It's Over

FIDELITY INTERNATIONAL CURRENCY ADVISOR A FUND, LLC, by the Tax Matters Partner, Plaintiff, v. UNITED STATES of AMERICA, Defendant.

For some time, I have been of the belief that the Tax Reform Act of 1986 killed tax shelters.  I'm still pretty much of that opinion.  When I find a case like Fidelity International Currency Advisors A Fund, LLC, which was just issued by the US District Court for Massachusetts last week (amending their previous May findings in the case), I'm reminded of a trope that would pop up on television series in the 1950's and 1960's. One or more Japanese soldiers on a remote island have to be convinced that they have lost the war and can go home now.  Gilligan and the Skipper had to deal with the problem in Episode 16 and Ensign O'Toole and the Appleby ran into it in Episode 6. 

Fidelity International has local gossip value too it I guess, but not because it has anything to do with the Boston firm that runs mutual funds.  The name is not a coincidence either, but that's part of the story.  The tax matters partner of Fidelity was Richard Egan, recently deceased.  He was one of the founders of EMC, which has its headquarters in Hopkington, MA. He was also the US Ambassador to Ireland, which, is in part, what led to this drama.

This case will likely merit more than one post.  Actually there are probably a couple of good novels in there, but for now I will explain one of the transactions and comment on the feature I find most intriguing.  Mr. Egan owned approximately 25 million shares of EMC, which traded at over $100 per share (Back then at the dawn of the millennium it was a well established law of nature that EMC stock could only go up).  His basis was approximately two cents per share.  Given that he founded a company noted for memory storage, it would have not been reasonable to try invoking the Steve Martin Rule  (That is not pay the tax and say "I forgot").  So he and his son Michael, who ran his family office, consulted with an attorney and some national firms. They wanted to find a way to eliminate capital gains and also shelter the income from the exercise of non-qualified stock options.  In this post I will comment only on the former.

The plan for eliminating capital gains works like this.  You write a very large option which entitles you to receive a large premium.  You use that premium to buy a very similar option.  When it unwinds you will most likely have a loss, particularly after fees, but not a very large loss relative to the notional amount of the options.  Get ready for the magic and if you are passionately attached to double entry remain calm.  Form a partnership and contribute these two contracts to the partnership.  Slowly.  Carefully.  One at a time.  First there is that option you bought for say 150,000,000 (Never mind where you got it from).  That's easy.  Your basis is 150,000,000, the partnerships basis in it is 150,000,000.  Increase your basis in your partnership interest by 150,000,000.  You probably want to take a break.  Now you've got that other thing.  The option that you wrote.  Well you got a lot of money and it seems like it could require you to pay out a lot of money.  In some ways it seems like a liability.  But remember this is a partnership.  You need to check Section 752.  Well something that you maybe have to pay isn't going to pass muster as a liability under 752.  So now you are done.  Your basis in your partnership interest is 150,000,000.

Now you put in your stock in Bigco which is worth 150,000,000 and has effectively zero basis.  After those options sort themselves out for some relatively negligible effect, you are ready for your next step.  You contribute your partnership interest into an LLC and make a 754 election.  You now have to allocate your basis in your partnership interest among the assets of the technically new partnership.  Your basis is still 150,000,000 and the only thing to allocate it to is the Bigco stock.  So now your partnership has basis in your Bigco stock.  It can sell it at a small gain or no gain or, as worked out in this case, a loss.  Mr. Egan's minions needed to put more and more EMC stock into the partnership to take advantage of all the shelter they had bought as the price of EMC collapsed.

There is something really really neat about this plan that I couldn't emphasize if I was presenting it to you as a client.  You see I am a member of the American Institute of Certified Public Accountants and thereby subject to its Statements on Standards for Tax Service, which were issued around the turn of the millennium.  Among the things I can't do is recommend a tax position that "Exploits the audit selection process of a taxing authority."  But since you and I are just pals and I am certainly not recommending this position I can tell you the really neat thing about it.  If it works as planned, you never have to put a really big ugly looking negative number anywhere on any return you file.  The basis that you created, as if by magic, enters into computing the gain or loss on your sale of Bigco stock.  If Bigco stock behaves like everybody thought EMC stock was going to behave it means you will be reporting a gain.  Just not as big a gain.  No tax shelter here just a hard working high tech billionaire paying more taxes than most people.

The only thing wrong with the plan is that creating basis out of thin air doesn't even make good nonsense.

This brings me to the part of the case I find most interesting.  The low reporting profile of the transaction was a big attraction.  What amazes me is how big a paper trail the advisers created discussing the low reporting profile of the transaction.  Stephanie Denby, an attorney, wrote in a memo to Mr. Egan:

. The IRS is certainly aware that these transactions are out there. They have implemented new reporting requirements to try to stop these transactions. To date new reporting requirements have focused solely on C corporations. Although, they could have easily applied similar restrictions to individuals, they have failed to do so.

These transactions clearly take advantage of “loopholes.” The reporting is consistent with tax law although the results are unintended. The promoters will provide tax opinion letters to avoid penalties if audited. It appears that there is a very low chance that these transactions would ever be picked up by the IRS. The promoters I have talked to have not had any audits

Secondly, some of the transactions focus on generating basis as opposed to capital loss. Basis is more discrete [sic] and less likely I believe to cross the IRS radar screen.

You see that's the neat part that I couldn't use to recommend the deal.

She also investigated insurance for the plan then sent an e-mail to James Reiss, CFO of Carruth Associates, Mr Egan's family office :

Marsh &; McLennan does not issue insurance for “transactions with no economic purpose other than the tax benefits.” I think if we pursue this and get rejected, we would be creating a bad trail. Accordingly, I think this is not something to pursue. Let me know if you agree.

Mr. Reiss responded

They probably help insure “straight” transactions. What fun is there to that? I agree with your comment.

The search went on.  Eventually Ms. Denby prepared a comparison of various methods being promoted by national firms rating them positively or negatively based on various attributes including :

Denby also rated and commented with respect to the manner in which the tax loss was generated, noting a plus if the transaction was “harder for [the] IRS to find” and a minus if the transaction was “easier” for the IRS to find

Denby also rated and commented with respect to their complexity, noting a plus if the complexity of the structure made it harder for the IRS to “unwind” or “pick-up” and a minus if the simplicity of the structure made it easier for the IRS to trace.

Ultimately they went with a plan being promoted by KPMG.  As part of the deal KPMG would prepare the returns.  Unfortunately, the landscape shifted between the time of the committment to the transactions and the filing of the affected returns.  KPMG decided that the transactions did need to be explicitly disclosed.  This was upsetting:

On August 30, 2002, Stephanie Denby sent Reiss and Shea a proposed draft letter to Tim Speiss at KPMG. (Ex. 3429). The letter stated that Denby was “astonished” that KPMG would not sign the tax return without a disclosure statement, and that she found the firm's position “shocking” and “untenable,” as well as “a breach of KPMG's fiduciary duty and patently unprofessional.” In her cover e-mail, she wrote that “it would make sense to send out [the letter] after we have confirmation that [Speiss] has purged his files.”

So they fired KPMG and got McGladrey to prepare the returns.  I have never seen a case go into as much detail on the minutiae of return preparation.  I'm hoping to write more on it in the weeks to come. 

The end result of the case was to blow up the transaction and subject it to a 40% gross overstatement penalty.  All the lesser 20% penalites were also found applicable, but they are not cummulative.  The letters from attorneys saying that positions were reasonable and disclosure was not required were of no avail.

When this case was announced in the media earlier this year there was some villification of Mr. Egan, which I really think was misplaced.  Mr. Egan was part of the team of people that helped put men on the moon.  His team of adivsers believed that there were geniuses in the national firms that had figured out a legitimate capital gain strategy.  In retropsect, it is easy to say that they should have realized the game was up when KPMG told them they had to disclose.  That was like the real life case of Second Lieutenant Hiroo Onoda on Lubang Island in the Philliphines.  When his former commander Major Taniguchi told him the war was over he came out of the jungle with his rifle, 500 rounds of ammo and some hand grenades.  It was 1974.  He was lucky not to have a letter from a law firm to contradict him.

Shoemaker's Children

WALLIS v. COMM., Cite as 106 AFTR 2d 2010-5755, 08/11/2010

Many tax professionals practice as partners in partnerships.  So you would think the tax aspects of professional partnerships would be pretty well worked out.  Think again.  When I think about thoroughly applying 704(c), for example, to an ongoing professional firm that has partners coming and going, I get a headache.  Thus, I can't really say I am shocked, shocked that a tax attorney couldn't prevail on the proper treatment of the guaranteed payments from his own partnership, but I'd still like to give you some comments on Wallis v Com. (106 AFTR 2d 2010-5755).  I'm not sure if my motivation is compassion or schadenfreude.  Since it's a tax attorney rather than a CPA it's probably schadenfreude.

Donald Wallis was a partner in the firm Holland & Knight. Under the partnership agreement he was awarded something called Schedule C units for each year of service.  When he withdrew from the partnership in 2003 he had a capital account of  $98,161.75 and $240,000 in "Schedule C" units.  In 2003 he began receiving quarterly payments of $28,180.15.  $20,000 of each payment was with respect to "Schedule C" payments and the the balance toward his capital account.  In 2005 the partnership sent him From 1099-MISC in the amount of $80,000 and deducted the payment to him in computing its taxable income. 

In preparing his 2005 return Mr. Wallis did not report the $80,0000 at all.  He subsequently abandoned the theory that the payment was non-taxable and took the position that it was in exchange for his partnership interest and should be accorded capital gains treatment.  The 11th circuit sustained the tax court in treating the payment as ordinary income and allowing an accuracy related penalty to be charged.

The argument about the penalty was the most interesting.  The court cited Section 6662 which requires you to be consistent with a partnership's treatment of transactions unless you notify the IRS that you are being inconsistent.  The notification is done by attaching Form 8082 which has the apt title of Notice of Inconsistent Treatment.  Mr. Wallis argued that since he didn't have a disagreement with his K-1, which apparently did not include the payment but rather with the 1099-MISC, the consistency requirement didn't apply.  The court was unsympathetic:


Section 6222 provides a means for a partner to inform the IRS when his own treatment of a partnership item “is (or may be) inconsistent with the treatment of the item on the partnership return.” 26 U.S.C. § 6222(b)(1). Given that Donald Wallis has 35 years of experience as a tax lawyer, the Tax Court reasonably could conclude that Wallis should have been aware there were inconsistencies between (1) his not reporting the Schedule C payments at all to the IRS and (2) the income Form 1099 he received from H&K. See Treas. Reg. 1.6664-4(b)(1).


The Wallises argue that they had no obligation to report under § 6222 because their inconsistency was with H&K's Form 1099-MISC, not with H&K's 2005 return. Nonetheless, § 6222 requires partners to report even possible inconsistencies to the IRS if they wish to treat partnership items differently on their own return from the partnership's return. And, Wallis's receipt of the Form 1099-MISC should have alerted him that the Schedule C payments would be reflected as deductions on H&K's partnership return. Rather than alerting the IRS to Wallis's (now-abandoned) theory that the payments did not represent taxable income, the Wallises made no mention of the Schedule C payments when they filed their return. Under the circumstances, the Tax Court did not clearly err in finding that the Wallises did not have reasonable cause for the underpayment or act in good faith with respect to it.


It is interesting to note that the instructions Form 8082 state "... you generally must report items consistent with the way they were reported to you on Schedule K-1."  It goes on to state, however, that you should report "any inconsistency" between your tax treatment and the way the partnership reported on "its return".  Presumably Mr. Wallis didn't see the H&K return, but apparently the 1099-MISC was supposed to be enough of a clue.

Pigs Get Fed

I've been struggling with the title for this particular post.  "Sometimes You Should Just Pay The Taxes" seemed apt, but I've used that title not that long ago.  My method of gathering material for the blog presents the danger of developing a jaundiced view toward aggressive tax planning.  Studying original source material can overemphasize the plans that go astray.  Even a taxpayer victory in Tax Court is not something to be envied. 

Nonetheless, we used to have a saying "Pigs get fed.  Hogs get slaughtered.".  I tried to research the origin of the expression and the claims of origin I found all post dated my first exposure to it.  As one of my partners commented we really had no idea if there was any agricultural reality to the expression.  Unlike some other expressions ("Same difference" "No harm. No foul."), though, I had a pretty clear idea of the inherent advice.  It was that you should be aggressive, but not too aggressive.  At the time I was working for somebody named Cohan and I was actually surprised to find that the Cohan Rule was named for somebody else.

Nowadays the way you tell if somebody was way too aggressive is when the penalties get piled on and are sustained by the tax court (Of course there are the people who are deprived of their liberty, but what they do has to have some characterization beyond aggressive).  Lizzie W. Calloway, et vir. v. Commissioner, 135 T.C. No. 3 makes for an interesting story in this regard.

Albert Calloway (he's the et vir.) owned stock in IBM with relatively low basis.  Rather than sell the stock, he entered into an agreement with Derivium Capital LLC which offered to loan him 90% of the value of the stock.  The stock was to serve as collateral .  In three years Mr. Calloway could pay off the loan with interest and reclaim the stock - or not. 

At the end of the day, the tax court ruled that the transaction was not really a loan.  What is interesting though is that the tax court decision was not unanimous at least in its reasoning.  The problem that they had with the transaction is that Derivium didn't actually hold the IBM stock.  It immediately sold it.  The proceeds of the "loan" were not determined by a valuation of the stock when it was delivered.  Rather it was 90% of the proceeds that Derivium received from selling it.

There is a long complicated analysis that brings the court to conclude that the transaction was not really a loan.  What I find most significant is that even the judges who did not agree with the analysis agreed with the deficiency and the penalties.  Their reasoning was that the taxpayer did not act like it was a loan.  They did not recognize as income the supposed IBM dividends that were being applied to the supposed interest charges.  Most significantly, when the three years elapsed they did not recognize the sale or income from the discharge of indebtedness.

The IRS likes to win when they go in to tax court.  So they pick on people with the worst facts. The transaction was probably not such a hot idea to begin with, but once adopted, it should have been followed through in detail, meticulously. 

The one thing that really troubles me about this case is the numbers.  The Calloway received $93,586.23 for IBM stock in which they had $21,171 in basis.  The deficiency in tax (before considering interest and penalties) was $30,911.  It was a 2001 case and although not explicitly stated it seemed that it was a long term gain.  I've decided to move on, but if someone can figure out the mystery, post a comment.