Holdings v. Comm'r of Internal Revenue, 21330–04.

CourtUnited States Tax Court
Writing for the CourtHOLMES
Citation128 T.C. No. 16,128 T.C. 192
PartiesKLIGFELD HOLDINGS, Kligfeld Corporation, Tax Matters Partner, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
Docket NumberNo. 21330–04.,21330–04.
Decision Date30 May 2007


In 2004, R sent a notice of deficiency to one of P's partners for his 2000 taxable year. Because the item which R adjusted was an affected item under section 6231(a)(5), I.R.C., R also issued a notice of final partnership administrative adjustment (FPAA) to P for its 1999 taxable year, which was the year in which P claimed the item on its taxes.

Both parties agree that the statute of limitations for assessing additional tax on the 1999 taxable year had already expired. P argues that if R is barred from assessing additional tax for 1999, he is also barred from issuing an FPAA for 1999. R claims that an FPAA can be issued at any time as long as at least one partner can still be assessed additional tax in relation to either an affected item or a partnership item (as defined by section 6331(a)(3), I.R.C.). P moved for summary judgment.

Held: Sections 6501(a) and 6229(a), I.R.C., do not preclude R from issuing an FPAA for P's 1999 taxable year.

Daniel J. Leer, for petitioner.

John A. Guarnieri, Meso T. Hammoud, and S. Katy Lin for respondent.


HOLMES, Judge.

Marnin Kligfeld contributed a large block of Inktomi Corp. stock to a partnership in 1999. The stock was shuttled from one partnership to another, theoretically gaining a greatly increased basis along the way. Most of this stock was sold in 1999. In 2000, the second partnership distributed the remaining stock with its allegedly increased basis along with the cash proceeds from the 1999 sale. Kligfeld sold the leftover stock and reported the sale on his 2000 joint return.1 The Commissioner challenges the amount of capital gains Kligfeld and Estrin reported on their joint return, but does so by attacking their reported basis. To do this, he issued a notice of final partnership administrative adjustment (FPAA) which adjusted items on a 1999 partnership return. The problem is that by the time the FPAA was issued, more than three years had passed since that partnership filed its 1999 tax return. The Commissioner says that it doesn't matter—the three-year restriction is only on assessments, not on adjustments. Kligfeld's partnership has moved for summary judgment, arguing that three years means three years and the Commissioner's FPAA was too late.

Background 2

This case is one battle in the Commissioner's war against an alleged tax shelter called Son–of–BOSS.3 Son–of–BOSS is a variation of a slightly older alleged tax shelter known as BOSS, an acronym for “bond and options sales strategy.” There are a number of different types of Son–of–BOSS transactions, but what they all have in common is the transfer of assets encumbered by significant liabilities to a partnership, with the goal of increasing basis in that partnership. The liabilities are usually obligations to buy securities, and typically are not completely fixed at the time of transfer. This may let the partnership treat the liabilities as uncertain, which may let the partnership ignore them in computing basis. If so, the result is that the partners will have a basis in the partnership so great as to provide for large—but not out-of-pocket—losses on their individual tax returns. Enormous losses are attractive to a select group of taxpayers—those with enormous gains.

Marnin Kligfeld was one such taxpayer. In 1999, he owned more than 80,000 shares of Inktomi Corporation, a software developer for Internet service providers. Inktomi's main product, a search engine, succeeded in displacing AltaVista. Eventually, Google displaced Inktomi, and Yahoo! bought what was left of the business in 2003; 4 but in 1999, at the height of the tech boom, Kligfeld's Inktomi stock was worth more than $10 million. Kligfeld had a basis in the stock of just over $300,000, so if he had simply sold it, he would have incurred a significant capital gain which would have likely resulted in a very large capital gains tax.

But Kligfeld did not simply sell the stock. Instead, he began a series of transactions that he asserts eliminated, or at least reduced, any capital gains built into the Inktomi stock:

• On September 20, 1999, Kligfeld—in conjunction with his wholly owned “S corporation” Kligfeld Corporation (Corporation)—formed Kligfeld Holdings (Holdings 1) as a California partnership. Kligfeld contributed approximately 83,600 shares of Inktomi stock.5

• On about November 1, 1999, Kligfeld Investments, LLC (Investments), whose sole member was Marnin Kligfeld, engaged in a short sale 6 of U.S. Treasury notes. Before closing the short sale, Investments transferred the resulting proceeds—along with the attached obligation—to Holdings 1.7 At the end of this transaction, Kligfeld owned 99 percent of Holdings 1 and Corporation owned one percent.

• On about November 3, 1999, Holdings 1 closed the short position by buying U.S. Treasury notes and using them to replace those borrowed.

• On November 15, 1999, Kligfeld transferred a 98–percent interest in Holdings 1 to Corporation through a non-taxable section 351 8 exchange.

Under section 708(b)(1),9 the transfer of more than 50 percent of Holdings 1 from Kligfeld to Corporation within a single 12–month period arguably triggered a statutory termination, and the creation of a new partnership also named Kligfeld Holdings (Holdings 2). This new partnership kept the same taxpayer identification number, but Kligfeld now owned only one percent of the partnership, and Corporation owned the remaining 99 percent.

To understand why this termination of Holdings 1 and creation of Holdings 2 matters, one must first understand the partnership-tax concepts of “ inside basis” and “outside basis”. Inside basis is a partnership's basis in the property which it owns. For contributed property, the inside basis is initially equal to the contributing partner's adjusted basis in the property. Sec. 723. Outside basis is an individual partner's basis in his interest in the partnership itself. When a partner contributes both cash and property to a partnership, his outside basis is initially equal to the amount of cash plus his adjusted basis in the contributed property. Sec. 722; sec. 1.722–1, Example ( 1 ), Income Tax Regs. Outside basis increases when a partner contributes additional assets to the partnership or when the partnership has a gain; it decreases when the partner contributes liabilities to the partnership, the partnership has a loss, or the partnership distributes assets to the partner. Sec. 705(a).

When Kligfeld initially contributed the Inktomi stock to Holdings 1, his outside basis in the partnership was equal to his basis in the contributed stock, or approximately $300,000. Likewise, the Inktomi stock continued to have the same inside basis to the partnership as it had before it was contributed—again, approximately $300,000. When Kligfeld (through Investments) later contributed the proceeds from the short sale, he arguably increased his outside basis in the partnership in an amount equal to the value of those proceeds. However, Kligfeld presumably reasoned that the attached obligation to close out the short sale, an obligation that he also contributed, was a contingent liability and therefore shouldn't reduce his outside basis as contributing a fixed liability would.10 As a result, Kligfeld conceivably ended up with an outside basis in Holdings 1 of just over $10.5 million, which wasn't reduced when Holdings 1 closed the short sale.11 Therefore, when Kligfeld transferred his partnership interest to Corporation, he also might have transferred his high basis and in return, received shares of Corporation stock with the same high basis.

When a new partner acquires a partnership interest, he typically pays fair market value for that interest, which can result in discrepancies between his outside basis and his share of the partnership's inside basis. To help balance out those discrepancies, section 754 allows a partnership to elect to adjust the inside basis of partnership assets to reflect the new partner's different outside basis.12 Since both Holdings 1 and Holdings 2 attached a section 754 election to their 1999 tax returns, Holdings 2 adjusted the inside basis of its Inktomi stock to almost $10.4 million to reflect Corporation's higher outside basis.13

Holdings 2 sold most of the Inktomi stock at the end of 1999 and reported the sale on its 1999 partnership return. The capital gain from that sale—now comparatively slight due to the increase in inside basis—flowed through to the partners, again increasing their outside basis. However, Holdings 2 didn't actually distribute the proceeds from the sale until 2000, when it distributed both the cash proceeds and the remaining shares of Inktomi stock to its partners.14 The distributed cash was treated as a return of capital (i.e., not taxable) since it didn't reduce the outside basis below zero—any cash distributed which exceeded outside basis would be considered a capital gain. Sec. 731(a). The remaining Inktomi stock that was distributed retained its inside basis in the hands of the partners to the extent of the partners' remaining outside basis after that basis was reduced by the amount of the cash distribution. Sec. 732.

To reflect the above transactions, each entity filed a tax return: Holdings 1 filed a partnership return for its brief 1999 taxable year (September 20, 1999November 15, 1999) on July 17, 2000. It listed the short sale of the U.S. Treasury notes and claimed sale proceeds of $9,938,281, a basis of $9,965,625, and a resulting loss of $27,344.15 Holdings 2 also filed a partnership return for its short 1999 taxable year (November 15, 1999December 31, 1999) on July 17, 2000, reporting $10,000,004 in proceeds from the sale of Inktomi stock and a gain of $523,337. The Kligfelds filed a joint return for 1999 on August 15,...

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