Economic Substance Redux

The Court of Federal Claims ruled against another Son of BOSS shelter, upholding penalties despite the taxpayers’ reliance on the advice of tax attorneys

The Welles family owned Therma-Tru Corp., a leading manufacturer of insulated doors. Between 1999 and 2000 the family negotiated the sale of the corporation to a private equity firm for a $450 million taxable gain. At the family’s request, its longtime attorney suggested they employ a gain-sheltering strategy marketed by the law firm of Jenkins & Gilchrist (J&G). That strategy would become known as Son of BOSS (bond option sales strategy) and lead ultimately to J&G’s demise. For other IRS victories against the shelter, see Jade Trading LLC v. U.S. (101 AFTR2d 2008-1411, “Tax Matters: Economic Substance Prevails Against Another Son of BOSS,” JofA, March 08, page 71); also Brandon Ridge Partners v. U.S. (100 AFTR2d 2007-5347, “Tax Matters: Son of BOSS Goes Into Overtime,” JofA, Nov. 07, page 79).

This version, which the Welleses set up beginning in March 2000, used foreign currency options plus a partnership termination to increase the basis of the corporation’s stock. Five months later, the IRS issued Notice 2000-44 that held such strategies lacked economic substance. J&G and the family attorney’s firm decided the J&G shelter was not similar to those in the notice, although notes made by the family attorney indicate he was not convinced by their analysis. The taxpayer paid more than $2 million in fees to J&G and more than $1 million to the other law firm.

J&G provided the Welleses with a tax opinion letter stating that the strategy should be effective. The government audited the partnership tax return and denied the tax benefit and imposed penalties. The taxpayer paid the tax and sued for a refund.

The Court of Federal Claims first determined that the strategy was consistent with the Internal Revenue Code as it existed at the time and rulings in Helmer v. Commissioner (TC Memo 1975-160) and Coltec v. Commissioner (98 AFTR2d 2006- 5249).

Second, the court ruled Treas. Reg. § 1.752-6, issued in 2003, could not be applied retroactively to deny the tax benefit. The regulation provides that if a partnership assumes the liabilities of a partner, the partner’s basis in the partnership is reduced by the amount of the liability, but not below the value of the partnership interest. The court also ruled that the regulation was interpretive and not statutory. Thus, it was not entitled to Chevron deference (Chevron USA Inc. v. Natural Resources Defense Council Inc., 467 U.S. 837 (1984)) and could be applied retroactively only in limited situations, the court said.

For a transaction to have economic substance, it must have a reasonable possibility of profitability. The taxpayer’s experts testified there had been a realistic possibility of a profit. But the court sided with the government expert’s opposite view, saying the taxpayer’s experts’ analysis was incomplete and in one case omitted information that was contained in a preliminary report. On the other hand, the government expert’s testimony was complete, used the recognized Black-Scholes model and demonstrated the lack of profit potential resulting from the high fee paid and the excessive price charged for the options. The court also noted the attorneys’ fee was based on the gain to be shielded, not the financial investment.

The court then upheld negligence penalties. Normally, the taxpayers would have been able to avoid penalties, since they discussed this issue with their regular attorneys as well as the law firm that proposed the strategy. However, because the regular attorneys were to receive one-third of the fee and brokered the strategy for J&G, they were not independent and their advice could not be relied upon as free from any conflict of interest, the court said.

The court then turned to the application of the economic substance doctrine. In one version of the doctrine, the transaction will be ignored if it lacks economic substance and was motivated solely by tax avoidance. The other version will disregard the transaction if either condition applies. The court applied the second version, based on the Supreme Court’s decision in Frank Lyon Co. v. U.S. (41 AFTR2d 78-1142).

Stobie Creek Investments LLC v. U.S., 102 AFTR2d 2008-5442

By Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.