REVISED MAY 21, 2009
IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT United States Court of Appeals
Fifth Circuit
FILED
May 15, 2009
No. 07-40861
Charles R. Fulbruge III
Clerk
KLAMATH STRATEGIC INVESTMENT FUND, by and through St Croix
Ventures (Managing member)
Plaintiff - Appellee - Cross-Appellant
v.
UNITED STATES OF AMERICA
Defendant - Appellant - Cross-Appellee
_________________________________________________
KINABALU STRATEGIC INVESTMENT FUND, by and through Rogue
Ventures LLC (Managing member)
Plaintiff - Appellee - Cross-Appellant
v.
UNITED STATES OF AMERICA
Defendant - Appellant - Cross-Appellee
Appeals from the United States District Court
for the Eastern District of Texas
Before GARWOOD, GARZA, and OWEN, Circuit Judges.
EMILIO M. GARZA, Circuit Judge:
No. 07-40861
In this tax case, Plaintiffs Klamath Strategic Investment Fund
(“Klamath”) and Kinabalu Strategic Investment Fund (“Kinabalu”) (collectively,
the “Partnerships”) filed suit against defendant the United States of America for
readjustment of partnership items. Both parties appeal various aspects of the
district court’s readjustment determination. For the following reasons, we
affirm in part, vacate in part, and remand.
I
This case involves a highly complex series of financial transactions, which
the district court categorized as a tax shelter known as Bond Linked Issue
Premium Structure (“BLIPS”). The transactions were undertaken by two law
partners, Cary Patterson and Harold Nix. Patterson and Nix’s law firm
represented the State of Texas in litigation against the tobacco industry and
each partner earned around $30 million between 1998 and 2000. Interested in
managing this wealth, Patterson and Nix requested their long-time accounting
firm, Pollans & Cohen, to investigate investment opportunities.
The accountants identified Presidio Advisory Services (“Presidio”), an
investment advisory firm purporting to specialize in foreign currency trading.
Presidio advocated a complex plan involving strategic investments in foreign
currencies pegged to the U.S. dollar. Patterson and Nix agreed to invest in
Presidio’s plan. Generally, the Presidio strategy was structured as a three-stage,
seven-year investment program. Stage I lasted 60 days and entailed relatively
low risk investments. Stage II lasted from day 60 through day 180, and the risk
was somewhat higher. Stage III extended from day 180 through the end of the
seventh year and involved the highest risk as well as potentially the highest
return. At each stage of the plan, Presidio required the investors to contribute
significantly more capital. The investors retained the right to exit the plan at
the end of Stage I and at each 60-day period thereafter.
2
No. 07-40861
To implement the strategy Presidio formed Klamath and Kinabalu as
limited liability companies, taxed as partnerships. Next, Presidio formed two
single-member LLCs, which are disregarded for tax purposes: St. Croix for
Patterson and Rogue for Nix. Patterson owned 100% of St. Croix, and St. Croix
became a 90% partner of Klamath. The other 10% partners of Klamath were
Presidio Resources LLC and Presidio Growth LLC. Presidio Growth was the
managing partner. Kinabalu had a similar structure. Nix owned 100% of
Rogue, and Rogue was a 90% partner of Kinabalu. The other 10% partners of
Kinabalu were Presidio Growth and Presidio Resources, with Presidio Growth
acting as the managing partner.
To fund Klamath and Kinabalu, Patterson and Nix (acting through St.
Croix and Rogue) made two distinct contributions. First, they each contributed
$1.5 million to their respective partnership. Second, they entered into loan
transactions with National Westminster Bank (“NatWest”), where the bank
loaned each company $66.7 million. This included $41.7 million denominated
as the “Stated Principal Amount” and $25 million as a “loan premium.” The
classification of the $25 million as something different than the principal loan
amount is central to this case. The loan premium was given in exchange for
Patterson and Nix paying NatWest a higher than market interest rate on the
principal: 17.97%. To protect NatWest from the possibility that the loans would
be repaid early and the benefit of the higher interest rate would not be realized,
the credit agreements required that a prepayment amount be paid if the loans
were paid off early. The prepayment amount would vary depending on when the
loan was repaid, starting at about $25 million and decreasing over seven years.
After year seven, no prepayment amount would apply.
Patterson and Nix each contributed the $66.7 million to Klamath and
Kinabalu and assigned the corresponding loan obligations to the Partnerships.
The Partnerships deposited the funds into accounts controlled by NatWest.
3
No. 07-40861
Presidio directed Klamath and Kinabalu to use these funds to purchase very low
risk contracts on U.S. dollars and Euros. They also made small, short 60- to 90-
day term forward contract trades in foreign currencies. These were the only
investments the Partnerships ever made, and Patterson and Nix elected to
withdraw from Klamath and Kinabalu before the end of Stage I. They received
cash and Euros on liquidation, and they sold the Euros in 2000, 2001, and 2002.
On their income tax returns for 2000, 2001, and 2002, Patterson claimed
total losses of $25,277,202 arising from Klamath’s activities and Nix claimed
total losses of $25,272,344 arising from Kinabalu’s. These massive losses
occurred because each partner claimed a significant tax basis in their respective
partnership. Generally, a partner’s basis in a partnership is determined by the
amount of capital he contributes to the partnership, and when a partnership
loses money the partners can only deduct the losses from their taxable income
to the extent of their basis in the partnership. When a partnership assumes a
partner’s individual liabilities, the liability amount is subtracted from the
partner’s basis.1 Patterson and Nix were able to report such high losses because
when they each calculated their basis in the partnership, they did not reduce it
by the $25 million loan premium amount. When Patterson and Nix contributed
the $66.7 million plus the $1.5 million to Klamath and Kinabalu, they would
have each had a $68.2 million basis in their partnership. However, the
Partnerships also assumed the loan obligations, so Patterson and Nix’s bases
had to be reduced by the amount of the liabilities. Patterson and Nix did not
consider the loan premiums to be liabilities, so they only subtracted the $41.7
million principal amount. Therefore, each claimed a taxable basis in the
partnership in excess of $25 million. This meant that when Patterson and Nix
1
These rules are defined in 26 U.S.C. § 752 et seq. of the Internal Revenue Code,
described more fully below.
4
No. 07-40861
sold the Euros, they were able to deduct over $25 million from their taxable
income.2
The IRS disagreed with this basis calculation, and in 2004 issued Final
Partnership Administrative Adjustments (“FPAAs”) to Klamath and Kinabalu
stating that under 26 U.S.C. § 752 of the Internal Revenue Code (the “Code”),
the partners should have treated the entire $66.7 million as a liability.
Alternatively, the IRS argued that the transactions were shams or lacked
economic substance and should be disregarded for tax purposes. The FPAAs also
made adjustments to operational expenses reported by the Partnerships and
asserted accuracy-related penalties. Patterson and Nix paid the taxes owed
based on the FPAAs, and then re-formed the partnerships in order to seek
readjustment in the district court.
The Partnerships filed suit against the Government under 26 U.S.C. §
6226 for readjustment of partnership items. The Partnerships moved for partial
summary judgment, and the Government cross-moved for summary judgment
on the issue of whether the partners’ tax bases were properly calculated;
specifically, whether the loan premiums constituted liabilities under § 752 of the
2
Specifically, the losses occurred from the following. Patterson received 67,341.88
Euros when Klamath liquidated. He treated these Euros as having a tax basis of $25,316,393,
calculated as:
Premium amount 25,000,000
Cash contributions 1,500,000
Interest income 91,307
Advisory fee to Pollans & Cohen 250,000
Cash distributions from Klamath (359,635)
Klamath partnership loss (1,165,279)
Basis 25,316,393
This meant that since Patterson was able to treat the loan premium as money he had put into
the partnership (i.e. not a liability that the partnership had to repay), he could claim a tax
basis of $365.94 in each Euro he received from Klamath. When he sold the Euros for much less
than this amount, large losses were created. Nix’s basis calculation was nearly identical.
5
No. 07-40861
Code. The district court granted the Partnerships’ motion and denied the
Government’s, holding that the loan premiums were not liabilities under § 752
and therefore the partners’ bases were properly calculated under the Code.
However, following a bench trial the district court held that the loan
transactions must nonetheless be disregarded for federal tax purposes because
they lacked economic substance. The district court also concluded that the
penalties asserted by the IRS did not apply and the Partnerships’ operational
expenses were deductible. The Government moved the court to reconsider and
vacate its summary judgment decision, arguing that the decision was mooted by
the bench trial judgment. The court denied this motion. Finally, the court
issued an order holding that it had jurisdiction to order a refund to the
Partnerships, and that Patterson and Nix could deduct the $250,000
management fee paid to their accountants.
The Government appeals the district court’s partial summary judgment
in favor of the Partnerships, arguing that the “loan premiums” constitute
liabilities under § 752. The Government also argues that the Partnerships are
liable for penalties, that operating expenses and fees may not be deducted, and
that the district court lacked jurisdiction to order a refund to the Partnerships.
The Partnerships cross-appeal the district court’s bench trial judgment, arguing
that the loan transactions had economic substance.
II
We review the district court’s grant of summary judgment de novo,
applying the same standard as the district court. Kornman & Assocs. v. United
States, 527 F.3d 443, 450 (5th Cir. 2008). On appeal from a bench trial, we
review findings of fact for clear error and legal issues de novo. Houston
Exploration Co. v. Halliburton Energy Servs., Inc., 359 F.3d 777, 779 (5th Cir.
2004). Specifically, we have held that a district court’s characterization of a
transaction for tax purposes is a question of law subject to de novo review, but
6
No. 07-40861
the particular facts from which that characterization is made are reviewed for
clear error. See Compaq Computer Corp. and Subsidiaries v. Comm’r, 277 F.3d
778, 780 (5th Cir. 2001) (citing Frank Lyon Co. v. United States, 435 U.S. 561,
581 n.16 (1978)).
III
We first consider the Partnerships’ cross-appeal, namely whether the
district court erred in determining that the loan transactions lacked economic
substance and must be disregarded for tax purposes.
The economic substance doctrine allows courts to enforce the legislative
purpose of the Code by preventing taxpayers from reaping tax benefits from
transactions lacking in economic reality. See Coltec Indus., Inc. v. United States,
454 F.3d 1340, 1353-54 (Fed. Cir. 2006). As the Supreme Court has recognized,
taxpayers have the right to decrease or avoid taxes by legally permissible means.
See Gregory v. Helvering, 293 U.S. 465, 469 (1935). However,“transactions[ ]
which do not vary control or change the flow of economic benefits[ ] are to be
dismissed from consideration.” See Higgins v. Smith, 308 U.S. 473, 476 (1940).
In a more recent pronouncement, the Supreme Court held that “[w]here . . .
there is a genuine multiple-party transaction with economic substance which is
compelled or encouraged by business or regulatory realities, is imbued with
tax-independent considerations, and is not shaped solely by tax-avoidance
features that have meaningless labels attached, the Government should honor
the allocation of rights and duties effectuated by the parties.” Frank Lyon, 435
U.S. at 583-84.
The law regarding whether a transaction should be disregarded as lacking
economic reality is somewhat unsettled in the Fifth Circuit, and a split exists
among other Circuits. The Fourth Circuit applies a rigid two-prong test, where
a transaction will only be invalidated if it lacks economic substance and the
taxpayer’s sole motive is tax avoidance. See Rice’s Toyota World, Inc. v. Comm’r,
7
No. 07-40861
752 F.2d 89, 91-92 (4th Cir. 1985). The majority view, however, is 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,
454 F.3d at 1355; United Parcel Serv. of Am., Inc. v. Comm’r, 254 F.3d 1014,
1018 (11th Cir. 2001); ACM Partnership v. Comm’r, 157 F.3d 231, 247 (3d Cir.
1998); James v. Comm’r, 899 F.2d 905, 908-09 (10th Cir. 1990). We have
previously declined to explicitly adopt either approach. See Compaq, 277 F.3d
at 781-82 (finding that the transaction in question had both economic substance
and a legitimate business purpose, so it would be recognized for tax purposes
under either the minority or majority approach).
We conclude that the majority view more accurately interprets the
Supreme Court’s prescript in Frank Lyon. The Court essentially set up a multi-
factor test for when a transaction must be honored as legitimate for tax
purposes, with factors including whether the transaction (1) has economic
substance compelled by business or regulatory realities, (2) is imbued with tax-
independent considerations, and (3) is not shaped totally by tax-avoidance
features. See Frank Lyon, 435 U.S. at 583-84. Importantly, these factors are
phrased in the conjunctive, meaning that the absence of any one of them will
render the transaction void for tax purposes. Thus, if a transaction lacks
economic substance compelled by business or regulatory realities, the
transaction must be disregarded even if the taxpayers profess a genuine
business purpose without tax-avoidance motivations.
The following facts found by the district court are critical to this issue:
Presidio and NatWest understood that the transactions would not last beyond
Stage I, despite the purported seven-year term—meaning that the high risk
foreign currency transactions were never intended to occur. If the investors
failed to withdraw voluntarily, NatWest could use economic pressure to force
them out because the credit agreements required the borrowers to maintain
8
No. 07-40861
collateral on deposit at NatWest that exceeded the value of the maximum
obligations owed to the bank by some varying amount. At the time the loans
were issued, this amount was at least 101.25% of the total $66.7 million.
NatWest had the discretion to determine whether the ratio was satisfied and
could accelerate the ratio to declare a default if the bank wished to force an
investor to withdraw. This requirement also meant that none of the $66.7
million loan could ever be used for investments—it had to stay in the accounts
at NatWest. NatWest and Presidio understood that the bank would hold the
money in relatively risk-free time deposits. Presidio’s management fee was
calculated as a percentage of the tax losses generated by the investment plan.
The district court determined, however, that Patterson and Nix pursued the
transactions with a genuine profit motive and were not solely driven by the
desire to avoid taxes.
Here, the evidence supports the district court’s conclusion that the loan
transactions lacked economic substance. Numerous bank documents stated that
despite the purported seven-year term, the loans would only be outstanding for
about 70 days. NatWest’s profit in the loan transactions was calculated based
on a 72-day period. In the event that the investors wanted to remain with the
plan beyond 72 days, NatWest would force them out. The bank noted in an
internal memo that it “had no legal or moral obligation to deal [with the
investors] after Day 60.” During that 60- to 70-day window the loan funds could
not be used to facilitate the investment strategy that Presidio designed. The
requirement of keeping at least 101.25% of the $66.7 million in the NatWest
account meant, as the Government’s expert testified, that the Partnerships could
not make any investments without supplying their own funds in excess of the
loan amount.
The Partnerships contend that the loan funds were critical to the high-risk
foreign currency transactions even if the funding amount could not be spent
9
No. 07-40861
because the money provided the necessary security for the high-risk
transactions. However, the structure of the plan shows that these high-risk
transactions could not occur until Stage III, which was never intended to be
reached. As the district court found, NatWest would force the investors out long
before Stage III, so the loan transactions served no real purpose beyond creating
a massive tax benefit for Nix and Patterson.
The Partnerships further argue that the loan transactions had a
reasonable possibility of profit, as evidenced by the fact that two small, low-risk
investments were actually made in foreign currencies. However, these
investments were made using the $1.5 million that Patterson and Nix
contributed to the Partnerships, not the funding amounts of the loans. Various
courts have held that when applying the economic substance doctrine, the proper
focus is on the particular transaction that gives rise to the tax benefit, not
collateral transactions that do not produce tax benefits. See Coltec, 454 F.3d at
1356-57; Nicole Rose Corp. v. Comm’r, 320 F.3d 282, 284 (2d Cir. 2002). Here,
the transactions that provided the tax benefits at issue were the loans from
NatWest. Therefore, the proper focus is on whether the loan transactions
presented a reasonable possibility of profit, not whether the capital contributions
from Patterson and Nix could have produced a profit. The loan transactions
could never have been profitable because the funding amount could not actually
be used for investments, and the high-risk investments for which the funding
amount might have provided security were never intended to occur.
The evidence clearly shows that Presidio and NatWest designed the loan
transactions and the investment strategy so that no reasonable possibility of
profit existed and so that the funding amount would create massive tax benefits
but would never actually be at risk. Regardless of Patterson and Nix’s desire to
make money, they entered into transactions controlled by Presidio and NatWest
that were not structured or implemented to make a profit. This particular
10
No. 07-40861
situation highlights the logic of following the majority approach to the economic
substance doctrine, because the minority approach would allow tax benefits to
flow from transactions totally lacking in economic substance as long as the
taxpayers offered some conceivable profit motive. In cases such as the instant
one, this approach would essentially reward a “head in the sand” defense where
taxpayers can profess a profit motive but agree to a scheme structured and
controlled by parties with the sole purpose of achieving tax benefits for them.
We therefore agree with the district court that since the loan transactions lacked
economic substance, they must be disregarded for tax purposes.
IV
Next we consider the Government’s appeal, namely whether the district
court properly granted the Partnerships’ motion for partial summary judgment,
declined to impose various penalties on the Partnerships, allowed the
Partnerships to deduct operational expenses and fees, and ordered a refund.
A
The Government argues that the district court erred in granting the
Partnership's motion for partial summary judgment, determining that the loan
premiums were not liabilities for purposes of § 752. The Government states in
its brief that they are appealing this issue “as a protective matter, due to
possible collateral estoppel implications” in several lawsuits pending against
Presidio in California.
Despite this adverse summary judgment ruling, the Government
ultimately prevailed at trial on economic substance grounds and received the
relief it requested when the loan transactions were disregarded for tax purposes.
As a general matter, a party who is not aggrieved by a judgment does not have
standing to appeal it. See Ward v. Santa Fe Indep. Sch. Dist., 393 F.3d 599, 603
(5th Cir. 2004). In some situations, adverse collateral estoppel implications may
show that a party is aggrieved by a particular ruling. See In re DES Litig., 7
11
No. 07-40861
F.3d 20, 23 (2d Cir. 1993). However, an interlocutory ruling will only have
collateral estoppel effect in subsequent litigation if the ultimate judgment in the
case was dependent upon the interlocutory ruling. Id. (finding that a prevailing
party had no standing to appeal adverse interlocutory rulings, regarding
jurisdiction and choice of law, because the ultimate judgment in the case was not
dependent on those rulings). Accordingly, where a party who ultimately prevails
in a case attempts to show they have standing to appeal an earlier adverse
ruling by arguing that the earlier ruling could have collateral estoppel effect in
other pending cases, standing will only exist where the ultimate judgment in the
case was “dependent” on the earlier adverse ruling. Id.
Here, the district court’s summary judgment ruling has no collateral
estoppel effect. The judgment following the bench trial was entirely based on
the district court’s conclusion that the loan transactions lacked economic
substance and must be disregarded for tax purposes. This determination was
totally independent of the partial summary judgment ruling that the loan
premiums were not liabilities under § 752. Though the Government further
argues that “[i]t could be concluded that [it] is aggrieved by the [summary]
judgment [ruling] to the extent it played a part in the District Court’s rejection
of the IRS’s imposition of penalties,” we conclude that the district court’s penalty
decision was likewise not dependent on the partial summary judgment
determination. Therefore, we hold that the Government lacks standing to
appeal the district court’s partial summary judgment ruling that neither § 752
nor Treas. Reg. § 1.752-6 operates to eliminate the claimed tax benefits arising
from the Partnerships’ participation in the loan transactions.
B
12
No. 07-40861
The Government also appeals the district court’s ruling that no penalties
may be imposed on the Partnerships.3 The district court found that the
Partnerships’ actions did not meet the statutory requirements for imposition of
the penalties, and that even if they were met, none of these penalties apply
because the Partnerships acted in good faith and with reasonable cause.
Specifically, the Government argues that the district court erred in finding that
the Partnerships’ actions did not meet the statutory requirements for the
imposition of penalties, and that the district court lacked jurisdiction to consider
the reasonable cause and good faith defenses. Since the issue of whether the
Partnerships’ conduct met the requirements for the penalties is moot if the
district court had jurisdiction to consider the reasonable cause and good faith
defenses, we first consider the jurisdictional issue.
This issue is governed by the Tax Equity and Fiscal Responsibility Act of
1982 (“TEFRA”), 26 U.S.C. § § 6221-6233. Under TEFRA, “the tax treatment of
any partnership item (and the applicability of any penalty, addition to tax, or
additional amount which relates to an adjustment to a partnership item) shall
be determined at the partnership level.” 26 U.S.C. § 6221. TEFRA specifically
sets forth the scope of judicial review:
A court with which a petition is filed in accordance with this section
shall have jurisdiction to determine all partnership items of the
partnership for the partnership taxable year to which the notice of
final partnership administrative adjustment relates; the proper
allocation of such items among the partners, and the applicability
of any penalty, addition to tax, or additional amount which relates
to an adjustment to a partnership item.
3
In the FPAAs, the IRS asserted four penalties against the Partnerships, all based on
§ 6662 of the Code: (1) a 40% penalty for gross valuation misstatement; (2) a 20% penalty for
substantial valuation misstatement; (3) a 20% penalty for substantial understatement of
income tax; and (4) a 20% penalty for negligence or disregard of rules and regulations. See 26
U.S.C. § 6662(a), (b)(1), (2), (3).
13
No. 07-40861
26 U.S.C. § 6226(f) (emphasis added). This provision clearly grants the district
court jurisdiction to determine the applicability of any penalty relating to an
adjustment of a partnership item. The Code also makes clear that if a taxpayer
acts in good faith and with reasonable cause in the calculation of his or her
taxes, penalties may not be applied: “[n]o penalty shall be imposed under section
6662 or 6663 with respect to any portion of an underpayment if it is shown that
there was a reasonable cause for such portion and that the taxpayer acted in
good faith with respect to such portion.” 26 U.S.C. § 6664(c)(1).
The Government argues that the district court lacked jurisdiction to
consider the reasonable cause and good faith defense because the court’s
jurisdiction in a TEFRA proceeding is limited to assessment of partnership-level
items. Here, the Government claims, reasonable cause and good faith is a
partner-level defense that can only be asserted in separate refund proceedings.
To support this argument, the Government cites Temporary Treasury
Regulation § 301.6221-1T, which states that assessment of penalties or any
addition to tax related to partnership items is determined at the partnership
level, and “[p]artner-level defenses to any penalty, addition to tax, or additional
amount that relates to an adjustment to a partnership item may not be asserted
in the partnership-level proceeding, but may be asserted through separate
refund actions following assessment and payment.” Temp. Treas. Reg. §
301.6221-1T(c)-(d) (1999).4 The regulation defines partner-level defenses as
“those that are personal to the partner or are dependent upon the partner’s
separate return and cannot be determined at the partnership level . . .
4
This regulation was temporary for the taxable years at issue. See Temporary Proced.
& Admin. Regs., 64 Fed. Reg. 3838 (Jan. 26, 1999). However, it was made final and applicable
to partnership taxable years beginning on or after Oct. 4, 2001. See § 301.6221-1(f), Proced.
& Admin. Regs.
14
No. 07-40861
[including] . . . whether the partner has met the criteria of . . . section 6664(c)(1)
(reasonable cause exception).” Temp. Treas. Reg. § 301.6221-1T(d).
The TEFRA structure enacted by Congress does not permit a partner to
raise an individual defense during a partnership-level proceeding, but when
considering the determination of penalties at the partnership level the court may
consider the defenses of the partnership. See New Millennium Trading, LLC v.
Comm’r, 131 T.C. No. 18, 2008 WL 5330940 at * 7 (2008). Though Temp. Treas.
Reg. § 301.6221-1T(d) lists the reasonable cause exception as an example of a
partner-level defense, it does not indicate that reasonable cause and good faith
may never be considered at the partnership level. Several courts have found
that a reasonable cause and good faith defense may be considered during
partnership-level proceedings if the defense is presented on behalf of the
partnership. See Santa Monica Pictures v. Comm’r, 89 T.C.M. 1157, 1229-30
(2005) (considering the reasonable cause and good faith defense asserted by the
partnership to determine whether accuracy-related penalties should apply); See
also Stobie Creek Investments, LLC v. United States, 82 Fed. Cl. 636, 703-04,
717-21 (2008) (considering the reasonable cause defense at the partnership
level). Here, reasonable cause and good faith were asserted on behalf of
Klamath and Kinabalu, by the current managing partners. Accordingly, we hold
that the district court did not err in considering the defenses.
The plaintiff bears the burden of proof on a reasonable cause defense. See
Montgomery v. Comm’r, 127 T.C. 43, 66 (2006). The most important factor is the
extent of the taxpayer’s effort to assess his proper liability in light of all the
circumstances. Treas. Reg. § 1.6664-4(b). Reliance on the advice of a
professional tax adviser does not necessarily demonstrate reasonable cause and
good faith; rather, the validity of this reliance turns on “the quality and
objectivity of the professional advice which they obtained.” Swayze v. United
States, 785 F.2d 715, 719 (9th Cir. 1986). The district court found that Patterson
15
No. 07-40861
and Nix sought legal advice from qualified accountants and tax attorneys
concerning the legal implications of their investments and the resulting tax
deductions. They hired attorneys to write a detailed tax opinion, providing the
attorneys with access to all relevant transactional documents. This tax opinion
concluded that the tax treatment at issue complied with reasonable
interpretations of the tax laws. At trial, the Partnerships’ tax expert concluded
that the opinion complied with standards established by Treasury Circular 230,
which addresses conduct of practitioners who provide tax opinions. Overall, the
district court found that the Partnerships proved by a preponderance of the
evidence that they relied in good faith on the advice of qualified accountants and
tax lawyers.
The Government argues only that the district court lacked jurisdiction to
consider the reasonable cause and good faith defense; it has not alleged error in
the substance of the district court’s finding that Patterson and Nix acted with
reasonable cause and in good faith. Therefore, having concluded that the district
court had jurisdiction to consider this defense, we affirm the district court’s
conclusion that no penalties should apply.
C
The Government also appeals the district court’s order that the
Partnerships may deduct “operational expenses” associated with the loan and
foreign currency transactions. These operational expenses include interest on
the loans, a breakage fee, a management fee paid to Presidio, and a $250,000 fee
paid to Pollans & Cohen.5 The Government argues that the district court erred
because no deduction may be taken for expenses related to a sham transaction.
The Code governs the deductibility of actual economic expenditures.
Although the district court did not specify the provision under which the
5
The Government concedes the deductibility of the trading losses suffered by the
Partnerships in the foreign currency transactions.
16
No. 07-40861
operating expenses are deductible, the Partnerships argue that they are entitled
to the deductions under 26 U.S.C. §§ 163, 165(c)(2), and 212. Section 163
governs the deductibility of interest expenses, stating generally that “[t]here
shall be allowed as a deduction all interest paid or accrued within the taxable
year on indebtedness.” 26 U.S.C. § 163(a). Under § 165, deductions are
permitted for “any loss sustained during the taxable year and not compensated
for by insurance or otherwise.” 26 U.S.C. § 165(a). Particularly, deductions for
losses of individuals are limited to “losses incurred in any transaction entered
into for profit . . . .” 26 U.S.C. § 165(c)(2). Section 212 allows deductions for “all
the ordinary and necessary expenses paid or incurred during the taxable year
[ ] for the production or collection of income.” 26 U.S.C. § 212.
Generally, when a transaction is disregarded for lack of economic
substance, deductions for costs expended in furtherance of the transaction are
prohibited. See Winn-Dixie Stores, Inc. v. Comm’r, 113 T.C. 254, 294 (1999)
(observing that “a transaction that lacks economic substance is not recognized
for Federal tax purposes” and that “denial of recognition means that such a
transaction cannot be the basis for a deductible expense”); see also Salley v.
Comm’r, 464 F.2d 479, 483 (5th Cir. 1972); Lerman v. Comm’r, 939 F.2d 44, 45
(3d Cir. 1991); Kirchman v. Comm’r, 862 F.2d 1486, 1490 (11th Cir. 1989). This
makes sense in light of the fact that the effect of disregarding a transaction for
lack of economic substance is that, for taxation purposes, the transaction is
viewed to have never occurred at all.6 Courts have determined that they may
6
The Partnerships rely extensively on Fabreeka Prods. Co. v. Comm'r, 34 T.C. 290,
299-300 (1960), vacated on other grounds by 294 F.2d 876 (1st Cir. 1961), for the proposition
that operational expenses incurred in connection with a sham transaction may be deducted as
long as they are “separable” from the underlying transaction. To the extent that this
proposition can be supported by the since-vacated opinion in Fabreeka, we conclude that the
Tax Court has subsequently failed to follow Fabreeka’s approach to the deduction of
operational expenses, and has instead maintained that expenses incurred in connection with
a sham transaction are generally not deductible. See Winn-Dixie, 113 T.C. at 294 (finding that
administrative fees “were incurred in connection with, and were an integral part of, a sham
17
No. 07-40861
not disregard a transaction for some purposes but not for others. See ACM
P’ship, 157 F.3d at 261 (observing that “we are not aware of any cases applying
the economic substance doctrine selectively to recognize the consequences of a
taxpayer’s actions for some tax purposes but not others”). This also supports the
idea that a transaction may not be disregarded under the economic substance
doctrine for purposes of determining a partner’s tax basis in a partnership, yet
still support the deduction of operational expenses and fees. However, 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. Comm’r, 752 F.2d 89, 95-96 (4th Cir. 1985) (allowing deductions
based on recourse note debt that was an element of a sham purchase
transaction, because the notes represented actual indebtedness).
Here, the district court concluded that the interest payments were
deductible because they were real economic losses. However, § 163 does not base
the deductibility of interest on whether or not the interest paid was a real
economic loss. Rather, the test is simply whether the interest was paid or
accrued on indebtedness. See Salley, 464 F.2d at 485 (disallowing interest
deductions under § 163 because the taxpayers did not take on actual
indebtedness: “[i]n no sense can it be said that taxpayers paid any interest . . .
as compensation for the use or forbearance of money . . . which is the standard
business test of indebtedness”) (internal quotations and citation omitted).
Further, “the fact that an enforceable debt exists between the borrower and
lender is not dispositive of whether interest arising from that debt is deductible
under section 163.” Winn-Dixie Stores, 113 T.C. at 279. The overall transaction
must have economic substance in order to show genuine indebtedness, otherwise
transaction and, as a result, were not deductible”).
18
No. 07-40861
“every tax shelter . . . could qualify for an interest expense deduction as long as
there was a real creditor in the transaction that demanded repayment.” Id.
In concluding that the loan transactions in this case lacked economic
substance, the district court found that “[i]n truth, NatWest did not make any
loans” and “[t]he loans . . . were not loans at all.” These findings preclude the
conclusion that the Partnerships took on actual indebtedness. As we found
above, the loan transactions in this case lacked economic substance partly
because they were structured such that the Partnerships could never actually
spend the loaned funds—101.25% of the funding amount had to stay in the
accounts at NatWest to prevent a default. Therefore, despite the appearance of
a loan, functionally the Partnerships never took on any actual debt. Since the
loans did not constitute indebtedness, the Partnerships may not deduct the
interest paid under § 163.7
Presumably, though not specified, the district court found the remainder
of the operating expenses and fees deductible under § 212 as necessary expenses
incurred. This provision requires a profit motive. See Agro Science, 934 F.2d at
576 (noting that an expenditure is deductible under § 212 “only . . . if the facts
and circumstances indicate that the taxpayer made them primarily in
furtherance of a bona fide profit objective independent of tax consequences”).
The Government argues that the profit motive must be determined based on
Presidio’s subjective intentions because Presidio acted as managing partner
when the transactions occurred. The district court, however, determined that
the proper focus is on the motives of Patterson and Nix. Having concluded that
Patterson and Nix entered into the transactions genuinely seeking to make a
profit, the district court allowed the deductions.
7
The Partnerships may likewise not deduct interest under other provisions of the Code
as a business expense or an expense paid for the production of income. See Salley, 464 F.2d
at 483 (noting that if lack of economic substance prevents the deduction of interest under §
163, the interest is likewise not deductible under §§ 162(a) or 212).
19
No. 07-40861
The profit motive of a partnership is determined at the partnership level.
Id.; Simon v. Comm’r, 830 F.2d 499, 507 (3d Cir. 1987). We have previously
observed that the “testimony of general partners and promoters taken as a whole
is relevant in determining a partnership’s profit motive, because these
individuals control a partnership’s activities.” Agro Science, 934 F.2d at 576
(internal citations omitted). Here, the district court concluded that the partners
had different motivations: Nix and Patterson at all times pursued the
investment strategy with a genuine profit motive, while Presidio’s primary
intent was to achieve a tax benefit. The crucial inquiry, then is which partner’s
intentions should be attributed to the Partnership. Under Agro Science, this
answer depends on which partner effectively controlled the partnership’s
activities. Id.; Simon, 830 F.2d at 507 (observing that “a determination of [a
partnership’s] profit objective can only be made with reference to the actions of
those . . . who manage the partnership affairs”).
During the time of the transactions in question, Presidio acted as the
managing partner but had less than 10% ownership of Klamath and Kinabalu.
Patterson and Nix each had 90% ownership. After reforming the Partnerships
to bring this lawsuit they became managing partners. Though Patterson and
Nix were never limited partners, the LLC agreements state that “the overall
management and control of the business and affairs of the Company shall be
vested solely in the Managing Member.” The district court, however, did not
analyze which partner retained control over the partnership. The district court
appears to have concluded, with little explanation, that Patterson and Nix’s
motives must be attributed to the Partnerships because they paid the expenses
at issue here and reported them on their individual tax returns.8 However, for
8
In its brief, the Government contends that it was the Partnerships that paid the
expenses, citing to Plaintiff’s Exhibits 49, 50, 142, and 143. Since these exhibits have
apparently not made it into the record on appeal, and have not been able to be obtained from
the district court, we cannot verify the Government’s contention. Nonetheless, whether it was
20
No. 07-40861
purposes of determining the deductibility of expenses it is the motive of the
Partnership that matters, regardless of whether certain operating expenses were
borne by one partner or another. None of the arguments articulated by the
Partnerships or the district court persuade us that the motives of Patterson and
Nix, to whom the overall control and management of the Partnerships was
expressly denied under the LLC agreements, should be attributed to the
Partnerships. We therefore hold that the district court erred as a matter of law
by failing to consider which partners effectively controlled the management of
the Partnerships’ affairs, at the time the transactions occurred, in determining
whether the operating expenses and fees are deductible.
D
We turn now to the Government’s argument that the district court lacked
jurisdiction to order a refund.
The district court based its authority to order the refund on its jurisdiction
to order readjustment of partnership items, see 26 U.S.C. § 6226(f), and the Code
provision stating that a partner should not have to file a claim for a refund
following this readjustment. See 26 U.S.C. § 6230(d)(5) (“any overpayment by
a partner which is attributable to a partnership item (or an affected item) and
which may be refunded under this subchapter [26 U.S.C. §§ 6221 et seq.], to the
extent practicable credit or refund of such overpayment shall be allowed or made
without any requirement that the partner file a claim therefor”). The district
court interpreted this provision to mean that it may order a refund following a
readjustment of partnership items under § 6226, since the refund is permitted
without the taxpayers filing a claim.
an individual partner or the Partnership that paid the expenses is not dispositive of the issue
of who effectively controlled the Partnerships’ activities, and we conclude that the district court
erred in relying on this fact to allow the deductions.
21
No. 07-40861
The Government argues, however, that the Code imposes a strict
“exhaustion of administrative remedies” jurisdictional prerequisite with respect
to tax refund actions, and that nothing in the Code grants the district court the
authority to eliminate this prerequisite by ordering a refund as part of
readjustment proceedings under § 6226. As the Government contends, §
6230(d)(5) only grants the IRS the authority to provide a refund attributable to
partnership items without requiring the party to file a claim first—it does not
expand the district court’s specifically defined jurisdiction to include the
authority to order a refund.
We have not previously confronted this question, and the few cases
available reach mixed conclusions. The Government cites an unpublished
opinion from the Ninth Circuit holding that “a district court does not have
jurisdiction to order a refund in an action brought pursuant to 26 U.S.C. § 6226.”
See Gold Coast Hotel and Casino v. United States, 139 F.3d 904, 1998 WL 74991,
at *2 (9th Cir. 1998) (unpublished). Another court has ordered refunds in a §
6226 action, though it did not explain its jurisdictional basis for doing so, and the
Second Circuit reversed on appeal such that no refund was ultimately awarded.
See TIFD III-E Inc. v. United States, 342 F. Supp. 2d 94, 121-22 (D. Conn. 2004),
rev’d on other grounds, 459 F.3d 220 (2d Cir. 2006).
We conclude that the Code does not grant the district jurisdiction to order
a refund in a readjustment action brought pursuant to § 6226. This provision
specifically sets forth the scope of the district court’s jurisdiction in readjustment
proceedings. See § 6226(f). Though the provision specifies the district court’s
jurisdiction to determine partnership items, allocate those items to individual
partners, and apply penalties, taxes, or additional amounts, it does not grant
jurisdiction to order a refund.
Generally, no suit or proceeding may be maintained for the recovery of a
refund “until a claim for refund or credit has been duly filed with the Secretary
22
No. 07-40861
. . . .” See § 7422(a). Section 7422(h) provides a special rule for refund actions
with respect to partnership items: “No action may be brought for a refund
attributable to partnership items . . . except as provided in section 6228(b) or
section 6230(c).” The applicable provision here, § 6230(c), does not grant refund
authority to the district court; rather, it sets forth the grounds on which a
partner of a TEFRA partnership may file an administrative refund claim
following a final partnership administrative adjustment. Specifically, a partner
may file a claim for refund on the grounds that (1) the Secretary failed to allow
a credit or to make a refund to the partner in the amount of the overpayment
attributable to the application to the partner of a settlement, a final partnership
administrative adjustment, or the decision of a court in an action brought under
§ 6226, or (2) the Secretary erroneously imposed any penalty, addition to tax, or
additional amount which relates to an adjustment to a partnership item. See
§ 6230(c)(1)(B)-(C).
We agree with the Government that the provision upon which the district
court based its jurisdiction, § 6230(d)(5), merely contemplates that “to the extent
practicable” the IRS may grant a refund for an overpayment attributable to
partnership items without any requirement that the partner file an
administrative claim. Nothing in § 6230(d)(5) authorizes the district court to
grant a refund pursuant to readjustment proceedings under § 6226, and it would
be unreasonable to conclude that this provision—which is not referenced in
§ 6226(f) and is placed under the heading “Additional administrative
proceedings”—alters the clearly defined limits of a district court’s jurisdiction in
readjustment proceedings.
We accordingly hold that the district court was without jurisdiction to
order a refund. The Partnerships may seek a refund through administrative
proceedings, as governed by § 7422.
V
23
No. 07-40861
For the foregoing reasons, we AFFIRM the district court’s judgment that
the loan transactions lacked economic substance and must be disregarded for tax
purposes. We also AFFIRM the district court’s judgment that no penalties
apply. We VACATE the district court’s order allowing the deduction of interest
and operating expenses and REMAND for reconsideration in accordance with
this opinion. We also VACATE the district court’s order directing the IRS to
grant the Partnerships a refund.
24