T.C. Memo. 2013-49



                         UNITED STATES TAX COURT



    6611, LTD., RICARDO GARCIA, TAX MATTERS PARTNER, ET AL.,1
    Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos. 13088-05, 13250-05,             Filed February 14, 2013.
                  13251-05.



      William A. Roberts and Kyle R. Coleman, for petitioners.

      Jeffrey Louis Bassin, Richard Hassebrock, Donna Leone, and Gary Shuler,

for respondent.




      1
        Although we did not consolidate these cases for trial, much of the testimony
and many of the exhibits were common to all three. In an order dated January 3,
2013, we consolidated 541, Ltd., Roberto Salazar, Tax Matters Partner, docket No.
13250-05, and 466, Ltd., Larry Lawrence, Tax Matters Partner, docket No. 13251-
05, with the lead case for purposes of opinion.
                                          -2-

[*2]           MEMORANDUM FINDINGS OF FACT AND OPINION


       HOLMES, Judge: Three personal-injury lawyers from the Rio

Grande Valley in Texas hit the jackpot in 2001 when each got paid over $1

million for their work in cases involving faulty Firestone tires. Each tried to reduce

his tax bill with a complicated transaction that featured almost perfectly offsetting

bets on foreign currency. Each of these lawyers was in the business

of estimating risk and reward in evaluating every case he considered, but in this

instance each sought refuge in a tax shelter whose builders used flawed designs and

constructed it from bad materials that do not survive close inspection.

                                    FINDINGS OF FACT

I.     Three Valley Lawyers

       A.      Life in the Valley

       “The Valley” is the four-county southernmost part of Texas just north of the

Rio Grande. It is still mostly farm and ranch land, and has shared only to a modest

extent the benefits of the strong economy in other parts of Texas. One result is that

some of the local legal elite--clustered in McAllen--are unusually tight-knit. The

main actors in these cases--the tax matters partners (TMPs)2 Larry Lawrence,

       2
           Under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Pub.
                                                                        (continued...)
                                          -3-

[*3] Roberto Salazar, and Ricardo Garcia--were all at one time from that city.

Salazar and Garcia are longtime friends and have worked together on several cases.

And Lawrence met Garcia through a mutual friend, Jamie Gonzalez--another

personal-injury attorney in the Valley.

      B.     The Three Lawyers

             1.     Larry Lawrence

      Larry Lawrence grew up in the Valley but moved away for college. He

earned his bachelor’s degree in economics from the University of Texas in Austin in

1992. He went to Loyola University Law School in New Orleans, where he took

one basic tax course and graduated in 1995.

      He moved back to the Valley that year and has practiced law ever since. He

first joined the firm of Dale & Klein, LLP--doing mostly personal-injury, family,

and insurance-defense work. Lawrence had been at Dale & Klein for only about

two years when he met Jaime Gonzalez--one of the Valley’s most respected

personal-injury attorneys. In January 1998 Gonzalez recruited Lawrence to join


      2
       (...continued)
L. No. 97-248, sec. 402(a), 96 Stat. at 648, any “partnership,” including all the
partnerships that brought these cases, must designate one of its partners as the tax
matters partner (TMP) to handle its administrative issues with the Commissioner
and manage any resulting litigation. Sec. 6231(a)(7). (Unless we say otherwise, all
section references are to the Internal Revenue Code in effect for the year in issue.)
                                         -4-

[*4] his firm, and Lawrence started working on products-liability and serious-

accident cases. It wasn’t long after that when Lawrence decided he wanted to

have a bigger stake in the cases he was working on. Gonzalez wasn’t ready to

give him that opportunity, so Lawrence started his own firm in January 1999.

Their split was amicable, and they have maintained a close professional and

personal relationship ever since.

      In his new firm Lawrence chose to focus his practice on personal-injury

work with clients paying him on a contingency-fee basis. Contingency-fee

practices have irregular cashflows, and can require large amounts of upfront

money that might not return, if ever, until years later. In 1999 and 2000 Lawrence

put most of his money into his practice, although he was able to set some aside in

stocks and bonds. By 2000 Lawrence’s law practice was doing pretty well: He

reported more than $150,000 in income from his firm for that year. But the

growth of his firm made his tax returns more complicated. So in 2000 he hired

David Drefke, a Texas CPA. Drefke had Lawrence make an election to treat his

firm as an S corporation,3 and Drefke prepared the initial S corporation tax return,

      3
        If a business meets the requirements of section 1361, it may elect to become
an “S corporation” and pay no corporate tax. Secs. 1362(a), 1363(a); sec. 1.1361-
1(b)(1), Income Tax Regs. An S corporation’s income and losses, like a
partnership’s, flow through to its shareholders, who then pay income tax. See sec.
                                                                        (continued...)
                                        -5-

[*5] Form 1120S, U.S. Income Tax Return for an S Corporation, in 2000. (The

Lawrences, however, didn’t make any estimated tax payments for 2000.)

      Drefke also helped the Lawrences set up the firm’s recordkeeping system and

had them use Quicken accounting software. But Drefke worked mostly with

Lawrence’s wife in preparing the Lawrences’ 2000 returns because it was she who

compiled the information for Drefke to prepare the returns. Lawrence, however,

performed all the “day-to-day mechanics” of bookkeeping, and made all the

investment decisions for his family and for his firm. According to Lawrence, he

“work[s] at making the living, and she works at making the living worthwhile.”

            2.     Roberto Salazar

      Roberto Salazar was the first in his family to attend college, and he graduated

from the University of Illinois with a J.D./M.B.A in 1983. While in school, Salazar

took some general finance and accounting courses and a basic tax class.

      After law school, Salazar moved to the Valley--his parents bought a house

there, and he found a job there too. He passed the Texas bar in 1983 and went to

work for an attorney in Alamo, Texas, mostly doing personal-injury work. He




      3
      (...continued)
1363(b).
                                          -6-

[*6] later moved to the Hidalgo County District Attorney’s Office, and then after

four years there (leaving in 1988), he opened his own practice in personal-injury and

criminal law.

      In the early ‘90s, Salazar became a municipal judge for the City of McAllen,

but the position was part time and he continued his private practice, which focused

on personal-injury law. Salazar has never worked on any tax cases, set up a

corporation, drafted a trust, or issued an opinion letter.

      For 2000 Salazar prepared his own federal income tax returns using

TurboTax software. He did, however, have his accountant review the returns and

give him a “stamp of approval” before he filed them. Salazar earned about

$200,000 of ordinary income from his law practice for 2000. His wife worked

primarily inside the home, but would occasionally act as the receptionist at Salazar’s

law office. Salazar himself, however, made the family’s investment decisions.

             3.     Ricardo Garcia

      Ricardo Garcia was born in Germany while his father was stationed there as a

military doctor. But when Garcia was still very young, his family moved to the

Valley after his father accepted a job in McAllen. Garcia grew up there but went
                                         -7-

[*7] away for college and law school. He graduated from St. Mary’s Law School in

San Antonio in 1982, where he took only the tax course St. Mary’s required.

      Garcia’s first legal job was working at the city attorney’s office in McAllen

handling misdemeanors from traffic tickets to simple assaults. After three months

with that office, he left to work for a personal-injury attorney in Weslaco, Texas.

But after seven months there, he moved to Colorado to attend the University of

Denver’s tax L.L.M. program in 1984. But that too didn’t stick--he quit the L.L.M.

program after nine months because he was bored. He then moved back to McAllen

to work for a personal-injury firm, Hendricks & Smith, and got married in

November 1984.

      In January 1985, Garcia opened up his own general practice. Garcia started

off with divorces, DWIs, and traffic tickets and even handled a criminal tax case for

a defendant who had failed to file tax returns for four years. But since 1997

Garcia’s practice has been made up of personal-injury cases.

      His practice has steadily grown over the years--he’s even hired other

attorneys and support staff. In 2000 and 2001, Garcia’s wife handled the firm’s

books and records, and she monitored the firm’s cash outlays. It was the Garcias’

accountant who prepared the couple’s 2000 return, and they reported more than

$500,000 of income from the law practice that year.
                                          -8-

[*8] C.      The Jackpot

      Around 2000, Bridgestone/Firestone, Inc. recalled some of the tires it had

built in Decatur, Illinois. The recalled tires had a high rate of failure on Ford

Explorers, and this had caused a number of wrecks and rollovers. See City of

Monroe Emps. Ret. Sys. v. Bridgestone Corp., 

 (6th Cir. 2005). Some

of these accidents happened in McAllen, and all three petitioners began lining up

injured clients. Those cases resulted in all three earning big paydays in 2001:

Lawrence got a fee of about $1 million, Salazar $1.5 million (with additional fees

structured for payout in later years), and Garcia $2.2 million.

             1.     Lawrence

      Lawrence’s ordinary income from his law practice that year was about $1.5

million, but he didn’t make any estimated tax payments. Instead, he bought a

finance company that gave people unsecured loans of $600 or less. He also

increased his stock and bond investments and bought some property near the beach.

These investments--at least before November 2001--were somewhat conservative,

with about 50-60% in fixed income investments, 20-30% in cash, and 15-20% in

equities.
                                        -9-

[*9]         2.    Salazar

       Salazar had about $1.5 million in net income from his law practice in 2001.

He, however, made $575,000 in estimated tax payments. He also invested most of

the remainder in equity and fixed-income mutual funds.

             3.    Garcia

       Garcia had over $2 million in net income from his law firm in 2001. Like

Salazar, he also anticipated a big tax bill and made $533,000 in estimated tax

payments. Like the other lawyers, he also put much of the Firestone windfall into

some mutual funds and blue-chip stocks.

II.    Enter Mr. Garza

       Joe Garza is an attorney from Dallas, Texas, who had a long-established

practice in insurance defense, ERISA, and bond financing before he moved into

tax planning--sometimes quite aggressive tax planning. See Garcia v.

Commissioner, T.C. Memo. 2011-85, 

; Estate of Hurford v.

Commissioner, T.C. Memo. 2008-278, 

; 7050, Ltd. v.

Commissioner, T.C. Memo. 2008-112, 

. It was he who sold the
                                         - 10 -

[*10] three lawyers on something none of them had heard of before--a variant of the

now notorious Son-of-BOSS deal using digital options and Canadian dollars.4

      A.     The Approach

      Around 1999 to 2000, Garza first became aware of Son-of-BOSS

transactions--Jenkens & Gilchrist was doing a lot of them, and several of his clients

wanted to do them too. Garza concluded that he could either refer his interested

clients to Jenkens & Gilchrist, or do the deals himself. He decided to learn how to

do the deals himself.

      First he consulted with Craig Brubaker--an ex-Arthur Andersen employee and

at the time a director at Deutsche Bank Alex Brown. Brubaker had been working

on a lot of these deals for Jenkens & Gilchrist, and Garza was confident of

Brubaker’s knowledge and abilities. Brubaker gave Garza some information on

how these deals worked and how much Deutsche Bank charged for them.

      Brubaker also suggested that Garza speak to another lawyer rumored to have

done a $100 million transaction for a local billionaire that “went real well” to

      4
        Garza wasn’t really urging a speculative foray in foreign currency--he was
promoting a type of Son-of-BOSS tax shelter (which is a variant of the Bond and
Options Sales Strategy (BOSS) shelter) that uses European digital options on
foreign currency. Unlike an “American” option, which can be exercised at any time
before it expires, a “European” option can be exercised only at a particular date and
time. An option is “digital” if it has the same payout no matter how far in the
money it is. Digital options are also known as “all-or-nothing” options.
                                          - 11 -

[*11] learn more. Garza followed Brubaker’s recommendation, and paid the lawyer

$50,000 for a dark-side CLE on the finer points of the deal. Included in the bargain

was a turnkey opinion letter--one that Garza could use in his own practice. (The

legal sections of the opinion letters he later sold to Lawrence, Salazar, and Garcia

closely resemble this draft opinion letter.) Part of Garza’s promotional pitch was

that if a taxpayer had a “good” tax opinion letter, he would not have to pay any

penalties even if the tax benefits were disallowed.

       Once Garza had his turnkey opinion letter and knew the transaction well

enough, he began pitching. The purpose of all Son-of-BOSS tax shelters is to

create “artificial tax losses designed to offset income from other transactions.”

Napoliello v. Commissioner, 

, 1062 (9th Cir. 2011) (citation and

internal quotation marks omitted). Garza’s scheme involved a partnership and

having his clients transfer assets along with significant liabilities to that

partnership. As a matter of economics, the liabilities would offset the value of the

assets, but those liabilities wouldn’t be completely fixed at the time of transfer,

and the purported partners would ignore them in calculating their outside bases in

that partnership. The partnership would also ignore the liabilities in computing its

inside bases in the contributed property, which conceivably became partnership

property. Ignoring the liabilities in calculating basis creates an inflated basis.
                                         - 12 -

[*12] When the purported partners liquidated their partnership interests, they would

get a distribution of property to which they would attach this high basis in the

partnership. And then when they sold that property it would produce large tax--but

not out-of-pocket--losses.

      Garza used a six-step deal: (1) buy a foreign-currency call option (and sell

an offsetting foreign-currency call option in the same currency to the same

counterparty)5 and also Canadian dollars through a single-member LLC; (2) form a

partnership with a third party or wholly owned LLC; (3) contribute the foreign-

currency options and Canadian dollars to the partnership; (4) recognize a gain or

loss by the partnership when the options expired or were exercised; (5) terminate

and liquidate the partnership; and (6) sell the Canadian dollars that the

single-member LLC received from the partnership’s liquidation. Garza also

testified that one considerable advantage of attaching the inflated basis to



      5
         We refer elsewhere in this opinion to such options as “long options” and
“short options.” “Long” can mean several things in finance-speak; here, it simply
means to buy and hold a position. “Short,” likewise, has multiple meanings: here, it
means to sell a position. Because the long and short legs in the option transactions
involved the same parties, the same periods, and the same counterparties, they
economically zeroed each other out except for the narrow spread between the two
strike prices: One party could buy the yen at $X from the second party, and the
second party could turn around and buy the yen at $X minus the spread from the
first party.
                                        - 13 -

[*13] Canadian dollars was to enable partners to store it in an account to be drawn

down as needed to shelter his customers’ ordinary income in later years.

      Garza says he would always have his clients choose which currency to use

but would make strong recommendations. He would also insist that each of his

clients talk with Brubaker. Brubaker would explain what trades would be made,

answer other questions, and help them set up their Deutsche Bank accounts. We

also note especially that Garza never asked Brubaker how Deutsche Bank valued

the options.

      B.       Garza Spreads to McAllen

      Bad ideas can be especially contagious in a small town. Garza had already

been doing some work in the Valley on pension plans in the late ‘90s, and even did

some work for Gonzalez on a subchapter S ESOP. That’s how he was introduced

to Lawrence in 1999--in a chance meeting in Gonzalez’s office that involved the

exchange of pleasantries.

      But it wasn’t until 2000 and 2001 that Garza began promoting the digital-

option Son-of-BOSS deal to his contacts in McAllen. It’s not surprising that

Lawrence and Gonzalez listened to his pitch: They were expecting big tax bills for

2001 because of the contingency fees from their Firestone cases. (Lawrence

actually got Gonzalez involved in the Firestone litigation because he couldn’t
                                        - 14 -

[*14] represent all of the people injured in a particular accident.) And Garza

pitched a way he said could drastically reduce their expected income-tax bill.

       Lawrence first met with Garza in 2000 to discuss the transaction and its tax

benefits. Sometime after their first meeting, Lawrence approached Albert Lopez,

his broker at Merrill Lynch, to see if he could execute the investment strategy Garza

advertised. Lopez said it wasn’t his area of expertise and wasn’t the type of

transaction he could do. (At some point, Garza also explained to Lawrence that he

couldn’t do the option trades at Merrill Lynch because the tax benefits depended on

setting up the trades through a series of entities, which Merrill couldn’t or wouldn’t

do.)

       Lawrence met with Garza again in 2001. Garza explained in greater detail

how the trades worked, how he was able to predict the movement of the Japanese

yen against the U.S. dollar, and how he would structure the investment to secure its

promised benefits. Lawrence admitted at trial that when he met with Garza in 2001,

he knew there were “important tax consequences to how you did the transaction.”

       Garcia and Salazar also caught the Son-of-BOSS bug in 2001. Gonzalez

held a meeting at his office around October or November 2001, and invited a few

others. Garza did a presentation on the digital-option deal. Although we aren’t
                                        - 15 -

[*15] sure whether Lawrence was at this meeting, we do know Garcia was invited

but didn’t show. Garcia had to work late that night, so he got the recap from

Gonzalez over the phone. That is how he first heard about Garza’s transaction, and

is what prompted him to call Garza to learn more.

       Garcia then flew to Dallas to talk with Garza in person and to check out his

firm. While he was there, Garza talked with him about the transaction and its tax

benefits, and then took him to meet Brubaker--whose office was only a short walk

away. Brubaker tried to sell Garcia on the deal, telling him that he’d done a lot of

similar transactions. Garcia then returned home and called Salazar to tell him about

his trip.

       Garcia mentioned to Salazar that both Garza and the deal looked legit, and he

was thinking about doing it. This wasn’t an unusual conversation: Garcia and

Salazar are close friends and had a history of investing together. By now Salazar

was interested in the transaction too and met with Garza in McAllen in late

November or early December 2001 to discuss the investment strategy and the

related tax benefits.

       We find that Garza told Lawrence, Garcia, and Salazar that the deal he was

offering would give them a 30 to 40% chance of doubling their money, and a very

remote chance of making a lot more than that if the spot rate landed on the sweet
                                         - 16 -

[*16] spot.6 Garza testified at trial that he tried very hard to make his clients money

on the options because he believed it would then be easier to prove a legitimate

profit motive for his scheme.

      We don’t know whether Garza provided written materials explaining the

transaction (other than the opinion letter) to Lawrence, Salazar, and Garcia. But we

do know that Garza told Lawrence, Salazar, and Garcia that if the investments were

structured carefully, they could take advantage of significant tax benefits. Although

Lawrence and Garcia denied it, we also find that Garza told all three of them that

the transactions had to be done before the end of 2001 to take advantage of those

benefits. Garza also specifically warned Garcia at least that it was more difficult to

make a profit with the deal late in the year because there was less time for the

market to “gyrate.”

      C.     The Deals That Were Done

      Garza charged Lawrence, Garcia, and Salazar $95,000 each for his services.

The bills that Garza sent to Lawrence, Garcia, and Salazar were entitled

“Statement for Services Rendered,” and said they covered “all services to be


      6
         If on the expiration date, the reference price for the foreign currency options
falls between the strike prices for the long and short positions, that is hitting the
“sweet spot.” That is because under this scenario the investor would receive a
payment under the long option without having to pay out under the short option.
                                          - 17 -

[*17] rendered in connection with [their] digital option transaction[s] and the related

legal opinion,” including:

        •       formation of LLC disregarded entity;

        •       formation of limited partnership;

        •       negotiations with investment bank and review of transactions;

        •       legal opinion letter;

        •       tax return preparation and review.7

        It also said that the $95,000 would cover “any and all services necessary in

the event that either you or the above entities are selected for an audit by the IRS in

the future.” This meant that Garza would cover their legal fees if the transaction

blew up.

        Garza required Lawrence, Salazar, and Garcia to pay the first installment of

$47,500 when they received their “Statement for Services Rendered,” and the

remaining $47,500 when he delivered their legal opinion. Lawrence paid the first

installment in October and the second in December 2001. Garcia and Salazar both

paid their first installments in December 2001, and the second only in the new

year.



        7
            Occasionally, Garza would review returns but he did not prepare them.
                                         - 18 -

[*18] All three attorneys knew that the entities were created to capture the tax

benefits of the digital option/Canadian dollar transaction, and all relied on Garza to

prepare the paperwork and file the necessary documents with the different state

authorities. Garza claimed that one reason to use the LLCs to do the investments

was that Deutsche Bank said doing so would get around a Securities and Exchange

Commission rule that required a 30-day waiting period for individuals who wanted

to set up an option-trading account. Garza, however, admitted at trial that the real

reason for creating the LLCs and then putting them into partnerships with their

owners was that he thought it necessary to do so to generate the tax benefits. And

he also admitted that buying Canadian dollars and disposing of them in a liquidating

distribution was also for tax purposes. We specifically find these latter two

admissions credible.

      Garza chose to organize the entities in Colorado and Georgia because those

states processed filings quickly and cheaply. He named the entities with numbers

because he wanted to avoid any snags that might have slowed the deal if someone

else had an LLC or partnership with the same name. And Garza didn’t draft any of

the entity agreements from scratch, but adapted the sample he already had. He

picked Deutsche Bank to execute the trades because he liked Brubaker more than
                                        - 19 -

[*19] the people at other banks, and he just assumed Deutsche Bank’s fees and

prices were fair.

             1.     The Lawrence SoB

      Garza launched the Lawrence transaction on October 19, 2001 and things

took off quickly:


      !      From October 25 to 30, 2001, Garza helped Lawrence form three
             entities: 0327 LLC, 67 LLC, and 466, Ltd.

             "      0327 is a disregarded entity for federal tax purposes, was formed
                    under Georgia law, and Lawrence is listed as its sole member.

             "      67 was formed as a Colorado limited liability company,
                    Lawrence was its sole member, and it never made an election on
                    Form 88328 to be classified as an association for federal tax
                    purposes.

             "      466 was formed as a Colorado limited partnership, and on its
                    2001 return it listed Lawrence as a 99% limited partner, and 67
                    as a general partner with a 1% limited-partnership interest.

      !      In late October 2001, Lawrence set up three accounts with Deutsche
             Bank--one for the Lawrence Law Firm, one for 0327, and one for 466.




      8
        A U.S. business entity with only one member is either a corporation or a
disregarded entity. If it doesn’t want to be disregarded, Form 8832, Entity
Classification Election, allows the entity to affirmatively elect to be taxed as a
corporation. Sec. 301.7701-3(b)(1)(ii), (c)(1)(i), Proced. & Admin. Regs.
                                      - 20 -

[*20] !     On October 30, 2001, $41,000 was deposited into 0327’s Deutsche
            Bank account--this was the only capital contribution made to 0327.

      !     On November 1, 2001, 0327 bought and sold offsetting long and short
            foreign-currency options on Japanese yen from Deutsche Bank for a
            $40,000 net premium. 9 Both options expired on December 12, 2001.

      !     On or about December 3, 2001, 0327 transferred both the long and
            short options to 466.

      !     On December 4, 2001, 0327 bought Can$1,100.12 for US$750 (at an
            exchange rate of .68174380 US$ to Can$).

      !     On December 12, 2001, the options expired in the money, and
            Deutsche Bank paid him $80,000 on December 21, 2001.

      !     On or about December 24, 2001, 0327 transferred the Can$1,100.12 to
            466.

      !     On December 26, 2001, Lawrence asked Deutsche Bank to transfer
            $47,500 to an account for Garza & Staples to pay his legal fees, and
            $5,000 to an account at another bank.

      !     On or about December 27, 2001, 466 transferred the Can$1,100.12 to
            the Deutsche Bank account for the Law Office of Larry Lawrence--but
            this may have been in error. However, only Can$385.04 (out of the
            Can$1,100.12) was transferred back to 0327’s account.




      9
       The premiums on the long and short positions were $4 million and
$3,960,000, respectively.
                                         - 21 -

[*21] !        On December 28, 2001, 0327 sold Can$385.04 (at an exchange rate of
               .49800029 US$ to Can$) for US$191.75, which was deposited into
                0327’s Deutsche Bank account.10

      !        On December 31, 2001, a Cancellation of Domestic Certificate of
               Limited Partnership was filed in Colorado for 466.


      There’s no evidence in the record that 0327, 67, and 466 did any other

deals. We find that they had no activities other than those listed above.

      Before the digital-currency options would’ve expired, Lawrence agreed to

settle them for a payment of $54,300 from Deutsche Bank. But the settlement

under that agreement took too long and didn’t go through in time. As we’ve

mentioned, this meant Lawrence lucked out and Deutsche Bank paid him $80,000.

      Lawrence’s wife wasn’t involved in the decision to buy into Garza’s plan,

and wasn’t involved in any part of the deal. Lawrence himself was not immersed

in the details. He blindly signed the paperwork as Garza gave it to him. He had

no relationship to the states where the entities were located, and the address listed in

the paperwork Garza sent to the Colorado secretary of state for him was the

same address Salazar and Garcia used. It was not his own. Lawrence made no

effort to determine if the $40,000 premium he paid for the options was a fair



      10
           The remaining Canadian dollars were apparently sold in 2002.
                                           - 22 -

[*22] price.11 Before November 2001, Lawrence had never invested in foreign

currency other than trading U.S. dollars against the Mexican peso back when he

was a busboy and waiter.

             2.        The Salazar SoB

      Garza launched the Salazar transaction on December 17, 2001, and it also

quickly took flight:

      !      On December 17, 2001, Garza helped Salazar form three entities: 0997
             LLC, 70 LLC, and 541, Ltd.

             "         0997 is a disregarded entity for federal tax purposes, it was
                       formed under Georgia law, and Salazar is listed as its sole
                       member.

             "         70 was formed as a Colorado limited liability company, Salazar
                       was its sole member, and it never made an election on Form
                       8832 to be classified as an association for federal tax purposes.

             "         541 was formed as a Colorado limited partnership, and on its
                       2001 return it listed Salazar as a 99% limited partner, and 70 as
                       a general partner with a 1% limited-partnership interest.

      !      In mid-December 2001, Salazar opened accounts with Deutsche Bank
             for 0997 and 541.



      11
         We talk about the value of the options later, but note here that the
Commissioner’s experts reasonably estimated the options to be worth about
$25,500 using the Black-Scholes formula for pricing options. Had Lawrence looked
into the premium, he might’ve noticed Deutsche Bank was charging him over a 50%
markup.
                                         - 23 -

[*23] !        0997 bought and sold offsetting long and short Japanese yen options
               from Deutsche Bank for a $40,000 net premium. 12 The paperwork is
               dated December 14, but the account wasn’t funded until December 19.
               Both options expired on December 21, 2001. Either on December 21--
               or one day earlier--0997 transferred both the long and short options to
               541.

      !        On December 19, 2001, $45,000 was deposited into 0997’s Deutsche
               Bank account–this was the only capital contribution made to 0997.

      !        On December 21, 2001, the options expired out of the money.

      !        On December 24, 2001, 0997 bought Can$7,027.44 for US$4,500 (at
               an exchange rate of .64034700 US$ to Can$).

      !        On December 28, 2001, 0997 sold Can$2,459.60 (at an exchange rate
               of .60753370 US$ to Can$) for US$1,494.29, which was deposited in
               0997’s Deutsche Bank account.13

      !        On December 31, 2001, a Cancellation of Domestic Certificate of
               Limited Partnership was filed in Colorado for 541.

      There’s no evidence in the record that 0997, 70, and 541 did any other deals,

or had any activity other than what we’ve listed.

      Salazar’s wife wasn’t involved in the transaction in any way, and she wasn’t

part of the decision to do it. Salazar wasn’t knee-deep in the details of the

transaction himself: He blindly signed the paperwork as Garza gave it to him.


      12
        The premiums on the long and short positions were $4 million and
$3,960,000, respectively.
      13
           It appears that the remaining Canadian dollars were sold in 2002.
                                         - 24 -

[*24] Like Lawrence, Salazar also had no relationship to the states where the

entities were located, and he also reported the same address to the Colorado

secretary of state as his friends. Like Lawrence, he made no effort to determine if

the $40,000 premium he paid for the options was a fair price. And before

December 2001, Salazar had never invested in foreign currency even casually in his

youth.

               3.    The Garcia SoB

         Garza did much the same for Garcia:

         !     On December 14, 2001, Garza helped Garcia form three entities: 464
               LLC, 96 LLC, and 6611, Ltd.

               "     464 is a disregarded entity for federal tax purposes, was formed
                     under Georgia law, and listed Garcia as its sole member.

               "     96 was formed as a Colorado limited liability company, Garcia
                     was its sole member, and it never made an election on Form
                     8832 to be classified as an association for federal tax purposes.

               "     6611 was formed as a Colorado limited partnership, and on its
                     2001 return it listed Garcia as a 99% limited partner, and 96 as
                     a general partner with a 1% limited-partnership interest.

         !     In mid-December 2001, Garcia set up accounts with Deutsche Bank
               for 464 and 6611.

         !     On December 14, 2001, 464 bought and sold offsetting long and short
               options on Japanese yen from Deutsche Bank for a $50,000 net
                                           - 25 -

[*25]            premium. 14 Both options expired on December 21, 2001. That same
                 day--or maybe a week before or maybe five days later (the paperwork
                 is murky)--464 transferred both the long and short options to 6611.

        !        On December 14, 2001, $55,000 was deposited into 464’s Deutsche
                 Bank account--this was the only capital contribution made to 464.

        !        On December 19, 2001, 464 bought Can$7,004.30 for US$4,500 (at an
                 exchange rate of .64246200 US$ to Can$).

        !        On December 21, 2001, the options expired out of the money, with
                 zero payout due to either party.

        !        On December 31, 2001, 464 sold Can$2,451.50 (at an exchange rate of
                 .60746890 US/Can) for US$1,489.21, which was deposited in 464’s
                 Deutsche Bank account.15

        !        On December 31, 2001, a Cancellation of Domestic Certificate of
                 Limited Partnership was filed in Colorado for 6611.

        There’s no evidence in the record that 464, 96, and 6611 did any other deals

or had any activity other than what we’ve listed.

        Garcia’s wife was as uninvolved as Lawrence’s and Salazar’s in the

transaction. And, like his friends, Garcia blindly executed all the documents

Garza gave him to sign. He knew that buying the currency options and

transferring them between 464 and 6611 was part of the plan he asked Garza to



        14
        The premiums on the long and short positions were $5,000,000 and
$4,950,000, respectively.
        15
             It appears that the remaining Canadian dollars were sold in 2002.
                                        - 26 -

[*26] carry out. He also knew that the only reason for buying and selling Canadian

dollars was that it was “part of the investment” and would serve as a triggering

event for the tax benefits. “Other than buying a Krugerrand during a vacation in

South Africa,” Garcia had also never invested in foreign currency before.

III.   Reporting the Transactions

       A.    Garza’s Opinion

       Garza provided opinion letters to Lawrence, Salazar, and Garcia dated

December 30, 2001. Each letter had about four pages of facts supposedly

describing the transaction and over 80 pages of boilerplate on tax-law doctrines--

running the gamut from partnership-basis rules, treatment of foreign-currency

contracts, the step-transaction doctrine, economic substance, disguised-sale

provisions, and partnership anti-abuse regulations. The letters also concluded that

the tax treatment Garza proposed would “more likely than not” withstand IRS

scrutiny.

       Garza, however, relied on certain “facts” to reach his “more likely than not”

conclusion, and these “facts” were just plain wrong. Here are some of the key

mistakes he made in the factual recitation section--the first four pages of each

opinion:
                                       - 27 -

[*27] •     The opinion letters say that the Lawrence, Salazar, and Garcia made
            the factual representations it recited.

            •      Lawrence, Salazar, and Garcia made no factual representations
                   with respect to the transactions. Garza stated them on his own.

      •     The opinion letters say that Lawrence, Salazar, and Garcia “believed
            there was [a] reasonable opportunity to earn a reasonable pre-tax profit
            from the transactions * * * (not including any tax benefits that may
            occur), in excess of all the associated fees and costs.”

            •      Garza’s $95,000 fee was ignored in reaching that conclusion.
                   The opinions don’t mention Garza’s fee at all.

      And here are some of the key factual mistakes made in the opinion letters’

discussion section, on which Garcia based key legal conclusions:

      •     The purchased (long) and sold (short) options had their own
            confirmations.

            •      The long and short options were the subject of the same
                   confirmation.

      •     The partnership had to deliver foreign currency if the short option was
            exercised.

            •      The partnership had no obligation to deliver foreign currency.

      •     As of the date of the opinion, the options have not yet expired--so it’s
            uncertain whether the partnership will have to satisfy its obligation
            regarding the short option.

            •      The options had already expired when Garza sent out the
                   opinion letters, and the obligations under the option contracts
                   were by that time certain.
                                        - 28 -

[*28] •     None of the partnerships’ (i.e., 466, 541, and 6611) partners were
            related.

            •      The partners of each partnership were related--Lawrence,
                   Salazar, and Garcia were the 99% limited partners, and each
                   man’s wholly owned and controlled LLC was the 1% general
                   partner.

      •     The assets contributed by a partner (Lawrence, Salazar, and Garcia)
            would not be the same assets distributed to that partner.

            •      The Canadian dollars distributed were the same ones contributed
                   by the partner.

      Garza admitted at trial that most of his clients got opinion letters because, in

the event the transaction wasn’t respected by the government, taxpayers could avoid

penalties with a good one. These letters do not mention, however, Notice 2000-44,

Tax Avoidance Using Artificially High Basis, 2000-2 C.B. 255, published on

September 5, 2000.

      B.    Return Preparers

      Ken Everhard prepared the 2001 partnership and joint returns for Garcia and

Salazar. But for Lawrence he prepared only 466’s 2001 Form 1065, U.S. Return of

Partnership Income. (Drefke prepared the Lawrences’ 2001 joint federal income tax

return and Form 1120S.)
                                         - 29 -

[*29]         1.     Ken Everhard

        Ken Everhard is a certified public accountant who has practiced in McAllen

since the 1960s, and has a good reputation. Part of Everhard’s practice includes the

preparation of both simple and complicated partnership tax returns. But Everhard

has not written tax opinions.

        Everhard first learned of the digital option/Canadian dollar transaction from

Garcia. In late 2000 Garcia’s CPA, Ann Howe, told him to find a new accountant

because she was leaving her practice to go work with her father. Everhard was the

obvious replacement: Garcia’s family had been friends with Everhard for decades

and they highly recommended him. In late November or early December 2001,

Garcia told Everhard that he “heard about Joe Garza and a plan that he had,” and

asked for Everhard’s thoughts. Everhard then called Garza and arranged a trip to

Dallas to meet him. Garza gave Everhard a draft opinion letter discussing the

transaction (with no names on it) when he arrived. On a second trip to Dallas, for

another client, Everhard met a second time with both Garza and Brubaker.

        At the recommendation of Garcia, Salazar hired Everhard in 2001. Like

Garcia, Salazar also talked to Everhard about the transaction in December of that

year. But Lawrence didn’t hire Everhard until March or April 2002, and even then

only at the recommendation of Garza.
                                           - 30 -

[*30] It is important for us to be precise in finding just what Everhard did in

addition to preparing the lawyers’ returns. We find that Everhard did investigate the

deal in some way--he read Garza’s opinion letters carefully, and he checked some of

the cases and rulings that it cited--at least the ones he thought were important. But

we find that Everhard did not do any other research--he couldn’t recall reading any

cases or guidance that weren’t cited in the opinion letter. We also find that he was

honest with Lawrence, Salazar, and Garcia about that: He told them that he read

some of the cases cited in Garza’s opinion letter but never suggested that he did

anything more.

       We do believe Everhard told Lawrence, Salazar, and Garcia that the

transaction was aggressive but that he saw some support for it. But we also find

that he told them that he was not giving them a tax opinion as to whether the

perceived tax benefits would stand up--they would have to rely on Garza for that.

We find that Everhard didn’t verify any of the factual assertions made in the opinion

letters--either independently or by questioning Lawrence, Salazar, or Garcia--even

though he did get some of the relevant documents. He just assumed the transaction

was executed as described in the opinion letters. And it was Everhard’s practice to

tell all of his clients that it’s their job to make sure that they have all the right

documents. He just uses the numbers that he’s given.
                                         - 31 -

[*31] We therefore find that Everhard handled only the reporting and preparation of

Lawrence, Salazar, and Garcia’s returns. He charged them only for return

preparation, not his advice. We do also find that he was not in cahoots with Garza.

Garza did pay him to prepare Lawrence’s partnership’s return, but Everhard didn’t

get any compensation from Garza other than this small return-preparation fee--only

about $2,200.

             2.     David Drefke

      David Drefke is another CPA in McAllen, and he prepared the Lawrences’

joint return and Form 1120S for Lawrence’s law practice for 2001. While Drefke

copied the information from 466’s Schedules K-1, Partner’s Share of Income,

Deductions, Credits, etc.; and Form 4797, Sales of Business Property, prepared by

Everhard to the Lawrences’ return, that was the extent of his work on the

transaction. Drefke reported the losses and deductions arising from the deal

(including the characterization and deductibility of Garza’s fees as a referral-fee

deduction), as Lawrence instructed and as Everhard had mapped out.

      Drefke lacked the necessary background knowledge to analyze the tax

consequences of the deal. Lawrence did not ask Drefke to check out the validity of

its tax benefits, and Drefke didn’t do it on his own. He was never given any of
                                         - 32 -

[*32] the relevant transactional documents, and he’s never represented himself to be

an expert in the taxation of foreign-currency-option transactions.

      C.     What Was Reported

             1.     Lawrence

      On its Form 4797, 466 reported a $14,300 ordinary gain from a “yen

currency option (section 988).” The acquisition date of the foreign-currency-option

was reported as November 1, 2001, and the disposition date was reported as

December 10, 2001. 466 listed its basis in the option as $40,000 and its gross sale

price as $54,300. But this wasn’t correct: The amount realized was $80,000, see

supra pp. 20-21, because Deutsche Bank paid $80,000 when both the long and short

options expired in the money. 466 allocated $14,157 of the $14,300 reported gain

to Lawrence and the rest--$143--to 67 on the Schedules K-1.

      On its partnership return for that year, 466 reported partner capital

contributions of $4,040,750--the $4 million long option notional premium; the

$40,000 net premium on the option spread; and the $750 in Canadian dollars.

(Reporting both the $4 million long option notional premium and the $40,000 net

premium on its return is double counting.) While 466 treated the $4 million long

option notional premium as a capital contribution, it did not report the liability

inherent in the $3,960,000 short option notional premium. 466 allocated
                                         - 33 -

[*33] $4,000,342 of the capital contributions to Lawrence and $40,408 to 67 on the

Schedules K-1.

      On its partnership return 466 also reported distributions of money (cash and

marketable securities) of $54,300, allocating $53,757 of the reported distributions

to Lawrence and $543 to 67. It reported distributions of property other than

money of $4,000,750, which resulted from treating the $4 million long option

premium notional amount as a contribution that would be distributed upon the

liquidation of 466. It did not, however, take into consideration the liability

inherent in the $3,960,000 short option premium. 466 allocated $3,960,742 of the

noncash distributions to Lawrence and $40,008 to 67 on the Schedules K-1.

      But remember that by this time the options had long since expired, so the

supposed basis in the long option can theoretically be attached to the only noncash

(i.e., non-American cash) asset 466 had left--the Can$1,100.12. By reporting this

$4,000,750 as a “distribution of property,” Everhard was effectively reporting it as

466’s basis in that property. Although we make only partnership-level

determinations here, we do note that Lawrence doesn’t seem to have used all of

that basis in 2001 because he didn’t sell all of the Canadian dollars that year.

Lawrence does seem to have sold Can$385.04 in 2001, and then claimed a loss of

$1,400,063. This claimed loss was conveniently close to the $1.5 million that
                                       - 34 -

[*34] Lawrence’s law practice netted in 2001, and left the Lawrences with only

$85,544 in taxable income.

      Lawrence even deducted Garza’s $95,000 fee as a “referral fee” paid by the

Lawrence Law Firm.

             2.    Salazar

      541’s 2001 partnership return reported a $40,000 ordinary loss on Form

4797, and identified the reported loss as from a “yen currency option (section 988).”

541 reported it had acquired the option on December 14, 2001, and disposed of it

on December 21, 2001. 541 reported its basis in the option was $40,000.16 Of the

reported $40,000 loss, 541 allocated $39,600 to Salazar and $400 to 70 on the

Schedules K-1.

      The partnership return reported partner capital contributions of $4,044,500--

the $4 million long option notional premium; the $40,000 net premium on the

option spread; and the $4,500 in Canadian dollars. (Reporting both the $4 million

long option notional premium and the $40,000 net premium is double counting.)

The partnership return treated the $4 million long option notional premium as a



      16
         Salazar and 541 reported their bases inconsistently. Salazar claimed a high
outside basis, while 541 claimed only a small loss when the options expired out of
the money.
                                         - 35 -

[*35] capital contribution, but did not report the liability inherent in the $3,960,000

short option notional premium.

      541 reported distributions of property other than money of $4,004,500, which

resulted from treating the $4 million long option premium notional amount as a

contribution whose basis would attach to any noncash property distributed upon the

liquidation of 541. This reporting did not, however, take into consideration the

liability inherent in the $3,960,000 short option premium. 541 allocated $3,964,455

to Salazar and $40,045 to 70 on the Schedules K-1. By reporting this $4,004,500 as

a “distribution of property,” Everhard was effectively reporting it as 541’s basis in

that property--the Can$7,027.44 Canadian dollars distributed. We note that when

Salazar sold 2,459.60 of those Canadian dollars in 2001, he claimed a loss of

$1,400,081. Like Lawrence, this claimed loss was conveniently close to the $1.5

million net profit from Salazar’s law practice in 2001, and left the Salazars with only

$64,892 in taxable income.

      For the Salazar Law Office part of the Salazars’ joint return, Everhard

claimed, at Salazar's request, a deduction of $47,500 in fees for “legal and

professional services.” Everhard did not know at that time that the $47,500 was

part of Garza’s fee.
                                         - 36 -

[*36]         3.     Garcia

        6611’s partnership return reported a $50,000 ordinary loss on Form 4797,

and identified the reported loss as from a “yen currency option (section 988).”17

6611 reported that it acquired the foreign-currency option on December 17, 2001,

and disposed of it on December 21, 2001. 6611 reported its basis in the option as

$50,000, and allocated $49,500 of the loss to Garcia and $500 to 96 on the

Schedules K-1.

        The partnership return reported partner capital contributions of $5,054,500--

the $5,000,000 long option notional premium; the $50,000 net premium on the

option spread; and the $4,500 in Canadian dollars. (Reporting both the $5,000,000

long option notional premium and the $50,000 net premium is double counting.) It

reported the $5,000,000 long option notional premium as a capital contribution, but

did not report the liability inherent in the $4,950,000 short option notional premium.

        On its partnership return 6611 also reported $5,004,500 in distributions of

property other than money, and allocated $4,954,455 of the distributions to Garcia



        17
         Like 541, 6611 was inconsistent in reporting its bases--claiming only a
small loss when the options expired implicitly recognizes the effect of the offsetting
options on basis--reporting a massive basis in the distributed Canadian dollars does
not. (The same might be said of 466 and its reporting of only a small gain at the
partnership level.)
                                         - 37 -

[*37] and $50,045 to 96 on the Schedules K-1. This was again a result of treating

the long option premium notional amount as a contribution that would later be

distributed when 6611 was liquidated, but not taking into account the offsetting

liability inherent in the $4,950,000 short option premium. But this is the way basis-

inflation shelters work, so 6611’s reporting this $5,004,500 as a distribution of

property other than money was effectively reporting it as 6611’s basis in the

Can$7,004.30 distributed. We note that Garcia sold only Can$2,451.50 in 2001,

but the sale had its desired effect, and he claimed a loss of $1,750,086--enough to

offset most of his $2.26 million net profit from his law practice--while letting him

store the rest of the basis-inflated Canadian dollars for future use.

      The Garcias also reported losses totaling $49,500 that passed through from

6611’s partnership return to their joint return. On the Schedule C for the Garcia

Law Office under “Legal and Professional Services,” Everhard included, at Garcia’s

request, a $47,500 deduction for what the law office’s general ledger described as

“Accounting Fees.” What Everhard did not know at the time was that the $47,500

was for only the first half of Garza’s $95,000 fee for the deal.
                                         - 38 -

[*38] IV.   Prelude

      The Commissioner issued notices of final partnership administrative

adjustment (FPAAs) to 466, 541, and 6611 in April 2005. The FPAAs adjusted

various items to zero and determined accuracy-related penalties under section

6662.18

      The FPAA sent to 466 made the following adjustments:



                  Partnership item                As reported     As adjusted


             Ordinary income (loss)
               (Form 4797, line 18)                 $14,300            -0-

             Capital contributions
               (Sched. M-2, line 2)               4,040,750            -0-

             Distributions of property
               other than money
                (Sched. K, line 23)               4,000,750            -0-

             Distributions of cash and
                marketable securities                54,300            -0-




      18
         An FPAA generally includes: (1) a Notice of Final Partnership
Administrative Adjustment, (2) Form 870-PT, Agreement for Partnership Items and
Partnership Level Determinations as to Penalties, Additions to Tax, and Additional
Amounts, including a Schedule of Adjustments, and (3) an “Exhibit A-Explanation
of Items,” listing the Commissioner’s other adjustments or determinations.
                                        - 39 -

[*39] The FPAA sent to 541:




                 Partnership item                As reported    As adjusted


            Ordinary income (loss)
              (Form 4797, line 18)                ($40,000)          -0-

            Capital contributions
              (Sched. M-2, line 2)               4,044,550           -0-

            Distributions of property
              other than money
               (Sched. K, line 23)               4,004,500           -0-


      And the FPAA to 6611:



                 Partnership item                As reported    As adjusted


            Ordinary income (loss)
              (Form 4797, line 18)                ($50,000)          -0-

            Capital contributions
              (Sched. M-2, line 2)               5,054,500           -0-

            Distributions of property
              other than money
               (Sched. K, line 23)               5,004,500           -0-

      In each case, the FPAA Schedule of Adjustments did not adjust the

partners’ outside bases. But in each FPAA “Exhibit A-Explanation of Items” sent
                                        - 40 -

[*40] to 466, 541, and 6611, the Commissioner did make determinations about

outside basis, including the determination that “the partners * * * have not

established adjusted bases in their respective partnership interests in an amount

greater than zero (-0-).” (The Commissioner seems to have copied 6611’s Exhibit

A-Explanation of Items from 466’s, but forgot to change all the “466”s to “6611”s.

We’ll treat it as a typo that no one was confused by.) This may or may not have

been sufficient to put outside basis at issue here, cf. Clovis I v. Commissioner, 

, 982 (1987), but the Commissioner later conceded that the FPAA did not

adjust outside basis and that outside basis wasn’t being challenged “at the

partnership level.” Unlike a concession on a point of law regarding whether we

have jurisdiction over outside basis at the partnership level, see Tigers Eye Trading

LLC v. Commissioner, 

, 74 (2012), the Commissioner’s concession here

simply notes that these particular FPAAs were not adjusting outside basis and that

he wasn’t seeking a determination of outside basis in this partnership-level

proceeding.

      We have previously held that parties, including the Commissioner, may

concede adjustments noted in the FPAA before we enter a decision. See, e.g.,

Von-Lusk v. Commissioner, 

, 208 (1995) (conceding FPAA

adjustment in amended answer); Rovakat, LLC v. Commissioner, T.C. Memo.
                                          - 41 -

[*41] 2011-225, 

 at *23 n.22 (conceding on brief by failing to

defend FPAA adjustment). While we are always required to satisfy ourselves that

jurisdiction exists before entering a decision, see Gray v. Commissioner, 

, 297 (2012), we don’t have to reach out and put into play issues the parties

don’t seek to adjudicate. In Tigers Eye Trading, we had to determine whether we

had jurisdiction because the petitioners argued we lacked it. But we agree with the

Commissioner that outside basis isn’t at issue here.

       What is at issue are the partnerships’ inside bases. Inside basis is the basis a

partnership has in its own assets, sec. 723; outside basis is the basis a partner has in

his partnership interest, sec. 722; sec. 1.722-1, Example (1), Income Tax Regs. If

the inflated basis in a Son-of-BOSS deal is attached to a partner’s interest in a

supposed partnership and a loss is realized when he disposes of that partnership

interest through sale or the partnership’s liquidation, it is called an outside-basis

SoB. If the inflated basis is attached to an asset that the partnership holds and a loss

is realized when the partner receives the asset in a distribution and then sells it, it is

called an inside-basis SoB.19


       19
         The usual rule is that an asset distributed by a partnership to one of its
partners has a basis equal to the partnership’s basis in that very asset. Sec. 732(a).
Inside-basis SoB deals claim to be able to transfer basis within the partnership from
one asset to another via section 732(b). See 7050, Ltd., 

, at *4.
                                                                          (continued...)
                                         - 42 -

[*42] These cases all involve inside-basis SoB deals. As in other Garza-inspired

transactions, see, e.g., 106 Ltd. v. Commissioner, 

, 73 (2011), aff’d, 

 (D.C. Cir. 2012); 7050, Ltd. v. Commissioner, 

, at *4-

*5, the inflated basis lay in foreign currency (in these cases, Canadian dollars) and

the partners’ goal was to have those dollars distributed to them and have as a store

of tax loss that they could use when needed. One distinction between inside-basis

and outside-basis SoB deals is that there is a conflict among courts about whether

outside basis is a partnership item. See Petaluma FX Partners, LLC v.

Commissioner, 

 (D.C. Cir. 2010), aff’g in part, rev’g in part, vacating

and remanding on penalty issues 

 (2008); Tigers Eye Trading, 138 T.C.

at 115-28. The Commissioner usually wants a penalty in both types of cases, so

whether an item is a “partnership item” then affects whether a penalty “relates to an

adjustment to a partnership item.” See Tigers Eye Trading, 138 T.C. at 139-42.




      19
         (...continued)
Section 732(b) requires that the distribution be in liquidation of the partner’s interest
in the partnership--not an issue here given the dissolution of the three partnerships at
the end of 2001. It does also require the partnership to know the basis of each of its
assets in the hands of the partner who contributed them--which is also part of
figuring out that partner’s outside basis. But the parties here agree that the claimed
tax benefits come from the disposition of an asset formerly held by a putative
partnership, not the disposition of a partner’s interest in that partnership.
                                          - 43 -

[*43] We happily avoid those disputes in these cases. The Commissioner does

want penalties in these cases, and the FPAA Explanations of Items determined that

       [A]ll of the underpayments of tax resulting from [the] adjustments of
       partnership items are attributable to, at a minimum, (1) substantial
       understatements of income tax, (2) gross valuation misstatement(s), or
       (3) negligence or disregarded rules or regulations. * * * It is therefore
       determined that, at a minimum, the accuracy-related penalty under
       Section 6662(a) of the Internal Revenue Code applies to all
       underpayments of tax attributable to adjustments of partnership items
       of [the partnership]. [Emphasis added.]

      The Explanations of Items went on to determine a 40% gross-valuation-

misstatement penalty, or barring that, a 20% substantial-valuation-misstatement

penalty. In the alternative, it asserted either a 20% penalty for negligence, disregard

of rules and regulations, or substantial understatement of income tax. 466, 541, and

6611 raise in response only the defense that they each had reasonable cause and

acted in good faith.20 The Commissioner reiterated that he didn’t seek penalties

related to the three lawyers’ outside bases in their partnerships; he

seeks them related to the inflated contributions to, and distributions from, the

partnerships--a partnership’s basis in an asset is usually its basis in the hands of the



       20
          They could have, but have not, argued that the imposition of penalties was
somehow otherwise defective. While we must satisfy ourselves about our own
jurisdiction, we deem any other counterargument regarding the imposition of
penalties--apart from reasonable cause and good faith--waived by all three
petitioners.
                                          - 44 -

[*44] partner who’s contributing that asset, sec. 723, and the basis of an asset other

than money (and that means American money) distributed to a partner is usually the

partnership’s basis in that asset, see sec. 732(a).

      There were plenty of other issues, and the three lawyers, in their roles as tax

matters partners for 466, 541, and 6611, filed timely petitions. We tried the cases

together in Dallas, Texas.21

                                       OPINION

I.    Jurisdiction

      Partnerships do not pay income tax. See sec. 701. But they do file

information returns, and partners are supposed to use the numbers from those returns

on their own individual returns. See secs. 6031, 6222(a). TEFRA is a set of special

tax and audit rules that apply to all partnerships (with exceptions that aren’t relevant

here). See sec. 6231(a)(1). The goal of TEFRA is to have a single point of

adjustment for all partnership items at the partnership level. See Kligfeld Holdings v.

Commissioner, 

, 200 (2007). TEFRA, however, limits our jurisdiction

at the partnership level to




       21
          466, 541, and 6611 were all defunct TEFRA partnerships when the
 petitions were filed, so any appeal would likely head to the D.C. Circuit. See sec.
 7482(b)(1).
                                         - 45 -

[*45] partnership items of the partnership for the partnership
      taxable year to which the notice of final partnership administra-
      tive adjustment relates, the proper allocation of such items among
      the partners, and the applicability of any penalty, addition to tax,
      or additional amount which relates to an adjustment to a partner-
      ship item.

Sec. 6226(f) (emphasis added).

       So what are partnership items? Section 6231(a)(3) says that

       [t]he term “partnership item” means, with respect to a partnership, any
       item required to be taken into account for the partnership’s taxable
       year under any provision of subtitle A to the extent regulations
       prescribed by the Secretary provide that, for purposes of this subtitle,
       such item is more appropriately determined at the partnership level than
       at the partner level. [Emphasis added.]

The Secretary has told us what he’s determined to be partnership items in section

301.6231(a)(3)-1, Proced. & Admin. Regs. Courts still disagree over what is a

“partnership item”--a very big problem given TEFRA’s structural framework, which

makes the distinction between partnership and nonpartnership items important to our

jurisdiction.

       But once we hold an item is a partnership item we have jurisdiction to

determine that partnership item regardless of whether the Commissioner adjusted it

in the FPAA. See, e.g., Tigers Eye Trading, 138 T.C. at 95. We also have

jurisdiction to determine “the proper allocation of [these] * * * items among the

partners and the applicability of any penalty, addition to tax, or additional amount
                                          - 46 -

[*46] that relates to an adjustment to a partnership item.” Id. This latter jurisdiction

isn’t unlimited, however, and we have recently gone to great pains to determine its

boundaries. See, e.g., id. at 95-143; Petaluma FX Partners, LLC v. Commissioner,

T.C. Memo. 2012-142, 

.

      A “nonpartnership item” is “an item which is (or is treated as) not a

partnership item.” Sec. 6231(a)(4). And an “affected item” is a nonpartnership item

that is affected by the determination of a partnership item. See sec. 6231(a)(5);

Ginsburg v. Commissioner, 

, 79 (2006). Like other nonpartnership

items, the Code tells us that we can determine affected items (with the exception of

certain penalties) only at the individual level and not in a partnership-level

proceeding. Because these cases are appealable to the D.C. Circuit, we must follow

that court’s precedent. See, e.g., Golsen v. Commissioner, 

, 757 (1970),

aff’d, 

 (10th Cir. 1971).
                                          - 47 -

[*47] II.    Partnership-Item Determinations and Adjustments22

       A.    Validity of the Partnerships

             1.     Unchecked Boxes

       The Commissioner says that 466, 541, and 6611 should all be disregarded

because they failed to satisfy the regulatory requirements to be treated as

partnerships. Under the check-the-box regulations, an entity with only one owner is

disregarded for tax purposes (i.e., treated as a “tax nothing”) unless it elects to be

taxed as a corporation. See sec. 301.7701-3(b), Proced. & Admin. Regs. If the

single owner is an individual, the regulation tells the Commissioner to treat the entity

as a sole proprietorship. See sec. 301.7701-2(a), Proced. & Admin. Regs.; see also

Pierre v. Commissioner, 

, 42-43 (2009) (“A sole proprietorship is

generally understood to have no legal identity apart from the proprietor”). An entity

with only one owner is thus ineligible for tax treatment as a partnership.

       But the 2001 partnership returns for 466, 541, and 6611 seemingly list more

than one owner:




       22
        We are deciding these cases on the preponderance of the evidence, so we
do not have to decide which party has the burden of proof. See, e.g., Estate of
Turner v. Commissioner, 

, 309 (2012).
                                        - 48 -

[*48] •      Lawrence is the 99% limited partner, and 67 is the 1% general partner
             of 466;

      •      Salazar is the 99% limited partner, and 70 is the 1% general partner of
             541; and

      •      Garcia is the 99% limited partner, and 96 is the 1% general partner of
             6611.

      The Commissioner says this doesn’t matter and argues that because 67, 70,

and 96 did not properly elect to be treated as corporations, they are disregarded

entities. See sec. 301.7701-3(b)(1)(ii), Proced. & Admin. Regs. Since the parties

stipulated that 67, 70, and 96 never elected to be classified as corporations on Forms

8832, we agree.23 That means that Lawrence, as the sole member of 67, will be

treated as owning all of 466; Salazar, as the sole member of 70, will be treated as

owning all of 541; and Garcia, as the sole member of 96, will be treated as owning

all of 6611. And we disregard a single-owner entity for tax purposes under sections

301.7701-2(a) and 301.7701-3(b)(1)(ii), Proced. & Admin. Regs., unless it elects to

be taxed as a corporation.




       23
         While individuals and entities may apply for an employer identification
number (EIN) using Form SS-4, Application for Employer Identification Number,
this form alone doesn’t make a valid election to be taxed as a specific type of entity.
For partnerships, only Form 8832 may be used to make an election. See sec.
301.7701-3(c)(1), Proced. & Admin. Regs.; see also Form SS-4, at 3 (Rev. Apr.
2000) (“Caution: This is not an election for a tax classification of an entity”).
                                          - 49 -

[*49] Each petitioner, however, has a fallback argument. All three are married.

And all three argue that because Texas is a community-property state, Lawrence’s

wife is the second owner of 67 and 466, Salazar’s wife is the second owner of 70

and 541, and Garcia’s wife is the second owner of 96 and 6611. And, although the

regulation’s default rule for entities owned by an individual is to treat them as sole

proprietorships, its default rule for entities owned by more than one individual is to

treat them as partnerships. See sec. 301.7701-3(a), (b)(1)(i), Proced. & Admin.

Regs.

        Federal law controls the classification of “partners” and “partnerships” for

federal tax purposes. See sec. 301.7701-1(a), Proced. & Admin. Regs.; see also

Commissioner v. Tower, 

, 288, 290 (1946). Things that State law may

regard as separate entities might not be separate entities under Federal tax law. See

sec. 301.7701-1(a)(3), Proced. & Admin. Regs. It all depends on the Code. Mere

coownership is not enough to create a separate entity, see sec. 301.7701-1(a)(2),

Proced. & Admin. Regs., and even electing to be taxed as a partnership under the

check-the-box-regulations is not always enough, see sec. 301.7701-3(c), Proced. &

Admin. Regs.

        Though Lawrence, Garcia, and Salazar do not cite it, there is a relevant

revenue procedure explaining the Commissioner’s view about the intersection of
                                         - 50 -

[*50] community-property law and the check-the-box regulations.24 Revenue

Procedure 2002-69, 2002-2 C.B. 831, provides that for a “qualified entity” that is

“owned solely by husband and wife as community property” the IRS “will respect a

taxpayer’s treatment of these entities as either disregarded entities or partnerships.”

But to qualify, a husband and wife must “wholly own[] * * * as community

property” a “business entity”25 not “treated as a corporation under [section]

301.7701-2,” and must uniformly treat such entity “as a partnership for federal tax

purposes”--including filing “the appropriate partnership returns.” Rev. Proc. 2002-

69, secs. 3.02, 4.02, 2002-2 C.B. at 831.

      This last requirement knocks 67, 70, and 96 out of partnership contention

under the revenue procedure: Both sides acknowledge that these three never filed

any tax return of any kind. Since 67, 70, and 96 remain disregarded entities

notwithstanding the revenue procedure and since no one has suggested any other

way to make them partnerships under the Code, they cannot be the second


       24
         We are not bound by revenue procedures, see Compaq Computer Corp. v.
Commissioner, 

, 372 (1999), but they are official statements of the
Commissioner’s position and we may let them persuade us, see Nationalist
Movement v. Commissioner, 

, 583 (1994), aff’d, 

 (5th Cir.
1994). Without deciding the validity of Revenue Procedure 2002-69, 2002-2 C.B.
831, we note that the Commissioner is the only party who argues it forecloses 67,
70, 96, 466, 541, and 6611 from being partnerships for federal tax purposes.
       25
            As defined by section 301.7701-2(a), Proced. & Admin. Regs.
                                        - 51 -

[*51] members of 466, 541, and 6611, respectively. 466, 541, and 6611 can

likewise only be “partnerships” for income tax purposes if Revenue Procedure 2002-

69 operates to make Lawrence’s, Garcia’s, and Salazar’s respective wives the

second member of each of those entities. For this to occur each couple must first be

deemed to have formed a “business entity” under the Code.

       Section 301.7701-2(a), Proced. & Admin. Regs., establishes that a business

entity is:

       [A]ny entity recognized for federal tax purposes (including an entity with a
       single owner that may be disregarded as an entity separate from its owner
       under [section] 301.7701-3) that is not properly classified as a trust under
       [section] 301.7701-4 or otherwise subject to special treatment under the
       Internal Revenue Code. [Emphasis added.]

As a threshold matter, Lawrence, Garcia, and Salazar must therefore establish that

they formed “entities” in 466, 541, and 6611 with their wives. Cf. Superior Trading,

137 T.C. at 81-82 (noting that two-company venture never constituted a taxable

partnership entity because neither party “‘join[ed] together as partners in the conduct

of a business’”). Coownership by itself is not enough. See sec. 301.7701-1(a)(2),

Proced. & Admin. Regs. (e.g., sole owner or tenants-in-common of farm property

rent that property to another individual for money or a share of crops). Instead we

look to several factors:

       •     the agreement of the parties and their conduct in executing its terms;
                                         - 52 -

[*52] •      the contributions, if any, which each party has made to the venture;

      •      the parties’ control over income and capital and the right of each to
             make withdrawals;

      •      whether each party was a principal and coproprietor, sharing a mutual
             proprietary interest in the net profits and having an obligation to share
             losses, or whether one party was the agent or employee of the other,
             receiving for his services contingent compensation in the form of a
             percentage of income;

      •      whether business was conducted in the joint names of the parties;

      •      whether the parties filed Federal partnership returns or otherwise
             represented to respondent or to persons with whom they dealt that they
             were joint venturers;

      •      whether separate books of account were maintained for the venture; and

      •      whether the parties exercised mutual control over and assumed mutual
             responsibilities for the enterprise.

Luna v. Commissioner, 

, 1077-78 (1964). The “essential question is

whether the parties intended to, and did in fact, join together for the present conduct

of an undertaking or enterprise.” Id. at 1077 (citing Commissioner v. Culbertson,

, 742 (1949)); see also Historic Boardwalk Hall, LLC v. Commissioner,

, 449 (3d Cir. 2012), rev’g and remanding 

 (2011);

Commissioner v. Tower, 327 U.S. at 286-87; Southgate Master Fund, L.L.C. ex. rel.

Montgomery Capital Advisors v. United States, 

, 488
                                         - 53 -

[*53] (5th Cir. 2011); TIFD III-E, Inc. v. United States, 

, 231 (2d Cir.

2006) (accepting the district court’s sham-transaction determination but reversing

and remanding so that the district court would analyze the arrangement under the

totality of the circumstances and determine whether a bona fide partnership existed)

.26 We will examine these factors for each of the purported partnerships at issue.

                    a.    466

      With regard to 466, most of the Luna factors require little discussion.

      Parties’ Agreement. Lawrence and his wife had no side agreement regarding

466, and Mrs. Lawrence did not sign and was not explicitly a party to 466’s

partnership agreement. This factor weighs against finding 466 was a partnership.27

      Parties’ Contribution to the Venture. Mrs. Lawrence had no knowledge of

466 until sometime well after its dissolution, and did not contribute any labor or




       26
         This entity-focused and intent-seeking approach to determining the
existence of a partnership applies broadly--not just to partnerships engaged in
questionable digital-option machinations. See, e.g., Historic Boardwalk Hall, 694
F.3d at 449.
       27
         We can imagine a case where one spouse may not be a formal party to the
partnership agreement, but may otherwise indicate an understanding that he was
bound by its terms. This is not the case here.
                                         - 54 -

[*54] property to it during its short lifespan. This factor weighs against finding a

partnership.

      Principal v. Employee. Mrs. Lawrence acted as neither principal nor

employee of 466. While in other contexts this fact could be neutral, here it

underscores Mrs. Lawrence’s lack of involvement with 466 and weighs against

finding it to be a partnership.

      Whether Business Was Conducted in Joint Name. Until trial Lawrence (and

Garza) did not hold Mrs. Lawrence out as being a member of 466, and she is

nowhere mentioned in 466’s records. This factor weighs against finding a

partnership.

      Separate Books. Lawrence and his wife did not keep separate books

regarding their interests in 466. But since we wouldn’t usually expect a husband and

wife business team to keep separate books, we’ll call this factor at least neutral.

      Mutual Control and Responsibility. Mrs. Lawrence may have had an interest

in 466, and may have been able to exercise some amount of control over its affairs

under Texas law. She did not--even in a perfunctory way--exercise whatever rights

she had. She had no responsibilities with 466 and didn’t help Lawrence organize or

“operate” the alleged business. This factor weighs against finding a partnership.
                                        - 55 -

[*55] Parties’ Control Over Income and Capital. The remaining two Luna factors

require slightly more analysis. As a spouse of 466’s principal, Mrs. Lawrence may

have had a community interest in Mr. Lawrence’s partnership shares and a right to a

share of any distribution of 466’s surplus property or profits. See Tex. Fam. Code

Ann. sec. 3.002 (West 2006) (community property is property, other than separate

property, acquired by either spouse during the marriage); see also Smoot v. Smoot,

 (Tex. Civ. App. 1978) (discussing whether an asset of partnership

between husband and his father was husband’s separate property or community

property). This quasi-interest does not, however, mean she could have controlled

466’s property, income, or capital.

      Under Texas law, a spouse retains “sole management, control, and disposition

of the community property that the spouse would have owned if single.” Tex. Fam.

Code Ann. sec. 3.102(a) (West 2006). Since Lawrence would have been 466’s sole

owner if he were single, he retained sole management and control over it without

regard for the community-property rights of Mrs. Lawrence. And Lawrence’s right

as a formal partner to manage and control 466 is not itself community property. See

Tex. Bus. Orgs. Code Ann. sec. 152.203(a) (West 2012).

      Mrs. Lawrence had no legal “right” to manage and control the income and

capital that constituted 466 (such as it was). Even if she had, she never exercised
                                         - 56 -

[*56] such rights or demonstrated any concern about whether they existed. This

factor weighs against finding a partnership entity between Lawrence and his wife.

      Return Filings. 466 filed a Form 1065 for its 2001 tax year in April 2002

listing 67 as its TMP. This return was not signed by Mrs. Lawrence, but was

apparently signed by Lawrence on behalf of 67, which was in turn 466’s general

partner. 466 issued two Schedules K-1: one to 67 and the other to “Larry W.

Lawrence, Jr.”

      While the return indicates that 466 held itself out as a federally recognized

partnership, it also shows that 466 did not consider Mrs. Lawrence to be one of its

partners. This underscores our finding that 466’s characterization of Mrs. Lawrence

as a partner is post hoc and self-serving. This factor weighs against finding it to be a

partnership.

      We have to conclude that Lawrence and his wife did not intend to “join

together” to undertake business under 466, and that she was not a partner in this

purported partnership.28 Not a single Luna factor or other fact weighs in favor of

finding a partnership entity, and several weigh heavily against it. During 2001

Mrs. Lawrence didn’t know that 466 existed, and she took no part in its


       28
        We could likewise have concluded on these facts that the spouse did not
“own” a capital interest in 466 within the meaning of section 704(e).
                                         - 57 -

[*57] management or control. She was not listed as one of its partners on its returns

or agreements or any other document--including its account at DB Alex Brown. And

she did not exercise dominion or control over either an interest in, or the assets of,

466. Despite the operation of Texas community-property laws--in fact consistently

with them--she was not a partner of 466, and Lawrence and his wife must be treated

as “one person.” Cf. sec. 6231(a)(12) (under default TEFRA procedure, husband

and wife are one person). Because we find 466 had only one participant, Lawrence,

we find that it is disregarded under section 301.7701-3(a), (b)(1)(ii), Proced. &

Admin. Regs.

                    b.     541

      We also find based on the facts and circumstances that Salazar’s wife did not

join with Salazar to form a partnership entity in 541. During 2001 she also didn’t

know that it existed, and did not have any management or other responsibility for

the purported partnership. She was not listed as a partner of 541 on its federal

return, agreements, or any other document, and she didn’t receive a Schedule K-1.

Salazar didn’t hold her out as a partner of 541. Beyond a possible stake in

Salazar’s 541 interest, she had no dominion or control over 541 or its assets. Her

name wasn’t on 541’s DB Alex Brown account. As with Mrs. Lawrence, Texas

community-property laws don’t make her a partner in 541, and she lacked the
                                         - 58 -

[*58] slightest indicia of joining together with her husband to conduct business as a

partnership. She was not a partner of 541, and so Salazar and his wife must also be

treated as “one person.” Because we find 541 had only one participant, Salazar, we

find that it too is disregarded under section 301.7701-3(a) and (b)(1)(ii), Proced. &

Admin. Regs.

                    c.    6611

      Garcia’s case is just the same. His wife, too, did not join with him to form a

partnership entity in 6611. During 2001 she too didn’t know that 6611 existed, and

she didn’t have any responsibility over or control of it or its assets. She too was not

listed as a partner of 6611 on its returns, agreements, or any other document, didn’t

receive a Schedule K-1, and was not on 6611’s DB Alex Brown account. She too

wasn’t held out as a partner of 6611. Like Mrs. Lawrence with regard to 466 and

Mrs. Salazar with regard to 541, Mrs. Garcia demonstrated none of the indicia of

being in a partnership entity with her husband, and we find that she wasn’t. Like

Lawrence and Salazar and their respective wives, Garcia and his wife must be

treated as “one person.” And since 6611 therefore had only one participant, Garcia,

we find that it is disregarded under section 301.7701-3(a), (b)(1)(ii), Proced. &

Admin. Regs.
                                          - 59 -

[*59]         2.     Tax-Motivated Business Purpose

        There is a second and separate obstacle to any finding that these entities were

partnerships: A partnership does not come into existence for tax purposes until it

begins its business activities. See Torres v. Commissioner, 

, 737 (1987).

The caselaw is clear, however, that the pursuit of business activity in furtherance of

tax avoidance “is no more a business purpose than actually engaging in tax

avoidance.” ASA Investerings P’ship v. Commissioner, 

, 513 n.6 (D.C.

Cir. 2000), aff’g T.C. Memo. 1998-305. The “absence of a nontax business purpose

is fatal.” Id. at 512; see also Boca Investerings P’ship v. United States, 

, 632 (D.C. Cir. 2003). We therefore must ask specifically if the “parties

intended to join together as partners to conduct business activity for a purpose other

than tax avoidance.” ASA Investerings, 201 F.3d at 513 (emphasis added).

        In the partnership agreements for 466, 541, and 6611, there is an identical

laundry list of stated purposes for each partnership. The primary purpose listed for

each one, for instance, is “to make a [p]rofit, increase wealth, and provide a means

for each [p]artner’s [f]amily to become knowledgeable of, manage, and preserve

[f]amily [a]ssets.” Even if we believe what the partnership agreements say (which

we don’t), courts have been reluctant to find that managing and preserving family
                                         - 60 -

[*60] assets is a legitimate and significant nontax reason for establishing a

partnership where the property doesn’t require active management. See, e.g., Estate

of Bigelow v. Commissioner, 

, 972-73 (9th Cir. 2007) (property

contributed consisted of a house that was rented to a tenant), aff’g T.C. Memo.

2005-65; Estate of Rosen v. Commissioner, T.C. Memo. 2006-115, 

, at *7 (assets contributed consisted primarily of stocks, bonds, and cash,

conducted no business activity and had no business purpose for its existence).

Managing family assets just doesn’t justify the existence of any entity that doesn’t

actively manage any property or carry on any business.

      The record paints a narrower picture of why 466, 541, and 6611 were

formed. They were created shortly before Lawrence, Salazar, and Garcia

purchased and contributed the options on yen and Canadian dollars. The

partnerships didn’t hold those assets for long--less than a month--before they

liquidated and distributed all of the remaining property to the purported partners.

Garza’s plan predetermined the mayfly-like lives of 466, 541, and 6611 from their

hatching to their dispatching. And we also find there wasn’t a nontax need to form

the partnerships to take advantage of any purported potential profits of investing in

digital options and Canadian dollars. We therefore find that the only purpose for

466, 541, and 6611 was to carry out a tax-avoidance scheme. And we find
                                         - 61 -

[*61] Lawrence, Salazar, and Garcia never intended to run businesses under the

umbrella of these entities, and will disregard 466, 541, and 6611 for tax purposes for

this reason too.

             3.     Consequences of Disregarding 466, 541, and 6611

      When we disregard a partnership for tax purposes, we are holding that the

rules of subchapter K of chapter 1 of the Code (which contains the substantive law

governing the income taxation of partners) no longer apply, and that we will deem

the partnership’s activities to be engaged in by one or more of its purported partners.

A disregarded partnership has no identity separate from its owners, and we treat it as

just an agent or nominee. See, e.g., Tigers Eye Trading, 138 T.C. at 94, 96 n.32, 99.

But disregarding the partnership doesn’t necessarily mean that the taxpayer’s

investment and all items reported by the disregarded partnership are permanently

reduced to zero. Although we don’t respect the form, we still need to deal with the

substance of the transactions to the extent we have jurisdiction. See, e.g., ACM

P’ship v. Commissioner, 

, 262-63 (3d Cir. 1998) (allowing deductions

for securities that had “objective economic consequences apart from tax benefits * *

* even when incurred in the context of a broader transaction that constitute[d] an

economic sham” (citations omitted)), aff’g in part, rev’g in part T.C. Memo.

1997-115; Tigers Eye Trading, 138 T.C. at 108-09 (stating we have
                                         - 62 -

[*62] jurisdiction under TEFRA to determine basis of property allegedly contributed

to a purported partnership, even if the partnership never existed).

      The Code tells us that TEFRA procedures will still apply in these cases as

long as the purported partnership filed a partnership return--which 466, 541, and

6611 all did for 2001.29 See secs. 6231(g), 6233; see also sec. 301.6233-1(b),

Proced. & Admin. Regs. This means we have to determine in these cases any items

that would have been “partnership items,” as defined in section 6231(a)(3), and

section 301.6231(a)(3)-1, Proced. & Admin. Regs., had 466, 541, and 6611 been

valid partnerships for tax purposes. See Tigers Eye Trading, 138 T.C. at 97. This is

the “hypothetical entity” approach. See id. at 148-49 (Halpern, J., concurring). We

now turn to the FPAA and the pleadings to decide which items are still in play for us

to decide.




       29
         TEFRA applies generally to any partnership, but there is an exception for
“small partnerships”--meaning those having 10 or fewer partners. Sec.
6231(a)(1)(B). But this exception doesn’t apply if any partner is a “pass-through
partner.” Sec. 301.6231(a)(1)-1(a)(2), Proced. & Admin. Regs. A “pass-through
partner” includes a “partnership, estate, trust, S corporation, nominee, or other
similar person.” Sec. 6231(a)(9). The Commissioner has determined this includes
disregarded entities, see Rev. Rul. 2004-88, 2004-2 C.B. 165, and we agree. Since
466, 541, and 6611 all had single-member LLCs as partners, TEFRA procedures
apply here.
                                         - 63 -

[*63] B.     Capital Contributions and Distributions of Property

      The Commissioner adjusted 466’s, 541’s, and 6611’s reported capital

contributions and distributions of property. Given that subchapter K doesn’t apply to

a simple agency relationship, there can be no contributions to or distributions from a

partnership that does not exist. See id. at 107. The property is effectively treated as

if it hadn’t been contributed to or distributed from the purported partnerships, and

setting “Capital Contributions” and “Distributions of Property other than Money” to

zero is appropriate. But that doesn’t mean the underlying property has no

substantive value. Since the basis (i.e. inside basis) of the allegedly contributed

option contracts and Canadian money would both have been partnership items if the

partnerships were respected, we have jurisdiction to determine them in this

partnership-level proceeding.

      With regard to the option contracts, each purported partner should have

treated the foreign currency options as a single option spread: The long and short

positions were part of one contract and couldn’t have been separated as a matter of
                                        - 64 -

[*64] fact and law.30 Cf. sec. 1092 (“straddle” rules). The long options that 0327,

0997, and 464 purchased as nominees of Lawrence, Salazar, and Garcia entitled

each purported partnership to receive millions of dollars from Deutsche Bank if the

long option was in the money when it expired--$8 million for 466, $8 million for 541,

and $10 million for 6611. But each was also required to pay an almost equal




       30
          The option legs were acquired on the same date, executed with the same
counterparty, in the same foreign currency, contingent on identical facts, listed on a
single transaction confirmation, and exercisable on the same date. The parties
simply placed bets on one fact: the price movement of the yen over a stated price.
A single net premium was paid for the spreads--the difference between the long and
short position. And the experts in these cases credibly testified that Deutsche Bank
would not have entered into the options unless they were treated as linked. If the
options were separable, Deutsche Bank’s risk would be too great: The TMPs in
these cases lacked the financial capacity to pay the $4-$5 million premiums on the
long options, and they lacked the financial capacity to pay the bank the millions of
dollars that would have been due if the short option, standing alone, expired in the
money.

       In Helmer v. Commissioner, T.C. Memo. 1975-160, 

, the
taxpayers beneficially owned real property that was subject to an option. Title to
the optioned property was held by an escrow agent, and the partnership which
granted the option received yearly option premium payments from the option holder,
and listed those amounts as distributions to the taxpayers on the partnership’s books
and tax returns. The taxpayers argued that the option payments were for a
contingent liability because the option was still outstanding. But we held that there
was no contingent liability because the transaction underlying the option was still
open, and the option premiums were not subject to forfeiture. Unlike the taxpayers
in Helmer, Lawrence, Salazar, and Garcia all lacked the financial capacity to close
the option transactions, and so Helmer is readily distinguishable.
                                        - 65 -

[*65] amount to Deutsche Bank if the short option was also in the money on that

day--$7,920,000 for 466, $7,920,000 for 541, and $9,900,000 for 6611.

      The appropriate bases in the options are simply what 0327, 0997, and 464

paid for them. See sec. 1012(a). That’s $40,000; $40,000; and $50,000,

respectively. The appropriate bases in the Canadian money are likewise just what

0327, 0997, and 464 paid for it as nominees of and agents for Lawrence, Salazar,

and Garcia, respectively; $750 for 466; $4,500 for 541; and $4,500 for 6611.

      C.     Ordinary Gain (Loss) Adjustments

      After the expiration of the options, 466 reported a $14,300 gain, 541

reported a $40,000 loss, and 6611 reported a $50,000 loss. The Commissioner is

correct that there can be no “partnership” loss (or gain) where there are no valid

partnerships. Yet the purported partnerships all bought and sold actual property for

Lawrence, Salazar, and Garcia. TEFRA says that we look to the rules of

subchapter K to discover our jurisdiction over items belonging to an unrecognized

“partnership”. If we had found 466, 541, and 6611 to be real partnerships, the

digital-option pairs would have been partnership property. And since they expired

in the hands of these partnerships, any gain or loss they would have given rise to

would have been a partnership item. Since the Commissioner wants to adjust these

items and we have jurisdiction, we must determine their tax treatment in this
                                         - 66 -

[*66] partnership-level proceeding, but without looking any further at the rules of

subchapter K.

      Section 183 disallows deductions for an activity not engaged in for profit,

except to the extent it produces income. Section 183 speaks of the activities of “an

individual or an S corporation,” but we have agreed with the Commissioner that

“section 183 of the Code applies to the activities of a partnership, and the provisions

of section 183 are applied at the partnership level,” Thompson v. Commissioner, 

, 231 (2011) (quoting Rev. Rul. 77-320, 1977-2 C.B. 78), appeal filed (8th

Cir. Mar. 26, 2012); see also, e.g., Krause v. Commissioner, 

, 168, 176

(1992), aff’d sub nom. Hildebrand v. Commissioner, 

 (10th Cir. 1994); Walford v. Commissioner, T.C. Memo. 2003-296, 

, at *4, aff’d, 123 Fed. Appx. 952 (10th Cir. 2005). And section

301.6231(a)(3)-1(b), Proced. & Admin. Regs., plainly states that “[t]he term

‘partnership item’ includes * * * whether partnership activities have been engaged in

with the intent to make a profit for purposes of section 183.”31


       31
         There may be some theoretical disagreement as to how section 183
operates to disallow deductions claimed by a partner that flow through to him from a
valid TEFRA partnership: The Ninth Circuit has held that section 183 “applies to
partnerships despite the statute’s failure to mention them * * *.” Hill v.
Commissioner, 

, 1218 (9th Cir. 2000). The Fifth Circuit, in contrast,
has held that while “deductions for partnership expenses are not allowed or
                                                                          (continued...)
                                        - 67 -

[*67] 466, 541, and 6611 are not real partnerships--they are merely agents or

nominees of Lawrence, Salazar, and Garcia, respectively. And this means their acts

are treated as if they were done directly by their principals. 466 does not have an

identity separate from Lawrence. 541 does not have an identity separate from

Salazar. And 6611 does not have an identity separate from Garcia. We will

therefore apply the rules of section 183 to 466, 541, and 6611.32

      While a taxpayer need not be reasonable in expecting to make a profit, he

must establish that he undertook the activity with a good-faith objective of doing


      31
       (...continued)
disallowed directly under [section] 183 itself,” the section 183 factors help
determine the requisite profit motive required by other Code sections. Copeland v.
Commissioner, 

, 335 (5th Cir. 2002), aff’g in part, rev’g in part T.C.
Memo. 2000-181; see also McGann v. United States, 

, 756-757
(Fed. Cl. 2007) (noting the different approaches taken by the Fifth and Ninth
Circuits and siding with the Fifth). And the D.C. Circuit has no position on this
point.

       There may not be much of a conflict here--the Fifth Circuit was analyzing a
real activity of a real partnership. In contrast, what we have here are tax nothings or
mere “hypothetical entities,” which we treat as if they were partnerships only as a
matter of TEFRA procedure, see sec. 6233.
       32
         The FPAAs also asserted that neither 541 and 6611 nor their purported
partners entered into the option positions or purchased foreign currency or stock
with a profit motive for purposes of section 165(c)(2). See Notice 2000-44, 2000-2
C.B. 255, 256 (citing Fox v. Commissioner, 

 (1984), for the
proposition that “in the case of individuals, these [paired-option] transactions [that
generate artificial tax losses] may be subject to challenge under [section]
165(c)(2)”).
                                         - 68 -

[*68] so. See sec. 1.183-2(a), Income Tax Regs. (“Although a reasonable

expectation of profit is not required, the facts and circumstances must indicate that

the taxpayer entered into the activity, or continued the activity, with the objective of

making a profit”). In making this determination at the partnership level, we generally

look to the actions of the promoter and general partner of the partnership. See, e.g.,

Peat Oil & Gas Assocs., 100 T.C. at 276 (“[I]n determining whether the

[p]artnerships had the requisite profit motive it is necessary to look at the motive and

objectives of the promoters and the managers of the [p]artnerships” (citation and

internal quotation marks omitted)), aff’d, Ferguson, 

. This means that

we look at the motives of Garza, the transactions’ promoter; and the managers of

466, 541, and 6611--who were also their TMPs. Section 1.183-2(b), Income Tax

Regs., lists a number of factors for us to consider:

      •      the manner of carrying on the activity;

      •      the expertise of the taxpayer carrying on the activity or his advisers;

      •      the time and effort of the taxpayer in carrying on the activity;

      •      the expectation that assets used in the activity will appreciate;

      •      the taxpayer’s success in carrying on other activities;

      •      the taxpayer’s history of income or losses with respect to the activity;

      •      the amount of occasional profits, if any;
                                         - 69 -

[*69] •      the financial status of the taxpayer; and

      •       whether the activity has elements of personal pleasure or recreation.

These factors are not exclusive, and we do not decide the issue on the basis of a

single factor or a mathematical preponderance of factors. See id.

      Salazar testified that the tax benefits were not his primary reason for following

Garza’s investment strategy; instead, it was the shot at doubling his investment and a

chance of making a lot more than that if the spot rate hit the “sweet spot.” Lawrence

and Garcia gave us a similar explanation for their deals. But we aren’t convinced

that any of them followed Garza’s plan with the primary purpose of making a profit

on the investment strategy.

      The chance of a “sweet spot” payout was incredibly unlikely. Deutsche Bank

told Garza to assume that a sweet spot payout would never happen, and reasonably

compared hitting the sweet spot to winning the lottery, in that there was a very “low

probability [that it would happen] and by itself [was] not a good reason to do the

[investment].” The experts’ reasonable computations of the theoretical probability of

this event fell in the range of 0.13% to 0.25%.

      But these lotteries were rigged: Deutsche Bank was the calculation agent,

which meant that it got to determine the spot-market exchange rate at a particular

minute on a particular day that would in turn trigger the payoffs on the options.
                                        - 70 -

[*70] And if Deutsche Bank followed industry market practices in determining the

spot-market exchange rate, it would have asked three or four other banks or brokers

to quote a “bid” price at which they would buy a currency and an “ask” price at

which they would sell a currency. That means Deutsche Bank would have received

a range of prices, and we have credible expert testimony that bid and ask prices are

generally at least $0.03 apart. Because the strike prices in Lawrence’s, Salazar’s,

and Garcia’s contracts were only $0.02 apart, Deutsche Bank could choose a price

outside the specified range and thus ensure that the options would never hit the sweet

spot. We therefore find that the realistic likelihood of a sweet-spot payout was nil.

      We also don’t believe Lawrence’s, Salazar’s, and Garcia’s claims that they

did the trades and transactions that Garza suggested because they wanted a chance

to double their money. Lawrence paid Deutsche Bank $40,000 for his options,

Salazar paid $40,000, and Garcia paid $50,000. But these attorneys didn’t

investigate whether Deutsche Bank’s prices were fair33 or whether they could do the

same investments somewhere else for less. The appropriate value of the option




       33
        The Commissioner’s experts estimated the options to be worth about
$25,500 for Lawrence, $30,800 for Salazar, and $38,500 for Garcia. Had any of the
business-savvy and entrepreneurial lawyers looked into the premium, they might’ve
noticed Deutsche Bank was charging them at least 30-35% more than the options
were worth.
                                         - 71 -

[*71] pair is the value of the long option minus the value of the short option. The

Commissioner’s experts reasonably calculated the theoretical net value of each pair

of options using the Black-Scholes model:34 $25,500 for Lawrence, $30,800 for

Salazar, and $38,500 for Garcia.

      They also--and this is rather obviously important--didn’t add Garza’s fees into

their profit analysis. Lawrence, Salazar, and Garcia each paid Garza $95,000 for

these deals. That means that Lawrence paid $135,000 for a less-than-19% shot at

$80,000, Salazar paid $135,000 for a less-than-14% shot at $80,000, and Garcia

paid $145,000 for a less-than-14% shot at $100,000. (These probabilities are from



       34
          The Black-Scholes model is a widely accepted formula for valuing
European-style options on liquid assets. It relies on five variables: the exercise
price of the option, the market price of the underlying asset, the volatility of the
underlying asset, the expiration date of the option, and the risk-free interest rate.
The Code doesn’t require us to use the Black-Scholes valuation method, but we
think it is a reasonable method for valuing the options pairs here.

       The biggest weakness we can see in using the Black-Scholes model in this
manner is that it doesn’t account for Deutsche Bank’s opportunity to fudge the
partnerships’ small chance for a big payday. It was statistically possible for the long
options to be in the money when the short options weren’t--but no more than a
0.25% chance. But Deutsche Bank had the sole authority to pick the exchange rate
when the options terminated, and there was only a $0.02 spread in the strike prices.
The Commissioner’s experts credibly testified that the prices from which Deutsche
Bank could choose routinely varied by $0.03, which means that the partnerships
would hit the sweet spot only if Deutsche Bank decided it wanted to lose millions of
dollars. The true value of the options is thus likely even lower than the Black-
Scholes model tells us.
                                         - 72 -

[*72] the Commissioner’s experts, whose calculations we find more likely than not

correct on this question.) The bet was a long shot before Garza’s fees, and any

potential for profit was completely eliminated once his fees were factored in. We

therefore find that these options weren’t purchased with the intent of making a profit,

but were just part of Garza’s plan to create tax benefits.

      Garza told Lawrence, Salazar, and Garcia that for them to take advantage of

the tax benefits, the transactions had to be done before the end of 2001. That is why

these trades were executed in November and December of that year. Lawrence,

Salazar, and Garcia wanted to reduce their tax liabilities on the money they got from

their Firestone cases. That was their motive for buying the options and the Canadian

dollars and contributing those assets to the partnerships.

      Other than to exploit the partnership-tax rules, there was no reason for the

options to be contributed to the partnerships. The partnerships didn’t do anything

with these options except hold them and then report a gain or loss when the contracts

terminated. We find that the only reason for the acquisition of the foreign-currency

options and Canadian dollars by the partnerships was to facilitate Garza’s tax-

avoidance scheme.35


       35
         We also find--just because such factors are also mentioned in closer cases--
that 466, 541, and 6611 were not in the business of foreign-currency trading, and
                                                                        (continued...)
                                         - 73 -

[*73] Garza was not a certified investment adviser or certified financial planner.

And he testified that the primary reason he tried to make his clients money on the

options was that he believed it would then be easier to prove that his clients had a

legitimate profit motive. The purchase of the foreign-currency options and Canadian

dollars followed Garza’s plan, but neither the partnerships nor the TMPs had

seriously invested in foreign currency before Garza came along.

      This means that none of the section 183 factors weighs in favor of finding a

for-profit venture. The manner, expertise, and purpose of the investments--and

Garza’s and Lawrence’s, Salazar’s, and Garcia’s own designs--centered wholly on

tax avoidance. The activities were engaged in solely because Lawrence, Salazar,

and Garcia wanted to shelter large amounts of income earned in their respective law

practices. The charade had one purpose--tax avoidance--and we refuse to

countenance self-serving post hoc revisionism to the contrary. We therefore find that

the activities of 466, 541, and 6611 were not engaged in “for profit,” but were only

the means for carrying out a tax-avoidance scheme.




      35
        (...continued)
did not undertake foreign-currency trading with the intent of making a profit in later
years (which should be obvious since the partnerships were all terminated at the end
of that year).
                                         - 74 -

[*74] The consequences of this finding are a bit different for each of the three

hypothetical entities. 541 and 6611 reported losses on their Schedules K, Partners’

Distributive Share Items, for 2001. Because we find that 541’s and 6611’s activities

were not engaged in for profit, we sustain the Commissioner’s determinations and

adjust those losses to zero.

      466 reported a small gain on the termination of the option contracts. The

FPAA issued to 466, however, zeroed out the $14,300 of income reported on

Schedule K, line 1, and Form 4797. Although this adjustment helps 466, Lawrence

argued that the Commissioner erred in adjusting the net gain on Form 4797 of

$14,300. We agree a bit with Lawrence that he made money in some sense

(ignoring Garza’s fee)--purely by mistake. But even on this small point, we find

that 466 misreported what happened. On its Form 4797, 466 reported the “sales

price” of the options as $54,300 and the partnership’s basis in the property as

$40,000. But the actual amount realized on the expiration of the options was

$80,000, because the proposed offer to unwind the option for $54,300 did not go

through. Therefore we have to adjust that item of income to $40,000--the

difference between $80,000 and 466’s basis of $40,000. But in the end, we get

back to the same place the Commissioner pointed us to: Section 183 allows losses
                                          - 75 -

[*75] up to the amount of income even in the absence of a profit motive, and here

Garza’s fee for this scheme swallows up that $40,000 gain.

III.   Penalties

       All that is left is the penalties the Commissioner seeks. We have jurisdiction

over these penalties at the partnership level because they “relate to” partnership-level

adjustments: We can adjust the amounts of partnership contributions and

distributions in light of our determination that the partnership doesn’t exist.

       The Commissioner meets his burden of production on the penalty with simple

arithmetic. A gross valuation misstatement exists if the value or adjusted basis of

any property claimed on the partnership return is 400% or more of the correct

amount. See sec. 6662(e)(1)(A), (h)(2)(A). Each partnership reported an adjusted

basis or value for Canadian dollars (described opaquely as distributions of property)

that was well more than 10,000% of the correct value. Any underpayment of tax

attributable to those gross-valuation misstatements is subject to a 40% penalty. See

sec. 6662(h)(1).

       The only issue in left in dispute is whether 466, 541, and 6611 had section

6664 reasonable-cause-and-good-faith defenses for the gross-valuation

misstatement penalty. We have held that a partnership can raise this defense to that
                                         - 76 -

[*76] penalty at the partnership level, see 106 Ltd., 136 T.C. at 76-77, and all three

partnerships here do.

      The gross-valuation-misstatement penalty can be rebutted by a showing of

reasonable cause and good faith, sec. 6664(c), and a taxpayer will often argue (as all

three lawyers here do) that he had reasonable cause and showed good faith by

relying on professional advice. The regulation somewhat unhelpfully states that

reliance on professional advice is “reasonable cause and good faith if, under all the

circumstances, such reliance was reasonable and the taxpayer acted in good faith.”

Sec. 1.6664-4(b)(1), Income Tax Regs. The caselaw lists three factors.

Neonatology Assocs., P.A. v. Commissioner, 

, 99 (2000), aff’d, 

 (3d Cir. 2002).

      •      First, was the adviser a competent professional who had sufficient
             expertise to justify reliance?

      •      Second, did the taxpayer provide necessary and accurate information to
             the adviser?

      •      Third, did the taxpayer actually rely in good faith on the adviser’s
             judgment?

      All three lawyers--acting in their capacity as TMPs and general managers of

their partnerships--claim reasonable reliance on Garza and Everhard as well.
                                         - 77 -

[*77] (Lawrence used Drefke to prepare some of his returns, but on brief did not

claim to rely on Drefke’s professional advice. For the reasons we summarized

supra pp. 31-32, this would not have been successful).

      We’ve already found that as a matter of fact that Everhard--though

independent of the deal--told Lawrence, Salazar, and Garcia that he was not giving

any of them a tax opinion and that they would have to rely on Garza for that. See

supra pp. 30-31.

      The question therefore becomes whether the partnerships’ reliance on

Garza’s advice was reasonable and in good faith.

      A.     Garza’s Expertise

      Garza was licensed and would have appeared competent even to a lawyer at

the time the partnerships prepared their returns--at least to lawyers not versed in tax

law, as these lawyers were not.

      B.     Provision of Necessary and Accurate Information

      We also find that the partnerships provided Garza with all the relevant

financial data needed to assess the correct level of income tax. See sec.

1.6664-4(c)(1)(i), Income Tax Regs. Garza in fact generated most of that

information and certainly had it all available.
                                          - 78 -

[*78] C.     Actual Reliance in Good Faith

      It’s the third point--the issue of the lawyers’ actual good-faith reliance on

Garza’s professional advice--that’s the major weakness in the partnerships’

defenses: Garza seems to fit the definition of a tax-shelter promoter.

      The partnerships can’t rely on Garza if he was. The caselaw is clear on this

point--promoters take the good-faith out of good-faith reliance. See, e.g., 106 Ltd.,

684 F.3d at 90-91, aff’g 

; Neonatology Assocs., 115 T.C. at 98. In 106

(another Garza case), we defined a promoter as “an adviser who participated in

structuring the transaction or is otherwise related to, has an interest in, or profits

from the transaction.” 106, Ltd., 136 T.C. at 79 (quoting Tigers Eye Trading, LLC

v. Commissioner, T.C. Memo. 2009-121, 

, at *19).

      We also decided in 106 Ltd. that we would apply this definition “when the

transaction involved is the same tax shelter offered to numerous parties.” See id. at

80. Based on the records in all these cases, we find again, as we did in 106 Ltd.,

that Garza not only participated in structuring the transaction, but arranged the entire

deal. It was he who set up the LLCs, provided a copy of the opinion letter, and

coordinated the deal from start to finish. And he profited from selling the

transaction to numerous clients--not just these three lawyers, but numerous others
                                        - 79 -

[*79] as well. Lawrence, Salazar, and Garcia all knew this. Garza charged each of

them a flat fee for implementing it and wouldn’t have been compensated at all if

they had decided not to go through with it. He wasn’t being paid to evaluate the

deal or tweak a real business deal to increase its tax advantages; he was being paid

to make it happen.

      This makes him a promoter. We therefore reject the partnerships’ defense to

the gross-misvaluation penalty.



                                                 Appropriate decisions will be

                                       entered.