Schizophrenic Application of Tax Penalties (Part I)

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July 29, 2010

Based our recent post on the Sala decision here, we have had several comments inquiring about the varied application of penalties in the “tax shelter” cases.   This is the first in a planned series of responses to those comments that will try to explain, iron out, or at least flag, some of the irregularities. 

When looking at the application of penalties to “shelter” cases generally, procedural posture matters.  A good example of this is Sala.  Why did the 10th Circuit discussion in Sala omit penalties?  Because it was a refund case in which the taxpayer appears to have filed a qualified amended return (“QAR”) prior to being “caught” by the IRS.  See generally 26 C.F.R. § 1.6664-2(c)(2).  There is a discussion of whether Sala’s amended return was qualified in the district court opinion and that ruling apparently was not a subject of the appeal.  Sala v. United States, 552 F. Supp. 2d 1167, 1204 (D. Colo. 2008).  Thus, in a refund suit posture, there may be procedural reasons why penalties are inapplicable.

The refund claim situation is contrasted for penalty purposes with either deficiency proceedings or TEFRA proceedings.  In either of the latter, penalties cannot be abated by a QAR (at least as to the matter at issue) because the taxpayer must have a deficiency or adjustment (to income) in order to bring either action.  See generally sections 6212 and 6225-6.  Thus, in cases such as Gouveia v. Commissioner, T.C. Memo 2004-25 (2004), the Tax Court addressed (and imposed) penalties in a deficiency context.  And, in Castle Harbor, the courts addresssed (but did not impose) penalties in the context of a TEFRA proceeding.  TIFD III-E Inc. v. United States, 2009 U.S. Dist. LEXIS 93853 (D. Conn 2009).  (We previously discussed the pending appeal in Castle Harbour here.)

While there is nothing mysterious about the foregoing, the different routes tax cases take can often cause an illusion that there is inconsistency in the application of penalties when, in fact, the cases are just procedurally different.  One other area in which this confusion is particularly common (and an area in which there is a bit of a dispute as to the correct application of the law) concerns whose behavior “counts” for purposes of the sections 6662 (reasonable basis) and 6664 (reasonable cause and good faith) defenses in the context of a TEFRA proceeding.  We will address that issue in our next post on penalties.

Tenth Circuit Reverses District Court in Sala

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July 26, 2010

In a brief (and some might say terse) opinion, the Tenth Circuit has reversed the District Court in Sala v. United States, 552 F. Supp. 2d 1167 (D. Colo. 2008)  (decision linked below).  As many readers will recall, Sala was considered an outlier among the tax shelter cases litigated over the past few years, with the taxpayer winning at trial in a Son-of-BOSS case.  See our prior discussion of the case here.

Citing to Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1356 (Fed. Cir. 2006), and Black & Decker Corp. v. United States, 436 F.3d 431, 441 (4th Cir. 2006), the Tenth Circuit focused narrowly on the specific transaction that gave rise to the claimed tax benefits, thus adding to the emerging trend of using a narrow definition of the transaction to defeat the efforts of tax planners. It remains to be seen whether the Tenth Circuit and other courts will embrace Coltec as closely when confronted with more traditional tax planning, rather than a Son-of-BOSS tax shelter.

Following its own precedent and a well-established approach to analyzing economic substance, the court concluded that the loss-generating transaction lacked economic substance.  In making this determination, the court considered both the taxpayer’s subjective business motivation in entering into the transaction, as well as whether the transaction had “objective economic substance.”  After engaging in a “common-sense examination of the evidence as a whole,” the court found it “clear that the transaction was designed primarily to create a reportable tax loss that would almost entirely offset Sala’s [tax year] 2000 income with little actual economic risk.”  The court also held that the “existence of some potential profit” is insufficient to imbue a transaction with economic substance where the purported tax benefits substantially outweigh the potential economic gains.  Holding for the government on the dispositive economic substance issue, the court declined to reach any of the other issues raised.

With this decision, Sala moves from being an interesting outlier to just another case in the mainstream of tax shelter decisions.  It is very unlikely that the taxpayer will be able to interest the en banc court or the Supreme Court in further review.  If he wants to try, a rehearing petition would be due on September 7 and a cert petition would be due on October 21.

Sala Tenth Circuit Opinion

Tenth Circuit Engaged in Lengthy Deliberation in Sala

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July 23, 2010

In what is considered by many an anomaly among the so-called “Son-of-BOSS” cases, the IRS lost the trial of a refund claim before the United States District Court for the District of Colorado in 2008.  See Sala v. United States, 552 F. Supp. 2d 1167 (D. Colo. 2008).  As many readers are no doubt aware, “Son-of-BOSS” is the nickname given to a type of loss-generating transaction described in IRS Notice 2000-44 (“BOSS” stands for “Bond and Option Sales Strategy”).  In one variation of such transactions, a taxpayer both buys and sells options on a given position and then contributes these options to an investment partnership.  Relying on Helmer v. Commissioner, T.C. Memo 1975-160, which held that liabilities created by short option positions are too contingent to affect a partner’s basis in a partnership, the taxpayer takes a basis in its partnership interest equal to the value of the long options position (i.e., not offset by the short options position).  Later, the investment partnership is liquidated and the assets sold, or the taxpayer’s interest is sold, with the taxpayer claiming substantial losses on what, economically speaking, was a pretty safe bet.

In Sala, the taxpayer invested in foreign currency options and contributed them to a partnership managed by renowned foreign currency trader, Andrew Krieger.  The amount of losses generated by the transactions at issue coincidentally offset a huge slug of income the taxpayer had in 2000 (approximately $60 million).  Despite the government’s best efforts, the court found for the taxpayer, holding that the transactions possessed economic substance.  The court also rejected the government’s attempt to retroactively apply regulations that reject the Helmer decision mentioned above.

The government appealed the case to the Tenth Circuit (briefing is linked below).  The government argues that the trial court erred in a number of respects, including: (1) determining that the transactions to be analyzed for economic substance are the entire array of transactions associated with a “legitimate” investment program, as opposed to the discrete options transactions giving rise to the claimed losses; (2) implicitly determining that the loss was a bona fide loss within the meaning of I.R.C. § 165; (3) invalidating or refusing to apply Treas. Reg. § 1.752-6 (which contains a basis-reduction rule designed to nullify “Son-of-BOSS” transactions); and (4) denying the government’s motion for a new trial after one of the taxpayer’s key witnesses (Krieger) recanted his testimony after accepting a plea agreement on criminal charges of promoting illegal tax shelters.

The taxpayer responded by arguing that: (1) the rule of Helmer was applicable law at the time of the contested transactions and should be followed; (2) the court blessed each phase of the contested transactions as having substance, not just the entirety; (3) the government did not adequately raise the § 165 argument at trial, and the provision nonetheless does not disallow the taxpayer’s loss; (4) Treas. Reg. § 1.752-6, as applied, is beyond the authority granted by the statute; and (5) the government did not meet its burden for obtaining a new trial.

Oral argument was held on November 16, 2009, and subsequently the government has directed the court’s attention pursuant to FRAP 28(j) to three of its recent wins in similar cases (supplemental submissions linked below).  Given that the case has been fully submitted for several months now, a decision could be imminent. The length of deliberation also may indicate that the court will engage in a detailed analysis that could depart from the opinions of other courts.  Should the taxpayer prevail, the case could be viewed as giving rise to a circuit split on the appropriate framework for analyzing alleged tax shelters, which could also have far-reaching implications for the recently codified economic substance doctrine.

Sala District Court Opinion

Sala Appellant Brief

Sala Appellee Brief

Sala Reply Brief

Supplemental 1

Supplemental Response 1

Supplemental 2

Supplemental Response 2

Supplemental 3

Supplemental Response 3