Palm Canyon X Invs., LLC v. Comm'r

T.C. Memo. 2009-288

UNITED STATES TAX COURT

PALM CANYON X INVESTMENTS, LLC, AH INVESTMENT HOLDINGS, INC., TAX
MATTERS PARTNER, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 5610-06. Filed December 15, 2009.

PC, a single-member LLC owned by AHI, entered into
offsetting market-linked deposit contracts with SG.
Each contract provided for potential premium interest
on the deposit; the terms of the potential premium
interest in each contract constituted a European-style
foreign currency digital option. Shortly thereafter,
CFA became a member in PC. As a result, PC was
classified as a partnership for tax purposes, and the
offsetting MLD options were treated as contributions to
the newly formed partnership. AHI claimed a basis in
its PC partnership interest that included the premium
it owed for the long MLD option, but AHI did not reduce
its partnership basis to account for any obligation
under the short MLD option under sec. 752(b), I.R.C.
Less than 2 months later, AHI acquired CFA’s PC
membership interest and again became PC’s only member,
causing liquidation of the PC partnership. Under sec.
732(b), I.R.C., in the only asset deemed distributed by
PC, a foreign currency position in Canadian dollars,
 - 2 -

AHI claimed a basis that equaled AHI’s basis in its PC
interest, minus cash it received, as a deemed
liquidating distribution. PC then sold the Canadian
dollars and claimed a substantial ordinary tax loss. R
issued a notice of final partnership administrative
adjustment in which he determined that PC was a sham
and that the MLD contracts lacked economic substance
and should be disregarded. P petitioned this Court
under sec. 6226(a), I.R.C.

Held: The MLD transaction is disregarded under
the economic substance doctrine.

Held, further, the accuracy-related penalty under
sec. 6662, I.R.C., applies.

Steven R. Mather and Lydia B. Turanchik, for petitioner.

Stephen M. Barnes, William R. Davis, Jr., Dennis M. Kelly,

and David W. Sorensen, for respondent.

CONTENTS

FINDINGS OF FACT............................................... 6

I. Background........................................... 6

II. Notice 2000-44....................................... 8

III. Investigating the MLD Strategy ...................... 9

IV. Executing the MLD Transaction....................... 15

A. Preliminary Steps.............................. 15

B. The MLD Contracts.............................. 17

C. Transactions Following the MLD Contracts ...... 22

D. Termination of the MLD Contracts............... 24

E. Activities Following the Termination of the
MLD Contracts.................................. 25
 - 3 -

F. Pryor Cashman Opinion.......................... 28

G. Palm Canyon’s Trading Activity After 2001...... 29

V. Relevant Tax Reporting for 2001..................... 30

A. Palm Canyon’s Return........................... 30

B. Thighmaster’s Return........................... 31

C. The Hamels’ Return............................. 33

VI. FPAA................................................ 34

OPINION....................................................... 35

I. Jurisdiction Under TEFRA............................ 35

II. Statute of Limitations on Assessments............... 37

III. Burden of Proof..................................... 39

IV. Economic Substance of the MLD Transaction.......... 40

A. Definition of a “Liability” Under Section 752.. 43

B. Section 1.752-6, Income Tax Regs............... 47

C. Economic Substance Doctrine.................... 50

1. Subjective Prong.......................... 55

a. The Hamel Companies’ Lack of a
Current or Foreseeable Need To Hedge
Foreign Currencies................... 56

b. Lack of Investigation Into the
Foreign Currency Aspects of the MLD
Contracts and the Participating
Parties.............................. 58

c. Lack of Rational Economic Behavior in
Pricing the MLD Contracts............ 59

d. CF Advisors’ Membership in Palm Canyon
Solely To Facilitate the Tax Benefit
Contemplated by the MLD Transaction.. 62
 - 4 -

e. The MLD Strategy as a Tax Shelter To
Offset Mr. Hamel’s Taxable Income.... 67

2. Objective Prong........................... 68

a. Palm Canyon’s Lack of Realistic
Chance of Hitting the Sweet Spot..... 69

b. Nullification of Any Potential Profit
by Palm Canyon’s MLD Transaction
Fees................................. 71

D. Conclusion..................................... 74

V. Section 6662 Accuracy-Related Penalty............... 75

A. Preliminary Matters............................ 76

1. Jurisdiction.............................. 76

2. Burden of Production...................... 78

B. Gross Valuation Misstatement................... 79

C. Negligence..................................... 86

D. Substantial Understatement..................... 92

E. Section 6664(c) Reasonable Cause Exception......99

VI. Conclusion......................................... 103

MEMORANDUM FINDINGS OF FACT AND OPINION

MARVEL, Judge: Respondent issued a notice of final

partnership administrative adjustment (FPAA) for 2001 pursuant to

section 6223(a)1 to AH Investment Holdings, Inc. (AHI), the tax

matters partner (TMP) of Palm Canyon X Investments, LLC (Palm

1
Unless otherwise indicated, all section references are to
the Internal Revenue Code (Code) in effect for the taxable year
in issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
 - 5 -

Canyon),2 a limited liability company classified as a partnership

for Federal income tax purposes.3 In the FPAA respondent

determined that Palm Canyon was a sham and that offsetting

market-linked deposit4 contracts (MLD contracts) entered into by

Palm Canyon lacked economic substance and should be disregarded

for Federal income tax purposes. Accordingly, respondent made

adjustments to the income, expense, deduction, and distribution

items reported by Palm Canyon on its 2001 Federal income tax

return and imposed an accuracy-related penalty under section

6662. A petition for readjustment of partnership items was filed

by AHI on behalf of Palm Canyon.

The parties tried and briefed the following issues:

(1) Whether Palm Canyon’s MLD contracts lacked economic

substance and should be disregarded for Federal income tax

purposes;

(2) alternatively, whether Palm Canyon should be disregarded

as a sham;

2
Palm Canyon is subject to the unified partnership audit and
litigation procedures of the Tax Equity and Fiscal Responsibility
Act of 1982, Pub. L. 97-248, sec. 402(a), 96 Stat. 648.
3
Palm Canyon’s 2001 partnership tax year began Oct. 19,
2001, and ended Dec. 18, 2001 (Palm Canyon’s 2001 tax year).
4
Hereinafter, we will refer to market-linked deposit(s) as
MLD(s).
 - 6 -

(3) alternatively, whether Palm Canyon’s short MLD contract

is a liability under section 752(a) and (b) or a contingent

liability under section 1.752-6, Income Tax Regs.;

(4) alternatively, whether the MLD contracts should be

treated as a single integrated transaction with a net tax basis

of $55,000 under the substance over form doctrine and section

988; and

(5) whether any underpayment of tax attributable to the

adjustments to partnership items is subject to the section 6662

accuracy-related penalty, as determined at the partnership level.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

The stipulations of the parties are incorporated herein by this

reference. On the date AHI filed its petition as Palm Canyon’s

TMP, Palm Canyon had no principal place of business, as it had

ceased to exist.

I. Background

In 1988 Alan Hamel (Mr. Hamel) and his wife, Suzanne Hamel,5

(collectively the Hamels) began promoting various retail

products, including the well-known “Thighmaster” piece of

exercise equipment. The Hamels enjoyed considerable success with

the Thighmaster, selling millions of units. By 2001 the Hamels’

5
Suzanne Hamel, also known as Suzanne Somers, is an actress
who is featured in advertisements for the “Thighmaster”. The
parties’ stipulations also reflect the spelling “Sommers”.
 - 7 -

retail operation included numerous products besides the

Thighmaster, including other fitness products, jewelry, books,

videos, and various food items. The Hamels’ businesses

manufactured over 1,000 products annually.

The Hamels operated their retail business through a

corporate structure headed by Thighmaster World Corp.

(Thighmaster).6 As of December 31, 2001, Thighmaster was the

parent corporation of seven subsidiary corporations engaged in

various business activities and organized by function and product

sales7 (collectively the Hamel companies). During 2001 Mr. Hamel

was Thighmaster’s sole shareholder.

Through 2001 none of the Hamel companies operated a business

or owned any manufacturing, storage, or sales facilities in a

foreign country. In 2001 the Hamel companies’ international

activities consisted primarily of sales through the Internet.

The Hamel companies also ordered a significant portion of the

materials used to make their products from Asia and had some of

their products manufactured there.

None of the Hamel companies’ businesses had any contracts

due in 2001 or 2002 that required payments in foreign currencies.

6
Mr. Hamel organized Thighmaster in 1995. Sometime after
2001 Thighmaster changed its name to ELO.
7
As of Dec. 31, 2001, six of the seven corporations were
qualified subch. S subsidiary corporations.
 - 8 -

Additionally, Thighmaster had no direct or indirect ownership

interest in any foreign entity or bank account and paid no

foreign taxes.

II. Notice 2000-44

On August 13, 2000, the Internal Revenue Service (IRS)

issued Notice 2000-44, 2000-2 C.B. 255, titled “Tax Avoidance

Using Artificially High Basis”; it was published in the Internal

Revenue Bulletin on September 5, 2000. In Notice 2000-44, supra,

the IRS addressed arrangements that produce noneconomic tax

losses on the disposition of partnership interests and described

two variations of loss-generating transactions. One described

transaction involved purchasing and writing options and

purportedly creating positive basis in a partnership interest by

transferring the options to a partnership. Id., 2000-2 C.B. at

255. In such a transaction, the taxpayer purports to have a

basis in the partnership interest equal to the cost of the

purchased call option, although the net economic outlay and the

value of the partnership interest are nominal or zero. Id. The

taxpayer then claims a tax loss on the disposition of partnership

interest without incurring a corresponding economic loss. Id.

In the notice the IRS stated that losses resulting from the

described transaction did not represent bona fide losses

reflecting actual economic consequences and were not allowable as

deductions for Federal income tax purposes. Id.
 - 9 -

In the notice the IRS also stated that “tax losses from

similar transactions designed to produce noneconomic tax losses

by artificially overstating basis in corporate stock or other

property are not allowable as deductions” and appropriate

penalties might be imposed on participants in these transactions.

Id. The IRS also stated that transactions that were the same as

or substantially similar to the ones described in the notice

could be subject to challenge under section 752, under section

1.701-2, Income Tax Regs., or under other antiabuse rules and

could result in the imposition of a section 6662 accuracy-related

penalty. Id., 2000-2 C.B. at 255-256.

III. Investigating the MLD Strategy

Mr. Hamel’s certified public accountant (C.P.A.), Clifton

Lamb (Mr. Lamb),8 was looking for a means to reduce the Hamels’

tax liability as early as August 2001 when he met with Aaron

Sokol and Steven Fuld of the Skyline Group, a financial services

firm, to discuss “high end tax products for big losses”. In a

telephone conversation on August 17, 2001, Mr. Hamel and Mr. Lamb

discussed foreign markets and foreign currencies. Shortly after

this conversation, Mr. Lamb met with John Ivsan (Mr. Ivsan), a

8
Mr. Lamb had advised Mr. Hamel on business and tax matters
since 1996. Mr. Lamb describes himself as an “outsource CFO” of
the Hamel companies. Mr. Lamb worked as a field agent with the
IRS for approximately 13 years. During 2001 and part of 2002 Mr.
Lamb was a partner in the accounting firm of Miod & Co., LLP
During 2002 he was an owner of Lamb Accountancy Corp.
 - 10 -

tax attorney with Cantley & Sedacca, LLP (Cantley & Sedacca),9 to

discuss foreign currency trading with MLDs (MLD strategy).10 Reg

Wilson (Mr. Wilson), an employee of EPIC Advisors, Inc. (EPIC), a

financial and retirement planning and advisory firm, referred Mr.

Lamb to Cantley & Sedacca.11 Paul Kestenbaum (Mr. Kestenbaum),

an attorney who introduced Mr. Lamb to Mr. Wilson, also attended

the meeting.12

The MLD strategy involved offsetting currency positions that

produced a capital or ordinary tax loss by exploiting the

provisions governing the tax treatment of partners and

partnerships. Mr. Ivsan introduced Cantley & Sedacca to the MLD

strategy around April 2001. During 2001 Cantley & Sedacca, with

9
Cantley & Sedacca was a law firm organized in Georgia. Its
principal place of business was in Dallas, Tex. The firm was
formed on Mar. 7, 2001, and dissolved in late 2002.
10
MLDs are money market instruments issued by financial
institutions whereby an investor deposits money with the
financial institution for a fixed period, and in lieu of all or
part of the interest to be paid on the deposit, the depositor has
the opportunity to earn a higher return than otherwise granted
for a traditional time deposit. The higher return depends on the
market performance of some other asset specified in the MLD
documentation.
11
EPIC received a flat fee of $137,500 from Cantley &
Sedacca for referring Mr. Lamb. Mr. Wilson paid Mr. Lamb
$45,833.43 of this amount.
12
Mr. Wilson also paid $45,833.29 of EPIC’s $137,500
referral fee from Cantley & Sedacca to Mr. Kestenbaum and his law
firm.
 - 11 -

the assistance of Daniel Brooks (Mr. Brooks),13 a former foreign

currency trader at Deutsche Bank AG,14 and Craig Brubaker (Mr.

Brubaker),15 an employee at the Dallas branch of Deutsche Banc

Alex. Brown,16 marketed the MLD strategy to accountants and

financial advisers nationwide and sold it to approximately 150

clients.17 Mr. Brooks knew the MLD strategy was a “tax

advantage” or “tax motivated” transaction.

Mr. Lamb’s initial reaction to the MLD strategy was that the

tax benefit was “too good to be true”. On August 23, 2001, Mr.

Lamb spoke with Mr. Hamel about the MLD strategy. Following the

discussion, Mr. Lamb reviewed a tax opinion by the law firm Bryan

13
Mr. Brooks has an M.B.A. degree and extensive experience
in the financial industry, having worked as a foreign currency
trader for several large banks before starting his own currency
adviser firm, Clarion Capital, in 2001.
14
Deutsche Bank AG is an international bank headquartered in
Germany, with offices in London and the United States. Mr.
Brooks worked at Deutsche Bank AG from 1999 to 2001.
15
Mr. Brubaker met Mr. Brooks during Mr. Brooks’ employment
with Deutsche Bank AG.
16
Deutsche Banc Alex. Brown is a licensed broker-dealer
engaged in the domestic securities brokerage business and is a
division of Deutsche Bank Securities, Inc., a wholly owned
subsidiary of Deutsche Bank AG.
17
The specific origin of the MLD strategy is not clear from
the record. However, Beckett Cantley (Mr. Cantley) of Cantley &
Sedacca testified that when Mr. Ivsan brought the MLD strategy to
Cantley & Sedacca around April 2001, Mr. Brooks and Mr. Brubaker
were held out as the originators of the strategy.
 - 12 -

Cave, LLP (Bryan Cave), dated August 24, 2001, on the MLD

strategy (Bryan Cave opinion).18

On September 11, 2001, Mr. Hamel met with Mr. Lamb and Mr.

Ivsan to discuss a possible transaction based on the MLD

strategy. At the meeting, Mr. Hamel and Mr. Lamb first learned

of Mr. Brooks. Under the proposed structure of the MLD

transaction, Mr. Brooks would serve as a foreign currency

investment adviser on behalf of Mr. Hamel.19

After the meeting Mr. Hamel told Mr. Lamb to continue

investigating a potential MLD transaction and to instruct Kenneth

Barish (Mr. Barish),20 an attorney with the law firm Kajan,

Mather, & Barish, P.C., also to investigate the MLD strategy and

analyze the Bryan Cave opinion. Mr. Lamb contacted Mr. Barish

about the MLD strategy and faxed Mr. Barish notes regarding his

review of a Bryan Cave draft discussion of the section 6662

penalty dated August 24, 2001. Mr. Lamb researched MLDs on the

Internet. Mr. Lamb and Mr. Barish also investigated the

18
Cantley & Sedacca hired Bryan Cave to determine whether a
transaction incorporating MLDs should be registered as a tax
shelter and to evaluate other potential tax issues.
19
Mr. Brooks served as a foreign currency investment adviser
in each of the approximately 150 MLD transactions in which he
participated.
20
Mr. Barish had advised Mr. Hamel on tax matters since the
late 1980s. Mr. Barish worked in the Criminal Tax Division of
the U.S. Department of Justice and the Tax Division of the U.S.
Attorney’s Office for the Central District of California before
entering private practice. Mr. Barish has experience in
litigating tax shelter cases.
 - 13 -

backgrounds of Mr. Ivsan and Mr. Brooks. Mr. Lamb conducted

Internet research on Mr. Brooks and his currency-adviser firm,

Clarion Capital. Mr. Barish confirmed that Mr. Ivsan had

received an LL.M. from New York University. Mr. Barish hired a

private investigator, Alan Wells (Mr. Wells), to conduct a

background check on Mr. Brooks.

On September 12, 2001, Mr. Lamb and Mr. Barish met with Mr.

Ivsan to discuss a potential MLD transaction and to give Mr.

Barish an opportunity to review the Bryan Cave opinion. After

reading the opinion, Mr. Barish was skeptical of the tax benefits

of the MLD strategy.

On or around September 13, 2001, Mr. Hamel instructed Mr.

Lamb to meet with Mr. Brooks to discuss the MLD strategy. Mr.

Lamb exchanged several emails with Mr. Brooks regarding Mr.

Brooks’ background and a potential MLD transaction. On September

20, 2001, Mr. Wells provided Mr. Barish a report regarding

background inquiries on Mr. Brooks. The background check

confirmed various aspects of Mr. Brooks’ identity. Following the

receipt of Mr. Wells’ report, Mr. Lamb sought to obtain a credit

report on Mr. Brooks. In an email to Mr. Brooks, Mr. Lamb stated

that good credit was an indication of business acumen and that

the Hamel companies typically examined an individual’s credit

before going into business with that person. However, Mr. Brooks
 - 14 -

did not deem his credit relevant and failed to provide the

necessary credit waiver.

On September 26, 2001, Mr. Lamb met with Mr. Brooks to

evaluate whether Mr. Brooks was trustworthy. Mr. Lamb also met

with Marc Kushner (Mr. Kushner), a tax attorney with the law firm

Pryor, Cashman, Sherman & Flynn, LLP (Pryor Cashman). Cantley &

Sedacca referred Mr. Hamel to Pryor Cashman. Mr. Ivsan and Mr.

Barish participated by telephone in the meeting with Mr. Kushner.

Mr. Ivsan also gave Mr. Barish and Mr. Lamb a copy of a

discussion of the section 6662 penalty contained in a Pryor

Cashman draft tax opinion on the MLD strategy.

Following the meetings with Mr. Brooks and Mr. Kushner, Mr.

Lamb recommended that Mr. Hamel proceed with the proposed MLD

transaction. Mr. Barish noted that the MLD strategy represented

an “aggressive tax opinion” that worked “from a technical

standpoint”, and he recommended creating a paper trail

memorializing discussions concerning offshore expansion and

currency transactions before executing the MLD strategy. On

October 4, 2001, Thighmaster held a management meeting for which

Herb Schmidt, Thighmaster’s chief financial officer (CFO) and

director of operations, prepared a memorandum regarding “Business

Opportunity/Business Plan” and Jim England, Thighmaster’s

president, prepared a memorandum regarding “International

Marketing”. The memoranda recommended expanding the Hamel
 - 15 -

companies’ business operations into foreign markets and outlined

potential strategies.21 Around this time, Mr. Hamel decided to

proceed with executing the MLD transaction.

IV. Executing the MLD Transaction

A. Preliminary Steps

On October 9, 2001, Mr. Hamel and Cantley & Sedacca executed

an agreement for legal services. That same day, Mr. Lamb, as

trustee of the Galway Trust,22 made a $325,000 wire transfer from

the Galway Trust’s account to Cantley & Sedacca for services

related to the MLD strategy that were rendered by various

parties.23

Sometime before October 9, 2001, Cantley & Sedacca sent Mr.

Lamb documents regarding the MLD transaction for Mr. Hamel to

sign and return to the firm. Those documents related to and

purported to implement the MLD transaction and included formation

documents for Palm Canyon and AHI, an operating agreement

effectively making Mr. Brooks (through CF Advisors, XL, LLC, an

21
The only recommendation contained in the memoranda that
the Hamel companies implemented in 2001 was a recommendation in
Mr. Schmidt’s memorandum related to measures designed to guard
against foreign currency fluctuations.
22
The parties stipulated that “Galway Trust was owned by
Alan and Suzanne Hamel”.
23
The $325,000 fee was nonrefundable provided that Pryor
Cashman issued a tax opinion with respect to the MLD transaction
before Apr. 15, 2002. From the $325,000 payment, Cantley &
Sedacca distributed $50,000 to Pryor Cashman for its tax opinion
and $137,500 to EPIC as a referral fee.
 - 16 -

entity created by Mr. Brooks under Clarion Capital (CF Advisors),

see infra p. 22) a member of Palm Canyon, and various operational

documents with banks involved in the MLD transaction. The

documents also included notice, agreement, and payment documents

related to buying out Mr. Brooks’ Palm Canyon interest (through

CF Advisors, see infra pp. 26-27) (which did not occur until

December 18, 2001), and a letter authorizing the sale of all

positions held by Palm Canyon (which did not occur until December

27, 2001). On or around October 9, 2001, Mr. Hamel signed but

did not date those documents.

On October 10, 2001, AHI was incorporated under the laws of

Delaware.24 Mr. Hamel received 1,000 common shares of AHI as the

company’s sole shareholder.

On October 10, 2001, Palm Canyon was formed as a limited

liability company under the laws of Delaware. On or around

October 11, 2001, Palm Canyon established a brokerage account

with Deutsche Banc Alex. Brown,25 and Mr. Lamb, as trustee of the

Galway Trust, transferred $825,000 to this account.26 On October

11, 2001, Mr. Hamel executed an operating agreement for Palm

24
Cantley & Sedacca prepared all documents related to the
formation and organization of AHI and Palm Canyon and filed the
formation or incorporation documents with the applicable
government agencies.
25
Palm Canyon did not have a financial or bank account with
any other financial institutions or broker-dealers during 2001.
26
Mr. Brubaker handled all transactions related to Palm
Canyon’s Deutsche Banc Alex. Brown account.
 - 17 -

Canyon, effective as of October 9, 2001, naming himself the sole

member and acknowledging his capital contribution of $825,000 in

exchange for 100,000 class A units.27 Mr. Hamel also signed a

Form SS-4, Application for Employer Identification Number, dated

October 11, 2001, identifying Palm Canyon as a multiple-member

limited liability company and checking the “Partnership” box.

Mr. Hamel also executed a “Full Trading Authorization with

Privilege to Withdraw Money and/or Securities” with Deutsche Banc

Alex. Brown, dated October 11, 2001, authorizing Mr. Brooks to

act on behalf of Palm Canyon with respect to its Deutsche Banc

Alex. Brown account. On or around October 15, 2001, Mr. Hamel

and CF Advisors entered into an agreement for services related to

foreign currency investments. Under this arrangement, Mr. Hamel

purportedly authorized Mr. Brooks to select which foreign

currency trades to make on behalf of Palm Canyon within certain

risk parameters that Cantley & Sedacca had set.

B. The MLD Contracts

On October 15, 2001, Palm Canyon entered into MLD contracts;

it executed the trades that were part of the MLD strategy and

received two trade confirmations from Société Générale,28 each

27
As a limited liability company with only one member, Palm
Canyon was disregarded as an entity separate from its owner for
Federal income tax purposes, absent an election to be classified
as a corporation. Secs. 301.7701-2(a) and (b), 301.7701-3(a) and
(b)(1), Proced. & Admin. Regs.
28
Société Générale is an international bank headquartered in
(continued...)
 - 18 -

identified as a currency linked deposit swap. The MLD contracts

provided for offsetting deposits between Palm Canyon and Société

Générale to be made on October 16, 2001, in the amounts of

54,945,050, or $50 million using the spot exchange rate of

0.9100 U.S. dollar per euro.29 The MLD contracts required Palm

Canyon and Société Générale to repay the deposits on December 18,

2001, in U.S. dollars, together with a fixed yield on the deposit

amount computed at an annual rate of 3.665 percent ($300,326).

The MLD contracts provided for a potential premium interest

payment on the deposit that was structured as a European-style,

foreign currency digital option.30 Ostensibly, Mr. Brooks made

the foreign currency trades on the bet that the U.S. dollar would

strengthen against the Japanese yen.

One MLD contract included a call option on Japanese yen

purchased by Palm Canyon from Société Générale (long MLD

28
(...continued)
Paris, France, with offices in the United States.
29
All of the amounts referenced in the MLD contracts were
denominated in euro. For purposes of this opinion, we substitute
U.S. dollars for euro using the Oct. 16, 2001, exchange rate of
0.9100 U.S. dollar per euro, consistent with the rate used in the
MLD contracts.
30
An option is a contract that gives the buyer of the option
the right, but not the obligation, to buy or sell an asset at a
predetermined price (strike price) at some time in the future.
The right to buy in the future is a call option, and the right to
sell is a put option. A European-style option cannot be
exercised before its expiration date. A digital option has a
fixed payout amount or no payout, depending on whether the price
of the underlying asset is above or below the strike price.
 - 19 -

option).31 The long MLD option required Palm Canyon to pay

Société Générale a $5 million premium on October 16, 2001.32

The long MLD option also required Société Générale to pay Palm

Canyon a fixed $8 million premium interest payment, payable on

December 18, 2001, if the Japanese yen to U.S. dollar exchange

rate on December 14, 2001 (spot market exchange rate), as

determined by Société Générale,33 were equal to or greater than

124.65. If the spot market exchange rate were less than 124.65

Japanese yen to a U.S. dollar, no premium interest was due.

The other MLD contract included a call option on Japanese

yen sold by Palm Canyon to Société Générale (short MLD option).34

The short MLD option required Société Générale to pay Palm Canyon

31
The party purchasing an option is in the “long” position
with respect to that option.
32
The purchaser of an option pays a premium for its
position, which amount represents the option’s value on the
transaction date.
33
Société Générale was the calculation agent for both MLD
contracts, giving the bank the exclusive right to select the spot
market exchange rate that would apply to the options. During
2001 the accepted industry practice for a calculation agent
determining a spot market exchange rate under an option contract
was to contact three or four banks on the determination date to
request a spot price of the currency under the contract. The
calculation agent would ask each bank for both a bid and an ask
price, the prices at which the bank would buy and sell the
currency, respectively. The bid-ask spread is generally 3 to 5
“pips” (a pip is the smallest price interval normally used in
pricing currencies; for Japanese yen per U.S. dollar quotations a
pip is .01). The calculation agent could choose any of those
prices as the spot market exchange rate.
34
The party selling the option is in the “short” position
with respect to that option.
 - 20 -

a $4,945,000 premium on October 16, 2001. The short MLD option

also required Palm Canyon to pay Société Générale a fixed

$7,912,000 premium interest payment, payable on December 18,

2001, if the spot market exchange rate, as determined by Société

Générale, were equal to or greater than 124.67 Japanese yen to a

U.S. dollar. If the spot market exchange rate were less than

124.67 Japanese yen to a U.S. dollar, no premium interest was

due.

The terms of the MLD contracts are summarized as follows:

Long MLD option Short MLD option

Deposit $50,000,000 $50,000,000
Fixed yield
(3.665 percent) 300,326 300,326
Premium payment 5,000,000 4,945,000
Potential premium
interest payment 8,000,000 7,912,000

On the basis of the offsetting positions of the long and short

MLD options, three possible outcomes existed with respect to the

premium interest provisions of the MLD contracts. First, if the

spot market exchange rate were below 124.65 Japanese yen to a

U.S. dollar, both the long and short MLD options would be “out-

of-the-money”, and neither Palm Canyon nor Société Générale would

receive a premium interest payout under the respective MLD

contract. Second, if the spot market exchange rate were at or

above 124.67 Japanese yen to a U.S. dollar, the long and short

MLD options would be “in-the-money”, and both Palm Canyon and

Société Générale would receive a premium interest payout under
 - 21 -

the respective MLD contract. In this circumstance, Palm Canyon

would receive a net premium interest payment of $88,000, the

difference between Société Générale’s $8 million premium interest

payment to Palm Canyon and Palm Canyon’s $7,912,000 premium

interest payment to Société Générale. Third, if the spot market

exchange rate were 124.65 or 124.66 Japanese yen to a U.S.

dollar, the MLD options would be in the “sweet spot”, and Palm

Canyon would receive a premium interest payout of $8 million

under the long MLD option while not owing a premium interest

payout to Société Générale under the short MLD option. Under no

circumstances would Palm Canyon owe premium interest to Société

Générale under the short MLD option without receiving a premium

interest payout from Société Générale under the long MLD option.

Neither Palm Canyon nor Société Générale transferred funds

with respect to the $50 million offsetting deposits on October

16, 2001. Additionally, neither party transferred funds

equivalent to the full option premiums required under the MLD

contracts; instead, on October 16, 2001, Palm Canyon paid Société

Générale a $55,000 net premium, the difference between the $5

million long MLD option premium Palm Canyon owed to Société

Générale and the $4,945,000 short MLD option premium Société

Générale owed to Palm Canyon.35

35
Of the $55,000 net premium, Société Générale retained
$12,500, paid Deutsche Banc Alex. Brown $20,500, and distributed
$22,000 to “Risk”.
 - 22 -

C. Transactions Following the MLD Contracts

As of October 17, 2001, Mr. Hamel assigned AHI his 100,000

class A units in Palm Canyon in exchange for 1,000 AHI shares,

making AHI the sole member of Palm Canyon. Mr. Hamel appointed

himself as AHI’s sole director, president, and treasurer-

secretary.

Also, as of October 17, 2001, Mr. Hamel transferred his

1,000 AHI shares to Thighmaster as a capital contribution, making

Thighmaster AHI’s sole shareholder. Thighmaster approved and

authorized the capital contribution of Mr. Hamel’s AHI shares,

accepted AHI as a qualified subchapter S subsidiary, and ratified

all prior actions by AHI’s directors and officers, including Mr.

Hamel.

By an amended operating agreement dated October 19, 2001,

AHI and CF Advisors made CF Advisors a member of Palm Canyon.36

The amended Palm Canyon operating agreement reduced AHI’s

ownership interest in Palm Canyon to 99,000 class A units and

stated that CF Advisors contributed $5,000 to be paid out of

investment adviser fees in exchange for 1,000 class B units. The

operating agreement also provided that CF Advisors would receive

36
Mr. Brooks also became a partner or member of the
partnership or limited liability company in each of the
approximately 150 MLD transactions in which he participated.
 - 23 -

a quarterly investment advisory fee and a one-time, fixed $20,000

fee specifically for 2001.37

When CF Advisors became a member in Palm Canyon, Palm Canyon

became classified as a partnership for Federal income tax

purposes.38 Accordingly, AHI, which until then had been the sole

member of Palm Canyon, was treated under section 721 as

contributing all of the assets of the limited liability company,

which on the date of the contribution consisted of $825,000 and

the long MLD option, to the new partnership in exchange for a

partnership interest.39 Under section 722, AHI’s basis in its

Palm Canyon partnership interest equaled its basis in the assets

that it was deemed to contribute to the newly created

partnership.40 Consequently, AHI claimed an initial $5,825,000

basis in its Palm Canyon partnership interest, which included the

original $825,000 contributed by Mr. Hamel and the $5 million

premium Palm Canyon purportedly paid under the long MLD option.

37
On Oct. 23, 2001, Palm Canyon paid CF Advisors $15,000 of
the $20,000 investment adviser fee owed.
38
When a limited liability company acquires two or more
members, it becomes classified as a partnership for Federal
income tax purposes, absent an election to be treated as a
corporation. Sec. 301.7701-3(a) and (b), Proced. & Admin. Regs.
39
CF Advisors’ $5,000 contribution to be paid out of
investment adviser fees was treated as a contribution to the new
partnership in exchange for an ownership interest in Palm Canyon.
40
CF Advisors’ basis in its Palm Canyon partnership interest
equaled the $5,000 it contributed to the partnership, to be paid
out of the investment adviser fee it was due.
 - 24 -

AHI did not account for any potential liability with respect to

the short MLD option under section 752(b).41 AHI’s $5,825,000

basis in its Palm Canyon partnership interest was significantly

higher than its net economic outlay in acquiring the partnership

interest, which was $825,000 and the $55,000 net premium Palm

Canyon paid with respect to the MLD options.

Between October 22 and November 21, 2001, Palm Canyon

entered into four separate 30-day foreign currency option

agreements with Deutsche Bank AG involving Swiss francs, Japanese

yen, British pounds, and Canadian dollars.42 Each contract

required a $5,000 premium payment, which Palm Canyon transferred

to Deutsche Bank AG. Palm Canyon earned a $2,076 net profit on

the four options.

D. Termination of the MLD Contracts

As of December 7, 2001 (termination date), Palm Canyon and

Société Générale terminated the MLD contracts,43 providing for a

full release of all respective obligations stated in the

41
Under sec. 752(b), any decrease in a partner’s share of
the partnership’s liabilities, or any decrease in a partner’s
individual liabilities through the assumption by the partnership
of the partner’s liabilities, is treated as a distribution of
money to the partner by the partnership. Under sec. 733, a
partner’s basis in his partnership interest is reduced by the
amount of any money distributed to the partner.
42
Mr. Brooks placed similar minor foreign currency trades
for each of his 150 MLD strategy clients.
43
Neither party raised an issue regarding the Federal income
tax consequences of the early termination of the MLD contracts.
 - 25 -

confirmations and for a termination payment of $61,600 by Société

Générale to Palm Canyon.44 On December 7, 2001, the Japanese yen

to U.S. dollar exchange rate reported by the New York Federal

Reserve Bank was 125.62, putting both the MLD short and long

options in the money. Because of the early termination of the

MLD contracts, Palm Canyon earned $6,600 on the MLD contracts,

the difference between the $61,600 termination payment and the

$55,000 net premium paid to Société Générale, before taking into

account the $345,000 in fees paid to Cantley & Sedacca and CF

Advisors.

Neither Palm Canyon nor Société Générale transferred $50

million on the termination date, or at any time thereafter, to

repay the offsetting deposits. Similarly, neither party paid the

fixed yield to its counterparty.

E. Activities Following the Termination of the MLD
Contracts

On December 14, 2001, Palm Canyon purchased Canadian dollars

at a conversion rate of 0.67226440 Canadian dollar per U.S.

dollar for $1,000 (Canadian dollars position).45

44
The termination payment represented the premium Société
Générale was willing to pay Palm Canyon to cancel the MLD
contracts.
45
Mr. Brooks bought Canadian currency in many of the other
MLD transactions in which he participated. In the instances
where he did not purchase Canadian currency, Mr. Brooks purchased
equity interests, presumably so the character of the loss on the
disposition of the equity interest would be capital instead of
ordinary.
 - 26 -

Both Mr. Lamb and Mr. Barish knew that AHI had to acquire CF

Advisors’ membership interest in Palm Canyon before the end of

Thighmaster’s 2001 tax year to recognize the MLD strategy’s tax

benefit.46 As of December 18, 2001, AHI purchased CF Advisors’

1,000 class B units in Palm Canyon for $5,000.47 Because of

AHI’s acquisition of CF Advisors’ membership units, AHI became

again the sole member of Palm Canyon.48 Consequently, under

section 708(b)(1), Palm Canyon’s partnership status was

terminated, triggering a deemed distribution of Palm Canyon’s

assets. See Rev. Rul. 99-6, 1999-1 C.B. 432. On December 18,

2001, Palm Canyon’s only assets were $820,522 and the Canadian

dollars position. Mr. Hamel, on behalf of AHI, transferred

$5,000 to CF Advisors in payment for its membership units, and

the remaining $815,522 and the Canadian dollars position were

deemed distributed to AHI. Under section 732(b),49 AHI claimed a

46
Mr. Brooks terminated his partnership or membership
interest before Dec. 31, 2001, in all of the approximately 150
MLD transactions he entered into in 2001.
47
AHI bought out CF Advisors’ Palm Canyon interest without
any negotiation, paying $5,000, the same amount as CF Advisors’
original contribution. Mr. Brooks was bought out without any
negotiation in each of the 150 MLD transactions in which he
participated in 2001.
48
Palm Canyon again became a single-member limited liability
company, causing it to be disregarded as an entity separate from
its owner for Federal income tax purposes, absent an election to
be classified as a corporation. Secs. 301.7701-2(a) and (b),
301.7701-3(a) and (b)(1), Proced. & Admin. Regs.
49
Under sec. 732(b), the basis of property (other than
(continued...)
 - 27 -

$5,001,000 basis in the Canadian dollars position, which equaled

AHI’s adjusted basis in its Palm Canyon partnership interest,

minus the cash it received in the liquidating distribution. See

infra p. 31.

By letter dated December 18, 2001, Mr. Hamel informed Mr.

Brubaker of CF Advisors’ sale of its interest in Palm Canyon to

AHI and indicated that Mr. Brooks no longer had investment

authority over Palm Canyon’s Deutsche Banc Alex. Brown account.

As discussed above, see supra pp. 15-16, on or around October 9,

2001, Mr. Hamel had signed but had not dated the agreement,

payment, and notice documents relating to CF Advisors’ sale of

its Palm Canyon partnership interest. The December 18, 2001,

dates on these documents were not in Mr. Hamel’s handwriting.50

After 2001 Mr. Brooks had no involvement with any of the

Hamel companies. Mr. Lamb turned over the Hamel companies’

foreign currency trading activities to Mr. Brubaker and Todd

Clendenning at Deutsche Bank Alex. Brown.

By letter dated December 24, 2001, Mr. Hamel authorized Mr.

Brubaker to sell Palm Canyon’s Canadian dollar position. Mr.

Hamel had signed the letter on or around October 9, 2001, but had

49
(...continued)
money) distributed by a partnership to a partner in liquidation
of the partner’s interest equals the partner’s adjusted basis in
the partnership, reduced by any money distributed in the same
transaction.
50
The record does not indicate who dated the Dec. 18, 2001,
letter or when it was dated.
 - 28 -

not dated it at that time.51 On December 27, 2001, pursuant to

the December 24, 2001, letter that Mr. Hamel had signed in

October 2001, the Canadian dollars position was sold at a

conversion rate of 0.59029500 Canadian dollar to a U.S. dollar

for $878.07. Thighmaster claimed an ordinary tax loss of

$5,001,000 as a result of the disposition of the Canadian dollars

position.52 See infra p. 32.

As of December 31, 2001, Mr. Lamb became a director and the

treasurer/CFO and secretary of AHI.

F. Pryor Cashman Opinion

On or around February 7, 2002, Mr. Hamel engaged Pryor

Cashman to issue a tax opinion with respect to the MLD

transaction.53 Cantley & Sedacca provided Pryor Cashman with

documents relating to the MLD transaction for Pryor Cashman to

use in the preparation of its tax opinion. On February 13, 2002,

Mr. Kushner mailed Mr. Lamb a copy of Pryor Cashman’s opinion

letter (Pryor Cashman opinion) regarding the MLD transaction. A

51
The handwriting dating the letter Dec. 24, 2001, was not
Mr. Hamel’s. The letter resulted in the sale of Palm Canyon’s
Canadian dollars position, which was purchased on Dec. 14, 2001,
for $1,000 and which had been deemed distributed to AHI on Dec.
18, 2001.
52
The disposition of the Canadian dollars position was a
foreign currency transaction that resulted in an ordinary loss.
See sec. 988(a)(1)(A), (b)(2), and (c)(1); sec. 1.988-1(a)(1),
Income Tax Regs.
53
During 2001 and 2002 Pryor Cashman prepared between 40 and
50 tax opinions relating to the MLD strategy.
 - 29 -

letter attached to the Pryor Cashman opinion stated that the

opinion could not be relied on until Mr. Hamel and Mr. Brooks

signed and returned a series of representations on which Pryor

Cashman relied in issuing its tax opinion. One of the

representations included a statement by Mr. Hamel that he entered

into the MLD transaction for business reasons with the intent to

make a profit. Mr. Brooks provided his representations to Pryor

Cashman, but Mr. Hamel did not.

In anticipation of receiving the representations of Mr.

Hamel and Mr. Brooks, Pryor Cashman issued an opinion concluding

that Palm Canyon’s tax treatment of the MLD transaction would

“more likely than not” be respected. However, because Mr. Hamel

never supplied the requested representations, neither Palm Canyon

nor Mr. Hamel was entitled to rely on the Pryor Cashman opinion

by reason of its terms, which were never satisfied.

Nevertheless, after reviewing the Pryor Cashman opinion, Mr. Lamb

and Mr. Barish gave Mr. Hamel a favorable recommendation

regarding the MLD transaction.

G. Palm Canyon’s Trading Activity After 2001

In 2002 Palm Canyon continued to make foreign currency

trades with Deutsche Bank AG, but at a reduced level. In 2002

Palm Canyon entered into three foreign currency investment

contracts and earned a total profit of $70,403. In 2003 the

Hamel companies stopped making foreign currency trades. On June
 - 30 -

1, 2005, Palm Canyon’s status as a limited liability company

under the laws of Delaware was canceled.

V. Relevant Tax Reporting for 2001

A. Palm Canyon’s Return

On July 19, 2002, Palm Canyon filed a Form 1065, U.S. Return

of Partnership Income, for 2001 (Palm Canyon’s return).54 Palm

Canyon’s return reported the following items for AHI and CF

Advisors:

AHI CF Advisors

Capital contributions $5,825,000 $5,000
Share of income/expenses (8,478) -0-
Guaranteed payments -0- 20,000
Distributions 5,816,522 5,000
Ending capital account -0- -0-

The $5,825,000 in capital contributions from AHI that Palm Canyon

reported on its return consisted of Mr. Hamel’s $825,000 and the

$5 million premium Palm Canyon purportedly paid to Société

Générale.

The net amount of Palm Canyon’s separately stated

partnership items was ($8,478), all of which Palm Canyon

allocated to AHI.55 This amount included, among other items of

54
On the recommendation of Mr. Ivsan, Robert Kipp, a partner
in the Tax Practice Group of BDA&K Business Services, Inc., an
accounting and tax preparation service located in Dallas, Tex.,
prepared Palm Canyon’s return.
55
Palm Canyon’s return reported the following separately
stated partnership items:

(continued...)
 - 31 -

income and expenses, $900,326 of interest income purportedly

attributable to the long MLD option and $893,726 of interest

expense purportedly attributable to the short MLD option.

The $5,816,522 distribution to AHI reported on Palm Canyon’s

return resulted from the liquidation of the Palm Canyon

partnership for Federal income tax purposes on December 18, 2001.

AHI claimed a $5,816,522 adjusted basis in its Palm Canyon

partnership interest at the end of Palm Canyon’s 2001 tax year.56

AHI received $815,522 in the deemed distribution, and under

section 732(b), it allocated its remaining basis in its Palm

Canyon partnership interest to the Canadian dollars position,

giving AHI a $5,001,000 adjusted basis in the Canadian dollars

position. See Rev. Rul. 99-6, supra.

B. Thighmaster’s Return

For 2001 Thighmaster was an S corporation for Federal income

tax purposes and the parent of a group of wholly owned subsidiary

55
(...continued)
Item Amount

Interest income $900,326
Interest expense (893,726)
Dividend income 3,004
Net gain on Deutsche Bank options 2,076
Guaranteed payment to CF Advisors (20,000)
Wire fees (50)
Nondeductible expenses (108)
Total (8,478)
56
AHI’s $5,816,522 basis in its Palm Canyon partnership
interest at the end of the partnership’s 2001 tax year
represented AHI’s $5,825,000 initial partnership interest basis
minus its share of separately stated partnership items ($8,478).
 - 32 -

corporations that filed a consolidated Form 1120S, U.S. Income

Tax Return for an S Corporation (Thighmaster’s return).57

Thighmaster included AHI on its return as a qualified subchapter

S subsidiary.58

On its return, Thighmaster reported the following items for

AHI: (1) Each of the separately stated items of income and

deductions from Palm Canyon (net amount of negative $8,478); (2)

$878 of additional interest income; and (3) $5,001,000 in “Other

deductions” for “loss on currency trading”. The additional

interest income and other deductions for loss on currency trading

represented Thighmaster’s tax reporting of AHI’s December 27,

2001, sale of the Palm Canyon Canadian dollars position for

$878.07. Although the sale of the Canadian dollars position

resulted in an economic loss of only $121.93 ($1,000 - $878.07),

Thighmaster claimed a $5,001,000 ordinary tax loss on the sale

because AHI allegedly had acquired a $5,001,000 adjusted basis in

the Canadian dollars position from the December 18, 2001,

liquidation of the Palm Canyon partnership.59 Sec. 732(b).

57
Mr. Lamb prepared Thighmaster’s 2001 Form 1120S.
58
By letter dated Dec. 31, 2001, the IRS notified
Thighmaster that it approved the qualified subch. S subsidiary
election for AHI and terminated AHI’s subch. S status.
59
It is not clear why Thighmaster calculated the loss on the
sale of the Canadian currency position without regard to the $878
proceeds of sale.
 - 33 -

On its 2001 return, Thighmaster combined AHI’s 2001

separately stated items of income and deductions distributed from

Palm Canyon with other separately stated items of income and

deductions of Thighmaster and its subsidiaries for 2001,

resulting in negative $18,431 of consolidated separately stated

items of income and deductions for 2001, all of which Thighmaster

allocated to Mr. Hamel, the sole shareholder of Thighmaster.

Thighmaster also combined AHI’s “Other deductions” of $5,001,000

with the income and expenses of Thighmaster and its other

subsidiaries for 2001, resulting in a consolidated ordinary loss

of $1,921,579 for 2001, all of which Thighmaster allocated to Mr.

Hamel.

C. The Hamels’ Return

On October 7, 2002, the Hamels filed a joint Form 1040, U.S.

Individual Income Tax Return, for 2001, which showed Mr. Hamel’s

distributive share of Thighmaster’s 2001 separately stated items

of income and deductions (net loss of $18,431) and Thighmaster’s

2001 ordinary loss of $1,921,579. The Hamels reported zero

taxable income on their return and no 2001 Federal income tax

liability. Excluding the items allocated to Mr. Hamel for 2001

from Palm Canyon and the MLD transaction, through AHI and

Thighmaster, the Hamels would have had taxable income of

$3,989,130 and an approximate Federal income tax liability of

$1,532,000.
 - 34 -

VI. FPAA

Respondent conducted an examination of Palm Canyon’s 2001

tax year. In March 2005 Palm Canyon entered into an agreement to

extend the period of limitations for assessment of tax for 2001

until December 31, 2005. The Hamels similarly agreed to extend

the period of limitations for assessment of tax, including items

attributable to partnership items, for 2001 to December 31, 2005.

On December 20, 2005, respondent separately mailed an FPAA

to Palm Canyon, its partners, AHI (as TMP), and Thighmaster.

Respondent determined that Palm Canyon was a sham and that the

MLD transaction lacked economic substance, had no business

purpose, and constituted an economic sham. Respondent

disregarded the effects of the MLD transaction and adjusted

various partnership items on Palm Canyon’s return, most notably

disallowing the $5,001,000 section 732(b) distribution that

resulted from the liquidation of Palm Canyon.60 This adjustment

effectively disallowed the resulting $1,921,579 ordinary loss

60
In the FPAA respondent made adjustments to the following
items on Palm Canyon’s return:

Item Reported Corrected Adjustment

Portfolio interest $900,326 -0- $900,326
Portfolio dividends 3,004 -0- 3,004
Other portfolio income 2,076 -0- 2,076
Deductions 20,050 -0- 20,050
Interest expense 893,726 -0- 893,726
Investment income 903,330 -0- 903,330
Investment expenses 20,050 -0- 20,050
Distributions 5,001,000 -0- 5,001,000
 - 35 -

that the Hamels claimed on their return. Respondent also

determined that the accuracy-related penalty under section 6662

should be imposed.

On March 20, 2006, petitioner timely filed a petition for

readjustment of partnership items and penalty under section 6226.

Petitioner contends that respondent’s proposed adjustments are

incorrect, that Palm Canyon correctly reported all items of

income, loss, basis, and contributions to capital on its return,

and that none of respondent’s alternative determinations with

respect to the section 6662 penalty are appropriate. Petitioner

also alleges that the statute of limitations on assessments bars

respondent’s proposed adjustments.

Petitioner’s case was tried at a special trial session in

Los Angeles, California. Petitioner called the following

witnesses: Mr. Hamel, Mr. Lamb, Mr. Brooks, Mr. Kushner, and Mr.

Barish. Petitioner did not present any expert testimony.

Respondent called the following witnesses: Mr. Barish, Mr.

Cantley, Mr. Wilson, and two expert witnesses, Hendrik

Bessembinder (Mr. Bessembinder) and Thomas Murphy (Mr. Murphy).

OPINION

I. Jurisdiction Under TEFRA

Under the unified partnership audit and litigation

procedures of the Tax Equity and Fiscal Responsibility Act of

1982, Pub. L. 97-248, sec. 402(a), 96 Stat. 648, the tax
 - 36 -

treatment of any partnership item, except as otherwise provided

in subchapter C, must be determined at the partnership level.

Sec. 6221. Section 6226(a) authorizes a TMP to file a petition

for readjustment of partnership items within 90 days after the

date on which an FPAA is mailed to the TMP. In a partnership-

level proceeding filed pursuant to section 6226(a), this Court

has jurisdiction to review all partnership items for the

partnership year to which the FPAA relates and to review the

allocation of such items among the partners. Sec. 6226(f).

Section 6231(a)(3) defines a “partnership item” as:

any item required to be taken into account for the
partnership’s taxable year under any provision of
subtitle A to the extent regulations prescribed by the
Secretary provide that, for purposes of this subtitle,
such item is more appropriately determined at the
partnership level than at the partner level.

Section 301.6231(a)(3)-1(a), Proced. & Admin. Regs., contains an

extensive list of matters that constitute partnership items,

including: (1) All items of partnership income, gain, loss,

deduction, credit, and liabilities, and each partner's share

thereof; and (2) partnership contributions and distributions.

Sec. 301.6231(a)(3)-1(a)(1)(i), (v), (4), Proced. & Admin. Regs.

In Petaluma FX Partners, LLC v. Commissioner, 131 T.C. 84, 97

(2008), we held that the determination whether a partnership is a

sham, lacks economic substance, or otherwise should be

disregarded for tax purposes is also a partnership item.
 - 37 -

A nonpartnership item is an item that is not a partnership

item and whose tax treatment is determined at the partner level.

Sec. 6231(a)(3) and (4). An affected item is any item to the

extent it is affected by a partnership item, the tax treatment of

which is determined at a partner-level proceeding after the

underlying partnership item(s) is determined at the partnership

level.61 Sec. 6231(a)(5); Jenkins v. Commissioner, 102 T.C. 550,

554 (1994).

II. Statute of Limitations on Assessments

Section 6229(a) provides that the Commissioner must assess

any deficiency attributable to a partnership item within 3 years

after the date the partnership tax return was filed or within 3

years after the due date of the partnership tax return

(determined without regard to extensions), whichever is later.

Under section 6229(b)(1), the 3-year period can be extended with

respect to all partners by an agreement entered into by the

Secretary and the TMP, or any other person authorized by the

partnership in writing to enter into such an agreement, before

the expiration of such period. The 3-year period is suspended

for at least the 90-day period following the mailing of an FPAA,

61
There are two types of affected items: (1) Computational
affected items that follow from the result of a partnership-
level proceeding and (2) affected items that may require factual
development at the partner level. See N.C.F. Energy Partners v.
Commissioner, 89 T.C. 741, 744-745 (1987).
 - 38 -

during which an action may be brought under section 6226.62 Sec.

6229(d). Additionally, if a petition is filed challenging the

FPAA under section 6226, the period in which an assessment can be

made is suspended until the decision of the court becomes final,

plus 1 additional year. Sec. 6229(d).

Petitioner argues that the statute of limitations on

assessments bars respondent’s proposed adjustments in the FPAA.

However, before the expiration of the 3-year period following the

filing of Palm Canyon’s return, petitioner (through Mr. Barish)

entered into an agreement with respondent extending the period of

limitations for 2001 until December 31, 2005. Respondent timely

mailed petitioner the FPAA on December 20, 2005,63 and under

section 6229(d), the 3-year period of limitations for assessment

was suspended at least for the 90-day period following the

mailing of the FPAA. When petitioner subsequently filed a

petition challenging the FPAA under section 6226, the assessment

period was further suspended until the decision of this Court

becomes final, plus 1 additional year. Sec. 6229(d).

Accordingly, the section 6229(a) period for assessments has not

yet expired, and we conclude that respondent is not barred from

62
Under sec. 6226(b), if the TMP does not file a petition
within the 90-day period, any notice partner and any 5-percent
group may file a petition within 60 days after the close of the
90-day period.
63
Petitioner concedes that respondent mailed the FPAA within
the 3-year assessment period, as extended by the agreement.
 - 39 -

assessing any deficiencies in tax relating to adjustments to

partnership items on Palm Canyon’s return.64

III. Burden of Proof

Generally, the burden of proof is on the taxpayer in actions

challenging the adjustments to partnership items made by the

Commissioner, unless otherwise provided by statute or determined

by the Court. Rules 142(a), 240(a). Section 7491(a)(1),

however, provides that the burden of proof shall be on the

Commissioner if the taxpayer introduces credible evidence with

respect to any factual issue relevant to ascertaining the

liability of the taxpayer for any income tax. For section

7491(a)(1) to apply, the taxpayer must also satisfy the

limitations contained in section 7491(a)(2). Petitioner does not

contend that section 7491(a)(1) applies, nor has it demonstrated

that it satisfies the requirements of section 7491(a)(2).

Consequently, we hold that petitioner has the burden of proof as

to any disputed factual issue. See Rules 142(a), 240(a).

64
Because petitioner commenced a proceeding in this Court
under sec. 6226, respondent is restricted from assessing and
collecting a deficiency attributable to a partnership item until
at least the decision of this Court is final. See sec.
6225(a)(2). In addition, respondent may need to send a
deficiency notice with respect to affected items. See sec.
6230(a)(2)(A)(i).
 - 40 -

IV. Economic Substance of the MLD Transaction65

This case arises from petitioner’s participation in a

strategy that respondent has characterized as a Son-of-BOSS tax

shelter.66 In its simplest terms, the MLD transaction purports

to produce a tax benefit in the form of a substantial loss by

manipulating the partnership tax rules and taking advantage of

caselaw established in other factual contexts that promoters of

the MLD strategy contend excludes contingent liabilities from the

definition of a liability under section 752. See Helmer v.

Commissioner, T.C. Memo. 1975-160, discussed infra pp. 43-47. An

MLD transaction typically involves several steps, and the MLD

65
The phrase “MLD contracts” refers to the contracts that
Palm Canyon entered into with Société Générale. The phrase “MLD
transaction” refers to the overall strategy, including the MLD
contracts and creation and termination of the Palm Canyon
partnership.
66
A Son-of-BOSS transaction can be summarized as follows:

a variation of a slightly older alleged tax shelter
known as BOSS, an acronym for “bond and options sales
strategy.” There are a number of different types of
Son-of-BOSS transactions, but what they all have in
common is the transfer of assets encumbered by
significant liabilities to a partnership, with the goal
of increasing basis in that partnership. The
liabilities are usually obligations to buy securities
and typically are not completely fixed at the time of
transfer. This may let the partnership treat the
liabilities as uncertain, which may let the partnership
ignore them in computing basis. If so, the result is
that the partners will have a basis in the partnership
so great as to provide for large--but not out-of-
pocket--losses on their individual tax returns. * * *

Kligfeld Holdings v. Commissioner, 128 T.C. 192, 194 (2007).
 -41-

transaction at issue in this case is no exception. The MLD

transaction consisted of the following. First, Palm Canyon

entered into the offsetting MLD contracts, whose terms called for

a $5 million premium payment from Palm Canyon to Société Générale

for the long MLD option and a $4,945,000 premium payment from

Société Générale to Palm Canyon for the short MLD option, but

resulted in only a net premium payment of $55,000 by Palm Canyon.

After Palm Canyon entered into the MLD contracts, CF Advisors

joined AHI as the second member in Palm Canyon, and Palm Canyon

became a partnership for Federal income tax purposes. On the

formation of the Palm Canyon partnership, AHI was treated as

contributing all of Palm Canyon’s existing assets, which included

$825,000 in cash and the long MLD option, to the new partnership

in exchange for a partnership interest. AHI took an initial

basis of $5,825,000 in its Palm Canyon partnership interest,

which represented $825,000 and the cost of the long MLD option,

the purported $5 million premium payment to Société Générale.

However, because Palm Canyon’s liability for the premium interest

payment under the short MLD option purportedly was contingent on

the spot market exchange rate, AHI did not reduce its basis in

its partnership interest under section 752(b) with respect to

Palm Canyon’s assumption of the short MLD option.67 Therefore,

67
AHI based its position on Helmer v. Commissioner, T.C.
Memo. 1975-160, which AHI contends stands for the proposition
(continued...)
 -42-

AHI claimed an inflated tax basis in its Palm Canyon partnership

interest that reflected a $5 million premium paid for the MLD

long option, even though AHI’s net economic outlay to acquire the

partnership interest and the value of the partnership interest

were significantly less. When CF Advisors subsequently sold its

Palm Canyon partnership interest to AHI, Palm Canyon’s

partnership status ceased under section 708(b)(1), triggering a

liquidation and a deemed distribution of Palm Canyon’s assets.

See Rev. Rul. 99-6, supra. In the liquidation, AHI was deemed to

receive $815,522 and the Canadian dollars position, Palm Canyon’s

only asset at the time. Under section 732(b), AHI took a

$5,001,000 basis in the Canadian dollars position, which equaled

its adjusted basis in its partnership interest minus the $815,522

liquidating distribution. Consequently, on the disposition of

the Canadian dollars position AHI claimed that it realized and

recognized a $5,001,000 ordinary loss for income tax purposes.

We must decide whether Palm Canyon’s MLD transaction should

be respected for Federal income tax purposes. First, we address

whether Palm Canyon’s tax treatment of the MLD transaction fits

within the literal meaning of the Code, as interpreted by caselaw

at the time. Second, we examine whether the MLD transaction

should be disregarded under the economic substance doctrine.

67
(...continued)
that a contingent obligation is not considered a liability for
purposes of sec. 752. See infra pp. 43-47.
 -43-

When considering the MLD transaction, we review the economic

substance of the transaction as a whole, including the MLD

contracts68 and the creation and liquidation of the Palm Canyon

partnership, that occurred as a result of CF Advisors’ transitory

membership in Palm Canyon.

A. Definition of a “Liability” Under Section 752

Under section 752(b), a partnership’s assumption of a

partner’s liability is treated as a distribution of money to the

partner by the partnership, which reduces that partner’s basis in

its partnership interest by the amount of the liability assumed.

Sec. 733. For petitioner to receive the tax benefit from the MLD

transaction, the short MLD option must be excluded from the

definition of a liability for section 752 purposes so that AHI

does not have to reduce its basis in its Palm Canyon partnership

interest.

At the time of the MLD transaction, the term “liability”, as

used in section 752, was not defined in either the Code or the

regulations. However, several courts, including this Court, had

held that a contingent obligation is not a liability under

section 752. In Helmer v. Commissioner, T.C. Memo. 1975-160, a

partnership granted an option to buy partnership property in

exchange for a series of cash premiums from the option holder.

68
Because the deposits and fixed yield provisions of the MLD
contracts were offsetting, in our analysis we ignore their
effect.
 -44-

Upon the exercise of the option by the option holder the

partnership would have had to reduce the property purchase price

by the cash premiums it received. The partnership, however, was

not obligated to return the cash premiums if the purchaser failed

to exercise the option. The partnership argued that the premium

payments were partnership liabilities because the partnership

would have to credit these payments against the purchase price if

the option holder exercised the option. We held that no

liability arose upon receipt of the option premiums because the

option agreement “created no liability on the part of the

partnership to repay the funds paid nor to perform any services

in the future.” In other opinions we have applied similar

reasoning and have held that comparable obligations were not

liabilities for section 752 purposes. See LaRue v. Commissioner,

90 T.C. 465, 479-480 (1988) (contingent obligations that were not

fixed obligations of the partnership and were not sufficiently

determinable in amount were not liabilities for section 752

purposes); Long v. Commissioner, 71 T.C. 1, 7-8 (1978)

(contingent or contested items such as creditor’s claims were not

liabilities for section 752 purposes until they became fixed or

liquidated), supplemented by 71 T.C. 724 (1979), affd. in part

and remanded on other grounds 660 F.2d 416 (10th Cir. 1981).

On its face, Palm Canyon’s liability under the short MLD

option was contingent on the spot market exchange rate. If the
 -45-

Japanese yen to U.S. dollar exchange rate were equal to or

greater than 124.67, Palm Canyon owed a $7,912,000 premium

interest payment; if the exchange rate were less than 124.67

Japanese yen to a U.S. dollar, Palm Canyon owed nothing. Because

Palm Canyon’s liability under the short MLD option appears on its

face to be a contingent obligation, the short MLD option would

not qualify as a section 752 liability if the Helmer analysis

applies.69 If, on the other hand, Palm Canyon’s liability under

the short MLD option was certain to arise because of the way the

entire MLD transaction was structured, then the reasoning of

Helmer would not control the case at hand.

Courts that have considered transactions in which partners

contributed pairs of options to partnerships have reached

inconsistent conclusions.70 See, e.g., Maguire Partners-Master

69
As discussed below, in 2003 the Department of the Treasury
promulgated proposed regulations that altered the definition of a
liability for sec. 752 purposes and explicitly stated that “The
definition of a liability contained in these proposed regulations
does not follow Helmer v. Commissioner, T.C. Memo. 1975-160.” 68
Fed. Reg. 37436 (June 24, 2003). These regulations were
finalized in 2005. See infra pp. 47-49. The new definition of
liability, however, applies only to liabilities incurred or
assumed by a partnership on or after June 24, 2003. Sec. 1.752-
1(a)(4)(iv), Income Tax Regs.
70
Recent cases addressing the definition of a sec. 752
liability in the context of short sales have been more
consistent; courts have held that an obligation to close out a
short sale constitutes a liability for sec. 752 purposes although
the value of the obligation at the time of its contribution is
indeterminable. See Kornman & Associates, Inc. v. United States,
527 F.3d 443 (5th Cir. 2008) (relying on Rev. Rul. 95-26, 1995-1
(continued...)
 -46-

Invs., LLC v. United States, 103 AFTR 2d 763 at 775, 2009-1 USTC

par. 50,215, at 87,447 (C.D. Cal. 2009) (characterizing a short

option as a liability for purposes of section 752 because such

characterization is consistent with the economic reality of the

partner’s contribution); Stobie Creek Invs., LLC v. United

States, 82 Fed. Cl. 636, 665-667 (2008) (stating that the legal

doctrines delineated in Helmer apply to the short option that was

contributed to a partnership along with a long option); Jade

Trading, LLC v. United States, 80 Fed. Cl. 11, 44-45 (2007)

(concluding that a sold call option contributed to a partnership

was not a liability for purposes of section 752). Because

70
(...continued)
C.B. 131, and holding that a short sale created a partnership
liability within the meaning of sec. 752 because it created an
obligation to return the borrowed securities and holding that
incurring the liability increased the partnership’s basis in its
assets by the amount of cash received on the sale of the borrowed
securities); Salina Pship. LP v. Commissioner, T.C. Memo. 2000-
352 (concluding, on the basis of the plain and ordinary meaning
of the term “liability”, that the taxpayer had a legally
enforceable financial obligation to return the shares it borrowed
and close out the short sale). In a typical short sale
transaction, the short seller borrows shares from a broker and
sells them; the short seller must then buy an equivalent number
of the borrowed shares and return them to the broker by a future
date. See Zlotnick v. TIE Commcns., 836 F.2d 818, 820 (3d Cir.
1988). The short seller earns a profit on the transaction if the
securities decline in value because this allows the short seller
to make the covering purchase of the borrowed shares at a lower
price than the initial short sale. Id.

The potential liability under the short MLD option is
distinguishable from an obligation to close out a short sale
because Palm Canyon did not have a fixed, legally enforceable
financial obligation to make the premium interest payment when
the partnership assumed the short MLD option.
 -47-

respondent contends that Palm Canyon’s liability under the short

MLD option was not what it appeared to be and given the parties’

arguments regarding the economic substance of the MLD

transaction,71 we must still address and decide whether the MLD

transaction had economic substance, regardless of how we decide

this issue. Consequently, we shall assume for purposes of the

analysis that AHI did not have to reduce its basis in its

partnership interest under section 752(b) as a result of Palm

Canyon’s assumption of the short MLD option, and we shall

evaluate the economic substance of the MLD transaction.

B. Section 1.752-6, Income Tax Regs.

On June 24, 2003, the Department of the Treasury promulgated

section 1.752-6T, Temporary Income Tax Regs., 68 Fed. Reg. 37416

(June 24, 2003), concerning a partnership’s assumption of certain

partner liabilities. On May 26, 2005, the temporary regulation

71
We also note that even if we were to conclude that the
obligation under the short option were a liability for sec. 752
purposes, sec. 752(a) would allow partners to increase their
bases in the partnership interests by their shares of the
liability that the partnership has assumed. See sec. 1.752-2,
Income Tax Regs. (addressing partner’s share of recourse
liabilities); sec. 1.752-3, Income Tax Regs. (addressing
partner’s share of nonrecourse liabilities). Notably,
application of sec. 1.752-6, Income Tax Regs., would not result
in a corresponding increase in the partner’s outside basis for
the increase in the partner’s share of partnership liabilities.
See, e.g., Klamath Strategic Inv. Fund, LLC v. United States, 440
F. Supp. 2d 608, 620 n.9 (E.D. Tex. 2006).
 -48-

became final. T.D. 9207, 2005-1 C.B. 1344.72 Section 1.752-6,

Income Tax Regs., generally provides that if a partnership in a

section 721(a) transaction assumes a liability of a partner, as

defined in section 358(h)(3),73 that is not treated as a

liability under section 752(a) or (b),74 then the partner’s basis

in the partnership is reduced by the amount of the liability.

This regulation was intended to apply retroactively to

72
The regulations changed the definition of a “liability”
for purposes of sec. 752 and also defined the term “obligation”.
See sec. 1.752-1(a)(4), Income Tax Regs. Sec. 1.752-1(a)(4)(ii),
Income Tax Regs., states that an “obligation” is any fixed or
contingent obligation to make payment without regard to whether
the obligation is otherwise taken into account under the Internal
Revenue Code and lists certain obligations that fit within this
definition, including “obligations under derivative financial
instruments such as options, forward contracts, futures
contracts, and swaps.” An obligation is a liability for sec. 752
purposes if it meets the requirements of sec. 1.752-1(a)(4)(i),
Income Tax Regs. While Palm Canyon’s short MLD option likely
constitutes an obligation within the new definition in sec.
1.752-1(a)(4), Income Tax Regs., the regulation is inapplicable
in this case because it applies only to liabilities incurred or
assumed by a partnership on or after June 24, 2003. Sec. 1.752-
1(a)(4)(iv), Income Tax Regs. The IRS’ intended application of
sec. 1.752-1(a)(4), Income Tax Regs., contrasts with the
retroactive application of sec. 1.752-6, Income Tax Regs.,
discussed above.
73
Sec. 358(h)(3) provides that the term “liability” includes
any fixed or contingent obligation to make payment, without
regard to whether the obligation is otherwise taken into account
for purposes of the Code.
74
Before the 2005 regulations were finalized, the term
“liability” was not explicitly defined in sec. 752 or its
corresponding regulations.
 -49-

assumptions of liabilities occurring after October 18, 1999, and

before June 24, 2003.75 Sec. 1.752-6(d), Income Tax Regs.

Application of section 1.752-6, Income Tax Regs., would

force AHI to reduce its basis in its Palm Canyon partnership

interest by the amount, on the date of assumption, of Palm

Canyon’s potential premium interest payment to Société Générale

under the short MLD option (but not below the adjusted value of

the partnership interest), because the short MLD option would

qualify as a contingent section 358(h)(3) liability assumed by

Palm Canyon. This reduction in the basis of AHI’s partnership

interest would effectively eliminate the tax benefit of the MLD

transaction because AHI would have no inflated basis in its Palm

Canyon partnership interest to transfer to the Canadian dollars

position under section 732(b).

The cases that have dealt with section 1.752-6, Income Tax

Regs., have focused on whether the regulation can properly be

applied retroactively. See Cemco Investors, LLC v. United

States, 515 F.3d 749, 752 (7th Cir. 2008) (regulation can be

applied retroactively); Murfam Farms, LLC v. United States, 88

Fed. Cl. 516 (2009) (regulation cannot be applied retroactively);

Maguire Partners-Master Invs., LLC v. United States, 103 AFTR 2d

763, at 776-778, 2009-1 USTC par. 50,215, at 87,448-87,450 (C.D.

75
Obligations assumed on or after June 24, 2003, that are
not described in sec. 1.752-1(a)(4)(i), Income Tax Regs., are
governed by sec. 1.752-7, Income Tax Regs.
 -50-

Cal. 2009) (regulation can be applied retroactively); Stobie

Creek Invs., LLC v. United States, 82 Fed. Cl. at 667-671

(regulation cannot be applied retroactively); Sala v. United

States, 552 F. Supp. 2d 1167 (D. Colo. 2008) (regulation unlawful

and cannot be applied retroactively); Klamath Strategic Inv.

Fund, LLC v. United States, 440 F. Supp. 2d 608, 625-626 (E.D.

Tex. 2006) (retroactivity of regulation is ineffective).

Recognizing the uncertain state of the law and in the interests

of judicial economy, we shall not enter the fray at this time.

Instead, we shall assume that the regulation cannot be applied

retroactively and evaluate the economic substance of the MLD

transaction. See Klamath Strategic Inv. Fund, LLC v. United

States, 568 F.3d 537, 546 (5th Cir. 2009).

C. Economic Substance Doctrine

Respondent argues that, even if petitioner complied with the

literal terms of the Code as petitioner contends it did, the MLD

options lacked economic substance and the partnership was a sham

and should be disregarded.76 Petitioner concedes that Palm

76
Respondent also argues that we should disregard Palm
Canyon’s status as a partnership under the so-called partnership
antiabuse regulation, sec. 1.701-2, Income Tax Regs. Generally,
the antiabuse regulation permits the Commissioner to recast
partnership transactions that make inappropriate use of the
partnership tax rules. Petitioner contends that the antiabuse
regulation is invalid. Because we decide petitioner’s case on
other grounds, we need not decide whether the partnership
antiabuse regulation is valid or whether it applies to the
transaction in this case.
 -51-

Canyon entered the MLD transaction in part because of its tax

benefits. However, petitioner points out that the fact that

favorable tax consequences were considered in entering the MLD

transaction does not compel disallowing those consequences. See

Frank Lyon Co. v. United States, 435 U.S. 561, 580 (1978); see

also ASA Investerings Pship. v. Commissioner, 201 F.3d 505, 513

(D.C. Cir. 2000) (“It is uniformly recognized that taxpayers are

entitled to structure their transactions in such a way as to

minimize tax.”), affg. T.C. Memo. 1998-305. Petitioner maintains

that all entities and transactions had bona fide economic

substance and business purpose and must be recognized for tax

purposes. We must analyze the MLD transaction and decide whether

the transaction had economic substance.

Under the economic substance doctrine, a court may disregard

a transaction for Federal income tax purposes if it finds that

the taxpayer did not enter into the transaction for a valid

business purpose but rather sought to claim tax benefits not

contemplated by a reasonable application of the language and

purpose of the Code or its regulations. See, e.g., Horn v.

Commissioner, 968 F.2d 1229, 1236 (D.C. Cir. 1992), revg. Fox v.

Commissioner, T.C. Memo. 1988-570. The origins of the economic

substance doctrine can be traced back to the Supreme Court’s

decision in Gregory v. Helvering, 293 U.S. 465 (1935). In

Gregory, the Court held that a reorganization complying with
 -52-

formal statutory requirements should be disregarded for tax

purposes because the taxpayer’s creation and immediate

liquidation of a corporation was an impermissible attempt to

convert ordinary income into capital gain. Id. at 467. The

Court recognized the taxpayer’s right to minimize taxes through

legal means but stated that “the question for determination is

whether what was done, apart from the tax motive, was the thing

which the statute intended.” Id. at 469. The Supreme Court

concluded that “The whole undertaking, though conducted according

to the terms of [the statute], was in fact an elaborate and

devious form of conveyance masquerading as a corporate

reorganization, and nothing else.” Id. at 470.

In Frank Lyon Co. v. United States, supra at 583-584, the

Supreme Court upheld a sale-leaseback transaction over objections

that it lacked economic substance. In reaching its decision, the

Supreme Court explained the circumstances in which a transaction

should be respected for tax purposes and upheld the economic

substance of the transaction at issue:

where * * * there is a genuine multiple-party
transaction with economic substance which is compelled
or encouraged by business or regulatory realities, is
imbued with tax-independent considerations, and is not
shaped solely by tax-avoidance features that have
meaningless labels attached, the Government should
honor the allocation of rights and duties effectuated
by the parties. * * * [Id.]

The standard articulated in Frank Lyon Co. has formed the

basis for the current application of the economic substance
 -53-

doctrine. Many courts have interpreted the Frank Lyon Co.

language as creating an economic substance doctrine that examines

two areas or prongs: (1) Whether the transaction had economic

substance beyond tax benefits (objective prong), and (2) whether

the taxpayer has shown a nontax business purpose for entering the

disputed transaction (subjective prong). See, e.g., ACM Pship.

v. Commissioner, 157 F.3d 231, 247-248 (3d Cir. 1998), affg. in

part and revg. in part T.C. Memo. 1997-115; Bail Bonds by Marvin

Nelson, Inc. v. Commissioner, 820 F.2d 1543, 1549 (9th Cir.

1987), affg. T.C. Memo. 1986-23; Rice’s Toyota World, Inc. v.

Commissioner, 752 F.2d 89, 91-92 (4th Cir. 1985), affg. in part

and revg. in part 81 T.C. 184 (1983).

The Courts of Appeals are split as to the proper

articulation of the economic substance doctrine, particularly as

to the relative weights given to the objective and subjective

prongs in determining whether a transaction should be respected

for tax purposes. Some Courts of Appeals have applied an

analysis, often referred to as “disjunctive”, under which a

transaction is respected under the economic substance doctrine if

the court finds that the transaction has either a subjective

business purpose or objective economic substance. See Horn v.

Commissioner, supra at 1236; Rice’s Toyota World v. Commissioner,

supra at 91-92. Other Courts of Appeals have applied an

analysis, often referred to as “conjunctive”, where a transaction
 -54-

will be respected under the economic substance doctrine only if

the court finds that the transaction satisfies both the

subjective and objective prongs. See Dow Chem. Co. v. United

States, 435 F.3d 594, 599 (6th Cir. 2006). A third group of

Courts of Appeals has rejected the notion of a “rigid two step

analysis” and elected to apply an approach under which the

subjective and objective prongs are collapsed into a single

inquiry. See Sacks v. Commissioner, 69 F.3d 982, 988 (9th Cir.

1995), revg. T.C. Memo. 1992-596.

For the reasons discussed below, we believe the MLD

transaction satisfies neither the subjective prong nor the

objective prong of the economic substance doctrine. Because the

MLD transaction fails both prongs of the economic substance

doctrine, our conclusion regarding the economic substance of the

MLD transaction is the same regardless of which analysis or

approach is applied.

We conduct our analysis by examining the MLD transaction

under both the subjective and objective prongs of the economic

substance doctrine. In conducting our analysis, we are mindful

that respondent’s determinations that the MLD transaction had no

economic substance and that the partnership was a sham and should

be disregarded are presumed correct, and petitioner has the

burden of proving that respondent’s determinations are in error.
 -55-

1. Subjective Prong

To satisfy the subjective prong, petitioner must demonstrate

that Palm Canyon executed the MLD transaction for a business

purpose aside from tax benefits. See, e.g., Horn v.

Commissioner, supra at 1237. Petitioner argues that Palm

Canyon’s primary purpose for entering the MLD contracts was to

become familiar with foreign currency hedging opportunities. Mr.

Hamel testified that he wanted to pursue foreign investments that

would give the Hamel companies the ability to hedge against

fluctuations in foreign currencies because he was concerned about

the effect such fluctuations could have on potential contracts

between the Hamel companies and offshore vendors. Petitioner

contends that the Hamel companies anticipated a need for foreign

currency hedging if Mr. Hamel decided to expand the companies’

business overseas. The MLD transaction, petitioner argues, also

allowed the Hamel companies to evaluate the performance of Mr.

Brooks and to determine whether to pursue further trading

activitites with Mr. Brubaker. Additionally, petitioner asserts

that Palm Canyon entered into the MLD contracts to earn a real

economic profit and that Palm Canyon did earn a $6,600 profit on

the contracts.

A necessary element of the MLD transaction as carried out

was adding and then terminating CF Advisors’ status as a member

of Palm Canyon, the overall effect of which was to create AHI’s
 -56-

basis in Palm Canyon that did not correspond with the economic

reality of AHI’s investment. Petitioner argues that CF Advisors’

membership allowed Mr. Brooks to gain trading authority over Palm

Canyon’s account and served as an incentive for Mr. Brooks to

perform on behalf of Palm Canyon.

The reasons petitioner offered for executing the MLD

transaction are not credible. Petitioner did not establish a

nontax business purpose for the MLD transaction. Accordingly, we

hold that the MLD transaction fails the subjective prong of the

economic substance doctrine. We base our holding on the

following facts.

a. The Hamel Companies’ Lack of a Current or
Foreseeable Need To Hedge Foreign Currencies

Before considering the MLD strategy, the Hamel companies had

no interest in foreign currency trading, and there is no evidence

that any of the Hamel companies had any experience in foreign

currency investments.

At the time of the MLD transaction, the Hamel companies had

no particular need to hedge foreign currencies.77 An option

contract can provide a hedge only if there is an existing risk to

77
According to Mr. Bessembinder, the MLD contracts, as
digital options, were also not appropriate for managing or
hedging the foreign exchange risks that would typically arise
when doing business in foreign markets. Generally, digital
options would not be used as a hedge in normal international
business operations, such as foreign sales, foreign production,
importing, and exporting.
 -57-

be managed. Palm Canyon was not at risk on account of unexpected

movements in the Japanese yen per U.S. dollar exchange rate from

October to December 2001. None of the Hamel companies’

businesses had any contracts due in 2001 or 2002 that required

payments in any foreign currency. During 2001 Thighmaster had no

ownership interest, directly or indirectly, in any foreign entity

or bank account, and it paid no foreign taxes. Although Mr.

Hamel testified that he wanted to expand the Hamel companies’

foreign business operations, petitioner introduced no evidence,

aside from self-serving memoranda prepared on the eve of the MLD

transaction, of any definite plans to expand operations overseas,

and none of the evidence supports a finding that the Hamel

companies would need foreign currency hedging in the foreseeable

future. Moreover, such a need never materialized for any of the

Hamel companies before the termination of the Palm Canyon

partnership in 2001 and the cessation of foreign currency trading

altogether in 2003.

Furthermore, petitioner’s contention that Palm Canyon

entered into the MLD transaction to become familiar with foreign

currency investments is not credible. Mr. Hamel could have

become familiar with such investments by consulting with his

investment advisers. He did not need to pay Cantley & Sedacca

$325,000 and CF Advisors $20,000 to acquire such knowledge.

Similarly, we do not give any weight to Mr. Hamel’s supposed need
 -58-

to assess Mr. Brooks’ investment performance, considering Mr.

Brooks’ temporary and limited role in Palm Canyon was already

planned before the MLD transaction was even executed. Mr.

Brooks’ involvement only facilitated the claiming of the tax loss

and had nothing to do with actually investing in foreign currency

or options.

b. Lack of Investigation Into the Foreign
Currency Aspects of the MLD Contracts and the
Participating Parties

None of the parties principally responsible for executing

the MLD transaction conducted a serious independent investigation

of the foreign currency aspects of the MLD contracts or the MLD

transaction participants. Neither Mr. Hamel nor Mr. Lamb sought

to verify independently the pricing of the options or the

possible outcomes under the MLD contracts with any person or

entity independent of the MLD strategy. None of the relevant

parties consulted with any of the banks the Hamel companies had

previously used for foreign investment advice. Mr. Lamb’s and

Mr. Barish’s investigation of Cantley & Sedacca and Mr. Ivsan was

limited, consisting of a cursory review of Mr. Ivsan’s

background. The parties performed little due diligence on Mr.

Brooks78 and conducted no meaningful investigation of the role of

Pryor Cashman or Mr. Kushner in promoting the MLD transaction.

78
Mr. Lamb exchanged several emails with Mr. Brooks
regarding Mr. Brooks’ background, and Mr. Wells provided Mr.
Barish a report regarding his inquiries on Mr. Brooks.
 -59-

The primary focus of the pre-MLD transaction investigation

was to provide the window-dressing that would ensure that the tax

benefits had some prospect of being respected, that even if the

tax benefits were not respected no penalty would be imposed, and

that some of the people who would be involved in the MLD

transaction were who they purported to be. Mr. Lamb and Mr.

Barish reviewed the Bryan Cave opinion for its analysis of the

tax benefits. Both parties paid particularly close attention to

the discussion of the section 6662 penalty in the Bryan Cave

opinion and Pryor Cashman’s draft tax opinion. Mr. Lamb and Mr.

Barish met with Pryor Cashman to discuss the tax aspects of the

MLD transaction and Pryor Cashman’s preparation of the tax

opinion. The focus of the parties on the tax treatment of the

MLD transaction, while ignoring all other aspects of the foreign

currency investment, demonstrates that the real purpose of the

MLD transaction was tax avoidance.

c. Lack of Rational Economic Behavior in Pricing
the MLD Contracts

Respondent’s experts, Mr. Bessembinder and Mr. Murphy, both

concluded that the MLD options were overpriced and thus did not

reflect reasonable market prices or rational economic behavior.79

79
Petitioner did not present any expert testimony and did
not convince us on cross-examination that respondent’s experts
were not credible. Consequently, we accept the conclusions of
respondent’s experts and do not spend time summarizing the
factual bases of their opinions.
 -60-

Using the Black-Scholes pricing model,80 both experts found that

the value of Palm Canyon’s long MLD option was approximately $1.6

million, while the value of Palm Canyon’s short MLD option was

approximately $1.594 million. Both Palm Canyon and Société

Générale thus purportedly obligated themselves to pay premiums

that were approximately $3.4 million more than their respective

MLD option’s market price. Because the premium purportedly

payable for the long MLD option essentially equaled the amount of

ordinary loss the MLD transaction produced, Palm Canyon had an

incentive to inflate the long MLD option’s premium to generate a

greater loss. By similarly overstating the price of the short

MLD option, Palm Canyon achieved its desired loss while

mimimizing the net premium payment to Société Générale; that net

premium payment was the extent of Palm Canyon’s economic outlay

in executing the MLD transaction (aside from fees). Respondent’s

experts also determined that Palm Canyon overpaid by nearly

$30,000 with respect to the net option premium. Additionally,

both experts concluded that the $61,600 termination payment Palm

Canyon received was significantly less than the difference

80
The Black-Scholes option pricing model is the industry
standard for pricing foreign currency option trades. Under the
Black-Scholes model, the premium on a standard currency option is
determined by six factors, including the spot market exchange
rate at the time the option is valued, interest rates on each of
the two currencies, the time until the option expiration date,
the option strike price, and the volatility of the spot market
exchange rate.
 -61-

between the then market values of the MLD options, with Mr.

Murphy estimating $90,000 as a more appropriate amount.

Petitioner introduced no expert testimony on the economics

of the MLD transaction, and petitioner offers no explanation why

the long and short MLD options were overpriced or why Palm Canyon

received a termination payment below market value. Petitioner

argues only that, unbeknownst to Mr. Brooks or any other relevant

party, Société Générale overstated Palm Canyon’s net premium so

that it could pay a hidden $20,500 fee to Deutsche Banc Alex.

Brown. While we will not speculate about the financial

arrangements among Palm Canyon, Société Générale, and Deutsche

Banc Alex. Brown with respect to the MLD transaction in the

absence of credible evidence regarding the arrangement, we cannot

conclude on the record that Mr. Brooks and others associated with

Palm Canyon did not know about the Deutsche Banc Alex. Brown fee.

Mr. Brooks and Mr. Ivsan determined the desired premium payments

for the long and short MLD options in formulating the terms of

the MLD contracts. Mr. Brooks testified that, in pricing the

long and short MLD options, he provided Palm Canyon’s desired

premium payment to Société Générale, and Société Générale, in

response, issued a strike price that Mr. Brooks concluded was

reasonable under the Black-Scholes option pricing model. Because

Société Générale issued a strike price in response to information

provided by Mr. Brooks, the record does not support a conclusion
 -62-

that Société Générale secretly overstated Palm Canyon’s net

premium payment.

Palm Canyon’s overpayment of the net premium, coupled with

the inflation of the premiums themselves and Palm Canyon’s

willingness to accept a termination payment below the MLD

options’ then market value, reflects Palm Canyon’s disregard for

the economics of the MLD contracts and evidences the tax

motivations behind the MLD transaction. Palm Canyon’s pricing of

the MLD options was not reasonable under commercial practices in

the option trading industry and demonstrates Palm Canyon’s lack

of profit motive in executing the MLD contracts.

d. CF Advisors’ Membership in Palm Canyon
Solely To Facilitate the Tax Benefit
Contemplated by the MLD Transaction

CF Advisors became a member of Palm Canyon solely to exploit

the partnership tax rules. CF Advisors’ membership in Palm

Canyon caused Palm Canyon to become a partnership for tax

purposes, which allowed AHI to claim an inflated basis in its

Palm Canyon partnership interest. Mr. Brooks entered into such

an arrangement (as a partner or member), ostensibly as a foreign

currency investment adviser, in each of the 150 MLD transactions

that he carried out for his MLD strategy clients in 2001. In its

role as foreign currency trader for Palm Canyon, CF Advisors,

through Mr. Brooks, purportedly had discretion to make whatever

foreign currency trades he deemed would garner a profit.
 -63-

However, Mr. Brooks simply carried out the trades necessary to

create the tax benefit contemplated by the MLD strategy. The

terms of the MLD contracts Mr. Brooks entered into had been

predetermined to ensure the necessary ordinary loss would be

generated to offset the Hamels’ estimated 2001 taxable income.

The other foreign currency trades that Mr. Brooks made in 2001

for Palm Canyon were significantly smaller in amount and, we

think, were an obvious attempt to legitimize his status as a

foreign currency trader for Palm Canyon.81

Shortly after CF Advisors joined Palm Canyon, AHI purchased

CF Advisors’ partnership interest to trigger liquidation of the

Palm Canyon partnership and deemed distribution of its assets

before the close of Thighmaster’s 2001 tax year. The liquidation

provided the occasion for the transfer of AHI’s inflated basis in

its Palm Canyon partnership interest to the Canadian dollars

position and allowed AHI to claim an ordinary loss on its

subsequent disposition.82

Petitioner argues that Palm Canyon was a special purpose

venture that was formed to conduct a venture of limited duration.

Petitioner suggests that the Hamel companies wanted experience in

81
Our conclusion is reinforced by the fact that Mr. Brooks
placed similar minor foreign currency trades for each of his 150
MLD strategy clients.
82
Mr. Brooks terminated his partnership or membership
interest before Dec. 31, 2001, in each of the 150 MLD
transactions in which he participated.
 -64-

foreign currency trading, and Mr. Lamb believed that the MLD

contracts satisfied this purpose. Petitioner claims that the

principal initial activity was a discrete transaction that would

last only 60 days, and Palm Canyon as an entity was designed

primarily for that initial venture.

Petitioner also contends that Palm Canyon was validly

formed, had at least two legitimate business purposes, and had

substantial economic effect. Petitioner claims that limited

liability was the first business reason for establishing Palm

Canyon as an entity. Petitioner also argues that Mr. Hamel’s

intention was that the foreign currency trading activities were

part of the Hamel companies. Petitioner states that the historic

model for the Hamel companies was that every separate activity

was placed within its own qualified subchapter S subsidiary

corporation, but because a subsidiary could not have an unrelated

party as a shareholder, Palm Canyon was needed to allow

Mr. Brooks’ ownership. Petitioner suggests this was the second

reason for creating Palm Canyon.

Although the goal of achieving limited liability through

establishing a limited liability company might have been a valid

business purpose for establishing Palm Canyon, we question the

purpose of adding and then terminating CF Advisors as a partner.

Although petitioner and Mr. Brooks claim that CF Advisors became

a member in Palm Canyon to allow Mr. Brooks to gain trading
 -65-

authority over Palm Canyon’s Deutsche Banc Alex. Brown account,

petitioner did not introduce any credible evidence to explain why

CF Advisors needed to become a member in Palm Canyon to gain such

authority. Before CF Advisors’ membership in Palm Canyon, Mr.

Hamel granted Mr. Brooks trading authority with respect to Palm

Canyon’s Deutsche Banc Alex. Brown account, and pursuant to this

authority, Mr. Brooks executed the MLD contracts before the Palm

Canyon partnership was created.

Petitioner also suggests that CF Advisors became a member of

Palm Canyon to encourage Mr. Brooks to perform well on Palm

Canyon’s behalf and that Mr. Brooks’ motive in joining the

partnership was to make money. That explanation, however, cannot

be reconciled with the prearranged buyout of CF Advisors; Cantley

& Sedacca prepared documents pertaining to CF Advisors’

termination from Palm Canyon at the outset of the MLD transaction

(which Mr. Hamel signed on or about October 9, 2001), before CF

Advisors even became a member in Palm Canyon. The record

contains Mr. Lamb’s notes of his September 26, 2001, meeting with

Mr. Kushner, in which Mr. Ivsan and Mr. Barish participated by

telephone. In paragraph 2 Mr. Lamb wrote:

2. Why is Clarion [Capital] bought out? Entirely up
to the client-–reason for termination--not comfortable
with derivatives area as investment strategy. Also
clients that have not made money not wanting to pay
quarterly management fees. Client can stay on. Can
keep Clarion as a partner in LLC. Termination of
partnership causes outside basis to be attached to
assets inside partnership. Transfer of partnership
 -66-

interest to a third party could also accomplish the
same thing. Termination of the partnership or
transfer of partnership interest is the only way to
get the loss needed.

At trial Mr. Lamb also testified that Mr. Brooks had to be

terminated as a member of Palm Canyon to ensure “that the tax

transaction would work correctly.”

The advance preparation of CF Advisors buyout documents as

part of the same packet as other transaction documents and

advance discussions about potential business reasons for buying

out CF Advisors’ interest in Palm Canyon show that all steps in

the MLD transaction were prearranged and that the parties had no

legitimate intention of pursuing foreign currency trading and

were concerned exclusively with producing the contemplated tax

benefit. We also find significant the fact that CF Advisors sold

its Palm Canyon interest without any negotiations; no

negotiations took place in any of Mr. Brooks’ 150 similar

transactions.

We conclude that the only purpose behind CF Advisors’

participation in the MLD transaction was to further a carefully

orchestrated and prearranged plan to manufacture a $5 million

ordinary loss. CF Advisors’ involvement as a foreign currency

trader was mere window dressing for its role in assuring the

recognition of this tax benefit.
 -67-

e. The MLD Strategy Was a Tax Shelter To Offset
Mr. Hamel’s Taxable Income

Mr. Brooks, Mr. Brubaker, and Mr. Ivsan developed the MLD

strategy as a tax avoidance scheme and not to create an

opportunity to hedge foreign currencies or achieve a pretax

profit. Mr. Brooks knew the MLD strategy was a “tax advantage”

or “tax motivated” transaction. Cantley & Sedacca marketed the

MLD strategy as a tax shelter to accountants and financial

advisers nationwide and sold it to approximately 150 clients.

Cantley & Sedacca, through Mr. Ivsan, presented the MLD

strategy to Mr. Lamb to reduce the Hamels’ 2001 Federal income

tax liability.83 For the 2000 tax year the Hamels reported

approximately $8.6 million in taxable income and paid nearly $3.4

million in Federal income tax, and estimates in June 2001 showed

that the Hamels expected taxable income between $7 and $9 million

in 2001. Cantley & Sedacca designed the MLD transaction to

reduce or eliminate the Hamels’ projected income by producing

(through Palm Canyon, AHI, and Thighmaster) a $5 million ordinary

loss. Because of the MLD transaction, the Hamels reduced their

2001 taxable income to zero and avoided approximately $1.5

million in 2001 Federal income tax. We find that Mr. Hamel

executed the MLD transaction for the sole purpose of sheltering

83
Mr. Lamb had been looking for a means to reduce the
Hamels’ tax liability as early as August 2001, when he met with
the Skyline Group to discuss “high end tax products for big
losses”.
 -68-

his income from tax, and we reject any testimony to the contrary

as not credible. We conclude that Palm Canyon entered into the

MLD transaction solely to reduce the Hamels’ 2001 Federal income

tax liability.

2. Objective Prong

To satisfy the objective prong, petitioner must demonstrate

that the MLD transaction had a reasonable prospect of earning a

profit. See, e.g., Horn v. Commissioner, 968 F.2d at 1237.

Petitioner contends that Palm Canyon had a substantial

opportunity to earn a profit on the MLD options. As discussed

above, Palm Canyon had three possible outcomes following the

expiration of the MLD contracts: (1) If both MLD options were

out of the money, Palm Canyon would lose its $55,000 net

investment; (2) if both MLD options were in the money, Palm

Canyon would earn a maximum net profit of $33,000; or (3) if the

long MLD option were in the money and the short MLD option were

out of the money, Palm Canyon would hit the sweet spot and net

$7,945,000. According to petitioner, Palm Canyon had a

significant opportunity to earn a $33,000 profit if both MLD

contracts were in the money and had a chance of receiving a high

profit from hitting the sweet spot. Petitioner claims that the

MLD contracts generated an actual economic profit of $6,600,

which equaled a 12-percent return on a 60-day investment,

and that Palm Canyon’s subsequent 2001 foreign currency trading
 -69-

activities generated an additional economic profit of $2,076.

Despite petitioner’s claims that Palm Canyon could have earned a

significant profit in two of the three possible outcomes, we find

that taking transaction fees into account, Palm Canyon did not

have a reasonable expectation of earning a profit on the MLD

contracts. Accordingly, we hold that the MLD transaction fails

the objective prong of the economic substance doctrine test. We

base our holding on the following factors.

a. Palm Canyon’s Lack of a Realistic Chance of
Hitting the Sweet Spot

Palm Canyon’s chances of hitting the sweet spot were remote.

Mr. Lamb acknowledged that the likelihood of hitting the sweet

spot was small. Mr. Brooks stated that there was only a 1.3-

percent chance of Palm Canyon’s hitting the sweet spot, and none

of his 150 clients involved in an MLD strategy transaction

received a sweet spot payout.84 Respondent’s experts concluded,

using the Black-Scholes pricing model, that the chance of hitting

the sweet spot was between 0.11 and 0.13 percent.

84
Mr. Brooks testified that the sweet spot was not something
he considered but that it would have been “wonderful” if the MLD
contracts had hit the sweet spot. Mr. Brooks also stated that he
terminated the Palm Canyon MLD contracts before maturity, despite
the Japanese yen per U.S. dollar exchange rate’s relative
proximity to the sweet spot, because he feared the market’s
volatility and wanted to lock in a profit. We reject Mr. Brooks’
testimony regarding his reason for terminating the MLD contracts
before maturity as not credible.
 -70-

From a practical standpoint, Palm Canyon’s chances of

hitting the sweet spot were zero under the terms of the MLD

contracts governing the determination of the spot market exchange

rate. The market practices at the time would have allowed

Société Générale, as the calculation agent and determinant of the

spot market exchange rate,85 to assure that Palm Canyon would not

hit the sweet spot.86 As explained by respondent’s experts, if

Société Générale had followed industry market practices in

determining the spot market exchange rate, Société Générale would

have asked three or four other banks or brokers to quote a “bid”

price at which they would buy a currency and an “ask” price at

which they would sell a currency. In response Société Générale

would have received a range of prices; generally, the bid and ask

spread was 3 to 5 pips. Société Générale could then have chosen

any price within that range.87 Because the strike prices in the

MLD contracts were only 2 pips apart,88 Société Générale could

85
At the time of the MLD contracts it was common industry
practice for the bank issuing the option to also serve as the
calculation agent.
86
We came to a similar conclusion on analogous facts in a
deficiency case, New Phoenix Sunrise Corp. & Subs. v.
Commissioner, 132 T.C. ___, ___ (2009) (slip op. at 27-29)
(relying on the testimony of the same expert).
87
Today, an independent agency sets the fixing rate for each
currency at 10 a.m. on the basis of an electronic average of
prices.
88
In order for Palm Canyon to hit the sweet spot under the
(continued...)
 -71-

assure that Palm Canyon would not hit the sweet spot by choosing

a price outside the specified range. According to respondent’s

experts, nothing prevented Société Générale from selecting an

exchange rate outside the sweet spot. Both experts concluded

that because of Société Générale’s incentive to avoid payment on

the long MLD option and its flexibility in selecting the spot

market exchange rate, it was impossible for Palm Canyon to hit

the sweet spot. Had Palm Canyon had a legitimate profit motive

in pursuing the MLD transaction, it could have attempted to avoid

this disadvantage by trying to negotiate for the designation of

an independent third party as the calculation agent or for a

provision to determine the spot market exchange rate in an

objective manner.

b. Nullification of Any Potential Profit by Palm
Canyon’s MLD Transaction Fees

Disregarding the potential for the $7,945,000 sweet spot

payout, petitioner maintains that the MLD options had an

opportunity of producing a $33,000 profit if both options were in

the money. However, if we account for the fees paid by Palm

Canyon in executing the MLD transaction, $325,000 to Cantley &

88
(...continued)
MLD contracts, the spot market exchange rate would have to be
equal to or greater than 124.65 but less than 124.67, a 2-pip
spread. The 2-pip spread in the MLD contracts was unusually
close. Respondent’s expert Mr. Murphy testified that he had
never priced an option 2 pips apart in his 20-plus years of
trading foreign currencies. In all of the 150 MLD transactions
Mr. Brooks participated in, the sweet spot was 2 pips apart.
 -72-

Sedacca and $20,000 to CF Advisors, Palm Canyon could not have

earned a profit.

Petitioner argues that the fees paid to Cantley & Sedacca

and CF Advisors cannot be charged as transaction costs in

determining the profitability of the MLD transaction. Petitioner

asserts that the $20,000 paid to CF Advisors was a flat annual

fee that covered not only the MLD contracts but also Mr. Brooks’

2001 foreign currency trading. Additionally, petitioner contends

that the $325,000 fee paid to Cantley & Sedacca must be

considered independent of any analysis pertaining to the

potential profitability of the MLD contracts because Palm Canyon

paid the fee to determine the appropriate tax treatment of the

transaction. Because Palm Canyon planned to claim a sizable tax

benefit as a result of the MLD transaction, petitioner asserts it

would have been irresponsible to claim such a large tax benefit

without assuring the entitlement to the benefit. Petitioner

argues that respondent cannot use the costs incurred to verify

the entitlement to the tax benefit to establish the

unprofitability of the MLD contracts.

Petitioner’s arguments are unavailing. The fees Palm Canyon

paid to Cantley & Sedacca and CF Advisors were for executing the

MLD transaction. We cannot ignore these fees in determining the

profitability of the MLD transaction.
 -73-

Palm Canyon’s $20,000 payment to CF Advisors was not a flat,

annual foreign currency adviser fee. The $20,000 payment went to

Mr. Brooks for his involvement in the MLD transaction, including

his execution of the MLD contracts, his role in CF Advisors’

membership and termination in Palm Canyon, and his attempt to

legitimize Palm Canyon’s investment activities through several

smaller foreign currency trades.

Similarly, the $325,000 Palm Canyon paid to Cantley &

Sedacca was for Cantley & Sedacca’s extensive role in executing

the MLD transaction. While petitioner attempts to create a

distinction between economic transaction fees and fees paid to

verify the tax treatment of an item, the record establishes that

Palm Canyon did not pay Cantley & Sedacca just to verify the tax

aspects of the MLD transaction. Cantley & Sedacca introduced the

MLD strategy to Mr. Hamel, structured the MLD transaction, and

carried out each of the steps necessary to achieve the desired

tax benefit. The extent of services provided beyond the

verification of tax benefits is evidenced by Cantley & Sedacca’s

outsourcing the task of drafting a tax opinion to Pryor Cashman,

to which it paid only $50,000 of its $325,000 fee.

Moreover, we reject petitioner’s argument that the costs

incurred to verify the tax aspects of the MLD transaction are not

attributable to the MLD transaction when examining its

profitability. Petitioner offers no authority to support this
 -74-

argument. Courts examining the profitability of a transaction in

an economic substance analysis generally consider the fees paid

to promoters, facilitators, and tax advisers associated with the

questioned transaction. See, e.g., Jade Trading, LLC v. United

States, 80 Fed. Cl. at 49-50. Furthermore, if petitioner’s

argument accomplishes anything, it reinforces Palm Canyon’s tax

avoidance purpose for entering the MLD transaction, because no

rational investor would enter a transaction, absent the tax

motivation, if the cost of verifying the tax aspects of the

transaction grossly exceeded the expected economic profit.

We hold that the $20,000 paid to CF Advisors and the

$325,000 paid to Cantley & Sedacca must be included in our

analysis of the profitability of the MLD transaction.

Accordingly, we conclude that Palm Canyon did not have a

reasonable opportunity to earn a pretax profit on the MLD

transaction because even if both options were in the money and

Palm Canyon earned a $33,000 profit, Palm Canyon would still have

lost approximately $312,000 on the transaction after taking into

account the transaction fees.

D. Conclusion

Petitioner has failed to prove that the MLD transaction,

including the steps of creating the Palm Canyon partnership and

terminating it approximately 2 months later, satisfied either the

subjective prong or the objective prong of the economic substance
 -75-

doctrine. Petitioner has not introduced credible evidence to

establish that Palm Canyon had a legitimate nontax business

purpose for entering into the MLD transaction, and the

transaction did not have a reasonable prospect of achieving a

pretax profit. A review of the MLD transaction reveals a

prearranged set of transactions that were not imbued with any

meaningful economic substance independent of tax benefits. See

Horn v. Commissioner, 968 F.2d at 1236; see also Sacks v.

Commissioner, 69 F.3d at 988. Inasmuch as the MLD transactions

satisfied neither the subjective nor the objective prong of the

economic substance doctrine, we conclude that the MLD contracts

and creation and termination of the Palm Canyon partnership did

not constitute genuine multiparty transactions with economic

substance that were compelled or encouraged by business or

regulatory realities, that were imbued with tax-independent

considerations, and that were not shaped by tax avoidance

features with meaningless labels. Accordingly, we sustain

respondent’s adjustments to Palm Canyon’s return.

V. Section 6662 Accuracy-Related Penalty

In the FPAA respondent determined that a 40-percent gross

valuation misstatement penalty under section 6662(a), (b)(3),

(e), and (h) applies. On brief respondent argues that AHI’s

purported $5 million contribution of the long MLD option should

have been either zero or alternatively, $55,000. Respondent also
 -76-

suggests that AHI overstated its basis in its partnership

interest and the basis in the Canadian dollars position

distributed in the purported liquidation of Palm Canyon by more

than 400 percent of the correct amount.

In the alternative, respondent determined a 20-percent

accuracy-related penalty under section 6662(a) on the portion of

any underpayment resulting from his adjustments to items on Palm

Canyon’s return attributable to negligence or disregard of rules

and regulations or resulting in a substantial understatement of

income tax.89 Sec. 6662(a) and (b)(1) and (2).

A. Preliminary Matters

1. Jurisdiction

The applicability of any penalty, addition to tax, or

additional amount that relates to an adjustment to a partnership

item must be determined at the partnership level. Sec. 6226(f);

sec. 301.6221-1(c), Proced. & Admin. Regs.; see also New

Millennium Trading, L.L.C. v. Commissioner, 131 T.C. ___ (2008)

(upholding the validity of section 301.6221-1T(c) and (d),

Temporary Proced. & Admin. Regs., 64 Fed. Reg. 3838 (Jan. 26,

1999)); sec. 301.6221-1T(c), Temporary Proced. & Admin. Regs.,

89
The Commissioner may not stack or compound alternative
components of the sec. 6662 penalty to determine a penalty
greater than the maximum penalty of 20 percent on any given
portion of an underpayment, or 40 percent if such portion is
attributable to a gross valuation misstatement. Sec. 1.6662-
2(c), Income Tax Regs.
 -77-

supra (providing that any penalty, addition to tax, or additional

amount that relates to an adjustment of partnership item, is

determined at the partnership level). Partnership-level

determinations include all the legal and factual determinations

that form the basis of the determination of any penalty, addition

to tax, or additional amount. Sec. 301.6221-1(c), Proced. &

Admin. Regs.

Partner-level defenses to any penalty, addition to tax, or

additional amount that relates to an adjustment to a partnership

item may not be asserted in the partnership-level proceeding.

Sec. 301.6221-1(c) and (d), Proced. & Admin. Regs.; sec.

301.6221-1T(c) and (d), Temporary Proced. & Admin. Regs., supra;

see also New Millennium Trading, L.L.C. v. Commissioner, supra at

___ (slip op. at 19-23). Individual partners may raise partner-

level defenses through separate refund actions following

assessment and payment of the penalty. Sec. 301.6221-1(c) and

(d), Proced. & Admin. Regs. Partner-level defenses are limited

to those that are personal to the partner or depend on the

partner’s separate return and cannot be determined at the

partnership level. Id. For example, a partner may raise a

personal reasonable cause defense under section 6664(c)(1). Id.

All other defenses are partnership-level defenses. Defenses of

AHI as Palm Canyon’s managing member and TMP are partnership-

level defenses. See, e.g., Whitehouse Hotel Ltd. Pship. v.
 -78-

Commissioner, 131 T.C. 112, 173 (2008); Santa Monica Pictures,

LLC v. Commissioner, T.C. Memo. 2005-104.

2. Burden of Production

Under section 7491(c), the Commissioner has the burden of

production in any court proceeding with respect to the liability

of any individual for any penalty, addition to tax, or additional

amount imposed by the Code. However, section 7491(c) does not

shift the burden of proof, which remains on the taxpayer. Higbee

v. Commissioner, 116 T.C. 438, 446-447 (2001).

Petitioner incorrectly implies that the burden of proof

falls on respondent with respect to the section 6662 accuracy-

related penalty. Petitioner does not, however, provide any

support for its position. It is well established that a taxpayer

has the burden of proving that the Commissioner’s determinations

regarding the section 6662 accuracy-related penalty are

incorrect. Id. What is not so clear, however, is whether

section 7491(c) imposes the initial burden of production

regarding the section 6662 accuracy-related penalty on the

Commissioner when the taxpayer is an entity that has petitioned

this Court under section 6226. By its terms, section 7491(c)

applies only to the liability of “any individual” for

penalties.90 Thus, in this proceeding section 7491(c) is

90
In contrast, sec. 7491(a), which provides the general rule
for shifting the burden of proof to the Commissioner in certain
(continued...)
 -79-

arguably inapplicable because petitioner is not an individual.

See Santa Monica Pictures, LLC v. Commissioner, supra; Long Term

Capital Holdings v. United States, 330 F. Supp. 2d 122 (D. Conn.

2004), affd. 150 Fed. Appx. 40 (2d Cir. 2005).

We need not resolve this uncertainty; even if we assume that

respondent has the initial burden of production under section

7491(c) with respect to the section 6662 accuracy-related

penalty, we are satisfied that respondent has carried any such

burden with respect to the appropriateness of applying the

accuracy-related penalty. Consequently, petitioner must come

forward with evidence sufficient to persuade us that respondent's

penalty determinations are incorrect. Higbee v. Commissioner,

supra at 447.

Respondent has made several alternative determinations with

respect to the accuracy-related penalty. We address each of them

below.

B. Gross Valuation Misstatement

Section 6662(a) and (b)(3) imposes a 20-percent

accuracy-related penalty on the portion of an underpayment

attributable to any substantial valuation misstatement. A

substantial valuation misstatement exists if the value of any

property, or the adjusted basis of any property, claimed by the

90
(...continued)
circumstances, applies in ascertaining the liability of a
“taxpayer”.
 -80-

taxpayer is 200 percent or more of the amount determined to be

the correct amount of such valuation or adjusted basis. Sec.

6662(e)(1). The penalty imposed by section 6662(a) increases

from 20 to 40 percent if the underpayment is attributable to a

gross valuation misstatement. Sec. 6662(h). A gross valuation

misstatement occurs if the value of any property, or the adjusted

basis of any property, claimed by the taxpayer is 400 percent or

more of the amount determined to be the correct amount of such

valuation or adjusted basis. Sec. 6662(h)(2)(A).

We have concluded that the MLD transaction, including the

MLD contracts and the creation and termination of the Palm Canyon

partnership, lacked economic substance. Our conclusion, as it

pertains to the admission of CF Advisors as a Palm Canyon member

and the purchase of its partnership interest, which in turn

resulted in creation and termination of the Palm Canyon

partnership, effectively disregards the Palm Canyon partnership

for Federal income tax purposes. In Petaluma FX Partners, LLC v.

Commissioner, 131 T.C. at 100, we held that if a partnership is

disregarded for tax purposes, the correct outside

bases of the purported partners is zero.91 In Petaluma we also

91
Although we have held that generally the basis in a
partner’s partnership interest is not a partnership item that
must be determined at a partnership-level proceeding, see
Domulewicz v. Commissioner, 129 T.C. 11, 20-21 (2007), affd. and
remanded on other grounds sub nom. Desmet v. Commissioner, 581
F.3d 297 (6th Cir. 2009), we have also held that if a partnership
(continued...)
 -81-

held that if a partnership is disregarded for tax purposes, the

gross valuation misstatement penalty applies.92 Id. at 105.

Petitioner argues that the gross valuation misstatement

penalty does not apply because the tax deficiency resulting from

respondent’s adjustments is attributable to the lack of economic

substance of the MLD contracts and not to a valuation

misstatement. In support of its argument, petitioner primarily

91
(...continued)
is disregarded for Federal income tax purposes, the Court has
jurisdiction in a partnership-level proceeding to determine that
there can be no outside bases in such partnership, see Petaluma
FX Partners, LLC v. Commissioner, 131 T.C. 84, 100 (2008).
92
The majority of the Courts of Appeals that have ruled on
the application of the valuation misstatement penalty in the
context of a disregarded transaction (under both sec. 6662 and
its predecessor statute, sec. 6659) follows a similar approach.
See, e.g., Merino v. Commissioner, 196 F.3d 147, 155 (3d Cir.
1999) (“whenever a taxpayer knowingly invests in a tax avoidance
entity which the taxpayer should know has no economic substance,
the valuation overstatement penalty is applied as a matter of
course”), affg. T.C. Memo. 1997-385; Zfass v. Commissioner, 118
F.3d 184, 191 (4th Cir. 1997) (the valuation overstatement
penalty applied because the value overstatement was a primary
reason for the disallowance of the claimed tax benefits), affg.
T.C. Memo. 1996-167; Illes v. Commissioner, 982 F.2d 163, 167
(6th Cir. 1992) (the entire artifice of the tax shelter at issue
was constructed on the foundation of the overvaluation of its
assets), affg. T.C. Memo. 1991-449; Gilman v. Commissioner, 933
F.2d 143, 151 (2d Cir. 1991) (“The lack of economic substance was
due in part to the overvaluation, and thus the underpayment was
attributable to the valuation overstatement”), affg. T.C. Memo.
1989-684 as supplemented by T.C. Memo. 1990-205; Massengill v.
Commissioner, 876 F.2d 616, 619-620 (8th Cir. 1989) (“When an
underpayment stems from disallowed depreciation deductions or
investment credit due to lack of economic substance, the
deficiency is attributable to overstatement of value”), affg.
T.C. Memo. 1988-427; see also Santa Monica Pictures, LLC v.
Commissioner, T.C. Memo. 2005-104; Jade Trading, LLC v. United
States, 80 Fed. Cl. 11, 54 (2007).
 -82-

relies on Gainer v. Commissioner, 893 F.2d 225, 228 (9th Cir.

1990), affg. T.C. Memo. 1988-416. In Gainer, the tax deficiency

at issue resulted from the taxpayer’s failure to place an asset

in service during the relevant tax year and not from the

overvaluation of the property itself. Id. Because the

Commissioner disallowed the taxpayer’s claimed tax benefits on

grounds independent from any valuation overstatement, the Court

of Appeals for the Ninth Circuit concluded that the resulting

underpayment of tax was not attributable to a valuation

misstatement. Id. at 228-229. Petitioner argues that AHI’s

overstated basis in its Palm Canyon partnership interest does not

constitute a valuation misstatement because it was not

attributable to the valuation of any asset or position.

The facts in Gainer v. Commissioner, supra, are

distinguishable from the present set of facts. In Gainer, the

court disallowed the claimed tax benefits on grounds independent

from any alleged valuation misstatement. In contrast, AHI’s

claimed inflated basis in its Palm Canyon partnership interest

directly contributed to our decision to disregard the MLD

transaction on economic substance grounds. Achieving an inflated

basis in AHI’s Palm Canyon partnership interest was the primary

objective of the tax avoidance scheme that Mr. Hamel pursued.

The substantial tax loss on the disposition of the Canadian

dollars position depended directly on AHI’s inflated basis in its
 -83-

Palm Canyon partnership interest. The $5 million overstatement

of basis claimed by AHI represented the predetermined amount Mr.

Hamel needed to negate his 2001 Federal income tax liability.

Accordingly, the underpayment resulting from our decision to

disregard the MLD transaction as a whole is directly attributable

to the overstatement of AHI’s adjusted basis in its Palm Canyon

partnership interest.

Petitioner also cites Klamath Strategic Inv. Fund, LLC v.

United States, 472 F. Supp. 2d 885 (E.D. Tex. 2007), affd. in

part, vacated in part and remanded 568 F.3d 537 (5th Cir. 2009),

in which the U.S. District Court for the Eastern District of

Texas held that the valuation misstatement penalty does not apply

when a transaction is disregarded for lack of economic substance,

finding that the resulting underpayment of tax is attributable to

the disregard of the transaction and not to a valuation

misstatement. The District Court cited Heasley v. Commissioner,

902 F.2d 380, 383 (5th Cir. 1990), revg. T.C. Memo. 1988-408, as

controlling. See Klamath Strategic Inv. Fund, LLC v. United

States, 472 F. Supp. 2d at 900. In Heasley v. Commissioner,

supra at 383, another case on which petitioner attempts to rely,

the Court of Appeals for the Fifth Circuit indicated that the

Commissioner can impose a valuation misstatement penalty only

where the underpayment is attributable to a valuation

overstatement and not where the deficiency is attributable to an
 -84-

improper deduction or credit. In Heasley, the Court of Appeals

for the Fifth Circuit noted that “Whenever the I.R.S. totally

disallows a deduction or credit, the I.R.S. may not penalize the

taxpayer for a valuation overstatement included in that deduction

or credit.” Id.; see also Keller v. Commissioner, 556 F.3d 1056,

1060-1061 (9th Cir. 2009), affg. in part and revg. in part T.C.

Memo. 2006-131.

We believe that we are not constrained by the precedents of

the Courts of Appeals for the Ninth or Fifth Circuit for the

following reasons. Under Golsen v. Commissioner, 54 T.C. 742,

757 (1970), affd. 445 F.2d 985 (10th Cir. 1971), we follow any

decisions of the U.S. Court of Appeals to which appeal lies that

are squarely on point. Section 7482(b)(1)(E) provides that in

the case of a petition filed under section 6226, a decision by

this Court may be reviewed by the U.S. Court of Appeals for the

circuit in which the partnership has its principal place of

business. Appellate venue under section 7482 is determined as of

the time the petition seeking redetermination of tax liability

was filed with the Court. Sec. 7482(b)(1) (flush language). If

for any reason no subparagraph of section 7482(b)(1) applies,

then the decision may be reviewed by the Court of Appeals for the

District of Columbia Circuit. Id. The Secretary and the

taxpayer may also elect to stipulate in writing the U.S. Court of

Appeals to which appeal lies. Sec. 7482(b)(2).
 -85-

Although both parties stated in their opening briefs that

this case is appealable to the Court of Appeals for the Ninth

Circuit, respondent has reversed course and argues in his reply

brief that venue for an appeal is the Court of Appeals for the

District of Columbia Circuit. We agree that venue for an appeal

is the Court of Appeals for the District of Columbia Circuit.

Palm Canyon’s partnership status was terminated for Federal tax

purposes on December 18, 2001, when AHI purchased CF Advisors’

partnership interest and Palm Canyon reverted to a single-member

limited liability company. Palm Canyon’s 2001 Form 1065 is

clearly marked as a final return. The parties also stipulated

that “Palm Canyon’s status as a limited liability company under

the laws of the State of Delaware was cancelled on June 1, 2005.”

Accordingly, we conclude that the Palm Canyon partnership did not

have a principal place of business when the petition was filed.

The Court of Appeals for the District of Columbia Circuit

has not yet considered the issue of whether the valuation

misstatement penalty applies to the underpayments attributable to

overstated basis in property where the transaction is a sham or

lacks economic substance. Accordingly, we may give effect to our

own views on the issue. See Golsen v. Commissioner, supra at

757. As discussed above, we have held that when a partnership is

disregarded for tax purposes, the gross valuation misstatement

penalty applies. Petaluma FX Partners, LLC v. Commissioner, 131
 -86-

T.C. at 105. Our holding is consistent with views of the

majority of the Courts of Appeals that have addressed whether the

valuation misstatement penalty applies to disregarded

transactions. See cases cited supra note 92.

We sustain the 40-percent gross valuation misstatment

penalty under section 6662(h).

C. Negligence

Section 6662(a) and (b)(1) imposes an accuracy-related

penalty of 20 percent on any portion of an underpayment of tax

attributable to negligence or disregard of rules or regulations.

For purposes of section 6662, the term “negligence” includes any

failure to make a reasonable attempt to comply with Code

provisions or to exercise ordinary and reasonable care in

preparing a tax return. Sec. 6662(c); sec. 1.6662-3(b)(1),

Income Tax Regs. Rules or regulations include the provisions of

the Code, temporary or final regulations issued under the Code,

and revenue rulings or notices issued by the IRS. Sec.

1.6662-3(b)(2), Income Tax Regs. Negligence is determined by

testing a taxpayer’s conduct against that of a reasonable,

prudent person. See Zmuda v. Commissioner, 731 F.2d 1417, 1422

(9th Cir. 1984), affg. 79 T.C. 714 (1982). Negligence is

strongly indicated where a taxpayer fails to make a reasonable

attempt to ascertain the correctness of a deduction, credit, or

exclusion on a return which would seem to a reasonable and
 -87-

prudent person to be “too good to be true” under the

circumstances. Sec. 1.6662-3(b)(1)(ii), Income Tax Regs. A

return position that has a reasonable basis is not attributable

to negligence. Sec. 1.6662-3(b)(1), Income Tax Regs. A

reasonable basis connotes significantly more than not being

frivolous or patently improper. Sec. 1.6662-3(b)(3), Income Tax

Regs. The reasonable basis standard is not satisfied by a return

position that is merely arguable or colorable. Id.

Petitioner argues that because the relevant inquiry is

whether AHI, as Palm Canyon’s managing member and TMP, was

negligent in executing the MLD transaction, we must focus solely

on the conduct of Mr. Hamel, the sole owner of AHI (through

Thighmaster) at all relevant times. Petitioner asks that we

exclude Mr. Lamb from our negligence analysis because he was not

an AHI officer until after the MLD transaction occurred and he

had no financial interest or legal authority over Palm Canyon or

AHI at that time. According to petitioner, Mr. Hamel reasonably

relied on several experts, including Mr. Lamb, Mr. Brooks, Mr.

Barish, and Pryor Cashman in his decision to enter the MLD

transaction. Petitioner argues that Mr. Hamel relied on Mr. Lamb

to investigate the MLD transaction, assess the credibility of Mr.

Brooks, discuss the Pryor Cashman opinion with Mr. Kushner, and

work with Mr. Kipp, Palm Canyon’s return preparer. Petitioner

also argues that Mr. Hamel relied on Mr. Brooks with respect to
 -88-

the investment decisions and technical aspects of the MLD

transaction and that Mr. Hamel depended on Mr. Barish to perform

due diligence with respect to the MLD transaction and Pryor

Cashman opinion. Lastly, petitioner argues that Mr. Hamel relied

on the Pryor Cashman opinion for the tax treatment of the MLD

transaction. Petitioner concludes that because the MLD

transaction involved complicated issues and ample credible legal

authority existed for the position Palm Canyon took on its

return, Mr. Hamel acted reasonably and in a prudent manner in

relying on their advice.

We do not agree with petitioner’s attempt to exclude Mr.

Lamb from the ambit of our analysis of the negligence penalty.

While we agree that we must examine the conduct of AHI because it

was the managing member and TMP of Palm Canyon,93 we are not

restricted to examining the behavior of Mr. Hamel. Mr. Lamb

served as a director and held the offices of treasurer/CFO and

secretary of AHI. While Mr. Lamb did not hold a formal position

with AHI until after the MLD transaction, he began serving as a

93
The applicability of the negligence penalty depends on the
conduct of the partnership’s partners. See Jade Trading, LLC v.
Commissioner, 80 Fed. Cl. at 55. While CF Advisors was also a
member in Palm Canyon in 2001, we do not examine the behavior of
CF Advisors’ sole member, Mr. Brooks, because he played no role
in the decision to execute the MLD transaction or in the
reporting of the tax treatment. As discussed above, CF Advisors’
transitory membership in Palm Canyon was merely a means to
achieve the tax benefit contemplated by the MLD transaction. See
supra pp. 62-66.
 -89-

director and officer as of December 31, 2001, before Palm Canyon

filed its return. During this time, Mr. Lamb had ample

opportunity to review the tax consequences of the MLD

transaction, including the conclusions reached in the Pryor

Cashman opinion, and investigate its proper tax reporting.

Because of his intimate involvement with the MLD transaction, Mr.

Lamb was well positioned to assess its viability. Mr. Lamb

acquiesced in Palm Canyon’s tax treatment of the MLD transaction

and signed Palm Canyon’s return as AHI’s CFO. Accordingly, we

analyze Mr. Hamel’s and Mr. Lamb’s involvement in the MLD

transaction in assessing whether AHI was negligent.

As we discussed above, Cantley & Sedacca promoted the MLD

strategy as a tax avoidance scheme to approximately 150 clients,

including Mr. Lamb, who then introduced the strategy to Mr.

Hamel. For a $325,000 fee, Cantley & Sedacca provided Mr. Hamel

with a foreign currency investment arrangement designed to

generate a substantial tax loss that would obliterate Mr. Hamel’s

projected 2001 income. Before 2001 neither Mr. Hamel nor Mr.

Lamb had experience with, or expressed interest in, foreign

currency investments, and the Hamel companies had no need for

those investments. Mr. Lamb’s initial reaction to the tax

benefits generated by the MLD strategy was that they were “too

good to be true”.
 -90-

Despite the numerous red flags surrounding the legitimacy of

the MLD strategy, Mr. Hamel and Mr. Lamb conducted a limited

investigation of the principal parties involved in executing the

MLD transaction. Mr. Hamel essentially delegated all

responsibility to investigate the MLD strategy to Mr. Lamb. Mr.

Lamb and Mr. Barish conducted only a superficial investigation of

the parties involved. Mr. Lamb’s background check on Mr. Brooks

consisted of Internet research. Mr. Barish’s investigation of

Cantley & Sedacca was limited to verifying whether it was a

“valid law firm” and confirming that Mr. Ivsan received an LL.M.

from New York University. No one investigated Mr. Kushner or

Pryor Cashman and their role in promoting the MLD strategy. The

background report on Mr. Brooks that Mr. Barish obtained from Mr.

Wells provided little information aside from confirming Mr.

Brooks’ identity. Mr. Lamb and Mr. Barish attempted to gain

authorization from Mr. Brooks to obtain his credit report, but

Mr. Brooks denied this request. Neither Mr. Lamb nor Mr. Barish

attempted to verify the clients Mr. Brooks claimed to have.

Mr. Hamel also delegated to Mr. Lamb and Mr. Barish all

responsibility to investigate the technical aspects of the MLD

strategy. However, Mr. Lamb limited his investigation of the MLD

contracts to Internet research on MLDs. Mr. Lamb did not attempt

to verify the pricing of the MLD options using the Black-Scholes

pricing model or consult anyone independent of Cantley & Sedacca
 -91-

regarding the technical aspects of the MLD transaction. Mr. Lamb

did not provide any opinion regarding the proper tax treatment of

the MLD transaction. He testified that he did not understand the

technical tax aspects of the MLD transaction and was unqualified

to analyze the technical issues contained in the Pryor Cashman

opinion.

Likewise, Mr. Barish did not provide an opinion regarding

the proper tax treatment of the the MLD transaction. Mr. Barish

relied on the Pryor Cashman opinion, and he and Mr. Lamb

recommended that Mr. Hamel proceed with the MLD transaction.

However, any reliance on the Pryor Cashman opinion was

unreasonable for several reasons. First, Pryor Cashman, which

prepared between 40 and 50 tax opinions relating to the MLD

strategy during 2001 and 2002, was part of the Cantley & Sedacca

promoter team and had a conflict of interest. See Hansen v.

Commissioner, 471 F.3d 1021, 1031 (9th Cir. 2006) (“a taxpayer

cannot negate the negligence penalty through reliance on a

transaction’s promoters or on other advisors who have a conflict

of interest.”), affg. T.C. Memo. 2004-269; Neonatology

Associates, P.A. v. Commissioner, 115 T.C. 43, 98 (2000)

(“Reliance may be unreasonable when it is placed upon insiders,

promoters, or their offering materials, or when the person relied

upon has an inherent conflict of interest that the taxpayer knew

or should have known about.”), affd. 299 F.3d 221 (3d Cir. 2002).
 -92-

Second, Pryor Cashman explicitly stated that the Pryor Cashman

opinion “may not be relied upon (and is not otherwise released)

unless and until” it receives signed investor representations

from Mr. Hamel. Mr. Hamel did not provide the required signed

representations.

Mr. Lamb, a C.P.A., is an experienced tax practitioner who

knew that the MLD strategy was highly suspect. He knew that the

MLD strategy was geared toward tax avoidance. Despite this

knowledge, Mr. Lamb, as treasurer and CFO of AHI, failed to make

a reasonable attempt to ascertain the correctness of Palm

Canyon’s tax treatment of the MLD transaction through a proper

and thorough investigation. Accordingly, we hold that the

underpayment resulting from the MLD transaction was attributable

to negligence, and we sustain respondent’s alternative

determination under section 6662(b)(1).

D. Substantial Understatement

Section 6662(a) and (b)(2) imposes a 20-percent

accuracy-related penalty on the portion of an underpayment

attributable to any substantial understatement of income tax.

An understatement is defined as the excess of the amount of tax

required to be shown on the return for a taxable year over the

amount of tax imposed that is shown on the return, reduced by any

rebate. Sec. 6662(d)(2)(A). An understatement of income tax is

substantial if the understatement exceeds the greater of 10
 -93-

percent of the tax required to be shown on the return for the

taxable year or $5,000 ($10,000 in the case of a corporation).

Sec. 6662(d)(1).

Any understatement is reduced to the extent it is

attributable to an item: (1) If there is or was substantial

authority for the taxpayer’s treatment for such item, or (2) the

taxpayer adequately discloses the relevant facts affecting the

item’s tax treatment in the return or a statement attached to the

return and there is a reasonable basis for the tax treatment of

such item by the taxpayer. Sec. 6662(d)(2)(B). However, if an

item is attributable to a tax shelter, adequate disclosure will

not allow a taxpayer to avoid the substantial understatement

penalty, and substantial authority will not reduce a taxpayer’s

understatement, unless the taxpayer reasonably believed that his

tax treatment of the item was more likely than not the proper

treatment. Sec. 6662(d)(2)(C)(i). For purposes of section

6662(d)(2)(C), a “tax shelter” is defined as: (1) A partnership

or other entity; (2) any investment plan or arrangement; or (3)

any other plan or arrangement, if a significant purpose of such

partnership, entity, plan, or arrangement is the avoidance or

evasion of Federal income tax. Sec. 6662(d)(2)(C)(iii).

Petitioner contends that Palm Canyon had substantial

authority for its tax treatment of the MLD transaction and that
 -94-

Palm Canyon adequately disclosed this position on its return.94

Petitioner also asserts that, even if the MLD transaction

constituted a tax shelter under section 6662(d)(2)(C)(iii), on

the basis of the existing authority at the time the MLD

transaction occurred, Palm Canyon reasonably believed that more

likely than not the tax benefits would be respected. Petitioner

cites the Bryan Cave opinion and the Pryor Cashman opinion as the

authority on which Mr. Hamel and his advisers relied in reaching

their conclusion that their position on the MLD transaction was

more likely than not proper.

Because the sole purpose of the MLD transaction was tax

avoidance, we have disregarded the effects of the MLD transaction

under the economic substance doctrine. Accordingly, we conclude

that the MLD transaction meets the definition of a tax shelter

under section 6662. Petitioner therefore may not reduce Palm

Canyon’s understatement by demonstrating adequate disclosure.

See sec. 6662(d)(2)(C)(i)(I). In order to avoid liability for

the section 6662(a) penalty under the substantial understatement

prong, petitioner must show that Palm Canyon had substantial

authority for its tax treatment of the MLD transaction and that

94
The amount of the understatement attributable to
respondent’s adjustments to Palm Canyon’s partnership items must
be determined at the partner level. See secs. 301.6231(a)(5)-
1(e), 301.6231(a)(6)-1(a)(3), Proced. & Admin. Regs. However,
whether Palm Canyon had substantial authority or adequately
disclosed the MLD transaction must be determined at the
partnership level. See sec. 6226(f).
 -95-

it reasonably believed that this tax treatment was more likely

than not proper. See sec. 6662(d)(2)(C)(i)(II).

Substantial authority for the tax treatment of an item

exists only if the weight of the authorities supporting the

treatment is substantial in relation to the weight of authorities

supporting contrary treatment. Sec. 1.6662-4(d)(3)(i), Income

Tax Regs. The weight accorded an authority depends on its

relevance and persuasiveness and the type of document providing

the authority. Sec. 1.6662-4(d)(3)(ii), Income Tax Regs.

Whether substantial authority exists is determined by an

objective standard involving an analysis of the law and

application of the law to relevant facts. Sec. 1.6662-4(d)(2),

Income Tax Regs. The taxpayer’s belief that there is substantial

authority for the tax treatment of an item is thus not relevant

in determining whether there is substantial authority for that

treatment. Sec. 1.6662-4(d)(3)(i), Income Tax Regs. The

substantial authority standard requires more than the “reasonable

basis” standard of section 1.6662-3(b)(3), Income Tax Regs.

(significantly higher than not frivolous or patently improper),

but is less stringent than the “more likely than not standard”

(greater than 50-percent likelihood of the position being

upheld). Sec. 1.6662-4(d)(2), Income Tax Regs. Substantial

authority must exist at the time the return is filed or must have

existed at the end of the taxpayer’s taxable year (in this case,
 -96-

July 19, 2002, and December 18, 2001, respectively). Sec.

1.6662-4(d)(3)(iv)(C), Income Tax Regs. Petitioner bears the

burden of proving substantial authority. See Higbee v.

Commissioner, 116 T.C. at 446.

Petitioner’s position with respect to the tax treatment of

the MLD transaction relies on Helmer v. Commissioner, T.C. Memo.

1975-160, and its progeny for the proposition that contingent

liabilities, such as the short MLD option, do not constitute

liabilities under section 752. However, reliance on Helmer is

not enough to establish substantial authority for Palm Canyon’s

reporting of the MLD transaction. Petitioner must also show that

it made a reasonable evaluation of the law regarding economic

substance and that that evaluation enabled it reasonably to

conclude that it was more likely than not that the MLD

transaction would be respected for Federal income tax purposes.

The ability of courts to disregard transactions devoid of

economic substance is well established. See Horn v.

Commissioner, 968 F.2d at 1236 (“The sham transaction doctrine is

an important judicial device for preventing the misuse of the tax

code”; the doctrine “generally works to prevent taxpayers from

claiming the tax benefits of transactions, which, although they

may be within the language of the Code, are not the type of

transaction Congress intended to favor.”). Any evaluation of

authority for purposes of section 6662 with respect to a tax
 -97-

shelter transaction must take the law with respect to economic

substance into account. Neither Palm Canyon nor its TMP and

advisers evaluated the MLD transaction for its economic

substance, and they did not conclude on the basis of any

reasonable investigation that the transaction would be respected

for Federal income tax purposes.

Palm Canyon received ample warning that respondent was not

likely to respect its tax treatment of the MLD transaction. On

September 5, 2000, more than a year before the MLD transaction

occurred, the IRS published Notice 2000-44, supra,95 in which the

IRS discussed certain types of transactions designed to produce

noneconomic tax losses by artificially overstating partnership

basis and explained that such losses were not allowable as

deductions for Federal income tax purposes and could result in

penalties to taxpayers. The notice provided the following

transaction as an example which, absent the offsetting $50

million deposits and fixed yield provisions, resembles the MLD

transaction:

a taxpayer purchases and writes options and purports to
create substantial positive basis in a partnership
interest by transferring those option positions to a
partnership. For example, a taxpayer might purchase
call options for a cost of $1,000X and simultaneously
write offsetting call options, with a slightly higher

95
Notices published by the IRS in the Internal Revenue
Bulletin are considered authority for purposes of determining
whether there is substantial authority for the tax treatment of
an item. Sec. 1.6662-4(d)(3)(iii), Income Tax Regs.
 -98-

strike price but the same expiration date, for a
premium of slightly less than $1,000X. Those option
positions are then transferred to a partnership which,
using additional amounts contributed to the
partnership, may engage in investment activities.

Under the position advanced by the promoters of
this arrangement, the taxpayer claims that the basis in
the taxpayer’s partnership interest is increased by the
cost of the purchased call options but is not reduced
under § 752 as a result of the partnership’s assumption
of the taxpayer’s obligation with respect to the
written call options. Therefore, disregarding
additional amounts contributed to the partnership,
transaction costs, and any income realized and expenses
incurred at the partnership level, the taxpayer
purports to have a basis in the partnership interest
equal to the cost of the purchased call options
($1,000X in this example), even though the taxpayer’s
net economic outlay to acquire the partnership interest
and the value of the partnership interest are nominal
or zero. On the disposition of the partnership
interest, the taxpayer claims a tax loss ($1,000X in
this example), even though the taxpayer has incurred no
corresponding economic loss. [Id., 2000-2 C.B. at
255.]

In the notice the IRS concluded that tax losses from these

transactions, and any other similar arrangements, were not

allowable as deductions for Federal income tax purposes. Id.

The notice also stated that transactions that are the same as or

substantially similar to the one described above may be subject

to challenge under section 752, section 1.701-2, Income Tax

Regs., or other antiabuse rules, and could result in the section

6662 accuracy-related penalty. Id., 2000-2 C.B. at 255-256.

There was no difference in essence between the MLD contracts and

the options described in the notice because the deposit and fixed

yield provisions of the MLD contracts were identical. Those
 -99-

identical provisions apart, what remains of the set of MLD

contracts is a pair of options, similar to the ones addressed by

the notice.

We conclude that, at the time petitioner filed Palm Canyon’s

return, petitioner did not have substantial authority for its tax

treatment of the MLD transaction. Consequently, we need not

decide whether petitioner reasonably believed that the tax

treatment of the MLD transaction was more likely than not proper.

We sustain respondent’s alternative determination that the

substantial understatement penalty is appropriate.

E. Section 6664(c) Reasonable Cause Exception

The accuracy-related penalty imposed under section 6662 does

not apply with respect to any portion of an underpayment as to

which the taxpayer can demonstrate reasonable cause and good

faith. Sec. 6664(c). Reasonable cause requires that the

taxpayer have exercised ordinary business care and prudence as to

the disputed item. See Neonatology Associates, P.A. v.

Commissioner, 115 T.C. at 98. The determination of whether a

taxpayer acted with reasonable cause and in good faith is made on

a case-by-case basis, taking into account all pertinent facts and

circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. The most

important factor is generally the extent of the taxpayer’s effort

to assess the taxpayer’s proper tax liability. Id.

Circumstances that may indicate reasonable cause and good faith
 -100-

include an honest misunderstanding of fact or law that is

reasonable in light of all the facts and circumstances, including

the experience, knowledge, and education of the taxpayer. Id.

A taxpayer may demonstrate reasonable cause through reliance

on the advice of a professional tax adviser as to the proper

treatment of an item. Id.; see also Neonatology Associates, P.A.

v. Commissioner, supra at 98. The taxpayer must demonstrate that

reliance on professional advice was reasonable and that the

taxpayer acted in good faith. Sec. 1.6664-4(b)(1), Income Tax

Regs. All facts and circumstances will be considered in

determining whether a taxpayer has reasonably relied in good

faith on professional tax advice as to the treatment of the plan

or arrangement under Federal tax law. Sec. 1.6664-4(c)(1),

Income Tax Regs. The professional advice must be based upon all

pertinent facts and circumstances and the law as it relates to

those facts and circumstances. Sec. 1.6664-4(c)(1)(i), Income

Tax Regs. The advice must consider the taxpayer’s purposes for

entering a transaction and for structuring a transaction in a

particular manner. Id. The advice cannot be based on

unreasonable factual or legal assumptions and cannot unreasonably

rely on the representations, statements, findings, or agreements

of the taxpayer or any other person. Sec. 1.6664-4(c)(1)(ii),

Income Tax Regs. Reliance may be unreasonable when it is placed

on insiders, promoters, or their offering materials, or when the
 -101-

person relied on has an inherent conflict of interest that the

taxpayer knew about or should have known about. See Hansen v.

Commissioner, 471 F.3d at 1031; Neonatology Associates, P.A. v.

Commissioner, supra at 98. Petitioner bears the burden of

proving reasonable cause. See Higbee v. Commissioner, 116 T.C.

at 446.

Petitioner argues that Palm Canyon had reasonable cause for

the reporting position it claimed on its return. Petitioner

contends that Mr. Hamel, who was not sophisticated in tax

matters, reasonably relied on his team of advisers in proceeding

with the MLD transaction. Petitioner claims that Mr. Hamel

employed Mr. Lamb to investigate the parties involved and Mr.

Barish to review the tax aspects of the MLD transaction.

According to petitioner, Mr. Lamb and Mr. Barish both reviewed

the Pryor Cashman opinion and advised Mr. Hamel to proceed with

the tax reporting of the MLD strategy on the basis of the

opinion’s conclusion that Palm Canyon’s tax treatment of the MLD

transaction would more likely than not be respected.

In assessing whether Palm Canyon had reasonable cause, we

examine AHI’s role in the MLD transaction as Palm Canyon’s

managing member and TMP. Specifically, we focus on the conduct

of Mr. Hamel, petitioner’s sole owner and an AHI director, and

Mr. Lamb, who also was an AHI director and its treasurer/CFO.
 -102-

Petitioner has not shown that AHI, as Palm Canyon’s managing

member, exercised ordinary business care and prudence in the tax

treatment of the MLD transaction. Mr. Hamel played virtually no

role in analyzing the tax aspects of the MLD transaction,

electing instead to delegate this responsibility to Mr. Lamb and

Mr. Barish. Neither Mr. Barish nor Mr. Lamb, as AHI’s

treasurer/CFO, conducted a proper investigation of the MLD

transaction, despite their recognition that the MLD strategy was

a tax avoidance scheme. Neither Mr. Barish nor Mr. Lamb provided

an opinion with respect to the MLD transaction. Instead, they

relied on opinions from Bryan Cave and Pryor Cashman.

Any reliance on the Pryor Cashman opinion was misplaced

because Pryor Cashman was part of Cantley & Sedacca’s promoter

team and had a conflict of interest. In addition, Palm Canyon

could not rely on the Pryor Cashman opinion because Mr. Hamel

failed to provide signed representations, which were an express

condition of reliance. Lastly, Palm Canyon could not rely on the

Pryor Cashman opinion because Palm Canyon and its advisers did

not provide Pryor Cashman with necessary facts that would have

affected Pryor Cashman’s conclusions. Sec. 1.6664-4(c)(1)(i),

Income Tax Regs. Significantly, Pryor Cashman did not receive

documents pertaining to the termination of CF Advisors as a

member of Palm Canyon or the early termination of the MLD

contracts nor did it receive information that might have led an
 -103-

independent professional adviser to conclude that the various

steps of the MLD transaction were predetermined. Any reliance on

the Bryan Cave opinion was improper because it was not prepared

for Palm Canyon and did not necessarily focus on facts peculiar

to it.

Accordingly, we reject petitioner’s contention that Palm

Canyon had reasonable cause and acted in good faith with respect

to its tax treatment of the MLD transaction, and we sustain the

section 6662 accuracy-related penalty determined by respondent.

VI. Conclusion

We sustain respondent’s adjustments to Palm Canyon’s return.

We find that the MLD transaction lacked economic substance and

thus hold that it should not be respected for Federal income tax

purposes.

We further sustain respondent’s determination as to the

section 6662 accuracy-related penalty. Petitioner failed to

establish that there was no gross valuation misstatement within

the meaning of section 6662(h). Alternatively, petitioner failed

to prove that Palm Canyon was not negligent within the meaning of

section 6662(b)(1) and that the penalty for substantial

understatement of income tax under section 6662(b)(2) should not

apply. Petitioner failed to establish that Palm Canyon had

reasonable cause under section 6664(c).
 -104-

We have considered all the other arguments made by

petitioner, and to the extent not discussed above, we conclude

those arguments are irrelevant, moot, or without merit.

To reflect the foregoing,

Decision will be entered for

respondent.