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GENIUS FAILS TO AVOID TAX PENALTIES

September 28, 2005

genius.jpgSo many things have not worked out for the super hedge fund Long-Term Capital Management. The fund, set up by some of the greatest minds in finance, triggered a worldwide financial crisis when it faced a liquidity crunch in the 1990s. Its story is told in the book "When Genius Failed."

Yesterday the Federal Second Circuit Court of Appeals upheld penalties of 20% for substantial understatement of income and 40% for gross valuation misstatement on LTCM for a leasing tax shelter it used when it was making money. The shelter itself was shot down in a decision last year; the fund appealed only the penalties, saying it relied in good faith on its tax counsel, King and Spalding, and should therefore be excused from the penalties. The appeals panel disagreed:

The district court found no credible evidence that Long-Term received the tax advice from K&S on which it claimed to have relied in reporting the $106 million loss on its tax return because Larry Noe's memo addressed only the allocation of the loss and Noe's testimony concerning his April 14, 1998 conversation with Mark Kuller was "vague" and "inconsistent." See Long Term Capital Holdings v. United States, 330 F. Supp. 2d 122, 207 (D.Conn. 2004). The court also found that even assuming, arguendo, that Long-Term had received relevant tax advice prior to filing its return, it had failed to demonstrate that K&S's advice was based upon all pertinent facts and circumstances and did not unreasonably rely on statements that the taxpayer knew were unlikely to be true. See Treas. Reg. 1.6664-4(c)(1) (stating the two threshold requirements a taxpayer must satisfy in order to show that it relied on advice reasonably and in good faith). Long-Term directed K&S to assume that Long-Term entered into the transaction with Onslow Trading & Commercial LLC ("OTC") for a valid and substantial business purpose independent of federal income tax considerations, that it reasonably expected to derive a material pre-tax profit from this transaction, and that there was no preexisting agreement on the part of OTC to sell its partnership interest to Long-Term Capital Management ("LTCM"). The record provides ample support for the district court's finding that Long-Term knew these assumptions to be false and that it was unreasonable for K&S to rely on these assumptions when a reasonably diligent review of the pertinent facts and circumstances would have revealed them to be false. The district court was similarly justified in finding that Long-Term's decision to report the $106 million loss as a "Net Unrealized Gain" on line 6 of Schedule M of its 1997 tax return did not constitute "good faith" within the meaning of Treas. Reg. 16664-4.
(Emphasis added.)

Burying a loss on the book-tax reconciliation as "Net Unrealized Gain?" Genius failure, indeed.

We discussed the pattern of this tax shelter in this post: BUILT-IN LOSSES - HERE TODAY, GONE TOMORROW UNDER THE NEW LAW

Links: District court decision

Second Circuit ruling

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