Long Term Capital Holdings Appeals Penalty

2. Whether the 40% enhanced penalty for a "gross valuation misstatement" (26 U.S.C. § 6662(b)(3),(e),(h)) can apply even though Appellants did not misstate the value of any asset.

2. Origins of the Preferred Stock. The controversy in this case centered on the proper tax treatment of Portfolio's sale of certain preferred stock of two U.S. corporations, Rorer and Quest. The stock was originally issued in the course of a series of leasing transactions among certain unrelated companies that occurred unbeknownst to Appellants in the summer of 1995. Those transactions conferred tax benefits on the U.S. corporations involved by "tak[ing] advantage of" certain disparities between United Kingdom and U.S. tax laws. SPA35-SPA36. The leases were "stripped," with a British corporation, Onslow Trading Corporation ("OTC"), acquiring lease obligations and rental prepayment rights while Rorer and Quest deducted rental payments and depreciated the leased assets. OTC then transferred its lease rights and obligations to Rorer and Quest in a tax-free section 351 exchange for preferred stock of those companies. SPA36-SPA37.

Under Code sections 351 and 358, OTC took a "carryover basis" in the preferred stock that was equal to the value of the rent prepayment rights that it transferred. That basis greatly exceeded the fair market value of the stock. Thus, as a by product of the leasing transactions, OTC acquired an asset having a valuable tax attribute; a high-basis, low-value asset has a "built-in tax loss" that can offset taxable income if the asset is sold. Id.

Such assets are marketable if they can be transferred in a way that allows the acquirer to retain the tax attribute. For example, when the U.S. government became the receiver of numerous failed thrifts during the savings and loan crisis of the 1980s, the government marketed those institutions by promoting the "tax benefits" available to private purchasers if they acquired the institution's devalued assets, which they could use to generate tax losses in order "to shelter other income." See Centex Corp. v. United States, Nos. 03-5087 and 5095, 2005 U.S. App. LEXIS 945, at *5 (Fed. Cir. Jan. 19, 2005), aff'g 49 Fed. C1. 691, 693-95 (2001).²

3. Long-Term's Acquisition and Disposition of the Preferred Stock. Babcock & Brown ("Babcock"), an investment banking firm that helped facilitate the leasing transactions, undertook to help OTC find a profitable U.S. taxpayer that might be interested in acquiring the preferred stock. In early 1996, Babcock sought assistance from Donald Turlington, a prominent tax lawyer who had previously done work for both Babcock and Long-Term. SPA50. Shortly thereafter, Turlington was at Long-Term's offices on an unrelated matter, and he asked Larry Noe, who had just been hired as Long-Term's in-house tax counsel, whether the Long-Term entities might be interested in acquiring a high-basis, low-value asset in exchange for a partnership interest. SPA50-SPA51. Noe then consulted with Myron Scholes, the Long-Term partner with primary responsibility for tax matters, and they determined that Turlington's idea warranted further inquiry. SPA51-SPA52.

Long-Term then investigated the merits of the proposed transaction looking into the business aspects and seeking professional advice on the proper tax treatment. For advice on whether the tax law would attach a high basis to OTC's preferred stock, Long-Term engaged Shearman & Sterling, a recognized expert in leasing transactions that was familiar with the OTC transactions because of work it had done for Babcock. SPA57-SPA58. In May 1996, Long-Term also engaged King & Spalding, the leading expert on partnership tax law, to advise on whether LTCM and its partners could recognize the built-in loss upon sale of the preferred stock under the proposed transaction. SPA61. With respect to the business aspects of the transaction, Scholes and Noe met with OTC principals in London to discuss the possibility of OTC becoming a partner in Partners, and they held similar meetings with Babcock representatives. SPA53-SPA54, SPA81-SPA82.

Both law firms conveyed to Noe the opinion that, if challenged, a court "should" agree with their respective analyses of the tax issues -- that is, that OTC's preferred stock had a basis that greatly exceeded its value and that the Long-Term entities would succeed to that basis such that sale of that stock after the proposed transaction would yield a tax loss to LTCM and its partners. SPA58-SPA59, SPA63-SPA64.³ Based on this advice and on the determination that having OTC and Babcock as partners would be beneficial, Long-Term determined to proceed with the transaction.

In August 1996, OTC acquired a limited partnership interest in Partners with an initial capital account of $5.34 million. In exchange, OTC contributed to Partners its high-basis Rorer preferred stock, valued at $616,058, plus other stock and cash. SPA38 & n.17. In November 1996, OTC acquired an additional partnership interest worth $5 million in exchange for a contribution to Partners of Quest preferred stock valued at $534,504, plus cash and other stock. SPA39-SPA40 & n.19. Partners immediately contributed the cash and preferred stock to Portfolio, the Long-Term entity that held its investments, with Partners' capital account in Portfolio being commensurately increased. SPA39, SPA41.

On the same dates as the exchanges, OTC purchased for $121,000 two sets of "put" options as a measure of protection against possible devaluation of its partnership interest. The "liquidity put" allowed OTC to sell its partnership interest to LTCM at its net asset value; the "downside put" allowed OTC to sell its partnership interest at a price equal to the value of its original investment. The options were exercisable during a five-day period in late October 1997. SPA39-SPA41.

On October 28, 1997, after a profitable fifteen months as a Long-Term partner, OTC exercised its "liquidity puts" and sold its partnership interest to LTCM at its market value of $12.61 million (for a profit of $2.27 million). SPA41. On December 30, 1997, Portfolio sold the preferred stock at a loss for a total of $1.08 million, which represented its fair market value on that date. SPA41-SPA42.

4. Tax Treatment of the Preferred Stock Sale. Long-Term's income tax returns for 1997 were due on April 15, 1998. Prior to that date, Long-Term had received written "should-level" opinions from Shearman & Sterling stating that the stock's basis in the hands of OTC was the relatively high carryover basis derived from the value of the property that OTC exchanged for the stock. SPA58-SPA59. During the 1996-98 period, Long-Term worked closely with King & Spalding on the transaction and engaged in oral consultations concerning the correct tax treatment of the preferred stock sale, but the firm did not complete a written opinion until January 1999. SPA61-SPA63.

On April 14, 1998, Noe prepared a file memorandum, reflecting that Mark Kuller of King & Spalding orally reconfirmed at that time that the sale by Portfolio generated a tax loss measured by the difference between the sale price and OTC's basis in the stock and that this loss was properly allocable to LTCM and its partners. SPA63-SPA64. Kuller averred that King & Spalding had "considered all pertinent facts and circumstances" in providing its opinion and that any factual statements or assumptions were based upon review of relevant documents or factual representations by the relevant parties. SPA64. "Based upon [this] advice," Portfolio filed its tax return, claiming the loss at issue here. Id.

The claimed tax treatment flowed directly from application of the relevant Code provisions. Section 721(a) provides that no gain or loss is recognized when property is contributed to a partnership in exchange for an interest in the partnership. Section 723 provides that the partnership's basis in the contributed property should be the same as the basis that the contributing partner held at the time of the contribution. Therefore, Portfolio held the preferred stock with the same relatively high basis that OTC had when it contributed the stock. When Portfolio sold the stock, it suffered a tax loss in accordance with the usual principle of measuring gain or loss by the difference between the sale price and the adjusted basis of the property. I.R.C. § 1001.

Under the partnership rules of Code section 704(c) governing contributed property sold within seven years of being contributed, a loss suffered on such a sale is allocable to the contributing partner or to its successor in interest. Since OTC was no longer a partner in Partners at the time of the preferred stock sale, section 704(c) directed that the loss on the sale be allocated to LTCM, as OTC's successor in interest. The loss then became one of the items of income and expense of LTCM that was allocated to its own partners under normal partnership rules. SPA45.⁴

5. The Trial Court's Decision. On audit, the IRS disallowed the loss claimed on the preferred stock sale, resulting in an additional $40 million in tax liability. In addition, the IRS asserted a variety of alternative "accuracy-related" penalties under Code section 6662 -- including a 40% penalty for "gross valuation misstatement" and a 20% penalty for "substantial understatement of tax." SPA172-SPA173. Appellants filed petitions for readjustment under section 6226(a)(2). After a trial, the court denied the petitions in full, thus upholding the IRS's claim to $40 million in additional tax and $16 million in penalties.

a. Tax Liability. The trial court did not question that Appellants correctly applied the provisions of the Code to the transaction. Rather, the court's disallowance of the claimed loss rested entirely on judicial doctrines that override the Code's rules. The primary ground was that OTC's sale of the preferred stock to Partners lacked "economic substance" because, in the court's view, the transaction had no objective economic substance beyond the creation of tax benefits and Long-Term had no business purpose for engaging in the transaction. SPA115-SPA161.

The court first concluded that the transaction objectively afforded no opportunity for profit, apart from the tax benefits. This conclusion was based on an analysis that took an expansive view of the costs of the transaction and a narrow view of the benefits. The court included various amounts paid by Long-Term to outside advisors and employees -- legal fees for tax advice (SPA127-SPA130), fees paid to Babcock under a consulting contract that the court found to be a "disguised fee" for Babcock's role in the OTC transaction (SPA130-SPA134), a payment to Turlington in settlement of threatened litigation of his claim to a "finder's fee" for the transaction (SPA134-SPA138), and a bonus paid to Noe (SPA139). In addition to these monies actually paid by Long-Term, the court included other amounts that it imputed to the partnership's profit potential on the OTC transaction -- namely, a more generous partnership allocation to Scholes (SPAI 38-SPA139) and $1.2 million in "Potential profit" that the court thought Long-Term could have earned had it invested in other ways funds that were committed to the OTC transaction. SPA139-SPA143. On the benefit side, the court excluded (as unrelated) more than $9 million in anticipated fees and premiums that Long-Term expected to earn from a contemporaneous deal that brought Babcock on board as an investor. SPA144-SPA148 & n.84.

The court began its analysis of Long-Term's subjective motivation with an extended discussion of the leasing transactions that "occurred prior to Long Term's involvement." SPA153. Acknowledging that "this background" "does not speak directly to Long Term's motivation," the court emphasized that Long-Term's transaction arose from the "context" of "a highly sophisticated marketplace in which [Babcock] . . . assiduously developed a scheme for selling tax deductions." SPA152. With respect to Long-Term's own actions, the court found that it took unusual steps to facilitate the OTC transaction because of the potential tax benefits. SPA153-SPA160. The court concluded that "Long Term entered in to the OTC transaction without any business purpose other than tax avoidance," and hence the tax benefits of that transaction should be disallowed because of the economic substance doctrine. SPA161.

Although the economic substance ruling supported a complete disallowance of Appellants' claimed deduction, the court proceeded to provide an alternative basis for that disallowance through an application of the "step-transaction doctrine" that disregarded OTC's and LTCM's acquisitions of partnership interests. SPA162-SPA172. The court found that it could ignore the form of the actual transaction because the parties had an "understanding" that OTC would exercise its put options to achieve "the ultimate result" of "the transference of OTC's preferred stock into the control of Long Term." SPA163. Accordingly, the court concluded "that what actually occurred was a sale by OTC of its preferred stock to Long Term followed by Long Term's sale of the stock (through Portfolio)." SPA165. The court acknowledged that its recharacterization of the transaction "ignore[d] . . . bona fide economic effects" (SPA168), such as OTC's sharing in partnership profits for fifteen months, but ruled that this was permitted by the step-transaction doctrine.

b. Penalties. 1. The basic structure of the penalty provisions that govern this case was enacted in 1989, reorganizing and modifying a scheme of less coordinated penalties established in 1981. Section 6662 establishes a standard "accuracy-related" penalty of 20% of the amount "attributable to" any one of five specified kinds of taxpayer conduct that cause an underreporting of tax. I.R.C. § 6662. These include "negligence" (§ 6662(b)(1),(c)), and four specific penalties triggered mathematically by the level of inaccuracy.

The Code also provides an enhanced 40% penalty that is triggered by quantitative measures of extreme instances of the type of misconduct that triggers the basic penalty. As relevant here, a "substantial valuation misstatement" yields a 20% penalty if the claimed "value of any property (or [its] adjusted basis)" is 200% of the "correct amount" (§ 6662(b)(3),(e)). If the valuation misstatement ratio is 400%, the penalty is doubled to 40% for a "gross valuation misstatement." I.R.C. § 6662(h).

Superimposed on this structure is a "reasonable cause" and "good faith" exception. Even if the taxpayer's return fails one or more of the accuracy tests, the Code provides that "no penalty shall be imposed" if there was "reasonable cause" for the underpayment and "the taxpayer acted in good faith." I.R.C. § 6664(c)(1).

2. The trial court upheld imposition of two of the accuracy-related penalties. First, the court invoked its alternative step-transaction ruling to justify imposition of the enhanced 40% penalty for a "gross valuation misstatement" under I.R.C. § 6662(b)(3),(e),(h). SPA179-SPA180. The court stated that its "application of the step transaction doctrine to the OTC transaction has the effect of imputing to Long Term a cost basis in the Rorer and Quest stock of approximately $1 million and thereby making Long Term's claimed adjusted basis well in excess of 400 percent of the amount determined to be the correct adjusted basis." Id.⁵ Second, in the alternative, the court sustained the 20% penalty for substantial understatement of tax under I.R.C. § 6662(d), ruling that no portion of the additional tax liability could be excluded from the substantial understatement calculation. SPA180-SPA193.

3. The court then found inapplicable the "reasonable cause" and "good faith" exception of I.R.C. § 6664(c)(1), which would have insulated Appellants from all penalties. SPA193-SPA210. The court noted that the regulations state that "the most important factor is the extent of the taxpayer's effort to assess the taxpayer's proper tax liability," and that "'reliance on professional advice . . . constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith.'" SPA194 (quoting Treas. Reg. § 1.6664-4(b)(1)). The court found, however, that Appellants' reliance on King & Spalding's tax advice was not "reasonable" and that Appellants did not act in good faith.

The court rejected Appellants' reliance on King & Spalding's oral advice given prior to the tax return's filing because of alleged "proof problems" that centered on the extent to which Appellants themselves delved into and independently questioned the details of their advisors' analysis. SPA196-SPA201. The court acknowledged that former King & Spalding partner Mark Kuller gave "exhaustive and detailed testimony" concerning his advice to Noe that could have provided grounds for Appellants' reliance argument "[i]f such conversations actually took place." SPA200. The court questioned Kuller's credibility, however, and concluded that "such conversations either never took place in the time period claimed or were so embellished at trial by Kuller's testimony that it is impossible to ferret out reality." SPA200-SPA201; see also SPA70-SPA74. The court rejected testimony from Noe and Scholes concerning this oral legal advice as too "vague" because the witnesses did not testify to certain specifics, such as when they received drafts of the opinion and whether they had discussed Second Circuit authority with Kuller. SPA199-SPA200. Hence, the court concluded that Long-Term did not "prove the content of any advice actually received from King & Spalding before claiming losses . . . for the purpose of showing it was based on all pertinent facts and circumstances and not on unreasonable assumptions." SPA201.

The court also ruled that, even if the substance of King & Spalding's written opinion had been conveyed to Appellants before the tax return was filed, that would not establish reasonable reliance because that opinion was flawed. SPA201-SPA207. The court observed that the opinion contained language asserting that it was subject to the "work product privilege," which "casts doubt on its contents as serving the purpose of providing a reasoned opinion on the application of tax law." SPA202. The court also criticized the assumptions and legal analysis in the opinion, contending, inter alia, that: it lacked citation to Second Circuit authority; its economic substance analysis relied too heavily on one Supreme Court case; its treatment of another case was "shallow"; and its failure to cite a Tenth Circuit case showed "selective" analysis of the legal authorities. SPA203-SPA206 & n. 110.

The court also stated that Long-Term lacked the requisite good faith for the "reasonable cause" defense because of the way it reported the transaction on the M-1 schedule of its tax return. SPA207-SPA210. The court found that Long-Term prepared a draft return that "truthfully reveal[ed]" the capital losses, but that it followed the recommendation of its advisors at two major accounting firms to revise the caption of the relevant entry and to report it on line 6 instead of line 7 of the Schedule M-1. SPA208. Because the court viewed the final entry as "misleading," however, it concluded that it was "of little moment" that it was counseled by the accountants. SPA209-SPA210.

Appellants satisfied this standard by doing precisely what a reasonable taxpayer would do when faced with a complex tax law question beyond the scope of the taxpayer's expertise. Appellants hired the leading experts in the field and worked closely with them from the start so that they had full access to all the pertinent facts. Appellants claimed the tax loss in question only after being advised by the experts that the proposed tax return position "should" be upheld by the courts, if challenged. In light of this close working relationship and King & Spalding's strong reputation and assurances, Appellants reasonably believed that they were getting sound advice not based on unreasonable assumptions.

The trial court rejected the "reasonable cause" defense because it erroneously believed that Appellants were required to engage in their own detailed analysis and second-guessing of their expert's advice. In particular, the court found the oral advice received by Appellants to be deficient because Appellants could not prove the content of the analysis that was conveyed. But the regulations establish that a taxpayer may rely on oral advice that consists of a conclusion, without detailed analysis, unless the taxpayer is aware of some reason why reliance would be unreasonable. Treas. Reg. § 1.6664-4(b)(2), Ex. 1, § 1.6664-4(c)(2). Indeed, it would have been unreasonable for Appellants to have second-guessed the analysis of the expert counsel that they retained. See, e.g., United States v. Boyle, 469 U.S. 241, 251 (1985). Thus, the trial court applied an unduly strict and legally erroneous standard in penalizing Appellants for failing to inquire about certain details of counsel's analysis.

When Appellants filed their return on the basis of King & Spalding's advice on a complex tax question, knowing that King & Spalding was conversant with all the relevant facts, Appellants had no reason to doubt the soundness of that advice. Similarly, Appellants acted in good faith when they completed the M-1 Schedule on their tax return in accordance with the advice of two major accounting firms.

II. A. Even if the reasonable cause exception is inapplicable, the 40% penalty must be vacated because Appellants did not make a "valuation misstatement." Under section 6662(b)(3), the penalty can be imposed only when the increased tax liability is attributable to a "valuation overstatement." The trial court therefore erred in construing section 6662(e) to apply here where the increased tax liability is attributable to a legal dispute over the proper characterization of a transaction, which in turn leads to different methods for computing basis under the Code. "Valuation" is an inherently factual concept, and the legislative history confirms that Congress intended the penalty to deter taxpayers from misstating the value of their property to obtain a tax advantage. When the taxpayer does not misstate the value of an asset, the penalty by its terms does not apply.

Moreover, the graduated nature of the penalty makes sense only if it is restricted to cases where the taxpayer misstates the value of an asset. In that situation, a more severe penalty logically attaches for the more egregious misconduct of making a greater valuation misstatement. If the penalty is applied in the absence of a valuation misstatement, where a legal dispute affects the correct basis methodology, it would yield the illogical result of an enhanced 40% penalty for taxpayer behavior that is no different from the behavior that triggers a 20% penalty. Finally, even if the penalty could apply without a valuation misstatement, it is inapplicable here because the "cost basis" imputed by the court through an application of the step-transaction doctrine is not the "correct" basis within the meaning of section 6662(e). That basis derives from an imaginary transaction hypothesized by the court: Appellants cannot reasonably be expected to have used that basis on their tax return.

B. Alternatively, the 40% penalty is inapplicable because it rests on an invalid use of the step-transaction doctrine. That doctrine may be invoked to collapse transitory or "meaningless intervening steps" into a single transaction. Grove v. Commissioner, 490 F.2d 241, 246 (2d Cir. 1973). Here, however, the trial court's analysis impermissibly disregarded meaningful steps having significant and permanent economic consequences. The court ignored the partnership aspects of the transaction -- both OTC's status as a partner in Partners for fifteen months and LTCM's subsequent increase of its own share by purchasing OTC's partnership interest -- by recharacterizing the transaction as a sale of stock from OTC to LTCM. As a result, the court's analysis failed to account for millions of dollars in partnership income for OTC during this period, $2.27 million in profit that OTC earned on its investment, and the increased stake that LTCM had in the fund's profits and losses after October 1997. The court's approach therefore fails the threshold requirement that a step-transaction analysis provide "a logically plausible alternative explanation that accounts for all the results of the transaction." Turner Broadcasting System, Inc. v. Commissioner, 111 T.C. 315, 327 (1998).

Whether Appellants are subject to the "valuation misstatement" penalty is a legal question involving interpretation of a statute and the scope of the step transaction doctrine. Accordingly, that issue is subject to de novo review.

The expert advice proved correct on the first count, but incorrect on the second. The trial court found that the economic substance and step-transaction doctrines overrode the tax treatment provided by the Code. As a result, the court both disallowed the claimed tax loss and imposed a 40% penalty. Appellants do not challenge the court's tax liability ruling, which rests on several adverse factual findings concerning the economic substance of the transaction. They do, however, challenge the imposition of penalties.

The Code's detailed and nuanced penalty provisions strike a balance between two competing considerations. On the one hand, Congress sought to deter taxpayers from taking unjustified tax positions in the hopes of winning the "audit lottery." On the other hand, Congress recognized that the complexity of the Code generates many tax disputes on which reasonable people can differ and penalties are not justified merely because a court ultimately disagrees with a position taken by the taxpayer. The result is a set of penalties, of graduated severity, that address specifically described conduct that Congress believed warranted a special deterrent and that explicitly except taxpayers who acted with reasonable cause and in good faith.

Appellants challenge the trial court's penalty ruling on two distinct grounds. First, no penalty should be imposed at all in this case because of the "reasonable cause" and "good faith" exception of I.R.C. § 6664(c)(1). The trial court committed legal error in rejecting Appellants' reasonable cause defense on the undisputed facts here because the court focused primarily on the conduct of Appellants' advisors rather than on "the taxpayer's effort" (Treas. Reg. § 1.6664-4(b)(1)) to hire expert advisors and follow their advice. The trial court's dismay concerning a "sophisticated marketplace" in which tax shelter promoters and advisors "developed a scheme for selling tax deductions" (SPA 152) apparently caused the court to punish Appellants for the actions of the participants in that marketplace, instead of recognizing Appellants' reasonable efforts to obtain expert advice. Second, even if the reasonable cause defense is inapplicable, the 40% penalty must be lifted. Appellants did not misstate the value of any asset, and therefore the court had no legal basis for imposing a penalty on the theory that the additional tax liability was "attributable to" a "valuation misstatement." I.R.C. § 6662(b)(3),(e),(h).

I. NO PENALTY SHOULD BE IMPOSED BECAUSE APPELLANTS ACTED WITH REASONABLE CAUSE AND GOOD FAITH WITHIN THE MEANING OF I.R.C. § 6664(c)(1)

Before 1989, the IRS had discretion whether to excuse taxpayers from penalties when they acted with reasonable cause and in good faith. Congress concluded that the IRS was not properly exercising this discretion, noting its "concern[] that the present-law accuracy-related penalties . . . have been determined too routinely and automatically by the IRS." H.R. Rep. No. 101-247, at 1393 (1989). Accordingly, Congress removed this discretion from the IRS and enacted section 6664(c)(1) to give taxpayers a statutory right to a "reasonable cause" exception that could be enforced by the courts. Congress expected that "providing greater scope for judicial review of IRS determinations of these penalties will lead to greater fairness of the penalty structure and minimize inappropriate determinations of these penalties." Id. The trial court undermined that goal here by unfairly upholding the IRS's routine imposition of penalties when Appellants acted with reasonable cause and good faith.

Taxpayers often must depend on the advice of specialized tax professionals in determining whether they have reasonable cause for a return position. This is especially true where the underlying transaction is complicated, implicates multiple tax rules, or requires an interpretation of ambiguous Code provisions or regulations. In such situations, the federal tax laws are simply too complex for even highly educated and sophisticated taxpayers to "decode the Code" with any degree of confidence.

Both the Supreme Court and this Court have recognized that taxpayers cannot be expected to second-guess the analysis of their expert advisors. In United States v. Boyle, 469 U.S. 241, 251 (1985), the Court observed:

The regulations apply this principle to the reasonable cause exception. Taxpayers who take a return position in "reliance on . . . professional advice" qualify for that exception so long as "such reliance was reasonable and the taxpayer acted in good faith." Treas. Reg. § 1.6664-4(b)(1). The regulations proceed to provide some guidance on when a taxpayer acts unreasonably in relying on a tax advisor: when the taxpayer should have known that the advisor lacked relevant expertise; when the advice is not based on all pertinent facts because the taxpayer fails to disclose a relevant fact; when the advice is based on unreasonable assumptions, such as an assumption the taxpayer knows is unlikely to be true; and when the advice rests on the invalidity of a regulation. See Treas. Reg. § 1.6664-4(c)(1).

Appellants recognized from the start that their entitlement to the claimed loss depended largely on the interpretation of a complex set of partnership tax rules far beyond their own expertise. Accordingly, Long-Term asked its outside tax counsel, Don Turlington, to recommend "someone who was expert in partnership matters." SPA62 (quoting [Tr. 651]). Turlington identified two or three names, and Long-Term selected William McKee of King & Spalding, author of the leading treatise on partnership taxation. McKee and his partner Mark Kuller began advising Long-Term in May 1996, almost two years before the filing of the tax return at issue here. [Tr. 649-51]

From the start, Long-Term worked closely with King & Spalding in order to ensure that it received well-informed and objective advice. As the trial court found (SPA 130), Long-Term wanted King & Spalding "to be involved from the outset so they were familiar with all facts, all circumstances, and . . . have an input in making decisions as we went along the way" and also "to ultimately render a tax opinion if and when it became necessary." SPA62 (quoting [Tr. 651-52]). "As the transaction was developing," Noe and Kuller would have "substantive discussions of all aspects of the transaction including all important facts, assumptions and representations." [Tr. 663].

Long-Term determined that it would not proceed unless King & Spalding concluded that Long-Term "should" be entitled to deduct the tax loss. SPA 128. Noe explained that a "should" level opinion "was very important to me," because it showed that the King & Spalding advisors "were very confident that they had all of the facts, had analyzed it and felt that their conclusion was correct." [Tr. 629]. Although a less optimistic "more-likely-than-not" opinion would still have provided good reason to expect a sizable tax benefit (and satisfied the strictest statutory standard of "reasonableness"), Long-Term sought a higher level of assurance to allow for some margin of error in its counsel's conclusion. See infra pp. 32-33 & note 7; SPA57 n.34; I.R.C. § 6662(d)(2)(C)(i)(II).

Although King & Spalding did not complete a formal opinion letter before Long-Term's tax return was due on April 15, 1998, Long-Term took appropriate steps to satisfy itself that its return position reflected the advice of counsel. Noe called Kuller on April 14th and "orally confirmed" that the proposed loss "should be sustained." SPA63. Noe's contemporaneous file memorandum reflects that, in rendering that advice, King & Spalding averred that it "considered all pertinent facts and circumstances" and that all "factual statements and assumptions are based upon their review of the documents" and other materials that they believed could reasonably be relied upon. SPA64.

In relying on King & Spalding's expertise and "should-level" advice when Portfolio claimed the loss on its tax return, Appellants acted with "reasonable cause" and "good faith" within the meaning of I.R.C. § 6664. In retaining a pre-eminent expert, Appellants used their best efforts to obtain excellent, unbiased advice. As the trial court recognized, Long-Term paid substantial hourly fees that surely provided reasonable assurance that King & Spalding was engaged in a thorough, rigorous analysis of the tax law's application to the transaction. See SPA206.

Long-Term also satisfied the regulatory requirement concerning the taxpayer's efforts to ensure that the advice is based on all pertinent facts and circumstances and not based on unreasonable assumptions. King & Spalding had been intimately involved in every aspect of the transaction for almost two years, and hence it had direct knowledge of the pertinent facts. Throughout the transaction, Noe had "detailed discussions with Mr. Kuller on every aspect." [Tr. 664]; see also [Tr. 663; Tr. 1819, 1823, 1827] (Scholes discussions with Kuller).

Thus, as Noe explained at trial:

The court's "reasonable cause" analysis is replete with instances where it held Appellants accountable for failing to second-guess and correct the alleged shortcomings of their advisors. For example, the court cited as evidence of unreasonableness the following perceived deficiencies in King & Spalding's advice: (i) "no citation to Second Circuit authority"; (ii) contains "little, if any, of what could be characterized as legal analysis of the economic substance of the OTC transaction" because the Supreme Court case on which the analysis relied is factually distinguishable; (iii) "minimal legal analysis of the application of the end result test for purposes of step transaction analysis"; (iv) "shallow" treatment of a leading case because the analysis focused on the legal principle of the case rather than its facts; (v) "selective discussion of authority" exemplified by the failure to discuss a Tenth Circuit case that criticized a favorable Tax Court decision. SPA203-SPA206 & n. 110.

To the extent the court focused on Appellants' efforts, it was to criticize their failure to second-guess King & Spalding's legal analysis. For example, Appellants allegedly acted unreasonably because: (1) Noe "had not read all authorities cited in the final written opinion" (SPA200); (2) Noe "could not recall whether he was concerned about the absence of Second Circuit authority in the opinion" (id.); and (3) only one of the Long-Term partners read the opinion letter (SPA207). But these criticisms miss the point. Appellants acted reasonably in hiring the best advisors available, ensuring they had access to all the relevant facts, and then following their advice on a complex tax law issue. Indeed, it would have been unreasonable for Appellants to second-guess and reject the advice of the man who literally wrote the book on partnership taxation. See Haywood, 178 F.2d at 771 ("We doubt if anyone would suggest that a client who stated the facts of his case to his lawyer must . . . inquire specifically about the applicability of various legal principles which may be relevant to the facts stated."); Stanford v. Commissioner, 152 F.3d 450, 461 (5th Cir. 1998); Mauerman v. Commissioner, 22 F.3d 1001, 1006 (10th Cir. 1994).

The trial court thus held Appellants to an erroneously high standard of reasonableness -- indeed, one that is more stringent than the "special rules" governing tax shelter items of corporations (which did not apply to non-corporate taxpayers like Appellants). See Treas. Reg. § 1.6664-4(e) (now § 1.6664-4(f)). These rules set forth a test containing objective and subjective components like the standard the trial court applied here. The taxpayer must show objectively that there is "substantial authority" for the claimed tax treatment. Treas. Reg. § 1.6664-4(e)(2)(i)(A). And the taxpayer must show that it "reasonably believed" that the claimed tax treatment was "more likely than not" correct -- by showing either that it analyzed the pertinent facts and authorities itself or that it reasonably relied on the opinion of a professional tax advisor. Treas. Reg. § 1.6664-4(e)(2)(i)(B).⁶

The trial court here essentially imposed the first, objective requirement on Appellants by criticizing the analysis of the King & Spalding opinion. And it went even beyond the second component by criticizing Appellants for failing to perform their own analysis of pertinent authorities; even a corporation governed by the "special rules" can show reasonable belief without performing its own analysis of the authorities if it shows that it reasonably relied on a professional advisor. The court's application of the wrong standard is a legal error that compels reversal of the penalties.⁷

"Reasonable cause" turns on the taxpayer's efforts to obtain reliable advice, and hence the regulations recognize that oral advice is no less valid than written advice. The regulations define "advice" as "any communication, including the opinion of a professional tax advisor, setting forth the analysis or conclusion of a person, other than the taxpayer, provided to . . . the taxpayer and on which the taxpayer relies." Treas. Reg. § 1.6664-4(c)(2). Because "[a]dvice does not have to be in any particular form" (id.), the regulations plainly allow taxpayers to rely on oral advice.

The trial court objected not to oral advice per se, but rather to Appellants' inability to prove in detail the specifics of the analysis conveyed orally that supported King & Spalding's should-level conclusion. Thus, the court found Appellants' proof inadequate because "Noe's testimony about advice received from Kuller prior to Long Term's filing was either too vague or inconsistent to provide a basis for evaluating whether and what advice was actually received." SPA199. Specifically, the court objected that Appellants could not establish oral receipt before April 15th of King & Spalding's analyses of the economic substance and step-transaction issues (SPA199-SPA201); Noe could not confirm which of the thirty-one representations and assumptions listed in the written opinion he had discussed with Kuller (SPA199-SPA200); and Noe "conceded that he had not read all the authorities cited in the final written opinion" prior to April 15th and "could not recall . . . whether he had even discussed with Kuller whether Second Circuit authority should be relied upon." SPA200.

The trial court's determination that Appellants' proof was deficient on these grounds is simply another manifestation of its fundamental error of requiring Appellants to second-guess their advisors' analysis. The regulations define "advice" as any communication setting forth the advisor's "analysis or conclusion." Treas. Reg. § 1.6664-4(c)(2) (emphasis added). Hence, a taxpayer can establish reasonable cause by relying on oral advice that provides the advisor's conclusion without detailing the underlying analysis. The first example illustrating the operation of the reasonable cause regulations confirms this principle:

Contrary to the trial court's approach, the example does not require the advisor to explain its analysis and certainly does not require the taxpayer to conduct an independent review of that analysis. Absent other facts about the taxpayer's behavior that show unreasonableness, the taxpayer is required only to seek advice from an advisor with the requisite expertise, ensure the advisor has the relevant facts, and follow the advice. Hence, the trial court erred in rejecting Appellants' reasonable cause defense on the ground that they did not establish "what substantive analysis undergirded" the conclusion orally provided prior to April 15, 1998. See SPA196.

The court also ruled, "[i]n the alternative," that the failure to prove the details of the oral advice provided before April 15, 1998, meant that Appellants had not established that the advice "was based on all pertinent facts and circumstances and not on unreasonable assumptions." SPA201. These requirements set forth in Treas. Reg. § 1.6664-4(c)(1) impose a duty on the taxpayer to act reasonably, but do not make the taxpayer strictly liable for shortcomings in the advisor's analysis. The focus remains on "the taxpayer's effort." Treas. Reg. § 1.6664-4(b)(1). The "pertinent facts and circumstances" requirement explains that the taxpayer must "disclose a fact that it knows, or should know, to be relevant to the proper tax treatment of an item." Treas. Reg. § 1.6664-4(c)(1)(i). The "no unreasonable assumptions" requirement explains that the advice must not be based on a representation or assumption "which the taxpayer knows, or has reason to know, is unlikely to be true." Treas. Reg. § 1.6664-4(c)(1)(ii).

As noted above, the record clearly showed that King & Spalding had full access to the pertinent facts. The court's objection hinged on the second requirement, with the court concluding that Appellants had not ensured that its advisors did not rely upon "unreasonable assumptions." The court identified two different problematic "assumptions" in the written opinion for which it held Appellants responsible (even though the court had elsewhere rejected the notion of using the "written opinion as a proxy" for the oral advice received before April 15, 1998). SPA200. Neither objection has merit.

The court criticized in detail King & Spalding's discussion of "the end result test," which is an element of the step-transaction analysis, and then concluded that "[t]his assumption that the end result test would not be properly applied is a paradigmatic example of an unreasonable legal assumption within the meaning of Treas. Reg. § 1.6664-4(c)(1)(ii)." SPA205-SPA206. But this statement mischaracterizes King & Spalding's legal analysis as an "assumption," and thus the court's conclusion simply reprises in a new form its pervasive error of requiring Appellants to second-guess their advisors' legal analysis. King & Spalding did not assume that the end result test would not apply; it analyzed the law and concluded that it would not apply. The trial court disagreed with that analysis because King & Spalding relied on a Tax Court decision that had been criticized by the Tenth Circuit. See SPA166-SPA167, SPA205-SPA206. The court's disagreement, however, does not convert the analysis into an "unreasonable assumption" that precludes a finding that Appellants reasonably relied on their advisors' conclusion.

The court also singled out one of the assumptions and representations listed in King & Spalding's written opinion -- namely, that "Long Term entered the OTC transaction for business purposes other than tax avoidance and reasonably expected to derive a material pre-tax profit from it." SPA202. The court observed that the opinion did not "demonstrate" why this was a reasonable assumption and that King & Spalding should have concluded from the facts that this assumption was "unreasonable and unsupportable." SPA203. Again, the court focused unduly on the advisors' failings and failed to consider the taxpayer's efforts and whether Appellants knew, or should have known, when Portfolio filed its return that King & Spalding's advice was based on "unreasonable assumptions."

In addressing the "dizzyingly complex" questions of business purpose and pre-tax profits, courts have grappled with the question of what items of income and expense are appropriately allocable to a specific transaction for purposes of computing pre-tax profit. Joseph Bankman, The Economic Substance Doctrine, 74 S. Cal. L. Rev. 5, 29 (2000-01). The cases reflect a wide disparity of views, with some courts construing the scope of the relevant transaction narrowly, and others construing it broadly. See, e.g., Salina Partnership v. Commissioner, 80 T.C.M. (CCH) 686, 695 (2000) (emphasizing that "the economic substance of a transaction turns on a review of the entire transaction" in refusing to divide a transaction into pieces to calculate pre-tax profit). See generally David P. Hariton, Kafka and the Tax Shelter, 57 Tax L. Rev. 1, 17-29 (2003). The trial court here took an expansive view of costs and a narrow view of the benefits of the transaction, but that was not the only reasonable way to calculate pre-tax profits. See supra pp. 10-11; SPA127-SPA148.

Appellants were aware that, while they had expertise in economics and finance, they needed the advice of experienced tax counsel for how to treat the items of income and expense associated with the transaction. As Scholes explained, "I was knowledgeable and informed, but I did not rely on my own advice." [Tr. 1692]. Accordingly, Scholes worked closely with Kuller on the pre-tax profit issue and made sure that he had the relevant facts. [Tr. 1678-79] ("I spent a lot of time with [Kuller] describing the economics and what our profit motives were and what our risks were involved in the transaction, and he was giving us advice and I was explaining to him a lot about what we were doing"); see also [Tr. 1819-27]. Kuller likewise explained that clients need "assistance" in understanding the legal parameters of "how does one determine what a pretax expectation of profit is, what goes into the calculation of a pretax expectation of profit, and those matters were discussed at length with the client." [Tr. 2161].

When King & Spalding orally advised Appellants that the loss could be claimed, Appellants reasonably understood that this advice reflected King & Spalding's legal analysis of the facts relevant to the pre-tax profit calculation -- not an "assumption" attributable to Appellants themselves that was blindly accepted by counsel. That understanding was specifically memorialized in Noe's file memorandum, which noted that any "assumptions are based upon [King & Spalding's] review of the documents, instruments, opinions, letters and materials and factual representations by the relevant parties." SPA64.

Finally, Long-Term reasonably assumed that a reputable firm like King & Spalding would not issue a "should' 'opinion if it believed that the transaction lacked the requisite business purpose and economic substance. Given King & Spalding's extensive familiarity with the transaction, when Portfolio filed its return Appellants had every reason to expect that the tax advisors were not relying on "unreasonable assumptions" in concluding that the transaction "should" survive scrutiny under the economic substance doctrine.

The government investigated the circumstances surrounding the preparation of the Schedule M-1, and apparently found no reason to question Appellants' good faith. It deposed three accountants who helped prepare Long-Term's returns, but called none of them as witnesses and did not introduce any of the deposition testimony into the record. See [Doc. 82, Exh. C]. In its trial memorandum, the government did not allege that Appellants lacked "good faith" and made no reference to the Schedule M-1. See [Gov't Trial Mem., at 167-71].

The trial court nevertheless concluded that the Schedule M-1 reporting was erroneous -- indeed, "disingenuous" (SPA210) -- and therefore that Appellants could not qualify for the section 6664(c)(1) exception because they lacked good faith. There is no basis for that conclusion. Noe explained on cross-examination why he was uncertain that the loss should be reported as a "deduction" on line 7 he had little experience with reporting a tax loss that was not a book loss, and Long-Term offset the loss, but did not take a "deduction." [Tr. 801-05]. The instructions accompanying the Schedule M-1 do not address this issue, nor are there any accounting standards or guidelines that clarify the proper reporting of capital losses on a Schedule M-1. Therefore, Noe sought advice from Long-Term's independent auditors, who advised him to net the capital gains and losses and report them as "Net Unrealized Gains" under Line 6, and then he followed that advice. [Tr. 805-07]. Long-Term's reliance upon its independent auditors to complete an ambiguous form plainly does not establish a lack of good faith. The trial court's suggestion that the accountants were not independent, but instead were "collaborating consultants" (SPA 209), is false and without any record support.

II. THE ENHANCED 40% PENALTY IS IN ANY EVENT INAPPLICABLE HERE BECAUSE THE ADDITIONAL TAX LIABILITY WAS NOT ATTRIBUTABLE TO A "VALUATION MISSTATEMENT" WITHIN THE MEANING OF I.R.C. § 6662

Even if the reasonable cause exception is inapplicable, the trial court erred in upholding the "gross valuation misstatement" penalty. The court reasoned that Appellants claimed a carryover basis of more than $100 million in computing their loss on the stock, but "[t]he Court's application of the step transaction doctrine to the OTC transaction has the effect of imputing to Long-Term a cost basis in the Rorer and Quest stock of approximately $1 million." SPA179-SPA180. If OTC had sold the stock to LTCM, as the court hypothetically recast the transaction, the Code would have required using a cost basis equivalent to the purchase price (I.R.C. § 1012) instead of the carryover basis that the Code required for the transaction as it actually occurred (I.R.C. § 723). Because the carryover basis exceeded the cost basis by more than 400%, the court held that Appellants were guilty of a "gross valuation misstatement" under section 6662(b)(3),(e),(h).

The court's reasoning is legally erroneous for two distinct reasons. First, there was no "valuation misstatement." "Valuation" is a factual concept, and Appellants made no factual misstatement concerning the value or adjusted basis of any asset. There were simply legal disputes unrelated to valuation concerning how the transaction should be characterized for tax purposes, with the proper characterization affecting how the Code directs computation of Appellants' basis in the stock. Second, even if the "valuation misstatement" penalty theoretically could apply in such a case, the court's decision cannot stand because it rested on a legally erroneous application of the step-transaction doctrine.

The committee reports elaborate on why Congress chose this particular kind of penalty, which is triggered by a quantitative measure of overvaluation. Congress "recognize[d] that valuation issues frequently involve difficult questions of fact" and are often "resolved simply by 'dividing the difference' in the values asserted by the Internal Revenue Service and those claimed by the taxpayer." Id. "[T]his approach to valuation questions," in Congress's view, "encouraged [taxpayers] to overvalue certain types of property." Id. Accordingly, Congress found it necessary to deter taxpayers from overvaluing assets in order to achieve a compromise resolution at a higher value. But "[i]n recognition of the fact that valuation issues often are difficult, especially where unique property is concerned," Congress drew a quantitative floor for imposition of the penalty so that "only significant overvaluations will be penalized," and it graduated the severity of the penalty depending upon the degree of valuation overstatement. Id. See also Staff of Jt. Comm. on Taxation, 97th Cong., General Explanation of the Economic Recovery Tax Act of 1981, at 332-34 (R. Comm. Print 1981).

In this case, Appellants did not engage in the behavior at which Congress aimed the valuation misstatement penalty. They did not misstate the value of the stock, and this case plainly did not involve any "difficult questions of fact" regarding the value of an asset. The disputes were legal -- whether the loss should be substantially reduced because the judicial step-transaction doctrine allegedly could be used to trigger a different basis methodology (or, alternatively, whether the judicial economic substance doctrine required complete disallowance of the loss).

The trial court did not address congressional intent or otherwise suggest how imposition of the valuation misstatement penalty here could comport with the purposes of the statute. The court simply held that a "valuation misstatement" penalty was authorized by the parenthetical language in section 6662(e), which provides in pertinent part as follows:

The court's interpretation is untenable because it takes the term "adjusted basis" completely out of its context as part of the definition of the term "valuation misstatement" found in section 6662(b)(3). See Robinson v. Shell Oil Co., 519 U.S. 337, 341 (1997) (statutory language should be analyzed "by reference to the language itself, the specific context in which that language is used, and the broader context of the statute as a whole"). Valuation is an inherently factual activity, and it is readily apparent from the context that the "valuation misstatement" penalty is directed only at discrepancies attributable to factual misstatements, not to legal disputes over how to compute basis.

The parenthetical language referring to adjusted basis is necessary because a factual valuation of property can affect tax liability in two ways. The value itself may be a direct component of the tax computation, like the example given in the Joint Committee report of a deduction for charitable contribution of property. See General Explanation of the Economic Recovery Tax Act of 1981, at 334. Alternatively, the value may be a more indirect component of the tax computation, in that a valuation of property can be a predicate to determining adjusted basis, which in turn directly affects the tax liability. See, e.g., I.R.C. §§ 358(a)(2), 1014, 1060; supra note 4. To cover that circumstance, the "valuation misstatement" provision explicitly encompasses a misstatement of "the value of any property (or the adjusted basis of any property)." But that parenthetical cannot be construed to change the entire focus of the "valuation misstatement" penalty by extending its reach to cases in which there is no factual "misstatement" and the dispute is not related to any "valuation." That would contradict section 6662(b)(3), which expressly confines the penalty to cases where the increased tax liability is "attributable to" a "valuation misstatement."

The graduated structure of the penalty provisions confirms that the "valuation misstatement" penalty is limited to cases that involve a factual valuation misstatement. The overriding objective of the Code's penalty provisions is to impose particular penalties for particular types of "proscribed behavior." H.R. Rep. No. 101-247, at 1390 (1989) (discussing valuation misstatement penalty). For more egregious taxpayer conduct, such as a valuation misstatement that exceeds 400% rather than 200%, Congress imposed a more severe penalty. I.R.C. § 6662(h). That gradation in severity logically distinguishes between two different levels of misconduct in the context of a factual misstatement of valuation. If a painting is worth $100,000, it is appropriate to punish a taxpayer more severely for claiming a value of $400,000 than for claiming a value of $200,000.

Where the penalty arises solely from a legal dispute concerning the correct method for calculating basis, however, there is no correlation between the severity of the penalty and the egregiousness of the taxpayer's behavior. For example, under the trial court's theory, Appellants acted improperly by following the Code provisions and using a "carryover basis" to compute the loss, instead of recasting the transaction as a sale and using a "cost basis." The discrepancy between the bases computed using those two different methods -- and thus whether the alleged "valuation misstatement" is "substantial" or "gross" or below the penalty threshold entirely -- turns entirely on the happenstance of what are the correct amounts of the "carryover basis" and the "cost basis." Applying an enhanced penalty in that situation significantly departs from the quantitative element of the statutory scheme that contemplates different gradations of penalty severity for different levels of taxpayer misconduct.

The contrast with the "substantial understatement" penalty of I.R.C. § 6662(d) highlights the limited scope of the "valuation misstatement" penalty. The substantial understatement penalty is a broad "strict liability" provision that is triggered whenever the taxpayer understates his tax liability by 10% -- even if the discrepancy is traceable entirely to a legal dispute. To prevent unfairness, that penalty also has a unique feature that excludes from the understatement calculation amounts attributable to a legal position for which the taxpayer has "substantial authority." I.R.C. § 6662(d)(2)(B)(i). The reason the valuation misstatement penalty has no similar provision is because Congress did not contemplate that it would apply where there is no factual misstatement of valuation, but merely a discrepancy traceable to a legal dispute that affects basis computation. See also I.R.C. § 6664(c)(2)(A) ("special rule for certain valuation overstatements" presupposes a factual overvaluation in conditioning the reasonable cause exception for charitable contributions on using a "qualified appraiser").

Moreover, even if the penalty could in some circumstances apply to a mere legal dispute over how to compute basis, it certainly cannot apply when the "correct" basis used in the percentage comparison is one that flows from the court's step-transaction analysis. That analysis is a hypothetical construction of a transaction that never happened. There are multiple ways in which a court might recast a transaction, which could yield different bases. The "correct" basis ought to be one that a taxpayer could divine from the Code and use on its return, like the fair market value basis that would have applied if the 2004 amendments were in effect in 1997. See supra note 4. But surely a taxpayer cannot be expected to anticipate how the court might apply the step-transaction analysis when it completes its tax return. Thus, although a step-transaction analysis can in appropriate cases support the disallowance of a claimed deduction, it cannot be the springboard for a valuation misstatement penalty. A hypothetical basis that could not have been used by the taxpayer cannot reasonably be viewed as the "correct" basis within the meaning of section 6662(e).

Although adopting a somewhat less restrictive reading than Todd, this Court has similarly emphasized that the scope of the penalty's operation must be confined to situations where the increased tax liability is attributable to a "valuation misstatement." Gilman v. Commissioner, 933 F.2d 143 (2d Cir. 1991), involved a complex computer leasing tax shelter in which the taxpayer claimed inflated depreciation based on a purchase price that greatly exceeded the value of the computers. This Court ruled that the transaction should be disregarded as lacking "economic substance," and hence that no depreciation deductions were allowable. Id. at 147-49.

The Court then concluded that the valuation overstatement penalty could be imposed, even though the rationale for the disallowance was "economic substance" and not that the asset overvaluation yielded excessive depreciation. The Court remarked that its conclusion was "not self-evident" from the statute, which "is most appropriately applied to instances where a taxpayer claims for an asset a value that the Commissioner determines is unduly high." Id. at 150. Indeed, the Court expressly "acknowledge[d] that applying the penalty somewhat strains the natural reading of the statutory phrase 'valuation overstatement."' Id. at 151.

The Court concluded, however, that its decision could be harmonized with the statutory language because its tax liability holding still rested, albeit less directly, on an actual misstatement of valuation by the taxpayer. Specifically, the economic substance holding rested on the finding that the taxpayer could not reasonably expect a profit because "the purchase price of $3 million was more than the computers were worth." Id. "In that way, the overvaluation of the computer equipment contributed to the Court's conclusion that the transaction lacked economic substance." Id. Thus, the connection in Gilman between the increased tax liability and the asset overvaluation was critical to the imposition of the penalty. See Pasternak v. Commissioner, 990 F.2d 893, 904 (6th Cir. 1993) (Gilman "held that when deductions are disallowed because of the transaction's lack of economic substance, if the lack of substance is due in part to an overvaluation of property . . . then the deficiency in tax is attributable to an overstatement of value and subject to the [valuation overstatement] penalty") (emphasis added); M. Saltzman, IRS Practice and Procedure paragraph 7B.03(4)(b), at 7B-73 n.279 (2d ed. 2004) (Gilman holds "that the disallowance of a claimed benefit does not preclude the imposition of the valuation overstatement penalty when the overvaluation of the property is an essential element component of the tax avoidance scheme") (emphasis added).

Gilman clearly does not authorize imposition of the valuation misstatement penalty here, where Appellants made no asset valuation to which the additional tax liability was "attributable." Indeed, the trial court's imposition of the penalty here not only departs from the statutory language, it fails even to serve the statutory policy that the government has previously identified -- namely, "to make tax shelters based on property overvaluations less attractive." Todd, 862 F.2d at 544. In sum, the trial court committed legal error in applying the "valuation misstatement" penalty to Appellants.

The trial court, however, misapplied the doctrine here because it disregarded meaningful steps having significant and permanent economic consequences. A key element of the actual transaction here was OTC becoming a partner in the Long-Term enterprise. OTC contributed the preferred stock to Partners and, in exchange, received a partnership interest in Partners. More than a year later, OTC sold that partnership interest to LTCM. The trial court recharacterized the transaction as a sale of stock from OTC to LTCM, ignoring the partnership transactions. The court ruled that the "end-result" test justified applying the step-transaction doctrine because there existed an understanding when OTC became a partner that OTC would later exercise its put options and transfer its partnership interest to LTCM. SPA162-SPA165.

The court erred, however, because "[t]he existence of an overall plan does not, alone, . . . Justify application of the step-transaction doctrine." Esmark, 90 T.C. at 195. See also Greene v. United States, 13 F.3d 577, 584 (2d Cir. 1994) (noting that "there was arguably a 'plan' of redemption" in Grove, where the step-transaction doctrine was held inapplicable). There are threshold limitations on a court's ability to recast a transaction pursuant to the step-transaction doctrine, even if the steps are part of a prearranged plan.

This case does not satisfy those threshold limitations because the court did not collapse "transitory" or economically "meaningless steps" into a single transaction. Instead, it disregarded meaningful steps in at least two major respects by inventing a different transaction that ignores significant and permanent economic effects inherent in the actual transaction. See SPA162-SPA163. That illegitimate use of the step-transaction doctrine cannot be sustained. See Grove, 490 F.2d at 247-48 (step-transaction doctrine "cannot generate events which never took place just so an additional tax liability might be asserted").

First, OTC was a partner in Partners for fifteen months, enjoying the significant advantages and perils of participating in the Long-Term business enterprise. In 1996 and 1997, respectively, OTC's share of partnership income was $600,797 and $2,231,188. See [P. Ex. 269, at C2621; P. Ex. 319, at C2834]. After owning its partnership interest for more than a year, OTC sold it at a profit of $2.27 million. The investment was profitable, but not without risk. Had OTC retained its investment for another year, it likely would have suffered a loss just like Babcock and others did when the Long-Term entities "imploded" in 1998 because of turmoil in the financial markets. See [Tr. 1680-81].

Second, OTC's sale of its partnership interest gave LTCM a greater share in Partners than it had prior to the transaction. As a result, LTCM and its partners received a greater share of the fund's profits in late 1997 and early 1998 and bore a greater share of its losses when the fund collapsed later in 1998. The trial court's recast of the transaction as a sale takes no account of these economic consequences because the hypothetical sale would not yield any change in LTCM's partnership share.⁸

As the Tax Court has explained, in order to invoke the step-transaction doctrine, the IRS "must have a logically plausible alternative explanation that accounts for all the results of the transaction." Turner Broadcasting System, Inc. v. Commissioner, 111 T.C. 315, 327 (1998). This is because the court's authority to disregard steps is limited to "meaningless" steps, and discarded steps plainly are not meaningless if the court's substitute transaction yields different economic results. Indeed, this Court has emphasized that meaningful economic steps cannot be disregarded even if "they have no purpose germane to the conduct of the business other than tax minimization." See Kraft Foods Co. v. Commissioner, 232 F.2d 118, 127-28 (2d Cir. 1956) (refusing to disregard distribution of an interest-bearing note because it changed the legal relationships of the parties). Thus, the trial court's step-transaction holding is fatally flawed by its failure to account for the significant and permanent economic consequences of the partnership aspects of the transaction.⁹

The trial court also asserted erroneously that three Second Circuit decisions support the Court's application of the step transaction doctrine here." SPA171. This assertion is clearly mistaken. One of the cases does apply the doctrine, but it provides no guidance for the very different factual situation presented here. In Blake v. Commissioner, 697 F.2d 473 (2d Cir. 1982), a taxpayer contributed stock to a charity, which "Immediately sold" the stock and, by agreement, used the proceeds to purchase the taxpayer's yacht. Id. at 475. This Court taxed the taxpayer on the gain from the stock sale by recasting the transaction as a sale of stock by the taxpayer and contribution of the yacht to the charity (thus disregarding the taxpayer's short-lived transfer of the stock to the charity). This was a typical exercise of the step-transaction doctrine. The Court collapsed three steps into two, disregarding a transitory step and leaving the parties in the same economic position as the actual transaction. Blake does not support using the step-transaction doctrine here to obliterate OTC's fifteen months of partnership status and to ignore other permanent economic effects of the transaction.

The other two cases rejected the IRS's attempt to invoke the step-transaction doctrine, and they describe the doctrine in terms that undermine the trial court's decision. In Greene, 13 F.3d at 583, the Court faulted the government for trying to "describe two actual transactions as two hypothetical ones" instead of collapsing steps into "a single transaction." Grove emphasized that steps can be disregarded only if they are "meaningless" and rejected the idea of "recasting[ing] two actual transactions . . . into two completely fictional transactions." 490 F.2d at 246, 247. Indeed, Grove is one of the key authorities repeatedly cited by the Tax Court for the basic step-transaction principles noted above that the trial court refused to follow. See Turner Broadcasting, 111 T.C. at 326-28; Esmark, 90 T.C. at 196, 200. The court thus committed legal error in recasting Appellants' transaction under the step-transaction doctrine, and therefore this Court must reverse the 40% penalty that rests on the step-transaction holding.¹⁰

2. This brief complies with the typeface requirements of Fed. R. App. P. 32(a)(5) and the type style requirements of Fed. R. App. P. 32(a)(6) because this brief has been prepared in a proportionally spaced typeface using Microsoft Word 9.0 in Times New Roman 14-point typeface.

² The government's promotional materials explained that the "tax basis of the assets of the acquired institution will carry over to the acquirer and permit the acquirer to recognize a tax loss upon the disposition of the acquired asset which has a tax basis greater than its fair market value." Centex, 2005 U.S. App. LEXIS 945, at *5-6.

³ "A 'should' level opinion evinces a fairly high level of comfort on the part of the tax practitioner that the legal conclusions follow as a matter of law from the factual representations and assumptions" -- a level of comfort significantly greater than "more likely than not." SPA57 n.34.

⁴ Congress recently amended section 704(c) to prevent this result. American Jobs Creation Act of 2004, Pub. L. No. 108-357, § 833, 118 Stat. 1418, 1589. In explaining the reason for the change, the legislative history confirms that Appellants correctly interpreted the Code in claiming the loss. The Conference Report describes a built-in loss transaction like the one involved in this case and states that, under pre-2004 law, "it appears that losses can be 'transferred' to other partners where the contributing partner no longer remains a partner." H.R. Conf. Rep. No. 108-755, at 609 (2004). The new statute, however, establishes that "if the contributing partner's partnership interest is transferred or liquidated, the partnership's adjusted basis in the property is based on its fair market value at the time of contribution, and the built-in loss is eliminated." Id. at 610-11.

⁵ The court did not hold that its economic substance ruling could support the penalty, acknowledging that, under that theory of increasing Appellants' tax liability, it would be "difficult" to contend that "any tax deficiency resulting from the basis claimed by Long Term is 'attributable'" to a misstatement of basis, as required by statute and by Gilman v. Commissioner, 933 F.2d 143 (2d Cir. 1991). SPA180 n.99.

⁶ This distinction between individual and corporate taxpayers no longer exists. Last year Congress amended the penalty provisions to extend the "substantial authority" and "more likely than not" requirements to individuals who claim tax-shelter-related deductions resulting from "listed or reportable transactions." American Jobs Creation Act, § 812, 118 Stat. at 1581.

⁷ The "reasonable cause" standard applicable to Appellants is the most lenient standard set forth in the regulations. It "may provide relief from the penalty . . . even if a return position does not satisfy the reasonable basis standard" that governs the negligence penalty. Treas. Reg. § 1.6662-3(b)(3) (2004). The "reasonable basis" standard in turn is more lenient than the standards applicable to corporate tax shelter items. See Treas. Reg. § 1.6662-4(d)(2) (substantial authority is "less stringent than the 'more likely than not' standard . . . but more stringent than the reasonable basis standard").

⁸ In addition, the court treated OTC as selling the stock directly to LTCM, even though in actuality the stock was held, and ultimately sold, by Portfolio (which had different partners than LTCM). Therefore, the court's recast transaction assigned the effects of the economic ownership of the stock, such as accrued dividends and the loss on the stock sale, to the wrong people.

⁹ The trial court quoted language from True v. United States, 190 F.3d 1165, 1177 (10th Cir. 1999), to support the assertion that the step-transaction doctrine "may ignore economic relations created by the parties." But the economic effects referenced there were the kind of events that "accompany almost any business dealing," like "adjustment of company books." Id. These effects can be transitory and thus inconsequential, as they were in True, and hence the quotation is irrelevant here where the court ignored permanent and substantial economic effects.

¹⁰ As the court essentially acknowledged in its opinion (SPA180 n.99), its disallowance of Appellants' claimed loss on "economic substance" grounds does not justify imposing a "valuation misstatement" penalty. The economic substance holding disregarded all tax consequences of the transaction on the ground that Appellants lacked business purpose. The amount of the claimed carryover basis in the stock was entirely irrelevant to that conclusion. Hence, the increased tax liability cannot be said to be "attributable to" a "valuation misstatement" as required by section 6662(b)(3). See Gilman, 933 F.2d at 151-52.