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I. Introducing Two Competing Legal Fictions
Over thirty-five years have passed (including a certain racehorse named "Iron Card") since the famous U.S. Tax Court case oí McDougal v. Commissioner, yet to this day taxpayers in partnerships, tax practitioners, and academics wrestle with the mystery of the precedential application of the recognition event described in that decision.1 A fierce academic debate continues over whether an existing partnership with appreciated or depreciated assets recognizes gains or losses when it transfers a capital interest (as opposed to a profits-only interest) in the partnership in exchange for services.2 A "profitsonly" interest is a distinctly different type of interest, and not the focus of discussion in this Article, as most of the issues surrounding the receipt of a profits-only interest by a service partner were resolved with the issuance of Revenue Procedure 1993-27, which generally treats receipt of such as a nontaxable event.3
All that being said, the Treasury's failure to finalize Proposed Regulations sections 1.721-1 (2005) and 1.83-6 (2005) may have been the magical silver bullet of finality putting to rest the already weakened "cash-out-cash-in" academic theory supporting nonrecognition.4 This Article analyzes whether or not there is any life remaining in the cash-out-cash-in theory, as a "reasonable basis" position if disclosed, and, if undisclosed, whether such is supported by "substantial authority," for the purposes of the preparer penalty and the substantial understatement of income tax penalty under sections 6694(a)(2) and 6662(d)(2)(B), respectively.
McDougal begins with a wealthy Texas couple, FC. and Frankie McDougal, who were in the business of breeding and racing horses.5 The McDougals had hired a horse trainer named Gilbert McClanahan who assisted them in the training of their horses.6 At one point in time, the McDougals decided to purchase (at a discount of $10,000) a successful racehorse called Iron Card who was previously diagnosed as suffering from a severe protein allergy. Their trainer, McClanahan, promised the McDougals he could restore the horse back to its full racing status with his secret and exclusive home remedy7 In return, the McDougals promised McClanahan an undivided one-half interest in the horse (at the time of the purchase) if he restored and trained the horse - but only after they recovered their initial economic outlay attributable to Iron Card's acquisition.8