T.C. Memo. 2012-306
UNITED STATES TAX COURT
DONALD J. KIPNIS, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
LAWRENCE L. KIBLER, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 30370-07, 30373-07. Filed November 1, 2012.
Dennis G. Kainen and Alan L. Weisberg, for petitioners.
W. Robert Abramitis, William Lee Blagg, and Brian A. Pfeifer, for
respondent.
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[*2] MEMORANDUM FINDINGS OF FACT AND OPINION
JACOBS, Judge: Respondent determined deficiencies in income tax with
respect to (1) Donald J. Kipnis of $650,914 for 2000 and $346,495 for 2001 and (2)
Lawrence L. Kibler of $629,361 for 2000 and $351,973 for 2001.
Donald J. Kipnis and Lawrence L. Kibler were each 50% shareholders in
Miller & Solomon General Contractors, Inc. (M&S), a Florida corporation that
elected to be treated as a subchapter S corporation for Federal income tax purposes.
During 2000 petitioners entered into a transaction structured to generate tax losses.
This type of transaction, referred to as a custom adjustable rate debt structure
(CARDS) transaction, has been the subject of numerous cases in this Court.
Petitioners claim they entered into the CARDS transaction primarily for nontax
reasons--to obtain funds to transfer to M&S. See infra pp. 6-7. Respondent
maintains the CARDS transaction lacked economic substance, and consequently he
disallowed the losses generated therefrom which petitioners deducted on their
respective 2000 and 2001 individual Federal income tax returns. The amounts of
the losses deducted were:
2000 2001
Donald J. Kipnis $1,933,122 $713,020
Lawrence L. Kibler 1,933,121 713,019
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[*3] The issues for decision are: (1) whether the CARDS transaction lacked
economic substance; (2) whether the loss deductions petitioners claimed for 2000
and 2001 should be disallowed; and (3) whether petitioners were entitled to deduct
certain fees paid with respect to entering into the CARDS transaction.1
For the reasons stated herein, we find that the CARDS transaction lacked
economic substance and thus hold that petitioners are not entitled to deduct (a) the
losses claimed and (b) the fees paid in connection with their entering the CARDS
transaction.
All Rule references are to the Tax Court Rules of Practice and Procedure, and
unless otherwise indicated, all section references are to the Internal Revenue Code
in effect at all relevant times.
FINDINGS OF FACT
We initially note that we have been unable to reconcile the amounts
petitioners paid into the CARDS transaction with the outflow amounts. This,
however, does not affect the holdings we reach herein.
1
Respondent made certain computational adjustments with respect to
petitioners’ itemized deductions and personal exemption deductions which need not
be addressed.
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[*4] Some of the facts are stipulated and are so found. We incorporate by
reference the stipulation of facts and attached exhibits. Each petitioner resided in
Florida at the time he filed his petition.
I. Petitioners and M&S
Mr. Kipnis graduated first in his class from the University of Florida’s
building construction program in 1982. Mr. Kibler graduated first in his class
from the University of Florida’s building construction program in 1975. Each was
highly regarded in the construction business.
Petitioners had been employees of M&S for a number of years before they
acquired the business in 1985 from the company’s founders, Messrs. Solomon and
Miller. Under petitioners’ guidance, M&S became one of the largest general
contractors in south Florida. Although M&S built a variety of major structures,
including a three-building medical school complex at Nova Southeastern, that
school’s Huizenga Business School, and the Miami Dolphins’ training facility, it
was primarily engaged in the construction of residential buildings, such as highrise
condominium and apartment buildings.
In 1999 M&S incurred a loss of over $3 million in connection with its
construction of a 26-story building. That loss substantially reduced M&S’
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[*5] working capital2 just as south Florida entered a construction boom. Because
of the anticipated construction boom, petitioners wanted to increase M&S’
bonding capacity, which in turn required an increase in M&S’ net quick.
Petitioners maintain they did not want to invest their own money in M&S,
2
The amount of M&S’ working capital was vital because it affected M&S’
ability to acquire surety bonding. Charles Nielson, an expert in surety bonding in
the construction industry, see infra p. 22, testified that as a building contractor,
M&S was generally required to obtain, and post with the lenders of developers who
are construction clients of M&S, a surety bond guaranteeing both its performance
under the construction contract and payments to its subcontractors. He further
stated that in order to determine a general contractor’s bonding capacity, a
calculation is required to determine the contractor’s (1) “net quick”, (2) bonding
multiplier, and (3) backlog of uncompleted work.
The contractor’s “net quick” is based on the contractor’s working capital. It
is the difference between the contractor’s current assets (exclusive of prepaid
expenses) and current liabilities. Current assets consist of receivables less than 90
days old, cash, justifiable underbillings, and long-term debt (i.e., debt due in more
than one year) which is subordinated by the creditor to the surety. Current liabilities
are debts due within one year.
Once the net quick is calculated, the contractor is assigned a multiplier based
primarily on the reputation of the contractor. A multiplier of 10 is normal. Because
of M&S’ reputation, its multiplier was 50. The contractor’s net quick is then
multiplied by its multiplier to determine the contractor’s nominal bonding capacity.
After the contractor’s nominal bonding capacity is determined, its available
bonding capacity is determined by subtracting the contractor’s backlog of
uncompleted projects. For example, if the contractor’s net quick is $500,000, and
its multiplier is 10, its nominal bonding capacity would be $5 million. If the
contractor had backlogged projects totaling $3 million, its available bonding
capacity would be $2 million.
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[*6] allegedly because it would be difficult to “get it back out”. Petitioners
purportedly attempted, but were unable, to secure long-term financing for M&S
through conventional bank sources. Mr. Kipnis asked his father to lend M&S
money, but he refused because M&S had previously borrowed $2.5 million from
him and he had no additional funds available. Petitioners also approached Merrill
Lynch (where M&S had a line of credit for short-term loans) about obtaining long-
term financing, but they were rebuffed.
II. Petitioners’ Entry Into the CARDS Transaction
Michael DeSiato was both petitioners’ and M&S’ accountant. In 2000 he
was introduced to Roy Hahn of Chenery Associates, Inc. (Chenery), the designer
and promoter of CARDS transactions. Mr. Hahn explained CARDS to Mr.
DeSiato who, in turn, explained it to petitioners. Mr. DeSiato told petitioners that
CARDS could be the source of the type of financing that could be contributed to
M&S and thus increase its net quick as well as provide tax benefits which would
flow to petitioners. Mr. Kibler, with input from Mr. Kipnis and Mr. DeSiato,
analyzed the CARDS transaction. In preparing his analysis, Mr. Kibler calculated
the costs associated with participation in the CARDS transaction, the tax savings
associated with those costs, and M&S’ projected future cashflows resulting from
bonding capacity multipliers of 20, 30, and 40. He determined that the profits
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[*7] from the additional work M&S would be able to secure would more than offset
the costs associated with petitioners’ participation in the CARDS transaction.
Projecting (1) M&S’ having a bonding capacity multiplier of 40, (2) $420,936 being
injected into M&S in 2000, and (3) the reinvestment of M&S’ after-tax earnings
into its business, using M&S’ historic average gross profit margin of 5%, Mr. Kibler
determined that M&S could achieve gross profits of $28,714,471 and after-tax net
income of $17,343,541 by 2006.3 After reviewing Mr. Kibler’s projections,
petitioners decided to enter into the CARDS transaction, doing so in December
2000.
Mr. Kibler did not examine the numerous steps of the CARDS transaction or
whether it would be profitable per se. Moreover, neither Mr. Kibler nor Mr.
DeSiato fully understood the complicated machinations involved in a CARDS
transaction. Nor did petitioners examine the books of the other parties to the
transaction or inquire whether those parties were solvent and could meet their
obligations under the transaction. Nor did petitioners review the rights and
obligations of each of the parties involved. But petitioners knew that by entering
3
As stated supra note 2, M&S’ bonding multiplier was 50, which would
make its gross and net incomes higher than projected in Mr. Kibler’s analysis.
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[*8] into the transaction, they would be guaranteed a flow-through tax loss which
could be used to offset their income.
As petitioners were reviewing the CARDS transaction, M&S was
experiencing a profitable year, despite the fact that M&S’ net quick was only $1.6
million by the end of 2000. According to M&S’ statement of income, in
2000 its net income was $2,552,836,4 and at no time did M&S have to forgo
construction of a project because it could not get bonding.
III. The CARDS Transaction
Chenery has implemented numerous CARDS transactions, including the one
at issue in this case, and received fees for each. A portion of the fees paid to
Chenery was used to pay third parties and their respective counsel in the specific
CARDS transaction. See Country Pine Fin., LLC v. Commissioner, T.C. Memo
2009-251.
A CARDS transaction has three phases: (1) the loan origination phase; (2)
the loan assumption phase; and (3) the operational phase. Generally, three parties
are required to carry out a CARDS transaction: (1) a bank; (2) a borrower; and (3)
an assuming party.
4
This amount does not include the loss M&S claimed from the CARDS
transaction.
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[*9] Chenery arranged for the New York branch of Bayerische Hypo-und
Vereinsbank, AG of Germany (HVB) to be the bank. HVB has participated in other
CARDS transactions. See Kerman v. Commissioner, T.C. Memo. 2011-54. As a
result of its involvement in the CARDS transactions, as well as its involvement in
other tax shelter transactions, HVB was charged with participating in a conspiracy
in violation of 18 U.S.C. sec. 371 to defraud the United States, committing tax
evasion, and making false and fraudulent tax returns. HVB ultimately entered into a
deferred prosecution agreement with the U.S. Department of Justice on February 13,
2006. See Gustashaw v. Commissioner, T.C. Memo. 2011-195, aff’d, __ F.3d __,
2012 WL 4465190 (11th Cir. Sept. 28, 2012); Sussex Fin. Enters., Inc. v.
Bayerische Hypo-und Vereinsbank AG, No. 08-4791SC, 2010 WL 2867724, at *4
(N.D. Cal. July 20, 2010), aff’d, 460 Fed. Appx. 709 (9th Cir. 2011); Rezner v.
Bayerische Hypo-und Vereinsbank AG, No. 06-02064JW, 2009 WL 8652919
(N.D. Cal. May 1, 2009), aff’d in part, rev’d in part, vacated in part, and remanded,
630 F.3d 866 (9th Cir. 2010).
The borrower in the CARDS transaction herein at issue was Wimbledon
Financial Trading LLC (Wimbledon). Wimbledon was established as a Delaware
limited liability company (LLC) on October 11, 2000, by Elisabeth A.D. Sylvester
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[*10] and Michael Sherry, both citizens and residents of the United Kingdom. 5 Ms.
Sylvester and Mr. Sherry are not strangers to this Court. Each has participated in
other CARDS transactions that have come before us, for example, in Country Pine
Fin. LLC, where they established another Delaware LLC that acted as the borrower
in that matter.
Petitioners were the assuming parties. Shortly after they entered into the
CARDS transaction, petitioners assigned their rights to receive the proceeds from
their portion of the credit facility, see infra p. 16, to M&S, effective December 27,
2000. Petitioners, however, remained liable for the loan to Wimbledon from HVB.
IV. The CARDS Transaction at Issue
A. Origination
On October 11, 2000, Wimbledon was formed, commencing the CARDS
transaction herein at issue. On December 5, 2000, Wimbledon entered into a credit
agreement with HVB, whereby HVB agreed to lend Wimbledon €6,700,000 for a
30-year period (credit facility). Interest on that loan accrued annually with the
exception of the first and second interest periods, which occurred in the first
5
Typically, a passthrough entity, the members of which are non-U.S. citizens
and residents, is used to ensure that there are no U.S. income tax effects at the
borrower level.
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[*11] year of the loan.6 The interest rates on the loan were to be reset annually by
HVB. On each interest reset date HVB, in its sole discretion, had the right to
require prepayment of the loan in its entirety. Hence the loan was in essence a one-
year revolving credit facility with a cancellation option in favor of HVB.
The agreement governing the credit facility required different collateralization
according to the quality of the collateral. If the collateralization consisted of cash,
deposit accounts, letters of credit, or certificates of deposit, Wimbledon was
required to deposit collateral equal to 102% of its obligations to
HVB. If the collateral consisted of other assets, Wimbledon was required to deposit
collateral equal to 108% of the obligations.
On December 5, 2000, Wimbledon informed HVB that it intended to
borrow the €6,700,000 and requested that the money be credited to its account.
Wimbledon issued a promissory note to HVB for €6,700,000, maturing on
December 5, 2030, and HVB credited the amount to Wimbledon’s account.
Wimbledon entered into a master pledge and security agreement in favor of HVB,
pledging as collateral all of Wimbledon’s holdings at HVB. On the same day,
Wimbledon purchased an HVB time deposit of €5,679,792, maturing on
6
The first interest period was from December 5, 2000, to January 5, 2001.
The second interest period was from the end of the first interest period to December
5, 2001. The interest rate for these periods was 5.51875%.
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[*12] December 5, 2001.7 The interest earned on Wimbledon’s time deposit was 50
basis points less than the interest Wimbledon owed HVB on the loan.8
B. Loan Assumption
On or about December 21, 2000,9 petitioners and Wimbledon entered into a
purchase agreement whereby Wimbledon sold each petitioner a portion of the credit
facility in the form of a term deposit in the amount of €502,500 (for a total of
€1,005,000), plus accrued interest, held in Wimbledon’s pledged HVB account.
This amounted to 15% of the €6,700,000 Wimbledon borrowed under the credit
facility. The money was transferred to petitioners’ HVB account on December 27,
2000. The purchase agreement provided that petitioners would be jointly and
severally liable for all obligations under the credit facility not covered by
Wimbledon’s collateral.
7
The record does not explain why, given the language of the credit agreement,
Wimbledon’s time deposit was less than the loan proceeds.
8
As stated supra note 6, the interest rate on Wimbledon’s loan for the first
two interest periods was 5.51875%. The interest rate paid on Wimbledon’s time
deposit was 5.01875%.
9
On the disclosure statement attached to M&S’ 2000 and 2001 Forms 1120S,
U.S. Income Tax Return for an S Corporation, see infra p. 20, the date of the
purchase agreement is stated to be “on or about December 5, 2000”. However, the
copies of the purchase agreement in the record, of which none are signed, states the
date of purchase to be “as of December 21, 2000”. We shall use December 21,
2000, as the date of petitioners’ purchase.
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[*13] Wimbledon also entered into assumption agreements with petitioners on
December 21, 2000, pursuant to which petitioners agreed to assume joint and
several liability for Wimbledon’s obligations under the credit facility and the notes
issued thereunder, including the repayment of the credit facility’s principal
of €6,700,000. Neither petitioners nor their advisers investigated the
creditworthiness of Wimbledon.
Petitioners pledged as collateral all their right, title, and interest in the deposit
accounts, securities accounts, and other instruments and investment property held
with HVB, as well as all proceeds thereof. Each petitioner had the right at any time
to request that any collateral be substituted, but HVB had sole discretion to approve
such a substitution.
Wimbledon and petitioners agreed that Wimbledon would be responsible
for interest payments on the credit facility and that petitioners would be
responsible for all other amounts due under the credit facility to the extent not
covered by Wimbledon’s collateral. The only amount, other than interest, not
covered by Wimbledon’s collateral was the €1,005,000 credited to petitioners.
Petitioners waived their right of contribution against Wimbledon, even in the
event Wimbledon failed to make the required interest payments. The assumption
agreement and the waiver resulted in petitioners being liable for the entire
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[*14] €6,700,000 even though Wimbledon still maintained control over part of the
proceeds. The assumption agreement and the waiver led petitioners to claim for tax
purposes the entire amount of the loan (i.e., €6,700,000) as their basis in the CARDS
transaction.
With these agreements in place, the three parties, Wimbledon (the borrower),
HVB (the bank), and petitioners (the assuming parties), began taking a number of
actions to execute the assumption of the credit facility. First, on December 21, 2000,
each petitioner wired $599,000 to HVB, a total of $1,198,000, to serve as cash
collateral to secure his obligation to HVB. The money was used to purchase three
time deposits that would mature on December 5, 2001. Then, on December 27,
2000, pursuant to direction by Wimbledon, HVB transferred the €1,005,000
referenced in the purchase agreement into petitioners’ HVB account. On that date,
HVB exchanged €733,750 of the €1,005,000 credited to petitioners for $682,387.50,
at a rate of .93 dollars to the euro. On January 11, 2001, HVB exchanged the
remaining €271,250 of the €1,005,000 credited to petitioners for $256,331.25, at a
rate of .945 dollars to the euro.
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[*15] Before petitioners’ receipt of the money, on December 22, 2000, petitioners
and HVB entered into a forward exchange contract (forward contract)10 to exchange
€1,090,00011 for $1,037,680. The forward contract matured on December 5, 2001,
the same maturity date as each of petitioners’ three time deposits. Effectively,
petitioners ended up in the same economic position upon the termination of the credit
facility as they were in when the CARDS transaction began, thus protecting
themselves from risk of loss that might otherwise result from currency fluctuations.
Notably, the forward contract prevented petitioners from profiting from the
exchange. See Country Pine Fin., LLC v. Commissioner, T.C. Memo. 2009-251.12
10
A forward contract is a contract that allows two parties to buy or sell an
asset at a specified time for a specified amount. In this case the forward contract
allowed petitioners to convert U.S. dollars (dollars) back into euro at the same
conversion rate at which the euro were converted into dollars.
11
The record does not reveal why petitioners entered into a contract to
exchange €1,090,000 instead of the €1,005,000 received in the CARDS transaction.
12
The record does not contain a copy of the forward contract. But the record
demonstrates that both the original euro to dollar conversion and the final dollar to
euro conversion were made at the same exchange rate. Moreover, because of the
decline of the euro against the dollar when the CARDS transaction ended,
petitioners should have received $70,200 more than they in fact received.
Petitioners did not object to this shortfall at the time. Petitioners testified that they
were unaware of the shortfall at the time of payment, even though they claim that
(continued...)
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[*16] On December 27, 2000, petitioners assigned their rights to the credit facility to
M&S.
C. Operational Phase
When petitioners deposited the $1,198,000 with HVB, HVB allowed M&S to
withdraw the $1,037,680 in credit facility proceeds from the bank to use as it
wished. The parties referred to this as a “collateral swap”.13 This differentiates the
CARDS transaction in this case from the CARDS transactions in other cases, for in
those cases the assuming parties offered to swap replacement collateral but the offers
were rejected by the respective banks. Therefore in each of those other cases no
collateral swap ever occurred. See Crispin v. Commissioner, T.C. Memo. 2012-70;
Country Pine Fin., LLC v. Commissioner, T.C. Memo. 2009-251.
On January 11, 2001, petitioners began using the proceeds from the credit
facility by wiring (1) $382,000 from their HVB account to an account held by
Chenery as the promoter of the CARDS transaction, which used a portion of these
12
(...continued)
they were closely monitoring the CARDS transaction.
13
In the other CARDS transaction cases the alleged purpose was to enable the
taxpayer to swap the loan proceeds from the CARDS transaction that were being
held by the bank as collateral for property, presumably which then could be used to
generate profits greater in amount than the costs of the CARDS transaction. See,
e.g., Country Pine Fin. LLC v. Commissioner, T.C. Memo. 2009-251.
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[*17] funds to pay Mr. DeSiato, and (2) $556,718.75 to M&S’ account at Mellon
Bank.14 After the payment of additional fees to Chenery and its counsel, Lasher
Holzapfel Sperry & Ebberson P.L.L.C. (Lasher), M&S retained only $423,000 of the
funds generated by the CARDS transaction. Thus, when all was said and done,
M&S had an additional $423,000 of net quick. Chenery, and its counsel, Lasher,
however, had received $500,000 and $15,000 in fees, respectively. These amounts
were either paid directly by Messrs. Kipnis and Kibler or taken from funds generated
by the CARDS transaction.
As noted supra p. 8, M&S’ construction activities in 2000 were very
profitable even before petitioners entered into the CARDS transaction. With the
proceeds from the credit facility in place, in 2001 M&S began constructing major
projects including high-rise apartments, the medical school complex at Nova
Southeastern University, the business school at Nova Southeastern University, and
a large bank branch building. However, the results were mixed. According to
M&S’ audited financial statements, M&S’ gross revenue increased from $54
million in 2000 to $82 million in 2001 and to $159 million in 2002 but sank to
$146 million in 2003. M&S’ net income was $2,552,836 for 2000, but dropped to
14
In addition, on January 12, 2001, $43,900 was wired from HVB to Messrs.
Kipnis’ and Kibler’s respective personal bank accounts.
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[*18] $1,256,381 for 2001, rebounded to $2,006,004 for 2002, and dropped again to
$1,134,965 for 2003.15
V. Unwinding the CARDS Transaction
As noted supra pp. 10-11, although the credit facility involved in the CARDS
transaction nominally was for 30 years, HVB had the right to terminate the
transaction earlier. HVB exercised that right on November 13, 2001, less than a year
after the initiation of the CARDS transaction. On that date HVB informed
petitioners that December 5, 2001, the date that petitioners’ three time deposits
would mature as well as the ending date of the forward contract, would be the
mandatory prepayment date. Moreover, on that date, petitioners’ deposits at HVB
were converted to euro at the December 22, 2000, exchange rate pursuant to the
forward contract. Had the dollars been converted to euro at the December 5, 2001,
exchange rate, petitioners would have had a $70,200 profit. All of the borrowed
funds were repaid with the pledged collateral, and no additional capital
contributions were ever made. Once the transaction closed, $143,809.07 remained
in petitioners’ account at HVB. This money was wired to M&S’ bank account on
December 14, 2001. At trial petitioners claimed that it was they who chose to
15
These net income amounts do not include the losses generated by the
CARDS transaction.
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[*19] terminate theCARDS transaction because they were concerned about the
strength of the dollar vis-a-vis the euro after the terrorist attacks of September 11.16
VI. M&S’ and Petitioners’ Income Tax Returns
A. M&S’ 2000 and 2001 Income Tax Returns
M&S timely filed its 2000 Form 1120S. On Form 4797, Sales of Business
Property, M&S reported a $4,548,630 basis in foreign currency sold, a sale price of
foreign currency sold of $682,388, and consequently a $3,866,242 loss as a result of
the December 27, 2000 euro conversion. The high basis arose from petitioners’
agreement to become liable for the entire €6,700,000 loan from HVB to Wimbledon.
As a result of the CARDS transaction, M&S claimed an ordinary loss deduction
from trade or business activities of $1,540,819 for 2000.
Attached to M&S’ income tax return was a disclosure statement notifying
the Internal Revenue Service of the currency transaction. The disclosure statement
stated:
16
When HVB terminated the CARDS transaction just one year into the 30-
year term of the credit facility, petitioners told Mr. DeSiato that they were
dissatisfied. At approximately this time, petitioners learned that HVB was subject
to the deferred prosecution agreement referenced supra p. 9. They complained to
Mr. DeSiato that the transaction was a ruse and that it was fictitious. Petitioners
were also angry because of incurred costs in connection with respondent’s audit
with respect to their reported losses arising from the CARDS transaction.
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[*20] On or about December 5, 2000, Donald Kipnis and Larry Kibler
(taxpayers) entered into a transaction to purchase a Credit Facility
from Wimbledon Financial Trading, LLC, a Delaware LLC.
They assigned the benefit of this facility to Miller and Solomon
General Contractors, Inc., on December 27, 2000. The Facility
was in the form of a 30 year zero coupon loan in the amount of
6.7M Euros. The Purchase Agreement was signed on December 5,
2000, and a disbursement was made in the amount of 733,210 Euros,
under the terms of the Agreement. This amount was converted to
dollars on which yielded $682,388. Pursuant to the opinion letter
of Brown & Wood, LLP, the above taxpayers had a basis in this
facility of $4,548,630, the dollar equivalent of the notional loan
principal using the conversion rate at that time of .93 Dollars to
1 Euro. Basis exists based upon the taxpayer’s [sic] personal liability
for the loan.
The disclosure statement further revealed that M&S realized an ordinary loss
of $3,866,242 under the provisions of section 988 and that petitioners incurred
business expenses of $500,000 paid to Chenery that were to be applied against
anticipated transaction costs. Finally, the disclosure statement stated that petitioners’
business purpose in entering into the transaction was to obtain funds to contribute to
M&S.
On Form 4797 attached to its 2001 tax return, M&S claimed a $1,682,370
basis in foreign currency and a sale price of foreign currency sold of $256,331
resulting in a loss of $1,426,039 as a result of the January 11, 2001 euro conversion.
Again, the high basis arose from petitioners’ agreement to become liable for the
amount of the entire €6,700,000 loan from HVB to Wimbledon.
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[*21] Taking into account the foreign currency loss, M&S claimed an ordinary loss
deduction from trade or business of $243,259.
B. Petitioners’ 2000 and 2001 Income Tax Returns
Because M&S was a subchapter S corporation, its losses flowed through to its
shareholders, i.e., petitioners. Petitioners timely filed their respective Forms 1040,
U.S. Individual Income Tax Return.17 On their respective 2000 income tax returns,
Mr. Kipnis and Mr. Kibler each reported a loss from M&S of $896,724. Their
respective losses consisted of 50% or $770,409 of the loss reported by M&S for that
year, and a prior-year suspended loss of $126,315. On their respective 2001 income
tax returns, Mr. Kipnis reported a loss of $312,629 which consisted of 50% or
$121,629 of the loss reported by M&S and “other expenses” of $191,000 that
represented costs paid in regard to the currency transactions, and Mr. Kibler reported
a loss of $312,629 which consisted of his share of the 50% of the loss reported by
M&S or $121,629 and his share of the “other expenses” which was $191,000.
Respondent determined that the CARDS transaction lacked economic
substance and that the loss deductions petitioners claimed were in connection with
17
Petitioners filed joint returns with their respective wives. However, the
notices of deficiency were issued to petitioners solely. There is no explanation for
this.
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[*22] a transaction that was “a sham in substance”. Thus, respondent increased each
petitioner’s distributive share of M&S’ income for 2000 and 2001 as set forth supra
p. 2.
VII. The Expert Reports
Respondent submitted an expert report prepared by Dr. Lawrence Kolbe. Dr.
Kolbe’s report focused on the CARDS transaction as a financing decision, and
therefore it analyzed the credit facility itself, not what was done with the proceeds
derived therefrom. Dr. Kolbe concluded that the CARDS transaction was not
economically rational because the expected rate of return on the amount invested did
not exceed or even equal the “cost of capital”, i.e., the expected rate of return in
capital markets on alternative investments of equivalent risk.
Petitioners did not submit a written expert report. Instead, they relied on the
testimony of Charles Nielson as an expert in surety bonding in the construction
industry.18 Mr. Nielson stated that the CARDS transaction was profitable if it is
considered as an aspect of M&S’ business strategy. He opined that even though
the costs for the credit facility were considerable, the profits generated from
obtaining additional construction projects which necessitated bonding (which in
18
Mr. Nielson is the president of Nielson, Hoover, & Associates, one of the
three largest privately owned brokers of surety bonds in the United States, and has
relationships with every surety company in Florida.
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[*23] turn required M&S’ net quick to be increased) resulted in the CARDS
transaction’s being a viable economical proposition from petitioners’ viewpoint.
OPINION
I. Introduction--The Economic Substance Doctrine
Taxpayers have the right to structure their transactions in a manner which
decreases the amount of what otherwise would be their taxes. Gregory v.
Helvering, 293 U.S. 465, 469 (1935). However, even if a transaction is in formal
compliance with the Code, the economic substance of the transaction determines
what is and what is not income to a taxpayer. United Parcel Serv. of Am., Inc. v.
Commissioner, 254 F.3d 1014, 1018 (11th Cir. 2001), rev’g T.C. Memo. 1999-
268.19 The economic substance doctrine provides that (1) a transaction ceases to
merit tax respect when it has no economic effects other than the creation of tax
benefits (the objective test), and (2) even if the transaction has economic
19
Tax deductions are a matter of legislative grace, and the taxpayer has the
burden of proving that he is entitled to the deductions claimed. Rule 142(a);
INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v.
Helvering, 292 U.S. 435, 440 (1934). The burden of proof on factual issues that
affect a taxpayer’s liability for tax may be shifted to the Commissioner where the
“taxpayer introduces credible evidence with respect to * * * such issue.” Sec.
7491(a)(1). Our resolution of the issues involved herein is based on a
preponderance of the evidence, not on the allocation of the burden of proof.
Consequently, we need not consider whether sec. 7491(a) applies. See Estate of
Bongard v. Commissioner, 124 T.C. 95, 111 (2005).
- 24 -
[*24] effects, it must be disregarded if it has no business purpose and its motive is
tax avoidance (the subjective test). Id. In the Eleventh Circuit, the circuit in which
an appeal of these cases lies, a transaction must satisfy both the objective and
subjective tests to enable a taxpayer to claim a loss. Id.20
This Court has examined other CARDS transactions promoted by Chenery.
And on each occasion, we have held that the CARDS transaction lacked economic
substance. See Crispin v. Commissioner, T.C. Memo. 2012-70; Kerman v.
20
The Courts of Appeals are split with respect to the proper weight to be
given to these tests in deciding whether to respect a transaction under the economic
substance doctrine, and alternative approaches have emerged. See Gerdau
Macsteel, Inc. v. Commissioner, 139 T.C. ___, ___ (slip op. at 60) (Aug. 30, 2012).
Some Courts of Appeals apply a disjunctive analysis, under which a transaction is
valid if it has economic substance or a business purpose. See, e.g., Horn v.
Commissioner, 968 F.2d 1229, 1236-1238 (D.C. Cir. 1992), rev’g Fox v.
Commissioner, T.C. Memo. 1988-570. Other Courts of Appeals apply a
conjunctive analysis, under which a transaction is valid only if the transaction has
economic substance beyond tax objectives and the taxpayer has a nontax business
purpose for entering into the transaction. See, e.g., Winn-Dixie Stores, Inc. v.
Commissioner, 254 F.3d 1313, 1316 (11th Cir. 2001), aff’g 113 T.C. 254 (1999).
Other Courts of Appeals adhere to the view that a lack of economic substance is
sufficient to invalidate the transaction regardless of whether the taxpayer has
motives other than tax avoidance. See, e.g., Coltec Indus., Inc., v. United States,
454 F.3d 1340, 1355 (Fed. Cir. 2006). Others treat the objective and subjective
tests merely as factors to consider in determining whether a transaction has any
practical economic effects beyond tax benefits. See, e.g., ACM P’ship v.
Commissioner, 157 F.3d 231, 248 (3d Cir. 1998), aff’g in part, rev’g in part T.C.
Memo. 1997-115. Pursuant to Golsen v. Commissioner, 54 T.C. 742, 757 (1970),
aff’d, 445 F.2d 985 (10th Cir. 1971), we follow a holding of a court to which appeal
lies that is squarely on point.
- 25 -
[*25] Commissioner, T.C. Memo. 2011-54; Country Pine Fin., LLC v.
Commissioner T.C. Memo. 2009-251.
The other CARDS transactions are essentially the same as the transaction in
this case, with one exception. In the other cases the taxpayers did not use the
proceeds arising from the CARDS transaction to actually make an investment.
Petitioners assert this difference is significant and mandates a holding that they are
entitled to the loss deductions claimed because they, in fact, used the proceeds
from the CARDS transaction to increase M&S’ net quick.
Respondent contends that the use of the proceeds derived from the CARDS
transaction is irrelevant. Specifically, respondent maintains the CARDS
transaction should be treated separately from the transfer of moneys from the
CARDS transaction to M&S. Respondent posits that to look to the use of the
proceeds from the CARDS transaction would permit taxpayers to legitimize sham
transactions by grafting them onto legitimate business transactions. Continuing,
respondent argues that petitioners had no business purpose in entering into the
CARDS transaction per se. In sum, respondent asserts that after all was said and
- 26 -
[*26] done, petitioners’ primary intent was to offset their significant business income
with the losses arising from their involvement in the CARDS transaction.21
II. Scope of Review
As stated supra pp. 24-25, we have reviewed other CARDS transactions. In
Country Pine Fin., LLC v. Commissioner, T.C. Memo. 2009-251, the taxpayers
argued, as petitioners do, that although the CARDS transaction itself may be
questionable, it was an integral part of an investment in real estate that they intended
to make--integral because the real estate investments would be funded entirely
through the proceeds derived from the CARDS transaction. Moreover, the taxpayers
therein asserted the real estate investments had every chance of being profitable.
Consequently, the taxpayers maintained that we should treat the CARDS transaction
and the subsequent real estate investments as one transaction. We rejected that
argument.
Initially, we noted in Country Pine Fin., LLC, that the real estate
investments to which the taxpayers referred did not happen. But, more
importantly, we held that even if the intended real estate investments had occurred,
21
Respondent also asserts that petitioners’ claimed loss deductions should be
disallowed under sec. 165 because the losses were not incurred in a transaction
entered into for profit and hence deductibility of the losses is limited by the at-risk
rules of sec. 465. We need not, and do not, consider these arguments because of
our other holdings set forth herein.
- 27 -
[*27] we only “look at the transaction that gave rise to the tax loss.” Id. We noted
that the intended real estate investment would have been a separate transaction from
the one giving rise to the tax benefit, “and any profit from the real estate investment
would not be a profit from the CARDS transaction.” Id.; see also Am. Elec. Power
Co. v. United States, 326 F.3d 737, 743 (6th Cir. 2003) (courts should not “evaluate
the transaction’s profitability after the challenged deduction has been allowed. To do
so would swallow the sham analysis entirely”); Winn-Dixie Stores, Inc. v.
Commissioner, 113 T.C. 254 (1999) (the possibility that tax benefits could be used
as a source of funds for the taxpayer’s obligations does not alter the fact that the tax
plan’s only function was to generate tax deductions that could offset the taxpayer’s
income), aff’d, 254 F.3d 1313 (11th Cir. 2001).
Petitioners respond that we are “obligated to analyze the entire transaction”,
see Kirchman v. Commissioner, 862 F.2d 1486, 1493-1494 (11th Cir. 1989), aff’g
Glass v. Commissioner, 87 T.C. 1087 (1986), and that “[s]egregating * * * [the tax
payer’s] investment * * * into two parts, as respondent suggests, would violate the
principle that the economic substance of a transaction turns on a review of the entire
transaction”, see Salina P’ship L.P. v. Commissioner, T.C. Memo. 2000-352.
Petitioners misinterpret these cases. We review the CARDS transaction separately
from the transfer of the proceeds to M&S.
- 28 -
[*28] In Salina P’ship L.P., the Commissioner argued that one leg of the loss-
generating transaction should be segregated from the other leg, which the
Commissioner conceded was economically substantive. We rejected that argument
and held that the entire transaction should be examined. As a result of reviewing the
transaction as a whole, we found that the transaction was economically substantive
and held that the taxpayer was entitled to claim its losses. In Kirchman, the Court of
Appeals for the Eleventh Circuit, in upholding our Opinion, reviewed the transaction
as a whole, instead of merely examining the one leg of the transaction that generated
the loss, and held that the entire transaction lacked economic substance.
III. Application of the Economic Substance Test
A. The Objective Test
The objective test involves a broad examination of whether, from an
objective standpoint, the transaction would likely produce economic benefits other
than generate a tax deduction. Kirchman v. Commissioner, 862 F.2d at 1492
(citing Bail Bonds by Marvin Nelson, Inc. v. Commissioner, 820 F.2d 1543, 1549
(9th Cir. 1987), aff’g T.C. Memo. 1986-23); see also Knetsch v. United States,
364 U.S. 361, 365-366 (1960) (transaction not recognized because there was
nothing of substance to be realized by the taxpayer from the transaction in
- 29 -
[*29] question beyond a tax deduction). “A reasonable opportunity for profit will
ordinarily be found only if there was a legitimate expectation that the nontax benefits
would be at least commensurate with the associated transaction costs.” Rovakat,
LLC v. Commissioner, T.C. Memo. 2011-225.
The CARDS transaction in this case is virtually identical to the transactions in
Country Pine Fin., LLC, Kerman, and Crispin. Indeed, HVB became familiar to us
in Kerman and returned in Gustashaw v. Commissioner, T.C. Memo. 2011-195.22
And as stated supra pp. 9-10, the members of Wimbledon, Ms. Sylvester and Mr.
Sherry, were first introduced to us in Country Pine Fin., LLC and came before us
again in Kerman.
At trial petitioners conceded that the CARDS transaction per se had no
profit potential aside from currency fluctuations. And we are mindful that the
manner in which the CARDS transaction was structured and executed prevented
petitioners from profiting from currency fluctuations. Petitioners candidly
testified that they did not research currency trading before entering the CARDS
transaction and that they did not consult an expert in the field. Indeed, M&S’
accountant, Mr. DeSiato, was unaware of any intent on petitioners’ part to profit
22
The taxpayers in Gustashaw v. Commissioner, T.C. Memo. 2011-195, aff’d,
__ F.3d __, 2012 WL 4465190 (11th Cir. Sept. 28, 2012), conceded that their
CARDS transaction lacked economic substance.
- 30 -
[*30] from the currency market. Further, while considering the CARDS transaction,
petitioners did not give “much thought” to profiting from the CARDS transaction
itself, and they never developed a strategy to profit from currency fluctuations.
The forward contract entered into by petitioners and HVB ensured that the
conversion of dollars back into euro at the end of the CARDS transaction would be
at the same rate as used to convert the borrowed euro into dollars at the beginning of
petitioners’ participation in the transaction. As a result, HVB was protected from
unfavorable currency fluctuations. And we doubt that HVB would have participated
in the CARDS transaction without such protection. Moreover, when the CARDS
transaction was terminated, the dollar had increased in value vis-a-vis the euro.
Consequently, petitioners should have received $214,000 at the conclusion of the
transaction, but in fact they received $143,809.07.
In any case, even if petitioners could have profited from the currency
transaction, they did not provide any evidence concerning the amount of profits
from the currency fluctuations they could have made. Further the $70,200 (i.e.,
$214,000 less $143,809.07) involved is minimal in comparison to the $5,292,282
petitioners ultimately deducted or to the nearly $1.2 million petitioners paid to
participate in the CARDS transaction. See Kirchman v. Commissioner, 862 F.2d
- 31 -
[*31] at 1494 (minimal risks of profit or loss are insufficient to provide economic
substance to a transaction); see also Sala v. United States, 613 F.3d 1249, 1254
(10th Cir. 2010) (the transaction lacked economic substance where the potential
profits were dwarfed by the expected tax benefit); Jade Trading, LLC v. United
States, 598 F.3d 1372, 1377 (Fed. Cir. 2010) (a transaction lacks economic
substance if it provides a disproportionate tax benefit compared to the amount
invested and the potential return).
In reviewing the CARDS transaction without reference to the transfer of the
proceeds to M&S, we find Dr. Kolbe’s report persuasive that the CARDS
transaction lacked economic substance. Indeed, petitioners, in the light of their
concession, do not dispute Dr. Kolbe’s expert report that the CARDS transaction
lacked profit potential and was cashflow negative, guaranteeing them a tax loss.
Dr. Kolbe noted that the CARDS transaction reduced petitioners’ wealth by more
than $500,000 and would have reduced it even more had the CARDS transaction
lasted longer than one year. This loss would exist no matter what investments
petitioners made with the proceeds because the same investments could have been
financed by a more conventional type of loan, and the artificial, unrelated loss
would remain even if we accepted petitioners’ position that we should consider the
- 32 -
[*32] transfer of the proceeds to M&S as part of the CARDS transaction. See
Country Pine Fin., LLC v. Commissioner, T.C. Memo. 2009-251.
B. The Subjective Test
Initially, we note that if a transaction fails the objective test, the subjective
motive of the taxpayer is irrelevant. See Kirchman v. Commissioner, 862 F.2d at
1492. The subjective test reviews the intent or business purpose of the taxpayer.
Having a business purpose does not mean the reason for a transaction is free of tax
considerations, but the purpose must be one that “figures in a bona fide, profit-
seeking business.” United Parcel Serv. of Am. v. Commissioner, 254 F.3d at 1019.
Thus, a transaction that would not have occurred in any form but for tax avoidance
reasons would not have a business purpose. Id. at 1020.
Petitioners were unequivocal about one thing: Any contribution to M&S
had to be in the form of a loan. Contributing their own money to M&S was not an
option. Both petitioners and their witnesses explained that the construction
industry was built on leverage. Moreover, Mr. Kipnis was emphatic that personal
considerations prevented him from putting his own money into M&S. And yet,
after all was said and done, Messrs. Kipnis and Kibler spent nearly $1.2 million of
their own money in order for $423,000 to ultimately reach M&S. No genuine
- 33 -
[*33] leveraging arose from the CARDS transaction. Petitioners deposited
$1,198,000 into accounts at HVB. HVB then advanced to petitioners $1,037,680.
After paying fees to the transaction promoters, the promoters’ lawyers, and their
accountant, petitioners contributed the remaining money, $423,000, to M&S.23
Had petitioners’ actions matched their stated intent, M&S would have repaid
the credit facility out of M&S’ growing gross business revenues. But when HVB
terminated the CARDS transaction and demanded prepayment of the
credit facility, M&S did not repay the credit facility. Rather, the personal funds
petitioners had deposited in HVB were used.
Petitioners stated that they could not convince a U.S. bank to offer M&S a
loan (presumably a conventional loan) because M&S had no assets which could
collateralize such an advance. We believe, however, that petitioners could have
borrowed money from a U.S. bank on the same terms as those obtained at HVB, or
better. We have no doubt but that the receipt of $423,000 in proceeds derived from
the CARDS transaction could have been obtained at far less cost had petitioners
used a U.S. bank. But we are mindful that borrowing money from a U.S. bank
23
The structure of the CARDS transaction makes it clear that despite the
appearance of a loan, functionally petitioners never took on any actual debt. In
order to withdraw the funds from HVB, petitioners were required to deposit a like
amount in HVB as replacement collateral.
- 34 -
[*34] would not have provided petitioners with the tax losses the CARDS
transaction promised.
IV. Fees Paid To Enter Into the CARDS Transaction
Petitioners paid $500,000 to Chenery and $15,000 to Lasher to participate in
the CARDS transaction, a total of $515,000. As noted supra pp. 16-17, petitioners
wired $382,000 of the credit facility’s proceeds to pay part of these fees.
Petitioners paid the remaining fees out-of-pocket. Respondent determined that
payment of the $382,000 in fees was for the purpose of purchasing a prestructured
transaction that guaranteed petitioners a tax loss and thus disallowed the deduction
claimed for that payment.
Fees incurred in connection with a sham transaction are generally not
deductible. Winn-Dixie Stores, Inc v. Commissioner, 113 T.C. at 294; see also
New Phoenix Sunrise Corp. v. Commissioner, 132 T.C. 161 (2009) (fees to
implement a transaction held to lack economic substance are not deductible),
aff’d, 408 Fed. Appx. 908 (6th Cir. 2010). Courts have upheld deductions based
on genuine debts where the debts are elements of a transaction that overall is
lacking in economic substance. See Rice’s Toyota World, Inc. v. Commissioner,
752 F.2d 89, 95-96 (4th Cir. 1985) (allowing deductions based on recourse note
debt that was an element of a sham transaction because the notes represented actual
- 35 -
[*35] indebtedness), aff’g in part, rev’g in part 81 T.C. 184 (1983). But the overall
transaction must have economic substance in order to show genuine indebtedness;
otherwise “‘every tax shelter * * * could qualify for an interest expense deduction
as long as there was a real creditor in the transaction that demanded repayment.’”
Klamath Strategic Inv. Fund v. United States, 568 F.3d 537, 550 (5th Cir. 2009)
(quoting Winn-Dixie Stores v. Commissioner, 113 T.C. at 279). In this matter the
CARDS transaction lacked economic substance in part because there was no
genuine indebtedness. As stated supra note 23, petitioners never took on any
actual debt in the CARDS transaction. In order to withdraw loan proceeds from
HVB, petitioners were required to deposit a like amount in the bank.
Economically, nothing of substance had changed. Since the CARDS transaction
did not constitute indebtedness, petitioners may not deduct the expenses related to
the CARDS transaction. Petitioners offer no reason the fees in this case should be
treated differently from fees in prior CARDS transaction cases. Consequently, we
uphold respondent’s disallowance of these deductions.
V. Conclusion
Petitioners’ CARDS transaction lacked economic substance. It could not be
profitable, and petitioners did not have a business purpose for entering into the
- 36 -
[*36] transaction. Because we find that the CARDS transaction lacked economic
substance, it is to be disregarded for tax purposes and petitioners’ claimed loss
deductions are disallowed. As a result, petitioners may not deduct the fees
related to the transaction.
To reflect the foregoing,
Decisions will be entered
for respondent.