Professional Tax Research Solutions from the Founder of Kleinrock. tax research
Parker Tax Pro Library
Accounting Tax Research Expert Tax Analysts professional tax research software Like us on Facebook Follow us on Twitter View our profile on LinkedIn Find us on Pinterest
CPA software
Professional Tax Software
tax and accounting
Tax Research Articles Parker's Federal Tax Bulletin CPA Sample Client Letters Tax Software Reviews - CPA Client Testimonials Tax Research Software Parker Research

Accounting Software for Accountants, CPA, Bookeepers, and Enrolled Agents

CPA Tax Software



Founder of Cannot Escape Penalties on Transaction to Shelter Stock Sale Gains.
(Parker Tax Publishing January 2014)

Capital losses arising from a businessman's participation in a tax shelter that lacked economic substance were properly disallowed because the series of financial transactions presented no reasonable probability of generating a profit; gross valuation misstatement and negligent underpayment penalties were imposed. Blum v. Comm'r, 2013 PTC 392 (10th Cir. 12/18/13).

In 1998, Scott Blum, a successful businessman, founded, an online retail marketing company. Scott made two sales of stock that resulted in $45 million in capital gains. Scott contacted KPMG, and one of its accountants recommended an Offshore Portfolio Investment Strategy (OPIS) tax shelter as an investment strategy for reducing the amount of capital gains Scott would have to report for tax purposes. The OPIS tax shelter was designed to create large, artificial losses for taxpayers by allowing them to claim a large basis in certain assets to offset actual capital gains. OPIS clients paid a relatively small amount of money in order to claim a disproportionately large basis in certain assets and use that basis to shelter their own otherwise taxable income. Scott signed an engagement letter that provided that KPMG would receive a fee for serving as tax adviser to Scott on the OPIS transaction. On his 1998 federal income tax return, Scott claimed a $45 million loss. Subsequently, KPMG provided Scott with an opinion letter that explained the legal justification for the financial transactions and concluded that the IRS would "more likely than not" view the transactions as legitimate. In 2001, investigations by Congress and the IRS revealed a widespread practice of using basis-shifting to create paper losses for clients, thereby reducing their tax liabilities. The investigation also revealed that, even within KPMG, there was concern about the potential illegality of these transactions.

The IRS disallowed losses generated by OPIS and similar transactions and, rather than individually prosecute each scheme, settled with the majority of OPIS purchasers in 2003. Scott did not accept a settlement offer. The IRS sent Scott a deficiency notice regarding his 1998 and 1999 returns, disallowing the losses he claimed in connection with the OPIS transaction and imposing penalties for gross valuation misstatement and negligent underpayment of taxes. In Scott's petition challenging the notice of deficiency, the Tax Court concluded that the IRS correctly disallowed the losses under the economic substance doctrine and both penalties were appropriate.

Under the common-law economic substance doctrine, tax benefits arising from transactions that do not result in a meaningful change to the taxpayer's economic position other than a purported reduction in federal income tax are denied.

OBSERVATION: The Health Care and Education Reconciliation Act of 2010 codified the economic substance test in new Code Sec. 7701(o). Effective for transactions entered into after March 23, 2010, Code Sec. 7701(o)(1) states that, for any transactions or series of transactions to which the economic substance doctrine applies, the transaction is treated as having economic substance only if: (1) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer's economic position, and (2) the taxpayer has a substantial purpose for entering into the transaction (apart from federal income tax effects).

Scott argued that the Tax Court erred in disallowing the OPIS losses under the economic substance rule and in imposing the gross valuation misstatement and negligent underpayment penalties because he relied in good faith on KPMG's representations.

The Tenth Circuit affirmed the Tax Court holding that the OPIS financial transactions were sham transactions that lacked economic substance. In rejecting Scott's argument that the OPIS transaction presented a reasonable probability of generating a profit, the court found that the OPIS transaction was designed to reduce Scott's tax liability. The court cited Jackson v. Comm'r., 966 F.2d. 598 (10th Cir. 1992), in which the Tenth Circuit held that, in determining whether to disregard a transaction, the court must ask: (1) what was the taxpayer's subjective business motivation and (2) did the transaction have objective economic substance?

The court noted that the Tax Court made four factual findings in support of its decision. First, the $45 million loss claimed by Scott was grossly disproportionate to the $6 million he invested in the OPIS. The loss was fictional, as Scott did not actually lose $45 million. Second, the OPIS transaction was planned and executed in a manner designed to produce a massive tax loss. The transaction, which included a stock purchase in the amount of the desired capital loss and an options collar, was timed to limit the potential for huge gains and was completely controlled by KPMG. Third, the transaction did not provide a reasonable expectation of profit. Fourth, the profit potential the OPIS transaction presented was de minimis compared to the tax benefits of declaring capital losses of $45 million. The court concluded that the Tax Court did not err in relying on expert testimony and finding that a remote possibility of profitability did not justify a large multi-step series of financial transactions. The court also noted that the timing of Scott's stock sale and execution of the KPMG engagement letter, along with his failure to investigate the economic consequences of the OPIS transaction, indicated his attraction to the OPIS transaction for its tax benefit potential and nothing more.

The Tenth Circuit held that the penalties for gross valuation misstatement and negligent underpayment under Code Sec. 6662 were properly imposed. The court calculated that Scott's basis in the transaction was no more than what he actually paid for the stock and options (almost $3 million) - a misstatement of over 400 percent of what Scott actually owed for taxes. Moreover, the invalidation of the transaction under the economic substance doctrine did not prohibit the imposition of the gross valuation misstatement. Further, although KPMG instigated the tax evasion scheme, Scott knew that KPMG was not rendering independent tax advice, he signed an engagement letter with a material misrepresentation, and he filed his return claiming an improper deduction before he received KPMG's formal tax opinion. Therefore, Scott did not act with reasonable cause or in good faith, the court concluded.

For a discussion of the economic substance doctrine, see Parker Tax ΒΆ99,700. (Staff Contributor Parker Tax Publishing)

Parker Tax Pro Library - An Affordable Professional Tax Research Solution.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

    ®2012-2017 Parker Tax Publishing. Use of content subject to Website Terms and Conditions.

IRS Codes and Regs
Tax Court Cases IRS guidance