Tax Court Rejects Everyone is Doing It As Reasonable Cause Penalty Defense In Son-of-Boss case

In 3k Investment Partners v. Commissioner; 133 T.C. No. 6 (9/3/09), the taxpayer, an "investor" in a Daugerdas / Jenkens deal, sought to assert this defense to a penalty and, in support of the defense, sought discovery from the IRS of all the Son-of-Boss opinions in its bowels or wherever. In his typical straight-forward fashion, Judge Thornton opined:

Petitioner alleges and respondent does not dispute that in connection with many Son-of-BOSS transactions, one or more law firms or accounting firms wrote opinion letters to the investors supporting the claimed tax treatment. Petitioner alleges, and respondent does not dispute, that respondent has a large number of these tax opinion letters. Petitioner contends: "The availability of a large number of law firms and accounting firms issuing tax opinion letters determining that so-called 'Son of Boss' transactions * * * would produce the tax results as reported by Petitioner on its subject tax return would bolster Petitioner's position that it had reasonable cause and that Petitioner acted in good faith." Similarly, at the hearing petitioner's counsel argued that "based upon the general consensus of national law firms across the country that were issuing tax opinion letters that were taking the same position as the Petitioner in my case was taking, I wanted to show that reasonable cause does exist to take the position that we took on the tax return."

Petitioner's argument appears to be a variant of the refrain, familiar to parents of teenagers, that "Everyone's doing it." For the same reason that this does not constitute reasonable cause for teenagers, it would not constitute reasonable cause for petitioner. Petitioner must establish the reasonableness of its position on the basis of the facts and merits of its own case. n6 See Avedisian v. Commissioner, supra ("each individual must rest on the validity of his own position under the applicable taxing provisions, independently of others"). The legal analysis, conclusions, and recommendations that some tax advisers may have given other taxpayers are irrelevant to the reasonableness of the positions the partnership took on its return. See P.T. & L. Constr. Co. v. Commissioner, 63 T.C. 404, 414 (1974).

n6 We also reject any suggestion that the requested information, which appears to involve only a small subset of tax advisers, shows any "general consensus" of tax advisers regarding Son-of-BOSS transactions.

With a follow-up punch, the Court held that the opinions were not relevant or likely to lead to the discover of admissible evidence, as required by the discovery rules.

Finally, the court held that the opinions sought were in any event tax return information prohibited from disclosure under § 6103. The court held that redaction of taxpayer identifying information did not make it any the less tax return information subject to the strictures of § 6103. Reliance on cases dealing with § 6110 is misplaced because that code section specifically lifts the veil if § 6103, with appropriate redactions, for the types of IRS general legal interpretation documents that Congress said should be in the public domain once shorn, by redaction, of taxpayer identification information.

Court declares Son of Boss Illegitimate

In Clearmeadow Investments LLC v. United States, ___ Fed. Cl. ___ (2009), decided 6/19/2007 [I will link to the decision when posted on website], the Court of Federal Claims (Judge Allegra) uses the parent-son metaphor to call a Son-of-Boss transaction the illegitimate child of an illegitimate father, although some might question the timing and use of the metaphor immediately before Father's Day (today). The opinion is long and very good. But, you'll get the key points from the following introduction from the decision (although I question Judge Allegra's inference that Son-of-Boss transactions present a sexy legal issue):

"When pondering sexy legal issues," one commentator recently noted, "it is doubtful that tax law crosses the minds of many." Yet, once in a while (alright, a long while), a tax dispute bursts into the mainstream. Take, for example, the legal controversy swirling around the so-called "Son of BOSS" transactions -- the quoted phrase being short for "sales option bond strategy," the legatee of the "bond and option sales" or "BOSS" strategy. While this case involves a Son of BOSS transaction, perhaps it is best to start by examining the earlier BOSS strategy -- "qualis pater talis filius," as the Romans used to say.

The BOSS strategy employed a series of transactions seemingly to increase the tax basis of an asset that would eventually be sold, supposedly at a loss. In its simplest form, it worked like this:

• Two companies are set up by a promoter -- Company A and Company B.
• Company A buys a bond with a market value of $50.
• Taxpayer X buys the bond from Company A for $1,000,050. However, Taxpayer X pays only $50 in cash, with the remainder of the purchase price taking the form of a promissory note payable by Taxpayer X to Company A for $1 million due in twenty years. Taxpayer X claims that his adjusted tax basis in the bond is $1,000,050.
• Taxpayer X then sells the bond to Company B for $50. Because Taxpayer X claims a basis in the bond of $1,000,050 and sells it for only $50, he argues that he has incurred a $1 million loss, which he promptly deducts to offset income that would otherwise be subject to tax.

In the Community Renewal Tax Relief Act of 2000 (the 2000 Renewal Act), Pub. L. No. 106554, § 309, 114 Stat. 2763A-587 to 638, Congress devitalized this strategy by modifying key provisions in the Internal Revenue Code (the Code) to prevent, in absolute terms, the increase in basis essential to generating the large loss deductions. n2 Even before the passage of the Act, however, tax planners had begun to direct their creative energies elsewhere, focusing, in particular, on the partnership provisions of the Code as a potential new engine for producing large tax losses.

Their efforts eventually led to the christening of the "Son of BOSS" strategy. Under this brainchild, the taxpayer typically would form a partnership and contribute to it an option he had purchased. The partnership would contemporaneously assume a second option that represented a liability of the taxpayer. The taxpayer would then claim that his basis in the partnership was increased by the cost of the purchased option, but not reduced by the partnership's assumption of the obligation. As in the BOSS transactions, this ultimately led the taxpayer to claim a sizable loss deduction when he sold either the partnership interest itself, or some asset whose tax basis was derivable therefrom. Though clothed in the partnership provisions of the Code, the Son of BOSS strategy shared a common aspiration with its forebear -- to generate large tax loss deductions with little in the way of capital outlays. And the Internal Revenue Service (the Service) reacted to the "son" much as it had to the "father" -- disallowing the claimed loss deductions and assessing a range of penalties.

That, in a nutshell, is what happened in the case sub judice, which is a partnership proceeding involving a Son of BOSS transaction, pending before the court on the parties' cross-motions for summary judgment. After carefully considering the parties' briefs and oral argument, the court grants defendant's motion for summary judgment and denies plaintiff's cross-motion for summary judgment. As will be described below, the court finds, as a matter of law, that the Son of BOSS transactions that led to the tax losses at issue did not, under the Code, generate the losses claimed and, at all events, lacked economic substance. It also holds that, aside from any defenses the individual partners may raise in later proceedings, the Service properly asserted the gross valuation overstatement penalty of section 6662 of the Code.

My only comment relates to Judge Allegra's "simplest form" illustration of the concept. I ask the readers to re-read the simplest form illustration. Judge Allegra describes nothing more or less than the exceedingly hokey -- and perhaps even fraudulent -- tax shelters of the late 1970s and early 1980s where all sorts of properties -- from paintings to plastic recylcing shelters -- were overvalued, purchased for the hyper-inflated values (usually with nonrecourse financing or some economic equivalent), and then purchaser-taxpayer or a flow-through entity claimed purchase price basis supported improper tax deductions. For an example of this type of earlier shelter, see Addington v. Commissioner, 205 F.3d 54 (2d. Cir. 2000).

Two Cases on Tax Shelter Exception to FATP-7525 Privilege

In Valero Energy Corp. v. United States, ___ F.3d ___ (7th Cir. 2009), available here, the Seventh Circuit blew the hopes of some taxpayers and professions that the tax shelter exception to the Federally Authorized Tax Practitioner ("FATP") privilege would apply only to mass-marketed, so called cookie-cutter tax shelters. Section 7525 confers the equivalent of attorney-client communications privilege for communications between a client and an FATP. SEction 7525(b)(2) excepts from the privilege "in connection with the promotion * * * in any tax shelter (as defined in section 6662(d)(2)(C)(ii))." Valero argued that the word "promotion" -- interpreted both literally and with recourse to the legislative history -- should confine the application of the exception to widely promoted tax shelters and not to one-on-one tax advice for a specific client for a special situtation. The Seventh Circuit disagreed. The opinion is straight-forward, well-written and short. I feel that would disserve the reader by trying to summarize the opinion beyond its bottom-line holding.

I will provide a short quote where the Court gives useful background and analysis for the FATP privilege that should serve as a guide for practitioners desiring to protect client communications:

We begin by noting that there is no general accountant-client privilege. United States v. Frederick, 182 F.3d 496, 500 (7th Cir. 1999). In 1998, Congress provided a limited shield of confidentiality between a federally authorized tax practitioner and her client. This privilege is no broader than the existing attorney-client privilege. It merely extends the veil of confidentiality to federally authorized tax practitioners who have long been able to practice before the IRS, see 5 U.S.C. § 500(c); 31 C.F.R. § 10.3, to the same extent communications would be privileged if they were between a taxpayer and an attorney. 26 U.S.C. § 7525(a)(1) (privilege does not apply in criminal proceedings). Nothing in the statute "suggests that these nonlawyer practitioners are entitled to privilege when they are doing other than lawyers' work. . . ." Frederick, 182 F.3d at 502; see also United States v. BDO Seidman, 337 F.3d 802, 810 (7th Cir. 2003) (BDO II). Accounting advice, even if given by an attorney, is not privileged.

This means that the success of a claim of privilege depends on whether the advice given was general accounting advice or legal advice. Admittedly, the line between a lawyer's work and that of an accountant can be blurry, especially when it involves a large corporation like Valero seeking advice from a broad-based accounting firm like Arthur Anderson. But we have set some guideposts to help distinguish between the two. For starters, the preparation of tax returns is an accounting, not a legal service, therefore information transmitted so that it might be used on a tax return is not privileged. In re Grand Jury Proceedings, 220 F.3d 568, 571 (7th Cir. 2000); Frederick, 182 F.3d at 500-01; United States v. Lawless, 709 F.2d 485, 487 (7th Cir. 1983). On the other side of the spectrum, communications about legal questions raised in litigation (or in anticipation of litigation) are privileged. In re Grand Jury Proceedings, 220 F.3d at 571; Frederick, 182 F.3d at 502. Of course, there is a grey area between these two extremes, but to the extent documents are used for both preparing tax returns and litigation, they are not protected from the government's grasp. In re Grand Jury Proceedings, 220 F.3d at 571; Frederick, 182 F.3d at 501. This circumscribed reading of the tax practitioner-client privilege is in sync with our general take on privileges, which we construe narrowly because they are in derogation of the search for truth. United States v. Evans, 113 F.3d 1457, 1461 (7th Cir. 1997).

I should also note to balance this discussion that the Tax Court recently gave a relatively taxpayer friendly application of the tax shelter exception to the FATP. In Countryside Limited Partnership v. Commissioner, 132 T.C. No. 17 (2009), here, the Tax Court held that, once the taxpayer establishes that the FATP privilege is applicable, the Government then bears the burden of showing that an exception -- there the tax shelter exception -- makes the privilege inapplicable. There, the long-time tax advisor merely responded to inquiries from the taxpayer and gave advice. The Tax Court held that the IRS had not established that these actions were a "promotion" of a tax shelter, reasoning:

Respondent has focused on Mr. Egan as "promoting the Countryside transactions." We read the conferees' statements quoted above as distinguishing tax advice given in the course of a relationship such as that between Mr. Egan and the Winn organization from the "promotion" of a client's participation in a tax shelter. There may be a point at which an FATP's actions cross the line, and will no longer be encompassed within the routine relationship between an FATP and his client and will amount to tax shelter promotion. Respondent has, however, failed to show us that Mr. Egan's communications with the Winn organization with respect to the partnership redemptions and associated transactions before us crossed that line. He rendered advice when asked for it; he counseled within his field of expertise; his tenure as an adviser to the Winn organization was long; and he retained no stake in his advice beyond his employer's right to bill hourly for his time. Respondent has failed to show us that he crossed the line from trusted adviser to promoter.

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.