106 LTD. v. COMMISSIONER OF INTERNAL REVENUE

• Citation: 136 T.C. 67,136 T.C. No. 3
• Decision Date: 10 January 2011
• Docket Number: No. 14586-05.,14586-05.
• Parties: 106 LTD., DAVID PALMLUND, TAX MATTERS PARTNER, Petitioner,<BR>v.<BR>COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: United States Tax Court

136 T.C. No. 3

106 LTD., DAVID PALMLUND, TAX MATTERS PARTNER, Petitioner,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 14586-05.

01-10-2011

[136 T.C. No. 2]

William A. Roberts and Kyle R. Coleman, for petitioner.

Nancy B. Herbert, Richard Hassebrock, and Jadie T. Woods, for respondent.

HOLMES, Judge:

David Palmlund bought into a bad deal to lose money but save on taxes. He has since filed an amended return and paid the tax he was trying to avoid. But he contests the penalty that the Commissioner asserts against him; he argues that he relied in good faith on professional advisers.

FINDINGS OF FACT

I. Palmlund

David Palmlund started his professional life in upstate New York. In 1964 he graduated with a dual degree in industrial engineering and management accounting from Syracuse University, then took a job in Rochester with Eastman Kodak as a cost engineer. After a year in the corporate world, duty called; he served in the Army as an ordnance officer stationed at the Aber-deen Proving Grounds, but also spent time in Vietnam with the State Department on matters he "can't talk about in Asia." Then 3 he returned to Syracuse, completed his MBA in 1968, and went back to Eastman Kodak.

But the draw of a larger city proved irresistible. Palmlund moved to New York to work for American Cyanamid Chemical Company from 1968 to 1972. He started out as an operations analyst— finding ways to improve the operations of subsidiaries—and moved up to become a budget analyst involved in major acquisitions. His entrepreneurial spirit caught the attention of like-minded young men, and together they formed a home-warranty company, American Home Shield, in 1972. As chief administrative officer, Palmlund set up American Home Shield's operations, developed the company's pricing model, and hired the contractors who would perform the covered home repairs. American Home Shield grew to be a successful, $800 million-a-year company.

Palmlund then moved to Merrill Lynch in 1975. He eventually became vice president and controller, as well as CEO of several Merrill subsidiaries. At one of these, Merrill Lynch Realty, Palmlund had 10,000 employees under his direction working in New York and London. He then returned to American Home Shield as chief operating officer. In 1980 he took four months off to care for his wife and moved to Dallas to be closer to her family.

Palmlund contacted some of the executive recruiters he met while working for Merrill—he got to know them well during the time he hired about one manager a week—to see what jobs there

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might be for him in Dallas. Instead, the recruiters recruited him to join their company. Palmlund wasn't interested at first because he didn't like the way recruiters operated, but the recruiters replied: "Fine, come in and change it." He agreed to give it a try, with the understanding that he could do things his way for a while; if it didn't work out, he would leave.

His way was based on personal contact. He would meet each candidate face to face, never offering anyone for a position whom he hadn't met in person. This was labor intensive—Palmlund accumulated over 10 million frequent-flyer miles—but his approach paid off. He became a partner at his firm, his firm became the world's largest, and he placed more senior executives than anyone else at it. All of his placements stayed in their new jobs at least a year; every other partner had to redo some.

Palmlund's success made his tax reporting complicated, and for many years he relied on Arthur Andersen. In the early '90s, his firm hired a financial planner who recommended setting up limited partnerships, living trusts, and other entities to help Palmlund meet his financial goals—and who also recommended, as the lawyer to set it all up, one Joe Garza. Palmlund ended up using Garza off and on over the next 20 years not only for the financial-planning-entity-creation work, but for all his legal needs. Garza in turn recommended Turner & Stone to Palmlund as a more affordable alternative to Arthur Andersen for tax preparation.

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But even at those lower rates, Palmlund was an active and frugal client who carefully reviewed every return—and noticed when one year Turner & Stone nearly doubled its fee to $2,700. He credibly testified that he "moaned and groaned" until it was reduced.

II. The Transaction

Sometime early in 2001, Garza called Palmlund to briefly pitch an "investment" in foreign currency. Palmlund dismissed the idea because he didn't have much experience in the field.^[1] But he was no neophyte investor—he ran a real-estate investment partnership, actively picked stocks, and formed a Texas family limited partnership named Palmlund, Ltd., with the stated business of "investments." He also had numerous personal bank and brokerage accounts that he actively managed.

Palmlund says that he warmed up to the transaction after receiving a "hot tip" at a cocktail party in mid-2001. But this tip came from his business partner's daughter, who mentioned that "the yen is weak and is going to get weaker." We do not think this is a credible explanation for Palmlund's interest in foreign-currency speculation, and instead find that his interest was really sparked when Garza resurfaced.

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right—was not entirely comprehensible. But Garza's tutorials never really got Palmlund interested in the theory of how to make foreign-currency options trading profitable. What got him interested—and we specifically find this based on the trial testimony—was the alluring tax benefit. Palmlund ran Garza's suggestion by his accountants at Turner & Stone. The accountants gave him the green light, telling him they themselves had used the same transaction. And Garza personally guaranteed the deal, promising to cover any taxes, penalties, or litigation costs if the transaction blew up.

This was good enough for Palmlund. He directed Garza to handle all the paperwork and told his secretary to forward any correspondence about the deal directly to Garza. Here are the mechanics:

• In November 2001, Palmlund formed three entities: 32, LLC ("32 LLC"); 7612, LLC ("7612 LLC"); and 106, Ltd. ("106"). The owners of 106 were David Palmlund (99 percent) and 32 LLC (1 percent). Palmlund's Texas family limited partnership, Palmlund, Ltd., is also involved in this case. Its partners were David Palmlund (49.5 percent), Suzanne Palmlund (49.5 percent) and the David Channing Palmlund Trust (1 percent).

• Also in November 2001, 7612 LLC bought offsetting long and short foreign-currency options. The termination date for both options was December 12, 2001, when they would expire out-of-the-money.

• On November 26, 2001, 7612 LLC transferred both long and short options to 106.

• On December 5, 2001, 7612 LLC bought Can$6,207.82 for US$4,000.

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• On December 24, 2001, 7612 LLC transferred the Canadian currency to 106 as a capital contribution.

• On December 26, 2001, 106 tried to assign all of its Canadian currency to Palmlund, Ltd., but actually distributed only Can$2,172.74. Can$4,035.08 remained with 106 until it sold the currency in October 2002.

Palmlund testified that he earned $10,000 in two weeks. Deutsche Bank paid out $40,000 on the options and charged a $30,000 net premium.^[3] If these had been the only expenses involved, the deal would have been profitable. But Palmlund doesn't include Garza's fees in his profit calculation. Those fees shrink the $10,000 "profit" to a loss of somewhere between $32,000 and $85,000.^[4]

III. Reporting the Transaction

Palmlund used Turner & Stone to prepare his 2001 return. A critical part of that preparation was the opinion letter Garza wrote, which Palmlund forwarded to them. The opinion letter contains a four-page introduction tailored to the deal, but the remaining 85 pages consist mostly of generic boilerplate on tax-law

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doctrines—running the gamut from partnership-basis rules, treatment of foreign-currency contracts, the step-transaction doctrine, economic substance, disguised-sale provisions, and partnership anti-abuse regulations. In the letter, Garza concluded that the tax treatment he proposed would "more likely than not" withstand IRS scrutiny.^[5] To reach this conclusion, Garza had to clear a few hurdles. In the introductory pages, he states that Palmlund represented that he

• "independently reviewed the economics underlying the investment,"

• "believed there was reasonable opportunity to earn a reasonable pre-tax profit * * * in excess of all associated fees and costs," and

• received "[t]he foreign currency and financial instruments * * * as Partnership liquidating distributions." (Emphasis added.)

Here's the first stumble—we find that Palmlund did no such things. But even if he had, Garza still didn't get it right—he

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failed to customize the opinion letter to fit the facts of the transaction. Here are a few of the mistakes:

• The foreign currency was distributed to Palmlund in liquidation of his partnership interest.

• No it wasn't; it was a nonliquidating distribution in 2001.

• Unrelated partners confirmed the partnership's legitimacy.

• All the partners were related—and Palmlund controlled them.

• Palmlund doesn't know if he will be called upon to satisfy his obligations under the sold digital option.

• The options had already been terminated by the time the opinion was drafted.

Relying on the opinion letter, Turner & Stone prepared returns for 106, 32 LLC, Palmlund, Ltd., and Palmlund in 2002. They charged $8,000 for return preparation; Palmlund didn't complain. He didn't review the returns or ask any questions, claiming that he "wouldn't even know what to ask" about the returns. The result was happy for a time—a noneconomic loss of about $1 million flowed through to his personal return.

Palmlund did get concerned when the IRS sent him a copy of Announcement 2004-46, 2004-1 C.B. 964, in May 2004. The announcement outlined terms of...