Economic Substance Prevails Against Another Son of BOSS


The IRS scored a major success in its war against Son of BOSS-type tax shelters in Jade Trading LLC . The Court of Federal Claims used the application of the economic substance doctrine in Coltec Industries to disallow losses involving partnerships and euro call options.

In 1999, after clearing approximately $40 million on the sale of their cable businesses in Kentucky, three brothers, Gary, Robert and Tim Ervin, each formed a limited liability corporation. The LLCs each purchased euro options from insurer and financial services company American International Group (AIG) for a premium of $15,000,020. At the same time, each LLC sold a euro option to AIG for $14,850,018 and paid AIG the difference, $150,002. Each LLC then contributed its option spread to Jade Trading LLC, an investment vehicle, and treated its basis as equal to the premium for the purchased call option. In so doing, the brothers’ LLCs ignored the premium for the sold call option by claiming that the call options assumed by Jade were contingent obligations. Shortly thereafter, each LLC redeemed its partnership interest at its fair market value—a relatively small amount equal to the difference in the options. In each case, a loss was claimed for the difference between the fair market value of the partnership interest and the claimed basis of almost $15 million. On their 1999 returns, each Ervin brother claimed close to $15 million in losses and expenses from the execution of the spread transaction and involvement in Jade. The IRS audited the returns and disallowed these losses. The Ervins appealed to the Court of Federal Claims.

The court held that the Jade transactions failed the economic substance doctrine as clarified in the Coltec decision (98 AFTR2d 2006-5249; see also “Tax Matters: Denial of Contingent Liability Loss Deduction,” JofA , Jan. 07, page 67). In Coltec, the Court of Appeals for the Federal Circuit (overturning the Court of Federal Claims) determined that the legitimacy of a transaction for tax purposes is not guaranteed merely because a technical interpretation of the Code would support the tax treatment. In Jade Trading, the Court of Federal Claims required additional scrutiny of the bona fides of the transaction, requiring that the transaction pass muster under the objective economic substance test. The court said the taxpayer has the burden of proving that the transaction giving rise to the tax benefit objectively had economic substance—as opposed to a transaction created for tax avoidance purposes.

The court said that the transaction resulted in a fictional loss, had no ability to realize a profit and resulted in a disproportionate tax advantage as compared with the amount invested and potential return. In addition, there was no nontax reason for conducting the original transactions in partnerships. The court upheld the government’s $14.7 million reduction of each partnership’s basis, plus a 40% gross valuation misstatement penalty. Because the court considered only partnership items, it lacked jurisdiction to consider the individual partners’ defenses to the penalties; these defenses could be taken up subsequently in individual partner-level proceedings.

In Notice 2000-44, 2000-36 IRB 255, the IRS warned that purported losses in arrangements similar to that of Jade are subject to challenge on a variety of grounds and that a variety of penalties may be imposed on participants, promoters, and reporters of these listed transactions. Tax shelters have become less attractive due to the IRS’s aggressive pursuit of transactions that appear to lack economic substance. Tax advantages gained are less likely to withstand IRS and judicial scrutiny.

Jade Trading LLC v. U.S. , 100 AFTR2d 2007-5591

Prepared by Alice A. Upshaw, CPA, MPA, instructor of accounting, and Darlene Pulliam, both of the College of Business, West Texas A&M University, Canyon, Texas.


Get your clients ready for tax season

These year-end tax planning strategies address recent tax law changes enacted to help taxpayers deal with the pandemic, such as tax credits for sick leave and family leave and new rules for retirement plan distributions, as well as techniques for putting your clients in the best possible tax position.


Keeping you informed and prepared amid the coronavirus crisis

We’re gathering the latest news stories along with relevant columns, tips, podcasts, and videos on this page, along with curated items from our archives to help with uncertainty and disruption.