirements of § 165(c)(2), it did not have to find that the transaction was a sham. See also Smith v. Commissioner, 78 T.C. 350 (1982), aff’d without published opinion, 820 F.2d 1220 (4th Cir. 1987), where the Tax Court found certain straddles not to be shams, but at the same time disallowed the resulting losses because the taxpayers lacked the requisite economic profit objective under § 165(c)(2).
In Ewing, 91 TC at 418, the Tax Court derived the following guidelines from Fox:
The ultimate issue is profit motive and not profit potential. However, profit potential is a relevant factor to be considered in determining profit motive.
Profit motive refers to economic profit independent of tax savings.
It is the overall scheme which determines the deductibility or nondeductibility of the loss.
If there are two or more motives, it must be determined which is primary, or of first importance. The determination is essentially factual, and greater weight is to be given to objective facts than to self-serving statements characterizing intent.
Because the statute speaks of motive in "entering" a transaction, the main focus must be at the time the transactions were initiated. However, all circumstances surrounding the transactions are material to the question of intent.
As discussed above, any alleged profit motive is dwarfed by the Investor’s interest in reducing his tax liability. As such, any losses generated by the transaction may be limited or denied under § 165(c)(2) because of the lack of a primary economic profit objective.
3. In this situation, § 267(d) must be applied under an aggregate approach.
When Investor sells his Middle Tier interest, the Investor is not permitted to use Upper Tier’s disallowed loss to offset the gain from the Investor’s sale of his Middle Tier interest because § 267(d) does not apply to the transaction in the manner claimed by the Investor. If a partnership sells to a partner an interest in a lower tier partnership at a loss and that loss is disallowed as a deduction because of § 707(b), the partner’s subsequent sale of the partnership interest at a gain may be offset with the earlier disallowed loss, as permitted by § 267(d). However, it is the purpose of § 267(d) to shield from income recognition any subsequent gain on the sale or exchange of the property that generated the disallowed loss. In order for the taxpayer to offset gain from the sale of property under § 267(d) with a loss that was disallowed under § 707(b), the loss must be properly attributable to the property that is subsequently sold by the taxpayer. Thus, in the case of a disallowed loss on a sale of a partnership interest, gain on the subsequent sale of the partnership interest may be offset only to the extent that the gain realized is allocable to (1) the same property that was held by the partnership when the disallowed loss was realized or (2) property the basis of which in the hands of the partnership is determined directly or indirectly by reference to property that was held by the partnership when the disallowed loss was realized. See § 1.267(d)-1(a). This aggregate approach to partnerships in the conte xt of § 267(d) is appropriate under § 1.701-2(e).
When the Investor sells the interest in Middle Tier, the disallowed loss from the sale by Upper Tier of its interest in Middle Tier to the Investor is not properly allocable to the interest in Middle Tier subsequently sold by the Investor at a gain. The partnership property that resulted in Upper Tier realizing a loss on the sale of its Middle Tier interest to the Investor was the loss inherent in the loss position of Lower Tier’s straddle. The loss that was inherent in the loss position was fully recognized by the Investor when that position was terminated. Alternatively, the loss was fully recognized by the Investor when Middle Tier sold its Lower Tier interest for a loss. Therefore, the Investor is not permitted to use the disallowed loss from Upper Tier’s sale of the Middle Tier interest to the Investor to offset the gain from the Investor’s sale of the Middle Tier interest.
4. The transaction should be recharacterized under the § 988 anti-abuse regulations.
Sections 985 through 989 of the Internal Revenue Code, enacted as part of the Tax Reform Act of 1986, set forth a comprehensive set of rules for the treatment of foreign currency transactions. Section 988(a)(1)(A) provides that foreign currency gain or loss attributable to a “section 988 transaction” is computed separately and treated as ordinary income or loss. The legislative history of sections 985 through 989 suggests a consistent concern about tax motivated transactions. The Senate Finance Committee Report accompanying the Tax Reform Act of 1986 stated that one reason for the enactment of these provisions was to address opportunities existing under prior law for taxpayers to engage in tax-motivated transactions. S. Rep. No. 313, 99th Cong., 2d Sess. 450 (1986). Accordingly, in enacting sections 985 through 989, Congress granted broad authority for the Service to promulgate regulations “as may be necessary or appropriate to carry out the purposes of [sections 985-989] . . ..” Section 989(c). The legislative history to the Technical and Miscellaneous Revenue Act of 1988 (“TAMRA”), in discussing the law prior to the enactment of TAMRA, stated that “[t]he Secretary has general authority to provide the regulations necessary or appropriate to carry out the purposes of [sections 985-989]. For example, the Secretary may prescribe regulations appropriately recharacterizing transactions to harmonize the general realization and recognition provisions of the Code with 13
the policies of section 988.” H.R. Rep. No. 795, 100th Cong., 2d Sess. 296 (1988); S. Rep. No. 445, 100th Cong., 2d Sess. 311 (1988) (containing identical language).
Under the authority of section 989(c), the Service has issued §1.988-2(f), which provides in part as follows:
If the substance of a transaction described in §1.988-(1)(a)(1) [i.e., a section 988 transaction] differs from its form, the timing, source, and character of gains or losses with respect to such transaction may be recharacterized by the Commissioner in accordance with their substance . . . .
If it is determined that the Investor did not own the entity holding the foreign currency positions from the outset of the transaction and that the participation of the Accommodating Party must therefore be taken into account, section 1.988-2(f) can be used to accelerate recognition of the loss leg of a foreign currency straddle prior to the Investor’s acquisition of its interests in such entity. Because the loss leg of the straddle is “locked in” at the time the gain leg is closed, the Investor is not exposed to economic fluctuations in the value of the foreign currency positions held by the partnership structure. Only narrow differences in timing account for the fact that losses that were economically incurred by the Accommodating Party are instead allocated to the Investor: the closure of the loss leg of the straddle is delayed just long enough for the Investor to obtain an interest in the partnership holding the loss position and claim an allocation of the loss. The loss thus allocated to the Investor derives from economic events that occurred prior to the Investor’s participation in the transaction. Accordingly, the tax consequences to the Investor and to the Accommodating Party may be realigned with the economic substance of the transaction by marking the loss leg of the straddle to market under section 1.988-2(f) before the Investor’s acquisition of any interest in the partnership structure and allocating the resulting tax loss to the Accommodating Party and away from the Investor.
5. The Investor is insufficiently at risk under § 465 to claim the losses generated by the Notice 2002-50 transaction.
A. The loan component of the structured loan transaction is not an obligation which creates an amount at risk for the Investor.
Section 465 generally limits deductions for losses in certain activities to the amount for which the taxpayer is at risk. In the case of an individual taxpayer, § 465 limits the taxpayer’s losses to the amount for which the taxpayer is at risk in the activity. Section 465(a)(1). Section 465(a) applies to all activities engaged in by the taxpayer in carrying on a trade or business for the production of income.
Section 465(c)(3)(A). Section 465(b)(1) provides that a taxpayer is considered at risk for an activity with respect to amounts including the amount of money and the adjusted basis of other property contributed by the taxpayer to the activity and amounts borrowed with respect to such activity. Under § 465(b)(2), a taxpayer is considered at risk for an activity with respect to amounts including amounts borrowed for use in an activity to the extent that the taxpayer either is personally liable for the repayment of such amounts, or has pledged property, other than property used in such activity, as security for such borrowed amount.
Section 465(b)(4) provides that notwithstanding the other provisions of § 465, a
taxpayer is not considered at risk with respect to amounts protected against loss through nonrecourse financing, guarantees, stop loss agreements, or other similar arrangements. Under § 465(b)(4), the legislative history provides that in evaluating the amount at risk, it should be assumed that a loss-protection guarantee, repurchase agreement or other loss limiting mechanism will be fully paid to the taxpayer. Id. (citing S.Rep. No. 938, 94th Cong., 2d Sess. 50 n.6 (1976)); See also, Moser v. Commissioner, 914 F.2d 1040 (8th Cir. 1990) (A theoretical possibility that the taxpayer will suffer economic loss is insufficient to avoid the applicability of § 465(b)(4)); Levien v. Commissioner, 103 T.C. 120 (1994), aff’d, 77 F.3d 497 (11th Cir. 1996).
The case law is not in complete accord on this issue. In Emershaw v. Commissioner, 949 F.2d 841, 845 (6th Cir. 1991), the court adopted a worstcase scenario approach and determined that the issue of whether a taxpayer is “at risk” for purposes of § 465(b)(4) “must be resolved on the basis of who realistically will be the payor of last resort if the transaction goes sour and the secured property associated with the transaction is not adequate to pay off the debt.” quoting Levy v. Commissioner, 91 T.C. 838, 869 (1988).
In contrast, the Second, Eighth, Ninth, and Eleventh Circuits look to the underlying economic substance of the arrangements under § 465(b)(4). Waters v. Commissioner, 978 F.2d 1310, 1316 (2nd Cir. 1992) (citing American Principals Leasing Corp. v. US , 904 F.2d 477 (9th Cir. 1990); Young v. Commissioner, 926 F.2d 1083, 1089 (11th Cir. 1991); Moser, 914 F.2d at 1048-49.) The view, as adopted by the Second, Eighth, Ninth, and Eleventh Circuits is that, in determining who has the ultimate liability for an obligation, the economic substance and the commercial realities of the transaction control. See Waters, 978 F.2d at 1316; Levien, 103 T.C. 120; Thornock v. Commissioner, 94 T.C. 439, 448 (1990), Bussing v. Commissioner, 89 T.C. 1050, 1057 (1987). To determine whether a taxpayer is protected from ultimate liability, a transaction should be examined to see if it “is structured - by whatever method - to remove any realistic possibility that the taxpayer will suffer an economic loss if the transaction turns out to be unprofitable.” American Principals, 904 F.2d at 483, See Young, 926 F.2d at 1088, Thornock, 94 T.C. at 448-49, Owens v. United States, 818 F. Supp. 1089, 1097 (E.D. Tenn. 1993), Bussing, 89 T.C. at 1057-58. “[A] binding contract is not necessary for [465(b)(4)] to apply.” American Principals, 904 F.2d at 482-83. In addition, “the substance and commercial realities of the financing arrangements presented . . . by each transaction” should be taken into account under § 465(b)(4). Thornock, 94 T.C. at 449. To avoid the application of § 465(b)(4), there must be more than “a theoretical possibility that the taxpayer will suffer economic loss.” American Principals, 904 F.2d at 483.
In the transaction, Investor asserts that his amount at risk is increased by Investor’s guarantee of Middle Tier’s debt. This debt is incurred in the context of a structured loan transaction with Bank. Middle Tier borrows an amount denominated in a foreign currency and invests the proceeds in Instrument (which functions like a certificate of deposit) denominated in a different currency. Middle Tier and Bank limit their foreign currency exposure by entering into a zero cost collar. The costless collar generally limits Middle Tier’s profit and loss potential to .5% of the loan amount. A portion of this loan, i.e., the amount of the desired tax loss, is guaranteed by the Investor.
Given the above, some Investors may still claim to bear the ultimate risk of loss if Bank were to declare bankruptcy, based on loan and guarantee documents which contain provisions which purport to waive the right of set-off. However, the at risk rules forbid the consideration of the potential insolvency of the party providing the loss protection. S. Rep. No. 938, 94th Cong., 2d Sess. 50 n.6 (1976). Further, contractual language which negates a right of set-off does not necessarily create at risk amounts. Hayes v. Commissioner T.C. Memo 1995-151. It is sufficient for the Service to show, as a practical matter, that it is unlikely that anyone would ever force the taxpayer to pay actual cash.
The structured loan transaction is akin to a reciprocal or circular obligation. As a cashless transaction, it resulted in nothing more than offsetting legal obligations , if any. The costless collars made it impossible for the structured loan transaction to result in a profit or loss beyond the collared amount. The reciprocal obligations of Bank and Middle Tier remove any realistic possibility of economic loss.
Therefore, because the Investor is insulated from economic loss and it is improbable that the Investor will ever have to pay on the obligation, the Investor is insufficiently at risk under § 465 and should not be allowed to deduct the noneconomic loss created by the Notice 2002-50 transaction.
B. The Investor’s guarantee was in substance a device to avoid the application of § 465. Consequently, the guarantee did not increase the Investor’s amount at risk and the Investor cannot claim the loss generated by the straddle transaction.
Prop. Reg. § 1.465-1(b) provides that in applying § 465, substance will prevail over form. Regardless of the form a transaction may take, the ta xpayer’s amount at risk will not be increased if the transaction is inconsistent with normal commercial practices or is, in essence, a device to avoid § 465. See also Prop. Reg. § 1.465-6(d).
Prop. Reg. § 1.465-4(a) provides, in part, that if a taxpayer engages in a pattern of conduct which is not within normal commercial practice or has the effect of avoiding the provisions of § 465, the taxpayer’s amount at risk may be adjusted to reflect more accurately the amount which is actually at risk. For example, increases in the amount at risk occurring toward the close of a taxable year which have the effect of increasing the amount of losses which will be allowed to the taxpayer under § 465 for the taxable year will be closely examined. If, considering all the facts and circumstance, it appears that the event which increases the amount at risk at the close of the taxable year will be accompanied by an event which decreases the amount at risk after the close of the taxable year, these amounts will be disregarded in determining the amount at risk unless the taxpayer can establish (1) the existence of a valid business purpose for increasing and then decreasing the amount at risk and (2) that the increases and decreases are not a device to avoid § 465. The facts and circumstances to be considered include:
The length of time between the increase and decrease in the amount at risk;
The nature of the activity and deviations from normal business practice in the conduct of that activity;
The use of those amounts which increased the amount at risk toward the close of the taxable year;
Contractual arrangements between parties to the activity; and
The occurrence of unanticipated events which make the decrease in the amount at risk necessary.
Therefore, in analyzing Notice 2002-50 transactions, the following facts should be considered in determining the Investor’s amount at risk. First, the duration and the time period of the Investor’s guarantee must be examined. A brief period at risk indicates an intention to avoid the at risk rules. Additionally, increasing one’s amount at risk toward the end of the taxable year indicates that the activity which increased the Investor’s amount at risk is a device to avoid § 465.22
Second, the commercial reasons for the loan guarantee and the waivers of setoff rights must be examined. Facts indicating that the guarantee and/or waiver were added at the suggestion of the Promoter demonstrate their tax avoidance purpose. Further, facts demonstrating that the guarantee was not secured in accordance with normal commercial practice (e.g., the initial non-managing member, upon which the requirement was imposed, was a limited liability company with limited assets) support the argument the guarantee was put in place to avoid the application of § 465.
Third, the guarantee equals the amount of loss that the Investor is seeking rather than the entire amount of the Bank loan. If the Bank truly needed a guarantor of the loan, then the Bank would limit the amount of the loan to the extent of the guarantee.
Finally, the guarantee itself is superfluous, thereby indicating its tax avoidance purpose. The purpose of a guarantee is to protect the lender against credit risk on the loan. The loan is collateralized by the combination of the pair of the Instrument and the collar trades which is in the custody in Bank. The loan is further collateralized by the required cash maintained on deposit with the Bank. As such, Bank has no commercial reason for implementing the guarantee, as its purported loan was fully collateralized.
C. The activities undertaken in each separate entity should be considered separate activities for purposes of the at risk rules.
The Investor takes the position that the guarantee is applicable to the transaction as a whole (i.e., all three tiers of the transaction should be viewed as one activity). This position relies upon the aggregation criteria set forth in the passive loss regulations to determine that the three tiers would be treated as one activity. The passive loss rules are a different statute, enacted at a different time, and for a somewhat different purpose. Although comprehensive regulations have not been issued to define how to determine if activities are to be aggregated for at risk purposes (See 1.465-1T), the legislative history of § 465 provides that aggregation is appropriate “where the activities involved do not have significant tax shelter potential” and conversely that separation is appropriate where they do. H.R. No. 95-1445 at 70, Aug. 4, 1978, reprinted in 1978 U.S.C.C.A.N. 7046, 7104.
“In the absence of regulations permitting or requiring aggregation, it is anticipated that each investment which is not part of a trade or business will be treated as a separate activity, and separate investments will not be aggregated.” Id. The legislative history also suggests that the appropriate tax shelter characteristics to be considered include the “mismatching of income and deductions, novel financing techniques which do not conform to standard commercial practices and property whose value is subject to substantial uncertainty, and the marketing of the activity to prospective i nvestors as a tax shelter.” Id.
Notice 2002-50 transactions have tax shelter potential as determined by applying the factors listed in the legislative history. See Id. First, income and deductions are clearly mismatched since the party that is allocated the gain from the closing of the gain leg of Lower Tier’s foreign currency straddle is not the party which is allocated the loss from the closing of the loss leg. Second, the loan component of the structured loan transaction is a novel financing technique, and when used as part of the structured loan transaction, yields an insignificant profit potential.
Lastly, in many cases Upper Tier makes investments in start-up companies with an uncertain value. Thus, given the legislative intent concerning when it is appropriate to aggregate separate activities, Lower Tier’s activity of investing in foreign currency straddles, Middle Tier’s activity of engaging in a structured loan transaction, and Upper Tier’s activity of investing in venture capital funds (if applicable) should not be aggregated.
Assuming the loss is otherwise allowable, the Investor can utilize Lower Tier’s loss from closing the loss leg of the foreign currency straddle only to the extent the Investor is at risk with regard to Lower Tier. The Investor’s amount at risk with regard to Lower Tier will be determined by the portion of the price paid for Middle Tier that is attributable to Lower Tier. Losses from Lower Tier, which exceed the Investor’s amount at risk with regard to Lower Tier, will be suspended until the Investor has sufficiently increased the amount at risk with regard to Lower Tier.
Assuming, again, that the loss is otherwise allowable, the Investor would be allowed to utilize Upper Tier’s loss on its sale of its interest in Middle Tier to the extent the Investor is at risk with regard to Upper Tier. The Investor offsets the gain recognized upon the sale of his Middle Tier interest with the suspended loss sustained by Upper Tier in the first year. However, since the Investor is only at risk with regard to Upper Tier to the extent of his cash investment, the at risk rules prevent the deduction of suspended losses by the Investor until the Investor increases his amount at risk with regard to Upper Tier, without regard to the fact that §267(d) would allow the taking of the loss. Accordingly, the Investor could only use the suspended losses from Upper Tier’s sale of its interest in Middle Tier to offset the gain recognized on the sale of Middle Tier to the extent of the Investor’s cash investment in Upper Tier (i.e., $100).
Therefore, segregation of the three tiers for at risk purposes will cause most of the losses to be unavailable to the Investor. The Investor will recognize the gain resulting from the sale of his interest in Middle Tier and will suspend the losses from Upper Tier and Lower Tier until the amount at risk is increased for those tiers. Because the tiers cannot be aggregated, even if the debt guarantee is valid, the Investor’s amount at risk will only be increased for Middle Tier, which is the only activity in the transaction that is sold at a substantial gain.
D. The Investor has Recapture Income Upon the Sale of the Investor’s Middle Tier Interest
Under § 465(e), if zero exceeds the amount for which the taxpayer is at risk in any activity at the close of any taxable year the taxpayer shall include in his gross income for such taxable year (as income from such activity) an amount equal to such excess.
A taxpayer’s at risk amount is increased for gain received or accrued from an activity. In a Notice 2002-50 transaction, the Investor typically increases his at risk amount by the gain realized, but not recognized, upon the Investor’s disposition of Middle Tier. However, no authority exists for allowing an increase to an at risk amount in a situation where gain is not recognized by the interplay of §§ 707 and 267. As a result, the Investor may not increase his amount at risk for this gain. Therefore, the Investor’s amount at risk will be reduced below zero. The purchasers of the interest in Middle Tier assume the liability from the Bank loan guarantee. This relief from indebtedness has the effect of reducing the Investor’s at risk amount below zero. Without another increase to the Investor’s at risk amount, pursuant to § 465(e), the Investor will be subject to recapture income to the extent that zero exceeds the Investor’s amount at risk.
6. Under judicial doctrines (i.e., step transaction, economic substance, and substance over form), the income from the gain leg of Lower Tier’s straddle should be allocated to Investor. In the alternative, the benefit of the noneconomic deduction claimed upon the termination of the loss leg of the straddle (or alternatively, upon Middle Tier’s sale of its interest in Lower Tier) should be denied.
The primary purpose of the transaction is not for the parties to trade and invest in foreign currency straddles, but rather, the transaction is a substantially meaningless series of steps that manipulate tax rules to artificially create permanent noneconomic tax losses for the Investor. Various judicial doctrines may be applicable to Notice 2002-50 transactions. The arguments have been classified under the general doctrines of step transaction, economic substance and substance over form.23 However, even in those cases when it is appropriate to raise the argument, judicial doctrines should only be asserted as a secondary or tertiary argument, following any appropriate technical arguments.
A. Step Transaction Doctrine
In tax avoidance situations such as the Notice 2002-50 transaction described above, the substance of a transaction, rather than its form, governs the federal income tax treatment of the transaction. Commissioner v. Court Holding Co., 324 U.S. 331 (1945); Gregory v. Helvering, 293 U.S. 465 (1935). The question of the applicability of the substance over form doctrine and related judicial doctrines requires "a searching analysis of the facts to see whether the true substance of the transaction is different from its form or whether the form reflects what actually happened." Harris v. Commissioner, 61 T.C. 770, 783 (1974). See also, Gordon v. Commissioner, 85 T.C. 309, 327 (1985); Gaw v. Commissioner, T.C. Memo. 1995-531, aff’d without published opinion, 111 F.3d 962 (D.C. Cir. 1997). One such judicially created doctrine is the step transaction doctrine. Under the step transaction doctrine, a series of formally separate steps may be collapsed and treated as a single transaction if the steps are in substance integrated and focused toward a particular result.
The step transaction doctrine generally applies in cases where a
taxpayer seeks to get from point A to point D and does so stopping
in between at points B and C. The whole purpose of the
unnecessary stops is to achieve tax consequences differing from
those which a direct path from A to D would have produced. In
such a situation, courts are not bound by the twisted path taken by
the taxpayer, and the intervening stops may be disregarded or
rearranged. [Citation omitted.]
Smith v. Commissioner, 78 T.C. 350, 389 (1982). See also Andantech v. Commissioner, T.C. Memo. 2002-97, aff’d in part and remanded in part, 331 F.3d 972 (D.C. Cir. 2003); Long-Term Capital Holdings, et al. v. United States, 330 F. Supp. 2d 122 (D. Conn. 2004). Courts have applied three alternative tests in deciding whether the step transaction doctrine should be invoked in a particular situation: the binding commitment test, the end result test, and the interdependence test.
The binding commitment test is the most limited of the three tests. It looks to whether, at the time the first step was entered into, there was a binding commitment to undertake the later transactions. This is the most rigorous test of the step transaction doctrine. Commissioner v. Gordon, 13 F.3d 577, 583 (2d Cir. 1994). If there were a moment in the series of the transactions during which the parties were not under a binding obligation, the steps cannot be collapsed under this test. As a practical matter, the binding commitment test is seldom used. See, e.g., Andantech v. Commissioner, supra; Long-Term Capital, supra.
The end result test analyzes whether the formally separate steps merely constitute prearranged parts of a single transaction intended from the outset to reach a specific end result. This test relies on the parties’ intent at the time the transaction is structured. The intent the courts focus on is not whether the taxpayers intended to avoid taxes, but whether the parties intended from the outset to “to reach a particular result by structuring a series of transactions in a certain way.” Additionally, they focus on whether the intended result was actually achieved. True v. United States, 190 F.3d 1165, 1175 (10th Cir. 1999).
Finally, the interdependence test looks to whether the steps are so interdependent that the legal relations created by one step would have been fruitless without a completion of the later series of steps. See Penrod v. Commissioner, 88 T.C. 1415, 1428-1430 (1987). Steps are generally accorded independent significance if, standing alone, they were undertaken for valid and independent economic or business reasons. Green v. United States, 13 F.3d 577, 584 (2d Cir. 1994); Sec. Insurance Company v. United States, 702 F.2d 1234, 1246 - 7 (5th Cir. 1983).
The existence of economic substance or a valid nontax business purpose in a given transaction does not preclude the application of the step transaction doctrine.
“Events such as the actual payment of money, legal transfer of property, adjustment of company books, and execution of a contract all produce economic effects and accompany almost any business dealing. Thus we do not rely on the occurrence of these events alone to determine whether the step transaction doctrine applies. Likewise, a taxpayer may proffer some nontax business purpose for engaging in a series of transactional steps to accomplish a result he could have achieved by more direct means, but that business purpose by itself does not preclude application of the step transaction doctrine.” True v. United States, supra, at
1177. See also Associated Wholesale Grocers v. United States,
927 F.2d 1517 (1991); Long-Term Capital Holdings, supra, at 193.
The three tests are not mutually exclusive and the requirements of more than one test may be met in one transaction. Further, the circumstances of a transaction need only satisfy one of the tests for the step transaction to operate.
Associated Wholesale Grocers, Inc. v. United States, 927 F.2d 1517, 1527-1528 (10th Cir. 1991) (finding the end result test inappropriate but applying the step transaction doctrine using the interdependence test). And finally, even if the step transaction doctrine does not apply to an entire transaction, it may allow the Government to collapse a portion of a transaction, which may be sufficient to prevent the intended tax avoidance result. For a recent detailed discussion of the application of the three alternative tests in lease stripping transactions, see Andantech L.L.C. v. Commissioner, supra, and Long-Term Capital, supra.
The step transaction doctrine is particularly tailored to the examination of transactions involving a series of potentially interrelated steps for which the taxpayer seeks independent tax treatment. True v. United States, 190 F.3d at 1177. As a general rule, courts have held that in order to collapse a transaction, the Government must have a logically p lausible alternative explanation that accounts for all the results of the transaction. Del Commercial Props. Inc. v. Commissioner, 251 F.3d 210, 213-214 (D.C. Cir. 2001), aff’g T.C. Memo. 1999-411; Penrod v. Commissioner, supra, at 1428-1430; Tracinda Corp. v. Commissioner, 111 T.C. 315, 327 (1998). The explanation may combine steps; however, some courts have declined to apply the doctrine where the Government’s alternative explanation would invent new steps or simply reorder the actual steps taken by the parties. “’Useful as the step transaction doctrine may be . . . it cannot generate events which never took place just so an additional tax liability might be asserted.’” See Grove v. Commissioner, 490 F.2d 241, 247-248 (2d Cir. 1973), aff’g T.C. Memo. 1972-98 (quoting Sheppard v. United States, 176 Ct. Cl. 244; 361 F.2d 972, 978 (1966))); see also Esmark, Inc. & Affiliated Cos. v. Commissioner, 90 T.C. 171, 196 (1988), aff’d without
published opinion, 886 F.2d 1318 (7th Cir. 1989); But cf. Long-Term Capital,
supra, at 196 (footnote 94)(indicating that Esmark may be of limited applicability and distinguishable where all of the parties necessary to achieve the ultimate result are privy to the mutual understanding between the parties.)
The step transaction doctrine may be applicable to a transaction similar to the one under discussion here, depending, of course, on how the actual transaction is structured. For example, the end result test and/or the interdependence test of the step transaction doctrine could be used to disregard the Accommodating Party’s transitory ownership of Upper Tier, thereby allocating all the gains from the closing of the gain leg to the Investor. If it can be shown that Accommodating Party’s transitory ownership of Upper Tier added nothing of substance to the transaction (other than a transitory tax neutral party to which the gain could be allocated and thereby increase the basis of the interest in Lower Tier and Middle Tier), then the Accommodating Party’s transitory ownership of the partnership interest may arguably be disregarded. Collapsing the transaction and allocating both gains and losses to the Investor would match-up the gains and losses from the straddles and, therefore, prevent the Investor from being allocated a noneconomic loss.
Examiners should look at the facts on a case-by-case basis to determine if the step transaction doctrine would be applicable in their specific case.
B. Economic Substance
Discretion must be exercised in determining whether to utilize an econo mic substance argument24 in any case. The doctrine of economic substance should be considered, but only in cases where the facts show that the transaction at issue was primarily designed to generate the tax losses, with little if any possibility for profit, and that such was the expectation of all the parties. Specifically, in a Notice 2002-50 transaction, the argument should not be raised when taxpayers can objectively demonstrate that the structure of the transaction has the real potential to allow the partnerships to realize substantial economic returns and substantial pre-tax profits.
The wide variety of facts required to support its application should be developed at the Exam level before this argument can be made. The sources for these facts will be similar: documents obtained from taxpayers, the promoter and other third parties; interviews with the same; and an analysis of financial data and industry practices. Summons should be promptly issued whenever necessary.
In order to be respected, a transaction must have economic substance separate and distinct from the economic benefit achieved solely by tax reduction. See Frank Lyon Co. v. U.S., 435 U.S. 561, 583-84 (1977). A transaction has economic substance if it is rationally related to a useful nontax purpose that is plausible in light of the taxpayer’s conduct and economic situation and the transaction has a reasonable possibility of profit. See Rice’s Toyota World v. Commissioner, 752 F.2d 89 (4th Cir. 1993); Pasternak v. Commissioner, 990 F.2d 893 (6th Cir. 1993); ACM P’ship v. Commissioner, 157 F.3d 231 (3d Cir. 1998).
A transaction’s economic substance is determined by analyzing the subjective intent of the taxpayer entering into the transaction and the objective economic substance of the transaction. The various United States Courts of Appeals differ on whether the economic substance analysis requires the application of a twoprong test or is a facts and circumstances analysis regarding whether the transaction had a “practical economic effect,” taking into account both subjective and objective aspects of the transaction. Compare Rice’s Toyota World and Pasternak at 898 (applying the two-pronged test) with Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995)(applying the facts and circumstances analysis).25
See also Gilman v. Commissioner, 933 F.2d 143, 148 (2d Cir. 1991)(“The nature
of the economic substance analysis is flexible…“).
Moreover, among the United States Courts of Appeals that apply a two-prong test, there is disagreement as to whether the test is disjunctive or conjunctive. For example, the Fourth Circuit Court of Appeals applies the test disjunctively: a transaction will have economic substance if the taxpayer had either a nontax business purpose or the transaction had objective economic substance. Rice’s Toyota World at 91-92.26 However, the Sixth Circuit Court of Appeals and Eleventh Circuit Court of Appeals apply the test conjunctively: a transaction will have economic substance only if the taxpayer had both a nontax business purpose and the transaction had objective economic substance. See Pasternak at 898 and United Parcel Service of America v. Commissioner, 254 F.3d 1014, 1018 (11th Cir. 2001)(citing Kirchman v. Commissioner, 862 F.2d 1486, 1492 (11th Cir. 1989)).
II. Subjective Intent – Business Purpose
The subjective business purpose inquiry “examines whether the taxpayer was induced to commit capital for reasons relating only to tax considerations or whether a nontax motive, or legitimate profit motive, was involved.” Shriver v. Commissioner, 899 F.2d 724, 726 (8th Cir. 1990)(citing Rice’s Toyota World, supra). To determine that intent, the following credible evidence is considered: (i) whether a profit was possible;27 (ii) whether the taxpayer had a nontax business purpose;28 (iii) whether the taxpayer, or its advisors, considered or investigated the transaction, including market risk;29 (iv) whether the entities involved in the transaction were entities separate and apart from the taxpayer doing legitimate business before and after the transaction;30 (v) whether all the purported transactions were engaged in at arm’s-length with the parties doing what the parties intended to do;31 and (vi) whether the transaction was marketed as a tax shelter in which the purported tax benefit significantly exceeded the taxpayer’s actual investment.32
Taxpayers engaging in a Notice 2002-50 transaction will likely assert a profit objective as the nontax business purpose. The lack of economic substance argument should be asserted only in transactions where it can be established that the transaction did not have a realistic pre-tax profit potential. Thus, evidence should be sought to demonstrate that the taxpayer and the promoter primarily planned the transaction for tax purposes.
Such evidence should include items such as the following: (i) documents or other evidence that the Notice 2002-50 transactions were sold as tax shelters with limited consideration of the underlying economics of the transaction; (ii) evidence that the Investor, or Investor’s advisors, did not investigate the profit potential and the market risk prior to entering into the Notice 2002-50 transaction; (iii) evidence that the independent parts making up the Notice 2002-50 transaction were not entered into at arm’s length or that the partnership or partners did not act as independent entities while engaging in the Notice 2002-50 transaction, and (iv) evidence that a prudent investor would have chosen a direct investment rather than choosing to indirectly invest through tiered partnerships.33
A direct source of such evidence regarding the taxpayer’s contention of a nontax business purpose is correspondence between the Promoter to the Investor, including, but not limited to, offering memos, letters identifying tax goals, emails and in-house communications at the offices of both the promoter and the accommodating parties. Written correspondence is the best evidence, but evidence of oral communications regarding tax goals is also useful. Indirect sources of the same include correlations between tax losses generated and tax losses requested, and between the Investor's income and the tax losses generated, particularly, if it can be shown that the income to be sheltered was attributable to an unusual windfall, like the liquidation of stock options, or sale of a business.34 Demonstrations of similarities of the nature and extent of tax losses acquired by other clients of the Promoter in this shelter (the "universe")
can be very important as well.
III. Objective Economic Substance
Courts have used different measures to determine whether a transaction has objective economic substance. These measures include whether there is a potential for profit, and whether the transaction otherwise altered the economic relationships of the parties.
This determination is generally made by reference to whether there was a reasonable or realistic possibility of profit.35 See e.g., Gilman v. Commissioner, 933 F.2d 143, 146 (2d Cir. 1991)(determine economic substance based on “if the transaction offers a reasonable opportunity for economic profit, that is, profit exclusive of tax benefits.”) The amount of profit potential necessary to demonstrate objective economic substance may vary by jurisdiction.36 However, a transaction is not required to result in a profit and similar transactions do not need to be profitable in order for the taxpayer’s transaction to have economic substance. See Cherin v. Commissioner, 89 T.C. 986, 994 (1987). See also Abramson v. Commissioner, 86 T.C. 360 (1986)(holding that potential for profit is found when a transaction is carefully conceived and planned in accordance with standards applicable to a particular industry, so that judged by those standards the hypothetical reasonable businessman would make the investment).
To determine whether a transaction has a realistic possibility of profit, courts have used both a cash flow analysis and a net present value analysis. Compare James v. Commissioner, 899 F.2d 905 (10th Cir. 1990); Casebeer v. Commissioner, 909 F.2d 1360 (9th Cir. 1990); Winn-Dixie, Inc. v. Commissioner, 113 T.C. 254 (1999) aff’d in part Winn-Dixie Stores, Inc. v. Commissioner, 254 F.3d 1313 (11th Cir. 2001) with ACM P’Ship v. Commissioner, T.C. Memo 1997-115 aff’d in part and rev’d in part 157 F.3d 231 (3d Cir. 1998); Soriano v. Commissioner, 90 T.C. 44, 54-57 (1988); Walford v. Commissioner, T.C. Memo 2003-296. although it is unclear whether a court would find that a transaction lacked economic substance if it had a negative net present value but a positive cash flow potential, courts that have utilized the cash flow method have appeared willing to find objective economic substance in transactions with a positive cash flow potential. See e.g. Casebeer v. Commissioner, 909 F.2d 1360 (9th Cir. 1990). In addition, it does not appear that any court has specifically repudiated the cash flow method in favor of the net present value method. See e.g. ACM P’Ship v. Commissioner, T.C. Memo 1997-115 aff’d in part and rev’d in part 157 F.3d 231, 259 (3d Cir. 1998).37 Because it is unclear whether the net present value method or the cash flow method would be more acceptable, a Notice 2002-50 transaction under review should be analyzed using both the cash flow method and the net present value method.38 See also Rothschild v. U.S., 186 Ct. Cl. 709 (Ct. Cl. 1969); Cohen v. Commissioner, 44 B.T.A. 709 (1941).39 Generally speaking, a potential for profit is present when a transaction is carefully conceived and planned in accordance with standards applicable to a particular industry, so that judged by those standards the hypothetical reasonable businessman would participate in the investment.40
In developing this prong of the argument, it is not enough to show that the transaction was not profitable or was only nominally profitable. The facts must support a conclusion that the taxpayer could not profit from the transaction or, at best, could realize only a nominal profit. All direct and indirect fees and costs paid by the taxpayer, any offsetting positions related to the overall transaction, and any indemnity agreements between the accommodating parties and the promoter should be determined. Evidence of circular flows of money and the invalidity of any loans must be fully developed.
Certain courts have been willing to recognize the economic substance of a transaction when, in lieu of a reasonable possibility of profit, the taxpayer establishes that the transaction altered the economic relationships of the parties. See Knetsch v. United States, 364 U.S. 361 (1960). For example, courts have found that objective economic substance existed where the transaction created a genuine obligation enforceable by an unrelated party. See United Parcel Services, supra, at 1018; Sacks, supra, at 988-990 (the use of recourse debt created a genuine obligation for the taxpayer and this illustrated a genuine economic effect); Black and Decker Corp. v. U.S., No. WDQ-02-2070 (D. Md. Aug. 3, 2004) (“The court may not ignore a transaction that has economic substance, even if the motive for the transaction is to avoid taxes.”)(citing Rice’s Toyota, supra, at 96).41 However, it does not appear that this secondary standard has been universally accepted. See, for example, Gilman v. Commissioner, 933 F.2d 143, 147-48 (2d Cir. 1991) in which the court rejected the taxpayer’s argument that the relevant standard for determining economic
substance is whether the transaction may cause any change in the economic positions of the parties (other than tax savings) and that where a transaction changes the beneficial and economic rights of the parties it cannot be a sham. See also Long Term Capital Holdings’ v. United States, 330 F. Supp. 2d 122 (D. Conn. 2004) quoting Gilman v. Commissioner.
In determining in which cases an economic substance argument should be advanced, it would be helpful to prove that the Promoter controlled all critical phases of the underlying transaction, from the formation of the necessary entities, through coordination with the Accommodating Party, to the timing and structure of the trades themselves. Direct sources of such evidence will be primarily from the transactional documents as well as correspondence from, and interviews with, all the parties. The scope of the Promoter's control must be shown to be broader than in otherwise legitimate investments. To the extent that any witness provides some rationalization for having surrendered control of virtually all critical aspects of the transaction, that should be memorialized.
If it is determined that the transaction as a whole lacks economic substance, the noneconomic deduction claimed by the Investor should be disallowed.
IV. Other Considerations
If it is determined that it is appropriate to assert economic substance with respect to a Notice 2002-50 transaction, consideration must be given to appellate venue. As discussed above, the various Courts of Appeals apply different standards in determining whether a transaction lacks economic substance. Prior to asserting economic substance, seek Counsel assistance to determine the appropriate standard. Moreover, although certain Courts of Appeals might view a nominally profitable transaction as lacking economic substance, based on the taxpayer’s subjective intent of tax avoidance with no other nontax purpose, an economic substance argument generally should not be asserted in such cases because it will be extremely difficult to establish that the taxpayer lacked the requisite pretax profit motive.
C. Substance Over Form Doctrine
Transactions that literally comply with the language of the Code but produce results other than what the Code and regulations intend are not given effect. In Gregory v. Helvering, 293 U.S. 465, 470 (1935), the Supreme Court found that even though the transaction did comply with the Code, “the transaction upon its face lies outside the plain intent of the statute.” Therefore, the Court found that to give the transaction effect would be to “exalt artifice above reality and to deprive the statutory provision in question of all serious purpose.” Id. In Knetsch v. United States, 364 U.S. 361 (1960), the Supreme Court once again found a transaction abusive, even though the transaction met every literal requirement of the Code. The Court stated that “there was nothing of substance to be realized by Knetsch from this transaction beyond a tax deduction.” Id. at 366.
Even if it is found that the Notice 2002-50 transaction described in this paper literally complies with the Code and regulations, the transaction produces results other than what the Code and regulations intended in that gain from the gain leg and loss from the loss leg of a straddle are separated and the tax neutral Accommodating Party is allocated the gain and the Investor is allocated the loss, but neither party has any economic gain or loss from the transaction. The only consequence is that the Investor claims a loss for tax purposes far in excess of its costs. While the form of this transaction purports to show that the Accommodating Party is a partner of the Partnership, the Accommodating Party does not enjoy a benefit commensurate with its purported partnership interest. For example, the Accommodating Party is allocated gain from the closing of the gain leg, which is never intended to be distributed to the Accommodating Party. Moreover, because the Accommodating Party’s sale of its interest in Upper Tier for approximately the amount of Accommodating Party’s investment is preplanned and certain, there is nothing of substance to be realized in this abusive transaction aside from substantial tax savings for the Investor.
A transaction that is entered into solely for the purpose of tax reduction and that has no economic or commercial objective to support the transaction is a sham and is without effect for federal income tax purposes. Estate of Franklin v. Commissioner, 64 T.C. 752 (1975); Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89 (4th Cir. 1985); Frank Lyon Co. v. United States, 435 U.S. 561 (1978); Nicole Rose Corp. v. Commissioner, 117 T.C. 328 (2001). When a transaction is treated as a sham, the form of the transaction is disregarded and the proper tax treatment of the transaction must be determined. Because the Notice 2002-50 transaction is a sham, the form of the transaction should be disregarded and the Investor should be treated as owning the Upper Tier
partnership interest from the outset of the transaction for purposes of allocating
both the gain and the loss from the termination of the straddle positions.
Accordingly, the Investor should be required to include 99% of the gain from the
gain leg into income when the leg is terminated. This has the effect of matching
the income from the gain leg with the losses from the loss leg and reflecting the
true economics of the transaction.
7. Legal, promoter fees, and “out of pocket expenses” should be disallowed.
Fees are not reported in a consistent manner by investors who engage in Notice 2002-50 transactions. For example, in some cases fees are paid to the Promoter through the indirect purchase of interests in limited liability companies which hold investments purchased from the Promoter or an affiliate at inflated prices.Losses flow through to the Taxpayer as the overvalued investments are written off as worthless. In other cases, the Taxpayer pays a fee to the Promoter and the fee is deducted on Schedule A of Form 1040.
Although, depending on the context, the issue may arise under several different Code provisions, fees and other out-of-pocket expenses incurred in connection with a Notice 2002-50 transaction are generally not deductible. Such expenses are commonly disallowed in the shelter context under § 212(2), for example—which, like § 162 and § 165(c)(2), discussed above, requires a primary nontax profit motive. See Agro Science Co. v. Commissioner, 934 F.2d 573, 576 (5th Cir. 1991), cert. denied, 502 U.S. 907 (1991); Simon v. Commissioner, 830 F.2d 499, 500-501 (3d Cir.1987). Similarly, the courts have repeatedly denied a deduction for a "theft loss" for cash out-of-pocket expenses that are paid to invest in shelter transactions. See Viehweg v. Commissioner, 90 T.C. 1248 (1988), cert. denied, 502 U.S. 819 (1991); Marine v. Commissioner, 92 T.C. 958 (1989), aff’d 921 F.2d 280 (9th Cir. 1991); Rev. Rul. 70-333, 1970-1 C.B. 38.42
Depending on the context, other provisions, such as §§ 162, 183, 195, 263, and 709, may come into play to disallow a deduction. See, e.g., Surloff v. Commissioner, 81 T.C. 210 (1983); Flowers v. Commissioner, 80 T.C. 914 (1983) (“Offeree representative” fees and costs of tax opinions prepared to promote sale of tax shelter not deductible under §§ 162, 212 and 709.43
Under these authorities, in the case of a Notice 2002-50 transaction, generally the Investor who concedes the case should agree to the disallowance of all losses and expenses associated with the investment, including any loss on the investment itself, losses resulting from disposition of distributed assets, any deductions for promoter fees, and any deductions for legal fees. However, certain fees may be deductible or amortizable, including legal fees paid to an attorney or accountant wholly independent from the promoter to analyze the transaction; fees paid to establish partnerships or other entities that are actually used in substantial business activities unrelated to the Notice 2002-50 transaction (subject to applicable capitalization rules); or reasonable fees paid to prepare the tax returns reporting the transactions. In some circumstances, § 183 may allow the deduction of losses and expenses, even without a profit motive, to the extent of gross income, if any, from the underlying transaction. Note that when fees incurred by, or passed through to, an individual investor are otherwise deductible, they are itemized deductions, subject to the limits provided by §§ 67 and 68.
8. The § 6662 accuracy-related penalty provisions apply to Notice 2002-50 transactions.
Section 6662 imposes an accuracy-related penalty in an amount equal to 20 percent of the portion of an underpayment attributable to, among other things: (1) negligence or disregard of rules or regulations, (2) any substantial understatement of income tax, and (3) any substantial valuation misstatement. There is no stacking of the accuracy-related penalty components. § 1.6662-2(c). Thus, the maximum accuracy-related penalty imposed on any portion of an underpayment is 20 percent (40 percent in the case of a gross valuation misstatement), even if that portion of the underpayment is attributable to more than one type of misconduct (e.g., negligence and substantial valuation misstatement). See D.H.L. Corp. v. Commissioner, T.C. Memo. 1998-461, aff'd in part and rev'd on other grounds, remanded by, 285 F.3d 1210 (9th Cir. 2002) [The Service alternatively determined that either the 40-percent accuracy-related penalty attributable to a gross valuation misstatement penalty under I.R.C. § 6662(h) or the 20-percent accuracy-related penalty attributable to negligence was
A. Negligence or Disregard of the Rules or Regulations
Negligence includes any failure to make a reasonable attempt to comply with the provisions of the Code or to exercise ordinary and reasonable care in the preparation of a tax return. See I.R.C. § 6662(c) and § 1.6662-3(b)(1). Negligence also includes the failure to do what a reasonable and ordinarily prudent person would do under the same circumstances. See Marcello v. Commissioner, 380 F.2d 499, 506 (5th Cir. 1967), aff'g 43 T.C. 168 (1964). Negligence is strongly indicated where a taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction, credit or exclusion on a return that would seem to a reasonable and prudent person to be "too good to be true" under the circumstances. Section 1.6662-3(b)(1)(ii). See also
Pasternak v. Commissioner, 990 F.2d 893 (6th Cir. 1993) (penalty for negligence was imposed on underpayment resulting from transaction that lacked economic substance).
In the Notice 2002-50 transaction, Investor reported losses that lacked economic substance and would have seemed, to a reasonable and prudent person, to be "too good to be true." As such, an accuracy-related penalty attributable to the negligent disregard of rules or regulations is appropriate.
B. Substantial Understatement of Income Tax
A substantial understatement of income tax exists for a taxable year if the amount of understatement exceeds the greater of 10 percent of the tax required to be shown on the return or $5,000 ($10,000 for a corporation, other than an S corporation or a personal holding company). I.R.C. § 6662(d)(1).44 In the case of any item of a taxpayer other than a corporation which is attributable to a tax shelter, understatements are generally reduced by the portion of the understatement attributable to: (1) the tax treatment of items for which there was substantial authority for such treatment, and (2) the taxpayer reasonably believed that the tax treatment of the item was more likely than not the proper treatment. I.R.C. § 6662(d)(2)(C)(i).45 For purposes of I.R.C. § 6662(d)(2)(C), a tax shelter is a partnership or other entity, an investment plan or arrangement, or other plan or arrangement where a significant purpose of such partnership, entity, plan or arrangement is the avoidance or evasion of federal income tax. I.R.C. § 6662(d)(2)(C)(iii). A taxpayer is considered to have reasonably believed that the tax treatment of an item is more likely than not the proper tax treatment if (1) the taxpayer analyzes the pertinent facts and authorities, and based on that analysis reasonably concludes, in good faith, that there is a greater than 50 percent likelihood that the tax treatment of the item will be upheld if the Service challenges it, or (2) the taxpayer reasonably relies, in good faith, on the opinion of a professional tax advisor, which clearly states (based on the advisor's analysis of the pertinent facts and authorities) that the advisor concludes there is a greater than 50 percent likelihood the tax treatment of the item will be upheld if the Service challenges it. Section 1.6662-4(g)(4).
The arrangement described in Notice 2002-50 has as a significant purpose the avoidance or evasion of federal tax and is a “tax shelter” for purposes I.R.C. § 6662(d). In these transactions, the understatement attributable to the disallowance of the losses claimed exceeds the greater of 10 percent of the tax required to be shown on the return or $5,000 ($10,000 for a corporation, other than an S corporation or a personal holding company). Therefore, an accuracy-related penalty attributable to a substantial understatement of income tax is appropriate.
C. Substantial Valuation Misstatement
For the accuracy-related penalty attributable to a substantial valuation misstatement to apply, the portion of the underpayment attributable to a substantial valuation misstatement must exceed $5,000 ($10,000 for a corporation, other than an S corporation or a personal holding company). A substantial valuation misstatement exists if the value or adjusted basis of any property claimed on a return is 200 percent or more of the amount determined to be the correct amount of such value or adjusted basis. I.R.C. § 6662(e)(1)(A). If the value or adjusted basis of any property claimed on a return is 400 percent or more of the amount determined to be the correct
amount of such value or adjusted basis, the valuation misstatement constitutes a "gross valuation misstatement." I.R.C. § 6662(h)(2)(A). If there is a gross valuation misstatement, then the 20 percent penalty under I.R.C. § 6662(a) is increased to 40 percent. I.R.C. § 6662(h)(1).
One of the circumstances in which a valuation misstatement may exist is when a taxpayer's claimed basis is disallowed for lack of economic substance. Gilman v. Commissioner, 933 F.2d 143 (2d Cir. 1991) (applying former I.R.C. § 6659). The Notice 2002-50 transaction relies on a series of predetermined steps to strip the gain leg of a foreign currency straddle and artificially increase the adjusted basis of Upper Tier’s interest in Middle Tier, and Middle Tier’s interest in Lower Tier. If the claimed adjusted basis of a partnership interest is 200 percent or more of the correct amount, then a substantial valuation misstatement exists; if the adjusted basis of a partnership interest is 400 percent or more of the correct amount, then a gross valuation misstatement exists.
In the transaction, stripping the gain leg of the straddle leads to noneconomic increases in basis which exceed 400 percent. Middle Tier’s overstated basis in its interest in Lower Tier enables noneconomic losses to flow through to the Investor when the loss leg of the straddle is subsequently closed. Alternatively, it creates a noneconomic loss when Middle Tier sells its interest in Lower Tier. Upper Tier also gets a noneconomic increase in basis of its interest in Middle Tier. When Upper Tier sells its Middle Tier interest to Investor, a noneconomic loss is created and allocated to the Investor, which Investor uses to offset gain upon his disposition of Middle Tier. Thus, a gross valuation misstatement, within the meaning of section 6662(h)(2)(A), exists due to the overstatement of partnership basis.
Even if an overstatement of partnership basis is not determined to be the source of the loss disallowance, the 40 percent gross valuation related penalty may still be appropriate because the entire transaction lacks economic substance. In Zfass v. Commissioner, T.C. Memo. 1996-167, aff’d, 118 F.3d 184 (4th Cir. 1997), the court of appeals held that when an underpayment stems from deductions that are disallowed due to a lack of economic substance, the deficiency is attributable to an overstatement of value and is subject to the valuation overstatement penalty. See Massengill v. Commissioner, 876 F.2d 616, 619-20 (8th Cir. 1989); Illes v.
Commissioner, 982 F.2d 163, 167 (6th Cir. 1992); Gilman v. Commissioner,
933 F.2d at151. In Zfass, the appellate court agreed with the Tax Court’s conclusion that when a transaction lacks economic substance, the correct basis is zero and any amount claimed is a valuation overstatement.
In addition to the partnership bases, Investor grossly overvalued his indirect interest in the VC Fund. Only a portion (typically less than 10%) of the amount paid for the VC Fund interest was attributable to its value. The remainder of the purchase price was attributable to fees. The VC Fund purchase was structured this way to hide fees from the Service and to allow Investor to claim Schedule D losses as the VC Fund’s assets became worthless. As such, the interest in the VC funds is grossly overvalued, and an accuracy-related penalty attributable a gross valuation misstatement is appropriate, unless the reasonable cause and good faith exception, described below, applies.
D. Reasonable Cause Exception
Section 6664 provides an exception to the imposition of the accuracy-related penalty if the taxpayer shows that there was reasonable cause for the underpayment and that the taxpayer acted in good faith. See I.R.C. § 6664(c). Whether a taxpayer acted with reasonable cause and in good faith is a factual question. § 1.6664- 4(b)(1)(C)(1)(i), (e)(1). Generally, the most important factor is the extent to which the taxpayer exercised ordinary business care and prudence in attempting to assess his or her proper tax liability. See Collins v. Commissioner, 857 F.2d 1383 (9th Cir. 1988)
(taxpayers did not act reasonably when they failed to investigate and simply relied on offering circulars and the advice of their accountant, who had no first-hand knowledge about the venture); Long Term Capital Holdings v. United States, 330 F.Supp.2d 122 (D. Conn. 2004) (taxpayer could not rely on advice that it did not receive before it filed its return).
The issue of whether the accuracy-related penalty is imposed on the underpayment resulting from the transaction must be determined upon the specific facts and circumstances of each case. Generally, the Investor’s tax opinion will not protect him from penalties if the tax advisor is a co-promoter of the transaction, or receives fees from the other promoters for its assistance in the transaction. See Neonatology Associates, P.A. v. Commissioner, 299 F.3d 221, 233-34 (3d Cir. 2002). These arrangements appear to be typical in these transactions. The Investor generally knew or should have known of this arrangement and thus generally knew or should have known that the opinion has not been rendered by an independent advisor. Furthermore, the Investor’s factual representations to the drafter of the opinion may be inaccurate. These factual flaws may include representations that the Investor performed meaningful due diligence before committing to the transaction, that the Investor had a reasonable expectation of pretax profit, that the purchase price paid by the Investor for Upper Tier was fair market value as determined based on the fair market value of the underlying assets, that Investor had a substantial business purpose for engaging in the transaction, or that Investor had substantial and valid business reasons for each of the transactions involving the acquisition and disposition of each of Upper Tier’s assets, including Middle Tier. In these situations, the Investor would not be protected from penalties under the reasonable cause and good faith exception in I.R.C. § 6664(c).
9. The § 6662A accuracy-related penalty provisions apply to Notice 2002-50
Section 6662A establishes a 20 percent accuracy-related penalty for any reportable transaction understatement, subject to a reasonable cause exception. The penalty is increased to 30 percent if the taxpayer does not adequately disclose relevant facts regarding a reportable transaction. The penalty applies to taxable years ending after October 22, 2004. Section 6664(d) provides a heightened reasonable cause exception for this penalty. To establish reasonable cause and good faith for purposes of avoiding the § 6662A penalty, the following requirements must be satisfied: (1) the taxpayer must have adequately disclosed the transaction in accordance with § 6011; (2) there is or was substantial authority for the tax treatment of the item; and (3) the taxpayer reasonably believed that the tax treatment was more likely than not the proper treatment. See also Notice 2005-12, 2005-7 I.R.B. 494. The taxpayer may not rely on a “disqualified opinion” or on the opinion of a “disqualified tax advisor” to establish reasonable belief. § 6664(d)(3)(B).
Section 6662A does not apply to any portion of an understatement on which the § 6663 fraud penalty or the § 6662(h) accuracy-related penalty for a gross valuation misstatement is imposed. Section 6662(e) (substantial valuation misstatement) does not apply to any portion of an understatement on which a penalty under § 6662A is imposed.
With respect to taxable years ending after October 22, 2004, consideration should be given as to whether the § 6662A penalty applies. Scenarios in which this issue may arise include returns filed for the 2004 or later tax years which claim carryforwards of losses from earlier years, as well as losses from the write off or worthlessness of venture capital fund assets.
1 The transaction can be structured so that the Accommodating Party is not a tax neutral entity.
2 The dollar figures used in this paper are for illustration purposes only and therefore, do not necessarily correspond to actual transactions either in amount or relation to each other.
3 The positions are not necessarily limited to foreign currency forward contracts. In addition, the straddles use positions generally denominated in minor currencies in order to avoid the application of the mark to market rules of § 1256.
4 § 1092(c)(3)(A).
5 Under § 1092, the loss from the termination of the loss leg cannot be recognized until the offsetting gain from the termination of the gain leg has been recognized. There is no prohibition or limitation regarding recognition of the gain from the closing of the gain position before the closing of the loss position. The Accommodating Party’s role in the transaction is to be allocated the gain from the termination of the gain leg (without tax consequences) so that the Investor can ultimately be allocated the loss leg of the straddle.
6 Generally, the simultaneous closing of the gain leg and the reestablishment of the straddle is known as a “switch” transaction. The “switch position” is the replacement leg that reestablishes the straddle.
7 For purposes of the example, the amount of the loss equals the amount of the gain. In reality, the amount of the loss would be slightly different than the amount of the gain leg previously closed.
8 In some situations, no Lower Tier is formed, and instead, a two tiered structure is set up.
9 Various documents may refer to this instrument as “OTC Deposit Annex” or “Deposit.”
10 The cash proceeds from the closing of the gain leg are never distributed to any partner.
11 For the sake of computational simplicity, 100% rather than 99%, of all gains, losses, and liabilities will be allocated to the 99% partners.
12 These instruments may be deep in the money currency options or certificate of deposits.
13 The US dollar equivalent of the borrowed amounts under the loan approximates the amount of the Investor’s desired tax loss. Further, the cash never leaves the possession of the Bank.
14 The costless employs the use of a pair of options entered into between Bank and Middle Tier.
15 Upper Tier is the initial guarantor, and later, when Investor purchases Upper Tier’s interest in Middle Tier, Upper Tier is released from the guarantee and Investor guarantees the loan component of the structured loan transaction.
16 If Middle Tier had made a § 754 election when Upper Tier sold its interest in Middle Tier to Investor, the Investor’s share of its basis in its interest in Lower Tier would have been adjusted, and therefore, the sale by Middle Tier of its interest in Lower Tier would not have generated a loss for the Investor. Alternatively, the Investor’s share of Middle Tier’s basis in Lower Tier would have been too low to report the loss generated by Lower Tier’s closure of the loss leg of its straddle.
17 In some transactions, the Accommodating Party is an employee of Promoter in which case, in lieu of a fee, a “discretionary bonus” is paid.
18 In instances in which the Promoter acquired the warrants, there is an intermediate step in which Promoter sells the warrants to Co-Promoter at an inflated price.
19 Other variations involve Investor directly purchasing interests in venture capital funds and Investor directly purchasing the LLC holding the warrants. In all cases, the Investors pay inflated prices.
20 The fees were structured as the purchase of an asset in order to enhance the Investor’s tax position with respect to the profit potential of the transaction. In addition, this structure allowed the Investor to circumvent the Schedule A limitations associated with miscellaneous deductions.
21 If the entity claiming the § 165 deduction is subject to the entity-level procedures under TEFRA, the issue of the entity’s profit intent under § 165(c)(2) should be raised in a TEFRA proceeding.
22 If the Notice 2002-50 transaction in question occurs over a 1 year period, the inapplicability of this one factor does not negate other § 465 arguments.
23 Note that some courts may categorize the doctrines in a different manner.
24 This doctrine is also referred to by the courts as the “sham transaction” or “sham in substance” doctrine. For purposes of this document, the doctrine is referred to as the “economic substance” doctrine.
25 In the Third Circuit, in determining “whether the taxpayer’s transactions had sufficient economic substance to be respected for tax purposes”, the analysis “turns on both the ‘objective economic substance of the transactions’ and the ‘subjective business motivation’ behind them.” ACM Partnership v. Commissioner, 157 F.3d 231, 247 (3d Cir. 1998), aff’g in part and rev'g in part, T.C. Memo. 1997-115, cert. denied, 526 U.S. 1017 (1999)(citing Casebeer v. Commissioner, 909 F.2d 1360, 1363 (9th Cir. 1990) [other citations omitted]. See also In re: CM Holdings, Inc., 301 F.3d 96, 102 (3rd Cir. 2002). However, this analysis does not require a rigid two-step analysis. See id. Similarly, in the Tenth Circuit, although the court recognized the two-prong test from Rice’s Toyota, the court held “The better approach, in our view, holds that ‘the consideration of business purpose and economic substance are simply more precise factors to consider in the [determination of] whether the transaction had any practical economic effects other than the creation of income tax losses.” James v. Commissioner, 899 F.2d 905, 908-9 (10th Cir. 1990)(citation omitted).
26 The Eighth Circuit appears to apply the disjunctive test provided in Rice’s Toyota, but indicates that a rigid two-part test may not be required. Shriver v. Commissioner, 899 F.2d 724, 725-8 (8th Cir. 1990). The DC Circuit and Federal Circuit apply the disjunctive test. See Horn v. Commissioner, 968 F.2d 1229, 1236 (DC Cir. 1992); Drobny v. U.S., 86 F.3d 1174 (Fed. Cir. 1996)(unpublished opinion). It is unclear whether the Second Circuit applies the test disjunctively or under a facts and circumstances analysis. Compare Gilman, supra, at 148 (citing Jacobson v. Commissioner, 915 F.2d 832, 837 (2d Cir. 1990)(additional citations omitted))(“A transaction is a sham if it is fictitious or if it has no business purpose or economic effect.”) with TIFD III-E Inc. v. U.S., 2004 WL 2471581, 12(D.Conn. Nov 01, 2004) (“The decisions in this circuit are not perfectly explicit on the subject. Recently, for example, Judge Arterton adopted the more flexible standard, but acknowledged some potentially contrary, or at least ambiguous, language in Gilman. Long-Term Capital Holdings v. United States, 330 F. Supp. 2d 122, 137 n.68 (D. Conn. 2004). That ambiguity, however, does not affect the decision of this case. As I will explain, under either reading I would conclude that the Castle Harbour transaction was not a ‘sham.’ The transaction had both a nontax economic effect and a nontax business motivation, satisfying both tests and requiring that it be given effect under any reading of the law.”) Similarly, in Compaq Computer Corp. v. Commissioner, 277 F.3d 778 (5th Cir. 2001), the Fifth Circuit considered both the standard in Rice’s Toyota World (that there be no business purpose and no reasonable possibility of a profit) [emphasis added] and the test in ACM (that these are mere factors in determining economic substance) and declined to accept one standard over the other.
27 See Goldstein v. Commissioner, 364, F.2d 734 (2d Cir. 1966); Sacks v. Commissioner, 69 F.3d 982 (9th Cir. 1995); Winn-Dixie, Inc. v. Commissioner, 113 T.C. 254 (1999) aff’d in part Winn-Dixie Stores, Inc. v. Commissioner, 254 F.3d 1313 (11th Cir. 2001), cert. denied, 535 U.S. 986 (2002).
28 See Rose v. Commissioner, 868 F.2d 851 (6th Cir. 1989); Casebeer v. Commissioner, 909 F.2d 1360 (9th Cir 1990); Newman v. Commissioner, 894 F.2d 560, 563 (2d Cir. 1990); Winn-Dixie, Inc. v. Commissioner, 113 T.C. 254 (1999) aff’d in part Winn-Dixie Stores, Inc. v. Commissioner, 254 F.3d 1313 (11th Cir. 2001); Salina Partnership v. Commissioner, T.C. Memo 2000-352 (2000); CMA Consolidated, Inc. v. Commissioner, T.C. Memo. 2005-16 (2005).
29 See Rose v. Commissioner, 868 F.2d 851 (6th Cir. 1989); Kirchman v. Commissioner, 862 F.2d 1486 (11th Cir. 1989); Casebeer v. Commissioner, 909 F.2d 1360 (9th Cir 1990); Salina Partnership v. Commissioner, T.C. Memo 2000-352 (2000); Nicole Rose Corp. v. Commissioner, 117 TC 328 (2001).
30 See IES Industries Inc. v. Commissioner, 253 F.3d 350, 355 - 56 (8th Cir. 2001).
31 See Rose v. Commissioner, 868 F.2d 851 (6th Cir. 1989); Kirchman v. Commissioner, 862 F.2d 1486 (11th Cir. 1989); James v. Commissioner, 899 F.2d 905 (10th Cir. 1990); Pasternak v. Commissioner, 990 F.2d 893 (6th Cir. 1993); IES Industries Inc. v. Commissioner, 253 F.3d 350, 356 (8th Cir. 2001).
32 See Pasternak v. Commissioner, 990 F.2d 893 (6th Cir. 1993).
33 In Long Term Capital Holdings v. United States, 330 F. Supp. 2d 122 at 165 (D. Conn. 2004) the District Court explained that evidence that the prudent economic actor would have invested directly in the portfolio rather than indirectly through OTC because direct investment “permitted much greater participation in the reasonably expected profit from the investment” was relevant in determining whether the transaction had economic substance.
34 It is not necessary that the taxpayer have an unusual income event. A taxpayer who generates substantial ordinary income can use this transaction to generate offsetting losses. Moreover, the flexibility afforded by this transaction can allow a taxpayer to control the timing of the recognition of losses over more than one taxable year to accommodate the uncertainties in the timing of income.
35 The appropriate inquiry is not whether the taxpayer made a profit but whether there was an objective reasonable possibility that the taxpayer could earn a pre-tax profit from the transaction.
36 In assessing the role of profit in determining whether a transaction has economic substance, the Third Circuit has held, based on Sheldon, that “a prospect of a nominal, incidental pre-tax profit which would not support a finding that the transaction was designed to serve a nontax profit motive.” ACM, supra, at 258 (citing Sheldon v. Commissioner, 94 T.C. 738, 768 (1990)). In making this determination, the court took into account transaction costs. Id. at 257. In this evaluation, some courts have considered a small chance of a large payoff to support a finding of economic substance. See Jacobson v. Commissioner, 915 F.2d 832 (2d Cir. 1990)(citing §1.183-2(a) (1990)).
37 In ACM, the Appellate Court held that it was not reversible error for the Tax Court to reduce the income expected to be generated to its net present value, but did not hold that a net present value analysis was the only appropriate manner for determining the profit potential of the particular transaction so long as the method adopted serves as an accurate gauge of the reasonably expected economic consequences of a transaction.
38 The present value of any asset is equal to the expected future cash flows that the holder of the asset will receive, discounted at the rate of return offered by comparable investment alternatives. Future cash flows are discounted to take into account the time value of money and risk. The net present value of an investment is calculated by subtracting the cost of the investment from its present value. An investment is considered profitable under an out-of-pocket cash flow analysis if the cash flows obtained from holding the investment exceed the costs of making the investment.
The out-of-pocket profit calculation does not take into account the time value of money or the risk of future cash flows.
39 Cf. Commissioner v. Groetzinger, 480 U.S. 23 (1987). In Groetzinger, the United States Supreme Court recognized that gambling may be a trade or business for purposes of § 162.
40 Cherin v. Commissioner, 89 T.C. 986,994 (1987).
41 The court in Coltec Industries, Inc. v. U.S., No. 01-072T (Ct. Cl. October 29, 2004), cites Black and Decker, supra, (and other cases) for the premise that satisfaction of the tax avoidance and business purpose tests of section 357(b) means that the economic substance test is satisfied. Coltec Industries, Inc. (citing Black and Decker, supra, at *6) [citations omitted].
42 In Nichols v. Commissioner, 43 T.C. 842 (1965), nonacq., 1970-1 C.B. xvii, the Tax Court held that a theft loss was allowable where the shelter promoter fraudulently failed to acquire bonds and perform other promised actions. Nichols is easily distinguishable from a Notice 2002-50 transaction, in which the shelter transactions are performed as promised and the only "loss" is the Investor's failure to achieve the desired tax consequences.
43 Section 183, technically an allowance provision and primarily directed at "hobby losses," is also commonly cited in connection with the disallowance of tax shelter losses, expenses, and other deductions, for lack of a profit motive. See, e.g., Brannen; Hildebrand v. Commissioner, 28 F.3d 1024 (10th Cir. 1994). To determine whether an activity is engaged in "for profit," the § 183 regulations list nine factors taken from case law. § 1.183-2(b). To cover all bases, however, the Service should be prepared to make an alternative analysis of the Investor's profit motive under § 1.183-2(b), bearing in mind the regulations stress that the determination is not made by a simple tally of factors. See Agro Science, 934 F.2d at 576 (Tax Court appropriately looked at § 183 factors, although comparison of tax and nontax benefits appeared sufficient).
44 For tax years ending after October 22, 2004, an understatement of a corporation is substantial if it exceeds the lesser of (1) 10 percent of the tax required to be shown on the return (or, if greater, $10,000), or (2) $10 million. P.L. 108-357, § 819(a).
45 For tax years ending after October 22, 2004, no taxpayer may reduce any portion of an understatement attributable to a tax shelter item. P.L. 108-357, § 812(d).
Index for Coordinated Issue Papers - LMSB