United States Tax Court

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T.C. Memo. 2026-21

OTAY PROJECT LP, ORIOLE MANAGEMENT LLC,

TAX MATTERS PARTNER,

Petitioner

COMMISSIONER OF INTERNAL REVENUE,

Respondent

__________

Docket No. 6819-20.

Filed February 23, 2026.

__________

George M. Gerachis, Adriana L. Wirtz, Matthew C. Hoffman, Kylan A.

Kinkade, William Q. Manuel, Elizabeth A. Matthews, and Zachary M.

Willis, for petitioner.

H. Barton Thomas, Matthew D. Thom, Jan M. Geht, Arvind Sabu, and

Henry C. Bonney, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

WEILER, Judge: At issue in this case is a positive basis

adjustment made under section 743(b) 1 to the assets of a limited

partnership, Otay Project, LP (OPLP), with respect to its limited

partner, Otay Project, LLC (OPLLC), resulting from the termination of

OPLP on October 3, 2012. By Notice of Final Partnership

Administrative

Adjustment

(FPAA)

respondent

disallowed

$713,759,615 of a more than $743 million claimed deduction (Basis

Deduction) reported on OPLP’s Form 1065, U.S. Return of Partnership

1 Unless otherwise indicated, statutory references are to the Internal Revenue

Code, Title 26 U.S.C. (Code or I.R.C.), in effect at all relevant times, regulation

references are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all

relevant times, and Rule references are to the Tax Court Rules of Practice and

Procedure. All monetary amounts have been rounded to the nearest dollar.

Served 02/23/26

[*2] Income (2012 Form 1065), for the short 2012 tax year ending on

October 3, 2012 (2012 tax period). The Basis Deduction is principally

related to the prior positive basis adjustment to OPLLC’s outside basis

in OPLP, made in 2007 and totaling more than $867 million.

In the FPAA respondent disallowed OPLP’s Basis Deduction on

the basis of Treasury Regulation § 1.701-2 (subchapter K anti-abuse

rule) and, alternatively, on the basis of the “partnership anti-abuse

rule,” under which respondent determined that most of the claimed

deduction should be disallowed because OPLP retains the right to

receive payments under certain contracts and/or incurred additional

liabilities, which were erroneously excluded from the section 743(b)

calculations. Respondent’s FPAA also asserted two penalties, a 40%

gross valuation misstatement penalty under section 6662(b)(3) and (h)

and a 20% negligence penalty under section 6662(b)(1).

After petitioner timely filed its Petition, respondent filed his

Answer, which asserted (as amended) that the adjustment in the

FPAA—disallowing OPLP’s Basis Deduction—is also supported by the

legal theories of the step transaction doctrine, the common law economic

substance doctrine, the codified economic substance doctrine found in

section 7701(o), the substance-over-form doctrine, and Treasury

Regulation § 1.460-4(k)(4). Respondent’s Answer also asserts a 20%

valuation misstatement penalty under section 6662(b)(3).

After concessions by the parties the issues for decision are

whether (1) respondent correctly disallowed OPLP’s Basis Deduction on

the grounds that OPLP’s section 743(b) basis adjustment should not be

respected under the common law economic substance doctrine; 2 (2) the

section 743(b) basis adjustment should be disallowed under one or more

of respondent’s alternative theories, including whether OPLP correctly

calculated the section 743(b) basis adjustment and/or respondent’s

authority under Treasury Regulation §§ 1.701-2 and 1.460-4(k)(4); 3 and

(3) the gross valuation misstatement penalty, substantial valuation

misstatement penalty, and negligence penalty apply to OPLP.

2 On brief respondent waives any reliance on the codified economic substance

doctrine since the transactions in question predate the effective date of section 7701(o).

3 On brief respondent does not ask this Court to apply the common-law steptransaction or substance-over-form doctrine; rather he focuses on the subchapter K

anti-abuse rule.

FINDINGS OF FACT

[*3]

Some of the facts are stipulated and are so found. The First

through Tenth Stipulations of Facts and the attached Exhibits are

incorporated herein by this reference.

OPLP is treated as a partnership subject to the Tax Equity and

Fiscal Responsibility Act of 1982 (TEFRA), Pub. L. No. 97-248, §§ 401–

407, 96 Stat. 324, 648–71, for federal income tax purposes. Petitioner,

Oriole Management, LLC (Oriole), is the tax matters partner for OPLP. 4

OPLP is organized under California law as a limited partnership with a

principal place of business in San Diego, California.

Relevant History of the Baldwin Brothers

Albert Baldwin (Al) and James Baldwin (Jim) are brothers, and

both were real estate developers in Southern California. After

graduating from college, Al and Jim joined their father as partners in

the real estate business. Shortly thereafter, Al and Jim acquired their

father’s business interest and continued to operate in the real estate

business for decades through Baldwin Builders, which operated as the

Baldwin Co. Al and Jim were involved in the acquisition of raw land in

the San Diego, California, area for subsequent development and

construction of residential neighborhoods. Al and Jim developed

neighborhoods including Sea Village, Carmel Del Mar, and Otay Ranch.

Acquisition and Initial Development of Otay Ranch

In 1988 Al and Jim purchased, through the Baldwin Co.,

approximately 22,000 acres of raw unentitled farming land in San Diego

County, California, referred to as Otay Ranch. Beginning in 1989 the

Baldwin Co. developed a master planned community for Otay Ranch

consisting of approximately 27,000 residential units and related civic

services. During the development of Otay Ranch—which occurred in

phases—it was necessary for Al and Jim to form single-purpose entities

(SPEs) to acquire land for subsequent development. They formed 25

SPEs for financing purposes and defense to widespread construction

defect litigation during the development of Otay Ranch.

4 Before its repeal TEFRA governed the tax treatment and audit procedures

for many partnerships, including OPLP.

[*4]

Bankruptcy of the Baldwin Entities

During the 1980s the residential real estate market was strong in

southern California, and demand for new homes exceeded supply.

However, the real estate market experienced a downturn and eventual

recession beginning in the 1990s. At this time Baldwin Co.’s lender

declared a nonmonetary default on their loans, sweeping all cash on

hand from Al and Jim’s company accounts.

Consequently, Baldwin Builders filed for chapter 11 bankruptcy.

At the conclusion of the bankruptcy proceedings, Al and Jim were able

to retain some 5,300 acres of land within Otay Ranch.

Development of Otay Ranch After Bankruptcy

OPLP was formed in January 1999. OPLLC contributed 5,300

acres of land to OPLP, with OPLLC owning a 99.9% general partnership

interest and South Bay Project, LLC, 5 and Otay Ranch Development,

LLC (ORD), collectively owning a 0.1% limited partnership interest.

Under the contribution OPLP assumed all of OPLLC’s obligations and

liabilities with respect to the 5,300 acres of land.

OPLP acted as master developer of Otay Ranch by performing

land entitlements and overseeing construction of land improvements

and infrastructure, such as development of lots, roads, and utilities.

Because of the size of the project, OPLP developed Otay Ranch in

phases, consisting of villages. A village consisted of high-density

housing, low-density single-family housing, retail, public areas, and

schools (Village). In sum, and as of the time of trial, OPLP had developed

14 Villages. Development of Otay Ranch from raw land to a master

planned community required an extensive entitlement process,

including (but not limited to) detailed subdivision plans, approval from

municipal authorities, and surety bonds guaranteeing construction of

certain required infrastructure.

In the course of developing Otay Ranch, OPLP sold subdivided

tracts of land to entities owned by Al and his family (AB Homebuilders)

and Jim and his family (JB Homebuilders)—each of which was

separately engaged in the business of constructing and selling homes

(collectively, Homebuilders)—and other unrelated third-party

5 South Bay Project, LLC, is a legal entity owned by the wealthy Pritzker

family (third-party family).

[*5] homebuilders. 6 OPLP would sell what is referred to within the

industry as “blue-top” lots, meaning lots already graded and with all

necessary infrastructure required to build a home. Under the terms of

its land sales to these homebuilding entities, OPLP was required to

complete all necessary infrastructure, which included, among other

requirements, construction of roads and public utilities (Construction

Obligations).

Because of its obligations to deliver blue-top lots, OPLP elected to

use the completed contract method of accounting (CCM) and defer

profits under the percentage of completion method of accounting (PCM),

as permitted under section 460 and Treasury Regulation § 1.460-4(d).

As one mechanism to finance the construction of infrastructure

related to Otay Ranch, OPLP, as master developer, obtained

reimbursements from proceeds of public bonds. More specifically, OPLP

established community facility districts for taxing purposes; and as

constructed homes were sold, a portion of property taxes was directed

toward common infrastructure costs. The City of Chula Vista issued and

sold public bonds backed by these future property taxes, thus creating a

supply of funds for development and construction of infrastructure.

OPLP submitted its costs to the City of Chula Vista for review and

reimbursement, and over the course of development of several Villages,

OPLP obtained funding for construction of infrastructure through this

reimbursement mechanism.

Arbitration Between Al and Jim

Following bankruptcy the sale of blue-top lots to AB

Homebuilders and JB Homebuilders eventually led to arbitration

between the brothers, lasting nearly a decade. Although Al and Jim had

agreed to share profits within OPLP equally, Jim’s cash withdrawals

from OPLP exceeded Al’s withdrawals by $18 million.

In June 2002 Al filed a demand for arbitration with AAA 7 under

the terms of the partnership agreement of OPLP. Before the arbitration

hearing, Al and Jim held a series of meetings with Ron Therrien, the

6 Both Al and Jim involved their children in the real estate business. After the

bankruptcy Al and Jim no longer jointly conducted homebuilding activities; rather,

they involved their children and sons-in-law in separate Homebuilder activities.

Beginning in 2002 blue-top lots developed by OPLP were sold to SPEs held by Al’s

Family or Jim’s Family.

7 The American Arbitration Association.

[*6] chief financial officer of OPLP, and other family members over the

course of three days, December 18, 19, and 20, 2002. Following this

series of meetings Al and Jim executed a memorandum of

understanding written by Mr. Therrien. Al and Jim also executed an

addendum to the original memorandum of understanding dated

December 21, 2002, and on December 24, 2002, Al and Jim entered into

another addendum to the memorandum of understanding (collectively

MOU). The principal terms of the MOU involved the equitable division

of all remaining parcels of land held by OPLP—with one brother, as

decided by a coin flip, dividing the remaining land into two groups and

the other brother having first choice of the two groups.

Later Al discovered Jim was violating the terms of the MOU and

resumed his demand for arbitration. In January 2005 Jim amended his

claims in arbitration, seeking, as part of his relief, dissolution of all

business relationships with Al, including dissolution of all jointly owned

entities. Then at a February 1, 2005, hearing, counsel for Al

acknowledged Jim’s right to dissolution under California law; however,

Al’s counsel requested the opportunity to consult with opposing counsel

regarding the tax implications of dissolution. Also at the February 1,

2005, hearing, Judge Lewis advised the parties of his intent to issue an

interim decision, after all evidence was presented, to allow Al and Jim,

by agreement, to modify the plan for dissolution according to tax

benefits.

On April 4, 2005, Judge Lewis issued his First Interim Partial

Award and Order of Arbitrator (April 2005 order) addressing several

issues in dispute. Judge Lewis’s April 2005 order enforced the terms of

the MOU between Al and Jim and provided for the division of property,

including the residential lots within Villages 2, 7, 12, and 13, and a

portion of Village 6 within six months. Judge Lewis performed the coin

flip and declared that Jim was obligated to first divide the residential

lots into two groups, and Al would have first choice of the two groups to

be created by Jim.

Judge Lewis also addressed the parties’ claims for dissolution. In

the April 2005 order he states as follows:

All joint entities holding title to mutually owned properties

shall be dissolved within sixty (60) days of when the last

piece of land is deeded out by that entity pursuant to the

terms of this Award. All property transfers and divisions

under the terms of this award and the MOU shall be

[*7]

accomplished within thirty-six (36) months from this date;

unless an extension is granted for good cause shown.

At the time of the April 2005 order entitlements were underway

and blue-top lots within Village 6 had been sold to Al’s and Jim’s

respective Homebuilders. Villages 2 and 7 were still under development

and included a written lotting study for development in the near future.

Village 12 was a planning area that did not include residential

development, while Village 13 was far from development since

entitlements to land had not begun.

In the April 2005 order Judge Lewis determined there were

continuing obligations under the MOU such as requiring Jim and Al to

conduct future business, continuing to allow OPLP to meet its

contractual obligations to complete the entitlement process, borrowing

funding from the issuance of public bonds and property taxes, and

continuing to receive and disburse funds collected from Al, Jim, and

their family, upon the sale of future lots.

Both Al and Jim decided to retain the services of third-party legal

and tax counsel to advise on implementing Judge Lewis’s April 2005

order. Al and Jim retained William Wasserman, who had previously

worked at the law firm of Loeb & Loeb, LLP (Loeb), and was presently

working at the accounting firm of Ernst & Young, LLP (EY). Al and Jim

each met with Mr. Wasserman separately and then retained EY under

a master tax services agreement. In addition to EY, Al and Jim also

retained Loeb to advise on implementing Judge Lewis’s April 2005

order.

Implementation of Judge Lewis’s April 2005 Order

Until December 14, 2006, OPLLC held a 99.9% sole general

partnership interest in OPLP while ORD held a 0.1% limited

partnership interest in OPLP. At the same time ORD held a 99%

membership interest in OPLLC, while Oriole held the remaining 1%

interest. Oriole was owned 50/50 by Al and Jim; while ORD was owned

50/50 by Southwind, LLC (Southwind) (an entity owned by Al and his

spouse Deeann), and Forstar, LLC (Forstar) (an entity owned by Jim

and his family). Between 1998 and 1999 approximately 34 SPEs were

formed—all state law limited liability companies (LLCs) (34 LLCs)—to

hold one or more (not yet developed) Villages of Otay Ranch. Each of the

34 LLCs was beneficially owned 50/50 by Al, Jim, or their respective

families, and each LLC held a membership interest in ORD. Of the 34

[*8] LLCs formed, OPLP referred to 19 as redeeming LLCs, and the

remaining 15 were referred to as nonredeeming LLCs.

In 2005 OPLP separately sold parcels of land in Village 7 to

entities owned by the Homebuilders in exchange for unsecured

promissory notes. In the purchase of parcels of land in Village 7, two

notes were issued by JB Homebuilders in favor of OPLP, for $28,104,747

and $37,285,114 respectively, and these notes were guaranteed by Jim.

In the purchase of parcels of land in Village 7 two notes were issued by

AB Homebuilders in favor of OPLP, for $28,360,835 and $37,856,643

respectively, and these notes were guaranteed by Al.

By the spring of 2005 there was approximately $240 million of

deferred profit under CCM, from OPLP’s land sales, and the remaining

land held by OPLP had an estimated built-in gain of $700 million.

In 2006 OPLP separately sold parcels of land in Villages 2 and 6

to entities owned by the Homebuilders in exchange for unsecured

variable Homebuilder Notes. JB Homebuilders acquired these parcels of

land through two unsecured variable Homebuilder Notes in favor of

OPLP in the amounts of $1,191,010 and $26,455,718 respectively.

Similarly, multiple Homebuilder Notes were issued by AB

Homebuilders in favor of OPLP. Consistent with prior practice Jim

guaranteed each of these promissory notes issued by JB Homebuilder,

while Al guaranteed each of these promissory notices issued by AB

Homebuilders.

Following OPLP’s land sales of Villages 2, 6, and 7 in 2005 and

2006, AB Homebuilders owed approximately $345 million in principal

and JB Homebuilders owed $329 million in principal, under the abovereferenced Homebuilder Notes.

Creation and Capitalization of Finco Entities

Both EY and Loeb provided tax planning to Al and Jim for

implementing the April 2005 order, and both E&Y and Loeb advised Al

and Jim that it was appropriate to restructure OPLP.

Loeb provided Al and Jim with a draft letter of intent outlining

the separation of all jointly owned assets and restructuring of OPLP.

However, Al and Jim ultimately could not reach an agreement on the

terms of Loeb’s draft letter of intent.

[*9] The tax planning by EY offered various potential transactions,

including the outright sale of the underlying land at Otay Ranch,

creation of financing companies, admission of a new general partner and

conversion of OPLLC’s interest to that of a limited partner, financing for

Village 2, and potential for distribution of assets within OPLP to its

partners. The tax advice rendered addressed division of receivables due

from the Homebuilder entities owned by Al and Jim; however, the tax

advice did not address a division of other joint liabilities within OPLP.

Particularly it did not address the ongoing Construction Obligations

within OPLP, which remained in dispute between Al and Jim. They

ultimately followed the recommendations made by EY.

In December 2005 OPLP restructured certain Homebuilder

Notes. JB Homebuilders paid OPLP approximately $21 million through

funds borrowed from JPB Investments—an entity owned by Jim.

Similarly, AB Homebuilders paid OPLP approximately $53 million

through funds borrowed from Pacifica—an entity owned by Al.

Simultaneously, OPLP in turn lent to JPB Investments approximately

$21 million in exchange for a 15-year variable promissory note, and to

Pacifica approximately $53 million in exchange for a 15-year fixed rate

promissory note. Essentially, after the transaction a substantial portion

of the outstanding Homebuilder Notes held by OPLP was exchanged for

15-year promissory notes issued by JPB Investments and Pacifica,

respectively.

ORD also restructured loans it held with OPLP, through the

transfer of $55 million in receivables owed by Pacifica to Southwind, and

$63 million in receivables owed by JPB Investments to Forstar. In

exchange for these two transfers of receivables, Southwind assumed

liabilities of $53 million due from ORD to OPLP, while Forstar assumed

liabilities of $61 million due from ORD to OPLP. Relating to this

assumption of liabilities, Southwind issued a 15-year fixed rate

promissory note to OPLP, and Forstar issued a 15-year variable rate

promissory note to OPLP. ORD issued two separate 15-year promissory

notes to OPLP, one having a fixed and one having a variable rate. The

restructuring of these notes moved the indebtedness from ORD—an

entity jointly owned by Al and Jim—to their respective separate entities

Southwind and Forstar.

On December 12, 2005, JB Finco, LLC (JB Finco), and AB Finco,

LLC (AB Finco), were formed as Delaware LLCs. Upon formation AB

Finco’s members were OPLP and AB Finco Common Partner, LLC—a

newly formed entity held by Al and his family. Similarly, upon

[*10] formation, JB Finco’s members were OPLP and JB Finco Common

Partner, LLC—a newly formed entity held by Jim and his family. 8

The membership interests in AB Finco and JB Finco function like

preferred and common stock with OPLP holding a preferred return and

the Common Partners holding a common interest in the respective Finco

entities. The Finco operating agreements contained special tax

allocations, with 80% of losses attributable to the Common Partners and

20% to OPLP. Similarly, OPLP losses from AB Finco were specially

allocated 70% to Al and 30% to Jim, and the same was true in the inverse

for JB Finco, with 70% of losses allocated to Jim and only 30% allocated

to Al. 9

Effective December 15, 2005, and as consideration for its

preferred membership interest, OPLP contributed to AB Finco certain

promissory notes from Southwind with a value of approximately $53

million, Pacifica with a value of approximately $53 million, ORD with a

value of approximately $30 million10 (collectively, Intercompany Notes),

and the remaining Homebuilder Notes of AB Homebuilders with a value

of approximately $66 million.

Effective December 15, 2005, and as consideration for its

preferred membership interest, OPLP contributed to JB Finco certain

promissory notes from Forstar with a value of approximately $61

million, JPB Investments with a value of approximately $21 million,

On December 12, 2005, AB Portola Holdings, LLC (AB Portola), and JB

Portola Holdings, LLC (JB Portola), were formed as Delaware LLCs. The initial

members of AB Portola were AB Finco, holding a 90% membership interest, and

Southwind—an entity owned by Al and his spouse—holding the remaining 10%

membership. Similarly, the initial members of JB Portola were JB Finco holding a 90%

membership interest and Forstar—an entity owned by Jim and his children—holding

the remaining 10% membership. Before formation of AB Portola and JB Portola,

Forstar and Southwind each held a 50% interest in Portola Project, LLC, and their

interests were contributed to the newly formed AB Portola and JB Portola; however,

it was deemed that JB Finco and AB Finco had made 90% of the respective

contributions.

9 Effective December 15, 2005, Jim, through contributions to JB Finco Common

Partner, contributed to JB Finco a 35% membership interest in Carmel Valley

Partners I, a 45% membership interest in Village Nurseries Wholesale, LLC, a

44.415% interest in Village Nurseries, LP, and his interest in a promissory note by

Carmel Valley Partners I to Al and Jim. Like Jim, and effective December 15, 2005, Al

made the identical membership interest contributions to AB Finco, through AB Finco

Common Partner.

10 The parties agree to this number, and it represents 50% of the receivables

due from ORD.

[*11] ORD with a value of approximately $30 million11 (collectively,

Intercompany Notes), and the remaining Homebuilder Notes of JB

Homebuilders with a value of approximately $65 million.

Admission of a New General Partner of OPLP, Followed by

Distribution of Assets from OPLP

Effective December 14, 2006, Oriole was admitted as a general

partner in OPLP with less than a 10% interest, and OPLLC’s

partnership interest in OPLP was converted to a limited partnership

interest. Immediately before the admission of Oriole as a partner in

OPLP, the assets of OPLP were revalued and the capital accounts of

OPLLC and ORD—the then partners of OPLP—were booked up to fair

market value and any unrealized gain or loss was allocated to the

partners. Following the admission of Oriole, OPLP had three partners,

Oriole as the general partner and OPLLC and ORD as limited partners.

Effective December 28, 2006, OPLP and OPLLC entered into an

Assignment and Assumption of Membership Interests (Assignment

Agreement). Pursuant to the Assignment Agreement, OPLP transferred

most of its assets, including all of its interest in AB Finco and JB Finco,

to OPLLC. As of this date OPLLC’s adjusted basis in its interests in

OPLP was $60,405,079, while the inside basis in the interests

transferred by OPLP was $970,980,604. Under the same Assignment

Agreement ORD transferred to Southwind an interest in AB Finco

valued at $7.4 million, and similarly ORD transferred to Forstar an

interest in JB Finco valued at $7.4 million.

Before the Assignment Agreement OPLP financial statements

reflect total assets over $1.5 billion, with OPLP’s investment in the

Fincos totaling approximately $1.1 billion. After the Assignment

Agreement Oriole held a 7.7002% general partnership interest, ORD

held a 1.0882% limited partnership interest, and OPLLC held a

91.2116% limited partnership interest in OPLP. Under the same

Assignment Agreement effective as of December 28, 2006, OPLLC then

transferred its interests in AB Finco and JB Finco to ORD, which in turn

transferred its interests in AB Finco to Al and his affiliated entities and

JB Finco to Jim and his affiliated entities.

11 Like the number supra note 10, this number is agreed to between the parties

and represents the remaining 50% of the receivables due from ORD.

[*12] H.

Estate Planning for Jim Baldwin

In 2005 Jim’s son Jason tragically died, survived by his spouse

Eve and two minor children. Jason’s estate was probated in California,

resulting in a settlement in which Jason’s interests in several SPEs

affiliated with Jim and his family were transferred into trust for the

benefit of Eve and her children (Eve’s Trust).

Jim converted some of his community property interests to

separate property of his spouse, Nancy. Nancy in turn entered into eight

separate installment sales through the execution of Purchase and Sale

Agreements with the Jami B. Trust 2, the Kelley R. Trust 2, the Jason

B. Trust 2, and the Joshua B. Trust 2 (collectively, JB Grandchildren’s

Trusts). The JB Grandchildren’s Trusts are structured as intentionally

defective grantor trusts (IDGTs).

On February 28, 2007, Summit Point Investments, LLC

(Summit), 12 OR Investments, LLC (OR Investments), and Otay Village

Four Investments, LLC (Otay Village Four Investments), were formed.

As part of Jim’s estate planning objectives, Forstar, OR Management J,

LLC (ORMJ), and the JB Grandchildren Trusts acquired interests in

Summit, OR Investments, and Otay Village Four Investments, making

various contributions of promissory notes and interests in

nonredeeming 13 and redeeming 14 SPEs relating to land in various

Villages. Collectively, Jim, Eve’s Trust, and his surviving children,

directly and indirectly (through Forstar and ORMJ), contributed all of

12 More specifically, the initial members of Summit were Jim, his children,

Eve’s Trust, Forstar, JJJ&K Investments, L.P., JPB Family Interests Six, ORMJ, and

the JB Grandchildren’s Trusts.

13 The nonredeeming SPEs include (i) Village One-West School; (ii) Village Two

Commercial; (iii) Village Two Multifamily; (iv) Village Two Residential; (v) Village Two

School 2; (vi) Village Two-West Residential; (vii) Village Seven Residential;

(viii) Planning Area 12 Commercial; (ix) Village Thirteen Commercial; (x) Village

Thirteen Golf Course; (xi) Village Thirteen Multifamily; (xii) Village Thirteen

Residential; and (xiii) Village Thirteen Resort.

14 The redeeming SPEs include (i) Village One Commercial; (ii) Village One

Multi-Family 15; (iii) Village One Multi-Family 19; (iv) Village One Multi-Family 21;

(v) Village One Multi-Family 47; (vi) Village One Residential Phase 2B; (vii) Village

One Residential Phase 4; (viii) Village One Residential Phase 7; (ix) Village One

School; (x) Village One-West Residential (NL); (xi) Village One West Residential (SL);

(xii) Village Two School 1; (xiii) Village Five Multifamily; (xiv) Village Five Residential;

(xv) Village Six Commercial; (xvi) Village Six Multifamily; (xvii) Village Six

Residential; and (xviii) Village Six School.

[*13] their interests in ORD and 31 of the 34 LLCs—which in turn held

interests in ORD.

In sum, the foregoing referenced transactions involving the

transfers by Nancy and Jim, along with the formation and capitalization

of Summit, OR Investments, and Otay Village Four Investments,

resulted in Jim’s family members’ owning and participating in a greater

percentage interest in OPLP through Forstar.

Estate Planning for Al Baldwin

On June 14, 2006, Al and Deeann established four separate

irrevocable trusts, each for the benefit of one of their four children, that

were initially funded with $96,000 in cash—Al and Deeann each giving

$12,000 per child.

In November 2006 Al formed the A. Baldwin Children’s Trusts,

and Deeann formed the D. Baldwin Children’s Trusts, with one trust for

each of their four children, collectively eight separate trusts (collectively,

Chileno Bay Trusts). Al and Deeann transferred to these Chileno Bay

Trusts interests in ocean front land in Cabo San Lucas, Mexico, that was

being held for development of a future golf course and hotel. 15

Al and Deeann then converted their community property

interests in Montecito Village II 16 to separate property and created

separate grantor retained annuity trusts (GRATs) with identical terms.

On December 28, 2006, Al and Deeann each transferred 19.71153%

interests in Montecito Village II to the respective GRATs. The GRATs

had a two-year term with the remainder interests passing to Al and

Deeann’s children after the annuity payments are made.

NoteCo, LLC, was formed on February 28, 2007, as a singlemember LLC in which Southwind was the sole member. Southwind

15 The Chileno Bay Trusts were irrevocable trusts established as grantor

trusts, with Al and Deeann paying all taxes on any income and gains, and with a

defined value clause resulting in any gain passing to a charity, the Catholic Charities

of Orange County, Inc.

16 On December 22, 2006, Al and Deeann lent $5 million to Montecito Village,

by promissory note payable in monthly installments. Effective December 20, 2006, Al

and Montecito Village formed a general partnership named Montecito Village II. Al

contributed a 39.350% interest in AB Finco Common Partner to the newly formed

partnership, Montecito Village II, in receipt of an 87.6068% general partnership

interest, and Montecito Village contributed the $5 million in borrowed funds, in receipt

of a 12.3932% general partnership interest in Montecito Village II.

[*14] contributed promissory notes issued by the 34 SPEs. Southwind

contributed a 10% interest in NoteCo, LLC, and its interests in several

SPEs 17 related to land in Villages 1, 2, 7, and 13, in exchange for a

31.7910% interest in V13 AB Family Holdco L.P (V13 AB Family

Holdco). 18 Similarly, ORMA contributed its interests in several SPEs 19

related to land in Villages 1, 2, 5, and 6, in exchange for a 34.9894%

interest in V13 AB Family Holdco. Lastly, the A. and D. Baldwin Family

Trust contributed its interests in several SPEs 20 related to land in

Villages 1, 2, 7 and 13, in exchange for a 0.1474% interest in V13 AB

Family Holdco.

On February 28, 2007, V4 AB Family Holdco, L.P. (V4 AB Family

Holdco), was formed. The initial partners of V4 AB Family Holdco were

entities affiliated with Al and included Southwind, ORMA, 21 and the

1985 A. and D. Baldwin Family Trust. 22

In sum, the foregoing estate planning transactions contemplated

the transfer of cash and interests in the 34 LLCs held by Southwind,

ORMA, and the various trusts from Al and Deeann to their children and

grandchildren and resulted in Al’s family members’ owning and

17 The SPEs include the same listed supra note 13.

On February 28, 2007, V13 AB Family Holdco was formed. The initial

partners of V13 AB Family Holdco were entities affiliated with Al and included V13

AB Family TrustCo, Southwind, OR Management A, LLC (ORMA), and the 1985 A.

and D. Baldwin Family Trust. V13 AB Family Trust contributed $20 million in

exchange for a 33.0726% interest in V13 AB Family Holdco. The $20 million in funds

contributed by the V13 AB Family Trust, however, were obtained through a loan from

the 1985 A. and D. Baldwin Family Trust.

19 The SPEs include the same listed supra note 14.

20 The SPEs include: Village One West School, LLC, Village Two Commercial,

LLC, Village Two Multifamily, LLC, Village Two Residential, LLC, Village Two School

2, LLC, Village Two West Residential, LLC, Village Seven Residential, LLC, Village

Thirteen Commercial, LLC, Village Thirteen Golf Course, LLC, Village Thirteen

Multifamily, LLC, Village Thirteen Residential, LLC, Village Thirteen Resort, LLC,

and Planning Area 12, LLC.

21 Southwind contributed its interests in Village Four Commercial, LLC, and

Village Four Residential, LLC, in exchange for a 60.0120% interest in V4 AB Family

Holdco. Similarly, ORMA contributed its interest in Village One Residential Phase 1B,

LLC, in exchange for an 8.4076% interest in V4 AB Family Holdco.

22 The A. and D. Baldwin Family Trust contributed its interests in Village Four

Commercial, LLC, and Village Four Residential, LLC, in exchange for a 0.6062%

interest in V4 AB Family Holdco. V4 AB Family Trust also contributed $10 million in

exchange for a 33.0726% interest in V4 AB Family Holdco. The $10 million in funds

contributed by the V4 AB Family Trust was obtained, however, through a loan from

the 1985 A. and D. Family Trust.

[*15] participating in a greater percentage interest in OPLP through

Southwind.

II.

Relevant History of OPLP

Recap of Ownership Structure of OPLP

Before Jim and Al’s estate planning, the ownership structure of

OPLP was as follows: Oriole held a 7.7% general partnership interest,

OPLLC held a 91.2116% limited partnership interest, and ORD held a

1.0882% limited partnership interest. The structure could be diagramed

as follows:

As previously explained, ORD was originally owned by Al and

Jim, when the third-party family was involved in OPLP. After the thirdparty family’s investment, which ended in 2001, other entities, including

Forstar, Southwind, and the 34 LLCs, were substituted for Al’s and

Jim’s interests in ORD.

After Al’s and Jim’s estate planning the ownership structure of

OPLP and OPLLC remained unchanged. However, the ownership

structures of Forstar, Southwind, and the 34 LLCs changed to now

include V13 AB Family TrustCo, V13 AB Family Holdco, V4 AB Family

TrustCo, and V4 AB Family Holdco on Al and his family’s side, while on

Jim’s side it now included Summit and Otay Village Four Investments.

A diagram of this structure follows:

[*16]

OPLP’s Method of Accounting

OPLP tracked annual revenue and costs relating to the sale of

land in Otay Ranch in an Excel schedule (CCM Schedule). The CCM

Schedule also tracked the progress of its Construction Obligations and

percentage of completion with respect to those obligations. In total

OPLP estimated under its CCM Schedule deferred profits of some $783

million relating to CCM and $2.09 million of deferred profits relating to

PCM as of December 31, 2006. The same CCM Schedule also reflected,

as part of OPLP’s sales or transfers of blue-top lots, reimbursements due

of $86.6 million and estimated costs of completion of $244 million as of

December 31, 2006.

[*17] C.

Restructuring and Termination of OPLP

On October 3, 2012, OPLP liquidated, and terminated as a

partnership under the Code. At the time of liquidation OPLP still had

outstanding Construction Obligations and had not recognized

substantial amounts of deferred income relating to its method of tax

accounting. At the time of liquidation, under OPLP’s CCM Schedule, the

deferred profits were $710,498,866 under CCM and $3,622,242 under

PCM.

III.

Tax Returns for OPLP Reporting Basis Adjustments and Tax

Advice Received

On its 2012 Form 1065 OPLP reported income of approximately

$716 million, which was almost entirely attributed to its profits deferred

under the CCM Schedule. OPLP, however, also reported $743,977,826

in “other deductions” attributable to its section 743(b) adjustment (i.e.,

its Basis Deduction). OPLP’s 2012 Form 1065 was chosen for

examination, and on March 20, 2020, respondent issued an FPAA

disallowing $713,759,615 of originally reported deduction attributable

to its section 743(b) adjustment. The FPAA also asserted penalties.

Some years earlier, and for the short year ending March 2, 2007,

OPLP filed a Form 1065 (March 2007 Form 1065) reporting income of

$2,638 and expenses of $202,235. This March 2007 Form 1065 also

reported that there was a technical termination of OPLP under section

708(b)(1)(B) and a section 743(b) basis adjustment of $888,539,588 for

OPLLC and −$275,779 for ORD.

OPLP later filed a Form 1065 for the short year beginning March

3, 2007, and ending April 20, 2007 (April 2007 Form 1065), reporting no

income and expenses of $197,200 and a revised section 743(b) basis

adjustment of $872,639,401 for OPLLC and −$277,732 for ORD.

Attached to both returns was the following statement, signed by Oriole 23

as general partner of OPLP:

Otay Project LP hereby elects under Section 754 of the

Internal Revenue Code to apply the provision of § 734 (b)

and § 743 (b) in adjusting the basis of the partnership

23 The first statement attached to the March 2007 Form 1065 was signed by Al

as general partner, and the second statement attached to the April 2007 Form 1065

was signed by Jim as VP of Oriole.

[*18] property for the taxable year ended . . . and all subsequent

tax years.

On the basis of the foregoing statement, and Treasury Regulation

§ 1.743-1(k), OPLP attached the following statement to its April 2007

Form 1065:

Section 708(b)(1)(b) Termination Disclosure Statement.

On March 30, 2007 and April 20, 2007 there were multiple

exchanges and together caused the transfer of a 50% or

greater interest in the capital and profits of upper tier

partnerships that directly or indirectly holds a 50% or

greater interest in the capital and profits for the above

referenced Taxpayer, causing a termination of both the

upper tier partnerships and the Taxpayer pursuant to

section 708(b)(1)(B) of the Internal Revenue Code. In

particular, Treasury Regulation Section 1.708-(b)(2)

provides in part as follows:

Moreover, if the sale or exchange of an interest in a

partnership (upper-tier partnership) that holds an

interest in another partnership (lower-tier

partnership) results in a termination of the uppertier partnership, the upper-tier partnership is

treated as exchanging its entire interest in the

capital and profits of the lower-tier partnership.

The Taxpayer has prepared this short period return for the

period of March 3, 2007, through April 20, 2007, to properly

reflect the multiple exchanges on March 30, 2007, and

April 20, 2007, that together cause the transfer of a 50% or

greater interest in the capital and profits of the Taxpayer

that were deemed to occur on April 20, 2007, pursuant to

the above referenced regulation. 24

Because all of the partnerships at issue here had section 754 elections

in place, the terminations of the partnerships resulted in OPLLC’s

claiming a section 743(b) adjustment to its assets of OPLP. This

adjustment was calculated as follows:

24 A similar statement was attached to the March 2007 Form 1065, indicating

a 50% or greater exchange of capital occurred on March 2, 2007.

[*19]

OPLLC’s share of outside basis in OPLP:

OPLLC’s share of inside basis with respect to OPLP

Cash on liquidation:

$106,608,746

Less estimated gain upon sale of OPLP assets:

Share of estimated net gain in assets:

$988,528,061

OPLLC’s percentage interest in OPLP

99.9%

Subtotal

$987,539,532

Less 743(b) adjustment for

Southbay purchase:

($13,949,100)

OPLLC’s share of net gain in OPLP assets:

$973,590,432

OPLLC’s share of inside basis with respect to OPLP:

($866,981,686)

Estimated section 743(b) adjustment allocable to

OPLLC with respect to Interest in OPLP:

$866,981,686

Loeb Memoranda

Loeb issued two memoranda dated September 14 and November

5, 2007, regarding the federal income tax consequences of the

reorganization of OPLP and the transfers of direct and indirect

partnership interests in OPLP that occurred in 2007. After reaching

their conclusions Loeb’s memoranda also address application of the

business purpose and economic substance doctrine as applied by the

courts and the “partnership anti-abuse rule” found in Treasury

Regulation § 1.701-2 to these transactions.

EY Opinion

EY issued two lengthy opinions dated October 15, 2007, and

January 15, 2008, with respect to the federal income tax issues

connected with restructuring transactions of the Otay Ranch real estate

development project entered into by entities affiliated with Al and Jim

as of April 1, 2007. EY analyzed relevant provisions of the Code,

Treasury regulations, published Internal Revenue Service rulings, and

judicial decisions, and concluded that, with respect to Oriole’s admission

to OPLP, and the nonliquidating distributions by OPLP, OPLLC, and

ORD, it was more likely than not that

(7) To the extent the distribution of the interest in V4 LLC

by OPLP or OPLLC results in the distributee holding the

V4 LLC interest with a basis less than the basis of such

interest in the hands of the distributing entity immediately

prior to such distribution, the distributing entity, if it has

[*20] a section 754 election in effect for the year of such

distribution, shall increase the basis of its retained assets

in accordance with section 755.

In sum, EY reached nine separate conclusions as to the tax

implications of these transactions. After reaching its conclusions EY’s

opinion also addressed the IRS’s application of “the substance-over-form

principles, the related sham transaction doctrine and step transaction

doctrine to disregard, recast or reorder these transactions” and the

“partnership anti-abuse rule” found in Treasury Regulation § 1.701-2 to

these transactions. Lastly, EY’s opinion addressed the penalty risks,

reportable transaction analysis, and required disclosures relating to

these transactions.

McKee Nelson Opinion

The law firm of McKee Nelson, LLP (McKee Nelson), issued two

opinions dated October 15, 2007, and January 15, 2008, regarding the

tax consequences relating to the restructuring of the ownership of the

assets and equity interests of a number of legal entities owned directly

and indirectly by Al and Jim. The entities included in the opinions by

McKee Nelson are OPLP, OPLLC, ORD, Oriole, Southwind, Forstar,

and the 34 LLCs. Similar to EY’s opinions, McKee Nelson’s opinions also

address the IRS’s application of “the substance-over-form principles, the

related sham transaction doctrine and step transaction doctrine to

disregard, recast or reorder these transactions” and the “partnership

anti-abuse rule” found in Treasury Regulation § 1.701-2 to these

transactions.

IV.

Expert Testimony Presented at Trial

Petitioner offered testimony from Melissa J. Bach, the U.S.

national lead for dispute and litigation support with the firm of

Cushman & Wakefield Western, Inc. Ms. Bach is a real estate appraiser,

holds the MAI 25 and CRE 26 designations, and was recognized, without

objection, as an expert in the field of retrospective real property fair

market valuation. Ms. Bach performed a retroactive appraisal by

valuing portions of fee simple interests in Otay Ranch, including the

Village 2 School and CPF-Sites, the Village 2 Commercial Sites, the

Planning Area-12 Site, and Village 13 as of March 2 and April 20, 2007.

25 The MAI or “member of the Appraisal Institute” is a designation offered by

the Appraisal Institute.

26 Counselor of Real Estate.

[*21] Ms. Bach concluded the retrospective fair market values for both

dates were $2.4 million for the Village 2 School and CPF-4 Sites,

$8.2 million for the Village 2 Commercial Sites, $30.5 million for the

Planning Area-12 Site, and $199 million for the Village 13 Site.

Petitioner also offered expert testimony from Nancy Henderson,

a founding partner and managing partner with the law firm of

Henderson, Caverly Pum, LLP. Ms. Henderson was accepted, without

objection, as an expert in estate and gift planning. Ms. Henderson

practices in California with her firm and has more than 30 years of

experience in complex estate planning.

Ms. Henderson reviewed Al and his spouse’s estate planning, and

as a whole found the plan implemented to be customary for estate

planning undertaken during that same timeframe by real estate

business owners residing in California holding similar objectives to

those held by Al. Ms. Henderson also found the estate planning vehicles

used by Al including irrevocable trusts were appropriate, the LLCs and

limited partnerships used to transfer interests in real estate were

customary, and the number of entities involved was typical and

customary in the light of the historic structure of his real estate

businesses. Ms. Henderson also concluded that the GRATs and

installment sales to IDGTs established for the benefit of Al’s heirs were

customarily used in estate planning for real estate business owners with

objectives similar to those held by Al. Ms. Henderson also found that the

loans made by Al to holding companies, including the amounts and

terms of the loans, were customarily used in estate planning for real

estate business owners with similar objectives to those held by Al.

Ms. Henderson likewise reviewed Jim and his spouse’s estate

planning, and as a whole found the plan implemented to be customary

for estate planning undertaken during that same timeframe by real

estate business owners residing in California holding similar objectives

to those held by Jim. Ms. Henderson also found the estate planning

vehicles used by Jim—including the LLCs and limited partnerships

used to transfer interests in real estate—were customary, and the

number of entities involved was typical and customary in the light of the

historic structure of his real estate businesses. Ms. Henderson concluded

the installment sales to IDGTs established for the benefit of Jim’s heirs

were customarily used in estate planning for real estate business owners

with similar objectives to those held by Jim.

[*22] Respondent likewise offered expert witness testimony from

Christopher M. James, Ph.D., the William H. Dial/Sun Trust Eminent

Scholar and Professor of Finance and Economics at the University of

Florida. Dr. James was accepted, without objection, as an expert in

financial economics. Dr. James has over 45 years of professional

experience in finance, previously was a senior economic advisor with the

U.S. Department of Treasury, Office of the Comptroller of the Currency,

and has served as a consultant for the FDIC 27 and the SEC. 28

At the request of respondent Dr. James analyzed the transactions

at issue from an economic and financial standpoint and provided the

Court his opinion. Dr. James concluded there was no meaningful nontax

economic benefit associated with the formation and capitalizations of

the Finco entities, nor was there a meaningful nontax economic benefit

associated with Oriole’s replacing OPLLC as general partner of OPLP.

He also concluded that OPLP artificially separated its ongoing

Construction Obligations and income from the collection of

Intercompany Notes and Homebuilder Notes relating to prior land sales

under the CCM of tax accounting.

In rebuttal to Dr. James petitioner recalled Ms. Henderson. She

explained how she had reviewed the last portion of Dr. James’s report

relating to technical partnership termination of OPLP and opined that

his conclusions about the estate planning transactions show a “lack of

understanding of estate planning for Real Estate Business Owners,

which is my area of expertise and has been my profession for the past

33 years.” Ms. Henderson also explained how, in fact, an important

estate planning objective is reducing Al’s and Jim’s federal estate tax

burdens and the transferring to junior family members direct or more

commonly indirect interests in real estate assets with the intent and

hope that the assets will appreciate after the transfers. She also noted

the importance of loans for estate planning including the Intercompany

Notes and how they had generated some $20 million in interest since

made. Ms. Henderson disputed Dr. James’s conclusion with respect to

the effectiveness of Al’s estate planning and noted how Dr. James’s

opinion with respect to estate freeze to eliminate the future

appreciation, in part, of Villages 4 and 13 from Al’s and Jim’s federal

taxable estates is evidence of its effectiveness, as this land has

27 The Federal Deposit Insurance Corporation, a Federal Agency.

28 The U.S. Securities and Exchange Commission, a Federal Agency.

[*23] significantly appreciated since the Great Recession. 29 Finally, Ms.

Henderson opined how nontax objectives, including transfer of wealth

to junior family members, while maintaining management and control,

have been achieved through Al’s and Jim’s estate planning transactions.

OPINION

Burden of Proof

Generally, in actions to readjust the Commissioner’s partnershiplevel adjustments in an FPAA, as in other actions in this Court, the

burden of proof is on the taxpayer, unless otherwise provided by statute

or determined by the Court. Rules 142(a), 240(a); Santa Monica

Pictures, LLC. v. Commissioner, T.C. Memo. 2005-104.

Respondent has pleaded new matters in his Answer, as amended,

including that the step transaction doctrine, the common law economic

substance doctrine, the codified economic substance doctrine found in

section 7701(o), 30 the substance-over-form doctrine, and Treasury

Regulation § 1.460-4(k)(4) are applicable. Under Rule 142(a),

respondent bears the burden of proof with respect to any new matter.

In certain cases, the burden of proof shall be on the Commissioner

if, in any court proceeding, the taxpayer introduces credible evidence

with respect to any factual issue relevant to ascertaining the liability of

the taxpayer for any tax imposed by subtitle A or B of the Code. I.R.C.

§ 7491(a)(1). Nonetheless, in the case of a partnership, corporation, or

trust, section 7491(a)(1) applies only if the taxpayer meets the net worth

limitations that apply for awarding attorney’s fees pursuant to section

7430; i.e., a corporation, trust, or partnership whose net worth exceeds

$7 million is ineligible for the benefits of section 7491(a)(1). I.R.C.

§§ 7491(a)(2)(C), 7430(c)(4)(A)(ii); 28 U.S.C. § 2412(d)(1)(B), (2)(B) (as in

effect on Oct. 22, 1986). Respondent alleges the record does not establish

that OPLP or OPLLC has met the net worth limitations. We agree.

Accordingly, section 7491(a) does not apply. See H.R. Rep. No. 105-599,

at 240, 242 (1998) (Conf. Rep.), reprinted in 1998-3 C.B. 747, 994, 996

(stating that the taxpayer has the burden of proving it meets the

requirements in I.R.C. § 7491(a)(2)).

29 Although not defined by Ms. Henderson we take judicial notice that the

Great Recession was a period of worldwide economic decline from 2007 to 2009.

30 Respondent abandoned this argument before trial.

[*24] Except for the items raised as new matters in respondent’s

Answer, as amended, we conclude that petitioner bears the burden of

proof with respect to the factual issues in the case.

II.

Analysis

Summary of Parties’ Arguments as to OPLP’s Basis

Deduction

Petitioner contends that a section 743(b) adjustment was

required as a result of the 50% or greater transfers of interests in upper

tier partnerships. More specifically, petitioner points to Al’s and Jim’s

transfers of interests in ORD and the 34 LLCs—the first tier in the

OPLP ownership structure in March and April 2007—resulting in a

deemed transfer of interests in ORD, and in turn OPLLC. Since ORD,

OPLLC, and OPLP all had section 754 elections in effect, petitioner

contends OPLP was required to adjust the basis of its assets under

section 743(b) with respect to OPLLC.

Petitioner further contends that its 2007 basis adjustment was

calculated pursuant to the express provisions of section 743(b) and in

accord with Treasury Regulation § 1.743-1(d). OPLP held long-term

contracts and used the CCM and PCM methods of tax accounting.

Petitioner, citing Treasury Regulation § 1.460-4(k)(3)(v)(B), contends

that under a hypothetical transaction (assumed upon termination of a

partnership) OPLP would dispose of its assets, including its CCM

contracts valued at $974 million, resulting in OPLLC’s share of inside

basis being negative $867 million and its outside basis being zero. Under

section 743(b), a basis adjustment to OPLLC of $867 million resulted. In

2012 OPLLC’s outside basis is equal to more than $743 million and,

upon liquidation of OPLP, it properly reported its Basis Deduction

attributable to these prior section 743(b) adjustments.

Respondent disputes OPLP’s claimed Basis Deduction as not

being available under the Code. Rather, he argues, the Code requires

OPLP to include section 752 liabilities in calculating OPLLC’s basis

adjustment under section 743(b), resulting in petitioner’s overstated

basis. Respondent also contends petitioner acted negligently and with

disregard of applicable rules and regulations in filing OPLP’s 2012 Form

1065 and that petitioner does not have reasonable cause excusing the

underpayment in question.

[*25] B.

Whether OPLP’s Section 743(b) Basis Adjustment Was

Calculated Correctly

Under section 708(b)(1)(B) a partnership terminates if within a

12-month period there is a sale or exchange of 50% or more of the total

interests in capital and profits of the partnership. This includes

termination of upper tier partnerships such as OPLP. See Treas. Reg.

§ 1.708-1(b)(2). This termination results in what is referred to under the

Code and regulations as a “new partnership.” See id. subpara. (4).

Accordingly, the deemed contribution of the upper tier partner’s entire

interest in the lower tier partnership is treated as a sale or exchange of

that interest for purposes of section 743(b).

In this case the termination of OPLP occurred through Al’s and

Jim’s estate planning transfers through the transfer of 50% or more of

the total capital and profits interests in 30 of the 34 LLCs. In turn, this

tiered partnership termination results in a termination of ORD, which

in turn resulted in a termination of OPLLC and ultimately a

termination of OPLP. On October 3, 2012, OPLP terminated and

liquidated under the Code. At the time of liquidation OPLP had not

recognized substantial amounts of deferred income under its CCM

Schedule, including deferred profits of $710,498,866 under CCM and

$3,622,242 under PCM. This termination of OPLP and recognition of

deferred income is not in dispute.

Respondent disputes OPLP’s Basis Deduction on several specific

grounds. On brief respondent contends OPLP should be treated as

retaining the right to receive payment under certain contracts, which

should have been included in the calculation of any section 743(b) basis

adjustment. Citing section 460, respondent contends that the

Homebuilder Notes do not constitute payment since they are not cash or

cash equivalents. Since OPLP retained the Construction Obligations, it

continued to retain the right to payment; and any divorce between these

obligations and payments should not be respected. On this theory,

respondent contends that OPLLC’s section 743(b) adjustment in 2007

should be only $253 million.

Respondent also argues that OPLP’s basis adjustment should be

disallowed since OPLP incurred liabilities that should have been

included in the calculation of any section 743(b) basis adjustment. First,

respondent contends that OPLP’s liabilities exceed the $175 million

reported since the definition of a liability under section 752 is broad and

includes all obligations, including the Homebuilder entities’ right to

[*26] rescind the sale of land upon OPLP’s failure to meet its

Construction Obligations.

In his Reply Brief respondent contends that section 743 does not

mandate OPLP’s basis adjustment and petitioner’s claims rely on an

improper reading of the regulations. First respondent points us to the

general and historical concepts on basis. See I.R.C. § 1012(a); Stern v.

Commissioner, 39 B.T.A. 501, 506 (1939). Using these concepts,

respondent contends that OPLLC’s share of basis in OPLP’s property

(i.e., inside basis) cannot go negative and therefore must fall between

zero and $28,062,072, the total amount of basis OPLP reported in its

assets upon distribution of the Finco interests to OPLLC. Citing the

generally applicable formula found in Treasury Regulation § 1.7431(d)(1) for determining a partner’s previously taxed capital, respondent

also contends that petitioner’s calculation of OPLLC’s share of inside

basis conflicts with section 743(b) and otherwise is illegal since the sum

of OPLP’s previously taxed capital and liabilities does not equal the total

basis of its assets; a fundamental principle made clear in the examples

of the section 743 regulations.

Petitioner disputes each of respondent’s arguments. First, it

contends respondent’s liabilities-based argument fails since under

section 752 OPLP’s liabilities should be no greater than its estimated

remaining Construction Obligations, which in any event are allocable to

Oriole as the general partner of OPLP. Next, petitioner contends that

the regulations under section 752 define liabilities to include only

OPLP’s Construction Obligations, and, citing Revenue Ruling 73-301,

1973-2 C.B. 215, contends these liabilities do not equal OPLP’s entire

basis in the Intercompany Notes.

Generally, the basis of partnership property is not adjusted upon

the transfer of a partnership interest. See I.R.C. § 743(a). However, if a

partnership has a section 754 election in effect, upon any transfer of an

interest in the partnership by sale or exchange, the partnership is to

adjust the basis of its assets. See I.R.C. § 743(b). In this case it is

undisputed that OPLP had a section 754 election in effect and section

743(b) is applicable. The dispute between the parties lies in the complex

issues involving application of this section and the applicable Treasury

regulations. Section 743(b) provides in full as follows:

Sec. 743(b). Adjustment to basis of partnership

property.—In the case of a transfer of an interest in a

partnership by sale or exchange or upon the death of a

[*27] partner, a partnership with respect to which the election

provided in section 754 is in effect or which has a

substantial built-in loss immediately after such transfer

shall—

(1) increase the adjusted basis of the

partnership property by the excess of the basis to the

transferee partner of his interest in the partnership

over his proportionate share of the adjusted basis of

the partnership property, or

(2) decrease the adjusted basis of the

partnership property by the excess of the transferee

partner’s proportionate share of the adjusted basis

of the partnership property over the basis of his

interest in the partnership.

Under regulations prescribed by the Secretary, such

increase or decrease shall constitute an adjustment to the

basis of partnership property with respect to the transferee

partner only. A partner’s proportionate share of the

adjusted basis of partnership property shall be determined

in accordance with his interest in partnership capital and,

in the case of property contributed to the partnership by a

partner, section 704(c) (relating to contributed property)

shall apply in determining such share. In the case of an

adjustment under this subsection to the basis of

partnership property subject to depletion, any depletion

allowable shall be determined separately for the transferee

partner with respect to his interest in such property.

The foregoing provision of the Code is intended to increase (or

decrease) the adjusted basis of the transferee partner’s interest in the

partnership (i.e., outside basis) upon the sale or exchange of a

partnership interest or upon the death of a partner. In this case the

adjustment applies to OPLLC, and the adjustment is to its outside basis

in OPLP. Section 743(b) expressly provides in part that “[a] partner’s

proportionate share of the adjusted basis of partnership property shall

be determined in accordance with his interest in partnership capital . . . .”

(Emphasis added.) Considering this statutory text, we reject any

computation adjusting a partner’s basis in a partnership which does not

fully consider that partner’s capital interest in the partnership.

The mechanics of a transferee partner’s basis adjustment are

found in Treasury Regulation § 1.743-1(d), which states that generally

a transferee’s share of the adjusted basis of partnership property is

[*28] equal to the sum of their interest, as a partner, in the

partnership’s “previously taxed capital, plus the transferee’s share of

partnership liabilities.” Treasury Regulation § 1.743-1(d) goes on to

state that a transferee’s “previously taxed capital” is equal to the

amount of cash the transferee would receive upon liquidation, increased

by the amount of tax loss that would be allocated to the transferee, and

decreased by the amount of tax gain that would be allocated to the

transferee, upon a hypothetical liquidation transaction. Treasury

Regulation § 1.743-1(d)(2) defines a “hypothetical transaction” to mean

the disposition by the partnership of all of the partnership’s assets,

immediately after the transfer of the partnership interest, in a fully

taxable transaction for cash equal to the fair market value of the assets.

Petitioner takes Treasury Regulation § 1.743-1(d) to mean that

OPLLC’s share of OPLP’s inside basis in 2007 was negative

$866,981,686, since its share in partnership capital, upon a hypothetical

liquidation, would result in OPLLC’s receiving $106,608,746 in cash,

decreased by allocable gain of $973,590,432. According to petitioner, this

negative capital held by OPLLC, upon the termination of OPLP in 2007,

results in a section 743(b) basis adjustment to OPLLC of this difference,

$866,981,686.

After considering section 743(b) and Treasury Regulation § 1.7431(d), we find respondent’s arguments made in his briefing to be

compelling. In this case the foregoing calculation resulting in the section

743(b) basis adjustment to OPLLC is illogical. The balance sheet of

OPLP, which was used to make these calculations, reflects assets of only

$28 million, liabilities of $71 million, and a total negative capital of $848

million. More specifically, OPLLC—the 99.9% partner in OPLP—

reflects negative capital of $911,595,423 ($912 million). Petitioner

provided no explanation as to these figures other than rejecting

respondent’s proposed changes to how the section 743(b) adjustment

was made.

We find respondent’s arguments compelling, since the contortion

of this balance sheet was the result of prior distributions made by OPLP.

OPLLC’s negative capital balance is the result of the distribution of taxdeferred profits along with the distribution of OPLP’s interest in the

Finco entities. These prior distributions of cash (or cash equivalents)

were ignored by petitioner when it calculated OPLLC’s section 743(b)

basis adjustment.

[*29] A partnership generally selects its method of accounting and

taxable year, see I.R.C. §§ 703(b), 706(b); it may choose a method of

accounting different from the method used by its partners, see Treas.

Reg. § 1.703-1(b)(1). In this case petitioner seeks to gain a tax benefit

through these differences in accounting methods. On the one hand

OPLP benefited from deferred taxable gains of some $921 million based

on its use of CCM, while on the other hand OPLP claims to have made

distributions of previously taxed capital of approximately $912 million

to its 99.9% partner, OPLLC. This disparity cannot be the case and must

ultimately be reconciled. Petitioner claims a hypothetical liquidation

would result in OPLLC’s receiving only $106,608,746 in cash; however,

in reality it has been allocated an additional $912 million in cash based

on OPLLC’s capital account, which has been booked against its capital

accounts as a liability or negative figure.

A primary feature of the Treasury regulations relating to section

704(b) and a partner’s distributive share are the allocations of items of

income, loss, etc. among partners and whether these allocations made

under any partnership agreement 31 satisfy the “substantial economic

effect” test. See Treas. Reg. § 1.704-1(b)(2). An allocation made to any

partner will not be considered to have “economic effect” unless it

comports with the underlying arrangements of the partners, and only if

it ensures that a partner who receives an economic benefit equally bears

an economic burden relating to the partnership for tax purposes. See id.

subdiv. (ii)(a). In other words, any tax items allocated to a partner for

tax purposes should have an equivalent impact on the amount of cash

that the partner would be entitled to receive upon liquidation of the

partnership. See id. subdiv. (ii)(b). Furthermore, if the partner has a

deficit balance in his capital account upon liquidation, after adjustments

are made for the partnership year, that partner is unconditionally

obligated to restore the amount of that deficit balance to the

partnership. See id. subdiv. (ii)(b)(3). The regulations also address when

a partner’s obligation to restore a deficit capital account will be

respected and consistent with guidance related to section 752 including

when a partner’s obligation is not legally enforceable, or the facts and

circumstances otherwise indicate a plan to circumvent or avoid the

obligation. See Treas. Reg. § 1.704-1(b)(2)(ii)(c)(2).

31 The term “partnership agreement” is broadly construed and includes all

agreements among the partners, oral or written, and also includes state and local laws

governing partnerships. See Treas. Reg. § 1.704-1(b)(2)(ii)(h).

[*30] As mentioned above, and at the time of OPLP’s section 743(b)

adjustment, OPLLC reflected negative capital of $912 million. This

negative figure is difficult to accept for a number of reasons. First, while

a partner’s capital account can go negative, here it defies logic that

OPLLC’s negative capital can realistically go beyond OPLP’s entire

balance sheet, which reflects total assets of $28 million and liabilities of

$71 million. OPLLC’s negative capital flies in the face of reality and

proper tax accounting.

Second, this negative capital is fundamentally impossible from a

cash perspective, meaning it is ordinarily impossible for any partner to

withdraw nearly a billion dollars in capital in excess of the amount of

capital that the partner previously contributed to the partnership. It is

apparent this discrepancy can only be attributed to the $921 million in

deferred profits listed on the CCM Schedules. In other words, for cash

(or book) accounting purposes OPLP has distributed deferred gains to

its partners, principally to OPLLC. However, for tax reporting purposes

no gain has been recognized since OPLP retains its Construction

Obligations under CCM. We refuse to accept (or otherwise recognize)

this otherwise illogical disparity reflected on OPLP’s balance sheet,

because doing so would defy tax accounting principles and would result

in a partnership with an overall negative value of $848 million.

Lastly, and importantly, to achieve a negative capital account of

nearly $912 million while maintaining substantial economic effect (as

required under the partnership agreement), OPLLC must (1) have an

equal unconditional obligation to restore the amount of its deficit capital

balance to the partnership and (2) bear an economic burden equal to its

previously received economic benefit relating to the partnership for tax

purposes. See Treas. Reg. § 1.704-1(b)(2)(ii)(a), (b)(3). Upon liquidation

of a partnership or a partner’s interest in a partnership, liquidating

distributions will be made in accordance with properly maintained

positive capital account balances. See id. subdiv. (ii)(b). Considering the

foregoing, since OPLP has treated the prior distributions of excess

capital to OPLLC of $912 million as having substantial economic effect,

OPLLC holds an unconditional obligation to restore its negative capital

account. Accordingly, the Basis Deduction calculation must account for

OPLLC’s negative capital, for the prior partnership distributions to

maintain economic effect. See id.

Petitioner’s engineered section 743(b) adjustment, absent the

deferred gain found on OPLP’s CCM Schedule and OPLLC’s liability

found in its negative capital account, is an incomplete calculation and

[*31] contrary to the partnership agreement. Thus, the Basis Deduction

calculation cannot be respected here. A correct section 743(b)

adjustment must account for OPLLC’s negative capital of $912 million

and its unconditional obligation to restore this negative balance through

a contribution of additional cash upon liquidation or recognition as a

liability. See I.R.C. § 752; Treas. Reg. §§ 1.743-1(d)(1)(i), 1.7041(b)(2)(ii)(b)(3).

In sum, we determine petitioner has not met its burden here and

has failed to correctly establish the Basis Deduction under section

743(b), as claimed on OPLP’s 2012 Form 1065. Accordingly, we will

sustain respondent’s disallowance of $713,759,615 of a more than $743

million claimed Basis Deduction reported on OPLP’s 2012 Form 1065

for the 2012 tax period.

Whether the Economic Substance Doctrine Can Be Applied

in This Case

Respondent also argues that the transactions at issue lack

economic substance and, in the alternative, argues the basis

adjustments discussed herein should be disallowed under his authority

granted under Treasury Regulation § 1.701-2. We have said this

regulation, and the economic substance doctrine, are coextensive and

function together as necessary. See Tribune Media Co. v. Commissioner,

T.C. Memo. 2021-122, at *106. Respondent uses these arguments to

override OPLLC’s basis adjustments reported by OPLP.

Petitioner contends that respondent should not be permitted to

override the tax result mandated by section 743(b) through application

of the economic substance doctrine. In support of this contention

petitioner contends that section 743(b) is unambiguous and that the

judicially created economic substance doctrine was never intended to

apply to all provisions of the Code or to all transactions. Petitioner also

contends that respondent cannot use the economic substance doctrine to

otherwise attack the transactions at issue since they have economic

substance.

We disagree with petitioner’s argument since other federal courts

have long recognized that the economic substance doctrine has required

disregarding, for tax purposes, transactions that comply with the literal

terms of the tax code but lack economic reality. See Coltec Indus., Inc. v.

United States, 454 F.3d 1340, 1352 (Fed. Cir. 2006). This principle is

rooted in multiple Supreme Court cases. Id.; see, e.g., Knetsch v. United

[*32] States, 364 U.S. 361 (1960); Commissioner v. Court Holding Co.,

324 U.S. 331 (1945); Gregory v. Helvering, 293 U.S. 465 (1935). 32 In

Frank Lyon Co. v. United States, 435 U.S. 561, 583–84 (1978), the

Supreme Court explained the circumstances in which a transaction

should be respected for tax purposes. The standard articulated in Frank

Lyon Co. remains the basis for the current application of the economic

substance doctrine. See, e.g., GWA, LLC v. Commissioner, T.C. Memo.

2025-34, at *45–47. 33 Whether a transaction has economic substance

requires a factual determination. United States v. Cumberland Pub.

Serv. Co., 338 U.S. 451, 456 (1950). Accordingly, and as an initial matter,

we reject petitioner’s contention that the economic substance doctrine is

inapplicable in this case.

The Scope of Economic Substance Inquiry

We recognize that “[t]he legal right of a taxpayer to decrease the

amount of what otherwise would be his taxes, or altogether avoid them,

by means which the law permits, cannot be doubted.” Gregory v.

Helvering, 293 U.S. at 469. The Supreme Court, however, has said this

right is a two-way street since “while 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, . . . and

may not enjoy the benefit of some other route he might have chosen to

follow but did not.” Commissioner v. Nat’l Alfalfa Dehydrating & Milling

Co., 417 U.S. 134, 149 (1974); see also id. at 148 (referring to “the

established tax principle that a transaction is to be given its tax effect

in accord with what actually occurred and not in accord with what might

have occurred”); Founders Gen. Corp. v. Hoey, 300 U.S. 268, 275 (1937)

(“To make the taxability of the transaction depend upon the

determination whether there existed an alternative form which the

statute did not tax would create burden and uncertainty.”). The ultimate

question for us to answer is “whether what was done, apart from the tax

32 See also Jeff Rector, Comment, A Review of the Economic Substance Doctrine,

10 Stan. J.L. Bus. & Fin. 173 (2004).

33 Courts have interpreted Frank Lyon Co. as creating an economic substance

doctrine that examines two areas or prongs: (1) whether the transaction had economic

substance beyond tax benefits (objective prong) and (2) whether the taxpayer has

shown a nontax business purpose for entering the disputed transaction (subjective

prong). See, e.g., ACM P’ship v. Commissioner, 157 F.3d 231, 247–48 (3d Cir. 1998),

aff’g in part, rev’g in part T.C. Memo. 1997-115; Bail Bonds by Marvin Nelson, Inc. v.

Commissioner, 820 F.2d 1543, 1549 (9th Cir. 1987), aff’g T.C. Memo. 1986-23; Rice’s

Toyota World, Inc. v. Commissioner, 752 F.2d 89, 91–92 (4th Cir. 1985), aff’g in part,

rev’g in part 81 T.C. 184 (1983).

[*33] motive, was the thing which the statute [here I.R.C. § 743]

intended.” Gregory v. Helvering, 293 U.S. at 469.

This case, absent a stipulation otherwise, would be appealable to

the U.S. Court of Appeals for the Ninth Circuit. See I.R.C. § 7482(b).

Within the Ninth Circuit, the standard in determining whether a

transaction has economic substance (i.e., is not a sham) is whether the

transaction has any practical economic effects other than the creation of

income tax losses (i.e., whether the taxpayer has shown that there was

a nontax business purpose for engaging in the transaction beyond the

creation of tax benefits). Sochin v. Commissioner, 843 F.2d 351, 354 (9th

Cir. 1988), aff’g Brown v. Commissioner, 85 T.C. 968 (1985); Bail Bonds

by Marvin Nelson, Inc. v. Commissioner, 820 F.2d at 1548–49.

The Ninth Circuit has stated that it “generally applies a twopronged inquiry addressing the objective nature of the transaction

(whether it has economic substance beyond tax benefits) and the

subjective motivation of the taxpayer (whether the taxpayer had a nontax business purpose for the transaction).” Reddam v. Commissioner,

755 F.3d 1051, 1057 (9th Cir. 2014), aff’g T.C. Memo. 2012-106; see Bank

of N.Y. Mellon Corp. v. Commissioner, 801 F.3d 104, 115 (2d Cir. 2015),

aff’g 140 T.C. 15 (2013) and T.C. Memo. 2013-225. The Ninth Circuit

has also noted, however, that “the economic substance doctrine is not a

‘rigid two-step analysis,’ but instead focuses holistically on whether ‘the

transaction had any practical economic effects other than the creation

of income tax losses.’” 34 Reddam v. Commissioner, 755 F.3d at 1060

(internal quotation marks and citations omitted) (first quoting Sacks v.

Commissioner, 69 F.3d 982, 988 (9th Cir. 1995), rev’g T.C. Memo. 1992596; and then quoting Sochin v. Commissioner, 843 F.2d at 354). 35

34 “The economic substance factor involves a broader examination of whether

the substance of a transaction reflects its form, and whether from an objective

standpoint the transaction was likely to produce economic benefits aside from a tax

deduction.” Reddam v. Commissioner, 755 F.3d at 1059 (quoting Casebeer v.

Commissioner, 909 F.2d 1360, 1365 (9th Cir. 1990)).

35 We surveyed relevant caselaw within the Ninth Circuit to better determine

application of the economic substance judicial doctrine. See Reddam v. Commissioner,

755 F.3d at 1057 (holding a $50 million a capital loss purportedly generated by several

Cayman Islands entities lacked economic substance); Sacks v. Commissioner, 69 F.3d

at 988 (holding a taxpayer’s sale-leaseback was a sham); Sochin v. Commissioner, 843

F.2d at 355 (holding a taxpayer’s minimal investment for ordinary losses and longterm gain was a sham); Bail Bonds by Marvin Nelson, Inc. v. Commissioner, 820 F.2d

at 1549 (holding fictitious loans using a circular flow of funds was a sham and not

[*34] Turning back to this Court, we have sometimes followed an

“integrated approach” and considered the substance of all activities, as

a whole and in relation to the tax benefit, in determining whether to

allow the benefit. See Salina P’ship v. Commissioner, T.C. Memo. 2000352. In other cases we have adopted a “bifurcated approach”

disassembling a transaction into separate steps or parts, focusing only

on the portion of the transaction that results in the tax benefits at issue.

See James v. Commissioner, 899 F.2d 905, 910 (10th Cir. 1990) (“The

only transactions at issue in this case are the purported sales by the

Communications Group to the joint ventures. These sales cannot be

legitimized merely because they were on the periphery of some

legitimate transactions.”), aff’g 87 T.C. 905 (1986); Smith v.

Commissioner, 91 T.C. 733 (1988), aff’d sub nom. Karr v. Commissioner,

924 F.2d 1018 (11th Cir. 1991), and rev’d and remanded, 937 F.2d 1089

(6th Cir. 1991). Here we approach the transactions at issue from an

integrated approach with the ultimate goal of determining whether (or

not) the Basis Deduction claimed is lacking in economic substance.

Summary of Parties’ Arguments as to Whether the

Transactions at Issue Lack Economic Substance

On brief petitioner argues that after a breakdown in the personal

and decades-long business relationships between Al and Jim and the

initiation of arbitration, the brothers took steps to separate their joint

assets, including the Homebuilders Notes held by OPLP, through the

sale of land at Otay Ranch.

Petitioner argues that to facilitate the separation of assets in late

2005 and 2006 the Finco entities were formed and the promissory notes

previously held by OPLP were contributed to Al’s and Jim’s respective

Finco entities. Before formation of the Finco entities, Al, through his

entities, bore 50% of all risk associated with AB Homebuilder entities.

The same was true for Jim—meaning he bore 50% of all risk associated

with JB Homebuilders. This risk sharing changed after the formation

and capitalization of the Finco entities. In further division of joint

assets, in late 2006 OPLP distributed its interests in the Finco entities

to OPLLC, which in turn distributed the AB Finco interests to Al and

his entities, and the JB Finco interests to Jim and his entities.

deductible); Zmuda v. Commissioner, 731 F.2d 1417, 1421 (9th Cir. 1984) (holding

three foreign trusts established to avoid taxes on the income from properties within

the United States were shams), aff’g 79 T.C. 714 (1982).

[*35] Petitioner contends that through OPLP’s admission of Oriole as a

limited partner and the division of assets to the Finco entities, both Al’s

and Jim’s personal exposure to future construction defect litigation was

reduced, supporting the proposition that there was economic substance

to the transactions.

Beginning in 2007 both Al and Jim undertook estate planning,

which was typical and customary in the light of the historic structure of

their respective real estate businesses. Through Al’s estate planning,

interests in Villages 13 and 4 were transferred to newly formed entities

which were held in trust for the benefit of Al’s Family. Similarly,

through Jim’s estate planning, interests in Villages 13 and 4 were

transferred to newly formed entities and in trust for the benefit of Jim’s

Family.

The estate planning of Al and Jim resulted in the transfer of 50%

or more of the total interests in the 34 LLCs, which in turn resulted in

a transfer of 50% or more of the total interests in ORD, and in turn

resulted in a transfer of 50% or more of the total interests in OPLLC and

resulted in a termination of OPLLC. Although respondent disputes the

nature of Al’s and Jim’s estate planning, it is undisputed by the parties

that it was these portions of the transactions at issue which resulted in

a deemed sale or exchange of its entire interests in OPLP, and

adjustment of OPLLC’s basis.

On brief respondent argues the unstated purpose of the

transactions at issue was to generate a tax deduction to shelter deferred

income upon liquidation of OPLP thereby ultimately eliminating or

indefinitely deferring tax upon the deaths of Jim and Al. Respondent

asserted the restructuring of OPLP lacks a bona fide nontax business

purpose and any practical business or economic effect on operations and

activities of OPLP, Al and Jim, and their families. Respondent, more

specifically, contends that the restructuring of OPLP—with the

distribution of its interests in the Finco entities while retaining ongoing

Construction Obligations—lacks economic substance and has a

principal purpose of avoiding tax in a manner inconsistent with the

Code.

Respondent contends that petitioner failed to provide valid

business reasons for separating the Homebuilder and Intercompany

Notes from the ongoing Construction Obligations of OPLP. According to

respondent, Al and Jim retained tax lawyers who engineered a series of

transactions to exploit an inside-outside basis disparity in OPLP,

[*36] inappropriately achieving indefinite deferral of income.

Respondent also contends that—despite the complex restructuring—Al

and Jim (and their respective families) maintained their 50/50 split of

Otay Ranch. Respondent further contends the transactions at issue were

not negotiated but were designed to benefit both Al and Jim from a tax

standpoint. Furthermore, if Al and Jim’s tax advisors intended to truly

address Jim’s “red and blue division” of Villages 2 and 7, then according

to respondent, they would have addressed both the division of the joint

assets and the liabilities for OPLP, including their joint public bond

obligations. The restructuring plans, however, involved only the

transfer of assets, evidencing the intent to create the Basis Deduction.

With respect to Al’s and Jim’s estate planning respondent

contends each fails to withstand scrutiny since Jim treated Forstar as

his alter ego, despite his family ownership interests. Similarly, Al

treated all of the cash in his family entities as belonging to him, despite

trusts’ and other family members’ holding interests. 36 Respondent also

contends that some transactional documents were backdated,

evidencing that the estate planning lacks economic substance. Although

OPLP transferred the Intercompany Notes, in substance, OPLP

retained ownership since the transferees were alter egos of Al and Jim.

In sum, respondent contends the transactions at issue lack economic

substance when we consider the objective factor.

Application of the Objective and Subjective Inquiry

We will first consider whether the restructuring of OPLP,

followed by estate planning by Al and Jim, held objective economic

substance outside of tax avoidance. To answer this question, we query

whether the transactions at issue held practical economic effects outside

of the tax benefits being challenged. See Reddam v. Commissioner, 755

F.3d at 1060–61.

From an objective standpoint we are to consider whether the

transactions at issue produced economic benefits aside from tax

benefits. See Casebeer v. Commissioner, 909 F.2d at 1365. Respondent

contends this is not a kind of transaction that people would enter into

without a tax motive, see Yosha v. Commissioner, 861 F.2d 494, 499 (7th

Cir. 1988), aff’g Glass v. Commissioner, 87 T.C. 1087 (1986), nor does

the transaction pose a realistic expectation of economic profit, see

36 The parties dispute the characteristics of Al’s and Jim’s estate planning and

whether they should be respected. We do not find the issue controlling, since neither

party disputes the termination of OPLP, followed by OPLLC, for tax purposes.

[*37] Goldstein v. Commissioner, 364 F.2d 734 (2d Cir. 1966), aff’g 44

T.C. 284 (1965), and the purchase price is not roughly equivalent to the

fair market value of the property, as required in Estate of Franklin v.

Commissioner, 544 F.2d 1045, 1048 (9th Cir. 1976), aff’g 64 T.C. 752

(1975). Petitioner contends that transactions that shift the potential for

gain or the risk of loss from one party to another have economic

substance. After considering all of the evidence before us, we find

respondent’s argument to be the more compelling of the two. 37

Looking at the original MOU and Judge Lewis’s April 2005 order,

the intent of Al and Jim was clear, namely dissolution of OPLP. In the

April 2005 order Judge Lewis states:

All joint entities holding title to mutually owned properties

shall be dissolved within sixty (60) days of when the last

piece of land is deeded out . . . all property transfers and

divisions under the terms of this award and the MOU shall

be accomplished within thirty-six (36) months from this

date.

However, sometime later, on advice received from EY, it was

decided that the transfer of property under the MOU was no longer to

be achieved through distribution, but with the sale of property to the

respective Homebuilder entities, followed by the capitalization of newly

created Finco entities using Intercompany Notes and newly formed

entities. Even though all of the underlying property of Otay Ranch

would be transferred to Al and Jim and their respective Homebuilder

entities, the Construction Obligations and the entitlement process

would remain within OPLP.

In considering the formation and capitalization of the Finco

entities we look to the cash funds of $21 million derived from Jim’s entity

JPB Investments and $53 million from Al’s entity Pacifica. The cash

funds were used to payoff of the Homebuilder Notes, which were then

replaced with newly issued Intercompany Notes. However, the question

arises as to why there was a need to replace the Homebuilder Notes with

the Intercompany Notes? We find this question is properly answered by

respondent. Respondent notes that

37 As a threshold matter, arrangements with subsidiaries that do not affect the

economic interests of independent third parties deserve particularly close scrutiny.

Coltec, 454 F.3d at 1357.

[*38] the restructuring purportedly separated OPLP’s CCM cash

from its CCM contracts, and the result (according to

petitioner) is that the income disappears. This separation

is unnatural, from a business standpoint, and the Finco

entities were merely vehicles to facilitate indefinite tax

deferral, as ultimately Al and Jim, indirectly, continued to

receive all payments and have all construction obligations.

These newly issued Intercompany Notes were then promptly

contributed by OPLP to the Finco entities, and in turn OPLP’s interests

in the Finco entities were distributed to Al and Jim. The purported

objective business purpose for this transaction was to minimize Al’s and

Jim’s respective business risks associated with their homebuilding

activities. We do not find this stated purpose to be compelling since

substantial continued joint Construction Obligations remained within

OPLP. Furthermore, entitlements to the land under the separate

Villages at Otay Ranch continued within OPLP, notwithstanding the

creation of the Finco entities.

We determine the flow of cash funds among Al, Jim, and OPLP to

be circular. We further determine the creation of the Finco entities to be

separate and apart from Al’s and Jim’s original goal to divest their

jointly held property for future development at Otay Ranch. In other

words, the formation of the Finco entities and the distribution of these

assets were not undertaken to effect the straightforward agreed-to

terms between Al and Jim under the MOU. Rather they were employed

on the recommendation of EY and made to establish a Basis Deduction

and future offset against Al’s and Jim’s deferred gains of $921 million,

as reflected on the CCM Schedule. We do accept petitioner’s premise;

namely that two siblings, previously in business together, chose to

conduct future business separate and apart. We decline to accept that

the formation of the Finco entities was in pursuit of their goal as

established under the MOU.

Furthermore, the substitution of Oriole as general partner, rather

than OPLLC, appears to be principally tax driven. For years OPLP

operated with OPLLC as a general partner, and upon entering

dissolution, as agreed by both Al and Jim, it seems to be illogical or at

the very least overly complex to insert Oriole as a new partner (likewise

owned 50/50 by Al and Jim). Considering the objective reason given by

petitioner, it appears the real reason for the conversion of OPLLC’s

interest to that of a limited partner was principally for OPLLC’s tax

benefit. While OPLLC’s conversion to the status of a limited partner

[*39] may have some perceived nontax benefit, we view this benefit to

be irrelevant in comparison to the tax benefits sought through the

conversion of OPLLC’s interest and in calculating its outside tax basis

in OPLP under section 752.

Next, under the subjective inquiry we are to determine whether

a taxpayer has shown a business purpose for engaging in the transaction

other than tax avoidance. See Casebeer v. Commissioner, 909 F.2d at

1364. The subjective factors focus on a taxpayer’s expectations and

motives to determine whether it has indeed engaged in a transaction for

business purposes other than tax avoidance. Bail Bonds by Marvin

Nelson, Inc. v. Commissioner, 820 F.2d at 1549. Pointing to the fact that

EY represented both Al and Jim jointly, respondent contends only

related parties, not parties acting at arm’s length, would have entered

into these transactions.

With respect to the subjective aspect of the transactions at issue,

respondent contends the restructuring “purportedly separated OPLP’s

right to cash payments on the CCM Notes,” by conversion to

Intercompany Notes, which was “an artifice to facilitate indefinite tax

deferral, as ultimately, the Baldwin Brothers and their families,

indirectly, continued to receive all payments and have all construction

obligations.” We agree; and when considering the subjective elements of

the transactions at issue, we struggle to find a compelling nontax

business purpose.

After examining the tax opinions rendered by EY it seems rather

apparent that the transactions at issue were predetermined and

engineered principally to create a substantial inside-outside basis

disparity within OPLP, the Finco entities, and OPLLC, which in turn

sought to achieve indefinite tax deferral for Al and Jim. Cf. John

Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. 1, 89 (2013)

(holding the test transactions did not lack economic substance when the

taxpayer determined that the “test transactions would contribute

towards diversifying its investments, provide a strong yield, and match

its long-term obligations”). The transactions at issue are exceedingly

complex and contrived by outside tax advisors in furtherance of one goal:

elimination of deferred taxable gain. Accordingly, after considering

these subjective factors we cannot conclude that the transactions at

issue contain a useful nontax business purpose. Although tax laws affect

nearly every business transaction, tax consequences should not and

cannot be the driving factor for structuring a transaction. Gregory v.

Helvering, 293 U.S. at 469.

[*40] We find the expert testimony presented by respondent compelling

and supportive of our conclusions here. Dr. James first concludes that

the capitalization of the Finco entities does not meaningfully change the

expected pre-tax profits because before the capitalization Al and Jim

held the potential pre-tax profits associated with the Intercompany and

Homebuilder Notes, and they retain this same potential pre-tax profit

after the transaction through their interests in the respective Finco

entities. Dr. James also found Jim’s preference for variable interest rate

Homebuilder Notes38 lacking meaningful economic consequences. Next,

Dr. James concludes that the formation of the Finco entities failed to

minimize risk in the event of default under the Homebuilder Notes by

either AB Homebuilders or JB Homebuilders since Al and Jim used

special tax allocations within the Finco structures (with 80% of losses

attributable to the Common Partners entities) and entered into personal

guaranties. Lastly, the capitalization of the Finco entities does not

meaningfully change OPLP’s liability risks since it maintained

significant sources of assets and faced de minimis economic risk related

to potential construction defect claims.

Dr. James also opines concerning Oriole’s replacement of OPLLC

as general partner of OPLP. He concludes Oriole’s illiquid capitalization

from notes due from related entities and the identified tax benefits

through admission of Oriole “suggest[] that there was not a meaningful

nontax economic benefit associated with Oriole replacing OPLLC as

general partner of OPLP.”

Dr. James opines that OPLP’s distribution of its Finco interests

marginally eliminated credit risk, after consideration of the special loss

allocations within the Finco entities, while it equally stripped out assets

within OPLP without addressing its ongoing Construction Obligations,

for which Al and Jim held personal liability. Dr. James concludes the

technical partnership termination of OPLP lacks economic effect since

it involves circular loans among related entities and the use of an estate

freeze to eliminate the future appreciation, in part, of Villages 4 and 13

from Al’s and Jim’s federal taxable estates, which could have been

achieved by transferring a partial interest in these Villages through the

children’s (and grandchildren’s) indirect ownership interest in OPLP.

Lastly, Dr. James adds that OPLP’s technical partnership termination

in 2012 lacks economic effect since it artificially separated income

38 Jim elected variable rate Homebuilder Notes for JB Builders, while Al did

not. Consequently, JB Builders owed $5.6 million less in interest under the

Homebuilder Notes than the AB Builder entities.

[*41] contrary to the legal concept of “previously taxed” income intended

under section 743(b) adjustments. He also points to the subsequent

cancellation of 80% of the total Homebuilder Notes between AB

Homebuilders and AB Finco through consolidation into a new entity—

thereby resulting in full repayment—in 2020 as further evidence that

OPLP’s technical partnership termination in 2012 lacks economic effect.

At trial evidence was presented reflecting how Al and Jim, after

years of business together, were compelled to split their joint business

operations. Al commenced arbitration in June 2002, and an MOU was

signed between Al and Jim on December 21, 2002. The original goal of

the MOU was to divide the business operations regarding Otay Ranch

held jointly by Al and Jim within OPLP. However, upon both Al’s and

Jim’s retaining Mr. Wasserman and EY, the terms of the MOU were

materially revised, namely involving the formations of the Finco entities

and the substitution of Oriole as the limited partner of OPLP. We find

the formation and funding of the Finco entities to be inconsistent with

Al and Jim’s overall plan for division of development of land at Otay

Ranch.

Respondent also correctly points us to the public bond and

construction obligations which OPLP retained as evidence that Al and

Jim did not intend to actually separate all business operations.

Accordingly, we conclude that the transactions at issue were a taxdriven sham since these transactions primarily resulted in mere tax

benefits. In other words, when considering the nontax reasons for the

transactions at issue, any third-party investor would not benefit from

the restructuring and distributions from OPLP.

When a taxpayer improperly implements applicable provisions of

subchapter K of the Code, we find ourselves compelled to find its actions

abusive, or otherwise lacking in economic substance, without a factual

finding that the planning contained objective economic substance

beyond mere tax benefits and nontax business motivations. See Reddam

v. Commissioner, 755 F.3d at 1057. In sum, and as additional grounds

for disallowance of the Basis Deduction claimed, we accept respondent’s

arguments and determine the transactions at issue should be

disregarded for lack of economic substance.

[*42] III.

The Imposition of Section 6662 Penalties

Respondent also seeks to impose the substantial valuation

misstatement penalty, the gross valuation misstatement penalty, and

an accuracy related penalty based on negligence.

Application of the Substantial Valuation Misstatement and

Gross Valuation Misstatement Penalties

The Code imposes a penalty equal to 20% of the amount of the

underpayment for “the portion of any underpayment [of tax] which is

attributable to . . . [a]ny substantial valuation misstatement.” I.R.C.

§ 6662(a), (b)(3). A misstatement is “substantial” if the adjusted basis of

any property claimed on a return is 150% or more of the correct amount.

I.R.C. § 6662(e)(1)(A). The penalty is increased to 40% in the case of a

“gross valuation misstatement[].” I.R.C. § 6662(h). A misstatement is

“gross” if the value or adjusted basis of property claimed on the return

exceeds 200% of the correct amount. I.R.C. § 6662(h)(2)(A)(i).

Since the adjusted basis of OPLLC originally claimed on the

return was $744 million—which is well in excess of 200% of the amount

determined here by this Court—we find that the adjusted basis reported

by OPLP is a “gross valuation misstatement.” This finding triggers

application of the 40% gross valuation misstatement penalty under

section 6662(e)(1)(A) and (h) to those portions of the 2012 underpayment

in excess of 200% of the adjusted basis amount, as permitted by

respondent.

Application of the 20% Accuracy-Related Penalty

Next, respondent seeks to impose an accuracy-related penalty

under section 6662(b)(1) and (c) on any portions of the underpayment

not attributable to the foregoing 40% gross valuation misstatement

penalty.

Section 6662(a) imposes a penalty equal to 20% of the portion of

an underpayment of tax attributable to a taxpayer’s negligence or

disregard of rules or regulations. See I.R.C. § 6662(a) and (b)(1).

Negligence includes any failure to make a reasonable attempt to comply

with the provisions of the Code, and the term “disregard” includes any

careless, reckless, or intentional disregard. See I.R.C. § 6662(c).

This penalty would apply to what might be called the “lower

tranche” of the underpayment, i.e., the portion of the underpayment by

[*43] OPLP that was not attributable to a valuation misstatement. See

Oconee Landing Prop. v. Commissioner, T.C. Memo. 2024-25, at *75

(citing Plateau Holdings, LLC v. Commissioner, T.C. Memo. 2021-133,

at *2). While the determination of an “underpayment” within the

meaning of section 6662(a) cannot be made at the partnership level, see

Plateau Holdings, T.C. Memo. 2021-133, at *4, we can, however,

determine at the partnership level the applicability of the penalty, see

Dynamo Holdings Ltd. P’ship v. Commissioner, 150 T.C. 224, 233 (2018);

Oconee, T.C. Memo. 2024-25, at *75. The Commissioner has no burden

of production with respect to penalties in a TEFRA partnership action.

Dynamo Holdings, 150 T.C. at 236. Thus, the burden of showing that

the negligence penalty does not apply—including the availability of any

defenses—is on petitioner. See id. at 236–37.

Reasonable Cause Defense to Penalties

Petitioner has raised the defense of reasonable cause to the

assertion of all penalties in this case. A taxpayer may avoid a section

6662 penalty by showing that there was reasonable cause for the

underpayment and that the taxpayer acted in good faith. I.R.C. §

6664(c)(1); Higbee v. Commissioner, 116 T.C. 438, 448–49 (2001). The

determination of whether a taxpayer acted with reasonable cause and

in good faith is made on a case-by-case basis, considering all of the

pertinent facts and circumstances, including the taxpayer’s efforts to

assess the proper tax liability and the taxpayer’s knowledge, experience,

and education. Treas. Reg. § 1.6664-4(b)(1).

One possible ground for claiming “reasonable cause” is reliance

on professional advice. Treas. Reg. § 1.6664-4(b). We have said that “if a

taxpayer alleges reliance on the advice of a tax professional, that ‘advice

must generally be from a competent and independent advisor

unburdened with a conflict of interest and not from promoters of the

investment.’” Oakhill Woods, LLC v. Commissioner, T.C. Memo. 202024, at *29 (quoting Mortensen v. Commissioner, 440 F.3d 375, 387 (6th

Cir. 2006), aff’g T.C. Memo. 2004-279); see Gustashaw v. Commissioner,

696 F.3d 1124, 1139 (11th Cir. 2012), aff’g T.C. Memo. 2011-195. “Advice

hardly qualifies as disinterested or objective if it comes from parties who

actively promote or implement the transactions in question.” Stobie

Creek Invs. LLC v. United States, 608 F.3d 1366, 1382 (Fed. Cir. 2010).

“A taxpayer advancing a reliance-on-professional-advice defense must

also show that it actually relied in good faith on the advice it received.”

Oakhill Woods, T.C. Memo. 2020-24, at *29; see also Neonatology

[*44] Assocs., P.A. v. Commissioner, 115 T.C. 43, 98–99 (2000), aff’d, 299

F.3d 221 (3d Cir. 2002).

On brief petitioner contends OPLP acted reasonably and in good

faith by relying on the advice of multiple advisors in reporting its Basis

Deduction. Specifically, petitioner points to the written opinions

received from EY and Loeb before the transactions at issue. OPLP

provided these advisors with a host of information requested, including

the business operations of Al and Jim; an explanation of the entitlement

process and ongoing development of the Otay Ranch using the

Homebuilder entities, including information concerning use of CCM;

estate planning for both Al and Jim; and the underlying issues in

dispute and in arbitration. After reviewing the opinions, it is apparent

to us that both EY and Loeb well understood the business activities of

Al and Jim and the underlying dispute which led to arbitration.

Petitioner also points to the advice received from Al and Jim,

respectively, relating to their estate planning. Finally, petitioner points

us to the subsequent advice they obtained, after the transactions at

issue were completed, from McKee Nelson, a law firm recognized

nationally as experts on matters of partnership taxation.

Respondent disputes Al and Jim’s reliance on the tax advice

received from the EY and Loeb firms. Moreover, respondent contends

that Al’s agent withheld relevant information from McKee Nelson when

rendering its tax advice. Finally, respondent contends that the EY

representations, found in its two opinions, were obviously false and that

Al and Jim knew, or should have known, these representations were

false. We disagree with respondent’s argument here since he fails to

point us to any specific material (or otherwise relevant) information

withheld by Al (or his agent), 39 and he has likewise failed to establish

how Al and Jim “knew or should have known these representations”

made by EY and Loeb were in fact false.

Treasury Regulation § 1.6662-3(b)(1) states that a return position

that has a reasonable basis, as defined in paragraph (b)(3), is not

attributable to negligence. This same regulation defines “reasonable

basis” to be a relatively high standard of tax reporting, that is,

significantly higher than not frivolous or not patently improper.

However, if a return position is reasonably based on one or more

39 Respondent only points us to Al’s and Jim’s alleged misrepresentation to

McKee Nelson that, at the time of the transactions at issue, there was no plan or

intention to liquidate OPLP. We do not find this representation (at the time it was

made) to be materially false, as alleged by respondent.

[*45] “authorities,” the return position will generally satisfy the

reasonable basis standard even though it may not satisfy the substantial

authority standard. Authorities include the Code, the regulations,

revenue rulings and procedures, court cases, and congressional

committee reports. Treas. Reg. § 1.6662-4(d)(3)(iii). It is undisputed that

the position taken by OPLP on its 2012 Form 1065 is predicated upon

the tax advice received. Having reviewed the opinions from EY, Loeb,

and McKee Nelson, we are satisfied that each contains substantial

authority for each and every conclusion reached therein.

“Negligence has been defined as lack of due care or failure to do

what a reasonably prudent person would do under like circumstances.”

Mill Road 36 Henry, LLC v. Commissioner, T.C. Memo. 2023-129, at *70

(citing Ocmulgee Fields, Inc. v. Commissioner, 132 T.C. 105, 123 (2009),

aff’d, 613 F.3d 1360 (11th Cir. 2010)). It “includes any failure to make a

reasonable attempt to comply with the provisions of the internal

revenue laws or to exercise ordinary and reasonable care in the

preparation of a tax return.” Treas. Reg. § 1.6662-3(b)(1).

With respect to petitioner’s reasonable cause defense we look to

OPLP’s tax matters partner and petitioner, Oriole, which in turn was

wholly owned and controlled by Al and Jim. Jim is deceased; however,

Al appeared and testified at trial. The parties have received substantial

tax opinions rendered in this case, from EY, Loeb, and McKee Nelson.

The tax advice being rendered is undisputably complex and involves

unique issues such as CCM and basis calculations within subchapter K.

Although no opinions made guaranties that they would be followed by

this Court, the opinions reached a confidence level of substantial

authority on each material issue relating to the transactions at issue.

Considering the above, we find Al’s and Jim’s reliance thereon to

be reasonable and predicated upon their ordinary understanding of the

Code, and with the opinions rendered being evidence of their reasonable

care and their efforts to comply with these complex provisions of the

Code. The substantial detail found in each opinion runs counter to the

notion of negligence; and the fact that Al and Jim obtained three

separate opinions only further negates any claims of negligence on their

part. In sum, we find petitioner’s reasonable cause defense to be

compelling after considering the substantial efforts and expense

undertaken on the part of Al and Jim in seeking tax advice with respect

to implementing Judge Lewis’s April 2005 order.

[*46] Considering the foregoing, we will not sustain the imposition of

penalties in this case.

IV.

Conclusion

Principally, having determined that OPLP incorrectly

determined its basis adjustment under section 743(b), we will sustain

respondent’s disallowance of its Basis Deduction. We will further

sustain respondent’s disallowance of its Basis Deduction having also

determined, in the alternative, that the transactions at issue should be

disregarded as shams lacking economic substance. However, on the

basis of its established reasonable cause defense, we will overrule

respondent’s imposition of penalties in this case.

We have considered all arguments that the parties made, and to

the extent they are not addressed herein, we consider them to be moot,

irrelevant, or without merit.

To reflect the foregoing,

Decision will be entered under Rule 155.

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