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BROKEN JADE

December 27, 2007

The IRS has won an across-the-board victory in the U.S. Court of Claims over the "Son of Boss" tax shelter.

The case involved three Texans who together had $40 million in capital gains on which they didn't care to pay taxes. They each bought bought a Euro option for $15,000,020 and sold an offsetting option for $14,850,018 - a spread of $150,002. Any increase in the value of one option was almost perfectly offset by a decline in the value of the other option, so there was only $150,002 really at stake, and that was all the each of the Three Texans were out-of-pocket. Well, that and $900,000 in fees to the promoters and facilitators of the shelter.

The partners contributed the offsetting positions to Jade Trading LLC, which was treated as a partnership under federal tax rules. They claimed a basis of $15,000,020 basis in each partnership interest, relying on a technical reading of the tax law that ignored their "contingent" liability for the $14,850,018 option they wrote. They then sold their partnership interests for their $150,000 fair market value, claiming the $14,850,000 difference as a capital loss.

The Court of Federal Claims struck down the transaction under what you might call the "too good to be true doctrine." The court said there was no "economic substance" to the deal, so the tax law does not have to respect its formalities:

A final indicium of the lack of economic substance here, while not dispositive in and of itself, is the highly disproportionate tax advantage to the underlying monetary outlay -- the tax loss per brother, $14.9 million, was roughly 65 times greater than each LLC's $225,002 financial commitment to Jade, almost 100 times each LLC's $150,002 investment in the spread transaction which generated the loss, and approximately 100 times the $140,000 potential net profit each LLC could have earned.
In sum, this transaction's fictional loss, inability to realize a profit, lack of investment character, meaningless inclusion in a partnership, and disproportionate tax advantage as compared to the amount invested and potential return, compel a conclusion that the spread transaction objectively lacked economic substance.

The court disallowed the deduction and upheld a 40% "gross valuation misstatement penalty," making the transaction a bad deal all around for the participants.

The shelter at issue in Jade Trading was the brainchild of accounting firm BDO Seidman's "TAX $ELLS!" division, "known internally as the 'Wolf Pack.'" Other national firms sold similar shelters, including those that triggered the KPMG criminal prosecutions. Defenders of the promoters used to say that "these shelters haven't been ruled illegal." Not any more.

The TaxProf has more, including a link to the opinion.

Other coverage:

Wall Street Journal

New York Times

Tags: son-of-boss.tax shelters.