Court Opinion

ID: 4340841
Source: CourtListenerOpinion
Date Created: 2018-11-14 08:45:18.97539+00
Date Added: 2024-06-11T14:21:12.945014
License: Public Domain

T.C. Memo. 2017-183

                            UNITED STATES TAX COURT

         KEITH A. TUCKER AND LAURA B. TUCKER, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

      Docket No. 12307-04.                        Filed September 18, 2017.

      George M. Clarke III, Robert H. Albaral, David Gerald Glickman, Phillip J.

Taylor, Mireille R. Oldak, Vivek A. Patel, John D. Barlow, and Kathryn E.

Rimpfel, for petitioners.

      Donald Kevin Rogers, Charles Buxbaum, Christopher Fisher, and John J.

Boyle, for respondent.

            MEMORANDUM FINDINGS OF FACT AND OPINION

      GOEKE, Judge: Respondent issued a notice of deficiency disallowing

petitioners’ claimed loss deduction of $39,188,666 for the 2000 tax year. This
                                         -2-

[*2] adjustment resulted in a $15,518,704 deficiency and a $6,206,488 section

6662 penalty.1 The claimed loss deduction arises from a series of offsetting

foreign currency digital options that petitioner Keith A. Tucker entered into

through passthrough entities. One set of offsetting foreign currency options

generated the loss, and a second set of offsetting foreign currency options

generated a tax basis in an S corporation through which petitioners claimed the

loss deduction. Through a technical application of statutory and regulatory

provisions, Mr. Tucker separated the loss and gain from the offsetting options and

claimed only the loss portion as U.S. source. Before trial petitioners conceded the

basis component but continue to assert the deductibility of a $2,024,700 loss for

2000 based upon their purported cash basis in the S corporation. Petitioners seek

to carry forward the remainder of the loss deduction to the extent of stock basis in

future years.

      On the basis of the concession, the issues for decision are: (1) whether

petitioners are entitled to deduct a loss for 2000 on the offsetting foreign currency

options. We hold that they may not because the underlying option transactions

      1
       Unless otherwise indicated, all Rule references are to the Tax Court Rules
of Practice and Procedure, and all section references are to the Internal Revenue
Code (Code) in effect for the year in issue.
                                        -3-

[*3] lacked economic substance; and (2) whether petitioners are liable for an

accuracy-related penalty under section 6662. We hold that they are not.

                              FINDINGS OF FACT

I.    Background

      At the time the petition was timely filed, petitioners resided in Texas.2 Mr.

Tucker received a bachelor of business administration degree with a major in

accounting and a minor in finance in 1967 and a juris doctor degree in 1970 from

the University of Texas. Mr. Tucker was licensed as a certified public accountant

(C.P.A.). He never practiced law. After his college graduation and while

attending law school, Mr. Tucker worked at KPMG or its predecessor (KPMG)

and became a partner in 1975. Mr. Tucker started his KPMG career preparing

individual tax returns and then life insurance company returns and eventually

began to provide technical advice on life insurance company tax matters. He

successfully developed his life insurance tax practice and a national reputation. In

1981 Mr. Tucker became the national director of KPMG’s insurance practice. In

1984 Mr. Tucker left the insurance taxation field and joined the investment

banking firm Stephens, Inc., as a senior vice president, becoming involved in

      2
       The parties filed stipulations of facts with accompanying exhibits which are
incorporated by this reference.
                                         -4-

[*4] mergers, acquisitions, public and private placements, and corporate finance.

In 1987 Mr. Tucker joined the private equity firm Trivest, Inc., as a partner,

working on middle-market leveraged buyouts. In 1991 Mr. Tucker left Trivest to

become an executive at Torchmark Corp., an insurance, financial services, and real

estate holding company. In 1992 Mr. Tucker became the chief executive officer

(CEO) of a Torchmark subsidiary, Waddell & Reed Financial, Inc. (Waddell &

Reed), a national mutual fund and financial services company targeting middle-

class individual investors and small businesses. In 1998 Torchmark spun off

Waddell & Reed as a publicly traded company. Mr. Tucker remained the CEO

and served as a director and the chairman of the board. Mr. Tucker remained in

these positions until his forced resignation in 2005. After leaving KPMG in 1984,

Mr. Tucker continued to maintain a relationship with the firm. KPMG served as

his personal tax adviser and return preparer. KPMG prepared petitioners’ returns

for 1984 through 2000 and advised Mr. Tucker on various investment, income,

and estate planning issues.

      A.     Executive Financial Planning Program

      After Waddell & Reed went public in 1998, Waddell & Reed established a

company-sponsored personal financial planning program for its senior executives

(WR executive program) that provided financial, estate, and income tax planning
                                         -5-

[*5] and tax return preparation services. Part of Waddell & Reed’s reasoning for

adopting the WR executive program was concern with its own reputation and

client relationships as affected by the ethical conduct of its executives, including

tax compliance issues. Waddell & Reed also wanted to ensure that senior

executives focused their attention on shareholder matters rather than their own tax

and investment affairs. Upon Mr. Tucker’s recommendation, Waddell & Reed

engaged KPMG to manage the WR executive program. KPMG also served as

Waddell & Reed’s auditor. Mr. Tucker recommended a friend and former KPMG

colleague, Eugene Schorr, to run the WR executive program. Bruce Wertheim, a

senior manager at KPMG, assisted Mr. Schorr as a principal adviser.

      Mr. Schorr has a bachelor’s degree in accounting and a master’s degree in

taxation and is a C.P.A. and a personal financial specialist. He worked in

KPMG’s tax compliance group and specialized in individual tax and financial

planning, gifts and estates, trust planning, and charitable contributions. Mr.

Schorr worked at KPMG (or its predecessors) from 1966 until he retired in 2003,

becoming a partner in 1976. During his career Mr. Schorr served as partner in

charge of KPMG’s New York individual tax practice and as partner in charge of

its national personal financial planning practice. During 2000 and 2001 he served

as partner in charge of KPMG’s national financial planning corporate program.
                                         -6-

[*6] Mr. Schorr taught an undergraduate estate and gift tax course for 10 years and

lectured on income tax, trust, and estate planning issues at various conferences and

institutes. He wrote tax articles and served on the editorial board of Taxation for

Accountants and as a director of the New York State Society of Certified Public

Accountants. Throughout this career Mr. Schorr emphasized the importance of

client relationships. In his experience, many senior executives lacked time to

handle their own financial and estate planning and tax matters. Mr. Schorr had

extensive experience in the development and administration of executive financial

planning programs such as the WR executive program. Mr. Tucker considered

Mr. Schorr trustworthy and knowledgeable and viewed him as the preeminent

person at KPMG for coordinating tax return compliance, tax planning, estate

planning, and financial planning for executives.

      From 1999 through 2001 KPMG provided Waddell & Reed’s senior

executives, including Mr. Tucker, with individual tax and financial planning

services pursuant to the WR executive program. As part of the WR executive

program, KPMG asked Waddell & Reed’s senior executives to complete a

comprehensive information-gathering document relating to the executives’

financial and tax situations and financial and nonfinancial goals. KPMG used the

information to develop specific recommendations for the executives.
                                        -7-

[*7] B.     Waddell & Reed Stock Options

      During his employment with Waddell & Reed, Mr. Tucker participated in

an executive deferred compensation stock option plan (WR stock options plan).

By 2000 Waddell & Reed’s stock had significantly appreciated in the short time

since it had gone public in 1998. KPMG anticipated that Waddell & Reed’s

executives, including Mr. Tucker, would exercise their WR stock options during

2000 to take advantage of the increased stock value and would experience

significant increases in their 2000 incomes as a result of exercising the WR stock

options. KPMG advised Mr. Tucker on timing and restrictions upon the exercise

of the WR stock options. On August 1, 2000, Mr. Tucker exercised 1,776,654

WR stock options. On that same date he exercised 119,513 WR stock options via

the Keith A. Tucker Children’s Trust Agreement, dated February 21, 2000. On

their 2000 joint income tax return, petitioners reported $44,187,744 in wages and

salaries, which included $41,034,873 in gain from the exercise of WR stock

options. Waddell & Reed withheld Federal income tax of approximately $11.4

million from Mr. Tucker’s compensation relating to the exercise of the options.

II.   Evolution of a Tax Strategy

      In May 2000 before exercising the WR stock options, Mr. Tucker met with

KPMG advisers to discuss his financial and tax planning for 2000 including his
                                        -8-

[*8] exercise of the WR stock options. They discussed the need to withhold

income tax upon the exercise of the WR stock options. Mr. Schorr also explained

the need for Mr. Tucker to diversify his investments. Mr. Tucker viewed his WR

investments as conservative and wanted to diversify into riskier investments. Mr.

Schorr advised Mr. Tucker that KPMG offered various investment programs that

could mitigate his income tax resulting from exercising the WR stock options.

Mr. Tucker viewed his conversations with KPMG as part of the WR executive

program. KPMG had trained and directed its partners to refer clients with income

over a certain threshold to KPMG’s Innovative Strategies Group. Mr. Schorr

identified Mr. Tucker as a potential client for the Innovative Strategies Group in

the spring of 2000 on the basis of Mr. Tucker’s 2000 income from his exercise of

the WR stock options. Mr. Schorr conferred with Timothy Speiss, the northeast

partner in charge of KPMG’s Innovative Strategies Group, and with other KPMG

partners with respect to Mr. Tucker. Mr. Schorr asked Mr. Speiss to meet with

Mr. Tucker to discuss tax strategies to mitigate his 2000 income tax. Mr. Speiss

has a bachelor’s degree in business with a major in accountancy and a master of

science degree in taxation. He began working at KPMG in 1983 and became a

partner in 1999. At trial in this case Mr. Speiss asserted his Fifth Amendment

privilege against self-incrimination when questioned by respondent’s counsel. Mr.
                                        -9-

[*9] Tucker relied on Mr. Schorr’s recommendation of Mr. Speiss because Mr.

Tucker trusted Mr. Schorr. Mr. Tucker viewed his meeting with Mr. Speiss as part

of the WR executive program. Mr. Tucker had not previously met Mr. Speiss and

was not familiar with KPMG’s Innovative Strategies Group, which Mr. Speiss

described as offering specialized investment and tax planning advice.

      By letter dated June 22, 2000, Mr. Wertheim provided Mr. Tucker with an

estimate of Mr. Tucker’s income from the planned August 2000 exercise of the

WR stock options in anticipation of their upcoming meeting. On June 26, 2000,

the KPMG advisers, Messrs. Speiss, Wertheim, and Schorr, met with Mr. Tucker,

and Mr. Speiss explained that part of his work was to identify investment

opportunities that also had tax benefits and to implement the tax benefits for

KPMG’s clients. KPMG proposed a tax strategy referred to as “short options” and

explained that the strategy would mitigate petitioners’ 2000 income tax from the

WR stock options (short options strategy). Mr. Schorr explained that the Internal

Revenue Service (IRS) could impose accuracy-related tax penalties and that

taxpayers could protect themselves from penalties by relying on counsel. Mr.

Tucker had previously been unfamiliar with IRS penalties.

      On the same day Mr. Tucker also met with a representative of Quadra

Associates who was a former KPMG colleague of Messrs. Tucker and Schorr to
                                         -10-

[*10] discuss a tax strategy for petitioners’ 2000 income tax referred to as the

Quadra Forts transaction. Mr. Schorr arranged this meeting. After these meetings

Mr. Tucker decided to further pursue and investigate KPMG’s short options

strategy. Mr. Tucker declined to engage in the Quadra Forts transaction in part

because it would require disposition of his WR stock, something he wanted to

avoid as Waddell & Reed’s CEO. KPMG sent a letter to Mr. Tucker, dated July

25, 2000, that described both tax strategies, which Mr. Tucker received during the

first week of August. On August 2, 2000, Mr. Tucker spoke with representatives

of KPMG and Helios Financial LLC (Helios) to discuss the mechanics of the short

option strategy. After these discussions Mr. Tucker viewed the short options

strategy as in a concept stage and he did not yet understand the transaction.

KPMG provided an engagement letter to Mr. Tucker, dated August 10, 2000, and

signed by Mr. Speiss, for services relating to the short option strategy for a fee of

$600,000.

      On August 11, 2000, the IRS issued Notice 2000-44, 2000-2 C.B. 255,

which described the son of BOSS tax shelter and identified as a “listed”

transaction the simultaneous purchase and sale of offsetting options and the

subsequent transfer of the options to a partnership. As a result of the issuance of

Notice 2000-44, supra, KPMG informed Mr. Tucker that the IRS had identified
                                        -11-

[*11] the short options strategy as a listed transaction and KPMG could no longer

recommend that strategy. Mr. Tucker no longer wanted to engage in the short

options strategy because of the potential negative impact on his personal and

professional reputation, his career, and Waddell & Reed’s reputation had he

engaged in an abusive tax scheme. Mr. Tucker discussed these concerns with

KPMG and indicated that he would not want to participate in an abusive tax

scheme. As a result of KPMG’s disclosure of Notice 2000-44, supra, and its

recommendation against the short options strategy, Mr. Tucker believed he could

trust KPMG not to advise him to invest in an abusive tax strategy. He believed

KPMG was fulfilling its responsibilities under the WR executive program to

prevent senior executives from entering into transactions that could create trouble

with the IRS.

      Mr. Tucker and KPMG began to discuss other tax mitigation strategies for

Mr. Tucker’s 2000 tax planning. In fall 2000 Mr. Tucker reconsidered the Quadra

Forts transaction, upon KPMG’s advice, and met with Quadra Associates. KPMG

provided tax advice to Mr. Tucker on the Quadra Forts transaction and consulted

with Quadra Associates as Mr. Tucker’s adviser. Mr. Tucker decided to

participate in the Quadra Forts transaction. The Quadra Forts transaction was

scheduled to commence on December 18, 2000. Issues arose concerning Quadra
                                       -12-

[*12] Associates’ unwillingness to share details about the transaction with KPMG,

and the lack of disclosure could have prevented KPMG from being able to sign

petitioners’ 2000 return as return preparer. On December 12, 2000, Quadra

Associates advised KPMG that financing for the Quadra Forts transaction was in

jeopardy and the transaction might not close. On December 14, 2000, Mr. Tucker

was advised that the Quadra Forts transaction could not be completed because of a

lack of financing. During this period, when Mr. Tucker first considered the short

options strategy in June 2000 through the failure of the Quadra Forts transaction in

mid-December 2000, Mr. Tucker had little direct communication with Mr. Speiss.

      After the Quadra Forts transaction fell through, Mr. Speiss discussed with

and sought approval from several members in KPMG’s tax leadership positions to

develop and propose a customized tax solution to mitigate Mr. Tucker’s 2000

income tax by the end of the year. Mr. Speiss informed Mr. Schorr that he

intended to propose a potential customized tax strategy to Mr. Tucker that

involved foreign currency options. Mr. Schorr followed up with at least one

member of KPMG’s tax leadership to confirm that the tax leadership approved a

customized tax solution for Mr. Tucker because of the sensitive nature of yearend

tax strategies and because Mr. Schorr understood that KPMG would not pursue
                                         -13-

[*13] certain types of tax strategies for its clients after issuance of Notice 2000-44,

supra.

         On December 15, 2000, Mr. Speiss spoke with Mr. Tucker and

recommended a transaction involving foreign currency options (FX transaction).

KPMG customized and recommended the FX transaction to three Waddell & Reed

senior executives, including Mr. Tucker. One of the other executives also

executed the transaction. Mr. Speiss identified four entities, Helios, Diversified

Group, Inc. (DGI), Alpha Consultants, LLC (Alpha), and Lehman Brothers

Commercial Corp. (Lehman Brothers), a global financial services firm, that would

collectively execute and manage the FX transaction. Mr. Tucker understood that

Helios, DGI, and Alpha (promoter group) were investment advisers that would

assist in implementing the FX transaction and that DGI had designed the FX

transaction. Individuals associated with the promoter group explained the

potential profit and loss associated with the FX transaction and informed Mr.

Tucker that both the potential profit and loss would be capped. The promoter

group told Mr. Tucker that he had a potential return of $800,000 on the FX

transaction, after transaction costs and fees, and the probability that he would earn

a profit was 40%. Mr. Tucker viewed an $800,000 profit over a short period as a

good investment. In fact Mr. Tucker had a net economic loss on the FX
                                       -14-

[*14] transaction of approximately $695,000. Mr. Tucker knew about the tax

benefits of the FX transaction; he also knew the IRS might disallow the loss

deduction from the transaction.

      On December 16, 2000, Mr. Speiss sent a letter to Mr. Tucker concerning

the FX transaction and transmitting a profit and loss summary for the FX

transaction and a summary of “review points” being considered by KPMG. The

letter included an attachment titled “CFC timeline”. The CFC timeline contained

the following table:

       Fri., Dec. 15      Purchase stock of CFC; enter into shareholder’s
                          agreement; fund CFC; acquire options.
       Wed., Dec. 27      Latest date for sale of gain legs and purchase of
                          replacement options
       Thurs., Dec. 28    Latest effective date of check-the-box election
       Fri., Dec. 29      Remaining positions expire or are sold
       Mar. 13, 2001      Latest date for making retroactive check-the-box
                          election
       Tax return due     Sec. 367(b) gain election
        date
       Sept. 15, 2001     Sec. 338 election

      On December 18, 2000, Mr. Tucker spoke with Messrs. Schorr and Speiss

by telephone about the FX transaction. Mr. Tucker decided to implement the FX

transaction and signed an engagement letter, dated December 27, 2000, for KPMG
                                         -15-

[*15] to provide tax consulting services relating to the FX transaction. Mr. Tucker

worked with Mr. Speiss to implement the transaction during the last two weeks of

December 2000, including after Mr. Tucker left for a two-week vacation on

December 19, 2000. Mr. Schorr did not participate in meetings and discussions

between Messrs. Tucker and Speiss relating to the FX transaction. Mr. Tucker

understood that Mr. Schorr was not involved in implementing the FX transaction.

III.     Relevant Entities

         Mr. Tucker implemented the FX transaction through three entities: Sligo

(2000) Company, Inc. (Sligo), Sligo (2000), LLC (Sligo LLC), and Epsolon, Ltd.

(Epsolon). In December 2000 Mr. Tucker incorporated Sligo under Delaware law,

with Mr. Tucker owning all outstanding stock. Sligo elected S corporation status

for Federal income tax purposes, effective December 18, 2000. In December 2000

Mr. Tucker also organized Sligo LLC under Delaware law pursuant to a limited

liability company agreement dated December 19, 2000. From its inception until

December 26, 2000, Mr. Tucker was the sole member of Sligo LLC. On

December 26, 2000, Mr. Tucker transferred his ownership interest in Sligo LLC to

Sligo.

         Epsolon was a foreign corporation organized under the laws of the Republic

of Ireland on November 6, 2000. When Epsolon was initially organized,
                                       -16-

[*16] Cumberdale Investment, Ltd. (Cumberdale), also a foreign corporation

existing under the laws of the Republic of Ireland, owned all 100 shares of

Epsolon’s issued and outstanding stock. On December 18, 2000, Sligo purchased

99 Epsolon shares from Cumberdale for $10,000. From December 18 through 31,

2000, Sligo owned 99 shares and Cumberdale owned 1 share. Petitioners did not

directly or indirectly own any interest in Cumberdale. Epsolon elected partnership

classification for Federal income tax purposes effective December 27, 2000.

      On December 18, 2000, Cumberdale and Sligo entered into a shareholder

agreement to make capital contributions to Epsolon: Cumberdale agreed to

contribute $15,300 and Sligo agreed to contribute $1,514,700 for a total

contribution of $1,530,000. Mr. Tucker opened two accounts at Lehman Brothers,

one on behalf of Epsolon (Epsolon account) and the other on behalf of Sligo LLC

(Sligo LLC account).3 On December 20, 2000, Mr. Tucker transferred $1,530,000

into the Epsolon account. Mr. Tucker made two transfers into the Sligo LLC

account of $510,000 and $500,000 on December 20 and 28, 2000, respectively.

      3
        Mr. Tucker signed new account forms with Lehman Brothers that
referenced Notice 2000-44, 2002-2 C.B. 255. The reference to the notice did not
raise concerns with Mr. Tucker about the validity of the FX transaction as he
considered it to be boilerplate.
                                         -17-

[*17] IV.    FX Transaction

      The FX transaction consisted of two components. The first component

(Epsolon loss component) was structured in accordance with the CFC timeline

outlined above. The second component (Sligo LLC basis component) was

structured to increase the basis in an S corporation, Sligo, through which the

Epsolon loss could pass through to Mr. Tucker.

      a.     Epsolon’s Loss Component

             i.      December 20, 2000, Foreign Currency Transactions

      On December 20, 2000, Epsolon purchased the following four foreign

currency options (euro options) from Lehman Brothers tied to the U.S. dollar and

the European euro (USD/euro) for a combined premium of $156,041,0

       Option             Strike price          Payoff amount        Premium
 Long euro call I      .9208 USD/euro           $187,637,704       $56,451,951
 Long euro call II     .9208 USD/euro             71,710,943        21,568,993
 Long euro put I       .8914 USD/euro            187,445,332        56,451,284
 Long euro put II      .8914 USD/euro             71,637,538        21,568,773

      On December 20, 2000, Epsolon wrote to Lehman Brothers the following

euro options for a combined premium of $157,500,000:
                                         -18-

[*18]

        Option            Strike price          Payoff amount         Premium
 Short euro call I      .9207 USD/euro          $189,827,513        $57,000,000
 Short euro call II     .9207 USD/euro            72,434,183         21,750,000
 Short euro put I       .8915 USD/euro           189,635,141         57,000,000
 Short euro put II      .8915 USD/euro            72,360,777         21,750,000

        The eight euro options expired on January 8, 2001. The total net premium

payable by Lehman Brothers to Epsolon relative to the above eight euro options

(December 20, 2000, euro options) was $1,458,999, which was posted as a credit

to the Epsolon account at Lehman Brothers. In addition to the net premium,

Epsolon was required to post a margin of $1,448,986. The sum of these amounts,

together with the accrued interest, was intended as collateral for the amount

Epsolon could owe on the December 20, 2000, euro options if the USD/euro

exchange rate was below .8914 or above .9208 at expiration.

        On the basis of the euro options, Mr. Tucker’s advisers determined there

were three possible outcomes at expiration:4

        1.    If the USD/euro exchange rate was below .8914 USD/euro, the
              parties would exercise four of the euro options (long euro put I, long

        4
      On brief respondent alleged three possible outcomes with slightly different
amounts of potential loss or gain and used exchange rates of .8915 USD/euro and
.9207 USD/euro. The difference is immaterial for our decision.
                                         -19-

[*19]         euro put II, short euro put I, and short euro put II), and Epsolon would
              owe a net $2,913,048 to Lehman Brothers, which would result in the
              return of the $1,458,999 credit and an additional loss of $1,454,049;

        2.    if the USD/euro exchange rate was above .8914 and below .9208
              USD/euro, the parties would not exercise any of eight options, and
              Epsolon would realize a gain of $1,458,999 (the net premium credited
              to its account); or

        3.    if the USD/euro exchange rate was above .9208 USD/euro, the parties
              would exercise four of the euro options (long euro call I, long euro
              call II, short euro call I, and short euro call II), and Epsolon would
              owe $2,913,049 to Lehman Brothers, which would result in the return
              of the $1,458,999 credit and an additional loss of $1,454,050.

              2.     December 21, 2000, Foreign Currency Transactions

        On December 21, 2000, the euro appreciated against the U.S. dollar. On

December 21, 2000, Epsolon disposed of the following four December 20, 2000,

euro options for a net gain of $51,260,455:

        Option              Sold for            Closed out for          Gain
 Long euro call I         $75,714,627                ---            $19,262,676
 Long euro call II         28,131,028                ---               6,562,035
 Short euro put I              ---              $38,155,202           18,844,798
 Short euro put II             ---                15,159,054           6,590,946

        On the same day, Epsolon purchased from Lehman Brothers the following

two foreign currency options tied to the Deutschmark (DEM) and the U.S. dollar

(Deutschmark options) for a combined premium of $103,918,493:
                                         -20-

[*20]

        Option            Strike price          Payoff amount      Premium
 Long DEM call I      2.1241 DEM/USD            $187,751,702     $75,760,627
 Long DEM call II 2.1241 DEM/USD                  71,779,358      28,157,866

        Epsolon sold to Lehman Brothers the following two Deutschmark options

for a combined premium of $53,316,100:

        Option            Strike price          Payoff amount      Premium
 Short DEM put I      2.1939 DEM/USD            $189,640,141      $38,156,208
 Short DEM put II     2.1939 DEM/USD              72,364,777      15,159,892

        Each of the Deutschmark options expired on January 8, 2001. On the basis

of the four Deutschmark options, Epsolon owed a net premium to Lehman

Brothers of $50,602,393. Epsolon paid the net premium in part by $50,531,399 in

proceeds from the disposition of four December 20, 2000, euro options. Epsolon’s

acquisition of the Deutschmark options required it to pay an additional $70,994

premium and to post an additional margin of $9,006.

              3.    December 28, 2000, Foreign Currency Transactions

        On December 28, 2000, Epsolon disposed of the following four foreign

currency options for a net loss of $38,483,893:
                                          -21-

[*21]

        Option               Sold for            Closed out for        Gain/loss
 Long DEM call I          $124,340,670                ---             $48,580,043
 Long euro put I              4,565,799               ---             (51,885,485)
 Short euro call I              ---              $125,715,399       (68,715,399)
 Short DEM put I                ---                  4,619,260         33,536,948

              4.      January 8, 2001, Foreign Currency Transactions

        On January 8, 2001, the four remaining euro and Deutschmark options

expired. As of January 8, 2001, Epsolon had not exercised four options, which

expired as follows:

        1.    the long DEM option call II expired, and Lehman Brothers owed
              $71,779,358 to Epsolon;

        2.    the short euro call option II expired, and Lehman Brothers owed
              $72,434,183 to Epsolon;

        3.    the long euro put option II expired out of the money; and

        4.    the short DEM put option II expired out of the money.

        B.    Sligo LLC Basis Component

        On December 21, 2000, Sligo LLC purchased from Lehman Brothers a long

put option to sell 14,392,491,546 Japanese yen (yen option) at a strike price of

108.96 yen to the U.S. dollar for a $51 million premium. Also on December 21,
                                        -22-

[*22] 2000, Sligo LLC sold a yen put option to Lehman Brothers to sell

14,277,335,279 yen at a strike price of 108.97 yen to the U.S. dollar for a premium

of $50,490,000. Both yen options expired on December 21, 2001, a one-year

period from execution to maturity. Sligo LLC owed Lehman Brothers a net

premium of $510,000 for the two yen options. If the yen/USD exchange rate was

above 108.96 at expiration, Sligo LLC would receive a net payment of

115,136,267 yen (worth between $1,081,390 and $1,068,710). If the yen/USD

exchange rate was below 108.96 at expiration, both yen options would expire

worthless, and Sligo LLC would lose the $510,000 premium paid to Lehman

Brothers.

      On December 26, 2000, Mr. Tucker transferred his 100% ownership interest

in Sligo LLC to Sligo. Epsolon took the reporting position that: (1) it was a

controlled foreign corporation (CFC) for a period of nine days before it elected

partnership classification, i.e., the taxable year ended December 26, 2000, and (2)

its partnership election resulted in a deemed liquidation of Epsolon but did not

result in any taxable income to Epsolon. See sec. 301.7701-3(g)(1)(ii), Proced. &

Admin. Regs. In calculating Mr. Tucker’s basis in his Sligo stock, petitioners

increased Mr. Tucker’s basis by the $51 million premium paid for the long yen put

option and $2,024,700 in purported cash contributions. However, Mr. Tucker did
                                        -23-

[*23] not decrease his Sligo stock basis by the premium received for the short yen

put option. Mr. Tucker claimed a basis in his Sligo stock of $53,024,700.

Petitioners’ basis calculation for the Sligo stock was based on the position that the

obligation to fulfill the short yen put option was a “contingent” obligation which

did not reduce Mr. Tucker’s basis in his Sligo stock under section 358(a) and (d).

      The Sligo LLC yen options created a basis component of the FX transaction

similar to the basis inflation identified in Notice 2000-44, supra. Mr. Tucker was

not aware that the FX transaction involved a basis component at the time he

executed the FX transaction. Mr. Tucker had received but did not read written

communications that referred to a basis component. Petitioners have conceded the

Sligo LLC basis component but continue to argue that Mr. Tucker is entitled to a

basis in his Sligo stock, as of December 31, 2000, for purported cash contributions

of $2,024,700 that he had made during the 2000 tax year.5

V.    Professional Advice on Mr. Tucker’s 2000 Tax Year

      KPMG represented to Mr. Tucker that the FX transaction was not covered

by Notice 2000-44, supra. Mr. Tucker did not read Notice 2000-44, supra,

because he did not think that he would understand it and because he trusted his

      5
       Respondent asserts that petitioners have not substantiated the capital
contribution.
                                        -24-

[*24] KPMG advisers. Mr. Tucker understood that KPMG would not provide an

opinion regarding the tax effects of the FX transaction because KPMG was Mr.

Tucker’s return preparer and because Mr. Speiss had planned the FX transaction.

KPMG orally communicated to Mr. Tucker that the claimed tax treatment of the

FX transaction was warranted. KPMG indicated that it would sign petitioners’

return reporting the FX transaction, giving Mr. Tucker comfort that the FX

transaction was a legitimate tax planning solution.

      A.    Brown & Wood Tax Opinions

      On or around December 26, 2000, Mr. Tucker engaged the law firm Brown

& Wood to provide a tax opinion with respect to the FX transaction upon KPMG’s

recommendation. KPMG had recommended three law firms to Mr. Tucker, and he

chose Brown & Wood to provide the opinions because he was familiar with the

firm. Mr. Tucker understood that he needed a legal opinion as an “insurance

policy” to ensure that the tax treatment of the FX transaction was proper and to

protect against risk of IRS penalties. Mr. Tucker did not understand that Brown &

Wood was involved with the development of the FX transaction. Mr. Tucker had

a conference call with Mr. Speiss and counsel from Brown & Wood on December

15, 2000.
                                         -25-

[*25] In late January 2001 James Haber, president of DGI, advised R.J. Ruble, a

tax partner at Brown & Wood, that Mr. Tucker would require two opinions with

respect to the FX transaction: one relating to the Sligo LLC basis component

(Sligo opinion) and the second relating to a loss generated by the Epsolon loss

component (Epsolon opinion). DGI’s general counsel had prepared a draft

memorandum, dated October 25, 2000, discussing the U.S. tax consequences of a

CFC strategy similar to that used in the Epsolon loss component (CFC

memorandum). The CFC memorandum included the CFC timeline given to Mr.

Tucker before he engaged in the FX transaction. DGI provided the CFC

memorandum and also a form legal opinion relating to the Sligo LLC basis

component to Mr. Ruble when he was preparing the two Brown & Wood opinions.

The two Brown & Wood opinions concluded Mr. Tucker’s tax treatment of the FX

transaction would more likely than not withstand IRS scrutiny and referenced

multiple tax-law doctrines, including the sham transaction doctrine, economic

substance, the step transaction doctrine, section 465 at-risk rules, and the basis

adjustment rules.

      Mr. Tucker received the Sligo opinion after filing his 2000 income tax

return, having filed the return approximately three weeks before the due date in

order to obtain his expected refund of the tax withheld with respect to the WR
                                        -26-

[*26] stock options. Mr. Tucker received the Epsolon opinion before he filed his

2000 return. Mr. Tucker questioned KPMG, as his tax return preparer, about the

need to wait to file his 2000 return until he received both opinions. KPMG

advised him that a delay in filing was not necessary because KPMG confirmed the

opinions were forthcoming. Petitioners presented expert testimony that it was

within acceptable practice standards at the time of the FX transaction to provide a

tax opinion after the filing of a tax return. Both opinions were backdated to

December 31, 2000; petitioners’ expert noted no advantage to backdating an

opinion, and backdating was not part of practice standards. Mr. Tucker did not

read the Brown & Wood opinions, believing that he would not understand their

technical nature. Mr. Tucker relied on KPMG to review the Brown & Wood

opinions, consistent with his normal practice. There is no evidence in the record

concerning Brown & Wood’s fee for the two opinions or how the fee was paid.

      B.     Speiss Memorandum

      Mr. Speiss prepared a 48-page single-spaced memorandum addressed to Mr.

Tucker, dated January 8, 2001 (Speiss memorandum), that summarized the FX

transaction and analyzed the tax consequences of the FX transaction. The Speiss

memorandum states it is not a tax opinion. The memorandum described the

application of the relevant Code provisions relied on for petitioners’ reporting
                                        -27-

[*27] position and provided an analysis of various statutory provisions and

judicial doctrines that the IRS could attempt to use to challenge or recharacterize

the FX transaction, including economic substance, sham transaction, sham

partnership, and step transaction doctrines, at-risk rules, and partnership antiabuse

rules. The Speiss memorandum concluded that Notice 2000-44, supra, should not

apply and the FX transaction should not trigger the substantial understatement

penalty. Mr. Tucker understood that the purpose of the Speiss memorandum was

to support KPMG’s signature as tax return preparer on petitioners’ 2000 return

claiming the loss from the FX transaction. KPMG prepared and signed

petitioners’ 2000 return in accordance with the Speiss memorandum. In January

2001 Mr. Tucker received a copy of the Speiss memorandum but did not read it.

      C.     Schorr Memorandum

      Mr. Schorr prepared an internal four-page memorandum to file (Schorr

memorandum) dated January 18, 2001, that described advice and

recommendations that KPMG provided to Mr. Tucker during 2000. Mr. Schorr

did not expect that Mr. Tucker would read the Brown & Wood opinions. Mr.

Tucker received the Schorr memorandum before filing his 2000 return. He read

the Schorr memorandum because it was a short document and because he had not

requested it and was not aware that Mr. Schorr had drafted a memorandum. He
                                        -28-

[*28] described the Schorr memorandum as written in layman’s terms for a client

to understand. The Schorr memorandum indicated that Mr. Schorr drafted it in

response to the IRS’ increased scrutiny of tax solutions as announced in Notice

2000-44, supra. The Schorr memorandum memorialized KPMG internal

discussions about the implementation of a tax solution for Mr. Tucker, including

the short options strategy, the Quadra Forts transaction, and the FX transaction.

The memorandum stated that Mr. Speiss had conferred with DGI and Brown &

Wood to develop a customized tax solution for Mr. Tucker and that Mr. Speiss had

developed the tax and investment structure with Helios and Brown & Wood.

Despite the statements in the Schorr memorandum, Mr. Tucker did not understand

that Brown & Wood had a conflict of interest that precluded its providing an

independent legal opinion.

      The Schorr memorandum summarized discussions with Mr. Tucker about

his unwillingness to enter into a transaction that could result in IRS penalties. The

memorandum indicated possible IRS penalties of $4 million as a result of the FX

transaction and advice given to Mr. Tucker to make a $5 million long-term

investment to hedge against penalties. Mr. Tucker invested $3 million in junk-

bond, high-yield securities and $1 million in fixed-income instruments and

hedging transactions. The Schorr memorandum also summarized KPMG internal
                                          -29-

[*29] discussions on fees charged to Mr. Tucker. KPMG charged Mr. Tucker a

$500,000 fee for services relating to the FX transaction, and the Schorr

memorandum referred to an initial fee of $250,000. The Schorr memorandum

stated that Mr. Speiss insisted on a larger fee because he had developed and

implemented the FX transaction from beginning to end. The memorandum also

stated that a fee based on hours of service would be between $250,000 and

$300,000. Mr. Tucker also paid a $1,020,000 fee to Helios relating to the FX

transaction. The relationship between Helios and DGI is unclear from the record.

      Mr. Schorr knew that the IRS might disallow the claimed tax treatment of

the FX transaction but believed that Mr. Tucker would not be subject to IRS

penalties. This comports with Mr. Tucker’s understanding of the advice he

received from KPMG. Although Mr. Schorr wrote in his memorandum that Mr.

Speiss developed the FX transaction with Helios and Brown & Wood, Mr. Schorr

did not realize that Brown & Wood would have a conflict of interest when

providing a tax opinion. Mr. Schorr did not receive copies of the Brown & Wood

opinions and did not read the opinions.

VI.   Tax Reporting

      For 2000, Epsolon, a foreign entity, reported a $38,483,893 net loss from

the December 28, 2000, disposition of the four foreign currency options plus an
                                         -30-

[*30] additional loss from transaction costs of $1,100,618 for a total loss of

$39,584,511 (option loss). Epsolon allocated $39,188,666 of the option loss to

Sligo on the basis of Sligo’s 99% ownership. Sligo reported this option loss on its

S corporation return for the period December 18 to 31, 2000. On their 2000 joint

return, petitioners reported a loss of $39,203,302, consisting, in large part, of the

$39,188,666 passthrough loss from Sligo. Petitioners also reported a $13,742,247

loss from Sligo on their 2001 joint return for a total loss of over $52.9 million for

the two years 2000 and 2001.6

VII. Subsequent Adviser Communications and Proceedings

      In March 2002 Brown & Wood, then part of Sidley, Austin, Brown & Wood

LLP (Sidley Austin), sent Mr. Tucker a letter informing him of the IRS’ newly

announced voluntary disclosure program, for taxpayers who had participated in

      6
        Epsolon was not subject to TEFRA procedures because it was a foreign
partnership pursuant to sec. 6031(e) for the year in issue. For 2001 Epsolon
reported a net loss of $13,890,954 relating to the January 8, 2001, expiration of the
four remaining foreign currency options. Sligo, as 99% partner, reported a
$13,758,878 loss from Epsolon on its 2001 S corporation return, and petitioners
reported a $13,742,247 loss from Sligo on their 2001 joint return. Respondent
issued a notice of deficiency to petitioners for 2001, and petitioners filed a timely
petition. The Court dismissed the case for lack of jurisdiction on the basis that the
notice of deficiency was invalid because of a related TEFRA partnership
proceeding, which was not yet completed. The 2001 losses are at issue in a
partnership-level proceeding filed in the Court of Federal Claims. That case has
been stayed pending the disposition of this case.
                                        -31-

[*31] tax shelters, that allowed taxpayers to avoid accuracy-related penalties. IRS

Announcement 2002-2, 2002-1 C.B. 304. Brown & Wood recommended that Mr.

Tucker consult his regular tax adviser about the voluntary disclosure program.

Mr. Tucker discussed IRS Announcement 2002-2, supra, with Messrs. Schorr and

Speiss, who advised Mr. Tucker not to make a voluntary disclosure about the FX

transaction or to seek amnesty from IRS penalties because the FX transaction was

not a tax shelter and was not subject to the voluntary disclosure program. By letter

dated April 24, 2002, Mr. Speiss sent Mr. Tucker a copy of the Speiss

memorandum.

      As part of a promoter examination of KPMG, the IRS issued summonses to

KPMG for the names of clients to whom KPMG had sold transactions covered by

Notice 2000-44, supra. In August 2003 KPMG advised Mr. Tucker for the first

time that the FX transaction was a tax shelter subject to Notice 2000-44, supra. In

September 2003 Mr. Tucker filed a John Doe lawsuit against KPMG in U.S.

District Court to enjoin the disclosure of his identity to the IRS. The Government

subsequently intervened, and the District Court dismissed the John Doe suit three

days before the period of limitations for petitioners’ 2000 tax year expired.

KPMG disclosed Mr. Tucker’s identity to the IRS in response to the summons.
                                        -32-

[*32] On April 15, 2004, respondent issued a notice of deficiency to petitioners

for 2000, disallowing a $39,188,666 loss deduction and determining a deficiency

of $15,518,704 and a section 6662 accuracy-related penalty of $6,206,488. Mr.

Tucker disclosed receipt of the deficiency notice to Waddell & Reed’s board of

directors and other senior executives. In May 2005 Mr. Tucker resigned from

Waddell & Reed as his tax issues began to draw more attention in the media. The

board of directors had advised Mr. Tucker that if he did not resign, he would be

fired.

         In August 2005 KPMG entered into a deferred prosecution agreement with

the Government in which it admitted that it had participated in tax shelter

transactions as part of a criminal conspiracy in an attempt to defraud the United

States. KPMG agreed to pay the Government $456 million in restitution,

penalties, and disgorgement of fees. In May 2007 Sidley Austin entered into a

settlement with the IRS in which it agreed to pay a tax shelter promoter penalty of

$39.4 million.

         In April 2009 Mr. Tucker filed an arbitration complaint against KPMG and

Sidley Austin before the American Arbitration Association for damages resulting

from alleged fraudulent conduct relating to KPMG’s advice in connection with the

FX transaction. Mr. Tucker alleged that KPMG had made false representations
                                        -33-

[*33] concerning the validity of the FX transaction and the risk of IRS penalties.

Mr. Tucker pursued the arbitration complaint to recover for damage to his

reputation and career as a result of his involvement in the FX transaction and the

resulting IRS case against him and to recover damages in connection with

potential IRS penalties for 2000 and 2001. Mr. Tucker learned during the

arbitration that his 2000 tax reporting position with respect to the FX transaction

involved a basis-inflation component. In November 2010 KPMG entered into a

settlement agreement with Mr. Tucker for an amount that would have substantially

compensated for Mr. Tucker’s lost salary, bonuses, and equity participation due to

his forced resignation from Waddell & Reed as alleged in the complaint. Sidley

Austin also settled Mr. Tucker’s claim for $1,050,000.

VIII. Expert Witnesses

      Respondent submitted two expert reports prepared by David F. DeRosa and

Thomas Murphy.7 Dr. DeRosa’s report focuses on analyzing whether each spread

position was a single economic position and concludes that each spread position

represented a single economic position. Dr. DeRosa explained that the options

      7
         Voir dire of Mr. Murphy at trial revealed that he had not updated his
curriculum vitae with respect to certain aspects of his employment history and
trials in which he had testified in the prior four years in violation of Rule
143(g)(1)(E). As a result, we did not permit Mr. Murphy to testify and did not
admit his report into evidence.
                                       -34-

[*34] were entered into as spreads and not as individual components and should

not be separated. Dr. DeRosa testified that if Epsolon and Sligo LLC had entered

into each option separately, Lehman Brothers would have required them to post

massive margin amounts to cover potential liabilities. The lack of such amounts

indicates that the parties to the options viewed each spread as a single economic

position according to Dr. DeRosa. Dr. DeRosa opined that the options were

economically inseparable. Dr. DeRosa also calculated that the expected rate of

return on the option transactions was negative, exclusive of fees. Dr. DeRosa also

concluded that both the Epsolon and Sligo LLC options were mispriced to Mr.

Tucker’s disadvantage.

      Petitioners submitted an expert report by H. Gifford Fong. Mr. Fong’s

report evaluates whether the Epsolon foreign currency option transactions were

valued consistent with market prices and whether Mr. Tucker had a reasonable

profit potential with respect to the Epsolon options. Mr. Fong concludes that the

option transactions were valued properly and that there was a reasonable prospect

for profit, net of fees and expenses. Mr. Fong determined that Mr. Tucker had a

40% chance of profit on both the Epsolon options and the Sligo LLC options. Dr.

DeRosa agreed with Mr. Fong’s probability calculation but also explained that Mr.
                                         -35-

[*35] Tucker would have needed to profit on both sets of options to earn a profit

net of fees and that the likelihood of profiting on both sets would be lower.

                                      OPINION

      Petitioners argue that they are entitled to deduct the loss on the Epsolon

options to the extent of Mr. Tucker’s basis in Sligo. Having conceded Sligo’s

basis arising from the Sligo LLC options, petitioners assert that Mr. Tucker had a

$2,024,700 basis in Sligo in 2000 on the basis of alleged cash contributions.

Petitioners assert that they are entitled to deduct $2,024,700 of Sligo’s loss in

2000 and to carry forward the remainder of the 2000 loss to future years to the

extent of Mr. Tucker’s basis in Sligo and its successor corporation, Starview

Enterprises, Inc. Petitioners argue that specific and detailed provisions of the

Code and the regulations dictate the tax treatment of the Epsolon options, which

we should respect. In support of their position, petitioners assert that the Epsolon

loss component yielded the loss claimed pursuant to the following analysis:

      (1) Epsolon realized an aggregate gain of $51,260,455 in 2000 when it

disposed of four euro options on December 21, 2000.

      (2) Epsolon did not recognize the $51,260,455 gain for U.S. tax purposes

because (i) Epsolon was a foreign corporation not subject to tax under section 881
                                         -36-

[*36] or 8828 at the time of the gain and (ii) Sligo was not required to include its

share of Epsolon’s gain under section 951 because Epsolon was a CFC for less

than 30 days when it elected partnership status.

      (3) Epsolon and Sligo were not required to recognize gain or loss when

Epsolon elected partnership status because Epsolon made an election that allowed

it to recognize gain equal to Sligo’s basis in its Epsolon stock and Sligo had a zero

basis in its Epsolon stock. See sec. 1.367(b)-3T(b)(4)(i)(A), Temporary Income

Tax Regs., 65 Fed. Reg. 3588 (Jan. 24, 2000).

      (4) After Epsolon became a U.S. partnership, it disposed of an additional

four foreign currency options for a net loss of $38,483,893 and transaction costs of

$1,100,618 in 2000 for a total loss of $39,584,511.

      (5) Sligo was required to take into account its distributive share of

Epsolon’s net loss, which passed through to Mr. Tucker, as Sligo’s S corporation

shareholder, and the loss was deductible under section 165(a) and characterized as

ordinary under section 988.

      8
       Sec. 881 imposes a tax of 30% on foreign corporations on amounts of
“fixed or determinable annual or periodical gains” income from sources within the
United States. Sec. 882(a)(1) taxes foreign corporations on income “effectively
connected with the conduct of a trade or business within the United States.”
                                         -37-

[*37] Respondent asserts several arguments against petitioners’ entitlement to the

ordinary loss deduction. Specifically, respondent argues that we should disallow

petitioners’ claimed loss deduction because (i) the Epsolon options lacked

economic substance, (ii) the Epsolon loss was not bona fide and the Epsolon

options were not entered into for profit, (iii) the step transaction doctrine prevents

separating the gain from the loss on the Epsolon options, (iv) the loss should be

allocated to Epsolon before the partnership election while it was a CFC because

the gain and loss legs of the options are a single economic position under section

988, (v) the principal purpose of Mr. Tucker’s acquisition of Epsolon and Sligo

stock was to evade or avoid Federal income taxes, and (vi) Mr. Tucker was not at

risk for the claimed loss under section 465.

      We agree with respondent that the Epsolon options lacked economic

substance. A taxpayer may not deduct losses resulting from a transaction that

lacks economic substance even if that transaction complies with the literal terms of

the Code. See Southgate Master Fund, LLC ex rel. Montgomery Capital Advisors

LLC v. United States, 659 F.3d 466, 479 (5th Cir. 2011); Coltec Indus., Inc. v.

United States, 454 F.3d 1340, 1352-1355 (Fed. Cir. 2006). Accordingly, we do

not address respondent’s remaining arguments.
                                        -38-

[*38] I.     Background: Code and Regulations Applicable to the FX
             Transaction

      Petitioners argue that the Code imposes clear, mechanical provisions to

determine the taxation of foreign corporations. Petitioners contend that we must

give effect to the applicable Code and regulatory provisions as written because

Congress “knowingly and explicitly” enacted laws to permit the tax treatment that

petitioners claimed. The tax strategy at issue involved two separate components

that both used offsetting foreign currency options to create a tax benefit: (1) the

Epsolon loss component used offsetting foreign currency options to generate

losses and (2) the Sligo LLC basis component used offsetting foreign currency

options to create a basis in an S corporation through which the Epsolon losses

could flow to petitioners’ joint tax return. These two components were structured

and executed to work in tandem in order to generate an artificial loss to offset

petitioners’ nearly $50 million in taxable gains in 2000 and 2001. As petitioners

argue that the mechanical provisions of the Code and the regulations dictate the

tax treatment of the loss on the Epsolon options, we review the tax treatment

below.
                                         -39-

[*39] A.     Epsolon Loss Component

      Mr. Tucker generated the claimed tax loss through Epsolon. At the time

Mr. Tucker acquired ownership of Epsolon, it was a foreign corporation for U.S.

tax purposes. Mr. Tucker owned 99% of Epsolon through his wholly owned S

corporation, Sligo. Epsolon executed the loss component in four steps: (1)

Epsolon acquired various offsetting foreign currency digital option spread

positions (spread positions); (2) it disposed of the gain legs of the spread positions

while Epsolon was a CFC; (3) it made a “check-the-box” election to become a

partnership for U.S. tax purposes; and (4) it disposed of the loss legs of the spread

positions. Petitioners argue that Epsolon’s gain on the options realized while a

CFC is foreign source and not recognized for U.S. tax purposes and that Epsolon’s

losses after it became a partnership are U.S. source and pass through to Sligo as

U.S. source loss. As an S corporation, Sligo would pass its losses through to Mr.

Tucker, its sole shareholder. Accordingly, Mr. Tucker claimed the Epsolon losses

on his joint return.

             1.        Taxation of Gain From Epsolon Options to a CFC

      Petitioners argue that Congress chose not to tax foreign source income of a

CFC in existence for less than 30 days with no business activities other than

buying and selling foreign currency options. Epsolon was a CFC for nine days.
                                        -40-

[*40] Section 882(a)(1) taxes foreign corporations engaged in a trade or business

within the United States. A trade or business within the United States generally

does not include trading in stocks, securities, or commodities through an agent.

Sec. 864(b)(2)(A) and (B). As Epsolon’s activities were limited to foreign

currency option trades through an agent, it did not have a trade or business within

the United States during 2000. Accordingly, Epsolon’s gain was not taxable under

section 882(a)(1). Furthermore, Epsolon’s gain on the options was not fixed or

determinable annual or periodical income taxable to foreign corporations under

section 881(a)(1). Sec. 1.1441-2(b)(2)(i), Income Tax Regs. (stating that gain

from the sale of property generally is not fixed or determinable annual or

periodical income).

      According to petitioners’ mechanical application of the Code and the

regulations, petitioners could be taxed on Epsolon’s gain only under section 951.

However, Epsolon avoided the application of the section 951 income inclusion

rules. Section 951 requires a U.S. shareholder of a CFC to include in gross

income its pro rata share of the CFC’s subpart F income. Subpart F income would

include gain on the Epsolon options. Secs. 951(a)(1), 952(a)(2), 954(c)(1)(C).

The section 951 income inclusion rule applies only if the corporation is a CFC for

an uninterrupted period of 30 days. Sec. 951(a)(1). Epsolon existed as a CFC for
                                         -41-

[*41] less than 30 days because it made an election to be treated as a partnership

for Federal income tax purposes. Accordingly, under the mechanical application

of the rules, Sligo was not required to include Epsolon’s gain on the options in its

income. Petitioners contend that the Epsolon gain nevertheless had U.S. tax

consequences on the basis that Sligo was required to account for the gain in its

earnings and profits.

             2.     Loss on Epsolon Options After Partnership Election

      Effective December 27, 2000, Epsolon elected partnership status, becoming

a partnership for Federal income tax purposes. The partnership election resulted

in two events: (i) the electing entity is deemed to distribute its assets and

liabilities to its shareholders in a complete liquidation and (ii) the shareholders are

then deemed to contribute the same assets and liabilities to a newly formed

partnership for Federal income tax purposes. Sec. 301.7701-3(g)(1)(ii), Proced. &

Admin. Regs. As a result of Epsolon’s partnership election, Epsolon distributed

the remaining eight options to its shareholders, Sligo and Cumberdale, a foreign

entity, in a complete liquidation on December 26, 2000. Sligo received a

carryover basis in its share of Epsolon’s assets that Sligo was deemed to receive in

the deemed liquidation. See sec. 334(b)(1). Section 332(a) provides for

nonrecognition treatment on a liquidating distribution from a corporation to
                                        -42-

[*42] another corporation. Section 332(b) defines the scope of the nonrecognition

treatment. Section 332(b) provides that a distribution is considered to be in

complete liquidation if (1) the corporate shareholder owns at least 80% of the total

combined voting power and 80% of the total number of shares of all other classes

of stock and (2) the distribution is in complete cancellation or redemption of all

the stock, and the transfer of all the assets occurs within the taxable year. By

interposing Sligo as the 99% owner of Epsolon, rather than directly owning

Epsolon himself, Mr. Tucker structured the transaction to take advantage of the

section 332 nonrecognition rule for corporate shareholders and avoided

recognizing gain from the deemed liquidation upon Epsolon’s partnership

election.

      Section 367(b) provides for an exception to the section 332 nonrecognition

treatment that would have required Sligo as a U.S. corporate shareholder to

recognize gain on the remaining eight options that were deemed distributed from

Epsolon upon the partnership election. Under section 367(b) and related

regulations, a domestic parent is generally required to include in income the

foreign subsidiary’s earnings and profits. However, petitioners were able to avoid

this exception and avoid gain or loss recognition because of temporary regulations

in effect at that time. The temporary regulations allowed Sligo to elect to recog-
                                         -43-

[*43] nize gain upon the deemed liquidation equal to either: (1) its built-in gain in

its Epsolon stock or (2) Epsolon’s earnings and profits attributable to Sligo. See

sec. 1.367(b)-3T(b)(4)(i)(A), Temporary Income Tax Regs., supra. The election in

the temporary regulations was available only for transactions that occurred

between February 23, 2000, and February 23, 2001. See T.D. 8863, 2000-1 C.B.

488. At the time of Epsolon’s partnership election, Sligo had no built-in gain on

its Epsolon stock; Epsolon had $51,260,455 of earnings and profits. Sligo elected

to recognize the built-in gain of zero upon the deemed liquidation. According to

petitioners, the deemed liquidation of Epsolon did not result in taxable income to

Epsolon or Sligo.

      After the deemed liquidation, Sligo was deemed to contribute the eight

options back to Epsolon as a newly formed partnership. See sec. 301.7701-

3(g)(1)(ii), Proced. & Admin. Regs. According to petitioners, neither Epsolon nor

Sligo recognized gain or loss upon Sligo’s deemed contribution of the options to

Epsolon. See sec. 721(a). Epsolon calculated its basis in the newly contributed

options pursuant to section 723 and received a carryover basis in the options; and

Sligo calculated its basis in its Epsolon partnership interest pursuant to sections

722 and 755. Petitioners calculated Sligo’s adjusted basis in its Epsolon

partnership interest as Sligo’s basis in the long options, subtracting the liability on
                                        -44-

[*44] the short options assumed by Epsolon. See sec. 752(a). After the

partnership election on December 26, 2000, Epsolon closed out four of the

remaining options for a net loss of over $38 million plus over $1 million in

transaction costs on December 28, 2000, and let the other four options expire,

unexercised, on January 8, 2001. Epsolon characterized the net loss on the

December 28, 2000, disposition of the four options as U.S. source.

      Through the above application of the mechanical rules of the Code and the

regulations, Mr. Tucker did not recognize the gain on the offsetting gain legs of

the Epsolon options but recognized the loss on the loss legs to offset his income

on his WR stock options. In this way, Epsolon separated the gain and loss legs of

the Epsolon options. Petitioners argue that both the loss and the gain were bona

fide, and the Code treats them differently.

      B.     Sligo LLC Basis Component

      As outlined above, the Epsolon loss passed through to Mr. Tucker’s S

corporation Sligo and then to Mr. Tucker. To take advantage of the loss, he

needed to have a sufficient basis in his Sligo stock. He created a stock basis

through a second set of offsetting foreign currency options (Sligo LLC basis

component). Petitioners have conceded that Mr. Tucker is not entitled to the basis
                                         -45-

[*45] in his Sligo stock created through the Sligo LLC options. We summarize

the Sligo LLC basis component below.

             1.     S Corporation Basis Adjustment Rules

      Pursuant to section 1366(a), S corporation shareholders take into account

their pro rata shares of passthrough S corporation income, losses, deductions, or

credits in calculating their tax liabilities. When an S corporation incurs losses, the

S corporation shareholders can directly deduct their shares of the S corporation

losses on their individual returns in accordance with the S corporation passthrough

rules. However, section 1366(d)(1) limits the amount of passthrough losses and

deductions that a shareholder may claim. The amount of losses cannot exceed the

shareholder’s adjusted basis in the S corporation stock plus the adjusted basis of

any debt owed to the shareholder by the corporation. Sec. 1366(d)(1). This

limitation is imposed to disallow a deduction that exceeds the shareholder’s

economic investment in the S corporation. Disallowed passthrough loss

deductions carry forward indefinitely and may be claimed to the extent that the

shareholder increases his or her stock basis in the S corporation. Sec. 1366(d)(2).

      S corporation shareholders must make various adjustments to their bases in

their S corporation stock. S corporation shareholders increase their bases in S

corporation stock by their pro rata shares of income and by capital contributions
                                         -46-

[*46] and decrease their bases by losses and deductions passed through to the

shareholders. Secs. 1012, 1367. A shareholder may increase his or her stock basis

if he or she makes an economic outlay to or for the benefit of the S corporation.

Underwood v. Commissioner, 63 T.C. 468, 477 (1975) aff’d, 535 F.2d 309 (5th

Cir. 1976); see Goatcher v. United States, 944 F.2d 747, 751 (10th Cir. 1991);

Estate of Leavitt v. Commissioner, 875 F.2d 420, 422 (4th Cir. 1989), aff’g 90

T.C. 206 (1988). An economic outlay is an actual contribution of cash or property

by the shareholder to the S corporation. Estate of Leavitt v. Commissioner, 875

F.2d at 422.

               2.   Sligo LLC Basis Computation

      To take advantage of the Epsolon losses, Mr. Tucker had to sufficiently

inflate his basis in his Sligo stock. To this end, he purported to establish the

necessary basis through offsetting yen options. Through Sligo LLC he bought and

sold put options with premiums of $51 million and $50.49 million, respectively,

and then contributed the options to Sligo by transferring his ownership in Sligo

LLC to Sligo. Mr. Tucker calculated his Sligo stock basis by increasing his basis

for the $51 million premium purportedly paid for the long yen option. However,

he did not decrease his stock basis for the offsetting $50.49 million premium

purportedly received for the short yen option on the basis that his obligation to
                                         -47-

[*47] fulfill the short yen option was a contingent liability that did not reduce his

stock basis under section 358(a) and (d). Mr. Tucker also increased his stock basis

by a purported cash contribution of $2,024,700. Thus, Mr. Tucker claimed a basis

in Sligo stock of $53,024,700. The basis computation above would have given

him a sufficient basis in his Sligo stock to claim the Epsolon passthrough losses on

his individual income tax return. Petitioners have conceded the $51 million basis

increase from the premium paid for the yen option and now seek to recognize

Epsolon losses to the extent they can establish a basis in Sligo through cash

contributions and carry over the remaining Epsolon losses to future years.

II.   Mechanical Application of the Code and Application of the Economic
      Substance Doctrine

      Petitioners argue that the Code and the regulations mandate the above

treatment of the gain and loss on the Epsolon options, and accordingly they are

entitled to deduct the loss from the Epsolon options to the extent of Mr. Tucker’s

basis in Sligo. They argue that Congress chose not to tax the gain realized on the

Epsolon options while Epsolon was a CFC for less than 30 days and chose to

allow the loss realized while Epsolon was a U.S. partnership. They urge the Court

to give effect to the statute as written and the regulatory choices made by the

Secretary. They argue that Congress purposefully taxed U.S. shareholders of
                                         -48-

[*48] CFCs only when the entities are CFCs for 30 days or more. Sec. 951(a)(1).

In addition, petitioners argue that during the limited period relevant here,

regulations allowed a parent company with a foreign subsidiary to elect to

recognize gain equal to either (1) the parent’s built-in gain in the subsidiary’s

stock or (2) the foreign subsidiary’s earnings and profits. Sec. 1.367(b)-

3T(b)(4)(i)(A), Temporary Income Tax Regs., supra. By having Epsolon in

existence as a CFC for less than 30 days, filing a partnership election, and electing

to recognize built-in gain once Epsolon became a U.S. partnership, petitioners

suggest that Mr. Tucker used the Code provisions as Congress intended to

effectively avoid recognizing a purported $51 million gain. Petitioners, however,

cite no legislative, regulatory, or other authority indicating that Congress intended

such a result. Rather, legislative history and congressional intent contradict

petitioners’ argument. The 30-day CFC rule of section 951(a) is a linchpin of the

FX transaction. Section 951 taxes U.S. shareholders of a CFC currently on their

pro rata shares of certain types of CFC earnings. The legislative history states that

the subpart F regime, which includes the 30-day rule under section 951(a), was

“designed to end tax deferral on ‘tax haven’ operations by U.S. controlled

corporations.” S. Rept. No. 87-1881 (1962), 1962-3 C.B. 707, 785; see also H.R.

Rept. No. 87-1447 (1962), 1962-3 C.B. 405, 462. It is clear that Congress neither
                                        -49-

[*49] contemplated nor intended to encourage this type of mechanical

manipulation of the rules when enacting these international tax provisions. The

courts have rejected a mechanical or formalistic compliance with the rules of

subpart F. Garlock, Inc. v. Commissioner, 58 T.C. 423 (1972), aff’d, 489 F.2d 197

(2d Cir. 1973); see Estate of Weiskopf v. Commissioner, 64 T.C. 78 (1975); Kraus

v. Commissioner, 59 T.C. 681 (1973), aff’d, 490 F.2d 898 (2d Cir. 1974); Barnes

Grp. Inc. v. Commissioner, T.C. Memo. 2013-109 (considering substance over

form doctrine with respect to the subpart F regime). The “mere technical

compliance with the statute [subpart F] is not sufficient.” Kraus v. Commissioner,

59 T.C. at 692. On multiple occasions, the courts have considered both the terms

and intent of the subpart F provisions and held U.S. shareholders were subject to

income inclusion and tax under subpart F consistent with the substance of the

transactions rather than their form.9

      Petitioners’ argument that Congress and the Secretary approved of Mr.

Tucker’s use of the check-the-box partnership election to allow a loss deduction

      9
       Sec. 988 does not preclude our application of the economic substance
doctrine. See Stobie Creek Invs. LLC v. United States, 608 F.3d 1366 (Fed. Cir.
2010). Sec. 988 provides that foreign currency gain or loss shall be computed
separately and treated as ordinary income or loss. Respondent relies on sec. 988
as an alternative argument for treating the Epsolon options as a single economic
position. We do not address this argument as we find the FX transaction lacked
economic substance.
                                        -50-

[*50] also contradicts legislative history. At the time of the promulgation of the

partnership check-the-box regulations, there was a concern that taxpayers might

use the partnership check-the-box election, as here, in an attempt to achieve results

that are inconsistent with legislative intent. The explanation of the provisions in

the preamble to T.D. 8697, 1997-1 C.B. 215, 216, which promulgated the check-

the-box regulations, states:

      As stated in the preamble to the proposed regulations, in light of the
      increased flexibility under an elective regime for the creation of
      organizations classified as partnerships, Treasury and the IRS will
      continue to monitor carefully the uses of partnerships in the
      international context and will take appropriate action when
      partnerships are used to achieve results that are inconsistent with the
      policies and rules of particular Code provisions or of U.S. tax treaties.

      Mr. Tucker used the partnership election to ignore economic reality and to

separate Epsolon’s gains from its losses--a critical step in his prearranged

transaction. This manipulation of the elective regime for creating a partnership is

patently inconsistent with legislative intent and is a prime example of the kind of

behavior that concerned the regulators when the flexible check-the-box rules were

promulgated. The offsetting Epsolon option spreads, the splitting of the gain and

loss legs through the check-the-box partnership scheme, and the election under

section 1.367(b)-3T(b)(4)(i)(A), Temporary Income Tax Regs., supra, assured that

Mr. Tucker would have the loss he needed to offset his WR stock option income
                                         -51-

[*51] without the need to recognize the offsetting gain on the options. Petitioners

lack any support for their argument that Congress intended to permit Mr. Tucker

to claim tax deductions equal to more than 75 times the amount of his actual

economic loss.

      Petitioners cite two 50-year-old cases from the Court of Appeals for the

First Circuit in support of their position that we should respect the mechanical

application of the Code and the regulations used to achieve the tax-avoidance

strategy in the FX transaction, Fabreeka Prods. Co. v. Commissioner, 294 F.2d

876 (1st Cir. 1961), vacating and remanding 34 T.C. 290 (1960), and Granite Tr.

Co. v. United States, 238 F.2d 670 (1st Cir. 1956). In both cases, the Court of

Appeals refused to apply judicial antiabuse doctrines despite the taxpayers’ clear

tax-avoidance motives. Both Fabreeka and Granite Tr. are readily distinguishable

on their facts and with respect to the intent of the relevant Code provisions.10

      10
        In Fabreeka Prods. Co. v. Commissioner, 294 F.2d 876 (1st Cir. 1961),
vacating and remanding 34 T.C. 290 (1960), a corporation purchased bonds at a
premium in part with loans, deducted the amortized bond premium as allowed by
the Code, and distributed the bonds as a dividend, which the shareholders resold
for substantially the same premium paid by the corporation. In effect the
corporation claimed a deduction for amounts distributed as dividends. In Granite
Tr. Co. v. United States, 238 F.2d 670 (1st Cir. 1956), a corporation disposed of
stock in a wholly owned corporation and then liquidated, thereby avoiding
nonrecognition of gain or loss upon a complete liquidation of a subsidiary by an
80% corporate shareholder. See sec. 112(b)(6), I.R.C. 1939. The cases’ continued
                                                                       (continued...)
                                        -52-

[*52] Neither case considers the requirements of the economic substance doctrine

as established by the Court of Appeals for the Fifth Circuit and discussed below.

In the Fifth Circuit judicial antiabuse principles are imposed to prevent taxpayers

from subverting legislative purpose by claiming tax benefits from transactions that

are fictitious or lack economic reality. The Court of Appeals has stated:

      The judicial doctrines empower the federal courts to disregard the
      claimed tax benefits of a transaction--even a transaction that formally
      complies with the black-letter provisions of the Code and its
      implementing regulations--if the taxpayer cannot establish that “what
      was done, apart from the tax motive, was the thing which the statute
      intended.”

Southgate Master Fund, 659 F.3d at 479 (fn. ref. omitted) (quoting Gregory v.

Helvering, 293 U.S. 465, 469 (1935)). Petitioners have offered nothing to indicate

that Congress intended to provide the tax benefits they seek through the formal

application of the Code and the regulations without conforming to economic

reality. Accordingly we consider the economic reality of the options at issue.

      10
         (...continued)
validity in relation to the economic substance doctrine has been questioned as both
cases apply a rigid two-part test that invalidates a transaction only if it lacks
economic substance and the taxpayer’s sole motivation was tax avoidance. See
Fid. Int’l Currency Advisor A Fund, LLC v. United States, 747 F. Supp. 2d 49 (D.
Mass. 2010), aff’d, 661 F.3d 667 (1st Cir. 2011). The Court of Appeals for the
Fifth Circuit uses a conjunctive three-part test for the economic substance
doctrine. Klamath Strategic Inv. Fund ex rel. St. Croix Ventures v. United States,
568 F.3d 537 (5th Cir. 2009).
                                        -53-

[*53] III.   Economic Substance Doctrine

      Taxpayers generally are free to structure their business transactions as they

wish even if motivated in part by a desire to reduce taxes. Gregory v. Helvering,

293 U.S. at 469. The economic substance doctrine, however, permits a court to

disregard a transaction--even one that formally complies with the Code--for

Federal income tax purposes if it has no effect other than on income tax loss. See

Knetsch v. United States, 364 U.S. 361 (1960); Southgate Master Fund, 659 F.3d

at 479. We will respect a transaction when it constitutes a genuine, multiparty

transaction, compelled by business or regulatory realities, with tax-independent

considerations that are not shaped solely by tax-avoidance features. Frank Lyon

Co. v. United States, 435 U.S. 561, 583-584 (1978). Whether a transaction has

economic substance is a factual determination. United States v. Cumberland Pub.

Serv. Co., 338 U.S. 451, 456 (1950). Generally, the taxpayer has the burden of

proving that the Commissioner’s determinations in a notice of deficiency are

incorrect. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). It is well

settled that “an income tax deduction is a matter of legislative grace,” and the

taxpayer generally bears the burden of showing his entitlement to a claimed

deduction. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992).
                                        -54-

[*54] Accordingly, the burden of proving economic substance rests on the

taxpayer. See Coltec Indus., Inc., 454 F.3d at 1355-1356 & n.15.

      The Courts of Appeals are split as to the application of the economic

substance doctrine.11 An appeal in this case would lie to the Court of Appeals for

the Fifth Circuit absent a stipulation to the contrary and, accordingly, we follow

the law of that circuit. See Golsen v. Commissioner, 54 T.C. 742 (1970), aff’d,

445 F.2d 985 (10th Cir. 1971). The Court of Appeals for the Fifth Circuit has

interpreted the economic substance test as a conjunctive “multi-factor test”.

Klamath Strategic Inv. Fund ex rel. St. Croix Ventures v. United States, 568 F.3d

537, 544 (5th Cir. 2009). In Klamath, the Court of Appeals stated that a

      11
        Some Courts of Appeals require that a valid transaction have either
economic substance or a nontax business purpose. See, e.g., Horn v.
Commissioner, 968 F.2d 1229, 1236-1238 (D.C. Cir.1992), rev’g Fox v.
Commissioner, T.C. Memo. 1988-570; Rice’s Toyota World, Inc. v.
Commissioner, 752 F.2d 89, 91 (4th Cir. 1985), aff’g in part, rev’g in part 81 T.C.
184 (1983). Other Courts of Appeals require that a valid transaction have both
economic substance and a nontax business purpose. See Dow Chem. Co. v.
United States, 435 F.3d 594, 599 (6th Cir. 2006); Winn-Dixie Stores, Inc. & Subs.
v. Commissioner, 254 F.3d 1313, 1316 (11th Cir. 2001), aff’g 113 T.C. 254
(1999). Still other Courts of Appeals adhere to the view that a lack of economic
substance is sufficient to invalidate a transaction regardless of the taxpayer’s
subjective motivation. See, e.g., Coltec Indus., Inc. v. United States, 454 F.3d
1340, 1355 (Fed. Cir. 2006). And still other Courts of Appeals treat the objective
and subjective prongs merely as factors to consider in determining whether a
transaction has any practical economic effects beyond tax benefits. See, e.g.,
ACM P’ship v. Commissioner, 157 F.3d 231, 248 (3d Cir. 1998), aff’g in part,
rev’g in part T.C. Memo. 1997-115.
                                         -55-

[*55] transaction will be respected for tax purposes only if: (1) it has economic

substance compelled by business or regulatory realities; (2) it is imbued with tax-

independent considerations; and (3) it is not shaped totally by tax avoidance

features. Id. at 544. Thus, the transaction must exhibit an objective economic

reality, a subjectively genuine business purpose, and some motivation other than

tax avoidance. Southgate Master Fund, 659 F.3d at 480. Failure to meet any one

of these three factors renders the transaction void for tax purposes. Klamath, 568

F.3d at 544. While Klamath phrases the economic substance doctrine as a

conjunctive, three-factor test, the Court of Appeals for the Fifth Circuit has

recognized that “there is near-total overlap between the latter two factors. To say

that a transaction is shaped totally by tax-avoidance features is, in essence, to say

that the transaction is imbued solely with tax-dependent considerations.”

Southgate Master Fund, 659 F.3d at 480 & n.40. The proper focus of the

economic substance doctrine is the particular transaction that gave rise to the tax

benefit at issue, not collateral transactions that do not produce tax benefits.

Klamath, 568 F.3d at 545. For the reasons discussed below, we find that the

Epsolon option transactions fail the economic substance doctrine as set forth by

the Court of Appeals for the Fifth Circuit.
                                          -56-

[*56] A.     Objective Economic Inquiry

      Under the objective economic inquiry of Klamath, a transaction lacks

economic reality if it does not vary, control, or change the flow of economic

benefits. Southgate Master Fund, 659 F.3d at 481. The objective economic

inquiry asks whether the transaction affected the taxpayer’s financial position in

any way, i.e. whether the transaction “either caused real dollars to meaningfully

change hands or created a realistic possibility that they would do so.” Id. at 481 &

n.41. Stated differently, the test for objective economic reality is whether there is

a reasonable possibility of making a profit apart from tax benefits. Id. at 481 n.43.

The inquiry is based on the vantage point of the taxpayer at the time the

transactions occurred rather than with the benefit of hindsight. Id. at 481.

      Petitioners argue that the Epsolon options materially changed the taxpayer’s

economic position. Petitioners further argue that Mr. Tucker had a reasonable

possibility of making a profit. He could have earned $487,707 profit net of fees if

both the Epsolon and Sligo LLC options had been profitable, which petitioners

argue reflects a reasonable possibility of profit sufficient to satisfy the objective

economic inquiry as articulated by the Court of Appeals for the Fifth Circuit.

Petitioners contend that Mr. Tucker had a 40% probability of earning a $1,458,999

profit on the Epsolon options and a 40% probability of earning a $558,708 profit
                                        -57-

[*57] on the Sligo LLC options for a total profit of $2,017,707 and a net profit of

$487,707 after payment of KPMG’s and Helios’ fees. Petitioners argue this

amount represents a large profit because it represents a 14% return over a short

period. The parties substantially agree on the amount and probability of Mr.

Tucker’s profit potential from the Sligo LLC and Epsolon options. At the time of

the FX transaction, Mr. Tucker also understood that the Sligo LLC options and

Epsolon options each had a 40% chance of profitability. Respondent notes that

Mr. Tucker needed to profit on both components to realize a net profit on the total

FX transaction to cover the nearly $1.5 million in fees that Mr. Tucker paid to

KPMG and Helios. Respondent argues that probability that both events would

occur could have been as low as 16%. Mr. Fong acknowledged that the likelihood

of profit on both components was between 16% and 40%, depending upon the

extent to which there was a correlation between the two events. Neither party’s

expert provided testimony of the appropriate correlation, however.

             1.    Reasonable Possibility for Profit

      The possibility of making any profit is not presumptively sufficient to show

a reasonable possibility of profit. The existence of “some potential for profit” is

not necessarily sufficient to establish economic substance. Keeler v.

Commissioner, 243 F.3d 1212, 1219 (10th Cir. 2001), aff’g T.C. Memo. 1999-18.
                                        -58-

[*58] A transaction lacks objective economic substance if it does not “appreciably

affect * * * [a taxpayer’s] beneficial interest except to reduce his tax.” Knetsch,

364 U.S. at 366 (quoting Gilbert v. Commissioner, 248 F.2d 399, 411 (2d Cir.

1957) (Hand, J., dissenting)). A de minimis economic effect is insufficient. Id. at

365-366 (finding a transaction involving leveraged annuities to be a sham because

possible $1,000 cash value of annuities at maturity was “relative pittance”

compared to purported value of annuities). Respondent argues that Mr. Tucker

did not have a reasonable probability of profit because the potential profit of

$487,707 as outlined above was not reasonable when compared with his $20

million tax savings from the FX transaction over 2000 and 2001. Petitioners argue

that we should not compare profit potential with tax benefits for purposes of the

economic substance doctrine and that we should independently consider Mr.

Tucker’s opportunity to earn a profit. We have previously compared potential

profit with tax savings in assessing economic substance. Reddam v.

Commissioner, 755 F.3d 1051, 1061 (9th Cir. 2014), aff’g T.C. Memo. 2012-106;

Sala v. United States, 613 F.3d 1249, 1254 (10th Cir. 2010); Gerdau Macsteel, Inc.

v. Commissioner, 139 T.C. 67, 174 (2012); Humboldt Shelby Holding Corp. &

Subs. v. Commissioner, T.C. Memo. 2014-47, aff’d, 606 F. App’x 20 (2d Cir.

2015). Thus, when analyzing the objective economic substance of a transaction, it
                                         -59-

[*59] is appropriate to view the reasonableness of the profit potential in the light

of the expected tax benefits.

      The Epsolon options gave rise to $52.9 million in tax losses over two years,

2000 and 2001, with petitioners claiming a $38 million loss for 2000 and a tax

benefit of over $20 million for 2000 and 2001. The $487,707 potential profit is de

minimis as compared to the expected $20 million tax benefit. Petitioners’ claimed

tax loss has no meaningful relevance to the minimal profit potential of $487,707

from the FX transaction. This amount is insignificant when compared to

petitioners’ $52.9 million in ordinary losses for 2000 and 2001 from the FX

transaction and when compared to petitioners’ tax savings of $20 million

manufactured by the FX transaction for 2000 and 2001. Petitioners’ tax savings

for 2000 alone were $15.5 million. By any objective measure, the FX transaction

defied economic reality. See Sala v. United States, 613 F.3d at 1254 (potential to

earn $550,000 profit was dwarfed by expected tax benefit of nearly $24 million);

Humboldt Shelby Holding Corp. & Subs. v. Commissioner, at *16 (potential profit

of $510,000 was inconsequential compared to the $25 million tax benefit

generated by the digital options); Blum v. Commissioner, T.C. Memo. 2012-16,

slip op. at 35 (a 19.1% chance at realizing a $600,000 profit and a 7.6% chance of

realizing a $3 million profit, were de minimis when compared to losses of over
                                        -60-

[*60] $45 million), aff’d, 737 F.3d 1303 (10th Cir. 2013). Thus, it is evident that

the Epsolon options, viewed objectively, offered no reasonable expectation of any

appreciable net gain but rather were designed to generate artificial losses by

gaming the tax code. Accordingly, the Epsolon options fail the objective prong of

the economic substance analysis.

      Petitioners suggest that we ascertain profitability by considering only the

Epsolon options on the basis of their concession with respect to the Sligo LLC

basis component. Petitioners contend that a comparison of the profit potential and

the tax benefit of only the Epsolon options shows that the profits and the tax

savings are sufficiently aligned to establish that the Epsolon options had economic

substance. Petitioners contend that with their concession, they are entitled to a

loss deduction of approximately $2 million for 2000, which results in tax savings

of roughly $800,000 for 2000. However, petitioners misstate the effect of their

concession as they seek to carry over the remainder of the 2000 $38 million loss to

future years to the extent that they can establish Mr. Tucker’s Sligo stock basis.

Petitioners further argue that we should recalculate the profit potential on the

Epsolon options by allocating the $1.5 million in fees paid to KPMG and Helios

equally between the Epsolon and Sligo LLC components. Under this calculation,

petitioners assert that Mr. Tucker would have a profit potential of $688,090 on the
                                         -61-

[*61] Epsolon options, which represents a 30% return over a 19-day period.

Petitioners argue that Mr. Tucker’s potential profit is “substantial” compared to

the $800,000 of tax savings petitioners claim for 2000, ignoring their carryover of

the 2000 loss.

      In assessing the economic substance of a transaction, we consider the

transaction that gave rise to the tax benefit and not collateral transactions that do

not produce tax benefits. Klamath, 568 F.3d at 545. The collateral transactions in

Klamath were investments made with actual capital contributions to the

partnership at issue which did not provide the tax benefits at issue. Id. The court

in Klamath refused to consider the profitability of these investments in its analysis

of the economic substance doctrine on the basis that the tax savings arose from an

inflated partnership basis and euro purchased and distributed by the partnership.

Id. Southgate Master Fund also involved two transactions (acquisition of

nonperforming loans and the creation of a partnership) where the Court of Appeals

for the Fifth Circuit considered which transaction created the tax savings at issue.

The case involved the tax treatment of losses claimed through a partnership. The

partnership’s acquisition of nonperforming foreign loans resulted in more than $1

billion in losses. Southgate Master Fund, 659 F.3d at 468. The court found that

despite the losses, the acquisition of the loans had economic substance. The
                                        -62-

[*62] investors prepared market research and a valuation analysis before acquiring

the loans, and the acquisition was within the partners’ core business of acquiring

distressed debt. Id. at 469-470. The court found that the losses were

unforeseeable and that a reasonable possibility of profit existed for the loans. Id.

at 481. For purposes of the economic substance doctrine, the Government sought

to compare the profit potential from the nonperforming loans with the tax savings

from the partnership structure. The court refused to make such a comparison as

the court would not combine its analysis of the loan acquisition and the

partnership structure. The court found that the partners would have acquired the

loans even if they had not received any tax benefits. Id. at 482. In fact one partner

invested in the loans without any expectation or receipt of tax benefits. Id. The

court found that the partnership was a sham, however, finding that the partnership

was created to generate artificial losses and tax benefits. The court recharacterized

the acquisition of the nonperforming loans as a direct sale to the individual

partners, compared the profit potential from the nonperforming loans and the tax

benefits from a direct sale, and found the tax benefits (from real, out-of-pocket

expenses) were not disproportionate to the expected profitability. Id. at 483.

      Petitioners’ argument that we should ignore the Sligo LLC basis component

fails for two reasons. First, the theory that we should wholly disregard one
                                        -63-

[*63] abusive component merely because it was conceded to be abusive does not

imbue the other equally abusive component with economic substance. To do so

would contravene the core purpose of the economic substance doctrine to give

effect to economic realities. Second, if we were to disregard the basis-inflation

component, we would also disregard the 40% probability of earning a $558,708

profit associated with it, thus effectively wiping out any profit potential unless we

agree with petitioners’ reallocation of fees on a 50-50 basis. Such a reallocation of

fees is not warranted as the fees related to the entire FX transaction. Mr. Tucker

would have had to profit on both the Epsolon and Sligo LLC option spreads to

cover the $1.5 million in fees paid to KPMG and Helios for the FX transaction.

Both the Sligo LLC and Epsolon loss components were essential to achieve the

mitigation of Mr. Tucker’s 2000 income tax from the WR stock options. Mr.

Tucker would not have executed the Epsolon options separate from the Sligo LLC

options. Cf. Southgate Master Fund, 659 F.3d 466. The two components were

interrelated, and Mr. Tucker depended on the Sligo LLC basis component in his

decision to proceed with Epsolon loss component. See Winn-Dixie Stores, Inc. &

Subs. v. Commissioner, 113 T.C. 254, 280 (1999), aff’d, 254 F.3d 1313 (11th Cir.

2001). The Court considers “the transaction in its entirety, rather than focusing
                                         -64-

[*64] only on each individual step.” Reddam v. Commissioner, T.C. Memo. 2012-

106, slip op. at 42, aff’d, 755 F.3d 1051 (9th Cir. 2014).

             2.    Actual Economic Effect

      Tax losses that fail to correspond to any actual economic losses “do not

constitute the type of ‘bona fide’ losses that are deductible” for Federal tax

purposes. ACM P’ship v. Commissioner,157 F.3d 231, 252 (3d Cir. 1998), aff’g

in part, rev’g in part T.C. Memo. 1997-115. “[T]he mere presence of potential

profit does not automatically impart substance where a commonsense examination

of the transaction and the record * * * reflect a lack of economic substance.” John

Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. 1, 79 (2013) (citing

Sala v. United States, 613 F.3d 1249, 1254 (10th Cir. 2010)); see Keeler v.

Commissioner, 243 F.3d at 1219. Mr. Tucker experienced a net economic loss of

approximately $695,000 on the FX transaction. However, this economic loss did

not cause real dollars to meaningfully change hands to the extent of the claimed

tax losses of $52.9 million for 2000 and 2001 or the claimed tax loss of $38

million for 2000. See Southgate Master Fund, 659 F.3d at 481. Mr. Tucker

should have expected to lose money on the FX transaction; he knew there was a

60% chance that each component would result in an economic loss. Yet his

potential for economic loss was severely limited, $1,488, 985 and $510,000 on the
                                        -65-

[*65] Epsolon and Sligo LLC options, respectively, when compared to his claimed

tax losses. This expected loss was part of the cost of engaging in the FX

transaction to achieve the desired tax savings and was not intended to change Mr.

Tucker’s financial position. Had the Epsolon options resulted in a profit, the

claimed artificial loss would have remained for petitioners to claim on their tax

return. The artificial $39 million loss for 2000 is unrelated to the $487,707 in

profit potential or the actual $695,000 economic loss that Mr. Tucker sustained.

      The economics of the FX transaction do not support petitioners’ claim to the

losses reported on their 2000 tax return. There were four possible outcomes for

the two sets of option transactions:

      (1)    Epsolon option transactions finished in-the-money; Sligo LLC
             option transactions finished in-the-money;

      (2)    Epsolon option transactions finished in-the-money; Sligo LLC option
             transactions finished out-of-the-money;

      (3)    Epsolon option transactions finished out-of-the-money; Sligo LLC
             option transactions finished out-of-the-money; or

      (4)    Epsolon option transactions finished out-of-the-money; Sligo LLC
             option transactions finished in-the-money.

      The parties rely on the economic analyses of their respective experts in

support of their positions concerning the options’ economic effect. Both experts

agree that Mr. Tucker could profit only under the fourth outcome, and only to the
                                        -66-

[*66] extent of $487,707 after accounting for fees. The other three outcomes

would result in an economic loss. Both experts also used the Black Scholes

Merton option pricing formula, but respondent’s expert, using Mr. Fong’s price

determinations for the individual legs of the spread positions, concluded that the

options were mispriced against Mr. Tucker. Mr. Fong did not price the spreads as

a whole, however. Petitioners dispute that the options were mispriced.

      Mr. Fong determined, and Dr. DeRosa agreed, that there was an

approximately 40% likelihood that the Epsolon option transactions would finish

out-of-the-money and an approximately 40% chance that the Sligo LLC option

transactions would finish in-the-money, both events were necessary for Mr.

Tucker to make the$487,707 profit, and the likelihood that both events would

occur would fall between 16% and 40%. Petitioners argue that we should not

consider the 60% likelihood that Mr. Tucker would lose money because Mr.

Tucker did not consider the FX transaction from a loss perspective. Rather he

considered only that he had a 40% chance of making a profit and could earn that

profit over a short period. To this end, Mr. Tucker acknowledged he knew the

options were riskier than his typical investments.

      Dr. DeRosa also analyzed the expected rate of return of the FX transaction

and the probability-weighted sum of the four possible outcomes, and he calculated
                                         -67-

[*67] that Mr. Tucker had a negative expected rate of return on both the Epsolon

and Sligo LLC option transactions, before and after accounting for fees. Dr.

DeRosa determined that Mr. Tucker’s expected rates of return for the Epsolon and

Sligo LLC options were !54.90% and !52.39%, respectively, after accounting for

fees. Dr. DeRosa explained that the expected rate of return analysis is a

fundamental tool in assessing the economics of the options because it accounts for

investment costs, possible payoffs, and probabilities of those payoffs. Dr. DeRosa

explained that an expected rate of return is indicative of whether an option is

priced correctly and the large negative expected rates of return present in this case

indicate that the options were “egregiously” mispriced against Mr. Tucker.

Petitioners argue that the expected rate of return analysis is not relevant to the

objective test of the economic substance doctrine because such an analysis fails to

address whether the options had profit potential. At times, courts have found that

negative expected rates of return indicate a lack of reasonable possibility of profit

while at other times courts have given little weight to such analyses. See Stobie

Creek Invs., LLC v. United States, 608 F.3d 1366, 1378 (Fed. Cir. 2012); Reddam

v. Commissioner, T.C. Memo. 2012-106; Blum v. Commissioner, T.C. Memo.

2012-16; Fid. Int’l Currency Advisor A Fund, LLC v. United States, 747 F. Supp.

2d 49, 196 (D. Mass. 2010), aff’d, 661 F.3d 667 (1st Cir. 2011). The extent to
                                        -68-

[*68] which a given analysis is instructive depends heavily on the facts of the

transaction in question. Significantly mispriced assets can indicate a lack of

economic substance. Reddam v. Commissioner, T.C. Memo. 2012-106; Blum v.

Commissioner, T.C. Memo. 2012-16.

      We have found that the FX transaction lacked profit potential on the basis of

a comparison of the minimal profit potential with the $52 million in tax savings

over two years. Accordingly, we do not need to rely on Dr. DeRosa’s expected

rate of return analysis. For the most part, both expert reports are in agreement and

use the same mathematical model and inputs. The reports, however, diverge in

two key respects. First, as explained above, Dr. DeRosa relies on an expected rate

of return analysis, and Mr. Fong determined profit probability. Second, the

experts disagree on how to interpret each options’ value. The experts agree that

the stated premium of each individual option was generally within 1% of its

theoretical value. That is, each option, valued independently, was traded at or near

market price at the time the trades occurred. Dr. DeRosa’s rebuttal report,

however, explains that the appropriate value to examine is the net premium paid or

received, relative to the theoretical value of the position, to determine whether the

FX transaction was fairly priced. While not determinative, a mispriced asset can

contribute to the overall picture of a transaction lacking in economic substance.
                                        -69-

[*69] See Blum v. Commissioner, slip op. at 37-38. Using Mr. Fong’s valuation

calculations, Dr. DeRosa compared a market-valued net premium of $2,212,12512

for the Epsolon euro options with the net premium of $1,458,999 payable by

Lehman Brothers to Epsolon. Dr. DeRosa determined that the amount payable to

Epsolon was 34% less than Mr. Fong’s value, or rather, Lehman Brothers

underpaid Mr. Tucker by $753,126.

      Between the 60% or greater likelihood that Mr. Tucker would lose money

on the options, the large negative expected rate of return, and the mispricing of the

options, the expert reports indicate that the Epsolon options were expected to, and

did in fact, generate an economic loss. Mr. Tucker made a minimal cash outlay,

had limited financial risk, and incurred an actual economic loss of roughly

$695,000, which stands in stark contrast to the claimed loss of $52.9 million over

two years. Viewed objectively, the Epsolon loss component was not designed to

make a profit, but rather arranged to produce a $52.9 million artificial loss. The

scheme involved separating the gains from the losses by allocating the gains to

Epsolon while it was a CFC, checking the box to become a partnership,

      12
        Dr. DeRosa believes that Mr. Fong’s calculation contains a simple
mathematical error and the correct value should be $2,388,167. If that error were
corrected, the difference between the market-valued net premium and the net
premium payable would increase to 39%.
                                        -70-

[*70] subsequently recognizing the losses, and creating a tiered passthrough-entity

structure through which to claim the artificial losses. No element of the Epsolon

loss and Sligo LLC basis components had economic substance; each was

orchestrated to serve no other purpose than to provide the structure through which

petitioners could reduce their 2000 and 2001 tax burden. Accordingly, because

the Epsolon option transaction lacked objective economic substance, it is void for

tax purposes. See Klamath, 568 F.3d at 544 (to have economic substance a

transaction must satisfy three factors). Failure to satisfy the objective economic

realities inquiry is sufficient to void the Epsolon options for tax purposes. For the

sake of thoroughness, we will examine whether petitioners satisfy the subjective

inquiries of business purpose and nontax motivation.

      B.     Subjective Business Purpose Inquiry

      The second and third Klamath factors, while enumerated separately, overlap

and derive from the same subjective inquiry of a subjectively genuine business

purpose or some motivation other than tax avoidance. Southgate Master Fund,

659 F.3d at 481. Accordingly we address the two factors together. Taxpayers are

not prohibited from seeking tax benefits in conjunction with seeking profits for

their businesses. Id. Taxpayers who act with mixed motives of profits and tax

benefits can satisfy the subjective test. Id. at 481-482. For purposes of the
                                        -71-

[*71] subjective inquiry, tax-avoidance considerations cannot be the taxpayer’s

sole purpose for entering into a transaction. Salty Brine I, Ltd. v. United States,

761 F.3d 484, 495 (5th Cir. 2014). That a taxpayer enters into a transaction

primarily to obtain tax benefits does not necessary invalidate the transaction under

the subjective inquiry. Compaq Comput. Corp. & Subs. v. Commissioner, 277

F.3d 778, 786 (5th Cir. 2001), rev’g 113 T.C. 214 (1999). However, “[t]he

existence of a relatively minor business purpose will not validate a transaction if

‘the business purpose is no more than a façade’.” Humboldt Shelby Holding Corp.

& Subs. v. Commissioner, at *16 (quoting ASA Investerings P’ship v.

Commissioner, 201 F.3d 505, 513 (D.C. 2000), aff’g T.C. Memo. 1998-305).

      Respondent asserts that Mr. Tucker engaged in the FX transaction for the

sole purpose of avoiding income tax that he owed upon the exercise of his WR

stock options. Petitioners counter that Mr. Tucker’s admitted desire for tax

savings does not negate his other motivations for entering into the FX transaction

--profit and diversification. Petitioners claim Mr. Tucker’s primary motivation

was profit. In an effort to show his profit motives petitioners characterize Mr.

Tucker’s investment in the FX transaction as relatively small and describe the 40%

chance of profit as very substantial and the $487,707 profit potential amount as

very large over a short period. On brief, petitioners analogize Mr. Tucker’s tax
                                        -72-

[*72] strategy to a double bacon cheeseburger--equating the $20 million expected

tax benefits to the two hamburger patties and the $487,707 profit potential to the

bacon--and urge us to believe that he “bought it for the bacon.” The record,

however, indicates otherwise.

      Mr. Tucker did not implement the options for a genuine business purpose.

Rather he entered into the Epsolon options for the sole purpose of reducing his

income tax. Mr. Tucker’s efforts to participate in other tax strategies before

ultimately engaging in the FX transaction, including the short options strategy

before KPMG terminated the strategy upon the issuance of Notice 2000-44, supra,

and the Quadra Forts transaction before its financing fell through, belie Mr.

Tucker’s claim that his motivations were anything other than tax savings. Mr.

Tucker did not approach the FX transaction as a normal investment but rather

approached it as a tax-avoidance strategy despite his extensive experience in the

field of finance. Mr. Tucker, a former CEO of a publicly traded financial services

company, attempts to portrait himself as an unsophisticated investor. For the FX

transaction he relied entirely on the advice of his tax adviser, KPMG, without any

review of his own into the investment potential of the Sligo LLC or Epsolon

options. His interactions with KPMG cast doubt on his purported profit

motivation for engaging in the FX transaction. KPMG approached Mr. Tucker in
                                          -73-

[*73] the spring of 2000 with the idea of a tax solution to mitigate the income tax

from the anticipated exercise of the WR stock options. Mr. Tucker decided to

pursue a short options strategy and then exercised his WR stock options on August

1, 2000. Shortly thereafter, the IRS issued Notice 2000-44, supra, and KPMG

terminated its short options strategy. KPMG sought an alternative tax solution for

Mr. Tucker, which also fell through in mid-December. At the 11th hour, Mr.

Speiss sought approval from KPMG’s tax leadership to create a customized tax

solution for Mr. Tucker. Mr. Speiss sought assistance from Helios, Alpha, and

DGI to orchestrate a tax solution that involved an elaborate array of steps,

including newly created entities, tax elections, and the acquisition of offsetting

foreign currency digital option spreads, for the sole purpose of generating a

multimillion-dollar ordinary loss in the final two weeks of the tax year. KPMG

arranged the FX transaction to ensure the amount of the generated tax losses

would be sufficient to offset Mr. Tucker’s income from the WR stock options.

They completed the transaction in a short time during the final two weeks of the

tax year for the purpose of avoiding taxes owed for that year, after two other failed

attempts at tax-avoidance transactions.

      Mr. Tucker’s testimony attempts to put a positive spin on the economic

realities of the transaction, testifying that he knew that the FX transaction was
                                        -74-

[*74] riskier than his typical investments and that he sought to diversify into

riskier investments. In actuality, Mr. Tucker should have expected the investment

to be a failure, as he knew that the Epsolon and Sligo LLC option transactions

each had a 60% chance of losing money. Mr. Tucker claims a diversification

motive and made other investments of less than $5 million at the time of the FX

transaction per KPMG’s advice in an attempt to show his nontax profit motives.

However, the record shows that the purpose of those investments was to protect

against IRS penalties and not to diversify. Mr. Tucker’s additional investments

do not imbue the FX transaction with tax-independent considerations. Moreover,

the Epsolon entity served no business purpose other than tax avoidance. At the

time he acquired Epsolon, Mr. Tucker did not intend to conduct any legitimate

business or investment activities through Epsolon. Epsolon was a shelf

corporation established by tax shelter promoters.

      Mr. Tucker’s decision to enter into the FX transaction was solely tax

motivated and did not have a genuine business purpose. Regardless of his

purported desire for profit and diversification, Mr. Tucker executed a transaction

that was structured for tax savings and not to make a profit. We note that even had

petitioners established a nontax or genuine business purpose for the Epsolon

options, such motivation would not have been sufficient to satisfy the conjunctive
                                          -75-

[*75] factor test for economic substance as set forth by the Court of Appeals for

the Fifth Circuit. The Epsolon options lacked any practical objective economic

effect.

IV.       Accuracy-Related Penalties

          Section 6662 provides that a taxpayer may be liable for a 20% penalty on

the portion of an underpayment of tax attributable to (1) a substantial

understatement of income tax, (2) negligence or disregard of rules or regulations,

or (3) any substantial valuation misstatement. Sec. 6662(a) and (b)(1), (2), and

(3). A “substantial valuation misstatement” occurs if the value of any property or

the adjusted basis of any property claimed on an income tax return is 200% or

more of the correct amount. Sec. 6662(e)(1)(A); sec. 1.6662-5(e)(1), Income Tax

Regs. If the valuation misstatement is 400% or more of the correct amount, the

misstatement is considered a gross valuation misstatement, and the 20% penalty

increases to 40%. Sec. 6662(h). The section 6662 penalties do not apply if

taxpayers demonstrate they acted with reasonable cause and in good faith. Sec.

6664(c)(1). In the deficiency notice, respondent determined in the alternative that

petitioners are liable for the 20% and 40% accuracy-related penalties for

negligence, a substantial understatement of income tax, a substantial valuation

misstatement, or a gross valuation misstatement. There is no stacking of penalties.
                                         -76-

[*76] Sec. 1.6662-2(c), Income Tax Regs. While more than one basis for the

section 6662 penalty may exist, the maximum allowed penalty is 40%. Id.

      The 40% gross valuation misstatement penalty would apply in this case on

the basis of petitioners’ claimed inflated basis in the Sligo stock. Sec.

6662(h)(2)(A). To allow for the Epsolon option losses to pass through Sligo to

petitioners’ 2000 tax return, Mr. Tucker had to establish a sufficient basis in his

Sligo stock, which he did through a basis-inflation transaction using offsetting

option positions in the Sligo LLC basis component which petitioners have since

conceded. Mr. Tucker bought and sold yen put options through Sligo LLC with

gross premiums of $51 million and $50,490,000, respectively, and then

contributed these positions to Sligo by transferring his Sligo LLC ownership to

Sligo. Mr. Tucker paid a net premium of only $510,000 on the yen options but

claimed a stock basis of $51 million, the gross premium of the purchased yen put

option. Mr. Tucker did not reduce his Sligo basis by the premium received for the

sold yen put option, arguing that the sold yen put option was a contingent liability

that did not reduce S corporation basis under section 358(a) and (d). Petitioners

have conceded this issue and now maintain that Mr. Tucker’s basis is limited to

cash contributions he made to Sligo during 2000. Petitioners allege that amount to

be $2,024,700. Even if we assume that Mr. Tucker had a basis in Sligo equal to
                                         -77-

[*77] $2,024,700, his reported basis of $51 million exceeded that amount by more

than 2,500%, far in excess of the 400% threshold required for the gross valuation

misstatement penalty to apply.

      Petitioners argue that they are not liable for the accuracy-related penalty

because they acted with reasonable cause and in good faith in reporting their 2000

tax liability. We determine whether a taxpayer acted with reasonable cause and in

good faith on a case-by-case basis, taking into account all pertinent facts and

circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. A taxpayer’s reliance on

the advice of an independent professional may constitute reasonable cause and

good faith. The advice must be based on all pertinent facts and circumstances and

the law as it relates to those facts and circumstances and must not be based on any

unreasonable factual or legal assumptions. Id. para. (c)(1). We have summarized

the requirements for the reasonable reliance on professional advice as: (1) the

professional is a competent tax adviser with sufficient expertise to justify reliance,

(2) the taxpayer provided necessary and accurate information to the adviser, and

(3) the taxpayer actually relied in good faith on the adviser’s judgment.

Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 98-99 (2000), aff’d,

299 F.3d 221 (3d Cir. 2002). A taxpayer’s education and business experience are

relevant to the determination of whether the taxpayer acted with reasonable
                                         -78-

[*78] reliance on an adviser and in good faith. Sec. 1.6664-4(b)(1), Income Tax

Regs. The Supreme Court recognized in United States v. Boyle, 469 U.S. 241,

251 (1985), that a taxpayer exercises “[o]rdinary business care and prudence”

when he reasonably relies on a professional’s advice on matters beyond the

taxpayer’s understanding.

      A taxpayer need not challenge an independent and qualified adviser, seek a

second opinion, or monitor advice on the provisions of the Code. Id. As the

Supreme Court noted in Boyle: “Most taxpayers are not competent to discern

error in the substantive advice of an accountant or attorney. To require the

taxpayer to challenge the attorney * * * would nullify the very purpose of seeking

the advice of a presumed expert in the first place.” Id. Advice need not be written

and includes any communication that provides advice on which the taxpayer relied

directly or indirectly. Sec. 1.6664-4(c)(2), Income Tax Regs. The most important

factor is the extent of the taxpayer’s effort to assess the taxpayer’s proper tax

liability. Id. para. (b). The focus of the reasonable cause defense is on the

taxpayer’s knowledge, not the adviser’s knowledge. Southgate Master Fund, 659

F.3d at 494.

      The reasonableness of any reliance depends on the quality and objectivity of

the advice. Klamath, 568 F.3d at 548. Reliance on an adviser is not reasonable or
                                         -79-

[*79] in good faith when the taxpayer knew or should have known that the adviser

had an inherent conflict of interest. See Chamberlain v. Commissioner, 66 F.3d

729, 732-733 (5th Cir. 1995), aff’g in part, rev’g in part T.C. Memo. 1994-228;

Paschall v. Commissioner, 137 T.C. 8, 22 (2011); Neonatology Assocs., P.A. v.

Commissioner, 115 T.C. at 98. Taxpayers cannot in good faith rely on the advice

of a promoter of a tax shelter transaction. However, the definition of a promoter is

not clear from case law. We have stated that a promoter is someone who

participated in the structuring of the tax shelter transaction offered to numerous

clients or otherwise has a financial interest or profits from the transaction. 106

Ltd. v. Commissioner, 136 T.C. 67, 80 (2011), aff’d, 684 F.3d 84 (D.C. Cir. 2012);

Tigers Eye Trading, LLC v. Commissioner, T.C. Memo. 2009-121. An adviser is

not a promoter when he has a long-term and continual relationship with the client-

taxpayer, does not give unsolicited advice regarding the tax shelter, advises the

client only within his field of expertise and not because of his regular involvement

in the tax shelter transactions, follows his regular course of conduct in rendering

his advice, and has no stake in the transaction besides his regular hourly rate. 106

Ltd. v. Commissioner, 136 T.C. at 80 (citing Countryside Ltd. P’ship v.

Commissioner, 132 T.C. 347, 352-355 (2009)). There is no bright-line test for

determining whether an adviser is a promoter. See Am. Boat Co. v. United States,
                                        -80-

[*80] 583 F.3d 471, 483 (7th Cir. 2009). We must also consider a taxpayer’s right

to structure his affairs in a way that minimizes tax and to seek tax advice to

accomplish that result. The reasonable cause defense does not require the

taxpayer to correctly anticipate the legal consequences that the Court will attach to

the underlying facts of the transaction. Southgate Master Fund, 659 F.3d at 494.

      We find that Mr. Tucker is not liable for the section 6662 penalty on the

basis of his reliance on Mr. Schorr of KPMG. Mr. Tucker had a long-term

relationship with both KPMG and Mr. Schorr, whom he viewed as a friend. Mr.

Schorr introduced and recommended Mr. Speiss. KPMG had prepared petitioners’

returns for 15 years without audit. Mr. Tucker had recommended Mr. Schorr to

manage the WR executive program when it was created. Mr. Tucker did not

solicit or initiate the contemplation of a tax strategy. Mr. Tucker believed that

KPMG was offering its services as part of the WR executive program, which

Waddell & Reed established to ensure that Waddell & Reed’s executives were in

compliance with tax law. Mr. Tucker had informed KPMG that he did not want to

engage in a transaction that would subject him to IRS scrutiny because of concern

for his professional reputation and career and the potential impact on Waddell &

Reed’s reputation as its CEO. After the issuance of Notice 2000-44, supra, Mr.

Tucker was adamantly against participating in such a transaction. KPMG
                                        -81-

[*81] repeatedly assured Mr. Tucker that Notice 2000-44, supra, did not apply to

the FX transaction. Mr. Tucker believed that KPMG would protect his interests as

KPMG had done when it terminated the short options strategy in response to

Notice 2000-44, supra. Mr. Tucker believed that KPMG would not recommend an

abusive tax shelter, and KPMG’s withdrawal of the short options strategy after the

issuance of Notice 2000-44, supra, confirmed this. He testified that KPMG’s

withdrawal of the short options strategy “made me feel better.” Accordingly,

when KPMG recommended the FX transaction, Mr. Tucker believed it was a

legitimate tax planning solution. Because of his past experiences, Mr. Tucker did

not expect that KPMG would recommend an abusive tax shelter. KPMG offered

the FX transaction to only a limited number of individuals, three Waddell & Reed

executives including Mr. Tucker. Mr. Tucker viewed KPMG’s actions with

respect to the FX transaction as an integral part of KPMG’s normal tax planning

advice on the basis of his longstanding relationship with KPMG, KPMG’s role in

the WR executive program, and his representations to KPMG that he did not want

to engage in a tax strategy that could jeopardize Waddell & Reed’s or his own

reputation within the financial services industry. In fact, Waddell & Reed engaged

KPMG to assist its senior executives in financial and tax planning in part to

protect Waddell & Reed’s reputation in the financial services industry. At
                                       -82-

[*82] KPMG’s recommendation, Mr. Tucker made $4 million in investments

separate from the FX transaction to protect himself from IRS penalties.

      At the time of the FX transaction KPMG was one of the largest accounting

firms in the United States. Mr. Tucker viewed Mr. Schorr as a preeminent person

for coordinating tax return compliance and tax and financial planning. Mr. Tucker

believes KPMG misled him. He was forced to resign as CEO of Waddell & Reed

and is no longer employable in the financial services industry. In the end, Mr.

Tucker lost his position at Waddell & Reed because of his participation in the FX

transaction and received a large settlement from KPMG for his lost future

compensation. We note that in our order dated August 24, 2015, we found that

Mr. Tucker’s representations in his arbitration proceeding against KPMG support

his assertion that he relied on the advice he received from KPMG in good faith.

Because of Mr. Tucker’s long relationship with Mr. Schorr, he was less likely to

question KPMG’s advice. While Mr. Tucker was motivated to reduce his 2000

income tax liability, he consistently represented to KPMG that he did not want to

put his own reputation or career on the line as a result of a tax scheme. When

KPMG recommended the FX transaction, Mr. Tucker believed in good faith that it

was not abusive. Accordingly, we find that the section 6662 penalty is not

applicable.
                                        -83-

[*83] Mr. Schorr was a competent tax professional and had access to all necessary

and accurate information about the FX transaction through his employment with

KPMG. Mr. Schorr did not have a financial interest in the FX transaction as a tax

shelter promoter would. While KPMG increased its fee above its initial fee, Mr.

Schorr did not financially benefit from the increase. Mr. Tucker knew that Mr.

Speiss at KPMG created the FX transaction as a customized tax solution to

mitigate his 2000 income tax. Yet he did not understand that Mr. Speiss’

involvement created an inherent conflict of interest with his longstanding

relationship with Mr. Schorr and KPMG as his return preparer. Mr. Schorr also

credibly testified that he did not believe Mr. Speiss’ involvement created a conflict

of interest. Further KPMG indicated to Mr. Tucker that Brown & Wood could

provide independent legal advice with respect to the FX transaction. Mr. Tucker

did not view KPMG as the promoter of a tax shelter for a number of reasons

including his longstanding relationship with KPMG, KPMG’s role in the WR

executive program, and his statements to KPMG that he did not want to engage in

a tax strategy that could jeopardize Waddell & Reed’s or his own reputation

within the financial services industry. He considered his main contact at KPMG,

Mr. Schorr, to be a friend who would look out for his best interests. Mr. Tucker

believed that KPMG would protect his interests as it had done when it terminated
                                         -84-

[*84] the short options strategy. KPMG withdrew the short options strategy as

abusive, and Mr. Tucker believed that KPMG would not recommend another

potentially abusive transaction. Mr. Tucker credibly testified that KPMG’s

withdrawal of the short options strategy strengthened his trust in KPMG and his

decades-old relationship with Mr. Schorr.

      We place little weight on Mr. Tucker’s failure to review certain documents

relating to the FX transaction. As a senior executive, Mr. Tucker depended

heavily on his personal assistant. We do not view Mr. Tucker’s following his

normal practices when dealing with his taxes as a failure of good faith or

reasonable diligence. As a senior executive, Mr. Tucker had a management style

of delegating to people whom he trusted. Having his administrative assistant open

and read emails relating to the FX transaction was consistent with Mr. Tucker’s

normal business practice. Likewise we do not find the fact that Mr. Tucker did not

read Notice 2000-44, supra, himself to preclude a finding of reasonable reliance

on his adviser. Respondent argues that Mr. Tucker should have read Notice 2000-

44, supra.13 Mr. Tucker, who had experience with insurance tax matters in the

early part of his career, left the tax field in 1984 and focused entirely on the

      13
       Lehman Brothers’ new account forms, which Mr. Tucker did not read, also
mentioned Notice 2000-44, 2000-2 C.B. 255.
                                        -85-

[*85] financial services industry. Mr. Tucker relied on KPMG because he

believed that he would not understand the technical tax implications of the FX

transaction. Despite his background, C.P.A. license, and law degree, Mr. Tucker

had little understanding of the complicated tax issues involved in the FX

transaction.

      We do not base our finding of Mr. Tucker’s reasonable cause and good faith

on the Brown & Wood opinions. Mr. Tucker did not receive at least one of the

Brown & Wood opinions before petitioners filed their 2000 joint return, did not

read either opinion, and had limited direct communication with Brown & Wood

attorneys. There is no evidence that Mr. Tucker directly paid any fees to Brown &

Wood for the opinions. Moreover, the promoter group provided drafts of the

opinions to Brown & Wood. The reasonable cause defense depends on the

particular facts and circumstances of each case. In this case, we find that

petitioners have established that they met the requirements of the reasonable cause

defense and find that they are not liable for the section 6662 penalty.14 Mr. Tucker

made a sufficient good-faith effort to assess his 2000 income tax and reasonably

      14
       Respondent argues that Mr. Tucker’s statements in the arbitration
proceeding against KPMG are admissions that prevent him from establishing
reasonable cause here. We disagree, as we held in our order dated August 24,
2015, denying respondent’s motion for summary judgment.
                                         -86-

[*86] relied on Mr. Schorr’s professional advice. To find otherwise would require

taxpayers to challenge their attorneys, seek second opinions, or try to

independently monitor their advisers on the complex provisions of the Code.

         In reaching our holdings herein, we have considered all arguments made,

and to the extent not mentioned, we conclude they are moot, irrelevant, or without

merit.

         To reflect the foregoing,

                                                Decision will be entered for

                                        respondent on the deficiency and for

                                        petitioners on the penalty.