Highwood Partners v. Comm'r of Internal Revenue

• Citation: 133 T.C. 1,133 T.C. No. 1
• Decision Date: 13 August 2009
• Docket Number: No. 24463–06.,24463–06.
• Parties: HIGHWOOD PARTNERS, B & A Highwoods Investments, LLC, Tax Matters Partner, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: United States Tax Court

133 T.C. 1

133 T.C. No. 1

HIGHWOOD PARTNERS, B & A Highwoods Investments, LLC, Tax Matters Partner, Petitioner

v.COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 24463–06.

United States Tax Court.

Aug. 13, 2009.

R issued P a notice of final partnership administrative adjustment (FPAA) after expiration of the 3–year period of limitations under sec. 6501(a), I.R.C., with respect to the assessment of income tax of the partners. The FPAA determined overstatements of the bases of partnership interests and certain other assets. R asserts that there was a substantial omission from gross income because the partnership and the partners failed to separately reflect the gain and loss from long and short options as required by sec. 988, I.R.C., and the 6–year period of limitations for a substantial omission from gross income under sec. 6501(e), I.R .C., applies. P asserts that the partnership and the partners properly reported the net loss from the long and short options and no omission occurred. The parties have filed cross-motions for summary judgment on the question of the applicability of sec. 6501(e), I.R.C.

Held: P's motion for summary judgment will be denied because the partnership and the partners omitted gross income by failing to separately compute foreign currency gain and loss pursuant to sec. 988, I.R.C., and the 6–year limitations period under sec. 6501(e), I .R.C., applies; and R's FPAA asserts alternative theories that would make the sec. 6501(e), I.R.C., 6–year limitations period applicable if sustained.

Held, further, R's motion for partial summary judgment will be denied because the Court will not render an opinion whether sec. 6501(e), I.R.C., would be applicable under R's economic substance or sham argument if that is the only position R is able to sustain, unless such a determination is necessary to resolve the case.

David D. Aughtry and William E. Buchanan, for petitioner.

William F. Castor, for respondent.

OPINION

GOEKE, Judge.

This case is before the Court on the parties' cross-motions for summary judgment pursuant to Rule 121.¹ Petitioner filed a motion for summary judgment arguing that respondent failed to issue the FPAA before the expiration of the 3–year limitations period provided in section 6501(a). Respondent opposes petitioner's motion and has filed a cross-motion for partial summary judgment arguing that the 6–year limitations period for a substantial omission of gross income in section 6501(e)(1) applies. The issues for decision are whether respondent is foreclosed by the explanations in the FPAA from asserting the 6–year limitations period under section 6501(e)(1) and the related issue whether the returns filed with respect to the partners, the partnership, or a related S corporation, Highwood Investors, Inc. (Highwood Investors), adequately disclosed the nature and amount of the omitted gross income.

We will deny petitioner's motion because we hold that the partners' returns contained a substantial omission from gross income within the meaning of section 6501(e)(1) as filed and that none of the relevant returns adequately disclosed the nature or amount of the omitted income. Respondent's partial summary judgment motion will also be denied without prejudice because resolution of the issues raised would require a ruling on an issue that the Court might not otherwise have to reach.

Background

For purposes of the pending motions, we assume the following facts. The parties treated Highwood Partners (Highwood) as having a principal place of business in Virginia for purposes of appellate venue under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Pub.L. 97–248, sec. 402(a), 96 Stat. 648.

The ultimate taxpayers are Michael and Karen Booth Adams, Richard and Mary Fowlkes, and the Booth and Adams Irrevocable Family Trust (the trust). On November 12, 1999, following the advice of the law firm of Jenkens & Gilchrist, Mrs. Adams, Mrs. Fowlkes, and the trust (the partners) each formed a single-member limited-liability company or L.L.C. (collectively, the LLCs). The LLCs were disregarded entities for Federal income tax purposes. On that same date, Mrs. Adams, Mrs. Fowlkes, and the trust, through their single-member LLCs, formed Highwood and owned partnership interests of 47.62, 29.76, and 22.62 percent, respectively.

On November 22, 1999, each of the LLCs entered into foreign exchange digital option transactions (FXDOTs) with Deutsche Bank AG New York branch (Deutsche Bank), in which the LLCs purchased a 30–day European-style digital option spread based on the U.S. dollar/Japanese yen (USD/JPY) exchange rate. The parties to a European-style option can exercise the option only on its termination date. A digital option has a predetermined fixed payout upon the parties' agreement at the time of the option's inception.

The notional principal amounts, the premiums, and the contingent payments of the FXDOTs varied among the LLCs. Through their respective LLCs, Mrs. Adams, Mrs. Fowlkes, and the trust entered into FXDOTs with notional principal amounts of $8 million, $5 million, and $3.8 million, respectively. Through their respective LLCs, Mrs. Adams, Mrs. Fowlkes, and the trust paid premiums with respect to the long leg of the FXDOTs of $4 million, $2.5 million, and $1.9 million, respectively, and received premiums with respect to the short leg of the FXDOTs of $3,960,000, $2,475,000, and $1,881,000, respectively.

In the long leg of each FXDOT, the LLCs paid an initial amount in exchange for the right to receive a predetermined, fixed amount from Deutsche Bank (long option) if the spot rate on the USD/JPY exchange rate was greater than or equal to ¥107.27 at 10 a.m. New York local time on the termination date. In the short leg of each FXDOT the LLCs received an initial amount from Deutsche Bank in exchange for agreeing to pay a specified, fixed amount (short option) if the spot rate on the USD/JPY exchange rate was greater than or equal to ¥ 107.29 at 10 a.m. New York local time on the termination date. The premiums paid by and to the LLCs, and the contingent payments to be paid to and by the LLCs, were all denominated in U.S. dollars. However, whether payments were required to be made would be determined by reference to the value of the Japanese yen.

The parties to the FXDOTs confirmed the terms of each FXDOT by letters dated November 30, 1999, that both parties to each FXDOT signed. The combined premium on the long component of the FXDOTs was $8,400,000, and the combined premium on the short component of the FXDOTs was $8,316,000. The partners, through their LLCs, paid only the net premium on the FXDOT, the difference between the premiums on the long and short components. The partners paid a combined net premium of $84,000. On November 23, 1999, the partners contributed the options, cash, and shares of Heilig–Meyers Co. (Heilig–Meyers) and Modis Professional Services, Inc. (Modis) stock to Highwood. In calculating their contributions for purposes of determining their outside bases in Highwood, the partners included the long option premiums of $8,400,000 unreduced by the short option premiums of $8,316,000.

On December 22, 1999, the FXDOTs expired unexercised while held by Highwood. The next day Mrs. Adams and Mrs. Fowlkes, through their LLCs, assigned their respective Highwood interests to a newly incorporated S corporation, Highwood Investors.² In determining their outside bases in Highwood, Mrs. Adams and Mrs. Fowlkes included the premiums on the long options totaling $6,500,000 unreduced by the premiums on the short options totaling $6,435,000. Upon the contribution of their partnership interests to Highwood Investors, Mrs. Adams' and Mrs. Fowlkes' outside bases in Highwood carried over to Highwood Investors pursuant to section 362(a).

On or about December 29, 1999, Highwood distributed cash and the Heilig–Meyers and Modis stock to Highwood Investors and the trust in full redemption of their partnership interests. Pursuant to section 732(b), Highwood Investors and the trust determined their adjusted bases in the distributed property by reference to their outside bases in Highwood immediately before the distribution, which they treated as having been increased by the long option premiums but not reduced by the short option premiums. Highwood Investors sold the Heilig–Meyers and Modis stock on December 30, 1999, at a claimed loss of $6,435,466. This loss resulted in part from the stepped-up bases under section 732(b) because Highwood did not reduce the partners' outside bases by the premiums from the short options. The pro rata shares of the losses on the stock sales, $3,960,415 and $2,307,690, passed through to Mrs. Adams and Mrs. Fowlkes, respectively. Likewise, the trust claimed a stepped-up basis in its shares of the Heilig–Meyers and Modis stock and sold the stock on December 30, 1999, for a claimed loss of $1,769,353.

On its Form 1065, U.S. Partnership Return of Income, filed for the taxable year ended December 28, 1999, Highwood reported contributions of $8,552,011 without disclosing that the contributions included the long option premiums of $8,400,000 unreduced by the short option premiums of $8,316,000. Highwood also reported a loss of $84,000 realized upon the expiration of the FXDOTs as “Other income (loss)”. To determine the $84,000 net loss, Highwood treated the expiration of the long options as causing the realization of a loss equal to the long option premiums of $8,400,000 and treated the expiration of the short options as causing the realization of a gain equal to the premiums of $8,316,000.³ Highwood attached a statement to its return describing the $84,000 loss as a section 988 loss. However, Highwood did not disclose that the net loss resulted from the expiration of the long and short options and did not separately report the $8,400,000 loss from the long options and the $8,316,000 gain from the short options.

Each partner reported a pro rata...