Palm Canyon X Investments, LLC v. Commissioner of Internal Revenue, T.C. Memo. 2009-288 (U.S.T.C. 12/15/2009), No. 5610-06.

CourtU.S. Tax Court
Writing for the CourtMarvel
Decision Date15 December 2009
Docket NumberNo. 5610-06.

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T.C. Memo. 2009-288
No. 5610-06.
United States Tax Court.
Filed December 15, 2009.

PC, a single-member LLC owned by AHI, entered into offsetting market-linked deposit contracts with SG.

Each contract provided for potential premium interest on the deposit; the terms of the potential premium interest in each contract constituted a European-style foreign currency digital option. Shortly thereafter, CFA became a member in PC. As a result, PC was classified as a partnership for tax purposes, and the offsetting MLD options were treated as contributions to the newly formed partnership. AHI claimed a basis in its PC partnership interest that included the premium it owed for the long MLD option, but AHI did not reduce its partnership basis to account for any obligation under the short MLD option under sec. 752(b), I.R.C.

Less than 2 months later, AHI acquired CFA's PC membership interest and again became PC's only member, causing liquidation of the PC partnership. Under sec. 732(b), I.R.C., in the only asset deemed distributed by PC, a foreign currency position in Canadian dollars,

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AHI claimed a basis that equaled AHI's basis in its PC interest, minus cash it received, as a deemed liquidating distribution. PC then sold the Canadian dollars and claimed a substantial ordinary tax loss. R issued a notice of final partnership administrative adjustment in which he determined that PC was a sham and that the MLD contracts lacked economic substance and should be disregarded. P petitioned this Court under sec. 6226(a), I.R.C.

Held: The MLD transaction is disregarded under the economic substance doctrine.

Held, further, the accuracy-related penalty under sec. 6662, I.R.C., applies.

Steven R. Mather and Lydia B. Turanchik, for petitioner.

Stephen M. Barnes, William R. Davis, Jr., Dennis M. Kelly, and David W. Sorensen, for respondent.

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MARVEL, Judge.

Respondent issued a notice of final partnership administrative adjustment (FPAA) for 2001 pursuant to section 6223(a)1 to AH Investment Holdings, Inc. (AHI), the tax matters partner (TMP) of Palm Canyon X Investments, LLC (Palm

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Canyon),2 a limited liability company classified as a partnership for Federal income tax purposes.3 In the FPAA respondent determined that Palm Canyon was a sham and that offsetting market-linked deposit4 contracts (MLD contracts) entered into by Palm Canyon lacked economic substance and should be disregarded for Federal income tax purposes. Accordingly, respondent made adjustments to the income, expense, deduction, and distribution items reported by Palm Canyon on its 2001 Federal income tax return and imposed an accuracy-related penalty under section 6662. A petition for readjustment of partnership items was filed by AHI on behalf of Palm Canyon.

The parties tried and briefed the following issues:

(1) Whether Palm Canyon's MLD contracts lacked economic substance and should be disregarded for Federal income tax purposes;

(2) alternatively, whether Palm Canyon should be disregarded as a sham;

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(3) alternatively, whether Palm Canyon's short MLD contract is a liability under section 752(a) and (b) or a contingent liability under section 1.752-6, Income Tax Regs.;

(4) alternatively, whether the MLD contracts should be treated as a single integrated transaction with a net tax basis of $55,000 under the substance over form doctrine and section 988; and

(5) whether any underpayment of tax attributable to the adjustments to partnership items is subject to the section 6662 accuracy-related penalty, as determined at the partnership level.


Some of the facts have been stipulated and are so found. The stipulations of the parties are incorporated herein by this reference. On the date AHI filed its petition as Palm Canyon's TMP, Palm Canyon had no principal place of business, as it had ceased to exist.

I. Background

In 1988 Alan Hamel (Mr. Hamel) and his wife, Suzanne Hamel,5 (collectively the Hamels) began promoting various retail products, including the well-known "Thighmaster" piece of exercise equipment. The Hamels enjoyed considerable success with the Thighmaster, selling millions of units. By 2001 the Hamels'

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retail operation included numerous products besides the Thighmaster, including other fitness products, jewelry, books, videos, and various food items. The Hamels' businesses manufactured over 1,000 products annually.

The Hamels operated their retail business through a corporate structure headed by Thighmaster World Corp. (Thighmaster).6 As of December 31, 2001, Thighmaster was the parent corporation of seven subsidiary corporations engaged in various business activities and organized by function and product sales7 (collectively the Hamel companies). During 2001 Mr. Hamel was Thighmaster's sole shareholder.

Through 2001 none of the Hamel companies operated a business or owned any manufacturing, storage, or sales facilities in a foreign country. In 2001 the Hamel companies' international activities consisted primarily of sales through the Internet. The Hamel companies also ordered a significant portion of the materials used to make their products from Asia and had some of their products manufactured there.

None of the Hamel companies' businesses had any contracts due in 2001 or 2002 that required payments in foreign currencies.

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Additionally, Thighmaster had no direct or indirect ownership interest in any foreign entity or bank account and paid no foreign taxes.

II. Notice 2000-44

On August 13, 2000, the Internal Revenue Service (IRS) issued Notice 2000-44, 2000-2 C.B. 255, titled "Tax Avoidance Using Artificially High Basis"; it was published in the Internal Revenue Bulletin on September 5, 2000. In Notice 2000-44, supra, the IRS addressed arrangements that produce noneconomic tax losses on the disposition of partnership interests and described two variations of loss-generating transactions. One described transaction involved purchasing and writing options and purportedly creating positive basis in a partnership interest by transferring the options to a partnership. Id., 2000-2 C.B. at 255. In such a transaction, the taxpayer purports to have a basis in the partnership interest equal to the cost of the purchased call option, although the net economic outlay and the value of the partnership interest are nominal or zero. Id. The taxpayer then claims a tax loss on the disposition of partnership interest without incurring a corresponding economic loss. Id. In the notice the IRS stated that losses resulting from the described transaction did not represent bona fide losses reflecting actual economic consequences and were not allowable as deductions for Federal income tax purposes. Id.

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In the notice the IRS also stated that "tax losses from similar transactions designed to produce noneconomic tax losses by artificially overstating basis in corporate stock or other property are not allowable as deductions" and appropriate penalties might be imposed on participants in these transactions. Id. The IRS also stated that transactions that were the same as or substantially similar to the ones described in the notice could be subject to challenge under section 752, under section 1.701-2, Income Tax Regs., or under other antiabuse rules and could result in the imposition of a section 6662 accuracy-related penalty. Id., 2000-2 C.B. at 255-256.

III. Investigating the MLD Strategy

Mr. Hamel's certified public accountant (C.P.A.), Clifton Lamb (Mr. Lamb),8 was looking for a means to reduce the Hamels' tax liability as early as August 2001 when he met with Aaron Sokol and Steven Fuld of the Skyline Group, a financial services firm, to discuss "high end tax products for big losses". In a telephone conversation on August 17, 2001, Mr. Hamel and Mr. Lamb discussed foreign markets and foreign currencies. Shortly after this conversation, Mr. Lamb met with John Ivsan (Mr. Ivsan), a

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tax attorney with Cantley & Sedacca, LLP (Cantley & Sedacca),9 to discuss foreign currency trading with MLDs (MLD strategy).10 Reg Wilson (Mr. Wilson), an employee of EPIC Advisors, Inc. (EPIC), a financial and retirement planning and advisory firm, referred Mr. Lamb to Cantley & Sedacca.11 Paul Kestenbaum (Mr. Kestenbaum), an attorney who introduced Mr. Lamb to Mr. Wilson, also attended the meeting.12

The MLD strategy involved offsetting currency positions that produced a capital or ordinary tax loss by exploiting the provisions governing the tax treatment of partners and partnerships. Mr. Ivsan introduced Cantley & Sedacca to the MLD strategy around April 2001. During 2001 Cantley & Sedacca, with

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the assistance of Daniel Brooks (Mr. Brooks),13 a former foreign currency trader at Deutsche Bank AG,14 and Craig Brubaker (Mr. Brubaker),15 an employee at the Dallas branch of Deutsche Banc Alex. Brown,16 marketed the MLD strategy to accountants and financial advisers nationwide and sold it to approximately 150 clients.17 Mr. Brooks knew the MLD strategy was a "tax advantage" or "tax motivated" transaction.

Mr. Lamb's initial reaction to the MLD strategy was that the tax benefit was "too good to be true". On August 23, 2001, Mr. Lamb spoke with Mr. Hamel about the MLD strategy. Following the discussion, Mr. Lamb reviewed a tax opinion by the law firm Bryan

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Cave, LLP (Bryan Cave), dated August 24, 2001, on the MLD strategy (Bryan Cave opinion).18

On September 11, 2001, Mr. Hamel met with Mr. Lamb and Mr. Ivsan to discuss a possible transaction based on the MLD strategy. At the meeting, Mr. Hamel and Mr. Lamb first learned of Mr. Brooks. Under the proposed structure of the MLD transaction, Mr. Brooks would serve as a foreign currency investment adviser on behalf of Mr. Hamel.19

After the meeting Mr....

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