UNITED STATES TAX COURT



HIGHWOOD PARTNERS, B & A HIGHWOODS INVESTMENTS, LLC, TAX MATTERS
                     PARTNER, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



    Docket No. 24463-06.              Filed August 13, 2009.



         R issued P a notice of final partnership
    administrative adjustment (FPAA) after expiration of
    the 3-year period of limitations under sec. 6501(a),
    I.R.C., with respect to the assessment of income tax of
    the partners. The FPAA determined overstatements of
    the bases of partnership interests and certain other
    assets. R asserts that there was a substantial
    omission from gross income because the partnership and
    the partners failed to separately reflect the gain and
    loss from long and short options as required by sec.
    988, I.R.C., and the 6-year period of limitations for a
    substantial omission from gross income under sec.
    6501(e), I.R.C., applies. P asserts that the
    partnership and the partners properly reported the net
    loss from the long and short options and no omission
    occurred. The parties have filed cross-motions for
    summary judgment on the question of the applicability
    of sec. 6501(e), I.R.C.
                               - 2 -

          Held: P’s motion for summary judgment will be
     denied because the partnership and the partners omitted
     gross income by failing to separately compute foreign
     currency gain and loss pursuant to sec. 988, I.R.C.,
     and the 6-year limitations period under sec. 6501(e),
     I.R.C., applies; and R’s FPAA asserts alternative
     theories that would make the sec. 6501(e), I.R.C., 6-
     year limitations period applicable if sustained.

          Held, further, R’s motion for partial summary
     judgment will be denied because the Court will not
     render an opinion whether sec. 6501(e), I.R.C., would
     be applicable under R’s economic substance or sham
     argument if that is the only position R is able to
     sustain, unless such a determination is necessary to
     resolve the case.



     David D. Aughtry and William E. Buchanan, for petitioner.

     William F. Castor, for respondent.



                              OPINION


     GOEKE, Judge:   This case is before the Court on the parties’

cross-motions for summary judgment pursuant to Rule 121.1

Petitioner filed a motion for summary judgment arguing that

respondent failed to issue the FPAA before the expiration of the

3-year limitations period provided in section 6501(a).

Respondent opposes petitioner’s motion and has filed a cross-

motion for partial summary judgment arguing that the 6-year

limitations period for a substantial omission of gross income in


     1
      All Rule references are to the Tax Court Rules of Practice
and Procedure, and all section references are to the Internal
Revenue Code (Code).
                                - 3 -

section 6501(e)(1) applies.    The issues for decision are whether

respondent is foreclosed by the explanations in the FPAA from

asserting the 6-year limitations period under section 6501(e)(1)

and the related issue whether the returns filed with respect to

the partners, the partnership, or a related S corporation,

Highwood Investors, Inc. (Highwood Investors), adequately

disclosed the nature and amount of the omitted gross income.

     We will deny petitioner’s motion because we hold that the

partners’ returns contained a substantial omission from gross

income within the meaning of section 6501(e)(1) as filed and that

none of the relevant returns adequately disclosed the nature or

amount of the omitted income.    Respondent’s partial summary

judgment motion will also be denied without prejudice because

resolution of the issues raised would require a ruling on an

issue that the Court might not otherwise have to reach.

                              Background

     For purposes of the pending motions, we assume the following

facts.   The parties treated Highwood Partners (Highwood) as

having a principal place of business in Virginia for purposes of

appellate venue under the Tax Equity and Fiscal Responsibility

Act of 1982 (TEFRA), Pub. L. 97-248, sec. 402(a), 96 Stat. 648.

     The ultimate taxpayers are Michael and Karen Booth Adams,

Richard and Mary Fowlkes, and the Booth and Adams Irrevocable

Family Trust (the trust).   On November 12, 1999, following the
                                - 4 -

advice of the law firm of Jenkens & Gilchrist, Mrs. Adams, Mrs.

Fowlkes, and the trust (the partners) each formed a single-member

limited-liability company or L.L.C. (collectively, the LLCs).

The LLCs were disregarded entities for Federal income tax

purposes.    On that same date, Mrs. Adams, Mrs. Fowlkes, and the

trust, through their single-member LLCs, formed Highwood and

owned partnership interests of 47.62, 29.76, and 22.62 percent,

respectively.

     On November 22, 1999, each of the LLCs entered into foreign

exchange digital option transactions (FXDOTs) with Deutsche Bank

AG New York branch (Deutsche Bank), in which the LLCs purchased a

30-day European-style digital option spread based on the U.S.

dollar/Japanese yen (USD/JPY) exchange rate.    The parties to a

European-style option can exercise the option only on its

termination date.   A digital option has a predetermined fixed

payout upon the parties’ agreement at the time of the option’s

inception.

     The notional principal amounts, the premiums, and the

contingent payments of the FXDOTs varied among the LLCs.    Through

their respective LLCs, Mrs. Adams, Mrs. Fowlkes, and the trust

entered into FXDOTs with notional principal amounts of $8

million, $5 million, and $3.8 million, respectively.    Through

their respective LLCs, Mrs. Adams, Mrs. Fowlkes, and the trust

paid premiums with respect to the long leg of the FXDOTs of $4
                               - 5 -

million, $2.5 million, and $1.9 million, respectively, and

received premiums with respect to the short leg of the FXDOTs of

$3,960,000, $2,475,000, and $1,881,000, respectively.

     In the long leg of each FXDOT, the LLCs paid an initial

amount in exchange for the right to receive a predetermined,

fixed amount from Deutsche Bank (long option) if the spot rate on

the USD/JPY exchange rate was greater than or equal to ¥107.27 at

10 a.m. New York local time on the termination date.    In the

short leg of each FXDOT the LLCs received an initial amount from

Deutsche Bank in exchange for agreeing to pay a specified, fixed

amount (short option) if the spot rate on the USD/JPY exchange

rate was greater than or equal to ¥107.29 at 10 a.m. New York

local time on the termination date.    The premiums paid by and to

the LLCs, and the contingent payments to be paid to and by the

LLCs, were all denominated in U.S. dollars.   However, whether

payments were required to be made would be determined by

reference to the value of the Japanese yen.

     The parties to the FXDOTs confirmed the terms of each FXDOT

by letters dated November 30, 1999, that both parties to each

FXDOT signed.   The combined premium on the long component of the

FXDOTs was $8,400,000, and the combined premium on the short

component of the FXDOTs was $8,316,000.   The partners, through

their LLCs, paid only the net premium on the FXDOT, the

difference between the premiums on the long and short components.
                               - 6 -

The partners paid a combined net premium of $84,000.   On November

23, 1999, the partners contributed the options, cash, and shares

of Heilig-Meyers Co. (Heilig-Meyers) and Modis Professional

Services, Inc. (Modis) stock to Highwood.   In calculating their

contributions for purposes of determining their outside bases in

Highwood, the partners included the long option premiums of

$8,400,000 unreduced by the short option premiums of $8,316,000.

     On December 22, 1999, the FXDOTs expired unexercised while

held by Highwood.   The next day Mrs. Adams and Mrs. Fowlkes,

through their LLCs, assigned their respective Highwood interests

to a newly incorporated S corporation, Highwood Investors.2     In

determining their outside bases in Highwood, Mrs. Adams and Mrs.

Fowlkes included the premiums on the long options totaling

$6,500,000 unreduced by the premiums on the short options

totaling $6,435,000.   Upon the contribution of their partnership

interests to Highwood Investors, Mrs. Adams’ and Mrs. Fowlkes’

outside bases in Highwood carried over to Highwood Investors

pursuant to section 362(a).

     On or about December 29, 1999, Highwood distributed cash and

the Heilig-Meyers and Modis stock to Highwood Investors and the

trust in full redemption of their partnership interests.

Pursuant to section 732(b), Highwood Investors and the trust



     2
      Mrs. Adams and Mrs. Fowlkes owned 61.54045 and 38.45955
percent of Highwood Investors, respectively.
                               - 7 -

determined their adjusted bases in the distributed property by

reference to their outside bases in Highwood immediately before

the distribution, which they treated as having been increased by

the long option premiums but not reduced by the short option

premiums.   Highwood Investors sold the Heilig-Meyers and Modis

stock on December 30, 1999, at a claimed loss of $6,435,466.

This loss resulted in part from the stepped-up bases under

section 732(b) because Highwood did not reduce the partners’

outside bases by the premiums from the short options.   The pro

rata shares of the losses on the stock sales, $3,960,415 and

$2,307,690, passed through to Mrs. Adams and Mrs. Fowlkes,

respectively.   Likewise, the trust claimed a stepped-up basis in

its shares of the Heilig-Meyers and Modis stock and sold the

stock on December 30, 1999, for a claimed loss of $1,769,353.

     On its Form 1065, U.S. Partnership Return of Income, filed

for the taxable year ended December 28, 1999, Highwood reported

contributions of $8,552,011 without disclosing that the

contributions included the long option premiums of $8,400,000

unreduced by the short option premiums of $8,316,000.   Highwood

also reported a loss of $84,000 realized upon the expiration of

the FXDOTs as “Other income (loss)”.   To determine the $84,000

net loss, Highwood treated the expiration of the long options as

causing the realization of a loss equal to the long option

premiums of $8,400,000 and treated the expiration of the short
                               - 8 -

options as causing the realization of a gain equal to the

premiums of $8,316,000.3   Highwood attached a statement to its

return describing the $84,000 loss as a section 988 loss.

However, Highwood did not disclose that the net loss resulted

from the expiration of the long and short options and did not

separately report the $8,400,000 loss from the long options and

the $8,316,000 gain from the short options.

     Each partner reported a pro rata share of the $84,000 net

loss without disclosing that the loss resulted from the

expiration of the long and short options.   The Adamses’ return

reported the loss as a nonpassive loss from a partnership and

included a statement identifying the loss as a section 988 loss

that passed through from an LLC.   The Fowlkeses included the loss

on their return without identifying the loss as passing through

from an LLC or as a section 988 loss.   The trust reported its

share of the loss as “other income” from an LLC.   None of the

partners reported a gain from the expiration of the short

options.   It is the reporting of the expiration of the long and

short options that is the subject of the controversy before us.


     3
      If a call option expires unexercised, the expiration is
treated as a sale or exchange on the expiration date. Sec.
1234(a)(1) and (2). The holder of the option (i.e., Highwood
with respect to the long leg of the FXDOTs) would realize a loss
upon the expiration in the amount of the premium paid for the
option. Rev. Rul. 78-182, 1978-1 C.B. 265. The obligor of the
option (i.e., Highwood with respect to the short leg of the
FXDOTs) would realize a gain upon the expiration. Sec.
1234(b)(1); Rev. Rul. 78-182, supra.
                               - 9 -

     On its 1999 S corporation return, Highwood Investors

reported a short-term capital loss from the sale of the Heilig-

Meyers stock of $2,996,411 using a sale price of $14,737 and a

cost of $3,011,148.   Highwood Investors reported the acquisition

and sale dates of the Heilig-Meyers stock as December 17 and 30,

1999, respectively.   Highwood Investors reported a long-term

capital loss from the sale of the Modis stock of $3,439,055 using

a sale price of $16,287 and a cost of $3,455,342.   Highwood

Investors reported the acquisition and sale dates of the Modis

stock as September 10, 1998, and December 30, 1999, respectively.

     On their Forms 1040, U.S. Individual Income Tax Return, for

1999, the Adamses and the Fowlkeses reported long-term capital

gains on the sale of stock in IXL Enterprises, Inc. (IXL), of

$2,585,924 and $2,307,690, respectively.   The Adamses’ and the

Fowlkeses’ returns reported passthrough losses from Highwood

Investors to offset the capital gains from the IXL stock.   The

Adamses reported a short-term capital loss of $1,844,005 and a

long-term capital loss of $2,116,410 from Highwood Investors.

The Fowlkeses reported a net short-term capital loss and a net

long-term capital loss from partnerships and other passthrough

entities of $1,152,406 and $1,322,645, respectively.

     On its 1999 Form 1041, U.S. Income Tax Return for Estates

and Trusts, the trust reported a long-term capital gain on the

sale of IXL stock of $1,777,494.   Likewise, the trust offset its
                               - 10 -

gain on the sale of the IXL stock with losses from the sale of

the Heilig-Meyers and Modis stock.      On its 1999 return, the trust

reported a short-term capital loss of $823,794 from the sale of

the Heilig-Meyers stock using a sale price of $4,131 and a cost

of $827,925.    The trust reported the acquisition and sale dates

as December 17 and 30, 1999, respectively.     The trust reported a

long-term capital loss of $945,559 from the sale of the Modis

stock using a sales price of $4,509 and a cost of $950,068.     The

trust reported the Modis stock as a gift and provided only a sale

date of December 30, 1999, not an acquisition date.     On their

1999 returns, the Adamses, the Fowlkeses, and the trust reported

$6,615,451.84, $3,216,290, and $1,777,494 of gross income,

respectively.

     Highwood and the partners timely filed their respective

returns for 1999 on or before April 15, 2000.     On June 19, 2003,

respondent served a “John Doe” summons on Jenkens & Gilchrist

seeking information about taxpayers who participated in listed

transactions.   On May 17, 2004, Jenkens & Gilchrist provided

information in response to the summons, identifying the Adamses,

the Fowlkeses, and the trust as having participated in a listed

transaction.    Respondent issued an FPAA to Highwood on August 30,

2006, after the expiration of the 3-year limitations period on

assessment and collection under section 6501(a) with respect to

the partners but within the 6-year limitations period on
                                - 11 -

assessment and collection under section 6501(e)(1) if that

section applies.4

     In the FPAA respondent adjusted the items on Highwood’s

return to zero, including the $84,000 loss reported as other

income, and asserted various penalties.5    Attached to the FPAA was

a document titled “EXHIBIT A - Explanation of Items”.    The

explanation of items provided numerous alternative arguments in

support of the adjustments made by the FPAA:

     (1)    That neither Highwood nor its partners had established

the existence of Highwood as a matter of fact;

     (2)    that even if Highwood was established as a partnership

in fact, it was formed and availed of solely for purposes of tax

avoidance by artificially overstating its partners’ outside

bases.     As a consequence, the partnership and the options should

be disregarded in full and any losses and basis adjustments

resulting from the options should also be disallowed.    Further,

the partners should be treated as having engaged directly in the




     4
      If sec. 6501(e)(1) applies, the limitations period would be
suspended for a period of 151 days beginning on Dec. 18, 2003 (6
months after service of the John Doe summons), until May 17,
2004, when the information was provided. See sec. 7609(e)(2).
The parties agree that, for purposes of the pending motions, if
sec. 6501(e)(1) applies, then the FPAA was issued while the
period for assessing tax against the partners was open and would
suspend that period under sec. 6229(d).
     5
      The FPAA also adjusted to zero an $80,000 deduction related
to portfolio income, capital contributions, and distributions.
                              - 12 -

option transactions as though no options were contributed to or

assumed by Highwood;

     (3)   that Highwood was a sham and availed of in connection

with a transaction inconsistent with the intent of subchapter K

of the Code;

     (4)   that the short options should have been treated as

liabilities under section 1.752-6, Income Tax Regs., and reduced

the partners’ bases in Highwood accordingly;

     (5)   that the purchased options claimed to have been

contributed to Highwood and the written options claimed to have

been assumed by Highwood were in substance a single integrated

financial transaction, and, pursuant to section 1.988-2(f),

Income Tax Regs., should be recharacterized as a single

integrated financial transaction to correspond with its

substance.   A result of this recharacterization would be that any

basis in Highwood that was derived from the option spreads would

be limited to the net of any premiums paid for the purchased

options and any premiums received for the written options;

     (6)   that the partners were not entitled to deduct losses

related to Highwood because the partners did not establish that

the partners had any at-risk amounts within the meaning of

section 465 that would allow them a deduction;

     (7)   that even if the FXDOTs were treated as contributed to

Highwood, the amount contributed, i.e., the premium paid for the
                                - 13 -

long option, should be reduced by the amount received, i.e., the

premium on the sale of the short option.

      The FPAA also explained the disallowance of a claimed

deduction for interest income and explained the reasoning behind

the imposition of alternative penalties under section 6662.

                            Discussion

      Respondent argues that petitioner’s motion should be denied

and respondent’s motion granted because Highwood’s and the

partners’ failure to report the $8,316,000 gain realized on the

expiration of the short options constitutes an omission of gross

income under section 6501(e).    Petitioner argues that its motion

should be granted on the ground that neither Highwood nor its

partners omitted any income because the expiration of the long

and short options resulted in an $84,000 net loss.    If Highwood

had reported the expiration of the short and long options as

separate taxable events, the options would have resulted in

income of $8,316,000 from the expiration of the short options and

a loss of $8,400,000 from the expiration of the long options.

I.   Summary Judgment

      Summary judgment is intended to expedite litigation and

avoid unnecessary and expensive trials.     Fla. Peach Corp. v.

Commissioner, 

, 681 (1988).     Summary judgment may be

granted where there is no genuine issue of any material fact and

a decision may be rendered as a matter of law.    Rule 121(a) and
                               - 14 -

(b); Sundstrand Corp. v. Commissioner, 

, 520 (1992),

affd. 

(7th Cir. 1994).      The moving party bears the

burden of proving that there is no genuine issue of material

fact, and factual inferences are drawn in a manner most favorable

to the party opposing summary judgment.      Dahlstrom v.

Commissioner, 

, 821 (1985).

II.    Section 6501 Burden of Proof

       The bar of the statute of limitations is an affirmative

defense, and petitioner bears the burden of proof.      See Rules 39,

142(a); Hoffman v. Commissioner, 

, 146 (2002).        We

find that petitioner has established a prima facie case that the

3-year period of limitations has expired.      Accordingly, the

burden of going forward shifts to respondent to produce evidence

that there was a greater than 25 percent omission of gross income

on each partner’s or the partnership’s return.      See Hoffman v.

at 146.    If respondent makes this showing,

the burden of going forward with the evidence shifts back to

petitioner to establish that the returns disclosed the omitted

income “in a manner adequate to apprise the Secretary of the

nature and amount of such item.”      See sec. 6501(e)(1)(A)(ii);

Hoffman v. 

at 147.

III.    Sections 6501 and 6229 in General

       Under the general rule set forth in section 6501(a), the

Internal Revenue Service (IRS) is required to assess tax (or send
                               - 15 -

a notice of deficiency) within 3 years after a return is filed.

Section 6501(e)(1) provides an exception to the general rule:

the IRS may assess tax within 6 years after a return is filed “If

the taxpayer omits from gross income an amount properly

includible therein which is in excess of 25 percent of the amount

of gross income stated in the return”.

     For purposes of section 6501, the term “return” means the

return that a taxpayer is required to file and does not include a

return of a person, such as a partnership, from which the

taxpayer has received an item of income, gain, loss, deduction,

or credit.   Sec. 6501(a).   Section 6229 sets forth special rules

to extend the period of limitations described by section 6501

with respect to partnership items or affected items.    Section

6229(a) provides that, except as otherwise provided, the period

for assessing any income tax against a person that is

attributable to a partnership item or an affected item shall not

expire before the date that is 3 years after the later of the

date that the partnership return is filed or the last day for

filing the return.   However, section 6229(c)(2) provides that if

any partnership omits from gross income an amount properly

includable therein that is in excess of 25 percent of the amount

of gross income stated in its return, the period described in

section 6229(a) is extended to 6 years.
                             - 16 -

     Section 6229 does not create a completely separate statute

of limitations for assessments attributable to partnership items

but merely supplements section 6501.   Bakersfield Energy

Partners, LP v. Commissioner, 

, 211 (2007), affd. 

(9th Cir. 2009); Rhone-Poulenc Surfactants &

Specialties, L.P. v. Commissioner, 

, 545 (2000).

Section 6229 may provide a longer period of limitations than

would otherwise apply under section 6501 if a partnership files

its return after the partners file their returns and will extend

the period of limitations to 6 years if the partnership omits a

substantial amount of income regardless of whether section

6501(e)(1) applies.

     In Rhone-Poulenc Surfactants & Specialties, L.P. v.

at 534-535, the Court stated:

          The Internal Revenue Code prescribes no period
     during which TEFRA partnership-level proceedings, which
     begin with the mailing of the notice of final
     partnership administrative adjustment, must be
     commenced. However, if partnership-level proceedings
     are commenced after the time for assessing tax against
     the partners has expired, the proceedings will be of no
     avail because the expiration of the period for
     assessing tax against the partners, if properly raised,
     will bar any assessments attributable to partnership
     items.

Accordingly, while the period for assessing partnership items is

ordinarily governed by each partner’s separate period for

assessment, the Court will not consider adjustments made in an

FPAA if the FPAA has been issued after the time for assessing tax
                              - 17 -

against all of the partners has expired.    

  Section

6229(d) provides that if an FPAA is issued with respect to a

taxable year, the period for assessing tax under section 6229(a)

(as modified by other provisions such as section 6229(c)(2)) is

suspended for the period during which an action may be brought

under section 6226 and, if a petition is filed with respect to

the FPAA, until the decision of the court becomes final, plus 1

year thereafter.   Accordingly, the issue we must decide is

whether the FPAA was issued while the time for assessing taxes

against any of the partners was still open.   See Bakersfield

Energy Partners, LP v. 

at 212.

IV.   Analysis

      A.   Omission From Gross Income Upon the Expiration of the
           Short Option

      Respondent alleges that the deficiency arises from the

partners’ artificially overstated outside bases in their Highwood

partnership interests which the partners shifted to the Heilig-

Meyers and Modis stock.   For purposes of the 6-year period of

limitations, respondent contends that the partners omitted income

arising upon the expiration of the short options, which

constitutes a “substantial omission of gross income” under

section 6501(e)(1).   The FPAA did not make an adjustment with

respect to income from the short options.   Petitioner contends

that Highwood reported the income from the short options because

it reported the $84,000 net loss on the offsetting options.
                                - 18 -

     Although not based on income from the options, the

deficiency determination is related to the options because the

offsetting options were a crucial component of the partners’

alleged tax-avoidance scheme.    The partners contributed the

options along with the Heilig-Meyers and Modis stock to the newly

formed partnership.    According to respondent, the partners

claimed artificially inflated outside bases in their Highwood

interests by using the long options to increase their outside

bases and treating the short options as contingent obligations

that did not reduce their outside bases under section 752.

Within a period of less than 2 months, the options expired

unexercised, Highwood redistributed the Heilig-Meyers and Modis

stock, and the partners shifted the artificially inflated outside

bases to the stock.    The partners then sold the stock to generate

large capital losses based on the inflated bases.    Respondent

alleges that the partners created the partnership and

artificially inflated the bases in the Heilig-Meyers and Modis

stock for the purpose of offsetting significant capital gains

from the partners’ sales of IXL stock.

     Section 6501(e)(1) applies when a taxpayer omits from gross

income an “amount properly includible therein”.   Section

6501(e)(1) does not define the term “gross income” for nontrade or

nonbusiness sales.    Gross income has the same meaning in sections

61 and 6501(a).   Hoffman v. 

at 148.    Although
                               - 19 -

the FPAA determined overstated bases for the partnership

interests, neither party contends that Colony v. Commissioner, 

(1958), and Bakersfield Energy Partners, L.P. v.

, control the outcome of this case.     Rather,

the parties focus on whether Highwood and the partners properly

reported the offsetting options as a net loss.

     The term “omission” means that a specific receipt or income

item is left out of gross income.   Colony v. 

at 32; see Bakersfield Energy Partners, L.P. v. 

at 213.   The fact that Highwood accurately calculated the

amount of the net loss arising from the offsetting options does

not preclude the application of the 6-year limitations period if

Highwood or the partners were required to compute and report any

gain from the short options separately from any loss from the long

options.

     Respondent contends that section 988 and the regulations

thereunder required Highwood and the partners to separately state

the gain upon the expiration of the short options from the loss

upon the expiration of the long options.   Section 988 prescribes

special rules for the treatment of gains and losses from

transactions that are denominated in a currency other than the

taxpayer’s functional currency or that are determined by reference

to the value of one or more nonfunctional currencies (foreign

currency gain or loss).   Sec. 988(c)(1)(A).   A section 988
                                 - 20 -

transaction includes “Entering into or acquiring any forward

contract, futures contract, option, or similar financial

instrument” where the amount that the taxpayer is entitled to

receive or is required to pay is based on nonfunctional currency.

Sec. 988(c); sec. 1.988-1(a)(1), Income Tax Regs.    Because the

payments to be made were determined by reference to a foreign

currency, section 988 applies to Highwood and the partners’

reporting of the long and short options.

     B.     Definition and Computation of Foreign Currency Gain or
            Loss

     Section 988(a)(1)(A) requires taxpayers to compute separately

any foreign currency gain or loss attributable to a section 988

transaction and to treat the foreign currency gain or loss as

ordinary income or loss.    Foreign currency gain or loss is

generally defined as any gain or loss from a section 988

transaction to the extent the gain or loss does not exceed the

gain or loss realized by reason of changes in exchange rates.

Sec. 988(b)(1) and (2).    Only the gain or loss due to exchange

rate fluctuations is generally treated as foreign currency gain or

loss.     Taxpayers must separately compute foreign currency gain or

loss from the gain or loss on the underlying substantive

transaction, i.e., the fluctuation in the fair market value of the

underlying property, unless an exception applies.

     In general any gain or loss from entering into or acquiring a

forward contract, futures contract, option, or similar financial
                               - 21 -

instrument is treated as foreign currency gain or loss if the

instrument is denominated in a nonfunctional currency.    Sec.

988(b)(3); sec. 1.988-1(a)(2)(iii)(A), Income Tax Regs.    The term

“similar financial instrument” includes a notional principal

contract if the payments required to be made or received under the

contract are determined by reference to a nonfunctional currency.

Sec. 1.988-1(a)(2)(iii)(B)(1), Income Tax Regs.   A notional

principal contract is a contract that provides for the payment of

amounts by one party to another at specified intervals calculated

by reference to a specified index upon a notional principal amount

in exchange for specified consideration or a promise to pay

similar amounts.   Sec. 1.988-1(a)(2)(iii)(B)(2), Income Tax Regs.;

see also sec. 1.446-3(c)(1), Income Tax Regs.   The FXDOTs qualify

as section 988 transactions because whether payments had to be

made was determined by reference to a nonfunctional currency, the

Japanese yen.

     Section 1.988-2, Income Tax Regs., provides rules for

recognizing and computing foreign currency gain or loss from a

section 988 transaction.6   Section 1.988-2(d), Income Tax Regs.,

provides a computational provision for foreign currency

derivatives including forward contracts, futures contracts, and

option contracts governed by section 988(b)(3).   Sec. 1.988-



     6
      The regulations refer to foreign currency gain or loss as
“exchange gain or loss”.
                               - 22 -

2(d)(1)(i), Income Tax Regs.   Section 1.988-2(d)(4)(i), Income Tax

Regs., provides:

           (4) Determination of exchange gain or loss--(i) In
     general. Exchange gain or loss with respect to a contract
     described in § 1.988-2(d)(1) [i.e., foreign currency forward
     contracts, futures contracts, and options] shall be
     determined by subtracting the amount paid (or deemed paid),
     if any, for or with respect to the contract (including any
     amount paid upon termination of the contract) from the amount
     received (or deemed received), if any, for or with respect to
     the contract (including any amount received upon termination
     of the contract). Any gain or loss determined according to
     the preceding sentence shall be treated as exchange gain or
     loss.

Under the computation provisions of section 1.988-2(d), Income Tax

Regs., foreign currency gain or loss on an option includes both

the gain or loss upon the exercise or expiration of the option and

the premium paid or received on the option.   See sec. 1.988-

2(d)(4), Example (3), Income Tax Regs.   Section 1.988-2(d), Income

Tax Regs., does not apply to section 988 notional principal

contracts even though they qualify as financial instruments

governed by the section 988(b)(3) definition of foreign currency

gain or loss.   Section 1.988-2(e)(1), Income Tax Regs., applies to

section 988 notional principal contracts defined in section 1.988-

1(a)(1)(ii) and (2)(iii), Income Tax Regs.    Sec. 1.988-2(d)(1)(i),

Income Tax Regs.   In general section 446 and the regulations

thereunder govern the timing and computation of income, deduction,

and loss with respect to a notional principal contract that is a

section 988 transaction.   Sec. 1.988-2(e)(1), Income Tax Regs.

However, section 1.988-2(e)(1), Income Tax Regs., does provide
                              - 23 -

that such income, deduction, or loss shall be treated as exchange

gain or loss.

     C.   Reporting of a Section 988 Transaction

     Section 1.988-1(e), Income Tax Regs., defines foreign

currency gain or loss as the amount of gain or loss realized on a

section 988 transaction as determined by the computational

provisions of section 1.988-2, Income Tax Regs.    Section 1.988-

1(e), Income Tax Regs., adds a further requirement that taxpayers

compute foreign currency gain or loss separately for each section

988 transaction and prohibits taxpayers from integrating the

foreign currency gain or loss among section 988 transactions even

where the transactions are economically related.   Section 1.988-

1(e), Income Tax Regs., provides:

     Except as otherwise provided in these regulations (e.g.
     § 1.988-5), the amount of exchange gain or loss from a
     section 988 transaction shall be separately computed for
     each section 988 transaction, and such amount shall not
     be integrated with gain or loss recognized on another
     transaction (whether or not such transaction is
     economically related to the section 988 transaction).
     * * *

The regulations specifically require taxpayers to separately

compute and report the amount of foreign currency gain or loss

realized on each section 988 transaction.   See T.D. 8400, 1992-1

C.B. 101, 102 (amending the regulation to clarify that the foreign

currency gain or loss from a section 988 transaction must be

separately computed for each section 988 transaction).   The

regulations prohibit taxpayers from netting foreign currency gains
                                - 24 -

or losses among section 988 transactions unless an exception

applies.

     Respondent argues that Highwood and the partners improperly

netted the foreign currency gain and loss on the offsetting long

and short options.   Respondent argues that section 1.988-1(e),

Income Tax Regs., requires Highwood and the partners to separately

report the gain arising upon the expiration of the short options

and to separately report the loss arising upon the expiration of

the long options.    Under respondent’s theory, the short leg of the

FXDOT is a section 988 transaction, and the long leg is a separate

section 988 transaction.   Respondent asserts that Highwood and the

partners’ failure to separately report the gain from the short

options is an omission from gross income for purposes of section

6501(e).

     Petitioner acknowledges that section 1.988-1(e), Income Tax

Regs., provides a general rule for the separate computation of

foreign currency gain and loss for each section 988 transaction

subject to certain enumerated exceptions provided in the

regulations.   However, petitioner argues that the application of

section 1.988-1(e), Income Tax Regs., to the FXDOT does not

require the separate reporting of the gain from the short options

and the loss from the long options because each pair of long and

short options in the FXDOT is a single section 988 transaction.

According to petitioner, since each pair is a single section 988
                                 - 25 -

transaction, netting of the gain and loss upon the expiration of

the long and short options is permitted under section 988.   In the

alternative, petitioner argues that respondent’s FPAA

determination to recharacterize the substance of the long and

short legs of each FXDOT as a “single integrated financial

transaction” under section 1.988-2(f), Income Tax Regs., is an

exception to the separate reporting requirement of section 1.988-

1(e), Income Tax Regs.   We must decide whether the offsetting long

and short options constitute separate section 988 transactions.

     Petitioner argues that each FXDOT consisting of an offsetting

pair of long and short options is a single section 988 transaction

because the same parties executed the options on a single contract

on the same date with one set of signatures.   In support of this

contention petitioner offered letter agreements executed more than

1 week after the parties entered the FXDOT by telephone that

evidence the terms of a single pair of long and short options.

The postdated letters do not persuade us that the long and short

options are a single contract.    Rather, we find that the long and

short options are separate and distinct financial instruments for

purposes of section 988.

     Highwood and the partners treated the long and short options

as separate financial instruments with independent tax

significance for purposes of the basis computation of the Highwood

partnership interests.   As Highwood and the partners intended for
                                - 26 -

the long and short options to have separate tax significance,

Highwood and the partners should be held to their treatment of the

long and short options as separate financial instruments for

reporting purposes as required by section 988.     The expirations of

the long and short options are separate realization and

recognition events that each require the determination of gain or

loss.   That the parties purported to execute the long and short

options on a single contract does not control the determination

under section 988 of whether the options are separate section 988

transactions.    Similarly, the fact that the options had the same

trade and termination dates or involved the same currencies is not

determinative.   The long and short options were priced separately.

Whether the LLCs or Deutsche Bank was required to make payments to

the other under either the long or the short option would be

determined by reference to the separate contract.     For example,

the determination whether the LLCs were required to make payments

to Deutsche Bank under the short option would be determined by

reference to the short option only.      The same is true of the long

option.   Whether Deutsche Bank would have to make payments to the

LLCs under the long option would be determined solely by reference

to the long option.   The short option would not affect any

payments made by Deutsche Bank to the LLCs, and the long option

would not affect any payments made by the LLCs to Deutsche Bank.

The regulations expressly require separate reporting of individual
                                - 27 -

section 988 transactions even where the transactions are

economically related.   Sec. 1.988-1(e), Income Tax Regs.

Pursuant to section 1.988-1(e), Income Tax Regs., Highwood and the

partners were required to compute and report the gain on each

short option separately from the loss on each long option.

Highwood and the partners’ netting of the gain and loss from the

long and short options was improper under section 988.    By netting

the gain and loss from the long and short options, Highwood and

the partners omitted a specific income item the Code required them

to report.   As discussed above, the long and short options are

separate financial instruments, not two sides of a single

contract.    Accordingly, section 1.988-2(d)(4)(i), Income Tax

Regs., does not apply in the instant case.

     As an alternative argument, assuming the long and short

components of the FXDOTs constitute separate section 988

transactions, petitioner contends that respondent’s alternative

FPAA determination to recharacterize the long and short options as

“a single integrated financial transaction” under section 1.988-

2(f), Income Tax Regs., renders the long and short options a

single section 988 transaction.    As an alternative position in the

FPAA, respondent determined that the long and short options were

in substance a single integrated financial transaction pursuant to

section 1.988-2(f), Income Tax Regs.     Section 1.988-2(f), Income

Tax Regs., grants the Commissioner the authority to recharacterize
                               - 28 -

the form of a section 988 transaction in accordance with its

substance.7   The regulation specifically provides that “In

applying the substance over form principle, separate transactions

may be integrated where appropriate.”   

that section 1.988-1(e), Income Tax Regs.,

expressly recognizes that exceptions to the separate reporting

rule exist and that section 1.988-2(f), Income Tax Regs., creates

an exception.   Under the single transaction theory, respondent

determined that any outside basis derived from the options is

limited to the net of the premiums paid for the long options and

the premiums received for the short options.   This determination

is an alternative means for denying the partners an increase in

their outside bases for the premiums from the long options

unreduced by the premiums from the short options. Petitioner

characterizes this alternative determination as a concession by

respondent.   Petitioner contends that netting the gain and loss

from the options is proper under respondent’s single transaction

theory.   Petitioner argues that Highwood and the partners realized

a net loss on the single integrated financial transaction and thus

Highwood and the partners could not have omitted any income.




     7
      Sec. 1.988-1(a)(11), Income Tax Regs., grants the
Commissioner the authority to recharacterize a transaction or a
series of transactions in whole or in part as a sec. 988
transaction if the effect of the transaction or the series of
transactions is to avoid sec. 988.
                                   - 29 -

     Respondent’s single integrated financial transaction

determination is not a concession that netting is proper or that

Highwood and the partners did not omit income from the short

options.       Rather, it is merely one of several alternative theories

to support respondent’s determination.      By relying on one of

respondent’s numerous determinations in the FPAA, petitioner seeks

to obtain integrated treatment of the long and short options for

which it would not otherwise qualify.       Section 1.988-2(f), Income

Tax Regs., grants the Commissioner the right to integrate separate

section 988 transactions for the purpose of preventing tax abuse.

Taxpayers are entitled to integrate section 988 hedging

transactions under section 988(d) and section 1.988-5, Income Tax

Regs.       Petitioner does not contend that Highwood or the partners

qualify for this limited exception.8

     We hold, assuming for purposes of petitioner’s motion the

fact of the legitimacy of the partnership and its transactions,

that section 988 requires the partners to separately compute and

report gain and loss from separate section 988 transactions, that

the long and short options are separate section 988 transactions,

and that Highwood and the partners’ failure to separately compute


        8
      Sec. 988(d) provides integrated treatment for sec. 988
hedging transactions entered into for the purpose of managing
risk from currency fluctuations with respect to property or
borrowings or obligations held or incurred by the taxpayer. Sec.
988(d)(2)(B) allows taxpayers to identify and integrate
qualifying sec. 988 hedging transactions under a strict set of
identification rules.
                               - 30 -

and report the gain from the short options is an omission from

gross income under section 6501(e).     We hold that Highwood omitted

from gross income gain of $8,316,000 from the expiration of the

short options by netting the gain and loss from the long and short

options.   The Adamses, the Fowlkeses, and the trust omitted gain

from the expiration of the short options of $3,960,000,

$2,475,000, and $1,881,000, respectively.    These amounts

constitute substantial omissions under section 6501(e).      Because

the partners omitted a specific income item the Code required them

to report, petitioner’s motion for summary judgment will be

denied.

     D.    Respondent’s Determinations in the FPAA

     Petitioner points out that the FPAA did not make a

determination with respect to omitted income from the short

options.   Petitioner argues that respondent’s determinations in

the FPAA should limit the application of the 6-year period of

limitations.   Specifically, petitioner contends that respondent’s

omitted income argument directly contradicts the FPAA

determination that the options should be disregarded in full.     In

the FPAA respondent determined that the long and short options

should be disregarded and also disallowed the basis increases

resulting from the contribution of the long options to the

partnership.   Petitioner argues that disregarded transactions

produce no omission from gross income at the partnership level.
                                 - 31 -

     The issue for purposes of section 6501(e)(1) is whether there

was an omission from gross income.    Not all of respondent’s

determinations in the FPAA preclude the Court from considering

whether the partners were required to separately compute and

report the gain and loss from the long and short options under

section 988 on the partnership return or whether the failure to do

so is an omission from gross income under section 6501(e)(1).

Therefore, petitioner’s motion for summary judgment that the 3-

year period of limitations applies must be denied for the reasons

stated above.   However, petitioner’s contention concerning the

inconsistency in respondent’s arguments requires us to deny

respondent’s motion as well.   Some of the alternative arguments

asserted by respondent serve to keep the 6-year period of

limitations on assessment open.    However, it is not clear that the

6-year period would apply were respondent to argue, and convince

this Court, that Highwood was a sham and that the FXDOTs lacked

economic substance.   Neither petitioner nor respondent have argued

how the 6-year period of limitations on assessment would apply

were we to ultimately decide this case by disregarding the FXDOTs

as lacking economic substance.    Neither party has pointed to any

authority explaining how the 6-year period of limitations is

affected if the reporting of a transaction at the partnership

level is ultimately found to be lacking economic substance.     We

are not holding that the 6-year period of limitations would not
                                  - 32 -

apply were we to uphold respondent’s determinations on the theory

that the transaction was a sham, only that we are not deciding

that question in the context of respondent’s motion for summary

judgment.

     Because neither party has cited any authority that would

establish how the 6-year period would apply to all of the

alternative arguments in the explanation of adjustments, we choose

not to entertain the question of the proper application of section

6501(e) to each of respondent’s distinct theories.    We likewise do

not consider arguments not yet addressed by the parties.

Accordingly, respondent’s motion for partial summary judgment will

be denied.

     E.     Adequate Disclosure

     Although it was not specifically raised by petitioner in

opposition to respondent’s motion for partial summary judgment, we

consider whether Highwood or the partners adequately disclosed the

nature and amount of the gain from the short options.   Section

6501(e)(1)(A)(ii) provides that any amount disclosed “in the

return, or in a statement attached to the return, in a manner

adequate to apprise the Secretary of the nature and amount of such

item” shall not be considered omitted gross income.

     Adequate disclosure is a factual question.   Whitesell v.

Commissioner, 

, 707-708 (1988).   Petitioner bears the

burden of proving that the nature and amount of the omitted income
                                    - 33 -

were adequately disclosed.        Univ. Country Club, Inc. v.

Commissioner, 

, 468 (1975).       Respondent accepts that

the Court should consider the partners’ individual returns as well

as the returns of the passthrough entities--Highwood and the

LLCs.9       See Hoffman v. Commissioner, 

; Robinson v.

Commissioner, 

, 317 (2001); Benson v. Commissioner,

T.C. Memo. 2006-55, affd. 

(9th Cir. 2009).

     For a disclosure to be adequate, it “must be sufficiently

detailed to alert the Commissioner and his agents as to the nature

of the transaction so that the decision as to whether to select

the return for audit may be a reasonably informed one.”         Estate of

Fry v. Commissioner, 

, 1023 (1987).       The disclosure

must be more substantial than providing a clue that would intrigue

the likes of Sherlock Holmes but need not recite every underlying

fact.        Quick Trust v. Commissioner, 

, 1347 (1970),

affd. 

(8th Cir. 1971).       The adequacy of a disclosure


         9
      Respondent accepts as controlling caselaw applicable to tax
years before the 1997 amendment to sec. 6501(a) that held that
when an individual return contains references to a passthrough
entity, the return of the passthrough entity is also considered
to determine whether there was adequate disclosure of the omitted
gross income. The 1997 amendment to sec. 6501(a) added that “the
term ‘return’ means the return required to be filed by the
taxpayer (and does not include a return of any person from whom
the taxpayer has received an item of income, gain, loss,
deduction, or credit).” Taxpayer Relief Act of 1997, Pub. L.
105-34, sec. 1284, 111 Stat. 1038. The 1997 amendment has been
held not to have changed the law with respect to which returns
are considered for purposes of adequate disclosure. Salman
Ranch, Ltd. v. United States, 

(2007), revd. on
other grounds ____ F.3d ___ (Fed. Cir., July 30, 2009).
                                - 34 -

is judged by a reasonable person standard:   whether the omitted

gross income would be apparent from the face of the return to the

“reasonable man”.    Univ. Country Club, Inc. v. 

at 471.    The standard for adequate disclosure does not require the

Commissioner to engage in a thorough examination of the return to

ascertain whether there is omitted gross income.   A misleading

statement on a return is not sufficient to apprise the

Commissioner of the nature and amount of an omitted item.    Estate

of Fry v. 

at 1023; CC&F W. Operations Ltd.

Pship. v. Commissioner, T.C. Memo. 2000-286, affd. 

(1st Cir. 2001).

     Highwood and the partners omitted gross income by their

failure to separately state the gain from the expiration of the

short options as section 988 requires.   According to respondent,

the partners engaged in a series of complicated transactions to

artificially inflate their respective bases in their Heilig-Meyers

and Modis stock to generate large noneconomic losses that they

used to offset significant capital gains on the sale of their IXL

stock.    Respondent alleges that the partnership was created for

the sole purpose of holding the options and the Heilig-Meyers and

Modis stock so that the partners could claim artificially inflated

bases for the redistributed stock.

     The short options were an essential part of the partners’

tax-avoidance scheme.   The partners used the short options to
                                - 35 -

avoid payment of the large premiums on the long options and at the

same time used the premiums from the long options to increase

their outside bases in Highwood to justify Highwood’s reporting

contributions to it of over $8.5 million.   However, Highwood did

not disclose that the contributions primarily included the

premiums for the long options or that the partners never paid the

stated premiums for the long options for which they claimed

increased outside bases because the partners paid only the net

premiums from the long and short options.

     In an attempt to disguise the purpose of the partnership and

the option transactions, Highwood and the partners reported a net

loss on the offsetting options rather than separately computing

gain and loss for each section 988 transaction as required by

section 988.    Highwood and the partners netted the gain and loss

from the long and short options to conceal the fact that the

partners contributed both long and short options to the

partnership and to conceal the fact that Highwood increased the

partners’ outside bases by the premiums on the long options

unreduced by the premiums on the short options.   Reporting the

offsetting options as a net section 988 loss is misleading and is

not adequate disclosure of the nature, amount, or existence of the

gain from the short options to apprise respondent of the omitted

gross income.   Highwood’s, Highwood’s investors’, and the

partners’ returns all failed to disclose that this loss resulted
                                 - 36 -

from the expiration of the long and short options.   There was no

indication on the returns that the partners contributed either

long or short options to Highwood or that the partners determined

their outside bases by reference to the unpaid premiums from the

long options.

     Highwood and the partners used this deceptive reporting

method to conceal how the partners calculated their bases for the

Heilig-Meyers and Modis stock.    The returns did not disclose that

the partners contributed the Heilig-Meyers and Modis stock to

Highwood or that Highwood redistributed the stock to the partners

less than 2 months later to create a step-up in basis of $8.4

million.   None of the returns disclosed that the claimed bases of

the Heilig-Meyers and Modis stock were derived from the long

options.

     Highwood’s return failed to mention the contributions of the

short options or the gains realized upon their expiration.

Highwood netted the gains and losses from the offsetting options

to conceal the contributions of the options.   A review of

Highwood’s, the Highwood investors’, and the partners’ returns did

not reasonably allow respondent to identify the omitted gains.

Accordingly, the safe harbor for adequate disclosure of omitted

income under section 6501(e)(1)(A)(ii) does not apply.
                            - 37 -

To reflect the foregoing,


                                     An order will be issued

                                denying petitioner’s motion

                                for summary judgment and

                                denying respondent’s cross-

                                motion for partial summary

                                judgment.