Tax Court Puts Another Nail in the Coffin of Helmer Tax Shelters

In New Phoenix Sunrise Corp., et. al. v. Commissioner, 132 T.C. No. 9 (4/9/09), the Tax Court rejected a Helmer tax shelter claim. In Helmer v. Commissioner, T.C. Memo. 1975-160, at the IRS's request, the Court held that contingent liabilities contributed to a partnership do not enter the basis reduction calculation. Taking Helmer at face (taking anything at face is often dangerous in the tax context), tax shelter promoters created many variations of a gambit that would permit a large artificial basis upon which to claim a large artificial loss. New Phoenix involved one of the variations (the so-called digital option), masterminded (if that is the right word) by the Daugerdas-Jenkins & Gilchrist team.

In beginning its discussion of his conclusions, the Tax Court moved quickly to the core point:

We note at the outset that neither Mr. Wray, New Phoenix, nor Capital actually
suffered a $10 million economic loss during 2001. The loss claimed as a result
of the stepped-up basis in the Cisco stock was purely fictional.

From that core observation, the result surely followed:

Absent the benefit of the claimed tax loss, there was nothing but a cash flow that was negative for all relevant periods -- the "'hallmark[] of an economic sham'" as the Court of Appeals for the Sixth Circuit has held. Dow Chem. Co. v. United States, 435 F.3d at 602 (quoting Am. Elec. Power Co. v. United States, 326 F.3d 737, 742 (6th Cir. 2003). Such a deal lacks economic substance. Id. Because we find that the transaction at issue lacked economic substance, we do not consider Mr. Wray's and Capital's profit motive in entering into the transaction. Id. at 605; Rose v. Commissioner, 868 F.2d at 853; Illes v. Commissioner, 982 F.2d at 165. Pursuant to the aforementioned cases, the BLISS transaction must be ignored for Federal income tax purposes. Accordingly, the overstated loss claimed as a result of the sale of the CISCO stock is disregarded, as is the flowthrough loss from Olentangy Partners.

Not only did the Court disallow the loss, the Court also disallowed the attorneys fees the taxpayer incurred in undertaking the transaction. Then, piling at least penalty, if not insult, to the substantive injury, the Court made the following key points on penalties:

1. The 40% gross valuation / basis misstatement penalty applies, specifically rejecting the notion that, because the deductions were denied on the basis of lack of economic substance. In doing so, the Court distinguished and rejected Heasley v. Commissioner, 902 F.2d 380 (5th Cir. 1990). Any notion derived from Heasley and its progeny that this penalty does not apply is quickly losing ground in the circuits.

2. The 20% substantial understatement of tax penalty applies. The Court found that the position lacked substantial authority and that the transaction was a tax shelter. Returning to his opening theme, The Court quoted Jade Trading, LLC v. United States, 80 Fed. Cl. 11, 58 as follows: "At bottom, the fictional nature of the transaction and its lack of economic reality outweigh Helmer in the substantial authority assessment."

3. The 20% negligence and intentional disregard penalty applies. The taxpayer urged in effect that Helmer and its progeny were substantial authority, and that authority had not been eroded below reasonable basis. In so holding, the Court noted that the IRS had already issued a statement of its position in Notice 2000-44 on Helmer and the taxpayer did not seek independent advice.

4. The taxpayer did not have reasonable cause and good faith for all the obvious reasons and some special twists unique to the facts.

5. Important to the penalty holdings was Jenkins & Gilchrist's clear conflict of interest that the taxpayer simply chose to ignore, thus eroding the reasonableness of reliance of the tax shelter opinion.

6. These penalties may not be stacked. Accordingly, the 40% penalty applies to the portion of the underlying tax attributable to the basis overstatement, but 20% penalty (either substantial understatement or negligence) applies to the balance.

Altogether, given the shift in the winds and prior precedents, this is not an altogether surprising opinion. Players in this area should note that interest on these penalties apply from the date the tax is due, so the cumulative cost of the tax, the penalties and the interest can be quite substantial.

Strategic Concessions - Government Outmaneuvered

The Code imposes:

1. A 20% penalty for tax due that is attributable to return reporting positions based on negligence or substantial understatement.

2. a 40% penalty applies to tax due that is attributable to return reporting positions based on gross valuation or basis misstatements. Gross valuation or basis misstatements are those that exceed 200%.

A split among the courts has developed as to whether, if the tax is disallowed in a judicial proceeding for some threshold reason (such as lack of economic substance or simply failing to meet some other requirement of the code), the 40% gross valuation or basis misstatement penalty can apply. In holding that the 40% penalty cannot apply, courts reason that the tax due is attributable to the threshold disqualifier and not to the gross valuation or basis misstatement. See e.g., Keller v. Commissioner, ___ F.3d ___ (9th Cir. 2009). Other courts reject that if the gross valuation or basis misstatement was an essential ingredient of the originally claimed reporting position. See e.g., Long Term Capital Holdings, Inc. v. United States, 338 F.Supp.2d 122 (D. Conn. 2004), aff’d by unpublished order (2nd Cir. 9/27/05).

A decision reported just yesterday shows how a taxpayer skillfully exploited this split in authority. Alpha I, L.P., v. United States, ___ Fed. Cl. ___ (3/16/2009), denying the Government's motion for reconsideration in Alpha I, L.P., v. United States, 84 Fed. Cl. 622, 634 (2008). Basically, in this TEFRA proceeding, the partnership conceded a threshold legal disqualifier to the tax benefits in issue and then moved for summary judgment on the gross valuation misstatement issue because the valuation was no longer relevant and hence the tax due (conceded for other reasons) was not attributable to the gross valuation misstatement. The Government opposed the motion. The Court granted the motion. Alpha I, L.P., v. United States, 84 Fed. Cl. 622, 634 (2008). The Government then moved for reconsideration. The Court rejected the motion for reconsideration essentially because it did not raise any matters not previously considered as to the proper interpretation and application of the penalty. The Court reasoned (such as it is) in this regard (which I quote in its entirety because I don't understand it),

According to plaintiffs, however, "Defendant has lost sight of the different policy underlying the valuation misstatement penalty from other penalties designed to punish and deter taxpayers from taking negligent, aggressive, or fraudulent positions." Pls.' Resp. to Def.'s Mot. for Recons. 16. The court addressed the policy behind the § 6662(e) penalties in its Opinion of November 25, 2008. See Alpha I, 84 Fed. Cl. at 632-33. The court concluded that "forcing a 'trial on alternative grounds for adjustments plaintiffs have already conceded violates the purpose and policy behind the valuation misstatement penalties and is simply a waste of the Court's and the parties' resources.'" Id. at 632 (quoting Plaintiffs' Reply in Support of Plaintiffs' Motion for Partial Summary Judgment 5).

Apparently, the Court thought that was the end of it from a legal analysis perspective.

But the Court proceeded to dispatch a Government policy consideration not relevant to the interpretation and application of the penalty. This policy related to how the Government induces taxpayers into settlement without trial by holding out the prospects of a worse result at trial. The Government argues that the partners of the Alpha I partnership making this strategic maneuver would be better off than other similarly situated taxpayers who settled. Adopting Alpha I's position on this matter, the Court held that whether or not the taxpayer partners in Alpha I were better off is not relevant and in any event not certain. And that was the end of that.

The bottom line takeaway for practitioners whose clients may be subject to the gross valuation misstatement penalty in an overly aggressive shelter or other return reporting position is to find some threshold disqualifier and go to a jurisdiction (such as the Fifth, Ninth, or Court of Federal Claims) and concede the tax on the basis of the disqualifier.