department of the treasury internal_revenue_service washington d c date cc psi br7 tl-n-5854-00 of f i c e of c h i e f c ou n s e l number release date uilc internal_revenue_service national_office field_service_advice memorandum for associate area_counsel -- from associate chief_counsel passthroughs and special industries cc psi subject research_credit this chief_counsel_advice responds to your memorandum dated date in accordance with sec_6110 this chief_counsel_advice should not be cited as precedent legend taxpayer directive supplement year year year year year date date date date date tl-n-5854-00 date date a b c d e_p q r s t u v w x y z issue dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure whether research that taxpayer performed on various research projects is funded under sec_41 where taxpayer is reimbursed by its customers for expenditures attributable to such research regardless of the outcome of the research conclusion research that taxpayer performed on various research projects is funded under sec_41 because amounts payable to taxpayer under the agreements governing cost_recovery are not contingent upon the success of the research and taxpayer performed such research with the expectation that it would be reimbursed for all expenses paid_or_incurred regardless of the outcome of the research facts taxpayer was created in year to serve its a shareholders shareholders by providing a common research_and_development center for the years at issue in this field_service_advice taxpayer was engaged principally in the rendition of technical services to support the activities of its shareholders tl-n-5854-00 in year taxpayer's board_of directors recognized a business need to ensure that funding was available for the timely initiation of studies and developmental efforts research projects the research projects generally were restricted to developmental efforts that would benefit at least b shareholders and that would most likely lead to multi-client projects product projects in c years taxpayer's total cost for research projects was not to exceed p annually taxpayer’s directive effective as of date and reissued on date outlines how research projects are approved how their cost is monitored and how their billing is deferred until they generate product projects specifically directive provides that if a research project is approved by taxpayer's president its billing is deferred for c years during that time the research project is expected to generate one or more product projects the research project's cost together with a financing charge calculated at an annual rate of d is recovered over a maximum period of b years from the time the project is initiated by a chargeback to the product projects although billing is deferred the cost of research projects is reported as it is incurred similar to any other external billable project research projects are tracked internally on a monthly basis to ensure that their total annual cost does not exceed p the approved level of expenditure for research projects in a fiscal_year deferred billing is recorded on taxpayer's balance_sheet as a debit to long-term or short-term deferred charges and on the income statement as a revenue adjustment with respect to cost_recovery directive provides that when a research project generates a product project the research project expires and its total cost including financing charges is recovered through a chargeback to the generated product project accordingly the research project is paid for by the shareholders benefitting from the generated product project the cost of which is also assumed by the shareholders put differently the cost of the generated product project includes its current_year expenses plus a chargeback for all or a portion of the research project's cost and financing charge typically taxpayer's work on a research project would lead to one or more fully-developed product projects that taxpayer would offer to its shareholders taxpayer also had the option however of offering a research project to a shareholder before a product project was generated in this case directive provides that the price paid_by the shareholder includes the research project's costs and any financing charges occasionally a shareholder that did not fund the research project would elect at a later date to participate in the generated product project in this case the shareholder would pay a fee that would result in credits to participating tl-n-5854-00 shareholders that had funded the research project finally directive provides that where a research project failed to recover its cost from chargebacks to generated product projects that cost was billed equally to all a shareholders at the end of year taxpayer embarked on a new program of work efforts recognizing a need for more advanced research projects that would encompass work of a much larger scale over a longer period of time on date taxpayer issued supplement which retroactively modified directive with respect to all research project expenses_incurred on or after date in relevant part supplement provides that taxpayer's total annual cost for research projects would be increased from p but was not to exceed q in year r in year and s in year the financing charge previously calculated at an annual rate of d would be calculated using e and allocated monthly to the unbilled cost supplement describes an additional method for the recovery_of research project cost shareholders were permitted to obtain components of research projects in the event the entire project did not meet their business needs when this method was used shareholders were charged based on full cost including interest estimates of the number of participants or buyers and usage levels this resulted in lower prices for shareholders than for outside industry clients and did not allow a shareholder price to exceed full cost supplement1 also includes a discussion of which is defined as unrecovered cost or the total cost for all research project work efforts including any unbilled cost carried over from previous years less amounts billed to clients revenue in connection with research projects taxpayer's board_of directors set limits for unrecovered cost of t at the end of year and u at the end of year on date taxpayer was sold to purchaser it is our understanding that purchaser paid approximately v for taxpayer which is the w aggregate purchase_price quoted by the sales and purchase agreement minus x in research project debt research project debt is described as in the sale and purchase agreement while neither directive nor supplement contains any explicit mention of this acquisition supplement does contain a provision stating that unrecovered research project cost shall be treated as corporate debt in the event taxpayer changes ownership before date however supplement continues if taxpayer does not change ownership before date then unrecovered cost is trued-up and billed equally to the shareholders the only other mention of the treatment of such directive contains no provision addressing directive does provide however that a research project's price will include the project's cost and any financing charges but will not include the meaning of the term is not explained in either directive or supplement tl-n-5854-00 unrecovered research project cost is found in a synopsis of minutes from a meeting of taxpayer's board_of directors held on date the minutes state that in the event of a sale of taxpayer the board will determine the treatment of unrecovered balance and post-sale revenues associated with the research projects taxpayer has filed a claim_for_refund on form 1120x for the year taxable_year taxpayer's total claim is for y z of which is attributable to research_credit law and analysis sec_41 allows taxpayers a credit against tax for increasing research activities generally the credit is an incremental credit equal to the sum of percent of the excess if any of the taxpayer's qualified_research_expenses for the taxable_year over the base_amount and percent of the taxpayer's basic_research_payments sec_41 provides that the term qualified_research_expenses means the sum of the following amounts which are paid_or_incurred by the taxpayer during the taxable_year in carrying on any trade_or_business of the taxpayer a in-house_research_expenses and b contract_research_expenses for purposes of the research_credit in taxable years through date the term qualified_research had the same meaning as the term research or experimental had under sec_174 except that the term did not include qualified_research conducted outside the united_states qualified_research in the social sciences or humanities and funded research for taxable years beginning after date sec_41 defines the term qualified_research as research with respect to which expenditures may be treated as expenses under sec_174 which is undertaken for the purpose of discovering information which is technological in nature and the application of which is intended to be useful in developing a new or improved business_component of the taxpayer and substantially_all of the activities of which constitute elements of a process_of_experimentation for a purpose described in sec_41 such term does not include any activity described in sec_41 tl-n-5854-00 sec_41 provides that the term qualified_research shall not include several specifically listed activities one of which is funded research the exclusion for funded research under sec_41 provides that the credit shall not be available for qualified_research to the extent funded by a contract grant or otherwise by another person or governmental entity sec_1_41-5 provides that research does not constitute qualified_research to the extent it is funded by any grant contract or otherwise by another person including any governmental entity all agreements not only research contracts entered into between the taxpayer performing the research and other persons shall be considered in determining the extent to which the research is funded amounts payable under any agreement that are contingent on the success of the research and thus considered to be paid for the product or result of the research are not treated as funding sec_1_41-5 provides in relevant part that if a taxpayer performing research for another person retains no substantial rights in research under the agreement providing for the research the research is treated as fully funded for purposes of sec_41 and no expenses paid_or_incurred by the taxpayer in performing the research are qualified_research_expenses sec_1_41-5 further provides that if a taxpayer performing research for another person retains no substantial rights in the research and if the payments to the researcher are contingent upon the success of the research neither the performer nor the person paying for the research is entitled to treat any portion of the expenditures as qualified_research expenditures sec_1_41-5 provides in relevant part that if a taxpayer performing research for another person retains substantial rights in the research under the agreement providing for the research the research is funded to the extent of the payments and fair_market_value of any property to which the taxpayer becomes entitled by performing the research a taxpayer does not retain substantial rights in the research if the taxpayer must pay for the right to use the results of the research the issue in this request for field_service_advice is whether expenses paid_or_incurred in the year taxable_year for research performed by taxpayer on the research projects are expenses for funded research under sec_41 this issue was first considered by the court of federal claims in 30_fedclaims_839 and thereafter by the court_of_appeals_for_the_federal_circuit which held adversely to the government see 71_f3d_868 fed cir finding that the trial_court incorrectly construed the contract between fairchild and the government the appeals court determined that t he inquiry turns on who bears the research costs upon failure not on whether tl-n-5854-00 the researcher is likely to succeed in performing the project fairchild industries f 3d pincite applying that test the court found that fairchild's right to payment was contingent on success because t he contract explicitly placed solely on fairchild the risk of failure of every line item of the contract id the court acknowledged that as each line item was successfully completed and accepted and the progress payments for that line item liquidated fairchild's total risk was reduced the court concluded however that fairchild's total risk was never eliminated to the extent it remained at risk until the research was successfully completed and the product of the research accepted the fairchild reversal was significant in that the federal_circuit made a compelling argument that the determination of who is at economic risk for unsuccessful research should be based upon the contractual events by which the parties choose to measure success or failure as a result the contract may encompass a risk-sharing arrangement whereby risk is allocated between the contractor and the customer in this case taxpayer and the shareholders respectively this allocation may shift during the course of the contract depending upon the level of progress and completion achieved however the allocation of risk is established by the terms of the contract and is present for the contract’s duration regardless of whether the outcome is success or failure see fairchild f 3d pincite noting that it was incorrect for the trial_court to change upon successful completion of the contract the allocation of risk that was established in the contract and was present throughout its performance the legislative_history the statute and the regulations all indicate that the meaning of the terms funded and contingent upon success is premised upon which party the customer or the contractor bears the economic risk of failure in other words the credit should go to the party who will be out-of-pocket in the event the research is unsuccessful this is clearly consistent with congress' intention to provide an incentive to researchers who would otherwise be dissuaded from undertaking costly research because of the possibility the research might result in failure the legislative_history of the research_credit provides little guidance on the meaning of the term funded in considering government contracting the original senate bill would have allowed a credit to the taxpayer who reimbursed a research contractor for wages it incurred in performing research services although it would have disqualified research or experimentation expenses to the extent funded by any grant contract or subcontract with any governmental entity see s rep no pincite h_r rep no pincite n thus congress concluded when research is performed for others the research is funded and the researcher is not entitled to the credit as long as the customer pays for the research tl-n-5854-00 the relevant regulations for the issue of whether research is funded are found at sec_1_41-5 and sec_1_41-2 which provide mirror rules allocating the research_credit to either the contractor when payment is contingent on success or the customer when payment is made regardless of the success of the research thus from the perspective of the contractor in this case taxpayer sec_1_41-5 provides that a ll agreements not only research contracts entered into between the taxpayer performing the research and other persons shall be considered in determining the extent to which the research is funded amounts payable under any agreement that are contingent on the success of the research and thus considered to be paid for the product or result of the research see sec_1_41-2 are not treated as funding emphasis added concomitantly from the perspective of the customer in this case the shareholders sec_1_41-2 provides that the customer may claim the research_credit based on payments made to a contractor only if its payments are made pursuant to an agreement that requires the customer to bear the expense even if the research is not successful however if the customer pays the contractor pursuant to an agreement under which payment is contingent on the success of the research the expense is considered paid for the product or result rather than for the performance of the research sec_1_41-2 emphasis added the regulations quoted above clearly suggest that research performed in connection with a contract is not funded unless the customer agrees to reimburse the researcher for its expenses regardless of whether the research is successful however if payments are contingent on the success of the research they do not constitute funding thus both sets of implementing regulations treat payments that are contingent on success as attributable to the commercial product or result of the research rather than to the contractor's performance of research case development hazards and other considerations in the present case taxpayer supported the activities of its shareholders by providing technical services specifically taxpayer engaged in formative studies and developmental efforts that is research projects for the benefit of its shareholders directive and supplement both issued by taxpayer’s comptroller and applicable for expenses paid_or_incurred by taxpayer for expenses relative to the research projects during the year taxable_year contain guidelines and tl-n-5854-00 procedures ensuring that funding would be available for the timely initiation of research projects that would generate product projects both directive and supplement generally provide that research project costs together with product project costs are assumed by the shareholders the cost of the generated product project includes its current_year expenses plus a chargeback for all or a portion of the research project’s cost and financing charge all of which are assumed by the shareholders even where a research project fails to recover its cost from chargebacks to generated product projects that cost was billed equally to all a shareholders notwithstanding the explicit provisions governing cost_recovery in directive and supplement taxpayer has claimed that reimbursement by the shareholders for taxpayer’s work on the research projects was not an enforceable right specifically in a recent memorandum in response to idr taxpayer states that supplement showed that directive in which the shareholders agreed among themselves to share the formative costs was subject_to significant contingencies and was not in any way enforceable by taxpayer against the shareholders we do not agree that directive was in any respect an agreement only between the shareholders in fact directive and supplement were directives issued by taxpayer’s board_of directors delineating the terms under which funding for the research projects would be assured those directives explicitly state that taxpayer would be reimbursed for research project costs tl-n-5854-00 as noted above fairchild stands for the proposition that the term contingent on success should be interpreted in terms of the explicit provisions of the contract wherein the parties prospectively allocate at the time the contract is entered into the economic or financial risk that the contracted-for research will not be successful applied to the facts of this case we are required therefore to examine the explicit terms of directive and supplement in determining which party taxpayer or the shareholders will be out-of-pocket in the event the research is unsuccessful under these facts provided it is clear that taxpayer does not bear the economic risk of failure thus the research is funded in applying the funded research exclusion a determination must also be made in addition to the contingency determination as to whether or not a taxpayer retains substantial rights in the research thus if a taxpayer performing research for another person retains no substantial rights in research under the research agreement the research is treated as fully funded and no expenses paid_or_incurred by the taxpayer in performing the research are qualified_research_expenses conversely if a taxpayer performing research for another person retains substantial rights in the research under the agreement providing for the research the research is funded to the extent of the payments to which the taxpayer becomes entitled by performing the research the crux of the government’s argument before the trial_court in fairchild was that fairchild’s research costs were funded and hence not eligible for the research_credit where payment is expected and likely to be made in the normal course of events fairchild fed cl pincite the trial_court explicitly rejected the government’s expected and likely standard finding that there was no statutory or legislative support for such a test it is interesting that this is essentially the argument being made by taxpayer in this case to the extent we are being asked to look beyond the four corners of the contract and consider the likelihood of success based upon the course of dealing between the parties tl-n-5854-00 for purposes of responding to your request for field_service_advice you have asked us to focus upon the issue of whether taxpayer’s research is funded and to disregard the issue of whether the research activities of taxpayer constitute qualified_research please contact the national_office if you require further guidance concerning these potential issues this writing may contain privileged information any unauthorized disclosure of this writing may have an adverse effect on privileges such as the attorney client privilege if disclosure becomes necessary please contact this office for our views please call if you have any further questions by christine e ellison chief branch passthroughs and special industries


internal_revenue_service number release date index nos cc it a b9 plr-121387-00 date dear this is in reference to a form_1128 application to adopt change or retain a tax_year submitted on behalf of the above- named taxpayers requesting permission to change their accounting_period for federal_income_tax purposes from a taxable_year ending to a taxable_year ending effective the taxpayers have requested that the form_1128 be considered timely filed under the authority contained in sec_301_9100-3 of the procedure and administration regulations the information furnished indicates that due to an error or misunderstanding the form_1128 was not timely filed however the request was filed within days of the due_date sec_1_442-1 of the income_tax regulations provides that in order to secure the commissioner's consent to a change in accounting_period the taxpayer must file an application on form_1128 with the commissioner on or before the 15th day of the second calendar month following the close of the short_period section dollar_figure of revproc_2000_11 i r b states in part that a form_1128 filed pursuant to this revenue_procedure will be considered timely filed for purposes of sec_1_442-1 b if and only if it is filed on or before the time including extensions for filing the return for the short_period required by such change sec_301_9100-3 of the regulations provides that requests for extensions of time for regulatory elections that do not meet the requirements of sec_301_9100-2 automatic extensions such as the instant case must be made under the rules of sec_301_9100-3 requests for relief subject_to sec_301_9100-3 will be granted when the taxpayer provides evidence to establish that the taxpayer acted reasonably and in good_faith and that the granting of relief will not prejudice the interests of the government based on the facts and information submitted and the representations made it is held that the taxpayers have acted reasonably and in good_faith and that the granting of relief will not prejudice the interests of the government accordingly the requirements of the regulations for the granting of relief have been satisfied in this case and taxpayers’ late filed form_1128 requesting permission to change to a tax_year ending effective is considered timely filed the ruling contained in this letter is based upon facts and representations submitted by the taxpayers and accompanied by a penalty of perjury statement executed by an appropriate party this office has not verified any of the material submitted in support of the request for a ruling verification of the factual information representations and other data may be required as part of an examination process this ruling addresses the granting of sec_301_9100-3 relief only no opinion is expressed regarding the tax treatment of the instant transaction under the provisions of any other sections of the code or regulations that may be applicable thereto or regarding the tax treatment of any conditions existing at the time of or effects resulting from the instant transaction specifically no opinion is expressed as to whether the taxpayers are permitted to change to the tax_year requested under revproc_2000_11 a copy of this letter_ruling and taxpayers' form_1128 are being forwarded to the service_center where the taxpayers file their federal_income_tax returns with instructions that the form_1128 be considered timely filed and processed in accordance with established procedures under revproc_2000_11 in accordance with the provisions of a power_of_attorney currently on file we are sending a copy of this letter_ruling to the taxpayers' authorized representatives this ruling is directed only to the taxpayers that requested it sec_6110 of the internal_revenue_code provides that it may not be used or cited as precedent sincerely yours associate chief_counsel income_tax and accounting s heather maloy enclosures copy of this letter copy for sec_6110 purposes


number release date id office uil cca_2009011508152542 ---------------- from ------------------ sent thursday date am to ---------------- cc ------------------ subject ----------------------------- i remind you that ------ handles contract interpretation you should probably get a--------- person to look at the agreement before you the service sign it the pertinent facts as we understand them are as follows taxpayers have outstanding income_tax liabilities for tax years ------- through ------- in the amount of dollar_figure----------- on --- ------------------ taxpayers entered into an installment_agreement for these ----- years pursuant to which they pay dollar_figure--------per month although the service knew that the installment_agreement will not full pay the taxpayers’ liability within the collection expiration dates the earliest of which will run in ------- it approved the agreement on ---- ---------- on -------------------- ----------------------- group manager ------------- recommended that the service accept an assignment of life_insurance benefits proposed by the taxpayers in an attempt to avoid enforcement action against the equity they hold in assets pursuant to the agreement taxpayers’ would assign to the internal_revenue_service the death_benefits from two life_insurance policies owned by ----------------- with respect to the --------------------policy ------------------represents that he has the unrestricted right to assign the policy subject only to notice and the consent of the insurance_company you have confirmed that according to the application_for the --------------------policy section 16-beneficiaries the owner may change any beneficiary unless designated as irrevocable you have confirmed that currently --------------------wife is designated as the primary beneficiary and his children as the secondary beneficiaries the children will be the beneficiaries if --------------------predeceases ----------------- you also have indicated that neither designation is marked irrevocable ------------------has represented that he has made no prior assignments of the policy and that the policy is not encumbered in any way ------------------noted in her recommendation to ---------------------- area counsel----------- - ----------- that ------------------has a terminal illness that likely will result in his death within the next four years ------------------recommended that the service accept the taxpayers’ proposal noting that the immediate liquidation of the polices would provide some immediate funds but would result in a significant shortfall with respect to the tax_liability the assignment of death_benefits would result in the liability being paid in full once an installment_agreement is entered it remains in effect for the term of the agreement except as otherwise provided in sec_6159 sec_6159 - provides that the service may terminate an installment_agreement if the information given to the service prior to the acceptance of the agreement was inaccurate or incomplete the collection of the tax to which the agreement relates is in jeopardy there is a subsequent change in the taxpayer’s financial conditions the taxpayer fails to provide a financial condition update when requested or the taxpayer fails to pay an installment or any other tax no levy may be made on any person with respect to any unpaid tax during the period that an installment_agreement for the payment of the tax is in effect as we understand it the taxpayers’ proposal was discussed prior to the acceptance of the installment_agreement but was never ratified we also understand that the taxpayers are up to date on their installments and their estimated payments for --------- and that no other reason exists that would allow the service to terminate the agreement consequently the service may not seize the taxpayers’ assets to pay any of the ---------------liability which is covered by the installment_agreement the taxpayers however still wish to assign the insurance policies to the service to pay whatever liability remains once ------------------dies although the -------------- have an extant installment_agreement and the service cannot seize any of their assets while the agreement is in effect the ------------- still owe the government taxes the eighth circuit has determined that a life_insurance_policy may be assigned as collateral without the consent of the beneficiary if the policy reserves that right to the insured 340_f3d_659 8th cir citing the minnesota supreme court’s decision in jamesville state bank v life ins co we recommend that if the --------------are willing to assign the benefits of the insurance policies to the united_states the service accept their offer there is nothing that prevents the service from accepting another form of payment outside of an extant installment_agreement ---------------------------------------------------------------------------- --------------------------------------------------------------------------------------------------------------------- --------------------------------------------------------------------------------------------------------------------- --------------------------------------------------------------------------------------------------------------------- --------------------------------------------------------------------------------------------------------------------- ----------------


t c memo united_states tax_court cecilia shao petitioner v commissioner of internal revenue respondent docket no filed date john b kern for petitioner daniel j parent for respondent memorandum opinion holmes judge cecilia shao transferred stock to derivium capital in and received money in return the commissioner calls this a sale but shao calls it a nonrecourse loan secured_by her stock because derivium promised her that she could get her stock back if she repaid the loan after three years derivium however was not what it appeared instead of hedging the upside risk that it was taking on--which is what derivium said it was doing--derivium simply sold shao’s stock almost as soon as it could the firm eventually went bankrupt and is widely reported to have been a ponzi scheme in calloway v commissioner t c ___ we held that one of derivium’s customers sold his stock when he transferred it to derivium’s control in this case we consider whether shao unlike calloway can avoid the penalty that the commissioner has asserted against her i shao background the facts in this case are largely uncontested cecilia shao moved to california from taiwan as a child and did well in school earning a degree in cultural anthropology from the university of california santa barbara in after college she put her degree to work in a museum but quickly began looking for better or at least better paying jobs--first at a finance company and in as an administrative assistant for veritas software corporation this was the start of the dot-com boom and veritas offered each new employee an initial stock grant and then more stock after each merit review shao didn’t have any experience with stocks and so she did what was like a default for veritas employees--she opened an account with e trade because it administered veritas’s merit grants and employee stock_option program now that she was working in the high-tech industry and had stock_options shao decided she needed to hire someone to prepare her tax returns so she turned to a firm named wade financial shao rose at veritas ultimately becoming a contracts administrator in the legal department over the next few years she accumulated more than big_number shares of veritas stock in her e trade account and saw it as a source_of_income for retirement-- her nest egg but at some point she needed money to buy a car and began looking for ways to unlock her stock’s value without selling shao turned to a certified financial planner named jovita honor for advice honor worked at wade financial and also prepared shao’s taxes honor suggested using a margin loan so shao signed up for one with e trade margin-loan brokers offer stockholders a loan worth some of their stocks’ value but usually require that the remaining value not fall below a certain limit or margin if the stock value falls too low to cover the margin the stockholder has to deliver more collateral or pay back part of the loan to keep the broker secured this makes a margin loan risky shao’s stock increased in value from less than dollar_figure to upwards of dollar_figure by date but shao was still riding the dot-com bubble when it began to leak--veritas stock began to sink in early shao like many who didn’t know the bubble was a bubble mistook the decline for a temporary correction and didn’t want to sell her nest egg but at this point shao also wanted to buy a home and needed cash for a downpayment so she asked honor about options with lower risk honor thought she had found something better for her clients like shao--she discovered a south carolina company called derivium capital llc derivium offered what it called loans worth percent of a stock’s value with interest usually set pincite or percent and a term of two to five years the loans were nonrecourse meaning that if a borrower didn’t repay derivium would not have to return the stock or its equivalent to the borrower but couldn’t sue for any unpaid balance and unlike e trade’s loans the derivium loans had no margin requirements derivium boasted to its potential clients that it could make these loans because it had a sophisticated hedging strategy honor recommended a derivium loan to meet shao’s objectives and shao agreed the loan was for three years pincite percent interest it was nonrecourse and at the end of the term left her with three choices she could retrieve her stock by repaying the loan plus interest surrender the stock or put off a final_decision by renewing the loan but renewing the loan wasn’t cheap--she would have to pay a fee of percent of the original value of her stock if its price had fallen during the period covered by the loan derivium reserved the right to assign transfer pledge repledge hypothecate rehypothecate lend encumber short sell and or sell outright some or all of the securities without notice to shao shao waived her rights to receive many of the benefits of the stock during the term of the loan and she could not prepay she did keep the right to receive any dividends which derivium promised to credit against the interest she owed--but since her stock didn’t pay dividends she never paid interest under this provision at the end of the loan term shao could repay the loan and get back the same number of shares of the same securities received as collateral which would reflect any and all stock splits conversions exchanges mergers or other distributions except dividends credited toward interest due shao believed that the only difference between derivium’s deal and her e trade margin_account was that she wasn’t subject_to margin calls with derivium shao and derivium’s president charles cathcart signed the master agreement on date that same day shao asked e trade to transfer her veritas shares and the associated margin the renewal fee in calloway v commissioner t c was a percentage of the balance due at maturity but shao’s documents show that the renewal fee derivium charged her was a percentage of the collateral value at the beginning of the loan term this appears to be the only difference between the structure of these two derivium deals and it doesn’t affect our analysis debt to derivium’s account at first union securities on july derivium confirmed the amount of the e trade margin debt it would accept when the shares were transferred derivium got shao’s shares on july on july derivium sold the veritas stock-- without shao’s knowledge--in several sales ranging between dollar_figure and dollar_figure a share that same day derivium sent shao a valuation confirmation letting her know that the precise hedged value of her stock was dollar_figure and that after accounting for the existing debt from her e trade margin loan she would receive dollar_figure cash via wire transfer shao got the loan proceeds on july derivium got the money from the veritas stock sale on july consistent with shao’s understanding of the transaction honor prepared shao’ sec_2001 tax_return without reporting a sale of the veritas stock shao never received a form 1099-b proceeds from broker and barter_exchange transactions for the sale of the securities nor a form 1099-c cancellation of debt and didn’t withhold any information from honor during the loan’s term derivium sent shao quarterly account statements reflecting the interest accrued the balance of the loan and the value of the shares in date these quarterly statements began coming from bancroft loan processing not derivium the change was apparent only in the very fine print at the bottom of the statements--bancroft’s statements otherwise looked identical to derivium’s the year-end statement and all shao’s later statements came from bancroft u s processing and when the three-year term was up it was bancroft ventures limited that wrote shao to remind her that she could renew the loan none of the statements from the various bancroft entities during the term of the first loan showed a business location other than the united_states they even listed a south carolina phone number despite the halving of her stock’s value over the three-year term of the loan shao nonetheless paid the renewal fee of more than dollar_figure to bancroft ventures in date to keep the loan alive but time and interest made this deal look doubtful to someone without shao’s optimism if she had repaid the loan instead of renewing it she would have needed to send bancroft over dollar_figure for stock worth only about dollar_figure shao though still had hope and credibly testified that she renewed the loan thinking the market would rebound and she could redeem her stock at the end of a second three-year term the new master loan financing and security_agreement which shao signed came from bancroft ventures ltd and prominently mentioned that bvl was a company based on the isle of man the provisions of this agreement were different from those of the first one for instance article prohibited shao from granting any security_interest in the collateral which remember had already been sold superior to bancroft’s interest and required bancroft to give shao notice if it did certain things with her stock the loan schedule however preserved derivium’s original rights to assign transfer pledge repledge hypothecate rehypothecate lend encumber short sell sell sell outright and or otherwise dispose_of some or all of the collateral the loan agreement rider made it explicit that borrower is the lawful owner of the collateral it also promised shao that all collateral pledged for all previous loans made to borrower under derivium documents has been in the custody of derivium as agent for bvl or in the custody of bvl and is in the custody of bvl as at the date hereof about a week after renewing her loan shao was laid off from veritas she got a letter from the california franchise tax board in date telling her the state was challenging her tax treatment of the loan proceeds in early she learned of problems other derivium clients were having and bancroft sent her a letter about some issues it was experiencing by this point honor had dumped shao as a client and shao turned to a the parties did not enter this letter into the record so we make no finding of fact regarding its contents beyond shao’s admissions at trial however we believe her testimony that the letter was sent date shao renewed her loan by writing a check to bancroft ventures dated date and a letter from bancroft dates shao’s new loan to date we therefore find as a matter of fact that shao received the franchise tax board letter after she renewed her loan man named mr nagy for additional tax_advice finally in date the commissioner sent shao a notice_of_deficiency asserting that she had sold her veritas stock in shao contested the notice_of_deficiency with a timely petition she was a californian when she filed the petition and we tried the case in san francisco ii derivium to understand the commissioner’s position however requires some understanding of derivium’s history charles cathcart started derivium capital in under the name first security capital in re derivium capital llc bankr bankr d s c cathcart formerly employed as the chief economist for the eastern division of citibank owned the company with his son scott and one yuri debevc id together they marketed 90-percent loans during the peak of the dot-com bubble often targeting individuals with low-basis stock that had although shao didn’t specify mr nagy’s first name one robert nagy was a defendant in an action to enjoin the promotion of tax-fraud schemes allegedly carried out by derivium and related entities united_states v cathcart no c n d cal date order denying defendant nagy’s second request for a stay severance and venue transfer united_states v cathcart no c n d cal date order denying defendant nagy’s first motion to sever and transfer venue this section is provided for background only--we make no findings_of_fact as to derivium’s history outside the already presented facts specific to shao’s case although this section summarizes other published decisions appreciated significantly but who didn’t have the means to engage in more sophisticated financial transactions on their own the derivium founders told borrowers that they used a proprietary hedging strategy to reduce the risk associated with making the 90-percent loans cathcart once referred to derivium’s secret hedging strategy as our own coca-cola syrup southall loyal to the company here’s how to hedge investment news date at the time commentators trumpeted the company as offering little guy investors opportunities that before had only been used by the ultrarich see eg gross how to salvage a portfolio n y times mag date pincite for a while the system seemed to work derivium made approximately big_number loans totaling about dollar_figure billion with commissions of dollar_figure million derivium capital llc v united_states trustee aftr 2d s d n y as loan terms expired some borrowers even repaid their loans and got their collateral back although derivium sold most of the stock immediately to pay off other investors it did make some small real_estate investments and even used profits from them to cover the cost of returning stock to some of the borrowers id but derivium’s asserted hedging activity apparently masked the fact that their long-term strategy reminiscent of south park’s underpants gnomes relied on a business plan of step make loans step step profit see comaford-lynch make your financing pitch sizzle business week online date http www businessweek com smallbiz content feb2007 sb20070219_940216 htm as the dot-com bubble burst there were fewer people holding appreciated stock and derivium ran out of new clients and new money in before derivium ran out of money altogether the california corporations commissioner sued to enjoin the firm from marketing the 90-percent loan alleging that either derivium was an unlicensed broker dealing in securities or that derivium was an unlicensed lender making consumer or commercial loans the court granted summary_judgment partially in derivium’s favor finding that derivium had engaged in marketing bona_fide loans not sales of stock people v derivium capital llc no 02as05849 cal super ct date see also derivium capital llc v united_states trustee aftr 2d s d n y the california superior court in sacramento county entered a dollar_figure judgment against derivium after derivium agreed that it broke california law requiring lenders and stock brokers be licensed people v derivium capital llc no 02as05849 cal super ct date the court also enjoined derivium’s owners from marketing brokering or making of stock loans in the state of california until they had a license id date bancroft had a harder time it did not appear for trial and the court found that bancroft had engaged in both unlicensed lending and unlicensed stock brokerage id date the court expressly finds that based on the evidence presented at trial that the stock loans transactions entered into by bancroft ventures limited amounted to the constructive purchase and sale of the securities pledged as collateral for the purpose of california corporations code section this litigation forced derivium to stop doing business in but bancroft agreed to continue running the business in derivium capital llc v united_states trustee aftr 2d s d n y but in the lawsuits began investors wanting their stock back found out that derivium didn’t have it and couldn’t afford replacement shares they filed suits in south carolina california wyoming connecticut delaware and new york not to be outdone in the irs began to investigate whether derivium and its related entities had promoted an abusive shao got statements from derivium until suggesting that derivium did not entirely stop doing business despite running out of money a few examples of opinions issued in the nearly civil cases brought as a result of the derivium scheme--150_fedappx_226 4th cir confirming arbitration award against derivium newton family llc v derivium capital llc no 07-cv-02964 d s c date jury verdict against cathcart for dollar_figure million schlacte v united_states aftr 2d ustc par big_number n d cal tax_refund case wcn gan partners ltd v cathcart no 05-cv-00282-j d wyo date order granting motion to transfer to south carolina mccarty v derivium capital llc no cv mrk d conn date order denying claims against american arbitration association tax_shelter in violation of sec_6700 the theory was that derivium falsely advise d customers that they can receive of the value of their securities without paying income_tax on capital_gains the government asserted that derivium made false statements about the tax benefits of its product including saying that it was marketing loans with potentially indefinite deferral of tax the government quoted derivium’s marketing materials as saying you don’t have to sell your shares and trigger a tax_liability because loans are not taxable events in fact depending on your individual tax situation the stock loan may even enable you to generate more cash than selling the position outright net of capital_gains_tax liabilities the government alleged the total_tax loss associated with derivium’s scheme to be almost dollar_figure million complaint united_states v cathcart no c n d cal filed date and won an injunction in late forbidding derivium from continuing to market the scheme united_states v cathcart no c n d cal date order of permanent injunction even before this last litigation loss derivium was beginning to crater and it had filed for bankruptcy in date derivium said at the time that it would move under u s c unless otherwise noted all section references are to the internal_revenue_code and the single rule reference is to the tax_court rules_of_practice and procedure sec_505 for a mass determination as to whether the stock loans constituted bona_fide loans or sales see derivium capital llc v united_states trustee aftr 2d s d n y it never did and borrowers were left scrambling to get their own judgments on a case-by-case basis the bankruptcy court appointed a trustee to oversee the disposition of derivium’s assets and the case was transferred to south carolina many of the claims that had been filed against derivium and cathcart in the years before the bankruptcy eventually ended up before the bankruptcy court as the bankruptcy went forward the trustee uncovered what he deemed a ponzi scheme grayson consulting inc v wachovia sec llc in re derivium capital llc bankr bankr d s c he also alleged that cathcart and derivium’s other owners had illegally shifted assets out of derivium into shell_corporations to avoid bankruptcy liquidation campbell v cathcart in re derivium capital llc bankr bankr d s c in an action for a permanent injunction and equitable relief against the cathcarts debevc nagy and derivium the northern district of california granted summary_judgment for the government finding that the loan transactions were sales of securities for purposes of tax code treatment as opposed to bona_fide loans united_states v cathcart aftr 2d ustc par big_number n d cal order granting summary_judgment and denying summary_judgment and miscellaneous rulings discussion we recently decided in another derivium case that the transfer of stock from a customer to derivium’s control was a sale under the code see calloway t c at slip op pincite we therefore hold that shao did sell her veritas stock in triggering the capital_gain that the commissioner and shao agreed upon in their stipulation the only remaining issue is whether shao owes the accuracy-related_penalty for not reporting the sale on her tax_return the commissioner claims that shao’s understatement was substantial --ie that it was more that dollar_figure and ten percent of the tax required to be shown on her return--and therefore she should pay a twenty-percent penalty see sec_6662 b d but shao tells us she shouldn’t have to pay the penalty because she acted with reasonable_cause and in good_faith see sec_6664 this is a determination we must make on a case-by- case basis considering all of the facts and circumstances sec_1_6664-4 income_tax regs among the facts and circumstances that we must consider is whether there was an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances including the experience knowledge and education of the taxpayer id although shao has a college degree her focus was in cultural anthropology and she didn’t have any investing experience before being hired at veritas when she entered into both of her stock transactions the e trade margin loan and the derivium transaction she did so only after consulting a certified financial planner the commissioner points out that shao worked at a finance company at one point but we note that this was around the time she wa sec_24 years old and between her jobs as an anthropologist at a museum and as a floating administrative assistant at veritas we do not therefore find her sophisticated in tax matters because of that one position shao herself began hiring tax professionals to prepare her returns as soon as she started getting stock_options when she entered the derivium transaction the only stock loan shao had ever entered was her e trade margin loan which she believed was similar to this transaction and whose legitimacy had never been questioned the relevant regulation also tells us that to find good_faith and reasonable_cause the most important factor is the extent of the taxpayer’s effort to assess the taxpayer’s proper tax_liability id shao sought financial advice from a trusted certified financial planner before entering the deal and also hired her to prepare the related tax returns the returns were consistent with shao’s understanding of the transaction and consistent with the information returns she received from third parties because she didn’t get a form 1099-b or 1099-c showing a sale of the stock or cancellation of debt we have also found it inappropriate to penalize taxpayers where a mistake of law was in a complicated subject area without clear guidance 113_tc_440 calloway was a case of first impression so there wasn’t any clear direction on whether a transaction with these characteristics was a loan or a sale while a derivium loan might not look particularly complicated to a stock broker or tax expert its subtle differences from shao’s e trade margin loan and the corresponding implications for stock ownership are not and were not to shao readily apparent on the basis of her extremely limited experience shao believed the derivium deal was like her margin loan the only difference in her mind was that with derivium she was protected from margin calls but that difference does not create a case where it would strain credulity to the breaking point to say shao didn’t know something fishy was going on 273_f2d_867 2d cir discrediting taxpayers’ claims they had no inkling something unusual was happening when each had received an dollar_figure unsecured undocumented no-interest loan from a source they hadn’t met until the transaction and later obtained a second loan this one nonrecourse and for significantly more than the market_value of the collateral at the time of the loan affg 31_tc_990 and 31_tc_998 at the time of the transaction shao reasonably and in good_faith thought she had received an oversecured loan she also believed that derivium was hedging its position so she had no reason to think it would ever be under- or unsecured in calloway t c at slip op pincite we found that a taxpayer in a nearly identical transaction failed to prove a reasonable-cause and good-faith defense based upon his behavior after the transaction calloway treated the transaction inconsistently with his own claim that it was a loan by failing to report dividends as income during the loan term and by failing to recognize gain or income from the discharge_of_indebtedness upon the termination of the so-called loan id at slip op pincite these actions are inconsistent with good_faith we also found that calloway could not claim reasonable reliance on either of his professional advisers--calloway didn’t establish one of his adviser’s credentials and the other one gave calloway a letter from a derivium promoter which couldn’t be reasonably relied upon id at slip op pincite calloway’s advisers then didn’t provide him with reasonable_cause we also noted that calloway admitted tax motivation for the transaction’s form which indicated that--consistent with his subsequent actions--he never truly intended it to be a loan id at slip op pincite this of course also cannot be considered good_faith in shao’s case we don’t find the circumstances that led the court to penalize calloway--there is no evidence of a wink-wink-nudge-nudge-say-no-more arrangement with derivium see monty python’s flying circus how to recognise different types of trees from quite a long way away bbc1 television broadcast date shao had legitimate nontax motivations for wanting to structure her deal as a loan instead of a sale--she wanted to reduce risk and use some of the stocks’ value without selling her nest egg her naivete but not we expressly find her negligence is especially prominent in her renewal of the loan at a steep price after three years unlike calloway shao treated her transaction like a loan throughout its existence proving her good_faith we therefore find that shao acted in good_faith upon an honest misunderstanding of the law that was reasonable in her circumstances she has proven her defense to the accuracy- related penalty decision will be entered under rule


internal_revenue_service number release date index number --------------------------- ------------------------------- ---------------------------------------- ------------------------------------------------------------- department of the treasury washington dc third party communication none date of communication not applicable_person to contact -------------------- id no ------------- telephone number --------------------- refer reply to cc psi b01 plr-145181-08 date date x --------------------------------------------------- ---------------------------- p -------------------------------- member --------------------------------------------------- -------------------------- a ----------------------------------------------------- ------------------ b ----------------------------------------------------- ----------------------------- country d1 d2 d3 year year --------------------- -------------------------- ---------------------- ----------------------- -------- ------- dear ------------------ this letter responds to a letter dated date and subsequent correspondence submitted on behalf of x by its authorized representative requesting a ruling under sec_301_9100-1 and sec_301_9100-3 of the procedure and administration plr-145181-08 regulations that x be granted an extension of time to file an election to be classified as a disregarded_entity under sec_301_7701-3 effective d2 facts the information submitted states that x was formed on d1 as a p under the laws of country under the laws of country the owners of a p have limited_liability member intended that x be treated as a disregarded_entity for federal tax purposes however due to inadvertence x failed to file a timely form_8832 entity classification election law and analysis sec_301_7701-3 provides that a business_entity that is not classified as a corporation under sec_301_7701-2 or an eligible_entity can elect its classification for federal tax purposes as provided in sec_301_7701-3 sec_301_7701-3 provides that unless it elects otherwise a foreign eligible_entity is a a partnership if it has two or more members and at least one member does not have limited_liability b an association if all members have limited_liability or c disregarded as an entity separate from its owner if it has a single owner that does not have limited_liability sec_301_7701-3 provides that an eligible_entity may elect to be classified other than as provided in sec_301_7701-3 or to change its classification by filing form_8832 with the service_center designated on form_8832 sec_301_7701-3 provides that an election made under sec_301 c i will be effective on the date specified by the entity on form_8832 or on the date filed if no date is specified on the election form the effective date specified on form_8832 cannot be more than days prior to the date on which the election is filed and cannot be more than months after the date on which the election is filed sec_301_7701-3 provides that for purposes of sec_301_7701-3 a foreign eligible entity's classification is relevant when its classification affects the liability of any person for federal tax or information purposes the date that the classification of a foreign eligible_entity is relevant is the date an event occurs that creates an obligation to file a federal tax_return information_return or statement for which the classification of the entity must be determined thus the classification of a foreign_entity is relevant for example on the date that an interest in the entity is acquired which will require a u_s_person to file an information_return on form_5471 sec_301_9100-1 provides that the commissioner has discretion to grant a reasonable extension of time under the rules set forth in sec_301_9100-2 and sec_301_9100-3 to make a regulatory election or a statutory election but no more than six months plr-145181-08 except in the case of a taxpayer who is abroad under all subtitles of the code except subtitles e g h and i sec_301_9100-1 defines a regulatory election to include an election whose due_date is prescribed by a regulation published in the federal_register sec_301_9100-2 provides the rules governing automatic extensions of time for making certain elections sec_301_9100-3 sets forth the standards the commissioner will use to determine whether to grant an extension of time for regulatory elections that do not meet the requirements of sec_301_9100-2 sec_301_9100-3 provides that requests for relief subject_to sec_301_9100-3 will be granted when the taxpayer provides evidence including affidavits described in sec_301_9100-3 to establish to the satisfaction of the commissioner that the taxpayer acted reasonably and in good_faith and granting relief will not prejudice the interests of the government conclusion based on the facts submitted and the representations made we conclude that the requirements of sec_301_9100-1 and sec_301_9100-3 have been satisfied as a result x is granted an extension of time of days from the date of this letter to file form_8832 with the appropriate service_center and to elect to be classified as a disregarded_entity for federal tax purposes effective d2 a copy of this letter should be attached to the form_8832 a copy is enclosed for that purpose this ruling is contingent on member timely filing amended returns including form_8858 information_return of u s persons with respect to foreign disregarded entities with respect to x if not already filed for the taxable years year through year if relevant if member fails to file form_8858 as described above unless member has already filed form_8858 with respect to x with respect to the taxable years described above this ruling is null and void this ruling is also contingent on member timely filing an amended_return for its taxable_year which includes d3 reflecting the income or loss member recognized as a result of the election described above and a and b timely filing amended returns for their taxable years which include their distributive shares of the income or loss of member described above and any other applicable items for its taxable_year which includes d3 this ruling is also contingent on x filing any necessary returns for the short taxable_year ended d3 if a b member or x fail timely to file the returns described above this ruling is null and void except as expressly set forth above no opinion is expressed or implied concerning the federal tax consequences of the facts discussed above under any other provision of the code plr-145181-08 this ruling is directed only to the taxpayer requesting it sec_6110 provides that it may not be used or cited as precedent in accordance with a power_of_attorney on file with this office we are sending a copy of this letter to x’s authorized representative sincerely curtis g wilson curtis g wilson associate chief_counsel office of the associate chief_counsel passthroughs special industries enclosures copy of this letter copy for sec_6110 purposes cc


department of the treasury i n t e r n al r e v e n u e s e r v i c e w ashington d c date of f i c e of c h i ef c ou n sel number info release date genin-121392-09 ------------------------ --------------------- ------------------------------- uil dear --------------- thank you for your letter of date to commissioner shulman regarding the tax consequences to victims of the investment fraud mr bernard l madoff perpetrated on date we issued guidance revrul_2009_9 and revproc_2009_20 on the tax treatment of losses from so-called ponzi schemes similar to that mr madoff operated i am enclosing copies for your information revrul_2009_9 explains the income_tax law that applies to an investor who loses money in a fraudulent investment arrangement it provides that an investor who was the victim of a fraudulent investment arrangement is entitled to a theft_loss deduction that is not limited by the rules that apply to capital losses investment theft losses are not subject_to limitations that apply to personal casualty and theft losses the theft_loss is deductible in the year the fraud is discovered except to the extent the investor has a reasonable_prospect_of_recovery the amount of the theft_loss includes not only the investor's unrecovered investment but also amounts reported as income from the investment in prior years and reinvested in the fraudulent investment arrangement a theft_loss deduction that creates a net_operating_loss for the investor can be carried back and forward according to the timeframes prescribed by law to generate a refund of taxes paid in other taxable years to claim a theft_loss deduction in any taxable_year an investor must prove that the loss genin-121392-09 was due to theft and that no reasonable prospect exists of recovering the investment investors often cannot make highly factual determinations with certainty in the year the loss is discovered for this reason we published revproc_2009_20 to provide a simplified_method for investors to compute and report their losses from fraudulent investment schemes this revenue_procedure generally allows an investor who was a victim of mr madoff’s fraud to claim a theft_loss in the amount the investor may deduct is up to percent of the loss less the amount of reimbursement he or she expects to receive as an advance for customer claims from the securities investor protection corporation sipc or from private insurance or other contractual arrangements that guarantee the investor against loss i hope this information is helpful please call me at ---------------------if i can further assist you sincerely john p moriarty chief branch office of associate chief_counsel income_tax and accounting enclosures