For almost 10 years, the IRS has been cracking down on abusive tax shelters that cost the government billions of dollars in lost tax revenue. Recently, the IRS won a big victory in a closely-watched case involving a very egregious tax shelter, known as Son of BOSS (Bond and Option Sales Strategy). The U.S. Court of Federal Claims agreed with the IRS that the transactions in Jade Trading, LLC v. U.S. (No.03-2164T), decided in December 2007, were abusive.

Wealthy investors

Son of BOSS was an abusive transaction aggressively marketed in the late 1990s and 2000 primarily to wealthy individuals.  According to the IRS, these transactions were developed and marketed by a network of accounting and law firms and investment banks.

The IRS claims it is aware of “several thousand” Son of BOSS transactions. Typically, taxpayers claimed losses of as much as $10 million. Overall, the transactions reportedly cost the government more than $6 billion, not including interest and penalties.

A few years ago, the IRS offered a limited amnesty program to taxpayers involved in Son of BOSS transactions.  In exchange for conceding 100 percent of the claimed tax losses and paying interest and penalties, the government agreed not to prosecute the taxpayers in court. At that time, the IRS warned taxpayers not to expect a better outcome in court than what they would have gotten in the settlement program. In this case, the IRS’ warning proved right on target.

Transaction

The transaction in this case involved limited liability companies (LLCs) that each purchased a spread position with foreign currency options based on the value of the euro. The two options were "reverse knock-out" options.

All of the LLCs then contributed their options to a single partnership. They each computed the basis of their partnership interests solely based on the $15 million premium of the purchased options. They interpreted Code Sec. 752(b) to mean that, while partners must decrease their partnership basis by any liabilities assumed by the partnership, this did not apply for contingent obligations. They argued that the short-sold options were contingent obligations.

The LLCs later caused the partnership to redeem their partnership interests in exchange for assets. When they later sold these assets, they claimed a basis equal to that of their partnership interest. The result was a multi-million dollar tax loss.

Court’s analysis

The Federal Claims Court found that the losses were artificial. The transaction was developed as a tax avoidance mechanism and not as a legitimate investment strategy, the court held.

The court also found that the transaction had no reasonable profit potential. The structure of the transaction and the unusually high fees required for participation prevented it from being profitable, no matter how the value of the euro performed, the court found.

(Jade Trading, LLC, FedCl, 03-2164T)