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Partnership Challenges IRS Basket Option Adjustments in Tax Court

MAY 1, 2019

GWA LLC et al. v. Commissioner

DATED MAY 1, 2019
DOCUMENT ATTRIBUTES

GWA LLC et al. v. Commissioner

GWA, LLC, GEORGE A. WEISS, Tax Matters Partner,
Petitioner,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent.

UNITED STATES TAX COURT

PETITION FOR READJUSTMENT OF PARTNERSHIP ITEM SUNDER CODE SECTION 6226

GWA, LLC, by and through George A. Weiss, Tax Matters Partner (“petitioner”) hereby petitions for readjustment of the partnership items and penalties set forth by respondent, Commissioner of Internal Revenue (“respondent”) in his Notices of Final Partnership Administrative Adjustment for the years ended December 31, 2009 and December 31, 2010. As a basis for this case, petitioner alleges as follows:

1. GWA. Petitioner is GWA, LLC (the “Partnership”), a Connecticut limited liability company, by and through George A. Weiss, Tax Matters Partner. The Partnership is treated as a partnership for U.S. federal income tax purposes, and subject to the TEFRA Unified Partnership Procedures of section 6221-62341 for the tax years ended 2009 and 2010. The Partnership's principal place of business and mailing address is One State Street, 20th Floor, Hartford, CT, 06103-3100. The Partnership timely filed its Forms 1065, U.S. Returns of Partnership Income, for 2009 and 2010 with the Internal Revenue Service in Ogden, Utah.

2. Tax Matters Partner. George A. Weiss (“Mr. Weiss”) is the tax matters partner of the Partnership for the years at issue. Mr. Weiss's current address is Tax Matters Partner, c/o GWA, LLC, One State Street, 20th Floor, Hartford, CT, 06103-3100.

2. a. Mr. Weiss is also a notice partner of the Partnership within the meaning of section 6231(b)(8). Mr. Weiss's State of legal residence is Florida.

2.b. Mr. Weiss has an ownership interest in the Partnership and has an interest in the outcome of this matter within the meaning of section 6226(d).

2.c. The tax matters partner did not file a petition for readjustment of partnership items within the period specified in section 6226(a).

3. Notices of Final Partnership Administrative Adjustment. The Notices of Final Partnership Administrative Adjustment, each of which is dated December 3, 2018, were issued by the Appeals Office of the Internal Revenue Service at Philadelphia, Pennsylvania. The FPAAs propose adjustments to partnership items of the Partnership for 2009 (the “2009 FPAA”) and 2010 (the “2010 FPAA”) (collectively, the “FPAAs”). Copies of the FPAAs are attached as Exhibit A. Pursuant to Rule 241(h) of the Tax Court Rules of Practice and Procedure, petitioner is filing this petition seeking readjustments with respect to the FPAAs.

4. Amounts in Dispute. In the 2009 FPAA, respondent adjusted the Partnership's ordinary income in the amount of $509,966,645, its portfolio income in the amount of $8,838,781, and its portfolio interest income in the amount of $1,925,846. In the 2010 FPAA, respondent adjusted the Partnership's ordinary income in the amount of $3,300,827 and its portfolio income in the amount of $3,327,781. All of the amounts in the FPAAs are in dispute. Respondent also imposed accuracy-related penalties under section 6662, all of which are also in dispute. In the FPAAs, respondent made a number of overlapping alternative adjustments, all of which are in dispute.

5. Assignments of Error. The adjustments set forth in the FPAAs are based on the following errors:

5. a. Respondent erred in determining that derivative contracts between the Partnership and Deutsche Bank (the “Contracts”) were neither contracts subject to section 1234A nor options subject to section 1234.

5. b. Respondent erred in attributing to the Partnership direct ownership of securities positions referenced by the Contracts (the “Reference Portfolios”).

5.c. Respondent erred in attributing to the Partnership income, gains and losses that the Partnership would have realized if the Partnership had directly owned and traded securities referenced by the Reference Portfolios.

5.d. Respondent erred in creating items of income and deduction that were not realized by either Deutsche Bank or the Partnership and attributing such created items to the Partnership.

5.e. Respondent erred in failing to treat each Contract termination that occurred in 2009 and 2010 as a sale or exchange of a capital asset, as required by section 1234 or section 1234A.

5.f. Respondent erred in determining, under various alternative theories, that, if the Partnership did not own and directly trade positions referenced by the Reference Portfolios, then changes in security positions referenced by the Reference Portfolios were discrete sales or exchanges of all or a portion of the Contracts under section 1001.

5.g. Respondent erred in determining that the Partnership was required to mark to market under section 475 any security positions imputed to the Partnership under respondent's alternative theories.

5.h. Respondent erred in determining that the Partnership was subject to an election under section 475(f).

5.i. Respondent was arbitrary, capricious, and unreasonable and erred in determining that his primary and alternative adjustments constitute a change in the Partnership's accounting method.

5.j. Respondent was arbitrary, capricious, and unreasonable and erred in determining that reporting each Contract termination as a sale or exchange of a capital asset under section 1001 was an improper method of accounting.

5.k. Respondent was arbitrary, capricious, and unreasonable and erred in determining that attributing ownership of securities to the Partnership and correspondingly creating thousands of imputed items of income, gain, loss, and expense constituted a change in the Partnership's accounting method.

5.l. Respondent was arbitrary, capricious, and unreasonable and erred in determining that requiring the Contracts or any other securities to be marked to market constituted a change in the Partnership's accounting method.

5.m. Because none of respondent's adjustments constituted a change in accounting method, respondent erred in determining a section 481 adjustment in 2009.

5.n. Based on the foregoing errors, respondent erred in adjusting section 734(b) basis adjustments.

5.o. Respondent erred in asserting accuracy-related penalties under section 6662.

5.p. Respondent erred in proposing a series of alternative adjustments as set forth on pages ten through twelve of the 2009 FPAA and pages nine and ten of the 2010 FPAA, for the same reasons as explained in paragraphs 5.a through 5.o of this petition.

6. Facts Relied Upon. The facts upon which the Partnership relies as the basis for this case are as follows:

The Partnership

6. a. The Partnership was formed in 1996. Since its formation, the Partnership has been classified as a partnership for U.S. federal income tax purposes.

6.b. At all relevant times, the Partnership's activities were limited to holding certain nonmarketable securities positions (including the Contracts); holding interests in subsidiary entities (including entities that were classified for U.S. federal income tax purposes as partnerships and disregarded entities); receiving contributions from, and making distributions to, its partners; and investing its equity either directly or through wholly or partially owned subsidiary entities. At no relevant time did the Partnership trade securities for its own account.

6.c. At all relevant times, the partners of the Partnership consisted of Mr. Weiss, persons and entities related to Mr. Weiss, and principals or employees of subsidiary entities that were engaged in investment advisory and securities trading business conducted by the Partnership's wholly or partially owned subsidiary entities.

Weiss Multi-Strategy Advisers LLC

6.d. At all relevant times, Weiss Multi-Strategy Advisers LLC (“Advisers”) was a partnership in which the Partnership held the majority of the outstanding interests.

6.e. Advisers' principal activity was developing investment strategies and implementing them on behalf of other persons. Advisers did not invest its own equity, but served as an investment advisor with the authority to trade investments owned by others.

QGI Associates, LLC

6.f. OGI Associates, LLC (“OGI”) was formed in 1994. OGI is a limited liability company organized under the laws of the State of Connecticut. Since June 1, 1998, the Partnership has owned all of OGI's membership interests. Since June 1, 1998, OGI has been classified as a disregarded entity for U.S. federal income tax purposes.

6.g. While OGI is classified as a disregarded entity for purposes of Treas. Reg. § 301.7701-2, it is a regarded entity for legal and commercial purposes. It contracts in its own name and for its own account. It maintained separate bank and investment accounts and traded securities in its own name and for its own account.

6.h. OGI has never been a dealer in securities. Since June 1,1998, OGI has actively conducted a trade or business of trading in securities.

The Barrier Option Contracts

6.i. Between 2003 through 2006, the Partnership entered into the Contracts with Deutsche Bank. The Contracts were bilateral contracts between the Partnership and Deutsche Bank. Under the Contracts, the Partnership made a single cash payment to Deutsche Bank. In exchange, on the termination date of the Contract, Deutsche Bank agreed to make a single payment to the Partnership in an amount (which might have been zero) determined in part by reference to cumulative changes in the value of a notional portfolio of reference securities (i.e., the Reference Portfolios).

6.j. Specifically, the Partnership and Deutsche Bank entered into a Contract on April 15, 2003, which was terminated on April 30, 2009. The Partnership and Deutsche Bank entered into four additional Contracts on December 12, 2006, which were terminated in May of 2010.

6.k. A principal benefit of entering into the Contracts, as compared to directly buying and selling securities, is that various margin limitations imposed by regulations governing extensions of credit by financial institutions did not apply. Thus, the amount of leverage that Deutsche Bank could provide through the Contracts enabled the Partnership to achieve returns on its equity that could not have been produced by direct investment and ownership of securities.

6.l. The regulations also prohibited financial institutions from financing the acquisition of securities with nonrecourse margin loans. Leverage provided through the Contracts, however, was nonrecourse, limiting the Partnership's downside risk and providing an additional benefit of entering into the Contracts, as compared to directly buying and selling securities.

6.m. For each Contract, the Partnership was required to make a payment of only ten percent of the initial notional value of the Reference Portfolio. Thus, the Contracts allowed the Partnership to leverage its equity investment in the Contracts, while limiting its downside risk to that amount.

6.n. The economic leverage that Deutsche Bank provided to the Partnership under a Contract was not enforceable as a debt of the Partnership to Deutsche Bank. The Partnership had no contractual obligation to make any additional payment to Deutsche Bank.

6.o. No Contract required Deutsche Bank to hold physical securities that corresponded to the securities referenced by the Reference Portfolios. No Contract required Deutsche Bank to pledge any securities to secure Deutsche Bank's obligation to the Partnership under a Contract.

6.p. The Contracts were “cash settled,” in that any obligation of Deutsche Bank on termination of a Contract could be satisfied only by paying cash in the amount of the cash settlement value determined under the Contract. Deutsche Bank did not have the right to settle any Contract by delivery of securities. The Partnership had no right to require Deutsche Bank to settle a Contract by delivering securities.

6.q. The cash settlement value of the Contracts was not the same as the value of the underlying positions referenced by the Reference Portfolios. Rather, the cash settlement value reflected, inter alia, the appreciation in the value of the underlying positions referenced by the Reference Portfolios.

6.r. If the cash settlement value of a Contract was positive on the termination date, Deutsche Bank was required to pay the cash settlement value to the Partnership. If Deutsche Bank failed to make payment, the Partnership's recourse was to sue for payment as a general unsecured creditor of Deutsche Bank.

6.s. If the cash settlement value was negative, the Contract would expire and the Partnership would not receive (or pay) anything.

6.t. On settlement of a Contract, the Partnership would not (and did not) receive sufficient cash to replicate the Reference Portfolios.

6.u. Each Contract had a barrier provision, which provided that the Contract would automatically terminate if the fair market value of the positions referenced by the Reference Portfolio fell below ninety-four percent of the initial notional value of the Reference Portfolio.

6.v. Under the Contracts, Deutsche Bank had the right to select an investment advisor to manage the composition of the securities positions referenced by the Reference Portfolios. Deutsche Bank indirectly retained Advisers to manage the composition of the securities positions referenced by the Reference Portfolios. Any physical securities resulting from managing the composition of the Reference Portfolios were allocated to Deutsche Bank accounts in which the Partnership had no right or interest.

6.w. Advisers had no right to require that Deutsche Bank hold physical positions that corresponded to the securities referenced by the Reference Portfolios.

6.x. Deutsche Bank created and maintained a list of securities that could not be referenced by the Reference Portfolios (the “Restricted List”). Deutsche Bank updated the Restricted List during the terms of the Contracts. Deutsche Bank enforced compliance with the Restricted List during the terms of the Contracts. The Restricted List would not have been necessary if the Partnership had maintained a prime brokerage account with Deutsche Bank and traded any securities it owned through such an account.

6.y. Deutsche Bank also required an investment advisory agreement (the “IAA”) that imposed detailed restrictions on the types and amounts of securities that could be referenced by the Reference Portfolio (the “Investment Guidelines”). The Investment Guidelines governed, for example, the types of positions in securities that could be referenced by the Reference Portfolios, the necessary diversification in the Reference Portfolios from an industry, issuer, and sector standpoint, and the balance between long and short positions in equity securities in the Reference Portfolios.

6.z. Deutsche Bank enforced compliance with the Investment Guidelines during the terms of the Contracts.

6.aa. The Restricted List and Investment Guidelines allowed Deutsche Bank to manage its regulatory compliance obligations and market risk.

6.bb. The Partnership did not hold title to any of the securities referenced by the Reference Portfolios. The Partnership had no right to vote any of the securities referenced by the Reference Portfolios.

6.cc. Deutsche Bank had the right to sell, lend, pledge, or hypothecate any position referenced by the Reference Portfolios that Deutsche Bank in fact owned at any time, without any obligation to replace the position. The Partnership had no authority to require Deutsche Bank to take any action with regard to any securities referenced by the Reference Portfolios that Deutsche Bank in fact owned.

6.dd. The Partnership could not trade, transfer, pledge, or hypothecate the Contracts without Deutsche Bank's prior, written consent except where the Partnership was amalgamated with, consolidated with, merged with or into, or transferred substantially all of its assets to, another entity.

The Partnership's Financial Reporting

6.ee. The Partnership's audited financial statements reflected each Contract as a separate asset labeled as an option. The Partnership's books and records specifically identified the Contracts as the Partnership's assets.

6.ff. The Partnership's audited financial statements listed the Contracts as securities that were not readily marketable. The Partnership's audited financial statements stated that the Contracts could not be offered or sold.

6.gg. The Partnership's audited financial statements and books and records did not include as assets any securities referenced by the Reference Portfolios.

The Partnership's and OGI's Tax Reporting

6.hh. The Contracts were terminated in 2009 and 2010. On the Partnership's federal income tax returns for 2009 and 2010, the Partnership reported capital gain under section 1001 equal to the excess of the cash settlement payment received from Deutsche Bank over the Partnership's basis in such Contract.

6.ii. The Partnership is a person within the meaning of section 7701(a)(1). OGI is a person within the meaning of section 7701(a)(1).

6.jj. At all relevant times, OGI has directly engaged, in its own name and for its own account, in a trade or business of trading in securities.

6.kk. As a disregarded entity, OGI was not required to file a separate federal income tax return.

6.ll. Section 475(f) was enacted in 1997 to allow a person who is engaged in the business of trading securities to elect to report trading gains and losses on securities held at the end of the year by marking them to market. In 1998, OGI was a person engaged in a securities trading business, and it desired to report its trading gains and losses under the mark-to-market method.

6.mm. Under the guidance available at the time, a trader desiring to make a mark-to-market election under section 475 was required to attach an election statement to its income tax return.

6.nn. Because OGI was a person entitled to make a mark-to-market election but was not required to file a separate income tax return, OGI included its election on the Partnership's Form 1065 (U.S. Return of Partnership Income) for the 1998 tax year. The election states “OGI, LLC is engaged in a trade or business as a trader in securities and elects to have Internal Revenue Code Section 475(f)(1) apply to such trade or business.”

6.oo. Since OGI made its election under section 475(f)(1), it has applied the mark-to-market method of accounting to its trading activities.

6.pp. The Partnership has never engaged in the trade or business of trading securities. The Partnership was not eligible to make an election under section 475(f)(1). The Partnership has never marked to market any of its securities.

6.qq. The limitations period under section 6501 has expired for all of the Partnership's tax years prior to 2009, including 2003, 2004, 2005, 2006, 2007, and 2008.

6.rr. Respondent's adjustments change the lifetime income of the Partnership and its partners.

6.ss. Respondent's attribution to the Partnership of direct ownership of securities positions referenced by the Reference Portfolios could not legally occur under various margin limitations governing extensions of credit by financial institutions.

Respondent's Assertion of Penalties

6.tt. The Partnership's tax treatment of the Contracts is supported by substantial authority.

6.uu. The Partnership's tax treatment of the Contracts has a reasonable basis.

6.vv. The Partnership adequately disclosed the relevant facts affecting the tax treatment of the Contracts on its partnership tax returns or statements attached to its partnership tax returns.

6.ww. The Contracts were not tax shelters under section 6662(d)(2)(C)(ii). The avoidance or evasion of federal income tax was not a significant purpose of the Partnership's investments in the Contracts.

6.xx. No penalty can apply to any amount attributable to an adjustment under section 481.

6.yy. Respondent did not comply with section 6751.

WHEREFORE, the Partnership requests that this Court hear this case and determine that:

1. The Partnership correctly reported all partnership items of the Partnership on its 2009 and 2010 tax returns;

2. The adjustments to the partnership items of the Partnership as determined by respondent for 2009 and 2010 are erroneous;

3. No adjustment of any partnership items is appropriate for tax years 2009 and 2010;

4. No section 6662 penalty is warranted on any underpayment for 2009 and 2010; and

5. The Partnership is entitled to such other and further relief as this Court deems just and proper.

Respectfully submitted,

Sheri A. Dillon
Morgan, Lewis & Bockius LLP
1111 Pennsylvania Avenue NW
Washington, D.C. 20004
Telephone No: (202) 739-5749
Tax Court Bar No: DS0248
sheri.dillon@morganlewis.com

Jennifer E. Breen
Morgan, Lewis & Bockius LLP
1111 Pennsylvania Avenue NW
Washington, D.C. 20004
Telephone No: (202) 739-5577
Tax Court Bar No: BJ1937
jennifer.breen@morganlewis.com

Jenny A. Austin
Morgan, Lewis & Bockius LLP
77 West Wacker Drive
Chicago, Illinois 60601
Telephone No: (312) 324-1487
Tax Court Bar No: AJ0616
jenny.austin@morganlewis.com

William F. Nelson
Morgan, Lewis & Bockius LLP
1111 Pennsylvania Avenue NW
Washington, D.C. 20004
Telephone No: (202) 373-6782
Tax Court Bar No: NW0106
william.nelson@morganlewis.com

ADMITTED

Michael D. Kummer
Morgan, Lewis & Bockius LLP
1111 Pennsylvania Avenue NW
Washington, D.C. 20004
Telephone No: (202) 373-6684
Tax Court Bar No: KM0588
michael.kummer@morganlewis.com

Counsel for GWA, LLC and
George A. Weiss, Tax Matters Partner

Dated: May 1, 2019

FOOTNOTES

1All “section” references are to the Internal Revenue Code of 1986 (26 U.S.C.) (I.R.C.), as amended and in effect for the years in issue, unless otherwise stated.

END FOOTNOTES

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