This article delves into the recent United States Tax Court Memorandum decision in GWA, LLC v. Commissioner, T.C. Memo. 2025-34, a case with significant implications for tax practitioners advising partnerships and their partners on complex financial transactions, accounting method changes, and the validity of tax elections made by disregarded entities.

Background: The Barrier Contracts and IRS Scrutiny

The case centered on GWA, LLC (GWA), a TEFRA partnership for which George A. Weiss, a hedge fund manager, served as the tax matters partner. During the 2000s, GWA executed ten transactions with Deutsche Bank AG (Deutsche Bank) referred to as the "Barrier Contracts". These transactions were structured as options, with GWA as the nominal buyer and Deutsche Bank as the seller, relating to an underlying basket of securities. Deutsche Bank held title to these securities, but GWA could occasionally instruct Deutsche Bank on exercising voting rights.

In 2010, the Internal Revenue Service (IRS) identified transactions resembling the Barrier Contracts as abusive. Subsequent investigations by the Senate Permanent Subcommittee on Investigations (PSI) concluded that Deutsche Bank had promoted these contracts to help hedge funds, including GWA, avoid federal taxes and leverage limits. The PSI estimated that Deutsche Bank helped GWA and other funds avoid over $3 billion in federal income tax, identifying GWA as one of the largest participants.

The IRS selected GWA’s 2009 and 2010 returns for examination and, on December 3, 2018, issued Notices of Final Partnership Administrative Adjustment (FPAAs). The FPAAs determined that, for federal income tax purposes, the Barrier Contracts were not "options" and that GWA was the substantive owner of the basket securities. This recharacterization resulted in total ordinary income adjustments exceeding $500 million for 2009 and 2010, along with the assertion of accuracy-related penalties for each year. The Commissioner also determined that treating GWA as the owner of the basket securities constituted a change in accounting method requiring a § 481 adjustment to prevent the omission of income.

Taxpayer’s Request for Relief: Challenging Recharacterization and Penalties

Before the Tax Court, GWA challenged the Commissioner’s determinations on several fronts. The primary requests for relief pertained to:

The characterization of the Barrier Contracts: GWA argued that the form of the Barrier Contracts as options should be respected for federal income tax purposes.
The validity of a mark-to-market election: GWA contended that it had made a valid mark-to-market election under § 475(f) of the Internal Revenue Code in 1998, applicable to its securities trading activities conducted through its wholly-owned disregarded entity, OGI. If the court rejected this, GWA argued the election was invalid and should be disregarded entirely.
The applicability of § 481 adjustments: GWA argued that the Commissioner’s adjustments did not constitute a "change in method of accounting" under § 446 and § 481.
The imposition of accuracy-related penalties: GWA contested the accuracy-related penalties for negligence under § 6662(b)(1) and substantial understatement of income tax under § 6662(b)(2). GWA did not raise a reasonable cause defense under § 6664(c).

Court’s Analysis of the Law and Application to the Facts

The Tax Court, in a comprehensive memorandum opinion authored by Judge Lauber, systematically addressed each of GWA’s arguments.

Proper Characterization of the Barrier Contracts: Substance Over Form

The court began by reiterating the well-established principle that substance, not form, governs the tax consequences of a transaction, citing Frank Lyon Co. v. United States, 435 U.S. 561, 573 (1978), and Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945). The court emphasized that this determination requires a factual inquiry into the objective economic realities of the transaction, referencing Altria Grp., Inc. v. United States, 658 F.3d 276, 284 (2d Cir. 2011).

Applying the "benefits and burdens of ownership" test, a multifactor analysis used to determine the substantive owner of property, the court considered several factors, including:

Risk of investment loss and opportunity for investment gain: The court found that GWA bore the economic risk and reward associated with the basket securities.
Ability to select and control the securities: While Deutsche Bank held title, GWA had significant influence over the composition and trading of the basket. The court drew an analogy to Webber v. Commissioner, 144 T.C. 321 (2015), where the taxpayer was deemed the owner of assets in segregated accounts underlying insurance policies due to their control over investment.
Ability to extract cash: GWA could effectively access the value of the basket securities, similar to the taxpayer in Webber.

The court concluded that the Barrier Contracts lacked the essential economic and legal characteristics of genuine options. They served primarily to provide GWA with leverage while deferring tax on the gains from trading the underlying securities. The court distinguished Frank Lyon, noting that the Barrier Contracts were not compelled or encouraged by business or regulatory realities independent of tax considerations. Therefore, the court held that GWA was the substantive owner of the basket securities for federal income tax purposes.

Mark-to-Market Election Under § 475(f): Disregarded Entity Issues and Impermissible Selectivity

The court next addressed GWA’s contention that it had made a valid mark-to-market election in 1998. GWA argued that even though OGI, the entity engaged in trading, was a disregarded entity, OGI was a "person" entitled to make the election under § 475(f)(1)(A).

The court rejected this argument, relying on the Second Circuit’s decision in McNamee v. Department of the Treasury, 488 F.3d 100 (2d Cir. 2007). The court reasoned that because OGI was a disregarded entity, its activities were treated as those of GWA. Therefore, GWA, not OGI, was the "person... engaged in a trade or business as a trader in securities" for purposes of § 475(f)(1)(A). The court did not need to definitively decide whether a disregarded entity could ever be a "person" under the Code, as OGI was not the relevant "trader" in this context.

Furthermore, the court found that the election statement attached to GWA’s 1998 return purported to be an election by OGI and limited its scope to securities held by OGI. The court held this to be an impermissibly selective election, as a valid § 475(f)(1) election for a securities trader must apply to the taxpayer’s entire business as a securities trader, citing H.R. Rep. No. 105-148, at 445, 1997 U.S.C.C.A.N. at 839. Relying on Plumb v. Commissioner, 97 T.C. 632, 640 (1991), the court concluded that an attempted election that is not legally available to the taxpayer is treated as no election at all. GWA could not elect mark-to-market treatment solely for the securities held by its disregarded entity while excluding those it held directly, especially given the tax avoidance objective of the Barrier Contracts.

Changes in Accounting Method and § 481(a) Adjustments

Having determined that GWA was the owner of the basket securities, the court addressed whether the Commissioner’s adjustments constituted a change in accounting method requiring a § 481(a) adjustment. Section 481 is designed to prevent the duplication or omission of income when a taxpayer changes its method of accounting and the statute of limitations bars reopening prior years.

The court noted that a change in the treatment of a material item involves the proper time for inclusion of the item in income, citing Treas. Reg. § 1.446-1(e)(2)(ii)(a) and Rankin v. Commissioner, 138 F.3d 1286, 1288 (9th Cir. 1998). GWA had reported gains and losses from the Barrier Contracts on an amalgamated net basis as long-term capital gain in the year of termination, while the IRS determined these items should be reported on a disaggregated basis in the year realized, received, paid, or accrued. The court concluded that this constituted a change in the treatment of material items affecting the timing of income recognition, and therefore, a change in method of accounting.

The court rejected GWA’s arguments that § 754 of the Code somehow precluded a § 481 adjustment. The court emphasized that § 481(a)(2) mandates adjustments to prevent amounts from being duplicated or omitted solely by reason of the change in accounting method. Because the income related to the basket securities was primarily realized in years likely closed by the statute of limitations, a § 481(a) adjustment in 2009 was necessary to prevent the permanent omission of this income.

Penalties for Negligence and Substantial Understatement of Income Tax

The IRS asserted accuracy-related penalties under § 6662(a) for negligence under § 6662(b)(1) and, alternatively, for substantial understatement of income tax under § 6662(b)(2).

Regarding negligence, defined as a failure to make a reasonable attempt to comply with the Code or to exercise ordinary and reasonable care, the court considered the sophistication and experience of GWA’s partners. The court found that the "extraordinary financial implications" of the Barrier Contracts should have prompted GWA to exercise due diligence regarding their tax legitimacy, citing Neonatology Assocs., P.A. v. Commissioner, 299 F.3d 221, 233 (3d Cir. 2002). The court noted two events that should have alerted GWA to the questionable status of the Barrier Contracts as options: Deutsche Bank’s proposed revisions to the "New MAPS" product and the issuance of IRS Generic Legal Advice Memorandum No. AM2010-005. The court also noted that GWA itself acknowledged its lack of awareness of any legal authority supporting its treatment of the Barrier Contracts. Therefore, the court sustained the penalty for negligence .

In the alternative, the court considered the penalty for substantial understatement of income tax, which exists if the understatement exceeds the greater of $5,000 or 10% of the tax required to be shown on the return (§ 6662(d)(1)(A)). An understatement can be reduced if there is substantial authority for the taxpayer’s treatment or if there was a reasonable basis and adequate disclosure (§ 6662(d)(2)(B)). Having already concluded that GWA lacked a reasonable basis for treating the Barrier Contracts as options , the court found that it a fortiori lacked substantial authority. Furthermore, GWA did not adequately disclose the relevant facts regarding the Barrier Contracts on its returns, failing to include Form 8275. Consequently, the court also sustained the accuracy-related penalty for substantial understatement of income tax.

Finally, the court addressed GWA’s argument that penalties should not apply to the portion of the underpayment attributable to the § 481(a) adjustment. The court disagreed, reasoning that the § 481(a) adjustment reflects income that should have been reported in prior years. Because Congress directed that these adjustments "shall be taken into account" in the year of the change (§ 481(a)(2)), they constitute tax "required to be shown on [the] return" for that year. The court cited precedent sustaining penalties calculated on § 481(a) adjustments, such as Boynton v. Pedrick, 228 F.2d 745, 746 (2d Cir. 1955), and Basic Eng’g, Inc. v. Commissioner, T.C. Memo. 2017-26.

Court’s Conclusions

The Tax Court ultimately concluded that:

GWA was the substantive owner of the basket securities underlying the Barrier Contracts for federal income tax purposes.
GWA did not make a valid mark-to-market election under § 475(f) in 1998 due to the attempted election being made by a disregarded entity and being impermissibly selective.
The Commissioner’s adjustments resulting from the recharacterization of the Barrier Contracts constituted a change in GWA’s method of accounting requiring a § 481(a) adjustment.
Accuracy-related penalties for negligence and substantial understatement of income tax were applicable to the underpayments for 2009 and 2010, including any underpayment attributable to the § 481(a) adjustment.

The court ordered that a decision be entered under Rule 155, requiring the parties to compute the final tax liability consistent with the court’s opinion.

Implications for Tax Practitioners

GWA, LLC v. Commissioner serves as a critical reminder of the enduring importance of the substance-over-form doctrine in tax law, particularly when advising clients on sophisticated financial instruments. Tax practitioners must look beyond the legal form of a transaction to its underlying economic realities.

The case also highlights the complexities of tax elections involving disregarded entities. Practitioners should be cautious about assuming that a disregarded entity can independently make tax elections, especially those related to the owner’s business activities. The owner, as the taxpayer, is generally the proper party to make such elections.

Furthermore, the decision underscores the scope and application of § 481 adjustments in correcting accounting method changes, even for items originating in years closed by the statute of limitations. Practitioners should be aware that the recharacterization of transactions can trigger a change in accounting method.

Finally, the court’s imposition of accuracy-related penalties emphasizes the need for taxpayers and their advisors to exercise due diligence in assessing the tax legitimacy of complex transactions and to ensure adequate disclosure of relevant facts on tax returns. The sophistication of the taxpayer will be considered when evaluating negligence.

This case provides valuable insights for CPAs advising partnerships and their partners on complex tax matters, reinforcing the need for a thorough understanding of both the technical rules and the underlying economic substance of transactions.

Prepared with the assistance of NotebookLM.