# Jade Trading, LLC ex rel. Ervin Capital, LLC v. United States

> United States Court of Federal Claims · December 21, 2007 · 80 Fed. Cl. 11

URL: https://www.frixlaw.com/law-library/cases/6657071

## Case

- **Full name:** JADE TRADING, LLC, by and through, Robert W. Ervin and Laura Kavanaugh Ervin on behalf of Ervin Capital, LLC, Partners Other Than the Tax Matters Partner v. United States
- **Court:** United States Court of Federal Claims
- **Decided:** December 21, 2007
- **Citations:** 80 Fed. Cl. 11; 100 A.F.T.R.2d (RIA) 7123; 2007 U.S. Claims LEXIS 405; 2007 WL 4553043
- **Precedential status:** Published
- **Opinion:** Opinion of the court by Williams
- **Judges:** Williams
- **Cited by:** 48 later opinions in the Frix Law Library

## Citator (automated)

- **Red flag:** Reversed on other grounds by Jade Trading, LLC Ex Rel. Ervin v. United States, 598 F.3d 1372 (2010).
- Negative treatments: 1
- Distinguished by: 0
- Full citator and citing cases: https://www.frixlaw.com/law-library/cases/6657071

## How later opinions describe it (automated extraction)

- concluding that a sold call option contributed to a partnership was not a liability for purposes of section 752
- noting that non-managing plaintiffs asserted a 16 No. 09-1109 partner-level defense, as compared to a similar defense by the partnership or managing partner
- noting that non-managing plaintiffs asserted a partner-level defense, as compared to a similar defense by the partnership or managing partner

## Opinion text

OPINION
WILLIAMS, Judge.
Introduction
This tax refund case presents the issue of whether investments of $450,000 which generated over $40 million in tax losses possessed economic substance. In 1999, the Er-vin brothers sold their cable business, netting over $40 million in profit. That same year, each of the three Ervin brothers, through his limited liability corporation (LLC), simultaneously purchased a euro option from AIG for a premium of $15,000,020 and sold a euro option to AIG for a premium of $14,850,018 but only paid AIG the difference—a net premium of $150,002. Each LLC contributed the option spread to Jade Trading, LLC (Jade), and upon exiting the partnership, claimed a basis of over $15 million in its Jade interest by including only the premium for the purchased call option and ignoring the premium for the sold call option. The artificially high basis generated a loss of almost $15 million when each LLC redeemed its partnership interest at its fair market value.
At issue in this case is whether the spread transactions contributed to Jade lacked economic substance such that they must be disregarded for tax purposes. This issue is complicated by the reality that precedent at the time of these transactions permitted each LLC to ignore the sold call option in computing its basis in its Jade interest because that option was a contingent obligation, not a liability, under section 752 of the Internal Revenue Code. 1 Poignantly at play here is the tension between technical compliance with the Internal Revenue Code and the longstanding common-law economic substance doctrine which compels courts to disregard transactions which lack economic substance despite their literal compliance with the Code. Plaintiffs characterize the tension differently, arguing that the economic substance doctrine cannot ignore “deliberately adopted rules of law,” in particular, the holding in Helmet v. Commissioner, 34 T.C.M. (CCH) 727 (1975), that contingent obligations do not constitute section 752 liabilities for purposes of calculating a partner’s basis. According to Plaintiffs, Helmet and its progeny construed section 752 to permit taxpayers to exclude contingent obligations like the sold option in calculating basis under the theory that the sold option did not create a fixed liability because it was uncertain when, at what price, or if AIG would ever exercise the option.
Plaintiffs’ theory cannot prevail in light of the Federal Circuit’s decision in Coltec Industries, Inc. v. United States, 454 F.3d 1340, 1352-54 (Fed.Cir.2006), reaffirming the vitality of the economic substance doctrine. Coltec teaches that the legitimacy of a transaction for tax purposes is not guaranteed merely because a technical interpretation of the Code would support the tax treatment. Id. at 1354 . Rather, Coltec mandates additional scrutiny of the bona fides of a transaction, requiring independently that the transaction pass muster under the objective economic substance test. Id. at 1355 . Further, the Coltec Court clarified the parameters for applying that test holding that the taxpayer has the burden of proving that the transaction which gave rise to the tax benefit objectively had economic substance, i.e., was a real transaction structured in a partic *14 ular way to provide a tax benefit as opposed to a transaction created for tax avoidance purposes. Id.
Here, several factors compel a conclusion that Plaintiffs have not met their burden of demonstrating that the spread transactions contributed to Jade objectively had economic substance. First, their claimed losses were purely fictional—each of the Ervins did not invest $15 million in the spread and did not lose $15 million when exiting Jade without exercising either option. 2 Second, although Plaintiffs contend that the spread transaction had the potential to earn a profit, that contention is belied by two factors—the structure of the transaction itself and the large and unusual fees the LLCs were forced to pay to do the transaction. The structure of this transaction delimited the maximum net profit to some $140,000 per LLC, no matter how high the euro climbed. The fees also undercut profit potential. Each LLC paid fees of $934,100 on an investment of $150,002. 3
Third, the spread transaction was developed as a tax avoidance mechanism and not an investment strategy. The transaction was devised and marketed by a tax accounting group, BDO Seidman’s “Tax $ells” Division, as a tax product, not by an investment advis- or as a vehicle to earn profit. The spread transaction was included in the chapter of BDO Seidmaris Tax Product Manual entitled “Capital Gain or Ordinary Income Eliminators” and was described as being structured around “anomalies in the tax law to allow for the creation of stepped-up basis that can be used to shelter gains.” Def.’s Ex. DX (DX) 665 at 019776.
Fourth, the requirement that the spread transaction be purchased outside the partnership and contributed to it had no effect whatsoever on the investment’s value, quality, or profitability, except to add cost and burden. However, packaging the investment in the partnership vehicle was an absolute necessity for securing the tax benefits.
A final indicium of the lack of economic substance here, while not dispositive in and of itself, is the highly disproportionate tax advantage to the underlying monetary outlay—the tax loss per brother, $14.9 million, was roughly 65 times greater than each LLC’s $225,002 financial commitment to Jade, almost 100 times each LLC’s $150,002 investment in the spread transaction which generated the loss, and approximately 100 times the $140,000 potential net profit each LLC could have earned.
In sum, this transaction’s fictional loss, inability to realize a profit, lack of investment character, meaningless inclusion in a partnership, arid disproportionate tax advantage as compared to the amount invested and potential return, compel a conclusion that the spread transaction objectively lacked economic substance.
The determination that the transaction lacked economic substance and the conclusion that each LLC’s basis in its partnership interests must be substantially reduced requires this Court to conclude that the IRS’s 40-pereent penalty is applicable at this juncture. Section 6662(h). Under the Code, the 40-percent gross valuation misstatement penalty applies as a matter of computation if the misstated basis was 400 percent higher than the corrected adjusted basis. Here, each LLC’s adjusted basis must be reduced *15 from some $15 million to $225,002,—meaning each LLC’s basis was misstated by well over 400 percent. The alternative 20-percent penalties for substantial understatement of income tax and negligence are also applicable. Because only partnership items are before the Court in this proceeding, the Court lacks jurisdiction to consider the individual partners’ defenses to the penalties, but these defenses may be entertained subsequently in individual partner-level proceedings.
Findings of Fact
4
The Ervins
In 1980, Gary Ervin applied for a cable franchise, and Ervin Cable Construction was awarded a cable franchise in the Ervins’ home town of Sturgis, Kentucky. Tr. 292-96, 322 (G. Ervin). 5 Gary Ervin and his two brothers, Robert and Tim, were equal partners in the cable business. Gary Ervin ran the office, handled the finances for the brothers, and had primary responsibility for dealing with investment advisors, bankers, lawyers, and accountants. Tr. 166-67 (Maid-man); Tr. 259-60 (Pace); Tr. 304-08 (G. Ervin); Tr. 403-06 (R. Ervin); Tr. 437-38 (T. Ervin). Tim and Robert Ervin relied on Gary to make all financial decisions for the family businesses and provided Gary with general powers of attorney in 1998 which authorized Gary to manage their financial, business, and tax affairs. Pis.’ Ex. (PX) 203-04; Tr. 309 (G. Ervin); Tr. 405 (R. Ervin); Tr. 440, 444, 446 (T. Ervin).
Selling the Cable Businesses in March 1999
In 1986 or 1987, the Ervins split their cable business into cable franchise and cable construction businesses, and in 1997 or 1998, split their businesses again, creating Apex Digital TV, Inc. (Apex). Tr. 298-99 (G. Er-vin). In 1998 or 1999, the Ervins decided to sell these businesses—Ervin Cable Construction (ECC), Apex, and Communications Systems Development (CSD). Tr. 315-18, 320-21 (G. Ervin). The Apex acquisition was structured as a reverse triangular merger, and the Ervins sold Ervin Cable Construction to Dycom in exchange for cash and Dycom stock. 6 Joint Stipulation of Facts (Stip.) H 3, 4; Tr. 317-18, 439-40 (G. Ervin). In March 1999, the Ervins realized a total gain of approximately $40,248,733 on the sale, approximately $13,500,000 per brother. Joint Ex. (JX) 96 at 89, JX 97 at 59, JX 98 at 57.
Because Dycom was a publicly traded company, Dycom disclosed the acquisition of the Ervin companies to the SEC. After that disclosure, Gary was inundated with calls from investment brokers who wanted to “help” the Ervins reinvest their capital. Tr. 318-23 (G. Ervin). John Eckstrom, a former competitor in the cable industry, recommended that *16 Gary talk to Cheyne Pace of Goldman Sachs for advice on investing the proceeds of the sale of these businesses. Tr. 324 (G. Ervin).
The Goldman Sachs Presentation: February 1999
In February 1999, Gary Ervin met with Cheyne Pace of Goldman Sachs in Sturgis, Kentucky. Tr. 209-10 (Pace); Tr. 324-26, 341 (G. Ervin). Pace recommended that the Ervins consider tax-advantaged investments such as oil and gas master limited partnerships (MLPs), and tax-exempt bonds. Tr. 219-20 (Pace); Tr. 327-29 (G. Ervin). Pace also recommended that the Ervins enter into “costless collars” to protect their position in Dycom stock. JX 2; Tr. 211-12 (Pace); Tr. 330-31 (G. Ervin). 7 Gary opened accounts for himself and his brothers with Goldman Sachs after his first meeting with Pace but did not execute the collars at that time because of the black-out period imposed by SEC Rule 144. Tr. 214-17 (Pace); Tr. 345-46 (G. Ervin). 8
The Ervins’ Referral to BDO Seidman
Pace recommended that Gary talk with an accountant, Philip Chandler, who in turn referred the Ervins to BDO Seidman, a tax and consulting firm, for a finder’s fee of $180,000. Tr. 221 (Pace); Tr. 336-37 (G. Ervin); see DX 523; see also Tr. 1503-04 (DiMuzio). 9
In March 1999, Gary spoke with John Pridnia of BDO Seidman about BDO’s proposal for tax-advantaged investments. Tr. 340-42 (G. Ervin). Pridnia and David DiMu-zio, another BDO Seidman employee, knew that the Ervins had reaped a large capital gain from the sale of their business in 1999. Tr. 1557-58, 1579-80 (DiMuzio). DiMuzio believed that BDO could provide a “value-added service” to the Ervins if they could find a way to make the tax liability associated with the brothers’ gain “disappear or be reduced.” Tr. 1579-80 (DiMuzio). Pridnia recommended that Gary talk with Jenkens & Gilchrist, a large law firm, to discuss tax-advantaged investments. Tr. 282, 340-44, 627-28 (G. Ervin).
The Jenkens & Gilchrist Proposal: March 1999
On or about March 25, 1999, a telephonic conference was held among Gary, David DiMuzio and John Pridnia of BDO Seidman, Martin McElroy, the Ervins’ long-time accountant, Vickie Davis, the Ervins’ general counsel, and lawyers from Jenkens & Gilchrist. Stip. H 8; JX 3; Tr. 279-81, 342-43 (G. Ervin). 10 BDO and Jenkens & Gilchrist presented a tax-advantaged investment based upon “a case the IRS had won,” by conference call. Tr. 345, 365-66, 628, 630 (G. Ervin). The tax strategy consisted of contributing foreign currency options to an S corporation in order to create a high-basis, low-value asset, the sale of which could result in a capital loss in excess of the cash that was contributed. Tr. 1506-07 (DiMuzio). Gary Ervin was troubled by the fact that there was no investment advisor to advise him on what trades he ought to pursue and there was almost no consideration given to the economics. AlS far as Gary Ervin could see, the tax-advantaged “investment” presented by BDO Seidman and Jenkens & Gilchrist had no investment component at all because the “primary thrust of the call with Jenkens & Gilchrist ... [was][t]o discuss ... the tax aspect of it.” Tr. 282, 345 (G. Ervin); Tr. 1404 (McElroy). Gary testified: “there was no investment to it, or none that I saw.” Tr. 345 (G. Ervin); Tr. 1404 (McElroy).
Gary Ervin concluded, on behalf of his brothers, that it did not make sense to rely *17 on a law firm to handle an investment. Tr. 1404 (McElroy). Consequently, the proposal was never brought up again. Tr. 285, 345 (G. Ervin); Tr. 1404 (McElroy). However, DiMuzio continued to contact Gary Ervin over the next few months in the hope of acquiring Gary as a client for BDO Seidman. Tr. 1510-11,1513 (DiMuzio).
Dagny Maidman and the Costless Collar and STARS Transactions: April-June 1999
On April 20, 1999, Gary opened accounts with Montgomery Securities in San Francisco in order to execute “costless collar” options. PX 202; Tr. 354-57 (G. Ervin); Tr. 128 (Maidman); JX 4. 11 On June 9, 1999, each of the Ervins, through a family LLC, entered into a set of “costless collar” options contracts with Dagny Maidman. JX 14-16; Tr. 129-33, 167 (Maidman); DX 667. These transactions had the net effect of guaranteeing the Ervins a minimum price for their Dycom stock—thus limiting potential losses while capping their potential profit. Tr. 178-82 (Maidman). As of July 31, 1999, each brother had approximately $3.6 million dollars in Dycom stock in the costless collars. See PX 223-225. 12
The Creation of the Spread Transaction: BDO Seidman, Curtis Mallet, Sentinel and AIG
BDO Seidman is a national accounting and tax consulting firm. Tr. 2759 (Field). BDO’s tax practice division used the logo, “TAX $ELLS!” See DX 578; see also Tr. 2880 (Field). The function of the TAX $ELLS! division of BDO was to sell tax products such as “Capital Gain Eliminators,” “Ordinary Income Eliminators,” and “NOL [Net Operating Loss]/Capital Loss Refresher.” DX 578, 593, 668; Tr. 2778 (Field). BDO priced these tax products based on the “value,” or dollar amount of taxes that the product could save its purchaser. See DX 578, 665, 668; Tr. 2876 (Field). BDO Seid-man likewise calculated employee bonuses on the amount of tax savings claimed or achieved by selling a given tax product. See DX 523, 668; see also Tr. 2847-48 (Field).
The tax practice team at BDO Seidman was known internally as the “Wolf Pack.” DX 578; see also Tr. 2880 (Field). According to Denis Field, then the managing partner of BDO’s tax practice, the ‘Wolf Pack” represented “cooperation, collaboration, communication, and concentration,” an attempt to make BDO’s tax practice more competitive and profitable. Tr. 2780, 2742-43, 2880 (Field); DX 578; Tr. 1596 (DiMuzio). As the leader of the tax practice, Denis Field described himself as the “alpha wolf.” Tr. 2742-43, 2880 (Field). As the “alpha wolf,” Field cultivated the TAX $ELLS! division and wolf pack ideas throughout BDO’s tax practice. Tr. 2878-79 (Field).
BDO compiled and updated a “Tax Product Sales Manual” that was used for the marketing and sale of BDO’s tax products. See DX 593, 665, 668; see also Tr. 2758-59, 2777-79 (Field); see also DX 600. 13
Sentinel Advisors
Sentinel Advisors, LLC (Sentinel), the tax matters partner and managing member of *18 Jade, was a hedge fund manager in New York. JX 19. Sentinel was formed in 1997, by Ari Bergmann 14 and Abraham Pfeiffer. 15 See JX 19; Tr. 806 (Pfeiffer). In 1999, Sentinel’s Chief Financial Officer (CFO) was Smi-ta Conjeevaram, a certified public accountant (CPA) and former tax manager. 16 See JX 19; Tr. 2594-96 (Conjeevaram). In 1999 and 2000, Sentinel controlled a subsidiary, New Vista, LLC, which was owned 75 percent by Sentinel and 25 percent by Michael Powlen, a California-based tax attorney. See JX 18 at 14; see also Tr. 1238 (Bergmann); Tr. 2609-11 (Conjeevaram). The bulk of Sentinel’s profits in 1999 arose from investments it executed for BDO. Tr. 1342 (Bergmann).
The Genesis of the Spread Transaction
Between January and March of 1999, Ari Bergman from Sentinel Advisors approached Charles Bee, a senior partner at BDO Seid-man responsible for developing its Tax Solutions Group’s business line, with the idea for the spread transaction. Tr. 2905-07(Bee); Tr. 1234-37 (Bergman). 17
Bee testified:
Q. The spread transaction I’m referring to is described as involving the purchase and sale of foreign currency options creating a spread position, which is contributed to a partnership. When the investor exits the partnership, a marketable asset is received which has a high basis and a low value, the sale of which generates a loss. Now, my understanding is that the idea for the spread transaction or the concept of the spread transaction was brought to you by Ari Bergmann. Is that right?
*19 A. Brought to BDO?
Q. Brought to BDO by Ari Bergmann.
A. By Ari Bergmann. That’s correct.
Q. Could you just describe to the Judge how it is that that idea or that concept was brought to BDO Seidman in the initial development or the early stages of it, the birth as it were of the spread transaction?
A. Well, Ari Bergmann was introduced to us, and I’m not exactly sure by whom. He either came to our offices or we had a meeting at his offices, and I don’t recall which. There were a few of us at the meeting, and he described an investment which we called a spread option,____ We had not heard—I hadn’t heard, and I don’t think anyone else at that meeting had ever heard—of the concept of a spread option or any tax benefits or other aspects of spread options at that time.
Q. And just to clarify, the time is when? Early 1999? Is that right?
A It must have been sometime between January and March of 1999.
Tr. 2905-07(Bee).
Bergmann testified as follows regarding the origin of the spread transaction:
A. We came to them [BDO Seidman]. They were our accountants. We had big problems with phantom income the year before in 1998 that we had very, very detrimental tax treatment on the derivatives. We went to BDO Seidman, and we asked them in every derivative product that we did what was the tax treatment. We heard that the tax treatment of short options was favorable ...
Q. Okay. And there was a transaction that was described to you in your discussions with BDO involving spread options?
A. To the best of my recollection it was not a transaction described. We asked them. Short options. What is the tax treatment like we asked everything else of them what was the tax treatment. That was what we asked.
Q. Did you learn of an economic mismatch that could take place between the economic results of a spread transaction and the tax results of a spread transaction in your conversations with BDO?
A. We learned of a different tax treatment. That is correct. A tax treatment.
Q. Okay. And that produced a mismatch between the economic results and the taxable income resulting from the transaction?
A. Yes.
Q. And that involved a short position that is then contributed to a partnership or trading fund?
A. We didn’t learn that it then contributed. We learned—that was not the gist of the conversation. The gist of the conversation was short positions. What is the value? We know the short position is a short. It has a negative value. If it’s contributed to a fund, what does it do to the basis? We had heard that it does not because it is so contingent. It doesn’t reach to the level of a liability. That’s what we asked them.
Q. Where had you heard this?
A. On the street. I don’t even know who. Tr. 1234-36 (Bergmann). Bee acknowledged that Bergmann had discussed tax ramifications of the spread:
Q. But Mr. Bergmann indicated that there were tax ramifications to the spread transaction, didn’t he?
A. Yes, he did.
Q. When Mr. Bergmann brought this spread transaction concept to BDO with the tax ramifications, tax benefits, what did BDO Seidman do?
A. We examined it. The first thing that struck me is that I called up a law firm that I had personally dealt with, the firm had dealt with for many years, and we had the utmost confidence in as an independent advisor and as extremely fine tax attorneys, and that is William Bricker and Curtis *20 Mallet. Bill is an international tax specialist, and we were talking about foreign currency options and for a whole host of reasons.
Tr. 2908, 2911-12(Bee).
BDO Seidman’s Tax Product Sales Manual’s “Spread Transaction”
Under Field’s leadership, BDO’s tax practice group updated the Tax Product Sales Manual. See DX 665. In August 1999, Section 250, Capital Gain Eliminators, and Section 300, Ordinary Income Eliminators, of the Tax Product Sales Manual were revised to include a tax product known as the “Spread Transaction.” DX 665; Tr. 2878 (Field). 18
According to BDO’s Tax Product Sales Manual, the spread transaction was a tax product that BDO claimed could create “stepped-up basis ... to shelter gains.” DX 665. The spread transaction was priced as a percentage of the gain to be sheltered. DX 665. Section 250 of the Tax Products Sales Manual stated that “[t]he fee for the Spread Transaction [would] typically be 8% of the gain.” DX 665 at 019777.
BDO’s Tax Products Sales Manual described the Spread Transaction as follows:
There are several different transactions which might deal with capital gains. Although each is structured around different statutory provisions, and have various structural differences, they each rely on anomalies in the tax law to allow for the creation of stepped-up basis that can be used to shelter gains.
Spread Transaction: This transaction requires a minimum gain of $15 million, and a taxpayer who meets certain minimum assets requirements that generally require gross assets of at least $10 million. A tax opinion is provided by a law firm on this transaction, which can be used for gains already recognized in 1999.
The Spread Transaction involves the purchase and sale of foreign currency options, creating a spread position,[ 19 ] which is contributed to a partnership. When the investor exits the partnership, a marketable asset is received which has a high-basis and low value, the sale of which generates a loss.
These transactions are structured around anomalies in the tax law that allow for the creation of stepped-up basis that results in an ordinary loss that can be used to shelter ordinary income ...
... including previously generated income in the same year.
DX 665 at 019776, 019778; see also Tr. 2869-72 (Field). 20
Curtis Mallet
BDO Seidman’s Bee had met William Bricker, a partner at the law firm of Curtis Mallet in New York, at a lecture. Tr. 912-13 (Bricker). Over a period of several months including April, 1999, Bee and Bricker had ongoing discussions about a potential foreign-currency-options transaction that would involve Sentinel Advisors, a hedge fund manager, doing the trading because BDO was not licensed to sell securities. Tr. 915, 985-87 (Bricker); Tr. 2905-06, 2911-13, 2922-24(Bee); JX 19. 21 Bricker and Curtis Mallet would provide tax opinion letters to investors concerning the transactions. Tr. 2941(Bee).
*21 BDO became a client of Curtis Mallet, and Bricker and his partner Eduardo Cukier, spoke with Ari Bergmann, Abraham Pfeiffer, and other members of Sentinel about the mechanics of the spread transaction. Tr. 913-14 (Bricker); Tr. 2709, 2713-14 (Cukier). In investigating the details of the spread transaction, Bricker spoke with employees of AIG, an investment firm, about AIG’s account opening forms and fees. Tr. 920-21 (Bricker). At some point during this process, the BDO Tax Group determined that it would refer clients to Sentinel to purchase the spread transaction and to Curtis Mallet for tax opinion letters. Tr. 1562-63 (DiMu-zio); Tr. 2922-25(Bee).
Throughout the first half of 1999, Bricker and Cukier reviewed and commented on draft documents from BDO, AIG, and other law firms regarding foreign currency option exchanges for the future execution of the Spread Transaction, including transaction documents relating to currency trading, a subscription agreement, a partnership agreement, an offering memo, an agreement with New Vista to provide services, and a withdrawal/redemption letter. Tr. 921-23, 987-89 (Bricker); see also DX 559, 598. After reviewing these documents, Bricker concluded that the spread transaction would “more likely than not” create a step-up in basis of the asset and allow for reportable losses under Federal tax law and issued an opinion to that effect to clients of BDO. JX90; Tr. 943-44 (Bricker).
Brieker’s opinion stated that the “transfer to the Partnership of the [option spread] should [be] viewed as a contribution of the Purchased Call Option ... to the Partnership and the Partnership’s assumption of the Sold Call Option. Thus, ... the Partnership interest equal[s] the basis of the Purchased Call Option____” JX 90 at 15-16. Interpreting Internal Revenue Code section 752, Bricker opined that the obligations created by the sold options assumed by the partnership were “contingent,” because they were not exercised and therefore not a liability for purposes of lowering the basis under section 752(b). JX 90, Tr. 943, 1015-16 (Bricker).
AIG: May-June 1999
In April or May of 1999, Bergmann met Ann Reed, the treasurer of AIG’s Trading Group, and Sheldon Pang, a salesperson on the foreign exchange desk at AIG. Tr. 1670-72 (Reed). At that meeting, Bergmann proposed transactions in which Sentinel clients would buy option spreads, and AIG would be paid account opening and transaction fees. JX 112 (Pang Dep. at 139); Tr. 1177-78 (Bergmann). 22 Pang was AIG’s principal contact with Sentinel on the “sales side,” where he was in charge of setting up accounts for Sentinel. Tr. 1672-74 (Reed). Reed was also an AIG contact for opening and setting up accounts with Sentinel, and she met with Sentinel to establish a working relationship. Tr. 1674-75 (Reed).
Before AIG would being trading with Sentinel clients executing the Spread Transaction, a series of required steps had to be established—these steps were recorded in a document entitled “Procedures for Transactions with AIG, Meeting at Sentinel with AIG on May 17, 1999 at 3 pm” that was prepared in conjunction with a meeting between AIG and Sentinel that day. DX 555; Tr. 1675-76 (Reed); Tr. 2631-48 (Conjeevaram). 23 These May 17, 1999 procedures set forth four primary steps required to complete each transaction and assigned responsibility for each step of the spread transaction. See DX 555; see also Tr. 2631-48 (Conjeevaram). The four steps were:
1. Trade To Be Done
2. Trade is Executed
3. Contributions into the Partnership
*22 4. Redemption from Partnership.
DX 555. Under each of these four steps, administrative tasks were listed. Under “Contributions into the Partnership,” the following steps were listed:
a. Assignment & Assumption agreement to be signed by Sentinel and Investor and sent to AIG for signature
b. Noreen to follow up with investor and AIG for signed and completed Assignment & Assumption Agreement
c. After Assignment & Assumption is signed by all parties, Sentinel to determine the date of the revaluation of the spread and the date for the Assignment & Assumption Agreement.
d. Contribution/Revaluation date and the date of the Assignment & Assumption should be the same
e. Udai/Jeremy should inform AIG the revaluation date
f. Revaluation reviewed and checked
g. Noreen to send investor a copy of the revaluation and the signed Assignment & Assumption agreement
Id.
The following tasks were listed under step four, “Redemption from Partnership”:
a. Letter from Investor
b. E-mail redemption date to Eli/Udai and Jeremy
c. E-mail assets to be redeemed to Udai/Jeremy
d. Reply to investor re. date of redemption
e. AIG to value the partnership’s assets-turn-around time is approximately 2 days after request
f. Untracht & Assoc. to review investor capital account
g. Determine the assets to be redeemed
h. Letter to AIG to transfer requisite amount of currency
Id 24
The Master Trading Agreements: September 15,1999
On September 15, 1999, the Ervin LLCs entered into a letter agreement with AIG authorizing Sentinel to act on their behalf in trading with AIG. See JX 34, JX 35, JX 36; see also Tr. 1695-96 (Reed). That same day, each Ervin LLC entered into a separate Master Trading Agreement with AIG, and Reed signed the agreements on behalf of AIG. Tr. 1679 (Reed); JX 31, JX 32, JX 33 25 These Master Trading Agreements were developed internally at AIG, and were specific to foreign exchange trading. Tr. 1679-80 (Reed).
Provision 11.1 of each Master Trading Agreement stated in part:
This Agreement may not be assigned by either party in whole or in part without the prior written consent of the other party. Transactions may be assigned to a new counterparty solely upon credit and legal approval of the new counterparty by AIG, such approval to occur in writing prior to any such assignment.
JX 31, JX 32, JX 33. According to Reed, this provision was intended to protect AIG’s interests by prohibiting either party from randomly assigning its position to anyone else. Tr. 1681-82 (Reed).
Schedule E of the Master Trading Agreements established original margin requirements for options sold to AIG by the Ervin LLCs as follows:
(a) For each Currency Contract, 5% of the Contract Value of that Transaction where the underlying currency pairs consist of Group A Currencies, as defined herein, and otherwise, between 10% and 20% of the Contract Value of that Transaction, as determined by AIG in its sole discretion. Except as otherwise agreed by the parties, “Group A Currencies” shall include the ... Euro and the U.S. Dollar.
*23 (c) For each Currency Option under which AIG is the Holder, the product of (i) 5% of the Contract Value of that Transaction where the underlying currency pairs consist of Group A Currencies, and otherwise, between 10% and 20% of the Contract Value of that Transaction, as determined by AIG in its sole discretion, and (ii) the delta for that Transaction (as determined by AIG in any commercially reasonable manner).
JX 31-33. 26 Ann Reed testified that the purpose of Schedule E of the Master Trading Agreements was to clarify “how original margin would be held for an option which was sold to AIG.” Tr. 1682-83 (Reed).
Paragraph 11.6 of the Master Trading Agreement provided: “Unless otherwise agreed, Counterpart shall, from time to time and as requested by AIG, pay to AIG a fee equal to 0.0275% multiplied by the notional amount of any Call spread or Put spread Option Transaction.” JX 31, JX 32, JX 33. Bergmann testified as follows regarding the fee provision in Section 11.6:
Now, we did with AIG something which was called either an account open fee or a facility fee because we knew that we were planning to trade these things in and out all the time, and if you would have to pay a bid offer every single time it would be very costly and onerous![ 27 ] We had a gentlemen’s agreement, an understanding with the traders, that we will pay a fee, a specific fee up front, which would be called either a facility fee or an account opening fee, whatever the terminology is, to allow us to trade reasonably a few times without having to pay additional bid offers to the tightest bid offer, which is like one-hundredth. That would allow us to trade and to make money without having to pay out every time.
Q. To pay out what every time?
A. A bid offer. The regular bid offers.
Tr. 1177-78. 28 Bergmann could not recall the name of the person at AIG with whom he reached the referenced “gentlemen’s agreement.” Tr. 1316 (Bergmann). He testified that provision 11.6 of the Master Trading Agreement was intended to reflect this agreement, but that the language is unclear. Tr. 1374-75, 3458-61 (Bergmann).
AIG did not normally require counterparties to pay an up-front fee prior to engaging in foreign exchange option trading. Tr. 1694-95 (Reed). Ann Reed, the Treasurer of AIG’s Trading Group and the primary contact with Sentinel for drafting the Master Trading Agreement testified as follows:
Q. Now, what is that fee for?
A. I don’t know.
Q. Is it a standard term in AIG’s multi agreement?
A. It was not in the basic multi agreement as developed, no.
Q. Do you know why it was included in this agreement?
A. I do not.
Q. Was it included in the master trading agreements for other Sentinel clients?
A. Yes. Now, I can’t say that they all have this, but I know that some of them did.
Q. Was it included in master trading agreements other than for Sentinel’s clients?
*24 A. I’ve never seen this provision that I recall outside of Sentinel’s clients.
Q. Was there a negotiation between AIG and Sentinel about the fees that were to be paid by Sentinel’s clients?
A. I don’t know.
Q. Do you know if AIG agreed to forego bid offers in favor of up front fees? A. I do not.
Q. So you’re not familiar with an informal agreement to that effect?
A. I am not.
Tr. 1686-87 (Reed).
Reed sent a draft of the Master Trading Agreement to Conjeevaram by fax on July 13, 1999, that did not contain provision 11.6. DX 564; Tr. 1689-90 (Reed). Reed acknowledged that the final version of the Master Trading Agreement used for Sentinel clients did contain this provision, but did not know when it was added. Tr. 1690-92 (Reed). Neither Conjeevaram nor Pang knew how or when provision 11.6 became part of the Master Trading Agreement. Tr. 2598 (Conjee-varam). JX 112 (Pang Dep. 73-74).
Dr. David DeRosa, Defendant’s expert in options and foreign exchange trading, testified that the $84,100 fee arrangement in the Master Agreement was unusual. Dr. DeRo-sa stated: “I’ve never paid such a fee, and none of the investment partnership hedge funds I’ve ever been associated with who I’ve ever heard of ever paid a fee like that.” Tr. 3184 (DeRosa). He opined that the reason he never had to pay such a fee was because “[his investments] were real opportunities for the investment bank.” Id. When asked why he believed the Ervin LLCs were asked to pay such a fee he stated:
I think the answer is because the business isn’t worth very much to AIG, and they had to make some money on it. But it’s certainly not a normal relationship, and I—you know, I’ve seen a lot of circumstances in this big world of foreign exchange, but I never saw anybody pay to play____There is no way I would do this____I’ve never heard of this. Honestly, I have never heard of this, an account opening fee before.
Tr. 3185-86 (DeRosa).
Neither Reed nor any other AIG employee assessed the creditworthiness of Sentinel’s clients individually, even though AIG had an established process for making such an assessment that would not have “taken very long.” Tr. 1685 (Reed). Instead, AIG relied on Sentinel’s assurance that each of its clients had net assets in excess of $10 million. Tr. 3454-55, 3462 (Bergmann). 29 AIG began trading with Sentinel in June of 1999. Tr. 1675 (Reed). According to Reed, AIG provided services to more than 50 Sentinel clients in 1999. Tr. 1677 (Reed). 30
BDO Seidman’s Tax Opinion Letter
In May 1999, BDO Seidman prepared a 37-page tax opinion for potential investors in the spread transaction. The opinion briefly described the investment aspects of the spread transaction,—the type of options to be purchased and sold, the strike price for each option, the dollar and euro value of each option, the expiration dates of the options, and profit potential of the transaction. JX 23 at 2 31 The opinion went into great detail about the tax consequences of the transaction. The opinion began:
THIS OPINION CONSIDERS CERTAIN FEDERAL INCOME TAX CONSEQUENCES OF A PROPOSED INVESTMENT TRANSACTION AND IS BASED ON A HYPOTHETICAL FACT PATTERN.
JX 23 at 1. The opinion outlined four steps of the investment strategy, which were: 1) Investment in Foreign Currency, 2) Contribution to a Partnership, 3) Partnership In *25 vestments, 4) Termination of Partnership Interests. JX 23 at 2-3. The opinion explained that the investor would first “purchase a European-style call option” and at “the same time ... sell a European-style call option.” JX 23 at 2. The investor would then contribute the purchased and sold call options to a partnership that had been previously formed under Delaware law. JX 23 at 2-3. “Sentinel Advisors [would be] the investment advisor to the Partnership, and [would] charge the Partnership an investment advisory fee.” JX 23 at 2. In return for the options contribution the investor would receive a “less than 50% interest in the partnership.” JX 23 at 3.
In the fourth step of the BDO Spread Transaction, “Termination of Partnership Interests,” the purchaser of the spread would exit the partnership, receive an asset with a claimed high-basis and low-value, and then sell that asset in order to generate a tax loss. JX 23 at 3; DX 665. The partnership would continue to exist and invest. See JX 23 at 3, § 4,112. BDO recommended to its customers that the amount of time between the second step (entering the partnership) and the fourth step (exiting the partnership) be no less than 60 days. Tr. 2969-70(Bee). BDO recommended this 60 day minimum for tax reasons—to establish that purchasers of the spread transaction were “partners” for purposes of substantive tax law. Tr. 2969-71(Bee).
The opinion summarized the federal income tax consequences of the spread transaction stating “it is more likely than not that:”
1. You should recognize gain on the transfer of the Purchased Call Option to the Partnership. You will not recognize any loss on the contribution of the Purchased Call Option to the Partnership.
2. Your basis for the Partnership interest should be equal to your basis in the Purchased Call Option, reduced by the amount of liabilities assumed by the Partnership. The sold call option should not be considered a liability for purposes of section 752.
3. Your share of any loss incurred by the Partnership should be deductible by you, and should not be subject to the passive activity loss rules.
4. You should not recognize gain or loss on the receipt of foreign currency from the Partnership in exchange for your Partnership interest.
5. The basis of the foreign currency received in liquidation of your Partnership interest should equal your basis for the Partnership interest.
6. The gain or loss recognized on your sale of the foreign currency should be treated as ordinary income or loss.
JX 23 at 4. The opinion provided a detailed analysis of Helmer, and concluded that a “Sold Call Option contract creates no obligation to return the premium to the purchaser. Indeed, the premium represents deferred income to the seller and is not a liability.” JX 23 at 13-14.
Dimuzio Introduces the Spread Transaction to the Ervins
On August 23, 1999, DiMuzio mailed BDO’s May 1999 draft model tax opinion to Martin McElroy. Tr. 1512, 1517 (DiMuzio); JX 22, 23. McElroy reviewed this opinion and was “impressed” with it. Tr. 1626 (Mountjoy). McElroy was impressed overall with Sentinel, BDO Seidman, Curtis Mallet, and the opinions and guidance they provided on the proposed transaction. Tr. 337-38 (G. Ervin); Tr. 1409, 1411-12 (McElroy); Tr. 1626 (Mountjoy). Jesse Mountjoy also reviewed the BDO Seidman model opinion at the request of Gary Ervin and found the model opinion to be thorough, well researched, and “balanced from the standpoint of presenting both sides of legal interpretation.” Tr. 1614 (Mountjoy).
Gary Ervin’s Failure to Restrike the Dy-com Options: Auyust 26,1999
In late August 1999, Maidman called Gary and told him that the Dycom stock price had dropped dramatically, from $48.56 per share on June 1, to $37.50 per share on August 26, 1999. Tr. 136 (Maidman); Tr. 357-58 (G. Ervin); JX 1. The Ervins’ put option gave them the right to sell the Dycom Stock at $42.2859 per share and realize a gain of $4.7859 per share. JX 1 at 5; JX 14 at 2, JX *26 15 at 2, JX 16 at 2. Maidman explained that the Ervins could restrike the appreciated put option in each collar, leave the call option unaltered, and reap an aggregate profit that exceeded $1.5 million. 32 Tr. 136-37 (Maid-man); Tr. 358 (G. Ervin). On the advice of Cheyne Pace, Gary did not restrike any of the options at this time. Tr. 359-60, 362-63 (G. Ervin); Tr. 222-23 (Pace). After the Dycom stock quickly recovered, Gary regretted that decision. Tr. 362-63 (G. Ervin). On behalf of himself and his brothers, he res-truek the purchased option the next time the opportunity arose. Tr. 484 (T. Ervin); JX 1 (Nov. 1,1999 Entry.) 33
The September 2, 1999 Meeting Between BDO Seidman and Gary Ervin
On September 2, 1999, DiMuzio met with Gary Ervin, Mountjoy, and McElroy at McElroy’s office in Henderson, Kentucky. Tr. 519, 522, 525, 634 (G. Ervin); Tr. 1513, 1574 (DiMuzio); see also PX 244. 34 At the meeting DiMuzio explained the substance and tax benefits of the Spread Transaction described in the model opinion letter. Tr. 1514 (DiMuzio); Tr. 520 (G. Ervin). No representative of Sentinel was present. Tr. 634 (G. Ervin); Tr. 1499, 1513, 1542 (DiMu-zio). DiMuzio, McElroy, Mountjoy, and Gary Ervin discussed the model opinion letter in “pretty good detail.” Tr. 1407,1438 (McEl-roy). 35 Specifically, DiMuzio recommended that Gary talk to Sentinel about trading euro options as Sentinel had a group of “very successful” and “very experienced” traders, and because the “tax advantage portion” of the Spread Transaction “was very similar to [BDO’s] earlier presentation.” Tr. 364-65, 369-70, 372-73 (G. Ervin); Tr. 1405 (McEl-roy).
Gary Ervin enlisted his long-time tax attorney, Jesse Mountjoy, a former IRS attorney, to attend this meeting with BDO Seid-man. Tr. 518-20 (G. Ervin). After Gary Ervin had described the Jenkens & Gilchrist deal to Mountjoy, he was skeptical, and Gary wanted him involved in the debate “to play devil’s advocate.” Tr. 518 (G. Ervin). Initially, Mountjoy, who is blunt, was skeptical, but by the end of the meeting Mounjoy became “convinced otherwise,” and told Gary Ervin so. Tr. 520 (G. Ervin). Had Mountjoy not been convinced, Gary Ervin would not have done the spread transaction. Tr. 519 (G. Ervin). Jesse Mountjoy had represented the Ervin family since the late 1980s, and Gary Ervin had uniformly followed his advice. Tr. 517 (G. Ervin); Tr. 1637 (Mountjoy).
DiMuzio told Gary Ervin to call Bricker of Curtis Mallet for tax advice in the form of an opinion letter. Tr. 699-700 (G. Ervin); Tr. 1518-19 (DiMuzio).
Gary Ervin’s Discussion With Bricker: Late August or Early September 1999
Following DiMuzio’s suggestion, Gary Er-vin contacted Bricker to discuss the spread transaction in late August or early September of 1999. Tr. 583, 699, 718 (G. Ervin); Tr. 923-24 (Bricker); Tr. 1518-19 (DiMuzio). The Ervins did not engage Mr. Bricker at that time, because they understood that they did not need to engage the law firm until they planned to exit the partnership, and they intended to retain Bricker when they left the partnership. Tr. 583, 738 (G. Ervin); Tr. 923-24 (Bricker). 36 During that initial *27 conversation, Gary asked Bricker questions about options and commodity trading and questioned him extensively about his educational background and professional experience with options and commodity trading. Tr. 924-27 (Bricker). In Bricker’s view, Gary Ervin was “conducting some sort of review or due diligence” on him and Curtis Mallet, and Bricker explained to Gary that he had 30 years of legal experience focusing on the tax consequences of commodity transactions and other issues. Bricker also gave Gary Ervin the background of Curtis Mallet, explaining that the firm “had been around a long time” and did “a lot of international work.” Tr. 926 (Bricker).
DiMuzio’s September 8,1999 Letter to Gary Ervin: Information on Sentinel and its Fee, and EDO’s Preparation of the Ervins’ 1999 Personal Tax Returns
In a letter dated September 8,1999, DiMu-zio informed Gary Ervin that Sentinel Advis-ors had agreed to a five-percent fee as long as the Ervins’ transaction was at least $40 million in total. JX 24. The letter stated:
To confirm my voice mail message, Sentinel Advisors agreed to the 5% fee, assuming a transaction of at least $40 million in total. All other fees and costs would remain the same as discussed in our meeting last Thursday.
Enclosed is information on Sentinel Advis-ors including biographies of the partners, a list of references and an Investment Advis- or Registration statement, which, by SEC regulation, is provided to prospective investors. Also enclosed is a private placement memorandum for New Wave I LLC. This will not be your investment vehicle; I simply included it to give you a sense of Sentinel’s other activities.
With respect to fees for preparing your personal tax returns, as I indicated, it is difficult to quote a fee without analyzing your prior year returns and knowing more about your current situation. Because time is short, we may not be able to get enough information to make a fully informed estimate. However, to resolve this issue in order to keep the transaction moving, BDO Seidman, LLP will agree to prepare tax returns for you and your brothers at a fee commensurate with your prior year returns. In other words, if your 1999 federal income tax return is substantially similar to your 1998 return except for the sale of the businesses and the proposed transaction, our fee will be no higher than what you paid last year. State returns will be prepared on the same basis.
I look forward to working with you, your brothers, Martin and Jesse in completing this engagement.
JX 24.
DiMuzio vaguely testified that the “proposed transaction” mentioned in his September 8 letter referred to an “investment with a Sentinel hedge fund:”
Q. What was the transaction though? I want—you used the word.
A. The investment.
Q. Would you please specify that?
A. If I’m being evasive, Your Honor, I don’t want to be. The Sentinel investment, the decision to invest in a Sentinel hedge fund partnership.
Q. Okay, that’s an investment. This is a transaction. You used the word twice. You said let’s keep the transaction moving, and then you said—
A. Yes, yes, I did.
Q. —later in the letter, “In other words, if your 1999 federal income tax return is substantially similar to your '98 return except for the sale of the businesses and the proposed transaction.”
A. That would be—I think I was referring to the Sentinel investment in both of those cases. That’s what I meant by transaction, yes.
Q. Okay. And what Sentinel Investment? Specify the transaction.
A: An investment with a Sentinel hedge fund, an investment with a Sentinel *28 hedge fund. I think that’s what I was referring to encompassing transaction.
Q. Had you been privy to the proposed transaction that the Ervins were contemplating at that time, the specific transaction, not just a general investment? I’m trying to get specifics here.
A. Oh, I was—I attended the meeting when Smita made a presentation about—-a detailed presentation about the options, about the trading of the options inside of the partnership, about knock-out options, about the leveraging that was allowed or that was available there, about the potential returns. So that’s what I was thinking about in connection with that.
Tr. 1567-69 (DiMuzio). In early September 1999, the Ervins became clients of BDO Seid-man. Tr. 519-25, 634 (G. Ervin); Tr. 1512-13, (DiMuzio).
BDO Seidman Introduces the Ervins to Sentinel: Late August or September 1999
In late August or early September of 1999, DiMuzio gave Gary Ervin’s contact information to Bergmann. Tr. 369, 3627-28 (Gary Ervin). Bergmann contacted Gary Ervin via telephone in August or September of 1999, and spoke to him for “a few hours” about possible investments and the services that Sentinel could provide. Tr. 367-69, 3627-28 (G. Ervin); Tr. 1069-72 (Bergmann). During the call Bergmann informed Gary Ervin of his professional experience in accounting and trading, provided professional background information on key personnel at Sentinel, and introduced Gary to several of the Sentinel partners. Tr. 367-69 (G. Ervin). Bergmann considered the Ervins to be “overly positioned” in Dycom stock and told Gary Ervin they needed to diversify their investments. Tr. 375 (G. Ervin). Bergmann recommended that Gary Ervin and his brothers diversify by investing in euro currency options where they could potentially make “10, 15, 20 times” their investment. Tr. 1072 (Bergmann); Tr. 375 (G. Ervin).
During Bergmann’s initial phone conversation with Gary Ervin, Bergmann informed him that a unique opportunity existed to make large investment returns from the euro and that derivatives were the ideal instrument to take advantage of the euro. Tr. 381 (G. Ervin); Tr. 1071 (Bergmann). Specifically, Bergmann testified that he told Gary: “1999 was a critical year, was the year of the introduction of the euro, and you have to realize that the euro ... was an event that seldomly happens in the lifetime, and in the lifetime of an investor the opportunities that you have to catch.” Tr. 1070 (Bergmann).
During the first telephone conference, in August or September 1999, and during telephone conferences over the next 30 days, Bergmann recommended engaging in heavy trading on euro options. Tr. 381-82 (G. Er-vin); Tr. 1070-71 (Bergmann). Gary Ervin recalled approximately eight different phone conversations with Bergmann during the August and September 1999 time frame. Tr. 3631-3632 (G. Ervin).
Bergmann recommended that the Ervins combine “two regular options in [their] trade called an option spread.” Tr. 1080 (Berg-mann). Bergmann also recommended acquiring “reverse knockout options.” Tr. 1077-79 (Bergmann); Tr. 382 (G. Ervin). Options like knockout options are often described as exotic strategies. Tr. 2509 (Shoji); See Tr. 3118 (DeRosa). One type of exotic option is a “barrier” option, which has a “price barrier” which, if hit, causes the option to expire immediately. Tr. 3118 (DeRosa). A knockout option has a barrier set below the strike price; if the currency ever trades at or below the barrier, the option immediately expires worthless. See DX 501 at 7-8; Tr. 3119-20 (DeRosa); DX 768 at 39. 37
Bergmann testified about how he described the reverse knockout to Gary Ervin during their initial phone conversation:
*29 The reverse knock-out allows you to have a multiple up to 38 to 1 if you are right, and if worse comes to worse you could lose your premium. You could lose your premium if the euro goes lower, or you can lose your premium if the euro goes too high. We thought it was an ideal instrument to present, and that’s what I told Gary.
And we told him, listen, if you want to do now an investment to get you a return, which is also levered [sic], not as levered [sic] and as tailored as a reverse knock-out, but also has a very good characteristic, is combining two regular options in your trade called an option spread.
He will basically double his money, not exactly, but around doubling his money. Tr. 1079-80 (Bergmann); see Tr. 385 (G. Ervin). Bergmann also told Gary Ervin that, based on a Swiss Franc study, the Ervins stood a one in five chance to reap an average return of 14:1 with the reverse knockout options. Tr. 385 (G. Ervin); Tr. 1367-68 (Bergmann).
Sentinel sent the Ervins copies of a Sentinel brochure, a Sentinel reference list (which listed clients such as Merrill Lynch, Morgan Stanley, PricewaterhouseCoopers, Dewey Balantine, and BDO Seidman), examples of restriking pairs of options at a profit, a euro knock-out explanation, the Confidential Offering Memorandum of Jade Trading, LLC, and the book Understanding Options by Dr. Robert W. Kolb. Tr. 578-79 (G. Ervin); Tr. 1141 (Bergmann); JX 21. The Sentinel brochure outlined the trading background of Sentinel’s principals and traders. JX 19; PX 227; Tr. 578-79 (G. Ervin). The other materials explained how option trading works, and more specifically, how the foreign currency investments that the Ervins were contemplating would work. Tr. 572-79 (G. Ervin); Tr. 1140-41 (Bergmann). The Sentinel marketing materials included the monthly historic returns for Sentinel’s Citadel fund from August 1997 to July 1999, and examples of how spreads could be restricken and profits could be earned on knockout options. JX 20, PX 232, 228; Tr. 667-68 (G. Ervin). 38
After speaking with Bergmann and reviewing the materials he was provided by BDO and Sentinel, Gary Ervin concluded that Bergmann was more knowledgeable and experienced in this area than Maidman and Pace. Gary Ervin was impressed with Berg-mann and his group at Sentinel. Tr. 372-74, 563-64 (G. Ervin).
Gary Ervin’s Inquiries About Sentinel
Gary Ervin asked both Pace and Maidman about Sentinel and its recommendations on the euro. Tr. 137-40 (Maidman); Tr. 225-26 (Pace); Tr. 491-93 (G. Ervin). Maidman also asked the “appropriate people around [her] department in New York,” about Sentinel but did not do a detailed background check. Tr. 199 (Maidman). Maidman told Gary that she knew of nothing negative about Sentinel, and said that her bank’s position on the euro was positive. Tr. 139-40, 203 (Maidman); Tr. 492-94 (G. Ervin). 39
Gary Ervin also asked Pace about his view on Sentinel, and Pace told Gary that the Sentinel principals had “distinguished backgrounds” and there was nothing negative to report. Tr. 224-25 (Pace); Tr. 515-16 (G. Ervin); JX 19. Pace informed Gary that he was positive on the euro. Tr. 226-27 (Pace); Tr. 516 (G. Ervin).
The Formation of the Ervin Single-Member LLCs: September 17,1999
Gary, Robert, and Tim Ervin formed Er-vin Holdings, LLC, Ervin Capital, LLC, and Ervin Investments, LLC, respectively, on September 17, 1999, as single-member limited liability companies under Delaware law. JX 28-30; DX 769; Tr. 3632-33 (G. Ervin). According to Gary Ervin, the Ervins formed the LLCs to execute the spread transaction *30 based on the advice of William Bricker in order to limit their personal liability if the spread options were ever “split apart.” Tr. 552-53 (G. Ervin). Gary believed that if they did not form LLCs and the spread options were separated in a manner beyond the Er-vins’ control, he and his brothers would lose their $15 million premiums in the purchased call options and would also be personally hable for the $300 million “total premium amount” of the sold call options. Tr. 553 (G. Ervin).
By fax dated September 21, 1999, Conjee-varam advised Gary Ervin:
Enclosed for your information is a copy of the business card for the attorney’s [sic] that are working on the documentation for the three single-member LLCs that [were] formed for the transactions. The names used for the three are Ervin Capital, LLC, Ervin Investments, LLC and Ervin Holdings, LLC. We should have the LLC operating agreements from the attorneys later this morning.
If you are happy with the names of the LLC’s I will have AIG work on revising the Master Trading Agreement. Please let me know.
I will call you later this morning to confirm our meeting on Thursday in Evansville. Either my partner, Ari Bergmann or I will meet with you.
JX 25.
Gary Ervin’s September 23, 1999 Meeting with Sentinel’s CFO
Gary Ervin recalled meeting with Conjee-varam, Sentinel’s CFO, twice before investing with Sentinel, but Conjeevaram only recalled one meeting. Tr. 638 (G. Ervin); Tr. 2608-09; 2669-71 (Conjeevaram). Neither Bergmann nor Pfeiffer ever met with Gary in person prior to the Ervins’ investment in Jade—their contact was strictly on the phone. See Tr. 638-39 (G. Ervin); Tr. 1301 (Bergmann). Conjeevaram never worked as a foreign currency trader, and had a heavy tax and accounting background. Tr. 2590-94 (Conjeevaram). 40
On September 23, 1999, Gary Ervin and Martin McElroy met with Conjeevaram at the airport in Evansville, Illinois. JX 26; Tr. 638, 3636 (G. Ervin); Tr. 1408 (McElroy). McElroy testified that the meeting was primarily a presentation of Sentinel “investments and the opportunities in the euros and their strategies on options,” and also included information regarding “big multiples on some other strategies that they were recommending.” Tr. 1408 (McElroy).
The Formation of Jade: September 23,1999
Jade was formed by Sentinel and Banque Safra on September 23,1999. JX 47, 84; Tr. 1092-93, 1223-24 (Bergmann). At some point during September 1999, Sentinel gave the Ervins copies of a “Confidential Private Offering Memorandum of Jade Trading, LLC,” which stated:
The investment objective of the Company is to realize short- and medium-term capital appreciation from the application of derivative trading strategies to a variety of investments in the foreign exchange and general fixed income global markets. The Company will seek to provide returns which are not correlated to the general fixed income and equity markets. Current income is not a primary objective.
JX 47 at 1; Tr. 572-73, 579 (G. Ervin); Tr. 1156-57 (Bergmann); Stip. 1128.
Jade’s Limited Liability Company Agreement described Jade’s purposes as follows:
Sec. 1.06 Purposes of the Company. The Company is organized for the purposes of investing substantially all of its assets in Securities ... and engaging in all activities and transactions as the Managing Member may deem necessary or advisable in con- *31 neetion therewith, including, without limitation:
(a) to invest, on margin or otherwise, in securities and other financial instruments of U.S. and foreign entities, including, without limitation: capital stock; shares of beneficial interest; partnership interests and similar financial instruments....
JX 60-62; Tr. 1186-88 (Bergmann). This agreement was drafted by Sentinel. JX 60-62; JX 47 at 1; Tr. 572-73 (G. Ervin); Tr. 1156-57; 1186-87 (Bergmann). According to the BDO opinion letter provided by DiMuzio to the Ervins, Jade was formed for the “purpose of acquiring financial investments, buying and selling call options on foreign currency, and conducting other investment activities.” JX 23 at 2.
Sentinel, the managing member and tax matters partner of Jade, held a profit interest, management fee, and incentive allocation that grew with the appreciation of Jade’s capital. Tr. 1221-23 (Bergmann). At the end of each accounting period, any net capital appreciation or depreciation of Jade would be allocated to Sentinel and the other members of Jade in proportion to each member’s capital account at the beginning of the accounting period. JX 47 at 000080. The management fee paid to Sentinel by the non-managing members, was an annualized two percent of the value of each non-managing member’s capital account balance on the first day of each quarter, or 0.5% each quarter. JX 47 at 000065. In addition, “[o]n June 30th and December 31st of each year ... an amount equal to 20% of any net capital appreciation allocated to the capital account of each Non-Managing Member ... [was to be] debited ... [as an] ‘Incentive Allocation.’ ” JX 47 at 000063. Further, a partner “would be subject to a withdrawal fee equal to five percent of the value of the partner’s capital account on the date of withdrawal” for withdrawing prior to 12 months from entering the partnership. JX 89 at 7; see DX 665.
The Ervins’ Spread Transaction: September 29,1999
One day after Gary Ervin’s meeting with Conjeeveram and the formation of Jade, September 24, 1999, the Ervin LLCs attempted to enter into the first set of euro options Sentinel was recommending. Tr. 561 (G. Ervin); 1145 (Bergmann). Their efforts were thwarted because the funds were not transferred, due to problems with the Ervins’ funds being wired to Sentinel—they sat in an AIG account for a few days before Sentinel actually received them. Tr. 560-61 (G. Er-vin). Gary Ervin said there was a “misfiring” of the wiring process. Id.
On September 29, 1999, the Ervin LLCs each established a spread option position on the euro with AIG. See JX 38-43. 41 The Ervins purchased the option spread on the advice of Sentinel/New Vista, although they did not yet have any consulting agreement •with either entity. Tr. 1146 (Bergmann); compare JX 38-43 with JX 48-50.
The terms of the option spreads purchased by each Ervin LLC were identical except for a 10-pip 42 difference in the strike price:
Face amount Strike price
Purchased Option €290,540,000 1.084
Sold Option €290,540,000 1.085
Tr. 1173-75 (Bergmann); JX 38-43. The premium to be paid by each Ervin LLC on the option purchased from AIG was $15,000,020. See JX 38-40. The premium to be received by each Ervin LLC on the option sold to AIG was $14,850,018. See JX 41-43. These premiums were netted, and each Ervin LLC actually paid AIG $150,002—not $15,000,020. JX 44-46. The expiration date of all six options was September 29, 2000, at 10:00 a.m. New York time. See JX 38-43. The options purchased by the Ervin LLCs were European options that typically can only be exercised at the expiration date. Tr. 1101, 1163 (Bergmann); Tr. 2486 (Shoji). 43
*32 AIG did not require margin from the Er-vin LLCs because the most the Ervin LLCs could lose was their initial purchase price, $150,002, the approximate difference in price between the two options in the spread. Tr. 2535-39 (Shoji); see also Tr. 3135 (DeRosa); Tr. 1701-02 (Reed). 44 From AIG’s perspective, the spread transaction was free of credit risk because under no circumstances would the Ervin LLCs owe AIG any money on the options. DX 501 at 11. However, AIG’s credit protection would disappear if the option components were separated or assigned to other parties. Id. Although the Ervin LLCs were prohibited from assigning their option strategies by paragraph 11.1 of the Master Trading Agreements, if the options were somehow split or assigned, AIG would have required the Ervin LLCs to post original margin. Tr. 1702-03 (Reed). Dr. DeRo-sa, Dr. Kolbe, and Dr. Kolb calculated that the original margin on the call options sold by the Ervin LLCs to AIG would have been approximately $8.4 million. DX 501 at 13-14; Tr. 3146 (DeRosa); Tr. 2367 (Kolbe); Tr. 3506 (Kolb). If the Ervin LLCs had separated the spread or assigned their obligations on the sold call options, AIG would have required the LLCs to pay the $15,000,020 premium for each call option purchased by the LLCs from AIG, plus the $8.4 million original margin for each call option sold by the LLCs to AIG. DX 501 at 13-14; Tr. 1702-03 (Reed); Tr. 2367-72 (Kolbe); Tr. 3506 (Kolb).
The Ervin LLCs each paid AIG $84,110 pursuant to provision 11.6 of the Master Trading Agreements in connection with then-acquisition of the option spreads. Stip. K 26.
The New Vista Consulting Agreement: October 3,1999
Each Ervin LLC entered into a consulting agreement with New Vista on October 2, 1999. JX 48-50. The consulting agreements obligated New Vista to
advise the [Ervin LLCs] with respect to Risk Management, including, without limitation, in connection with the sale, pledge, loan, conveyance, assignment, transfer or other disposition of any instrument or investments, and the creation of hedging positions to preserve or limit the loss of value of any positions or otherwise through the use of one or more interest rate, currency, or other derivative products, including, without limitation: (i) swaps, options, warrants, caps, collars, floors and forward rate agreements; (ii) spot and forward currency transactions; and (iii) agreements relating to or securing such transactions. The Consultant will also (i) give advice regarding macroeconomic issues in structuring transactions and (ii) provide derivatives expertise training to the Client and/or any of the Client’s employees.
JX 48 at 1-2; 49 at 1-2; 50 at 1-2.
Gary understood that if the Ervins did not pay the New Vista fee they would not be admitted as partners in Jade. Tr. 567, 569-70 (G. Ervin). Although the Ervins were required to pay the New Vista fee as a prerequisite for entering Jade, Sentinel did not pay a fee. Tr. 1315 (Bergmann).
Legal and Consulting Fees
Each Ervin LLC paid the following fees in addition to the $150,002 premium paid to AIG:
Fee Amount
New Vista consulting fee $750,000 45
AIG account opening fee $ 84,100
Curtis Mallet legal fees $100,000
Total $934,100
JX 26, 37, 48-50, 85-87; Tr. 928 (Bricker); Tr. 1650-51 (Mountjoy). In addition to the fees listed above, the Ervins were also re *33 quired to pay Sentinel a two-percent management fee of the net asset value of their contribution in Jade Trading ($225,002 per brother) and 20 percent of any profits earned by Jade. Tr. 1314-15 (Bergmann); see JX 57-59.
It is unclear what value the Ervins received for the $750,000 consulting fee. New Vista provided the Ervin LLCs with reports on foreign exchange and other financial markets as well as investment periodicals reporting on different European investments. These brief reports covered the current market conditions in the foreign exchange market. Tr. 3193-96 (DeRosa); JX 69. DeRosa testified as follows regarding the New Vista fee and services provided to the Ervin LLCs:
I cannot for the life of me understand why any fees would go to New Vista at all. It doesn’t make any sense to me whatsoever. Those are big numbers. Three-quarters of a million times three? And the purported thing is buying research—well, research is free .... there are any number of foreign exchange dealers that supply research continuously to market participants. I haven’t traded in a long time. I still get fully covered by research from the major houses. I get inundated with it.
Tr. 3191-92 (DeRosa).
Dr. DeRosa opined:
It is not clear to me, however, that New Vista provided any meaningful or useful consulting to the Ervin LLCs. For example, New Vista was not even retained at the time the Ervin LLCs did their only significant foreign exchange transaction, when they entered into the spread strategies. New Vista was not on board when the Ervin LLCs theoretically ought to have needed its assistance the most. The documents I have reviewed (that New Vista supplied to the Ervin LLCs) and the comments made by Mr. Bergmann in his deposition lead me to believe that New Vista’s services were of practically no use to the Ervin LLCs. Furthermore, after the Ervin LLCs contributed their spread strategies to Jade, the only trading that they did was to liquidate the final distribution from Jade. Thus whatever advice New Vista had to offer would have been wasted on the Ervin LLCs in this regard.
DX 501 at 21-22.
The $84,100 paid to AIG covered the costs associated with opening a new account. JX 26, 37. Ari Bergmann testified that he negotiated this fee with AIG as a “gentlemen’s agreement” in lieu of having to pay “bid offers” every time Sentinel clients did a trade with AIG. Tr. 1177 (Bergmann). However, this gentlemen’s agreement was wholly uncorroborated.
Reed was unaware of who at AIG negotiated the fee arrangement with Sentinel, although she presumed it might have been Pang. Pang likewise professed ignorance regarding the origin of the $84,100 fee, testifying that fees were “not [his] area,” and that he thought the fee arrangement was “odd.” JX 112 (Pang Dep. 73-74). Pang testified that AIG published research reports on foreign exchange trading “daily,” sent them to customers to generate business, and “typically” did not charge customers for those reports. JX 112 (Pang Dep. 81).
Each Ervin LLC paid $100,000 to Curtis Mallet for a tax opinion letter. The opinion letter was requested to cover “certain aspects of United States Federal income tax in connection with (i) investments in foreign currency that [the Ervins had] made and (ii) transactions in which [they] engaged with a partnership that ... trades in foreign cur-rency____” JX 89 at 1. The $100,000 fee was a one-time fee for each LLC. Gary Ervin believed the fee of $100,000 per LLC was excessive since the opinion was going to be essentially the same opinion for each LLC, but he was unsuccessful in negotiating a lower fee with Bricker. See Tr. 584-86 (G. Ervin), 928-29 (Bricker), 1651-53 (Mountjoy).
The Ervins also incurred fees from their long-time accountant MeElroy and outside attorney Mountjoy for services rendered regarding the spread transaction, although the amount of fees paid to these advisors is not in the record. Tr. 432-33 (T. Ervin); Tr. 517-18 (G. Ervin).
*34
The Ervins’ Entry Into Jade: October 6, 1999
On October 6, 1999, the three Ervin LLCs entered Jade. In total there were five partners in Jade—the Ervin LLCs, Sentinel Ad-visors, and Banque Safra. 46 Tr. (G. Ervin) 286-87; JX 57-59, 84. Gary testified that the Ervin LLCs entered Jade Trading because Bergmann had told him that he planned to actively trade on behalf of the Ervin LLCs and if the LLCs were members of the partnership, Bergmann had the ability to get better terms on behalf of the LLCs. Tr. 566-68 (G. Ervin). Specifically, Gary testified:
Q. Please, can you explain what you were told?
A. There were I guess volume. [Berg-mann] could trade for all the partners instead of doing it individually in different accounts. It was the trading, you know. He was going to do the knock-outs and the more aggressive type of trading. It was going to be, you know, I understood be very actively traded. I guess his ability to have discretion and to trade actively into that partnership. That was my understanding.
Tr. 567-68 (G. Ervin).
Bergmann testified that by entering Jade, the Ervin LLCs were able to pool assets and make larger more diverse trades than they would be able to execute on their own, and they were also able to obtain lower “institutional pricing” on trades executed by the partnership. Tr. 1151-54 (Bergmann). Specifically, Bergmann testified as follows:
Q. Excuse me. Are you saying getting into the partnership you get superior pricing?
A. Yes, you get what’s called the institutional pricing.
A. Second thing is when a partnership, because there are more assets an investor is able to achieve diversification.
Tr. 1151,1153 (Bergmann).
On that same date, each Ervin LLC transferred its spread to Jade executing an “Assignment and Assumption Agreement.” 47 JX 54-59.
Dr. DeRosa testified that it was “highly unusual” for the Ervin LLCs to purchase the spread options and later contribute them to Jade. Tr. 3385-86 (DeRosa). DeRosa testified that it was common practice in the business world for investors to invest cash in a fund or a partnership, but not a “pair of unusual options.” Tr. 3386 (DeRosa). Specifically, Dr. DeRosa testified:
I don’t understand what the advantage to them is. I assume when people do—you know, it’s a complex transaction involving three LLCs, and then a partnership. I don’t understand why they would buy them on their own and then contribute them to Jade, to a partnership. So I’m just a little bit mystified. If somebody wanted to trade, they would just keep trading in the LLCs. But I don’t see any advantage to them of taking these options that they bought, the three LLCs have bought, and then going to the whole trouble of getting permission and all that, assigning them and then dumping them into the partnership.
Tr. 3410-11 (DeRosa).
Each Ervin LLC also contributed $75,000 cash to Jade. See JX 51-53. 48
*35
Trading Activities While In Jade
Jade engaged in a number of foreign currency trades from October 6, 1999, when the Ervins entered Jade, until December 2,1999, when the last Ervin LLC provided notice that it intended to withdraw from Jade. See JX 67. However, only the October 13, 1999 reverse knockout transaction was of any significance, and the majority of the trades executed by Jade during that two-month period were short-term trades and not profit generators. See JX 67, 68; PX 281 at 21; Tr. 1833 (Kolb); Tr. 3189-90 (DeRosa).
The reverse knockout option invested in by Jade had the following features:
Strike price: 1.0770
Barrier price: 1.1309
Expiration date: November 3, 2000
Number of euros: 62,140,483.00
Number of dollars: 66,925,300.19
Purchase Price: $103, 015
JX 68. The October 13, 1999 knockout option had a maximum payoff potential of $3,343,158, resulting in a best-case scenario profit potential of $3,240,143 after the option premium was paid. See DX 501 at 8; PX 281 at 17. The likelihood of hitting this maximum payoff, however, was very small. In fact, it was highly unlikely that the knockout would yield any net profit at all. DX 501. Dr. Kolbe explained that the knockout option transaction engaged in by Jade only “paid off if (1) the exchange rate did not reach $1.1309 per euro ..., and (2) the exchange rate was ... above the $1,077 per euro exercise price at option expiration.” DX 505 at 16 (emphasis in original). Dr. Kolbe opined that the “odds of getting any positive payout” from the knockout option were “small.” Id. (emphasis in original).
Movement of The Euro in October-November 1999
The euro began a sharp decline in value on October 18, 1999, and in late October 1999, Sentinel and Bergmann changed their positions on the euro. Tr. 575-77 (G. Ervin). In trader parlance, the euro failed. JX 111; Tr. 1203-04 (Bergmann). Through November, the euro continued to decline, nearing what is called “parity” by the end of the month. Parity is a currency trading term that refers to a 1:1 ratio between the euro and the U.S. dollar. Tr. 1211 (Bergmann). The euro had not previously dropped that low, and in the downward trend, the euro threatened to run below parity. Parity is a significant benchmark that threatened to trigger a “sell-off’ of the euro, compounding its decline. Tr. 1210-11 (Bergmann).
After losing one-half of the initial investment, Gary Ervin lost faith in Sentinel, New Vista, and the euro. Tr. 555, 577 (G. Ervin). Gary testified that he decided that he and his brothers should cut their losses and salvage any available tax benefits. As Robert specifically recalls, Gary told him they needed to get out of Jade because “it’s going south, ... and we need to get out.” 408 (R. Ervin). Robert and Tim followed their brother’s advice. Tr. 408 (R. Ervin); 577 (G. Ervin); 1410-11 (McElroy).
Exiting Jade: November 30,1999
As of November 10, 1999, BDO Seidman was instructing members of the Tax Solutions Group, including DiMuzio, to ensure that “everyone who has entered into partnerships managed by Sentinel understands that they need to give notice soon if they want to withdraw this year.” JX 517; Tr. 1524-27 (DiMuzio). By November 18, 1999, 43 days after the Ervins had entered Jade, DiMuzio was working with Gary Ervin and McElroy to calculate the amount of the Ervins’ capital and ordinary losses. JX 57-59; DX 519; Tr. 693-94 (G. Ervin); Tr. 1529-30, 1570-71 (DiMuzio); Tr. 1410-11,1416 (McElroy).
Each Ervin brother sent a nearly identical letter to Sentinel’s Conjeevaram formally requesting withdrawal from Jade effective December 15,1999, approximately 60 days after the Ervin LLCs purchased the three option spreads and transferred them to Jade. See JX 72-74. On November 30, Gary formally requested redemption, and on December 2, 1999, Robert and Tim Ervin formally requested redemption. 49
*36 On December 17, 1999, Sentinel sent each Ervin brother a letter stating that the Er-vins’ withdrawal proceeds would be sent to them in a combination of “currency and equity securities.” See JX 78-80. On December 21, 1999, Sentinel sent each Ervin brother a letter valuing his interest in the partnership at approximately $126,122. JX 81-83. The letter also indicated that, in redemption of each brother’s interest, Sentinel had sent each brother a combination of euros and Xerox stock with a total market value of approximately $126,122. See JX 81-83; see also DX 503 at 13.
The Ervin brothers sold a substantial portion of the Xerox stock before December 31, 1999. Tr. 696 (G. Ervin).
Curtis Mallet Opinion Letters to the Er-vins: July 7, 2000
Prior to July 7, 2000, Bricker sent the Ervins a draft opinion letter asking them to confirm the factual representations in the letter. Tr. 953 (Bricker). After discussing this draft opinion letter with Davis, McElroy, and Mountjoy, the Ervins did not suggest any changes, and Bricker assumed the facts were correct. Tr. 588-90, 706 (G. Ervin); Tr. 954-55 (Bricker).
On July 7, 2000, Curtis Mallet issued identical opinion letters to each Ervin brother regarding the substantive tax treatment of the Spread Transaction, accompanied by three identical 124-page memoranda of law. See JX 89, 90. 50 The Curtis Mallet opinion letters stated that the Ervins decided to invest in Jade after determining that their “profit potential from [their] investment in the Partnership was in excess of all fees, transaction costs and expenses associated with or attributable to such investments in the Partnership (including any advisory fees under the [New Vista] Consulting Agreement which may be attributable to the investment in the Partnership).” See JX 89 at 7. The opinion stated:
Your trading strategy in establishing the European Call Options was to earn a profit on the expected appreciation of the Euro via-a-vis the U.S. dollar while limiting your economic risk to your actual investment. To this end, your currency positions were heavily leveraged (which was intended to increase the potential return on investment). You reasonably anticipated that the European Call Options would provide the opportunity to earn a profit in the range of 50% to 100% of the actual investment, which returns would be in excess of all fees and costs incurred by you in connection with the European Call Options.
JX 89 at 3.
In addressing the profit potential of the Ervins’ transactions in the opinion letters, Bricker stated that he considered: (1) the AIG account opening fees and other “related fees” AIG may have charged; (2) the Sentinel two-percent management and 20-percent performance fees; and (3) the legal fees for the opinion letters. Tr. 934-35 (Bricker). Bricker did not consider all of the New Vista fees in evaluating profit potential, and he could not say what portion of the fees, if any, he did consider. 51 Tr. 935-38; 940 (Bricker). *37 The tax benefits offered by the spread transaction were available only if the spread was purchased outside the partnership and then contributed to it. See JX 23; JX 90 at 2-5; Tr. 851-52 (Pfeiffer).
Bricker concluded in the opinion letters that it was more likely than not that no penalties would apply due to the Ervins’ reporting losses relating to the “currency option program,” stating:
1. You did not recognize gain on the transfer of the Purchased Call Option by the [Ervin Family] LLC to [Jade] and you did not recognize any loss on the assumption of the Sold Call Option by [Jade];
2. Your basis for the [Jade] Partnership interest that the [Ervin Family] LLC acquired in the Partnership exchange for the transfer of the Purchased Call Option equaled the basis in the Purchased Call Option transferred by the [Ervin Family] LLC to the Partnership ($15,000,020.00) plus the amount of cash contributed to the Partnership, reduced by the amount of liabilities assumed by the Partnership, and that a Sold Call Option would not be considered a liability for purposes of Section 752;
3. All income or loss recognized by you, the [Ervin Family] LLC or the Partnership on foreign currency contracts was ordinary income or loss (as opposed to capital gain or loss);
4. Your distributive share of any loss incurred by the Partnership was deductible, and should not have been subject to the passive activity loss rules;
5. Upon the [Ervin Family] LLC’s withdrawal from the Partnership, you did not recognize gain or loss on the receipt of foreign currency and publicly traded stock that the Partnership transferred to the [Ervin Family] LLC in exchange (redemption) of its Partnership interest. It is more likely than not that your combined interest in the foreign currency and publicly traded stock received in liquidation of the [Er-vin Family] LLC’s Partnership interest equaled your basis in such Partnership interest. It is more likely than not that any income or loss that you recognized on the sale of such foreign currency was treated as ordinary gain or loss. It is more likely than not that any income or loss that you recognized on the sale of such publicly traded stock was treated as capital gain or loss;
6. The case law doctrines known as the Step Transaction Doctrine and the Sham Transaction Doctrine that the Internal Revenue Service (the “IRS”) and courts have used to deny certain tax outcomes did not apply to the transactions; and
7. The Anti-Abuse Regulations under Treas. Reg. § 1.701-2 did not apply to the transaction.
JX 89 at 11-13, see JX 91; see also Tr. 943-44 (Bricker).
The Curtis Mallet opinion extensively reviewed ease law on the economic substance doctrine and concluded:
You engaged in these transactions with the expectation that fluctuations in the market value of the foreign currencies would provide you with the opportunity to earn a reasonable profit. Based on this profit motive, it is more likely than not that your transactions described above will not be treated as sham transactions.
... [Y]ou determined that the investments in foreign currencies, including the European Call Options, had a reasonable possibility of returning significant profits (independent of any tax benefits) to you in excess of all fees and costs incurred by you in connection with each respective investment, including the investment in the Partnership, even if fees related to the in *38 vestments (including the fees under the Consulting Agreement even if such fees are attributable to your Partnership interest) were taken into account. Accordingly, it is more likely than not that the transactions had “economic substance____
You determined that its investments in foreign currency, foreign currency options, and the Partnership had a reasonable possibility for profit after expenses and fees ... Therefore, it is more likely than not that the transactions had a subjective business purpose. Because your transactions had objective economic substance and you had a non-tax business purpose in entering the transactions, it is more likely than not that the transactions would not be rechar-acterized ____
JX 90 at 87, 91-92.
The Experts’ Views on the Profitability of the Spread Transaction
The experts for Plaintiffs and the Government agreed that the profit potential of the Spread Transaction was limited. Plaintiffs’ expert in trading foreign exchange options, Mr. Shoji, testified that the Ervins could have profited from the spread transaction on any appreciation of the euro above 1.0840, but only up to a rate of 1.0850—the Ervins would not have profited from any increases above 1.0850. Tr. 2462-63, 2473, 2534-39; (Shoji); PX 283 at 7. 52 Mr. Shoji explained that the maximum net profit potential of the Spread Transaction under all circumstances was $140, 538, and the maximum loss was the net premium amount, $150,002—if the euro did not rise above 1.0840. Tr. 2534-39 (Sho-ji); PX 283 at 7.
Similarly, Defendant’s expert in economics and finance and foreign exchange options Dr. DeRosa, calculated that the maximum profit from the spread would have been $140, 538 if the euro was trading at 1.0850 at the option’s expiration date. DX 501; Tr. 3058 (DeRo-sa). 53 This profit figure does not take into account the fees paid by each Ervin LLC. Dr. DeRosa concluded that when including the fees paid by each Ervin LLC, it was unlikely that the Ervins would have made any profit at all. DX 501. Specifically, Dr. DeRosa testified: “The money that these people [the Ervins] have invested in this, the fees they’ve paid, dwarf any of these trading profits, these phantom trading profits that they never tried to do anyway.” Tr. 3252 (DeRosa).
Dr. Kolbe, Defendant’s expert in the areas of financial economics, risk return, valuation, investment and leverage, and capital market principles, opined that the expected rate of return of the Spread Transaction executed by each Ervin LLC was “a negative $929,000,” or a “negative 80.2 percent rate of return” based on total outlays. Tr. 2319 (Kolbe). 54
Dr. Kolbe concluded that each Ervin LLC’s total cost to execute the Jade Spread Transaction was approximately $1.17 million counting the cost of the spread option and the $75,000 contributed to Jade and $940,000 in required fees. DX 505 at 3 (Kolbe). He explained:
To break even on these outlays absent the claimed tax deduction, [each Ervin LLC] needed a rate of return on their Jade contributions ... of ... 420 percent----It is wholly unrealistic to expect such a rate of return on the contribution to Jade.
*39
Id.
55
Jade’s Partnership Return
Jade filed its 1999 Form 1065 Partnership Income Return on March 23, 2000. See JX 84. Jade’s partnership return for tax year 1999 was prepared by Untracht & Associates (Untracht), Sentinel’s accounting firm. JX 84; Tr. 2632 (Conjeevaram). The return was signed by Untracht & Associates. JX 84 at 000009. The return treated the Ervin LLCs as partners in Jade and reflected that each Ervin brother contributed capital of approximately $236,918, received assets worth approximately $132,760 in redemption, and lost approximately $104,158 in their participation in Jade. See JX 84 at 000028 (Ervin Holdings, LLC); JX 84 at 000032 (Ervin Investments, LLC); JX 84 at 000040 (Ervin Capital, LLC).
The Ervins’ Individual Returns
Although McElroy prepared the Ervins’ individual and business tax returns every year from the mid to late 1980s forward, BDO Seidman prepared their 1999 and 2000 individual returns. Tr. 1436-37 (McElroy). Gary Ervin testified that he wanted the reputation of BDO to “stand behind the advice that they had given” with respect to tax planning for the spread transaction. Tr. 738 (G. Ervin). When Dimuzio was asked why he prepared and signed the 1999 returns, he responded:
Initially we talked about the complexity of the transactions that they had undertaken in 1999, the sale of the business, the collaring of the stock, all of the rest of it, and whether or not Martin McElroy may have been overwhelmed and whether or not they wanted BDO Seidman ... a larger organization, a national organization, to take over the preparation of the return. That was the basis of the discussion. It turned out ultimately that Martin [MeEl-roy] really carried the laboring oar there ultimately.
Tr. 1565-66 (DiMuzio). DiMuzio’s testimony on this is inconsistent with McElroy’s. McElroy testified that his role with respect to the Ervins’ 1999 tax returns was limited to gathering the necessary information and providing it to DiMuzio so that he could prepare the returns. Tr. 1413-15 (McElroy). 56
The Ervins filed their individual 1999 tax returns on August 15, 2000. Tr. 1436 (McEl-roy); see JX 96-98. Schedule D of Gary Ervin’s 1999 Form 1040 reflects a short-term capital loss of $10,447,107 described as “Salo-mon Smith Barney” with an acquired date of “VARIOUS,” a sold date of December 23, 1999, a price of $90,043, and a cost of $10,537,150. JX 96 at 147. 57 Schedule D of Robert Ervin’s 1999 Form 1040 reflects a short term capital loss $10,447,107 described as “[Salomon] Smith Barney” with an acquired date of September 29, 1999, a sold date of December 29,1999, a price of $90,043, and a cost of $10,537,150. JX 97 at 114. Schedule D of Tim Ervin’s 1999 Form 1040 reflects a short term capital loss of $10,447,107 described as “S[a]lomon Smith Barney” with an acquired date of “VARIOUS,” a sold date of December 23, 1999, a price of $90,043, and a cost of $10,537,150. JX 98 at 115. Gary and Robert Ervin listed a long-term capital gain on their 1999 Form 1040s of $8,727,759 under the description of “Ervin Cable Const Inc. (KY).” Tim Ervin listed a long-term capital gain of $8,727,760 under the same description. JX 96 at 149; JX 97 at 115; JX 98 at 117. Form 4797 of *40 Gary’s, Robert’s, and Tim’s 1999 Form 1040 reflect ordinary losses of $776,746 for “foreign currency trades.” JX 96 at 155, JX 97 at 86, JX 98 at 85. Schedule D of Gary’s, Robert’s, and Tim’s 2000 Form 1040 reflects a long-term capital loss described as “Salo-mon Smith Barney” of $3,717,779, $3,717,779, and $3,717,778, respectively. PX 260 at 77, 259 at 203, 261 at 62. 58 In total, each Ervin brother claimed approximately $14,941,632 in losses and expenses from the execution of the spread transaction and involvement in Jade.
IRS Notice 2000-44
IRS Notice 2000-44 was issued on August 11, 2000, and published in the Internal Revenue Bulletin on September 5, 2000. JX 95; Notice 2000^4, 2000- 36 I.R.B. 255 . The Notice warned taxpayers of transactions calling for the simultaneous purchase and sale of offsetting options which were then transferred to a partnership. Under the position advanced by the promoters of the arrangement, once the partnership held the offsetting options the taxpayer claimed that the basis in his partnership interest increased by the cost of the purchased option, but was not reduced under section 752 by the partnership’s assumption of the sold option. The Notice determined that the purported losses from such offsetting option transactions did not represent bona fide losses reflecting actual economic consequences, and that the purported losses were not allowable for federal tax purposes. The Notice also warned taxpayers that penalties might be imposed on the participants and promoters of such transactions, including accuracy-related penalties under section 6662.
Notice 200(M4 was issued several days prior to August 14 and 15, 2000, the dates the Ervins and their spouses signed and filed their 1999 federal tax returns. Stip. 1156; see JX 96-98. DiMuzio called McElroy several weeks after the Ervins filed their tax returns and informed him of the Notice. Tr. 1428 (McElroy). On August 16, 2000, Curtis Mallet issued a memorandum to clients potentially engaged in activities covered by the Notice summarizing the Notice and stating that the firm was analyzing its ramifications. JX 99. Once made aware of Notice 2000-44, Gary Ervin spoke with McElroy, Mountjoy, Davis, and BDO Seidman regarding its ramifications. Tr. 593-94 (G. Ervin). Gary also re-engaged Curtis Mallet and requested that counsel review their previous opinion letters of July 2000. Tr. 593 (G. Ervin); see JX 89-91. Curtis Mallet provided a supplemental memorandum dated October 11, 2000, addressing Notice 2000-44, stating that the Er-vins’ spread transaction investments were “possibly” distinguishable from Notice 2000-44 and that it was more likely than not the Notice did not change the substantive law regarding the Ervins’ spread transaction or impact conclusions set forth in Curtis Mallet’s previous opinion letters. JX 102-104. McElroy and Mountjoy concurred with the conclusions in Curtis Mallet’s supplemental memorandum. Tr. 594-95 (G. Ervin). As a result, the Ervins did not amend their 1999 tax returns in light of the Notice. Tr. 710-11 (G. Ervin).
The Audit
In June 2002, the IRS initiated an audit of the Ervins’ 1999 individual returns. Tr. 1934-35 (Hogue). On December 16, 2002, the IRS initiated a partnership-level audit of Jade’s 1999 return. Tr. 1935 (Hogue); JX 105-108. Revenue Agent Jim Hogue handled both audits. Tr. 1934 (Hogue). As part of the audit, Hogue interviewed the Ervins on April 9, 2003, at the IRS office in Owens-boro, Kentucky. Tr. 3001-02 (Hogue). The Ervins, their representatives, and Revenue Agent Janice Ambrose of the IRS’s Owens-boro office attended the interview. Tr. 3001-02 (Hogue).
The FPAA
On April 15, 2003, the IRS issued a Final Partnership Administrative Adjustment (FPAA) to Jade Trading with respect to Jade’s partnership items for the 1999 tax year. JX 109; Stip. If 62. The FPAA disallowed the deductions claimed for losses purportedly incurred from the spread transaction. Specifically, the FPAA made the following determinations regarding Jade:
*41 1. It is determined that Jade Trading, LLC, is a sham and, under [Treasury Regulation] § 1.701-2, was formed or availed of in connection with a transaction or transactions in taxable year 1999, a principal purpose of which was to reduce substantially the present value of the partners’ aggregate federal tax liability in a manner that is inconsistent with the intent of Sub-chapter K of the Internal Revenue Code. It is consequently determined that the partnership is disregarded and that all transactions engaged by Jade Trading, LLC, are treated as engaged in directly by the purported partners. This includes the determination that the euros and Xerox stock purportedly acquired by the partnership were acquired directly by purported partners Ervin Holdings, LLC, Ervin Capital, LLC, and Ervin Investments, LLC.
2. It is determined that, under § 1.701-2 of the Treasury Regulations, euro currency options, purportedly contributed to or assumed by the partnership, are treated as never having been contributed to or assumed by the partnership and any gains or losses purportedly realized by the partnership on the options are treated as having been realized by the purported partners Ervin Holdings, LLC, Ervin Capital, LLC, and Ervin Investments, LLC.
3. It is further determined that, under § 1.701-2 of the Treasury Regulations, Er-vin Holdings, LLC, Ervin Capital, LLC, and Ervin Investments, LLC, should be treated as not being partners in the partnership.
4. It is further determined that, under § 1.701-2 of the Treasury Regulations, contributions to the partnership will be adjusted to reflect clearly the partnership’s or partners’ income.
5. Even if euro currency options were to be treated as contributed to the partnership, the bases of the options are reduced, both in the hands of the contributing partners and the partnership, by any amount received by the contributing partner from the contemporaneous sale of a substantially similar option to the same counter-party. Thus, any amount treated as an increase in outside basis from the contribution of euro currency options is disallowed.
JX 109.
Discussion
Jurisdiction
This Court has “jurisdiction to hear and to render judgment upon any petition under section 6226 ... of the Internal Revenue Code....” 28 U.S.C. § 1508 . Section 6226(f) gives this Court
jurisdiction to determine all partnership items of the partnership for the partnership taxable year to which the notice of final partnership administrative adjustment relates, the proper allocation of such items among the partners, and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item.
26 U.S.C. § 6226 (f). 59
Invoking section 6226, Plaintiffs bring this partnership tax refund action seeking judicial review of the FPAA issued to Jade which adjusted partnership items relating to the spread transaction. JX 109. 60 The Court’s *42 jurisdiction over partnership items is explained by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), which added sections 6221-6231 to the Internal Revenue Code. 61
TEFRA was enacted “to provide a method of uniformly adjusting items of partnership income, loss, deduction, or credit that affect each partner.” Roberts v. Comm’r, 94 T.C. 853, 859 , 1990 WL 77203 (1990). Prior to TEFRA’s passage, tax liability adjustments of individual partners based on the operations of the partnership were rendered at the partner-level, often resulting in duplication of administrative and judicial resources and inconsistent results among audited partners. Callaway v. Comm’r, 231 F.3d 106, 107 (2d Cir.2000).
With the enactment of TEFRA came a “single unified procedure for determining the tax treatment of all partnership items at the partnership-level, rather than separately at the partner-level.” AD Global Fund, LLC v. United States, 67 Fed.Cl. 657, 660 (2005), aff'd, 481 F.3d 1351 (Fed.Cir.2007) (quoting Callaway, 231 F.3d at 108 ). TEFRA’s process allows for one proceeding to determine all “partnership items,” and the result of this proceeding then applies to each individual partner’s tax returns. AD Global, 67 Fed.Cl. at 660 ; Roberts, 94 T.C. at 859-60 . 62
A “partnership item” is defined by statute as “any item required to be taken into account for the partnership’s taxable year under any provision of subtitle A to the extent ... such item is more appropriately determined at the partnership-level than at the partner-level.” Section 6231(a)(3). More commonly, partnership items are “items of ineome[,] gain, loss, deduction, or credit of the partnership.” AD Global, 67 Fed.Cl. at 661 n. 2 (quoting Callaway, 231 F.3d at 108 ). In essence, partnership items are those items a partnership is required to determine for purposes of its books and records or for purposes of furnishing information to a partner.
Further guidance on what constitutes a partnership item can be gleaned from Treasury Regulation § 301.6231(a)(3)-l(a), which defines the following items as partnership items:
(1) The partnership aggregate and each partner’s share of each of the following: (i) Items of income, gain, loss, deduction, or credit of the partnership;
(v) Partnership liabilities (including determinations with respect to the amount of the liabilities, whether the liabilities are nonrecourse, and changes from the preceding taxable year) ...
(4) Items relating to the following transactions, to the extent that a determination of such items can be made from determinations that the partnership is required to make with respect to an amount, the character of an amount, or the percentage interest of a partner in the partnership, for purposes of the partnership books and records or for purposes of furnishing information to a partner:
(i) Contributions to the partnership;
(ii) Distributions from the partnership ...
Treas. Reg. § 301.6231 (a)(3)-l(a). The regulation further provides that the term partnership item includes “the legal and factual de *43 terminations that underlie the determination of the amount, timing, and characterization of items of income, credit, gain, loss, deduction, etc.” Treas. Reg. § 301.6231 (a)(3)-l(b).
The regulation goes on to state that with respect to contributions, the partnership needs to determine “[t]he character of the amount received from a partner” and “[t]he basis to the partnership of contributed property (including necessary preliminary determinations, such as the partners’ basis in the contributed property).” Treas. Reg. § 301.6231 (a)(3)-l(c)(2). Similarly, with respect to distributions, the regulation specifies that the partnership needs to determine “the adjusted basis to the partnership of distributed property” and “the character of partnership property.” Treas. Reg. § 301.6231 (a)3-l(c)(3).
In Nussdorf v. Commissioner, 129 T.C. 30, 44 (2007), an action also involving the contribution of offsetting options to a purported partnership, the Tax Court held that the character of the property the partnership received from each member “such as whether any such property received from each member was a contribution ... and whether any such property should be aggregated with other property received from each such member, and the basis to [the partnership] of any property contributed to it by each member, including necessary preliminary determinations, such as the basis of each such member in such property” were partnership items. The Tax Court reasoned that the partnership there, Evergreen Trading, was required to make determinations regarding these matters for purposes of its books or records or furnishing information to partners. Id. at 43 . The Nussdorf Court further recognized that whether the property received from each member was a contribution or a liability—was also a partnership item. Id. at 44 n. 16. The Tax Court stated:
determining whether any property that Evergreen Trading received from each member was a contribution or a liability, Evergreen Trading was required to determine whether the so-called obligation leg (i.e., the short position) of the Euro options in question was a liability that Evergreen assumed.
Id. Similarly here, because Jade had to make the underlying determinations regarding the Ervin LLCs’ contributions to Jade and the distributions to them for purposes of its books and records and furnishing information to its partners, these are partnership items.
In sum, the matters addressed in the FPAA here are partnership items and must be determined at the partnership-level. As such, this Court’s jurisdiction extends to determining the tax treatment of those items. 26 U.S.C. §§ 6221 , 6226; see AD Global, 481 F.3d at 1354-1355 ; Conway v. United States, 326 F.3d 1268, 1271 (Fed.Cir.2003); Transpac Drilling Venture v. United States, 83 F.3d 1410, 1412 (Fed.Cir.1996); Santa Monica Pictures, L.L.C. v. Comm’r, 89 T.C.M. (CCH) 1157, 1224 (2005); Long Term Capital Holdings v. United States, 330 F.Supp.2d 122, 166 (D.Conn.2004), aff'd, 150 Fed.Appx. 40 (2d Cir.2005).
Standard of Review
This Court makes a de novo determination regarding the partnership items of Jade that were adjusted by the FPAA. Atlantic Richfield Co. v. Dept. of the Treasury, No. 96-2867, 1996 WL 788366 at *1, 1996 U.S. Dist. LEXIS 19891 at *3 (D.D.C.1996) (“A court hearing plaintiffs [FPAA] readjustment petition would have jurisdiction to determine de novo [a partnership’s] taxable income, deductions, and credits ...”).
Although the Spread Transactions Contributed to Jade Literally Complied With the Code They Lacked Economic Substance
Literal Compliance With the Code
In 1999, the Ervins realized a gain of approximately $40 million on the sale of then-cable companies—approximately $13.5 million per brother. After consulting with BDO Seidman, Sentinel, and Curtis Mallet and their personal attorneys and accountant, Plaintiffs simultaneously bought and sold offsetting pairs of euro options, creating a spread position. The premium paid by each Ervin LLC on the options purchased from AIG was $15,000,020 and on the options sold to AIG was $14,850,018. These premium amounts were netted, and each Ervin LLC actually paid AIG $150,002—not $15,000,020. *44 Each LLC then transferred the option spread to Jade and contributed $75,000 cash to the partnership. Some 60 days after entering Jade, the LLCs exited the partnership and received euros and Xerox stock in exchange for their partnership interests.
Plaintiffs claim that their bases in their Jade partnership interests increased by the value of the purchased option but did not decrease by the value of the sold option assumed by the partnership. 63 Section 722 addresses partnership basis, stating:
The basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership shall be the amount of such money and the adjusted basis of such property to the contributing partner at the time of the contri-bution____
At issue here is whether each Ervin LLC was required to reduce its basis in its partnership interest by the sold option assumed by Jade, or whether this type of “liability” was too uncertain to fit within the parameters of a “liability” within the meaning of section 752. The statute itself does not define liability or address this issue in haec verba. Section 752(b) states:
Any decrease in a partner’s share of the liabilities of a partnership, or any decrease in a partner’s individual liabilities by reason of the assumption by the partnership of such individual liabilities, shall be considered as a distribution of money to the partner by the partnership.
Plaintiffs argue that the sold options assumed by Jade were contingent obligations, not liabilities for purposes of lowering the basis in the Ervin LLCs’ partnership interests under section 752(b). In so arguing, Plaintiffs seize upon the construction of section 752 by the Tax Court in Helmer v. Commissioner, 34 T.C.M. (CCH) 727 (1975), which at the time of their transactions was good law. 64
In Helmer , the Tax Court held that a contingent obligation such as an option was not a liability under section 752 because a partnership’s obligation under the option does not become fixed until the option is exercised. Helmer’s reasoning that contingent obligations are not liabilities was applied in subsequent cases. Salina P’ship L.P. v. Comm’r, 80 T.C.M. (CCH) 686, 697 (2000). (recognizing Helmer stands for the general proposition that amounts owed or paid to a partnership in an open transaction for tax purposes do not generate adjustments to the partners’ bases in their partnership interests until the transaction is closed and the tax characteristics of the transaction can be determined.); see also LaRue v. Comm’r, 90 T.C. 465, 479-80 (1988) (non-fixed obligations of a partnership could not be used to adjust the partners’ bases under section 752); Long v. Comm’r, 71 T.C. 1 (1978) (stating that contested or contingent liabilities such as claims were not liabilities within the meaning of section 752); see generally Cemco Investors, LLC v. United States, No. 04-8211 2007 WL 951944 , 2007 U.S. Dist. LEXIS 22246 (N.D.Ill. Mar. 27, 2007), appeal docketed, No. 07-2220 (7th Cir. May 25, 2007) (recognizing that Helmer was good law prior to Notice 2000-44, permitting a taxpayer to ignore a short option as a liability under section 752). 65
*45 Thus, under Helmer and its progeny, the sold call option contributed to Jade would not be considered a liability for purposes of section 752 and the inflated bases resulting from the Ervin LLCs’ contribution of the spread transaction to Jade complied with section 752.
Nonetheless, under Coltec, such compliance with the Code is insufficient in and of itself for Jade to reap the tax benefits claimed here. Coltec, 454 F.3d at 1355 . Rather, the transaction must also meet the objective economic substance test.
The Economic Substance Doctrine In the Federal Circuit
The Federal Circuit in Coltec put to rest any question about the continued vitality of the economic substance doctrine. The Coltec Court disregarded a transaction for tax purposes despite its literal compliance with the Code on the ground it lacked economic substance. The Federal Circuit described the economic substance doctrine as “a judicial effort to enforce the statutory purpose of the tax code” stating:
From its inception, the economic substance doctrine has been used to prevent taxpayers from subverting the legislative purpose of the tax code by engaging in transactions that are fictitious or lack economic reality simply to reap a tax benefit.
Coltec, 454 F.3d at 1353-54 . 66 Transactions are considered to have economic substance when “imbued with tax-independent considerations, and ... not shaped solely by tax-avoidance features____” Frank Lyon Co. v. United States, 435 U.S. 561, 584 , 98 S.Ct. 1291 , 55 L.Ed.2d 550 (1978).
In unequivocally confirming the viability of the economic substance doctrine, the Federal Circuit articulated five general principles espoused by the doctrine:
• First, the law does not permit the taxpayer to reap tax benefits from a transaction that lacks economic reality.
• Second, it is the taxpayer who bears the burden of proving that the transaction has economic substance.
• Third, the economic substance of a transaction must be viewed objectively.
• Fourth, the only transaction to be analyzed is the one that gave rise to the alleged tax benefit.
• Finally, arrangements with subsidiaries that do not affect the economic interests of independent third parties deserve particularly close scrutiny. Coltec, 454 F.3d at 1355-57 . This Court applies each of these principles in turn.
1. Did the Spread Transaction Lack Economic Reality?
As articulated by the Federal Circuit, the economic substance doctrine subsumes an overarching principle—although a taxpayer has an unquestioned right to decrease or avoid his taxes by means which the law permits, the law does not permit a taxpayer to reap tax benefits from a transaction that lacks economic reality. The Ervins’ spread transaction clearly fits within the scope of this prohibition.
Although the Ervins purchased a euro option from AIG for a premium of $15,000,020 and sold a euro option to AIG for a premium of $14,850,018, they only paid AIG the difference—a net premium of $150,002. They contributed the spread to Jade, and upon exiting the partnership, claimed a basis of over $15 million in their Jade interests by including only the premium for the purchased call option, and ignoring the premium for the sold call option, viewing it as a contingent obligation, not a liability. The artificially high basis generated a $14.9 million tax loss, but the loss was purely fictional. Each Ervin *46 LLC did not invest $15 million in the spread transaction contributed to Jade and did not lose almost $15 million upon exiting Jade without exercising either option. As the District Court for the Northern District of Illinois recognized in characterizing a similar transaction in Cemco, “it is important to highlight one point upon which [the parties] agree: the loss of $3,563,211.71 claimed on CEMCO’s ... return was fictional.” Cemco, 2007 WL 951944 at *3, 2007 U.S. Dist. LEXIS 22246 at *9.
Further, the formation of the Jade partnership as the vehicle through which to make investments had no real economic purpose. Funneling the trades through the partnership did nothing to enhance the investment potential of the spread transaction or the other trades Jade did, but it was crucial for tax purposes to have the individual partners contribute the spreads to Jade and redeem the unexercised spreads from Jade in order to generate the inflated bases. Absent the partnership, the spreads would have had no meaningful economic consequences—other than the cost of playing. As Dr. DeRosa recognized, there was no economic reason for the Ervin LLCs of going to the trouble of structuring these transactions as they did. He testified: “If somebody wanted to trade they would just keep trading in the LLCs. But I don’t see any advantage to them of taking these options that they bought ... and then going to the whole trouble of getting permission and all that, assigning them and then dumping them into the partnership.” Tr. 3410-11 (DeRosa).
2. The Taxpayer Has the Burden to Prove Economic Substance
The Coltec Court held that the taxpayer has the burden of proving that a transaction has economic substance, dispelling any notion that the Government is required to demonstrate a transaction’s lack of economic substance. Coltec, 454 F.3d at 1355 . 67 In explaining the nature of this burden, the Federal Circuit harked backed to Rothschild v. United States, 186 Ct.Cl. 709 , 407 F.2d 404 (1969), a decision of its predecessor, the Court of Claims, and quoted that decision’s fundamental recognition:
Gregory v. Helvering requires that a taxpayer carry an unusually heavy burden when he attempts to demonstrate that Congress intended to give favorable tax treatment to the kind of transaction that would never occur absent the motive of tax avoidance (citation omitted).
407 F.2d at 411 . 68
Plaintiffs have attempted' to shift this burden to Defendant to prove that their transaction lacked economic substance under section 7491. Pis.’ Posh-Trial Br. at 7-8; Pis.’ Reply to Def.’s Post-Trial Br. at 27. Under section 7491, the burden of proof will shift to the Government with respect to any factual issue relevant to ascertaining the liability of the taxpayer if: (1) the taxpayer introduces credible evidence with respect to such issue; (2) the taxpayer has complied with all applicable substantiation requirements; (3) the taxpayer has maintained all records otherwise required by the Internal Revenue Code; (4) the taxpayer has cooperated with reasonable requests by the Service for meetings, interviews, witnesses, information and documents; and (5) the taxpayer, if not an individual, satisfies the net worth requirements described in section 7430(c)(4)(A)(ii). Section 7491(a)(l)-(2). The taxpayer has the burden of establishing that the requirements of sec *47 tion 7491 have been met. Long Term Capital Holdings, 330 F.Supp.2d at 166 .
Plaintiffs seek to shift the burden of proof to the Government with respect to four issues:
1. Whether Jade was formed and operated as a partnership entity;
2. Whether the investors contributed and assigned separately purchased and sold call options and cash to Jade;
3. Whether the partners’ transfer of such options to Jade had economic substance; and
4. Whether Jade and its partners had the potential to earn pre-tax profits.
Pis.’ Post-Trial Br. at 12-19; Pis.’ Reply to Def.’s Post-Trial Br. at 25-28.
Because these are legal, not factual issues, the Court does not shift the burden of proof. First, whether Jade Trading was formed and operated as a partnership entity is an ultimate legal issue. Second, whether the offsetting options contributed to Jade by its members were, for federal tax purposes, separately purchased and sold call options, or are a single position also implicates a question of law. What transpired as a matter of fact with regard to the purchase and sale of offsetting options is not disputed—it is the legal import of those transactions—their characterization and treatment for tax purposes which is at issue—a legal question. See Frank Lyon, 435 U.S. at 581 n. 16, 98 S.Ct. 1291 (“The general characterization of a transaction for tax purposes is a question of law----”). Third, whether the partners’ transfer of such options to Jade had economic substance is a component of the ultimate issue before the Court—it addresses one step in the challenged transaction. The fourth issue on which Plaintiffs seek to shift the burden does have some factual elements— the potential of Jade and its partners to earn pre-tax profits. However, that issue is no longer a relevant inquiry in light of Coltec. It matters not whether Jade and its partners had the potential to earn pre-tax profits in all of their endeavors. What matters is whether the single transaction which gave rise to the tax benefits—here the spread transaction contributed to Jade—had the ability to earn pre-tax profits. Coltec, 454 F.3d at 1356 (stating “the transaction to be analyzed is the one that gave rise to the alleged tax benefit.”). In sum, the burden of proof clearly remains on Plaintiffs to establish the economic substance of the spread transaction contributed to Jade.
3. The Economic Substance of a Transaction Must Be Viewed Objectively Rather Than Subjectively
The Federal Circuit has clarified that in applying the economic substance doctrine, the “objective economic reality of the transaction” is paramount. The Court explained:
The Supreme Court cases and our predecessor court’s eases have repeatedly looked to the objective economic reality of the transaction in applying the economic substance doctrine. Gregory, 293 U.S. at 469-70, 55 S.Ct. 266 , 79 L.Ed. 596 ; Frank Lyon Co., 435 U.S. at 584 , 98 S.Ct. 1291 ____ While the taxpayer’s subjective motivation may be pertinent to the existence of a tax avoidance purpose, all courts have looked to the objective reality of the transaction is assessing its economic substance. See, e.g., Black & Decker, 436 F.3d at 441—42 (noting that economic substance inquiry requires an “objective determination of whether a reasonable possibility of profit from the transaction existed”) ...; Dow Chem. Co. [v. U.S.], 435 F.3d [594] at 599 [(6th Cir.2006)]; In re CM Holdings, Inc., 301 F.3d [96] at 103 [(3d Cir.2002)] (stating that the objective economic substance inquiry is “whether the transaction affected the taxpayer’s financial position in any way”); United Parcel Serv. of Am., Inc. [v. C.I.R.], 254 F.3d [1014] at 1018 [(11th Cir.2001)]; Rice’s Toyota World, Inc. v. Comm’r of Internal Revenue, 752 F.2d 89, 94 (4th Cir.1985).
Coltec, 454 F.3d at 1356 n. 16 (citations omitted in part). Thus, a determination of the objective reality of contributing the spread transaction to Jade requires assessing the transaction itself—its reasonable possibility of profit and its effect on the Ervins’ financial positions. The inquiry is not whether the Ervins believed the Jade transaction was a real investment capable of making a profit, *48 but whether the Jade transaction in fact objectively was a real investment capable of making a profit and altering their financial positions. 69
4. The Only Transaction to Be Analyzed for Economic Substance Is the One That Gave Rise to the Tax Benefit
Plaintiffs characterize the Ervins’ investment in Jade as a bet that the euro would rise. This is an inaccurate picture of what Jade did. While there was extensive testimony regarding the Ervins’ decision to invest in the euro, including the persuasive sales pitch from Sentinel about the unique opportunity for investing in a newly offered foreign currency and “exotic options” like the reverse knockout options with potential returns of 38-to-l, this hype was a red herring since the investment in offsetting options was a hedge—the Ervins were protected and their gains and losses limited no matter how the euro performed. Under Coltec, the spread transaction which gave rise to the inflated basis and the large tax benefit is the only transaction to be scrutinized. As such, Plaintiffs’ claims that they could have increased profitability by executing the reverse knockout option and other trades in Jade cannot be considered because these transactions did not give rise to the tax benefit. 70 Here, both the structure of the spread transaction and the unusually high fees required for participation ensured that no matter what the euro did, the spread transaction did not have a reasonable profit potential.
The objective economic substance test requires that a taxpayer prove that a transaction had a “realistic financial benefit” beyond tax avoidance. Coltec, 454 F.3d at 1356 n. 16 (quoting Rothschild, 407 F.2d at 411 ); see also ACM P’ship v. Comm’r, 157 F.3d 231, 251 (3d Cir.1998). More precisely, the economic substance inquiry requires an objective determination of whether a reasonable possibility of profit from the transaction existed, exclusive of tax benefits. Coltec, 454 F.3d at 1356 (citing Black & Decker Corp. v. United States, 436 F.3d 431, 441-442 (4th Cir.2006)); see also Gilman v. Comm’r, 933 F.2d 143, 146 (2d Cir.1991); Lerman v. Comm’r, 939 F.2d 44 , 49 (3d Cir.1991); Rice’s Toyota World, Inc. v. Comm’r, 752 F.2d 89, 91 (4th Cir.1985); IES Indus. v. United States, 253 F.3d 350, 353 (8th Cir.2001).
Several courts have analyzed economic substance objectively by viewing an investment transaction through the eyes of a “prudent investor” at the time of the transaction-asking whether a prudent investor would engage in the transaction with a belief that profits could be earned. See Gilman, 933 F.2d at 146-47 (requiring the plaintiff to demonstrate that a prudent investor could have concluded that there was a realistic opportunity for a profit); Estate of Strober v. Comm’r, 63 T.C.M. (CCH) 3158, 3160 (1992) (“We conclude that ... a prudent investor, relying upon independently obtained appraisals and research, would not have concluded that [the] transaction offered a reasonable opportunity for economic gain exclusive of *49 tax benefits.”); Long Term Capital Holdings, 330 F.Supp.2d at 172 (finding that the transaction lacked economic substance because, “at the time the transaction was entered into, a prudent investor would have concluded that there was no chance to earn a non-tax based profit return in excess of the costs of the transaction”).
Plaintiffs’ and Defendant’s experts, Mr. Shoji and Dr. DeRosa, agreed the maximum profit potential on the spread at expiration, on its face, was roughly $140,000, no matter how high the euro climbed. See JX 38-43; Tr. 2536-2539 (Shoji); Tr. 3129 (DeRosa); DX 501 at 27. Dr. DeRosa testified:
The only thing that can happen is you come up to the counter. You plop down $150,000. If you’re lucky, you’re going to win net $140,000. You’re never going to get more than that. You could get less than that because if it’s in between the strikes the payoff won’t be the whole $140,000, but if it’s at 1.0840 or less say goodbye to your $150,000. It’s gon

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Source: Frix Law Library, https://www.frixlaw.com/law-library/cases/6657071. Public record. Not legal advice.