UNITED STATES TAX COURT

T.C. Memo. 2000-352

UNITED STATES TAX COURT

SALINA PARTNERSHIP LP, FPL GROUP, INC., A PARTNER

OTHER THAN THE TAX MATTERS PARTNER, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 25084-96.

Filed November 14, 2000.

In 1991, FPL incurred a substantial capital loss on

the sale of a subsidiary.

In December 1992, GS, an

investment bank, persuaded FPL to invest in a domestic

limited partnership, S, newly formed at GS’s request by

two affiliates of ABN, an international bank based in The

Netherlands. S, at GS’s suggestion, took a substantial

short position in U.S. Treasury bills. FPL purchased a

98-percent limited partnership interest in S to take

advantage of desired tax benefits and to enhance its

return on its short-term, fixed-income investments.

Immediately following FPL’s investment, S closed its

short position in U.S. Treasury bills.

Relying on a series of complex partnership basis

adjustment provisions, S concluded that it realized a

$344 million short-term capital gain, of which $337

million was allocated to FPL. FPL thereupon claimed a

capital loss carryover from 1991 to offset nearly all of

its distributive share of S’s capital gain.

- 2 During 1993 and most of 1994, S pursued a

sophisticated investment strategy. S was liquidated in

1994. FPL, which had increased its outside basis in its

interest in S by the $337 million gain it had reported in

1992, claimed large ordinary losses attributable to its

interest in S for the taxable years 1994 through 1997.

R

issued

a

notice

of

final

partnership

administrative adjustment to S determining that S did not

realize a $344 million short-term capital gain for the

period ended Dec. 31, 1992, on the alternative grounds

that: (1) FPL’s initial investment in S was a sham in

substance; and/or (2) S failed to properly compute its

substituted basis (from its partners) pursuant to sec.

752, I.R.C. FPL filed a timely petition for readjustment

in its capacity as a notice partner of S.

FPL’s investment in S was not a sham in

Held:

substance inasmuch as FPL invested in S in order to

achieve legitimate business objectives independent of

purported tax benefits and FPL’s investment produced

objective economic consequences.

Held, further, R’s

adjustments are sustained on the ground that S’s short

position in Treasury bills generated a partnership

“liability”, within the meaning of sec. 752, I.R.C.,

which liability S failed to account for in computing its

substituted basis (from its partners) in its assets.

Robert T. Carney and Paul S. Manning, for petitioner.

Sergio Garcia-Pages, John T. Lortie, and Gary F. Walker, for

respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

JACOBS,

Judge:

Respondent

issued

partnership

administrative

adjustment

Corporation,

N.V.,

matters

the

tax

a

notice

(FPAA)

partner

to

(TMP)

of

final

Caraville

of

Salina

Partnership, LP (hereinafter, Salina or the partnership), setting

- 3 forth adjustments to the partnership’s tax return for its taxable

year ended December 31, 1992.

Respondent subsequently mailed a

copy of the FPAA to FPL Group, Inc. (FPL or petitioner), a Salina

notice partner.

FPL, in its capacity as a partner other than the

TMP, filed a timely petition for readjustment contesting the FPAA.1

See sec. 6226(b).

The issue for decision is whether the partnership realized a

short-term capital gain of $344,234,365 for the taxable year ended

December 31, 1992.2

(The situation presented in this case is one

in which “normal” roles of the parties appear to be reversed

inasmuch as FPL is defending Salina’s reporting of the $344 million

gain against respondent’s assertion that Salina realized a shortterm capital gain of only $334,214.) Respondent’s determination is

based on alternative grounds, including arguments that:

(1) FPL’s

purchase of a 98-percent partnership interest in Salina was a sham

in substance; and (2) Salina erred in failing to apply section 752

in computing its substituted basis (from its partners) in its

assets.

1

The parties stipulated that venue for purposes of

appeal is to the U.S. Court of Appeals for the Eleventh Circuit.

See sec. 7482(b)(2).

2

The parties agree that if petitioner prevails, the

amount of the partnership’s interest income is $700,713 for the

period in question, whereas if respondent prevails, the amount of

the partnership’s interest income is $147,252.

- 4 Unless otherwise indicated, section references are to the

Internal Revenue Code in effect for 1992, and Rule references are

to the Tax Court Rules of Practice and Procedure.

All dollar

amounts are rounded.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The

stipulated facts and exhibits are incorporated herein by this

reference.

I.

FPL

FPL, the stock of which is publicly traded, is a holding

company

and

the

parent

of

various

wholly

owned

subsidiaries

including Florida Power and Light Co. (Florida Power), the largest

electric public utility in the State of Florida, and FPL Capital

Group (FPL Capital).

FPL filed consolidated returns with its

various subsidiaries during the period in question.

A.

FPL Officers

Paul Evanson assumed the position of chief financial officer

of FPL on December 7, 1992.

Prior to joining FPL, Mr. Evanson’s

professional experience included 6 years as a tax specialist at

Arthur Andersen, a large firm of certified public accountants, and

5 years as president and chief operating officer of Lynch Corp.

Prior to his employment at Arthur Andersen, Mr. Evanson was awarded

a juris doctor degree from Columbia University School of Law and an

LL.M. in taxation degree from New York University.

- 5 James Higgins, FPL’s vice president for taxes, was responsible

for all income tax planning, research, and compliance.

Dilek

Samil, FPL’s corporate treasurer, was responsible for financial

forecasting and analysis.

In addition, Ms. Samil was responsible

for managing FPL’s long-term and short-term funding needs.

FPL’s

long-term funding needs normally were satisfied by issuing debt and

equity securities, while FPL’s short-term funding needs were met

through

the

company’s

normal

cash-flow

and

the

issuance

of

commercial paper. Jeffrey Holtzman, FPL’s assistant treasurer, was

primarily

responsible

investments.

Michael

for

bank

Wynn,

relations

an

FPL

and

assessing

financial

FPL’s

analyst,

was

responsible for various cash management activities and special

projects.

B.

FPL’s Restructuring Plan/Cash-flow

In early 1991, FPL decided to restructure its operations by

selling noncore businesses and focusing on its utility businesses,

particularly Florida Power.

Between 1991 and 1999, FPL sold a

number of its subsidiary businesses including Colonial Penn Group

(CPG)--an insurance holding company, Telesat--a cable television

operation,

Alandco--a

real

estate

subsidiary,

Turner

Foods--a

citrus producer, and a separate banking business.

During

offering.

1992,

FPL

raised

cash

through

a

secondary

stock

FPL also had excess cash-flow from normal operations.

- 6 FPL usually held its short-term investments in commercial paper

with rates of return averaging 3.25 percent.

C.

FPL’s 1991 Capital Loss (Sale of CPG)

On its consolidated income tax return for 1991, FPL reported

a capital loss of $581,921,987 attributable to its sale of CPG.

FPL carried back approximately $131 million of the CPG loss to

taxable years prior to 1991. On its consolidated income tax return

for 1992, FPL claimed a loss carryover of approximately $311

million attributable to its CPG loss.

Respondent issued a notice of deficiency to FPL for, among

other years, 1991 and 1992.

Respondent determined, in pertinent

part, that FPL had understated the amount of its CPG loss subject

to disallowance pursuant to section 1.1502-20, Income Tax Regs.3

FPL filed a petition for redetermination with the Court (docket No.

5271-96)

contesting

respondent’s

determination

regarding

the

correct amount of its CPG loss and challenging the validity of

section 1.1502-20, Income Tax Regs.

II.

The Partnership Proposal

A.

Goldman Sachs & Co./STAMPS

FPL was a client of Goldman Sachs & Co. (Goldman Sachs), a

large investment bank.

3

Goldman Sachs had advised FPL with regard

Sec. 1.1502-20(a), Income Tax Regs., states the general

rule that no deduction is allowed for any loss recognized by a

member of the affiliated group with respect to the disposition of

stock of a subsidiary.

- 7 to both the purchase of CPG in 1985 and the sale of the company in

1991.

At all relevant times, David A. Ackert was a vice president

at Goldman Sachs.

In 1992, Mr. Ackert developed an investment strategy called

Special Treasury and Mortgage Partnership Units (STAMPS).

The

STAMPS strategy employed leveraged and hedged investments in shortterm U.S. Treasury securities, mortgage-backed securities, and

other arbitrage positions in fixed-income securities, in an effort

to provide a cash investment vehicle for corporate or institutional

clients seeking above-market returns.

The STAMPS strategy was designed not only as an investment

strategy,

but

considerations.

also

involved

accounting,

tax,

and

legal

Mr. Ackert concluded that it would be preferable

for corporate investors to pursue the STAMPS investment strategy

through a partnership that would allow the investor the possibility

of “off balance sheet” accounting treatment.

Mr. Ackert believed

that off balance sheet accounting treatment was essential to making

the STAMPS strategy appealing to potential investors because, to

the extent that the program required a leveraged position, the

investor’s balance sheet would reflect the net amount of its

investment without showing any related debt.

B.

BEA Associates/MAPS

In conjunction with the creation of the STAMPS investment

strategy, Mr. Ackert approached Mark Silverstein, vice president

- 8 and portfolio manager at BEA Associates (BEA), an investment

advisory and cash management firm based in New York, to inquire

whether BEA would be interested in serving as the investment

adviser and portfolio manager for potential investors in the STAMPS

strategy. Mr. Silverstein agreed to work with Mr. Ackert’s clients

on the understanding that BEA would be compensated for its services

through management fees computed as a percentage of the assets

under its direction.

BEA, recognized as a leading fixed-income portfolio manager,

utilized an investment strategy with similarities to STAMPS known

as mortgage arbitrage partners or MAPS. The MAPS strategy included

leveraged and hedged investments in U.S. Treasury securities,

asset-backed

securities,

mortgaged-backed

international and corporate bonds.

securities,

and

Though comparable in some

respects with the STAMPS strategy, the MAPS strategy contemplated

investments in a broader array of securities with maturities

(approximately 3 to 6 months) of shorter duration.

C.

Mr. Ackert’s Proposal to FPL

Mr. Ackert was aware that FPL had incurred a substantial

capital loss on its sale of CPG in 1991.

In early October 1992,

Mr. Ackert met with FPL representatives in Florida and proposed

that FPL purchase a 98-percent limited partnership interest in a

preexisting

domestic

limited

partnership

controlled

by

an

international bank for the purpose of investing in the STAMPS

- 9 strategy.

Mr. Ackert promoted the STAMPS strategy as a means to

increase the return on FPL’s short-term, fixed-income investments.

At the same time, Mr. Ackert informed FPL that it should rely upon

its own independent accounting, legal, and tax advisers regarding

the consequences of the STAMPS investment strategy.

During a

private meeting with Mr. Higgins, Mr. Ackert suggested that the

partnership’s investments could be arranged so that, upon entry

into the partnership, FPL would recognize a capital gain for

Federal income tax purposes and simultaneously create a built-in

loss in its partnership interest.

In late October 1992, Mr. Ackert introduced Mr. Silverstein to

FPL’s representatives.

Mr. Silverstein took the opportunity to

explain the MAPS investment strategy and to offer BEA’s investment

services to FPL.

In mid-November 1992, FPL representatives met

with Mr. Silverstein at BEA’s New York office.

At FPL’s request,

Mr.

analyses

Silverstein

presented

FPL

with

several

of

the

financial risks and rewards associated with the MAPS investment

strategy under a variety of economic scenarios.

Using Treasury

bills (with a then 3 percent annual rate of return) as a benchmark,

Mr. Silverstein projected that the MAPS strategy would allow FPL to

earn between 4 and 7 percent over current Treasury bill yields.

However, Mr. Silverstein cautioned that he could not guarantee a

specific return inasmuch as FPL’s investment would be subject to

market risks.

FPL’s representatives concluded that the company

- 10 could earn a higher return under the MAPS strategy relative to

historic

returns

that

it

had

earned

investing

in

short-term

commercial paper.

FPL began preparations to enter into the proposed partnership

in early December 1992.

On December 9, 1992, Mr. Silverstein

issued a memorandum to Mr. Wynn at FPL stating that he was in the

process of arranging credit with certain securities dealers and

requesting information from FPL regarding the partnership.

On

December 14, 1992, Margaret Watson, a vice president for Chemical

Bank (Chemical), forwarded a memorandum to Mr. Wynn stating that

Chemical had assigned an account number to a multi-currency master

custody

account

Partnership.

for

a

partnership

identified

as

New

Coral

Upon receipt of the memorandum, Mr. Wynn struck the

reference to New Coral Partnership, entered the name “Salina

Partnership”, and forwarded the memorandum to Mr. Silverstein at

BEA.

D.

ABN AMRO Bank, N.V.

ABN AMRO Bank, N.V. (ABN) is a large bank based in The

Netherlands with international operations.

During 1992, Jaap Van

Burg, an attorney, served as an assistant managing director at two

ABN affiliates known as ABN AMRO Trust Co., N.V. (ABN Trust) and

N.V. Fides.

In October 1992, concurrent with his discussions with FPL, Mr.

Ackert informed Mr. Van Burg that he had a client that might be

- 11 interested in pursuing the STAMPS investment strategy and inquired

whether ABN would be interested in forming a partnership for use in

connection with that strategy.

Mr. Ackert informed Mr. Van Burg

that the partnership would be most marketable to his client if the

partnership held a $350 million short position in Treasury bills.

Mr. Van Burg obtained approval for ABN to participate in the

transaction as outlined by Mr. Ackert.

III.

Salina Partnership

On July 16, 1992, and October 22, 1992, ABN formed two limited

liability companies, Caraville Corporation, N.V. (Caraville), and

Pallico

Corporation,

N.V.

(Pallico).

Caraville

initially were each capitalized with $6,001.

and

Pallico

ABN controlled

Caraville and Pallico through ABN Trust and N.V. Fides, as managing

directors, respectively (both of which were in turn owned by ABN).

As foreign entities, ABN, Caraville, and Pallico were not subject

to U.S. income tax.

Caraville owned the stock of Aldershot Corp.

On August 17,

1992, Aldershot Corp. paid a dividend of $1,928,669 to Caraville.

A.

Formation of the Partnership

On December 16, 1992, Caraville and Pallico formed Salina as

a limited partnership under the laws of the State of Delaware.

The

Salina partnership agreement stated in pertinent part that the

partnership was organized to invest in “Permitted Investments”, a

term defined as obligations of the United States and obligations of

- 12 any agency that are backed by the full faith and credit of the

United States with remaining terms to maturity of no more than 10

years, mortgaged-backed securities with a stated maturity of no

more than 7 years, and certain repurchase and reverse repurchase

contracts.

On

December

17,

1992,

Caraville

contributed

$750,000

in

exchange for a 1-percent general partnership interest in Salina,

while Pallico contributed $74,250,000 in exchange for a 99-percent

limited partnership interest.

The funds that Pallico contributed

to Salina were transferred to Pallico through a revolving credit

agreement between ABN and Escorial Corporation, N.V., an ABN

affiliate managed by ABN Trust.

Mr. Van Burg assumed that ABN also

was the source of Caraville’s contribution to Salina.

The partnership agreement stated that the partnership would

pay a quarterly management fee of $125,000 to Caraville.

B.

Salina’s Short Year December 17 Through 27, 1992

On December 17, 1992, Salina opened a custodial account with

ABN’s New York office.

On December 17, 1992, Salina purchased,

through ABN, U.S. Treasury notes with a face value of $140 million

for a price of $139,891,953 (net of $320,192 accrued interest).

The Treasury notes each bore an interest rate of 4.625 percent and

were

due

to

mature

on

November

30,

1994.

Salina

financed

approximately one-half of the purchase price of the Treasury notes

through a master repurchase agreement with Goldman Sachs (the

- 13 Salina/Goldman

Sachs

master

repurchase

agreement)

under

which

Salina borrowed $70,087,500 from Goldman Sachs and collateralized

the loan with a portion of the Treasury notes it had purchased.4

Salina treated the Goldman Sachs loan as a liability on its opening

balance sheet as of December 28, 1992.

On December 17, 1992 (consistent with Mr. Ackert’s earlier

request to Mr. Van Burg), Salina entered into a short sale of U.S.

Treasury bills with a face value of $350 million for a price of

$344,066,593.5

The Treasury bills were due to mature on June 17,

4

Repurchase agreements (repos) and reverse repurchase

agreements (reverse repos) are frequently used by dealers in

government securities, financial institutions, and others as

methods for temporary cash management, interest rate arbitrage,

or the borrowing of securities used in the course of a dealer’s

business. In a repo transaction, the first party (e.g., a

dealer) sells securities (generally U.S. Treasury and Federal

agency securities) to a second party (e.g., a customer) and

simultaneously agrees to repurchase a like amount of the same

securities at a stated price (generally greater than the original

sales price) on a fixed, future date. Repo transactions, from

the viewpoint of the seller (such as a dealer), provide financing

to acquire newly issued government securities or other portfolio

assets; from the viewpoint of the purchaser, a repo transaction

provides a means by which funds can be invested for a desired

period while holding as collateral a virtually risk-free asset in

the event the seller breaches its agreement to repurchase. See

Price v. Commissioner, 88 T.C. 860, 864 n.9 (1987)

5

One commentator has described a short sale as follows:

More completely, a short sale may be defined as

consisting of two transactions: (1) the taxpayer’s

sale of property (typically, securities) borrowed from

another person (typically, a broker), and (2) the

subsequent closing out of the short position by the

taxpayer’s delivery of securities to the person who

loaned the securities that were sold.

(continued...)

- 14 1993.

Salina completed the short sale transaction described above

to the extent of $175 million executed through Goldman Sachs and

$175 million executed through ABN.

To complete delivery of the

Treasury bills, Salina entered into a master repurchase agreement

with ABN (the Salina/ABN master repurchase agreement) under which

Salina lent $343,875,000 to ABN, and ABN collateralized the loan

with the Treasury bills that Salina sold short. Salina treated the

amount it was due from ABN under the Salina/ABN master repurchase

agreement ($343,875,000) and accrued interest thereon ($278,921) as

assets on its opening balance sheet.

Salina treated the amount of

5

(...continued)

In the absence of statutory guidance, the

treatment of * * * [short sale] transactions would be

unclear because the first transaction is in form a sale

but gain or loss cannot be computed because the

taxpayer’s cost for the securities is unknown, whereas

the second transaction is in form the repayment of a

loan. [Fn. ref. omitted.]

2 Bittker & Lokken, Federal Taxation Of Income, Estates And

Gifts, par. 54.3.1, at 54-21 (2d ed. 1990).

The strategy of a short sale is that by the time the

security is covered, the seller will have acquired the security

by purchasing it on the open market at a price lower than that

for which it was sold, thereby making a profit. Another way to

cover a short position is to use the security obtained in a

reverse repo transaction. Reverse repo transactions are the

mirror images of repo transactions–-securities are purchased by

the first party subject to the obligation of the second party to

repurchase them. Notwithstanding the first party’s obligation to

sell (in a reverse repo transaction) a like amount of the same

securities back to the second party, the first party generally is

entitled to use the securities in transactions with third

parties. See Price v. Commissioner, supra at 864-865 nn. 9, 11.

- 15 the Treasury bills that it sold short ($344,447,250) as a liability

on its opening balance sheet.

For the period December 17 through 27, 1992, Salina earned

$398,292 on its investments for an annualized return of 17.62

percent.

C.

FPL’s Investment in Salina

On December 14, 1992, Mr. Evanson obtained authorization from

FPL’s board of directors to invest in the Salina partnership.

The

minutes of the December 14, 1992, board of directors’ meeting state

in pertinent part:

[The Chairman] reported that the officers of the

Corporation were considering investing approximately $75

million of the funds raised from the sale of common stock

in 1992 for future capital requirements in an investment

partnership. These funds were not needed immediately and

were currently invested in short-term securities yielding

a little more than 3% per annum.

Investing in the

partnership would increase the return on the funds

substantially and still keep them available for capital

expenditures as needed.

In addition, the partnership

could engage in certain transactions that could utilize

certain of the tax losses from the sale of Colonial Penn.

Mr. Evanson then explained the proposed investment

activities of the partnership.

FPL conditioned its participation in the partnership upon

Salina’s

agreements

to:

(1)

Appoint

Mr.

Silverstein

as

its

investment manager, and (2) liquidate its investments by December

30, 1992.

Salina agreed to FPL’s conditions.

On December 28,

1992, Salina executed a “Financial Advisory Agreement” appointing

- 16 BEA

to

serve

as

its

financial

adviser

“with

respect

to

all

securities and property with an initial value of $75,398,292.47"

held by Chemical Bank.

On December 28, 1992, Caraville, Pallico, and FPL executed an

amended partnership agreement that included an expanded list of

permitted investments.

The partnership agreed to pay quarterly

management fees to Caraville (totaling $750,000) during 1993 and

1994.

The partnership agreement states that the partnership would

be obliged to redeem FPL’s partnership interest or dissolve and

liquidate at FPL’s request.

On December 28, 1992, Goldman Sachs issued a letter to FPL

stating that FPL did not rely upon Goldman Sachs for advice or

information relating to the financial, legal, tax, accounting, or

other matters in connection with FPL’s investment in Salina.

On December 28, 1992, FPL transferred $76,540,327 to Pallico

in exchange for a 98-percent limited partnership interest in

Salina.

FPL treated $73,890,327 of its $76,540,327 payment to

Pallico as capital invested in the partnership.

The $73,890,327

includes $390,327 representing Pallico’s share of Salina’s net

partnership gain during the period December 17 to 27, 1992.

Pallico retained $50,000 of the $76,540,327 payment that it

received from FPL.

Pallico transferred $73,890,327 to ABN–-the

same amount that FPL treated as its capital contribution to Salina-in partial repayment of the loan that ABN provided to Pallico in

- 17 connection with the formation of Salina. In addition, Pallico made

the following payments on behalf of FPL:

Payee

Amount

Andrews & Kurth, LLP

ABN AMRO Bank

Goldman Sachs

$350,000

1,000,000

1,250,000

Purpose

Legal fees

Fees

Brokerage fees

Ms. Samil recalled negotiating the $1,250,000 fee paid to

Goldman Sachs. None of FPL’s representatives specifically recalled

negotiating the fees paid to Andrews & Kurth, LLP, or ABN.

The $1

million amount paid to ABN represented ABN’s fee for forming the

Salina partnership, arranging the partnership’s investments to

satisfy

FPL’s

tax

planning

objectives,

and

allowing

ABN’s

affiliates to remain in the partnership so that FPL could pursue

its short-term investment objectives.

FPL did not deduct the fees that it paid to ABN, Goldman

Sachs, and Andrews & Kurth, LLP on its 1992 tax return, nor did it

include the amount of these fees in its Salina capital account.

The parties agree that FPL’s adjusted basis in Salina as of

December 28, 1992, should be increased by the amount of these fees.

D.

Liquidation of Salina’s Original Investments

On December 28, 1992, Mr. Silverstein recommended that Salina

liquidate its existing investments so that Mr. Silverstein could

reinvest the proceeds pursuant to the MAPS investment strategy. On

the same day, Salina provided BEA with written authorization to

liquidate its investments.

On December 30, 1992, Mr. Silverstein

- 18 closed Salina’s short position in Treasury bills by directing the

purchase of Treasury bills with a face value of $350 million for a

price of $344,675,333.

On December 31, 1992, Mr. Silverstein sold

Salina’s long position in Treasury notes for $140,408,750 and

repaid Goldman Sachs approximately $70 million representing the

amount borrowed under the Salina/Goldman Sachs repo agreement. The

proceeds of these transactions were held in bank deposits pending

Mr. Silverstein’s reinvestment of those amounts under the MAPS

strategy after January 1, 1993.

For financial reporting purposes,

Salina realized a book gain of $334,214 for the period December 17

through 31, 1992.

E.

Salina’s Investments (January 1993 - November 1994)

After

Salina’s

January

1,

investments

1993,

Mr.

pursuant

to

Silverstein

the

MAPS

actively

managed

strategy.

Mr.

Silverstein executed approximately 2,000 trades on behalf of Salina

between January 1, 1993, and November 30, 1994, earning management

fees of approximately $1,500,000 in the process.

During the period January 1993 to November 1994, BEA prepared

monthly transaction and performance summaries detailing all of

Salina’s transactions for the particular month.

In addition, Mr.

Silverstein routinely communicated with Salina’s partners in order

to apprise them of market developments and BEA’s strategy.

Salina conducted regular partnership meetings attended by

representatives of FPL, Caraville, and Pallico. At Salina’s August

- 19 26, 1993 partnership meeting, the partners decided to direct BEA to

decrease the leverage in Salina’s portfolio in order to reduce the

partnership’s level of risk.

During 1993, Salina earned a gross return of approximately 10

percent

under

the

MAPS

strategy.

After

paying

BEA’s

fee,

Caraville’s management fee, and other partnership fees, Salina’s

net return was approximately 8 percent.

During 1994, the MAPS strategy was hindered by rising interest

rates.

During

1994,

Salina

had

no

earnings

under

the

MAPS

strategy.

F.

Salina’s Termination and Liquidation

On November 22, 1994, FPL requested that Caraville liquidate

Salina.

Accordingly, on November 30, 1994, Salina was liquidated,

and its assets were distributed to its partners.

FPL received a

total distribution of $79,888,748, consisting of $63,175,099 in

cash and $16,713,749 in mortgage-backed securities.

The record

does not reflect the specific amounts distributed to Caraville and

Pallico or the ultimate disposition of those distributions.

IV.

Tax Reporting

A.

Salina’s Partnership Returns

In July 1993, Salina filed a U.S. Partnership Income Tax

Return (Form 1065) for the short tax year December 17 to December

27, 1992, reporting investment income of $467,110, investment

expenses of $327,812, and unrealized trading profits of $314,526.

- 20 In July 1993, Salina filed a Form 1065 for the short tax year

December 28 to December 31, 1992, reporting portfolio income of

$700,713, investment expenses of $19,469, and a net short-term

capital gain of $344,234,365.

On Schedule K-1, Partner’s Share of

Income, Credits, Deductions, Etc., attached to the return, Salina

allocated $337,343,455 of its short-term capital gain to FPL.

Salina concluded that it realized a $344,234,365 net shortterm capital gain following the December 30, 1992, liquidation of

its investments based upon a complex set of partnership basis

adjustment rules that were purportedly invoked upon FPL’s purchase

of its 98-percent Salina partnership interest.

In particular,

relying on sections 708(b)(1)(B) and 732(b), and section 1.7081(b)(1)(iv), Income Tax Regs., Salina concluded that upon FPL’s

acquisition of its 98-percent partnership interest on December 28,

1992,

(1)

the

partnership

was

deemed

terminated,

(2)

the

partnership’s assets (consisting of $140 million in 2-year Treasury

notes and a $344,575,000 loan receivable due from ABN pursuant to

the Salina/ABN master repurchase agreement) were deemed distributed

in pro rata shares to the new Salina partners, and (3) those assets

were deemed recontributed to the partnership with a substituted

basis equal to the aggregate of the partners’ outside bases.

Relying on the aforementioned statutory and regulatory provisions,

Salina determined that its substituted basis (from its partners) in

its assets was less than the fair market value of the assets in the

- 21 hands of the partnership.

Upon liquidation of its investments on

December 30, 1992, Salina concluded that it realized a $337,343,455

short-term

capital

gain,

representing

the

difference

between

Salina’s purported substituted basis in its assets and their fair

market value.

Salina

$6,177,300.

filed

a

Form

1065

for

1993

reporting

income

of

FPL’s distributive share of Salina’s 1993 net income

was $6,053,754.

Salina filed a Form 1065 for 1994 reporting a loss

of $12,163.

B.

FPL’s 1992 Income Tax Return

On its original 1992 consolidated income tax return, FPL

reported

a

$337,343,455

capital

gain

attributable

to

its

distributive share of the capital gain that Salina purportedly

realized upon the liquidation of its investments on December 30,

1992.

FPL offset a substantial portion of the aforementioned

capital gain by reporting a loss carryover attributable to its 1991

sale of CPG. After accounting for the loss carryover, FPL reported

and paid additional income tax of $5,904,046 (attributable to its

Salina investment) on its 1992 income tax return.

In May 1993, FPL filed an amended return for 1992 reporting an

increase in the amount of its CPG loss available for carryover from

1991 and claiming a refund of $5,904,046.

FPL claimed that it was

entitled to a greater loss carryover from 1991 on the ground that

- 22 the loss disallowance rules prescribed in section 1.1502-20, Income

Tax Regs., are invalid.

After reporting $337,343,455 as its distributive share of

Salina’s net short-term capital gain for the period December 28

through 31, 1992, FPL added that amount to its original capital

investment in Salina ($73,890,327) to arrive at a total outside

basis in the partnership of $411,804,596.

FPL later adjusted its

basis to account for its distributive share of Salina’s items of

income and expense for the taxable years 1993 and 1994, as well as

the value of the cash and mortgaged-backed securities that Salina

distributed to FPL in liquidation of its interest in November 1994.

As of November 30, 1994, FPL claimed an adjusted tax basis in

Salina of $339,631,665, which it allocated to the mortgage-backed

securities.

As FPL received payments on the mortgage-backed

securities during 1994, 1995, 1996, and 1997, FPL reported ordinary

losses (determined by computing the excess of its basis in those

assets over the amount realized) in the amounts of $1,101,833,

$14,107,759, $212,280,777, and $112,000,000, respectively.

V.

FPAA

As previously stated, respondent issued an FPAA setting forth

adjustments to Salina’s partnership return for the period ending

December 31, 1992.

Relying on alternative theories, respondent

disallowed $343,900,151 of the $344,234,365 net short-term capital

gain that Salina reported for the taxable year ending December 31,

- 23 1992, leaving a corrected net short-term capital gain of $334,214.

Petitioner filed a timely petition for readjustment contesting the

FPAA.

OPINION

Salina computed its short-term capital gain for its taxable

year ended December 31, 1992, pursuant to a complex set of tax

basis adjustment provisions contained in subchapter K, Partners and

Partnerships, of subtitle A of the Internal Revenue Code (the

Code).

We begin our analysis with a review of the statutory

provisions in question.

Pursuant to sections 701 and 702, a partnership is treated as

a flow-through entity for purposes of Federal income taxation. See

United States v. Basye, 410 U.S. 441, 448 (1973); Brannen v.

Commissioner, 722 F.2d 695, 703-704 (11th Cir. 1984), affg. 78 T.C.

471 (1982).

As such, a partnership’s items of income, gain, loss,

deduction, and credit pass through the entity to its individual

partners.

Consequently, although respondent adjusted Salina’s

partnership return by substantially reducing the amount of the net

short-term capital gain reported for the period ended December 31,

1992, the ultimate impact of this adjustment is to substantially

reduce FPL’s distributive share of the gain, which in turn nearly

eliminates the ordinary losses that FPL reported on its tax returns

for 1994, 1995, 1996, and 1997.

- 24 Section

partnership’s

706(c)(1)

taxable

provides

year

the

shall

not

general

close

rule

upon

the

that

a

sale

or

exchange of a partner’s interest in the partnership except, among

other events, in the case of a termination of the partnership.

Section

708(b)(1)(B)

provides

that

a

partnership

shall

be

considered terminated if, within a 12-month period, there is a sale

or exchange of 50 percent or more of the total interest in the

partnership’s capital and profits.

See P.D.B. Sports, Ltd. v.

Commissioner, 109 T.C. 423, 431-432 (1997).

Relying upon section

708(b)(1)(B), Salina concluded that FPL’s purchase of a 98-percent

partnership

interest

caused

a

technical

termination

of

the

partnership on December 27, 1992.

The regulations underlying section 708 provide special rules

governing the deemed distribution of partnership assets in the

event of a partnership termination.

Specifically, section 1.708-

1(b)(1)(iv), Income Tax Regs., provides in pertinent part:

(iv) If a partnership is terminated by a sale or

exchange of an interest, the following is deemed to

occur: The partnership distributes its properties to the

purchaser and the other remaining partners in proportion

to their respective interests in the partnership

properties; and, immediately thereafter, the purchaser

and the other remaining partners contribute the

properties to a new partnership, either for the

continuation of the business or for its dissolution and

winding up.

Following

a

deemed

distribution

pursuant

to

section

1(b)(1)(iv), Income Tax Regs., section 732(b) provides:

1.708-

- 25 SEC. 732(b).

Distributions in Liquidation.--

The basis of property (other than money) 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 reduced by any money distributed in the same

transaction.

Pursuant to sections 732 and 723, upon the recontribution of the

property back to the partnership, the partnership’s substituted

basis in the property is equal to the adjusted basis of the

property in the hands of the contributing partner.

Based upon these provisions, Salina concluded that its assets

were deemed distributed to FPL, Caraville, and Pallico, and,

immediately thereafter, deemed recontributed to the partnership

with bases equal to the partners’ outside bases in the partnership.

Respondent determined that Salina is not entitled to rely upon the

provisions outlined above, citing several alternative grounds.

1.

Economic Substance

Respondent first contends that FPL’s investment in Salina

during

the

period

December

28

through

31,

1992,

should

disregarded for tax purposes as a sham in substance.

be

In so

arguing, respondent asserts that the Court should segregate FPL’s

investment in Salina into two parts:

(1) FPL’s investment in

Salina during the period December 28 through 31, 1992, and (2)

FPL’s investment in Salina during the period January 1, 1993,

through the dissolution and liquidation of the partnership in

November 1994.

Although respondent concedes that FPL had a valid

- 26 business purpose for investing in Salina during the latter period,

respondent contends that FPL’s entry into the partnership was

structured solely to provide the company with a perceived tax

benefit.

Respondent argues in pertinent part:

In effect, there were two partnerships as a matter

of economic substance. The first partnership’s destiny

was to accomplish a specific tax purpose in its

predetermined life span of 48 hours. This partnership is

an economic sham. In contrast, the second partnership

had the legitimate role of implementing Mr. Silverstein’s

investment strategy commencing on January 1, 1993. The

economic substance of this partnership is not disputed.

Respondent contends that Goldman Sachs, fully aware that FPL

had incurred a large capital loss on the sale of CPG, arranged for

ABN to form Salina and orchestrated Salina’s $350 million short

position in Treasury bills so that, following FPL’s investment in

the partnership and the immediate liquidation of the partnership’s

investments, Salina would realize a substantial (paper) capital

gain.

Continuing, respondent maintains that FPL would be able to

use its CPG capital loss carryover to offset its distributive share

of

the

Salina

capital

gain

while

simultaneously

creating

an

equivalent built-in loss in its Salina partnership interest-–a loss

that FPL would be able to realize at will through its control of

Salina.

In this regard, respondent maintains that FPL improperly

used its investment in Salina to avoid the 5-year limitation on the

use of loss carryovers set forth in section 1212(a).

Respondent argues that FPL’s investment in Salina during the

initial investment period lacked economic substance because FPL had

- 27 no intention to profit from Salina’s investments under the STAMPS

strategy inasmuch as FPL always intended for those investments to

be immediately liquidated and reinvested under the MAPS strategy.

Respondent further asserts

significant

negotiations

that (1) there is no evidence of

between

FPL

and

ABN

prior

to

FPL’s

investment in Salina, and (2) the $2.25 million in fees paid to

Goldman Sachs and ABN are nothing more than fees for the perceived

tax benefits underlying the transaction.

Petitioner counters by claiming that Salina was formed and

operated as a legitimate investment partnership and that FPL

invested in Salina solely to enhance the returns on its short-term

investments. Petitioner maintains that, although FPL understood

that Salina would realize a substantial capital gain upon the

liquidation of its investments in late 1992, FPL viewed any such

transaction as tax neutral insofar as FPL had a large capital loss

carryover (the CPG loss) to offset any gain.

It is well settled that taxpayers generally are free to

structure their business transactions as they please, even if

motivated

by

tax

avoidance

considerations.

See

Gregory

v.

Helvering, 293 U.S. 465, 469 (1935); Rice’s Toyota World, Inc. v.

Commissioner, 81 T.C. 184, 196 (1983), affd. in part, revd. in

part, and remanded 752 F.2d 89 (4th Cir. 1985).

However, to be

accorded recognition for tax purposes, a transaction generally is

expected

to

have

“economic

substance

which

is

compelled

or

- 28 encouraged by business or regulatory realities, is imbued with taxindependent considerations, and is not shaped solely by taxavoidance features that have meaningless labels attached”.

Frank

Lyon Co. v. United States, 435 U.S. 561, 583-584 (1978); see WinnDixie Stores, Inc. v. Commissioner, 113 T.C. 254, 278 (1999).

This

principle, which finds its origin in Gregory v. Helvering, supra,

is better known as the “economic substance doctrine”.

“A sham transaction is one which, though it may be proper in

form,

lacks

benefits.”

economic

substance

beyond

the

creation

of

tax

Karr v. Commissioner, 924 F.2d 1018, 1022-1023 (11th

Cir. 1991), affg. Smith v. Commissioner, 93 T.C. 378 (1989).

An

evaluation whether a transaction is a substantive sham generally

requires: (1) A subjective inquiry whether the transaction was

carried out

for

a

valid

business

purpose

independent

of

tax

benefits, and (2) a review of the objective economic effect of the

transaction.

See Karr v. Commissioner, supra at 1023; Kirchman v.

Commissioner, 862 F.2d 1486, 1490-1491 (11th Cir. 1989), affg.

Glass

v.

Commissioner,

87

T.C.

1087

(1986);

see

also

ACM

Partnership v. Commissioner, 157 F.3d 231, 247-248 (3d Cir. 1998),

affg. in part and revg. in part on another ground T.C. Memo. 1997115; Casebeer v. Commissioner, 909 F.2d 1360, 1363 (9th Cir. 1990),

affg. in part, revg. and remanding in part on another ground Larsen

v. Commissioner, 89 T.C. 1229 (1987), affg. T.C. Memo. 1987-628,

affg. Sturm v. Commissioner, T.C. Memo. 1987-625, and affg. Moore

- 29 v. Commissioner, T.C. Memo. 1987-626; Rose v. Commissioner, 868

F.2d 851, 853-854 (6th Cir. 1989), affg. 88 T.C. 386 (1987).

Only

after we conclude that a transaction is not an economic sham do we

review the tax consequences of the transaction under the Code.

See

ACM Partnership v. Commissioner, T.C. Memo. 1997-115, affd. in part

and revd. in part on another ground 157 F.3d 231 (3d Cir. 1998).

A taxpayer may establish that a transaction was entered into

for a valid business purpose if the transaction is “rationally

related to a useful nontax purpose that is plausible in light of

the taxpayer’s conduct and * * * economic situation.” Compaq

Computer Corp. & Subs. v. Commissioner, 113 T.C. 214, 224 (1999)

(citing ACM Partnership v. Commissioner, supra); see Kirchman v.

Commissioner, supra at 1490-1491.

transaction

has

objective

A taxpayer may establish that a

economic

consequences

where

the

transaction appreciably affects the taxpayer’s beneficial interest.

See Knetsch v. United States, 364 U.S. 361, 366 (1960) (quoting

Gilbert v. Commissioner, 248 F.2d 399, 411 (2d Cir. 1957) (Hand,

J., dissenting)); see also ACM Partnership v. Commissioner, 157

F.3d at 248; Northern Ind. Pub. Serv. Co. v. Commissioner, 115 F.3d

506, 512 (7th Cir. 1997), affg. 105 T.C. 341 (1995).

Stated

differently, a transaction has economic substance if it offers a

reasonable opportunity for profit exclusive of tax benefits.

See

Gefen v. Commissioner, 87 T.C. 1471, 1490 (1986), and cases cited

therein.

Generally, there must be a reasonable expectation that

- 30 nontax benefits will meet or exceed transaction costs.

See Yosha

v. Commissioner, 861 F.2d 494, 498 (7th Cir. 1988), affg. Glass v.

Commissioner, 87 T.C. 1087 (1986).

Modest profits relative to

substantial tax benefits are insufficient to imbue an otherwise

dubious transaction with economic substance.

See Sheldon v.

Commissioner, 94 T.C. 738, 767-768 (1990); Saba Partnership v.

Commissioner, T.C. Memo. 1999-359.

Contrary to respondent’s position, we decline to analyze the

economic substance of the disputed transaction by focusing solely

on events occurring during the period December 28 through 31, 1992.

Segregating

FPL’s

investment

in

Salina

into

two

parts,

as

respondent suggests, would violate the principle that the economic

substance

of

transaction.

a

transaction

turns

on

a

review

of

the

entire

See Kirchman v. Commissioner, supra at 1493-1494;

Winn-Dixie Stores, Inc. v. Commissioner, supra at 280. Although we

agree with respondent that Goldman Sachs structured FPL’s purchase

of the Salina partnership interest to provide FPL with a perceived

tax benefit, this factor, standing alone, is insufficient to render

the transaction a sham in substance.

Considering all the facts and circumstances, we conclude that

FPL entered into the Salina transaction to achieve a valid business

purpose independent of tax benefits.

The record demonstrates that

FPL entered into the Salina partnership for the primary purpose of

enhancing the return on its short-term investments.

Each of FPL’s

- 31 representatives testified convincingly on this point.

their

testimony

was

bolstered

by

their

detailed

Moreover,

review

and

consideration of the proposed investment and the minutes of the

board of director’s meeting approving the investment.6

We need not dwell on respondent’s contention that FPL failed

to evaluate fully the STAMPS investment strategy. We are convinced

that FPL evaluated the STAMPS strategy in sufficient detail to

determine that the strategy presented greater market risk than it

was willing to accept.

FPL invested in Salina on the condition

that Salina’s STAMPS portfolio would be promptly liquidated and

reinvested under the MAPS strategy.

There is no dispute that FPL

carefully evaluated the potential risks and rewards of the MAPS

strategy.

FPL’s “due diligence” included two meetings with Mr.

Silverstein. Moreover, at FPL’s request, Mr. Silverstein presented

FPL with several analyses of the financial risks and rewards

associated with the MAPS investment strategy under a variety of

economic scenarios.

We are convinced that FPL’s investment in Salina provided a

reasonable opportunity for FPL to earn profits independent of tax

benefits. As previously discussed, FPL carefully evaluated the

potential risks and rewards of the MAPS strategy.

6

Mr. Silverstein

Although the minutes also mention a potential tax

benefit associated with the investment, we infer that FPL did not

consider the tax benefit to be paramount to the transaction,

rather merely ancillary or collateral thereto.

- 32 projected that under normal market conditions, the MAPS strategy

would allow FPL to earn between 4 and 7 percent over Treasury bills

which were

then

yielding

respondent

concedes

that

approximately

Mr.

3

percent.

Silverstein’s

In

fact,

projections

were

reasonable.

Relying upon Sheldon v. Commissioner, supra, and Saba v.

Commissioner,

supra,

respondent

contends

that

the

transaction

lacked economic substance on the ground that FPL’s potential

profits were de minimis when compared with the potential tax

benefit. In particular, respondent reasons that while FPL stood to

earn approximately $5.3 million annually on its investment, the

transaction provided the potential for FPL to save up to $118.8

million in taxes.

Respondent’s computation of $118.8 million is

based upon the assumption that FPL would have been unable to use

any of its CPG loss during the applicable 5-year loss carryover

period prescribed in section 1212(a)(1)(C).

Respondent’s view of the potential tax benefit associated with

FPL’s Salina investment is significantly inflated.

The record

reveals that FPL was in the process of restructuring its operations

by selling noncore businesses in order to concentrate on its

utility businesses.

FPL’s sale of CPG was undertaken as part of

this restructuring.

We are convinced that, as of late 1992, FPL

reasonably anticipated that it would realize substantial capital

gains

over

the

next

several

years

on

the

sale

of

various

- 33 subsidiaries (including Telesat, Alandco, Turner Foods, and a

separate banking business).

On the basis of the record presented,

we conclude that FPL would have used most, if not all, of its CPG

loss within the 5-year period for reporting loss carryovers under

section 1212(a).

precisely

Accordingly, although we shall not attempt to

quantify

the

potential

value

of

the

tax

benefit

associated with FPL’s investment in Salina, we are satisfied that

the potential profits associated with the investment were not de

minimis relative to the perceived tax benefit.

2.

Section 752

Having

concluded

that

FPL’s

investment

in

the

Salina

partnership was not a sham in substance, we now review the disputed

transaction on its merits.

Respondent maintains that Salina

substantially overstated the amount of its short-term capital gain

by failing to treat its obligation to return the Treasury bills

that it sold short as a “liability” under section 752(a).

Section 752(a) provides:

SEC. 752.

Treatment of Certain Liabilities.--

(a) Increase In Partner’s Liabilities.-–Any increase

in a partner’s share of the liabilities of a partnership,

or any increase in a partner’s individual liabilities by

reason of the assumption by such partner of partnership

liabilities, shall be considered as a contribution of

money by such partner to the partnership.

Assuming

that

Salina’s

obligation

to

close

its

short

sale

constituted a partnership liability under section 752, respondent

posits that FPL’s pro rata share of the liability would have

- 34 increased FPL’s outside basis in its partnership interest, thereby

increasing Salina’s substituted basis in its assets following the

deemed termination of the partnership pursuant to section 1.7081(b)(1)(iv),

Income

Tax

Regs.

Such

an

increase

in

Salina’s

substituted basis would have virtually eliminated the short-term

capital gain that Salina reported following the closing of its

short position.

Respondent relies upon Rev. Rul. 88-77, 1988-2 C.B. 128, and

the preamble to section 1.752-1T, Temporary Income Tax Regs., 53

Fed. Reg. 53143 (Dec. 30, 1988), in support of the proposition that

Salina’s obligation to close out its short sale (by returning

Treasury bills to ABN and Goldman Sachs) represents a partnership

- 35 liability

within

the

meaning

of

section

752.7

Although

acknowledging that Salina’s obligation to replace the borrowed

securities was secured under the Salina/ABN master repurchase

agreement (under which Salina lent $343,875,000 to ABN and ABN

collateralized its loan with the Treasury bills that Salina sold

short), respondent asserts that Salina incurred an obligation in

the amount of $344 million that should be considered a liability

under section 752(a).

The various provisions of subchapter K of the Code blend two

approaches, the entity and the aggregate approaches, for taxation

of partnerships and partners.

See Coggin Automotive Corp. v.

Commissioner, 115 T.C. ___ (2000) (slip. op. at 21); see also S.

Rept. 1622, at 89-100, 83d Cong., 2d Sess. (1954).

The entity

7

The portion of the preamble to sec. 1.752-1T, Temporary

Income Tax Regs., 53 Fed. Reg. 53143 (Dec. 30, 1988), that

respondent relies upon states in pertinent part:

The allocation of partnership liabilities among

the partners serves to equalize the partnership’s basis

in its assets (“inside basis”) with the partners’ bases

in their partnership interests (“outside basis”). The

provision of additional basis to a partner for the

partner’s partnership interest will permit the partner

to receive distributions of the proceeds of partnership

liabilities without recognizing gain under section 731,

and to take deductions attributable to partnership

liabilities without limitation under section 704(d)

(which limits the losses that a partner may claim to

the basis of the partner’s interest in the

partnership). By equalizing inside and outside basis,

section 752 simulates the tax consequences that the

partners would realize if they owned undivided

interests in the partnership’s assets, thereby treating

the partnership as an aggregate of its partners. [T.D.

8237, 1989-1 C.B. 180, 182.]

- 36 approach, which recognizes a partnership as an entity separate and

distinct from its partners, is reflected in part in section 703(a),

which provides that items of income, gain, loss, deduction, and

credit are determined at the entity or partnership level.

The

aggregate approach, which recognizes a partnership as an aggregate

of its partners, is reflected through provisions such as sections

701 and 702, which provide that partnership items are passed

through the partnership to its individual partners for purposes of

imposing income tax.

See United States v. Basye, 410 U.S. 441, 448

(1973).

In an effort to avoid distortions in income tax reporting

associated with the blending of the entity and aggregate approaches

within subchapter K, Congress enacted a number of provisions that

generally are intended to equate the aggregate of the partnership’s

inside bases in its assets with the aggregate of its partners’

outside bases in their partnership interests.

See 1 McKee et al.,

Federal Taxation of Partnerships and Partners, par. 6.01, at 6-3

(3d ed. 1997) (McKee).

section

722,

which

The carryover-basis rules contained in

provide

that

a

partner’s

basis

in

his

partnership interest equals the amount of money plus the adjusted

basis of property contributed to a partnership, generally results

in a matching of inside and outside bases upon the formation of a

partnership.

See Coloman v. Commissioner, 540 F.2d 427, 429 (5th

Cir. 1976), affg. T.C. Memo. 1974-78.

Similarly, adjustments to

basis prescribed under section 705(a) to account for income and

- 37 expenses from partnership operations generally preserve the balance

between inside and outside bases.

See id.

Finally, section 752

prescribes bases adjustments to reflect increases and decreases in

a

partner’s

share

of

partnership

liabilities.

See

LaRue

v.

Commissioner, 90 T.C. 465, 477 (1988).

Under section 752(a), an increase in a partner’s share of

partnership liabilities is considered a contribution of money,

which

results

in

an

partnership interest.

increase

in

the

partner’s

basis

in

his

See sec. 1.752-1(b), Income Tax Regs.8

The

practical impact of the basis adjustment prescribed in section

752(a) has been described as follows:

If a partnership borrows money, the basis of its

assets increases by the amount of cash received, even

though the receipt of the borrowed funds is not income.

By treating the partners as contributing cash in an

amount equal to their shares of the debt, inside/outside

basis equality is preserved and distortions are avoided.

If a liability for borrowed money were not added to the

partners’ bases, they could be taxed on a distribution of

the borrowed cash even though there is no gain inherent

in the partnership’s assets.

A similar result could

occur if a partnership incurs a purchase money liability

to acquire property, since the liability is added to the

partnership’s basis in the property.

McKee, supra, par. 7.01[1], at 7-2; see Laney v. Commissioner, 674

F.2d 342, 345-346 (5th Cir. 1982), affg. in part and revg. in part

on another ground T.C. Memo. 1979-491.

In the instant case, the parties disagree whether Salina’s

8

On the other hand, sec. 752(b) provides that a decrease

in a partner’s share of partnership liabilities is considered a

distribution of cash to the partner, which results in a decrease

in the partner’s outside basis in his partnership interest.

- 38 obligation to close out its short sale transaction by returning the

Treasury

bills

represents

a

that

it

liability

borrowed

within

from

the

ABN

and

Goldman

Sachs

meaning

of

section

752.

Resolution of this issue is complicated by the lack of a definition

of “liabilities” within subchapter K or the underlying regulations.

Although the Commissioner has not adopted a definition of the term

“liabilities” within the controlling regulations, the Commissioner

has addressed the subject in earlier temporary regulations and

revenue rulings.

In Rev. Rul. 88-77, 1988-2 C.B. 128, the Commissioner revoked

Rev. Rul. 60-345, 1960-2 C.B. 211, and concluded that accrued but

unpaid partnership expenses and accounts payable (obligations that

arguably would satisfy the plain meaning of “liabilities”) are not

liabilities within the meaning of section 752 for purposes of

computing

the

partnership

adjusted

using

the

basis

of

a

cash

method

partner’s

of

interest

accounting.9

in

a

In

so

concluding, the Commissioner drew an analogy to the computation of

a shareholder’s basis under section 357(c)(3) when a shareholder

contributes property and liabilities to a controlled corporation in

9

In Rev. Rul. 60-345, 1960-2 C.B. 211, the Commissioner

concluded (with no analysis) that, in computing the adjusted

basis of a partner’s interest in a partnership using the cash

method of accounting, for purposes of determining the extent to

which the partner would be allowed a deduction for his

distributive share of the partnership’s loss for the year

pursuant to sec. 704(d), the term “liabilities” under sec. 752

includes the partnership’s obligation to pay outstanding trade

accounts, notes, and accrued expenses.

- 39 exchange for stock.

The Commissioner noted that Congress had

provided that a shareholder’s basis generally is not increased by

liabilities, the payment of which would give rise to a deduction,

except for liabilities the incurrence of which resulted in the

creation of, or an increase in, the basis of any property.10

The

Commissioner also found it significant that, in amending section

704(c) under the Deficit Reduction Act of 1984, Pub. L. 98-369,

sec. 71(a), 98 Stat. 494, Congress expressly rejected Rev. Rul. 60345, supra, stating in the legislative history that “accrued but

unpaid items should not be treated as partnership liabilities for

purposes of section 752.”

On the basis of these factors, the

Commissioner interpreted section 752 as follows:

Under P’s method of accounting, P’s obligations to

pay amounts incurred for interest and services are not

deductible until paid. For purposes of section 752 of

the Code, the terms “liabilities of a partnership” and

“partnership liabilities” include an obligation only if

and to the extent that incurring the liability creates or

increases the basis to the partnership of any of the

partnership’s assets (including cash attributable to

borrowings), gives rise to an immediate deduction to the

partnership, or, under section 705(a)(2)(B), currently

decreases a partner’s basis in the partner’s partnership

interest. [Rev. Rul. 88-77, 1988-2 C.B. 129.]

10

Sec. 357(c) generally provides that a taxpayer who

transfers property to a corporation with liabilities in excess of

adjusted basis is considered to have realized a gain. Sec.

357(c)(3)(A) generally provides that, for purposes of a sec. 351

exchange, liabilities in excess of adjusted basis are excluded

from consideration if the liability would give rise to a

deduction or if it would be considered a distributive share or

guaranteed payment under sec. 736(a). Sec. 357(c)(3)(B) provides

that subparagraph (A) shall not apply to a liability to the

extent that the incurrence of the liability resulted in the

creation of, or an increase in, the basis of any property.

- 40 A

few

months

Commissioner

issued

after

issuing

section

Rev.

Rul.

1.752-1T(g),

88-77,

supra,

the

Temporary

Income

Tax

Regs., 53 Fed. Reg. 53143, 53150-53151 (Dec. 30, 1988), defining

“liability” in pertinent part as follows:

(g) Liability defined.--Except as otherwise provided

in the regulations under section 752, an obligation is a

liability of the obligor of purposes of section 752 and

the regulations thereunder to the extent, but only to the

extent, that incurring or holding such obligation gives

rise to-(1) The creation of, or an increase in,

the basis of any property owned by the obligor

(including cash attributable to borrowings);

(2) A deduction that is taken into

account in computing the taxable income of the

obligor; or

(3) An

expenditure

that

is

not

deductible in computing the obligor’s taxable

income and is not properly chargeable to

capital.

For reasons that are unclear, the final regulations under section

752 do not contain a definition of the term “liabilities”.

See

sec. 1.752-1, Income Tax Regs.

In

Rev.

Rul.

95-26,

1995-1

C.B.

addressed the question presented herein:

131,

the

Commissioner

Whether a partnership’s

short sale of securities creates a liability within the meaning of

section 752.

The revenue ruling states that a partnership entered

into a short sale of securities on a national securities exchange.

The partnership’s broker-dealer took securities on hand and sold

them on behalf of the partnership.

The partnership left the cash

- 41 proceeds from the sale with the broker-dealer as collateral and

deposited

additional

collateral.

cash

with

the

broker-dealer

as

further

The partnership was obligated to deliver identical

securities to the broker-dealer to close out the short sale.

On these facts, the Commissioner concluded that the short sale

created a partnership liability within the meaning of section 752,

citing Rev. Rul. 88-77, supra, for the proposition that a liability

under section

752

includes

an

obligation

to

the

extent

that

incurring the liability creates or increases the basis to the

partnership of any of the partnership’s assets, including cash

attributable to borrowings. The Commissioner reasoned that a short

sale creates such a liability inasmuch as:

(1) A short sale

creates an obligation to return the borrowed securities, citing

Deputy v. du Pont, 308 U.S. 488, 497-498 (1940); and (2) the

partnership’s basis in its assets is increased by the amount of

cash received on the sale of the borrowed securities.

Rul. 95-26, supra at 132.

See Rev.

Accordingly, the Commissioner concluded

that the partners’ bases in their partnership interests were

increased

under

section

722

to

reflect

their

shares

of

the

752

simply

partnership’s liability under section 752.

Petitioner

inapplicable.

first

In

asserts

particular,

that

section

petitioner

maintains

is

that

the

substantial difference between Salina’s inside basis in its assets

and FPL’s outside basis in its partnership interest is dictated by

- 42 section 1233 and section 1.1233-(1)(a), Income Tax Regs., which

require a short sale to be treated as an “open transaction” for

income tax purposes. Because a short sale of securities is treated

as

an

open

transaction

for

income

tax

purposes,

and

income

recognition is deferred until the transaction is closed with the

replacement of the borrowed shares pursuant to section 1233,11

petitioner reasons that section 705 requires that any adjustments

to the partners’ outside bases in their partnership interests be

deferred until the short sale is closed.

In connection with this

argument, petitioner contends that the Commissioner’s position in

Rev. Rul. 95-26, supra, conflicts with

Rev. Rul. 73-301, 1973-2

C.B. 216, and the Court’s holding in Helmer v. Commissioner, T.C.

Memo. 1975-160.

We are not convinced that the treatment of a short sale as an

open transaction for income tax purposes under section 1233 is

controlling with respect to the proper treatment of the transaction

for

purposes

of

the

partnership

contained in subchapter K.

basis

adjustment

provisions

Petitioner’s argument overlooks the

disparate policies that sections 1233 and 752 are intended to

promote.

Section 1233 affords open transaction treatment to a

short sale, i.e., defers recognition of gain or loss until the

11

A short sale of securities is treated as an open

transaction for income tax purposes because the taxpayer’s

ultimate gain or loss on the transaction cannot be determined

until the taxpayer purchases securities to replace those that

were borrowed (and sold) in the first leg of the transaction.

See sec. 1.1233-1(a), Income Tax Regs.

- 43 short sale is closed, to clarify and simplify the tax treatment of

a transaction that is something of a hybrid.

See Hendricks v.

Commissioner, 423 F.2d 485, 486-487 (4th Cir. 1970), affg. 51 T.C.

235 (1968). In contrast, the basis adjustment provisions contained

in subchapter K, including sections 705 and 752, are intended to

avoid distortions in the tax reporting of partnership items by

promoting parity between a partnership’s aggregate inside basis in

its assets and its partners’ outside bases in their partnership

interests. For present purposes, we observe that the provisions of

sections 1233 and 752 are mutually exclusive.

In other words, the

conclusion that a partnership’s short sale of securities creates a

partnership liability within the meaning of section 752 (thereby

increasing

the

partners’

outside

bases

in

their

partnership

interests) does not create tension or conflict with the deferred

recognition of gain or loss prescribed for short sale transactions

under section 1233.

Further, we are not persuaded that the Commissioner’s position

in Rev. Rul. 95-26, supra, conflicts with Rev. Rul. 73-301, supra,

or the Court’s holding in Helmer v. Commissioner, supra.

The

pertinent facts in Rev. Rul. 73-301, supra, are as follows: During

1971, ABC partnership, which reported its income on the completed

contract method, was awarded a 2-year contract for the construction

of a building.

During 1971, ABC had performed all the services

required under the contract in order to be entitled to receive

- 44 progress payments totaling $120x.

During 1971, ABC received total

progress payments of $100x and incurred liabilities for total costs

of $80x.

The facts stated in the revenue ruling reveal that the

Commissioner allocated a pro rata share of the $80x liabilities for

costs incurred under the contract to the partners for purposes of

determining their adjusted bases in their partnership interests.

On these facts, the Commissioner framed the issue to be addressed

as whether:

the deferred income of 100x dollars as of December 31,

1971 (representing progress payments on the contract),

represents “liabilities of a partnership” within the

meaning of section 752(a) of the Code and, as such,

additions to basis of the partnership interests of the

partners. [Rev. Rul. 73-301, 1973-2 C.B. 216.]

The Commissioner concluded that the progress payments qualified as

“unrealized

receivables”

under

section

751(c),

liabilities within the meaning of section 752.

as

opposed

to

In this regard,

the revenue ruling states that “The income or loss from performance

of the contract will affect the basis of the partnership interests

of the partners, as provided in section 705(a), when such income or

loss is recognized for Federal income tax purposes.”

301, supra at 216.

not

(Emphasis added.)

Rev. Rul. 73-

In sum, the partners were

permitted to adjust their outside bases with reference to the

$100x in progress payments that the partnership received during

1971 until income or loss from the transaction would be recognized

for tax purposes.

However, the Commissioner recognized that the

- 45 partners were entitled to increase their outside bases by a pro

rata share of the $80x of liabilities for construction costs that

the

partnership

incurred

in

1971

in

generating

the

progress

payments.

In Helmer v. Commissioner, supra, the taxpayers were partners

in a partnership that had entered into an agreement granting a

third

party

an

option

to

purchase

real

partnership held a two-thirds interest.

estate

in

which

the

During the term of the

option agreement, the partnership retained the right to possess and

enjoy profits from the property in question, and there was no

provision in the option agreement for repayment of the amounts paid

under the agreement should the agreement terminate.

During the years in issue, the taxpayers received payments

directly from the third party pursuant to the option agreement-amounts

that

the

partnership

listed

taxpayers on its books and tax returns.

as

distributions

to

the

During the years in issue,

the taxpayers received partnership distributions, and had the

partnership pay personal expenses, in excess of their adjusted

bases in the partnership.

The Commissioner determined that,

although the option payments qualified as deferred income at the

partnership level, the taxpayers nevertheless were subject to

income tax to the extent that they had received distributions from

the

partnership

in

excess

partnership interests.

of

their

adjusted

bases

in

their

In response, the taxpayers argued that

- 46 their adjusted bases in their partnership interests should be

increased by their pro rata shares of the option payments, which

they characterized as partnership liabilities under section 752.

The Court agreed with the Commissioner that no liability

within the meaning of section 752 arose upon the partnership’s

receipt of the option payments.

provisions

restrictions

in

the

on,

option

the

The Court noted that there were no

agreement

option

payments.

for

repayment

Further,

of,

the

or

Court

emphasized that income attributable to the option payments was

subject to deferral at the partnership level due only to the

inability of the partnership to determine the character of the

gain, not because the partnership was subject to a liability to

repay the funds paid or to perform any services in the future.

We are not convinced that either Rev. Rul. 73-301, supra, or

Helmer v. Commissioner, T.C. Memo. 1975-160, provides a sound basis

for determining whether a short sale transaction generates a

partnership liability within the meaning of section 752.

On the

one hand, both authorities stand for the general proposition that

amounts owed or paid to a partnership (or its partners) in a

transaction that qualifies as an open transaction for tax purposes

do not generate adjustments to the partners’ outside bases in their

partnership interests until the transaction is closed and the tax

characteristics of the transaction can be determined. On the other

hand, in Rev. Rul. 73-301, supra, the Commissioner recognized that

- 47 the partners therein were entitled to immediate adjustments to

their

outside

bases

equal

to

their

pro

rata

shares

of

the

partnership’s liabilities for costs incurred in qualifying for the

Similarly, Helmer v. Commissioner, supra,

progress payments.

suggests that a partnership liability under section 752 may arise

where

a

qualifies

partnership

as

an

receives

open

payments

transaction

in

for

a

tax

transaction

that

purposes

the

if

partnership is subject to a liability to repay the funds or to

perform any services in the future.

In sum, the authorities that

petitioner relies upon demonstrate that, although the amounts

received by a partnership in an open transaction generally are not

characterized as a liability under section 752, the transaction

must nevertheless be examined to determine whether the partnership

incurred related liabilities that may require partner-level basis

adjustments pursuant to section 752.

considerations,

we

reject

In light of these competing

petitioner’s

argument

that

the

Commissioner’s reasoning in Rev. Rul. 95-26, 1995-1 C.B. 131,

conflicts with Rev. Rul. 73-301, supra, and the Court’s holding in

Helmer v. Commissioner, supra.

Petitioner attempts to draw an analogy between the option

payments that the partnership received in Helmer v. Commissioner,

supra, with the cash proceeds that Salina received on its sale of

the borrowed Treasury bills.

Although the two transactions are

both considered open transactions for purposes of application of

- 48 the income tax, the transactions are materially different for

purposes of analysis under section 752.

The option payments that

the

v.

partnership

received

in

Helmer

Commissioner,

supra,

represented fixed payments on the sale of a partnership asset that

were free and clear of any claim for repayment or demand for

further services.

In contrast, Salina’s gain or loss on the sale

of borrowed Treasury bills was dependent upon the cost to Salina of

fulfilling its obligation to replace the borrowed Treasury bills.

Consequently, we hold that Helmer v. Commissioner, supra, does not

support petitioner’s position in this case.

As

an

alternative

to

its

“open

transaction”

argument,

petitioner cites Deputy v. du Pont, 308 U.S. 488, 497-498 (1940),

for the proposition that Salina’s short sale of Treasury bills did

not generate a partnership “liability” within the meaning of

section 752. Petitioner’s reliance on Deputy v. du Pont, supra, is

misplaced.

In Deputy v. du Pont, supra, the taxpayer entered into a short

sale

of

securities

and

agreed

to

pay

to

the

lender

of

the

securities the dividends paid on the securities during the period

that the short sale remained open. The taxpayer claimed the amount

that he paid to the lender as a deduction for interest paid or

accrued on indebtedness under section 23(b) of the Internal Revenue

Code of 1928.

The Supreme Court questioned whether the taxpayer’s

obligation to transfer the dividends to the lender constituted an

- 49 indebtedness

within

the

meaning

of

the

statute,

stating

in

pertinent part that “although an indebtedness is an obligation, an

obligation is not necessarily an ‘indebtedness’”.

Id. at 497.

Nevertheless, the Supreme Court’s rejection of the taxpayer’s

argument was more firmly rooted in the Court’s holding that the

disputed payments did not constitute

the meaning of the statute.

a payment of interest within

See Deputy v. du Pont, supra at 498.

Petitioner’s interpretation of Deputy v. du Pont, supra, for

the proposition that “Salina’s short sale obligation” is “not an

‘indebtedness’ that constitutes a ‘liability’ under Section 752 of

the Code”, overstates the Supreme Court’s holding in that case. In

the first instance, the Supreme Court’s statement in Deputy v. du

Pont, supra at 497, that “an obligation is not necessarily an

‘indebtedness’”, which was directed at the taxpayer’s obligation to

transfer an amount equivalent to the dividends paid on the borrowed

securities to the lender, does not constitute a blanket holding

that a borrower’s obligation to close a short sale by returning the

borrowed securities to the lender will never be considered an

indebtedness.

Moreover, petitioner attempts to equate the term

“indebtedness”, as contemplated under section 23(b) of the Internal

Revenue Code of 1928, with the term “liabilities” as used in

section

752,

without

any

meaningful

analysis

or

citation

to

precedent. We, of course, are in no way constrained (nor prepared)

- 50 to assume that a liability within the meaning of section 752 must

satisfy the definition of an indebtedness as that term is used

elsewhere in the Code.

Although

petitioner

asserts

that

Salina’s

short

sale

of

Treasury bills did not result in a partnership liability within the

meaning of section 752, petitioner does not offer the Court a

definition of the term “liability” to support its position.

As

previously indicated, the term “liability” is not defined in either

the Code or the Commissioner’s final regulations under section

752.12

In the absence of any indication that Congress intended

otherwise, we apply the term taking into account its plain and

ordinary meaning.

See, e.g., Deputy v. du Pont, supra at 498.

Black’s Law Dictionary 925 (7th ed. 1999), defines the term

“liability” in pertinent part as follows:

1. The quality or state of being legally obligated

or accountable; legal responsibility to another or to

society, enforceable by civil remedy or criminal

punishment. * * * 2. A financial or pecuniary obligation

* * *.

Based upon the aforementioned meaning of the term “liability”,

and consistent with the policy underlining section 752, we hold

that Salina’s obligation to close its short sale by replacing the

Treasury

bills

that

it

borrowed

from

Goldman

Sachs

and

ABN

represented a partnership liability within the meaning of section

752.

In particular, as part and parcel of its short sale of the

12

Neither petitioner nor respondent argues that the

current regulations provide insight on the question presented.

- 51 Treasury

bills,

Salina

had

a

legally

enforceable

financial

obligation to return the borrowed Treasury bills to Goldman Sachs

and ABN.

Significantly, Salina reported the obligation as a

liability on its opening balance sheet.

Consistent

with

the

preceding

discussion,

we

sustain

respondent’s adjustment to Salina’s tax return inasmuch as Salina’s

partners were required to increase their outside bases in their

partnership interests to reflect their pro rata shares of the

aforementioned liability.

A final matter.

Petitioner observes that section 1.708-

1(b)(1)(iv), Income Tax Regs., was amended effective May 8, 1997,

to eliminate the basis adjustment provision underlying the present

dispute.13

Because the regulation was amended prospectively, it is

of no aid to this Court in deciding the question presented in this

case.

See, e.g., Compaq Computer Corp. & Subs. v. Commissioner,

113 T.C. 214, 225-226 (1999).

Under the circumstances, we need not consider the parties’

remaining arguments.

To reflect the foregoing, and the agreement

of the parties, see supra note 2,

Decision will be entered

13

Pursuant to an amendment to sec. 1.708-1(b)(1)(iv),

Income Tax Regs., effective May 8, 1997, constructive partnership

terminations are no longer treated as deemed distributions of

partnership assets. Pursuant to the amendment, the new

partnership is now required to take a carryover basis from the

old partnership.

- 52 under Rule 155.