# Fidelity International Currency Advisor a Fund, LLC v. United States

> District Court, D. Massachusetts · October 18, 2010 · 747 F. Supp. 2d 49

URL: https://www.frixlaw.com/law-library/cases/2477399

## Case

- **Full name:** FIDELITY INTERNATIONAL CURRENCY ADVISOR a FUND, LLC, BY the TAX MATTERS PARTNER, Plaintiff, v. UNITED STATES of America, Defendant; Fidelity High Tech Advisor a Fund, LLC, by the Tax Matters Partner, Plaintiff, v. United States of America, Defendant
- **Court:** District Court, D. Massachusetts
- **Decided:** October 18, 2010
- **Citations:** 747 F. Supp. 2d 49
- **Precedential status:** Published
- **Opinion:** Opinion by Saylor
- **Judges:** Saylor
- **Cited by:** 21 later opinions in the Frix Law Library

## Citator (automated)

- No negative treatment found by the automated citator. That is not the same as a confirmation that the case is good law; read the citing cases.
- Full citator and citing cases: https://www.frixlaw.com/law-library/cases/2477399

## How later opinions describe it (automated extraction)

- concluding as a matter of law that “Even if taxpayers invest in a partnership with the individual objective of making a profit, they are not entitled to deduct any amounts invested in the partnership as losses under Section 165(c)(2) if the partnership transactions are not ent…

## Opinion text

AMENDED [CORRECTED] FINDINGS OF FACT AND CONCLUSIONS OF LAW
SAYLOR, District Judge.
This is a dispute concerning two complex tax shelter transactions. The plaintiffs in these consolidated actions are Fidelity International Currency Advisor A Fund, LLC and Fidelity High Tech Advisor A Fund, LLC. The tax matters partner, and the principal taxpayer who invested in and benefltted from the tax shelter transactions at issue, was Richard J. Egan.
1
Richard Egan was one of the founders of EMC Corporation and the former ambassador to Ireland. He entered into the tax shelter transactions to avoid large tax liabilities on the sale of EMC stock and the exercise of non-qualifled stock options. Together with his wife, Maureen, Richard Egan claimed a tax loss of $158.6 million in 2001, a further tax loss of $1.7 million in 2002, and capital losses of $167.1 million in
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2002 as a result of their participation in the tax shelter transactions.
The IRS disallowed the tax treatment claimed by the Egans and issued Final Partnership Administrative Adjustments adjusting various partnership items and assessing accuracy-based tax penalties, This litigation followed.
The case was tried before the Court over 44 trial days beginning in late 2008. The Court also received more than 3,700 exhibits, and heard extensive testimony from multiple expert witnesses. For the reasons set forth below, the Court con-eludes that the partnership item adjustments made by the IRS are correct, and accordingly will enter judgment for the United States. The Court also finds that various accuracy-related penalties are applicable.
TABLE OF CONTENTS
I.INTRODUCTION..........................................................65
A. Summary of Facts....................................................65
B. Summary of Legal Conclusions.........................................67
II.NATURE OF PROCEEDINGS..........................:...................69
III.FINDINGS OF FACT......................................................70
A. Jurisdictional Facts...................................................70
1. Fidelity High Tech...............................................70
2. Fidelity International.............................................71
B. EMC, the Egans, and Related Parties...................................72
1. EMC and Richard Egan..........................................72
2. The Egan Family................................................72
3. Carruth Management and Subsidiaries..............................73
4. Burke, Warren Law Firm.........................................74
C. The Tax Promoters and their Associates.................................74
1. The Diversified Group Incorporated................................74
2. Helios Financial LLC.............................................74
3. KPMG, LLP ....................................................74
4. Alpha Consultants, LLC..........................'................75
5. Samuel Mahoney.................................................75
6. Refco Capital Markets Limited ....................................75
7. Proskauer Rose, LLP ............................................75
8. Sidley Austin Brown
&
Wood, LLP.................................75
9. RSM MeGladrey, Inc...................'...........................75
D. The Egans’ Tax Problems..............................................75
1. Low-Basis EMC Stock...........................................75
2. Non-Qualified Stock Options ......................................76
E. The Delegation of Authority for Tax Affairs to Michael Egan and Carruth...........................................................76
F. Early Discussions Concerning Tax Shelters..............................77
G. The “Short Option Strategy”...........................................79
H. The May 2000 Meetings ...............................................80
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1. The May 15, 2000 Meetings in New York............................80
2. The May 19, 2000 Meeting in Chicago...............................83
3. Denby’s Comparison of the Tax Strategies — May 2000 ................84
4. The May 25, 2000 Meeting in Massachusetts.........................85
I. Further Developments in July 2000 .....................................86
1. The July 10-13, 2000 Meetings in Chicago...........................86
2. The July 18, 2000 Meeting with Helios in Chicago....................88
3. Carruth’s Due Diligence Concerning the Promoters...................89
J. Formation of Fidelity Entities in July 2000...............................90
1. Fidelity High Tech Transaction Entities ............................90
2. Fidelity International Transaction Entities..........................90
K. Carruth Prepares to Implement the Strategies ...........................91
1. Denby’s Fax of July 20, 2000 ......................................91
2. Further Discussions in July 2000 ...................................91
3. The August 2, 2000 Meeting in Boston..............................92
L. IRS Notice 2000^44 and Its Aftermath ..................................92
1. The Issuance of IRS Notice 2000-44 ................................92
2. The Reaction to IRS Notice 2000-44................................93
3. The August 23, 2000 Conference Call...............................95
4. The Initial Draft Legal Opinions for Fidelity High Tech...............96
M. Carruth Resumes Implementation of the Capital Gains Strategy............97
1. The September 5, 2000 Memorandum...............................97
2. The Parties Begin Implementation of the High Tech Transaction......98
3. The Withdrawal of HSBC as the Counterparty.......................98
4. The Selection of Refco as the Substitute Counterparty................99
5. The First Registration of EMC Shares..............................99
6. Carruth Puts the Fidelity High Tech Transaction on Hold............100
7. The Year-End Transfer of Maureen Egan’s Fidelity High Tech Interest......................................................100
N. Resumption of the High Tech Transaction in January 2001 ................101
1. The January 23, 2001 Tax Analysis by Shea ........................101
2. The January 24, 2001 Memorandum from Shea......................101
3. The Initial Draft Legal Opinion Letter from Proskauer..............102
4. The January 29, 2001 Memorandum by Shea........................102
5. The Decision to Allocate 99% of the High Tech Transaction to Maureen Egan................................................103
6. Planning for Tax Reporting of the High Tech Transaction............103
7. The Second Registration of EMC Shares...........................104
O. Implementation of the Fidelity High Tech Transaction....................104
1. Index A and Option A Enter into Option Trades.....................104
2. The Possibility of a One-Option Payout............................105
3. The Capitalization of Fidelity High Tech...........................106
4. The Purported Increase in Basis..................................106
5. The Receipt of McData Stock Dividend ............................107
6. The Cover/Termination of NASDAQ 100 Options....................107
P. “Stuffing” of Additional Low-Basis Stock into Fidelity High Tech..........109
1. “Stuffing” Activities in May and June 2001 .........................110
2. Additional “Stuffing” in Late 2001 .................................Ill
Q. The Change of Structure of the Fidelity High Tech Transaction............112
1. The Original Final Step of the Transaction.........................112
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2. The October 31,2001 Tilevitz “Stock Dribble” Memorandum..........113
3. The Initial Proposal to Use a Subchapter S Corporation..............113
4. The Change to a Partnership.....................................114
5. The Transfer of Maureen Egan’s Interest to an LLP and Section 754 Elections.................................................114
6. Discussions at Year-End 2001 Concerning Sale of Stock..............116
7. The Sale of Stock Held by Fidelity High Tech in 2002................116
R. The Egans Continue to Explore an Ordinary Loss Strategy...............117
1. Exercise of Options...............................■...............117
2. The Search for Ordinary Income Strategies ........................118
S. The Design and Development of the FDIS Strategy......................120
1. DGI’s “2001 Partnership Strategy Memorandum”...................120
2. Further Development of the “Financial Derivatives Investment Strategy”....................................................120
3. The Foreign Partners — Mahoney and Hawkes......................121
4. The Model Opinion for FDIS Strategy.............................122
5. The 2001 FDIS Transactions .....................................122
T. KPMG and Helios Pitch the FDIS Strategy to the Egans.................123
1. The September 2001 KPMG PowerPoint Presentations...............123
2. Further Discussions and the “Outline of Proposed Transaction”.....124
3. The Decision to Adopt the FDIS Strategy..........................124
U. Implementation of the Fidelity International Transaction .................125
1. Step One: Creation of Entities....................................125
2. Step Two: Fidelity World Enters Into Interest Rate Options.........125
3. Step Three: Capitalization of Fidelity International .................126
a. The Contribution of Fidelity World............................126
b. The Purported Increase in Basis..............................127
c. Other Capital Contributions ..................................127
4. Step Four: Fidelity International Enters Into Foreign Currency Options......................................................128
a. The Terms of the Foreign Currency Options....................128
b. The Structure of the Foreign Currency Option Pairs.............129
c. The Possibility of a One-Option Payout........................130
d. Targeting of Gains...........................................131
5. Step Five: Termination of Gain Legs and Entering Into Replacement Legs ............................................131
6. Step Six: Buyout of Foreign “Partner” ............................134
7. Step Seven: Close Out of Interest Rate Options.....................134
8. Step Eight: Termination of Remaining Foreign Currency Options.....135
9. The Stockton and Mariner Investments............................136
10. The Actual Economic Loss From the Termination of the Foreign Currency Options.............................................136
V. Documentation of the Purported “Business Purpose” of the Fidelity International Transactions..........................................137
1. The October 5, 2001 Buesinger Memorandum.......................137
2. The Proposed David Henry Memorandum..........................138
3. “Business Purpose” Discussions in October-Deeember 2001 ..........138
4. Proposed Discussions with Samuel Mahoney........................139
5. The December 18,2001 Shea Memorandum.........................139
6. The March 12, 2001 Speiss Memorandum...........................140
W. The Proskauer and Sidley Austin Opinion Letters........................141
1. The Proskauer Legal Opinion for the High Tech Transaction.........141
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2. The Sidley Austin Legal Opinion for the Fidelity International Transaction..................................................143
3. Payment of the Legal Fees of Proskauer and Sidley Austin...........146
X. Costs and Fees for the Transactions....................................147
1. Costs and Fees on the Fidelity High Tech Transaction...............147
a. Helios and KPMG Fees......................................147
b. Refeo Fees.................................................148
c. Other Fees.................................................149
2. Costs and Fees on the Fidelity International Transaction.............149
a. Helios and KPMG Fees......................................149
b. Refeo Fees.................................................149
e. Other Fees.................................................150
Y. The KPMG Engagement Letters ......................................150
1. KPMG Engagement Letter Policy for the Short Option Strategy.....150
2. The Initial Negotiations Concerning a High Tech Engagement Letter.......................................................151
3. The Proposed Modifications to the High Tech Engagement Letter.....151
4. The Fidelity International Engagement Letter......................152
5. The Egans’ Concerns about Appearing on a “List”...................153
6. Renewed Discussions Concerning the High Tech Engagement Letter.......................................................153
Z. The Preparation and Filing of the Egans’ 2001 Tax Returns...............155
1. The Partnership Tax Returns (Forms 1065) ........................155
2. The Individual Income Tax Return (Form 1040).....................155
3. The Impact of the New IRS Regulations in June 2002................156
4. The Proskauer Non-Disclosure Letter.............................157
5. KPMG’s Refusal to Sign the Egans’ 2001 Tax Return................159
AA. The Preparation and Filing of the Egans’ 2002 Tax Returns...............163
BB. The Tax Consequences of the Fidelity High Tech Transaction Claimed by the Egans......................................................163
1. The Egans’ Claimed Tax Basis in Their Partnership Interests in Fidelity High Tech............................................163
2. Fidelity High Tech’s Claimed Tax Basis in Stock Contributed by Egans.......................................................164
CC. The Reporting of the Fidelity High Tech Transaction on Partnership Returns (Form 1065)...............................................165
1. Form 1065 for the Short Tax Year Ending December 21, 2001.....165
2. Form 1065 for the Short Tax Year Ending December 31, 2001.....166
3. Form 1065 for the Tax Year Ending December 31, 2002..............166
a. Reporting of Claimed Losses .................................166
b. Other Required Explanations and Disclosures...................167
DD. Reporting of the Fidelity High Tech Transaction on the Egans’ 2002 Individual Return (Form 1040) ......................................167
EE. The Tax Consequences of the Fidelity International Transaction Claimed by the Egans..............................................168
1. Richard Egan’s Claimed Basis in His Partnership Interest in Fidelity International..........................................168
2. The Claimed Allocation of $163 Million Gain to Mahoney.............169
3. The Claimed Allocation of $163 Million Loss to Richard Egan.........169
4. The Capitalization of Fees........................................170
5. The Reallocation of Fees to Richard Egan..........................171
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FF. The Reporting of the Fidelity International Transaction on the 2001 Partnership Return (Form 1065).....................................171
1. The Netting of Gains and Losses..................................171
2. The Reporting of the Loss as “Other Income”........................171
3. The Treatment of the Currency Option “Loss” as a Section 988 Loss.........................................................172
4. The Failure to File a Form 4797 ..................................172
5. The Failure to Report the Net Loss as a “Trade or Business” Loss.........................................................173
6. The False Entries on Schedules L and M-2.........................173
a. The Purpose of Schedule L...................................173
b. The 2001 Fidelity International Schedule L.....................173
(1) “Investment in Fidelity World” of $150,304,982 ..............174
(2) Investment in “Foreign Exchange Options” of $134,832,153...........................................174
(3) The Effect of the False Reporting on Schedule L.............175
7. The Purpose of Schedule M-2 ....................................175
8. The 2001 Fidelity International .Schedule M-2 ......................176
9. The Effect of the False Schedule M-2 on the Schedule K-l...........176
10. The Ultimate Effect of the False Schedules L and M-2 ..............177
11. The Failure to Disclose the Transaction Otherwise ..................177
a. Schedule K-l, Line 25.......................................177
b. Form 8275 .................................................177
c. Schedule K-l, Line G........................................178
GG. The Reporting of the Fidelity International Transaction on the 2002 Partnership Return (Form 1065).....................................178
1. The Reporting of the Capital Loss as an Ordinary Loss..............178
a. The Purported “Section 988 Loss”.............................178
b. The Failure to Report the Loss on Schedule D..................178
c. The Resulting Tax Benefit....................................179
d. A Capital Loss..............................................179
2. The Use of the Accrual Method of Accounting ......................179
3. The False Statements on Schedules L and M-2 and on Richard Egan’s Schedule K-l..........................................180
HH. The Reporting Of The Fidelity International Transaction on the Egans’ 2001 1040 Return..................................................181
1. The Reporting of the “Loss” as a “White-Paper Netting-Transaction” .................................................181
2. The Reporting of the “Loss” under “Miscellaneous Income’...........182
a. The Reporting on Statement 1................................182
b. The Reporting of the “Loss” on Schedule E.....................183
3. The Reporting of the Options Income as “Other Income”.............183
II. The Reporting of the Fidelity International Transaction on the Egans’ 2002 1040 Return..................................................183
1. The Reporting of the Claimed Loss................................183
2. The Resulting Tax Benefits.......................................184
JJ. The Egans Sought to Conceal the Transactions from the IRS..............184
1. Denby’s Discussions with Reiss in April 2000 .......................184
2. Denby’s May 2000 Analysis.......................................185
3. Discussions in July 2000 .........................................185
4. Discussions of Increased Risk after Notice 2000-44..................185
5. Later Discussions Concerning Reporting and Audit Risk.............186
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KK. From a Subjective Standpoint, the Transactions Had No Business Purpose..........................................................187
LL. From an Objective Standpoint, the Transactions Had No Economic Substance ........................................................187
1. Reasonable Hedging or Risk-Shifting Function.....................188
2. Reasonable Possibility of Profit...................................188
MM. The Fidelity High Tech Transaction Lacked Economic Substance..........188
1. The Transaction Served No Reasonable Hedging Function...........188
a. The NASDAQ 100 Option Transactions Were Not a Rational Economic Hedge..........................................188
b. Various Components of the Transaction Served No Hedging Function.................................................189
2. There Was No Reasonable Possibility of Profit on the Fidelity High Tech Transaction.........................................190
a. The Costs and Fees for the Transaction Were Extremely High.....................................................190
b. The Expected Return on the Transaction Was Materially Negative.................................................191
c. The Net Present Value of the Options Was Materially Negative.................................................192
d. The One-Option Payout Was Not a Real Possibility..............192
e. The Options Were Not in Fact Profitable.......................192
NN. The Fidelity International Transaction Lacked Economic Substance........192
1. The Transaction Served No Reasonable Hedging Function...........192
a. The Interest Rate and Currency Option Transactions Were Not Rational Economic Hedges.............................192
(1) The Interest Rate Options ................................193
(2) The Currency Options....................................194
b. Various Components of the Transaction Served No Hedging Function.................................................195
2. There Was No Reasonable Possibility of Profit on the Fidelity International Transaction......................................195
a. The Capital Structure Was Not Rational .......................195
b. The Costs and Fees for the Transaction Were Extremely High.....................................................196
c. The Expected Rate of Return of the Transaction Was Materially Negative .......................................196
(1) The Expected Return Before Fees.........................197
(2) The Expected Return on the Transaction Was Materially Negative..............................................199
d. The One-Option Payout Was Not a Real Possibility..............200
e. The Court Does Not Credit the Conclusion of Plaintiffs Expert...................................................201
f. The Fidelity International Transaction Was Intended to be Profitless.................................................201
OO. Mahoney Was Not a Real Partner in Fidelity International................202
1. Mahoney Participated in 47 Identical Transactions in 2001............202
2. Mahoney’s Capital Contributions Were Treated as Costs of the Promoters ...................................................203
3. Any Value of the Remaining Interests of Mahoney Was Split Among the Promoters.........................................204
4. Mahoney Was Reimbursed for His Expenses and Paid a Fee for His Participation..............................................204
5. Mahoney Could Not Realize a Profit on the FDIS Transactions, Absent Fees..................................................204
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PP. Fidelity High Tech Was a Sham Partnership for Federal Income Tax Purposes .........................................................206
QQ. Fidelity International was a Sham Partnership for Federal Income Tax Purposes .........................................................206
RR. The Step Transaction Doctrine Applies to Collapse Steps of the Fidelity High Tech Transaction......................................206
1. The Steps of the Fidelity High Tech Transaction Should Be Collapsed under the “Interdependence” Test .....................206
a. None of the Individual Steps Had an Independent Business Purpose..................................................206
b. Certain Intermediate Steps Had No Business Purpose...........207 (1) There Was No Business Purpose to the Formation and Use of the Index A and Option A to Acquire the Options...............................................207
(2) There Was No Business Purpose to the Transfer of Maureen Egan’s Interest to MEE Holdings...............207
2. The Steps of the Fidelity High Tech Transaction Should Be Collapsed Under the “Component” Test..........................208
SS. The Step Transaction Doctrine Applies to Collapse Steps of the Fidelity International Transaction ...................................208
1. The Steps of the Fidelity International Transaction Should Be Collapsed Under the “Interdependence” Test.....................208
a. None of the Individual Steps Had an Independent Business Purpose..................................................208
b. Certain Intermediate Steps Had No Business Purpose...........209
(1) There Was No Non-Tax Business Purpose for the Use of Fidelity World to Purchase the Options...................209
(2) None of the Other Intermediate Steps of the Transaction, Standing Alone, Had Any Independent Business Purpose ..............................................209
2. The Steps of the Fidelity International Transaction Should Be Collapsed Under the “Component” Test...........................210
TT. The Fidelity High Tech and Fidelity International Paired Options Were, Economically, Single Positions........... 210
1. The Parties Treated the Option Pairs as a Single Position............210
2. Separating the Paired Options Would Have Required Huge Amounts of Collateral or Margin................................211
UU. The Egans Did Not Receive Independent Legal Advice from Proskauer and Sidley Austin..................................................212
1. Proskauer and Sidley Austin Did Not Provide Independent Legal Advice.......................................................212
2. The Egans Knew That the Legal Advice from Proskauer and Sidley Austin Was Not Independent.............................213
W. The Proskauer Opinion for Fidelity High Tech Was Based on Unreasonable Factual Assumptions ..................................213
1. The Opinion Contained False and Misleading Factual Assumptions..................................................214
a. Investor Representation No. 1 Was False ......................214
b. Investor Representation No. 2 Was False ......................214
c. Investor Representation No. 3 Was False ......................215
d. Investor Representation No. 10 Was False or Misleading.........215
e. The Date of the Original Contribution of EMC Stock Was False....................................................216
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2. The Opinion Omitted Essential Facts..............................216
3. Proskauer Knew That the Opinion Contained False and Misleading Factual Assumptions and Omitted Critical Facts.....216
4. Richard Egan Did Not Read the Certificate of Facts or the Proskauer Opinion Letter......................................217
WW. The Sidley Austin Opinion for Fidelity International Was Based on Unreasonable Factual Assumptions..................................217
1. The Opinion Contained False and Misleading Factual Assumptions..................................................217
a. Investor Representation No. 1 Was False ......................217
b. Investor Representation No. 2 Was False ......................218
c. Investor Representation No. 3 Was False ......................218
d. Investor Representation No. 9 Was False or Misleading..........218
2. The Opinion Omitted Essential Facts..............................219
3. Sidley Austin Knew That the Opinion Contained False and Misleading Factual Assumptions and Omitted Critical Facts.....219
4. Richard Egan Did Not Read the Investor Representation Letter.....220
XX. Both the Proskauer Opinion Letter and the Sidley Austin Opinion Letter Were Based on Unreasonable Legal Assumptions................220
YY. The Egans Did Not Reasonably Rely on Any Other Professional Advisors for Tax Advice............................................223
1. The Egans Did Not Reasonably Rely on the Tax Advice of KPMG.....223
2. The Egans Did Not Reasonably Rely on the Tax Advice of RSM McGladrey...................................................224
3. The Egans Did Not Reasonably Rely on the Tax Advice of Stephanie Denby..............................................224
IV. CONCLUSIONS OF LAW..................................................224
A. Jurisdiction and Nature of Proceeding..................................224
B. The Economic Substance Doctrine.....................................225
1. The Doctrine Generally..........................................225
2. The Doctrine in the First Circuit..................................228
3. The Objective Inquiry...........................................231
4. The Subjective Inquiry ..........................................232
C. The Treatment of Sham Partnerships ..................................233
D. The Step Transaction Doctrine........................................233
1. The “Interdependence” Test......................................234
2. The “End Result” Test ..........................................234
E. The Partnership Anti-Abuse Rules — Treasury Regulation § 1.701-2 .......234
F. Recharacterization of Transactions Based on Substance Rather than Form ............................................................235
G. Section 165(c).......................................................235
H. Accuracy-Related Penalties...........................................236
1. Gross Valuation Misstatement Penalty.............................237
2. Substantial Valuation Misstatement Penalty........................239
3. Substantial Understatement Penalty...............................239
a. “Substantial Authority”......................................240
b. “Adequately Disclosed” and “Reasonable Basis”.................240
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c. Limitation on Relief for Tax Shelter Transactions ............... 241
4. Negligence or Disregard of Rules Penalty..........................241
5. Defense to Penalties.........................................'____242
V. SUMMARY FACTUAL CONCLUSIONS ....................................243
A. Fidelity High Tech...................................................243
B. Fidelity International ................................................244
C. Penalty Issues.......................................................244
D. Other Issues........................................................246
VI. CONCLUSION............................................................246
I.
INTRODUCTION
A.
Summary of Facts
Richard J. Egan was one of the founders of EMC Corporation, a large, publicly-traded manufacturer of computer storage devices. By the year 2000, Richard Egan and his wife Maureen had amassed enormous personal wealth, the great majority of which was in the form of EMC stock.
The Egans were highly sophisticated taxpayers; Richard Egan was one of the most successful businessmen in the history of the United States. His personal and family financial affairs, including the management of his wealth and the payment of his taxes, occupied an entire organization of twenty or so employees, which included his three sons, at least two certified public accountants, and a variety of other business and financial specialists. Richard and Maureen Egan expressly delegated power over their tax affairs to their son Michael, and explicitly and implicitly delegated authority for those matters throughout the family organization.
With the Egans’ wealth and income came potentially large tax liabilities. As of 2000, the Egans beneficially owned approximately 25 million shares of EMC stock. At its peak in September 2000, EMC shares traded at more than $100 per share. Because the Egans’ basis in those shares was extremely small — approximately two cents per share — the sale of any substantial portion of that stock would have produced huge capital gains, subject to a long-term capital gains tax at a rate of 20%.
In addition, the Egans owned non-qualified options to purchase more than 8 million shares of EMC stock at very low strike prices. The exercise of those options would generate large amounts of ordinary income, subject to taxes at a marginal rate that approached 40%.
In early 2000, Richard Egan and his son Michael became interested in investing in tax shelters to avoid taxes on the capital gains and ordinary income that was likely to result from the sale of EMC stock and the exercise of the options. With the assistance of an attorney from Chicago named Stephanie Denby, the Egans interviewed several tax shelter promoters in May 2000. They eventually selected the large international accounting firm KPMG. Through KPMG, the Egans were introduced to a small firm called Helios, which (with a related company called Diversified Group International, or DGI) had designed a highly complex tax shelter transaction that it was marketing to wealthy individuals.
The original tax shelter scheme involved the contribution of both paired offsetting
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options (in large notional amounts) and appreciated assets (such as EMC stock) to an entity taxed as a partnership. In simplified terms, the promoters claimed that the purchased option was an asset, but that the sold option was not a liability; the taxpayer thus supposedly contributed assets to the partnership entity, but not liabilities, creating a grossly inflated basis in his interest in the entity. The taxpayer’s interest would then be sold, and the taxpayer would claim that the inflated basis (from the contribution of the options) “eliminated” any gain from the disposition of the stock or other assets. Variations of the scheme were designed to create artificial losses to offset ordinary income.
A significant feature of the scheme was the fact that four major law firms — including Proskauer Rose and Brown & Wood, eventually Sidley Austin Brown & Wood— had been recruited by the promoters to provide favorable opinion letters. The taxpayers were told in advance that they could choose one of the four firms for their favorable opinion. The opinion letters were in essence intended to serve as insurance against tax penalties should the IRS ever discover the transactions, and thus to induce investors to invest in the tax shelters.
By early August 2000, the Egans were on the brink of engaging in a transaction with KPMG and DGI/Helios that was designed to eliminate up to $200 million in capital gains by artificially inflating basis, and were considering a follow-up transaction designed to create up to $200 million in artificial losses to offset ordinary income.
In August 2000, the IRS issued Notice 2000-44. That notice directly attacked the types of tax shelter schemes that the Egans were about to enter into, and stated that the IRS would not recognize transactions of the type described in the Notice.
In the wake of Notice 2000^44, the promoters and their law firms concluded that it was too risky to proceed with the ordinary income portion of the scheme in its present form. The promoters and the Egans nonetheless pressed forward with the capital gains strategy, with a transaction designed to create $160 million in artificial basis. The strategy involved an orchestrated series of steps that were principally conducted through Fidelity High Tech Advisor A Fund, LLC. The essential steps of the transaction, other than the sale of the stock, were completed by early 2001. Unfortunately for the Egans, however, the price of EMC stock declined, to the point where they had created a purported “basis” of $160 million without sufficient offsetting assets to take advantage of it. The Egans accordingly decided to “stuff’ additional low-basis stock into Fidelity High Tech in an effort to use the artificial basis they had created.
In the meantime, the Egans continued to speak with the promoters about a possible tax shelter strategy for ordinary income from the exercise of the options. By early 2001, the promoters had devised a new variation of the strategy that they called the “Financial Derivatives ■ Investment Strategy,” or FDIS. The FDIS strategy, among other things, generated paper “losses” for taxpayers by assigning any offsetting “gains” offshore — to one of two Irish confederates of the tax promoters (neither of whom, of course, filed U.S. tax returns).
The Egans exercised their stock options at various points in 2001, resulting in a gain of $162.9 million. By early October 2001, the Egans had decided to use the FDIS strategy to shelter that income from taxes. Like the prior transaction, the strategy involved an orchestrated series of steps, this time through Fidelity International Currency Advisor A Fund, LLC.
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The various steps of the transaction were completed by the end of 2001.
The IRS, however, continued its efforts to crack down on tax shelters. In June 2002 — before the Egans had filed their individual tax return for the year 2001— the IRS adopted a temporary regulation that required the filing of a disclosure statement if a taxpayer had participated in certain tax shelter transactions. KPMG, which was preparing the Egans’ return, concluded that such a disclosure statement was required with the Egans’ return. Rather than make the disclosure, however, the Egans fired KPMG and hired an accountant at another law firm — who was also a confederate of the promoters — to sign them return.
Around the same time, and as promised by the promoters, the Egans received opinion letters from Proskauer Rose (as to the Fidelity High Tech transaction) and Sidley Austin (as to the Fidelity International transaction) purporting to opine that it was “more likely than not” that the proposed tax treatment would be upheld. The Egans also received a separate letter from Proskauer Rose opining that the disclosure insisted upon by KPMG was not required.
The Fidelity International transaction resulted in the creation of artificial “losses” of $158.6 million in 2001, which the Egans used to offset the ordinary income of $162.9 million from the option exercise on their 2001 income tax return that year. The disclosure statement that was prepared by KPMG, and never filed, stated that “expected reduction in federal income tax liability” from the Fidelity International transaction was $65.5 million. The Egans also claimed a loss of $1.7 million from Fidelity International on them 2002 tax return.
The Egans sold all of the stock in Fidelity High Tech in 2002, for $76.2 million in proceeds. The real basis for that stock was $8.7 million; the inflated claimed basis was more than $163 million. Instead of reporting a capital gain of $67.4 million from the sale of that stock for 2002, the Egans reported a huge loss.
The IRS eventually learned of the scheme, and disallowed the treatment of the transaction on the various partnership returns on multiple grounds.
B.
Summary of Legal Conclusions
In substance, plaintiffs Fidelity High Tech and Fidelity International seek to overturn the various adjustments made by the IRS to items on the partnership tax returns. The principal argument advanced by the government in response is premised on the economic substance doctrine, sometimes referred to as the sham transaction doctrine.
A fundamental principle of tax law is that transactions without economic substance, or sham transactions, will not be recognized. The precise contours of the economic substance doctrine have not been set, and vary from circuit to circuit. Nonetheless, it is clear that courts are required to consider the substance of a transaction, rather than its mere form, in considering the tax effect to be given to it. In making that determination, courts normally are required to consider two aspects of a transaction: the subjective purpose of the taxpayer (that is, whether the taxpayer actually had a non-tax business purpose for entering into the transaction) and the objective purpose of the transaction (that is, whether the transaction, objectively viewed, had a reasonable possibility of profit or other business benefit).
Here, the Egans claim that the principal purpose of the transactions, viewed objectively, was to serve as a hedge: to mitigate the risk of a decline in the price of EMC
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stock (in the case of the Fidelity High Tech transaction) or to mitigate the risk of fluctuating interest rates or foreign currency values (in the case of the Fidelity International transaction). From an objective standpoint, however, the transactions were entirely irrational; they were unnecessarily and extravagantly expensive, and did not hedge the purported risks effectively (or at all). The Egans also appear to claim that the transactions were entered into for profit. If so, they were also irrational for that purpose; the transactions were designed and intended to lose money, and in fact did so.
The objective features of the transactions were irrational because, of course, the Egans subjectively had no actual business purpose for entering into them. None of the participants in these complex transactions believed that they were real business transactions, with any purpose other than tax avoidance. Indeed, it is highly doubtful that any participant believed, even for a minute, that the transactions would withstand legal scrutiny if discovered. No one with the slightest understanding of the tax laws could reasonably believe that $160 million in basis could be created out of thin air, or that $160 million in income could be made to vanish in a puff of smoke. In accordance with that belief, the Egans and their ad-visors went to great lengths to try to ensure that the IRS would never find out about the transactions — including, among other things, the filing of partnership and individual tax returns with multiple false and misleading entries.
The Egans contend that their subjective intentions are irrelevant. In substance, they contend that as long as the transactions were not fictitious — that is, as long-as the entities existed, the money was transferred, and the options were purchased and sold — the economic substance doctrine does not apply. But the transactions at issue were “real” only in the sense that a performance by actors on stage is “real.” The actors are real human beings, and the stage sets are made of real wood and real paint. But the actors are reading from a script. No one watching “Macbeth” believes that they are witnessing the murder of a Scottish king, and the actors do not believe it either, Here, too, the participants were simply following a script — a script that had little or no connection to any underlying business or economic reality.
' The Egans also make a number of technical arguments, all of which assume that the transactions were real and should be respected. The linchpin of the scheme from a technical standpoint was a potential anomaly in the tax code: under a line of cases interpreting Section 752, a purchased option is an asset, but a sold option is only a contingent liability. The Egans thus take the position that a taxpayer can purchase offsetting options and contribute them to a partnership entity, and thereby contribute an asset but not a liability. From there, it is but a few steps to use the “asset” to inflate the basis of the partner’s interest in the entity. If the tax system depended entirely on form over substance, the argument might well pass muster.
But tax liabilities are not so easy to dodge. It would be absurd to consider offsetting options — purchased and sold at the same time, and with the same counter-parties — as separate items, and to act as if the one item existed and the other did not. That is particularly true where (as here) the individual option positions were gigantic, and might bankrupt the taxpayer or the options dealer if no offset were in place.
The Egans also point to the longstanding principle that it is perfectly legitimate to arrange one’s affairs so as to pay as low a tax bill as possible. That assertion is
*69
trae, as far as it goes, It is entirely appropriate, for example, for a taxpayer to decide to buy a house rather than to rent, in order to take advantage of the many tax advantages of home ownership. A taxpayer may buy a house with a mortgage in order to take advantage of the deductibility of mortgage interest. But a taxpayer cannot undertake phony or meaningless transactions and claim a tax advantage; he cannot, for example, lend money to himself, pay “interest” on the loan, and claim the interest deduction. If the tax laws permitted such a result, they would be nonsensical, and anyone who paid taxes would be a fool. The tax laws are neither so simple nor so easily evaded.
Finally, the Egans claim that they relied in good faith on formal legal opinions issued by Proskauer Rose and Sidley Austin, two highly prominent law firms. It is true that both firms issued opinions to the Egans. And it is true that both firms opined that it was more likely than not that their tax treatment of the transactions would be upheld.
But those opinions, too, were just additional acts of stagecraft. The lawyers were not in the slightest rendering independent advice; the promoters of the tax shelters had arranged favorable opinions from those firms well in advance, and as part of their marketing strategy. Indeed, the promoters (not the Egans) paid the law firms’ fees. More fundamentally, the opinions were themselves fraudulent: they were premised on purported “facts” that the Egans and the law firms knew were false, and reached conclusions that everyone involved knew could not possibly be correct. The opinions had but one purpose: to serve as a form of insurance against the imposition of penalties if the transactions were ever to come to light.
The claim of good faith reliance on counsel is thus wholly without merit. The Egans knew that the opinion letters were simply part of the tax shelter scheme, and did not for a moment believe that they were receiving independent legal advice after a full disclosure of all underlying facts.
In short, the Fidelity High Tech and Fidelity International transactions were complete shams, without any economic substance of any kind. For that reason, and for the other reasons set forth below, the transactions should not be recognized, and the adjustments made by the IRS will be upheld.
II.
NATURE OF PROCEEDINGS
These consolidated cases were brought by Richard J. Egan pursuant to 26 U.S.C. § 6226 to challenge adjustments made by the Internal Revenue Service to tax returns filed by Fidelity High Tech Advisor A Fund, LLC and Fidelity International Currency Advisor A Fund, LLC for their 2001 and 2002 tax years. Richard Egan brought the matters in his capacity as tax matters partner and notice partner of both entities.
See
26 U.S.C. § 6226 (a). The IRS’s adjustments were set forth in various notices of Final Partnership Administrative Adjustment (“FPAAs”), issued in 2005 and 2006. Plaintiffs calculated the taxes due by reason of those adjustments and made deposits of those amounts with the IRS. Plaintiffs then filed these actions to obtain a refund of the deposits.
Fidelity High Tech and Fidelity International are limited liability companies (“LLCs”). As LLCs, they are treated as partnerships for federal income tax purposes.
See
Treas. Reg. § 301.7701-2 (a). Partnerships are “flow-through” entities and are not subject to an entity-level tax, although they must file annual informational returns (Forms 1065) reporting various items. 26 U.S.C. §§ 701 , 6031(a). Tax liability on a partnership’s income is
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calculated and imposed at the partner level. Accordingly, Fidelity High Tech and Fidelity International did not pay federal income tax on their income; instead, they allocated their income among their partners.
This Court has jurisdiction to determine all partnership items of Fidelity High Tech and Fidelity International that were raised in the FPAAs.
See
26 U.S.C. §§ 6221 and 6226(f). Unlike other judicial tax proceedings, such a decision does not determine the amount of tax owed by a taxpayer or the amount of any refund of tax due to a taxpayer. Instead, the determination of partnership items in a case such as this is in the nature of a declaratory judgment. This proceeding determines the nature or amount of partnership items, and those determinations are then applied uniformly in subsequent, separate, partner-level proceedings to determine each partner’s separate tax liability. 26 U.S.C. § 6231 (a)(5), (6).
Although this proceeding generally addresses partnership-level items, not partner-level matters, it does not mean that the treatment of the two transactions on the Egans’ individual tax returns is irrelevant. To the contrary, the goal of the entire enterprise was to minimize the tax liability of Richard and Maureen Egan, and the tax shelter scheme included the making of false entries on the Egans’ individual tax returns in order to minimize the risk of audit and detection. The tax returns of the Egans are therefore discussed at some length in this opinion, although no adjustments to those individual returns are made in this proceeding.
In summary, and for the reasons stated below, the Court will uphold the administrative adjustments made by the IRS as to the nature of the partnerships and the relevant transactions. Among other things, the Court concludes that (1) the Fidelity High Tech and Fidelity International transactions lacked economic substance; (2) that Fidelity High Tech and Fidelity International were sham partnerships, and should be disregarded for federal income tax purposes; (3) that Samuel Mahoney, the Irish citizen who was a purported “partner” in Fidelity International, was not in fact a true partner; and (4) that the offsetting options pairs should be treated as a single position for federal income tax purposes. The Court also finds that various accuracy-related penalties, including the 40% gross valuation misstatement penalty, are applicable.
See
26 U.S.C. § 6662 (f).
For the sake of convenience, the Court will use the following terms, unless the context indicates otherwise:
“Fidelity High Tech” means Fidelity High Tech Advisor A Fund, LLC,
“Fidelity International” means Fidelity International Currency Advisor A Fund, LLC.
“The Egans” means Richard and Maureen Egan and their son Michael, when acting on their behalf under a power of attorney or otherwise as their agent or representative.
III.
FINDINGS OF FACT
A.
Jurisdictional Facts
1.
Fidelity High Tech
1. Fidelity High Tech Advisor A Fund, LLC (“Fidelity High Tech”) timely filed its U.S. Return of Partnership Income (Form 1065) with the IRS for its December 21, tax year by mailing it on April 15, 2002.
(Id.).
2. Fidelity High Tech timely filed its tax return with the IRS for its December 31, tax year by mailing it on April 15, 2003.
(Id.).
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3. At the time he filed these actions, Richard Egan was the Tax Matters Partner (“TMP”) of Fidelity High Tech for its 2001 and 2002 tax years. (Ex. 108).
4. Richard Egan was the authorized and proper party to bring the Fidelity High Tech cases under section 6226(a).
(Id.).
5. As a notice partner of Fidelity High Tech, Richard Egan was the authorized and proper party to bring the Fidelity High Tech cases under section 6226(b).
(Id.).
6. On October 11, 2006, the IRS sent a Notice of Beginning of Administrative Proceeding (“NBAP”) to the TMP of Fidelity High Tech with respect to its December 31, 2002 tax year.
(Id.).
I.
On October 13, 2006, the IRS mailed a Notice of Final Partnership Administrative Adjustment (“FPAA”) to the TMP of Fidelity High Tech with respect to its December 21, 2001 tax return.
(Id.).
8. On October 13, 2006, the IRS mailed an FPAA to the TMP of Fidelity High Tech with respect to its December 31, 2002 tax return.
(Id.).
9. On November 13, 2006, Richard Egan timely filed a complaint with respect to Fidelity High Tech’s December 21, 2001 tax year pursuant to section 6226.
(Id.).
10. On November 13, 2006, Richard Egan timely filed a complaint with respect to Fidelity High Tech’s December 31, 2002 tax year pursuant to section 6226.
(Id.).
II. Prior to filing the complaint in the Fidelity High Tech cases, Richard Egan deposited $13.6 million with the IRS.
(Id.).
12.At the time the complaints in the Fidelity High Tech cases were filed, Fidelity High Tech’s principal place of business was located in Westborough, Massachusetts.
(Id.).
2.
Fidelity International
13. Fidelity International Currency Advisor A Fund, LLC (“Fidelity International”) timely filed its tax return with the IRS for its 2001 tax year by mailing it on April 15, 2002.
(Id.).
14. Fidelity International timely filed its tax return with the IRS for its 2002 tax year by mailing it on April 15,2003.
(Id.).
15. Richard Egan was the TMP of Fidelity International for the 2001 and 2002 tax years.
(Id.).
16. In his capacity as both the TMP and a notice partner of Fidelity International, Richard Egan was the authorized and proper party to bring the Fidelity International cases under section 6226(a) and (b).
(Id.).
17. On April 6, 2005, the IRS mailed an FPAA with respect to Fidelity International’s 2001 tax return to the TMP ofFICAAFund.
(Id.).
18. On September 1, 2005, Richard Egan timely filed a complaint with respect to Fidelity International’s 2001 tax year.
(Id.).
19. On April 26, 2006, the IRS mailed an FPAA to the TMP of Fidelity International with respect to its 2002 tax return. (Ex. 265).
20. On June 30, 2006, Richard Egan timely filed a complaint with respect to Fidelity International’s 2002 tax year. (Ex. 108).
21. Prior to filing the complaints in the Fidelity International cases, Richard Egan deposited $62,600,000 with the IRS ($62,100,000 for its 2001 tax year and $500,000 for its 2002 tax year).
(Id.).
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22. At the times that the complaints in the Fidelity International cases were filed, Fidelity International’s principal place of business was located in West-borough, Massachusetts.
(Id.).
23. Richard J. Egan died on August 28, 2009. (Docket # 513).
24. Michael J. Egan and John R. Egan, as co-executors of the estate of Richard J. Egan, have been substituted as plaintiffs for Richard J. Egan. (Docket # 513).
B.
EMC, the Egans, and Related Parties
1.
EMC and Richard Egan
25. EMC Corporation is a large, publicly-traded corporation headquartered in Hopkinton, Massachusetts. It develops and sells, among other things, data storage and retrieval technology and products. In 2000, it had revenues of more than $8.8 billion and more than 24,000 employees. (Ex. 108; Ex. 788).
26. Richard Egan co-founded EMC in 1979. (Ex. 108).
27. Richard Egan held the position of Chief Executive Officer from the founding of EMC until 1992. (R. Egan, 1:111-12).
28. Richard Egan was the Chairman of the Board of Directors of EMC from January 1988 until January 17, 2001, when he was named Chairman E merit us. (Ex. 108).
29. Richard Egan resigned as Chairman E merit us of EMC on September 10, 2001.
(Id.).
30. Richard Egan served as the U.S. Ambassador to Ireland from September 10, 2001, until January 31, 2003.
(Id.).
31. EMC had its initial public stock offering, and became a publicly-traded company, in 1986. (R. Egan, 1:110, Exs. 108, 788).
32. Prior to EMC’s first public offering, Richard Egan owned approximately 70% of the stock of EMC. (R. Egan, 1:110). All, or almost all, of the EMC stock that the Egan family owned at the beginning of 2000 was unregistered founders stock.
(Id.
at 2:13; Denby, 28:42).
33. The number of EMC shares held by Richard Egan grew over time due to multiple stock splits. (R. Egan, 2:29-30).
34. As of September 7, 2001, Richard and Maureen Egan beneficially owned approximately 25 million shares of EMC stock. (Ex. 108). As of January 1, 2001, Richard and Maureen Egan also owned fully-vested options to purchase 8,320,000 shares of EMC stock at relatively low strike prices. (Ex. 1414).
35. Richard and Maureen Egan were subject to various restrictions on the sale of their stock, including SEC rules and EMC policies that restricted stock trades to certain windows of time. (Exs. 21, 22, 326).
36. On August 28, 2009, after the trial of this matter, Richard Egan died. (Docket # 507).
2.
The Egan Family
37. Richard and Maureen Egan were married, (R. Egan, 1:107-08).
38. The Egans had three sons, Michael, John (also known as “Jack”) and Christopher, and two daughters, all of whom were adults at the relevant times.
(Id.
at 1:108).
39. Richard Egan was a resident of Massachusetts.
(Id.
at 1:107).
40. During the relevant years, Maureen Egan claimed residency in Flori
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da, although the couple was not legally separated.
(Id.
at 1:108; M. Egan, 5:47).
41. Maureen Egan was a director of EMC from March 1993 until she resigned effective January 17, 2001. (Ex. 108).
3.
Carruth Management and Subsidiaries
42. The appreciation in the price of EMC stock in the 1990’s rapidly increased the Egan family’s wealth. (R. Egan, 2:28; M. Egan, 5:36, 44).
43. In the early 1990’s, Richard Egan formed a “family office” to manage his wealth, make investments, and handle personal administrative matters. (Ex. 108; R. Egan, 2:26-30).
44. Michael Egan, who previously had worked at EMC, began working full-time at the family office in approximately 1992. (M. Egan, 5:29, 36). Jack Egan and Christopher Egan also began working for the family office in the 1990’s.
(Id.
at 5:78-79).
45. In the 1990’s, the Egan family office began to operate under the name Carruth Management.
(Id.
at 5:26).
46. Carruth Management LLC was formed in Delaware in 1997. (Ex. 120). It is located in Westborough, Massachusetts. (M. Egan, 5:26). Carruth is owned in equal parts by Michael, Jack, and Christopher Egan. (Exs. 120,108).
47. Michael Egan is the Chief Executive Officer of Carruth Management. During the relevant time, he had general authority to invest and manage Egan family assets. (R. Egan, 2:31, 39, 50).
48. In 2000-2001, the Egan family’s investments consisted principally of the following asset classes: EMC stock and options; commercial real estate; publicly-traded stocks and other securities; and private equity investments. (Exs. 73,120, 201).
49. Christopher Egan largely handled real estate investments for Carruth, and Jack Egan largely handled venture capital and private equity investments. (M. Egan, 5:78-79; Ex. 120).
50. Carruth Partners is a wholly owned subsidiary of Carruth Management. (M. Egan, 5:79). Carruth Partners was used to control the commercial real estate that the Egans owned.
(Id.;
Ex. 120).
51. Carruth Associates LLC was formed in Delaware in 2000, and is a wholly-owned subsidiary of Carruth Management. (Ex. 120).
52. During the period from 2001 to 2003, Carruth Associates had approximately twenty employees. (Reiss, 26:119).
53. The following persons were employees of Carruth Associates during the relevant time:
(a) James Reiss was the Chief Financial Officer of Carruth Associates.
(Id.
at 26:112; Ex. 120). He has been a certified public accountant since 1989. (Reiss, 26:114). He joined the Egan family office in 1996.
(Id.
at 26:117).
(b) Patrick Shea was the Chief Operating Officer of Carruth Associates. (Shea, 14:91; Ex. 120). He has been a certified public accountant since 1981. (Shea, 14:91). He joined Carruth on June 26, 2000.
(Id.
at 14:91, 15:128). Among other things, Shea was the supervisor of the tax and accounting group at Carruth.
(Id.
at 14:92).
(c) Melissa Seaver was the Senior Tax Manager of Carruth Associates. She joined Carruth in July 2001.
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(Seaver, 25:116, 120). She has been a certified public accountant since 1999.
(Id.
at 25:119).
(d) Carolyn Fiddy was the Manager of Investments at Carruth Associates until March 2002. (Calkins, 35:27-28).
(e) Robin Calkins was an Investment Assistant at Carruth Associates in 2000. In March 2002, when Fiddy left Carruth, Calkins became Manager of Investments.
(Id.;
Ex. 120).
(f) David Henry was the Director of Investments at Carruth Associates. He joined Carruth in March 2001. (Henry, 4:106; Ex. 120).
54. In the period from 2001 to 2003, Carruth was generally responsible for preparing and reviewing tax returns for Richard and Maureen Egan and various Egan family entities. (Seaver, 25:120-23).
55. Carruth also relied on outside accountants and advisors for tax advice and preparation of tax returns. (Seaver, 25:125; M. Egan, 5:67).
4.
Burke, Warren Law Firm
56. The law firm of Burke, Warren, MacKay
&
Serritella, P.C. is located in Chicago, Illinois.
57. Stephanie Denby was a partner of Burke, Warren. (Denby, 28:8-9). Richard and Maureen Egan became clients of Denby in 1994, when she was hired by Michael Egan to assist them with estate planning.
(Id.
at 28:10-11; R. Egan, 2:54).
C.
The Tax Promoters and their Associates
1.The Diversified Group Incorporated
58. The Diversified Group Incorporated (“DGI”) was a self-described “boutique merchant banking firm” based in New York that, among other things, designed and marketed tax shelter products. (Ex. 811).
59. James Haber was the President of DGI.
(Id.).
60. Orrin Tilevitz was Vice-President and General Counsel of DGI.
(Id.).
61. Mox Tan was a Managing Director of DGI based in Chicago.
(Id.).
62. Philip L. Kampf, Jr., was a Managing Director of DGI based in Chicago.
(Id.).
2. Helios Financial LLC
63. Helios Financial, LLC was also a self-described “boutique merchant banking firm” based in Chicago. (Ex. 28). Helios had a contractual relationship with DGI under which, among other things, it marketed DGI tax shelter products and assisted in their development. (Ex. 400). As described by one colleague, James Haber had two companies that ran “similar deals” because he had “different partners.” (Ex. 29).
64. James Haber was the Managing Director of Helios. (Ex. 28).
65. Mox Tan and Phil Kampf were Principals of Helios.
(Id.).
3.
KPMG, LLP
66. KPMG, LLP is a national accounting firm.
67. John Schrier was a partner of KPMG. He was a member of KPMG’s “Innovative Strategies Group” in the New York office. (Ex. 470).
68. Timothy Speiss was a partner of KPMG. He was a member of KPMG’s “Personal Financial Planning” (“PFP”) group in the New York office. (Ex. 1684).
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69. Robert Prifti was a Senior Manager in KPMG’s Boston office and was a member of its PFP group.
(Id.).
70. Brian Rivotto was a partner in KPMG’s Boston office and was a member of its PFP group. (Exs. 249, 658).
4.
Alpha Consultants. LLC
71. Alpha Consultants, LLC is a Florida limited liability company that, among other things, conducted trades in options and foreign currencies. (Ex. 811).
72. Ivan J. Ross was the managing member of Alpha.
(Id.).
73. Ronald Buesinger was a manager of Alpha.
(Id.).
5.
Samuel Mahoney
74. Samuel Mahoney is a citizen of Ireland. He was a director and owner of Biosphere Finance Limited, an Irish company, with offices in Dublin, Ireland. (Mahoney Dep. at 4-5; Ex. 1012).
6.
Refco Capital Markets Limited
75. Refco Capital Markets Limited (“Refco”) was a dealer in options. (Ex. 108).
7.
Proskauer Rose, LLP
76. Proskauer Rose, LLP (“Proskauer”) is a national law firm.
77. Ira Akselrad and Janet Korins were partners in the New York office of Proskauer.
78. Matthew Sabloff and Michael Swiader were associates in the New York office of Proskauer.
8.
Sidley Austin Brown & Wood, LLP
79. Sidley Austin Brown & Wood, LLP (“Sidley”) is a national law firm. Sidley was the result of a merger in May 2001 between Sidley Austin and Brown & Wood, LLP (“Brown
&
Wood”).
80. R.J. Ruble was a partner in the New York office of Brown
&
Wood. He became a partner in Sidley in May 2001.
9.RSM McGladrey, Inc.
81. RSM McGladrey, Inc. (“RSM”) is a national accounting firm.
82. Ronald G. Wainwright, Jr., was Director of Tax Services in the Raleigh, North Carolina, office of RSM McGladrey. (Wainwright Dep. 1:27-28, 33-34).
D.
The Egans
’
Tax Problems
1.
Low-Basis EMC Stock
83. As a result of the success of EMC Corporation, the value of its stock rose enormously from 1979 to 2000.
84. The market price of EMC stock peaked in September 2000, when it traded at more than $100 per share. (Ex. 108). As of that date, the Egans’ shares were worth more than $2 billion. (Ex. 278).
85. The basis of Richard Egan’s shares of EMC was very low. For example, the EMC shares that were eventually sold as part of the Fidelity High Tech transaction had a basis of $0.0208 per share. (Ex. 10).
86. In 2000 and 2001, EMC stock and options comprised the great majority of Richard Egan’s wealth. (R. Egan. 2:14; M. Egan, 5:46; Ex. 278).
87. The long-term capital gains tax rate for high-income taxpayers was 20% in 2000 and 2001. Accordingly, if Richard Egan had sold EMC stock for $150 million, he would likely be sub
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ject to a long-term capital gains tax of approximately $30 million.
2.
Non-Qualified Stock Options
88. As of January 1, 2001, Richard and Maureen Egan owned fully-vested options to purchase an additional 8,320,-000 shares of EMC stock. (Ex. 1414).
89. The options had been granted in 1996 and 1997. (Exs. 325, 780, 791). The strike prices varied, but ranged between approximately $1.15 and $3.05. (Exs. 325, 780, 791).
90. The options were “non-qualified options” within the meaning of the Internal Revenue Code. (Shea, 15:72). As a result, any gain from the exercise of those options would result in income taxable at the ordinary income tax rate, rather than at the lower long-term capital gains tax rate.
91. The highest marginal federal income tax rate in 2000 was 39.6%, and in 2001 it was 39.1%. For planning purposes, and to take other taxes into account, the Egans and their advisors assumed an effective tax rate on income from the exercise of options of 40%-43.5%. (Exs. 471, 1034). Accordingly, if Richard Egan had exercised non-qualified options producing a gain of $150 million, he would likely be subject to tax on that gain of approximately $60 million to $65.25 million.
92. As described above, Richard Egan became Ambassador to Ireland on September 10, 2001. In order to become ambassador, it was necessary for Egan to resign as chairman of EMC. (Ex. 791).
93. The non-qualified options held by Richard Egan would expire upon his resignation from the board of EMC.
(Id.).
E.
The Delegation of Authority for Tax Affairs to Michael Egan and Carruth
94. During the relevant time, Michael Egan had primary responsibility for his parents’ tax affairs. That responsibility included the decision to invest in the tax shelters at issue in this litigation, and the filing of the 2001 and 2002 individual income tax returns of Richard and Maureen Egan, which he signed under a power of attorney. (Exs. 8, 232).
95. On October 12, 2001, Richard Egan executed a power of attorney granting Michael Egan broad authority, including authority as to his “tax matters.” (Ex. 1128).
96. On December 12, 2001, Maureen Egan executed a power of attorney granting Michael Egan broad authority, including authority as to her “tax matters.” (Ex. 15).
97. Richard Egan had knowledge of, and was involved in, the decision to invest in the tax shelters at issue and the later filing of tax returns with the IRS, although he delegated much of the responsibility, particularly the day-to-day responsibility, to Michael Egan and employees of Carruth.
98. Maureen Egan had no role at all with regards to her tax affairs, which were handled by her husband Richard and her son Michael. (Maur. Egan Dep. at 15-16, 59).
99. Employees of Carruth, acting at Michael Egan’s direction and pursuant to his delegation, also exercised authority over the tax affairs of Richard and Maureen Egan to various degrees. James Reiss, the CFO, and (after June 2000) Patrick Shea, the COO, had day-to-day responsibility at Carruth for the tax matters at issue in this litigation.
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F.
Early Discussions Concerning Tax Shelters
100. By late April 2000, the Egan family and its advisors had begun discussing possible strategies to minimize or eliminate taxes on the exercise of options and sale of EMC shares. In particular, the Egans began considering tax strategies that would generate an artificial step-up in basis to eliminate capital gains or the creation of artificial losses to offset ordinary income.
101. The strategies they were considering, and that they eventually adopted, were tax reduction strategies — not investment strategies that were intended to make money, or hedging strategies that were intended to reduce risk or preserve capital.
102. Jim Reiss of Carruth and attorney Stephanie Denby of the law firm Burke, Warren took the early lead in exploring possible tax strategies and setting up meetings with tax advisors and promoters.
103. On April 25, 2000, Reiss wrote to Denby that Michael Egan was “anticipating unloading his father’s EMC shares at $140” per share, and asked if she had a “good lead on a transaction and insurance.” (Ex. 3568). The “transaction” he had in mind was one that would avoid taxes. (Denby, 28:71).
104. On April 27, 2000, Denby wrote a memorandum to Richard Egan regarding the availability of “capital gains offset strategies.”
(Id.
at 28:72; Ex. 3566). Denby wrote:
There are several strategies still in play which through a series of transactions will create for tax purposes a step-up in basis or capital loss while transactions net out as economically neutral. The basis or
loss could then be used to offset capital gains upon the sale of EMC stock. These transactions exploit instances in which the tax code has inconsistent treatment for what is in effect offsetting positions.
In 1998 we looked at several of these transactions. Similar types of transactions are still available. 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.
(Ex. 3566).
105.In her April 27 memorandum, Denby also addressed the audit risks, as follows:
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. The reported tax cases for similar transactions all involve C corporations .... There are further steps that we can take to limit these risks. First, some of the promoters limit use of the transactions to 5 to 7 clients. Therefore, they will only allow to be used in large situations. Secondly, some of the transactions focus on generating basis as opposed to capital loss. Basis is more
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discrete [sic] and less likely I believe to cross the IRS radar screen.
(Id.).
106. In her April 27 memorandum, Denby also addressed the availability of penalty insurance to further offset the risk of audit, as follows:
We are simultaneously looking at the availability of purchasing insurance to further offset risk in case of audit. Initially, I was optimistic that this product will be available for these type of transactions. However, as we are digging deeper it appears that this is a less likely option. I do not think that we will know whether insurance is available until we are a little further down this path because insurance companies will have to look at the tax opinions before making a final decision.
(Id.).
107. Finally, Denby balanced the possible tax savings from the strategies against the cost and risk, as follows:
I think the risk of this transaction catching the IRS attention is very low. At least for one of these transactions, the fees involved will be less than 25% of the potential tax liability.
(Id.).
108. From the inception of their search for tax strategies, the Egans and their advisors knew that these strategies were not normal business transactions and would likely expose them to tax penalties if the transactions were ever discovered by the IRS.
109. Before writing the April 27 memorandum, Denby had investigated the possibility of obtaining insurance to cover any tax liability or tax penalty that might be assessed if the transactions were disallowed.
110. By e-mail dated April 19, 2000, with the subject line “income tax techniques,” Denby wrote to Reiss regarding the availability of such insurance from an offshore entity:
Today I met with a representative of AIG on an unrelated matter. They are underwriting tax liabilities with a tax opinion letter.... The cost is 10% of the tax exposure and it also covers interest and penalties. This would suggest that you go for it and the total cost would [be] lets estimate 10% of the tax exposure with no future risk. They are also underwriting offshore so that you don’t have to worry about a public policy bar to coverage for the penalties. If my estimate of the costs is correct we could get the insurance on one of these techniques, it would appear to be a 50% home run (easy money — maybe too easy). We may need to have structures in place before sales for some of the techniques — so let me know if you want me to get moving. Do you have any particular techniques in mind? Let me know what you think.
(Ex. 3595).
111. By e-mail dated May 2, 2000, Den-by wrote to Reiss as follows:
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. (Denby, 28:69; Ex. 3600 (internal quotation marks in original)).
112. That same day, Reiss replied by email as follows:
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They probably help insure “straight” transactions. What fun is there to that? I agree with your comment.
(Denby, 28:69; Ex. 3600 (internal quotation marks in original)).
113. After May 2, 2000, the Egans made no further attempt to acquire insurance for tax liabilities or tax penalties.
114. The bill sent by Burke, Warren to the Egans for April 2000 for the work performed by Denby includes entries for “reviewing possible income tax strategies,” “exploring capital gains strategies,” and “capital loss strategies risk assessment insurance alternatives.” (Ex. 2802). The bill for May 2000 includes entries for “tax strategies, shelter legislation and insurance” and “issues regarding gains techniques.” (Ex 2803).
G.
The “Short Option Strategy”
115. The record does not indicate who developed the initial variant of the tax shelter strategies at issue in this litigation. Nonetheless, by early 2000, KPMG, DGl/Helios, and Alpha were working together (and with other firms) to develop, market, and implement paired-option tax shelter strategies.
116. The basic strategy involved the use of offsetting short and long options that were contributed to an entity taxed as a partnership, in which the taxpayer took the position that one leg of the options created a “loss” or a “step-up” in basis and the other leg should be disregarded.
117. One of the keys to the tax shelter strategy was the general principle, set forth in
Helmet v. Comm’r,
34 T.C.M. (CCH) 727 (1975), that the claim of the holder of an option against the grantor of an option is not a liability within the meaning of section 752. The strategy took the position that when a taxpayer contributed paired offsetting options to a partnership, the taxpayer contributed an asset but not a liability.
118. By early 2000, KPMG was marketing the tax shelter strategy under the name “Short Option Strategy.” (Ex. 458).
119. Variations of the strategy could function as a “gain eliminator” or a “loss generator.” A “gain eliminator” would create an artificial step-up in basis to avoid capital gains taxes on the sale of appreciated property. A “loss generator” would create an artificial loss to offset capital gains or ordinary income.
120. For example, by e-mail dated July 14, 2000, Peter Prescott of KPMG sent James Haber of DGl/Helios a “short summary of short options strategy variations.” (Ex. 464). The e-mail summarized several variations on the “plain vanilla” strategy that could be used to “increase” basis or generate a purported “loss.”
(Id.).
121. By June 2000, KPMG had developed a PowerPoint presentation for the Short Option Strategy for marketing to prospective clients. (Ex. 458). The PowerPoint presentation showed how the strategy could offset capital gains from the sale of appreciated property.
(Id.).
122. An important aspect of the Short Option Strategy was the preparation of individual legal opinion letters for each taxpayer and each “investment.” (Ex. 426). A law firm would agree in advance to provide a favorable opinion letter after the transaction was consummated, in order to induce the taxpayer/investor to purchase the strate
*80
gy and to serve as a form of insurance against tax penalties.
123. Four law firms worked with DGI/Helios and KPMG to develop and market the strategy and to issue favorable opinions: Brown & Wood (later Sidley Austin Brown
&
Wood); Proskauer Rose; Bryan Cave; and Lord, Bissell & Brook.
124. KPMG and DGI/Helios used a “model opinion” from Brown & Wood to assist them in marketing the Short Option Strategy. (Exs. 443, 132, 3565).
125. The fee paid by the tax payer/investor for the Short Option Strategy normally included the cost of the opinion letter on the transaction, which was paid directly by DGI/Helios to the law firm. (Exs. 563,1519, 2771).
126. Helios had a fee sharing arrangement with KPMG with respect to the Short Option Strategy. (Exs. 3231, 3232). Helios also had a fee sharing arrangement with DGI and Alpha. (Exs. 1640, 2771).
127. The Short Option Strategy was marketed to dozens of taxpayers. (Ex. 532).
128. As described below, the IRS issued a notice on August 11, 2000, that in substance identified the Short Option Strategy as an abusive tax shelter. Four days later, KPMG issued a directive to “stop marketing” the strategy. (Ex. 282). KPMG partners continued, however, to work with DGI and Helios on new variations of the paired-option strategies.
H.
The May 2000 Meetings
1.
The May 15, 2000 Meetings in New York
129. In May 2000, Stephanie Denby helped set up a series of meetings in New York City between the Egan Family and the law firm Jenkens
&
Gilchrist (“J & G”) and the accounting firms KPMG and Ernst & Young LLP (“E
& Y”)
in order to explore tax shelter strategies. (Denby, 28:63-64; Ex. 431).
130. By e-mail dated May 4, 2000, Den-by wrote to Reiss that she had “hooked up” with Steven Rosenthal, a tax partner at KPMG. (Denby, 28:83; Ex. 3226). Denby had contacted Rosenthal at Reiss’s suggestion, and spoke with him about “techniques in conjunction with the sale of EMC stock.” (Denby, 28:83). Rosenthal cautioned that he was “very skeptical about these kinds of techniques,” but “offered to look over any techniques [and] offer his risk assessment.” (Ex. 3226). Denby did not pursue Rosenthal’s offer. (Denby, 28:84).
131. On May 4, 2000, Denby e-mailed Reiss concerning planned meetings with J
&
G and E
&
Y.
(Id.
at 28:93; Ex. 3227). Denby wrote:
... the E & Y guys are very squirrelly. I am having a hard time getting detail out of them. They are very proprietary....
(Ex. 3227).
132. On May 5, 2000, Denby sent the following e-mail to Reiss:
Have hooked up with the right person at KPMG (John Schweiyer) [sic]. He is very knowledgeable about the market. He has 2 transactions that are interesting. I would like to add him to the [May 15] event. Even if we do not use his product he has a good knowledge of the range of products out there and a good critical eye for the pluses and minuses. He would be a good special consultant.... This is
*81
also heavy stuff so I hope we don’t have overload....
(Ex. 3229).
133. By e-mail to Reiss dated May 8, 2000, Denby confirmed that she had made a tentative schedule for Richard Egan and Michael Egan to meet sequentially with KPMG, J
&
G, and E & Y in New York on May 15. (Den-by, 28:88; Ex. 3228). Denby noted that the planned meeting with J & G would be “fairly short since they are only talking about one strategy” and that “[t]he KPMG meeting should be the most informative since the presenter [John Schrier] is familiar with all these types of strategies & is very helpful in risk assessment etc.” (Ex. 3228). Denby again noted, “I am having a hard time getting additional information from E
&
Y.”
(Id.).
134. J & G required the Egans and their representatives to sign non-disclosure agreements prior to the meeting at which they disclosed their tax strategy. (Exs. 432, 438, 3552, 3554).
135. On May 11, 2000, KPMG sent Denby a copy of a PowerPoint presentation as “preparation material for your upcoming meeting.” (Ex. 131).
136. Before the planned meeting with J
&
G on May 15, 2000, J
&
G provided Denby with a memorandum dated April 2000, entitled “Tax Consequences of Contribution of Option Spread to Partnership or Corporation,” that described its tax strategy. (Denby, 28:92; Ex. 434).
137. On May 10, 2000, E & Y sent a fax to Denby outlining its “Personal Investment Corporation Strategy.” (Denby, 28:96-97; Ex. 437).
138. On May 12, 2000, three days prior to the planned meetings in New York City, Denby faxed Michael Egan charts that she had prepared outlining her analysis of “each of the strategies” that were to be presented by J
&
G, KPMG, and E & Y. (Denby, 28:62-63; Ex. 3551).
139. One of Denby’s charts was entitled “Jenkens & Gilchrist Step Up in Basis for EMC Stock.” (Ex. 3551). Next to “Step 1,” Denby noted that the strategy was implemented using “short and long currency positions which offset each other” with “very limited downside risk.”
(Id.).
Next to “Step 2,” Denby noted that the transaction “generates $100 million of basis [for Maureen Egan] when the transaction is economically neutral.”
(Id.).
Next to “Step 3,” Denby noted:
When options expire, [Maureen Egan] contributes LP units to LLC. Transfer will allow 754 election. This ‘unleashes’ the basis so it can be applied against the sale of EMC stock.
(Id.).
140. Another of Denby’s charts was entitled “KPMG Capital Gains Elimination Strategy.”
(Id.).
Denby noted the following in her May 12 cover letter:
The KPMG strategy involves creation of a lot of entities and subsequent redemptions and liquidations. Therefore, the chart is very confusing. However, these redemptions and liquidations create the same type of tax inconsistency that occurs in the Jenkens & Gilchrist structure.
(Id.).
141. Another of Denby’s charts was entitled “Ernst
&
Young Deferral Strategy.”
(Id.).
Next to “Step 3,” Denby noted “Capital gains triggered by sale of EMC stock offset by investment ‘losses’ generated under Step 1.”
(Id.).
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142. On May 15, 2000, Richard Egan, Michael Egan, Reiss, and Denby met with representatives of KPMG, J & G, and E
&
Y in New York. (Ex. 3532; M. Egan, 6:112; Denby, 28:34; Reiss, 27:8-9).
143. Michael Egan and Denby testified that the Egans attended the meetings in New York on May 15 because the Egans were looking for a new accounting firm to replace O’Connor & Drew, the local accounting firm that they had been using. (M. Egan, 5:72, 76, 6:112; Denby, 28:34).
144. In response to a question as to what was “the purpose of that trip” to New York on May 15, Michael Egan testified:
As I understood it, we were — I was looking for — to talk to other accounting firms, more larger — Big Eight size accounting firms to understand if they had ideas, they were qualified to be our new lead accountant.
(M. Egan, 5:72). He acknowledged that “tax planning was discussed” at the meetings.
(Id.
at 5:74). He said, however, that the KPMG presentation “wasn’t that interesting” and “wasn’t really useful.”
(Id.
at 5:83).
145. Richard Egan testified that he did not remember much about the May 15 meetings. (R. Egan, 2:47-48). He testified that he understood he was included in the meetings in order to “size up the people that Michael was looking to learn from or hire.”
(Id.
at 2:47). He also testified that he did not recall that he and Michael Egan, or anyone else at the family office, “ever talk[ed] about taxes.”
(Id.
at 2:55-56). He attributed his lack of memory to the fact that he kept excusing himself from the meetings. (R. Egan, 2:48).
146. The Court does not find the testimony of Michael Egan, Stephanie Denby, or Richard Egan concerning the purpose of the May 15 meetings to be credible.
147. The purpose of the meetings in New York on May 15, 2000, was for the Egans and their representatives to listen to presentations by J & G, E & Y, and KPMG concerning tax avoidance strategies.
148. On May 16, 2000, the day after the meetings, Reiss sent the following email to Denby:
Dick [Egan] did tell Mike [Egan] on the trip back that he’d rather have us help him make money than save it (i.e. [tax] Reduction Strategies are not his cup of tea I guess). I’ll ping Mike more on this later in the week.
(Denby, 28:105; Ex. 3230).
149. On May 17, Denby sent the following e-mail: “Interesting. Keep me up to date if there is anything more they want me to do on the reduction strategies.” (Denby, 28:105-06; Ex. 3562). Reiss then replied as follows:
Mike’s comment to me today was ‘that may have been what you heard but that’s not what he really said.’ Dick knows how to make money but may not know how to save it. I.e. we should keep pursuing our options.
(Ex. 3562).
150. The bills sent by Burke, Warren to the Egans for May 2000 did not include any reference to work performed to replace O’Connor & Drew. (Ex. 2803). For May 15, 2000, Denby billed the Egans 8.5 hours, which she described as “Meet with client regarding loss strategies.”
(Id.).
For May 16, 2000, Denby billed the Egans 3.5
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hours, which she described as “Issues regarding reliance on opinion. Review [Redacted].”
(Id.).
For May 4, 2000, Greg Winters, an associate at Burke, Warren, billed the Egans 5 hours, which he described as “draft memorandum to Stephanie Denby regarding substantial understatement of tax penalty and tax shelters.”
(Id.).
2.
The May 19, 2000 Meeting in Chicago
151. During the presentation in New York City on May 15, 2000, John Schrier of KPMG told Denby about Helios and recommended that she meet with them. (Denby, 28:110; Ex. 3527). Although the details are unclear, it appears that Schrier suggested Helios as a promoter of a more complex or sophisticated variant of the Short Option Strategy.
152. On May 18, 2000, Denby sent the following e-mail to Jim Reiss:
I am meeting with [Helios] tomorrow. It sounds like a very similar transaction to the [Jenkens] transaction. It uses Nasdaq options. It is a more limited circulation. Brown
&
Wood supplies the opinion letter. The letter will be more likely than not or possibly should be. The actual options are more expensive. Between 2.5% to 3.5%. After that the fee component is priced similarly and subject to the same type of negotiation.
(Denby, 28:107; Ex. 3565).
153. Reiss responded to the May 18 email as follows:
Company is called [Helios]? Is Brown & Wood reputable (should be opinion is unusual)? No issue with corps allowed into this strategy ? I think we need to start to grid out the different products for concepts, permanent, deferral, #/types of entities, breakdown of fees, opinion letter, compliance, etc.
Let’s include info on KPMG Option strategy as well.
(Ex. 3565).
154. On May 19, 2000, Denby met with Mox Tan of Helios in Chicago to discuss the Helios tax strategy. (Denby, 28:109; Ex. 3527).
155. The proposed tax strategy involved the use of offsetting options on the NASDAQ 100 Index Tracking Stock, which are also referred to as “QQQ” options, based on their stock ticker symbol,
156. Immediately following her May 19 meeting with Tan, Denby sent an email to Michael Egan and Reiss with the subject line “Helios strategy.” (Denby, 28:109; Ex. 3527). The email summarized what she had learned about Helios, including the fact that Helios had both a gain elimination strategy for capital gains stock and a loss generation strategy for ordinary income. (Ex. 3527). She also proposed a follow-up meeting with Helios in Boston:
As I discussed with Jim [Reiss], Helios offers a very similar transaction to the [Jenkens] & Gilchrist transaction. Helios is the group that KPMG recommended. The foreign currency transaction can be used to offset ordinary income on the sale of EMC options. They also offer a QQQ strategy with Nasdaq options. This can only be used to offset capital gain (not EMC options). I think the Helios will be a much more customized solution compared to [Jenkens]. They have also limited distribution. Currently they have only done 12 foreign cur
*84
rency swaps. The QQQ strategy is new so there have been none of these yet. The QQQ will only be marketed to individuals. Some corps have done the foreign currency swap. Jim [Reiss] thought you would be interested in meeting with them.
(Id.).
157. On May 19, after the meeting with Denby, Mox Tan of Helios sent her a “form of a tax opinion from Brown & Wood.” (Ex. 132). In the cover memorandum, Tan wrote, “Although the opinion discusses an investment in foreign currency, the analysis for the QQQ trade should be the same, with the exception of the [Internal Revenue Code] Section 988 discussion.”
(Id.).
158. The Brown & Wood opinion sent by Tan was labeled as a “model opinion” in bold letters at the top, and stated that it was intended “for the purpose of facilitating an analysis of the issues.”
(Id.).
159. Patrick Shea received a copy of the model opinion after he joined Carruth in June 2000, on which he made handwritten notes. (Ex. 2768).
160. Shea’s notes on the model opinion include the following:
1). Business reason — hedge against drop in EMC stock
2). Need to be a partnership for [Section] 721 [nonrecognition] of gain on transfer to partnership
3). Section 752 states short option not a liability, therefore, not a reduction in basis to fund
4). No penalties under [Section] 6662 due to reasonable basis for tax treatment
5). Reasonable assurance more likely than not from attorneys
(Id.).
161. Also on May 19, Reiss notified Michael Egan that Denby wanted them to meet with Helios on May 25 “to discuss their tax reduction strategy.” (Denby, 28:127-28; Reiss, 27:24-25; Ex. 442).
3.
Denby’s Comparison of the Tax Strategies
— May
2000
162. On May 22, 2000, Denby sent Reiss a letter enclosing an outline for the proposed Helios transaction, a summary “Comparison of Structures,” and a separate chart for each of the E
&
Y, J & G, KPMG, and Helios strategies “that weighted] the advantages and disadvantages of the various capital loss techniques.” (Denby, 28:113; Ex. 3555).
163. In her May 22 outline of the Helios transaction, Denby noted the following:
> Eliminates ordinary income and capital gains so strategy can be used for both EMC stock options and EMC stock
> Can have third party purchase for step-up (I like this)
> Brown and Wood opinion letter
> Customize option period to meet your business goals
> Have done 12 or so transactions
> Can do similar strategy with QQQ but will only work for EMC stock (not options)
(Ex. 3555).
164. In each of the May 22 charts that Denby prepared for the E
&
Y, J & G, KPMG, and Helios strategies, she rated and commented upon the strategies, noting a plus if the transaction was a tax “elimination” strategy and a minus if the transaction was only a tax “deferral” strategy.
(Id.).
For the
*85
“Helios Elimination Strategy,” she noted that it “eliminates capital gains and ordinary income so can use for options as well as stock.”
(Id.).
165. Denby also rated and commented upon the length of time to implement the strategies, noting a plus if the transaction time was shorter and a minus if the time for completion of the implementation and receipt of the tax benefits was longer.
(Id.).
She gave a positive rating to the “Helios Elimination Strategy.”
(Id.).
166. 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.
(Id.).
For the “Helios Elimination Strategy,” she noted that it “will be structured as basis offset so harder for IRS to find (other Helios deals done as loss offset).”
(Id.).
167. 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.
(Id.).
For the “Helios Elimination Strategy,” she noted a concern that its “simplicity of structure” might “make it easier for IRS to trace.”
(Id.).
168. Denby also rated and commented with respect to the breadth of the marketing of each strategy, noting a plus if the transaction had “limited marketing” and a minus if the transaction was “broadly marketed.”
(Id.).
For the “Helios Elimination Strategy,” she noted as a positive that it had “limited marketing (expect no more than 20ish [customers]).”
(Id.).
169. Denby also rated and commented with respect to the proffered opinion letter, noting a plus if the opinion was not issued directly by the marketing firm and a minus if it was.
(Id.).
170. Denby summarized her conclusions in a chart entitled “Comparison of Structures,” in which she listed and compared the fees for the “instruments” and the “advisors.” All the strategies involved a fee based on a percentage of the size of the transaction.
(Id.).
171. Denby also specifically noted that the Helios strategy made it “[e]asier to establish business purpose” because it “can be used to hedge EMC stock depending on your market view.”
(Id.).
4.
The May 25, 2000 Meeting in Massachusetts
172.
By e-mail dated May 23, 2000, Reiss advised Jack Egan about the upcoming meeting with Helios, stating:
I wanted to touch base with you to let you know we have recently coordinated a meeting for a group called Helios to come in ... to discuss their tax reduction strategy. Stephanie Denby and I preliminarily like what this group has to offer. They even have a strategy for stock options as well as straight stock.
(Reiss, 27:27; Ex. 442).
173. The meeting with Helios was placed on the calendar for Michael Egan as a “Mtg. w/ Helios, S. Denby & Jim to discuss tax reduction strategy.” (Ex. 447).
174. The meeting with Helios occurred at Carruth’s offices in Hopkinton, Massachusetts, on May 25, 2000. (Exs. 427, 442). Michael Egan, Den-by, and Reiss attended the meeting
*86
for Carruth. (Denby, 28:133-34; Ex. 442).
175. On May 26, 2000, Denby sent Reiss an e-mail regarding the previous day’s meeting and her discussions with Helios after the meeting concerning fees:
... after the meeting I discussed with Helios the fees. The fees are based on a 3% rate. If KPMG were not involved Helios would just pocket a larger percentage. Since our connection came from KPMG, Helios would pay them a referral fee anyway. I think at the same rate. So [their] involvement does not cost more but just results in reallocation of the base fee. I know from other situations this reallocation occurs simply from [our] getting the name [from] KPMG. We are in the wrong business!
(Denby, 28:134; Ex. 3232).
176. Reiss responded by e-mail the same day, stating: “Mike [Egan] has some very specific opinions about this. I like his thoughts on this though.” (Reiss, 35:82-83; Ex. 3232).
177. The bill sent by Burke, Warren to the Egans for May 2000 describes the work performed by Denby on May 25 as, among other things, “Attend meeting regarding capital loss strategies.” (Ex. 2803).
I.
Further Developments in July 2000
1.
The July 10-13, 2000 Meetings in Chicago
178. On July 10, 2000, Pat Shea (who had joined Carruth as COO on June 26), Jim Reiss, and Stephanie Denby met to discuss the proposed Helios transaction. (Ex. 3236).
179. At one or more times between July 11 and 13, 2000, Pat Shea, Jim Reiss, Stephanie Denby, and a Burke, Warren attorney named Wayne Cooper met with representatives of Helios in Chicago.
(Id.;
Exs. 3235, 3237). James Haber, Phil Kampf, and Mox Tan attended on behalf of Helios. (Ex. 3237). The purpose of the meetings with Helios was “to review the tax elimination strategies.”
(Id.).
180. Shea took handwritten notes on July 13 that he titled “Helios Deal-Capital Gain Reduction.” (Shea, 15:108; Ex. 2569). The notes were based on information provided by Haber.
181. In his notes, Shea outlined the tentative steps of a capital gains reduction strategy, including (1) “Dick [Egan] transfers stock to Maureen [Egan]”; (2) “Maureen [Egan] creates an entity and buys option positions, either QQQ or foreign currency options”; (3) Maureen Egan “holds the options for at least 14 days”; (4) “on day 15 [she] contribute^] the EMC stock and the option position” to Fidelity High Tech “along with [a] second partner with exactly [the] same securities”; and (5) “on day 31 [a] Helios entity buys [the securities] for FMV of EMC stock and value of the options,” less a fee of 2.1%. (Ex. 2569).
182. Shea’s notes indicated that the “basis in the partnership” would be the “long position in the options ... plus [the] basis in EMC stock (low).” (Ex. 2569). He also noted that the purported “business purpose” would be a “hedge against [a] downward drop in EMC [stock].”
(Id.).
183. Shea’s notes also stated the following:
— shows as one line item on tax returns
— clean transaction — not easily discovered
*87
— easily reported
(Id.).
184. Under the heading “Risk,” Shea listed three items. First, he noted that any risk that Helios would “not do [the] deal” was addressed by the fact that “they don’t get paid until the deal is done.” Second, he noted that there was a risk that the “IRS [would] disallow” the transaction, in which case the Egans “[would be] facing interest charges, [but] no penalties, as we [would] have [a] legal opinion letter.” Third, he noted that there would be risk of a “gain [or] loss on [the] options and stock price fluctuations.”
(Id.).
Shea also noted that “we want Maureen to do the transaction because there will be a capital gain here and we do not want it subject to [Massachusetts] taxes.
(Id.).
185. Shea also took notes on July 13 that he titled “Helios Ordinary Income Reduction.” (Shea, 15:103; Ex. 496). Those notes detail a sequence of steps to implement an ordinary income reduction strategy: (1) “Dick [Egan] exercises his options NQO’s— personally or through special trust— transfers shares to Maureen”; (2) “Helios
&
Alpha create an entity as a hedge fund”; (3) “Maureen’s entity purchases a foreign currency options position — 100m long — 98m short— cost approx 2m — Maureen gets basis for 100m long position (cost of 2m)”; (4) “Maureen holds for 30-90 days when partnership distributes foreign currency to Maureen for her interest in the fund”; (5) “Maureen liquidates the foreign currency to trigger the loss”; and (6) “Code Section 988 treats loss on foreign currency as ordinary loss.” (Ex. 496).
186. Shea noted that it was “risky that we have reporting entity EMC for options,” which made it “hard to bury on the [tax] return.”
(Id.).
Shea further noted that the exercise of the options would be a “taxable reportable event by EMC” that would result in the issuance to Richard Egan of a Form 1099 or W-2.
(Id.).
187.Shea also prepared typewritten notes dated July 13, 2000. (Ex. 3237). In those notes, he described the planned roles and timing for implementation of the Helios strategy as follows:
Their strategy involves using various code sections and Egan and unrelated entities to eliminate tax on stock and options.
[Helios] with KPMG will handle all filing and paperwork to effect the transaction.
Depending on size of transaction their fee is between 3-4% — seems we have some negotiation room there
Timing — need 2 weeks to hold stock — 30-90 days in partnership is recommended to show IRS business purpose — transaction to be completed in the same tax year. Point being — if we want to do need to consider windows for selling and timing for paperwork to complete prior to 12-31
We should get decision makers involved to understand the risk/rewards to see if we want to do in 2000 or 2001 — please advise KPMG is involved with Helios in this transaction — We discussed w/ them possibility of bundling their services to Carruth Management LLC____
Will follow up w/ a meeting with John Schrier of KPMG — to discuss fees and their services.
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(Id.).
2.
The July 18, 2000 Meeting with Helios in Chicago
188. A further meeting was scheduled with Helios in Chicago for July 18, 2000. (Shea, 15:64; Ex. 26).
189. Prior to the July 18 meeting, Den-by prepared an updated analysis that included updated charts outlining both the “Helios Capital Gain Strategy” for the EMC stock and the “Helios Ordinary Income Strategy” for the options. (Denby, 28:146; Ex. 3549). Denby also prepared a “Timeline and Fees Chart” and a “Comparison of Structures” chart comparing the two Helios transactions to the KPMG, J & G, and E & Y products. (Ex. 3549). The “Comparison of Structures” table included a column for the “tax reporting profile” of the various strategies; the Helios Capital Gain Strategy profile was described as “extremely low,” and the others were described as “visible.”
(Id.).
190. Denby noted that the “Capital Gains Elimination Strategy” had “very clean reporting on [the] tax return” so it would be “hard for [the] IRS to find.”
(Id.).
191. The scheduled meeting with Helios was held in Chicago on July 18, 2000. (Shea, 15:64; Ex. 26). The participants at the meeting included Michael Egan, Pat Shea, and Jim Reiss of Carruth; Stephanie Denby; John Schrier of KPMG; James Haber, Mox Tan, and Phil Kampf of Helios; and Ivan Ross of Alpha. (Shea, 15:64; Ex. 26).
192. At the July 18 meeting, both Haber and Schrier made presentations about “tax reduction strategies.” (Shea, 15:65-66).
193. Prior to the July 18 meeting, Shea prepared a typewritten list of questions that he wanted to discuss with Helios.
(Id.
at 15:63; Ex. 471).
194. At the meeting, Shea wrote in, by hand, notes from the meeting with respect to his questions. (Shea, 15:67-68, 70-73; Ex. 26). Shea’s typewritten notes include the following questions and corresponding notes as to the answers to his questions:
Q. Do you have a narrative for various code sections that you rely on and a description of the strategy other than a legal opinion ?
A. He gave us case and Stephanie has draft legal opinion.
Q. Do you have to register as a tax shelter ?
A. No
Q. How will we handle the reporting on the returns — can we run through Schedule E to avoid a large loss on the face of 1040-would like to bury with other entities on Schedule E.
A. Schrier and KPMG to handle.
Q. Does KPMG handle filing all entity returns — is that included in our transaction fee or are there additional fees?
A. —included in the fee
— they
will file returns and structure the deal
Q. What is the chronology of the transactions? Do you have some sort of document detailing the chain of events and the timing of the same?
A. —They will walk us through and will go as fast as we want
Q. Wdiat is the role of each?
Helios
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Alpha
KPMG
A. [no handwriting]
Q. What mix of [non-qualifíed options] and long term shares — it is advantageous for us taxwise to use NQO’s because bigger tax savings for us 40% vs. 20% — what about state impact — will state follow fed rules here?
A. Mike [EganJ’s preference [is] to use shares as Dick [Egan] wants to sell some
now—
Q. We need to confirm how EMC will report the option income to Dick-W-2 or 1099 form.
A. Jim [Reiss] to push for answer
Q. We need to decide the size of the transaction and the size of each
block
— we need to get pricing from them reflecting the volume rate and apply that to our blocks.
A. Looks like 250m^300m on stocks
— maybe
another 100m on NQO’s Michael will discuss with family to get
amounts—
(Ex. 26 (emphasis added)).
195. Thus, as of July 18, 2000, the Egans were considering entering into a capital gains elimination transaction of between $250-$300 million and possibly another $100 million for an ordinary income loss generator.
(Id.).
The size of the transaction had not, however, been determined, and following the July 18 meeting, Michael Egan was to discuss the size of the investment in the proposed Helios tax reduction strategy with his family.
(Id.;
Shea, 15:73).
196. At the July 18 meeting, the parties discussed the fact that EMC might issue a Form W-2 or 1099 to Richard Egan if he exercised his non-qualified options, reflecting the payment of ordinary income. (Shea, 15:74; Ex. 26).
197. At the July 18 meeting, the parties also discussed various ways that a large loss might be disguised on the face of the Egans’ tax return, such as reporting it on a Form 4797 (Foreign Currency Transaction) filed with a partnership return. (Denby, 29:147-150; Exs. 468, 3582).
198. Shea also took handwritten notes of the July 18 meeting. (Ex. 468). In those notes, he wrote, “how do we handle the [$]500,000,000 1099 form[?]”
(Id.).
199. On July 19, 2000, Shea had a telephone conversation with John Schrier of KPMG. (Ex. 472). Among other things, Shea and Schrier discussed a “short option” strategy in order “to generate ordinary loss.”
(Id.).
200. The bill sent by Burke, Warren to the Egans for July 2000 include entries for work on “tax deferred strategies,” “capital loss strategy,” and “capital loss strategy issues.” (Ex. 2806). There are no entries in those bills that refer to hedging or investment strategies.
3.
Carruth’s Due Diligence Concerning the Promoters
201. On July 19, 2000, Jim Reiss sent an e-mail to Stephanie Denby and Pat Shea with the subject line “Re: Elimination Strategy.” (Ex. 3238). Reiss reported that he and Shea had met that afternoon with Richard Egan, and that “we got a lukewarm response from him. He really wants us to do due diligence on Helios.”
(Id.).
202. On July 20, 2000, Phil Kampf of Helios sent a fax to Shea responding to questions about Helios. (Ex. 28).
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The fax included marketing materials about Helios that included the following statement:
Because our transactions are “document intensive,” we view our ability to firmly manage and control the process of getting two to four sets of attorneys and accountants to expeditiously reach the desired conclusions as being one of our most valuable contributions to our clients.
(Id.).
203. On July 21, 2000, Shea wrote a memorandum entitled “Memo Re: Due Diligence Helios Financial LLC.” (Shea, 15:91-92; Ex. 29). In that memorandum, Shea wrote that “before entering into a significant transaction with Helios as a facilitator we wanted reasonable assurance they were experienced in transactions of this size and could handle our deal.” (Ex. 29). The memorandum describes the due diligence conducted to date.
(Id.).
According to the memorandum, Schrier told Shea that he had worked with Haber for several years, and that Haber had a history of working on tax shelter deals going back as far as the late 1980’s and early 1990’s, and that litigation had been brought against Haber when a tax shelter deal went sour.
(Id.).
J.
Formation of Fidelity Entities in July 2000
204. By mid-July 2000, the proposed transactions with Helios and KPMG had progressed to the stage where the Egans decided to form the various entities necessary to implement the transactions.
205. On July 19 and 20, 2000, certificates of formation were filed in Delaware for five different limited liability companies.
206. Each of these LLCs was named with the word “Fidelity” at the beginning of its name. Fidelity Investments is the name of a well-known company in Boston that sells mutual funds and other investment products. (Denby, 29:14). Michael Egan selected the name “Fidelity” for these entities.
(Id.).
207. The selection of the name “Fidelity” was intended, at least in part, to help disguise the transactions.
1.
Fidelity High Tech Transaction Entities
208. Fidelity High Tech Advisor Fund, LLC was formed as a Delaware LLC on July 19, 2000. Richard and Maureen Egan were its two members. (Exs. 1,108).
209. Fidelity High Tech Option A LLC (“Option A”) was formed as a single-member Delaware LLC on July 19, 2000, on behalf of Maureen Egan. (Exs. 1,108).
210. Fidelity High Tech Index A Fund LLC (“Index A”) was formed as a single-member Delaware LLC on July 20, 2000, on behalf of Richard Egan. (Exs. 1,108).
2.
Fidelity International Transaction Entities
211. Fidelity World Currency Advisor A Fund, LLC (“Fidelity World”) was formed as a single-member Delaware LLC on July 19, 2000. (Exs. 2, 108). Richard Egan was the sole initial member of Fidelity World. (Ex. 108). The Limited Liability Company Agreement for Fidelity World was signed by Richard Egan and Michael Egan. (Ex. 2).
212. Fidelity International Currency Advisor A Fund, LLC was formed as
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a Delaware LLC on July 19, 2000, on behalf of Richard Egan.
(Id.;
Ex. 108).
K.
Carruth Prepares to Implement the Strategies
1.
Denby’s Fax of July 20, 2000
213. On July 20, 2000, Stephanie Den-by faxed various documents to Pat Shea, including a memorandum entitled “Steps for Capital Gains Elimination Strategy” that detailed the planned steps to implement the strategy. (Denby, 29:13; Ex. 3240.1). In that memorandum, Denby wrote:
For business purpose reasons, it may be desirable to purchase QQQ [i.e., NASDAQ 100 index] options. However, you can also use foreign currency options or a combination of the two.
(Ex. 3240.1).
214. On July 20, 2000, in anticipation of implementing the capital gains reduction strategy, Richard Egan transferred 4 million shares of EMC stock to Maureen Egan. (Ex. 778). At the time, EMC stock was tading at approximately $86.00 per share. The 4 million shares of EMC therefore had a market value of approximately $344 million.
2.
Further Discussions in July 2000
215. On July 25, 2000, Pat Shea attended a meeting with Richard Egan, Michael Egan, and Jack Egan concerning the tax reduction strategy. (Ex. 489, Ex. 490). Shea prepared a memorandum of the meeting that listed the following topics for discussion: “Fee, Risk vs. Reward” and “Audit Representation.” (Ex. 489).
216. On July 26, 2000, Shea sent a memorandum to Michael Egan recapping the July 25 meeting. (Ex. 490). In that memorandum, Shea stated:
Dick will commit to the following 200m capital gains reduction strategy—
200m ordinary income reduction strategy—
I will follow up with Jack to see how much, if any, if he wants to participate.
(Id.).
217. Shea spoke on July 27 with Jack Egan, who indicated he was interested in participating in a $30 million capital gains reduction strategy.
(Id.;
Shea, 15:99). Ultimately, however, Jack Egan did not participate.
218. Following the July 25 meeting, Shea instructed the accounting department of Carruth to begin preparations for the Helios capital gains and ordinary income transactions. (Shea, 15:99-101).
219. On July 26, 2000, the accounting department of Carruth held a meeting to discuss the Helios “special strategies” for reducing taxes on “200 mill stock” and “200 mill, non-qualified stock options.” (Ex. 2477). The meeting was attended by Pat Shea, Jim Reiss, and members of the accounting department.
(Id.;
M. Egan, 7:21-22). The meeting notes taken by one of the Carruth participants state that part of the strategy was to “increase cost basis by putting in new entity.” (Ex. 2477).
220. On July 28, 2000, Pat Shea, James Haber of Helios, and Ivan Ross of Alpha participated in a telephone conference call. (Shea, 15:101-02; Ex. 2564). In his notes of the call, Shea wrote: “Cap gains EMC stock-200m Maureen-30m Jack” and “Foreign
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Currency 200 mill-4 Currencies 50 mill each.” (Ex. 2564).
221. On July 31, 2000, Ross e-mailed Shea a spreadsheet containing several foreign currency option trades showing a net investment ranging from 1% to 1.5%. (Ex. 32). Shea wrote the following on the document: “They want us to show that we are investing more than the fees we are paying to show IRS a good economic deal.” (Ex. 31).
3.
The August 2, 2000 Meeting in Boston
222. On August 2, 2000, a meeting was held in Boston. The attendees were Michael Egan, Jim Reiss, Stephanie Denby, Pat Shea, John Schrier of KPMG, and James Haber of Helios; Ivan Ross of Alpha participated by telephone. (Ex. 502). The purpose of the meeting was to discuss the implementation of the tax strategies.
-(Id.).
Among other topics, the participants discussed the “benefits [and] drawbacks of an Egan entity remaining in the QQQ investment partnership for an extended period of time after Helios buys the main interest out.”
(Id.).
223. Michael Egan took notes at the August 2 meeting. (M. Egan, 7:36; Ex. 2565). These notes diagram how the Helios strategies appeared to him. (M. Egan, 7:36; Ex. 2565).
224. Pat Shea wrote a memorandum to the file concerning the August 2 meeting. (Ex. 502). That memorandum lists the following as “to do” items with respect to the planned Helios strategies:
Confirm what family members are interested and which program and how much
Confirm that Dick is in for 200m QQQs
Confirm how much Dick wants for foreign currency — 100-200m Confirm [stock] registration requirements with EMC Capitalize the partnerships to begin option trading
Review and sign the engagement letter for KPMG
Get engagement letters for other family members
(Id.).
225. On Thursday, August 10, 2000, Shea sent a fax to Denby stating the following:
I spoke with Mike [Egan] this
AM
— we will execute Helios next week — Tues [August 15] or Wed [August 16] — Can you and I get all the groundwork done before then so we can just sign and execute — I have enclosed the process as I see it — please comment and let me know if I am missing anything— (Ex. 3248).
L.
IRS Notice 2000-44 and Its Aftermath
1.
The Issuance of IRS Notice 2000-44
226. On Friday, August 11, 2000, the Internal Revenue Service released IRS Notice 2000-44. (Ex. 137). The Notice was entitled “Tax Avoidance Using Artificially High Basis.” It addressed certain “transactions that were being marketed to taxpayers for the purpose of generating artificial tax losses,” and concluded that the “purported losses” from such transactions do not represent bona fide losses reflecting “actual economic consequences” and were not allowable as deductions.
(Id.).
It also noted that penalties might be imposed on taxpay
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ers or promoters who participated in such transactions.
(Id.).
227. IRS Notice 2000-44 provided two examples of the type of transactions it was targeting.
(Id.).
Both examples involved a taxpayer artificially stepping up the basis of his interest in a partnership. One of the examples referred to a taxpayer transferring paired options to a partnership where the taxpayer claimed that only the purchased option should be taken into account in calculating his basis in the partnership. In the example, the taxpayer took the position that the sold option could be ignored because it was not a liability for purposes of Section 752.
(Id.).
2.
The Reaction to IRS Notice 2000-44
228. On August 11, 2000, John Schrier of KPMG sent Pat Shea and Stephanie Denby a fax attaching a copy of IRS Notice 2000-44. (Ex. 137).
229. Later that same day, August 11, Schrier sent Shea and Denby a fax attaching a copy of Treasury Decision 8896 announcing new temporary regulations. (Ex. 520). Among other things, the new regulations required certain tax promoters to maintain a list of persons who were sold an interest in a tax shelter.
(Id.).
230. Minutes later on August 11, Mox Tan of Helios sent a fax to Denby attaching a copy of IRS Notice 2000-44. (Ex. 521).
231. On August 11, 2000, Pat Shea and Jim Reiss of Carruth, Stephanie Den-by, John Schrier of KPMG, and Phil Kampf and Mox Tan of Helios participated in a telephone conference call. (Ex. 519). The subject of the call was IRS Notice 2000-44 and its potential impact on the planned transactions.
(Id.;
Shea, 15:125).
232. Among other things, the participants in the August 11 conference call were concerned that the transactions would have to be described on a list that the IRS could review, and that the law firms participating in the strategy would no longer issue a favorable opinion. Shea’s notes of the conference state the following:
— More likely than not opinion— need to wait for the opinion before we do anything-
— These are listed transactions-
— Time frame for the opinion-not
clear
yet — lawyers have to read notice and decide if they will give opinion—
— list requirements — not sure what details are or will be—
— registration issue — 2 registrations — SEC filings
— The beauty of the transaction was [that it was] so hidden but now it is not hidden—
(Ex. 519 (emphasis in original)).
233. Also on August 11, Richard Egan sent a copy of a news article from the Boston Globe bearing the headline, “ ‘Son of BOSS’ Tax Shelter on U.S. Hit List” to Michael Egan, Shea, and Reiss. (R. Egan, 2:63-64; Ex. 518). The article referred to a notice issued by the Treasury Department targeting certain tax shelter transactions. (Ex. 518). It further stated that the “government’s action spells out the practices the IRS has found objectionable and puts taxpayers on notice that they cannot use those practices to avoid paying taxes.”
(Id.).
It also quoted an anonymous Treasury official as stating that the new tax shelter was being marketed by one or two of
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the “Big Five” major accounting firms, and listed KPMG by name.
(Id.).
234. Richard Egan testified that he circulated the article because he knew his son Michael “wasn’t happy” with the accounting firm of O’Connor & Drew, the article contained “a list of accounting firms in it, all the big ones,” and his son “was thinking of moving up, so to speak.” (R. Egan, 2:64).
235. The Court does not find Richard Egan’s testimony concerning the reason he forwarded the news article to be credible. The reason Richard Egan sent the article was because he was concerned that the proposed tax shelter transaction might be subject to the new IRS rules.
236. On August 14, 2000, Shea spoke with John Sehrier at KPMG regarding the status of the transactions in the wake of IRS Notice 2000-44. (Ex. 526). In his notes of that call, Shea wrote that KPMG “doesn’t know if they will stand behind the transaction yet.”
(Id.).
237. On August 15, 2000, KPMG advised its employees to “stop marketing” the Short Option Strategy in light of Notice 2000^44. (Ex. 282).
238. On August 15, 2000, Shea met with Richard Egan, Jack Egan, and Christopher Egan to discuss the impact of Notice 2000-44 on the proposed transactions. (Shea, 15:131; Ex. 529). In his notes of the meeting, Shea wrote:
Helios Tax Deal
I discussed the IRS notice released [sic ] and advised
1). We don’t proceed now until we get a confirmation that KPMG will continue to promote the program 2). We need to be assured that Brown & Wood will do an opinion letter and will stand behind it
3). We get a definition of what penalties, if any, we are exposed to—
4). If this program is dead we can look to Helios for other deals—
(Ex. 529). He added, “Dick still stated that he liked the ordinary income portion and wants to sell stock during this window.”
(Id.).
239. On August 16, 2000, Mox Tan of Helios sent an e-mail to Jeffrey Eisheid of KPMG, on the subject “KPMG SOS Opportunities as of August 11, 2000.” (Ex. 532). In the e-mail, Tan stated he was providing a “highly confidential” list of the “roughly 40 SOS opportunities we have discussing with your partners, with a general status as 8/11/2000 (pre-notice).”
(Id.).
The first category of the list of opportunities was entitled “due diligence completed-single member LLC has been formed-preparing to do the trade.”
(Id.).
One of those “opportunities” was “Dick and Maureen Egan”; according to the summary prepared by Tan, the Egans were preparing to do a “$230 [million] basis bump on appreciated stock,” and that there was a “potential follow-on deal” for a $200 million “trade for stock option OI [ordinary income].”
(Id.).
240. On August 16, 2000, Stephanie Denby and Pat Shea spoke by telephone concerning the impact of Notice 2000-44. (Shea, 16:6-11; Ex. 533). By that point, Denby had learned the reactions of the law firms who were expected to render favorable opinions. Denby told Shea that she understood that it was “95% certain” that Proskauer would give a “favorable opinion letter” on the capital gains strategy,
*95
because that strategy was “not triggering a loss.” (Ex. 533). Denby also told him, however, that Brown & Wood was “not at this point comfortable with [an] opinion letter, especially [with] KPMG,” that neither Brown & Wood nor Proskauer would “give [an] opinion on [the] ordinary income portion [of the strategy] because this triggers a loss,” and that “loss generation is what the notice attacks.”
(Id.).
Denby also told Shea that Brown & Wood would not give an opinion letter to a KPMG client because it was “too broad a market” with “too many circumstances,” and because KPMG might keep an “investor list” and presents a “bigger audit risk.”
(Id.).
241. In a follow-up call, Denby told Shea that “Brown & Wood [was] clearer on opinion letter but not with KPMG — [they] don’t want to mass produce the letter.”
(Id.).
3.
The August

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Source: Frix Law Library, https://www.frixlaw.com/law-library/cases/2477399. Public record. Not legal advice.