Tax Court Calls Out Yet Another Bullshit Tax Shelter But Relieves Taxpayer of 6662 Penalties (2/24/26 as corrected; 2/25/26)

Major Correction: I made an error in the original blog post, by misreading the court's application of the 40% Substantial Valuation Misstatement and Gross Valuation Misstatement Penalties in § 6662(e)(1)(A) and I.R.C. § 6662(h) but not picking up that the reasonable cause defense it sustained effectively wiped out all 6662 penalties.

Yesterday, the Tax Court (Judge Weiler) decided Otay Project LP v. Commissioner, T.C. Memo. 2026-21, TC Dkt here at # 349, TN here, and GS here [to come], tanking another bullshit tax shelter. There is no indication that this is a syndicated shelter creating basis and thus deductions out of thin air in complex structures taxed as partnership; as presented it seems like “one-off” imagined by creative minds and blessed by firms that have played prominently in tax sheltering—E&Y and McKee Nelson LLP; moreover, I suspect (suspicion only) that variations on the shelter were promoted on and opined upon on other occasions.

I find it a bit odd that, although Judge Weiler says he read the those firms’ opinions (Slip Op. 45), but he does not identify the persons signing the opinions. Oh well, let’s move on to the main points for tax procedure enthusiasts.

On the Merits of the Complex Machinations:

The actual bottom-line tax costs of the shelter failing must await the Rule 155 computation, but the Court concludes on the merits (other than penalties) (Slip Op. 31):

In sum, we determine petitioner has not met its burden here and has failed to correctly establish the Basis Deduction under section 743(b), as claimed on OPLP’s 2012 Form 1065. Accordingly, we will sustain respondent’s disallowance of $713,759,615 of a more than $743 million claimed Basis Deduction reported on OPLP’s 2012 Form 1065 for the 2012 tax period. 

I believe it would not be helpful to most tax procedure enthusiasts to wade into the complex facts and partnership tax law discussed in the opinion. Although this appeared not to be one of the abusive shelters of the late 1990s and early 2000s (e.g., BLIPS or variants used by different accounting and law firms), I suspect that some of the fanciful notions asserted in those earlier versions were deployed here in a more complex and “engineered” (Slip Op. 30-32) journey through esoteric partnership tax provisions.

Suffice it to say that the Court rejected that “engineered” journey on the merits of the partnership tax law and also based on economic substance doctrine. In this regard, because it preceded the effective date, the transaction was not subject to the codified economic substance doctrine in § 7771(o) or the penalty in § 6662(b)(6). (See Slip Op 2 n. 2.)

 The Penalties:

 After denying the gambit on its merits, the Court then addressed  penalties as follows (Slip Op. 42-46):

• found the 40% Substantial Valuation Misstatement and Gross Valuation Misstatement Penalties in § 6662(e)(1)(A) and I.R.C. § 6662(h) to apply because the overstated basis well exceeded 200%
• but relieved the taxpayer of all potentially applicable § 6662 penalties based on the reasonable cause defense in § 6664(c). The Court noted in this regard the taxpayer reliance on the E&Y  and McKee Nelson opinions which, the Court said (Slip Op. 45), (i) “contains substantial authority for each and every conclusion reached therein.” And (ii) “the opinions reached a confidence level of substantial authority on each material issue relating to the transactions at issue.”

The Court's acceptance of the reasonable cause defense surprised me since, as I read the facts as found and the law as held by the court, the legal opinions blessed, at least to the level of alleged substantial authority, basis and resulting deductions created by legal hocus pocus, essentially out of thin air by multiple complex entities and strained readings of the partnership tax sections. Yet the Court found that the taxpayer had reasonable cause and acted in good faith. I have not read the opinions, so I cannot say for sure that they lacked substantial authority (whatever exactly that is). Great job by the taxpayer's counsel. 

The Court does note that the IRS assertion that the two underlying taxpayers (brothers) involved in the commotion withheld information from McKee Nelson (Slip Op. 44 n. 39): 

39 Respondent only points us to Al’s and Jim’s alleged misrepresentation to McKee Nelson that, at the time of the transactions at issue, there was no plan or intention to liquidate OPLP. We do not find this representation (at the time it was made) to be materially false, as alleged by respondent.

Does that mean that the representation (i) was not false or (ii) even if false, was not material to the McKee Nelson opinion? As it is written, it would appear to be the latter (but that is not certain since the Court earlier said it was an alleged misrepresentation but then seems to treat the representation as having been made). The Court does not explain why any such false representation, if made, would not have been material to the opinion.

I am reminded of perhaps similar false representations required in the earlier round of shelters that the taxpayer did the transaction creating the magical deductions with a profit motive rather than a tax motive. That representation was not truthful (at least in most cases I observed), but the taxpayers knew the opinions would not issue without the representation. Was that false representation material? (As I say, I have not read the opinions in Otay, so I am not sure that is a good analogy.)

Miscellanea

1. McKee & Nelson in the firm name are authors of what I think is still the principal authority on partnership taxation: Federal Taxation of Partnerships and Partners, here, listing five authors, the last two of which are McKee and Nelson; but during most of my practising career, the two named authors were McKee and Nelson; I generally found the text outstanding (although as always I checked it out)).

2. The opinion shorthands Ernst & Young to “EY” but, in the same paragraph, refers to EY and E&Y (the latter being the sole reference to E&Y). I use E&Y in this blog.

3. From the docket entries, here, it appears that the trial lasted 8 days in the period from 10/15/24 through 10/28/24. The opinion, dated 2/23/26, was # 349 on the docket entries. So, I infer the machinations in court were as complex as the machinations to cobble together this abusive scheme.

4. (added 2/25/26 7:45pm): Today, my Charlottesville NonFiction Book Club discussed Charles Freeman,’s The Closing of the Western Mind, Amazon here. Perhaps Freeman’s main theme is that, in the previously proclaimed dark ages, the western mind directed by bishops and priests (usually as puppets of political leaders such as Constantine) turned to mystery and magic rather than applying Artistotelan-inspired reason (see Wikipedia here). That is a simplistic statement of Freeman’s historical argument, but, based somewhat on that simplism, I could not help but think that somehow the tax community may operate the same way. The E&Y and McKee Nelson legal opinions spun a fantastic story of mystery and magical deductions used to, in the story told by the tax returns filed based on the legal opinions, make fantastical claims that only the privileged few (such as the persons rendering the opinions, like religious and political authorities in the supposed dark ages) could discern and impose on the others without powers of discernment. Reason (exemplified by the Otay merits discussion) burst the bubble of that spinning, but Reason still bowed the spinning of mystery and magic in the penalties discussion.