Jade Trading Argues Claims Court Erred; Transactions Had Economic Substance

B. The following cases are based on the same issue as this case. They are all pending in the Court of Federal Claims:

On January 4, 2008, Sentinel Advisors, LLC, the tax matters partner, filed a Motion to Participate and a Motion for Reconsideration solely on the issue of whether the Court could impose penalties against the partnership. That Motion pointed out certain errors in the Opinion. On January 16, 2008, the Court issued an Order Correcting Clerical Mistakes in the original Opinion of December 21, 2007.

The trial court granted Sentinel's Motion to Participate on January 30, 2008, but denied Sentinel's Motion for Reconsideration on March 20, 2008. Jade timely filed a Notice to Appeal on February 25, 2008. The due date of this brief was extended once to August 1, 2008.

2. Did the trial court possess the jurisdiction to draw the reasonable cause conclusion compelled by its findings?

Also on advice from people they trusted, the Ervins agreed to listen to another investment advisor with impressive trading credentials who specialized in foreign currency trading. (JA00028) That investment advisor -- Sentinel -- Advisors also presented a strategy using pairs (and other configurations) of options to capture profits on an anticipated rise of the Euro against the dollar. (JA00028) The Euro, then newly introduced in January 1999, was traded on the Interbank Foreign Currency Market, the world's most liquid trading market with over $1 trillion traded each day. (JA00028, JA05782)

Sentinel explained how Gary and his brothers could profit on an anticipated rise in the Euro by using highly leveraged currency options and more exotic options such as knock-out options that could produce returns in excess of 30:1.⁶ (JA00028) Prior to making any investment, Gary, on behalf of himself and his brothers, performed an extraordinary amount of due diligence on Sentinel and the Euro, as detailed by the trial court in its opinion at JA0030-2. After concluding that Sentinel's trading strategy could result in substantial profits, each Ervin brother purchased an option (the "Purchased Euro Option") from AIG International, Inc. ("AIG")(JA00033) one of the largest and most reputable foreign currency trading houses on the Interbank market. (JA0241) Simultaneously, each Ervin brother sold an option (the "Sold Euro Option") to AIG. (JA00033) Each brother paid $15 million for the Purchased Euro Option and received $14.85 million for the Sold Euro Option (JA00033).⁷ As to the nature of each option:

• The Ervins, through single member LLCs,⁸ each owned a Purchased Euro Option (JA04430-2, JA07517);

• AIG owned the Sold Euro Option (JA04433-5, JA00258);

• The Purchased Euro Option constituted an asset in the Ervins' hands (Id.);

• The Sold Euro Option constituted a contingent obligation in the hands of the Ervins (JA00054-55);

• The two options were separate legal instruments with separate documentation (JA04430-5);

• The over-the-counter market requires each option to be entered separately, valued separately, and confirmed separately (JA07524-5);

• AIG treated the options as separate legal instruments, recorded them on their books as separate legal instruments, and issued two separate trade confirmations (Id.);

• Upon contribution to Jade, as a matter of accounting, each option was recorded separately (JA05826);

• Each option could be separately bought or sold without altering the other option (JA00475-6, JA07509);

• Each option could be separately restricken (i.e. closed and replaced with a new option) without altering the other to capture profits (Id); and

• Each option could be separately "legged-out" of a spread configuration or "legged-into" a different configuration for substantial profits (JA02877-8, JA07510).

These initial options presented the Ervins with the opportunity to almost double their investment. (JA00044) Even after the AIG fee, the Ervins had the potential to earn a return of $66,000 on a net investment of $150,000, or a 40% annual return. By trading these options, much greater returns were possible, as confirmed by the actual trading results Sentinel provided the Ervins.¹⁰ (JA05757-9)

During the first week after the Ervins entered into these options, the options increased in value as the Euro began its predicted climb against the dollar. (JA04683-5) In just the first two weeks their Euro options appreciated 15 percent -- for an annualized rate that the IRS economist calculated to be 3,300 percent. (JA02740-1, JA02876-7, JA04683-5) During this period, the Ervins entered into a 15 month consulting agreement with a Sentinel affiliate for consulting advice on all the Ervins' investments, including the $20 million in Dycom stock that would become unrestricted in 2000.¹¹ Each Ervin agreed to pay Sentinel $750,000 to provide investment advice through December 2000.¹² (JA00035, JA04483-5, JA04507-9, JA04515-7) The Ervins then also agreed in principle to make a long term investment with Jade, and as part of that investment, contributed the appreciated options plus additional cash to Jade in order to allow Jade's managing member, Sentinel, to actively manage these positions as well as enter into more exotic trades (JA00037) for the benefit of all five Jade partners, including Banque Safra, which represented Brazilian investors. (JA01420)

Jade presented the Ervins with the ability to engage in sophisticated trading with other types of options which had the possibility of making 10, 15 or 20 times their investment. (JA00029) Jade in fact entered into knock out options which presented a high risk/higher reward ratio with multiples up to 33:1. (JA00039, JA06944) In just the first two weeks of trading, Jade's profit potential exceeded $3.6 million:

                                           GROSS            NET

Sentinel's bullish Euro prediction faltered two weeks after the Ervins began investing in the bullish Euro positions when the Euro collapsed against the dollar. (JA00039) After over a month of virtually daily declines against the dollar, Sentinel advised the Ervins that it was no longer bullish on the Euro. (JA00039, JA00917-8) Based on Sentinel's reversal and the reality that their trades were plummeting in value, the Ervins notified Sentinel that they wished to withdraw from Jade. (JA00039) After withdrawing from Jade, each Ervin brother sold the property distributed by Jade and reported losses on his individual federal income tax return from the sale of Euros and Xerox stock.¹⁴ (JA00040)

Just as they had relied upon their independent investment advisors before purchasing the options (JA00030), the Ervins relied upon their local tax advisors and upon nationally known tax professionals to make sure they handled the tax aspects of the Jade investment correctly. With no college degree, much less any tax training (JA00631), the Ervins turned to their longtime CPA and trusted tax attorney as a sounding board for the tax advice from the respected international CPA firm (BDO Seidman) and well-known international law firm headquartered in New York (Curtis Mallet-Prevost, Colt & Mosle). (JA00024-5, JA00041)

Based on a case called Helmer, as well as other authorities, all advisors confirmed that the Ervins' outside basis in their partnership interest was $15 million each based on the cost of the Purchased Euro Option, without reduction for the contingent obligation represented by the Sold Euro Option. (JA00042, JA01968) The trial court confirmed that "at the time of [the Ervins'] transactions Helmer was good law." (JA00054-5)

Ultimately, the trial court's opinion, teeters on the most stacked economic substance calculation imaginable -- stacking the grand total of all trading expenses and all tax advisory fees, not against the sum of potential trading profits and tax benefits and not even against the potential trading profits from even the first two weeks of bullish trading before the Euro turned, but against just the profit potential from just one slice of the trading. All else in the court's analysis of the merits, the penalties, and the substantial authority flows from that stacking. Logic and the law, however, demand that one either compare aggregate costs with the corresponding aggregate benefits, or compare segregated costs with the corresponding segregated benefits.

To stack aggregate costs against one slice of segregated benefits collides with three fundamental rules of law governing taxation at the time the Ervins had to make their decision. First, since the dawn of our nation's tax system, the courts have assured citizens that they have the right to structure their affairs to minimize or even eliminate their taxes. To assure citizens of the right to structure their affairs to minimize their taxes and then to condemn them by isolating only one element of that investment structure reduces this most fundamental rule of tax law to a baited hook.

Second, for over 40 years, the Government persuaded the courts to prohibit recognition of contingent obligations (no matter what the substance of those obligations may be).¹⁵ Indeed, the evidence in this case demonstrates that the IRS consciously chose to preserve that rule in this context because it served the IRS' interests elsewhere. (JA07560-2) The IRS simply reverses that 40 year old rule under the banner of economic substance when it does not like the result.

And third, Congress mandated that taxpayers must be able to defend themselves by showing reasonable cause prior to the imposition of penalties (Code § 6664(c)). The trial court carefully catalogued Gary's extraordinary efforts to obtain the best advice for his brothers and himself from every available source. Only an (invalid) regulation precluded the Court from drawing the reasonable cause conclusion compelled by the Court's findings. Upon invalidation of that regulation, those findings support entry of judgment or, at a minimum, a remand -- regardless of the final economic substance resolution.

Suppose, for example, that the investor buys $150,000 worth of Euros and then the market climbs 2 percent. He profits $3,000. Suppose instead that, as here, he sells a large Euro option, applies the premium due him to the purchase of a similarly sized option, and pays the $150,000 price differential. The 2 percent market rise yields a profit not of $3,000 but of $140,000. All of the experts confirmed that trading in spread options constitutes a common -- and "often prefer[red]" -- practice on the Interbank Market regardless of tax consequences. Sentinel also recommended trading more sophisticated "exotic" options known as reverse knock-out options. Based on a four-year Swiss Franc study, those options represented a high risk/higher reward position with a one-in-five chance of being in-the-money, an average return of 14:1 when in-the-money, and multiples as high as 29:1. Sentinel stressed that trading bullish Euro knock-out options could present returns as high as 38:1. During these presentations and the initial trading, the Euro continued to climb as Sentinel predicted.

Secondly, Jade presented the opportunity for significant tax benefits based on then well-established principles such as the long line of cases recognizing the right of citizens to structure their affairs to minimize their taxes, the long line of contingent obligation cases embodied in Helmer, and the equally long line of cases recognizing the separate substance of simultaneous long and short positions. The Helmer line of cases represented the heart of tax planning because, as the trial court agrees, that line accurately recognizes that short options constitute contingent obligations and contingent obligations do not constitute fixed liabilities that reduce partnership basis under Section 752. As a result, a specific statute prescribes every aspect of the treatment.¹⁶ Hence, the benefits flow entirely from the Helmer principle the trial court -- and so many other courts -- confirm as correct.

A. REAL TRANSACTIONS THAT VARY CONTROL BETWEEN UNRELATED PARTIES OR CHANGE THE FLOW OF BENEFITS CANNOT BE IGNORED.

The IRS "conclusively established" that the Purchased Euro Options and the Sold Euro Options actually occurred and that the Ervins and AIG are unrelated parties. (JA00242, JA00257, JA04015) The stipulated terms of the contracts dictate both the "distinct legal entitlements" and the change in economic benefits. The IRS simply seeks to disregard and/or rewrite those contracts based on their results.

Often the tax law renders startling results. How often has the IRS or the courts told a citizen faced with results "too bad to be true" that "it's just the way the tax law works"? When the IRS does not like the result, it has sometimes persuaded courts to resort to result-driven doctrines. Yet, the law is the law. When the Code generates results that appear "too bad to be true" or "too good," the courts recognize the solution lies with Congress. See, e.g., Commissioner v. Banks II, 543 U.S. 426, 432-33 (2005) ; Gitlitz v. Commissioner, 531 U.S. 206, 220 (2001); Coggin Auto. Corp. v. Commissioner, 292 F.3d 1326, 1334 (11th Cir. 2002); Hillman v. IRS, 250 F.3d 228, 234 (4th Cir. 2001); Brown Group, Inc. v. Commissioner, 11 F.3d 217, 222 (8th Cir. 1996); Textron, Inc. v. United States, 561 F.2d 1023, 1025, n. 2 (1st Cir. 1977); Speltz v. Commissioner, 124 T.C. 165 (2005). The amorphous economic substance concept provides a poor substitute for actual transactions or the code system of laws.

In Coltec, this Court emphasized that the economic substance doctrine applies only to transactions that "do not vary control or change the flow of economic benefits." Coltec, at 1355, quoting Higgins v. Smith, 308 U.S. at 476 (emphasis in original). The converse must also be true: the economic substance concept does not alter transactions with a business purpose, that serve a non-tax "function," vary control, or change the flow of economic benefits. As the Court emphasized, Coltec lacked this fundamental principle ("transactions here could only affect relations among Coltec and its own subsidiaries"). In contrast to Coltec's shifting asbestos liabilities from one wholly-owned subsidiary to another, the Ervins' purchase of the Euro Options from AIG on September 29, 1999 created control over a contract they did not own previously and secured the future flow of economic benefits or detriments for them. Each day's appreciation or depreciation increased or decreased that flow.

When the Ervin brothers chose to contribute the Purchased Euro Options to Jade Trading, they radically altered their 100 percent direct ownership in those options by converting them (and cash) into a 30.7 percent partnership interest. That action simultaneously bestowed indirect ownership interests over each option upon the other partners -- including the two unrelated partners, Sentinel and the Brazilian investors represented by Banque Safra. (JA001420) In even sharper contrast to the feature that the Coltec Court found so critical (i.e., no impact on third party claimants), Jade Trading radically altered the Ervins' 100 percent exposure on their contingent obligation to AIG arising under the September 29, 1999 Sold Euro Options when Jade assumed "all such obligations" pursuant to a written agreement -- consented to and signed by AIG, the third-party contingent obligee. (JA04526-37) From that point, the Ervins' economic benefits flowed exclusively through their interest in Jade's diversified trading. For both Jade and its five partners, the assets under control varied and the flow of economics changed with each new partner, each new trade, and each new movement in the market.

For example, the Supreme Court rejected the IRS attempt to collapse both sides of the mortgage swap in Cottage Sav. Ass'n v. Commissioner, 499 U.S. 554 (1991).¹⁷ The IRS argued that, as determined by the FHLBB, the two sides were "substantially identical" and the losses "lacked economic substance." Id., 499 U.S. at 567. The Supreme Court concluded that the exchanged mortgages were "materially different" because they "embodied legally distinct entitlements." Id., at 566. That concept reflects the law upon which the Ervins and their advisors relied that involves directly applicable spread options, futures straddles, and the like.

The Tax Court specifically addressed spread options in Laureys v. Commissioner, 92 T.C. 101, 102 (1989). The IRS disallowed the claimed losses on the contention the transactions were "devoid of the substance necessary for recognition," the losses would "distort economic reality . . . [and] no genuine loss occurred." Id., at 119. The Court concluded that the transactions were not shams and must be accorded separate significance.

Recently, the United States District Court for Colorado addressed simultaneously purchased and sold spread options in foreign currency. As here, the investor contributed the purchased option to a partnership which also assumed the sold option. Sala v. United States, 552 F.Supp.2d 1167 (D. Colo. 2008). Faced with the same IRS expert (Dr. DeRosa), the District Court rejected the exact same IRS arguments urged here, including the economic substance of the options. Laureys and Sala follow the well established path set by earlier cases.

In the first of those cases, Valley Waste Mills v. Page, 115 F. 2d 466, 468 (5^th Cir. 1941), the Fifth Circuit agreed with the IRS that coinciding sale and purchase cotton futures contracts must be respected as separate and independent.¹⁸ When the shoe was on the other foot in Maloney v. Commissioner, 25 T.C. 1219 (1956) (Reviewed¹⁹), the Tax Court rejected the IRS "form-over-substance" attempt to collapse a straddle consisting of a purchased soybean futures contract (50,000 bu. in job-lot quantities) and a simultaneous sold soybean futures contract (50,000 bu. in round-lot quantities). The Tax Court concluded that, due to the difference in the lot types, the contracts must be respected as "entirely separate and distinct" with a difference of "true economic significance." Id., at 1227. Again in Smith v. Commissioner, 78 T.C. 350, 395 (1982), the Tax Court addressed a straddle and rejected the IRS sham/substance attempt to collapse the offsetting purchase of 42 silver futures contracts and sale of 42 silver futures contracts. The Tax Court concluded that purchase and sale contracts did not constitute shams and required recognition of their separate significance for purposes of measuring gains and losses. Seven years later, the Tax Court applied the same reasoning to the spread options in Laureys and reached the same conclusion as to each separate option.

In their original reports, the IRS experts limited themselves to only the one most extreme possibility out of the exceedingly broad, if not infinite, range of alternatives in trading one Euro option without altering the other Euro option. The trial court never addressed any of those alternatives. Together with the defining features of these contracts, the other alternatives undeniably prove the independence of each option to a degree equal to or greater than the separate contracts in Sala, Laureys, Moloney, Richardson, Smith, and Cottage Savings:

The United States Court of Appeals for the Fifth Circuit dealt with an analogous mismatch in Compaq Computer Corp. v. Commissioner, 277 F.3d 778, 782-83 (5^th Cir. 2001). There, the IRS pressed its economic substance conclusion by resorting to a "half pre-tax/half after-tax" comparison that forced the desired result based on that mathematical mismatch, by considering the foreign tax credit in the formula where it served the IRS' interest and ignoring the impact of that credit where disregard served the IRS' interests on the other element of the comparison. The Fifth Circuit rejected this disturbing inconsistency and reversed.

To be consistent, one must either compare the segregated expenses with the corresponding segregated potential benefit, or compare the combined expenses with the corresponding combined potential benefits.

In addition to Compaq, the weight of authority favors the latter approach of considering the totality of the circumstances. Consider the holding of Frank Lyon. There, the Supreme Court refused to focus solely on the "sale-leaseback of the building" -- the Court viewed the "nature of the entire transaction" to conclude it had sufficient economic substance to be recognized for tax purposes. Frank Lyon, 435 U.S. at 583. See also, Commissioner v. Clark, 489 U.S. 726, 738 (1989) (reviewing court must make a determination on the basis of the entire transaction); Gregory v. Helvering, 293 U.S. 465, 470 (1935), aff'g, 69 F.2d 809 (2d Cir. 1934) (analyzing the "whole undertaking"); Salina Partnership v. Commissioner, T.C. Memo. 2000-352 (court rejected Government's attempt to segregate the loss-making transaction from the longer term investment program, holding that to segregate an integrated investment program "would violate the principle that the economic substance of a transaction turns on a review of the entire transaction").²⁰

Hence, either the $140,000 profit potential of the initial trades should be matched with their AIG facility fee ($84,000), or both the expense and benefit sides should be aggregated.

When a fair and logical match is made, the Euro options and the Jade investment as a whole objectively presented the potential for robust profits. Both parties agree that the Ervins were told they could double their equity on the original set of spread options -- and, objectively, they could. (JA00044, JA00723-24) They were given actual examples of leveraging the equity through multiple trades into returns of 86, 101, and 94 percent. (JA05757-59) In just the first two weeks, their Euro Options undeniably appreciated 15 percent (calculated by the IRS expert as 3,300 percent per annum). (JA02875-77) Both the contemporaneous written materials and uncontroverted testimony confirm that Sentinel told its partners they could leverage their investments into high multiples by contributing the options and cash to Jade -- and, objectively, they could.²¹ (JA00908-10, JA04299-04302) The Jade Trading Offering Memorandum noted that Jade intended to employ extensive leverage. (JA04450) The greater the margin, the greater the return and Jade had the ability to leverage/margin 30-50 percent of the appreciating value of the options into new positions. (JA01533-34, JA03781-82)

In sum, the bullish Euro option trades fall squarely within the realm of real transactions that vary control between unrelated parties and change the flow of their economic benefits.

B. THE TRIAL COURT POSSESSED THE JURISDICTION TO REACH THE REASONABLE CAUSE CONCLUSION COMPELLED BY ITS FINDINGS.

As confirmed by its findings of fact, the trial court clearly concluded that the three Ervin brothers went above and beyond ordinary care to confirm that the tax treatment was well grounded in the law. The court not only confirmed the technical soundness of the advice given the Ervins about the heart of the tax planning, but also carefully adopted extensive findings as to their efforts to determine that the advice they were given was correct. With no college degree among the three of them, the Ervin brothers turned to their longtime CPA and their trusted tax lawyer in Western Kentucky to serve as a sounding board for the very sophisticated foreign currency options taxation guidance they received from the large international accounting and law firms. That written and oral advice told the Ervins the law was well established -- the law the IRS and the trial court have since validated. Regardless of the economic substance resolution, those findings compel a reasonable cause conclusion (without the necessity of a remand).

The trial court, nonetheless, found itself ensnared by a regulation that purports to restrict the court's jurisdiction to determine "the applicability of any penalty" -- specifically, to bar the court from ruling on the Ervins' reasonable cause with respect to the Ervins' partner-specific outside basis that the accounting firm reported on the Ervins' individual returns, not the partnership return.

Allow us to set this reasonable cause dispute in this one-page context:

In fairness, how can the Ervins be simultaneously penalized and barred from defending themselves on their partner-specific outside basis? How can they fall short of "ordinary care," the standard for reasonable cause (Treas. Reg. § 1.6664-4), when they and their longtime advisors followed the advice of highly qualified tax specialists -- advice the Court concluded after exhaustive analysis was largely accurate? And how can the Ervins be second guessed for following that advice in 1999 and 2000, when the trial court (i) confirmed the technical soundness of that advice, (ii) concluded in 2005 that it could make no decision about the economic substance concept until this Court handed down its Coltec opinion (with its acknowledgment of a conflict among the circuits) in July 2006, and (iii) even then needed additional time to reach its decision on December 21, 2007, a decision that the trial court later concluded needed correction?

The trial court expressed misgivings about the tension between (i) the statutes that require the court to determine the "applicability of the penalties . . . to the partnership items" (Sections 6221 and 6226(f)), (ii) the reasonable cause statute (Section 6664) that universally bars the imposition of penalties in the face of good faith reasonable cause, and (iii) the IRS regulation (Temp. Treas. Reg. § 301.6221-1T(c) and (d)) that purports to bar consideration of the partners' reasonable cause. Despite that tension, the trial court concluded that it was obligated to follow the regulation barring a conclusion as to the Ervins' reasonable cause.

Actually, the trial court possessed the jurisdiction to draw the reasonable cause conclusion compelled by its findings for two reasons. One, no interpretive regulation or other act by an administrative agency may restrict statutorily granted judicial jurisdiction.²³ And two, a regulation may be invalid in its application, such as the IRS applying this regulation to bar the partner-level reasonable cause embedded in the partner-level "outside basis."²⁴ Further, no penalty should be applied to the Ervins for even more compelling reasons than those that resulted in (i) no suggestion that Coltec should be penalized and (ii) no penalties in the "contingent obligation" partnership cases of Klamath, Salina, Kornman, and Sala.²⁵

The legislative history proves that reasonable cause should be considered "BEFORE" the imposition of any penalty under Section 6662. Section 6664(c) was enacted to provide a "standardized exception criterion for all . . . accuracy-related penalties." H.R. Rep. No. 101-247, at 1392-93 (1989), reprinted in 1989 U.S.C.C.A.N. 1906, 2862-63 (emphasis added). The House Report explained:

Notably, the court focused on the outside basis of some, but not all, of the partners -- basis never reported on the Partnership Return. That highlights the peculiar circumstances compounded by the IRS's post-trial characterization of that penalty foundation as a nonpartnership item. Two years after trial, the IRS stated:

A great deal of authority supports the IRS view that outside basis constitutes an "affected item" jurisdictionally barred from consideration in a TEFRA Partnership Proceeding. See, e.g., Treas. Reg. § 301.6231(a)(5)-1(b) (outside basis is an affected item to the extent it is not a partnership item); Dial USA, Inc. v. Commissioner, 95 T.C. 1, 6 (1990) (outside basis is an affected item barred from consideration at the entity level); Gustin v. Commissioner, T.C. Memo. 2002-64 (because a partner's outside basis requires partner-specific determinations, it cannot be litigated at the partnership level).²⁹ The penalty aspect of these problems should be cured by the now confirmed accuracy of the outside basis advice.

 

Existing authority contrary to a position that options create liabilities . . . need regulation to overrule Helmer . . . Re: Helmer, etc., if we [IRS] had to choose one position or another, [IRS Chief Counsel Brown] tended to agree with Helmer (a position IRS perhaps needs, lesser of two evils). (Emphasis added.) (JA07560-62) See also, Tandon, Crystal, IRS, Treasury Shared Views of Shelter Lawyers, IRS Documents Says, 2005 TNT 198-1 (October 14, 2005).

In its 2007 opinion, the trial court drew the same correct conclusion the IRS drew in 1995 and again in 2003: the court confirmed the accuracy of the Helmer doctrine. (JA00053-4) The trial court then noted the problem in punishing someone for taking a position that is not only reasonable but is accurate:

While Jade awaited trial, the Court of Federal Claims handed down its Coltec opinion on October 29, 2004 and concluded that, consistent with a Supreme Court opinion by Justice Scalia, real doubt existed about the vitality of the so-called "economic substance" doctrine and that this "judge-made law" could not override statutes enacted by Congress. Coltec Industries, Inc. v. United States, 62 Fed. Cl. 716, 753 (2004), citing Cipollone v. Liggett Group, Inc., 505 U.S. 504, 544-45 (1992) (J. Scalia). The various courts of appeal also struggled with formulations of the test. See, e.g., Black & Decker Corp. v. United States, 436 F.3d 431, 441 (4^th Cir. 2001); Compaq Computer Corp., at 781; UPS, at 1018.

The parties in this case then tried Jade from September 6 through 23, 2005. The Court set closing argument for December 14, 2005 and asked if she should wait to render her opinion until the Federal Circuit ruled on the Coltec "economic substance" appeal. Over Jade's objections, the trial court concluded that -- six years after the Ervins had to make their decisions -- the court could still not rule on economic substance without this Court's Coltec opinion. This Court handed down that opinion on July 12, 2006 and stated what the commentators and at least one court called the "slice-and-dice" test -- an approach most tax practitioners view as inconsistent with the Supreme Court "totality" precedent in Frank Lyon. The Coltec opinion departed from the Fourth Circuit conjunctive test (that the Federal Circuit previously followed in Drobny v. United States, 86 F.3d 1174 (Table) (Fed. Cir. 1996)) and noted the conflict among the circuits.

The trial court then required an additional 17 months to apply these daunting concepts to the facts of this case. Part of that time was consumed waiting for the Supreme Court to rule on the petition for certiorari that sought a resolution of the conflict among the circuits. In the meantime, Congress grappled with codification of an "economic substance" standard on at least four occasions and, in each instance, could reach no conclusion.³¹

Penalties based on unpredictable conclusions drawn from amorphous "soft doctrines" place courts in awkward positions. For example, the Tax Court concluded in Compaq that, based on a sham theory, the taxpayer was both wrong and negligent. An appellate panel, however, concluded that not only were negligence penalties inappropriate, the company was right on the merits. See Compaq Computer Corp. at 781-82. Again in UPS, T.C. Memo. 1999-268, the Tax Court relied on a sham/economic substance hybrid to rule against UPS on the merits and impose penalties. Again an appellate panel concluded that penalties were not only inappropriate, UPS was correct on the law. UPS, 254 F.3d at 1017-8.

Appellate courts are not immune to these contradictions. Take the consolidated trial of Smith/Karr v. Commissioner, 91 T.C. 733 (1988). Following a taxpayer loss, Smith was appealed to the Sixth Circuit and Karr was appealed to the Eleventh Circuit. That's right -- the Eleventh Circuit sustained the IRS' imposition of the negligence penalties in Karr v. Commissioner, 924 F.2d 1018 (11th Cir. 1991) and the Sixth Circuit concluded that the IRS was wrong on the merits in Smith v. Commissioner, 937 F.2d 1089 (6th Cir. 1991). Consider Coltec -- right on the law at trial, wrong on the law on appeal -- with no suggestion of a penalty. How can the same case be both wrong and negligent in front of one judge and yet constitute the correct rule of law on the merits before an appellate panel?³² Amorphous concepts are no substitute for fair warning.

Given that the IRS regulations define "reasonable cause" in terms of "ordinary care," given what the Ervins knew when they had to make their decisions, given Gary's efforts to obtain the best available advice for his brothers and himself, and given the difficulties the trial court, the Courts of Appeal, and Congress faced since -- how can one fairly punish the Ervins based on some revisionist view of "ordinary care"?

The Tax Court handed down Salina in December of 2000, four months after the Ervins filed their 1999 returns. It involved the question of whether a Treasury Note short sale constituted a "contingent obligation." Three aspects of that opinion bear significance here. One, the Court rejected the IRS' economic sham collapse of the offsetting long and short positions. Two, the Tax Court cited Helmer with approval in the realm of options (as opposed to short sales). And three, no one suggested that penalties should be applied to this uncharted area.

Of the remaining cases, Sala most closely resembles Jade's situation for it involves entry by an investor into a set of foreign currency spread options followed by contribution of the purchased option to a partnership. The IRS disallowed the ultimate losses and asserted the same array of penalties the Ervins face. The United States District Court for Colorado ultimately concluded that no need existed to reach the penalties because the taxpayer was correct on the merits.

Klamath dealt with the same principles arising from a different type of contingent obligation, one involving a loan premium. Like the trial court in Jade, the Klamath court concluded (by way of partial summary judgment) that Helmer represented prevailing law during 1999. Klamath Strategic Inv. Fund, LLC v. United States, 440 F.Supp.2d 608 (E.D. Tex 2006). Later, the Court concluded that the organizers knew -- for reasons undisclosed to the investors -- that no profit could be reaped, and denied the tax consequences under an economic substance theory. The Court still concluded that reasonable cause (reliance upon counsel) barred the same Section 6662 penalties faced here. Klamath Strategic Inv. Fund, LLC v. United States, 472 F.Supp.2d 885 (E.D. Tex. 2007)(on appeal).

The recent Fifth Circuit opinion in Kornman & Associates v. United States, 527 F.3d 443 (5th Cir. 2008), like Salina, dealt with whether a Treasury Note short sale constituted a contingent obligation or a fixed liability. The Court concluded that it constituted a liability but, even though Mr. Kornman was referred to as a promoter,³³ the IRS recognized that no penalties should be asserted.

These cases convey the principle that penalties cannot in good conscience be applied on an ex post facto basis via a still evolving amorphous judicial doctrine.

Allow us to outline the law of invalid regulations and then to apply that law to this peculiar circumstance -- a partnership proceeding that imposes penalties on items reported only on the individual returns of those partners who exercised extraordinary care and simultaneously bars the Court's conclusion as to their care.

Since only the democratically elected Congress can constitutionally make law, the Treasury Department cannot legislate by regulation. Interpretive regulations can neither contract nor expand a statute. Stephenson Trust v. Commissioner, 81 T.C. 283, 286 (1983). As the Supreme Court confirmed in Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 842-843 (1984), the courts must protect the democratic process against administrative views that undermine Congressional intent. "If the intent of Congress is clear, that is the end of the matter." Id. Interpretive regulations of even ambiguous statutes must reasonably interpret the Congressional intent. Id., at 866; Southern Co. v. F.C.C., 293 F.3d 1338, 1343 (11^th Cir. 2002).

As noted, the application of a regulation in a particular context that exceeds the meaning of its statutory source (such as determining the "applicability of any penalty" to a partner's return item by barring that partner's reasonable cause) independently renders that aspect of the regulation invalid. For example, the application of the regulations in National Westminster Bank, PLC, 512 F.3d 1347, 1354 (Fed. Cir. 2008) (foreign tax regulation invalid as applied to the taxpayer), and Horton Homes, 357 F.3d at 1211 (excise tax regulation invalid as applied to toters that pull manufactured homes) contradicted the statutes as applied to their facts. In Horton Homes, the Eleventh Circuit reasoned as follows:

• "[T]he tax treatment of any partnership item (and the applicability of any penalty . . . which relates to an adjustment to a partnership item) shall be determined at the partnership level" (Code § 6221) (emphasis added);

• "A court with which a petition is filed in accordance with this section shall have jurisdiction to determine all partnership items of the partnership for the partnership taxable year to which the notice of final partnership administrative adjustment relates . . . and the applicability of any penalty to the tax, or additional amount which relates to an adjustment to a partnership item" (Code § 6226(f) (emphasis added);

• "Imposition of Penalty. -- If this Section applies to any portion of an underpayment of tax required to be shown on a return, there shall be added to the tax an amount equal to 20 percent of the portion of the underpayment to which this section applies" (Code § 6662 (a)) (emphasis added); and

• "No penalty shall be imposed under this part with respect to any portion of an underpayment if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion" (Code § 6664(c)) (Emphasis added.)

No more profound proof can exist as to the significance of "allows" than this -- the regulation's author deliberately substituted the mandatory prohibitions of "can only" and "may not assert" for the permissive "allows." The courts agree that the word "allows" conveys a permissive, not mandatory, meaning. Virginia v. Black, 538 U.S. 343, 397 (2003) ("permissive inference or presumption 'allows -- but does not require -- the trier of fact to infer the elemental fact . . .'"); County Court of Ulster County, N.Y. v. Allen, 442 U.S. 140, 157 (1979): Keeffe Bros. v. Teamsters Local Union No. 592, 562 F.2d 298, 302-303 (4th Cir. 1977) ("This provision, however, is stated in permissive and not mandatory terms and 'allows the courts in their discretion to determine whether pursuit of such remedies is required"'): TGIP, Inc. v. AT&T Corp., 512 F.Supp.2d 696, 707 (E.D. Tex. 2007) ("But 'allows for' is permissive, not mandatory: just because the device 'allows for' charging and recharging does not mean that it has to be used for both").³⁸

In addition to contradicting the permissive "allows" language in Section 6230(c)(4), Temp. Treas. Reg. § 301.6221-1T(c) and (d) does not simply exclude defenses relating to nonpartnership items from the partnership proceeding, it purports to bar partners from offering the essential Section 6664 reasonable cause evidence in determining "the applicability of any penalty . . . to PARTNERSHIP ITEMS," where, as here, a court has considered something reported on the partner's return as a partnership item. Temp. Treas. Reg. § 301.6221-1T(c) and (d) overtly violates both the Section 6664 prohibition against imposing penalties without determining reasonable cause and the Section 6221 mandate that the "applicability of penalties" relating to "partnership items" shall be determined at the partnership level.

In sum, the application of this administrative restriction on judicial authority must be invalidated -- especially where it operates to simultaneously impose penalties and bar the reasonable cause conclusion as to a partner-specific item. And the trial court's extensive findings leave no doubt about that reasonable cause. What more can ordinary care require, beyond the Ervins engaging both their longtime CPA and trusted lawyer to serve as tax translators and sounding boards for the extraordinarily sophisticated foreign currency tax advice rendered by respected international accounting and law firms?

1. The Brief of Plaintiff-Appellant Jade Trading, LLC contains 12,690 words.

2. The brief has been prepared in proportionally spaced typeface using Times New Roman 14 point font in text produced by Microsoft Word for Windows XP.

3. Undersigned counsel understands that a material misrepresentation in completing this certificate, or circumvention of the type-volume limits in FED. R. APP. P. 32(a)(7), may result in the Court's striking the brief and imposing sanctions against the person who signed it.

Plaintiff-Appellant:

² Please note that we do object to imposing penalties upon the Ervins based on matters never disclosed to them at the time they had to make their decisions.

³ SEC Rule 144 restricts the sale of stock for one year. (JA00707-12, JA01429-33, JA04073)

⁴ In total, the Ervins had approximately $20 million trapped in restricted Dycom stock.

⁵ That young investment advisor, with fewer than 2 1/2 years of experience, was Dagny Maidman. Seeking additional investment advice, the Ervins also consulted with another young broker, Cheyne Pace from Goldman Sachs and then Merrill Lynch.

⁶ This testimony is corroborated by the summary of the Swiss Franc (CHF) study Sentinel conducted on the knock-out option and supplied to Gary:

                                    Table 1

⁷ As is common industry practice, each brother netted the $14.85 million received from AIG against the $15 million owed to AIG and paid AIG only the net difference, or $150,000.

⁸ The Ervins formed these single member limited liabilities -- which served no tax purpose -- as a limitation on liability arising from what is known as the "Olympia York" problem. The "Olympia York" problem refers to the risk that a receiver for the counterparty on two options could split the options, honor the option that favors the receiver, and repudiate the option that favored the Ervins. (JA00030, JA01186-7, JA01512-17)

⁹ Mr. Pang of AIG and Mr. Bergmann of Sentinel Advisors referred to the fee as a "facility fee" to allow Sentinel to trade in and out of the positions instead of paying a bid-ask each time. (JA07533, JA03776-8) The government's expert, Dr. DeRosa, confirmed that he estimated the bid-ask spread paid on these options was .01 whereas the normal bid-ask spread for this period was 20 to 40 times higher. (JA05804, n.33, JA03561-2) Mr. Shoji and Dr. Kolb testified no bid-ask spread was paid for these options. (JA02911, JA03874-9)

¹⁰ Mr. Bergmann achieved returns of 86, 101, and 94 percent by legging in and out of options similar to the Ervins' options.

¹¹ Consistent with the Ervins' long-term investment needs, Gary discussed with Sentinel that the Rule 144 restriction expired in March 2000 and the Ervins would have an additional $20 million to invest with Sentinel upon the expiration of that restriction. (JA000711, JA03982-3)

¹² Gary Ervin vetted the consulting fee with Dagny Maidman who confirmed that fees upwards of 5% were in line with sophisticated option trading programs. (JA00479-80, JA00841-2)

¹³ Assuming both counterparties hold the options through maturity (as opposed to leveraging profits through restriking).

¹⁴ Section 732 (b) provides that the basis of property (other than money) distributed by a partnership to a partner in liquidation of the partner's interest is equal to the adjusted basis of such partner's interest in the partnership, commonly referred to as "outside basis."

¹⁵ This rule remained the law of the land at least until Congress (not the IRS or the courts) re-defined liabilities to include contingent obligations in corporate transactions. Section 309 of the Community Renewal Tax Relief Act of 2000, Pub. L. 106-554, 114 Stat. 2763 at 2763A-638, codified in 26 U.S.C. §§ 357 and 358 ("Section 309"). Section 309 changed the law regarding contingent obligations in the corporate context and authorized the Secretary to prescribe "comparable rules" for partnership transactions. On June 24, 2003, the Treasury Department revised regulations under 26 U.S.C. § 752 to define liability as "any fixed or contingent obligation to make payment." This regulation is not at issue here as the Euro options were contributed prior to its effective date, October 18, 1999. (JA00038)

¹⁶ Specifically, (i) Section 1012 prescribes the basis of the purchased asset as its cost; (ii) Section 722 dictates that the partner's basis in his partnership interest shall be the sum of the money and the basis of the property he contributes; and (iii) whenever he withdraws, Section 732(b) assigns the partner's basis in his partnership interest to the assets distributed to him in liquidation of that interest.

¹⁷ Undisputed findings in the Tax Court confirmed that solely tax considerations compelled the Cottage Savings exchange.

¹⁸See also, Richardson v. Commissioner, 121 F.2d 1, 4 (2nd Cir. 1941) (Rejecting attempt to collapse simultaneous ownership of stock (long position) and short sale of stock).

¹⁹ "Reviewed" Tax Court opinions indicate an en banc decision. In this instance, 12 Tax Court judges joined in the majority, with only four dissenters.

²⁰ In Shell Petroleum, Inc. v. United States, ___ F.Supp.2d ___, 2008 WL 2714252 (S.D. Tex. 2008), the Court found no support for "slicing and dicing . . . an integrated transaction solely because the Government aggressively chooses to challenge an isolated component of the overall transaction."

²¹ Even from the perspective of the fund manager/managing member, who had to "look for the good for the fund" (regardless of the partner's tax considerations), the contribution of the options greatly benefitted the fund because they were obtained at mid-market with no bid-ask charge on future restriking. (JA01502)

²² The IRS admitted (and thereby "conclusively established" per R.C.F.C. 36(b)) that the Ervins were members of Jade, the statutory standard for partner status under Section 761. (JA00230) Prior to trial, the Defendant also conceded the existence of the partnership for federal tax purposes. (JA02324-5)

²³See, e.g., Murphy Exploration & Prod. Co., v. U.S. Dep't of Interior, 252 F.3d 473, 479 (D.C.Cir. 2001).

²⁴See, e.g., Horton Homes v. United States, 357 F.3d 1209 (11^th Cir. 2004).

²⁵Sala v. United States, ___ F.Supp.2d ___, 2008 WL 1836693 (Dist. Colo.); Klamath Strategic Inv. Fund, LLC v. United States, 472 F.Supp.2d 885 (E.D. Tex. 2007)(on appeal); Kornman & Associates v. United States, 527 F.3d 443 (5th Cir. 2008); Salina Partnership v. Commissioner, T.C. Memo. 2000-352.

²⁶ The reasonable cause exception applies to all Section 6662 penalties (with a caveat for charitable valuation overstatements that lack a qualified appraisal and a good faith investigation of the value of the contributed property). See Section 6664(c)(2)(A) and (B).

²⁷ Section 6662 (a) applies penalties only to "any portion of an underpayment of tax required to be shown on a return . . ." (Emphasis added.) The unambiguous definition of "understatement" in Section 6662 (d)(2)(A) focuses on the same point: "(i) the amount of tax required to be shown on the return for the taxable year, over (ii) the amount of the tax which is shown on the return. . . ." (Emphasis added.)

²⁸ The Internal Revenue Code provides separate penalties to address the Court's concern regarding the conduct of any organizers. See Code §§ 6694, 6695.

²⁹ The IRS' "affected items" characterization and these cases reveal the trial court's mistaken reliance on Nussdorf v. Commissioner, 129 T.C. 30, 41 (2007) -- a case that conflicts with Gustin and Dial and, unlike Jade, involves losses reported by the partnership on its U.S. Partnership return. For the same reason, the trial court mistakenly relies on Santa Monica Pictures, LLC v. Commissioner, T.C. Memo. 2005-104, and Long Term Capital Holdings v. United States, 330 F.Supp. 2d. 122 (D. Conn.), aff'd, 150 Fed. Appx. 40 (2d Cir. 2005) that, again unlike Jade, dealt with losses incurred and reported by the partnership on its return.

³⁰ The recurring lines of cases also constitute "substantial authority" -- the same authority that the Ervins were told -- and "reasonably believed" -- was correct. See Code § 6662(d)(2)(C). For that reason as well, no penalty applies.

³¹ CARE Act, S. 476, 108th Cong. § 701 (2003); Jobs and Growth Tax Relief Reconciliation Act, S. 1054, 108th Cong. § 301 (2003); Taxpayer Accountability Act, H.R. 1555, 108th Cong. § 101 (2003); The Heartland, Habitat, Harvest and Horticulture Act of 2007; S. Rep. No. 110-206, 110th Cong., 1st Sess. (Oct. 26, 2007). The Coltec opinion noted the repeated Congressional refusals to write economic substance into the law: Congress had yet to accede to the wisdom of codifying the doctrine: "In fact, a few days ago Congress passed a major federal tax bill, but again declined to codify the economic substance doctrine. See American Jobs Creation Act of 2004, H.R. 4520, 108th Cong. (2004)." Id. at 756.

³² The tax community has not missed this imponderable. See Courts Can't Agree On When Negligence Penalty Applies, 84 J. Tax'n 191 (March 1996); Courts Still Can't Agree on When Negligence Penalty Applies, 90 J. Tax'n 377 (June 1999) (both articles questioning how a taxpayer can be negligent when courts themselves cannot agree on the proper tax treatment of particular transactions).

³³Compare Cemco Investors, LLC v. United States, 515 F.3d 749 (7th Cir. 2008), where the Court applied penalties against a "promoter"/lawyer who structured his own transaction. Cemco also dismisses Helmer as a nonprecedential memorandum opinion, without addressing the Supreme Court and other precedent.

³⁴ The temporary regulation is applicable to partnership taxable years beginning before October 4, 2001. See T.D. 8965, 66 FR 50541, October 4, 2001.

³⁵ Section 7805(a) directs the Secretary to "prescribe all needful rules and regulations for the enforcement of this title. . . ."

³⁶ Prior to 1997, all penalties were affected items that had to await the conclusion of the partnership proceeding.

³⁷ The contemporaneous interpretation by the Joint Committee Staff uses the same concept of "allows." Staff of the Joint Committee on Taxation, 105th Cong., General Explanation of Tax Legislation Enacted in 1997 at 377 (Jt. Comm. Print 1997). Moreover, this amendment was part of the Taxpayer's Relief Act of 1997 and should be construed as providing additional taxpayer relief, not removing them.

³⁸ In Stobie Creek, the Court asserted that the word "allowed" means partners are "allowed" to raise defenses in a refund forum but are not "required" to do so. Stobie Creek Inv., LLC v. United States, Nos. 05-748T and 07-520T (Fed. Cl. Filed March 11, 2008) (Order on motion to confirm jurisdiction) at p. 6. That begs this question. WHY WOULD CONGRESS HAVE ASSUMED THAT -- UNLESS IT INJECTED THE WORD "ALLOWED" -- A REFUND CLAIM TO ASSERT PENALTY DEFENSES WAS SUDDENLY SOMEHOW MANDATORY?