Tax Court Reconsiders, Sustains IRS Partnership Adjustments

Veronica L. Richards and Daniel L. Timmons, for respondent.

[*4] Respondent examined the LLCs' 2000 returns, and by the FPAAs he made adjustments to partnership items that would eliminate the losses reported by the corporations. He justified his adjustments in part on the ground that the LLCs had been "formed and availed of solely for purposes of tax avoidance by artificially overstating basis in the partnership interests of its purported partners." Because the transactions and partnership had "no business purpose other than tax avoidance", they "lacked economic substance", and so, respondent determined, he would disregard them for tax purposes and disallow deductions for the related losses.

We conducted a trial in these cases, and the testimony at trial consisted principally of expert testimony concerning the economics of option spreads. Respondent called two expert witnesses, Thomas Murphy, who was accepted by the Court as an expert in valuing and trading foreign currency options, and John B. Finnerty, Ph.D., who was accepted by the Court as an expert in finance with a particular expertise in derivatives. Petitioners called one expert witness, Scott D. Hakala, Ph.D., who was accepted by the Court as an expert on the pricing of currency options with some familiarity with industry practice.

In our Memorandum Opinion AD Inv. 2000 Fund LLC v. Commissioner, at *4, *29-*30, we held that the LLCs should not be recognized as entities for [*5] Federal tax purposes, and, on that basis, we sustained respondent's adjustments that would eliminate the loss deductions claimed by the corporations.

We found:

Dr. Hakala, petitioners' expert, did not explain why the corporations entered into more complicated transactions when simpler ones with higher probabilities of profit were available, even opining that he did not see anything that suggested an "intent of really beating the market at [a] sophisticated level". Id. at *17-*18 (alteration in original). When asked whether he thought the purpose of the option spreads was actually to profit from foreign currency markets in the light of the fact that the purported tax benefits made profiting immaterial, he stated: "I understand that to some extent, as I would say, the tail wagged the dog". Id. at *18.

Petitioners called Ronald Buesinger as a fact witness. He is an experienced option trader who had assisted Mr. Haber in implementing FXIS. He testified that he had priced the option trades that were necessary to execute FXIS and was very familiar with the economics of the trades. He further testified that he had negotiated the terms of the trades with Lehman Brothers Commercial Corp. [*8] (Lehman), which was both the counterparty and the calculation agent for those trades.⁴ He testified that Lehman was uncomfortable with the risk that the option spreads would expire on the "sweet spot" (the remote possibility that, on the expiration of an option pair, the long option is in the money but the short option is not), which risk figured in setting the market spread to be taken into account in determining whether the sweet spot was hit. He acknowledged that, if Mr. Haber was concerned about the net payoff amount from options trades, then a simpler strategy would have been to invest in single (we assume "unpaired") option transactions.

And while the existence of a sweet spot undoubtedly offered the corporations and the LLCs at least the theoretical possibility of a huge payout, Mr. Buesinger analogized the probability of hitting the sweet spot to "hitting the lottery" (or "hitting the head of a pin"). Mr. Murphy was certain that the sweet spot would never be hit. He testified that Lehman, as the calculation agent, had [*9] discretion to pick from a range of prices wider than the sweet spot⁵ and that, under the terms of the relevant trade confirmations, neither Lehman or the corporations owed a fiduciary duty to the other. He testified that it would be both commercially reasonable and in its interest (as the counterparty to the transaction) for Lehman to pick a price not at the sweet spot. Mr. Murphy convinced us that Lehman would not have closed a transaction on the sweet spot, AD Inv. 2000 Fund LLC v. Commissioner, at *15, and we found that the option spreads at issue "would never have expired on the 'sweet spot'", id. at *14. There is, however, other testimony that (putting aside Mr. Murphy's testimony) leads us to the same conclusion. Dr. Finnerty was of the opinion that the probability that the paired options would have expired on the sweet spot is "essentially zero." His reasoning was similar to Mr. Murphy's: "As the calculation agent and the counterparty technically exposed to this risk [i.e., payoff if the sweet spot is hit], it seems very unlikely that Lehman would allow the paired options to actually expire within the sweet spot. Lehman would take advantage of the flexibility that it had in determining terms." Dr. Hakala conceded that, as a practical matter, the option [*10] spread would never actually expire on the sweet spot.Id.at *16. He added that he had never seen it happen and that, if the option spread was close to being in the money, the parties would close it out before expiration at an agreed price. Id. And while that might mean that a spread owner could profit from a spread that was not actually in the money if it were close to being in the money near to its expiration date (or might enjoy an increased profit if the spread were already in the money and close to the sweet spot near to its expiration date), Dr. Hakala did not quantify the "price" (bonus) that would be agreed upon to avoid the possibility of an option spread's expiring on the sweet spot. For that reason, we cannot do much with his opinion that the parties would price away the risk of a sweet spot hit, and we see no reason to change our fifth numbered finding; i.e., if foreign currency investing and diversification were the goal, there were simpler alternatives with a higher probability of generating profit. Disregarding Mr. Murphy's testimony does not change our assumption expressed in that finding that there were simpler alternatives with a higher probability of generating a profit.

Upon reconsideration of the expert testimony, disregarding Mr. Murphy's testimony, we make the same fifth numbered finding that we made in our Memorandum Opinion AD Inv. 2000 Fund LLC v. Commissioner, at *29, viz, "if [*11] foreign currency investing and diversification were the goal, there were simpler alternatives with a higher probability of generating profit."

An appropriate order will be issued, and decisions will be entered for respondent.

¹ All Rule references are to the Tax Court Rules of Practice and Procedure.

² On March 16, 2016, during a trial conducted by another Division of the Court, in Tucker v. Commissioner, T.C. Dkt. No. 12307-04 (filed July 14, 2004), voir dire of Mr. Murphy revealed that he had not updated his curriculum vitae with respect to certain aspects of his employment history and the trials in which he had testified in the prior four years. As a result, we did not permit Mr. Murphy to testify in that case.

³ Although petitioners did not do so, we will treat petitioners as having made an untimely motion pursuant to Rule 161 for us to reconsider our findings or opinion. We grant petitioners leave to so move and hereby grant the motion.

⁴ As "counterparty", Lehman bought the options that the corporations sold (it would receive payouts from the corporations if the options expired in the money) and sold the options that the corporations bought (it would have to make payouts to the corporations if the options expired in the money). As "calculation agent", Lehman was responsible for determining the exchange rate price when the options expired. See AD Inv. 2000 Fund LLC v. Commissioner, at *8 n.4.

⁵ More specifically, Mr. Murphy testified that the market spread on exchange rates was three pips wide, and calculation agents such as Lehman would have discretion to pick a price at least within that range. Because the sweet spot for all of the option spreads was only one pip wide, it, in effect, gave Lehman discretion to always pick a price outside of the sweet spot.