Larry Lawrence, Roberto Salazar and Ricardo Garcia were instrumental in winning their clients large settlements from Firestone in 2001. They each got paid over a million dollars in fees. Being a plaintiff’s lawyer has some elements of feast or famine about it. It is understandable that they wanted to do something about the large tax liabilities in the wakes of their ships that had finally come in. They sought help from Joe Garza, an attorney from Dallas, Texas. The result was not great for them as this recent Tax Court decision shows. The case has both humor and practical utility.
The humor comes in little nuggets that the Court scattered through the decision. For example it explains that Mr. Garza learned about the “Son-of-Boss” deals that he recommended by paying $50,000 for some “dark side” continuing legal education. The networking that brought Mr. Garza in front of Lawrence, Salazar and Garcia is summed up in the sentence – Bad ideas can be especially contagious in a small town.
The most important practical part of the case is the ruling that a partnership or an LLC consisting of yourself and your own disregarded entity is not a partnership for income tax purposes. The transactions were also disallowed on Section 183 grounds (activities not entered into for profit).
What Mr. Garza designed for his legal brethren was a quite elegant version of the Son-of-Boss transaction. The idea is that you sell a foreign currency call option and use the proceeds of the sale to purchase a foreign currency call option in the same currency with the same counterparty and the same expiration date. There is a slight difference in strike price. You are more or less guaranteed to lose on the transaction, particularly after transaction costs, but, in principle, if on the option expiration the currency price is in the very narrow range between the two contracts, “the sweet spot”, you hit a home run.
The tax magic of the transaction comes from putting both contracts into a partnership. On a variation of an old accounting joke, I call the technique “debit by the window, credit out the window”. You have basis in the call option that you bought, but your obligation under the call option that you wrote does not meet the definition of a liability. In essence you have created basis in your partnership interest out of thin air. The variations on the technique have to do with how you use that free basis.
Mr. Garza’s technique was elegant. The partners also contributed a few thousand dollars in Canadian currency. After the options expired the partnership was liquidated. In a partnership liquidation you apply the partners basis to the property distributed. So you end up with say $10,000 in Canadian currency with $1,000,000 basis. Foreign currency losses are generally ordinary. This is really great because you now have a pool of potential ordinary loss that you can use as needed.
The Tax Court disbelieved the attorneys when they said that they were really in it for the big score they would get by hitting the sweet spot. Apparently the sweet spot is something of an illusion, because the counterparty Deutsche Bank was in a position to rig the scoring so they would never hit it. When Deutsche Bank determined the market price on the option expiration it had as much as three cents of play in the pricing. The “sweet spot” was only two cents wide. The Tax Court noted that the attorneys did not have extensive experience in foreign currency trading:
Before November 2001, Lawrence had never invested in foreign currency other than trading U.S. dollars against the Mexican peso back when he was a busboy and waiter.
“Other than buying a Krugerrand during a vacation in South Africa,” Garcia had also never invested in foreign currency before.
I find one of the other reasons that the transaction failed even more interesting. Each lawyer formed a single member LLC that was the other member of the LLC that received the option contracts and Canadian currency. They did not have the LLCs that were supposed to be their partners elect corporate status leaving them as disregarded entities. In order to have a partnership, you need partners (plural). If it is you and your disregarded entity that does not do it. They tried to argue that Texas community property laws made the disregarded entities deemed partnerships, but that did not fly.
When we disregard a partnership for tax purposes, we are holding that the rules of subchapter K of chapter 1 of the Code (which contains the substantive law governing the income taxation of partners) no longer apply, and that we will deem the partnership’s activities to be engaged in by one or more of its purported partners. A disregarded partnership has no identity separate from its owners, and we treat it as just an agent or nominee.
If the deal had otherwise worked it would have been really devastating to lose it on that basis, since an election by the disregarded entities to be treated as corporations would have saved it. Actually it was just another nail in the coffin, but one to watch out for in transactions of more substance.
You can follow me on twitter @peterreillycpa.
Originally published on Forbes.com Feb 24th, 2013