District court allows $60 million of income to be offset by Son-of-Boss shelter
Sala v. U.S. (DC Co 4/22/08) 101 AFTR 2d ¶ 2008720
Mike Habib, EA
myIRSTaxRelief.com A district court has allowed an individual to offset $60 million of compensation income with losses from a Son-of-Boss transaction.
Facts. Carlos E. Sala had income in 2000 of more than $60 million. However, he claimed a tax loss that essentially nullified his tax burden. Sala achieved the loss through his involvement in a foreign currency options investment transaction known as Deerhurst. He claimed that the $60 million loss resulted from a series of steps that made use of an S corporation (Solid Currencies, Inc.) and an investment in a partnership (Deerhurst Investors, GP). These steps were orchestrated under a then-existing tax rule that disregarded short options as liabilities for purposes of establishing partnership basis. Under this rule, liabilities created by short options were considered too contingent to affect a partner’s basis in the partnership.
IRS challenged this transaction, which is commonly known as a Son-of-Boss shelter, on various grounds. The district court faced these key issues:
(1) whether the transactions creating Sala’s 2000 tax loss were sham transactions;
(2) whether Sala had a profit motive for entering into the transactions creating his 2000 tax loss;
(3) whether the transactions creating Sala’s 2000 tax loss, as executed, allowed the tax loss; and
(4) whether any allowable tax loss was rendered retroactively disallowed by Reg. § 1.752-6.
Background. On June 24, 2003, IRS issued temporary and proposed regs which expanded the definition of liability under Code Sec. 752 to include “any fixed or contingent obligation to make payment without regard to whether the obligation is otherwise taken into account for purposes of the Internal Revenue Code.” This particular change, which was a part of broader regulatory changes in this area, was adopted as final Reg. § 1.752-1(a)(4)(ii) in May 2005. However, IRS made the reg retroactively effective for all assumptions of “liabilities” (as newly defined) by partnerships occurring after Oct. 18, ’99, and before June 24, 2003. It did so through Reg. § 1.752-6 (also issued as a temporary reg), which requires a partner to reduce his basis in his partnership interest by the amount of any contingent obligation, assumed by the partnership between Oct. 18, ’99, and June 24, 2003.
When it issued the temporary reg on June 24, 2003, IRS noted in an accompanying Treasury release that it had previously said in Notice 2000-44, 2000-2 CB 255, that Son of Boss transactions don’t work.
District court sustains the shelter. The district court reached these pro-taxpayer conclusions:
(1) Sala’s participation in the Deerhurst Program possessed a reasonable possibility of profits beyond the tax benefits, was entered into for a business purpose other than tax avoidance, and was motivated by a desire for profits above and beyond the tax benefits sought.
(2) Sala’s basis in Solid Currencies was approximately $69 millionand Solid Currencies’ basis in Deerhurst GP was an identical amount;
Observation: Sala transferred 24 foreign currency options to Solid Currencies and then to Deerhurst GP. The court said Solid Currencies’ basis in Deerhurst GP was increased by the value of the long options, $60,987,867, but was not offset by the $60,259,569 cost of the short options. Accordingly, Solid Currencies’ claimed basis in Deerhurst GP was approximately $69 millionthe value of the cash plus the long options.
(3) the 24 options contracts contributed by Sala to Solid Currencies and by Solid Currencies to Deerhurst GP were separate financial instruments.
(4) Solid Currencies received property upon the liquidation of Deerhurst GP.
Observation: Upon liquidation of Deerhurst GP, Solid Currencies received a portion of Deerhurst GP’s liquidated assets equal to the proportionate size of Solid Currencies’ basis. Solid Currencies received approximately $8 million in cash and two foreign currency contracts. The foreign currency contracts were considered to be “property.” The value of the foreign exchange contracts distributed to Solid Currencies, therefore, was approximately $61 million$69 million (Solid Currencies’ original basis in Deerhurst GP) less the $8 million in cash. When Solid Currencies sold the foreign currency contracts, its loss was equal to the $61 million dollar value of the contracts, offset by any profit received from their sale.
(5) IRS exceeded its authority when issuing Reg. § 1.752-6(b)(2); and
(6) IRS exceeded its authority when making that reg retroactive.
Accordingly, Sala prevailed in using the Son-of-Boss transaction to offset about $60 million of income.
Observation: It remains to be seen whether IRS will appeal this case. But it has previously won a number of Son-of-Boss cases. In one winning case for IRS, the Seventh Circuit upheld the retroactive reg (see Cemco Investors, LLC v. U.S., CA 7, 101 AFTR 2d ¶2008-452).