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Wednesday, May 14, 2014

Another Bullshit Shelter Bites the Dust Even with Variations (5/14/14)

I write today on the defeat of another bullshit tax shelter of the Son-of-Boss ("SOB") variety.  The Markell Company, Inc. v. Commissioner, T.C. Memo. 2014-86, here, decided yesterday.  If it were just another ho-hum SOB, it would be worth noting only in passing.  But, it has a twist -- both the twist and the outcome is projected in the opening two short paragraphs:
This case began when the Commissioner found the remains of a corporation on an Indian reservation in an extremely remote corner of Utah. The tribe claimed not to know how the corporation's stock had ended up in its hands. And there was little or no money or valuable property left inside the corporate shell. 
All signs pointed to the corporation's manager, a sophisticated East Coast moneyman, as the key person of interest. And his method was a series of complex transactions that bore a striking resemblance to Son-of-BOSS deals already examined many times before by this Court -- but with a corporate-partner twist.
The last sentence of the first paragraph resonates with the equally bullshit intermediary transactions.  One of the strategies in shelters is to push tax consequences to an empty shell of a company, so that the IRS is left without anyone to collect tax clearly due.

The Son-of-Boss transactions in their pure bullshit form seemed to promise to the gullible or complicit that the taxable income disappearing from the taxpayer's tax ledger would just go away.  But, every one I know that gave a hard and knowledgeable look knew that, even if the imagined scheme worked to push the income from the original taxpayer (always a doubtful proposition), some taxpayer down the line would be liable for the tax.  Enter the intermediary gambit to make sure that taxpayer down the line had no assets to pay the tax because the taxpayer and the promoters would have sucked all the value out of the company.  Thus, this intermediary was designed to deal with an inherent and blatant flaw in the SOB transactions.  (Of course, SOB transactions had flaws in them before reaching this stage, but the intermediary was a fine artistic touch to put on the bullshit.)

The Merits


The Court had this to say.
This case is another of the Commissioner's battles against a tax shelter called Son-of-BOSS. While there are different varieties of Son-of-BOSS deals, what they have in common is the transfer of assets encumbered by significant liabilities to a partnership, with the goal of inflating basis in that partnership. See Kligfeld Holdings v. Commissioner, 128 T.C. 192 (2007). The liabilities are usually obligations to buy securities, and they are always contingent at the time of transfer. Taxpayers who engage in these deals claim that this allows the partner to ignore those liabilities in computing basis, which allows the partnership to ignore them in computing basis. The result is that the partners will have bases in the partnership high enough to provide for large noneconomic losses on their individual tax returns. At issue here is an "outside basis" Son-of-BOSS deal: the inflated basis is the partner's outside basis in the partnership. n11 The version here involves a corporation as the partner, and an intermediary transaction; namely, Markell's stock sale immediately followed by an asset sale.
   n11 The usual "outside basis" Son of BOSS deal requires a taxpayer to buy the options and then contribute them to the partnership in exchange for a partnership interest. In an "inside basis" Son-of-BOSS deal, the partnership itself purchases the options and the inflated basis is attached to the inside basis of the partnership. In that case, the loss is realized when the partner receives the asset in a distribution and then sells it. See, e.g., 6611 Ltd. v. Commissioner, T.C. Memo. 2013-49. 
In the middle of this was MC Trading, which Markell formed and to which it contributed $75,000 cash. n12 MC Trading then contracted for the short and long options -- independent investments, according to Markell, because the terms of each option were set out in separate confirmations and in theory the options could be transferred or assigned independently of each other. When Markell then contributed its interest in MC Trading to MC Investments it claims to have bought a partnership interest, and calculated its basis in MC Investments without taking into account as a liability MC Trading's contingent liability. See sec. 752. This step is of extreme importance in Son-of-BOSS deals -- a partner who gets his partnership to assume a liability has to reduce his basis in the partnership by the amount of that liability. See sec. 752(b). Doing so would, however, defeat the goal of inflating basis to create a giant artificial loss.
   n12 Under federal tax law, a single-member LLC that does not make an election is a disregarded entity -- a tax nothing. The result is that the member is treated as personally engaging in the transactions engaged in by the LLC. Treas. Reg. sec. 301.7701-3(b)(1)(ii), Proced. & Admin. Regs.; Med. Practice Solutions, LLC v. Commissioner, 132 T.C. 125 (2009) (holding the "check-the-box" regulations are valid), aff'd without published opinion sub nom. Britton v. Shulman, 2010 WL 3565790 (1st Cir. 2010). 
So when Markell did this, it was setting up its argument that its outside basis in MC Investments was only its basis in the long option -- approximately $15 million. MC Investments then bought the QQQ stock for less then $10,000 and distributed most of it along with a nominal amount of cash to Markell in liquidation of Markell's partnership interest. Under section 732, Markell's supposed outside basis of $15 million (minus the cash received) became its basis in the distributed stock. Markell then sold the stock for about $5,000. But rather than calculate its gain or loss by subtracting the actual purchase price of its shares from the actual sale price, it claimed that it could subtract the $15 million pretend basis for those shares from the actual sale price. Thus, at the end of the paper shuffle, it claimed a capital loss just shy of $15 million from the sale of the QQQ stock -- an amount sufficient to almost completely offset its previous capital gains from the asset sale a month earlier.
So, as expected, the Court spent the rest of the opinion shooting down the taxpayer's claims of the validity of the bullshit transaction.  Nothing particularly new and exciting here.

Adverse Inference from Promoters Fifth Amendment Claim

There is one interesting part of the Court's inevitable journey in holding against the taxpayer on the merits.  The Court discusses its application of the evidentiary concept of adverse inference.  One James Haber was the master of ceremonies of this shelter, doing everything from A to Z in the creation and implementation of the shelter, including pushing the company onto the Indian reservation. He invoked the Fifth Amendment.  (Haber was at the center or in near proximity to the center of the SOB craze in the late 1990s and early 2000s, as well as other abusive tax concoctions and appears to have been a target of one or more criminal investigations in their aftermath, although he was never indicted; for other blogs on Haber, see here.)  The Court said Haber was sufficiently connected to the transaction that, in a civil case, the Court could draw an adverse inference from his invocation of the Fifth Amendment.  The Court reasoned:
Adverse Inferences. We begin by looking at what we can infer about MC Investment's alleged business purpose from Haber's invocation at trial of his Fifth Amendment right to remain silent. We don't doubt that he had the right to do so. Following an ex parte hearing, and for reasons we explained in the sealed portion of the transcript, we sustained his claim and released him. n14 The Fifth Amendment, however, does not prohibit adverse inferences against parties to civil actions when they refuse to testify in the face of probative evidence against them. Baxter v. Palmigiano, 425 U.S. 308, 318 (1976); LiButti v. United States, 107 F.3d 110, 124 (2d Cir. 1997); United States v. Ianniello, 824 F.2d 203, 208 (2d Cir. 1987) (applying the Baxter rule even if the government is the beneficiary of the adverse inference). The assertion of the Fifth Amendment by a nonparty may also warrant an adverse inference against a party depending on the relationship between the two.LiButti, 107 F.3d at 121; FDIC v. Fid. & Deposit Co. of Md., 45 F.3d 969, 977 (5th Cir. 1995) ("'A non-party's silence in a civil proceeding implicates Fifth Amendment concerns to an even lesser degree'" (quoting RAD Servs., Inc. v. Aetna Cas. & Sur. Co., 808 F.2d 271, 275 (3d Cir. 1986))) (citing Rosebud Sioux Tribe v. A & P Steel, Inc., 733 F.2d 509, 521 (8th Cir. 1984)).
   n14 Transactions like the one in this case that KPMG had devised were investigated by the U.S. Attorney's Office for the Southern District of New York. That investigation let to several indictments. See United States v. Stein, No. 1:05-cr-00888-LAK (S.D.N.Y. filed Aug. 24, 2005). During his deposition in Ironbridge Corp. v. Commissioner, T.C. Memo. 2012-158, aff'd, 528 Fed. Appx. 43 (2nd Cir. 2013), Haber gave testimony indicating he believed he had become a "potential" target of the criminal investigation around "2002 or 2003," though he has never been indicted or tried. Stein ended in June 2009, but the related criminal investigation seems to continue. 
The Second Circuit in Libutti listed four factors for a trial court to weigh in deciding whether to draw on adverse inference from a nonparty's refusal to testify:
the nature of the relationship;
the degree of control over the nonparty;
the degree to which the nonparty and the party share the same interests in the outcome of the litigation; and
the degree to which the nonparty witness played a key role in the underlying events. 
LiButti, 107 F.3d at 123. The question for us then is to determine whether Haber's nearly unfettered authority over Markell lets us draw an adverse inference against Markell. We find it does. Haber was in control of Markell throughout the entire OPS arrangement, and placed himself in managerial positions in every entity necessary for the OPS to work: Markell, MC Investments, MC Trading, and MCOA. He signed all the documents and undeniably shares the same interests as Markell in the outcome of this litigation. 
We ourselves have added that we may draw an adverse inference in a civil case from a party's claim of privilege only if there is some additional evidence independent of the invocation on which to base the inference. Petzoldt v. Commissioner, 92 T.C. 661, 685 (1989). And on this point, we find there is considerable circumstantial evidence contradicting Markell's claim of a profit motive given the structure, terms, and likelihood of profit of the paired options. 
Paired Options. The paired options in this case consisted of short and long European digital call options. These cash-or-nothing options can be valued by multiplying the present value of the cash payoff amount by the probability calculated from the Black-Scholes-Merton (BSM) model that the digital option will be in the money at the expiration date. Applying this model, the combined value for the paired options was $59,041.15 The difference in the amount actually paid, $75,000, and the option's value using the BSM model is essentially an amount paid indirectly to the dealer for the transaction. In this deal, that markup was 22%, which is astounding in light of credible expert-witness testimony that market practice is that a markup should not exceed 5% to customers, and that markups in excess of 5% violate a background norm in the industry that a broker-dealer comply with the basic principles of fair and equitable trade. So we find that Markell grossly overpaid for the options.
   n15 According to the BSM model, the digital call option values are $0.2986928 for the long option, and $0.2986507 for the short option per dollar of cash payout. Thus, the market value of the long option was $14,987,312, and the short option was -$14,928,270. MC Trading itself calculated a theoretical value of the paired options of $56,892. 
The terms of the option spread were also unusual. The strike prices were only $0.03 -- or three "pips" as the industry calls them -- apart and very far out-of-the-money. The strike prices were so close together that, from a risk-management perspective, they were indistinguishable. Refco, as the calculating agent, had the choice of any price that was printed between 9:30 a.m. and 9:45 a.m. on the date of expiration. The key fact is that the option sold could not have been disposed of without the option purchased: We specifically find that Refco would never have allowed Markell, which had only $75,000 in its Refco account, to collect $14.9 million as premium for the short leg due to the credit risk involved in selling an option. And here, the credit risk to Refco would be the inability to collect from MC Trading or Markell if the short leg was in-the-money at expiration. So, Refco in its own economic self-interest would never choose a rate that fell in the "sweet spot." And if, for the sake of argument, the investment objective was never to hit the sweet spot but rather to spend $75,000 for a maximum payout of $190,611 based on the NASDAQ index's going up in price, there was a simpler choice that had a higher probability of achieving that objective. We agree with the Commissioner's experts that Markell could have spent the same $75,000 for a single European digital call with the same possible payout of $190,611 but a strike price close to the then-current rate of $1,477.30, rather than the far-out-of-the-money strike price of $1,591.01 that it actually agreed to pay for the long leg of the paired option. 
Between Haber's inextricable relationship with Markell and its related entities, and the dubious investment objectives surrounding the paired options, we find that Haber's claim of privilege permits us to draw an adverse inference against MC Investments's having a business purpose at all. See LiButti, 107 F.3d at 123; Petzoldt, 92 T.C. at 685.
Gross Valuation Misstatement

The Court also applied the gross valuation misstatement penalty.  Section 6662(h)(1).  Nothing startling here.

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