Or, Payback of Loan Principal is Not Income

 Judge Paris so holds in Rick Fishman, T. C. Mem. 2011-102, filed 5/18/11.

Rick ran what amounted to a multi-level insurance sales operation. He first sold policies and recruited subordinates to sell insurance policies; later, as the business grew, he recruited subordinate managers who sold and recruited and managed other salespeople. Every link in the chain was an independent contractor, and IRS doesn’t dispute that.

Because everyone was paid on commission, and because the premium dollars to fund the commissions came in monthly, Rick would advance six months’ worth of commission to each salesperson for each policy sold. If six months’ worth of premium was eventually paid, the salesperson was compensated and owed nothing. But if the premiums remained unpaid for any portion of the six months, the salesperson owed the advanced premium to Rick, with interest.

Likewise Rick would advance certain business expenses to salespeople. He kept what Tax Court called “rudimentary” records, showing advances and repayment to his subordinate managers (called “district leaders”).

There was a written business plan that said all this, and the IRS was given a copy (twice), but the IRS agent never mentioned it in her report.

Now let’s see what Judge Paris said: “Respondent determined deficiencies based solely on the following two-pronged argument: (1) Petitioner paid expenses on behalf of the district leaders and deducted the expenses on his Schedules C; [footnote omitted](2) the district leaders eventually reimbursed petitioner for these expenses, and the reimbursements constituted gross income to petitioner, which he omitted from his return. To establish an underpayment based on this position, respondent must produce clear and convincing evidence that the reimbursements were properly characterized as gross income.” 2011 T.C. Mem. 102, at pp. 16-17.

This IRS could not do. All IRS could show was a stipulation that Rick paid for certain of the salespeoples’ business expenses and that he was reimbursed. But the salespeople were independent contractors and were obligated to repay Rick the sums he advanced.

Tax Court said:  “Simply put, respondent has not produced clear and convincing evidence that the reimbursements constitute gross income.[footnote omitted]. Rather, petitioner’s receipt of the reimbursements gave rise to nothing more than a loan repayment. Because receiving repayment of a loan does not give rise to gross income, respondent has not met his initial burden. Thus, petitioner need not produce evidence of offsetting expenses. Therefore, the Court holds that respondent has not proven that petitioner underpaid the Federal income tax required to be shown on his returns for the tax years at issue. Because respondent did not prove that petitioner underpaid his Federal income tax during the tax years at issue, the Court need not discuss whether petitioner acted with fraudulent intent.” 2011 T.C. Mem. 102, at pp. 21-22.

Moreover, since IRS conceded that, if IRS could not prove fraud, the statute of limitations would bar assessment of deficiencies for the years at issue, Rick walks.

Takeaway: Rudimentary records plus a written and adhered-to business plan are indispensable aids to a winning case.

Sorting through much financial maneuvering, the details of which I’ll spare you,  Judge Marvel gives us a roadmap to business activities that permit a controlled entity to be considered a separate entity for tax purposes, even when there is no substantial business purpose, in Weekend Warrior Trailers, Inc., T.C. Mem 2011-105, released 5/19/11.

Weekend Warrior (“WW”) created a management services C Corp called Leading Edge (“LE”). IRS contended LE was formed with no legitimate business purpose or economic substance, and should be disregarded as a sham. 2011 T.C. Mem. 105, at p. 44.

Tax Court rejects IRS’ position, and expressly denies that it reaches its conclusion on Section 482 grounds.

Citing Moline Props., Inc. v. Commissioner, 319 U.S. 436 (1943), at pp. 438-439, Tax Court states: “Whether the purpose be to gain an advantage under the law of the state of incorporation or to avoid or to comply with the demands of creditors or to serve the creator’s personal or undisclosed convenience, so long as that purpose is the equivalent of business activity or is followed by the carrying on of business by the corporation, the corporation remains a separate taxable entity. [Fn. refs. omitted.]”. 2011 T.C. Mem. 105, at p.45.

Now for the kicker. Moline sets out alternative methods of deciding the validity of a controlled entity. Substantial business purpose is one, and business activity is another; either will do to save the controlled entity. But how do you (or more to the point, how does Tax Court) define an “equivalent of a business activity”, absent a valid business purpose (and Tax Court found none here)?

Judge Marvel tells us, at least based on the facts of this case: “Even if a corporation was not formed for a valid business purpose, it nevertheless must be respected for tax purposes if it actually engaged in business activity. . . .

“Leading Edge provided personnel services to Weekend Warrior. It maintained an investment account and bank accounts. It paid its employees by check, adopted a retirement plan, which respondent does not timely argue was a sham, kept books and records, and engaged Mr. . . . to appraise its stock. Leading Edge invested excess funds and at least from August 2003 through December 2004 purchased and sold stocks and received dividends. Corporate formalities were followed. Leading Edge filed Federal income tax and employment tax returns. We conclude Leading Edge carried on sufficient business activity to be recognized for Federal income tax purposes. 2011 T.C. Mem 105, at pp.48-49.

So bank accounts and corporate books by themselves aren’t enough, it seems. The personnel services and employment tax filings, together with the financial activities, over a 15-month period, seem to save LE.

The takeaway? Even a little substance matters.

If You Rely On State Law, Especially If It’s Unclear

That’s the takeaway from Richard J. and Jacqueline Rocchio, 2011 T.C. Sum. Op. 58, released 5/11/11. It’s another 7463 with some good principles, so you can argue it even if you can’t cite it. Unclear State law could save the taxpayer.

Richard J. was a stockholder in the family Sub S along with his siblings, but the Sub S was run exclusively by Papa. When Mama died and Papa married Wife Number 2, Papa spent all the Sub S’s profits on Wife Number 2 and cut Richard J. and the siblings out. The Sub S was a New York corporation, so under New York law Richard J. and the siblings sued for dissolution of the Sub S.

New York law provides that where stockholders seek dissolution, the non-dissolvers can buy out the dissolvers’ shares at fair value. Papa bought out Richard J. and siblings, but between buy-out and pay-out, the Sub S had taxable income, for which the Sub S filed an 1120-S, and sent Richard J. a K-1. Richard J. did not report the K-1 income on his and Jacqueline’s 1040, claiming he had been bought out before the income was earned and never got any of the income.

IRS sought unpaid tax, interest and Section 6662(a) substantial understatement penalty.

No penalty, says Tax Court. While New York law says you value the stock as of the day before dissolution, New York law seems to be that the stockholder isn’t out until he’s out. There isn’t a totally clear answer from the New York State Court of Appeals, New York State’s highest court. Under New York State’s somewhat eccentric structure, the Court of Appeals is New York State’s highest court; paradoxically, the New York State Supreme Court is its lowest court of general jurisdiction. As they say in New York, go figure.

So while various New York trial courts and intermediate appellate courts say that the bought-out but not paid-out shareholder is entitled to dividends and other income, and perhaps other benefits and burdens of share ownership, given the complexities of Sub S taxation and no clear guidance from the New York Court of Appeals, Richard J. at least had the minimal reasonable basis and good faith excuse for not paying.

He does owe the tax and interest, of course. But Special Trial Judge Armen softens the blow at the very end of his decision: “Finally, we observe, without commenting on the validity of such, that petitioner may have a remedy pursuant to New York State law with respect to the undistributed earnings…reported on the Schedule K-1….” 2011 T.C. Sum. Op. 58, at p. 13.

Or, Don’t Jump the Gun

 That’s the lesson Judge Kroupa delivers in Lattice Semiconductor Corporation, 2011 T.C. Mem. 100, released 5/9/11.

Lattice wanted to change its accounting method to take advantage of the proposed change in the regulations to Section 263,  that took effect 2004. The old rule for accrual basis taxpayers, and the one Lattice had followed, was that expenses fully incurred in one tax year and not applicable to more 12 calendar months, but in part applicable to the succeeding tax year, had to be capitalized. But the rules changed in 2004 to allow all such expenses to be deducted in the tax year incurred, even for accrual basis taxpayers.

Lattice applied for the change for years prior to the effective date of the new regulations, but IRS rejected the application, because the final regulations were not effective at the time Lattice applied. Lattice argued that IRS failed to take into account the proposed change and a Seventh Circuit case (even though Lattice was a Ninth Circuit domiciliary).

No go, says Judge Kroupa. IRS warned taxpayers in the Notice of Proposed Rulemaking not to apply for a change prior to the final regulations becoming effective. Lattice’s argument that IRS’ warning amounted to an “automatic rejection” policy fails for want of substantiation.

More importantly, IRS consent underpins the proper collection of revenue. Absent consent, taxpayers would cherry-pick accounting methods and eviscerate the proper collection of revenue. IRS has broad discretion over accounting method changes. Tax Court finds no abuse of IRS’s discretion.

The takeaway? Don’t jump offside, taxpayers. Wait for the regulations.

No, Intertwined and Inseparable Result

“A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines.” Ralph Waldo Emerson, 1803-1882. Well, maybe so, but not for FSCs owned by IRAs, says Judge Nims in Michael S. and Pamela S. Ohsman, 2011 T.C. Mem. 98, filed 5/3/11.

Relying on Hellweg v. Commissioner, 2011 T.C. Mem. 58, filed 3/9/11, Tax Court held that, as IRS permitted the Ohsmans’ IRA to own the shares of the Foreign Sales Corporation (FSC) to which the Ohsmans directed their sales commissions, and allowed the tax treatment the Ohsmans used for their FSC, IRS was bound to accord the same treatment to the Ohsmans’ IRA. Tax Court granted the Ohsmans summary judgment.

IRS first contended they needed discovery to resolve factual issues in dispute, without stating what those factual issues were. Judge Nims gave IRS short shrift, stating: “Respondent has not contested any part of [Ohsmans expert’s] affidavit and claims only that he is unable to do so because he has not had a reasonable opportunity to conduct discovery. While respondent may require discovery to obtain the evidence necessary to resolve the factual issues that are in dispute, the absence of discovery should not prevent him from being able to identify what those disputed issues are. Respondent may not rely on generalized allegations that material issues of fact potentially exist.” 2011 T.C. Mem. 98, at p. 5.

IRS next wanted to use the good old standby substance-over-form, to argue that the FSC’s payments to the IRA were really payments to the Ohsmans, who then made excess IRA contributions, invoking the 6% Section 4973 excise tax.

No go, says Judge Nims, unless IRS recharacterizes the income tax as well as the excise tax aspects of Ohsmans dealings. Tax Court finds, citing Hellweg, that “(W)e held that the Commissioner could not do so without also making a corresponding income tax adjustment because (1) section 4973 was intertwined with and inseparable from the income tax regime and (2) the Commissioner’s approval of the transactions for income tax purposes undermined his attempted use of the substance-over-form doctrine.” 2011 T.C. Mem. 98, at p. 6.

Here no recharacterization for income tax purposes, so no recharacterization for the “intertwined and inseparable” excise tax purposes.

Takeaway? Consistency is not always foolish.

Or, Of What Had You Made Certain, After You Had Made Certain You Had Made Certain Of  Nothing?

Tax Court asks Sherlock Holmes’ acid question (“The Adventure of the Golden Pince-Nez”) of Gertrude Saunders’ estate, in denying a $30 million estate tax deduction.  Estate of Gertrude Saunders, 136 T.C. 18, released 4/28/11.

The question was the value to be placed on a contingent liability of Gertrude’s late husband, William Jr. William Jr. was being sued at his death by the estate of a former client, Stonehill. Stonehill’s estate alleged that William, Jr., was a snitch for the IRS who railroaded his client into a $90 million deficiency, which stripped Stonehill of his business and cash.

Stonehill’s estate sued for the $90 million. To settle William Jr.’s estate, Gertrude’s estate agreed with IRS that Gertrude would carry the weight of any successful judgment or settlement. Gertrude’s estate claimed a $30 million deduction, and IRS allowed $1.00, with any further deduction to be allowed when Gertrude’s estate closed. The amount actually paid during the administration of the estate may be deducted in accordance with section 20.2053-1(b)(3), Estate Tax Regs.

In fact, the estate settled for around $600K, but that was years afterward.

The case comes up based on stipulated facts and experts’ reports, Tax Court stressing that it does not decide the case by way of summary judgment.

First, Tax Court distinguishes between valuation of a claim as at date of death with reasonable certainty for inclusion, as against exclusion. Is the valuation for inclusion in gross estate (taxable) or exclusion (deduction)? Or as the real estate operator’s first-grader answered when the teacher asked him “Johnny, how much is two plus two?”, “Teacher, am I buying or selling?”

Judge Cohen put it simply:  “In other words, a value may be determined for asset inclusion purposes that does not satisfy the “ascertainable with reasonable certainty” standard for deduction purposes. It is essentially undisputed that postdeath events are not considered in valuing assets in an estate because of the rule stated in Ithaca Trust Co. v. United States, 279 U.S. 151, 155 (1929), that an estate ‘so far as may be is settled as of the date of * * * [decedent’s] death.’” 136 T.C. 18, at pp. 20-21.

Liability deduction (exclusion) is another story. Here Tax Court examines a raft of cases and concludes, almost in despair, “‘at times it is like picking one’s way through a minefield in seeking to find a completely consistent course of decision’. Unfortunately, the difficulty has not diminished, and we maintain our position that reconciliation need not be undertaken here. We do not consider the subsequent settlement in our discussion of the question of whether the value of the Stonehill claim was ascertainable with reasonable certainty as of November 2004. We have addressed this dispute only to demonstrate that there is a difference between valuing claims in favor of an estate and allowing deductions for claims against an estate.” 136 T.C. 18, at p.23.

Finally, Gertrude’s estate’s platoon of experts, each with a different number and each with a different rationale for arriving thereat, ultimately win the case for IRS.

Cutting the Gordian knot of expert opinions, Judge Cohen makes it simple: “Our review of the estate’s expert reports, standing alone, convinces us the value of the Stonehill claim against the Saunders estate is too uncertain to be deducted as of November 2004.” 136 T.C. 18, at p. 24. The blind men and the elephant, perhaps?

After an exhaustive (and exhausting) dissection of the several experts’ reports and their proffered testimony brought forward by Gertrude’s estate, Judge Cohen concludes: “In summary, stating and supporting a value is not equivalent to ascertaining a value with reasonable certainty. Neither the estate’s experts nor their offer of proof satisfies the applicable legal standard.” 136 T.C. 18, at p. 26.

In fact, the more experts you have, and the more their conclusions vary, the more certain it is that you have made certain of nothing.

Or, When is a Regulation Not a Regulation?

 This was the riddle with which Tax Court grappled in Carpenter Family Partnership, 136 T.C. 17, released 4/25/11, with Judge Wherry for the majority and Judges Halpern, Hughes and Thornton concurring.

The issue was which statute of limitations (hereinafter the “SOL”) applied–either the three-year statute of limitations (hereinafter “3SOL”) applied to the partnership’s return for tax year 2000, or the substantial understatement six-year statute (hereinafter the “6SOL”). Taxpayer agreed to an extension of time to assess in 2007; if 3SOL applied, it had already run and there was nothing to extend, as an extension is valid only if made prior to running of the applicable SOL. See Section 6501(c)(4).

The underlying tax issue was the phony stock or foreign currency transaction, whereby a low basis in property is inflated by contributing it to a partnership, with a simultaneous but unrecognized offsetting contribution. The basis thus increased, the property is sold, and gain minimized. See my blog for January, 2011, for Stobie Creek and its offspring.

But the heart of the question is the SOL. 3SOL or 6SOL? IRS claims it issued temporary regulations in 2009, clarifying that overstatement of basis equals understatement of tax, other than in a trade or business, neither of which taxpayer concededly is, and therefore 6SOL. Of course, Tax Court struck down the temporary regulations, so IRS made them permanent and is trying to apply them here.

No way, says Judge Wherry. Ditto, say Judges Halpern and Hughes, and “Amen” says Judge Thornton, though their reasoning differs.

To begin with, the applicability date of the permanent regulations was circular, as it applied the regulations to unclosed years, which were rendered unclosed solely by virtue of those self-same regulations. Treasury tries to solve the problem with a semantic song-and-dance, which Tax Court brushes aside.

Tax Court parses the Colony decision (Colony, Inc. v. Commissioner, 357 U.S. 28 (1958)), the Supreme Court’s Chevron decision (Chevron USA Inc. v. Natural Res. Def. Council, 467 U.S.837 (1984), and the most recent Supreme Court pronouncement, Mayo Foundation for Medical Education and Research v. United States, 562 U.S.___, 131 S.Ct. 704 (2011). Did Congress leave a gap for the agency to fill? If Congress did and the agency fills the gap, “arbitrary or capricious in substance, or manifestly contrary to the statute”, are the only grounds upon which a court can set a regulation aside.

Tax Court says, however you slice it, the regulations cannot extend 6SOL to this case. I leave a detailed analysis of Judge Wherry’s 43-page exegesis, and Judges Halpern, Hughes and Thornton’s 15-page concurrences, to the law review writers. I am a simple practitioner. The takeaway–until Congress or the Supreme Court say otherwise, the 3SOL controls substantial understatement anywhere but in a trade or business.

And you may be sure there will be an appeal.

 The Doctrine Explained, and My Inventory Discussed

The doctrine of mitigation, found in Sections 1311 through 1314, allows a party to apply an adjustment to an item of gross income embodied in a Tax Court determination as to an open year, to the same class of item in an otherwise closed year. A thorough explanation is found in a 7463 not-for-nothin’ opinion, Tuwana Jynne Anthony, 2011 T.C. Sum. Op. 50, released 4/18/11.

Tuwana was the sole proprietor of a cosmetic consultancy. She also sold cosmetics and kept an inventory for sale to her customers. In the course of an IRS examination, Tuwana adjusted her year-end inventory valuation to reflect her purchase price of the goods, rather than the price at which she sold the goods to her customers. As she marked up her goods by more than 100%, the adjustment was considerable.

However, the adjustment was embodied in a stipulation, which in turn was embodied in a final Tax Court order, in a prior proceeding resulting from that examination. IRS asserted a deficiency for a closed year in the present proceeding, based upon the stipulated adjustment in the prior proceeding. Tuwana petitioned timely, and Judge Swift held for IRS.

Judge Swift thus defines the parameters of the doctrine: “…the mitigation provisions… permit the correction of an item that is shown to be erroneous by a determination in an administrative or judicial proceeding relating to another year or to a related taxpayer. Fruit of the Loom, Inc. v. Commissioner, T.C. Memo. 1994-492, affd. 72 F.3d 1338 (7th Cir. 1996). The limited conditions under which the mitigation provisions will be applied may be described generally as follows: (1) There has been a determination (as defined in section 1313(a)); (2) the determination must fall within one of the specified “circumstances of adjustment” or  “doubling-up” situations described in section 1312; (3) with respect to the treatment of the item in question for the determination year, the party against whom the mitigation provisions are invoked must have maintained a position inconsistent with the treatment of the item in another year of the same (or related) taxpayer, which year is barred by the generally applicable period of limitations or by some other rule of law, see sec. 1311(b); and (4) the party who seeks to employ the mitigation provisions must act timely thereunder and in the proper manner to make a corrective adjustment, see sec. 1314.” T.C. Sum.Op. 2011-50, at pp. 6-7.

Note that general statements concerning a stipulation in a Tax Court order, but not particularizing stipulated terms, is insufficient to trigger mitigation, as the order is not a “determination” within the meaning of Section 1313(a). Here, the order in the prior proceeding had sufficient particulars to qualify under Section 1313(a), the only real disputed factor in Tax Court’s mitigation analysis.

So Tuwana had to adjust her ending inventory for the prior (closed) year to harmonize with the opening inventory for the (stipulated) year, thus triggering the mitigating adjustment and the deficiency for the (otherwise closed) year.

Takeaway for the practitioner–less is more. If you don’t want to open the door to mitigation, keep it simple; no details about stipulations. And watch out for the colloquies in Court; the transcripts can contain enough particulars to haunt you.

Further takeaway–Tuwana was self-represented in the first and the second proceedings. When the draft order was prepared in the first proceeding, she didn’t object to the particularizing. Warning–even when you settle, your adversary is not your friend.

Tuwana wanted to bring in some unrelated items to offset the closed-year deficiency, but Section 1314(c) makes that a non-starter. Taxpayer has no credits or off-sets for any item other than the specific item adjusted.

And now for a different kind of inventory. I’ve been running this blog for four months. I’ve had no feedback and no comments.

Does anybody read this stuff? If you do, even a simple “yeah” in the “Comment” section of each of my posts would be appreciated. I’d appreciate suggestions on how to make the blog more useful to the practitioner in the trenches even more. I’m writing for the front-line tax professional, not for the academician or the theoretician, although they’re welcome here too. I’m always happy to adjust my inventory.

So says Judge Dawson in James Bruce Thornberry and Laura Anne Thornberry, 136 T.C. 16, released 4/19/11, to both the taxpayers and IRS. IRS sent James and Laura notices of lien and notices of intent to levy. James and Laura timely responded with a request for due process hearings, attaching to their requests a form they downloaded from a tax protesters’ website. A settlement officer in Appeals replied with a SO 4380 letter, treating James’ and Laura’s request as no request, pursuant to the Section 6702 frivolity kick-out. Frivolous requests for hearings, installment agreements and hardship relief are treated as no requests at all, and are not reviewable by Tax Court; no hearing, no response necessary. See also Section 6330(g).

James and Laura petitioned Tax Court. IRS says “no jurisdiction. Once IRS determines the request is frivolous, Tax Court is ousted of jurisdiction.”

Not so, says Judge Dawson. After a lengthy review of the procedures for requests for hearings following notice of lien and notice of intent to levy (which I recommend to practitioners as a good review of the procedural aspects), Tax Court dealt with IRS’ argument that the SO 4380 letters were not “determinations.” The heading of a paper does not determine its function, says Judge Dawson. The SO 4380 letters say “we’re ignoring your non-request.” That is a determination.

Tax Court said: “Essentially, respondent’s position is that because the Appeals Office treated petitioners’ request in toto as if it were never submitted, the determination to proceed with collection was not in response to a request for an administrative hearing. Respondent asserts that the Appeals Office’s determination regarding petitioners’ request is not subject to any judicial review by this Court pursuant to section 6330(g)” 136 T.C. 16, at p.15.

Reviewing the legislative history behind the adoption of Section 6330(g), Tax Court finds it was intended to clean out frivolous requests and petitions used by tax protesters to stall collection of revenue. But Section 6703 requires a hearing before any Section 6702 penalty (the $5,000 frivolity penalty) may be imposed.

The legislative history shows Congress required IRS to state periodically what positions IRS deems frivolous. Tax Court extends this to require IRS to state in the instant case what argument is advanced by James and Laura to delay collection of revenue, or is frivolous.

Judge Dawson said: “Section 6703(a) clearly contemplates judicial review of a determination by the Appeals Office that a specified submission, including a request for an administrative hearing under sections 6320 and 6330, is a specified frivolous submission. Consequently, while section 6330(g) prohibits judicial review of the portion of a request for an administrative hearing that the Appeals Office determined is based on an identified frivolous position or reflects a desire to delay, it does not prohibit judicial review of that determination by the Appeals Office.” (emphasis by the Court) 136 T.C. 16, at p. 19.

Judge Dawson had already observed: “The determination letters did not specify which statements or individual grounds listed in petitioners’ requests or the attachments thereto were frivolous issues or otherwise identify anything in the request, the attachment, or petitioners’ administrative file or conduct that reflected a desire to delay or impede Federal tax administration.” 136 T.C. at p. 5.

Patience exhausted, Judge Dawson admonishes both sides:  “The delay in resolving this case has been caused by both parties’ using boilerplate ‘one size fits all’ forms. Thus, in these circumstances, this Court has jurisdiction, and respondent’s motion to dismiss for lack of jurisdiction will be denied. … we conclude that the settlement officer could not treat petitioners’ entire request as if it were never submitted. Section 6330(g) requires the Appeals Office to determine the specific portions of petitioners’ request for a hearing that are regarded as frivolous or reflect a desire to delay or impede the administration of Federal tax laws, leaving only for hearing the legitimate and bona fide issues petitioners raised. The Appeals Office has not yet done this. Petitioners, on the other hand, have set forth in their administrative hearing request a litany of recitations lifted from an Internet Web site, many of which tend to show an attempt to delay or impede the administration of Federal tax laws. We have in this Opinion notified petitioners that merely attaching a list downloaded from the Internet that includes grounds that clearly do not apply to their case without identifying specific issues and grounds relevant to their hearing request does not satisfy the requirements of sections 6320(b)(1) and 6330(b)(1). Accordingly, the Court will require petitioners to identify the specific issues and the grounds they wish to raise before taking further action in this case.” 136 T.C. 16, at pp. 27-28.

In short, you’ve both got to be more specific.

When it comes to mark-to-market foreign currency deals.

The issue for Tax Court in Ricardo A. and Tari Scurlock Garcia, T.C. Mem. 2011-85, filed 4/13/11, is whether the foreign exchange options Ricardo contributed to the Holy Innocents Building Fund were in fact Section 1256 foreign exchange contracts.  If so, the $3,000,000 loss that Ricardo claimed was valid. If not, Ricardo owes much tax, interest and penalties.

Note that facts are not found in a summary judgment motion like this one; they are assumed from the pleadings, as there is no substantial question of fact for the Court to determine. See Fed R. Civ. P. 52(a).

The deals were made between Ricardo’s sole member-sole manager LLC (disregarded entity) and  Montgomery Global Advisors V LLC, based in San Francisco. Ricardo lived in Texas and his LLC was Georgia-domiciled. While the options had “knock-in” and “knock-out” barriers, meaning the rate of exchange during the option period had either to hit or miss a certain level before the option could be exercised, Tax Court held that this feature did not convert the option to a contract.

The good news for taxpayers is that Section 1256(a)(1) generally permits certain financial instruments to be marked to market on the last business day of the taxable year and any gain or loss on those contracts to be included on the taxpayer’s Federal income tax return. And gain or loss is recognized immediately upon contribution to a Section 501(c)(3) entity, as Holy Innocents presumably was.  Any gain or loss with respect to a “section 1256 contract” is treated as a short-term capital gain or loss to the extent of 40 percent of such gain or loss and a long-term capital gain or loss to the extent of 60 percent of such gain or loss. Section 1256(a)(3).

The bad news for Ricardo and Tari is that Section 1256(b) excludes from the definition of a “section 1256 contract” any option on a currency futures contract unless the option is subject to the regulations of, and traded on, a regulated exchange, like a national securities exchange which is registered with the Securities and Exchange Commission, a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission, or any other exchange, board of trade, or other market which the Secretary determines has rules adequate to carry out the purposes of section 1256. See Section 1256(g) and Section 1256(g)(7).

First, Tax Court held an option is not a contract for Section 1256 purposes. Relying on Summitt v. Commissioner, 134 T.C. 248 (2010), Tax Court holds that Section 1256 (a)(1) does not apply, because the option allows Ricardo to walk away rather than be required to settle, whether in cash or by physical delivery of currency, at expiry of the option. The plain words of the statute require a binding contract, says Judge Haines, not what Sam Goldwyn called a “definite maybe”.

Second, Tax Court held that Section 1256(b) requires the contracts be subject to regulation by, and be traded on, a regulated exchange, and these non-contracts weren’t so regulated or traded.

The game here, as in Summitt, is to straddle a currency position with offsetting puts and calls. The puts are written in “major currencies” (yen, euros, sterling), the calls in “minor” currencies (Danish kroner). The major put was claimed to fall within Section 1256 mark-to-market and take-the-loss rules when assigned to Holy Innocents (how innocent in fact was Holy Innocents is not explored in the decision); the minor call was not, so the offsetting gain on the minor currency call didn’t have to be marked or reported. And the barrier was claimed to qualify an otherwise disqualified deal. No go, says Judge Haines; the deals are not subject to the rules of, nor traded on, a regulated exchange, and besides, there is no requirement to settle in cash or kind at maturity, so barrier or no barrier, Section 1256 does not apply.

Ricardo and Tari argued that testimony of a foreign currency exchange expert was necessary to determine this case. No, says Judge Haines. “The testimony suggested by petitioners is nothing more than the legal conclusions of a supposed industry expert. We made our legal determination on the section 1256 issue in Summitt.” 2011 T.C. Mem. 83, at p.13.

Takeaway? As Job said, “He disappointeth the devices of the crafty, so that their hands cannot perform their enterprise.” Job 5:8. Don’t be too clever.

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