Appeals Court Overturns Taxpayer Win in Tax Shelter Case

The U.S. Court of Appeals for the Tenth Circuit has held that a taxpayer’s investment in a “son of boss” tax shelter lacked economic substance and therefore did not generate deductible losses ( Sala, No. 08-1333  (10th Cir. 7/23/10)). This holding reverses a rare taxpayer win on the issue of son of boss tax shelters in which a district court had allowed the taxpayer to deduct losses from the investment (Sala, No. 05-cv-00636-LTB (D.C. Colo. 4/22/08)).

The taxpayer invested in a so-called son of boss shelter called the Deerhurst Program by acquiring a combination of long and short foreign currency options and contributing them to a short-lived partnership. Upon liquidating the partnership, the taxpayer claimed a tax loss of more than $60 million, offsetting $60 million of income for the tax year, and he reported owing no federal taxes for the year. After amending his return, the taxpayer ended up claiming a $24 million refund for the tax year. The IRS disallowed the refund, but at trial the district court ruled in favor of the taxpayer on all issues.

The IRS argued that the transactions that generated the tax loss had no economic substance—that they were entered into purely to generate the tax loss. The district court looked at all the taxpayer’s transactions over a five-year period—including transactions that had no tax benefit—and held that the taxpayer had a “reasonable possibility of profits beyond the tax benefits” and had a “business purpose other than tax avoidance.”

The Tenth Circuit held that the district court had erred in broadening the focus beyond the taxpayer’s participation in the phase of the Deerhurst Program that occurred in 2000 (the Deerhurst GP). It then examined whether the Deerhurst GP phase of the Deerhurst Program had economic substance and concluded that it did not, determining that “the claimed loss generated by the program was structured from the outset to be a complete fiction.” Although the taxpayer could have made a profit from the offsetting options purchased in the Deerhurst GP phase in 2000, the appeals court determined that the potential profits from the scheme were dwarfed by the potential tax benefits. Therefore, the Tenth Circuit reversed the district court’s decision and instructed it to enter judgment in favor of the IRS.