Note: The following is an excerpt from the introduction to the article as published in The Tax Lawyer. Author citations have been omitted for brevity. Tax Section members may read the article in its entirety in Adobe Acrobat format.
COBRA Strikes Back: Anatomy of a Tax Shelter
Karen C. Burke and Grayson M.P. McCouch*
Paul M. Daugerdas has gained notoriety for himself and his erstwhile firm, Jenkens & Gilchrist, as the designer of a tax shelter technique that uses contingent liabilities to generate artificial tax losses on a grand scale. For all its surface complexity and sophistication, the basic shelter transaction is surprisingly simple in concept. In essence, it uses offsetting options to inflate the basis of property that is distributed by a partnership and then contributed to and sold by another partnership, resulting in a large tax loss without any corresponding economic loss. In principle, this type of shelter could be replicated indefinitely and generate unlimited tax losses. Mr. Daugerdas is by no means unique. The transactions that he approved as shelter counsel on behalf of Jenkens & Gilchrist differ only in trivial details from myriad other transactions peddled by other lawyers and accountants.
This Article does not address the question of how the profits interest of a manager of a private equity fund should be taxed. Rather, the focus of this Article is on the more general question of how the receipt of a compensatory partnership interest should be taxed. However, the analysis and conclusions of this Article are relevant to the resolution of the questions concerning the taxation of a manager of a private equity fund.
This article offers a preliminary assessment of several challenges faced by Congress, the Treasury, and the courts in dealing with contingent-liability tax shelters. The article proceeds as follows. Part II examines the role of Daugerdas and his firm in creating and marketing contingent-liability shelters, against the broader background of the tax shelter industry. Part III explains the basic structure of the offsetting option transaction and its attempt to manipulate the partnership tax provisions—in essence, the transaction turns on a simple question of whether (and in what amount) contingent liabilities must be taken into account in determining the basis of an investment for tax purposes. Part IV analyzes the contrasting rationales of two recent judicial decisions involving defective tax shelters. Part V argues in favor of applying regulations retroactively to shut down contingent-liability tax shelters and avoid unnecessary
and wasteful litigation.
*Karen C. Burke is a Warren Distinguished Professor, University of San Diego School of Law. Garyson M.P. McCouch is a Professor, University of San Diego School of Law.