Economic Substance Prevails against Another Son of BOSS

By Upshaw, Alice A.; Pulliam, Darlene | Journal of Accountancy, March 2008 | Go to article overview

Economic Substance Prevails against Another Son of BOSS


Upshaw, Alice A., Pulliam, Darlene, Journal of Accountancy


The IRS scored a major success in its war against Son of BOSS-type tax shelters in Jade Trading LLC. The Court of Federal Claims used the application of the economic substance doctrine in Coltec Industries to disallow losses involving partnerships and euro call options.

In 1999, after clearing approximately $40 million on the sale of their cable businesses in Kentucky, three brothers, Gary, Robert and Tim Ervin, each formed a limited liability corporation. The LLCs each purchased euro options from insurer and financial services company American International Group (MG) for a premium of $15,000,020. At the same time, each LLC sold a euro option to AIG for $14,850,018 and paid AIG the difference, $150,002. Each LLC then contributed its option spread to Jade Trading LLC, an investment vehicle, and treated its basis as equal to the premium for the purchased call option. In so doing, the brothers' LLCs ignored the premium for the sold call option by claiming that the call options assumed by Jade were contingent obligations. Shortly thereafter, each LLC redeemed its partnership interest at its fair market value--a relatively small amount equal to the difference in the options. In each case, a loss was claimed for the difference between the fair market value of the partnership interest and the claimed basis of almost $15 million. On their 1999 returns, each Ervin brother claimed close to $15 million in losses and expenses from the execution of the spread transaction and involvement in Jade. The IRS audited the returns and disallowed these losses. The Ervins appealed to the Court of Federal Claims.

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The court held that the Jade transactions failed the economic substance doctrine as clarified in the Coltec decision (98 AFTR2d 2006-5249; see also "Tax Matters: Denial of Contingent Liability Loss Deduction," JofA, Jan. 07, page 67). In Coltec, the Court of Appeals for the Federal Circuit (overturning the Court of Federal Claims) determined that the legitimacy of a transaction for tax purposes is not guaranteed merely because a technical interpretation of the Code would support the tax treatment. …

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