7th Circuit Upholds Retroactive Application of "Son-of-Boss" Regs, Contrary to Klamath

I previously blogged the district court's decision in Klamath Strategic Investment Fund LLC v. United States, 440 F. Supp. 2d 605 (E.D. Tex. 2006), which held that the anti-"Son of Boss" Reg. § 1.752-6 could not be applied retroactively by the IRS to tax shelters entered into prior to June 24, 2003 (when § 1.752-6 was issued as a temporary regulation) .  The Seventh Circuit today upheld the application of Reg. § 1.752-6 retroactively to October 18, 1999.  Cemco Investsors, LLC v. Forest Chartered Holdings, Ltd, No. 07-2220 (7th Cir. 2/7/08).  The opening of Judge Easterbrook's unanimous opinion foreshadowed the result:

Paul M. Daugerdas, a tax lawyer whose opinion letters while at Jenkins & Gilchrist led to the firm’s demise (it had to pay more than $75 million in penalties on account of his work), designed a tax shelter for himself, with one client owning a 37% share.

The Seventh Circuit described the tax shelter this way:

A transaction with an out-of-pocket cost of $6,000 and no risk beyond that expense, while generating a tax loss of $3.6 million, is the sort of thing that the IRS frowns on. The deal as a whole seems to lack economic substance; if it has any substance (a few thousand dollars paid to purchase a slight chance of a big payoff) then the $3.6 million “gain” on one premium should be paired with the $3.6 million “loss” on the other; and at all events the deal’s nature ($36,000 paid for a slim chance to receive $7.2 million) is not accurately reflected by treating Euro 56,000 as having a basis of $3.6 million.

Update:  Joe Kristan has more here.