United States District Court, S.D. New York
AD GLOBAL FX FUND, LLC, A.D. EQUITY INVESTMENT FUND LLC, and A.D. GLOBAL 2001 FUND LLC, Plaintiffs,
UNITED STATES, Defendant.
OPINION and ORDER
RICHARD K. EATON, District Judge.[*]
This is a consolidated action brought by three related limited liability companies, A.D. Global FX Fund, LLC ("AD FX"), A.D. Equity Investment Fund LLC ("AD Equity"), and A.D. Global 2001 Fund LLC ("AD 2001"), formed by Alpha Consultants Inc. ("Alpha") and The Diversified Group Inc. ("Diversified") (the source of the "AD" in the name of each fund) (collectively, "plaintiffs"), challenging the Internal Revenue Service's ("IRS" or "defendant") Notice of Final Partnership Administrative Adjustments ("FPAA") issued to each plaintiff. In each company's respective FPAA, the IRS determined that the entities were formed as tax shelters intended to create artificial tax losses to offset the individual fund's corporate partners' unrelated taxable gains and, thus, the entities were to be disregarded as shams for tax purposes. These consolidated actions were commenced by plaintiffs pursuant to 26 U.S.C. § 6226(a) (2000), which allows a partnership to seek a readjustment of determinations made in a FPAA. Plaintiffs have moved for partial summary judgment. For the reasons stated below, the motion is granted in part.
This case involves the alleged organization of limited liability companies as tax shelters in order to produce large, artificial tax losses for the companies' corporate partners. In each case, the individual partners took the following steps to create a putative loss for tax purposes. First, the partner simultaneously purchased from and sold to Lehman Brothers Commercial Corporation ("Lehman") paired options on foreign currency, giving the partner the right to purchase or "call" the currency (the "long option") and the obligation to sell or "put" the currency (the "short option") at some point in the future for a pre-determined price in U.S. Dollars. Pls.' Local Rule 56.1 Statement ¶¶ 3, 19, 32 (ECF Dkt. No. 50) ("Pls.' 56.1"). In each case, the strike price for both the long and short options was nearly identical, such that the partner would neither gain nor lose any appreciable amount upon the exercising of the pair of options. See Pls.' 56.1 ¶¶ 3, 19, 32. In all cases, the purchase price of the long option was higher than the purchase price of the short option. Pls.' 56.1 ¶¶ 3, 19, 32. As a result, the only amount actually paid by each partner to Lehman was equal to the difference in the purchase price of the options. Pls.' 56.1 ¶¶ 3, 19, 32.
For example, Moxon Corp. ("Moxon"), a partner in A.D. FX, simultaneously purchased a long option on the Canadian Dollar for $40 million USD, and sold a short option on the Canadian Dollar to Lehman for $39.8 million USD. Pls.' 56.1 ¶ 3. "The net result was that Moxon paid Lehman $200, 000." Pls.' 56.1 ¶ 3.
Second, each partner contributed the option pairs in exchange for partnership interests in their respective limited liability companies. Pls.' 56.1 ¶¶ 4, 20, 33. The percentage interest received by the contributing partner was determined by the partnership based on the value of the long options, without consideration of the partner's obligation under the short option. Pls.' 56.1 ¶¶ 4, 20, 33. Presumably, this was because the value of the short option was sufficiently speculative that it might be ignored when computing basis. Accordingly, each partner's capital account reflected an initial contribution of property valued at the gross purchase price of the long option, without netting the offsetting liability incurred under the paired short option. Thus, each partner's capital account valued the contributed long option at an amount far in excess of the amount actually expended to acquire that option. For example, Moxon's capital account in A.D. FX reflected an initial contribution of approximately $40 million, the purchase price of the long option. This was notwithstanding that Moxon only paid approximately $200, 000 to acquire the option because of the contemporaneous sale of the short option to Lehman for approximately $39.8 million. Pls.' 56.1 ¶¶ 3, 4.
Third, the partnership liquidated its assets and each partner withdrew from the partnership. Pls.' 56.1 ¶¶ 9, 23, 36. Upon withdrawal, each partner received the value of its share of the partnership's assets, which was a relatively small amount, especially when compared to the value of the partner's initial contribution, as reflected in the partnership's capital account. See Pls.' 56.1 ¶¶ 9, 12, 23, 25, 36, 39.
Finally, on its federal income tax return, each plaintiff partnership took the position that it had received the options from its partners as contributions to a partnership within the meaning of 26 U.S.C. § 721, with a carryover basis determined under 26 U.S.C. § 723. Pls.' 56.1 ¶¶ 10, 24, 37. In each case, the partnership claimed that each partner's initial contribution was equal to the value of the long option, without considering the partnership's assumption of the partner's offsetting liability under the short option. Pls.' 56.1 ¶¶ 10, 24, 37. Likewise, upon withdrawal, each partner claimed an outside basis in its partnership interest equal to the gross price of the long option, without a setoff for the partnership's assumption of the obligations under the short option. Pls.' 56.1 ¶¶ 12, 25, 39.
For example, upon withdrawal, Moxon received approximately $60, 000 as the value of its investment in A.D. FX. When subtracted from the $40 million value of the long option contributed as its initial capital investment in A.D. FX, this resulted in a claimed tax loss in excess of $39 million. Pls.' 56.1 ¶ 12. In other words, Moxon's claimed basis in its partnership interest was approximately $40 million, and its claimed partnership interest upon withdrawal was approximately $60, 000. Moxon then claimed a tax loss equal to the difference in its alleged basis ($40 million) and its alleged share of assets on liquidation ($60, 000). Pls.' 56.1 ¶ 12.
For each partnership, the IRS issued an FPAA challenging these reported losses. Pls.' 56.1 ¶¶ 13, 26, 40. According to the government, these transactions were merely "son of the BOSS" tax shelters orchestrated to create losses to offset taxable gains. United States of America's Mem. of Law in Opp'n to Pls.' Mot. For Partial Summ. J. 4 (ECF Dkt. No. 38) ("Def.'s Br."). The IRS determined that these partnerships were mere shams intended to create tax losses, as the transactions at issue had no economic substance. Accordingly, the IRS determined that the partnership form and the claimed losses resulting from the foregoing transaction would be disregarded in determining the tax liability of the partners.
The FPAA issued for A.D. 2001 ("AD 2001 FPAA"), which was virtually identical in substance to the FPAAs for A.D. FX and A.D. Equity, made the following findings:
1. It is determined that neither A.D. Global 2001 LLC Fund nor its purported partners have established the existence of A.D. Global 2001 Fund LLC as a partnership as a matter of fact.
2. Even if A.D. Global 2001 Fund LLC existed as a partnership, the purported partnership was formed and availed of solely for purposes of tax avoidance by artificially overstating basis in the partnership interest of its purported partners. The formation of A.D. Global 2001 Fund LLC, the acquisition of any interest in the purported partnership by the purported partner, the purchase of offsetting options, the transfer of offsetting options to a partnership in return for a partnership interest[, ] the purchase of assets by the partnership, and the distribution of those assets to the purported partners in complete liquidation of the partnership interests, and the subsequent sale of those assets to generate a loss, all within a period of less than 5 months, had no business purpose other than tax avoidance, lacked economic substance, and, in fact and substance, constitutes an economic sham for federal income tax purposes. Accordingly, the partnership and the transaction described above shall be disregarded in full and any purported losses resulting from these transactions are not allowable as deductions for federal income tax purposes.
3. It is determined that A.D. Global 2001 Fund LLC was a sham, lacked economic substance and, under § 1.701-2 of the Income Tax Regulations, was formed and availed of in connection with a transaction or transactions... a principal purpose of which was to reduce substantially the present value of its partners' aggregate federal tax liability in a manner that is inconsistent with the intent of Subchapter K of the Internal Revenue Code [governing partnerships]....
4. It is determined that the obligations under the short positions (written call options) transferred to A.D. Global 2001 Fund LLC constitute liabilities for purposes of Treasury Regulation §1.752-6T, the assumption of which by A.D. Global 2001 Fund LLC shall reduce the purported partners' bases in A.D. Global 2001 Fund LLC in the amounts of $14, 900, 000 for JSB Montana Inc. and Subsidiaries, but not below the fair market value of the purported partnership interest.
5. It is determined that neither A.D. Global 2001 Fund LLC nor its purported partners entered into the option(s) or purchased the foreign currency or stock with ...