Tax Court Memo 2025-45, Stevens v. Commissioner, provides important insights for tax practitioners advising clients engaged in complex financial transactions, particularly those involving purported debt designed to generate significant tax deductions. This case examines whether notes issued as part of a "Bermuda Call Option Agreement" constituted true indebtedness for purposes of Internal Revenue Code (I.R.C.) section 163, and the taxpayers’ liability for accuracy-related and excessive-refund penalties.

Background and Transaction Structure

The petitioners, Kirk and Shannon Stevens, were the owners of SLS International Holdings, Inc. (SLS), an S corporation. SLS sold its transportation-brokerage business assets, resulting in substantial income. To potentially offset the tax liability from this sale, the petitioners, with assistance from their attorneys and a financial consultant, explored a transaction designed by the consultant, Jaime Dermody.

The Dermody transaction involved an issuer ostensibly lending a large sum to an investor, who would simultaneously use the loan proceeds to buy an option from the issuer. Exercise of the option would entitle the investor to a payment from the issuer equal to the loan balance. The option also included a feature requiring a payment if market interest rates exceeded certain thresholds, funded by separate cash financing from the investor. Notably, "[e]xcept for this feature of the option, the Dermody transaction had no economic effect". The potential for interest deductions from the loan was discussed in relation to offsetting the sale income.

Hedge Red, LLC (Hedge Red), wholly owned by MVP Financial, LLC (a broker-dealer), was specifically organized to issue the Bermuda call option to SLS and fulfill related obligations. Hedge Red conducted no other business.

The 2014 Transaction

On August 29, 2014 (referred to as "Date.0"), SLS entered into a promissory note with Hedge Red (the 2014 note) with a principal amount of $99 million, maturing on January 1, 2016, and accruing interest at 4.5% per quarter, compounded quarterly. The 2014 note stated it was issued as partial payment for a Bermuda Call Option described in a separate agreement of even date (the 2014 option agreement).

Crucially, the 2014 note limited SLS’s liability to Hedge Red’s security interest in the call option. Hedge Red had no recourse against any other assets of SLS.

On the same day, Hedge Red purchased an interest-rate cap from the National Bank of Canada (NBC) for $609,000, which was its fair market value. This cap had a notional amount of $11,200,000 and a strike rate of 8%. Hedge Red’s only assets after this purchase were the NBC interest-rate cap and the 2014 note (plus a small cash balance).

SLS paid $609,000 to Hedge Red (via escrow) to acquire the call option. This payment was acknowledged as separate from a transaction fee. Hedge Red used this $609,000 to buy the NBC interest-rate cap.

Petitioners received a tax opinion letter from Jeffrey Rubinger, dated November 24, 2014, concluding that the 2014 note would be treated as indebtedness for federal income tax purposes, allowing SLS to deduct accrued interest. However, before filing the 2014 return, petitioners’ CPA, Bill McDermott, raised concerns about disclosing the transaction as a tax shelter. Petitioners were subsequently informed by their attorney, Jonathan Gopman, that Rubinger advised against claiming the interest deductions, despite his opinion letter.

For tax year 2014, SLS claimed an interest deduction of $6,142,838. This deduction flowed through to petitioners’ individual return.

The 2016 Transaction

The 2014 note matured on January 1, 2016, without being repaid, with a balance of $125,363,397. Between June and July 2016, SLS and Hedge Red entered into a new promissory note (the 2016 note) for $126,629,694 principal, effective January 1, 2016, and maturing on October 1, 2046. Interest accrued at 1.5% per quarter. Like the 2014 note, SLS’s liability on the 2016 note was limited to Hedge Red’s security interest in the call option, with no recourse against other SLS assets. The 2016 note was considered by the parties to replace the 2014 note. Hedge Red’s assets remained the NBC interest rate cap and the 2016 note (plus small cash).

Between September and October 2016, the parties executed a new option agreement (the 2016 option agreement) that replaced, amended, and restated the 2014 option agreement, with a retroactive effective date of August 29, 2014. The 2016 option agreement specified that SLS had paid $609,000 and issued a note (referencing the 2014 note amount, though slightly inaccurate) in exchange for the call option.

SLS claimed interest deductions related to these notes of $20,238,527 for 2015 (on the 2014 note) and $7,808,135 for 2016 (on the 2016 note). These deductions also flowed through to petitioners’ individual returns. Petitioners subsequently filed an amended return for 2013, claiming a refund based on a net operating loss carried back from 2015, resulting from the interest deductions.

IRS Examination and Asserted Positions

Respondent (the Commissioner) issued Notices of Deficiency disallowing the claimed interest deductions for 2014, 2015, and 2016. This led to significant tax deficiencies. Respondent also determined penalties: a 40% penalty under I.R.C. section 6662(a) and (i)(1) for 2014, and 20% penalties under section 6662(a) and (b)(1) for 2015 and 2016. A section 6676(a) penalty for an excessive refund claim for 2013 (based on the NOL carryback) was also determined.

In the course of litigation, respondent refined penalty theories, ultimately pursuing 20% accuracy-related penalties under section 6662(a) and (b)(1) for negligence for 2014, 2015, and 2016, and the section 6676(a) penalty for 2013. Respondent conceded other penalty theories. Petitioners challenged the penalties on the merits (reasonable cause based on reliance on tax advice) and procedurally (lack of timely supervisor approval under section 6751(b)).

Petitioners’ Arguments Regarding Indebtedness

Petitioners contended the 2014 and 2016 notes constituted true indebtedness. Focusing their detailed arguments on the 2016 note and 2016 option agreement, they raised three main points:

Duration-Gap Scenario: They argued SLS could call the option early, resulting in a payment from Hedge Red, while the 2016 note remained outstanding until maturity, potentially generating a profit for SLS.
Formosa Bond Analogy: They analogized the transaction to a Formosa bond, described as a cancelable fixed-rate bond without periodic interest payments until maturity.
Interest-Rate Cap Potential: They claimed the interest-rate-cap component of the option had upside potential for SLS, contributing to the economic substance.

Court’s Analysis of Indebtedness

The Court focused its analysis on the operation of the 2016 note and 2016 option agreement, as petitioners’ arguments were centered there. The Court agreed with respondent’s view that SLS would never pay off the 2016 note except through an offset against the predetermined portion of the payment required from Hedge Red upon exercise of the option, an amount that was a "mirror image" of the note.

The 2016 option agreement provided Hedge Red with an election between physical settlement and cash settlement if SLS exercised the call.

Physical Settlement: If Hedge Red elected physical settlement, it was required to deliver bonds with a "face amount" equal to the first component of Bundle.k (the predetermined portion of the option value). SLS was required to pay the strike price, SPRICE.k, and any "HOLDER DEBT" (including the balance on the 2016 note) on Date.(k+8), two years after exercise. Expert analysis, accepted by the Court, showed that the balance on the 2016 note at Date.(k+8) exactly equaled the first component of Bundle.k minus SPRICE.k. Since Hedge Red’s only asset for the predetermined payment was the 2016 note itself, the Court concluded that in physical settlement, Hedge Red would make the predetermined payment by releasing the 2016 note.
Cash Settlement: If Hedge Red elected cash settlement, it would pay SLS a cash amount equal to the face amount of the bonds less "the sum of SPRICE.k and HOLDER DEBT," with amounts discounted from Date.(k+8) to the Exercise Date. The Court determined that "HOLDER DEBT" included the balance on the 2016 note, as it was debt incurred "associated with Call purchase". Furthermore, "HOLDER DEBT" was to be calculated as the amount outstanding on Date.(k+8). Taking this into account, the cash payment required from Hedge Red to SLS, considering only the predetermined component of the option, would be essentially zero. The 2016 option agreement explicitly stated that cash settlement satisfies "all obligations of Issuer and Holder associated with the Call and any such debt associated with Call," meaning the 2016 note would be satisfied. Under cash settlement, SLS would have no obligation to make any separate payment of the strike price or "HOLDER DEBT".
Option Expiration: If SLS never exercised the option (last date Oct 1, 2044), the option would expire valueless. The 2016 note matured on October 1, 2046, but Hedge Red could only collect against the option, which would be valueless. Thus, the note would be a nullity.

Conclusion on Indebtedness

The Court concluded that the 2016 note did not constitute indebtedness within the meaning of section 163. Regardless of whether the option was exercised (physical or cash settlement) or expired, the 2016 note would inevitably disappear having no effect. In the event of exercise, the note was eliminated either by release or satisfaction; if unexercised, it became uncollectible. The Court cited Knetsch v. United States, 364 U.S. 361 (1960), and BB&T Corp. v. United States, 523 F.3d 461 (4th Cir. 2008), for this principle.

The Court specifically rejected petitioners’ arguments:

The duration-gap scenario is "nonexistent" because the 2016 note is eliminated upon exercise of the option under either physical or cash settlement. The fact that Hedge Red was not compensated for this purported risk and its absence in contemporaneous documents further undermined the argument.
The Formosa bond analogy fails because a true Formosa bond involves a transfer of funds the borrower can use, whereas the 2016 note proceeds could only be used to purchase the option that would eliminate the note upon exercise. Cancellation is not inevitable for a Formosa bond but was effectively inevitable for the 2016 note if the option was exercised.
The interest-rate-cap component, while valuable and fairly priced, does not make the 2016 note true indebtedness because it was paid for with cash ($609,000), not the note proceeds. The note financed the predetermined payment right that would offset the note itself.

Analysis of Penalties

The Court found petitioners liable for the penalties asserted by respondent.

Negligence (Section 6662(b)(1)): Respondent had the burden of production on negligence. Respondent met this burden by showing petitioners commissioned the tax opinion letter for protection from penalties rather than compliance. Petitioners knew Rubinger advised against claiming the deductions but claimed them anyway. Furthermore, the significant interest deductions claimed (millions of dollars) compared to the relatively small economic cost ($890,000 or $930,000 including some fees) meant the tax benefits were "too good to be true," strongly indicating negligence.
Reasonable Cause/Good Faith (Section 6664(c)(1)): Petitioners had the burden of persuasion to show reasonable cause and good faith. The Court found they failed to meet this burden. Soliciting Rubinger’s opinion was for penalty protection, not assessing proper tax liability. They did not reasonably or in good faith rely on the opinion regarding the treatment of the note because they knew Rubinger did not stand behind it. The "too good to be true" nature also negated reasonable reliance.
Excessive Refund Claim (Section 6676(a)): Petitioners also failed to prove reasonable cause for the excessive refund claim in 2013, which was based on the disallowed interest deductions. They knew when filing the amended return that Rubinger did not support the deductions, and the gross disparity between claimed deductions and economic cost was apparent.
Supervisor Approval (Section 6751(b)(1)): Respondent had the burden of production to show timely written supervisor approval. The Court found that Revenue Agent Battaglino made the initial determination to impose penalties, as supported by penalty approval forms and testimony. His supervisor, Biggerstaff, approved this determination in writing on October 19, 2018. Petitioners argued this approval was untimely as it occurred after the Letter 5153 (May 17, 2018), which they contended was the first formal communication of penalties. However, applying the Ninth Circuit’s holding in Laidlaw’s Harley Davidson Sales, Inc. v. Commissioner, 29 F.4th 1066 (9th Cir. 2022) (which governs under Golsen v. Commissioner, 54 T.C. 742 (1970)), supervisor approval for deficiency-procedure penalties is timely if obtained before the supervisor loses discretion, which occurs upon issuance of the notice of deficiency. Since Biggerstaff’s approval on October 19, 2018, occurred before the Notices of Deficiency were mailed on November 22, 2019, he still retained discretion. Therefore, the penalties were supervisor approved pursuant to section 6751(b).

Conclusion

The Court upheld the disallowance of the interest deductions for tax years 2014, 2015, and 2016, finding that the underlying notes did not constitute true indebtedness because they were structured to be eliminated upon exercise of the associated option or become a nullity if the option expired. The Court also sustained the 20% accuracy-related penalties for negligence for these years and the 20% excessive-refund-claim penalty for 2013, rejecting the petitioners’ arguments for reasonable cause and finding the penalties were properly approved by a supervisor. This case underscores the critical importance of genuine economic substance and risk in debt instruments and highlights the challenges taxpayers face in establishing reasonable cause based on professional advice when benefits appear "too good to be true" or the reliance on the advice is questionable.

Prepared with assistance from NotebookLM.