U.S. Court of Appeals for the D.C. Circuit Affirms Son of Boss Accuracy-Related Penalty

Aug 01, 2012   

  On June 22, 2012, the United States Court of Appeals for the District of Columbia Circuit affirmed that a partnership which utilized a Son of Boss tax shelter to overstate its basis in partnership interests had also failed to establish a reasonable cause defense to the accuracy-related penalty. A full copy of the decision, entitled 106 Ltd. v. Commr, case no. 11-1242, is available here.

According to the facts set forth in the D.C. Circuits opinion, a “Son of Boss” tax shelter employs a series of transactions to create artificial financial losses that are used to offset real financial gains, thereby reducing tax liability.  In 2001, the IRS identified the Son of Boss tax shelter as an abusive transaction if used to generate artificial losses for tax purposes and would not allow the deductions for federal tax purposes. We have previously reported on issues relating to Son of Boss tax shelters herehere, here, and here.

David Palmlund, a Dallas businessman and the tax matters partner, appealed the decision of the U.S. Tax Court upholding the imposition of a 40% accuracy-related penalty by the Internal Revenue Service (IRS). The Tax Courts decision is available here.

Long before this matter ended up in court, Joe Garza, Palmlunds personal lawyer, approached Palmlund about a foreign currency investment opportunity that was a variation of the Son of Boss shelter.  Garza explained the mechanics of the shelter and its tax advantages and encouraged Palmlund to consult with Turner & Stone, an accounting firm that had prepared Palmlunds tax returns for more than ten years.  Turner & Stone told Palmlund that they had worked on similar shelters in the past and recommended that he proceed.  Furthermore, Garza guaranteed the transaction by promising to pay Palmlunds litigation costs if the shelter were challenged and to refund his fee if the shelter were invalidated.  Ultimately, Palmlund directed Garza to take the necessary steps to implement the shelter.

The mechanics of the transaction are explained in the opinion.  In November 2001, Palmlund executed documents forming three entities which he controlled: (1) the partnership, (2) 32 LLC and (3) 7612 LLC.  7612, LLC bought offsetting long and short foreign currency for $30,000, the difference of the $3 million and $2.97 million premiums.  7612 LLC then transferred both digital options to the partnership.  Next, 7612 LLC bought $4,000 worth of Canadian currency and transferred the currency to the partnership.  Lastly, the partnership distributed 35% of the Canadian currency to Palmlund Ltd., the family limited partnership previously formed by Palmlund.  At Palmlunds request, the partnership terminated the digital options for a profit of $10,000 excluding fees owed to Garza for implementing the shelter.  Garza also provided a comprehensive opinion letter explaining the shelter and general topics like partnership law, disguise-sale provisions, and the treatment of foreign currency options.  The letter concluded that the structure would more likely that not withstand IRS scrutiny  

The partnerships 2001 tax return prepared by Turner & Stone reported a basis in the distributed Canadian currency of $2,974,000.  On Palmlunds return, also prepared by Turner & Stone, he claimed a flow-through loss of $1,030,491 from the Canadian currency distribution.  By utilizing the Son of Boss shelter, Palmlund reduced his total income by over $1 million and thereby reduced his tax liability by nearly $400,000.  Turner & Stone charged Palmlund $6,500 more than what they had charged for preparing his previous tax returns due to the returns more complex nature.

The IRS first communicated with Palmlund in May 2004 by sending him a copy of IRS announcement 2004-46, which outlined the IRSs proposed terms of settlement for any taxpayer utilizing a Son of Boss tax shelter.  Palmlund then met with Garza and Turner & Stone and decided to amend his individual return by removing the loss attributable to the Canadian currency and paid an additional $349,329 in taxes.  He did not amend the partnerships tax return. 

Consequently, the IRS issued a final partnership administrative adjustment (FPAA) to the partnership in May 2005.  The FPAA reduced the partnership basis to $0 and pursuant to § 6662, available here, imposed a 40% accuracy-related penalty to the underpayment of taxes resulting from the partnerships overstatement of its basis in the Canadian currency.  The Tax Court granted partial summary judgment in favor of the commissioner.  Thus, the only remaining issue was whether the partnership had a reasonable cause defense under § 6664(c)(1), available here,  to defeat the penalty.

Section 6664 provides a defense to an accuracy-related penalty if the taxpayer proves it had reasonable cause for the underpayment and acted in good faith.  The taxpayer can show reasonable cause if it shows that it relied on advice from a competent and independent professional advisor.  To show reasonable cause, the advice must be based on upon all pertinent facts and circumstances and the law as it relates to those facts and circumstances.  The advice must not be based on unreasonable factual or legal assumptions, including if the taxpayer knows or should have known it is unlikely to be true.  Lastly, the taxpayers reliance must itself be objectively reasonable.

In affirming the Tax Courts decision, the D.C. Circuit found no error in the determination that the Partnership failed to establish a reasonable cause defense because Palmlund unreasonably relied on both Garzas and Turner & Stones advice.  First and foremost, Garzas and Turner & Stones role of promoting, implementing, and receiving fees from the Son of Boss strategy creates an inherent conflict of interest.   It is unreasonable of Palmlund to rely on their professional advice if they had a role in promoting the tax shelter.  According to the Court of Appeals, Palmlund knew or should have known that Garza and Turner & Stone were working together to structure and implement the tax shelter.  Therefore, Garza and Turner & Stone could not provide independent advice regarding the tax shelter.

Additionally, Palmlund unreasonably relied on Garzas opinion letter.  The letter relied on inaccurate representations as to the purposes of entering into the transaction.  The letter stated that Palmlund entered into the transaction because he believed there was reasonable opportunity to earn a reasonable pre-tax profit.  However, Palmlunds personal banker testified that Palmlund said he entered into the transaction as a tax strategy to lose money. 

There were other inaccuracies contained in the letter.  The letter stated Palmlund received the distributed Canadian currency in a partnership liquidating distribution.  However, the partnership distributed only 35% of the Canadian currency and Palmlund demonstrated his awareness of this inaccuracy as he directed Turner & Stone to amend his individual tax return to reflect the 35% distribution.  The letter also stated that the partnership did not know if it would be called upon to satisfy its obligations under the digital options.  Yet, by the time the letter was written, Palmlund had terminated the options and eliminated the partnerships obligations under them.

The DC Circuits opinion concluded by explaining that even if Palmlund did not know about the conflicts of interest, his motive for entering into the tax shelter and his business experience demonstrated his lack of good faith reliance.  The $1 million dollar loss from the transaction that earned Palmlund $10,000 should have alerted a person with Palmlunds business experience and sophistication to the shelters illegitimacy.  Thus, the D.C. Circuit affirmed the U.S. Tax Courts judgment in determining that the partnership failed to establish a reasonable cause defense to its accuracy-related penalty pursuant to § 6664(c)(1).

The attorneys at Fuerst Ittleman, PL have extensive civil and criminal tax litigation experience before the U.S. District Courts, the U.S. Tax Court, and the U.S. Circuit Courts of Appeal.  You can contact us by calling 305.350.5690, or by emailing us at contact@fidjlaw.com.