New Phoenix Sunrise Corp. v. Comm'r of Internal Revenue, 23096–05.

• Decision Date: 09 April 2009
• Docket Number: No. 23096–05.,23096–05.
• Citation: 132 T.C. 161,132 T.C. No. 9
• Parties: NEW PHOENIX SUNRISE CORPORATION and Subsidiaries, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Tax Court

132 T.C. 161

132 T.C. No. 9

NEW PHOENIX SUNRISE CORPORATION and Subsidiaries, Petitioner

v.COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 23096–05.

United States Tax Court.

April 9, 2009.

P is the parent of a consolidated group of corporations and a wholly owned subsidiary S. During 2001 S sold substantially all of its assets, realizing a gain of about $10 million. Also during 2001, S entered into a transaction whereby: (1) S purchased from and sold to a foreign bank respectively a long and a short option in foreign currency, paying only the net premium to the foreign bank; (2) S and W, a part owner of P, formed partnership O; and (3) S contributed the long and short options to O, increasing its basis in O by the amount of the premium on the purchased long option but not reducing its basis by the amount of the premium on the sold short option. The long and short options expired worthless. Shortly thereafter the partnership dissolved and distributed shares of stock in Cisco Systems, Inc., to S in redemption of its partnership interest. S sold the stock for a small economic loss. On its consolidated return P claimed a loss of about $10 million on S's sale of the stock. P calculated the amount of the loss by claiming an inflated basis of about $10 million in the Cisco Systems, Inc. stock distributed by O. The claimed $10 million loss was used to offset the $10 million gain on the sale of S's assets. O filed an information return showing a loss on the expiration of the long and short options and allocating that loss to S and W.

Because O qualified as a small partnership under sec. 6231(a)(1)(B)(i), I.R.C., the unified audit and litigation procedures of the Tax Equity and Fiscal Responsibility Act of 1982, Pub.L. 97–248, sec. 401, 96 Stat. 648, do not apply. R issued a notice of deficiency to S, and P petitioned upon a consolidated return which included S. The notice of deficiency disallowed the claimed loss on the sale of the stock, the claimed flowthrough loss from O, and claimed deductions for legal fees. The notice was based in part on R's belief that the transaction entered into by P lacked economic substance and should be disregarded for Federal tax purposes. The notice also imposed penalties under sec. 6662, I.R.C.

Held: The transaction S entered into lacked economic substance and is disregarded.

Held, further, the legal fees are not deductible by P.

Held, further, S is liable for sec. 6662, I.R.C., penalties.

John P. Tyler, Anthony J. Rollins, and Willard N. Timm, for petitioner.

R. Scott Shieldes and Kathryn F. Patterson, for respondent.

GOEKE, Judge.

Respondent determined a deficiency of $3,355,906 in petitioner's Federal income tax for 2001 and imposed a penalty under section 6662 of $1,298,284. ¹ For the reasons stated herein, we uphold the determinations in the notice of deficiency and find the section 6662 penalty applicable.

FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulations of fact and accompanying exhibits are incorporated herein by this reference.

On April 30, 1973, the Pruett–Wray Cattle Co. was incorporated pursuant to the laws of the State of Arizona. In 1990 it changed its name to New Phoenix Sunrise Corp. (New Phoenix).

1. Mr. Wray

Timothy Wray (Mr. Wray) became president and CEO of New Phoenix in 1996. Mr. Wray graduated from Princeton University with a bachelor of arts degree and then obtained a master's degree in business administration from Stanford University. Mr. Wray was a member of the U.S. Rowing Team from 1990 through 1995. After graduating from college, but while still a member of the rowing team, Mr. Wray worked for Vanguard, a securities firm.

After retiring from rowing, Mr. Wray began to examine the family business, New Phoenix. At that time New Phoenix was managed by nonfamily members and experiencing financial difficulties. Mr. Wray worked to refinance the company's debt by securing a new lender and as part of the arrangement took over as president and CEO until New Phoenix's dissolution in 2001. In addition to serving as New Phoenix's president and CEO, Mr. Wray worked from 1996 until 2001 as a research analyst for Questor Management Co., a private equity firm.

2. Capital Poly Bag

Capital Poly Bag, Inc. (Capital), was incorporated in 1972 under the laws of the State of Ohio. Capital manufactured plastic bags for sale to large institutions and had manufacturing facilities in Columbus, Ohio, and Atlanta, Georgia. New Phoenix purchased the stock of Capital in 1986. At all relevant times thereafter, Capital was a subsidiary of New Phoenix and filed consolidated income tax returns with the New Phoenix group of corporations.

3. Elsea, Collins & Co.

Elsea, Collins & Co. (Elsea Collins) was an accounting firm in Columbus, Ohio. Elsea Collins provided financial accounting and performed State and local tax work for Capital starting in the 1980s. During 2001 and 2002 James Hunter (Mr. Hunter) was a C.P.A. and a partner at Elsea Collins.

4. Bricker & Eckler, L.L.P.

Bricker & Eckler, L.L.P. (Bricker & Eckler), is a law firm based in Columbus, Ohio. Bricker & Eckler provided legal services for Capital from the 1970s until the company's dissolution. During 2001 and 2002 Gordon F. Litt (Mr. Litt) was an attorney and a partner at Bricker & Eckler.

5. Joseph W. Roskos & Co.

In 2001 and 2002 Joseph W. Roskos & Co. (Roskos & Co.) was a subsidiary of Bryn Mawr Bank Corp. in Bryn Mawr, Pennsylvania. Roskos & Co. provided office services, including accounting, consulting, tax services, and fiduciary support for high-networth individuals. Elsea Collins prepared New Phoenix's financial statements, upon which Roskos & Co. relied in providing services to New Phoenix.

In 2001 and 2002 Robert M. Fedoris (Mr. Fedoris) was Roskos & Co.'s president, and Andrew King (Mr. King) was an employee. Mr. Fedoris prepared New Phoenix's consolidated Form 1120, U.S. Corporation Income Tax Return, as well as Form 1065, U.S. Return of Partnership Income, for Olentangy Partners, discussed below.

6. Jenkins & Gilchrist

During 2001 and 2002 Jenkens & Gilchrist, P.C. (Jenkens & Gilchrist), was a law firm based in Dallas, Texas, with offices in Chicago, Houston, Austin, San Antonio, Los Angeles, and Washington, D.C.

7. Sale of Capital

In November 2000 negotiations commenced regarding the sale of substantially all of Capital's assets to Pitt Plastics, Inc., an unrelated third party (the asset sale). At the time, Capital was the only operating company within the New Phoenix consolidated group of corporations.

On April 24, 2001, the shareholders of New Phoenix approved the sale of substantially all of Capital's assets to Pitt Plastics, Inc. On April 30, 2001, the asset sale was consummated. Capital sold substantially all of its assets to Pitt Plastics, Inc., for $15,292,767. Mr. Litt represented New Phoenix in connection with the asset sale and also advised New Phoenix regarding the tax consequences of the asset sale and the contemplated liquidation of the New Phoenix group.

After the asset sale Mr. Wray became Capital's president, treasurer, and sole director. Capital realized a gain of $10,338,071 from the asset sale. After the asset sale Capital's only real asset consisted of approximately $11 million in cash. In July 2001 New Phoenix estimated that its gain from the asset sale was approximately $10.3 million.

8. Mr. Wray Meets Attorneys of Jenkens & Gilchrist

In the fall of 2001 Mr. Litt introduced Mr. Wray to Paul Daugerdas (Mr. Daugerdas) and John Beery (Mr. Beery) of Jenkens & Gilchrist. Messrs. Daugerdas and Beery were promoting a tax strategy called “Basis Leveraged Investment Swap Spread” (the BLISS transaction or the transaction at issue). A one-page executive summary of the BLISS transaction provided the following steps:

1. Taxpayer, through a single-member limited liability company treated as a disregarded entity for tax purposes, enters into two swaps (notional principal contracts) paying an upfront payment (yield adjustment fee) to acquire one swap, and receiving an upfront payment with respect to the other. Such transaction is a nontaxable event, notwithstanding the receipt of cash proceeds as an upfront payment, however such amount (and the amount paid for the other swap) must be amortized into income and expense over the life of the swap. A business and/or investment reason for this investment strategy must exist (e.g., the position should hedge an investment, or currency prices will increase or decrease, etc.).

2. Taxpayer and another partner or his wholly owned S Corporation (“S Corp.”) form a partnership or limited liability company designed to be taxed as a partnership (referred to herein as “Partnership”), in which Taxpayer is 99% partner, and S Corp. (or other party) is a 1% partner.

3. Taxpayer contributes the purchased swap entered into to the Partnership, together with the short swap. This contribution should result in Taxpayer's tax basis in his partnership or membership interest being equal to the cost of the swap contributed. The short swap is, more likely than not, not treated as a liability for tax purposes, achieving this result.

4. Throughout the duration of the swap, the Partnership makes or receives payments pursuant to the swap terms and conditions, and recognizes economic gain or loss on the transaction. At maturity, the swap terminates.

5. Partnership purchases foreign currency or marketable securities for investment. Alternatively, the Partnership may receive a capital asset as a contribution from its partners.

6. Taxpayer (and, other partner) contributes his stepped-up Partnership interest to S. Corp. This results in the Partnership only having one partner, and therefore it liquidates. This results in a step-up in the basis of the assets formerly held by Partnership to the stepped-up outside basis of the S. Corp. partner.

7. S Corp. sells the stepped-up assets, generating an ordinary or capital loss, as the case may be.

On November 15, 2001,...