In Part One, A Piece of the Action, I discussed the pitfalls of relying upon the same experts, who sold and promoted the deal, to avoid penalties when the IRS unwinds the deal. Now here is another instance where the experts can hurt the taxpayer–when counsel hasn’t carefully worked with experts, reviewed their reports, and carefully prepared the experts for depositions and trial testimony.

The Court of Claims, in an exhaustive and exhausting review of the expert testimony (three for taxpayer, of whom one was disqualified as testifying on a matter of law, which it was the Court’s function to determine, and one for IRS), focused on the anticipated economic profitability of the foreign currency “collar” transactions, which the Court found to lack economic substance or substantial business purpose for want of reasonable expectation of profitability.

If the Court could find a reasonable expectation of profit without considering the tax impact, the taxpayer wins.

Taxpayer’s experts’ credentials were impressive; their performance, both before and during trial, was much less so.

One of taxpayer’s experts never bothered to calculate the probability of economic profit. The other did, but never figured in the transaction costs (multi-millions in legal fees plus the premium paid to Deutsche Bank, the counterparty to the purchased foreign currency options that comprised the collar). One of taxpayer’s experts failed to run an industry-accepted formula for calculating the expected outcome of the option trades.

IRS’s expert did all of the above, ran all the numbers with all the right formulas, and came to a conclusion that would have warmed Max Bialystok’s heart (cf. The Producers)– the deal had better than a 70% chance of making nothing. In fact, the chances of hitting the “sweet spot” (where the collar paid off big time) were, for all practical purposes, zero. But for an anomaly in the Regulations to Section 752, the deal would be insane, but because the Regulations at that time allowed one-half the deal to count for tax purposes but not the other, taxpayers were taking advantage. The Court bought the IRS’s expert’s testimony 100%.

The takeaway for counsel? As with currency trades, every litigated case has a “sweet spot”, the one disputed point your side must prove to win.  Before choosing experts, ask what you want your experts to establish to hit the “sweet spot”. Work with them. Learn their craft, so far as possible. And sweat them good, both in preparation of their reports and in preparation for depositions. And if they can’t properly opine, it’s time for a major heart-to-heart with the taxpayer-client.

IRS won this case at the report exchange stage, because taxpayer’s experts could not establish the one point needed to win. Incomplete analyses are worthless, and the Stobie Creek taxpayer must have paid plenty for them.

The Court threw taxpayer and those similarly situated a bone by refusing to apply the Treasury’s fix to the Section 752 Regulations retroactively. To the extent the Court devoted an extensive analysis to retroactivity of Treasury Regulations, the Court did all taxpayers a service. It’s worth reading.

For the rest, it’s a cautionary tale to tax advisors. The woodshed is your, and your experts’, best friend. Woodshed your experts, or watch them get shredded on the trial.