UNITED STATES TAX COURT
Agency decision
Ask Donna
What actually matters in this document.
Text
144 T.C. No. 11
UNITED STATES TAX COURT
CNT INVESTORS, LLC, CHARLES C. CARROLL, TAX MATTERS
PARTNER, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 27539-08.
Filed March 23, 2015.
C and his wife and related individuals owned appreciated real
estate through an S corporation (S). C and the related individuals
engaged in a Son-of-BOSS transaction to create outside basis in a
purported partnership to which S contributed the appreciated real
estate. A series of further transactions left C and the related
individuals holding the real estate through the partnership. No party
reported recognizing any of the real estate's built-in gain. For 1999 R
determined that the partnership was a sham and adjusted to zero the
partnership's reported losses, deductions, distributions, capital
contributions, and outside basis. R also determined a penalty under
I.R.C. sec. 6662 on multiple grounds. In this TEFRA partnershiplevel proceeding, C, as TMP, conceded that the partnership and the
Son-of-BOSS transaction were shams having no business purpose but
challenged the FPAA's timeliness and the penalty.
Held: The step transaction doctrine applies to the transactions at
issue. Collapsing the steps, S distributed the appreciated real estate to
SERVED Mar 23 2015
-2its shareholders and should have recognized gain under I.R.C. sec.
311(b). The parties' stipulation that the partnership and the Son-ofBOSS transaction were shams does not compel us to disregard the
real estate's transfer or the gain it generated because this transfer was
the object and end result, not a mere component, of the subject series
of transactions.
Held, further, under Rhone-Poulenc Surfactants & Specialties, L.P.
v. Commissioner, 114 T.C. 533, 540-543 (2000), for each partner in a
TEFRA partnership, the limitations period for the assessment of tax
attributable to partnership items or affected items is the longer of the
period specified in I.R.C. sec. 6229 or that prescribed by I.R.C. sec.
6501. C and the related individuals entirely omitted from their
respective tax returns passthrough I.R.C. sec. 311(b) gain.
Consequently, R contends the six-year limitations period of I.R.C.
sec. 6501(e)(1)(A) applies. Under United States v. Home Concrete
Supply, LLC, 566 U.S. _, 132 S. Ct. 1836 (2012), for purposes of
determining whether I.R.C. sec. 6501(e)(1)(A) applies to any
taxpayer, we must disregard any omitted gain that is attributable
solely to the basis overstatement resulting from the Son-of-BOSS
transaction.
Held, further, for each partner, a portion of the omitted gain was
not attributable to the basis overstatement. With respect to C and his
wife (W), that portion constitutes a substantial omission from income
under I.R.C. sec. 6501(e)(1)(A). With respect to the other partners, it
does not. Therefore, the FPAA was timely issued with respect to C
and W only, and C and W, but not the other individual partners, are
proper parties to the action under I.R.C. sec. 6226(d)(1)(B).
Held, further, the adjustments in the FPAA are sustained.
Held, further, no I.R.C. sec. 6662 penalty applies because C, as the
partnership's TMP, relied reasonably and in good faith on
independent professional advice.
-3Steven R. Mather, for petitioner.
John W. Stevens, for respondent.
CONTENTS
FINDINGS OF FACT ............................................... 5
I.
Introducing the Carroll Family ................................... 7
II.
Solving the Low Basis Dilemma ................................ 11
III.
Selling the Son-of-BOSS Strategy ............................... 16
IV.
Achieving the Basis Boost ..................................... 19
A.
B.
C.
Son-of-BOSS .......................................... 21
BasisBoost ............................................24
RealEstateExtraction....................................26
V.
Reporting the Transactions ..................................... 28
A. CNT's 1999 Returns ..................................... 29
B. CCFH's1999Return ....................................31
C. Individuals' 1999 Returns ................................ 32
VI.
Challenging the Transactions ................................... 33
OPINION ........................................................ 34
I.
Preliminary Matters ........................................... 34
A. When Appellate Venue Matters . . . . . . . . . . . . . . . . . . . . .. ... . . . 34
B.
II.
Why Appellate Venue Does Not Matter Here . . . . . . . . . . . . . . . . . 36
Timeliness oftheFPAA ....................................... 39
A.
B.
Timeliness Under TEFRA ................................ 40
Theory ofOmission ..................................... 42
C.
D.
E.
F.
G.
III.
-4Omission by Bootstrapping ............................... 44
Scope of Sham ......................................... 48
1.
Gregory Revisited.................................. 53
2.
Sham Transaction Doctrine .......................... 60
3.
Step Transaction Doctrine ........................... 66
4.
5.
Blending the Doctrines .............................. 69
Conclusion ....................................... 74
1.
Legal Standard .................................... 84
Definition ofOmission ................................... 75
1. Mr. Carroll ....................................... 79
2. Ms. Cadman ...................................... 81
3. Ms. Craig ........................................ 82
Adequacy ofDisclosure .................................. 84
2. Petitioner's Proof .................................. 86
3. Returns'Revelations ............................... 87
Conclusion ............................................93
Consequences of the Sham Stipulation .................... ........ 93
IV. Liability for the Accuracy-Related Penalty . . . . . . . . . . . . . . . . . . . . . . . . 95
A. Penalties' Applicability . . . .. . . . . .. .. . . . . . .. . . . . . . . . . . . . . . 96
B. Petitioner's Defense ..................................... 97
1.
2.
3.
V.
Sufficient Expertise? .............................. 100
Necessary Information? ............................ 107
GoodFaithReliance? .............................. 110
Conclusion ................................................. 118
.
WHERRY, Judge: This case constitutes a partnership-level proceeding
under the unified partnership audit and litigation procedures of the Tax Equity and
Fiscal Responsibility Act of 1982 (TEFRA), Pub. L. No. 97-248, sec. 402(a), 96
-5Stat. at 648 (codified as amended at sections 6221-6234).¹ On August 25, 2008,
respondent mailed a notice of final partnership administrative adjustment (FPAA)
to CNT Investors, LLC (CNT), for its taxable period ending December 1, 1999.
Pursuant to section 6226, petitioner, Charles C. Carroll, CNT's tax matters partner
(hereinafter referred to as Mr. Carroll or petitioner), timely petitioned this Court
on November 12, 2008, for readjustment of CNT's partnership items determined
in the FPAA. After concessions by petitioner, which we discuss below, the issues
remaining for decision are:
(1) whether the six-year limitations period of section 6501(e)(1)(A) applies
to CNT's partners for their 1999 taxable years, such that the FPAA was timely;
(2) whether the adjustments in the FPAA should be sustained; and
(3) whether a section 6662 valuation misstatement or accuracy-related
penalty applies to any underpayment attributable to the partnership-level
determinations made in the FPAA, to the extent sustained herein.
FINDINGS OF FACT
Petitioner lived in California when he filed CNT's petition. CNT, the
limited liability company to which the FPAA was directed, was, as agreed to by
¹Unless otherwise indicated, all section references are to the Internal
Revenue Code of 1986, as amended and in effect for the year at issue, 1999, and
all Rule references are to the Tax Court Rules of Practice and Procedure.
-6the parties, a sham entity with no business purpose. CNT did, however, file
Federal income tax returns annually from 1999 through at least 2010. On its 1999,
2000, and 2001 returns CNT provided a California address and reported
ownership of real property. As of January 22, 2015, online grantor/grantee
records of the Ventura County, California, Recorder reflected that CNT held legal
title to interests in four parcels of real property situated within that county.2 Those
2A court may take judicial notice of appropriate adjudicative facts at any
stage in a proceeding whether or not the parties request it. See Fed. R. Evid.
201(c), (f). In general, the court may take notice of facts that are capable of
accurate and ready determination by resort to sources whose accuracy cannot
reasonably be questioned. Id. subdiv. (b).
As we do here, a court may take judicial notice of public records not subject
to reasonable dispute, such as county real property title records. See, e.g.,
Velazquez v. GMAC Mortg. Corp., 605 F. Supp. 2d 1049, 1057-1058 (C.D. Cal.
2008) (taking judicial notice of two deeds of trust and a full reconveyance
recorded in the Official Records of the Los Angeles County, California,
Recorder); Haye v. United States, 461 F. Supp. 1168, 1174 (C.D. Cal. 1978)
(taking judicial notice of deeds recorded with the Los Angeles County Index).
Ample precedent exists for our reliance on electronic versions of public records.
See, e.g., Marshek v. Eichenlaub, 266 Fed. Appx. 392, 392-393 (6th Cir. 2008)
(holding that court could take judicial notice of information on the Inmate Locator,
which enables the public to track the location of Federal inmates, is maintained by
the Federal Bureau of Prisons, and is accessed through the agency's Web site, to
discover that appellant had been released since the filing of his appeal and
conclude that there remained no actual injury which the court could redress with a
favorable decision and, thus, dismiss the appeal as moot); Denius v. Dunlap, 330
F.3d 919, 926-927 (7th Cir. 2003) (holding that District Court erred when it
refused to take judicial notice of information on official Web site of Federal
agency that maintained medical records on retired military personnel, the fact of
which was appropriate for judicial notice because it is not subject to reasonable
(continued...)
-7records also reflected that CNT leased some portion of its real property interests to
"SCI California Funeral Services, Inc.", in 2004. The lease agreement(s) had a 15year term and included an option to purchase.
I.
Introducing the Carroll Family
After serving in the United States Marine Corps at the time of World War II,
Mr. Carroll attended mortuary science college. He also became a licensed
embalmer. Mr. Carroll began operating Charles Carroll Funeral Home (funeral
home) in 1954. The funeral home was an archetypal family business. Mr. Carroll
and his wife, Garnet, lived for many years and raised their twin daughters, Teri
Craig and Nancy Cadman, at various times in homes above, behind, and next door
to their mortuaries.3 Mr. and Mrs. Carroll both worked for the funeral home from
1954 until the business was sold in 2004, and their daughters and Ms. Craig's two
sons also worked for the funeral home during various periods.
2(...continued)
dispute); Sears v. Magnolia Plumbing, Inc., 778 F. Supp. 2d 80, 84 n.6 (D.D.C.
2011) (taking judicial notice of corporate resolutions available through the
Maryland Department of Assessments and Taxation's Web site); Lengerich v.
Columbia Coll., 633 F. Supp. 2d 599, 607 n.2 (N.D. Ill. 2009) (taking judicial
notice of a corporation filing for Columbia College Chicago on the Illinois
secretary of state's Web site).
3We refer to Mr. and Mrs. Carroll, Ms. Craig, and Ms. Cadman collectively
as the Carroll family, and to Mr. Carroll, Ms. Craig, and Ms. Cadman (i.e., the
Carroll family, less Mrs. Carroll) collectively as the Carrolls.
-8Although Mr. Carroll was an astute and successful businessman, he
understood only basic tax principles and lacked sophistication in various stock and
bond type fmancial matters. Hence he sought counsel and assistance from
professional advisers on legal and accounting issues relating to the funeral home.
Attorney J. Roger Myers began working with Mr. Carroll in the late 1970s or early
1980s, when he assisted Mr. Carroll in acquiring two additional mortuaries. Mr.
Myers thereafter became the funeral home's de facto general counsel, providing
general business consultation, maintaining records, and advising on employment
and regulatory issues. The Carroll family regularly consulted Mr. Myers on legal
issues arising in connection with the funeral home, and Mr. and Mrs. Carroll also
engaged Mr. Myers to prepare their estate plan, which included an inter vivos
givmg program.
As of 1999 Mr. Myers had practiced law for almost 30 years, most of them
spent in a business-oriented private practice involving some civil litigation.
Although he did not hold himself out as a tax lawyer and typically referred clients
to specialists for complicated income tax advice, Mr. Myers had taken basic
Federal income and estate tax courses in law school, had previously prepared
estate tax returns, and had advised Mr. Carroll on general tax law principles.
_9_
Certified Public Accountant (C.P.A.) Frank Crowley also began working
with Mr. Carroll in the early 1980s, and Mr. Carroll followed him when Mr.
Crowley changed accounting firms. Mr. Crowley provided general bookkeeping
and monthly payroll services for the funeral home, and he prepared its fmancial
statements and Federal income tax returns. In the late 1990s Mr. Crowley
conferred with Mr. Carroll monthly concerning the funeral home's financial
statements. He interacted more frequently with Ms. Cadman and Ms. Craig, who
performed in-house bookkeeping duties for the funeral home. Mr. Carroll relied
on Mr. Crowley for routine income tax advice although the funeral home's
operations rarely gave rise to complex tax issues.
In addition to his C.P.A. credential, Mr. Crowley held bachelor's and
master's degrees in accounting and was a certified fmancial planner. He had taken
classes in individual and corporate income tax and partnership and estate tax
during his degree programs. Before meeting Mr. Carroll, Mr. Crowley had
worked as a cost accountant at a publicly held company and practiced at multiple
private accounting firms. His work entailed advising clients on accounting and
income and estate tax issues, and as of 1999, financial matters.
By the mid-1990s, the funeral home's operations had expanded to five
mortuaries. The Carrolls owned the funeral home through a corporation, Charles
- 10 Carroll Funeral Home, Inc. (CCFH), which also held title directly or indirectly to
the mortuary buildings and underlying real property.4 Mr. Carroll was the funeral
home's original owner and CCFH's only shareholder until he implemented the
giving program through which he transferred annual tranches of shares to his
daughters.5 As of 1999 Mr. Carroll held 94.4512% of CCFH's outstanding shares,
4Some evidence in the record suggests that, before November 1999, Mr. and
Mrs. Carroll held legal title to one of the five real properties as trustees of the
Carroll Family Trust. The record also suggests, however, that for all practical
purposes, the Carroll family treated this fifth property as if it, too, were owned by
CCFH. Ms. Cadman testified that CCFH owned all five properties. Ms. Craig
initially confirmed her sister's statement. After prompting from counsel, however,
she stated that she did recall something but was not an expert, then agreed when
counsel asked her to confirm her recollection that one property was owned by a
trust. She emphasized that, operationally, the distinction did not matter. Mr.
Crowley, who had for many years prepared the Carroll family's individual tax
returns and those for CCFH and who also assisted Ms. Craig with bookkeeping for
the business, apparently believed that CCFH owned all five properties. In a
facsimile message sent in August 1999 to the promoter of the tax shelter that led to
this case, Mr. Crowley listed all five properties as assets of the corporation,
breaking out the book values of the land and buildings on each parcel. When
asked by respondent's counsel whether the promoter needed this information in
order to calculate the amount of gain that the shelter transaction would need to
offset, Mr. Crowley answered that he believed so. We found Mr. Crowley
credible as a witness and conclude that he would not have sent the promoter
information inconsistent with the Carroll family's and CCFH's past tax reporting.
Accordingly, we find that, for tax purposes, CCFH owned all five properties, even
if one was titled in what amounted to a nominee's name.
5Some evidence in the record suggests that Mr. and Mrs. Carroll originally
held CCFH's shares through a form ofjoint ownership, and that Mr. and Mrs.
Carroll jointly held a partnership interest in CNT. Other evidence is to the
(continued...)
- 11 and Ms. Cadman and Ms. Craig each held 2.7744%. CCFH had initially operated
as a C corporation but elected S corporation status at some time before 1999.
II.
Solving the Low Basis Dilemma
Mr. Carroll was 73, going on 74, in early 1999. He and his family had
begun to contemplate his retirement and the funeral home's sale. Mr. Carroll
intended to sell the funeral home business but retain ownership of the real
property, which would be leased to the buyer(s). SCI, a mortuary company that .
had recently begun operating in the area, had followed this model for acquisitions
of other local mortuaries, and SCI had contacted the Carrolls about purchasing the
funeral home.
Mr. Carroll believed that, if a national mortuary chain purchased the funeral
home, it would not want to purchase the real property. Retaining and leasing the
real estate would also provide the family with a periodic income stream during
retirement. Mr. Carroll was financially conservative, and he had no extensive
investment experience. Before 1999 he had never invested in United States
5(...continued)
contrary. In their supplemental stipulation of fact the parties have simplified
matters by referring to Mr. Carroll as holding his interests in CCFH and CNT and
as participating in the transactions at issue independently from his wife. We
follow the parties' lead and refer herein only to Mr. Carroll given that, in any
event, Mr. and Mrs. Carroll filed joint Federal income tax returns for 1999 and
2000.
- 12 Treasury notes (T-notes), traded stocks, bonds, or other securities on margin, or
participated in a short sale transaction. In 1999 Mr. Carroll's interests in the
funeral home and five mortuary properties represented almost 100% of his net
worth, and his only other holdings consisted of certificates of deposit and cash.
To facilitate sale of the business without the real estate, Messrs. Myers and
Crowley determined that the two needed to be separated. They initially concluded
that the preferred mechanism for achieving this separation would be for CCFH to
divest itself of the mortuary properties, leaving it holding only the funeral home's
business operations. They could not, however, identify a way of transferring the
real estate out of CCFH without triggering recognition of substantial built-in gain,
caused largely by inflation in real estate prices.6 As of November 1999, in the
aggregate CCFH's real estate holdings had an adjusted tax basis of $523,377 and a
fair market value of $4,020,000.
By late 1999 Mr. Crowley considered the real estate's proposed transfer
from CCFH a "dead issue" because, after a few years of analysis and
brainstorming with Mr. Myers and other attorneys, he had identified no way for
the Carrolls to accomplish the transfer without incurring significant tax liability.
6Depending on when CCFH filed its S election, some or all of the
recognized gain could have been subject to two levels of income tax because of
sec. 1374(a).
- 13 Nevertheless, while sale of CCFH's stock (after divestiture of the real estate)
appeared a nonstarter, sale of its business assets remained a possibility. In that
case, however, CCFH could lose its S election and become subject to dual-level
income taxation within three years after the asset sale because of the passive
income limitation of section 1362(d)(3). Either way, retention of the real estate
would have income tax implications.
In 1999 Mr. Myers encountered a potential solution. Over lunch with a
longtime acquaintance, local financial adviser Ross Hoffman, Mr. Myers
described Mr. Carroll's problem in general terms, explaining that he had a client
who.needed to transfer appreciated assets out of a corporation for estate planning
purposes. Mr. Hoffman advised Mr. Myers that he knew of a strategy that might
work.
Earlier in the year Mr. Hoffman had attended a Las Vegas conference
sponsored by Fortress Financial, a New York-based tax planning firm. Erwin
Mayer, an attorney with the law firm Jenkens & Gilchrist, gave a seminar at the
conference on a strategy he called a "basis boost" that could allegedly increase the
- 14 tax basis of low-basis assets. The basis boost strategy Mr. Mayer presented was,
in substance, a Son-of-BOSS transaction.7
Mr. Hoffman was not a tax professional and did not hold himself out as one.
In 1999 he was a certified financial planner and regularly advised clients on
liquidity, life insurance, asset allocation, and investment planning, with a focus on
7Throughout this Opinion, for brevity and ease of reference, we characterize
the T-note short sales and purported partnership capital contributions made by Mr.
Carroll and his daughters as a Son-of-BOSS transaction. We recognize, however,
that the overall series of transactions did not entirely align with the definition we
have previously provided for a Son-of-BOSS transaction:
Son-of-·BOSS is a variation of a slightly older alleged tax shelter
known as BOSS, an acronym for "bond and options sales strategy."
There are a number of different types of Son-of-BOSS transactions,
but what they all have in common is the transfer of assets encumbered
by significant liabilities to a partnership, with the goal of increasing
basis in that partnership. The liabilities are usually obligations to buy
securities and typically are not completely fixed at the time of
transfer. This may let the partnership treat the liabilities as uncertain,
which may let the partnership ignore them in computing basis. If so,
the result is that the partners will have a basis in the partnership so
great as to provide for large--but not out-of-pocket--losses on their
individual tax returns. Enormous losses are attractive to a select
group of taxpayers--those with enormous gains. [Kligfeld Holdings
v. Commissioner, 128 T.C. 192, 194 (2007).]
Here, as explained below, rather than use the Son-of-BOSS to offset unrelated,
recognized gains, the Carrolls used the Son-of-BOSS to eliminate gain
prospectively. We note that in Kligfeld Holdings, the taxpayer likewise executed
the Son-of-BOSS transaction to boost the tax basis of an appreciated asset (in Mr.
Kligfeld's case, stock) to forestall gain recognition upon its disposition. See id. at
194-197.
- 15 estate planning. He offered clients "industry designed" tax-advantaged products,
such as limited partnerships, municipal bonds, and annuities. Mr. Hoffman
attended the Las Vegas conference to learn about strategies and ideas that he could
sell to clients or to their attorneys or C.P.A.'s. Before attending the conference,
Mr. Hoffman was unfamiliar with Mr. Mayer and with Jenkens & Gilchrist and
had never traded stocks or conducted any T-note or short sale transactions for
clients. Mr. Hoffman never fully understood the Son-of-BOSS transaction that
Mr. Mayer pitched at the conference, but he nevertheless described it to Mr. Myers
at the luncheon as a possible solution for Mr. Myers' client.
Mr. Myers wanted to understand the Son-of-BOSS transaction better before
presenting it to Mr. Carroll, so Messrs. Hoffman and Myers met again, this time
for a conference call with Mr. Mayer. Bill Fairfield, another Ventura, California,
attorney who had clients situated similarly to the Carrolls, also participated in the
call. After speaking with Mr. Mayer, Mr. Myers understood that the proposed
transaction would involve a short sale and would conclude with the real estate's
being transferred out of CCFH with a new basis. At Mr. Myers' request, Mr.
Mayer sent him a memorandum prepared by Jenkens & Gilchrist describing and
analyzing the transaction. Mr. Myers reviewed the memorandum and consulted
some of the legal authorities cited therein, albeit not in extreme detail.
- 16 Thereafter, on two occasions Messrs. Myers and Hoffman met with the
Carrolls and Mr. Crowley at Mr. Myers' office to discuss the proposed transaction.
Using visual aids, Mr. Hoffman described in broad strokes how Mr. Carroll could,
through a short sale of securities, create basis in a new entity, and he mentioned
that Ted Turner had engaged in a similar transaction and, in a subsequent case
concerning it, prevailed. Ms. Cadman found the Ted Turner story persuasive,
reasoning that, if someone who could afford the very best legal and tax advice had
engaged in this kind of transaction, it must be effective.8 After the second meeting
with Mr. Hoffman, the Carrolls decided to proceed with the Son-of-BOSS
transaction.
III.
Selling the Son-of-BOSS Strategy
Mr. Hoffman pitched the Son-of-BOSS transaction to the Carrolls, but the
Carrolls never became his clients or paid him any compensation. He never
provided any tax advice to Mr. Carroll, gave a written opinion as to the
transaction, or expressly represented that the transaction would achieve Mr.
8By agreement between the parties' counsel, and despite respondent's
subpoenas, which respondent did not seek to enforce, neither Mr. nor Mrs. Carroll
testified at trial, in both cases for health reasons. Petitioner's counsel represented,
and letters from Mr. and Mrs. Carroll's attending physician lodged with the Court
confirm, that neither Mr. Carroll nor Mrs. Carroll would be able to testify to any
meaningful recollection of the relevant events.
- 17 Carroll's desired result. He did, however, answer Mr. Carroll's and his advisers'
questions, parroting what he had heard from Mr. Mayer and consulting with Mr.
Mayer when he needed more information. Messrs. Myers and Crowley and Ms.
Cadman all perceived, after meeting with him, that Mr. Hoffman supported and
recommended the transaction. Once Mr. Carroll decided to go forward with the
transaction, Mr. Hoffman assisted ministerially with finalizing paperwork. He
expected to receive a "finder's fee" in the form of a percentage of Fortress
Financial's fee if Mr. Carroll proceeded with the transaction.
After the various presentations, meetings, and phone calls, Mr. Myers
believed that he had a good grasp of how the Son-of-BOSS transaction would
work and of the legal theories behind it. He had met with fellow Ventura attorney
Bill Fairfield and had researched Jenkens & Gilchrist in Martindale Hubbell and
on the Internet, learning that the firm had offices throughout the United States,
including in Chicago, where Mr. Mayer worked. He had spoken by telephone
with Mr. Mayer about the transaction. He had reviewed Mr. Mayer's
memorandum and the supporting legal authorities. And he had been present for
Mr. Hoffman's presentation. Mr. Myers believed the transaction was feasible and
that the Carrolls should seriously consider it. He advised Mr. Carroll that the
transaction looked like a viable way to resolve CCFH's low basis dilemma.
- 18 Mr. Myers' opinion did not change as the transaction proceeded. During the
implementation phase, he spoke by telephone with Mr. Mayer on multiple
occasions. Mr. Myers did not know all of the details of the transaction. He did
not know, for instance, how much money was actually at risk in the Son-of-BOSS
component of the transaction, had no financial information about the short sale,
and was unaware that the short sale would almost certainly generate no profit. He
did not know how much Jenkens & Gilchrist would charge Mr. Carroll to
implement the transaction. On the basis of what he did know, however, Mr. Myers
formed the opinion that the transaction was legitimate and proper, and he shared
this opinion with Mr. Carroll. Mr. Myers was working only for Mr. Carroll, billed
Mr. Carroll monthly for work on the transaction at his regular hourly rate, and
received no other compensation or incentive for recommending it.
Like Mr. Myers, Mr. Crowley did not know how much money was actually
at risk in the Son-of-BOSS transaction, had no financial information about the
short sale, and was unaware that the short sale would almost certainly generate no
profit. Also like Mr. Myers, Mr. Crowley was working only for Mr. Carroll and
received no unusual compensation for his counsel to the Carroll family. However,
his advice was more ambivalent than Mr. Myers': Mr. Crowley did not conceal
his lack of complete understanding of the transaction, and rather than affirmatively
- 19 endorse it, he told Mr. Carroll that he would "go along with" it. He was willing to
do so because the transaction had been developed by what he thought was a
knowledgeable national law firm that was sufficiently confident to promise, in
writing, that it would defend the transaction if it were challenged. As a C.P.A. in a
small, two-partner firm, Mr. Crowley felt intimidated by the Jenkens & Gilchrist
brand and essentially "acquiesced". Notwithstanding Mr. Crowley's uncertainty,
Ms. Cadman testified that the family believed he and their other advisers
recommended proceeding with the Son-of-BOSS transaction. According to Ms.
Cadman, had Mr. Crowley advised against it, the Carrolls would not have moved
forward.
IV.
Achieving the Basis Boost
Once the "go" decision had been made, Mr. Mayer formed four limited
liability companies (LLCs): (1) CNT, which elected to be treated as a partnership
for income tax purposes,9 (2) Teloma Investments, LLC (Teloma), of which Mr.
Carroll was the sole member, (3) Santa Paula Investments, LLC (Santa Paula), of
which Ms. Craig was the sole member, and (4) S. Mountain Investments, LLC (S.
9The parties have stipulated that CNT was a sham entity with no business
purpose. Respondent further contends that CNT was not a partnership as a matter
of fact, and that its partners should not be treated as such. We use the terms
"partnership" and "partner" and related terms for convenience only.
- 20 Mountain), of which Ms. Cadman was the sole member.¹° Each of the LLCs was
formed under Delaware law." Each was a sham entity with no business purpose.
Pursuant to directions from and with the active control of Mr. Mayer and his
colleagues at Jenkens & Gilchrist, the following sequence of transactions
occurred.¹²
¹°Teloma, Santa Paula, and S. Mountain would ordinarily be disregarded as
entities separate from their respective sole owners. See secs. 301.7701-2(c)(2) and
301.7701-3(a), (b)(1)(ii), Proced. & Admin. Regs. None of these three entities
ever filed a Federal income tax return, and CNT identified the entities' individual
owners, not the entities themselves, as partners even though the individuals made
their capital contributions through their respective LLCs.
"Online records of the Delaware Division of Corporations reflect that CNT
Investors, LLC, was formed in Delaware on August 26, 1999. Those records do
not reflect whether CNT remains in good standing, but it evidently has not been
dissolved. Online records of the California secretary of state reflect that a "CNT
Investors, LLC" was formed in California on June 26, 2009. Those records list
Ms. Cadman as that entity's agent for service of process and list the entity's
address as that provided on CNT's 1999, 2000, and 2001 Federal income tax
returns. We take judicial notice of these adjudicative facts pursuant to Fed. R.
Evid. 201(b). See Sears, 778 F. Supp. 2d at 84 n.6 (taking judicial notice of
corporate resolutions available through the Maryland Department of Assessments
and Taxation's Web site); Grant v. Aurora Loan Servs., Inc., 736 F. Supp. 2d
1257, 1265 (C.D. Cal. 2010) (taking judicial notice of, inter alia, Delaware
secretary of state's certificate of authentication for a certificate of incorporation
and a certificate of conversion from a corporation to an LLC); Lengerich, 633 F.
Supp. 2d at 607 n.2 (taking judicial notice of a corporation filing for Columbia
College Chicago on the Illinois secretary of state's Web site); supra note 2.
¹²We explain the intended tax consequences of each transaction merely to
illustrate how the shelter was designed to work. We expressly do not find that any
(continued...)
-21A.
Son-of-BOSS
On November 18, 1999, the five real properties were transferred by deed to
CNT. The book value of the transferred real estate was credited to CCFH's capital
account. See supra note 4. At that time, the five properties' aggregate adjusted
tax basis, and hence CCFH's initial outside basis in CNT, was $523,377.'3
On November 24, 1999, Mr. Carroll, Ms. Craig, and Ms. Cadman, via their
respective LLCs, engaged in short sales of T-notes.¹4 Once the proceeds had
¹²(...continued)
of these consequences actually ensued.
¹³Under sec. 722, "[t]he basis of an interest in a partnership acquired by a
contribution of property * * * to the partnership shall be the * * * adjusted basis of
such property to the contributing partner at the time of the contribution"--that is,
an exchanged basis. Hence, as no taxable gain was recognized at that time,
CCFH's tax basis in its partnership interest would equal its tax basis in the
contributed real estate. The Schedule K-1, Partner's Share of Income, Credits,
Deductions, etc., CNT issued to CCFH for CNT's tax year ending December 1,
1999, reports the amount of CCFH's capital contributions during the tax year as
$523,377.
¹dIn a short sale, the investor borrows securities and incurs an obligation to
return identical securities within a specified period. The investor then sells the
borrowed securities for cash, planning to purchase replacement securities later for
return to the lender. If the securities' market price declines in the meantime, the
investor will make a profit. If the securities' market price increases, the investor
will incur a loss. When an investor conducts such a transaction through a broker,
the broker may require that the investor post the sale proceeds as security and/or
deposit funds into a "margin account" so that, if the market price has increased
and the short sale proceeds are insufficient to fund the purchase of replacement
(continued...)
- 22 settled, on November 26, 1999, the Carrolls transferred a total of $2,877,343 in
cash proceeds from the short sales, together with the related obligations and a
nominal amount of cash, apparently $10,800, to CNT. These transfers were sham
transactions having no business purpose. The transferred proceeds and cash,
totaling $2,877,343, were credited to Mr. Carroll, Ms. Cadman, and Ms. Craig's
capital accounts and established their respective initial outside bases in CNT as
$2,716,609, $80,367, and $80,367. See supra note 13. On the premise that the
transferred obligations were not liabilities for purposes of determining the
purported partners' capital contributions, their capital accounts and outside bases
were not reduced to reflect the partnership's assumption of these partner
obligations.¹5
"(...continued)
securities, the broker can apply the funds in the margin account to the deficit. See
generally Farr v. Commissioner, 33 B.T.A. 557, 559 (1935) (explaining a short
sale conducted on the New York Stock Exchange through a broker).
In opening the short sale transaction and in later contributing the open
positions and obligations to CNT, the Carrolls acted through their respective
wholly owned LLCs. Because we disregard these three LLCs as entities separate
from their owners, see supra note 10, and for brevity, we refer to the individuals
directly.
¹sUnder sec. 752(b), "[a]ny 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." The
partner's outside basis decreases by the amount of the deemed distribution. Sec.
(continued...)
- 23 CNT immediately used the transferred proceeds and cash to purchase Tnotes having a principal amount slightly greater than the amount the Carrolls had
sold short. It did so under an agreement with Deutsche Bank whereby Deutsche
Bank agreed to repurchase the T-notes (repo). Through this offsetting repo
transaction, CNT reduced to near zero its risk of incurring a loss on the short sale.
On November 29, 1999, CNT closed the repo transaction and used the
proceeds to satisfy the obligations that had been transferred to it, repurchasing the
same number of T-notes that Mr. Carroll, Ms. Craig, and Ms. Cadman had
previously sold short and closing the short sale positions. This transaction, which
generated a nominal $2,268 loss to CNT, had an estimated less than 1%
probability of generating a gain or loss greater than the additional $10,800 margin
that Deutsche Bank had required the Carrolls to post in connection with the
transaction. The transaction did, however, leave CNT allegedly holding only the
real estate with an adjusted tax basis, or inside basis, of $523,377.16 By
5(...continued)
733(1). The partner's capital account also decreases by the amount of the deemed
distribution. Sec. 1.704-1(b)(2)(iv)(h)(4), Income Tax Regs. Of course, if a
partnership were to assume a partner's obligation that did not qualify as a
"liability" for purposes of sec. 752, as was intended here, then the downward
adjustments of outside basis and capital would not occur.
'6Under sec. 723, a partnership's basis in contributed property is "the
(continued...)
- 24 comparison, its partners' aggregate adjusted basis in their partnership interests, or
outside basis, was $3,400,718.
B.
Basis Boost
On December 1, 1999, Mr. Carroll, Ms. Cadman, and Ms. Craig, who were
CCFH's only shareholders, purported to transfer their respective partnership
interests in CNT to CCFH. As a result of these transfers, CCFH became CNT's
sole owner.
The transfers triggered the termination of CNT as a partnership." For tax
purposes, the following events were deemed to occur: CNT liquidated,
transferring all of its assets to its partners in proportion to their interests, and the
three individual partners then contributed the assets received in the liquidation to
CCFH, leaving CCFH holding all of the real estate.¹8 Each of CNT's partners took
¹6(...continued)
adjusted basis of such property to the contributing partner at the time of the
contribution"--that is, a transferred basis--so CNT would have taken CCFH's tax
basis in the real estate since neither one recognized any gain that could have added
to that basis.
"Sec. 708(b)(1)(B) provides that a partnership is considered terminated if
"within a 12-month period there is a sale or exchange of 50 percent or more of the
total interest in partnership capital and profits." Here, 84.6% of CNT changed
hands.
¹8See Rev. Rul. 99-6, 1999-1 C.B. 432.
- 25 a tax basis in the assets received in the deemed liquidation equal to that partner's
outside basis.¹9 With that step, the real estate's aggregate adjusted tax basis rose
from $523,377 to $3,396,716, ostensibly without any taxable event's having
occurred.
Upon the deemed contribution of CNT's assets to CCFH, the real estate's
newly boosted basis transferred to CCFH, and the Carrolls' aggregate basis in
their CCFH stock increased by the same amount.2° Inside and outside bases were
once again allegedly aligned. All that remained to be done was to transfer the real
estate out of CCFH.
¹9Under sec. 732(b), "[t]he basis of property * * * distributed by a
partnership to a partner in liquidation of the partner's interest shall be an amount
equal to the adjusted basis of such partner's interest in the partnership". Here, the
partners' initial aggregate outside basis, $3,400,718, would have been reduced
pursuant to sec. 705(a)(2) for the $2,268 short-term capital loss and $1,734 of
interest expense incurred by CNT in connection with the short sale.
2°Under sec. 351(a), persons transferring property to a corporation recognize
no gain or loss if the transfer is made "solely in exchange for stock in such
corporation and immediately after the exchange" such persons hold stock
representing 80% of the corporation's combined voting power and 80% of the
other shares of the corporation. In this case, the Carrolls held 100% of CCFH's
outstanding shares both before and after the transaction and so would have
recognized neither gain nor loss. Their basis in their CCFH stock would have
increased pursuant to sec. 358(a) by the amount of their basis in their partnership
interests adjusted pursuant to sec. 705(a)(2), see supra note 19, or $2,873,955.
Under sec. 362(a), CCFH would have taken a transferred basis of $2,873,955 in
the 84.6% of CNT that it received in the exchange, giving it a total basis in CNT
of $3,396,716.
- 26 C.
Real Estate Extraction
On December 31, 1999, CCFH distributed percentage interests in CNT
(totaling 100%) to its three shareholders in proportion to their respective interests
in CCFH. The deemed liquidation and contribution occurring on December 1
resulted in ownership of the real estate's shifting, for tax purposes, from CNT to
the Carrolls, and then from them to CCFH! But title to the real estate did not
change; CNT continued to hold title to the property. For tax purposes, the
distribution of CNT interests on December 31 resulted in (1) a deemed distribution
of the real estate to CCFH's shareholders, followed by (2) their deemed
contribution of the real estate to a new partnership, New CNT.2¹
Upon the deemed distribution of the real estate, CCFH recognized gain
equal to the difference between its aggregate adjusted tax basis in the real estate,
$3,396,716, and the real estate's then-current fair market value, $4,020,000--that
is, $623,284.22 Because CCFH was an S corporation, that $623,284 gain passed
2¹See Rev. Rul. 99-5, 1999-1 C.B. 434.
22Sec. 311(b) provides, generally, that if a corporation distributes to a
shareholder property, the fair market value of which exceeds its adjusted tax basis,
the corporation must recognize gain "as if such property were sold to the
distributee at its fair market value."
- 27 through and was taxable to CCFH's shareholders.23 The passthrough gain
increased each shareholder's outside basis in CCFH, possibly giving each a
sufficient basis to absorb the distribution without further gain recognition.24 The
shareholders' aggregate basis in the distributed real estate, and the amount of the
distribution, was its fair market value, $4,020,000.25 That fair market value basis
transferred to New CNT upon the deemed contribution.26 The deemed
contribution also revived CNT as a partnership in the form of New CNT.
This series of transactions divested CCFH of its real estate holdings and
concluded with Mr. Carroll, Ms. Cadman, and Ms. Craig owning the five mortuary
23Under sec. 1366(a)(1), (c), an S corporation shareholder's gross income
for any tax year includes the shareholder's pro rata share of the S corporation's
"items of income" for the S corporation's tax year ending with or within the
shareholder's tax year.
²4Sec. 1367(a)(1) provides that an S corporation shareholder's basis in his
stock shall be increased by the sum of income items of the S corporation passed
through to the shareholder under sec. 1366(a)(1). Under sec. 1368(b) and (c), a
distribution to an S corporation shareholder is nontaxable to the extent of either
the shareholder's basis (if the S corporation has no earnings and profits), or the net
amount of passthrough income and loss from the S corporation reported by the
shareholder, less prior distributions (ifthe S corporation has earnings and profits).
25Under sec. 301(b), the amount of a distribution is its fair market value.
Under sec. 301(d), a corporate shareholder takes a fair market value basis in
property distributed by a corporation.
26Under sec. 723, a partnership takes a transferred basis in property
contributed by a partner in exchange for a partnership interest.
- 28 properties through New CNT, purportedly generating only $623,284 of taxable,
long-term capital gain in the process. Absent the basis boost to the real estate
from the Son-of-BOSS transaction, the amount would have been $3,496,623.27
Jenkens & Gilchrist charged $116,000 for its services in arranging, executing, and
assisting with reporting of the series of transactions. The firm also delivered to
Mr. Carroll, Ms. Cadman, and Ms. Craig similar opinion letters describing the
transactions and attesting to their probable tax consequences.
V.
Reporting the Transactions
Mr. Crowley prepared all relevant Federal income tax returns for the
transactions. When asked to prepare returns for tax year 1999, Mr. Crowley
sought further explanation about the transactions from Mr. Mayer. Jenkens &
27Because sec. 311(b) requires a corporation to recognize gain on the
distribution of appreciated property as if it had sold that property for fair market
value, we calculate gain absent the basis boost as the difference between CCFH's
amount realized, the property's fair market value of $4,020,000, and CCFH's
original tax basis, $523,377. Respondent agrees with these figures for the real
estate's fair market value and adjusted tax basis but calculates the amount of gain
that would have been recognized by CCFH (and passed through to its
shareholders) absent the Son-of-BOSS transaction as $3,497,239. Respondent
does not explain why his computation exceeds the difference between basis and
the amount realized by $616, but this amount does equal CCFH's distributive
share of CNT's net loss reported on its December 1 return. Because whether
CCFH's shareholders may ultimately be required to recognize $616 of gain as a
result of this loss's disallowance is a legal question, we describe here only the gain
recognition compelled by secs. 311(b) and 1366(a).
- 29 Gilchrist later reviewed Mr. Crowley's first drafts of CCFH and CNT's 1999 tax
returns at his request and recommended some changes.
A.
CNT's 1999 Returns
Because of its mid-year termination and subsequent revival, CNT filed two
Forms 1065, U.S. Partnership Return ofIncome, for tax year 1999: one for the
taxable period September 15 through December 1, 1999 (December 1 return), and
one for a one-day taxable period, December 31, 1999 (December 31 return).
On the December 1 return, CNT reported interest expense of $1,734 and, on
Schedule D, Capital Gains and Losses, a $2,268 short-term capital loss incurred on
November 29, 1999, on a short sale of T-notes. On the appended Schedules K-1
CNT reported capital interests, capital contributions, distributive shares of shortterm capital loss and interest expense, distributions, and yearend capital accounts
as follows:
- 30 -
Charles and
Garnet
Nancy
Teri
Item
Carroll
Cadman
Craig
CCFH
Total
Capital interest
79.88%
2.36%
2.36%
15.40%
100%
Capital
contributions
$2,716,607
$80,367
$80,367
$523,377
$3,400,718
capital loss
(1,811)
(54)
(54)
(349)
(2,268)
Interest expense
(1,385)
(41)
(41)
(267)
(1,734)
(80,273) (522,761)
(3,396,716)
Short-term
Distributions
Yearend
capital account
(2,713,409) (80,273)
-0-
-0-
-0-
-0-
-0-
On the December 31 return, New CNT reported no income, deductions,
gains, or losses. On the appended Schedules K-1, New CNT reported capital
interests, capital contributions, distributions, and yearend capital accounts as
follows:
Capital
interest (%)
Capital
contributions
Distributions
Yearend capital
account
Garnet Carroll
94.4512
$3,164,116
---
$3,164,116
Nancy Cadman
2.7744
92,942
---
92,942
TeriCraig
2.7744
92,942
---
92,942
100
3,350,000
---
3,350,000
Partner
Charles and
Total
- 31 B.
CCFH's 1999 Return
CCFH filed a single Federal income tax return for 1999 on Form 1120S,
U.S. Income Tax Return for an S Corporation. On the appended Schedules K-1,
Shareholder's Share of Income, Credits, Deductions, Etc., CCFH identified its
shareholders and their ownership percentages as: Charles Carroll, 94.4512%;
Nancy Cadman, 2.7744%; and Teri Craig, 2.7744%. CCFH's shareholders and
their ownership percentages remained unchanged from the beginning of the tax
year.
On a Treasury "Reg. Sec. 1.351-3(b) Statement" (351 statement) appended
to its return, CCFH reported receiving, as a contribution to capital, an 84.6%
interest in CNT having a basis in the transferor's hands of $2,873,955 as of
December 1, 1999. Jenkens & Gilchrist provided the 351 statement to Mr.
Crowley for attachment to CCFH's 1999 return, and Mr. Mayer told him that it
was a "necessary disclosure".
With regard to CCFH's distribution to shareholders of CNT interests, Mr.
Mayer explained that disclosure was unnecessary because there had been a
"simultaneous transaction". On the basis of this guidance, Mr. Crowley did not
report the transaction as a deemed asset sale on Schedule D, Capital Gains and
Losses and Built-In Gains, which he believed would ordinarily be required. Mr.
- 32 Crowley did not understand Mr. Mayer's explanation but nonetheless followed his
instructions. CCFH did not report any short- or long-term capital gain or loss for
1999 and did not file Schedule D that year. It reported total nondividend
distributions to shareholders during the year of $245,470.
C.
Individuals' 1999 Returns
On their respective 1999 Forms 1040, U.S. Individual Income Tax Return,
Mr. and Mrs. Carroll, Ms. Cadman and her husband (Cadmans), and Ms. Craig
and her husband (Craigs), each couple filing jointly, reported only passthrough
ordinary income from CCFH. None of them reported any passthrough capital gain
from CCFH, and none of them reported any otherwise taxable distribution from
CCFH.
Mr. and Mrs. Carroll filed their 1999 return on October 15, 2000. The
Cadmans and the Craigs filed their 1999 returns on October 18, 2000. Respondent
received from Mr. and Mrs. Carroll and the Cadmans on September 5, 2006, and
from the Craigs on September 8, 2006, signed Forms 872-I, Consent to Extend the
Time to Assess Tax As Well As Tax Attributable to Items of a Partnership,
extending the period for assessment as to their 1999 tax years to October 15, 2007.
On June 28, 2007, respondent received from each couple a second signed Form
872-I extending the limitations period to December 31, 2008.
- 33 VI.
Challenging the Transactions
On August 5, 2008, respondent mailed an FPAA with respect to CNT's
December 1 return. In the FPAA, respondent adjusted to zero CNT's reported
losses, deductions, distributions, capital contributions, and outside basis for the
applicable tax period. The FPAA cites myriad bases for these adjustments,
including that CNT was not, as a factual matter, a partnership, lacked economic
substance, and was formed or availed of solely for tax avoidance purposes; and
that both the Son-of-BOSS transaction and the individual partners' subsequent
contribution of their interests to CCFH were sham transactions undertaken solely
for tax avoidance purposes. Respondent also determined an accuracy-related
penalty under section 6662 of 20% or 40% of any underpayment attributable to a
gross or substantial valuation misstatement, negligence or disregard of rules and
regulations, and/or a substantial understatement of income tax.
CNT, through its tax matters partner, Mr. Carroll, timely petitioned this
Court on November 12, 2008, for readjustment of partnership items under section
6226, challenging each of respondent's adjustments and all alleged bases for the
determined penalty.
- 34 OPINION
I.
Preliminary Matters
We have listed above only three issues for decision in this case, but the
parties have, between them, raised several others. Before proceeding to the issues
we will decide, we explain why we do not decide two others: (1) whether the
venue for appeal in this case is in the U.S. Court of Appeals for the Ninth Circuit
(Ninth Circuit) or the U.S. Court of Appeals for the District of Columbia Circuit
(D.C. Circuit); and (2) whether this Court has jurisdiction over the accuracyrelated penalty determined in the FPAA. We need not answer the second question
because the U.S. Supreme Court has already done so--in the affirmative--in United
States v. Woods, 571 U.S. ___ , ___, 134 S. Ct. 557, 564 (2013). We need not
resolve the first question because, after Woods, the answer will not affect our
analysis of the substantive issues in this case.
A.
When Appellate Venue Matters
Section 7482(b) governs the venue for appeal from a decision of this Court.
Where our decision readjusts partnership items pursuant to a petition under section
6226, the appellate venue is the U.S. Court of Appeals for the circuit in which the
partnership's principal place of business is located. Sec. 7482(b)(1)(E). If,
however, the subject partnership has no principal place of business when the
- 35 petition is filed, the appellate venue will be the D.C. Circuit. Sec. 7482(b)(1)
(flush language); see also AHG Inys., LLC v. Commissioner, 140 T.C. 73, 82
(2013) (where it was not established whether a partnership had a principal place of
business at the time the petition was filed, concluding that the case would be
appealable in the D.C. Circuit). Respondent contends that CNT had no principal
place of business when the petition was filed, and that the D.C. Circuit is the
proper venue for appeal. Petitioner, however, insists that the venue for appeal in
this case is the Ninth Circuit.28
As a trial court, we do not ordinarily opine on the venue for appeal of our
decisions. See Peat Oil & Gas Assocs. v. Commissioner, T.C. Memo. 1993-130,
28Respondent argues that he issued the FPAA with respect to CNT's
December 1 return, and under sec. 708(b), the partnership for which that return
was filed terminated on December 1, 1999, and could therefore have had no
principal place of business when the petition was filed nearly seven years later.
Moreover, the parties have stipulated that CNT was a sham entity, and respondent
contends that a sham entity cannot have a principal place of business. Either way,
respondent reasons, the appellate venue is in the D.C. Circuit.
CNT contends that whether a partnership has terminated or is a sham for tax
purposes does not affect its legal or factual existence as a legally existing business
entity. As evidence of a principal place of business in California, it points to
CNT's purported ownership of California real estate and its filing of income tax
returns reflecting such ownership and stating a California address. Petitioner
alleges that CNT filed such returns "for many years after the sham transfers of
property occurred"; that, as a limited liability company, it remains in good
standing; and that it has continuously held four of the five mortuary properties
since 1999.
- 36 -
65 T.C.M. (CCH) 2259, 2264 (1993). However, this Court "follow[s] a Court of
Appeals decision which is squarely in point where appeal from our decision lies to
that Court of Appeals and to that court alone." Golsen v. Commissioner, 54 T.C.
742, 757 (1970), aff'd, 445 F.2d 985 (10th Cir. 1971). Where the proper venue for
appeal determines how we should apply the law, "[w]e believe it appropriate * * *
to consider the issue of venue". Brewin v. Commissioner, 72 T.C. 1055, 1059
(1979), rev'd and remanded on other grounds, 639 F.2d 805 (D.C. Cir. 1981).
B.
Why Appellate Venue Does Not Matter Here
In their briefs, the parties invoke the Golsen rule with respect to two related
issues. First, the substantial and gross valuation misstatement penalties apply with
respect to any understatement of tax "attributable to" the misstatement. Sec.
6662(b)(3), (h). If the venue for appeal is the Ninth Circuit, petitioner contends
we would be bound to follow that court's decisions in Keller v. Commissioner,
556 F.3d 1056 (9th Cir. 2009), aff'g in part, rev'g in part T.C. Memo. 2006-131,
and Gainer v. Commissioner, 893 F.2d 225 (9th Cir. 1990), a_ff'g T.C. Memo.
1988-416, interpreting the phrase "attributable to"..
In Gainer v. Commissioner, 893 F.2d at 226, the taxpayer purchased an
interest in a shipping container at an inflated value, paying most of the purchase
price with a promissory note, then claimed an investment tax credit and deducted
- 37 depreciation on the basis of the inflated value. The Commissioner disallowed the
deduction because the container was not placed in service in the tax year at issue,
1981, and also determined a valuation misstatement penalty. E Affirming this
Court, the Ninth Circuit held that the taxpayer's understatement of income tax was
not "attributable to" his overstatement of the container's value. E at 228. Rather,
the understatement was attributable to the container's not having been placed in
service, a fact that precluded the taxpayer from deducting any depreciation. See
il In Keller v. Commissioner, 556 F.3d at 1060-1061, the Ninth Circuit extended
Gainer's reasoning to disallow a gross valuation misstatement penalty where the
taxpayer engaged in a sham transaction and then claimed deductions for and
reported basis in assets that he never actually acquired. On petitioner's reading,
these precedents compel us to disallow any valuation misstatement penalty here
because any understatement of tax results from CNT's sham status, not from a
valuation misstatement.
In making this argument, petitioner did not have the benefit of the Supreme
Court's subsequently released decision in Woods. Specifically citing Keller, the
Supreme Court rejected the premise on which the Ninth Circuit's rule rests--that
is, that a transaction's lack of economic substance and an overstatement of basis
are necessarily independent possible causes for an understatement of tax. Woods,
- 38 571 U.S. at ___, 134 S. Ct. at 567. Where "partners underpa[y] their taxes because
they overstate[] their outside basis * * * because the partnership[] * * * [is a]
sham[]", the Court had "no difficulty concluding that" any resulting underpayment
was attributable to the misstatement of outside basis. Il at _, 134 S. Ct. at 568.
Woods governs the valuation misstatement penalty's applicability here, regardless
of the appellate venue.
Second, under section 6221 we may consider the applicability of a penalty
only to the extent that it "relates to an adjustment to a partnership item". If the
venue for appeal is the D.C. Circuit, petitioner contends we would be bound to
follow that court's decision in Petaluma FX Partners, LLC v. Commissioner, 591
F.3d 649 (D.C. Cir. 2010), aff'g in part, rev'g in part, vacating and remanding in
pa 131 T.C. 84 (2008). There, the D.C. Circuit strongly hinted that, where the
Commissioner determines that a penalty applies to an understatement of income
tax, and that understatement is attributable to an adjustment of outside basis, this
Court lacks jurisdiction over the penalty in a partnership-level proceeding because
outside basis is an affected item "to be resolved at the partner level". See id. at
655-656.
This Court has twice before examined the scope and import of the D.C.
Circuit's holding. Seee Tigers Eye Trading, LLC v. Commissioner, 138 T.C. 67,
- 39 136-138 (2012); Petaluma FX Partners, LLC v. Commissioner, 135 T.C. 581, 586587 (2010). We need not revisit the question here because, in the interim, the
Supreme Court has had the final word. In Woods, 571 U.S. at ____, 134 S. Ct. at
564, where the allegedly misstated item was outside basis in a sham partnership,
the Supreme Court concluded that a trial court in a partnership-level proceeding
has jurisdiction to determine whether the partnership's lack of economic substance
can "justify imposing a valuation-misstatement penalty on the partners."
Regardless of the appellate venue, Woods confirms that we have jurisdiction to
consider the valuation misstatement penalty.
We need not invoke the Golsen rule for either reason raised by the parties.
We will apply the same legal principles to the issues in this case whether the
venue for appeal is the D.C. Circuit or the Ninth Circuit. For us to undertake to
resolve the correct appellate venue, inasmuch as it would not affect the disposition
of this case, "would, at best, amount to rendering an advisory opinion. This we
decline to do." See Greene-Thapedi v. Commissioner, 126 T.C. 1, 13 (2006).
II.
Timeliness of the FPAA
The parties have stipulated that CNT and the Son-of-BOSS transaction were
shams. One might view this stipulation as a concession by petitioner of the entire
case. It is not. Petitioner offers a defense to the penalties determined in the
- 40 FPAA, and more importantly, vigorously contests the FPAA's validity in the first
instance, claiming that its issuance was untimely.
A.
Timeliness Under TEFRA
In the context of an FPAA issued under TEFRA procedures, timeliness for
statute of limitations purposes is derivative:
The Internal Revenue Code prescribes no period during which
TEFRA partnership-level proceedings, which begin with the mailing
of the * * * [FPAA], must be commenced. However, if partnershiplevel proceedings are commenced after the time for assessing tax
against the partners has expired, the proceedings will be of no avail
because the expiration of the period for assessing tax against the
partners, if properly raised, will bar any assessments attributable to
partnership items.
Generally, in order to be a party to a partnership action, a
partner must have an interest in the outcome. If the statute of
limitations applicable to a partner bars the assessment of tax
attributable to the partnership items in issue, that partner would
generally not have an interest in the outcome. See sec. 6226(c) and
(d). However, * * * a partner may participate in such action for the
purpose of asserting that the period of limitations for assessing any
tax attributable to partnership items has expired and that we have
jurisdiction to decide whether that assertion is correct. * * * [RhonePoulenc Surfactants & Specialties, L.P. v. Commissioner, 114 T.C.
533, 534-535 (2000); fn. refs. omitted.]
Section 6229(a) prescribes a three-year limitations period, commencing on
the later of the date on which the partnership return is filed or the last day for
filing such return without regard to extensions, for the assessment of tax
- 41 attributable to any partnership item or affected item. However, we have held that
"[s]ection 6229 provides a[n] [alternative] minimum period of time for the
assessment of any tax attributable to partnership items (or affected items)" that can
extend, but not reduce, the limitations period otherwise prescribed by section
6501. Rhone-Poulenc Surfactants & Specialties, L.P. v. Commissioner, 114 T.C.
at 540-543.
Respondent issued the FPAA with respect to CNT's December 1 return,
which covered the taxable period September 15 through December 1, 1999. That
taxable period ended within the partners' common 1999 taxable year, so we must
ascertain whether the period for assessment for the 1999 tax year had expired as to
any or all of CNT's partners when respondent issued the FPAA on August 25,
2008. See sec. 706(a) (partner must include partnership items in income in the
partner's tax year within or with which the partnership's tax year ends).
It is undisputed that the alternative three-year limitations periods in sections
6501(a) and 6229(a) had both lapsed with respect to all partners' 1999 tax years
when respondent issued the FPAA. Instead, respondent hangs his hat on section
6501(e)(1)(A), which extends the limitations period to six years where a taxpayer
"omits from gross income an amount properly includible therein which is in excess
of 25 percent of the amount of gross income stated in the return".
- 42 In that case, the time for assessment would have expired on October 15,
2006, as to Mr. and Mrs. Carroll, and three days later as to the Cadmans and the
Craigs.29 Before their respective expiration dates under section 6501(e)(1)(A), but
after their respective expiration dates under sections 6501(a) and 6229(a), Mr. and
Mrs. Carroll, the Cadmans, and the Craigs all agreed to extend the periods for
assessment for their 1999 tax years, including with respect to tax items attributable
to CNT, to October 15, 2007. See sec. 6501(c)(4). Before that date, each couple
agreed to further extend the limitations period to December 31, 2008. Respondent
issued the FPAA before that later date. The FPAA's timeliness therefore turns on
whether section 6501(e)(1)(A) applies.3°
B.
Theory of Omission
The statute of limitations is an affirmative defense to be pleaded and
ultimately proven by petitioner; but because respondent asserts that the six-year
statute of limitations in section 6501(e)(1)(A) applies, respondent bears the burden
29CCFH, the fourth partner identified on CNT's December 1 return, was a
passthrough entity wholly owned by the named individuals, so we do not consider
it separately in our analysis of the applicable limitations periods.
3°If the FPAA was timely, then it tolled the statute of limitations as to
CNT's partners for the duration of this proceeding, until one year after our
decision in this case becomes final. See sec. 6229(d); Rhone-Poulenc Surfactants
& Specialties, L.P. v. Commissioner, 114 T.C. 533, 551-557 (2000).
- 43 of going forward with the evidence regarding the alleged omission of income. See
Hoffman v. Commissioner, 119 T.C. 140, 146-147 (2002). If respondent satisfies
that burden, then petitioner must introduce evidence of his own to rebut
respondent's showing. See id. at 146.
Relying on stipulated facts and the tax returns in the record, respondent
offers the following: Pursuant to the parties' stipulations, CNT, Teloma, Santa
Paula, and S. Mountain are all disregarded as shams, and the transfer of short sale
proceeds and related obligations to CNT is also disregarded as a sham. Therefore,
CCFH in fact distributed its interest in the highly appreciated assets of CNT (the
five mortuary properties) to its shareholders, the Carrolls.
Under section 311(b), if a corporation distributes appreciated property to a
shareholder, the corporation must recognize gain as if it had sold the property for
fair market value. Where the corporation is an S corporation, that gain passes
through and is taxable to the corporation's shareholders pursuant to section
1366(a)(1). Yet neither CCFH nor its shareholders reported any of this gain.
Hence, an item of gross income was omitted from CCFH's 1999 Form 1120S and
from its three shareholders' 1999 Forms 1040. By respondent's computations,
because this omission amounted to more than 25% of gross income for each
partner, section 6501(e)(1)(A) applies.
- 44 We conclude that respondent has met his burden of going forward with
evidence as to the longer, six-year period of limitations. We turn now to
petitioner's response. Petitioner offers four alternative reasons section
6501(e)(1)(A) will not avail respondent here. We examine each of these
arguments in turn.
C.
Omission by Bootstrapping
First, petitioner charges respondent with attempting to "bootstrap" an
alleged omission by a different taxpayer, using a transaction occurring outside the
tax period covered by the return that is the subject of the FPAA (the December 1
return), to hold open the period of limitations with respect to items reported on
that return. Petitioner contends this approach stretches our caselaw too far.
We view petitioner's "bootstrapping" critique as aimed at two mismatches:
between CNT and the taxpayers from whose returns the income item was allegedly
omitted, and between the tax period covered by the December 1 return and the tax
period in which the event giving rise to the income item occurred. Neither of
these incongruities is unprecedented.
In Rhone-Poulenc Surfactants & Specialties, L.P. v. Commissioner, 114
T.C. at 536, the taxpayer corporation had purportedly transferred property to a
partnership in exchange for an interest therein. The Commissioner, discerning a
- 45 sale disguised as a capital contribution, issued an FPAA adjusting items relating to
the purported contribution. hl Before this Court, the Commissioner claimed that
while no income had been omitted from the partnership's return, if the FPAA
adjustments were sustained, the taxpayer corporation would have failed to report a
substantial gain on its own return. Il at 538. Because of this omission by a partner, the six-year limitations period of section 6501(e)(1)(A) would apply with
respect to that partner. See id. We agreed with the Commissioner's analysis. See
id. at 551.
Petitioner contends that respondent stretches Rhone-Poulenc beyond its
moorings by relying on an omission by a third-party entity. But as we have
elucidated above, if the FPAA's adjustments are sustained, then it will necessarily
follow that Mr. Carroll, Ms. Cadman, and Ms.. Craig will each have omitted
income from his or her own return--that is, passthrough section 311(b) gain,
includible under section 1366(a)(1). It is this omission, not CCFH's omission of
the section 311(b) gain from its 1999 Form 1120S, that would trigger section
6501(e)(1)(A) as to the Carrolls. Granted, the omitted item does not flow through
to the individ-ual partners directly from CNT but instead from another source,
CCFH. Yet in Rhone-Poulenc Surfactants & Specialties, L.P. v. Commissioner,
114 T.C. at 536, likewise, the omitted item did not flow through to the taxpayer
- 46 corporation from the partnership but instead arose under section 1001. And here,
as in Rhone-Poulenc, there will have been an omission only if the adjustments in
the FPAA are sustained. Id. at 551. Given these essential similarities, we think
that Rhone-Poulenc squarely applies to the facts before us.3¹
Petitioner further cites as unprecedented respondent's reliance on an omission arising from a transaction that occurred outside the partnership tax period
covered by the subject return. Yet in Kligfeld Holdings v. Commissioner, 128
T.C. 192 (2007), we addressed a highly similar situation. There, in 1999, an individual taxpayer engaged in a Son-of-BOSS tax shelter transaction and contributed
the proceeds and related obligations to a partnership along with highly appreciated
Inktomi stock. E at 194-195. The partnership sold most of the stock in 1999 but
distributed the proceeds and the remaining stock to its partners--the taxpayer and
his wholly owned S corporation--in 2000. Id..at 197. In 2004 the Commissioner
issued to the partnership an FPAA based upon its 1999 Form 1065. E at 198.
The partnership's tax matters partner petitioned this Court and raised a statute of
limitations defense. Id. at 199.
3¹Here the alleged omission results from sustaining the partnership-level
adjustments, not from a wholly independent source.
- 47 The Commissioner asserted that the FPAA was timely because the
limitations period with respect to the individual taxpayer's 2000 tax year had not
expired when the FPAA was mailed, and the adjustments in the FPAA would, if
sustained, affect items reported on that taxpayer's 2000 tax return, namely, the
distributed proceeds from the stock sale. See id. at 199. Scrutinizing TEFRA, we
discerned that "Congress anticipated that the taxable year in which an assessment
is made would not always be the same as the taxable year in which the adjustments
are made." E at 205. Specifically rejecting the tax matters partner's timing
mismatch arguments, we held that the FPAA was timely when issued because the
limitations period had not yet run as to the taxable year in which an assessment
triggered by the FPAA's adjustments would be made. Id. at 202, 206-207.
Kligfeld Holdings more than justifies respondent's position here. There, no
overlap existed between the taxable period covered by the FPAA and the taxable
period for which, if its adjustments were sustained, an assessment would be made.
Here, given that the alleged omission arose from a transaction occurring on
December 31, 1999, any assessment as to CNT's partners would be made for their
1999 tax year. CNT's December 1 return covers a period entirely within that same
tax year.
Moreover, contrary to petitioner's assertion, there was a third-party entity
in play in Kligfeld Holdings. As here, the only other partner in the purported
- 48 partnership created by the individual taxpayer in Kligfeld Holdings v.
Commissioner, 128 T.C. at 194-195, was his wholly owned S corporation, to
which (as occurred here) he contributed a sufficiently large interest in the
partnership to trigger a technical termination under section 708(b)(1). And while
in Kligfeld Holdings the FPAA's adjustments would have flowed through directly
to the individual taxpayer's return, sustaining those adjustments would also have
resulted in additional passthrough income to the taxpayer under section
1366(a)(1). See id. at 199 (explaining Commissioner's position that S corporation
should have reported capital gain on the partnership's distribution of cash
proceeds from the stock sale).
Between them, Rhone-Poulenc and Kligfeld Holdings provide ample
support for respondent's theory and decisively answer petitioner's "bootstrapping" argument. We therefore proceed to petitioner's second argument.
D.
Scope of Sham
Petitioner insists that--pursuant to the parties' stipulation and on the basis of
the entire record--every step in the series of transactions the Carrolls undertook
should be disregarded. Petitioner contends that transfer of the real estate was part
of an integrated series sham of transactions, that the entire series should be
disregarded, and that CCFH should be treated as the real properties' continuous
- 49 tax owner.32 Accordingly, petitioner concludes, the transaction generating the
3²At trial, petitioner introduced a chart comparing the amount of
depreciation that could have been taken on the real estate had the transactions at
issue not occurred with the depreciation possible after the basis boost for tax years
2002-10. Petitioner's counsel explained that the chart aimed to show the Carrolls'
"net tax benefit" from the transactions. We admitted the chart as Exhibit 116.
Petitioner also sought to introduce a second chart marked as petitioner's Exhibit
117 which purported to depict the amounts by which New CNT's net income and
the flowthrough income of its partners would have increased if the real estate's
basis had remained unchanged throughout the transaction. Respondent objected to
the figures as a hypothetical scenario representing expert opinion, and respondent
further disputed the figures themselves. After ascertaining that the numbers in the
exhibit had been drawn from proposed amended returns submitted to, but not
accepted by, respondent, the Court reserved decision on the exhibit's admission.
With regard to respondent's expert testimony objection, although the exhibit
represents a hypothetical, we think it one to which Mr. Crowley could testify as a
lay witness under Fed. R. Evid. 701. Mr. Crowley prepared the tax returns that
were actually filed. The exhibit reflects how he would have prepared those returns
differently pursuant to Internal Revenue Code and Internal Revenue Service (IRS)
requirements had the transactions at issue not occurred--in which case, there
would have been no sec. 311(b) gain to recognize. No special expertise is needed
for a witness to opine on how that witness would have applied undisputed rules
differently under hypothetical, alternative circumstances. See, e.g., United States
v. Cuti, 720 F.3d 453, 457-458 (2d Cir. 2013) (where accountants who had not
been qualified as experts testified to how accounts they prepared under undisputed
accounting rules would have differed had they been aware of certain facts, finding
testimony admissible as lay opinion). We further fmd Exhibit 117 relevant to
petitioner's argument that the events detailed here represent a single, integrated
sham transaction and that the parties therefore remain in their pretransaction tax
positions. The exhibit reflects petitioner's view of the Carrolls' tax liabilities if
his argument prevails. Although Exhibit 117 omits any gain from the transactions
at issue, Fed. R. Evid. 401 sets a low bar for relevancy. We will therefore admit
the exhibit as relevant to petitioner's aforementioned argument, and for the limited
purpose of proving how Mr. Crowley would have prepared the Carrolls' post-1999
returns had the transactions at issue not taken place. We give it weight
commensurate with its probative value.
- 50 allegedly omitted income never occurred, so no income could have been omitted.
Respondent, naturally, demurs. In his view only the Son-of-Boss
transaction was a sham because it was entered into solely to artificially eliminate
the built-in gain in the real estate, while the remaining steps were cognizable for
tax purposes. The parties' arguments implicate three closely related and
frequently conflated legal doctrines: the economic substance doctrine, the sham
transaction doctrine, and the step transactiön doctrine.
Although these doctrines' distinct names might suggest corresponding
substantive distinctions, the lines between and among them blur upon
examination. Congress reduced prospective confusion as to the economic
substance doctrine's tenets when it codified that doctrine in March 2010. See
Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152, sec.
1409, 124 Stat. at 1067-1070 (codified at section 7701(o)). Yet the flurry of
commentary that followed the issuance by the IRS of Notice 2014-58, 2014-44
I.R.B. 746, interpreting the codified provision amply demonstrates the degree of
remaining uncertainty as to the scope, contours, and sources of economic
substance and the other, noncodified judicial doctrines. See, e.g., Jasper L.
Cummings, Jr., "The Sham Transaction Doctrine", 145 Tax Notes 1239 (2014);
Amy S. Elliott, "Economic Substance Notice's Sham Treatment Prompts
- 51 Criticism", 145 Tax Notes 377 (2014); Susan Simmonds, "Economic Substance
Cases Still Reflect a Vague Doctrine", 146 Tax Notes 32 (2015).
If one looks to the caselaw, the economic substance, sham transaction, and
substance over form doctrines resemble a Venn diagram. In a statutorily mandated
1999 study the Joint Committee on Taxation attempted to define and distinguish
these three doctrines as well as the business purpose and step transaction
doctrines. See Staff of J. Comm. on Taxation, Study of Present-Law Penalty and
Interest Provisions as Required by Section 3801 of the Internal Revenue Service
Restructuring Act of 1998 (Including Provisions Relating to Corporate Tax
Shelters) (Vol. I) at 186-198 (J. Comm. Print 1999). The study candidly
acknowledges that "[t]hese doctrines are not entirely distinguishable, and their
application to a given set of facts is often blurred by the courts and the IRS. There
is considerable overlap among the doctrines, and typically more than one doctrine
is likely to apply to a transaction." hd. at 186.
The doctrines' substantive similarities would not, alone, generate
uncertainty for taxpayers (or tenure opportunities for tax academics) if courts
applying the doctrines did so using consistent terminology. We have not.33
33We have described the step transaction doctrine, for example, as simply an
extension or application of the "substance over form" doctrine. See, e.g., Holman
(continued...)
- 52 Despite their lexical imprecision, prior opinions of this Court and other
courts form a substantial body of precedent for the application ofjudicial doctrines
to disallow tax results in transactions that, on their face, technically strictly
conform to the letter of the Code and the regulations.34 In identifying the source of
those doctrines, courts typically point to Gregory v. Helvering, 293 U.S. 465
(1935). Gregory has come to stand for so many principles that, in order to define
33(...continued)
v. Commissioner, 130 T.C. 170, 187 (2008) ("'The step transaction doctrine
embodies substance over form principles[.]'" (quoting Santa Monica Pictures,
L.L.C. v. Commissioner, T.C. Memo. 2005-104)), aff'd, 601 F.3d 763 (8th Cir.
2010). Similarly, courts have used the term "sham" to characterize transactions
lacking economic substance, see, e.g., United States v. Woods, 571 U.S. __, ___,
134 S. Ct. 557, 567 (2013), or characterized the economic substance and sham
transaction doctrines as equivalents, see, e.g., UnionBanCal Corp. v. United
States, 113 Fed. Cl. 117, 129 n.29 (2013).
34Some may quibble with the notion that widely accepted legal doctrines can
develop within so short a span as 30 or even 80 years. See, e.g., Jasper L.
Cummings, Jr., "The Sham Transaction Doctrine", 145 Tax Notes 1239, 1241
(2014). The common law's development has been described as a "gradual
[process], building on past decisions, drawing on new experience, and responding
to changing conditions." See Ohio v. Roberts, 448 U.S. 56, 64 (1980), abrogated
on other grounds by Crawford v. Washington, 541 U.S. 36 (2004). For better or
worse, the pace at which those "conditions" change has inexorably quickened in
recent decades. Social, technological, economic, and political changes all occur
far more rapidly now than in the days of Blackstone or even Holmes. We do not
find it implausible that common law principles should coalesce more swiftly in
this environment. Nor, it seems, does Congress, which recognized economic
substance as a common law doctrine in 2010. See Health Care and Education
Reconciliation Act of2010, Pub. L. No. 111-152, sec. 1409, 124 Stat. at 10671070 (codified at sec. 7701(o)).
- 53 our premises before applying them to the facts of this case, what the Supreme
Court actually said and what it was doing in that case bear reexamination.
1.
Gregory Revisited
Gregory and subsequent Supreme Court opinions relying upon it contain the
seeds of each of the doctrines attributed to it.35 Mrs. Gregory had conducted a
series of transactions that, she asserted, satisfied all requirements for a
reorganization under then-applicable law, such that her wholly owned
35Courts and commentators have variously characterized Gregory v.
Helvering, 293 U.S. 465 (1935), as: (1) interpolating a business purpose
requirement into the predecessor statute of sec. 368, see, e.g., Bazley v.
Commissioner, 4 T.C. 897, 901-902 (1945), aff'd, 155 F.2d 237 (3d Cir. 1946),
aff d, 331 U.S. 737 (1947); Cummings, supra, at 1246-1247; (2) reading a
business purpose requirement into the Code more generally, see, e.g., Weller v.
Commissioner, 270 F.2d 294, 297 (3d Cir. 1959), aff'g 31 T.C. 33 (1958), and
aff'g Emmons v. Commissioner, 31 T.C. 26 (1958); (3) identifying and
disregarding a sham transaction, see, e.g., Helvering v. Minn. Tea Co., 296 U.S.
378, 385 (1935); Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89, 95 (4th
Cir. 1985), aff g in part, rev'g in part 81 T.C. 184 (1983); (4) enunciating a broad
substance over form principle, see, e.g., Gilbert v. Commissioner, 248 F.2d 399,
403 (2d Cir. 1957), remanding T.C. Memo. 1956-137; Alvin C. Warren, Jr., "The
Requirement of Economic Profit in Tax Motivated Transactions", 59 Taxes 985,
986 (1981); and (5) applying the step transaction principle, see, e.g., Assoc.
Wholesale Grocers, Inc. v. Uñited States, 927 F.2d 1517, 1522 (10th Cir. 1991).
Courts also routinely cite Gregory in applying the economic substance doctrine.
See, e.g., ACM P'ship v. Commissioner, 157 F.3d 231, 246 (3d Cir. 1998), aff'g in
part, rev'g in part T.C. Memo. 1997-115. But ef. David P. Hariton, "Sorting Out
the Tangle of Economic Substance", 52 Tax Law. 235, 241-245 (1999) (crediting
Judge Learned Hand's opinion for the Court of Appeals for the Second Circuit in
Gregory as the doctrine's source).
- 54 corporation's transfer to her of highly appreciated stock, ensconced within a
transient corporate shell, was nontaxable. See Gregory v. Helvering, 293 U.S. at
467-468. In its opinion the Supreme Court asked "whether what was done, apart
from the tax motive, was the thing which the statute intended." Id. at 469. The
Court's answer to that question implicates two rationales. First, the Court read the
statute to apply only to transfers made in pursuit of a "business or corporate
purpose". See id. Second, the Court emphasized its focus on the substance, rather
than the form, of what had transpired, characterizing the transaction as "a mere
device which put on the form of a corporate reorganization as a disguise for
concealing its real character". See id.
Less than one year later, the Court echoed these two themes in Helvering v.
Minn. Tea Co., 296 U.S. 378, 385 (1935), another reorganization case. The Court
distinguished the case before it from Gregory as involving a "bona fide business
move" (i.e., business purpose). Id. Further, the Court explained that Gregory had
"revealed a sham[,] * * * a mere device intended to obscure the character of the
transaction", but confirmed that Gregory had "disregarded the mask and dealt with
realities." Id The Court thus used the word "sham" to describe a transaction, the
true "character" of which did not align with its form, and thereby tethered the term
"sham" to substance over form principles. See id.
- 55 Hence, the sham transaction doctrine originated as an extension of
Gregory's substance over form principle.36 We have described that doctrine as
having two strands: (1) a factual sham is a transaction that did not, in fact, take
place, and (2) a legal or economic sham, also known as a sham in substance, is a
transaction that did take place but that had no independent economic significance
aside from its tax implications. See Krumhorn v. Commissioner, 103 T.C. 29, 38,
46 (1994). The latter strand can be traced to Gregory. In a transaction that is a
sham in substance, papers may have been signed and money moved around, but in
concrete, econornic terms, the transaction is a nullity. Afterward, the parties'
beneficial interests remain essentially unchanged.
Courts typically apply the substance over form principle to recharacterize a
transaction to make its form (on the basis of which it will be taxed) consistent with
the economic, nontax substance of what occurred. When the transaction is an
economic sham, such that nothing of substance in fact occurred (or could have
36We have previously characterized the sham transaction doctrine as
founded on or related to substance over form principles. See, e.g., Klaas v.
Commissioner, T.C. Memo. 2009-90, 97 T.C.M. (CCH) 1467, 1472 (2009), aff'd,
624 F.3d 1271 (10th Cir. 2010); Andantech L.L.C. v. Commissioner, T.C. Memo.
2002-97, 83 T.C.M. (CCH) 1476, 1501 (2002), aff'd in part and remanded on
other grounds, 331 F.3d 972 (D.C. Cir. 2003); Gaw v. Commissioner, T.C. Memo.
1995-531, 70 T.C.M. (CCH) 1196, 1226 (1995), aff'd without published opinion,
111 F.3d 962 (D.C. Cir. 1997).
- 56 occurred as the transaction was structured), we disregard it altogether, just as we
would do with a factual sham.37
Only five years later, in Higgins v. Smith, 308 U.S. 473, 476 (1940), the
Court deemed substance over form a "broad and unchallenged principle". The
taxpayer in that case had claimed an ordinary loss deduction in connection with a
sale of securities to his wholly owned corporation, which he had created solely to
achieve income and estate tax savings. See id. at 474-475. Because substance
over form "furnishe[d] only a general direction", the Court looked to Gregory's
37Knetsch v. United States, 364 U.S. 361, 365-366 (1960), the first tax case
in which the Supreme Court used the phrase "sham transaction", illustrates this
rationale. Mr. Knetsch purchased from an insurance company an annuity contract
"with a so-called guaranteed cash value at maturity * * * which would produce
* * * substantial life insurance proceeds in the event of his death before maturity."
Pursuant to the contract, however, he also borrowed repeatedly and regularly
against the annuity's cash value, such that "the net cash value, on which any
annuity or insurance payments would depend," remained negligible. E at 366.
He claimed a deduction for interest paid on the loans under sec. 163. Id. at 363364. Quoting Gregory, the Court asked "'whether what was done, apart from the
tax motive, was the thing which the statute intended'" and concluded the answer
was no. E at 365 (quoting Gregory v. Helvering, 293 U.S. at 469). The alleged
premium and interest payments simply offset the alleged loans and "did 'not
appreciably affect * * * [the taxpayer's] beneficial interest except to reduce his
tax'". See id. at 365-366 (quoting Gilbert v. Commissioner, 248 F.2d 399, 411 (2d
Cir. 1957) (Learned Hand, J., dissenting)). "What he was ostensibly 'lent' back
was in reality only the rebate of a substantial part of" his interest payments. Il at
366. In sum, "there was nothing of substance to be realized by Knetsch from this
transaction beyond a tax deduction." E (emphasis added). Hence, it was a
"sham." Id.
- 57 business purpose theme and extrapolated from it: "[If] the Gregory case is viewed
as a precedent for the disregard of a transfer of assets without a business purpose
but solely to reduce tax liability, it gives support to the natural conclusion that
transactions, which do not vary control or change the flow of economic benefits,
are to be dismissed from consideration." E at 476. Gregory, the Court implied,
supports the twin propositions that any property transfer must have a nontax
purpose and that transactions without nontax, economic consequences may be
disregarded for tax purposes. See id. These propositions now make up the two
prongs of the codified economic substance doctrine.38
Gregory, as interpreted by the Court in its subsequent opinions, spawned the
economic substance, sham transaction, business purpose, and substance over form
doctrines.39 We do not trace these doctrines back to Gregory in order to add to the
38Congress has mandated that, in applying "the common law doctrine under
which tax benefits * * * with respect to a transaction are not allowable if the
transaction does not have economic substance or lacks a business purpose" to any
transaction to which it is "relevant", the Federal courts use a conjunctive test. Sec.
7701(o)(1), (5)(A). Of course, the transactions at issue occurred before
codification, so if we were to apply the economic substance doctrine in this
Opinion, we would do so on the basis of relevant caselaw rather than in
accordance with the later-enacted statute. We will not apply the doctrine,
however, because the Government has not invoked the doctrine and because, in
any event, the case may be resolved through the application of other principles.
39As an extension of the substance over form principle, see supra note 33,
(continued...)
- 58 extensive literature parsing Gregory and related caselaw, or in order to propose a
discrete doctrinal taxonomy. We source the judicial doctrines to Gregory to draw
attention not to what the Court said, but to what it was doing, in that case and
subsequent cases.
Gregory, like much of the caselaw using the economic substance, sham
transaction, and other judicial doctrines in interpreting and applying tax statutes,
represents an effort to reconcile two competing policy goals. On one hand, having
clear, concrete rules embodied in a written Code and regulations that exclusively
define a taxpayer's obligations (1) facilitates smooth operation of our voluntary
compliance system, (2) helps to render that system transparent and administrable,
and (3) furthers the free market economy by permitting taxpayers to know in
advance the tax consequences of their transactions. On the other side of the
scales, the Code's and the regulations' fiendish complexity necessarily creates
space for attempts to achieve tax results that Congress and the Treasury plainly
39(...continued)
the step transaction doctrine likewise finds its roots in Gregory. When a group of
transactions is so "integrated", "interdependent", and "focused on a particular end
result" that evaluating the tax consequences independently will not "reflect[] the
actual overall result", we disregard the transactions' formal separateness and treat
them, in substance, as one. See Gordon v. Commissioner, 85 T.C. 309, 324
(1985); see also Superior Trading, LLC v. Commissioner, 137 T.C. 70, 88-90
(2011), aff'd, 728 F.3d 676 (7th Cir. 2013).
- 59 never contemplated, while nevertheless complying strictly with the letter of the
rules, at the expense of the fisc (and other taxpayers).
In Gregory, the Court confronted such an extreme result and, on the basis of
equitable principles, interpreted and applied the relevant statute so as to subject
Mrs. Gregory's transaction to tax. Likewise, the various other judicial doctrines
applied in tax cases all represent efforts to rein in activity that, while within the
technical letter of the rules, deeply offends their spirit.® Attempts to parse and
define the doctrines merely intellectualize what is, ultimately, an equitable
exercise. Those who favor transparency might prefer a strictly circumscribed
taxonomy ofjudicial doctrines, to include exclusive definitions of the
circumstances in which they should be applied. Those who favor administrability,
protection of the fisc, and respect for congressional purpose might prefer that
courts exercise carte blanche in disallowing results of transactions perceived as
abusive. Gregory and its progeny represent an ongoing effort to reconcile these
opposing principles and methodologies. Litigants and courts employ specialized
*Such efforts lie squarely within the courts' role in interpreting the law in
ways consistent with congressional intent. "[C]ourts in the interpretation of a
statute have some scope for adopting a restricted rather than a literal or usual
meaning of its words where acceptance of that meaning would lead to absurd
results, * * * or would thwart the obvious purpose of the statute[.]" Helvering v.
Hammel, 311 U.S. 504, 510-511 (1941).
- 60 terminology to make this effort appear more rigorous, but candidly, underneath,
we are simply engaged in the difficult, commonsense task ofjudging.
We attempt to apply Gregory's teachings to the transactions at issue.
2.
Sham Transaction Doctrine
The parties have stipulated numerous exhibits--including real estate deeds,
account agreements, trade confirmations, and account statements--demonstrating
that the transactions at issue actually occurred, so we consequently focus on the
economic sham strand of the sham transaction doctrine. See Krumhorn v.
Commissioner, 103 T.C. at 38, 46 (distinguishing factual shams from shams in
substance). We ask whether any of these transactions had "nontax substance" or
affected the parties' beneficial interests otlier than by reducing their tax
obligations. See Knetsch v. United States, 364 U.S. 361, 366 (1960).
The parties have stipulated that CNT, Teloma, Santa Paula, and S. Mountain
were sham entities with no business purpose. They have likewise stipulated that
the Carrolls' purported contribution of short sale proceeds and related obligations
(along with a nominal amount of cash) to GNT in exchange for partnership
interests in CNT was a sham transaction with no business purpose. They have not,
however, stipulated that any of the other transactions at issue, nor the entire series
of transactions, constitutes a sham. On the basis of our factual findings and
- 61 review of the record, we identify six separate actions undertaken here: (1) CCFH
contributed the five mortuary properties to CNT; (2) the Carrolls opened short sale
positions; (3) the Carrolls contributed those short sale positions to CNT; (4) CNT
closed the short sale positions; (5) the Carrolls contributed their CNT interests to
CCFH; and (6) CCFH distributed New CNT interests to its shareholders.
Following Knetsch, we must determine whether these transactions had "nontax
substance" and were thus what they purported to be--that is, not economic shams.
Examining each step independently (before determining whether and to
what extent the step transaction doctrine should apply), we find that steps (1), (3),
and (5) were all sham transactions, principally because CNT was a sham entity.
The parties have stipulated, and the record reflects, that CNT lacked any legitimate
business purpose. Rather, it was formed solely as a vehicle for effecting the Sonof-BOSS transaction and artificially "boosting" the real estate's aggregate adjusted
tax basis. Hence, consistent with the parties' stipulation, it was a sham
partnership. See Commissioner v. Culbertson, 337 U.S. 733, 742 (1949)
(explaining that, to form a valid partnership under Federal law, "the parties in
good faith and acting with a business purpose [must] intend[] to join together in
the present conduct of the enterprise"). We therefore disregard its existence. S_ee
g, Sparkman v. Commissioner, 509 F.3d 1149, 1156 n.6 (9th Cir. 2007), a_f_f'f'g
- 62 T.C. Memo. 2005-136; Andantech L.L.C. v. Commissioner, 331 F.3d 972, 980
(D.C. Cir. 2003), aff'g and remanding T.C. Memo. 2002-97, 83 T.C.M. (CCH)
1476 (2002); see also Moline Props., Inc. v. Commissioner, 319 U.S. 436, 439
(1943) (explaining, in a tax case, that "the corporate form may be disregarded
when it is a sham or unreal").
We likewise disregard as shams the purported contributions of property to,
and contributions of interests in, the sham partnership that occurred at steps (1),
(3), and (5). Although deeds were signed and funds moved among accounts,
economically, the parties' positions did not change. CCFH and the Carrolls could
not have contributed property in exchange for interests in a nonexistent
partnership. They acquired nothing of substance and relinquished nothing of
substance. A transaction undertaken with a sham entity is, a fortiori, a sham.
We further conclude that steps (2) and (4), together, constituted a sham
transaction. The Carrolls opened the short sale positions, and--disregarding the
positions' purported contribution to the sham partnership, CNT--closed them mere
days later pursuant to a prearranged plan. Pursuant to that same plan, during the
brief period for which the short sale positions remained open, the short sale
proceeds were invested in the same T-notes sold short, in an almost identical
amount, thereby reducing to near zero the risk of a loss on the short sale.
- 63 Conversely, respondent's expert concluded, and petitioner does not specifically
dispute, that the short sale as structured had virtually no chance of generating a
profit. As designed, the short sale could have had no lasting economic
consequence and would alter only the individuals' tax positions, through the
creation of basis in a purported partnership.4¹ Hence, like the offsetting premium
payments and loans in Knetsch, which "did 'not appreciably affect * * * [the
taxpayer's] beneficial interest except to reduce his tax'", steps (2) and (4)
constitute an economic sham. See Knetsch, 364 U.S. at 365-366 (quoting Gilbert
v. Commissioner, 248 F.2d 399, 411 (2d Cir. 1957) (Learned Hand, J.,
dissenting)); see also, e.g., Horn v. Commissioner, 968 F.2d 1229, 1236 (D.C. Cir.
1992) (describing an economic sham as a transaction structured "in such a way as
to create the tax benefits while completely avoiding economic risk"), rev'g Fox v.
Commissioner, T.C. Memo. 1988-570, and rev'g Kazi v. Commissioner, T.C.
Memo. 1991-37; Neely v. United States, 775 F.2d 1092, 1094 (9th Cir. 1985)
4¹Although as explained, supra note 38, we do not herein apply the
economic substance doctrine, the facts suggest that the T-note short sale also ran
afoul of that doctrine. The parties have stipulated that Mr. Carroll had never
before engaged in a short sale or any remotely similar financial transaction.
Petitioner has offered, and we can discern, no nontax purpose for the T-note short
sale.
- 64 (defining a sham transaction as "one having no economic effect other than to
create income tax losses").
Step (6), however, was different. If, for the reasons explained above, we
disregard the preceding steps as shams and look through New CNT to its then
partners, at this step CCFH transferred the five mortuary properties to the Carrolls.
This transfer materially changed the Carrolls' and CCFH's economic positions,
entirely aside from tax considerations. CCFH was a passthrough entity for tax
purposes, but for other legal purposes it was a legal entity distinct from its owners.
The parties have not stipulated, and the record does not reflect, that CCFH was a
sham entity. On the contrary, CCFH was a going concern that had operated a
viable business and held the real properties for several years, not an ephemeral
shell created solely for this series of transactions. In distributing the real estate to
its shareholders, it reduced its balance sheet and lost the right to control and
dispose of a valuable asset. Its shareholdeis, meanwhile, acquired the "bundle of
rights" associated with ownership of real property. In particular, the Carrolls
acquired the right to lease and receive rental income from the properties, as they
had contemplated doing. All obligations connected with ownership of land
likewise passed from CCFH to the Carrolls.
- 65 Moreover, as petitioner essentially acknowledges, a substantial, nontax
purpose motivated the transfer, and attainment of that purpose altered the parties'
economic positions in a meaningful way. The Carroll family wanted to retire from
the mortuary business and hoped to sell the funeral home, retaining the real estate
as a source of ongoing income. Their advisers had concluded that the best means
of achieving this goal would be to separate the real estate from the operating assets
by transferring the real estate out of CCFH. In sharp contrast to the annuity
arrangement in Knetsch, this transaction's participants did realize something of
substance beyond a tax deduction: They implemented the business disposition and
rental income retirement plan recommended by their advisers.
For the foregoing reasons, we conclude that step (6) had nontax substance,
and we will not disregard CCFH's transfer of the real estate as a sham transaction.
Petitioner, however, repeatedly emphasizes that the Carrolls and their
advisers refrained from causing CCFH to transfer the real estate until they had
identified an ostensible means of accomplishing it without tax consequences. He
contends that, but for the Son-of-BOSS transaction, the real estate would never
have been transferred at all. This contention essentially invokes the step
transaction doctrine. Even if, on its own, step (6) had nontax substance, must we
- 66 nevertheless disregard it because it was part and parcel of an integrated sham
transaction?
3.
Step Transaction Doctrine
It is axiomatic that "a transaction's true substance rather than its nominal
form governs its Federal tax treatment." Superior Trading, LLC v. Commissioner,
137 T.C. 70, 88 (2011), aff'd, 728 F.3d 676 (7th Cir. 2013); see also
Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945) ("The incidence of
taxation depends upon the substance of a transaction."). Before recharacterizing a
transaction's form to align with its substance, we conduct "a searching analysis of
the facts to see whether the true substance of the transaction is different from its
form or whether the form reflects what actµally happened." Harris v.
Commissioner, 61 T.C. 770, 783 (1974); see also Gordon v. Commissioner, 85
T.C. 309, 324 (1985) ("[F]ormally separate steps in an integrated and
interdependent series that is focused on a particular end result will not be afforded
independent significance in situations in which an isolated examination of the
steps will not lead to a determination reflecting the actual overall result of the
series of steps.").
Three alternative tests of varying degrees of permissiveness exist for
determining whether to invoke the step transaction doctrine: the binding
- 67 commitment test, the end result test, and the interdependence test. Superior
Trading, LLC v. Commissioner, 137 T.C. at 88. "[A] transaction need only satisfy
one of the tests to allow for the step transaction doctrine to be invoked." Id. at 90.
Under the binding commitment test, we ask whether, at the time of the first
step to occur, there was a binding commitment to undertake the subsequent steps.
See Commissioner v. Gordon, 391 U.S. 83, 96 (1968). Courts have seldom used
this test, and we have typically applied it only where "'a substantial period of time
has passed between the steps that are subject to scrutiny.'" Superior Trading, LLC
v. Commissioner, 137 T.C. at 89 (quoting Andantech LLC v. Commissioner, 83
T.C.M. (CCH) at 1504). Because all steps here occurred within little over one
month, the binding commitment test is likely inappropriate to these circumstances.
See id.; see also Assoc. Wholesale Grocers, Inc. v. United States, 927 F.2d 1517,
1522 n.6 (10th Cir. 1991) (declining to apply binding commitment test where case
did not involve series of transactions over multiple years).4²
Under the end result test, we examine "whether the formally separate steps
are prearranged components of a composite transaction intended from the outset to
arrive at a specific end result." Superior Trading, LLC v. Commissioner, 137 T.C.
42Were we to apply the test regardless, it would not alter our ultimate
conclusion because the transactions at issue satisfy the other two tests.
- 68 at 89; see also True v. United States, 190 F.3d 1165, 1175 (10th Cir. 1999)
(observing that what matters is whether the parties "intended to reach a particular
result by structuring a series of transactions in a certain way"). The
interdependence test similarly asks whether the various steps are so interdependent
that each alone accomplishes no independ¢nt business purpose and "would have
been fruitless without completion of the la er series of steps." Superior Trading,
LLC v. Commissioner, 137 T.C. at 90. Petitioner readily admits that the series of
transactions undertaken by the Carrolls and their wholly owned entities were
orchestrated solely to achieve a particular goal, established at the outset, of
removing the real estate from CCFH and that each step in the series would not
have occurred but for the others. Under either the end result test or the
interdependence test, then, the step transaction doctrine plainly applies.
We thus collapse the series of transactions into one, disregarding CNT,
Teloma, Santa Paula, and S. Mountain as sham entities pursuant to the parties'
stipulation. Before the series of transactioás began, CCFH owned the five
mortuary properties. When the dust settled, Mr. Carroll, Ms. Cadman, and Ms.
Craig owned the properties. Accordingly, the "stepped" transaction is a transfer of
the five properties by CCFH to the three individuals, and for the reasons discussed
above, that transaction had nontax substance. It was not, as petitioner would have
- 69 it, a nonevent. "[I]n cases where a taxpayer seeks to get from point A to point D
and does so stopping in between at points B and C", we apply the step transaction
doctrine to ignore the interim stops, Smith v. Commissioner, 78 T.C. 350, 389
(1982), not to return the taxpayer to point A.
The foregoing conclusion is decidedly not the one petitioner seeks. Rather
than simply stop there, we must consider a strand of authority he raises on brief
that, in effect, blends the sham and step transaction doctrines.
4.
Blending the Doctrines
Where a sham transaction consists of multiple steps, we have recognized
that "there is authority [for the proposition] that a sham transaction may contain
elements whose form reflects economic substance and whose normal tax
consequences therefore may not be disregarded." Alessandra v. Commissioner,
T.C. Memo. 1995-238, 69 T.C.M. (CCH) 2768, 2770, 2773 (1995) (requiring
inclusion of income generated by T-bills purchased and interest-bearing account
opened in connection with a sham transaction), aff'd without published opinion,
111 F.3d 137 (9th Cir. 1997).
In most such cases, courts determined that interest paid on bona fide
indebtedness could be deducted even when the indebtedness had been incurred in
connection with or in anticipation of a sham transaction. See, e.g., Jacobson v.
- 70 Commissioner, 915 F.2d 832, 840 (2d Cir. 1990) (concluding that interest and
loan commitment fees were deductible), aff'g in part, rev'g in part on other
grounds T.C. Memo. 1988-341; Bail Bonds by Marvin Nelson, Inc. v.
Commissioner, 820 F.2d 1543, 1549 (9th Cir. 1987) (finding that a loan was a
sham, but implying that if it were bona fide, interest would be deductible), aff'g
T.C. Memo. 1986-23; Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89,
96 (4th Cir. 1985) (in a sham sale-leaseback transaction financed with notes,
holding that taxpayer could deduct interest paid on a recourse note because it
represented a genuine obligation), aff'g in part, rev'g in part 81 T.C. 184 (1983);
Rose v. Commissioner, 88 T.C. 386, 423-424 (1987) (allowing deduction of
interest payments "attributable to the forbearance of amounts due on genuine
indebtedness" in connection with a transaction lacking economic substance), aff'd,
868 F.2d 851 (6th Cir. 1989).
On the other hand, we have declined to sever interest payments from a
multistep sham transaction where the interest payments were "an integral part of
the tax-motivated sham."43 Alessandra v. Commissioner, 69 T.C.M. (CCH) at
43In such cases we disregard both the income and the deductions generated
by the sham transaction. See Sheldon v. Commissioner, 94 T.C. 738, 762 (1990);
see also Arrowhead Mountain Getaway Ltd. v. Commissioner, T.C. Memo. 1995-
54, 69 T.C.M. (CCH) 1805, 1821-1822 (1995), aff'd without published opinion,
(continued...)
- 71 -
2772; see, e.g., Sheldon v. Commissioner, 94 T.C. 738, 762 (1990) (disallowing
deductions for interest owed to securities repo counterparties where the repo
transactions "lacked tax-independent purpose"); Sevkota v. Commissioner, T.C.
Memo. 1991-541, 62 T.C.M. (CCH) 1116, 1117, 1119 (1991) (disallowing
current-year deductions for interest paid to a commercial lender where the
taxpayer borrowed the funds to purchase capital assets that would be sold in the
following tax year, thereby both deferring recognition of income and converting
ordinary income to capital gain); see also Goldstein v. Commissioner, 364 F.2d
734, 740 (2d Cir. 1966) (affirming disallowance of interest deductions where debt
was incurred solely for its anticipated tax consequences), aff'g 44 T.C. 284 (1965).
Petitioner argues that the latter strand of caselaw governs here because
CCFH's transfer of the real estate was "integral" to the sham Son-of-BOSS
transaction and would not have occurred but for that transaction. Thus, petitioner
asks us to disregard the tax consequences flowing from the transfer and to hold,
for tax purposes, that CCFH still owns the real estate.
43(...continued)
119 F.3d 5 (9th Cir. 1997); Seykota v. Commissioner, T.C. Memo. 1991-541, 62
T.C.M. (CCH) 1116, 1118 (1991).
- 72 Petitioner's characterization of the real estate's transfer as a mere
component of a sham transaction represents a category mistake.44 Transferring the
real estate was the reason for and objective of the series of transactions at issue,
not simply one of the transactions. Taxpayers have most commonly used Son-ofBOSS transactions retrospectively, to offset recognized gains from unrelated,
completed transactions. See supra note 7. Here, the Carrolls used the Son-ofBOSS transaction prospectively, to avoid recognizing gains on a planned
transaction--to wit, separation of the real estate from the funeral home business.
We think this a distinction without a difference. A Son-of-BOSS transaction is a
tax shelter undertaken, as its moniker implies, to offset, or "shelter", income that
would otherwise be subject to tax. Neither the sham transaction doctrine nor the
step transaction doctrine nor the two combined requires us to disregard the
income-producing event along with the shhlter transaction designed to offset it.
Such an interpretation would render the doctrines toothless and yield absurd
results.
44"[A] category mistake treats a concept 'as if [it] belonged to one logical
type or category * * * when [it] actually belong[s] to another'". Planned
Parenthood of Idaho, Inc. v. Wasden, 376 F.3d 908, 930 n.21 (9th Cir. 2004)
(quoting Gilbert Ryle, The Concept of Mind 15 (1949)).
- 73 None of the cases petitioner cites as supporting his position persuades us
otherwise. In Sheldon v. Commissioner, 94 T.C. at 762, where we disallowed
interest deductions generated by sham repo transactions, we held that the
taxpayers need not recognize the "relatively small amounts of interest income"
generated by the transactions; we did not discuss, much less disregard as shams,
the transactions that had produced the ordinary income the taxpayers presumably
hoped to shelter with the interest deductions. Accord Arrowhead Mountain
Getaway Ltd. v. Commissioner, T.C. Memo. 1995-54, 69 T.C.M. (CCH) 1805
(1995), aff'd without published opinion, 119 F.3d 5 (9th Cir. 1997); Sevkota v.
Commissioner, T.C. Memo. 1991-541.
In United States v. Wexler, 31 F.3d 117, 126 (3d Cir. 1994), a criminal tax
fraud case, the Court of Appeals for the Third Circuit found clear error in a jury
instruction that would have recognized as valid interest deductions "constituting
the tax benefits of the entire [sham] transaction." The "profits from other
transactions" that had been offset by these deductions were not at issue. See id. at
120. And in Goldstein, where we disallowed deductions of interest paid on loans
that were shams, we did not hold that the taxpayer need not recognize the
sweepstakes income that her son had engineered the loans to offset. Goldstein v.
Commissioner, 44 T.C. at 286-287, 296, 300 (likewise disallowing interest on
- 74 loans incurred solely to obtain a deduction, without concurrently disregarding
sweepstakes income).
We would no more disregard the transfer of the real estate here than we
would Mrs. Goldstein's sweepstakes win. Here, the gain-producing transaction
and the shelter transaction occurred pursuant to a plan, and the shelter transaction
arguably preceded realization of the gains t was designed to shield. But if we
were to disregard the gain-producing transaction along with the shelter
transaction, we would encourage taxpayers to hedge against the audit lottery by
structuring their tax shelter transactions to precede and intertwine with their
income-producing activities. We will not do so. "[W]hile a taxpayer is free to
organize his affairs as he chooses, nevertheless, once having done so, he must
accept the tax consequences of his choice, whether contemplated or not".
Commissioner v. Nat'l Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149
(1974).
5.
Conclusion
In sum, we hold that the step transachion doctrine applies to the transactions
undertaken by the Carrolls; that applicatiori of that doctrine collapses the various
transactions to a transfer of the real estate from CCFH to the Carrolls; and that this
- 75 transfer was not simply part and parcel of a larger sham transaction. We will not
disregard the transfer or the gain it generated.
E.
Definition of Omission
Although we will not disregard CCFH's transfer of the real estate as
petitioner urges, he has another arrow in his quiver. He contends that, under the
Supreme Court's decision in United States v. Home Concrete Supply, LLC, 566
U.S. __, 132 S. Ct. 1836 (2012), the allegedly omitted item--gain recognized on
CCFH's distribution of appreciated property to its shareholders--does not
constitute an omission within the meaning of section 6501(e)(1)(A) because it
derives entirely from an overstatement of outside basis.
In Home Concrete, 566 U.S. at __, 132 S. Ct. at 1841, the Supreme Court
held that its interpretation in Colony, Inc. v. Commissioner, 357 U.S. 28, 36
(1958), of a prior version of section 6501(e)(1)(A) applies with equal force to the
current statute: To "omit" an amount properly includible in gross income is to
leave something out entirely. When a taxpayer "overstates his basis in property
that he has sold, thereby understating the gain that he received from its sale",
section 6501(e)(1)(A) does not apply. Home Concrete, 566 U.S. at __, 132 S. Ct.
at 1839. In such a case, the taxpayer has reported, not omitted, the item of gain,
albeit in an incorrect amount.
- 76 As we have explained, respondent's theory here is that, in purporting to
distribute interests in New CNT to its shareholders, CCFH in fact distributed the
appreciated real estate. Both CCFH (undef section 311(b)) and its shareholders
(under section 1366(a)(1)) should have reported gain as if the property had been
sold for its fair market value. Neither CCFH, nor Mr. Carroll, nor Ms. Cadman,
nor Ms. Craig reported this gain. Hence, respondent concludes, CNT's partners
each entirely left out an income item from;its, his, or her return, so Home
Concrete's rule is inapposite.
If one considers the supposed omission from a different angle, however,
Home Concrete appears far more relevant. The amount of gain that the partners
were obliged but failed to report was the difference between the real estate's
aggregate fair market value and its adjusted tax basis. See secs. 311(b), 1001(a),
1366(a)(1). If that difference was zero because CCFH had overstated its basis in
the real estate as equal to the real estate's fair market value, then Home Concrete
would apply squarely to the alleged omission. The Son-of-BOSS transaction in
which the Carrolls engaged was designed to inflate the real estate's tax basis so as
to eliminate or minimize the tax consequences when CCFH transferred the
property. Basis overstatement was the essence of the transaction. Hence, we must
determine whether the allegedly omitted gain derives entirely from a basis
- 77 overstatement, and if so, whether the correction of that overstatement by
respondent is barred by the statute of limitations.
We have concluded that for tax purposes CCFH transferred the property
directly to the Carrolls. In our findings, we found that this transfer would have
resulted in recognition of $3,496,623 of gain under section 311(b), and we also
described the tax treatment the Carrolls intended their transactions to receive.
Even affording the transactions and entities involved the Carrolls' desired tax
treatment and accepting all overstatements of basis as accurate, CCFH should have
recognized and reported $623,284 of gain under section 311(b) on its distribution
of CNT interests to its shareholders. CCFH did not report any gain. Hence, of
CCFH's omitted section 311(b) gain, $623,284 of the omitted amount cannot be
explained by the basis overstatement resulting from the Son-of-BOSS transaction.
Therefore, under section 1366(a)(1), even accepting all overstatements.ofbasis as
accurate, CCFH's shareholders should have included a total of $623,284 of gain in
their income, allocated among them in the following amounts:
Shareholder
Amount
Mr. Carroll
$588,699.22
Ms. Cadman
17,292.39
Ms. Craig
17,292.39
Total
623,284.00
- 78 None did so. Because these omissions cannot be attributed to a basis
overstatement, Home Concrete does not necessarily bar the application of section
6501(e)(1)(A).
To determine whether these omissions exceeded 25% of "the amount of
gross income stated in the return", sec. 6501(e)(1)(A), for Mr. Carroll, Ms.
Cadman, and/or Ms. Craig, we must first compute the amounts of gross income
stated in their respective 1999 Federal income tax returns, each of which was filed
jointly with a spouse. For this purpose "'gross income' means those items listed in
section 61(a), which includes, among other things, gains derived from dealings in
property." Insulglass Corp. v. Commissiorier, 84 T.C. 203, 210 (1985) (quoting
section 6501(e)(1)(A)). Gross income does not, however, include losses derived
from dealings in property, as section 62, not section 61, provides for the deduction
of such losses. Schneider v. Commissioner, T.C. Memo. 1985-139, 49 T.C.M.
(CCH) 1032, 1034 (1985); see also Barkett v. Commissioner, 143 T.C. __, _
(slip op. at 7-13) (Aug. 28, 2014) (reaffirming Insulglass and Schneider and
holding that, outside the context of sales of goods or services, gross income is
calculated under the general statutory definition, such that gain from the sale of
investment property, not amount realized, is includible).
- 79 Section 6501(e)(1)(A)(i) provides a corollary to the general rule that gross
income comprises only those items identified in section 61: "In the case of a trade
or business, the term 'gross income' means the total of the amounts received or
accrued from the sale of goods or services * * * prior to diminution by the cost of
such sales or services". Thus "[i]n the case of a trade or business, 'gross income'
is equated with gross receipts." Insulglass Corp. v. Commissioner, 84 T.C. at 210.
We apply these principles to Mr. Carroll, Ms. Cadman, and Ms. Craig, in turn.
1.
Mr. Carroll
Beginning with Mr. Carroll, he and Mrs. Carroll reported the following
items of income on their 1999 Form 1040: $36,000 of wages, salaries, and/or tips,
$33,220 of taxable interest, $963 of taxable refunds, credits, or offsets of State and
local income tax, and $23,028 of taxable Social Security benefits. These amounts
all constitute income within the meaning of section 61 and thus are all includible
in Mr. Carroll's stated gross income. See sec. 61(a); Insulglass Corp. v.
Commissioner, 84 T.C. at 210. Mr. and Mrs. Carroll also reported $1,811 of
capital loss, which represented their distributive share of the short-term capital
loss CNT reported on its December 1 return, but we will not reduce Mr. Carroll's
stated gross income by the amount of this loss. See Schneider v. Commissioner,
- 80 -
49 T.C.M. (CCH) at 1034. In sum, Mr. Cárroll reported $93,211 of nonbusiness
gross mcome.
Mr. and Mrs. Carroll also reported income on Schedule E, Supplemental
Income and Loss, from three business activities: (1) CNT,45 (2) CCFH, and (3)
"Business Interest Charles Carroll", an S gorporation. CNT reported no gross
receipts for either of its short tax years in 1999. CCFH reported gross receipts of
$1,841,144 for 1999, of which Mr. and Mrs. Carroll's 94.4512% share was
$1,738,982.60. The record contains no evidence of gross receipts to associate
with "Business Interest Charles Carroll", nor any other evidence regarding that
activity. Hence, on the record before us, Mr. Carroll reported a total of
$1,738,982.60 of business gross income.
For purposes of applying section 6501(e)(1)(A), Mr. Carroll's 1999 stated
gross income equals the sum of his nonbusiness income and his share of the three
business activities' gross receipts--that is, $1,832,193.60, 25% of which is
$458,048.40; $588,699.22 exceeds that amount. Hence, Mr. Carroll's omission
exceeded 25% of his stated gross income.
45As the parties have stipulated, and as we have found, CNT was a sham
entity with no business purpose. However, we will treat CNT as a business within
the context of this analysis because we consider here the omissions that would
exist even if we were to afford the Carrolls and their business entities their desired
tax treatment.
- 81 2.
Ms. Cadman
Turning to Ms. Cadman, for 1999 she and her husband reported $98,528 of
wages, salaries, and/or tips, $6 of taxable interest, $16 of ordinary dividends, $915
of taxable refunds, credits, or offsets of State and local income tax, and $61,321 of
taxable pension and annuity distributions. These amounts all constitute income
within the meaning of section 61 and thus are all includible in Ms. Cadman's
stated gross income. See sec. 61(a); Insulglass Corp. v. Commissioner, 84. T.C. at
210. The Cadmans also reported $143 of capital loss. This amount represented
the sum of Ms. Cadman's $54 distributive share of the net short-term capital loss
CNT reported on its December 1 return and her $89 distributive share of the net
long-term capital loss reported for the 1999 tax year by an unrelated partnership in
which she was a partner. As with Mr. Carroll, we will not reduce Ms. Cadman's
stated gross income by the amounts of these capital losses. See Schneider v.
Commissioner, 49 T.C.M. (CCH) at 1034. In sum, Ms. Cadman reported
$160,786 of nonbusiness gross income.
Like Mr. and Mrs. Carroll, the Cadmans did not file Schedule C, Profit or
Loss from Business. Also like Mr. and Mrs. Carroll, they listed three activities on
Schedule E: CNT, CCFH, and the unrelated partnership. As noted above, CNT
reported no gross receipts for either of its short 1999 tax years. Ms. Cadman's
- 82
2.7744% share of CCFH's 1999 gross receipts was $51,080.70. Like CNT, the
unrelated partnership reported no gross receipts on its 1999 Form 1065. Hence,
Ms. Cadman reported a total of $51,080.70 lof business gross income.
For purposes of applying section 6501(e)(1)(A), Ms. Cadman's 1999 stated
gross income equals the sum of her nonbusiness income and her share of the three
business activities' gross receipts--that is, $211,866.70, 25% of which is
$52,966.68; $17,292.39 does not exceed that amount. Hence, Ms. Cadman's
omission did not exceed 25% of her stated gross income.
3.
Ms. Craig
Ms. Craig and her husband reported $51,129 of wages, salaries, and/or tips,
$1,486 of taxable interest, and $16 of ordinary dividends. These amounts all
constitute income within the meaning of section 61 and consequently are all
includible in Ms. Craig's stated gross income. See sec. 61(a); Insulglass Corp. v.
Commissioner, 84. T.C. at 210. The Craigs also reported $144 of capital loss.
This amount represented the sum of Ms. Craig's $54 distributive share of the net
short-term capital loss CNT reported on its Deceinber 1 return and her $89
distributive share of the net long-term capital loss reported for the 1999 tax year
by the same unrelated partnership in which Ms. Cadman was a partner. We will
not reduce Ms. Craig's stated gross income by the amounts of these capital losses.
- 83 See Schneider v. Commissioner, 49 T.C.M. (CCH) at 1034. In sum, Ms. Craig
reported $52,631 of nonbusiness gross income.
On Schedule C Ms. Craig and her husband reported gross receipts of
$112,138 from "Mark Craig Productions", a music production activity. On
Schedule E they reported interests in the unrelated partnership, CNT, and CCFH.
As noted above, both the unrelated partnership and CNT reported no gross receipts
for 1999. Ms. Craig's 2.7744% share of CCFH's 1999 gross receipts was
$51,080.70. Hence, Ms. Craig reported a total of $163,218.70 of business gross
InCome.
For purposes of applying section 6501(e)(1)(A), Ms. Craig's 1999 stated
gross income equals the sum of her nonbusiness income and her share of her
business activities' gross receipts--that is, $215,849.70, 25% of which is
$53,962.43; $17,292.39 does not exceed that amount. Hence, Ms. Craig's
omission did not exceed 25% of her stated gross income.
In sum, for Mr. and Mrs. Carroll, the omitted amount exceeded 25% of
reported gross income for tax year 1999; for Ms. Cadman and Ms. Craig, it did
not. Accordingly, Home Concrete prohibits application of the six-year statute of
limitations in section 6501(e)(1)(A) to Ms. Cadman and Ms. Craig, but not to Mr.
and Mrs. Carroll. Because the limitations period remained open as to at least one
- 84 of CNT's partners, its expiration as to two of the other partners did not render the
FPAA meaningless. See Rhone-Poulenc Surfactants & Specialties, L.P. v.
Commissioner, 114 T.C. at 534-535.
F.
Adequacy of Disclosure
Finally, petitioner contends that the six-year limitations period cannot apply
because the allegedly omitted item was adequately disclosed in the relevant
returns.
1.
Legal Standard
Section 6501(e)(1)(A)(ii) provides that "[i]n determining the amount
omitted from gross income, there shall not be taken into account any amount
which is omitted from gross income stated in the return if such amount is disclosed
in the return, or in a statement attached to the return, in a manner adequate to
apprise the Secretary of the nature and amount of such item." In short, adequate
disclosure in the return will insulate a taxpayer from application of the six-year
limitations period of section 6501(e)(1)(A). For purposes of section 6501(e), the
"return" in question consists of a taxpayer's own return, and if the taxpayer is a
partner in a partnership or a shareholder in an S corporation, the partnership or S
corporation's information return as well. See Harlan v. Commissioner, 116 T.C.
31, 53 (2001).
- 85 In evaluating an alleged disclosure, we ask whether a reasonable person
would discern the fact of the omitted gross income from the face of the return.
Univ. Country Club, Inc. v. Commissioner, 64 T.C. 460, 471 (1975). Whether a
return adequately discloses omitted income is a question of fact. Rutland v.
Commissioner, 89 T.C. 1137, 1152 (1987). In addressing that question, we bear in
mind that in enacting the predecessor statute of section 6501(e)(1)(A)(ii),
"Congress manifested no broader purpose than to give the Commissioner * * *
[additional time] to investigate tax returns in cases where, because of a taxpayer's
omission to report some taxable item, the Commissioner is at a special
disadvantage in detecting errors. In such instances the return on its face provides
no clue to the existence of the omitted item." Colony, Inc. v. Commissioner, 357
U.S. at 36.
Given this relatively narrow congressional purpose, we have held that for an
alleged disclosure to qualify as adequate, the return need not recite every
underlying fact but must provide a clue more substantial than one that would
intrigue the likes of Sherlock Holmes. See Highwood Partners v. Commissioner,
133 T.C. 1, 21 (2009) (citing Quick Trust v. Commissioner, 54 T.C. 1336, 1347
(1970), aff'd, 444 F.2d 90 (8th Cir. 1971)). A disclosure need only be
"sufficiently detailed to alert the Commissioner and his agents as to the nature of
- 86ithe transaction so that the decision as to whether to select the return for audit may
be a reasonably informed one." Estate of Fry v. Commissioner, 88 T.C. 1020,
1023 (1987). We have also cautioned, however, that an alleged disclosure will not
qualify as adequate if the Commissioner mµst thoroughly scrutinize the return to
ascertain whether gross income was omitted, Highwood Partners v. Commissioner,
133 T.C. at 22, or the disclosure is misleading, Estate of Fry v. Commissioner, 88
T.C. at 1023.
2.
Petitioner's Proof
To demonstrate adequate disclosure; petitioner invites the Court's attention
to various aspects of CCFH's, CNT's, and the individuals' 1999 tax returns. First,
petitioner points to the December 1 return as disclosing CNT's formation and the
contributions of the short sale proceeds and positions and the real estate. Second,
he contends that the December 1 return also disclosed the short positions' closure.
Third, petitioner cites the 351 statement as disclosing the Carrolls' contribution of
their interests in CNT to CCFH. And fourth, he asserts that the December 31
return disclosed CCFH's distribution of CNT to its shareholders because it did not
identify CCFH as a partner. In rebuttal, respondent narrows the aperture to
CCFH's 1999 return, arguing that the Schedules K-1 do not reflect the appreciated
- 87 real estate's distribution in any manner and that the 351 statement provides no clue
as to the omitted income.
Petitioner frames the inquiry as whether the transaction was adequately
disclosed, but to fmd that the Carrolls qualify for the statutory safe harbor, we
need not conclude that the returns reasonably disclose each transactional step that
they undertook. Rather, the statute requires disclosure "of the nature and amount"
of the omitted item. See sec. 6501(e)(1)(A)(ii). This distinction matters. We
conclude below that the returns adequately disclose the Carrolls' transactions-specifically, that CCFH distributed the real estate to its shareholders. But the
returns do not reveal the one additional fact they must disclose for CNT's partners
to qualify for the safe harbor: that the real estate's fair market value exceeded its
adjusted basis,.such that CCFH, and hence its shareholders, should have
recognized some amount of gain in connection with the distribution--in short, that
the real estate had appreciated.
3.
Returns' Revelations
CCFH's 1999 return lies at the heart of our inquiry, and we begin there.
Schedule L, Balance Sheet per Books, reflects that when 1999 began, CCFH
owned land, buildings and other depreciable assets with a combined depreciated
book value of $735,765. Schedule L further reflects that, at yearend, CCFH held
- 88 buildings and other depreciable assets with a combined, depreciated book value of
$99,853, but no land. Plainly, CCFH engaged in a transaction involving its real
estate at some point during the year.
CCFH's return does not readily disclose the form or nature of that
transaction. As is most relevant here, the 1|999 instructions to Schedule D (Form
1120S), Capital Gains and Losses and Built-In Gains, directed S corporations to
use this schedule to report, inter alia, "[g]ains on distributions to shareholders of
appreciated capital assets." Yet for 1999 CCFH did not file Schedule D.
Moreover, although the 1999 instructions to Form 1120S directed that "[n]oncash
distributions of appreciated property * * * valued at fair market value" be reported
on line 20 of Schedule K, Shareholders' Slíares of Income, Credits, Deductions,
etc., CCFH reported on that line only $245,470--an amount less than the decrease
in book value of CCFH's real estate and other depreciable assets, and far less than
.the distributed real estate's aggregate fair rnarket value. Consequently, CCFH did
not properly report the distribution, and it reported no other transaction that could
account for the change in book value of its real estate and other depreciable assets.
For example, CCFH did not file Form 4797, Sales of Business Property, on which
it would have reported the sale or exchange of noncapital or business assets. Nor
- 89 did it report having engaged in a like-kind exchange or other nontaxable
transaction for which reporting is required.
Where, then, did the real estate go? CNT's December 1 return provides a
plausible answer. That return reports that CCFH transferred $523,377 of property
to CNT in exchange for a 15.4% interest in CNT, and that CNT terminated on
December 1, 1999, after distributing $522,761, a near-equal amount of property, to
CCFH. Looking again to CCFH's 1999 tax return, the attached 351 statement
discloses that one or more existing CCFH shareholders transferred an 84.6%
interest in CNT to CCFH on or after December 1, 1999 From these two returns
one can reasonably discern that CNT's December 1 termination occurred pursuant
to section 708(b)(1)(B); that CNT made only deemed, not actual, distributions to
CCFH and its other interest holders; that CNT continued to hold the assets CCFH
contributed to it; and that it became a disregarded entity wholly owned by CCFH
when CCFH's shareholders contributed their CNT interests to CCFH. All of the
foregoing suggests that CCFH contributed the real estate to CNT, thereby
converting its real estate assets to a non-real-estate asset without a taxable event.
New CNT's December 31 return completes the picture. The December 1
return coupled with the 351 statement revealed that CCFH became CNT's sole
owner on December 1, 1999. On the appended Schedules K-1, the December 31
- 90 return identifies as New CNT's partners the same individuals identified as CCFH's
shareholders on the Schedules K-1 appended to CCFH's 1999 return. The
individuals' percentage interests in the two entities are identical. These details
indicate that CCFH must have distributed interests in CNT, and indirectly its
former real estate holdings, to its shareholders on December 31, 1999. Hence,
CCFH and CNT's returns, which constitute part of Mr. Carroll's return for present
purposes, provided a sufficient clue that an S corporation had distributed real
estate to its shareholders.
But one crucial piece of the puzzle remains missing. Section 311(b)
requires that a corporation recognize gain on a distribution of appreciated property
to its shareholders as if it had instead sold the property for fair market value; if the
property has not appreciated, no gain is recognized. The parties have stipulated
that the aggregate fair market value of the five mortuary properties as of December
1999 was $4,020,000. That number appears nowhere in the various tax returns.
Indeed, the returns nowhere disclose a fair market value for the real estate that
would enable a reasonable revenue agent to discern that the real estate had
appreciated, such that section 311(b) gain should have been reported.
CCFH's return reports only the real estate's book value together with that of
other depreciable assets, not its fair market value. Schedule L of CNT's
- 91 December 1 return lists no book values for the assets purportedly contributed to
CNT (which would include the short positions and offsetting obligations
purportedly contributed by the Carrolls in addition to the real estate), or for any
other assets. Schedule M-2, Analysis of Partners' Capital Accounts, identifies the
contributed property's book value, which would ordinarily equal its fair market
value on the date of contribution, sm sec. 1.704-1(b)(2)(iv)(d)(1), Income Tax
Regs., as $3,400,718. New CNT's December 31 return lists buildings and other
depreciable assets (but no land) with a book value of $3,350,000 and capital
contributions with an equal book value.
The returns making up Mr. Carroll's return for section 6501(e)(1)(A)(ii)
purposes contain no clue that the fair market value of the property CCFH
distributed to its shareholders was $4,020,000, or in any event, some amount
greater than its tax basis. The returns disclose no shred of information that would
alert the occupant of 221B Baker Street, let alone a reasonable revenue agent, to
the facts that--basis overstatement notwithstanding--CCFH had omitted section
311(b) gain from its return and its shareholders had omitted section 1366(a)(1)
passthrough gain from theirs.
Our caselaw is consistent with this conclusion. In Estate of Fry v.
Commissioner, 88 T.C. at 1023, for example, we found a corporation's disclosure
- 92 on its tax return of a $150,000 payment to be inadequate for purposes of section
6501(e)(1)(A)(ii) because the return "failed to show that the transaction was a
redemption; i.e., a payment to a shareholder or that the payment was in fact a
transfer of real property valued at $150,000". The returns under scrutiny here
present the converse problem: They disclose that a transfer of real property
occurred, but not the real property's value.
In Univ. Country Club, Inc. v. Commissioner, 64 T.C. at 470, we found
adequate disclosure where the taxpayer fully reported a transaction consistently
with the taxpayer's desired tax characterization, but the Commissioner later
recharacterized the transaction. Here, in contrast, the Carrolls and their business
entities did not fully report their transactions consistently with their desired tax
characterization because, as we have explained, their transactions as reported
should have resulted in $623,284 of recognized gain. Finally, in Quick Trust v.
Commissioner, 54 T.C. at 1347, the Commissioner determined additional gross
receipts for a partnership and argued that a partner had omitted them from income.
We found adequate disclosure of the omitted income in the partnership's reporting
of distributions to the partner far greater than the amount reported on the partner's
return. Id. Here, however, no amount reported on any of the various tax returns
- 93 hints at the source of the omitted item, the discrepancy between the real estate's
tax basis and its fair market value.
For the foregoing reasons, Mr. and Mrs. Carroll may not claim the safe
harbor of section 6501(e)(1)(A)(ii).
G.
Conclusion
We hold that the period for assessment for the 1999 tax year had expired
with respect to Ms. Cadman and Ms. Craig before respondent issued the FPAA.
They are not parties to this proceeding and will not be affected or bound by any
readjustments determined herein. See secs. 6226(c), (d)(1)(B), 6228(a)(4)(B). We
further hold that the six-year limitations period of section 6501(e)(1)(A) applies to
Mr. and Mrs. Carroll for the 1999 tax year, and that this limitations period
remained open when respondent issued the FPAA.
III.
Consequences of the Sham Stipulation
Because petitioner's statute of limitations arguments obliged us to consider
the merits of some of respondent's determinations in the FPAA, we need only
briefly discuss the second issue before us, whether the adjustments in the FPAA
should be sustained. Petitioner conceded respondent's sham entity theory for
determining the adjustments in the FPAA. At trial the parties essentially ignored
the merits issues, concentrating instead on the statute of limitations and penalties,
- 94 but on brief, respondent asserts that petitioner should be deemed to have conceded
all theories raised in the FPAA because respondent's determinations enjoy a
presumption of correctness. Petitioner claims that his concession mooted
respondent's other theories and rendered litigation of them unnecessary.
Petitioner's concession and our holdings herein more than suffice to sustain
the FPAA adjustments, and we decline to analyze respondent's other theories
unnecessarily. We conclude that the FPAA adjustments to CNT's December 1
return should be sustained considering the parties' stipulation that CNT was a
sham and our conclusions above concerning the sham and step transaction
doctrines' applicability.46
46In the FPAA respondent reduced to zero CNT's reported capital
contributions, distributions, and outside partnership basis. We sustain these
adjustments principally on the basis of the parties' stipulation that CNT was a
sham partnership. Because CNT was not, for tax purposes, a partnership, it could
neither receive contributions nor make distributions for purposes of subchapter K
of the Code, and its partners' having outside bases greater than zero was a "legal
impossibility". See Woods, 571 U.S. at ___, 134 S. Ct. at 565 n.2.
Respondent also disallowed CNT's reported $2,268 of short-term capital
loss and $1,734 of interest expense, both of which were incurred in connection
with the Son-of-BOSS transaction. We sustain these adjustments because the
short sale transaction was structured to assure it would have few or no economic
consequences. It was, as we concluded above, an economic sham, so its direct tax
consequences--the short-term capital loss and the interest expense--are properly
disregarded. Disallowance of deductions for these passthrough items would
ordinarily affect the Carrolls' bottom-line income in two ways: (1) directly,
through elimination of their distributive share of CNT's reported interest expense
(continued...)
- 95 IV.
Liability for the Accuracy-Related Penalty
In the FPAA respondent determined that all underpayments of tax resulting
from his adjustments of CNT's partnership items were attributable, in the
alternative, to (1) gross (or if not gross, substantial) valuation misstatement(s), (2)
substantial understatements of income tax, or (3) negligence or disregard of rules
and regulations. Hence, respondent determined that either a 40% penalty or a 20%
penalty would apply to any underpayment. See sec. 6662(a), (b)(1)-(3), (c)-(e),
(h).
The Commissioner bears the burden of production and "must come forward
with sufficient evidence indicating that it is appropriate to impose the relevant
penalty." Sec. 7491(c); see Higbee v. Commissioner, 116 T.C. 438, 446 (2001).
Once the Commissioner has met his burden of production, the burden shifts to the
*(...continued)
($1,385) and short-term capital loss ($1,811), and (2) indirectly, through
elimination of their distributive share of CCFH's distributive share of CNT's
reported interest expense ($267) and short-term capital loss ($349). However,
although CNT issued a Schedule K-1 to CCFH that reflected its distributive shares
of these passthrough items, CCFH did not report the items on its 1999 return, and
the Schedules K-1 CCFH issued to its shareholders reflect no interest expense or
short-term capital loss. Because CCFH apparently did not reduce its income by
the amount of its $616 passthrough loss from CNT attributable to the short-term
capital loss and the interest expense, disallowance of these underlying tax items
will have no indirect effect via CCFH on the Carrolls' income.
- 96 taxpayer to prove an affirmative defense or that he or she is otherwise not liable
for the penalty. Higbee v. Commissioner, 116 T.C. at 446-447.
A.
Penalties' Applicability
Section 6662(a) and (b)(3) provides for imposition of a 20% penalty on the
portion of an underpayment of tax required to be shown on a return that is
attributable to a substantial valuation misstatement. For returns filed on or before
August 16, 2006, as is relevant here, a substantial valuation misstatement occurs
when "the value of any property (or the adjusted basis of any property) claimed on
any return of tax imposed by chapter 1 is 200 percent or more of the amount
determined to be the correct amount of such valuation or adjusted basis (as the
case may be)". Sec. 6662(e)(1)(A). Section 6662(h) increases this penalty to 40%
if the value or adjusted basis claimed on the return is 400% or more of the actual
value or adjusted basis. A regulation clarifies that when the actual value or basis
is zero, any claimed value is considered 400% or more of the correct amount. Sec.
1.6662-5(g), Income Tax Regs.47
47Petitioner objects to the application of this regulation as inconsistent with
precedent of the Ninth Circuit, to which he maintains this case is appealable. As
we have explained, however, the Supreme Court's decision in Woods abrogates
that precedent.
- 97 In the FPAA respondent adjusted to zero several items on CNT's December
1 return, including partnership outside basis. We have sustained those
adjustments in their entirety.48 Consequently, for each of these items, the reported
value exceeded the correct value by 400% or more. Respondent has satisfied his
burden of production with respect to the gross and substantial valuation
misstatement penalties, and petitioner does not question respondent's
computations. Because we find the 40% gross valuation misstatement penalty
applicable to any underpayment resulting from respondent's adjustments, we need
not address the substantial understatement and negligence penalties. See sec.
1.6662-2(c), Income Tax Regs. (explaining that if a portion of an underpayment of
tax is attributable to more than one type of misconduct described in section 6662,
the applicable penalty is the highest percentage penalty triggered by the relevant
types of misconduct).
B. .
Petitioner's Defense
A section 6662 penalty will not apply to any portion of an underpayment
resulting from positions taken on the taxpayer's return for which the taxpayer had
48Because the parties have stipulated that CNT is a sham entity, we
disregard even CCFH's purported contribution of the real estate to CNT, so the
value of CCFH's capital contribution and its outside basis in its CNT interest are
both properly zero. CCFH simply retained its original basis in the real estate until
it distributed that real estate to its shareholders on December 31, 1999.
- 98
reasonable cause and with respect to which the taxpayer acted in good faith. See
sec. 6664(c). Petitioner claims reasonable cause and good faith on the basis of his
reasonable reliance on the advice of Messrs. Myers and Crowley.
Partner-level defenses, including reasonable cause and good faith, may not
be asserted in a partnership-level TEFRA proceeding such as this one. See New
Millennium Trading, LLC v. Commissioner, 131 T.C. 275, 288-289 (2008)
(upholding temporary regulation as "a valid interpretation of the statutory
scheme"); sec. 301.6221-1T(d), Temporary Proced. & Admin. Regs., 64 Fed. Reg.
3838 (Jan. 26, 1999). But when the reasonable cause defense rests on the
partnership's actions, we may entertain the defense at the partnership level,
"taking into account the state of mind of the general partner," Superior Trading,
LLC v. Commissioner, 137 T.C. at 91 (citing New Millennium Trading, LLC v.
Commissioner, 131 T.C. 275), in this case, Mr. Carroll.49
We determine "whether a taxpayer acted with reasonable cause and in good
faith * * * on a case-by-case basis, taking into account all pertinent facts and
49Mr. Carroll did not testify at trial; 1 s. Craig and Ms. Cadman did. We
decline petitioner's implicit invitation, on brief, to consider the Carrolls' collective
good faith and reliance in determining whether he has satisfied his burden of proof
as to the sec. 6664(c) defense. We will instead give Ms. Cadman's and Ms.
Craig's testimony its proper weight and consider it, along with other testimony
and evidence in the record, to the extent it constitutes circumstantial evidence of
Mr. Carroll's state of mind.
- 99 circumstances", sec. 1.6664-4(b)(1), Income Tax Regs., including "[t]he
taxpayer's mental and physical condition, as well as sophistication with respect to
the tax laws, at the time the return was filed", Kees v. Commissioner, T.C. Memo.
1999-41, 77 T.C.M. (CCH) 1374, 1378 (1999); accord Ruckman v. Commissioner,
T.C. Memo. 1998-83, 75 T.C.M. (CCH) 1880, 1886 (1998); Escrow Connection,
Inc. v. Commissioner, T.C. Memo. 1997-17, 73 T.C.M. (CCH) 1705, 1714 (1997).
Reliance on professional advice will absolve the taxpayer if such reliance was
reasonable and the taxpayer acted in good faith. Sec. 1.6664-4(b)(1), Income Tax
Regs. In such a case "the taxpayer must prove by a preponderance of the evidence
that the taxpayer meets each requirement of the following three-prong test: (1)
The adviser was a competent professional who had sufficient expertise to justify
reliance, (2) the taxpayer provided necessary and accurate information to the
adviser, and (3) the taxpayer actually relied in good faith on the adviser's
judgment." Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000),
aff'd, 299 F.3d 221 (3d Cir. 2002).
We examine below whether petitioner's professed reliance upon Mr. Myers
satisfied each of these three requirements. Petitioner also contends that he relied
on Mr. Crowley's advice, but this claim plainly fails. Ms. Cadman, who joined
Mr. Carroll at the various meetings described herein, credibly testified that she
- 100 believed Mr. Crowley endorsed the transaction. But Mr. Crowley testified, and
Ms. Cadman confirmed, that Mr. Crowley had openly acknowledged that he did
not fully understand the transaction. Even if, contrary to his testimony, Mr.
Crowley endorsed the transaction and did not just tepídly agree to "go along with"
it, petitioner's reliance on that endorsement could not have been reasonable and in
good faith given Mr. Crowley's admitted confusion. Whatever constitutes
"sufficient expertise to justify reliance," se kl.at 99, we think the adviser must, at
the very least, hold himself out as possessing sufficient expertise to understand the
transaction at issue. Mr. Crowley made no such pretense here--quite the opposite,
in fact--so to the extent Mr. Carroll relied on his advice, that reliance was
unjustified and unreasonable.
1.
Sufficient Expertise?
The sufficiency of Mr. Myers' expertise poses a more difficult question.
Rather than set a specific standard, the regulations under section 6664(c) outline
certain baseline competency requirements. First, rather than mandate that the
adviser possess knowledge of relevant aspects of Federal tax law, the regulations
stipulate only that "reliance may not be reasonable or in good faith if the taxpayer
knew, or reasonably should have known, that the advisor lacked" such knowledge.
Sec. 1.6664-4(c)(1), Income Tax Regs. Second, the adviser must base his or her
- 101 advice on "all pertinent facts and circumstances and the law as it relates" to them.
I_dd, subpara. (1)(i). Third, the adviser must not himself or herself "unreasonably
rely on the representations, statements, findings, or agreements of the taxpayer or
any other person." Id, subpara. (1)(ii) (emphasis added).
In applying these general guidelines, this Court has not articulated a
uniform standard of competence that an adviser must satisfy but has instead
demanded expertise commensurate with the factual circumstances of each case.
See, e.g., 106 Ltd. v. Commissioner, 136 T.C. 67, 77 (2011) (the taxpayer's
longtime attorney and accounting firm, who "would have appeared competent to a
layman", and especially so to the taxpayer, had adequate expertise to advise on a
Son-of-BOSS-type transaction), aff'd, 684 F.3d 84 (D.C. Cir. 2012); Neonatology
Assocs., P.A. v. Commissioner, 115 T.C. at 99 (an insurance agent who was not a
tax professional lacked sufficient expertise to advise on tax implications of a
complex, group whole/term-hybrid life insurance plan); Thousand Oaks
Residential Care Home I, Inc. v. Commissioner, T.C. Memo. 2013-10, at *13, *41
(the taxpayers' longtime accountant, an enrolled agent with a master's degree in
business administration, was a competent professional with sufficient expertise to
advise on employment plan contributions); Kirman v. Commissioner, T.C. Memo.
2011-128, 101 T.C.M. (CCH) 1625, 1633 (2011) (taxpayer failed to establish that
- 102 part-time tax return preparer who held an accounting degree was a competent
professional with sufficient expertise to advise on business expense and charitable
contribution deductions).
Under the circumstances of this case, we think that Mr. Myers possessed
sufficient expertise to justify reliance by Mr. Carroll. As of 1999 Mr. Myers had
practiced law for 30 years and had represented Mr. Carroll for almost 20 of them.
Mr. Carroll had relied on Mr. Myers' advice in growing his business through
acquisitions, properly maintaining his corporation, complying with regulations,
managing his employees, and formulating his estate plan. Although Mr. Myers
did not hold himself out as a tax specialist and tended to refer clients out for
complicated tax matters, he had studied tax in law school and prepared estate tax
returns, and he had previously advised Mr. Carroll on general tax law principles.
The record reflects that Mr. Myers was Mr. Carroll's go-to attorney and trusted
counselor.
The record also reflects that Mr. Ca oll, while a successful businessman,
was not a financial sophisticate. Althougl Mr. Carroll did hold a post-high-school
degree in mortuary science, he had obtained it approximately 50 years earlier, and
the record does not reflect that he obtained any further education. To the extent
that his mortuary science college curriculum incorporated any finance, tax, or
- 103 economics material, that material would have been sorely out of date by 1999.
Indeed, Mr. Myers credibly testified that Mr. Carroll understood only basic tax
principles. According to Mr. Crowley, Mr. Carroll had never before invested in
even garden-variety mutual funds or securities, let alone participated in a short
sale transaction involving T-notes. When presented with the exotic financial
engineering proposed by Mr. Hoffman, Mr. Carroll naturally relied on Mr. Myers,
to whom he had turned in the past for all forms of legal advice, including with
regard to more general tax matters.
Mr. Myers performed due diligence. After Mr. Hoffman pitched the Son-ofBOSS transaction to him, in an effort to better understand the proposal Mr. Myers
held a conference call with Mr. Mayer. This conversation left Mr. Myers
unsatisfied with his grasp of how the transaction would work, so he requested, and
Mr. Mayer sent, a memorandum and an article from a tax publication describing
and analyzing the transaction and citing various legal authorities. Mr. Myers
reviewed Mr. Mayer's memorandum and consulted some of the legal authorities
cited therein, albeit not in extreme detail. He also researched Jenkens & Gilchrist.
During the implementation phase, he spoke by telephone with Mr. Mayer several
times.
- 104 Mr. Myers believed that he had a good grasp of how the Son-of-BOSS
transaction would work and of the legal theories behind it. Although Mr. Myers
did not know all of the details of the transaction, the record does not indicate that
he shared this fact with Mr. Carroll. Rather, Mr. Myers formed the opinion that
the transaction was "legitimate [and] proper", and he did share this opinion with
Mr. Carroll. He advised Mr. Carroll that the transaction looked like a viable way
to resolve CCFH's low basis dilemma.
We find that Mr. Carroll could justifiably rely upon that advice. To Mr.
Carroll, a tax and fmancial layperson, Mr. Myers would have appeared ideal, not
simply competent, to advise him on the feasibility and implications of the basis
boost transaction. See 106 Ltd. v. Commissioner, 136 T.C. at 77.
Respondent offers two counterarguments. First, he emphasizes that Mr.
Myers was not a "tax professional". What constitutes a "tax professional" is
debatable. Mr. Myers, for example, did provide some general tax advice to clients
and also prepared estate tax returns, although he did not prepare other income tax
returns (most attorneys do not) or specialize in dispensing tax advice. More to the
point, the regulations under section 6664(c) define "advice" as including, but not
as consisting solely of, communications of a "professional tax advisor". Our
caselaw has never restricted the reasonable reliance defense to advice from
- 105 persons bearing this moniker or any other. That caselaw prompts us to examine
the substance of Mr. Myers' expertise under the particular factual circumstances of
this case, which we have done.
Second, respondent suggests that Mr. Myers unreasonably and
impermissibly relied, himself, on representations of Mr. Mayer. The regulations
prohibit such reliance on a third party, see sec. 1.6664-4(c)(1)(ii), Income Tax
Regs., and where, as here, the third party is a promoter, reliance is doubly
forbidden, see Canal Corp. v. Commissioner, 135 T.C. 199, 218 (2010) ("Courts
have repeatedly held that it is unreasonable for a taxpayer to rely on a tax adviser
actively involved in planning the transaction and tainted by an inherent conflict of
interest."); Swanson v. Commissioner, T.C. Memo. 2009-31, 97 T.C.M. (CCH)
1127, 1129 (2009) (holding that relied-upon advice must "be from competent and
independent parties, not from the promoters of the investment"). But see Bruce v.
Commissioner, T.C. Memo. 2014-178, at *56 & n.30 (finding that where a
taxpayer retained his "longtime tax adviser" to meet with tax shelter promoters
and advise him on the proposed transaction, the taxpayer reasonably relied upon
the adviser rather than the promoters). Where the record establishes that the
adviser himself relied solely upon the promoters' opinions, the taxpayer's reliance
might not be reasonable.
- 106 We acknowledge this issue is a close one. Mr. Myers did testify to having
repeat
This text is long and has been trimmed here. Open the source document for the complete record.
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.