JADE TRADING, LLC et al v. USA

Filing 406

PUBLISHED OPINION. Signed by Judge Mary Ellen Coster Williams. (tb1) Copy to parties.

In the United States Court of Federal Claims
No. 03-2164T
(Filed: April 29, 2011)

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JADE TRADING, LLC, ET AL.,
Plaintiffs,
v.
THE UNITED STATES,
Defendant.

Tax Equity and Fiscal
Responsibility Act of 1982,
26 U.S.C. §§ 6226, 6662;
Jurisdiction to Apply
Accuracy-Related Penalties in
a Partnership Proceeding;
Outside Basis; Lack of
Economic Substance.

* * * * * * * * * * * * * * * * * * * * * * ** * * * *
David D. Aughtry, Chamberlain, Hrdlicka, White, Williams, & Martin, 191 Peachtree
Street, N.E., 34th Floor, Atlanta, GA, and Linda S. Paine, Chamberlain, Hrdlicka, White,
Williams, & Martin, 1200 Smith Street, 14th Floor, Houston, TX, for Plaintiffs.
Joseph B. Syverson, U.S. Department of Justice, P.O. Box 26, Ben Franklin Post Office,
Washington, D.C., for Defendant.
_____________________________________________________________________
OPINION AND ORDER FOLLOWING REMAND
_____________________________________________________________________
WILLIAMS, Judge.
This tax case comes before the Court on remand from the United States Court of Appeals
for the Federal Circuit for a determination of whether this Court possesses jurisdiction to apply
accuracy-related penalties in this partnership proceeding. In Jade Trading, LLC v. United States,
80 Fed. Cl. 11 (2007) (“Jade Trading I”), this Court found that a variation of a bond and options
sales strategy (“Son of BOSS”) transaction lacked economic substance and that accuracy-related
penalties applied at the partnership level.
On appeal, the Federal Circuit affirmed that the transaction lacked economic substance but
vacated the determination that penalties applied because this Court had relied upon the individual
partners’ outside bases, which are not partnership items, in applying the penalties. The Federal
1

Circuit remanded the case to this Court to determine “whether any part of the penalties could have
been assessed without relying on the Ervins’ outside bases.” Jade Trading, LLC v. United States,
598 F.3d 1372, 1381 (Fed. Cir. 2010) (“Jade Trading II”). On remand, this Court concludes that
none of the penalties could have been applied without relying on the individual partners’ outside
bases. As such, the Court lacks jurisdiction to determine the applicability of the penalties in this
partnership proceeding.
Background
Robert W. Ervin and his two brothers were equal partners in a cable business. They sold
the business in 1999, resulting in a total gain per brother of approximately $13.5 million. In
September of 1999, the Ervin brothers each formed a single-member LLC (collectively, the “Ervin
LLCs”). On September 15, 1999, each Ervin LLC entered into a separate master trading
agreement with American International Group, Inc. (“AIG”), requiring each Ervin LLC to pay an
$84,100 account opening fee. On September 29, 1999, each Ervin LLC purchased from AIG a
call option on the euro at a strike price of 1.0840 for $15,000,020 and sold to AIG a call option on
the euro at a strike price of 1.0850 for $14,850,018. “The options were all European-style options
that expired on September 29, 2000, and had a face amount of 290,540,000 euros.” Jade Trading
II, 598 F.3d at 1375. Each Ervin LLC paid AIG only $150,002 -- the difference in the premiums
of the offsetting options. On October 2, 1999, each Ervin LLC entered into a 15-month
consulting agreement with New Vista, LLC (“New Vista”), requiring each Ervin LLC to pay New
Vista $750,000 for “consulting services.” Id. Payment of this fee was a prerequisite to the Ervin
LLCs being admitted to the Jade Trading, LLC partnership (“Jade”), which Sentinel Advisors,
LLC (“Sentinel”) and Banque Safra, a Luxembourg financial institution, had created on
September 23, 1999; Sentinel was the managing partner. On October 6, 1999, each Ervin LLC
entered Jade as a partner.1 That same day, each Ervin LLC contributed these euro call options as
well as $75,000 cash to Jade. In December of 1999, each Ervin LLC withdrew from Jade. Each
Ervin LLC’s interest in assets distributed to it by Jade was valued at $126,122 and consisted of
Xerox stock, which was sold in 1999, and euros.
Each Ervin brother claimed approximately $15 million in tax losses for tax year 1999,
resulting from each brother increasing the basis of his interest in Jade -- outside basis -- by the $15
million cost of the purchased call option and “not decreasing this basis by the amount of the
potential liability that Jade assumed under the sold call option.” Id. at 1375-76.
On its Schedule K for tax year 1999, Jade reported a loss of “other income” in the amount
of $292,015 and “[o]rdinary loss from Sec. 988 transactions” in the amount of $314,416. Jt. Ex.
84. The Government asserted that the $314,416 in reported losses included the disregarded
spread transaction but could not explain what other transactions were included in the Section 988

1

Plaintiffs aver that Jade included two other partners who received no tax benefits as a
result of the transaction. Tr. 13. Unless otherwise indicated, “Tr.” refers to the transcript of the
January 12, 2011 oral argument that was held in this matter on remand.
2

transactions or what portion of the $314,416 in losses the spread transaction generated.2 Tr.
136-43.
After auditing Jade’s partnership return for tax year 1999, the Internal Revenue Service
(“IRS”) issued a Notice of Final Partnership Administrative Adjustment (“FPAA”) to Jade. The
FPAA made the following determinations:
1. It is determined that Jade Trading, LLC, is a sham and, under [Treasury
Regulation] § 1[.]701-2, was formed or availed of in connection with a
transaction or transactions in taxable year 1999, a principal purpose of which
was to reduce substantially the present value of the partners’ aggregate federal
tax liability in a manner that is inconsistent with the intent of Subchapter K of
the Internal Revenue Code. It is consequently determined that the partnership is
disregarded and that all transactions engaged [in] by Jade Trading, LLC, are
treated as engaged in directly by the purported partners. This includes the
determination that the Euros and Xerox stock purportedly acquired by the
partnership were acquired directly by purported partners Ervin Holdings, LLC,
Ervin Capital, LLC, and Ervin Investments, LLC.
2. It is determined that, under § 1[.]701-2 of the Treasury Regulations, Euro
currency options, purportedly contributed to or assumed by the partnership, are
treated as never having been contributed to or assumed by the partnership and
any gains or losses purportedly realized by the partnership on the options are
treated as having been realized by the purported partners Ervin Holdings, LLC,
Ervin Capital, LLC, and Ervin Investments, LLC.
3. It is further determined that, under § 1[.]701-2 of the Treasury Regulations,
Ervin Holdings, LLC, Ervin Capital, LLC, and Ervin Investments, LLC, should
be treated as not being partners in the partnership.
4. It is further determined that, under § 1[.]701-2 of the Treasury Regulations,
contributions to the partnership will be adjusted to reflect clearly the
partnership’s or partners’ income.
5. Even if Euro currency options were to be treated as contributed to the
partnership, the bases of the options are reduced, both in the hands of the
contributing partners and the partnership, by an amount received by the
contributing partner from the contemporaneous sale of a substantially similar
option to the same counter-party[.] Thus, any amount treated as an increase in
outside basis from the contribution of Euro currency options is disallowed.
2

Although the Court afforded the parties an opportunity for supplemental briefing to
address this issue, neither party deemed it necessary. Tr. 149-51.
3

6. Accuracy-Related Penalties[:] It is determined that the underpayment of tax
for the taxable year 1999 is due to a gross valuation misstatement of the
adjusted basis in the partners’ basis in their partnership interest and the
consequent basis in the Euros and Xerox stock distributed to partners to which
their partnership basis attached[.] Therefore, the 40 percent penalty is
imposed on the underpayment attributable to the gross valuation misstatement
as provided by Sections 6662(a), 6662(b)(3), 6662(e) and 6662(h) of the
Internal Revenue Code.
Alternatively, it is determined that all or part of the underpayment of tax for the
taxable year 1999 is due to negligence or disregard of rules and regulations for
filing income tax returns. Consequently, the 20 percent penalty is imposed on
the underpayment attributable to negligence or disregard of rules and
regulations as provided by Sections 6662(a), 6662(b)(1), [and] 6662(c) of the
Internal Revenue Code.
Alternatively, it is determined that the underpayment of tax for the taxable year
1999 is due to an underpayment attributable to substantial understatement of
income tax. Consequently, the 20 percent penalty is imposed on the
underpayment attributable to the gross valuation misstatement as provided by
Sections 6662(a), 6662(b)(2), [and] 6662(c) of the Internal Revenue Code.
Alternatively, it is determined that the underpayment of tax for the taxable year
1999 is a substantial understatement of income tax because the transaction is a
tax shelter, no substantial authority has been established for the position taken,
and there was no reasonable belief upon the filing of the return that the position
taken was more likely than not the correct treatment of the transaction.
Consequently, the 20 percent penalty is imposed on the underpayment
attributable to the gross valuation misstatement as provided by Sections
6662(a), 6662(b)(2), [and] 6662(c) of the Internal Revenue Code.
Jt. Ex. 109.
Jade Trading I
In Jade Trading I, the Court held that the spread transaction lacked economic substance,
stating:
In sum, this transaction’s fictional loss, inability to realize a profit, lack of
investment character, meaningless inclusion in a partnership, and disproportionate
tax advantage as compared to the amount invested and potential return, compel a
conclusion that the spread transaction objectively lacked economic substance.
80 Fed. Cl. at 14.
4

The Court further determined that the accuracy-related penalties applied because
§ 6226(f) confers jurisdiction on this Court to determine the “applicability of any penalty, addition
to tax, or additional amount which relates to an adjustment to a partnership item.” Id. at 41
(quoting 26 U.S.C. § 6226(f)). Specifically, § 6226(f) provides:
Scope of Judicial Review. A court with which a petition is filed in accordance
with this section shall have jurisdiction to determine all partnership items of the
partnership for the partnership taxable year to which the [FPAA] relates, the proper
allocation of such items among the partners, and the applicability of any penalty,
addition to tax, or additional amount which relates to an adjustment to a partnership
item.
26 U.S.C. § 6226(f). Section 6231(a)(3) defines “partnership item” as follows:
Partnership item. The term “partnership item” means, with respect to a
partnership, any item required to be taken into account for the partnership’s
taxable year under any provision of subtitle A . . . to the extent regulations
prescribed by the Secretary provide that, for purposes of this subtitle . . . such item
is more appropriately determined at the partnership level than at the partner level.
26 U.S.C. § 6231(a)(3). Section 6231(a) also defines “nonpartnership item” and “affected
item”:
(4) Nonpartnership item. The term “nonpartnership item” means an item which
is (or is treated as) not a partnership item.
(5) Affected item. The term “affected item” means any item to the extent such
item is affected by a partnership item.
26 U.S.C. § 6231(a)(4),(5). An affected item is not a partnership item. Petaluma FX
Partners, LLC v. Comm’r, 135 T.C 29, 2010 WL 5209376, at *3 (Dec. 15, 2010)
(“Petaluma III”), appeal docketed, No. 024717-05 (D.C. Cir. Mar. 8, 2011).
Penalties Applied in Jade Trading I
In Jade Trading I, this Court applied a 40 percent gross valuation misstatement penalty
because the Ervin LLCs’ bases in their Jade partnership interests exceeded the correct amounts by
400 percent or more. Specifically, this Court found that although each Ervin LLC treated its
partnership interest in Jade as having a basis of approximately $15 million, the actual basis was
$225,002. 80 Fed. Cl. at 53.
In the alternative, this Court applied the 20 percent negligence penalty at the partnership
level, reasoning:

5

[I]n the instant case, Sentinel’s principal, Bergmann, while not an attorney, was a
CPA with tax experience, having headed the Transaction Development Group at
Bankers Trust which, inter alia, advised clients on tax transactions and hedge fund
structures. Bergmann was instrumental in developing the spread transaction with
BDO Seidmann [sic] and paramount in marketing the transaction to the Ervins. It
was Bergmann’s pitch, along with BDO Seidman’s and Curtis Mallet's
recommendations, which persuaded the Ervins to do the deal. Further, while
Sentinel and Bergmann were to do the trading, that was not their only role -Sentinel’s CFO, Conjeevaram, prepared the paperwork for the Ervin LLCs and
worked with AIG devising the procedures to be followed -- using Sentinel personnel
and its accounting firm, Untracht. Sentinel was involved not only in executing the
spread transaction but also in facilitating contributions to and redemptions from the
partnership, including valuing the partnership assets and determining the assets to be
redeemed. Finally, Sentinel’s accounting firm, Untracht, prepared and signed
Jade’s 1999 tax return.
The spread transaction contributed to Jade was structured to yield and did yield tax
benefits which Bergmann should have recognized as being “too good to be true.”
The Ervin LLCs only had to “invest” $150,002 to purchase the spread options but in
return received approximately $15 million each in taxable losses. The Ervin LLCs
were protected from realizing any significant financial losses as they could lose no
more than their initial investment in Jade. The transaction which Bergmann
brought to BDO Seidman from the street was an elaborate fictional construct with no
economic consequences other than tax benefits. A reasonably prudent investor
with Bergmann’s hedge fund and market experience would have known there was
no investment and no potential for profit in the spread transaction. A reasonably
prudent person with Bergmann’s CPA background and tax experience would not
have conducted himself as Bergmann did here in promoting and facilitating the
reporting of such substantial tax losses from a fictional transaction.
Nor does the Ervins’ reliance on Curtis Mallet and BDO Seidman defeat the
partnership’s negligence penalty here. “While it is true that actual reliance on the
tax advice of an independent, competent professional may negate a finding of
negligence . . . the reliance itself must be objectively reasonable in the sense that the
taxpayer supplied the professional with all the necessary information to assess the
tax matter and that the professional himself does not suffer from a conflict of interest
or lack of expertise that the taxpayer knew of or should have known about.” Both
BDO Seidman’s model opinion and Curtis Mallet’s opinion were premised on the
fallacy that the spread transaction could generate a profit. Moreover, Jade itself did
not obtain an opinion from Curtis Mallet, only the Ervins did. Nor does Sentinel’s
and the Ervins’ reliance on BDO Seidman advance their cause. “It is well
established that taxpayers generally cannot reasonably rely on the professional
advice of a tax shelter promoter.”

6

Id. at 56-57 (internal citations omitted).
Sentinel moved the Court for reconsideration, arguing that the Court erred in applying the
negligence penalty at the partnership level because the partnership item in dispute was each
Plaintiff’s outside basis in Jade, which was not reported on Jade’s return, and Sentinel’s conduct
should not have been considered in applying the negligence penalty. See Jade Trading, LLC v.
United States, 81 Fed. Cl. 173, 174 (2008). In denying reconsideration, the Court stated:
“[the Ervin LLCs’] contributions to Jade and Jade’s distributions to them for
purposes of its books and records and furnishing information to its partners, were
‘partnership items’” . . . The negligence penalty clearly related to the inflated basis
the spread transaction in the partnership generated on the Ervins’ individual returns
-- which in turn caused the Ervins’ tax losses. . . . [T]he Court’s jurisdiction extends
to all the legal and factual determinations that underlie the determination of any
penalty. . . . [T]he character of spread transactions contributed to and redeemed
from the partnership were determinations underlying the application of the
negligence penalty which the Court had to make.
Id. at 176 (internal citations omitted).3 The Court further observed that applying the penalty in
Jade Trading I was proper because “‘packaging the investment in the partnership vehicle was an
absolute necessity for securing the tax benefits.’” Id. (quoting Jade Trading I, 80 Fed. Cl. at 14).
In addition to the gross valuation misstatement and negligence penalties, the Court
determined, in the alternative, that a substantial understatement penalty applied. An
understatement is substantial if it exceeds the greater of $5,000 or 10 percent of the tax required to
be reported on the return. Jade Trading I, 80 Fed. Cl. at 57. To obtain relief from the penalty, the
taxpayer has the burden of showing that “substantial authority” supported its position. Id.
Where, as here, an understatement was attributable to a tax shelter, the taxpayer is required to
prove that it “‘reasonably believed that [its position] was more likely than not the proper
treatment.’” Id. (citation omitted). This Court accepted Plaintiffs’ argument that Helmer v.
Comm’r, 34 T.C.M. (CCH) 727 (1975), and its progeny supported “the premise that a sold call
option would not constitute a liability under Section 752 for purposes of calculating a partner’s
basis in its partnership interest.” Id. at 58. However, the Court concluded that the substantial
understatement penalty applied because “the fictional nature of the transaction and its lack of
economic reality outweigh[ed] Helmer in the substantial authority assessment.” Id.4
3

Although the Federal Circuit did not reference Sentinel’s motion for reconsideration in Jade
Trading II, it is clear that this Court’s reasoning in the reconsideration decision was likewise
vacated because this Court’s application of the negligence penalty depended upon “the inflated
basis the spread transaction in the partnership generated on the Ervins’ individual returns.” Jade
Trading, 81 Fed. Cl. at 176.
4

The Court in Jade Trading I held that reasonable cause defenses to penalties could not be
litigated in the partnership-level proceeding. 80 Fed. Cl. at 60. Lacking jurisdiction over the
7

Jade Trading II
Although the Federal Circuit upheld this Court’s determination that the spread transaction
lacked economic substance, the Court vacated the decision applying accuracy-related penalties.
The Federal Circuit found that this Court lacked jurisdiction because, in applying the penalties,
this Court had relied upon outside basis -- the value assigned to a partner’s investment in its
partnership interest -- which is not a partnership item. Jade Trading II, 598 F.3d at 1379-80
(citing Petaluma FX Partners, LLC v. Comm’r, 591 F.3d 649 (D.C. Cir. 2010) (“Petaluma II”),
aff’g in part, rev’g in part, and vacating in part, 131 T.C. 84 (2008)). Applying Petaluma, the
Federal Circuit explained:
The parties’ arguments on appeal in Petaluma were strikingly similar to those in
this case. As in the present case, Petaluma argued that outside basis is an affected
item, not a partnership item and, therefore, the Tax Court had no right to determine
that its partners’ outside bases were zero. Also similar to this case, the
government conceded that outside basis is not a partnership item but then argued
that outside basis is an affected item whose elements are largely or entirely
partnership items.
The D.C. Circuit agreed with Petaluma, stating that “the partners’ outside bases are
affected items, not partnership items. Unlike partnership items, affected items are
determined not at the partnership level, but at the individual partner level.” The
court observed that not only are partnership items and affected items treated at
different levels, the assessment procedures are different. In the case of a
partnership item, the IRS may directly assess the tax against the individual partner
by making a computational adjustment -- applying the new tax treatment of all
partnership items to the partner’s return -- and the partner must bring a refund claim
to challenge the computation. However, if the partner’s liability relates to affected
items, the IRS must send a notice of deficiency to that partner, thereby initiating a
deficiency proceeding against him individually.
The court concluded that under § 6226(f) the Tax Court did not have jurisdiction to
review the determination that the individual partners had no outside basis in
Petaluma. The court rejected the government’s contention that, although an affected
item, outside basis could be determined in the partnership-level proceeding. “The
fact that a determination seems obvious or easy does not expand the court’s

reasonable cause defenses, the Court did not make findings of fact with respect to whether any
individual partner met the particularized requirements of the reasonable cause exception in
§ 6664(c)(1). Jade Trading, 81 Fed. Cl. at 178. The Federal Circuit vacated the Court’s holding
that the Ervin LLCs could not raise partner-level defenses at the partnership level because its
vacatur of the application of the penalties rendered potential defenses to these penalties moot.
Jade Trading II, 598 F.3d at 1381.
8

jurisdiction beyond what the statute provides. In other words, it does not matter
how low the fruit hangs when one is forbidden to pick it.”
Id. (internal citations omitted).
Discussion
Issue on Remand5
In Jade Trading II, the Federal Circuit vacated the Court’s application of penalties for lack
of jurisdiction because this Court had relied solely upon outside basis in applying the penalties.
598 F.3d at 1380. The Federal Circuit remanded the issue of “whether any penalties could have
been assessed without relying on the Ervins’ outside bases,” noting “[b]ecause it is possible that at
least some portion of the penalties could have been computed without relying on the partners’
outside bases, we conclude that the penalty issue should be vacated and remanded.” Id.
As the proponent of jurisdiction, Defendant bears the burden of establishing the Court’s
jurisdiction. Reynolds v. Army & Air Force Exch. Serv., 846 F.2d 746, 748 (Fed. Cir. 1988);
Stephenson v. United States, 58 Fed. Cl. 186, 191 n.5 (2003) (explaining that the proponent of
subject matter jurisdiction has the burden to establish it); see generally McNutt v. GMAC, 298
U.S. 178, 181 (1936) (burden of proving jurisdiction is on the one asserting jurisdiction).
Contrary to the Federal Circuit’s instructions on remand, Defendant did not persuasively
identify any item that could support applying any penalty or portion of a penalty at the partnership
level without relying upon the Ervin LLCs’ outside bases. Instead, Defendant posited three
partnership items that either ignored the fact that outside basis would have to be relied upon or that
could not support the application of any penalty. First, Defendant postulated that the claimed
findings that Jade was a sham and the spread transaction lacked economic substance carried the
day in permitting the application of penalties without regard to the Ervin LLCs’ outside bases.
According to the Government, such determinations reduced Jade’s inside basis in the spread
transaction to zero and constituted partnership items. However, both the Federal Circuit in Jade
Trading II and the D.C. Circuit in Petaluma recognized that penalties could not be applied on the
ground that the partnership was a sham and/or lacked economic substance because such findings
relied upon inflated outside bases these fictional partnerships yielded -- what the appellate courts
clearly ruled was an affected item.

5

Although the parties addressed the issues on remand via cross-motions for summary
judgment and Plaintiffs’ motion to strike, these procedural vehicles are inappropriate. The Court
is neither entering summary judgment on these penalties nor striking matters. Rather, in
addressing the narrow issue framed by the Federal Circuit on remand, the Court is determining its
subject-matter jurisdiction to apply any penalties in this partnership proceeding.
9

Defendant avers that because the FPAA determined that Jade was a sham and the Court
denied Plaintiffs’ petition for readjustment of the FPAA, “every finding in [the FPAA] was
untouched by this Court or the Federal Circuit and therefore it’s a valid administrative finding.”
Tr. 31. Even if this Court had expressly determined that Jade was a sham, such a finding would
not vest this Court with jurisdiction to determine the applicability of the accuracy-related
penalties. As the D.C. Circuit held in Petaluma, even though the Tax Court’s sham determination
constituted a partnership item, the Tax Court lacked jurisdiction to determine whether the partners’
outside bases were zero because outside basis is not a partnership item. Petaluma, 591 F.3d at
652-55. From this, the D.C. Circuit concluded that the Tax Court lacked jurisdiction to apply
penalties relying on outside basis. Id. at 654-55. The D.C. Circuit expressly disagreed that the
Tax Court’s “determination that Petaluma should be disregarded for tax purposes sufficed to give
it jurisdiction over accuracy-related penalties.” Id. at 655-56. In Jade Trading II, the Federal
Circuit reached the same conclusion, stating:
Because outside basis is not a “partnership item” we conclude that the Court of
Federal Claims lacked jurisdiction to determine that the Ervins had no outside basis
in Jade. As explained above, under § 6226(f), the trial court has jurisdiction over
“the applicability of any penalty . . . which relates to an adjustment to a partnership
item.” The penalty in this case was imposed on the underpayment of income tax
due to the gross valuation misstatement of the partners’ outside basis in the
partnership. Outside basis is an affected item, not a partnership item; thus, the
penalty here relates to an adjustment of an affected item, not a partnership item.
Accordingly, the trial court did not have jurisdiction over the applicability of this
particular penalty.
598 F.3d at 1380.
On remand in Petaluma, a majority of the Tax Court similarly concluded that the finding of
a sham partnership did not vest that court with jurisdiction over penalties:
There is a question [of] whether “outside basis” is the correct term because the
partnership has been held to be a sham, but there clearly are adjustments at the
partner level that will relate to the partners’ bases in assets that they sold. We are
directed that such adjustments are beyond our jurisdiction and the related penalties
are also.
***
The determination that the partnership is a sham implies negligent conduct
regarding formation of the partnership, but in this case that determination does not
trigger a computational adjustment to taxable income of the partners. The Court
of Appeals declined to allow the general effect of the partnership determination of
sham to confer jurisdiction of the penalty relating to valuation because the
valuation related to outside basis, an affected item. The Court of Appeals instructs
10

that for us to have jurisdiction over a penalty at the partnership level it must
“‘[relate] to an adjustment to a partnership item.’” It must also be capable of being
“computed without partner-level proceedings,” leading at least potentially to only a
computational adjustment to the partners’ returns. The effect of the mandate
concerning the section 6662 penalty is that if the penalty does not relate directly to
a numerical adjustment to a partnership item, it is beyond our jurisdiction. In this
case there are no such adjustments to which a penalty can apply. The adjustment
is an affected item. The sham determination in this case only indirectly affects
basis at the partner level. There is no partnership item flowing through to the
partners’ returns as a computational adjustment.
Petaluma III, 2010 WL 5209376, at *4 (internal citations omitted).
Defendant cannot convert what it characterizes as a determination that Jade was a sham
and the Court’s finding that the spread transaction lacked economic substance into a wholly
separate finding that something other than the individual partners’ outside bases justifies applying
penalties at the partnership level. As Plaintiffs persuasively argue, “the sham characterization in
Petaluma may represent a legitimate ‘partnership item’ but the impact on the partner-specific
‘outside basis’ stands one step removed from the partnership proceeding.” Pls.’ Mem. in Support
of Mot. to Strike & Summ. J. (“Pls.’ Mem.”) at 12. The accuracy-related penalties this Court
applied were all predicated on misstatements and erroneous reporting attributable to the Ervin
LLCs’ inflated bases in Jade. Jade Trading II, 598 F.3d at 1380 (“The penalty . . . was imposed .
. . due to the gross valuation misstatement of the partners’ outside basis in the partnership.”). The
fact that these inflated bases were generated because of transactions that lacked economic
substance or via the otherwise meaningless construct of a partnership does not alter the fact that
here the application of all penalties depended upon the individual partners’ outside bases.
Second, Defendant contends that Jade reported the contributions of the spread transaction
and claimed a positive basis in order to implement an abusive tax shelter and reap significant tax
benefits. Defendant argues that this overstatement of Jade’s basis -- inside basis -- constitutes a
gross valuation misstatement of a partnership item, which vests the Court with jurisdiction over the
penalties. This argument ignores what has been litigated for years in this proceeding -- that the
FPAA based the penalties solely on the partners’ bases in their partnership interests without
mentioning contributions, as did this Court in applying the penalties in Jade Trading I.
Defendant’s attempt to backpedal and now for the first time on remand claim that inaccurate
reporting of contributions can justify the application of penalties at the partnership level does not
work. Defendant invites the Court to focus on these contributions in isolation -- without regard to
the ultimate treatment of the spread transactions itself, which ignored the contingent liability leg of
the spread in calculating outside basis, thereby inflating that basis to create a fictional loss -- and
then use these contributions, standing alone, to trigger penalties. However, Defendant has not
demonstrated that any understatement of tax, let alone an understatement sufficient to trigger
penalties, resulted from the contribution of the spread transaction to Jade.

11

Third, Defendant argues that a purported inaccuracy on Jade’s return warrants application
of the accuracy-related penalties -- Jade’s reporting of the ordinary losses from Section 988
transactions in the amount of $314,416, which the Government asserts included the disregarded
spread transaction. Until this phase of the proceedings, the Section 988 transactions were of no
import to anyone. Indeed, it is not clear what these Section 988 transactions encompassed. 6
Plaintiffs represented that the Section 988 transactions included hundreds of other transactions, not
at issue in this litigation:
Plaintiffs’ Counsel: There’s hundreds of other transactions in the $314,000 loss.
The knockout options. There’s all manner of trading. There are hundreds of
transactions in the $314,000 loss . . . . You don’t know if it results in an
underpayment, an essential element of the penalty the government asserts, and so
all of that missing evidence was evidence that should have been brought forward by
the Defendant . . .
***
The Court: Well, but assume for a moment that part of the transactions were the
spreads at issue, and they’re disregarded. Then, it might be said that those
transactions would be inaccurately reflected. That’s I think the government’s
position, but even accepting that, we don’t know much of the other $314,000-loss is
accurate, which would not warrant the statement of a penalty.
Plaintiffs’ Counsel: That’s right, so you don’t know what portion. What you do
know is all those transactions are pushed down to the partner level, which for
jurisdictional reasons is comforting. The single rule that remains consistent with
the mandate is that no partnership penalty jurisdiction exists here because no
partnership penalty computational adjustment can be made without resort to
affected-item determinations in the partner level, the forbidden frontier right now.
Tr. 141-44; see also Tr. 77-78.
Plaintiffs contend that the Government “has not produced and not pointed to any evidence
that says what the inside basis was,” that the inside basis was “inaccurate,” and/or that “the
inaccuracy of the inside basis generates or could conceivably generate a penny of underpayment.”
Tr. 41-42; Pls.’ Mem. at 21. Defendant, returning to a rehash of its sham transaction and
lack-of-economic substance predicate for penalty jurisdiction, argues that it does not matter, as
reflected in the following exchange:

6

This Court’s decision in Jade Trading I made no mention of ordinary loss from Section 988
transactions.
12

Court: All right. Let’s go back to the partnership return because I want to
understand exactly what was inaccurate on the partnership return that justifies the
imposition of the accuracy-related penalties.
***
Defendant’s Counsel: [T]here’s a line item for ordinary loss from [Section] 988
transactions. . . . That was losses that they reported on foreign currency transactions
engaged in by the partnership, so that loss is reported there and that loss . . . is in
fact sort of reversed out in the adjustments in the FPAA.
Court: The loss is reversed by the FPAA?
Defendant’s Counsel: Yes.
Court: What did that loss relate to? . . .
Defendant’s Counsel: Specifically, it related to, among other things, the
transactions whereby the spread options that were contributed to Jade were closed
out, and that’s how we get to the specific statement of inside basis here, so in
reporting that loss, they attributed some non-zero basis to the contributed spread
options. I think [Plaintiffs’ Counsel] is correct to the extent that he says there is
nothing I would say definitive in our record where they say okay, well here’s how
we calculated that. That’s not in our record, but we don’t need that here to reach
the conclusion that there was a gross valuation misstatement. That’s because the
effect of the conclusions that the contribution lacked economic substance, the effect
of that was reducing gains basis in the contributed options to zero.
Tr. 96-98 (emphasis added); see also Tr. 99-100, 103-04, 136-37. Thus, the Government has not
advanced the Section 988 transactions as a readjusted partnership item that did not rely on outside
basis to justify applying the penalties at the partnership level. Rather, Defendant has merely
identified these transactions as another example necessitating reduction of the inside basis to zero,
claiming that this suffices to bestow jurisdiction over penalties on this Court. As explained
above, this supposed inaccuracy regarding the Section 988 transactions used by Defendant to
reduce inside basis to zero cannot be viewed in isolation from the totality of the transaction that
generated outside basis. Defendant has not demonstrated that this reporting of the contributed
spread by itself generated an understatement warranting application of the penalties.7

7

Defendant acknowledges that it does not “know yet whether there is an understatement” or
the amount of such understatement. Tr. 130; see also Tr. 115 (“[W]e wouldn’t know without
looking at partner items what the understatement was . . . . [W]e don’t know whether there’s an
understatement at all . . . .”); Tr. 128 (“There’s not an understatement of tax at the partnership
[level] at all . . . .”).
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Alternative Penalties
In the alternative, the Government argues that the Court has jurisdiction to determine the
applicability of the 20 percent negligence and substantial understatement penalties because the
Federal Circuit did not “disturb this Court’s reasoning and conclusions” regarding those penalties.
Def.’s Mem. in Support of Mot. Summ. J. (“Def.’s Mem.”) at 2. This is nonsense. The Federal
Circuit vacated application of any and all penalties that relied upon outside basis. This Court’s
application of these other penalties was predicated on the finding that the spread transaction in the
partnership vehicle gave rise to inflated outside basis.
With respect to the negligence penalty, Defendant appears to be under the misimpression
that this Court’s findings giving rise to the application of the negligence penalty are somehow still
viable. Defendant takes it as a given that “as this Court has already found, Jade was negligent in
treating the spread transactions as having economic substance.” Def.’s Reply at 10-11.
However, this Court’s “finding” that the Jade partnership was negligent was a legal conclusion
made in the context of applying the negligence penalty, and that legal conclusion was clearly
vacated by the Federal Circuit for lack of jurisdiction. It is elementary that vacated rulings are
null and void, as are rulings made without jurisdiction.
Defendant then relies upon this vacated legal conclusion to extrapolate that because the
partnership was negligent in treating the transactions as having economic substance, the
partnership was:
negligent in erroneously reporting the purported contribution to it of the spread
options and the purported distribution of property to the Ervins in redemption of
their purported interests in Jade. . . . Consequently, Jade’s negligence relates to
partnership items, and the Court has jurisdiction to determine that the negligence
penalty applies in this proceeding.
Id. at 11 (citations omitted). Reliance upon a finding that was vacated does nothing to establish
this Court’s jurisdiction over the negligence penalty.
This Court’s findings giving rise to the negligence penalty (like the other penalties)
depended upon the generation of inflated outside basis using the partnership vehicle. Nothing
brought forth in the remand proceedings has altered this need to rely upon outside basis to apply
the penalties.

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Conclusion
This Court lacks jurisdiction to determine the applicability of accuracy-related penalties in
this partnership proceeding. As such, it is ordered that with the exception of adjustments that
relate to penalties under § 6662, the adjustments to the partnership items of Jade Trading are
correct as determined and set forth in the FPAA.8

s/Mary Ellen Coster Williams
MARY ELLEN COSTER WILLIAMS
Judge

8

Despite the lack of jurisdiction over the penalties, this Court does not dismiss Plaintiffs’
petition for readjustment of the FPAA in part, insofar as Plaintiffs challenge the FPAA’s
application of penalties. This is because § 6226(h) provides that a “decision of the court
dismissing the action shall be considered as its decision that the [FPAA] is correct.” Here, this
Court’s ruling on remand that it lacks jurisdiction to determine the applicability of penalties does
not constitute a decision finding the application of the penalties in the FPAA to be correct. In
contrast, given the Court’s lack of jurisdiction, those findings in the FPAA on penalties have not
been subject to judicial review in this partnership proceeding.
15