In order for a transaction to be respected for Federal income tax purposes, it must have economic substance. So-called “tax shelters” often generate tax losses with minimal economic loss to their participants and they often do no survive IRS challenge. For example, the Tax Court in Endeavor Partners Fund, LLC, et al. v. Commissioner (TC Memo 2018-96) refused to allow certain taxpayers to claim losses arising from certain transactions in foreign currency options.
Endeavor Partners involves a group of tax shelter promotors who engaged in various trades of foreign currency options to allow participants to “roll forward” excess losses generated from previous tax shelters. The options used were paired, in the sense that a gain on one contract would generally be entirely offset by a loss on the other contract. Although the transactions in form were very complex, the purported tax result was to generate taxable income to participants in the first year, which would be offset by prior tax shelter losses, and similarly sized losses in the second year, thus “rolling” the losses into the second year.
Although the exact standards for economic substance (now codified at Sec. 7701(o) of the Internal Revenue Code) has varied among the circuits, the two tests generally used are:
- The transaction must have an objective potential for economic profits
- The transaction must have a substantial business purpose, aside from an attempt to drive tax results
Upon examining the transactions, the Tax Court found that they did not meet either test, and thus disallowed the loss deductions in the second year. In addition, the Tax Court also disallowed losses from other tax motivated transactions, this time for the benefit of the shelter promoters, on similar grounds.
Lastly, the Tax Court turned to the matter of accuracy-related penalties. Although the Tax Court stated that the conduct of the partnerships clearly merited the application of accuracy-related penalties, it found the penalty were not approved by the immediate supervisor of the IRS auditor who initially determined the penalty. Therefore, the Tax Court had no choice but to eliminate the accuracy-related penalty.