                              T.C. Memo. 2014-86



                        UNITED STATES TAX COURT



             THE MARKELL COMPANY, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 20551-08.                        Filed May 13, 2014.



      Jasper George Taylor, III and Susan V. Sample, for petitioner.

      Elaine Harris, Julie Gasper, and Veronica Trevino, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      HOLMES, Judge: This case began when the Commissioner found the

remains of a corporation on an Indian reservation in an extremely remote corner of

Utah. The tribe claimed not to know how the corporation’s stock had ended up in
                                        -2-

[*2] its hands. And there was little or no money or valuable property left inside

the corporate shell.

      All signs pointed to the corporation’s manager, a sophisticated East Coast

moneyman, as the key person of interest. And his method was a series of complex

transactions that bore a striking resemblance to Son-of-BOSS deals already

examined many times before by this Court--but with a corporate-partner twist.

                               FINDINGS OF FACT

I.    James Haber

      The central player in this mystery is James Haber, a CPA and founder of

Diversified Group, Inc. (DGI), where he was sole owner, director, president, and

CEO. He was also the director of Helios Trading LLC (Helios). Haber is an

exceptionally smart man, and exceptionally gifted in designing complex

transactions. A decade ago he designed what he thought was a way to use DGI

and Helios to solve a very particular tax problem: how to unlock the value lying

in C corporations1 with low basis in capital assets by creating deals that generated

enormous capital losses--losses large enough to offset the corporate-level tax on


      1
       “C corporation” is tax jargon for a corporation governed under the laws of
subchapter C of the Internal Revenue Code. S corporations are governed under
the laws of subchapter S, and partnerships are governed under the laws of
subchapter K.
                                          -3-

[*3] capital gains--and thereby largely eliminate corporate-level taxes. He

marketed this plan as the “Option Partnership Strategy” (OPS). The OPS featured

a contribution of paired options by a corporation to a limited liability company

that was managed by a company of which Haber was president. One part of the

pair was a short option, and one a long.2 The short option, in any reasonable

economic view, is a potential liability. But Haber and those who undertook

similar deals claimed to adopt the position that the potential liability of the short

option did not offset the potential payoff of the long option, and so could be

ignored as a matter of tax accounting. That would, in turn, overstate the capital

contribution3 and give the C corporation a tax benefit in the nature of a built-in

capital loss on the sale of the C corporation’s partnership interest. To realize the

benefit, the C corporation would resign from the partnership, take a transferred




      2
         An option is a contract that gives its buyer the right, but not the obligation,
to buy or sell an asset at a predetermined “strike” price at some point in the future.
A short option gives its buyer a right to sell the asset; a long option gives its buyer
a right to buy the asset.
      3
        For partnership tax purposes, each partner has both a tax-basis and book-
basis capital account. A partner’s tax-basis capital account is increased or
decreased depending on specific adjustments, such as the partner’s initial
contributions, his distributive share of the partnership’s taxable income or loss,
and any distributions made to him. A partner’s outside basis in the partnership can
then be calculated by adding his share of liabilities to his tax-basis capital account.
                                           -4-

[*4] basis4 in the securities distributed to it in liquidation of its interest, and

subsequently sell those assets at a huge loss--all due to the omission of the short-

leg option.

        Markell’s brief admits that Haber had considerable experience with the

selection, acquisition, and management of European-style digital options.5 And

Haber was a serial dealmaker, who did at least 12 of these deals as the president of

DGI and Helios from 2000-2002. But these deals caught the attention of the U.S.

Attorney for the Southern District of New York--and though Haber has never been

indicted or even made a target, he chose to plead the Fifth during the trial of this

case.

II.     Markell

        The corporate corpse in this case is The Markell Company, formed by one

F.E. Markell in late 1934 with an initial capital contribution of $1,000. Markell, a

widower, kept most of the stock in the company but amended the articles of

        4
        The partner’s outside basis in its partnership interest becomes the partner’s
basis in the contributed property. Sec. 731. (Unless otherwise indicated, all
section references are to the Internal Revenue Code in effect for the year in issue.
All Rule references are to the Tax Court Rules of Practice and Procedure.)
        5
        A digital option has only two possible outcomes at expiration: some fixed
payoff amount, or else nothing. Digital options are typically also European-style
options, which means that they can be exercised only on the option’s expiration
date.
                                        -5-

[*5] incorporation a few years later to give a portion to his daughter and

granddaughter. The company operated as a personal holding company6 for more

than half a century, and by 2001 was still family owned, with its shareholders’

registry a family tree of Markell descendants through his granddaughter. By the

time Haber entered the scene, Markell’s 4 great-grandchildren and his 11 great-

great-grandchildren owned, through trustees, 100% of Markell’s stock. Bruce

McClaren was the youngest of the 4 great-grandchildren and an officer of the

company at the time. By 2001 the company had assets of approximately $22.8

million in appreciated securities with a built-in gain of nearly $15 million. By

2002 family discord over the firm’s future led three of the four siblings to decide

they would invest individually rather than through the family company.

      McClaren discussed the possibility of redemption with the other

shareholders, and meanwhile contacted KPMG to help him find a buyer for the

Markell stock. Mel Adess, the KPMG partner McClaren worked with, had a

reputation of knowing certain transactional structures that would lead to particular

tax advantages. KPMG agreed in 2001 to help find a buyer for a flat fee of




      6
        Under section 542, a corporation is a personal holding company if it meets
certain income and stock ownership requirements.
                                         -6-

[*6] $500,000. Before McClaren even signed the agreement, Adess already had

just the man in mind: Haber.

       Within two weeks McClaren’s siblings unanimously consented to redeem

their shares.7 In January 2002 Markell borrowed $13 million from Midwest Bank

to finance the redemption, secured by its portfolio of appreciated securities, and a

few days later Markell redeemed all but the 248.5 shares owned by McClaren and

the trustee for his children. The next day, McClaren became Markell’s sole

director, president, and secretary.

III.       Skull Valley Band of Goshute Indians

       Far to the west are the third group of players in this mystery. The Skull

Valley Band of Goshute Indians of Utah, a federally recognized Indian tribe in

Tooele County, is a very small band of fewer than 50 members. The tribal

chairman at the time was Leon Dale Bear. But with so few people on the

reservation, tribal government had a town-meeting feel, and the members would

meet and pass resolutions granting Chair Bear specific authority to pursue certain

business opportunities for their benefit. In May 2001 one such opportunity arose

and the Band’s executive committee passed a resolution authorizing the formation


       7
        They owned 76% of the corporation’s stock. McClaren and a trustee for
his children owned the rest.
                                        -7-

[*7] of KR Acquisition LLC (KRA), a Wyoming LLC. The committee authorized

Chair Bear to execute and deliver the KRA operating agreement. The operating

agreement named DGI, in the person of James Haber, as manager of KRA.

      KRA morphed through several names but settled on MCO Acquisition LLC

(MCOA). The first name change was executed by James Haber, president of DGI,

as manager of MCOA. The final name change was also executed by James Haber,

but as manager of Helios, the mysterious new manager of MCOA. All rights,

interest, and control of the company, its operation, and its business affairs were

vested solely in the manager. The bank accounts of the company were to be

maintained solely by the manager. And no member of the LLC was entitled to any

distribution from the company or to demand any return of any part of its capital

contribution. Members could not even expel the manager without the manager’s

own consent. There was nothing Haber could do to MCOA, and through MCOA

to Markell, that anyone could complain about.

      Haber had taken full control of MCOA and was ready to begin the OPS.

IV.   The Intermediary Transaction: MCOA Buys Markell

      On February 4, 2002, McClaren accepted an offer by MCOA to buy all

outstanding Markell shares for 94% of the company’s net asset value. (The 6%

discount was only a fraction of the capital-gains tax rate Markell would have paid
                                         -8-

[*8] if it had sold its portfolio of securities in the normal way.) Haber, as

MCOA’s manager, signed this stock purchase agreement, which in addition to

setting a price for Markell’s stock required MCOA to repay the loan from Midwest

Bank.

        It was then time to liquidate Markell’s portfolio. On February 7, UBS

formally offered to buy the Markell portfolio with net proceeds of $21.9 million.

Markell directed that the proceeds be paid to MCOA, and McClaren resigned as

president of Markell. Here’s the deal so far:




MCOA, by now the sole shareholder of Markell, elected Haber and a man named

John Huber as Markell’s new directors. Haber and Huber then elected each other

president and vice president of Markell, respectively.
                                        -9-

[*9] V.      Markell After Haber Took Control

      Markell was now just a tiny pile of money and a potentially large tax

liability tucked into a corporate form. But Haber was not done with it quite yet.

In March 2002 he formed MC Investments LLC with two Irish companies,

Brenview Holdings Limited and Cumberdale Investments Limited.8 Each

corporation contributed $5,000 in exchange for a 50% membership interest in MC

Investments. MC Investments’ operating agreement is explicit that members shall

“take no part whatsoever in the control, management, direction or operation of the

affairs of the Company and shall have no power to act for or bind the Company.”

The operating agreement goes on to explain that only the manager (who was

Haber, again) had this authority. The agreement also states that the capital

accounts of the members will be maintained in accordance with section 704(b) and

the accompanying regulations. The agreement was signed by Haber as well as two

Irish lawyers representing Cumberdale and Brenview.

      As president of Markell, Haber then formed MC Trading LLC and

contributed $75,000 as startup capital to it. On March 22, 2002, MC Trading

      8
        Brenview and Cumberdale were both formed in 1995 by Kearney Curran
& Co. naming William Curran and Philip O’Donoghue as directors. Such “off-
the-shelf” corporations have easily replaceable directors because although they are
incorporated, they have not yet been used for any business purpose. See Estate of
Angle v. Commissioner, T.C. Memo. 2009-227.
                                       - 10 -

[*10] contracted with Refco Capital Markets (Refco), a Bermudian subsidiary of

Refco, Inc., to buy short and long options for a NASDAQ index.

      The deal now looked like this:




      The Refco contract, which incorporated the International Swap Dealers

Association (ISDA) Master Agreement, had a netting provision:

      If on any date amounts would otherwise be payable . . . in respect of
      the same Transaction, by each party to the other, then . . . each party’s
      obligation to make payment of any such amount will be automatically
      satisfied and discharged and . . . replaced by an obligation upon the
      party by whom the larger aggregate amount would have been payable
      to pay to the other party the excess of the larger aggregate amount
      over the smaller aggregate amount.

Each option had its own individual confirmation, but there was a single trade

confirmation for the entire transaction. The paired options consisted of a short and

long European digital option. The price of the NASDAQ index when Refco and
                                      - 11 -

[*11] MC Trading traded the option was $1,477.30. The short option had a

premium of $14,925,000 (nominally paid by Refco to MC Trading) and required

MC Trading to pay Refco $49,985,726 if the index was trading at $1,591.04 or

higher on June 21, 2002. The long option had a premium of $15 million

(nominally paid by MC Trading to Refco) and entitled MC Trading to

$50,176,337 from Refco if the index was trading at $1,591.01 or higher on June

21, 2002. Both options named Refco as “calculating agent,” the person

responsible for deciding what the market price of the index was during a specific

15-minute window on the expiration date.

      Markell then contributed its interest in MC Trading to MC Investments in

exchange for an 82.76% interest in MC Investments. Markell’s admission as a

member of MC Investments was accepted by DGI as manager of Investments

signed, of course, by Haber.

      Cumberdale and Brenview’s interests decreased to 8.62% as a result of this

contribution:
                                       - 12 -

[*12]




        On April 1, 2002, MC Investments bought 275 shares of another NASDAQ

index-linked security (which we’ll call QQQ, its trading symbol) for $9,836.75.

And it was now time for Markell to harvest the fruit of this paper orchard:

Markell redeemed its interest in MC Investments on June 13, 2002, and received

$43 cash and 230 QQQ shares in exchange. It sold the stock a month later for

$5,554 but would report that its tax loss on the sale was a remarkable $14,994,403.

Pryor Cashman charged Markell $22,500 for an opinion justifying Markell’s tax

treatment of those transactions.
                                        - 13 -

[*13] VI.    Procedural History

      Haber, as president of DGI, in DGI’s capacity as manager of MC

Investments, filed MC Investment’s 2002 partnership return late in 2003. That

return omitted the short option from its partnership liabilities for tax purposes, but

took it into account for financial-accounting purposes. Haber also filed Markell’s

2002 tax return. This return reported a long-term capital gain from the sale of the

Markell portfolio of $14,048,102 and a short-term capital loss from the sale of the

QQQ stock of $14,994,403 that Markell had received upon disposition of its

ownership of MC Investments. The reported net loss was $946,301.

      The Commissioner found out, and after a prolonged examination issued a

notice of deficiency to Markell for the 2002 tax year. The notice disallowed the

$14 million capital loss and determined a deficiency of nearly $4.8 million plus

accuracy-related penalties under section 6662.

      Markell timely filed its petition in this case. Its offices are listed as the New

York office of DGI.9 Trial of this and similar cases was delayed by the possibility

of parallel criminal proceedings.


      9
        We think this means an appeal would be in the Court of Appeals for the
Second Circuit. See Golsen v. Commissioner, 54 T.C. 742 (1970) (applying the
rules of the circuit in which the case would be appealed), aff’d, 445 F.2d 985 (10th
Cir. 1971).
                                         - 14 -

[*14]                                  OPINION

I.      Jurisdiction

        Partnerships do not pay taxes, but they do file information returns that their

partners then use to calculate their own individual tax liability. See sec. 701.

Special tax and audit rules apply to most partnerships,10 with a few notable

exceptions. The relevant one here is under section 6231(a)(1)(B)(i): The term

“partnership” shall not include any partnership having 10 or fewer partners each of

whom is an individual (other than a nonresident alien), a C corporation, or an

estate of a deceased partner. So our jurisdiction in this case is not dependent on

the distinction between partnership and nonpartnership items for purposes of

section 6226(f) because MC Investments had only three partners: Brenview,

Cumberdale, and Markell.

II.     Intermediary Variation of Son-of-BOSS

        This case is another of the Commissioner’s battles against a tax shelter

called Son-of-BOSS. While there are different varieties of Son-of-BOSS deals,

what they have in common is the transfer of assets encumbered by significant

        10
         Under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA),
Pub. L. No. 97-248, sec. 402(a), 96 Stat. at 648, any “partnership,” including all
the partnerships that brought these cases, must designate one of its partners as the
tax matters partner to handle its administrative issues with the Commissioner and
manage any resulting litigation. Sec. 6231(a)(7).
                                         - 15 -

[*15] liabilities to a partnership, with the goal of inflating basis in that partnership.

See Kligfeld Holdings v. Commissioner, 128 T.C. 192 (2007). The liabilities are

usually obligations to buy securities, and they are always contingent at the time of

transfer. Taxpayers who engage in these deals claim that this allows the partner to

ignore those liabilities in computing basis, which allows the partnership to ignore

them in computing basis. The result is that the partners will have bases in the

partnership high enough to provide for large noneconomic losses on their

individual tax returns. At issue here is an “outside basis” Son-of-BOSS deal: the

inflated basis is the partner’s outside basis in the partnership.11 The version here

involves a corporation as the partner, and an intermediary transaction; namely,

Markell’s stock sale immediately followed by an asset sale.

      In the middle of this was MC Trading, which Markell formed and to which

it contributed $75,000 cash.12 MC Trading then contracted for the short and long


      11
         The usual “outside basis” Son of BOSS deal requires a taxpayer to buy the
options and then contribute them to the partnership in exchange for a partnership
interest. In an “inside basis” Son-of-BOSS deal, the partnership itself purchases
the options and the inflated basis is attached to the inside basis of the partnership.
In that case, the loss is realized when the partner receives the asset in a distribution
and then sells it. See, e.g., 6611 Ltd. v. Commissioner, T.C. Memo. 2013-49.
      12
         Under federal tax law, a single-member LLC that does not make an
election is a disregarded entity--a tax nothing. The result is that the member is
treated as personally engaging in the transactions engaged in by the LLC. Treas.
                                                                         (continued...)
                                          - 16 -

[*16] options--independent investments, according to Markell, because the terms

of each option were set out in separate confirmations and in theory the options

could be transferred or assigned independently of each other. When Markell then

contributed its interest in MC Trading to MC Investments it claims to have bought

a partnership interest, and calculated its basis in MC Investments without taking

into account as a liability MC Trading’s contingent liability. See sec. 752. This

step is of extreme importance in Son-of-BOSS deals--a partner who gets his

partnership to assume a liability has to reduce his basis in the partnership by the

amount of that liability. See sec. 752(b). Doing so would, however, defeat the

goal of inflating basis to create a giant artificial loss.

       So when Markell did this, it was setting up its argument that its outside

basis in MC Investments was only its basis in the long option--approximately $15

million. MC Investments then bought the QQQ stock for less then $10,000 and

distributed most of it along with a nominal amount of cash to Markell in

liquidation of Markell’s partnership interest. Under section 732, Markell’s

supposed outside basis of $15 million (minus the cash received) became its basis

       12
        (...continued)
Reg. sec. 301.7701-3(b)(1)(ii), Proced. & Admin. Regs.; Med. Practice Solutions,
LLC v. Commissioner, 132 T.C. 125 (2009) (holding the “check-the-box”
regulations are valid), aff’d without published opinion sub nom. Britton v.
Shulman, 2010 WL 3565790 (1st Cir. 2010).
                                         - 17 -

[*17] in the distributed stock. Markell then sold the stock for about $5,000. But

rather than calculate its gain or loss by subtracting the actual purchase price of its

shares from the actual sale price, it claimed that it could subtract the $15 million

pretend basis for those shares from the actual sale price. Thus, at the end of the

paper shuffle, it claimed a capital loss just shy of $15 million from the sale of the

QQQ stock--an amount sufficient to almost completely offset its previous capital

gains from the asset sale a month earlier.

      A.     MC Investments as a Partnership

      One of the essential parts of this deal is that MC Investments be a

partnership, because it is only the basis rules for partnerships that seem to lend

themselves to this kind of manipulation. And Markell insists that MC

Investments’ status as a partnership must be respected. Federal law controls the

classification of an entity for federal tax purposes, Luna v. Commissioner, 42 T.C.

1067, 1077 (1964), so we must first determine whether MC Investments--

organized as an LLC--was in fact a bona fide partnership under the Code.

      Markell begins by arguing that MC Investments was a valid LLC created

under Delaware law and that under regulation section 301.7701-3(b)(1)(i), Proced.

& Admin. Regs., it should be considered a partnership. That regulation does tell

us that an LLC with more than one member is by default classified as a partnership
                                        - 18 -

[*18] for tax purposes. (Such an LLC may elect to be treated as a corporation, sec.

301.7701-3(b)(1)(i), Proced. & Admin. Regs., but MC Investments didn’t.) But

this is the first barrier that Markell’s argument crashes into: As the Seventh

Circuit pointed out in Superior Trading, LLC v. Commissioner, 728 F.3d 676, 681

(7th Cir. 2013), aff’g 137 T.C. 70 (1011) and T.C. Memo. 2012-110, the purpose

of section 301.7701-3(b)(1)(i), Proced. & Admin. Regs., is “merely to determine

whether the default tax treatment of the entity shall be under the corporate or the

partnership provisions of federal tax law”--not whether an entity can avail itself of

the benefits afforded by those provisions should they be found inapplicable for

other reasons. Superior Trading, 728 F.3d at 681; see also Jimastowlo Oil, LLC v.

Commissioner, T.C. Memo. 2013-195, at *41-*42 (“the import of these so-called

Luna factors has not dissipated any after the promulgation of sec. 301.7701-3(a),

Proced. & Admin. Regs.”).

      The term “partnership” is defined as a syndicate, group, pool, joint venture,

or other unincorporated organization, through or by means of which any business,

financial operation, or venture is carried on. Secs. 761, 7701(a)(2). Mere co-

ownership is not, by itself, enough. See sec. 301.7701-1(a)(2), Proced. & Admin.

Regs. Instead, we look to several factors:

      (1)    the agreement of the parties and their conduct in executing its terms;
                                        - 19 -

[*19] (2)    the contributions, if any, which each party has made to the venture;

      (3)    the parties’ control over income and capital and the right of each to
             make withdrawals;

      (4)    whether each party was a principal and coproprietor, sharing a mutual
             proprietary interest in the net profits and having an obligation to share
             losses, or whether one party was the agent or employee of the other,
             receiving for his services contingent compensation in the form of a
             percentage of income (not a relevant distinction in this case);

      (5)    whether business was conducted in the joint names of the parties;

      (6)    whether the parties filed Federal partnership returns or otherwise
             represented to respondent or to persons with whom they dealt that
             they were joint venturers;

      (7)    whether separate books of account were maintained for the venture;

      (8)    whether the parties exercised mutual control over and assumed
             mutual responsibilities for the enterprise.

Luna, 42 T.C. at 1077-78; see TIFD III-E, Inc. v. United States, 459 F.3d 220,

231-32 (2d Cir. 2006). The “essential question” is whether the parties intended to,

and did in fact, join together for the present conduct of an undertaking or

enterprise. Commissioner v. Culbertson, 337 U.S. 733, 742 (1949); Commissioner

v. Tower, 327 U.S. 280, 286-87 (1946); Historic Boardwalk Hall, LLC v.

Commissioner, 694 F.3d 425, 449 (3d Cir. 2012), rev’g and remanding 136 T.C. 1

(2011); Southgate Master Fund, L.L.C. ex. rel. Montgomery Capital Advisors v.

United States, 659 F.3d 466, 488 (5th Cir. 2011); TIFD, 459 F.3d at 230;
                                       - 20 -

[*20] Jimastowlo Oil, LLC v. Commissioner, T.C. Memo. 2013-195.13 We will

examine each of the applicable factors.

             Parties’ Contribution to the Venture. MC Investments was

established March 18, 2002 with initial contributions from Brenview and

Cumberdale of $5,000 and Markell’s contribution of the paired-option bundle.

This factor weighs in favor of finding a partnership.

             Agreement of the Parties and Whether Business Was Conducted in

Joint Name. There is a wisp of a formal agreement--Brenview and Cumberdale

appear in the operating agreement--but that is the only document where they

appear. All the actual activity was shunted through a single conduit: James

Haber, as President of DGI and manager of Markell. And the only “business” MC

Investments conducted was a single stock purchase. Under any definition,

“business” means a “‘course of activities engaged in for profit.’” Brook Inc. v.

Commissioner, 799 F.2d 833, 839 n.7 (2d Cir. 1986), aff’g T.C. Memo. 1985-462

and T.C. Memo. 1985-614; Lamont v. Commissioner, 339 F.2d 377, 380 (2d Cir.

1964) (quoting 4 Mertens Law of Federal Income Taxation, sec. 25.08 (1960)).

The phrase “course of activities” implies more than a single transaction; it implies

      13
        This entity-focused and intent-seeking approach to determining the
existence of a partnership applies broadly--not just to partnerships engaged in
dubious digital-option deals.
                                       - 21 -

[*21] routine, or a series of transactions. Here, there was no “business” to

conduct, just a single transaction, and even it wasn’t in joint name. These factors

weigh very heavily against finding a partnership.

             Mutual Control and Responsibility. Brenview and Cumberdale may

have had interests in MC Investments, but they were foreclosed under the

operating agreement from exercising any power over management. The agreement

is explicit: members will “take no part whatsoever in the control, management,

direction, or operation of the affairs of the Company and shall have no power to

act for or bind the Company.” None of the members could operate the alleged

business. Only Haber, by an irrevocable power of attorney, could bind the

company and sign any document on behalf of the members--which he did. None

of the members could even transfer its interest without Haber’s approval. There

was no mutual control, there was only one-man control. This factor also weighs

against finding a partnership.

             Separate Books and Return Filings. Haber does seem to have kept

MC Investments’ books separate from his other similar ventures, and MC

Investments did file partnership Form 1065, U.S. Return of Partnership Income,

for its 2002 tax year--a return which only he signed--in October 2003. The LLC

did also issue three Schedules K-1: one to Cumberdale, one to Brenview, and one
                                         - 22 -

[*22] to Markell. And the return shows that MC Investments held itself out as a

federally recognized partnership, and it also states that MC Investments

considered Cumberdale and Brenview joint venturers along with Markell. This

factor does weigh in favor of finding MC Investments to be a partnership.

      But this entire multifactor test turns on the fair and objective

characterization of considering all the circumstances. What we find is a

scrupulous adherence to the formal requirements of making MC Investments look

like a partnership, but a complete absence in the partnership’s operating agreement

and actual operations of any objective indication of a mutual combination for the

present conduct of an ongoing enterprise.

      B. Business Purpose

      There is a second and separate hurdle to any finding that MC Investments

was a partnership however: A partnership must conduct some kind of business

activity. See Torres v. Commissioner, 88 T.C. 702, 737 (1987). The caselaw on

the subject is explicit that the pursuit of a business activity in furtherance of tax

avoidance is “no more a business purpose than actually engaging in tax

avoidance.” ASA Investerings P’ship v. Commissioner, 201 F.3d 505, 513 n.6

(D.C. Cir. 2000), aff’g T.C. Memo. 1998-305; see also Boca Investerings P’ship v.

United States, 314 F.3d 625, 632 (D.C. Cir. 2003). We must ask therefore whether
                                       - 23 -

[*23] the parties intended to join together as partners to conduct a business

activity for a purpose other than tax avoidance.

             Adverse Inferences. We begin by looking at what we can infer about

MC Investment’s alleged business purpose from Haber’s invocation at trial of his

Fifth Amendment right to remain silent. We don’t doubt that he had the right to

do so. Following an ex parte hearing, and for reasons we explained in the sealed

portion of the transcript, we sustained his claim and released him.14 The Fifth

Amendment, however, does not prohibit adverse inferences against parties to civil

actions when they refuse to testify in the face of probative evidence against them.

Baxter v. Palmigiano, 425 U.S. 308, 318 (1976); LiButti v. United States, 107

F.3d 110, 124 (2d Cir. 1997); United States v. Ianniello, 824 F.2d 203, 208 (2d

Cir. 1987) (applying the Baxter rule even if the government is the beneficiary of

the adverse inference). The assertion of the Fifth Amendment by a nonparty may

also warrant an adverse inference against a party depending on the relationship

      14
        Transactions like the one in this case that KPMG had devised were
investigated by the U.S. Attorney’s Office for the Southern District of New York.
That investigation let to several indictments. See United States v. Stein, No.
1:05-cr-00888-LAK (S.D.N.Y. filed Aug. 24, 2005). During his deposition in
Ironbridge Corp. v. Commissioner, T.C. Memo. 2012-158, aff’d, 528 Fed. Appx.
43 (2nd Cir. 2013), Haber gave testimony indicating he believed he had become a
“potential” target of the criminal investigation around “2002 or 2003,” though he
has never been indicted or tried. Stein ended in June 2009, but the related criminal
investigation seems to continue.
                                          - 24 -

[*24] between the two. LiButti, 107 F.3d at 121; FDIC v. Fid. & Deposit Co. of

Md., 45 F.3d 969, 977 (5th Cir. 1995) (“‘A non-party’s silence in a civil

proceeding implicates Fifth Amendment concerns to an even lesser degree’”

(quoting RAD Servs., Inc. v. Aetna Cas. & Sur. Co., 808 F.2d 271, 275 (3d Cir.

1986))) (citing Rosebud Sioux Tribe v. A & P Steel, Inc., 733 F.2d 509, 521 (8th

Cir. 1984)).

      The Second Circuit in Libutti listed four factors for a trial court to weigh in

deciding whether to draw on adverse inference from a nonparty’s refusal to testify:

      •        the nature of the relationship;

      •        the degree of control over the nonparty;

      •        the degree to which the nonparty and the party share the same
               interests in the outcome of the litigation; and

      •        the degree to which the nonparty witness played a key role in the
               underlying events.

LiButti, 107 F.3d at 123. The question for us then is to determine whether Haber’s

nearly unfettered authority over Markell lets us draw an adverse inference against

Markell. We find it does. Haber was in control of Markell throughout the entire

OPS arrangement, and placed himself in managerial positions in every entity

necessary for the OPS to work: Markell, MC Investments, MC Trading, and
                                        - 25 -

[*25] MCOA. He signed all the documents and undeniably shares the same

interests as Markell in the outcome of this litigation.

      We ourselves have added that we may draw an adverse inference in a civil

case from a party’s claim of privilege only if there is some additional evidence

independent of the invocation on which to base the inference. Petzoldt v.

Commissioner, 92 T.C. 661, 685 (1989). And on this point, we find there is

considerable circumstantial evidence contradicting Markell’s claim of a profit

motive given the structure, terms, and likelihood of profit of the paired options.

             Paired Options. The paired options in this case consisted of short and

long European digital call options. These cash-or-nothing options can be valued

by multiplying the present value of the cash payoff amount by the probability

calculated from the Black-Scholes-Merton (BSM) model that the digital option

will be in the money at the expiration date. Applying this model, the combined

value for the paired options was $59,041.15 The difference in the amount actually

paid, $75,000, and the option’s value using the BSM model is essentially an

amount paid indirectly to the dealer for the transaction. In this deal, that markup

      15
         According to the BSM model, the digital call option values are
$0.2986928 for the long option, and $0.2986507 for the short option per dollar of
cash payout. Thus, the market value of the long option was $14,987,312, and the
short option was -$14,928,270. MC Trading itself calculated a theoretical value of
the paired options of $56,892.
                                        - 26 -

[*26] was 22%, which is astounding in light of credible expert-witness testimony

that market practice is that a markup should not exceed 5% to customers, and that

markups in excess of 5% violate a background norm in the industry that a broker-

dealer comply with the basic principles of fair and equitable trade. So we find that

Markell grossly overpaid for the options.

         The terms of the option spread were also unusual. The strike prices were

only $0.03--or three “pips” as the industry calls them--apart and very far out-of-

the-money. The strike prices were so close together that, from a risk-management

perspective, they were indistinguishable. Refco, as the calculating agent, had the

choice of any price that was printed between 9:30 a.m. and 9:45 a.m. on the date of

expiration. The key fact is that the option sold could not have been disposed of

without the option purchased: We specifically find that Refco would never have

allowed Markell, which had only $75,000 in its Refco account, to collect $14.9

million as premium for the short leg due to the credit risk involved in selling an

option. And here, the credit risk to Refco would be the inability to collect from

MC Trading or Markell if the short leg was in-the-money at expiration. So, Refco

in its own economic self-interest would never choose a rate that fell in the “sweet

spot.”
                                        - 27 -

[*27] And if, for the sake of argument, the investment objective was never to hit

the sweet spot but rather to spend $75,000 for a maximum payout of $190,611

based on the NASDAQ index’s going up in price, there was a simpler choice that

had a higher probability of achieving that objective. We agree with the

Commissioner’s experts that Markell could have spent the same $75,000 for a

single European digital call with the same possible payout of $190,611 but a strike

price close to the then-current rate of $1,477.30, rather than the far-out-of-the-

money strike price of $1,591.01 that it actually agreed to pay for the long leg of

the paired option.

      Between Haber’s inextricable relationship with Markell and its related

entities, and the dubious investment objectives surrounding the paired options, we

find that Haber’s claim of privilege permits us to draw an adverse inference

against MC Investments’s having a business purpose at all. See LiButti, 107 F.3d

at 123; Petzoldt, 92 T.C. at 685.

      We also have to note that the facts here fall squarely within a pattern of

other cases disallowing deductions in Son-of-BOSS deals.

      In 6611 Ltd. v. Commissioner, T.C. Memo. 2013-49, the taxpayers scored

gigantic paydays in contingency fees. A promoter approached the taxpayers with

an aggressive tax planning strategy involving digital options and Canadian dollars.
                                        - 28 -

[*28] The scheme began with the purchase of foreign-currency short and long

options as well as Canadian dollars through a single-member LLC, the formation

of a partnership with a third party, and the contribution of the options and the

Canadian dollars to that partnership. The options would then expire worthless,

creating huge tax losses at the partnership level that could be unlocked when the

single-member LLC sold the Canadian dollars it received when the partnership

liquidated. There, the Commissioner argued the LLCs were single-member LLCs

and should be disregarded for tax purposes. The taxpayers countered that because

theirs was a community-property state, their wives were the second owners of the

LLCs, making the LLC a partnership by default under the regulations. See sec.

301.7701-3(a), (b)(1)(i), Proced. & Admin. Regs. We disagreed with the

taxpayers, because not a single Luna factor weighed in favor of finding a

partnership entity and several weighed heavily against it.

      In Historic Boardwalk, the Third Circuit concluded that a partner who

avoids any meaningful downside risk in the partnership, while enjoying a dearth of

meaningful upside potential, was not a bona fide partner at all. 694 F.3d at 455-

60. Following the Second Circuit in TIFD, the Third Circuit held that to be a bona

fide partner for tax purposes, a party must “have a meaningful stake in the success
                                        - 29 -

[*29] or failure of the enterprise.” Id. at 449. The Second Circuit itself had

disregarded two foreign banks as possible partners because the prevailing

character of their interest resembled debt, rather than equity. TIFD, 459 F.3d at

231 (finding the purported interests “overwhelmingly in the nature of a secured

lender’s interest, which would neither be harmed by poor performance of the

partnership nor significantly enhanced by extraordinary profits”).

      The Seventh Circuit in Superior Trading disregarded a supposed partnership

where it lacked a valid business purpose aside from tax motivation. In that case,

the partners created an LLC and contributed to it uncollectible accounts receivable

from a defunct Brazilian company. The partners then sold their interests to

outsiders who could then take advantage of the losses on the sales of the worthless

receivables16 --all due to a loophole in the Code since closed by the American Jobs

Creation Act of 2004, Pub. L. No. 108-357, sec. 833, 118 Stat. at 1589, amending


      16
          Under the rules of Subchapter K, the contribution of an asset to a
partnership defers the recognition of gain or loss attributable to any change in the
asset’s value until the partnership sells the asset. See sec. 721(a). If the asset has
gone down in value, it is known colloquially as a built-in loss asset, and a loss will
be recognized and usable to reduce taxable income only when the partnership sells
it. See sec. 704(c)(1)(A). If the contributing partner sells his partnership interest
before the partnership sells the contributed asset, the buyer of the partnership
interest steps into his shoes and will recognize the built-in loss or gain if and when
the partnership sells the asset. Sec. 1.704-3(a)(7), Income Tax Regs.; see also
Superior Trading, 728 F.3d at 679.
                                           - 30 -

[*30] sections 704(c) and 743. The court found that the sole purpose of creating

the LLC was to transfer the losses of the bankrupt Brazilian retailer to U.S.

taxpayers who could then deduct the losses from their taxable income. The court

also found that a bona fide partnership requires a joint business goal by the

partners. Superior Trading, 728 F.3d at 680 (no joint business goal where one

partner aimed to extract value on a worthless asset, and the other aimed to make

the loss of that asset a “tax bonanza”).

      MC Investments’s operating agreement states that its purpose is to “acquire,

own, invest in, sell, assign, transfer and trade United States and foreign currencies

and futures contracts relating to currencies and other commodities * * * put and/or

call options including interest rates * * * and to conduct all lawful activities as the

Managers may agree from time to time.” The actual facts undermine this grand

statement: They show that Markell created MC Investments just days before

Markell, through MC Trading (itself a disregarded entity for tax purposes) bought

the paired options and NASDAQ index stock. Markell then contributed its interest

in MC Trading to MC Investments. As a result, MC Trading remained a

disregarded entity, meaning that for tax purposes, it was as though Markell

directly contributed the paired options to MC Investments in exchange for a

partnership interest. Markell then cashed out a few months later. There is no
                                         - 31 -

[*31] evidence that during this time the partnership did anything other than buy

the 275 QQQ shares that were required for Markell to achieve its tax benefit. We

therefore find that MC Investments was created to carry out a tax-avoidance

scheme, and we find that Markell never intended to run a business through the

entity. We therefore will disregard MC Investments.

       We find that Markell had no intention to join MC Investments to share in

profits and losses from business activities--it left after ten weeks and unwound the

only transaction MC Investments ever made. And that transaction was done

through MC Investments only to move forward with a tax-avoidance scheme. We

find that the character of the resulting tax loss, and not any potential for profit, was

the primary consideration Markell had in buying, contributing, and then

distributing assets using MC Investments.

III.   Section 1.752-6T, Temporary Income Tax Regs.

       Even if we were to find that MC Investments was a bona fide partnership,

we would still have to hold that Markell’s outside basis in its partnership interest

was radically lower than what it reported because section 752 compels Markell to

report the short option as a liability that MC Investments was assuming.17

       17
        In Countryside Ltd. P’ship v. Commissioner, T.C. Memo. 2008-3, we
endorsed the Second Circuit’s reasoning in Goldstein v. Commissioner, 364 F.2d
                                                                   (continued...)
                                        - 32 -

[*32] Section 752 deals with the treatment of certain liabilities and provides that

the assumption of a partner’s liability by the partnership is considered a

distribution from the partnership to that partner, while the assumption of a

partnership’s liability by a partner is considered a contribution by that partner to

the partnership. See sec. 752(a) and (b). Together with section 722, section

752(b) reduces the partner’s outside basis if the partnership assumes a “liability”

of the partner. Markell relies on Helmer v. Commissioner, T.C. Memo. 1975-160,

and Jade Trading, LLC v. United States, 80 Fed. Cl. 11 (2007), aff’d in part, rev’d

in part and remanded in part, 598 F.3d 1372 (Fed. Cir. 2010), for the proposition

that short options are contingent and uncertain and are therefore not “liabilities”

under sections 752 and 722.

      Soon after the release of Notice 2000-44 which alerted taxpayers to the

IRS’s crackdown on the Son-of-BOSS transactions,18 the Treasury Department


      17
        (...continued)
734 (2d Cir. 1966), aff’g 44 T.C. 284 (1965), that literal compliance with the
conditions for application of a particular Code section is not enough where the
underlying transaction fails to comport with Congress’ purpose in enacting that
section. When an out-of-pocket loss of $75,000 is wedded to a tax loss of $14
million--it’s usually “the sort of thing that the IRS frowns on.” See Cemco
Investors LLC v. United States, 515 F.3d 749, 751 (7th Cir. 2008).
      18
        The Notice enumerates several variations of the Son-of-BOSS transaction,
including one where a partner purchases and writes options and purports to create
                                                                    (continued...)
                                         - 33 -

[*33] issued section 1.752-6 in 2003 as a temporary regulation, and then in 2005

as a permanent one. T.D. 9207, 2005-1 C.B. 1344, 70 Fed. Reg. 30334 (May 26,

2005). That regulation states that it applies to assumptions of liabilities occurring

“after October 18, 1999, and before June 24, 2003.”19 It provides that if, in a

transaction described in section 721, a partnership assumes a liability (as defined

in section 358(h)(3)) of a partner (other than a liability to which section 752(a) and

(b) apply), then, after application of section 752(a) and (b), the partner’s basis in

the partnership is reduced (but not below the adjusted value of such interest) by

the amount of the liability, determined as of the date of the exchange. Cemco

Investors, LLC v. United States, 515 F.3d 749, 752 (7th Cir. 2008). All of which

is to say that contingent liabilities must be counted in calculating basis.

      The courts are in disagreement as to whether this regulation applies

retroactively. Compare Murfam Farms, LLC v. United States, 88 Fed. Cl. 516

(2009) (regulation invalid), and Klamath Strategic Inv. Fund, LLC v. United



      18
        (...continued)
positive basis in a partnership interest by transferring those options to the
partnership.
      19
        The Seventh Circuit has explained the norm that a regulation or law
should apply only prospectively “may be superseded by a legislative grant from
Congress authorizing the Secretary to prescribe the effective date with respect to
any regulation.” 26 U.S.C. sec. 7805(b)(6); Cemco, 515 F.3d at 752.
                                        - 34 -

[*34] States, 440 F. Supp. 2d 608, 619-25 (E.D. Tex. 2006), with Cemco, 515 F.3d

at 752. Markell argues that we cannot apply the regulation retroactively; the

Commissioner disagrees and urges us to follow the Seventh Circuit in Cemco. We

agree with the Commissioner, and hold the regulation valid because it was issued

under a specific congressional grant of authority in section 309(c)(1) of the 2000

Consolidated Appropriations Act, 2001, Pub. L. No. 106-554, app. G., sec.

309(c)(1), 114 Stat. at 2763A-587, 638 (2000). See Cemco, 515 F.3d at 752

(noting Act specifically allowed the retroactive application of associated

regulations).

IV. Effects

      What would be the effects of either of these analyses on the ultimate issue in

this case?

      Our primary holding is that MC Investments was not, as a matter of fact, a

partnership at all.

      The absence of a valid partnership means the rules of subchapter K no

longer apply to the transaction. A disregarded partnership has no identity separate

from its owners, and we treat it just as an agent or nominee. See, e.g., Tigers Eye

Trading LLC, v. Commissioner, 138 T.C. 67, 94, 96 n.32, 99 (2012). Although we

don’t respect the form, we still need to deal with the substance of the transactions.
                                        - 35 -

[*35] See ACM P’ship v. Commissioner, 157 F.3d 231, 262-63 (3d Cir. 1998),

aff’g in part, rev’g in part T.C. Memo. 1997-115.

      Disregarding MC Investments as a partnership, we treat MC Investments as

having purchased the QQQ stock on behalf of Markell as its agent. MC

Investments initially bought 275 shares for $9,837, and Markell later sold 230 of

those shares for $5,554. Markell thus incurred a loss on the sale of the QQQ stock

of $2,673.

      Turning to the treatment of the options, Markell conceded that the options

were a single option as an economic matter, and we see no reason why they should

not also be viewed as a single option as a legal matter. Markell priced the options

as an economic unit, and looked for its profit to the net value of the pair at

expiration, not to the off-chance that a single option would expire in the money.

They were acquired on the same date, executed with the same counterparty,

contingent on identical facts, and exercisable on the same date. Although they did

have separate confirmations, the ISDA Master Agreement’s netting provision

collapsed the two into a single unit. We therefore find that Markell should have

treated the options as a single option spread since the long and short legs were part

of one contract and couldn’t have been separated as a matter of fact and law. Cf.

sec. 1092 (“straddle” rules). This makes Markell’s basis equal to $75,000. This
                                        - 36 -

[*36] was the only money that changed hands between Markell and Refco and is

the appropriate basis. When the options expired worthless, Markell could claim a

$75,000 loss. Even our alternative holding--that if one assumes MC Investments

was a bona fide partnership, the basis rules of section 1.752-6, Income Tax Regs.,

would still pop the inflated-basis balloon--would lead to much the same result.

The contributed options would have a basis of $75,000. Under the regulation

Markell’s outside basis in MC Investments would then be only $75,000. On the

liquidation of its interest, under section 731, Markell would get a transferred basis

in the property distributed under section 732 equal to its outside basis in the

partnership at the time, reduced by any money received. Because Markell

received $43 in cash, its transferred basis is $74,957, and upon the sale of the

QQQ shares, it would recognize a loss of $69,402.68. In any event, we sustain the

Commissioner’s determination on the disallowance of the giant loss and the

recognition of Markell’s giant gain on the sale of its stock portfolio.

V.    Penalties

      The Commissioner argues that Markell owes a penalty under section 6662

for the underpayment of tax due to a valuation misstatement, and not just any

valuation but one that is “gross”. A gross-valuation misstatement increases the

usual 20% accuracy-related penalty to 40%. Sec. 6662(h)(1). For returns filed
                                       - 37 -

[*37] before 2006, section 6662(h)(2)(A)(i) defined a valuation misstatement as

“gross” if it was 400%, and overstatement of an asset’s adjusted basis is a

misstatement of value. Sec. 6662(e)(1)(A); Cemco, 515 F.3d 749; Santa Monica

Pictures, LLC v. Commissioner, T.C. Memo. 2005-104; Long Term Capital

Holdings v. United States, 330 F. Supp. 2d 122, 199 n.99 (D. Conn. 2004), aff’d,

150 Fed. Appx. 40 (2d Cir. 2005). Markell reported a basis in the shares of

$14,999,957 when in fact its basis was $75,000. This is more than 400% over the

correct amount, and makes Markell prima facie liable for the 40% misstatement

penalty.

      Markell, however, claims that it has a defense. That defense requires

Markell to show that it acted with reasonable cause and in good faith.20 We decide

these questions on a case-by-case basis, taking into account all

the facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. These

include an examination of whether a taxpayer had an honest misunderstanding of

fact or law that was reasonable in the light of the experience, knowledge, and

education of the taxpayer. Id.


      20
        Because this is a case of a gross-valuation misstatement, we apply the
reasonable-cause rules associated with the application of the penalty on that
ground. See Gustashaw v. Commissioner, T.C. Memo. 2011-195, aff’d, 696 F.3d
1124 (11th Cir. 2012); sec. 1.6664-4(b)(1), Income Tax Regs.
                                        - 38 -

[*38] On this question we reach no different answer here than we did recently in

Humboldt Shelby Holding Corp. v. Commissioner, T.C. Memo. 2014-47, at *25-

*26. Markell’s underpayment did not result from an honest misunderstanding of

the law. Haber is a sophisticated tax planner who deliberately exploited a

perceived loophole in the law to try to eliminate a substantial built-in capital gain.

Haber’s extreme sophistication defeats any effort to say this attempted

manipulation of the partnership form and indifference to an applicable regulation

was done in good faith.

      Markell’s efforts to show that it had reasonable cause likewise fails. It was

based entirely on Haber’s unreasonable interpretation of Helmer. But Helmer is

an increasingly wobbly authority on which to rest. Compare Palm Canyon X

Invs., LLC v. Commissioner, T.C. Memo. 2009-288 (Helmer superseded by

Notice 2000-44), Cemco, 515 F.3d at 751 (Helmer not controlling in that court “or

anywhere else”), and Maguire Partners-Master Invs., LLC v. United States, 104

A.F.T.R.2d (RIA) 2009-7839 (C.D. Cal. 2009) (following Cemco), aff’d sub nom.

Thomas Inv. Partners, Ltd. v. United States, 444 Fed. Appx. 190 (9th Cir. 2011),

with Jade Trading, LLC, 80 Fed. Cl. 11 (Helmer as controlling authority), and

Stobie Creek Invs., LLC v. United States, 82 Fed. Cl. 636, 666 (2008) (Helmer

significant factor), aff’d, 608 F.3d 1366 (Fed. Cir. 2010). In Helmer, we held that
                                          - 39 -

[*39] there was no contingent liability where the transaction underlying the option

was left open, and the option premiums were not subject to forfeiture. But we

recently held in 6611 Ltd., that Helmer is distinguishable from situations where a

party selling a put option lacks the financial capacity to ever close it out. And no

taxpayer should be able to pretend that Helmer exists in a vacuum: On August 13,

2000, more than a year before the MC Investments arrangement, the IRS published

Notice 2000-44, alerting taxpayers that these types of transactions--those designed

to overstate outside basis by producing noneconomic losses--are abusive tax

shelters and would be subject to penalties. The notice explicitly lists the

offsetting-option device as one such transaction. So Haber (and through him

Markell) received ample warning that the Commissioner was not likely to respect

the tax treatment of the transaction.21




      21
          Another way to show reasonable cause and good faith is to reasonably and
in good faith rely on a professional tax adviser’s opinion. Markell does not argue
that the tax opinion it received for this very purpose satisfies the reasonable-belief
requirement. And, since we’ve already found that MC Investments had no
business purpose, we must deny Markell any deduction for the $22,500 in fees
paid to that firm for its opinion on the deal. See Brown v. Commissioner, 85 T.C.
968, 1000 (1985), aff’d sub nom. Sochin v. Commissioner, 843 F.2d 351 (9th Cir.
1988).
                                     - 40 -

[*40] We therefore reject Markell’s defense to the gross valuation-misstatement

penalty.

                                              An appropriate decision

                                     will be entered.
