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By Kathleen Ford Bay, Esq.
Richards Rodriguez & Skeith LLP, Austin, TX
In Blum v. Comr.,1 using a grantor trust, the Blums invested in an offshore portfolio investment strategy (OPIS) transaction through KPMG, an accounting firm. As the result of direct and indirect interests in UBS stock held by the grantor trust, the grantors reported a $45 million loss. The IRS noticed and was concerned that the grantor did not, "in fact or substance, incur a $45 million loss," and took the position that no loss was allowable. After the fact (that is, after the income tax returns for both the grantor trust and grantors had been filed), KPMG provided an opinion that the loss "would more likely than not" work.
Judge Kroupa obviously enjoyed writing this opinion; it is a good read. The opinion includes a short history of the entrepreneurial and quite successful Scott Blum, who sold his toys, parked cars for a hotel, sold women's shoes, and started his first company when he was 19 years old, selling computer memory products. About two years later, he sold that company for $2 million. Then he started Pinnacle Micro, Inc., with his parents. Nine years later, after having taken that company public, they sold it. In 1997, Mr. Blum started Buy.com, an online retailer, which was the fastest growing company in United States history during its first year of operation. In 1998, he sold a minority interest held by a grantor trust in two sales for a total of $45 million. He had a zero basis in the stock and, therefore, sought advice from his accountants, investment advisors, and attorneys on how to minimize income taxes. As a result of this advice, Mr. Blum created three interrelated foreign entities - Benzinger LP, Benzinger GP, Inc., and Alfaside Limited - and used them together with the grantor trust to enter into the following transaction:
Step 1: The Blum Trust purchased UBS stock and entered into an equity swap with Alfaside.
Step 2: Benzinger LP entered into a delayed settlement agreement to purchase UBS stock and then constructed a collar on the losses by purchasing a put option and selling a call option. A collar is an option strategy which limits the positive or negative returns on the underlying investment.
Step 3: UBS redeems the 163,980 shares while the Blum Trust purchases 163,980 call options.
Step 4: The Blum Trust then closed out the OPIS transaction by letting its call option expire as worthless and selling the UBS stock purchased.
The Tax Court observed that: "At the conclusion of this convoluted and contrived series of transactions, the net cost of the OPIS transaction to Mr. Blum was approximately $1.5 million. For that cost, the OPIS transaction yielded over $45 million in capital losses to offset capital gains on tax returns petitioners [Blums] filed." The Blum Trust, on the only tax return it ever filed, reported a $45 million loss which, since it was a grantor trust, became the Blums' loss and, thereby, eliminated the gains from the sale of Buy.com stock. In mid-May 1999, KPMG issued a 99-page opinion dated December 31, 1998 stating, essentially, that the losses could "more likely than not" be taken on their tax return.
Although the Blums sued KPMG, as did many others, regarding the abusive tax shelter, they still took the position on audit and in the Tax Court that they entered into the OPIS for investment purposes, that there was a reasonable possibility of profiting from the transaction, and that because they relied, reasonably, on their long-time tax advisers, they should not be liable for penalties if they were found to owe taxes.
However, the Blums were unsuccessful in persuading the Tax Court that their investment in the OPIS had "economic substance." The opinion notes that:KPMG painstakingly structured an elaborate transaction with extensive citations to complex Federal tax provisions. The entire series of steps, however, was a subterfuge to orchestrate a capital loss. A taxpayer may not deduct losses resulting from a transaction that lacks economic substance, even if that transaction complies with the literal terms of the Code. See Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1352-1355 (Fed. Cir. 2006); Keeler v. Commissioner, 243 F.3d 1212, 1217 (10th Cir. 2001), affg. Leema Enters., Inc. v. Commissioner, T.C. Memo 1999-18.
As there are some differences in the way the "economic substance" rule applies in different circuits and an appeal of the Tax Court's decision will, if made, be to the Tenth Circuit, the court used the Tenth Circuit's "unitary analysis," looking simultaneously at both the taxpayers' subjective business motivation and the objective economic substance of the transaction.
Factors discussed by the court in concluding that there was a lack of economic substance are:
(1) the existence of prearranged steps specifically designed to generate loss;
(2) Mr. Blum did not approach the transaction as an investor;
(3) the losses were not only intentional but also artificial;
(4) the loss dwarfed profit potential, because, in the testimony of the Blums' own expert, they had a 76.3% chance of losing money and a 7.6% chance of making $3 million; and
(5) the potential for profit was not sufficiently high to serve as the primary purpose of the transaction.
The court noted that the mere presence of some chance of making a profit does not require it to find that there is economic substance.
The court concluded that the OPIS investment was intended to create a significant capital loss and it worked exactly as intended. However, the court held that the loss was created in such a way that it was not deductible for income tax purposes.
The court then considered whether the accuracy-related penalties assessed by the IRS were appropriate. There is a 20% accuracy-related penalty on the portion of an underpayment of income tax attributable to, among other things, negligence or disregard of rules or regulations.2 This penalty increases to 40% rate to the extent that the underpayment is attributable to a gross valuation misstatement.3 The accuracy-related penalty does not apply if a taxpayer had reasonable cause and acted in good faith.4 Good faith reliance on the advice of an independent, competent professional satisfies reasonable cause and good faith standard.
The IRS assessed a 40% accuracy-related penalty on the underpayment that resulted from the disallowed losses reported for 1998 and a 20% accuracy-related penalty based on the disallowed loss and omitted income for 1999.
The Blums argued that they had acted in good faith in relying on the opinion provided by KPMG. The court, however, determined that there was no reasonable cause, no good faith. Firstly, the court noted that the fact that KPMG was the promoter of the OPIS was problematic.5 And even if KPMG had not been the promoter, the court concluded that the Blums did not rely on its 99-page opinion because that opinion was not finalized until after theyhad filed their tax return for 1998. Moreover, the opinion relied in part on representations by Mr. Blum to KPMG that he had independently reviewed the economics of the underlying investment strategy and believed it had a reasonable opportunity to earn a reasonable pretax profit. Ultimately, the court concluded that the plan to create the $45 million loss was "too good to be true" and Mr. Blum, as a savvy businessman, should have sought out truly independent advice on which to rely. Accordingly, the court sustained the accuracy-related penalties.
This commentary also will appear in the March 2012 issue of the Tax Management Estates, Gifts and Trusts Journal. For more information, in the Tax Management Portfolios, see Tarr and Drucker, 634 T.M., Civil Tax Penalties, and in Tax Practice Series, see ¶3830, Penalties.
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