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In PPL Corporation & Subsidiaries, 111 AFTR 2d ¶2013-723 (5/20/2013), the Supreme Court, in an unanimous decision,  per Justice Thomas, resolved a split of authority between the Fifth and Third Circuits, and held that the United Kingdom’s one-time “windfall tax” paid by the taxpayer through a U.K. based partnership, were creditable foreign taxes  under §901(a). The Supreme Court agreed with the Tax Court below and the taxpayer that the windfall tax in issue  had the predominant characteristic of an “excess profits tax” within the meaning of Treas. Reg. §1.901-2(a) and therefore was creditable under §901.  Thus, the Court reversed the decision of the Third Circuit Court of Appeals holding to the contrary.

The “windfall tax” in issue was imposed under a new Labour Party adopted rule when it took over control of the Parliament in 1997.  Previously, the Labour Party objected to the concept of privatization embraced by the Conservative wing. The new tax was imposed on 32 U.K. companies that were authorized to privatize between 1984 and 1996 by the Conservative government. PP&L Resources, Inc. (PP&L) was a global energy company. Through various subsidiary corporations, it produced electricity, sold wholesale and retail electricity, and delivered electricity to customers. It provided such services in the United States in the Mid-Atlantic and Northeast regions and also in the United Kingdom. During 1997, South Western Electricity plc (SWEB) a U.K. private limited liability company, was PP&L’s indirect subsidiary. Its principle activities at the time included distribution of electricity to 1.5 million customers in England.

In 1990, the U.K. privatized 12 regional electric companies including SWEB. The ordinary shares or common stock of these companies were sold to the public as part of a “flotation”. Some of the companies were required to continue providing services for a fixed period at the same rates offered under government (pre-privatized) control. Many of these companies became far more efficient and earned substantial profits in the process of the privatization.  The one-time windfall profits tax was 23% of the difference between each company’s “profit-making value” and its “flotation value,” the price for which the U.K. government sold the stock which many British subjects felt was priced below value.

The relevant statute defined each company’s “profit-making value” as its average annual profit times its price-to-earnings ratio. Average annual profit was defined as the average daily profit over a stated “initial period” which for SWEB was the first four years after privatization times 364. Instead of using the companies’ actual price-to-earnings ratios, the statute imputed a ratio of 9 for all companies, as the government thought that such ration “approximates to the lowest average sector price-to-earnings ratio of the companies liable to the tax”. SWEB filed the windfall tax return with the Department of Inland Revenue in November 1997 and paid its windfall tax obligation.

Under §901(b), a credit for foreign taxes accrued or paid by a taxpayer is allowed only for those taxes imposed by a foreign country or U.S. possession which are income, war-profits, or excess profits taxes; or taxes imposed in lieu of income taxes upon gross income, gross sales, or units of production. For a foreign tax to be creditable, its predominant character must be that of an income tax in the U.S. sense. The predominant character of a foreign tax is that of an income tax in the U.S. sense if the foreign tax is likely to reach net gain in the normal circumstances in which it applies and isn't a soak-up tax (i.e., a tax liability which depends on the availability of a credit for the tax against an income tax liability to another country).  Treas. Regs. §§ 1.901-2(a)(1)(ii), Reg. § 1.901-2(a)(3).

The petitioner in the tax case, PPL Corporation, was a part owner of the privatized SWEB, and claimed, against its U.S. income tax liability, its pro rata share of the credit for the windfall tax the plc paid in 1997.  In doing so it relied upon §901(b)(1) which provides that any “income, war profits and excess profits taxes” paid overseas are creditable against U.S. income taxes. Treas. Reg. §1.901-2(a)(1)  provides that a foreign tax is creditable if its “predominant character” is that of an income tax in the U.S. sense. This regulation codified a longstanding principle that can be sourced to Biddle v. Commissioner, 302 U.S. 573, 578-579 (1938). See also United States v. Goodyear Tire & Rubber Co., 493 U.S. 132, 145 (1989(application to §902)).  

The Internal Revenue Service, in auditing PPL’s 1997 corporate income tax return, denied the foreign tax credits for the “windfall tax” paid by the U.K. plc for 1997.   SWEB’s windfall tax was approximately 90.5 million pounds. In response to proposing a deficiency in federal income tax for the believed to be “non-creditable” foreign tax, the taxpayer filed a petition with the Tax Court. The Tax Court found for PPL since the windfall tax was an amount, under U.S. tax principles, which could be viewed as a tax on excess profits in accordance with the regulations, i.e., its “predominant character” is that of an income tax in the U.S. sense. The tax was on the “net gain” derived by the U.K. plc of which a pro rata portion directly passed through to its U.S. partner. See 135 T.C. 304 (2010).

The government appealed the Tax Court’s decision before the Third Circuit Court of Appeals. The Tax Court’s decision was reversed. 665 F.2d 60, 68 (2011).  The appellate court opined that the terms “income, war profits, and excess profits” referred to in Treas. Reg. §1.901-2 should be thought of in the singular sense of whether it is an “income tax”. Accordingly, the Third Circuit stated that a foreign assessment is an “income tax” if it has the predominant character of an income tax in the U.S. tax sense. It therefore must satisfy the U.S. income tax concepts of: (i) a realization event requirement; (ii) the gross receipts requirement; and (iii) the net income requirement. See Treas. Reg. §1.901-2(b). The Service argued that the windfall tax did not meet either the gross receipts or net income requirement. The Third Circuit felt that that the tax base used in the windfall tax could not be the initial period profit alone unless the Court rewrote the tax rate.  In its view, the windfall tax is in substance a tax on the difference between the company’s “flotation value” and its imputed “profit-making value” the later term being based on a formula.  It is the price that the Labour government believed that each company should have been sold for given the actual profits earning during the initial period. The Third Circuit’s decision was in conflict with the Fifth Circuit Court of Appeals taxpayer-favorable decision in Entergy Corporation & Affiliated Subsidiaries v. Commissioner, 683 F.3d 233, 239 (5^th Cir. 2012).

The Supreme Court held that the “predominant character” of the windfall tax is that of an excess profits tax and is creditable under §901.  In reviewing the subject regulation, Treas.Reg. §1.901-2(a)(1), there are several principles that must be addressed. First, the “predominant character” of a tax or the normal manner in which a tax applies is controlling. A foreign tax on income, war profits, or excess profits, in most instances will be creditable even where it affects a handful of taxpayers differently.  Second, a foreign government’s characterization of the tax is not determinative for purposes of Treas. Reg. §1.901-2(a), instead it is its economic effect. Stated more directly, “foreign tax creditability depends on whether the tax, if enacted in the United States, would be an income, war profits, or excess profits tax”.  Third, the regulation provides that the predominant character of the tax is like a U.S. income tax “[i]f …the foreign tax is likely to reach net gain in the normal circumstances in which it applies”. There are three tests under the regulations for determining whether a foreign tax is imposed on net gain.  Again, as mentioned, those three parts are realization, gross receipts and net income . See Treas. Regs. §§1.901-2(b)(2), 2(b)(3) and 2(b)(4).  The Supreme Court viewed the windfall tax as imposed on realized net income which was disguised as a tax on the difference between flotation value and initial period value. In analyzing the algebraic formulation of the tax, the Court noted that the economic effect of the formula was to convert floatation value into the profits a company should have earned given the assumed price-earnings ratio.

The Supreme Court stated that the rearranged tax formula demonstrates that the windfall tax is economically equivalent to the difference between the profits each company actually earned and the amount the Labour government believed it  should have earned given its floatation value. For the 27 companies that had 1,461-day initial periods, the U.K. tax formula effectively imposed a 51.71% tax on all profits earned above a threshold; “a classic excess profits tax”.  It is not, as argued, an imputed gross receipts tax and not creditable.

Based on the logic set forth in the Tax Court’s opinion below and as further magnified in the opinion of Justice Thomas, it may be contended that reason and logic prevailed. It did.  Clearly the regulation in issue should not have been “compressed” into solely a tax on income as the Third Circuit felt. The fact the Court was unanimous in its view, although Justice Sotomayer, in her concurring opinion, wanted to note that if the record were different the tax may not have been analogous to an excess profits tax, is indeed important and may even be surprising to some. For PPL as well as many tax practitioners, the result made perfect sense.

 

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The plaintiffs challenged a set of tax adjustments and related penalty determinations made by the Internal Revenue Service to nine partnership returns subject to the TEFRA entity audit rules that were introduced under the Tax Equity and Fiscal Responsibility Act of 1982 . Kearney Partners Fund, LLC (“Kearney Partners”), Nebraska Partners, and Lincoln Partners were formed as limited liability companies that were taxable as partnerships. On December 4, 2001, a Mr. Sarma acquired a direct partnership interest in Nebraska Partners and indirect partnership interests in Lincoln Partners and Kearney Partners based on Nebraska Partners' 99% ownership interest in Lincoln Partners and Lincoln Partners' 99% ownership interest in Kearney Partners. This three-tiered partnership structure is referred to by the acronym “FOCus”.

During 2002, the IRS started an investigation of FOCus and its use of a multi-tiered partnership structure, which it claimed was a “tax shelter” through which Sarma derived substantial tax benefits.

 

Under TEFRA rules, when the IRS initiates an audit of a partnership return, and believes that the positions taken on the return are not all correct, it is required to mail each partner a Notice of Beginning of Administrative Proceeding (“NBAP”) “no later than 120 days before” the issuance of the Final Partnership Administrative Adjustment (“FPAA”). 26 U.S.C. §§ 6223(a) & (d). The IRS' failure to do so entitles the partner the option to opt-out of the partnership examination or judicial proceedings. § 6226(e).

 

On June 6, 2003, the IRS issued Plaintiffs, but not Sarma, the NBAP. On December 9, 10, and 11 2009, the IRS sent Plaintiffs and Sarma the FPAAs with a cover letter advising Sarma that the IRS had failed to mail him the NBAPs within the required time and informing him of his right to opt-out of the partnership examination. On January 23, 2010, Sarma elected to opt out. However, on February 25, 2010, the IRS sent a letter to Sarma's counsel acknowledging that it had erred in informing Sarma of his right to opt-out because he was not entitled to directly receive the NBAPs and thus could not elect to not be bound by the partnership examination. The plaintiffs filed a motion for summary judgment arguing that Sarma properly opted out of this proceeding which divests this Court of subject matter and personal jurisdiction.

 

A motion to dismiss for want of subject matter jurisdiction as to one member, Sarma, was made.  The Federal District Court for the Middle District of Florida noted that, at its discretion, it may rule on a motion to dismiss on the basis of affidavits alone, may choose to permit discovery in aid of the motion, or may conduct an evidentiary hearing on the merits of the motion. See, e.g., Internet Solutions Corp. v. Marshall, 557 F.3d 1293, 1295 (11th Cir. 2009); Eaton v. Dorchester Dev., Inc., 692 F.2d 727, 730–31 (11th Cir. 1982) (recognizing a qualified right to jurisdictional discovery in the Eleventh Circuit).

 

TEFRA Entity Level Audit Rules

 

TEFRA, under Section 6223, sets forth  procedures designed to notify certain partners of the beginning and end of an administrative proceeding or audit. When the IRS audits a partnership with fewer than 100 partners, such as FOCus, TEFRA requires the Service to issue a notice of an administration proceeding at the partnership level, or NBAP, to the tax matters partner and to each notice partner who, because of the magnitude of their interests in the partnership are entitled to direct notice. §6223(a)(1).

 

Where the audit results in tax adjustments on partnership items, the IRS must send a notice of the final partnership administrative adjustment from such proceeding – an FPAA.   § 6223(a)(2). Section 6223 requires the Secretary to mail the NBAP no sooner than 120 days before the issuance of the FPAA. § 6223(d).  Therefore,  at least 120 days must separate the first (NBAP) and last (FPAA) notices to the partners. Where the IRS  fails to comply with this timeline, TEFRA, in Section 6223(e) allows each of the notice partners to whom a timely notice was not mailed to decide whether to opt-out of the partnership examination or judicial proceeding and to have his or her partnership items treated as non-partnership items.  

 

Jurisdiction of the Court Based on TEFRA Notice Provisions

 

 

The issue here was whether Sarma appropriately “opted out” of the partnership proceedings following Defendant's failure to send “the NBAPs less than 120 days before the FPAAs were mailed.” The parties agree that because this case is a federal income tax partnership proceeding brought under 26 U.S.C. § 6226(a) to contest the findings of the IRS with respect to Plaintiffs' partnership items, a partner's valid decision to opt-out of the partnership proceedings warrants dismissal of the partner from this action. Plaintiffs therefore argue that this Court has no subject matter or personal jurisdiction. Defendant responds that because the IRS was under no obligation to send the initial NBAP, Sarma had no right to opt-out.

 

Collateral Estoppel and Sarma's Right to Opt-Out of These Proceedings

 

The United States’ argued that Sarma was collaterally estopped from asserting his right to opt out of this TERFA action because the Tax Court rejected the same argument in a prior proceeding.  The U.S. further argued that the Tax Court  had previously dismissed Sarma's petition for a redetermination of his tax obligations due to a lack of subject matter jurisdiction. Under the IRS Code, once a partner decides to “opt out” by electing to convert partnership items into non-partnership items, the IRS must issue the partner a timely notice of deficiency. 26 U.S.C. § 6230(a)(2)(ii). The taxpayer may then challenge the deficiency in Tax Court.

 

On December 3, 2011, the IRS sent Sarma a notice of deficiency even though it had previously informed him that he had no right to opt-out of the partnership proceedings. The IRS sent the notice of deficiency  to protect its ability to assess and collect additional taxes if it were later determined that Sarma had validly opted out of the TERFA proceedings. The government further argued that had it until this question was submitted to this Court, the IRS would have been time-barred from assessing and collecting any additional taxes owed as a result of the FOC-us generated loss claimed on Sarma's tax return.  Once Defendant concluded that Sarma had no right to opt-out, it moved the Tax Court to dismiss Sarma's petition.

 

The government’s motion to dismiss before the Tax Court asserted nearly identical grounds of dismissal in the case at bar. Again, Sarma’s  petition to the Tax Court was invalid because he was not entitled to an NBAP and thus had no right to elect out of the partnership proceedings.

On June 30, 2011, Sarma filed his opposition to the motion, concurring that his petition before the Tax Court should be dismissed for lack of jurisdiction, but offering different bases for dismissal on jurisdiction grounds. Sarma averred that the IRS' notice of deficiency was invalid because the Agency was equitably estopped from issuing the notice due to its February 25, 2011 letter informing Sarma of his right to opt-out of the partnership proceedings. According to Sarma, the IRS' error in submitting the letter estopped it from issuing a notice and the tax court from exercising jurisdiction over the petition.

 

On March 16, 2012, the Tax Court entered an Order of Dismissal. The Order notes that both parties agree that the notice of deficiency was invalid and therefore that the court lacks jurisdiction over the case. And even though the court “granted [Defendant's] Motion to Dismiss for Lack of Jurisdiction,” the Order fails to explain the basis of dismissal and whether it adopted Defendant's argument that Sarma's petition was invalid because he had no right to opt out of the partnership proceedings. The Court concluded that it was unable to determine whether the issues material to the instant Motion to Dismiss were actually litigated before the Tax Court and whether the determination of these issues were critical and necessary to the Tax Court's decision to dismiss. Accordingly, the Court declined to decide Sarma's Motion to Dismiss on collateral estoppel grounds.

 

Sarma Was Not Entitled to Notice and Is Precluded From Electing Out of These Proceedings

 

The Federal District Court’s jurisdiction over Sarma is based on whether he was entitled to and received timely notice of the partnership audit. Plaintiffs argue that this Court has no subject matter or personal jurisdiction because Sarma elected to opt-out of these proceedings following the IRS' failure to issue an NBAP at least 120 days before the FPAAs were mailed.

 

The United States again stated that  Sarma was not entitled to an NBAP, that the IRS was under no obligation to send the notice, and that therefore Sarma had no right to opt-out of these proceedings.

 

The Service's duty to notify under Section 6223(a) arises only if the names, addresses, and profit interests of partners and indirect partners are furnished in one of two forms described in section 6223(c). Jaffe v. C.I.R., T.C.M. 2004-122, aff'd. 175 F. App'x 853 (9th Cir. 2006). First, the Service  may be provided the referenced information through the tax return of the partnership under audit. See 26 U.S.C. § 6223(c)(1). Second, the information can be provided in a statement to the IRS that fulfills the “regulations prescribed by the Secretary,” under 26 C.F.R. § 301.6223(c)-1(b). 4 26 U.S.C. § 6223(c)(2). Neither party argues that Plaintiffs provided the necessary information through either of these two means. Plaintiffs cite Section 6223(a) and Treas. Reg. §301.6223(c)-1(f) that the IRS should have relied on any other information available to it to mail an NBAP.

 

However, Treas. Reg. §301.6223(c)-1(f) indicates that even though the Secretary “may use other information in its possession (for example, a change in address reflected on a partner's return) ... the [Secretary] is not obligated to search its records for information not expressly furnished under this section” (emphasis added). 26 C.F.R. § 301.6223(c)-1(f).

 

The Federal District Court held that the permissive language of the regulation does not impose a duty on the IRS to rely on any other available information to issue a notice of an audit. The IRS may use other information that is available to it; however, it is not required to “search its records” to obtain information not provided in the forms required by Section 6223(c)”); Walthall v. United States, 131 F.3d 1289, 1296 (9th Cir. 1987) (“the mere fact that the IRS possesses in its database the name and address of indirect partners does not mean that it has been “furnished with” this information . Therefore, “[W]e thus hold that the Walthalls failed to trigger the notice requirement of Section 6223(a), and therefore were not entitled to direct notice pursuant to the Act”).

 

Plaintiffs’ reliance on  Murphy v. C.I.R., 129 T.C. 82 (2007) to suggest otherwise was incorrect.  The Murphy case  addressed whether the IRS appropriately elected to send an FPAA to the indirect partner as opposed to a direct partner of a partnership. The court held that the notice to an indirect partner was valid because TERFA and the applicable regulations permit, but do not require, the Secretary to rely on other readily available information to send an FPAA. As the court made clear, the Secretary's “duty to give notice under Section 6223(a) arises to the extent [it] is furnished with readily available information ... through the tax return of the partnership [or] ... a statement that meets the requirements of Treas. Reg. § 301.6223(c)-1T,”  whereas it has “no obligation to search his record to obtain information not provided to him under either of the ways set forth in section 6223(c)(1) and (2).”

 

Therefore, the Federal District Court found that  Murphy, supra contradicts Plaintiffs' assertion that Defendant was required to send notice of the partnership audit to Sarma. While the facts in the case might be unique, the court conceded, the IRS mistakenly sent a form letter to Sarma acknowledging that it had failed to send the notices within the time required under Section 6223(d) and informing him of his right to opt-out of the partnership proceedings. After Sarma elected to do so, the IRS reversed course by a letter that directed Sarma to “disregard” the February 8, 2010 letter, explaining that because the IRS was not required to provide the NBAP, Sarma did not have the right to elect out of the partnership proceedings.

 

Despite the Agency's mistake, the Court held that Sarma may not opt-out of this case. While the Agency's error (subsequently rescinded) is regrettable to the extent it muddied the waters, it does not alter the fact that there was no legal obligation to provide the NBAP to Sarma in the first place and the letter to the contrary does not change that circumstance.

 

Section 6223(e) of TERFA sets forth the circumstances under which a partner may opt-out of a partnership audit. The provision provides that “[t]his subsection applies where the Secretary has failed to mail any notice specified in subsection (a) to the partner entitled to such notice within the period specified ....” 26 U.S.C. § 6223(e)(1)(A). In other words, Section 6223(e)'s remedy provision, which includes the right to opt-out, applies only when a partner is entitled to but does not receive timely notices of the audit. Here, Sarma was not entitled to any notice because it failed to provide the requisite information to the IRS. Sarma may not capitalize on the IRS' mistake to invoke the right to a remedy that was not provided by the statute.

 

The Court therefore denied  Plaintiffs' Motion to Dismiss on jurisdictional grounds.

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Chalk up another economic substance doctrine win for the Service. This one from a three judge panel of the Third Circuit Court of Appeals, in affirming the Tax Court below, in Crispin v. Commissioner, 111 AFTR2d 2013-XXXX (2/25/2013).  

The  taxpayer in this case , Neal D. Crispin, a businessman-entrepreneur  was involved in leasing, structured finance, aircraft acquisition and mortgaged back securities lending. He was a practicing CPA and  experienced in tax matters, including tax shelters. He had invested in a “custom adjustable rate debt structure” or CARDS transaction which was designed to generate a substantial artificial ordinary loss deduction.  The Service disagreed with the loss claimed an imposed an accuracy-related penalty under Section 6662. The Tax Court disallowed the claimed loss on the grounds that Crispin's CARDS transaction lacked economic substance and held that he could not avoid the penalty based on reasonable cause because he had not relied reasonably or in good faith on the advice of an independent and qualified tax professional. He was therefore saddled with a 40% gross valuation misstatement penalty. The Third Circuit affirmed.

Factual Background

 

For over 24 years, Crispin purchased and leased commercial aircraft through investment syndicates. The typical deal would involve his company’s (S corporation)  purchase of used aircraft with a cost between $1M and $10M and then leases the planes for 10 years before reselling them. In 2001, the year in issue, he planned on purchasing 3 aircraft through his S corporation which he owned 50-50 with another investor. Enter the CARDS transaction.

 

The Third Circuit referred to a CARDS transaction in less than glowing terms, i.e., a tax-avoidance scheme that was widely marketed to wealthy individuals during the 1990's and early 2000's. It purports to generate, through a series of pre-arranged steps, large “paper” losses deductible from ordinary income.

 

The general structure of a CARDS transaction is thoroughly explained  in Gustashaw v. Commissioner, 696 F.3d 1124, 1127 [110 AFTR 2d 2012-6169]–28, 1130–31 (11th Cir. 2012). As a quick summary, first, a tax-indifferent party, such as a foreign entity not subject to United States taxation, borrows foreign currency from a foreign bank (a “CARDS Loan”). Then, a United States taxpayer purchases a small amount, such as 15%, of the borrowed foreign currency by assuming liability for a an equal amount of the CARDS Loan. The taxpayer also agrees to be jointly liable with the foreign borrower for the remainder of the CARDS Loan and so the taxpayer purports to establish a basis equal to the entire borrowed amount. Then,  the taxpayer exchanges the foreign currency he purchased for U.S.dollars. That exchange is a taxable event, and the taxpayer claims a loss equal to the full amount of his supposed basis in the CARDS Loan, less the proceeds of the relatively small amount of currency actually exchanged. The taxpayer uses that loss to shelter unrelated income. CARDS marketing materials describe the transaction as providing “financing” to the taxpayer. However, there is no net cash available to the taxpayer, because the foreign bank requires that all of the currency purchased with the proceeds of the CARDS Loan (including the portion purchased by the taxpayer) remain at the bank as collateral for the CARDS Loan. The taxpayer only has access to the proceeds of the CARDS Loan if he delivers to the bank an equal amount of cash, cash equivalents, or other collateral acceptable to the bank.

 

The IRS, in Notice 2000-44, 2000-2 C.B. 255 (8/13/2000), placed the tax community on notice in 2000, prior to the events occurring in Crispin, supra, about claiming tax deductions sourced from artificial losses generated by inflated bases in certain assets. The Notice containing that warning said that the IRS would not recognize transactions that created an artificially high basis if they lacked economic substance or a valid business purpose.  Recognizing that the CARDS transaction was being used, it issued a second notice, Notice 2002-21, 2002-1 C.B. 730 (3/18/2002) again attacking CARDS transactions. It imposed disclosure obligations on CARDS promoters and users. Eventually, the IRS announced a settlement initiative that allowed CARDS users to avoid penalties for gross valuation misstatements applicable under Section provided that they conceded their CARDS-related tax benefits and agreed to pay a reduced penalty. See Announc. 2005-80, 2005-2 C.B. 967 (Oct. 28, 2005). Some 2,000 taxpayers elected to settle, paying roughly $2 billion in back taxes.

 

Crispin wanted to shelter more than $7M in corporate level income for 2001. He learned of the CARDS program and proceeded to wrap his intended aircraft purchase to be consummated by his S corporation as part of a CARDS transaction. The specific transaction involved a foreign entity  that would enter into a 30-year CARDS Loan denominated in a Swiss francs; the loan proceeds would be retained by the lender; Crispin would purchase 15% of the foreign currency obtained through the CARDS Loan, and he would agree to be jointly and severally liable for the entire CARDS Loan; he would agree to repay the principal at the maturity date; and he would exchange the foreign currency he purchased for United States dollars, claiming as his basis the full amount of the CARDS Loan and garnering a tax loss equal to 85% of the total loan value. Hahn also provided Crispin with a sample tax opinion blessing the transaction. The taxpayer thought he and his partner would offset his 2001 income of $7.6 million from the mortgage securities business from losses of an offsetting amount.

 

Crispin’s CARDS transaction was placed with Croxley Financial Trading LLC acting as the foreign borrower and  Zurick bank as the lender. In December ,2001, Zurich loaned $74 million Swiss francs to Croxley for a stated 30-year term but callable and repayable at any time after the first year. The proceeds of the CARDS Loan were transferred to Croxley's account at Zurich and pledged to Zurich as collateral for the loan. Later during the same month, Crispin purchased  4.8 million Swiss francs (the “loan assumption proceeds”) in exchange for Crispin's agreement to be jointly and severally liable for a share of the loan obligations to Zurich with a value of $9.4 million. Crispin immediately transferred the loan assumption proceeds to the Zurich account of the S corporation, which in turn guaranteed Crispin's loan obligations, and which pledged the Swiss francs to Zurich as collateral for the loan. On the same day, the S corporation exchanged 3.1 million Swiss francs for United States dollars. Crispin's S corporation received $1.8 million, which it used to purchase a Zurich promissory note that matured at the end of one year and that was held by Zurich as collateral for the corporation's guaranty of Crispin's obligations on the CARDS Loan.

 

In August 2002, Zurich notified Crispin that it was exercising its right to terminate the CARDS Loan. The collateral securing the S corporation’s  guarantee was transferred to Croxley, which used it, together with the remainder of the loan proceeds held by Zurich, to repay the loan. The Croxley loan ended up lasting approximately one year, typical of the CARDS Loans that Zurich provided to the financial advisor’s clients.

 

Prior to filing his 2001 return, Crispin hired a law firm, which had provided tax opinions to the financial advisor to other clients entering into CARDS transactions. While the law firm’s opinion noted the IRS’ opposition, as reflected in its notices, the law firm opined that Crispin's transaction “should have sufficient business purpose to be respected” by the IRS because “[t]he business purpose for [his] entering into the [t]ransactions is clear” and “[t]he financing available to [him] through the [t]ransactions has reduced [his] costs and has afforded [him] the ability to have access to large amounts of capital on a long-term basis to operate the  aircraft.

 

The aircraft business posted a loss of $7.6 million on its 2001 tax return, the difference between its claimed basis (equal to Crispin's $9.4 million assumed share of the CARDS Loan, guaranteed by the partnership) and the $1.8 million of proceeds it received from the currency exchange. That loss offset virtually all of operating entity’s income for 2001. As a result, Crispin reported only $3,244 of flow-through income from his allocable share of the net income of the S corporation.

 

IRS Audit

 

Upon audit, the IRS disallowed the venture’s $7.6 million ordinary loss. A notice of deficiency was eventually issued in July, 2007 by the Commissioner to Crispin seeking not only the tax, but imposing a $1.2 million penalty plus interest for 2001.

 

Tax Court Memorandum Decision, Judge Diane L. Kroupa

 

In March 2012, the Tax Court issued a memorandum opinion affirming the Commissioner's determination that Crispin was not entitled to an ordinary loss deduction from his allocable share of loss from his S corporation which directly participated in the CARDS transaction. The Service proposed to assess an accuracy-related penalty under Section 6662. The basis for its holding was that the CARDS transaction lacked economic substance because Crispin had no valid business purpose and had tax-avoidance as his primary motivation.  It further held that Crispin was liable for a 40% penalty for underpayment that results from a gross valuation misstatement, per Section 6662(h)(1), and that Crispin was not entitled to relief from the penalty under the exception applicable to taxpayers who rely on expert tax advice reasonably and in good faith, pursuant to Section 6664(c)(1).

 

Crispin appealed to the Third Circuit court of appeals. This timely appeal followed.

 

Third Circuit Affirm’s Tax Court’s Decision Below

 

Crispin’s loss needed to meet the requirements under Section 165(a) as a “bona fide loss”. For a loss to be bona fide, it must therefore satisfy the economic substance doctrine, among other requirements.  “The economic substance doctrine ... applies where the economic or business purpose of a transaction is relatively insignificant in relation to the comparatively large tax benefits that accrue (that is, a transaction ... which exploit[s] a feature of the tax code without any attendant economic risk) ....”Neonatology Assocs., P.A. v. Comm'r , 299 F.3d 221, 231 [90 AFTR 2d 2002-5442] n.12 (3d Cir. 2002) (citation and internal quotation marks omitted). “[I]n that situation, where the transaction was an attempted tax shelter devoid of legitimate economic substance, the doctrine governs to deny those benefits.” Id.

 

“The inquiry into whether the taxpayer's transactions had sufficient economic substance to be respected for tax purposes turns on both the objective economic substance of the transactions and the subjective business motivation behind them.”  (citations omitted). The subjective intent inquiry focuses on whether the taxpayer entered into the transaction intended to serve a useful business purpose (citations omitted).  The Tax Court found that Crispin's CARDS transaction failed both the objective and subjective tests for economic substance. The Court noted that Crispin experienced only a paper loss of $7.6 million,  and that, after the CARDS Loan was repaid, Crispin experienced no consequences other than receiving the tax deduction. As a result, the Court concluded that “[t]he ordinary loss claimed from the CARDS transaction was fictional” , which it noted was “the hallmark of a transaction lacking economic substance.”

 

As to Crispin's stated business purpose, the Tax Court determined that both the structure of the CARDS transaction and the record belie Crispin's contention that he engaged in the transaction to obtain long-term financing for use in his aircraft leasing business. Although the Zurich loan had a stated 30-year maturity, the proceeds remained in Zurich's complete possession and control as collateral for the loan, and Zurich had the ability to call the loan at any time after the first year, which it in fact did. Also, Crispin never took any action to obtain and use the proceeds of the loan, knowing that he would have to post an offsetting amount of cash collateral. Nor did he ever take any steps to secure Zurich's approval to substitute aircraft for cash as collateral for the loan. Finally, there was no potential for profit, because the interest rate charged on the CARDS Loan was greater than the interest paid on the proceeds deposited as collateral at Zurich. Based on the foregoing, all of which is well-supported by the record, the Third Circuit found no error, let alone clear error, in the Tax Court's ultimate finding that Crispin's CARDS transaction lacked economic substance.

 

The Penalty Phase

 

The taxpayer argued that even if he lost the case the gross valuation misstatement penalty should not apply.

 

1. Applicability of the Valuation Misstatement Penalty

 

Section 6662 of the Internal Revenue Code imposes a 20%  penalty on an underpayment that results from a “substantial valuation misstatement,” which includes a misstatement of “basis” if “the adjusted basis of any property[] claimed on any return of tax imposed by chapter 1 is 200% percent or more of the amount determined to be the correct amount of such ... adjusted basis.” See Sections 6662(b)(1)–(3), (e)(1)(A). Such penalty may be increased to 40% if the taxpayer claims an adjusted basis in the property that is 400 percent or more of the correct amount; this is known as a “gross valuation misstatement.” See 6662(h). The Third Circuit has held that “where a claimed tax benefit is disallowed because it is an integral part of a transaction lacking economic substance, the imposition of the valuation overstatement penalty is properly imposed ....”Merino v. Comm'r , 196 F.3d 147, 159 [84 AFTR 2d 99-6790] (3d Cir. 1999).

 

Here, the Third Circuit was concerned that the Tax Court may not have determined the correct basis of the particular “asset” in issue, which was the “loan assumption proceeds” even though it did conclude that Crispin made a gross valuation misstatement when he claimed $9.4 million in adjusted basis for that asset on his 2001 tax return.

 

There were two ways to analyze the penalty under a gross valuation misstatement lens. First, treat the entire CARDS Loan for which the taxpayer agreed to be jointly and severally liable ($9.4 million in Crispin's case). What was in fact the taxpayer’s cost to enter into that loan. That cost, which may be viewed as representing the taxpayer's basis, is limited to the value of th foreign actually purchased by the taxpayer and exchanged for U.S. dollars ($1.8 million). The amount of the valuation misstatement is thus the difference between the basis that the S corporation  claimed on its 2001 tax return and that cost. (The difference is the $7.6 million deduction claimed and disallowed by the S corporation causing an increase in Crispin’s taxable income).  

 

The second way of evaluating a gross valuation misstatement is to consider a CARDS loan is not as one transaction but as two closely related transactions: first, the purchase and exchange of the foreign currency (for which the taxpayer actually assumed liability) and second, the agreement to be jointly and severally liable for the amount of the CARDS Loan in excess of that purchase. So, by focusing only on the second CARDS-related transaction, the basis is zero because that part of the transaction plainly lacks economic substance. Therefore, the overstatement is the full amount of the basis attributable to that second transaction (the $7.6 million deduction disallowed by the Commissioner.) See Gustashaw, supra, 696 F.3d at 1133 (noting that “a basis of zero ... is the correct amount when a transaction lacks economic substance”).

 

While the Court noted the vagaries of the calculation of the penalty amounts, which it urged the Service to clarify, it ruled that because the underpayment in Crispin's taxes is directly traceable to the inflated basis in the loan assumption proceeds, that underpayment is “attributable to” a valuation misstatement of over 400%, then the 40% penalty is applicable.

 

2. Reasonable Reliance on the Pullman Opinion

 

Section 6664(c) provides a “reasonable cause” exception for avoiding a penalty under Section 6662 for any portion of an underpayment where the taxpayer can demonstrate reasonable cause and having acted in good faith. This is a factual test. See Treas. Reg. §1.6664-4(b)(1).

In analyzing the record, the facts did not support a reasonable cause defense for Crispin based on the law firm’s opinion. In fact the opinion referred to the outstanding guidance issued from the service that no loss would be allowed and that CARDS was a “listed transaction” on which penalties may be imposed. Crispin's “experience, knowledge, and education,” as a former CPA and chief financial officer also strongly suggest enough familiarity with tax matters that he should be expected to have understood the warnings that Pullman included in the opinion.

The Third Circuit noted that the taxpayer made a series of misrepresentations on why he entered into the transaction and its business purpose. He knew or should have know such representations were false.  It noted the Tax Court’s finding that “the record does not reflect that petitioner actually relied on the tax opinion” because “[Crispin] received the finalized opinion after the 2001 tax returns for [Crispin] and [the S corporation] were filed.”

 

Using a metaphor it couldn’t refrain from not using to drive home the point, the Third Court stated:

“When, as here, a taxpayer is presented with what would appear to be a fabulous opportunity to avoid tax obligations, he should recognize that he proceeds at his own peril.” (citation omitted). Crispin gambled at CARDS and lost, and he is liable for both the underpayment of his taxes and the accuracy-related penalty as determined by the Commissioner.

 

The Third Circuit affirmed the Tax Court on all grounds.

 

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In Bank of New York Mellon Corporation, Successor in Interest to the Bank of New York, Company, Inc. (“BNY”) v. Commissioner, 140 T.C. No. 2; No. 26683-09 (filed 2/11/2013), the Tax Court, in a fully reviewed decision with Judge Diane L. Kroupa writing for the majority, upheld a proposed deficiency in federal income tax against the BNY consolidated group for 2001 and 2002 in the amount of $100 million (2001) and $115 million (2002). It should be expected that BNY will appeal to the Second Circuit Court of Appeals.

The case involved BNY’s entering into a Structured Trust Advantaged Repackaged Securities transaction (STARS transaction). The STARS transaction provided BNY with allegedly below market cost financing from a U.K. bank, Barclays. It was part of a set of steps to generated foreign source income and foreign tax credits and expenses to BNY in a tax-arbitrage type play that the government would attack as lacking any economic substance other than to generate tax savings.

As part of the STARS transaction, BNY  transferred income-producing assets to a trust with a U.K. trustee and subject the trust asstes to U.K. tax on its income. As a result, BNY claimed foreign tax credits and deductible expenses on its 2001 and 2002 consolidated income tax returns as a result of the STARS transaction. It further reported income from the assets transferred to the trust as foreign source income on the returns.

Upon audit, the government alleged that the STARS transaction was a sham and lacked economic substance. It therefore disallowed the claimed foreign tax credits, the expense deductions and the reporting of the asset income as foreign source. The Court ruled that since the STARS transaction, based on the record before it, lacked economic substance and could not be respected for federal tax purposes, including treaty purposes. Accordingly, BNY could not claim foreign tax credits, the claimed deductible expenses or the foreign source income treatment.

The affiliated group through BNY entered into the STARS transaction in 2001 with Barclays Bank, PLC (Barclays), a global financial services company headquartered in London, United Kingdom. The STARS transaction generated approximately $199 million in foreign tax credits for the combined years at issue. The opinion sets forth the background leading up to the structuring and implementation of the STARS transaction. The key players were of course BNY, Barclays and KPMG, STARS was represented as a "below market loan" in KPMG's initial presentation. KPMG indicated that STARS required a U.K. counterparty and a certain trust structure holding income-producing assets. KPMG explained that the below-market cost would be achieved by the U.K. counter party "sharing" U.K. tax benefits from STARS through an offset to the cost of the loan. Finally, KPMG indicated that the U.K. tax benefits would be generated by subjecting income-producing assets held by a trust to U.K. tax and thus generating foreign tax credits that BNY could use to offset its U.S. tax liability.

BNY notified KPMG in August 2001 that it was prepared to move forward with a STARS transaction with Barclays as the U.K. counterparty. BNY proposed that it would contribute assets that would generate $93 million of annual U.K. tax costs and expected Barclays to reduce the loan's annual cost by half that amount. Shortly thereafter, BNY agreed to supplement STARS by engaging in a "stripping transaction." The effect would be to accelerate and increase the tax benefits STARS produced (i.e., foreign tax credits). And just before STARS closed, BNY indicated to Barclays that it had decided to increase the targeted benefit.

The specific components of the STARS transaction are chronicled in the factual background provided by the Court in rendering its decision. The interested reader should review carefully the Courts description of the transaction, including transaction models. The Tax Court noted that the STARS transaction represented a case of first impression for it to decide. 

Tax Court’s Analysis

I. Merits of the STARS Transaction Under the Economic Substance Doctrine

The Tax Court began by acknowledging the age-old axiom that taxpayers may structure business transactions that result in the lease amount of tax. The idea that there is no patriotic duty to pay more than what a taxpayer is required to pay. See Boulware v. United States, 552 U.S. 421, 430 n.7 (2008) (citing Gregory v. Helvering, 293 U.S. 465, 469 (1935)); Gerdau Macsteel, Inc. v. Commissioner, 139 T.C. ___, ___ (slip op. at 163-164) (Aug. 30, 2012).

But formalistic adherence to the Code does not necessarily follow that Congress intended to cover the transaction and allow a tax benefit. Knetsch v. United States, 364 U.S. 361, 365 (1960); Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff'd, 293 U.S. 465 (1935).

In situations where complex, multi-party transactions are seeking validation for federal income tax purposes, the Supreme Court’s comments in  Frank Lyon Co. v. United States, 435 U.S. 561, 583-584 (1978),  are frequently invoked as a marker or guide, as was the case in BNY.

“[W]here, as 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. * * *"

This leads to the application of the economic substance doctrine which has two prongs or consists of a two-factor test: (1) whether the transaction had economic substance beyond tax benefits (objective prong), and (2) whether the taxpayer had shown a non-tax business purpose for entering into the disputed transaction (subjective prong). (citations omitted). (Note that the years in issue here were prior to the codification of the economic substance test in Section 7701(o)).

As noted by the Tax Court, there has been a difference in judicial opinion as to the proper application of the economic substance doctrine. Some courts have required that only one of the two prongs be satisfied for the transaction under review to be respected. 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; Rice's Toyota World, Inc v. Commissioner, 752 F.2d 89, 91 (4th Cir. 1985), aff'g in part, rev'g in part 81 T.C. 184 (1983). Other appellate courts require that the two prong test of objective profit motive and subjective business purpose  be met. See Dow Chem. Co. v. United States, 435 F.3d 594, 599 (6th Cir. 2006); Winn-Dixie Stores, Inc. v. Commissioner, 254 F.3d 1313, 1316 (11th Cir. 2001), aff'g 113 T.C. 254 (1999); United Parcel Serv. of Am., Inc. v. Commissioner, 254 F.3d 1014, 1018 (11th Cir. 2001), rev'g T.C. Memo. 1999-268; Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1355 (Fed. Cir. 2006).  A third view was to consider both as only factors in determining whether the transaction has economic substance beyond the intended 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.

Under the Tax Court’s administrative rule of convenience announced in Golsen v. Commissioner, 54 T.C. 742 (1970), aff'd, F.2d 985 (10th Cir. 1971), the appeal from the BNY case would rest with the Second Circuit absent a stipulation to the contrary. The Second Circuit was noted as approving of the flexible analysis test in determining economic substance and will evaluate both the subjective business purpose of the taxpayer in engaging in the transaction  and the objective potential for economic profit aside from tax benefits. Gilman v. Commissioner, 933 F.2d 143 (2d Cir. 1991), aff'g T.C. Memo. 1989-684; Long Term Capital Holdings v. United States, 330 F. Supp. 2d 122 (D. Conn. 2004), aff'd, 150 Fed. Appx. 40 (2d Cir. 2005).  The ultimate determination of whether a transaction lacks economic substance is a question of fact. See Nicole Rose Corp. v. Commissioner, 320 F.3d 282, 284 (2d Cir. 2003), aff'g 117 T.C. 328 (2001).

B. Scope of the Economic Substance Inquiry

After identify the applicable standard, the Court noted that the government argued that the components of the STARS transaction should be bifurcated into its two main.  The Court agreed. It stated that for applying the economic substance test it had to focus on the transaction that yielded the disputed foreign tax credits (FTCs). The FTCs were generated by circulating income through the STARS structure. Indeed the below-market loan was not needed for the STARS structure to yield the disputed FTCs. So the use of the STARS structure is the key factor in testing for economic substance.

C. Economic Substance of the STARS Structure

1. Objective Economic Substance of the STARS Structure

The objective economic substance test requires whether the transaction created a reasonable opportunity for economic profit; i.e., a profit exclusive of tax benefits. The Court, as had been argued by the Service, viewed that there was no reasonable opportunity for an economic profit aside from the tax benefits and therefore the STARS structured lacked objective economic substance. Corroborative of its holding was its finding that : (i) the STARS structure did not increase the profitability of the STARS assets in anyway. To the contrary, it reduced their profitability by adding substantial transaction costs, e.g., professional service fees and foreign taxes incurred as result of using the STARS structure; (ii) the activities or transactions that the STARS structure was used to engage in did not provide a reasonable opportunity for economic profit; and (iii) the STARS structure's main activity was to circulate income between itself and Barclays. More specifically, each month, as pre-arranged, the subisidiary of BNY involved in the transaction would transfer pre-determined amounts of income to the U.K. managed trust. Substantially all of the trust income was distributed to the Barclays blocked account, which in turn was immediately recontributed such funds to the trust and then passed the same funds back to the BNY subsidiary where it was available for BNY's use. These circular cashflows or offsetting payments had no non-tax economic effect. Circular cashflows strongly indicate a transaction lacks economic substance. See Altria Group, Inc., 658 F.3d at 289 (citing AWG Leasing Trust v. United States, 592 F. Supp. 2d 953, 983 (N.D. Ohio 2008)) (circular payments from and back to foreign bank "strongly indicate" that SILO transaction "has little substantive business purpose other than generating tax benefits"); Merryman v. Commissioner, 873 F.2d 879, 882 (5th Cir. 1989) (tax structuring disregarded where "money flowed back and forth but the economic positions of the parties were not altered"), aff'g T.C. Memo. 1988-72.  

The STARS structure was also used in connection with the interest stripping transaction that was part of the overall plan. The interest stripping transaction also resulted in a circular cashflow and did not provide a reasonable opportunity for economic profit. Here the trust sold its right to receive interest income from the trust collateral securities to the BNY subsidiary for a lump-sum payment taxable in the United Kingdom, which the BNY subsidiary made with funds provided by  BNY. This reallocated the income and principal payments associated with the trust collateral securities within the STARS structure. It did not alter the amount and timing of the cashflows generated by the underlying assets. And because the sale of the interest rights was funded by BNY and between entities within the STARS structure, the interest stripping transaction had no potential to generate a non-tax economic profit on the aggregate.

Furthermore, the Tax Court found that  BNY's control and management over the STARS assets did not materially change as a result of their transfer to the STARS structure.Additionally, the STARS structure had no effect on the income stream generated by the STARS assets. Accordingly, the STARS assets would have generated the same income regardless of being transferred to the trust. Thus, income from the STARS assets was not an incremental benefit of STARS, i.e., it had no objective economic substance.

2. Subjective Economic Substance

Did BNY have a legitimate non-tax business purpose for the use of the STARS structure? The taxpayer argued it used the STARS structure to obtain "low cost financing" from Barclays.The Court felt that the record does not support petitioner's claimed business purpose. The STARS structure lacked any reasonable relationship to the loan. And the loan was not "low cost." To the contrary, the Tax Court viewed the loan cost was overpriced and not by just a little an further required BNY to incur substantially more transaction costs than a similar financing available in the marketplace. The Tax Court found that BNY’s motivation for entering into the STARS transaction was tax avoidance and not a valid business purpose. It cited several factors in support which are set forth in some detail in the Court’s opinion.

3. BNY’s Argument That the STARS Transaction’s Generation of FTCs Was Authorized by Congress

With economic substance in doubt, the taxpayer argued Congressional intent. Thus, the taxpayer claimed that the disputed tax benefits, the FTCs, were intended to be allowed by Congress and that the economic substance doctrine does not warrant disallowing the disputed tax benefits because Congress intended the foreign tax credit for transactions like STARS. The Court took a jaundiced view of this “policy” argument. In responding, it indeed noted the tax policy of the foreign tax credit rules and that was to alleviate  double taxation arising from foreign business operations. See United States v. Goodyear Tire & Rubber Co., 493 U.S. 132, 139 (1989); Am. Chicle Co. v. United States, 316 U.S. 450, 451 (1942); Burnet v. Chicago Portrait Co., 285 U.S. 1, 7 (1932). Congress intended the foreign tax credit to neutralize the effect of U.S. tax on the business decision of where to conduct business activities most productively. 56 Cong. Rec. App. 677-678 (1918) (statement of Rep. Kitchin). The enactment of the foreign tax credit was also informed by fairness. See National Foreign Trade Council, Inc., International Tax Policy for the 21st Century, (Dec. 15, 2001).

The Tax Court viewed that the STARS transaction was outside of the circle of taxpayers that Congress wanted to benefit from paying foreign taxes on foreign source income. The STARS transaction was a complicated scheme centered around arbitraging domestic and foreign tax law inconsistencies. The U.K. taxes at issue did not arise from any substantive foreign activity. Indeed, they were produced through pre-arranged circular flows from assets held, controlled and managed within the United States. Based on the circular flow of funds involved herein, the Tax Court disagreed with BNY on its policy argument and concluded that  Congress did not intend to provide foreign tax credits for transactions such as STARS.

 

II. Deductibility of STARS-Related Expenses

Aside from the FTCs, which the Court denied, BNY claimed it was proper to deduct transactional expenses, including the zero coupon swap interest, associated with the STARS transaction for 2001 and 2002. It argued that the U.K. taxes paid on trust income are deductible where the FTCs are denied. Again, the Service argued that the transations lacked economic substance and therefore the claimed deductions, including for foreign taxes, should be disallowed.

The Tax Court made it clear as it did with the FTC issue that expenses incurred in furtherance of a transaction that is disregarded for a lack of economic substance are not deductible. See Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. at 294 (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 Gerdau Macsteel, Inc. v. Commissioner, 139 T.C. ___ (slip op. at 188). The claimed transactional expenses, the zero coupon swap interest expense and the U.K. taxes were all incurred in furtherance of the STARS transaction, are non-deductible for lack of economic substance.  

 

III. Foreign Source Income Adjustment

Another argument or position taken by BNY had to do with the IRS adjustment to BNY’s foreign source income. The taxpayer reported the income from the trust assets as foreign source income based on a "resourcing" provision in paragraph 3 of Article 23 of the U.S.-U.K. Income Tax Treaty. Again the government’s viewed was upheld by the Tax Court. The readjustment of the income as domestic source income was upheld on the basis that the STARS transaction, since it lacked economic substance, is disregarded for U.S. tax purposes. Therefore, the income generated from the trust was U.S. property and therefore U.S. source income. The Court, in its opinion, noted that the economic substance doctrine extends to tax treaties. Del Commercial Props., Inc. v. Commissioner, T.C. Memo. 1999-411 (citing Gregory v. Helvering, 293 U.S. 465, 470 (1935), and Johansson v. United States, 336 F.2d 809, 813 (5th Cir. 1964)), aff'd, 251 F.3d 210 (D.C. Cir. 2001).

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In a recent memorandum decision of the Tax Court in Howell, TCM 2012-303, a couple was held liable for a deficiency in self-employment taxes, plus statutory additions and interest, for 2000 and 2001, with respect to payments made to Mrs. Howell by their (California) limited liability company. The business operations conducted by the LLC provided software and hardware to hospitals for record retention purpose.

 

The payments in question were originally reported by the LLC on its information returns signed by Mr. Howell, as the tax matters partner (by delegation by Mrs. Howell), as guaranteed payments made to Mrs. Howell. Later, on delinquent returns filed for 2000 and 2001, the taxpayers argued that instead as originally reported by the LLC, the payments constituted distributions from the limited liability company and were not subject to self-employment tax. They also invoked the exception under Section 1402(a)(3) that as to her distributive share of LLC income, Mrs. Howell was not subject to SE tax as she was merely a passive (“limited partner”) investor. The Court found in favor of the Service.

           

            Application of Self-Employment Tax to Members of a Limited Liability Company and Limited Partners in a Limited Partnership

 

Under Sections 1401(a) and (b), a taxpayer's self-employment income is subject to self-employment (“SE”) tax. SE tax is assessed and collected as part of the income tax and taken into account as well for estimated tax purposes. Self-employment income generally is defined as “the net earnings from self-employment derived by an individual”. Under Section 1402(a), “net earnings” from SE means the gross income derived by an individual  from any trade or business carried on by such individual, less the deductions allowed by this subtitle which are attributable to such trade or business, plus his distributive share (whether or not distributed) of income or loss described in Section 702(a)(8) from any trade or business carried on by a partnership of which he is a member.

 

Treas. Reg. §1.1402(a)-1 provides that as to a partner or member of a LLC taxable as a partnership, Section 702(a)(8) provides that, in determining a partner's income tax, “each partner shall take into account separately his distributive share of the partnership's ... taxable income or loss, exclusive of items requiring separate computation under other paragraphs” in Section 702(a).  

 

In general, a partner must include his distributive share of income as income from SE. However, Section 1402(a)(13) provides that in certain circumstances, a limited partner may exclude his distributive share of income from net earnings from SE. In particular, Section 1402(a)(13) provides that “[T]here shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707(c) (i.e., guaranteed payments are payments received by a partner from a partnership that are calculated without regard to the partnership's income for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services).  Section 1402(a)(13) does not define the term “limited partner”.  

 

In Howell, supra, Judge Paige Marvel, who issued the Court’s Memorandum decision, cited the Tax Court’s recent fully reviewed opinion in Renkemeyer, Campbell & Weaver, LLP v. Commissioner, per majority opinion issued by Judge Jacobs, 136 T.C. 137, 149-150 (2011) as applying the correct standard of law.  In Renkemeyer, supra,  the Tax Court applied  accepted principles of statutory construction in determining whether the taxpayers' partnership interests in a law firm organized as a limited liability partnership should be considered limited partner interests for purposes of  Section 1402(a)(13). The Court viewed it had to look at Congress’ intent in enacting the SE tax, as well as setting forth the limited partner exception. It interpreted the legislative intent was to distinguish between  individuals who merely invested in a partnership who would not, with respect to such investment, receive credits for Social Security purposes, in which case SE tax would not be imposed, versus a limited partner or member of a limited liability partnership who performed services for a partnership in his capacity as a partner (i.e., acting in the manner of self-employed persons), where SE tax should be imposed. 

 

In Renkemeyer, supra, the Tax Court held that members of a law firm operated as a limited liability partnership, sometimes called a registered limited liability partnership (RLLP) under applicable state law, were not limited partners for purposes of Section 1402(a)(13) because the distributive shares received “arose from legal services [the taxpayers] performed on behalf of the law firm” and “did not arise as a return on the partners' investment”.

 

            Initial Tax Information Return Positions of  the LLC; Later Inconsistent Positions Taken by Mrs. Howell on Delinquent Income Tax Returns

 

In Fall, 1999, the petitioners and another investor formed a California LLC to provide software and hardware to hospitals to enable doctors to access hospital records from outside the hospital. The Howells collectively received 60% of the LLC interests, issuing Mrs. Howell 39% and Mr. Howell 21% due to her better credit in order to secure credit cards and loans for the business. The other investors held the remaining ownership interest 40%. Mr. Howell and the newly formed LLC entered into a management services agreement which  delegated to  him “the total and exclusive control of all management and operations” of the company. He also served as the "tax matters partner" and signed the LLC's information returns.

 

On its 2000 information return (Form 1065), the LLC reported gross receipts of $302,456, a gross profit of $250,259, and ordinary income of $12,355. In calculating its ordinary income, the LLC deducted guaranteed payments to partners (members), including Mrs. Howell,  of $165,525.  The guaranteed payments among all members were substantially in excess of “bottom line” income under Section 702(a)(8).  In the succeeding year, 2001, the LLC reported gross receipts of $379,146, gross profit of $342,865, and ordinary income of $18,794. In calculating its “bottom line” income, the LLC deducted guaranteed payments to partners of $259,500. By 2001, Mr. Howell presumably transferred his LLC interest to Mrs. Howell increasing her ownership to approximately 60%.

 

The taxpayers failed to file timely returns for 2003-2005 and after filing, an IRS audit commenced. The audit was extended to 2001 and 2002. During 2005 the IRS began an examination for the Company’s  2003-05 taxable years. Respondent's examination eventually expanded to include an examination of the Howell’s 2000-2001 taxable years for which returns had not been filed. While the appeals review of the LLC adjustments was pending, the Howells submitted deliquent income tax returns for 2000 and 2001. 

 

On December 1, 2009, the Service issued a statutory notice of deficiency for 2000 and 2001. The IRS determined that Mrs. Howell received guaranteed payments of $63,850 and $149,500 for 2000 and 2001, respectively, and ordinary income of $4,757 and $10,713 for 2000 and 2001, respectively. SE tax was to be assessed on the ordinary income as well as the guaranteed payments. Mrs. Howell contended that the guaranteed payments she received were not subject to SE tax and argued that as to the "bottom line" income of the LLC, she fell with the limited partner exception in Section 1402(a)(13).

 

The Service contended that by reporting (LLC level) certain payments to the Howells as guaranteed payments, and in light of Mr. Howell being the tax matters partner for the LLC, the Howells could not disavow the original reporting positions unless supported by applicable precedent citing  Norwest Corp. v. Commissioner, 111 T.C. 105, 144 (1998), and Pinson v. Commissioner, T.C. Memo. 2000-208 The Service further conended that Mrs. Howell was not a true member of  the LLC but instead was a nominee for Mr. Howell. As such, the guaranteed payments must be included in his net earnings from SE. In the alternative, the Service argued that Mrs. Howell was an active participant in the LLC and can not exclude the guaranteed payments under the exception in Section 1402(a)(3). 

 

            Judge Marvel’s Memorandum Decision Analysis

 

Judge Marvel first addressed the “duty of consistency” type argument advanced by the Service to the effect that the Howells were bound by the form in which the transactions were reported by the LLC. In resolving the question in the Commissioner’s favor, the Court analyzed: (i) wether the taxpayer seeks to disavow his or her own tax return treatment for the transaction; (2) whether the taxpayer's tax reporting and other actions show an honest and consistent respect for the alleged substance of the transaction; (3) whether the taxpayer is unilaterally attempting to have the transaction treated differently after it has been challenged; and (4) whether the taxpayer will be unjustly enriched if permitted to alter the transactional form. For the taxpayer to prevail, the taxpayer must provide strong proof as to the asserted substance of the transaction which imposes on the taxpayer a greater evidentiary burden than the normal preponderance of credible evidence standard. See Estate of Durkin v. Commissioner, 99 T.C. 561, 572-574 (1992); Illinois Power Co. v. Commissioner, 87 T.C. 1417, 1434 (1986).

 

Next, Judge Marvel turned to the record and found that the taxpayer could not meet its evidentiary burden ("strong proof" standard) including taking notice of: (i) the LLC, on both its 2000 and 2001 returns, reported making guaranteed payments to Mrs. Howell;  and (ii) Mr. Howell, acting as  the LLC’s TMP, signed the LLC’s 2000 and 2001 returns; (iii) the Howells are now disavowing the reporting positions “they took” on the LLC’s returns; and (iv) the inconsistent position by the Howells were first taken on delinquent returns.  No strong proof was reflected on the record for the petitioners to argue that the LLC return positions on guaranteed payments was wrong.

 

Then, the Court addressed the limited partner exception under Section 1402(a)(3). The exception did not apply to guaranteed payments received by a limited partner were those payments were received “for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services”.  Unless the taxpayers could provide strong proof the contrary, i.e., that the payments were not made in exchange for Mrs. Howell’s services, the payments were SE income and taxable under Section 1402(a)(3). The record reflected that Mrs. Howell had provided marketing advice, signed documents and entered into contracts on behalf of the LLC, and allowed the LLC to use her credit card and credit rating. The operating agreement recited that  Mrs. Howell contributed a business plan and intellectual property to  the LLC and that she, as the majority owner, delegated management authority to her husband but still consulted  with him from time to time.  Judge Marvel opined that Mrs. Howell was not merely a passive investor in the LLC and that to some extent the payments were for services she rendered. The record was silent on whether only some portion of the payments to Mrs. Howell were for services and therefore the taxpayers did not carry this burden as well.

 

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Petitioner-taxpayer leased land and telecommunication towers to his wholly owned S corporation, in exchange for a percentage of the Company’s revenues from its leases of tower access to third parties. Petitioners also leased three parcels of land to the Company on which no telecommunication towers were located. The Company sold and serviced radios and provided specialized mobile radio (SMR) services to customers for a monthly subscriber fee. Four of the towers leased to Company housed antennas in free (unused) space for the rent-free use of the Company’s SMR customers. The Petitioners-taxpayers reported the net income from his leases to the Company as passive activity rental income per §469(c)(2).  

Petitioners' returns for the years in issue reported the income and loss from the leasing of towers and land to ICE as passive activity income and loss for purposes of section 469. Those returns listed each of the individual land and tower rentals as a separate activity. On the S corporation informational returns for the years in issue, the Company did not separately report the income or loss from its various activities. Rather, it reported its total net income as “ordinary business income”. The Forms K-1 that it issued to the Petitioner for each of the years in issue, included his 100% distributive share of its income as ordinary business income. On the Petitioners’ individual tax returns, the net income was reflected as ordinary, non-passive activity income.

Upon audit, the Service took issue with the reporting by the S corporation. It recharacterized Petitioner’s income from profitable rentals of towers and/or land from passive activity income to non-passive-activity income for purposes of  §469.  It did not recharacterize Petitioner's losses from unprofitable tower and land rentals. On that basis, the Service recharacterized $428,128 and $590,054 for 2004 and 2005, respectively, from passive activity income to non-passive-activity income, attributable to profitable rental properties, but he did not so recharacterize $143,829 and $157,824 for 2004 and 2005, respectively, of losses attributable to unprofitable rental properties.

The Respondent-government argued that the taxpayer’s rental income from the lease of the tower and land to his wholly owned S corporation should be characterized as “active” income based on his material participation in the S corporation’s business activities citing Prop. Reg. §1.469-2(f)(6) but only as to the profitable tower and land leases. As to unprofitable tower and land leases, the Service characterized such activities as “passive” and therefore losses from such activities were “passive” losses. The government further argued that the Petitioner’s income from three land-only leases to his S corporation  constituted non-passive-activity income pursuant to Temp. Reg. §1.469-2T(f)(3), because less than 30% of the leased property's unadjusted basis was subject to depreciation.

In a fully reviewed decision of the Tax Court, per Judge Halpern, the Court held: (i) the S corporation used the towers and associated land which it leased from its sole shareholder in a rental activity and was not part of its core “trade or business” activity. Therefore, the taxpayer’s (shareholder's) income with respect to those leases constituted passive activity income (or loss) under §469(c) regardless of the Petitioner’s material participation; (ii) the first holding renders moot the Petitioner’s objection to treating his losses from unprofitable tower and land leases to as passive activity losses; and (iii) because certain land leases were functionally separate from the land leased on which towers were placed, those land lease only activities cannot be grouped with the tower and land leases per Treas. Reg. §1.469-4(d)(2) and therefore, since less than 30% of the property covered by those leases was depreciable, the Court agreed with the Service’s alternative argument that the  taxpayer’s income from such leases constituted non-passive activity income under Temp. Reg. §1.469-4T(f)(3).

Central to the Court’s determination was its interpretation of the self-rental rule contained in Treas. Reg. §1.469-2(f)(6). The Court required that two conditions must be present to invoke the regulation: (i) that the S corporation used the leased properties in a trade or business activity (other than a rental activity); and (ii) the Petitioner  materially participated in that trade or business activity. The Court ruled that the S corporation did not use the telecommunications towers in a trade or business activity and therefore the regulation was found to be inapplicable in resolving the issues before the Court.

The Court stated that labeling a lease agreement as a “license” or “service contract” is not determinative if the underlying payments are made for the use of tangible property. The fact that the Company’s various activities may have complemented one another does not change the “fundamental fact” that the Company’s leasing of towers and land to unrelated third parties was a rental activity under §469(j)(8) and Treas. Reg. §1.469-1T(e)(3)(i), even if routine services were provided to the tenants. Such supportive activities are not trade or business activities and does not bring its tower leasing activities within any of the exceptions to the definition of a rental activity that are described in Temp. Treas. Reg. § 1.469-1T(e)(3)(ii)(A)-(F). The “rental exceptions” contained in the Temporary Regulations were not present here such as: (i) rentals of 7 days or less; (ii) rentals of 30 days or less where “significant” lessor services are provided; (iii) rentals accompanied by “extraordinary personal services” (i.e., the use of the property is “incidental” to the receipt of the services); (iv) rentals “incidental to a nonrental activity of the taxpayer”; (v) rentals where the property is made available “during defined business hours for nonexclusive use by various customers”; and (vi) rentals to a passthrough entity where the taxpayer has made property available to the entity “in the taxpayer's capacity as an owner of an interest in” the entity (e.g., by way of capital contribution) for use in a nonrental activity.

The government focused its argument on the fact that for the years in issue, the Company reported (both on its own returns and on the Schedules K-1 issued to petitioner) all of its income as a single, undifferentiated amount shown as “ordinary business income”. The taxpayer, the government argued, provided “no evidence in the records showing what income and expenses are attributable to each of [the S corporation’s] .”  The IRS further argued that the Company’s grouping of its activities as a single activity producing “ordinary business income” was proper under Treas. Regs. §§ 1.469-4(c) and (d) and that under Treas. Reg. §1.469-4(e)(1), the S corporation may not “regroup” those activities and  that under Treas. Reg. §1.469-4(d)(5)(i), the Petitioner may not treat those activities as separate activities for the years in issue.

In response, the Petitioner argued that even if the tower rental activity was to be combined as part of an “appropriate economic unit” per Treas. Reg. §1.469-4(c)(1), the actual disconnect between that activity and the Company’s other activities, save for “the limited and rent-free use in the SMR business of antennas mounted in 'free space' *** [atop] some of the towers”, mandates its treatment as a passive activity thereby rendering the self-rental rule of Treas. Reg. §1.469-2(f)(6) inapplicable to Petitioner's tower and land rentals to the S corporation during the years in issue. The Court agreed.

Judge Halpern observed that the Company’s grouping of its activities and its reporting of those activities on its returns for the years in issue and on the Schedules K-1 issued to Petitioner as a single business activity generating “ordinary business income” was indeed improper and in contravention of Treas. Reg. §1.469-4(d)(1). This regulation prohibits the grouping of a rental activity and a trade or business activity unless those activities constitute an “appropriate economic unit” per Treas. Reg. §1.469-4(c).

Treas. Reg. §1.469-4(d)(1)(i)(C) allows grouping of a taxpayer's rental and trade or business activities, which form an “appropriate economic unit”, where “[e]ach owner of the trade or business activity has the same proportionate ownership interest in the rental activity. Based on the facts, the Court concluded that the IRS application of the self-rental rule to recharacterize, from passive activity to non-passive activity income, any portion of its income from the tower and land rentals to the Company was erroneous.

The next question was whether the S corporation’s erroneous grouping of its rental and other activities and its treatment of those activities as a single “ordinary business” activity is nevertheless, under the last sentence of Treas. Reg. §1.469-4(d)(5)(i), binding on Petitioner with respect to his tower and land rentals.  may not treat any of Company's activities as separate activities. The Court ruled that because the Petition wore his lessor hat and not his shareholder hat that the last sentence of Treas. Reg. § 1.469-4(d)(5)(ii) was not applicable. It only bound the Company from regrouping its activities by the shareholder. It does not affect Petitioner's reporting of the Company’s  rental payments to him.

This decision is not only important to evaluate for purposes of Section 469, but also will have an impact under Section 1411 which, beginning in taxable years starting on or after January 1, 2013, net investment income, including net income from passive activities, will be subject to a 3.8% income tax for individuals, trusts and estates to the extent the threshold amount of taxable income is exceeded.

 

 

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The United States District Court for the District of Utah, Central Division, on November 8, 2012, Judge Nuffer, granted the United States its motion for summary judgment for the taxpayer-defendant’s, Jon Mc Bride, willful failure to report his interest in foreign bank accounts in contravention of 31 U.S.C. Section 5314 for the years 2001 and 2002. (U.S. v. McBride, No. 2:09-cv-00378 (D. Utah 2012). Penalties were assessed of approximately $200,000 plus interest.

 

Mc Bride had engaged in a scheme to launder U.S. business income through foreign shell companies that he established. He employed a financial management firm to set up accounts in the name of several international business corporations to shelter or non-report, U.S. business income and then repatriated the funds. He did not file FBAR reports for the tax years in which the accounts existed. The government filed a civil suit to collect an FBAR penalty from Jon McBride, alleging that he had failed to properly report interest in several foreign accounts for the 2000 and 2001 tax years. McBride had entered into an elaborate scheme to launder his U.S. business income through foreign shell companies.

 

A key question before the Court was the standard to be used in whether the government’s request to impose FBAR penalties in the subject proceeding would be granted. Would it be a “by a preponderance of the evidence” standard, or a “clear or convincing standard”? Granted the case was civil in nature. Judge Nuffer cited U.S. v. Williams, No. 1:09-cv-00437 (E.D. Va. 2010) as the only court to consider this issue. That court held that because the FBAR penalty is monetary only, preponderance was the correct standard, pointing to acceptance of that standard by federal appellate courts in other civil tax penalty cases. The Utah federal district court in the Mc Bride case agreed. In applying this standard it held that the government met its burden of proof based on a preponderance of the evidence as to the elements of: (i) ownership of the funds; (ii) willful failure of the defendant-taxpayer to file FBAR reports either by reckless disregard of a known duty or by willful blindness or neglect to read the contents of the income tax return; and (iii) the taxpayer was found to have purposely kept this information about his foreign bank accounts (and tax evasion scheme) from his tax return preparer. See Global-Tech Appliances, Inc. v. SEB S.A., 131 S. Ct. 2060, 2068-69 (2011) ("persons who know enough to blind themselves to direct proof of critical facts in effect have actual knowledge of those facts") (citing United States v. Jewell, 532 F.2d 697, 700 (9th Cir. 1976) (en banc)). The civil penalty for FBAR willful failures to file is up to 50% of the account balance for each year the offense is committed.

 

After making a substantial number of findings of fact, the Court then addressed the standard of proof and then the taxpayer’s willful failures to file the FBAR reports. f. McBride's Failure to Report His Interest in the Foreign Accounts was willful. See Lefcourt v. United States, 125 F.3d 79, 83 (2d Cir. 1997) (defining "willfulness" in the context of a civil penalty for willfully failing to disclose required information to the IRS as conduct that "requires only that a party act voluntarily in withholding requested information, rather than accidentally or unconsciously."); accord Denbo v. United States, 988 F.2d 1029, 1034-35 (10th Cir. 1993) (defining "willful" conduct as a "voluntary, conscious and intentional decision") (quoting Burden v. United States, 486 F.2d 302, 304 (10th Cir. 1973), cert. denied, 416 U.S. 904 (1974)). Conduct that evidences "reckless disregard of a known or obvious risk" or a "failure to investigate . . . after being notified [of the violation]" also satisfies the civil standard for willfulness in such contexts.

 

Willfulness may also "be proven through inference from conduct meant to conceal or mislead sources of income or other financial information." United States v. Sturman, 951 F.2d 1466, 1476-77 (6th Cir. 1991). Moreover, willful intent may be proved by circumstantial evidence and reasonable inferences drawn from the facts because direct proof of the taxpayer's intent is rarely available. Spies v. United States, 317 U.S. 492, 499 (1943)).

 

The Court found that the defendant was fully aware that he was engaged in a plan to avoid income taxes by hiding his interest in assets in overseas shell corporations and also the FBAR filing requirements, which filings would in effect interfere with his scheme.

 

On this issue of imputing willful failure to file FBAR reports when taxpayer check-the-foreign bank account “no” on their income tax return, the Court surveyed the law in this area and turned to United States v. Williams, supra,  as the “only  case to examine willfulness in the context of a civil FBAR penalty”. In Williams, the Fourth Circuit recently held that a taxpayer was willful in failing to comply with FBAR requirements when he signed a federal tax return that failed to disclose the existence of foreign accounts, "thereby declaring under penalty of perjury that he had 'examined this return and accompanying schedules and statements' and that, to the best of his knowledge the return was 'true, accurate, and complete.'" The Fourth Circuit reversed the district court's findings of fact as "clearly erroneous," on the grounds that the district court failed to consider the taxpayer's signature on his returns sufficient evidence of his knowledge of his failure to comply with the FBAR requirement. "A taxpayer who signs a tax return will not be heard to claim innocence for not having actually read the return, as he or she is charged with constructive knowledge of its contents." At a minimum, "line 7a's directions to '[s]ee instructions for exceptions and filing requirements for Form TD F 90-22.1'" puts a taxpayer "on inquiry notice of the FBAR requirement." Id. As a result, the Fourth Circuit held that Williams's explicit statement that he never consulted Form TD F 90-22.1 or its instructions, never read line 7a, and "never paid any attention to any of the written words on his federal tax return" constituted a "'conscious effort to avoid learning about reporting requirements,'" and his false answers on his federal tax return "evidence conduct that was 'meant to conceal or mislead sources of income or other financial information.'" Id. (quoting Sturman, 951 F.2d at 1476).

A taxpayer's signature on a return is sufficient proof of a taxpayer's knowledge of the instructions contained in the tax return form and in other contexts. "In general, individuals are charged with knowledge of the contents of documents they sign -- that is, they have 'constructive knowledge' of those contents." Consol. Edison Co. of N.Y., Inc. v. United States, 221 F.3d 364, 371 (2d. Cir. 2000).  

 

While there are cases that have stated that "[a] taxpayer's signature on a return does not in itself prove his knowledge of the contents, but knowledge may be inferred from the signature along with the surrounding facts and circumstances, and the signature is prima facie evidence that the signer knows the contents of the return." See, e.g., United States v. Mohney, 949 F.2d 1397, 1407 (6th Cir 1991); accord Hayman v. Comm'r, 992 F.2d 1256, 1262 (2d Cir. 1993) (holding that where a taxpayer "claims to have signed the returns without reading them, [he or] she nevertheless is charged with constructive knowledge of their contents").

 

Inferring knowledge of the contents of a return signed by the taxpayer is consistent with the conclusion drawn by the Sixth Circuit in United States v. Sturman, which held that, "It is reasonable to assume that a person who has foreign bank accounts would read the information specified by the government in tax forms," including the reference on Schedule B to the FBAR. 951 F.2d at 1477. Moreover, the line of criminal cases dealing with whether or not a taxpayer's signature on a return demonstrates knowledge of the contents has upheld convictions where the jury was permitted to infer knowledge of the contents of the return from the signature on the return alone. See, e.g., United States v. Olbres, 61 F.3d 967, 971 (1st Cir. 1995) (in prosecution for tax fraud, "jury may permissibly infer that a taxpayer read his return and knew its contents from the bare fact that he signed it"); United States v. Romanow, 509 F.2d 26, 27 (1st Cir. 1975) (jury could believe from the uncontested signature of the defendant on return that he had read the form, despite his claim that he merely signed the return that was prepared by bookkeeper).

 

Judge Nuffer also cited a recent Northern District Court of Illinois case, Thomas v. UBS, AG, No. 1C4798, 2012 WL 2396866, where the plaintiffs alleged that a bank had a duty to inform its depositors of the FBAR requirement. In response, the Thomas court rejected the plaintiffs’ argument of justifiable or reasonable reliance on any advice given (or not given) by the bank in interpreting the instructions on the tax return.

 

The District Court in McBride held that the defendant had knowledge of his obligation to file FBAR reports for the foreign accounts, and failed to do so. Such knowledge can easily be imputed. Indeed the tax return speaks to such obligation and filing of Form TD F 90-22.1. Accordingly, McBride is charged with having reviewed his tax return and having understood that the federal income tax return asked if at any time during the tax year, he held any financial interest in any foreign bank or financial account. McBride's willfulness is supported by evidence of his false statements on his tax returns for both the 2000 and the 2001 tax years, and his signature, under penalty of perjury, that those statements were complete and accurate. Moreover,  McBride actually read the marketing and promotional materials provided to him by  the financial advisor who helped him carry out the scheme that under federal law he was required to report his interest in foreign banks and financial accounts. This led to the finding by Judge Nuffer that McBride “had actual knowledge of his duty to file an FBAR for any account in which he had a financial interest prior to filing his 2000 and 2001 tax returns. McBride even testified that "the purpose of Merrill Scott" was to avoid disclosure and reporting the existence of interests "because . . . if you disclose the accounts on the form, then you pay tax on them, so it went against what [he] set up Merrill Scott for in the first place.’ "

 

If that wasn’t enough, the Court also found McBride’s conduct reckless sufficient to rise to the level of willfull.  Continuing on, the Court stated that “’[A]n individual's actions may be deemed willful if the individual recklessly ignores the risk that conduct is illegal by failing to investigate whether the conduct is legal. Taxpayers have long been cautioned that they have a responsibility to "investigate claims when they are likely 'too good to be true.'" Pasternak v. Comm'r, 990 F.2d 893, 903 (6th Cir. 1993) .

 

The Court did not stop here but went further to block any escape route on appeal for the defendant. The effort of the Court to go over every path that leads to a finding to willfulness and precluding the presence of any path that would excuse the taxpayer-defendant was quite obvious.

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Last month the Supreme Court of Canada (SCC) rendered a unanimious decision in GlaxoSmith Kline, supra. The decision provides insights into the high court’s view that all relevant facts and circumstances must be taken into account in addition to the selection of the appropriate pricing model or method. While the Canadian version of our Section 482 has since be revised, Canadian commentators (lawyers) explain that the decision is expected to have “a major influence on the interpretation and application of Canada’s transfer pricing rules” involving non-arms-length parties. See Mirandola and Lindsay, “Canada's Glaxo Ruling Provides Transfer Pricing Guidance”, Tax Notes International, October 29, 2012 which provides a concise and thoughtful review of the case.  

 

Factual Background of the GlaxoSmithKline Decision

 

Over a four year period commencing in 1990, Glaxo Canada purchased an active ingredient in its well-known, anti-ulcer drug Zantac, from a related non-Canadian company at a price between C $1,512 per kilogram and C $1,651 per kilogram. There was evidence that this price was excessive and did not reflect an arms length price. More specifically, during the same period generic phara companies manufacturing in Canada purchased the same ingredient, i.e. “rantidine”, from unrelated parties for use in generic anti-ulcer drugs at nearly 5-7 times lower, i.e., C $194 per kilogram and C $304 per kilogram.  Glaxo Canada was reassessed under form ITA section 69(2) (present ITA section 247(2)).

 

There were two agreements that were directly relevant to the transfer pricing issue: (i) a Related Party Supply Agreement: Glaxo Canada purchased rantidine from Adechsa S.A., a related company located in Switzerland, under a supply agreement.  Glaxo Canada acquired the ranitidine, which was in effect already manufactured, put it into a delivery mechanism, and then packaged and marketed it as Zantac, a patented and trademarked drug; and (ii) Related Party License Agreement:  Glaxo Group Ltd. (Glaxo Group), another related company, owned the Zantac trademark and the patent for ranitidine. Glaxo Group granted rights under the patent and trademark to Glaxo Canada under a license agreement. The license agreement conferred other rights and benefits on Glaxo Canada, including: access to new products, the right to the supply of raw and bulk materials, marketing support, and technical support for setting up new product lines.

Glaxo Canada argued that the determination of the appropriate transfer price for ranitidine should be influenced by the rights and benefits conferred by the license agreement because it was inextricably linked to the supply agreement. The MNR argued that the appropriate transfer price should be determined on a transaction-by-transaction basis (that is, on the basis of the supply agreement, without regard to the license agreement).

 

Decision of the Tax Court of Canada in Glaxo Canada

 

The Tax Court of Canada held that the license agreement and the supply agreement must be considered independently from one another and that the rights and benefits to Glaxo Canada under the licensing agreement, per se, was not to be taken in determining the arm's-length price for the supply of ranitidine. In going about its work, the Tax Court used the “comparable uncontrolled price method” as the preferred transfer pricing methodology and accepted the highest price paid by the several generic pharmaceutical companies to arm's-length suppliers as introduced into evidence by counsel for the government as the relevant CUP. Aside from allowing a minor increment of C $25 per kilogram, the TCC affirmed the reassessment based on the substantially greater prices paid by the Canadian generic drug companies. Again, the Tax Court of Canada held that the licensing agreement was not relevant.

 

The Canadian Federal Court of Appeals Decision in Glaxo Canada

 

The Federal Court of Appeal held that the Tax Court of Canada had erred in refusing to consider the license agreement as a factor in the transfer pricing dispute. In granting the taxpayer’s request, it remitted the matter back to the Tax Court for redetermination of the "reasonable amount" payable for Glaxo Canada's ranitidine transactions. The MNR argued before the Federal Court of Appeal that the trial court 's approval of the assessment dimade no error of law (or fact) in its analysis. Glaxo Canada cross appealed contending that the case should not have been remitted back to the trial court and that the underlying proposed assessments should be rejected.

 

Decision of the Canadian Supreme Court

 

The Supreme Court of Canada  rejected the MNR’s appeal from the Federal Court of Appeal’s decision to remand by the Tax Court and further rejected Glaxo Canada’s cross-appeal to dismiss the assessment on the narrow thought that the Tax Court failure to consider the transfer pricing determination based on both the license and supply agreements meant its decision was flawed and was therefore “demolished”.

 

After reviewing the relevant statutory standards and the OECD transfer pricing guidelines for 1979 and 1995, which OECD guidelines the Court acknowledged were not binding on the Court but simploy were used as aides in its analysis, the Supreme Court first stated that there are a number of methods for resolving whether transfer prices are  consistent with prices determined between parties dealing at arm's length. There needs to be consideration by the trial court of what it referred to as the "economically relevant characteristics" of the arm's length and non-arm's length circumstances to ensure they are "sufficiently comparable." Where no related transactions are present or are not relevant, the Court stated that a  transaction-by-transaction approach may be appropriate. However, "economically relevant characteristics of the situations being compared" may make it necessary to consider other transactions that impact the transfer price under consideration.  The Supreme Court acknowledged that “other transactions” will include agreements that may confer rights and benefits in addition to the purchase of property where those agreements are linked to the purchasing agreement.

 

Therefore, “the objective is to determine what an arm's length purchaser would pay for the property and the rights and benefits together where the rights and benefits are linked to the price paid for the property. However, transfer pricing is not an exact science and it is highly unlikely that any comparisons will yield identical circumstances and the court will be required to exercise its best informed judgment in establishing a satisfactory arm's length price.”

 

The Supreme Court viewed that  Glaxo Canada was paying for certain rights and benefits under the License Agreement as part of the purchase prices for ranitidine from Adechsa. As such, the License Agreement was relevant and could not be discarded. Viewing both the license and the supply agreements as integrated both must be considered for transfer pricing purposes.  In this respect the Supreme Court opined that the Tax Court of Canada focused too narrowly on just what the prices paid by the generic pharma companies in Canada for rantidine as relevant in a transfer pricing case. Instead, it is only after identifying the circumstances arising from the License Agreement that are linked to the Supply Agreement that arm's length comparisons under any of the OECD methods or other methods may be determined.

 

On the other hand, the Glaxo Canada cross appeal motion to eliminate the assessment was addressed and summarily rejected.

 

The Supreme Court therefore agreed with the Federal Court of Appeal, that the matter be remitted to the Tax Court of Canada,  to be redetermined, having regard to the effect of the Licence Agreement on the prices paid by Glaxo Canada for the supply of ranitidine from Adechsa. Whether or not compensation for intellectual property rights is justified in this particular case, is a matter for determination by the Tax Court.

 

Remand Back to the Tax Court of Canada Affirmed

 

On remand, the Tax Court of Canada will have to take into account the royalty or licensing fees that Glaxo Canada under the License Agreement and its direct impact on the proper arms length standard assuming that the MNR and the taxpayer do not otherwise propose to settle the dispute without another trial. The Supreme Court noted that the separate agreements may have resulted in the effective conversion of a royalty. Subject to withholding, into a purchase price (no withholding required) and the consequential tax benefit that could affect the price an arm's-length party would pay.

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A district court in Arizona has rejected cross motions for summary judgement filed by the taxpayers and the government in a tax refund case involving the amount of basis that could be established with respect to "equity" type rights that a policyholder had in several life insurance policies issued by a mutual insurance company which was demutualized into a stock company. The taxpayers received cash for the "equity" rights.  The court rejected: (1) IRS's position that the trust had a zero basis in the stock, which would have caused it to have a large gain, and (2) the trust's position that it should be permitted to use the open transaction doctrine, which would have allowed it to report zero gain by treating past premium payments as basis in the stock. Bennett and Jacquelynn Dorrance v. United States, (DC AZ 7/9/2012) 110 AFTR 2d ¶ 2012-5067

In 1995, Plaintiffs formed a Trust, which presumably was a grantor trust for federal income tax purposes, that purchased five life insurance policies in 1996. The policies were purchased with 5 different insurances for coverage of close to $88M in scheduled death benefits. The trust was designed to implement the clients’ efforts to provide liquidity to pay Plaintiffs' estate taxes upon their death. All of the polices were purchased with mutual insurance companies where the policyholder, i.e., the Trust, had an “equity” type interest in the company in addition to owning the policy. This interest provides the policyholder with certain rights, including the right to vote on corporate decisions and the right to receive the mutual company's surplus should the company liquidate. Policyholders cannot sell the mutual rights separately from their underlying policies. Where a life insurance policy held with a mutual insurance company is terminated, the mutual rights are extinguished as well.

The five mutual life insurance companies for which policies were owned by the Trusts were demutualized over a 5 year period ending in 2001. In a demutualization,  a mutual life insurance company changes its corporate structure into that of a stock company, often through a procedure governed by state statute. Policyholders must vote to approve a demutualization before the process can proceed. Prior to seeking policyholder approval, at least one of the companies promised policyholders that if they voted for demutualization, premiums would not increase, and in fact none of the premiums Plaintiffs paid increased after demutualization.

From a federal income tax standpoint the demutualization process, in general, does not present the policyholder with a taxable event. In Rev. Rul. 2003-19, 2003-1 C.B. 468, the Service ruled that the conversion of a state mutual insurance company to a stock insurance company qualified as both a Type E recapitalization per §368(a)(1)(E) and a Type F reorganization under §368(a)(1)(F). Under Rev. Rul. 2003-19, supra, one scenario described that the mutual company members surrendered their membership interests in exchange for all of the stock company's voting common stock. In a second scenario, the mutual company formed a mutual holding company, which incorporated into a stock holding company. The mutual company's members received membership in and controlled the mutual holding company, which planned to maintain control of the stock holding company. The mutual holding company would then control the stock company. In a third situation, the mutual holding company owned all of the stock in the stock holding company, which owned all of the stock company. Each situation was determined to be a tax-free Type E and as a Type F reorganization. See also PLRs 954004, 9834019 and 9835009. Still, where the policyholder is paid cash for the release or conversion of their policy rights, the gain is treated as taxable “boot”.

Where mutual (life insurance) companies demutualized, the policyholders, e.g., the policyholders (including Plaintiffs) retained their policies and continued to pay premiums as previously prescribed. Their “equity” type rights were eliminated and the companies provided policyholders with the option of receiving stock in the new companies or receiving a cash payment in lieu of stock. When determining how much stock to give policyholders, the companies calculated a “fixed” component to correspond to policyholders' loss of voting rights, and a “variable” component designed to measure “the policyholders' contribution to the surplus of the company.” Although the companies used slightly different methods to measure their policyholders' contribution to the company's surplus, all obtained independent actuarial opinions that the methods were “fair and equitable.” See Tancredi v. Metropolitan Life Ins. Co., 149 F. Supp. 2d 80, 86–87 (S.D.N.Y. 2001).

In this case the stock the Trust  received during the demutualizations had a total value of $1,794,771. The Trust sold all the stock on June 23, 2003, for an aggregate price of $2,248,806. The Trust reported its stock basis in the mutual company stock at zero. Plaintiffs paid tax on the reported gain (for cash payments received) and then filed a claim for refund, and after denial of the claim by the Service, filed a tax refund suit in federal district court.  

The Service argued, in its motion for summary judgment, that no part of Plaintiffs' periodic payments for their original insurance policies was paid to acquire the mutual rights under the policy, and therefore all of the premium was paid to purchase the policies. This would result in a zero stock basis for the “equity” type rights so that any cash received was taxable as "boot". The Plaintiffs, in their motion for summary judgment, argued that the demutualization should be governed by the open transaction doctrine, which is employed in circumstances where the basis in property that is split cannot be allocated to the resulting assets. See Treas. Reg. § 1.1001-1(a). Burnet v. Logan, 283 US 404, 412 (1931) Under the “open transaction” approach, which the regulations provide should only be allowed in “rare and extraordinary” circumstances, all of the proceeds from Plaintiffs' sale of stock would be considered return of capital from their payment of insurance premiums, and therefore not taxable.  

Under FRCP 56(c), the trial court stated summary judgment is only appropriate where the evidence reflecting in the pleadings and supporting affidavits, interrogatories, depositions, documents produced during discovery, etc., viewed in the light most favorable to the nonmoving party, shows “that there is no genuine issue as to any material fact and that the movant is entitled to judgment as a matter of law.” Only disputes over facts that might affect the outcome of the suit will preclude the entry of summary judgment, and the disputed evidence must be “such that a reasonable jury could return a verdict for the nonmoving party.” Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248 (1986). “[A] party seeking summary judgment always bears the initial responsibility of informing the district court of the basis for its motion, and identifying those portions of [the record] which it believes demonstrate the absence of a genuine issue of material fact.” Celotex Corp. v. Catrett, 477 U.S. 317, 323 (1986).

The government argued that the Plaintiffs are not entitled to the refund based on its motion for summary judgment. Plaintiffs cited Fisher v. United States, 82 Fed. Cl. 780, 795 (Fed. Cl. 2008), aff’d w/o opin., 333 Fed. App’x 572 (2009), for support that as a matter of law the demutualization of a mutual insurance company is indeed one of the “rare and extraordinary” circumstances in which the open transaction doctrine should apply.

Thus, the question that needed to be addressed by the Court was whether summary judgment was appropriate, and if so, for which party. The issue was that of determining the Plaintsiffs’ stock basis in the demutualized stock. See §1012. The taxpayer has the burden of proof with respect to establishing basis. Coloman v. Commissioner, 540 F.2d 427 (9^th Cir. 1976). What is required, the Court opined, is that the taxpayer prove by objective evidence some investment into the property. Here, the problem was indeed the mutual insurance policy itself. The taxpayer could easily prove up the premiums paid, but what portion of the premiums paid were for “basis” or “cost” in the equity features of the various policies. Court such “cost” be estimated? See Cohan v. Commissioner, 39 F.3d 540 (2^nd Cir. 1930).  Indeed, the Ninth Circuit, to which an appeal in this case would lie, has shown a liberal attitude to granting a taxpayer basis even if the “cost” can not be demonstrated with exactitude. United States v. Marabelles, 724 F.3d 1374 (9^th Cir. 1984).

The Court rejected the government’s “zero basis” approach and therefore denied it its motion for summary judgment. Indeed, in the Court's eyes, something was in fact paid for the equity rights. The question therefore was how basis should be allocated among the two assets created, the life insurance rights as distinct from the equity or ownership rights,  when the companies demutualized. Again, the Plaintiffs received cash for their sale of equity rights in the mutual company.

After examining the “open transaction doctrine” emanating from Burnet v. Logan, supra, and its progeny, the District Court closely examined the Fisher, supra, case. In 2008, the Court of Federal Claims in Fisher, supra, applied the open transaction doctrine in a case where a taxpayer had received a cash payment in exchange for his mutual rights during the demutualization of a life insurance company. The government argued in Fisher the mutual rights had no value. Nevertheless, the Court of Federal Claims found for the taxpayer noting that “the ownership rights were, at the outset, inextricably tied to the underlying insurance policy and were not separately sellable.” It applied the open transaction doctrine, permitting the tax free recovery of basis to the extent of all premium payments he had made during the course of the policy as capital investment, and deferring any payment on the proceeds that the taxpayer had received in exchange for his rights. The Federal Circuit affirmed without opinion. Fisher v. United States, 333 Fed. Appx. 572 (2009). But see Cadrecha v. United States, ____Fed. Cl.__ (Fed. Cl. 4/2/2012) (declining to apply Fisher when the taxpayer's claim was untimely).  See Olsen, Chuck v. Goliath: Basis of Stock Received in Demutualization of Mutual Insurance Companies, 9 Hous. Bus. & Tax L.J. 360, 382–83 (2009); Galindo,Revisiting the “Open Transaction” Doctrine: Exploring Gain Potential and the Importance of Categorizing Amounts Realized , 63 Tax Lawyer 221, 234 (2009).

Despite Fisher, supra, the trial court was unpersuaded that “open transaction” reporting was appropriate, i.e., the Plaintiffs have failed to show that allocating basis between the mutual rights and the stock is so difficult that this case requires applying the open transactions doctrine. Despite the parties as to what Plaintiffs may have paid for their mutual rights, there is no question that at the time of demutualization, both the value of the stock and the market value of the policy itself could be calculated. Summary judgment for the Plaintiffs was also denied.

The Court was of the view that the facts particular at bar required rejection of the application of the open transaction doctrine. In Fisher, supra,  the plaintiff opted for the “cash election” upon demutualization, and thereby received an immediate payment in exchange for his mutual rights. Here, Plaintiffs received stock, held it for years, and sold it for $454,035 more than its market value at the time of demutualization. The open transactions doctrine would therefore allow Plaintiffs to apply this gain to basis accrued through policy payments made before mutualization, even though the increase in value took place entirely after the rights were split. At the same time, since the open transaction doctrine would not recognize any separate bases in the policy and the stock, policy payments made after the companies demutualized would increase the total basis towards which the stock sale would be applied, even though these payments were not made to obtain the mutual rights or the stock. Without engaging in further speculation on when the open transaction doctrine could apply, the trial court ruled that there was indeed value to the equity rights purchased for cash and that Treas. Reg. §1.61-6 applied. It found that the record did not convince it what method should be used to make such equitable apportionment. In rejecting therefore the Plaintiffs motion for summary judgment the case will proceed to trial unless the parties agree to the basis from which apportionment should be made and file a settlement document with the Court.

 

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In David E. Watson, P.C. v. Commissioner, 668 F.3d 1008 (8^th Cir. 2012), aff’g 757 F. Supp. 2d 877 (DC Iowa) the Eighth Circuit affirmed a federal district court of Iowa’s decision recharacterizing a substantial portion of dividend distributions made by an S corporation to its sole shareholder as wages for FICA purposes. Presumably, such characterization would control for purposes of withholding, FICA and would be required to be reported as compensation for services (“wages”) rendered.

 

Watson specialized in partnership taxation. After leaving his position and Ernst & Young, Watson obtained a 25% interest in an accounting firm located in West Des Moines, Iowa, known as Larson, Watson, Bartling & Eastman. At trial, Watson testified he received no salary when the firm first began operations because the entity did not have money to pay him. Eventually, one partner exited and the firm added a new partner, reemerging as Larson, Watson, Bartling & Juffer, LLP (LWBJ). In 1996, Watson incorporated David E. Watson, P.C. Watson (DEWPC) transferred his individual 25% interest in LWBJ to DEWPC, and thereafter DEWPC replaced Watson as a partner in LWBJ. Watson served as DEWPC's sole officer, shareholder, director, and employee. Through an employment agreement, DEWPC employed Watson, but Watson exclusively provided his accounting services to LWBJ for the period relevant to this dispute. From its inception, DEWPC elected to be taxed as an S Corporation.

 

In both 2002 and 2003, DEWPC distributed $24,000 to Watson as employment compensation. Watson testified that the LWBJ partners made the determination that LWBJ had sufficient cash flow where it could distribute $2,000 a month to each partner, regardless of the seasonality of the business. There were no documents reflecting these salary discussions, and no other LWBJ partner testified at trial. Ultimately, DEWPC is the entity that authorized and paid Watson's salary. In addition to salary, Watson, through DEWPC, received $203,651 from LWBJ as profit distributions for 2002. In 2003, Watson, through DEWPC, received $175,470 as profit distributions from LWBJ. Thus, in 2002 and 2003, after DEWPC paid Watson's salary and other expenses, it distributed all remaining cash to Watson as dividends.

 

The IRS, in examining DEWPC, determined that it underpaid certain employment taxes pursuant to FICA, see I.R.C. §§ 3111(a), (b), in 2002 and 2003. The IRS assessed additional tax and penalties against DEWPC for the eight quarters covering 2002 and 2003. On April 14, 2007, DEWPC paid the delinquent tax, penalty, and interest for the fourth quarter of 2002  and sought a refund from the IRS. The IRS denied DEWPC's refund claim, and DEWPC then sued the United States in district court. The United States counterclaimed, seeking to recover employment taxes, penalties, and interest that remained unpaid for 2002 and 2003.

 

Federal District Court of Iowa’s Decision in Favor of Service

 

After denying DEWPC's motion for summary judgment, the district court held a bench trial on the merits. At trial, the government's expert, Igor Ostrovsky, opined that the market value of Watson's accounting services was approximately $91,044 per year for 2002 and 2003. Ostrovsky is a general engineer with the IRS and has worked on approximately 20 to 30 cases involving reasonable compensation issues. In forming his opinion as to Watson's salary, Ostrovsky relied on several compensation surveys and studies particular to accountants. Primarily, Ostrovsky focused on the Management of an Accounting Practice (MAP) survey conducted by the American Institute of Certified Public Accountants, which contained adjustments for specific regions. Ostrovsky discovered that an owner–defined as an investor and an employee–in a firm the size of LWBJ would receive approximately $176,000 annually, which reflected both compensation and return on investment. Ostrovsky also discovered that a director–an employee with no investment interest–would receive approximately $70,000 in compensation alone. Because owners billed at rates 33% higher than directors, and because Ostrovsky viewed Watson as a de facto partner of LWBJ, Ostrovsky increased the director compensation by 33% to arrive at owner compensation or $93,000. Ostrovsky then made a downward adjustment to $91,044, accounting for untaxable fringe benefits. In reaching his conclusion, Ostrovsky used average billing rates rather than Watson's actual billing rates.

 

Ultimately, the district court adopted Ostrovsky's opinion and determined that the reasonable amount of Watson's remuneration for services performed totaled $91,044. Therefore, the district court rendered a tax deficiency judgment against DEWPC, which included unpaid employment taxes, penalties, and interest in the amount of $23,431.23. DEWPC appealed to the Eighth Circuit.

 

Eighth Circuit Affirms Federal District Court’s Holding In Favor of IRS

 

The Eighth Circuit did not have a difficult time affirming the trial court’s decision. It first cited the Seventh Circuit’s decision in Joseph Radtke, S.C. v. United States, 895 F2. 1196, 1197 (1990) as the leading authority in resolving the FICA issue presented for appeal as to “whether, based on the statutes and unusual facts involved, the payments at issue were made to [Watson] as remuneration for services performed.”It then cited its own precedent in Schneider.  Where, as here, “the corporation is controlled by the very employees to whom the compensation is paid, special scrutiny must be given to such salaries, for there is a lack of arm's length bargaining.” Charles Schneider & Co. v. Commissioner, 500 F.2d 148, 152 (8th Cir. 1974). Ultimately, whether payments to a shareholder “represent compensation for services or constitute a distribution of profits is essentially the determination of a matter purely of fact.” Standard Asbestos Mfg. & Insulating Co. v. Commissioner, 276 F.2d 289, 294 (8th Cir. 1960) (internal quotation omitted).

 

When it determined the amount that constituted remuneration for employment, the district court required DEWPC to prove it paid Watson reasonable compensation, which DEWPC claims was error. According to DEWPC, because the district court allegedly applied an incorrect legal standard, it incorrectly found that $91,044 constituted Watson's wages in 2002 and 2003. To buttress this argument, DEWPC repeatedly asserted that there is no statute, regulation, or rule requiring an employer to pay minimum compensation. And, by requiring proof of reasonable compensation, DEWPC argues, the district court imposed a minimum compensation requirement. Rather than looking to whether compensation was reasonable, DEWPC contends that the district court should have focused on taxpayer intent when characterizing the payments.

 

The Eighth Circuit viewed that the trial court had the right to determine to what extent was what Watson received from DEWPC was “reasonable compensation” for §162(a) purposes which is determined in this Circuit by a  factors test . In applying the factors, the district court found the value of Watson's services was $91,044 for 2002 and 2003.

 

Although reasonable compensation is usually an issue found in the context of an income tax deduction, the IRS finds the concept equally applicable to FICA tax cases. In Revenue Ruling 74-44, 1974-1 C.B. 287, an S corporation distributed dividends to its two sole shareholder-employees but did not pay any wages for their services. The IRS took the position that it could recharacterize the nature of “dividend” payments for FICA tax purposes because “the “dividends” paid to the shareholders ... were in lieu of reasonable compensation for their services.” Id. (emphasis added). Notwithstanding Revenue Ruling 74-44, we have not had the opportunity to decide whether a reasonableness analysis is appropriate in determining if certain payments are in fact remuneration for employment subject to FICA tax.

 

In Joseph Radtke, S.C. v. United States, 712 F. Supp. 143, 144, (E.D. Wis. 1989), aff'd per curiam, 895 F.2d 1196 (7th Cir. 1990), the taxpayer-S corporation made dividend distributions to its only shareholder-employee but did not pay him any salary. Because the shareholder-employee also served as the corporation's only director, who authorized the dividend payment, the district court applied a substance-over-form analysis and determined the employee's ““dividends” were in fact “wages” subject to FICA ... taxation.” On appeal, the Seventh Circuit affirmed, concluding that the payments “were clearly remuneration for services performed by [the shareholder-employee].” Joseph Radtke, S.C., 895 F.2d at 1197.

 

Other courts addressing similar FICA characterization cases have looked a the economic substance of the transaction rather than the form chosen by the taxpayer. See, e.g., Veterinary Surgical Consultants, P.C. v. Commissioner, 117 T.C. 141, 145–46 (2001) (characterization of payments as corporate distribution of net income “is but a subterfuge for reality”), aff'd sub nom., Yeagle Drywall Co. v. Commissioner, 54 F. App'x 100 (3d Cir. 2002); Spicer Accounting, Inc. v. United States, 918 F.2d 90, 93 (9th Cir. 1990) (finding that “intention of receiving the payments as dividends has no bearing on the tax treatment of these wages”). See Boulware v. United States, 552 U.S. 421, 430 (2008), and one the applicable Treasury Regulations seem to compel in this case, and Treas. Regs. §§ 31.3121(a)-1(c) to (e).  Stated somewhat differently, by looking at compensation paid (or omitted) for its reasonableness can be a guide in deciding how to characterize payments for FICA purposes. See Joly v. Comm'r, 76 T.C.M. (CCH) 633, 1998 (1998) (rejecting claim that compensation was reasonable and finding that amount did “not reflect the true character of such payments”), aff'd, 211 F.3d 1269 (6th Cir. 2000) (unpublished table decision).

 

Here, the finding made by the trial court was proper. DEWPC had understated wage payments to Watson by $67,044 based on certain findings: (i) Watson was an exceedingly qualified accountant with an advanced degree and nearly 20 years experience in accounting and taxation; (ii) he worked 35–45 hours per week as one of the primary earners in a reputable firm, which had earnings much greater than comparable firms; (iii) LWBJ had gross earnings over $2 million in 2002 and nearly $3 million in 2003; (iv) $24,000 is unreasonably low compared to other similarly situated accountants; (v) given the financial position of LWBJ, Watson's experience, and his contributions to LWBJ, a $24,000 salary was exceedingly low when compared to the roughly $200,000 LWBJ distributed to DEWPC in 2002 and 2003; and (vi) the fair market value of Watson's services was $91,044. Based on the record, the district court did not clearly err.

 

Still, Watson had not given up. He argued that instead of focusing on the reasonableness of the compensation, the trial court should have focused on DEWPC’s intent. See Treas. Reg. §1.162-7(a). Taxpayer intent, like reasonableness, is usually part of a § 162(a)(1) compensation deduction analysis, although less commonly employed. See O.S.C. & Assocs. v. Commissioner, 187 F.3d 1116, (9th Cir. 1999). Under §162(a)(1), a deduction may be made if salary is both (1) “reasonable” and (2) “in fact payments purely for services.” Treas. Reg. § 1.162-7(a).

 

In response, the opinion issued by the Court noted that the Ninth Circuit views this as a two-pronged test, the second prong of which requires proof of a “compensatory purpose.” Elliotts, Inc. v. Commissioner, 716 F.2d 1241, 1243 (9th Cir. 1983). Usually, courts only need to examine the first prong, i.e., whether compensation was reasonable. Indeed, “[t]he inquiry into reasonableness is a broad one and will, in effect, subsume the inquiry into compensatory intent in most cases.” Id. at 1245. However “[i]n the rare case where there is evidence that an otherwise reasonable compensation payment contains a disguised dividend, the inquiry may expand into compensatory intent apart from reasonableness.” Id. at 1244. This “intent is subjective and difficult to prove.” O.S.C. & Assocs., 187 F.3d at 1120.

 

Finally, DEWPC  argued the Tax Court Memorandum decision in Pediatric Surgical Assocs., P.C. v. Commissioner, 81 T.C.M. (CCH) 1474, 2001 (2001), to illustrate that intent is the determining factor for characterization purposes. Pediatric Surgical Assocs., P.C., involved a § 162(a)(1) compensation deduction where reasonableness was not at issue. The Eighth Circuit rejected the intent test and felt the factual setting for that decision was different from the one at bar, …. Pediatric Surgical Assocs., P.C., was a “rare case where there is evidence that an otherwise reasonable compensation payment contains a disguised dividend.” Elliotts, Inc., supra, 716 F.2d at 1243. However, even if intent does control, after evaluating all the evidence, the district court specifically found “Watson's assertion that DEWPC “intended” to pay Watson a mere $24,000 in compensation for the tax years 2002 and 2003 to be less than credible.” DEWPC further argues that if the district court applied the principles of Pediatric Surgical Assocs., P.C., it would have limited the amount it characterized as wages to the amount of revenue each shareholder-employee personally generated, less expenses.

 

In this case, like Pediatric Surgical Assocs., P.C., non-shareholder-employees also contributed to LWBJ's earnings. Thus, determining Watson's compensation is more complicated than if Watson had served as the only employee generating income for LWBJ. Compare Veterinary Surgical Consultants, P.C., 117 T.C. at 145 (determining that distributions of corporate net income to sole shareholder-employee were wages); see also Walter D. Schwidetzky, Integrating Subchapters K and S–Just Do It, 62 Tax Law. 749, 799 (2009) (opining that in a pure services S corporation with a sole practitioner, nearly all of the corporation's income may likely be treated as remuneration for employment under FICA).

 

Therefore, as noted earlier, since the district court applied the correct legal standard, the Eighth Circuit affirmed its determination of Watson's FICA wages.

 

Comment

The government has been very successful in applying its long standing ruling to impute “wages” for shareholder-employees of an S corporation whom it may believe underreport the value of their services rendered to reduce payroll taxes, including HI tax, to the government. With this new “win” it should be expected that the Service will press on and attack “low service” income personal service S corporations where the facts under review lend themselves to this type of argument. Tax advisors should continue to look at Rev. Rul. 74-44 and the case law which follows its holding on imputing "wages" to shareholder-employees of S corporations.

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In a recently issued Tax Court Memorandum decision written by Judge Holmes the taxpayers were denied charitable deductions for millions of dollars in value of real property which they contributed by donation in 2003 and 2004 for the benefit of three charities as remaindermen of a charitable remainder unitrust. The taxpayers were denied any deduction on the basis that they failed to meet the substantiation and qualified appraiser requirements under the regulations to §170(a) with respect to each contribution of property made during such years. 

 

Charitable Contribution Deductions for Transfers of Property to Charitable Trusts

 

Section 170 allows an individual or other taxpayer to claim a charitable contribution deduction for a contribution or gift made “to or for the use of” a charitable or educational organization for the fair market value of the property gifted subject to applicable limitations.  For donations to a qualifying charitable remainder unitrust or CRUT. See §§ 170(f)(2)(A), 2055(e)(2), 2522(c)(2).  

 

For federal income tax purposes,  a taxpayer can claim an immediate deduction for a portion of the value of property settled in a split-interest trust, with respect to the value of the portion irrevocably contributed to the trust for the charity's benefit. Under a charitable remainder annuity trust or CRAT, the annual distribution must be a sum certain that is not less than 5% or more than 50%of the initial net fair market value of the property placed in trust. § 664(d)(2)(A). Under a charitable remainder unitrust or CRUT, the required distribution must be a fixed percentage, not less than 5% or more than 50%t, of the net fair market value of the trust assets, valued annually. A second type of CRUT, an “income only” unitrust,  limits the annual payout to the trust's income for the year but may provide for a shortfall for any year to be made up from excess income in later years. §664(d)(3). For donations to a qualifying CRUT, a taxpayer can claim an immediate deduction for a portion of the value of property settled in a trust, the income of which goes to the donor for life or for a term not to exceed 20 years with the remainder to charity.

 

Substantiation Requirements; Qualified Apraiser Rules

 

In 2003 and 2004, when the donations at issue were made, the regulations imposed strict requirements for substantiating charitable deductions greater than $5,000. Under Treas. Reg. § 1.170A-13(c)(2), the donor had to: (i) obtain a qualified appraisal (see below) for the property contributed; (ii) attach a fully completed appraisal summary to the tax return on which the deduction was claimed; and (iii) maintain records relating to the claimed deduction. The qualified appraisal had to be made no more than 60 days before the date of the transfer by gift and no later than the due date of the return, had to be signed by a qualified appraiser, had to include specific information (e.g., description of the property), and couldn't involve a prohibited fee. The appraiser couldn't be the donor, the taxpayer claiming the deduction, or the donee of the property. Treas. Reg. § 1.170A-13(c)(5)(iv). (emphasis added)

 

The Mohamed’s Charitable Donations of Real Property to a CRUT

 

 

Mr. Mohamed, the Petitioner,  is a real-estate broker and appraiser who lives in Sacramento, California. In 1998, he and his wife formed a charitable remainder unitrust or CRUT, which allowed the taxpayers to claim an immediate deduction under §170 for a portion of the value of the property transferred to the CRUT for the value of the remainder interest passing to charity. The donors reserved an unitrust payout (fraction of FMV) to be made each year for up to 20 years. The charitable remaindermen were the Shriners Hospitals for Children, the Sacramento Food Bank & Family Services, and the Pacific Legal Foundation.

 

Five years later in 2003 (and 2004) the couple donated five properties worth millions of dollars to the CRUT which were in the Sacramento area. Mr. Mohamed  filled out the 2003 tax return himself, including the Form 8283, Noncash Charitable Contributions. At trial, he admitted he did not read the instructions before completing the form which requires specific information about the donated property a in this instance, copy of a complete and signed appraisal.The instruction form related to contributions of art and not real estate.

 

The taxpayer, reporting the donations of the 5 parcels used his own appraisal for the properties which he claimed had an aggregate value of $14,873,921. He didn't report his basis, but stated that he had bought all the properties in the 1970s and 1980s. The contribution deductions claimed on the 2003 return for the real property was approximately $3.67M. He left blank the Declaration of Appraiser because it stated, “I declare that I am not the donor, the donee, a party to the transaction,” and Joseph recognized that he was the donor (and the donee, since he was trustee of the Trust). But he did sign the Donee Acknowledgment saying that the Trust was a qualified organization under section 170(c) (governing which organizations qualify as charities) and that the Trust had actually received the claimed donations.  He provided the addresses of the properties transferred and detailed descriptions of their value. Mr. Mohammed signed the return schedule indicating that he was the “Real Estate Broker/Appriaser”. He was conscious of not overvaluing the property donated.

In 2004 the Mohameds donated a shopping center near Sacramento to the CRUT and Joseph Mohammed again  filled out the 2004 return and once more acknowledge he did not read the instructions to Form 8283 (charitable donations). On his 2004 Form 8283, Joseph wrote the address of the shopping mall and valued it at $2 million. He wrote “statement attached” in the boxes marked “Date acquired by donor” and “How acquired by donor,” but left blank the box where he should have written his basis. He claimed a $488,040 deduction for 2004. He again didn't sign the declaration, but did sign the donee acknowledgment on behalf of the Trust. Other information was provided but the taxpayer’s statement gave no specific appraisal information, and he did not sign it.

 

Mr. Mohamed prepared another statement for the shopping center that looked much like the one he attached to his 2003 return. This one listed the income and expenses from the shopping center and used a 6.5% “cap rate” to compute a market value of $2,642,190.62. Joseph signed this statement, but listed his job title as “Owner and Licensed Real Estate Broker.” Joseph says he attached this to his 2004 tax return, but the Commissioner says he didn't get it until sometime in 2006 after the audit.

 

IRS Audit and Challenge to the Reported Charitable Contribution Deductions

 

Commencing an audit for the 2003 return two years later, the Service was critical of the taxpayer’s self-appraisal of valuable real estate for which sizeable charitable contribution deductions were claimed. In response, the taxpayers hired an independent appraiser for valuing the contributed real estate. The Court noted that the independent appraisals were similar, but not identical, in value  to values reported by the taxpayers. 

         .

Regardless of the relative consistency of the appraisals between the independent appraiser and Mr. Mohammed’s “opinions”, the Service believe the Mohameds still overstated the values of the properties. In addition, the Service argued that the taxpayers had made several mistakes in filing their charitable deduction disclosures (Forms 8283) for 2003 and 2004, and amended the answer to the Petition to disallow the Mohameds any charitable deduction and moved for partial summary judgment under T.C. Rule 121(b). See Fla. Country Clubs, Inc. v. Comm’r, 122 T.C. 73, 76 (2004), aff’d, 404 F.3d, 1291 (11^th Cir. 2005). 

 

Tax Court Agrees With Commissioner and Grants Respondent IRS’ Motions For Partial Summary Judgment

In starting, Judge Holmes noted the extensive substantiation requirements for charitable contribution deductions in excess of $5,000 contained in Treas. Reg. §1.170A-13(c). See also §170(a)(1). In Treas. Reg. §1.170A-13(c)(2)(i) there are, in general, three specific substantiation requirements: (a) submission of a “qualified appraisal” for the property contributed; (b) attach an appraisal summary on the tax return on which the deduction for the contribution is first reported or claimed; and (b) maintain required records set forth in Tres. Reg. §1.170A-13(b)(2)(ii).

On the first requirement of a “qualified appraisal”, it must be made no more than 60 days before the gift and no later than the due date of the return, must be signed by a qualified appraiser, must include specific information (such as a description of the property and certain disclosures by the appraiser), and must not involve a prohibited fee. Treas. Reg. §1.170A- 13(c)(3)(i). Quite important to this case is that the donor or taxpayer claiming the deduction or the donee of the property cannot be the “qualified appraiser”. Treas. Reg. §§1.170A-13(c)(5)(iv)(A), (C). It is unequivocally clear in this case that the donor-taxpayer was not eligible to be the qualified appraiser. He was also ineligible as trustee of the CRUT. Moreover, for the same and added reasons,  the information as to the value for the various properties did not meet the requirements of an “appraisal summary”.Treas. Reg. §1.170A-13(c)(4). Thus, material information concerning the contributions, as required by the regulations was lacking. The taxpayer did not follow the regulations, i.e., "[H]is appraisals weren't qualified because he did them himself, his attached statements weren't appraisal summaries, and his untimely independent appraisals came too late to be either qualified appraisals or remedial appraisal summaries. This means the Commissioner has to win unless we hold that the regulations are invalid, or unless we find that Joseph [Mohamed]  has raised a genuine dispute that he substantially complied with the regulations, or we find some legal merit in the peculiar problems that he points to in the appraisal form itself.”

The Court found the substantiation and qualified appraiser rules contained in the regulations where valid. Indeed, under §170(a)(1), “A charitable contribution shall be allowable as a deduction only if verified under regulations prescribed by the Secretary”. See also Deficit Reduction Act of 1984, P.L. 98-369, §155. This express delegation of authority to the Treasury and the Service to create rules by regulation  about how a donation is to be verified is entitled to great deference. See Chevron, U.S.A., Inc. v. Natural Res. Def. Council, 467 U.S. 837, 843-44 (1984); Mayo Found. for Med. Educ. & Research v. United States, 131 S. Ct. 704, 714 (2011). The requirements violated here were found by the Court are not “are arbitrary, capricious, or manifestly contrary to the statute.”

The taxpayers argued further that even if the regulation is valid, and granted they did not strictly comply with the regulation, they should be granted the charitable deductions since they were in substantial compliance” citing Bond v. Comm’r, 100 T.C. 32 (1993). But the Court noted that the “substantial compliance” argument under this regulation had, in more recent cases, been rejected by the Court. Todd v. Comm’r, 118 T.C. 334, 336, 347 (2002); Hewitt, 109 T.C. at 260, 264; Jorgenson v. Comm’r, T.C. Memo. 2000-38; Smith v. Comm’r, T.C. Memo. 2007-368, aff'd, 104 AFTR 2d 2009-7830 (9th Cir. 2009).  The Court ruled that based on §170(a)(1), as amplified by DEFRA §155, as well as the case law, substantial compliance requires a qualified appraisal. The Court then proceeded to look at the reporting of the values for each of the gifted properties and found that each was defective from a compliance standpoint. The Court then ruled that the government’s motions for summary judgment were granted and the charitable contributions disallowed in full for 2003 or 2004. The Court was, should we say, “sympathetically, unsympathetic” as to the taxpayers’ loss when it closed by stating:

“We recognize that this result is harsh—a complete denial of charitable deductions to a couple that did not overvalue, and may well have undervalued ,their contributions—all reported on forms that even to the Court's eyes seemed likely to mislead someone who didn't read the instructions. But the problems of misvalued property are so great that Congress was quite specific about what the charitably inclined have to do to defend their deductions, and we cannot in a single sympathetic case undermine those rules. “

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The Third Circuit, in partially reversing the Tax Court, in DeNaples v. Commissioner, 109 AFTR 2d 2012-1419 in a three judge panel opinion filed on March 19, 2012,  held that two couples were in receipt of tax-exempt interest income under §103 with respect to installment payments made under an out-of-court settlement agreement with the State of Pennsylvania that arose out of an eminent domain proceeding.  The holding that the amount of stated interest representing “delay damages” was not within §103, which was also determined by the Tax Court, was affirmed by the Third Circuit based on the taxpayers’ failure to meet its required burden of proof.

 

Code Section 103 (26 U.S.C.)

 

 

Section 103(a) of the Internal Revenue Code holds in relevant part: “gross income does not include interest on any State or local bond.” A “State or local bond” is defined in §103(c)(1) as “an obligation of a State or political subdivision thereof.” Since the inception of the Code in 1913, interest on obligations of states and their political subdivisions has been excluded from the interest recpient’s gross income. The rationale for the exclusion was to avoid a perceived unconstitutional burden on the borrowing power of state and local governments Drew v. United States, 551 F.2d 85, 87 (5th Cir. 1977); Holley v. United States, 124 F.2d 909, 911 (6th Cir. 1942).  As a tax exemption, which is true of any rule of income exclusion contained in the Code, the Courts have universally required the scope of the exclusion be narrowly construed. See, e.g., In re Hechinger Inv. Co. of Delaware, Inc., 335 F.3d 243, 259 (3d Cir. 2003) .

 

Factual Background in DeNaples v. Commissioner

 

The taxpayers, Dominick,Louis, Betty and Mary Ann DeNaples, through their ownership in several pass through entities, owned several parcels of  real property in Pennsylvania that was condemned by the Pennsylvania Department of Transportation (DOT) to facilitate the construction of the Lackawanna Valley Industrial Highway. In 1993 and 1994, to permit construction to go forward, the State and the DeNaples entered into two rights of entry, which permitted the State to enter onto the land but did not alter the DeNaples' entitlement to just compensation. In 1998, the State initiated condemnation proceedings against the properties in the Pennsylvania Court of Common Pleas by filing a Declaration of Taking pursuant to former 26 Pa. Stat. § 1-402(a). The DeNaples objected, contending that the declaration did not adequately describe the property. The court agreed and dismissed some of the suits. On the remaining suits, a jury trial was commenced and then stayed when the parties indicated that they had settled.

 

On November 7, 2001, the parties signed a memorandum of intent to settle. The DeNaples agreed that, in exchange for all their ownership interest in all the parcels of land, they would receive compensation of approximately $40,900,000, of which $24,600,000 was allocated to principal, and $16,300,000 was allocated to interest (“settlement interest”). The condemnation proceeding record omitted how the allocation between principal and interest was determined and did not incorporate the settlement agreement. Instead the parties moved to dismiss the proceeding.

 

Payment was to be made in five annual payments, with the first payment of $8,100,000 plus accrued interest due by March 1, 2002, and the remaining four payments of $8,200,000 plus accrued interest due by March 1, 2003, 2004, 2005, and 2006. Interest accrued annually on the unpaid settlement amount at the rate set by (former) rule 238 of the Pennsylvania Rules of Civil Procedure (Pa. R. Civ. P. 238)(“interest on deferred payment amounts”).

 

The DOT paid the DeNaples each $10,111,193 in 2003, $9,289,353 in 2004, and $17,739,276 in 2005. The obligation was discharged in full a year earlier than required. On their 2003 through 2005 federal income tax returns, each taxpayer reported taxable interest income of $545,664, $545,664, and $1,091,328, respectively, and excluded from gross income $2,040,054, $1,629,134, and $2,838,545, respectively, as tax-exempt interest under §103 of the Code. More specifically, as to the settlement interest income, the DeNaples received approximately $4,300,000 for 2002 through 2004 and $8,700,000 for 2005. They excluded from gross income under §103 any interest received above 6% (the stated rate under former Pa. R. Civ. P. 238 on the stated interest amount of $16,700,000. As to the “interest on deferred payments”, the DeNaples excluded all of such interest income in computing gross income again based on Section 103.

 

The IRS, upon audit and review of the DeNaples returns for the years 2003 thru 2005, disagreed with the tax-exempt interest positions taken on the returns and issued a statutory notice of deficiency for $2,300,000 in underpayments in income tax against each couple for the years 2003 through 2005, comprised of $714,019 for 2003, $587,257 for 2004, and $1,023,299 for 2005.

 

Tax Court Memorandum Decision Issued by Judge Nims

 

 

After the case was fully stipulated and briefed before the Court, the Tax Court sided with the government and held that no part  of the “settlement interest” or “interest on deferred payments” was excludable from gross income as tax-exempt interest under Section 103. See DeNaples v. Comm’r, T.C. Memo. 2010-171.

 

As to the “settlement interest”, the Tax Court concluded that the DeNaples had failed to demonstrate that they received interest income above and beyond what was legally required and therefore the settlement interest was not an obligation of the State described within §103  because it did not invoke the State's borrowing authority. It also found that the stated allocation to interest was excessive, i.e., the ratio of interest to principal approached 40%.

 

As to the “interest on deferred payments”,  Judge Nims held again that no amount was excludable under §103 finding that the DeNaples were entitled to be compensated for agreeing to receive the settlement payments in installments where the "interest" on the deferred payments was  part of their right to just compensation. Accordingly, the Tax Court entered an order affirming the IRS' deficiency calculations in full.

 

The DeNaples’ then filed a  motion for reconsideration which was denied.  Tax Court refused to reopen the record to allow the taxpayers to introduce evidence of the prevailing commercial rate of interest as proof that a portion of the settlement interest was excludable from gross income. It held that to recompute the deficiencies in tax for each year as part of a Rule 155 computation would inappropriately allow the taxpayers to introduce evidence that it failed to produce at trial.  The Tax Court found that the DeNaples had therefore failed to meet their burden of proof that the deficiency was inaccurate with respect to the “interest on deferred payments”. T.C. Memo. 2011-46 (2011).

 

The taxpayers filed an appeal to the Third Circuit, which heard the case de novo as to the Tax Court’s findings of law and the construction and application of the Internal Revenue Code and under the clear error standard for factual findings and inferences drawn therefrom.  PNC Bancorp, Inc. v. Comm'r, 212 F.3d 822, 827 (3d Cir. 2000)

 

The Third Circuit Court of Appeals Reverses In Part the Tax Court Memorandum Decision

 

The Third Circuit reversed in part and affirmed in part the lower court’s decision.

 

In reviewing applicable precedent in the area, the Third Circuit noted its reliance on a long-standing Supreme Court decision in Helvering v. Stockholms Enskilda Bank, 293 U.S. 84, 86-87,  which requires for purposes of §103,  an “obligation” of a state or local government should not be “extended to include interest upon indebtedness not incurred under the borrowing power”.  Where, however, the state or local governmental authority’s borrowing power is the source for the obligation to pay interest, then interest on the underlying indebtedness falls within the exemption. In contrast, where, for example,  a state’s obligation to pay interest arises by operation of law, the state’s borrowing power is not implicated and §103 is unavailable. Where the state’s obligation to pay interest is part of a voluntary negotiation, howeer, its obligation to pay interest does find as its source the state’s borrowing authority and may be excludable §103.

 

After laying out the ground rules for determining whether interest paid by a state or governmental body as part of a settlement of an eminent domain proceeding falls within §103, the Third Circuit focused on  Pennsylvania law on eminent domain proceedings. It observed, that in many instances, the state’s obligation to pay interest in a condemnation proceeding arises by operation of law. This occurs where the state delays in making payment of the just compensation amount which entitles the condemnee to interest by operation of law.  Hughes v. Dep’t of Transportation, 523 A.2d 747, 753 (1983)(where owner can prove under former law that the statutory 6% rate is insufficient, a higher rate of interest on delayed condemnation payments may be established as part of just compensation award). See Wasserott v. PennDOT, 13 Pa. D. & C. 4^th 593, 595 (Ct. Com. Pl. 1991). In Hughes, supra, the Supreme Court of Pennsylvania ruled, aligning itself with a majority of jurisdictions, that “ if the property owner produces evidence that the 6% rate is constitutionally insufficient, he should be entitled to a higher rate of return as just compensation”.  Where interest is owed by the condemning authority by operation of law, the interest is not excludable under §103. See 26 Pa. Cons. Stat. §713 (2006)(interest rate for delay damages changed to prime plus 1%).

 

            Interest on Deferred Payments

 

Resolving the question of whether §103 applied to interest on deferred payments received by the DeNaples would turn, in the view of the Third Circuit, on whether the DOT’s interest obligation arose by operation of law or was solely the product of voluntary bargaining. The record below established that the DOT and the DeNaples negotiated a complete arms-length settlement of Pennsylvania's claims. The DeNaples agreed, as part of the out-of-court settlement agreement, to receive a lower, variable interest rate for the purpose of extending credit to Pennsylvania and not a higher rate that would have applied under then statutory rule. Therefore, interest on the deferred payments under the facts of the case met the requirements under §103. This portion of the Tax Court’s decision was reversed. The Third Circuit noted that the same analysis was essentially adopted by the Ninth Circuit in Stewart v. United States, 739 F.2d 411, 414 (9th Cir. 1984).

 

In elaborating on its voluntary negotiation rationale, the Third Circuit looked at the DeNaples and the DOT as having entered into an arms-length settlement agreement, albeit in the “shadow of the ongoing condemnation proceeding with its attendant rights and obligations, including the DeNaples' right to interest for any payment delay.” However, the taxpayers agreed to a rate of interest on deferred payments as part of the bargain and that bargain implicated the State of Pennsylvania’s borrowing authority. Thus, the interest paid on the deferred payments was not part of a judicial award of just compensation which would fall outside of  §103. In this case the State's obligation to pay interest at a fixed rate did not arise by operation of law but instead by a  “freely-negotiated contract that contemplated no further judicial intervention.”  

 

In distinguishing the case at bar from the government’s reliance on the Sixth Circuit’s decision in Holley v. United States, supra, the Third Circuit noted that in Holley a settlement agreement between the condemning authority and the condemnee was part of the court’s order or award whereas in this case DeNaples and Pennsylvania agreed to a total settlement which extinguished the condemnation proceeding. No court award of “interest” was made as the condemnation proceeding was “settled, discontinued and ended”. The Third Circuit viewed that this difference was critical to its reaching its conclusion. A quote from the Court’s opinion drives home this distinction:

 

“ To be clear, we do not hold that any interest payment made pursuant to a voluntary settlement agreement is automatically excludable under Section 103. Rather, it is excludable here because, given the nature of how and what the parties agreed to in the settlement agreement, it is clear that the obligation to pay interest at the Rule 238 rate arose not by operation of law but through the voluntary, arms-length negotiations between the DeNaples and Pennsylvania.”

 

Settlement Interest

 

The Tax Court’s holding on the “settlement interest” of $14,000,000 stated in the settlement agreement as not constituting tax exempt interest was affirmed. The Third Circuit also held that the Tax Court did not err when it refused to reopen the record by rejecting the taxpayers’ motion for reconsideration to receive evidence about the prevailing commercial loan rate.

 

The taxpayers argument was that the “settlement interest” agreed to by the parties compensated them for the delay between the time of the initial right of entry and the entering into the settlement agreement. Based on the former Rule 238's reference to a  6% rate under Pennsylvania law which Rule was applicable at the time, the DeNaples excluded from their gross income only the delay interest in excess of 6%. The taxpayers viewed that since the 6% rate was required by law for delay payments, interest above 6% was the product of voluntary bargaining.  

 

The Third Circuit agreed with Judge Nims’ opinion on this issue on several grounds. First, it agreed with the fact finding that the allocation made by the parties between interest and principal was arbitrary and excessive. Second, it rejected the taxpayers efforts in its motion for reconsideration to recalculate what the proper amount of interest would be based on prevailing commercial rates of interest for the years in issue. Such evidence was not produced at trial. The taxpayers simply failed to meet their burden of proof that the amount of the deficiency was incorrect. Finally, it agreed that an effort to recompute the deficiency under the guise of a Tax Court Rule 155 recomputation was outside of the scope and purpose of such provision. Rule 155 does not permit either party to have what is in effect an opportunity for retrial of what was left off the record.   Blonien v. Comm'r, T.C. Memo. 2003-308;  Paccar, Inc. v. Comm'r, 849 F.2d 393, 400 (9th Cir. 1988).  

 

Both the Tax Court as well as the Third Circuit left open the thought that if the State or governmental authority enters into a voluntary agreement awarding just compensation as well as delay damages, the interest representing the delay damages computation may implicate the condemning authority borrowing authority and fall within §103 if the interest amount is reasonable based on prevailing commercial rates, the parties voluntary negotiated the rate of interest as part of an arms length bargain, and the agreement, once reached, was not incorporated in a court order.

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Taxpayer invested $310,000 in an oil and gas partnership in 2001 consisting of cash of $110,000 and a subscription note issued by the taxpayer obligating him to pay $200,000 at the stated maturity date of December 31, 2009. The oil and gas partnership used the taxpayer’s, as well as the other investors’ notes a security on a “turnkey note” it issued to a drilling company. The taxpayer had signed an “assumption agreement” which had the legal effect of making him personally liable on the turnkey note (and security) to the extent of the amounts he was required to pay under the subscription note. For 2001 and 2002, the taxpayer-partner was allocated deductions(losses) of close to $300,000 which reduced his capital account balance from from $310,000 to $32,407. In 2003 the partnership terminated and distributed $32,407 to the taxpayer.

The taxpayer had not made payment of the principal amount on the $200,000 subscription note and failed to meet certain other requirements of the subscription agreement for interest payments. In auditing the taxpayer’s return, the Service issued a notice of deficiency determining that the taxpayer’s liability on the subscription note and assumption agreement became unenforceable in 2003. As a result, the Service contended that the taxpayer must include $200,000 in income for 2003. The taxpayer argued that if no liability existed in 2003, then the taxpayer was not liable on the same indebtedness as "nongenuine" as well when issued in 2001. As a result, since the statute of limitations for 2001 had expired, the Service could not challenge the taxpayer’s 2001 return.

 

Judge Goeke, in issuing a Memorandum opinion, found for the Commissioner holding: (i) the taxpayer’s liability on the subscription note and related assumption agreement, after reviewing the evidence submitted by both parties at trial, first became “nongenuine” in 2003; (ii) the taxpayer must recognize a $200,000 gain for 2003 under §465(e), at-risk recapture; and (iii) the taxpayer was liable for an accuracy related penalty of 20% under §6662.

 

Factor reflected by the case law to determine whether a genuine debt exists includes: (i) whether the promise to repay is in writing; (ii) whether interest is charged (and paid); (iii) whether a fixed schedule of payments is required (and paid); (iv) the presence of collateral to secure repayment; (v) whether the borrower had the ability to repay the debt; and (vi) whether the “lender” expected repayment to corroborate that the debt was real.

 

Section 465(e) provides for the recapture of losses where a taxpayer’s amount at risk in an activity is less than zero at the close of any taxable year by distributions, changes in the status of a debt from recourse to nonrecourse, or as in this case, “nongenuine”, or other similar arrangement which reduces the taxpayer’s risk of loss. In such event §465(e)(1)(A) requires the taxpayer to include in gross income from the at-risk activity an amount equal to such negative at-risk amount. The amount recaptured, however, is limited to the excess of the losses previously allowed in the subject activity over any amounts previously recaptured. The negative-at-risk amount added to income may later be treated as a deduction allocable to the activity in the first succeeding year if and to the extent that the taxpayer's at-risk amount is increased.

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U.S. Income Tax Treatment of Personal Service Income or Royalty Income of a Non-resident

Non-residents of the U.S. are subject to U.S. income tax on U.S. source fixed and determinable annual or periodic income, as described in Section 871(a), which income, subject to treaty override, is subject to a flat 30% tax rate without deductions. Such persons are further subject to U.S. income taxation on a “net” basis and at graduated rates with respect to income derived from the carrying on of a U.S. trade or business under Section 864(b).  As applied to a non-resident, professional athlete, engaging in a U.S. trade or business includes any  business activity in the United States that involves one's own physical presence. Treas. Reg. §1.864-2.  It is clear that earnings derived from Goosen’s playing in golf tournaments in the U.S. is income from carrying on a U.S. trade or business. On the other hand, U.S. source income from royalties is generally treated as fixed and determinable annual or period income (“FDAP”). Royalty income paid for the right to use intangible property generally is sourced where the property is used or is granted the privilege of being used. § 861(a)(4). Neither foreign source royalty income nor foreign source personal services income is subject to U.S. tax unless it is related to the conduct of a U.S. trade or business.

 

Petitioner Retief Goosen

This case involved Retief Goosen, the 2001 & 2004 U.S. Open Champion and considered by many to be one of the leading golfers in the world. His official website, www.retiefgoosen.com, highlights his many achievements in professional and amateur golf. 

 

IRS Issues Notice of Deficiency Issued Against Mr. Goosen for 2002 and 2003

 

Goosen’s U.S. income tax liability with respect to his U.S. source income for 2002 and 2003 was the subject of a challenge by the IRS and led to a decision by the Tax Court, J. Kroupa, finding for the Petitioner in part and for the Commissioner in part.  At the time the Tax Court Petition was filed, Goosen was a citizen of South Africa but a tax resident of the United Kingdom. His wife is a U.K. citizen and resident.

 

In a summary of the facts set forth in the Official Tax Court Syllabus, Goosen had entered into endorsement agreements with sponsors Acushnet, TaylorMade, Izod, Upper Deck, Electronic Arts and Rolex. He agreed to allow all sponsors to use his name, face, image and likeness in advertising and marketing campaigns worldwide. Goosen also agreed to perform some services for the sponsors. All endorsement agreements paid Mr. Goosen a base endorsement fee. Acushnet, TaylorMade and Izod prorated the base endorsement fee if he did not annually play in a specified number of golf tournaments, i.e., on-course endorsement fees. Moreover, Acushnet, TaylorMade and Izod provided bonuses to Goosen for achieving a specific finish in a PGA or European Tour tournament or a specified ranking on the World Golf Rankings.

 

Goosen characterized the endorsement fees and bonuses from Acushnet, TaylorMade and Izod as 50% personal services income and 50% royalty income on his nonresident Federal income tax returns (Forms 1040NR) for 2002 and 2003. He treated or characterized the endorsement fees from Upper Deck, Electronic Arts and Rolex as 100% royalty income. He reported approximately 7% of the total endorsement income as U.S.-source income. The Service asserted that Goosen should have characterized the endorsement fees and bonuses from Acushnet, TaylorMade and Izod as 100% from personal services income. It also reallocated a larger percentage of Goosen’s endorsement fees as U.S.-source income. The deficiency proposed by the Service was $20,224 for 2002 and $144, 474 for 2003.  Accuracy related penalties were set forth in the deficiency notice but were later conceded prior to trial by the Service.

 

Tax Court’s Analysis and Decision

First, the Court considered whether the endorsement income was, in whole or in part,  personal services income or royalty income. Both parties agreed that endorsement fees under the off-course endorsement agreements that Goosen had received were royalty income.  The issue then was whether endorsement income derived solely from  the on-course endorsement agreements,  which includes the TaylorMade, Izod and Acushnet agreements, was royalty income  (or personal service income) as well.  

 

The taxpayer’s argument for treating on-course endorsement payments as royalty income was that under such agreements he was paid for the right to co-market and co-brand the sponsors' products with petitioner's name and likeness. His counsel relied upon case law that supported the notion that such  payments are royalties because the person has an ownership interest in the rights granted. See Cepeda v. Swift & Co., 415 F.2d 1205 (8th Cir. 1969); Haelan Lab., Inc. v. Topps Chewing Gum, Inc., 202 F.2d 866 (2d Cir. 1953). Cf.  Boulez v. Commissioner, 83 T.C. 584 (1984) (intellectual property creator receives only personal services income if the creator lacks an ownership interest in the underlying property); Kramer v. Commissioner, 80 T.C. 768 (1983); Uhlaender v. Hendricksen, 316 F. Supp. 1277 (D. Minn. 1970).  The taxpayer adduced expert testimony to support the argument that the three companies primarily paid for his name and likeness rather than for the performance of services.

 

The IRS position as to the on-course endorsement income was that Goosen was primarily paid to perform personal services including playing golf and carrying or wearing the sponsors’ products and logos. The IRS relied upon the fact that the endorsement agreements provided for a proration (partial reduction) of the endorsement fees if Goosen did not play in a minimum number of golf tournaments. Therefore, any income received by Goosen from such on-course endorsements was only marginally for use of his name and likeness (royalty income). After review of the record, the Court  found that the income received from the on-course endorsement agreements was part royalty income and part personal services income citing  Kramer v. Commissioner,  80 T.C. 584 (1983). The Court allocated 50% of the on-course endorsement income as personal services income and 50% as royalty income.

 

The next issue was what portion of the on course endorsement income is sourced to the United States and whether any U.S. source royalty income was effectively connected to a U.S. trade or business.  §861(a)(4), §862(a)(4). The burden is on the taxpayer to demonstrate that he made a reasonable allocation of the royalty income between U.S. and foreign sources. The sponsors had the right to use Goosen’s name and likeness worldwide and the contracts allocated 25% of the royalty income as sourced to the United Kingdom and 75% to the rest of the world. No provision was contained in the agreement on how to source the royalty to the United States. The Tax Court rejected the contractual sourcing provision for determining U.S. source royalty income.  Where the contracting parties fail to make a reasonable allocation, the courts have generally allocated all of the royalty income to the U.S. unless the taxpayer can demonstrate a sufficient basis for making a proper allocation. A sufficient basis is present when a taxpayer establishes that he has property rights outside of the U.S. and furnishes evidence on the value of such rights. The Tax Court made fact findings on each endorsement agreement and the proper allocation of U.S. source royalty income from non-U.S. source royalty income. The allocations determined to be proper by the Court varied with each contract. For example, the Upper Deck endorsement agreement royalty payments were found to be 92% U.S. source income and the Electronic Arts royalty to be 70% U.S. source income.

 

The next issue was whether the non-U.S. source royalty income is effectively connected to a U.S. trade or business. It was undisputed that  Goosen was engaged in the U.S. trade or business of playing golf (“ECI”)  when playing in the U.S. and that his tournament earnings were to be taxed at regular graduated rates.   The IRS did not assert however, and the Court agreed, that  since Goosen did not maintain an office or fixed place of business in the U.S. his non-U.S. source royalty income is not part of his trade or business of playing golf.  The succeeding issue was to what extent the U.S. source royalty income should be treated as royalty income or personal services income.  Under Treas. Reg. §1.864-4(c)(3)(i), U.S. source royalty income is ECI where the activities of the trade or business are a material factor in realizing the royalty income.  

 

The Court ruled that Goosen’s U.S. source royalty income from on-course endorsement agreements was ECI but that that his U.S. source royalty income from off-course endorsement agreements was not ECI since the payments did not depend on whether he played in any golf tournaments in the U.S. Treas. Reg. §1.864-4(c)(3)(ii), Ex. (2). Thus, such U.S. source royalty income was FDAP and subject to a 30% flat rate.

 

The final issue was whether, as Goosen had argued, he was entitled to treaty protection in reducing the rate or avoiding the imposition of tax on his U.S. source royalty income by application of the U.S.-U.K. tax conventions. See §894(a)(1). Under the tax conventions, the U.K. will tax a U.K. resident, non-domiciliary on non-U.K. source income only to the extent the income is remitted to or received in the United Kingdom. See U.S.-U.K. tax treaty art. 1(7). The U.S. can not subject the same taxpayer to double taxation. Goosen failed to meet his burden of proof that his non-U.K. endorsement income was remitted to or received in the U.K. Therefore, the Tax Court held  that Goosen was not eligible for any treaty benefits.

 

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In Russian Recovery Fund, Ltd., 108 AFTR2d ¶2011-5494, the  Court of Federal Claims ruled that the Internal Revenue Service may proceed with a collection action against a partner in a lower-tier partnership or “indirect partner” provided such partner’s return was filed within three years of the issuance of a final partnership administrative adjustment (FPAA) to the upper-tier partnership with respect to partnership level items that were adjusted. The tax items finally resolved in the FPAA to the upper-tier partnership directly impacted on the tax liability of the lower-tier partner. The Court further held that the Internal Revenue Service was not allowed to proceed with collection action against an “indirect partner” who filed his individual return more than three years before the issuance of the final partnership administrative adjustment. 

In accordance with the entity level audit rules enacted into law as part of the Tax Equity and Fiscal Responsibility Act (“TEFRA”), 26 U.S.C. §§ 6221–6233 (2006), the case filed in this action is a petition for readjustment of partnership items brought under 26 U.S.C. § 6226(a) by Russian Recovery Advisors, LLC (“RRA”) as the tax matters partner for Russian Recovery Fund, LTD (“RRF”). Plaintiffs allege, inter alia, that the Internal Revenue Service's (“IRS”) issuance of a FPAA for the tax year ending December 31, 2000, was untimely and therefore invalid, and that the representative partners' 2000 and 2001 tax years are closed for adjustment and assessment. The Court of Federal Claims had previously held in this case it was improper for an FPAA to adjust an individual partner’s amount at-risk based on its distributive share of non-recourse partnership liabilities and that the remedy for improper adjustment of a non-partnership item set forth in an FPAA does not invalidate the FPAA. See Russian Recovery Fund Ltd. v. United States, 81 Fed. Cl. 793 (2008).

Entity Audit Rules under TEFRA

As announced by TEFRA, under the partnership audit rules, the tax treatment of any partnership item, including the applicability of any penalty, addition to tax or additional amount which relates to an adjustment to a partnership item, is generally determined at the partnership level. §6221. Where the Internal Revenue Services wants to adjust any  “partnership items,” it must notify the individual partners through issuing an FPAA. §6226. See also §§6229, 6501. For period of 90 days after the FPAA is issued, the tax matters partner of the entity level partnership (or LLC) has the exclusive right to  file a petition for readjustment of the partnership items in the Tax Court, the Court of Federal Claims, or a U.S. District Court. §6226(a). After this 90 exclusivity period expires, the other partners (members) are granted an additional period of 60 days to file a petition for readjustment. §6226(b)(1).  Any partner (member) whose individual tax liability might be affected by the outcome of the litigation of partnership items may participate in the proceeding. §6224. The Internal Revenue Service may assess additional tax liability against individual partners within one year of the final conclusion of the partnership's tax determination. §6229(d). A partner may challenge the tax liability so determined by paying the assessment and filing a refund suit in the Court of Federal Claims for example. The partner is prohibited from brining an action for a refund attributable to partnership items. See §7422(h).

Statutes of Limitation: Assessment of Income Tax

It is universally acknowledged that the general statutory period of limitations for the assessment of income tax may not be made more than three years after the later of the date the tax return was filed or the due date of the tax return. §6501(a). Subject to exceptions and special rules, similarly the period for assessing tax attributable to a partnership item (or affected item), for a partnership tax year won't expire before the date that is three years after the later of: (1) the date the partnership return was filed, or (2) the last day for filing the return for that year (without regard to extensions). §6229(a).

As the tax matters partner for the Russian Recovery Fund, LTD (“RRF”), Russian Recovery Advisors, LLC. (“RRA”), filed a petition with the U.S. Court of Federal Claims for readjustment of partnership items per §6226(a). It challenged the IRS on the basis that the FPAA that the Service issued on 10/15/2005 for the tax year ending 12/31/2000 was issued beyond the permitted statute of limitations and was invalid as it affected an indirect partner who had filed a return more than three years before the FPAA.  Accordingly, the Court of Federal Claims previously held it improper for an FPAA to adjust an individual partner's amount at-risk in its distributive share of nonrecourse partnership liabilities as part of such FPAA. A deposit issue was also involved. See §6226(e). RRF was a limited partnership of ten partners that specialized in distressed asset transactions. Two of its partners were RRA and FFIP, LP (FFIP).

RRF filed its 2000 income tax return on Aug. 14, 2001. In the 2000 tax year, RRF allocated $46,424,782 of net section 988 (foreign currency)  losses to FFIP. On Oct. 14, 2005, the Service  issued an FPAA to RRF for the 2000 tax year, proposing adjustments to RRF partnership items. In the 2000 FPAA, IRS proposed to characterize this $46,424,782 disallowed the entire claimed losses which were allocated to FFIP.

FFIP, a partner of RRF, and also a pass thru entity, filed its own 2000 partnership tax return on or before August 16, 2001. After netting the losses it received from RRF with its own losses, FFIP reported $4,205,838 in losses for the 2000 tax year and $25,272,185 in losses for the 2001 tax year. The original $46.4 million in foreign currency section 988 losses that were allocated from RRF make up a large portion of both of these loss figures.

Nancy Zimmerman was an indirect partner of RRF through FFIP. She filed her 2001 return on Oct. 15, 2002, which was less than three years before the FPAA was issued. She filed her 200 income tax return more than 3 years before the issuance of the 2000 FPAA to RRF.  James DiBiase was an indirect partner of RRF through FFIP. He filed his 2001 and 2000 returns more than three years before the FPAA.

On May 10, 2005, FFIP, through its TMP, entered into an extension agreement with the IRS on Form 872-P, Consent to Extend the Time to Assess Tax Attributable to Partnership. The extension effectively allowed the Service to assess additional federal income tax attributable to the partnership items of FFIP against any partner for the period ending December 31, 2001 through August 31, 2006. Beginning in 2005, the Service audited  FFIP's 2001 partnership return including a detailed review of RRF's net section 988 losses reported on FFIP's 2001 tax return. The IRS completed the review of FFIP's 2001 partnership return and issued a “no adjustments” letter to FFIP. This extension allowed IRS to assess any federal income tax attributable to the partnership items of FFIP against any partner for the period(s) ended Dec. 31, 2001 at any time on or before Aug. 31, 2006.

Conclusions of the Court

After setting forth a detailed analysis of the facts and the law on each issue that was the subject of cross motions for summary judgment, the Court of Federal Claims reached several conclusions.  

1. Statute of Limitations Affirmative Defense Raised by Indirect Partners. The IRS asserted that RRA, as TMP to RRF, lacked standing to assert the statute of limitations defense on behalf of indirect partners. The Court of Federal Claims held that §6226 permits partners other than the tax matters partner to raise the statute of limitation defense and yet such  in no way prevents the TMP from raising the defense of their behalf.  See, e.g., AD Global Fund, LLC. v. United States, 481 F.3d 1351 (Fed. Cir 2007); Blak Invs. v. Comm'r, 133 T.C. 431 (2009). It is noted in the Court’s analysis that when a partner attempts to raise the statute of limitations defense at a partner level proceeding, it is foreclosed because the defense must be raised in the partnership level proceeding. Prati v. United States, 603 F.3d 1301, 1307 (Fed. Cir. 2010);Chimblo v. Comm'r , 177 F.3d 119, 125 [83 AFTR 2d 99-2610] (2nd Cir. 1998).

In Keener v. United States, 551 F.3d 1358 (Fed. Cir. 2009), the Federal Circuit held that the subject of a statute of limitations defense is appropriately viewed as a partnership item and handled in a partnership proceeding as opposed to a partner-level proceeding. Section 6221 provides that “[e]xcept as otherwise provided in this subchapter, the tax treatment of any partnership item ... shall be determined at the partnership level.” 26 U.S.C. § 6221 (2006). The Court of Federal Claims read  Keener and section 6221 together to mean that it is necessary for a statute of limitations defense, as a partnership item, to be raised in the partnership-level proceeding. See §6226(d)(1)(B).  Thus, while the statute allows partners other than the tax matters partner to raise a statute of limitations defense, it does not prevent the tax matters partner from raising the defense on their behalf.

2. One Year Rule Under Section 6229(d). RRA contended that due to the running of the statutes of limitation under §§6229 and 6501, summary judgment should be granted to the petitioners since the FPAA in this case was issued more than 3 years after RRF filed its 2000 return FPAA. In accordance with §6229(d) the statute of limitation for assessing RRF’s (indirect partner) 2001 return for “any tax imposed . . . which is attributable to any partnership item (or affected item) for a partnership taxable year,” was suspended until one year after the Court's final decision. The  RRA argued that the Service could only have assessed the losses on RRA’s 2001 return by issuing an FPAA to FFIP for the 2001 tax year. The Service argued that such losses must be adjusted at their source, RRF, not at FFIP, a second-tier partnership. The Court said that IRS could have issued an FPAA to FFIP, but to adjust the losses, an FPAA had to be issued at their source (RRF). The issuance of the FPAA to RRF had the effect of disallowing the foreign currency section 988 losses in 2000. The Court then held that the losses reflected on Nancy Zimmerman’s  2001 individual return were “attributable to” the disallowed RRF 2000 losses.

3. Assessment Against Lower Tier Partner  Permitted.

The Court therefore concluded that RRF loss adjustments arising from the 2005 FPAA could result in the assessment of income taxes as to Zimmerman’s tax liability for 2001. Under §6229(d), the issuance of the FPAA to RRF on October 14, 2005 suspended the statute of limitations for assessing any tax that is due to, caused by, or generated by any RRF partnership or affected items from the RRF 2000 tax year. As long as the individual partner's statute of limitations had not run prior to the issuance of the FPAA, that partner may be assessed. Simply put, this means that Ms. Zimmerman's 2001 tax return, insofar as it reflects tax attributable to 2000 RRF partnership or affected items, was  still open for assessment. Plaintiffs argue that the IRS could only have assessed the losses on Ms. Zimmerman's 2001 return by issuing an FPAA to FFIP for the 2001 tax year. Defendant responds that the losses must be adjusted at their source, RRF, not at FFIP, a second tier partnership. The question, therefore, is whether after FFIP carried the losses forward into 2001, they ceased to be RRF partnership items and moved beyond the reach of an RRF partnership proceeding.

The Service is permitted to issued multiple FPAAs in tiered partnerships. Since RRF was the source of the losses reported and allocated to FFIP, also a pass through entity, the issuance of an FPAA to the lower tier partnership, i.e., FFIP, would be inappropriate for disallowing the RRF losses. See Sente Investment Club Partnership v. Commissioner, 95 T.C. 243 (1990); Kligfield Holdings v. Commissioner, 128 T.C. 192, 202 (2007)(FPAA issued to adjust partnership items in a closed year in order to assess a deficiency in a partner's later year return). See also §6231(a)(6). from the source down to the indirect partners in order to consider whether individual partners owe any tax. Under TEFRA, losses must be disallowed at their point of origin.

The Court found the Plaintiffs' argument for the issuance of multiple FPAAs unconvincing. The IRS could have issued an FPAA to FFIP, but to adjust the §988 losses, an FPAA had to be issued at their source, which was RRF.   The issuance of the FPAA to RRF had the effect of disallowing the section 988 losses in 2000. The issuance of the FPAA to RRF on October 14, 2005, suspended the statute of limitations for assessing any tax that is due to, caused by, or generated by any RRF partnership or affected items from the RRF 2000 tax year. As long as the individual partner's statute of limitations had not run prior to the issuance of the FPAA, that partner may be assessed. This meant that Ms. Zimmerman's 2001 tax return, insofar as it reflects tax attributable to 2000 RRF partnership or affected items, was, in the view of the Court, still open for assessment (but under the facts of the case, not for Ms. Zimmerman’s 2000 tax return). It does not matter if the disallowed losses are also FFIP partnership items in 2001 because that fact does not prevent the FPAA from disallowing the losses at the RRF origination point and then assessing Ms. Zimmerman's 2001 tax return through a computational adjustment. The Court held that the FPAA issued to RRF in 2000 validly suspended the limitation period for assessing Ms. Zimmerman's 2001 individual tax return relating to partnership tax items involving the upper-tiered partnership.

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In Boltar LLC et al v. Commissioner, 136 T.C. No. 14 (4/15/2011) the Tax Court granted the government’s motion in limine, which motion was timely submitted pre-trial, to strike the admission of the taxpayer’s experts’ report into evidence at trial based on its argument that the report was  “unrealiable and irrelevant” under FREV 702 and the Supreme Court’s landmark decision in Daubert v. Merrell Dow Pharmaceutical, Inc., 509 U.S. 579 (1993). The Court , in a fully reviewed  decision, sustained the government’s motion in limine and excluded the taxpayer’s expert report from evidence and then agreed with the IRS’s expert’s determination of the value of the conservation easement . The government’s  notice of deficiency (Final Partnership Administrative Adjustment (“FPAA”)) was upheld for the amount stated.  The FPPA allowed only $42,400 out of a total $3,245,000 claimed as a charitable deduction on the partnership return of Boltar as the value of a conservation easement with respect to real property located in Indiana. The deficiency in the partners’ federal income tax resulting from the decision would approximate $1.12M (based on an assumed marginal income tax rate of 35% with respect to the disallowance of the excess deduction amount).

 

The Tax Court announced in Boltar, LLC, supra, that the standards of reliability and relevance  (for admitting expert testimony) apply in trials without a jury, such as in the United States Tax Court, subject to the discretion of the trial judge to receive such evidence. In this case the Court ruled that the taxpayer’s experts failed to apply the correct legal standard in that there was no determination made of the value of the donated conservation easement before and after the valuation, the valuation failed to value contiguous parcels owned by the partnership and assumed development which was not feasible on the subject property.

 

It is noteworthy that  there was no gross valuation misstatement or, alternatively, substantial valuation misstatement penalty, involved in this case. The penalty could have been 40% of the underlying deficiency based on the government's position on value.  Indeed, no penalty was proposed in the FPAA. Fifteen months after the government’s answer to the petition  was filed, 6 months after one continuance on respondent's motion, and 2-1/2 months before the next scheduled trial date, the  respondent-IRS moved to amend the answer to assert a "pass-through penalty adjustment of $1,281,040". The Court granted the taxpayer’s move to strike the penalty on the basis that the motion was untimely and prejudicial. Thus, further cost and damage to the taxpayer’s filing position and failed expert testimony was avoided.

 

Background: Deduction for Value of Donation of a Conservation Easement

Section 170(a)(1) allows a taxpayer to deduct, in computing taxable income, and as subject to further limitations, the amount or value of a qualifying charitable contribution. Under Treas. Reg. Section 1.170A-1(c)(1), where a contribution is made is property other than money, the amount of the charitable deduction “is the fair market value of the property at the time of the contribution". Fair market value, as defined by the regulations, "is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts." Treas. Reg. Section 1.170A-1(c)(2). For partial interests in property, the deduction is the fair market value of such partial interest at the time of the contribution.  

 

As is relevant to contributions of a perpetual conservation easement, Treas. Reg. Section 1.170A-14(h)(3)(i) provides that the value of the easement its is fair market value at the time of the contribution. Where a substantial record of sales of easements comparable to the donated easement (such as purchases pursuant to a governmental program) is present, the fair market value of the donated easement is based on the sales prices of such comparable easements. The regulations further explain that where no substantial record of market-place sales is available to use as a meaningful or valid comparison, as a general rule,  the fair market value of a perpetual conservation restriction is equal to the difference between the fair market value of the property it encumbers before the granting of the restriction and the fair market value of the encumbered property after the granting of the restriction. See Hilborn v. Commissioner, 85 T.C. 677, 688-689 (1985). The “before and after” approach is used in various contexts in resolving certain types of tax disputes. See, e.g., Browning v. Commissioner, 109 T.C. 303, 311-316 (1997); Symington v. Commissioner, 87 T.C. 892, 894-895 (1986); Thayer v. Commissioner, T.C. Memo. 1977-370; S. Rept. 96-1007, at 14-15 (1980), 1980-2 C.B. 599, 606; Rev. Rul. 76-376, 1976-2 C.B. 53; Rev. Rul. 73-339, 1973-2 C.B. 68.

 

Expert Reports Filed By the Parties

As required in accordance with TC Rule 143(g), the parties exchanged their expert reports at pre-trial conference and were submitted to the Court. Rebuttal reports would soon be filed before trial again in accordance with Tax Court rules. The tax return (partnership informational return) for the year of the charitable donation claimed by Boltar, 2003 attached the appraisal report filed by its experts, who reviewed only a draft of the easement prior to issuing their appraisal on March 7, 2004 and did not rely on the final version of the recorded easement.  The easement granted a Land Trust, Co., on December 29, 2003, to perpetually restrict the use of the subject  8 acres on the eastern side of a parcel (one of two) held by the partnership. The easement prevented any use of the property that would impair the conservation values of the property. Some of the factual nuances and details are set forth in the findings of fact made by the Court or as stipulated by the parties and are too lengthy to summarize in this post.

 

The taxpayer’s experts valued the subject property’s “highest and best use”,  as either raw land or multi-family development, and arrived at the foregone use value by virtue of the easement at $3,245,000 leaving a residual value to the subject property of only $68,000. The deduction claimed by Boltar LLC for 2003 was based then on the multi-family development scenario.  On the other hand, the government’s valuation expert stated that the value transferred (deductible) was only $42,400, and criticized the taxpayer’s expert report since it failed to determine the value of the restricted area both  before and after the grant of the easement as required in the regulations to Section 170. The government’s expert valued the eased property strictly on permitted land use restrictions, i.e., single family residences.

 

In accordance with the Court's standing pretrial order and Rule 143(g), the parties exchanged and submitted expert reports. Petitioner's expert report consisted of the Integra appraisal and a transmittal letter to petitioner dated March 7, 2004, and a letter to petitioner's counsel dated April 15, 2010. In the letter dated April 15, 2010, the taxpayer’s experts addressed the views of the Internal Revenue Service valuation engineer (rebuttal report) but did not make any adjustments in their value opinion, maintaining that the amount determined in their 2004 appraisal was "supportable and appropriate.

 

Government’s Criticism of Taxpayer’s Expert Report

Prior to trial, the government filed a motion in limine arguing that the taxpayers’ appraisal was not reliable and was also irrelevant for several reasons: (i) the report did not include both a before and after value of the subject eased property as required in the regulations although the petitioner argued that such comparision had been done; (ii) the taxpayer’s report did not value all contiguous parcels it owned and encumbered by the conservation easement at issue in this case as required by regulation; and (iii)  the 174 condominium unit development  analysis used by the taxpayer’s expert included as part of an alternative scenario in the taxpayer’s experts’ report was not a permitted  use on the eight acre subject property. The government contended that this hypothetical value on property that could not from a land use standpoint be converted into a 174 condominium unit project required that the taxpayer’s expert report be stricken. Indeed, this high-density potential (hypothetical) use caused the value “before” on the eased property to be substantially greater than the single family residential “highest and best” use scenario. The Court noted it would defer ruling on the motion in limine until all evidence was presented at trial. The Court deferred ruling on respondent's motion in limine because of the importance of the issues raised and the substantial effect on the case of eliminating petitioner's primary evidence. The taxpayer’s expert report was marked and the related testimony of petitioner's experts was heard solely as an offer of proof. Whether the report and testimony would ultimately  be received into evidence and considered in determining fair market value of the easement depended, in the Court’s view, on application of principles expressed in Daubert v. Merrell Dow Pharm., Inc., supra, 509 U.S. at 591, as related to rules 702 and 703 of the Federal Rules of Evidence. The Tax Court ruled, as discussed herein, it was inadmissible.

 

Taxpayer’s Arguments for Admissibility of Its Expert’s Report

The valuation experts claimed that there was nothing wrong with including in the appraisal a  hypothetical development project that could not fit on the land they purportedly valued, was not economically feasible to construct and would not be legally permissible to be built in the foreseeable future. As to the government’s invoking the Daubert rule, the taxpayer argued it is inapplicable in this instance since there is no jury in a Tax Court proceeding, and therefore TC Rule 143(g) requires that the report be received into evidence.

 

Federal Rule of Evidence 702  

FREV 702 provides that where scientific, technical, or other specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact in issue, a witness qualified as an expert by knowledge, skill, experience, training, or education, may testify thereto in the form of an opinion or otherwise, if: (i) the testimony is based upon sufficient facts or data, (ii) the testimony is the product of reliable principles and methods, and (iii) the witness has applied the principles and methods reliably to the facts of the case.

 

The Supreme Court in Daubert, supra, acknowledged that it is the trial court that serves as the “gatekeeper” as to what evidence is excluded as unreliable. See Kumho Tire Co. v. Carmichael, 526 U.S. 137, 148 (1999), the Supreme Court applied the same standard to expert testimony that was not "scientific". More importantly, the application of the Daubert rule is not limited only to jury trials.. See Atty. Gen. of Okla. v. Tyson Foods, Inc., 565 F.3d 769, 779 (10th Cir. 2009); Seaboard Lumber Co. v. United States, 308 F.3d 1283, 1302 (Fed. Cir. 2002) (standards of relevance and reliability must be met in bench trials). In any event, rule 702 of the Federal Rules of Evidence applies to bench trials as well as to jury trials and specifically sets forth applicable standards of reliability.

 

The Tax Court then stated that like other federal courts it too would strike the admission of unreliable evidence as a gatekeeper of the admissibility of expert reports as well. Laureys v. Commissioner, 92 T.C. 101, 127 (1989).  The Tax Court further stated  that an expert loses usefulness as well as credibility when giving testimony tainted by overzealous advocacy. Buffalo Tool & Die Manufacturing Co. v. Commissioner, 74 T.C. 441, 452 (1980)(other citations omitted). Expert opinions that disregard relevant facts affecting valuation or exaggerate value to incredible levels are rejected. See Estate of Newhouse v. Commissioner, 94 T.C. 193, 244 (1990)(other citations omitted).

The Tax Court, in an opinion written by Judge Cohen, stressed that the Court’s gatekeeper role in a non-jury trial enhances trial efficiency while at the same time making the fact finder more objective in reaching its final determination. It rejected being burdened by “  unreasonable, unreliable, and irrelevant expert testimony”.

 

At this point the opinion puts many tax professionals and valuation experts on notice. “ In addition, the cottage industry of experts who function primarily in the market for tax benefits should be discouraged. Each case, of course, will involve exercise of the discretion of the trial judge to admit or exclude evidence. In this case, in the view of the trial Judge, the expert report is so far beyond the realm of usefulness that admission is inappropriate and exclusion serves salutary purposes.” (emphasis added). This case therefore has wide-sweeping implications since valuation issues arise in many contexts in the Code, including federal estate and gift tax valuation disputes.

 

Here, the taxpayer’s experts failed to apply realistic or objective assumptions. One alternative determination of value reached by the taxpayer’s experts was based on raw land which supported only a modest or small deduction.  Its alternative and yet unfeasible condominium use value supported the claimed deduction of $3,270,000 generating potential federal income tax savings in excess of $1.1 M.  While making these alternative assumptions, the report fails to determine the highest and best use of the property after the easement is granted, it did not consider potential residential use of the property and thus did not value the property at its highest and best use after the easement was granted. From other evidence presented at trial, including the existing zoning ordinances and restrictions, the Tax Court noted that only single-family residential use was feasible (as an alternative to valuation as raw land) after the easement was granted and could have been developed within  the conservation easement restrictions. Since the taxpayer’s experts made no attempt to determine the highest and best use of the property after the easement was granted by considering the potential for single-family residential development the report was stricken based on Daubert considerations and the deficiency om tax for the amount claimed by the Service upheld based on the value opined by the government’s experts.

 

The taxpayer also argued that the Service accepted the appraisal it filed as “qualified” under pertinent portions of the regulations and therefore the government should be estopped from denying such report's admissibility. The Tax Court quickly disposed of this argument by stating that an  appraisal may be "qualified", i.e., sufficiently independent,  for one purpose but lacking in evidentiary weight for another. See Section 170(f)(11)(E) (“qualified appraiser” requirement for substantiation of charitable contributions of property in excess of $500,000). See Evans v. Commissioner, T.C. Memo. 2010-207. TC Rule 143(a).

 

Therefore, the Court ruled that the taxpayer’s expert report was not the product of reliable methods and the appraisers did not apply reliable principles and methods reliably to the facts in the case. This is based on the finding that the report assumes scenarios that are unrealistic in view of the facts of the case and therefore are not relevant. It  granted the government’s motion in limine and found the record in the case fully supported the government’s experts of the valuation (deduction amount) for the conservation easements. Indeed it had no other conclusion to reach on the record assuming that the government's expert report was admissible which it was.

 

Implications of The  Tax Court's Boltar Decision 

 

The Boltar case should be viewed as a “wake up” call to tax practitioners and estate planners that the Tax Court will throw out biased or improperly based expert reports when, as to the latter situation, it finds that the reports themselves lack foundation based on methodology or ignore the essential facts concerning the nature of the property that is the subject of the valuation dispute. Note again that the government was very late in asserting penalties be imposed in this case and therefore the taxpayer lost the case but was not penalized . Had such penalties been timely raised by the government the taxpayer may have had a most difficult time to overcome its burden of persuasion  against an enhanced accuracy related penalty given the application of the Daubert principle by the Tax Court in this case. The penalty in this case could have been imposed for up to 40% of the underlying deficiency in tax. See Sections 6662(b)(3), 6662(b)(5), 6662(e), 6662(g) and 6662(h).

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Section 6662 imposes an accuracy-related penalty for various types of infractions in tax, including underpayments attributable to negligence or disregard of rules or regulations (§6662(b)(1)) or a “substantial understatement of income tax” (§6662(b)(2)). A substantial understatement of income tax exists where the amount of the understatement for a taxable year exceeds the greater of 10% of the tax required to be shown on the return for the taxable year or $5,000. For a regular or C corporation a substantial understatement of income tax is present where the amount of the understatement for the tax year exceeds the lesser of $10,000 or $10,000,000. The substantial understatement penalty is reduced by the portion of the understatement attributable to the tax treatment of any item contributing to the understatement for which there is or was “substantial authority”, or, alternatively where the questionable item was adequately disclosed on the tax return. This relief rule does not apply to “tax shelters” which term is broadly defined for purposes of this provision. Other accuracy-related penalties are imposed on valuation misstatements, substantial estate or gift tax valuation understatements or substantial overstatement of pension liabilities. More recently, Section 6662(b)(6) imposes a special accuracy related penalty of up to 40%, generally accuracy-related penalties are limited to 20% of the resulting tax caused by the violation, for claimed tax benefits that are undisclosed on the return which are disallowed by application of the economic substance doctrine under Section 7701(o). Penalties for the failure to comply with the reportable transaction rules also subjects a taxpayer to a separate penalty under Section 6662A.

 

Under Section 7491(c), the Commissioner bears the burden of production and must produce sufficient evidence that the imposition of the penalty is appropriate in a given case. Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Once the Commissioner meets this burden, the taxpayer must come forward with persuasive evidence that the Commissioner's determination is incorrect. Tax Court Rule 142(a).

 

Mitigation of the Accuracy-Related Penalty

 

It is only natural that when the particular treatment of an item on a tax return runs the risk of being challenged by the Service, including the assertion of an accuracy-related penalty, the tax advisor will consult with its client and discuss the risks involved in taking what might be labeled as “aggressive” position and whether a penalty can be avoided if the item in question generates a deficiency in tax. As mentioned, in some cases the presence of “substantial authority” for the treatment of a particular item on the return (which treatment is ultimately determined to be incorrect) or the filing of an adequate disclosure statement giving the Service notice of the particular item in question and its treatment on the return, will, in many instances, avoid the imposition of the penalty.  In addition, there is always the idea that the taxpayer’s reliance on its tax advisor(s) in taking the questionable position on the return provides a sufficient basis to avoid the penalty. More specifically, Section 6664(c)(1) provides that "[n]o penalty shall be imposed under section 6662 ... 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." Under Treas. Reg. §1.6664-4(b)(1), reliance on professional advice can meet the requirements of “reasonable cause” and “good faith” provided, under all circumstances, such reliance was reasonable and the taxpayer in fact acted with good faith. Treas. Reg. §1.6664-4(c)(1) states that "[a]ll facts and circumstances must be taken into account in determining whether a taxpayer has reasonably relied in good faith on advice (including the opinion of a professional tax advisor) as to the treatment of the taxpayer ... under Federal tax law.” The presence of actual reliance on a qualified professional tax advisor may not assure a successful defense to an accuracy-related penalty will be the outcome although dictum from the Supreme Court’s decision in Boyle might be persuasive that a “per se” rule is proper. In United States v. Boyle, 469 U.S. 241, the Supreme Court stated: "When an accountant or attorney advises a taxpayer on a matter of tax law, such as whether a liability exists, it is reasonable for the taxpayer to rely on that advice. Most taxpayers are not competent to discern error in the substantive advice of an accountant or attorney. To require the taxpayer to challenge the attorney, to seek a ‘second opinion,’ or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place.... ‘Ordinary business care and prudence’ does not demand such actions." 

 

Under Treas. Reg. §1.6664-4(c)(2), “advice” is “any communication *** setting forth the analysis or conclusion of a person, other than the taxpayer”. (emphasis added). See §7701(a)(14). The determination of whether a taxpayer acted with reasonable cause and in good faith depends upon the facts and circumstances, including the taxpayer's efforts to assess its proper tax liability; experience, knowledge, and education; and reliance on the advice of a professional tax advisor.   The Tax Court recently addressed the reasonable cause defense in Seven W. Enterprises, Inc. v. Commissioner, 136 T.C. No. 26 (2011) and in Woodsum v. Commissioner, 136 T.C. No. 29 (2011). 

 

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The Tax Court, in a consolidated case involving a distressed asset/debt tax shelter, held that several partnerships’ basis in purchased consumer debt acquired from a Brazilian company was zero and that the transfer to the partnerships and subsequent redemption of the Brazilian company's partnership interests were a sale of receivables. The Service’s imposition of accuracy related penalties was upheld.

 

The transaction in issue has been referred to as a “DAD” or distressed asset debt transaction. In contrast to a Son-of Boss transaction, which exploited the narrow definition of partnership liability under §752 to deny liability assumption for a contingent debt obligation which is still reflected in outside basis, the DAD deal is far more pedestrian in the sense that it does not rely on hyper-technical interpretations of the Code and regulations. As to the Son-of-Boss basis plays see, e.g., Cemco Investors LLC v. United States, 515 F.3d 749, 752 (7th Cir. 2008); New Phoenix Sunrise Corp. & Subs. v. Commissioner, 132 T.C. 161, 185 (2009), affd. 408 Fed. Appx. 908 (6th Cir. 2010); Jade Trading, LLC v. United States, 80 Fed. Cl. 11 (2007), revd. on other grounds 598 F.3d 1372, 1376 (Fed. Cir. 2010).  

 

In a DAD transaction, the loss is claimed by application of §§723 and 704(c) from the alleged contribution of a built-in loss asset by a tax indifferent party to a partnership However, this loss is preordained to be nullified by a matching gain upon the dissolution of the venture. Consequently, the tax benefits sought by the tax sensitive party are, absent other factors, confined to timing gains. Moreover, claiming these benefits requires sufficient "outside basis", which, in turn, entails an investment of real assets.

 

In a consolidated Tax Court proceeding, the facts of the case focused to a large extent on the business dealings between Warwick Trading LLC and Lojas Arapua, S.A., (“Arapua”) a Brazilian retail company in a bankruptcy proceeding/reorganization. In particular, Arapua transferred its troubled consumer receivables to Warwick in exchange for a membership or ownership interest in Warwick and an expectation to receive a cash distribution within a relatively short period of time. 

 

Warwick next transferred the low value or trouble consumer debt several trading companies, and investors acquired interests in those companies through several holding companies that were all organized as LLCs. The various LLCs elected partnership treatment and claimed bad debt deductions related to the Brazilian consumer receivables. The investors claimed the deductions on their tax returns. Warwick also claimed losses related to the receivables.

 

The IRS issued notices of final partnership administrative adjustments (“FPAA”) denying the members of the LLCs, including Warwick losses on the worthless debt and applied accuracy related penalties for lack of economic substance, violation of the partnership anti-abuse regulation, and disguised sales provisions.   

 

The various LLCs subject to the FPAA filed petitions with the Tax Court and the cases were consolidated. In a full opinion of the Court, per Judge. Wherry Jr., the Tax Court upheld the proposed deficiiencies in income tax set forth in the FPAAs, finding that two necessary conditions for allocation of the built-in losses of the distressed debt contributed among the various LLCs were not met. The Court first denied that the alleged partnership that Arapua formed with the managing member or Warwick was not a partnership for federal income tax purposes. Instead, Arapua wanted cash from the receivables and Warwick wanted the receivables to generate deductible tax losses. The Tax  court also found that the second condition for allocation of the built-in losses, that there had been a bona fide contribution of the distressed receivables, had not been met.

 

The Tax Court recharacterized the contributions as disguised sales under  §707(a)(2)(B) since Arapua received money within two years of the transfer of the receivables. As a purchase, Warwick’s cost basis in the receivables was the amount of cash paid and there was no transferred or exchanged basis for which built in losses could be claimed. Applying the step transaction as a judicial aide or rule of construction, the several steps were joined into a single transaction, i.e., Arapua’s sale of receivables to Warwick for the amount of cash paid. Therefore, the losses are measured against a zero basis as a factual matter and not deductible. The gross valuation misstatement penalty under §6662(h) was imposed since the taxpayers failed to show that they acted with reasonable cause and in good faith in their reporting of the losses.

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Petitioners, husband and wife, were shareholders in an S corporation which provided wireless cellular service. The IRS asserted a deficiency in tax for approximately $16 million for the 5 years in issue (1996-2001) . At the heart of the dispute was the length in years of the recovery period that the S corporation was required to use in computing its annual cost recovery allowance for the wireless cellular assets, i.e., including antenna support structures, cell site equipment and leased digital equipment, used in the corporation's businss operations. Such class period recovery was set forth based on different asset class by the Service in Rev. Proc. 87-56, 1987-2 C.B. 674, which was in effect for the years in issue. The Tax Court agreed that the antenna  support structures fall within asset class 48.14 and have a recovery period of 15 years per Rev. Proc. 87-56, supra. The cell site equipment, excluding the switch, and the leased digital equipment, were held to fall within asset class 48.12 with a recovery period of 10 years. In contrast, the taxpayers’ reported the antenna support structures as under “Telegraph, Ocean Cable, Satellitte Communications Activity category and Asset Class 48.32 and recoverable over a shorter 7-year period.

The Tax Court, per the opinion of Judge Kroupa, held that the structures were more appropriately within the Telephone Communications activity category and therefore per Rev. Proc. 87-56, supra, Similarly, taxpayers' classification of a wide variety of cell site equipment, including base station and switch, as computer-based telephone central office switching equipment coming under Asset Class 48.121 with 5-year recovery period was, except for switch, also inappropriate; instead, and despite presence of some computerized components, remaining cell site equipment had to be classified under Asset Class 48.12 with 10-year life because radio was key component. Also, no depreciation was available for other/ leased digital equipment until year it was placed in service/year corp. switched from analog to digital service.

The authority to set forth class live periods by the IRS is granted by Congress. §167(m). Such guideline classes and lives or periods are established, supplemented and revised where necessary. Treas. Reg. §1.167(a)-11(b)(4)(ii). The Secretary has the authority to prescribe class lives for each class of property. The revenue procedure in effect for the years at issue was Rev. Proc. 87-56, 1987-2 C.B. 674.

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In Henry Samueli et al v. Commissioner, 132 T.C. No. 4 (2011), the Tax Court, per Judge Kroupa’s opinion for the majority, in response to the petitioners and respondent (IRS) filing of cross motions for summary judgment in a consolidated proceeding, upheld the Service’s deficiencies in income tax for denying the taxpayers interest deductions claimed on the underlying “margin loans” used to acquire the securities, were disallowed on the basis the purported payments of “interest” were not made with respect to an actual debt. Instead the arrangement was treated as a stock sale and immediate repurchase and the issuance of a forward contract to the taxpayers to later acquire (and sell) the same securities.

 

Section 1058 In General

Section 1058 provides that where an owner of “securities”, as such term is defined under §1236(c), loans securities to another person, such as a broker or investor engaging in a short sale, the owner is not treated as having engaged in a “sale” in which gain or loss is recognized, either when the securities are transferred to the borrower or when they are later returned to the taxpayer. §1058(a).

In order to qualify for non-recognition treatment, certain agreement provisions must be satisfied in accordance with 1058(b): (i) the agreement provides for the return to the lender of securities that are identical to those transferred; (ii) payments must be made to the transferor of the shares for amounts equivalent to all interest, dividends and other distributions which the owner of the securities is entitled to receive during the period beginning with the transfer of the securities by the transferor and ending with the transfer of identical securities back to the transferor; (iii) the agreement doesn’t reduce the transferor (owner’s) risk of loss or opportunity for gain with respect to the securities transferred; and (iv) the agreement complies with the requirements set forth under the regulations. The third element was of direct consequence in the Samuelis case as discussed below which the Court ruled was not satisfied.

Where the borrower returns to the taxpayer securities which are different from those transferred by the taxpayer, or, if the borrower fails to deliver anything to the taxpayer, gain or loss is recognized at the time of the borrower's default.

According to the proposed regulations, the payments compensating the taxpayer for interest, dividends, and other distributions are treated as “a fee for the temporary use of property,” not as interest or dividend income. Where the equity holder is a tax-exempt organization, such payments are exempt from unrelated business taxable income as if the interest and dividends were received. For purposes of §1058, “securities” includes corporate stock, a “certificate of stock or interest in any corporation,” a bond or other debt instrument, and “any evidence of an interest in or right to subscribe to or purchase any of the foregoing.”

 

Recent Tax Court Decisions on Section 1058

 

In a recent decision of the Tax Court, Anshutz Co. v. Comm’r, 135 T.C. No. 5 (2010), the Court characterized “share-lending agreements” as contracts which are frequently entered into by equity holders of stock who have taken a “long” position with respect to such shares and plan on holding the stock for an extended period of time. The equity owner may contract to “lend” the stock to a counterparty, who can use the borrowed shares to increase market liquidity and facilitate stock sales. For example, the equity owner can lend shares to an investment bank, which could then use the loaned shares to execute short sales on behalf of its clients.

In another recent Tax Court decision, Calloway v. Commissioner, 135 T.C. No. 3 (2010), the Court held that a purported securities lending arrangement was in fact a disguised sale. The arrangement involved the equity owner’s transfer of shares of stock to another party in exchange for “”loan payments” for the use of the lender’s funds for an agreed amount. The owner of the stock had retained the right to pay off the loan and require the return of the same stock after 3 years had elapsed. The Tax Court analyzed this agreement as a disguised sale since the purported borrower couldn't repay the “loan” and demand return of his stock before the end of the three year period, he didn't retain the benefit of being able to sell his interest in the stock during that period, and also bore no risk of loss if the stock's value decreased. As such, the transaction failed to meet the requirements under §1058(b)(3) and was not a qualified securities lending agreement.

 

The Samuelis Case

 

Two couples were the petitioners in the case, the Samuelis’ (S) and the Rickses’ (R). S and R entered into a structured securities transaction in which they owned a 99.5% interest with S and his wife holding 10% interests indirectly through their operating company, a pass thru entity, and the balance of the same interests in an limited liability company, H&S Ventures, LLC (H&S Ventures) and the balance of the interests in a grantor trust holding interests in H&S Ventures. R owned the remaining .5% along with another individual. Mr. Samuelis, as noted in the Court’s opinion, is a billionaire who co-founded Broadcom Corporation, a publicly traded company listed on the NASDAQ Exchange.

The agreement involved S and R, through H&S Ventures, acquiring securities, i.e., $1.64 billion in value, from their securities broker Refco Securities LLC (RS LLC), on margin and then immediately loaning the securities back to RS LLC in 2001. Under the arrangement, RS LLC promised to transfer identical securities to H&S Ventures on Jan. 15, 2003. The securities consisted of a $1.7 billion principal STRIP of the $5.7 billion principal on an unsecured fixed-income obligation issued by Freddie Mac. The maturity date of the obligation was February 15, 2003, and the yield to maturity on October 17, 2001, at which the securities accrued interest, was fixed at 2.581 percent. The agreement allowed for an earlier transfer of the same or identical between H&S Ventures and RS LLC which permitted the “lender” to require an earlier transfer of the identical securities by termination on July 1, or December 2, 2002. H&S Ventures sold the securities back to RS LLC on January 15, 2003.

H&S Ventures, and therefore S and R to the extent of their proportionate interest in the limited liability company, reported the transaction under §1058 as a securities lending arrangement. H&S Ventures reported approximately $50.6 million in long-term capital gain on the sale in 2003. H&S Ventures also deducted millions of dollars of interest with respect to the transaction which was allocated among its various members. The petitioners also deducted as interest, payments made or accrued with respect to the initial margin loan with RS LLC in acquiring the securities.

The Service challenged the taxpayers’ reporting of the transaction contending that H&S Ventures purchased the securities from RS LLC and immediately sold the securities back to RS LLC in 2001 for no gain or loss and then repurchased from a deemed forward contract the same securities in 2003 realizing an approximate $13.5 million short term capital gain. The transaction was not, in the eyes of the Service, a securities lending transaction or arrangement per §1058. The Service further disallowed all of H&S Ventures’ interest expense reported since there was no true debt obligation present under the facts. Respondent also disallowed all of the petitioners’ interest deductions because the corresponding debt that petitioners claimed was related to the transaction did not exist. Inotherwords, despite the “margin loan” documentation, there was no actual debt to RS LLC as part of the arrangement.

 

Tax Court Rules in Favor of Respondent-IRS

Acknowledging that the issue presented in the case was one of “first impression”, the Tax Court upheld the Service’s position finding that the agreement under which S and R, through H&S Ventures, transferred the securities was not an agreement described in §1058(b)(3) since the agreement did reduce their opportunity for gain because there were only 3 days during the transaction period where S and R could have the securities transferred back to them to sell for a gain. The taxpayers arguments that their opportunity for gain was not reduced, a requirement under §1058(b)(3), was therefore rejected by the Court.

Responding to the parties filing cross motions for summary judgment in accordance with Tax Court Rule 121 (FRCP 56), the Tax Court, in an opinion issued by Judge Diane Kroupa, noted that not only were the requirements under §1058(b)(3) not established but the arrangement did not coincide with the legislative intent in enacting this provision. Indeed, the Court opined that the legislative history to §1058 provides that a securities loan agreement should result in the lender of the securities being placed in the same economic position the lender would have been in absent the agreement. Since the transaction was a sale, S (and R), through H&S Ventures, were not entitled to their claimed interest deductions made to RS LLC in 2001 and 2003 because an “actual debt” did not exist. The Court upheld the proposed deficiencies in income tax of $2,177,532 deficiency for 2001 and a $171,026 deficiency for 2003 in the Federal income taxes of Henry and Susan F. Samueli and a $6,126 deficiency for 2001 in the Federal income tax of Thomas G. and Patricia W. Ricks.

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In U.S. v. Fort, 107 AFTR 2d ¶2011-739 (11^th Cir. 4/19/2011) a three-judge panel of the Eleventh Circuit upheld a federal district court's (Northern District of Georgia) decision, granting the Department of Justice, Civil Tax Division, summary judgment on that issue that under the constructive receipt doctrine, a consulting partner's sale of an interest in Ernst & Young was a fully taxable in the year the interest was sold to Cap Gemini in exchange for the stock. The lower court rejected the taxpayer’s argument that since he was subject to a five year contractual restriction on selling the shares received in the exchange and was subject to a forfeiture provision for certain conditions based on the post-sale profitability of the consulting company operated by E&Y, such limitation and restrictions did not postpone the year in which a taxable realization occurred for federal income tax purposes. The government brought the action against the taxpayer, Danny C. Fort, to recover a tax refund of over $300,000 which it argued was erroneously refunded.

Constructive Receipt Doctrine In General

A fundamental principle of federal income taxation is that, in general, the receipt of property and/or cash for services rendered or to be rendered or as part of a sale or other disposition of property the amount includible in gross income is the year in which such property is received. §451(a). Where the taxpayer utilizes the cash method of accounting, income must be reported in the year in which the taxable receipts are "actually" or "constructively" received, whichever first occurs. Treas. Reg. §1.451-1(a). In addition, items of gross income are taxable in the year in which the taxpayer is in receipt of an "economic benefit" even if there is earlier no actual or constructive receipt. See also §409A (acceleration of year of gross income realization plus 20% surcharge for deferred compensation that violates the contract requirements contained in the regulations).

As to the constructive receipt doctrine, the courts have determined that the following conditions are required to cause income realization: (1) the amount must be due; (2) the amount must be appropriated on the books of the obligor; (3) the obligor must be willing to pay; (4) the obligor must be solvent and able to pay; and (5) the obligee must have knowledge of the foregoing facts. Moreover the constructive receipt doctrine requires that an amount be credited to an individual's account and be subject to unqualified demand. Robinson v. Commissioner, 44 T.C. 20 (1965); Basila v. Commissioner, 36 T.C. 111 (1961) acq., 1962-1 C.B. 3; Oates v. Commissioner, 18 T.C. 570 (1952), aff'd, 207 F.2d 711 (7th Cir. 1953). See Treas. Reg. § 1.446-1(c)(1)(I).

Factual Background

In early 2000, Ernst & Young ("E&Y") prepared to spin off and sell its information-technology consulting business to Cap Gemini, S.A. ("Cap Gemini"), a French corporation. At this time, Fort was a partner in that consulting business. On February 28, 2000, E&Y and Cap Gemini executed a Master Agreement that detailed the terms of the transaction. Under the Master Agreement, the proceeds of the sale were divided among E&Y's partners. For consulting partners who qualified as accredited investors under SEC rules, such as Fort, the consulting partner agreed to terminate his or her interest in E&Y, and in exchange, received a distribution of Cap Gemini shares. Additionally, these partners would begin working at a new entity, Cap Gemini Ernst & Young ("CGE&Y"), under employment agreements containing noncompete clauses. There were limitations imposed on the receipt of Cap Gemini. Cap Gemini shares would not be distributed outright to each partner. Instead, 25% of each partner's shares would be sold immediately to cover that partner's income taxes incurred as a result of this transaction, and the other 75% of the shares (the "Restricted Shares") were placed into an individual account in the partner's name at Merrill Lynch. There were limitations placed on the Restricted Shares. They could not be withdrawn from the partner's account at Merrill Lynch immediately, and therefore, the Merrill Lynch accounts were like escrow accounts. For four years and 300 days following the closing, partners could only sell portions of the Restricted Shares at scheduled times. After the four-year, 300-day period, the partners could withdraw all remaining Restricted Shares from the Merrill Lynch account. The former tax director of E&Y's consulting practice, who helped structure this transaction, stated that the reason for these restrictions was to prevent all of the partners from selling too many Cap Gemini shares at once, thereby diminishing the value of the shares.

The Restricted Shares were also subject to forfeiture as "liquidated damages" if a partner (1) breached his employment agreement; (2) voluntarily left his employment; or (3) was terminated. The amount of forfeitable shares decreased with each anniversary of the closing date that the partner remained at CGE&Y, so, generally, the longer a partner worked for CGE&Y, the fewer shares he or she would forfeit if the forfeiture provision were triggered. In addition, the termination forfeiture requirement applied to only two types of termination, and the number of Restricted Shares forfeited upon termination depended on under which type a partner was terminated. If a partner was terminated "for cause," the partner forfeited the full amount of the forfeitable Restricted Shares. However, if a partner was terminated for "poor performance," the partner forfeited at least 50% of the forfeitable Restricted Shares, but could keep a percentage of the remaining 50%, as determined by a review committee.

Partners also would have dividend and voting rights in the Restricted Shares. The dividends paid on the Restricted Shares were not subject to forfeiture, and partners could withdraw these dividends shortly after they were declared. As for voting, Merrill Lynch's French affiliate would vote a partner's shares "as instructed by [the partner] as beneficial owner." Because of the restrictions placed upon the Restricted Shares, the Master Agreement stated that, for tax purposes, the Restricted Shares would be valued at 95% of the closing price of Cap Gemini stock on the closing date. Fort subsequently signed the Partner Agreement, making him a party to the Master Agreement.

The transaction closed on May 23, 2000. Twenty-five percent of Fort's shares were sold at closing and the proceeds turned over to Fort, to cover taxes due based on receipt of the full value of all the stock in 2000. The remaining 75%, the Restricted Shares, were deposited into Fort's Merrill Lynch account.

 

Fort reported gross proceeds of $1,759,097 from this transaction on his 2000 income tax return. At this time, the Cap Gemini stock was worth approximately $156 per share. In other words, the entire value of the Cap Gemini stock received was included in the amount realized on the sale in 2000. Fort’s basis in his interest in E&Y would then be reduced from the amount realized in arriving at taxable income. The characterization of the gain would be determinate in accordance with §§741 and 751.

In September 2003, Fort was terminated as part of a downsizing. At this time, the value of the Cap Gemini shares had declined substantially

The District Court Grants the Government's Motion for Summary Judgment

The district court granted the government's motion for summary judgment and awarded it the disputed amount. 105 AFTR 2d 2010-2559, (N.D. Ga. 5/10/2010) at 3 (N.D. Ga. May 20, 2010). The court stated that taxable income during a given taxable year includes all income from whatever source derived that is "actually" or "constructively" received during that year. While the court assumed that Fort did not actually receive the Restricted Shares, it concluded that he constructively received them, because: he alone stood to gain or lose money based on the stock's performance. He received the benefit of the dividends paid on the shares, and he had the right to direct how the shares would be voted. Moreover, he knowingly agreed to the sale restriction and the forfeiture provision. He also agreed to the amount of the discount.The district court also rejected Fort's argument that the forfeiture provision prevented him from constructively receiving the Restricted Shares in 2000. The court explained that "the fact that the partners risked having to return some of their shares at a later time does not mean that they did not constructively receive the shares in the first place."Id.

Fort Appeals to the Eleventh Circuit

In review of the district court’s grant of summary judgment de novo, i.e., viewing the moving party’s evidence and all factual inferences arising from it in the light most favorable to such party, there is nevertheless, no genuine issue of any material fact and the moving party is entitled to judgment as a matter of law. Fort has appealed the grant of summary judgment in the government's favor, arguing that he did not "receive" the escrowed shares of stock in the year 2000 for tax purposes, and, therefore, was not taxable for their value in that year.

Government’s Danielson Rule Argument Rejected.

The government used the Danielson doctrine or rule in challenging that Fort’s ability to amend his 2000 return is limited because the CGE&Y agreement stated that Fort agreed to report his receipt of the Restricted Shares as income in 2000. See Comm’r v. Danielson, 378 F.2d 771 (3^rd Cir. 1967). The government argues, citing to Danielson, that Fort's ability to challenge his 2000 tax return is limited, because the CGE&Y agreement stated that Fort agreed to report his receipt of the Restricted Shares as income received in 2000. Fort responds that the Danielson rule is inapplicable to this case. The Court agreed. The taxpayer argued that the agreed upon form of the transaction had particular tax consequences and since the form of the transaction was not in dispute, the Danielson doctrine did not apply. See, e.g., United States v. Fletcher, 562 F.3d 839, 842–43 (7th Cir. 2009) (in a case dealing with this same transaction and materially identical facts as the one at bar, the Seventh Circuit rejected reliance on the Danielson rule, writing that "because [the former E&Y partner] does not try to recharacterize the transaction, doctrines that limit or foreclose taxpayers' ability to take such a step are beside the point"); United States v. Nackel, 686 F. Supp. 2d 1008, 1019 [105 AFTR 2d 2010-474] (C.D. Cal. 2009) (in another case involving this same transaction, the District Court for the Central District of California wrote: "The government impermissibly conflates case law concerning a party's effort to look through and re-characterize the form of a transaction with that which addresses what the parties intended would be the tax consequences of a transaction. The former is subject to the heightened scrutiny sought now by the government, the latter is not."). The Eleventh Circuit panel of judges agreed that the Danielson rule was inapplicable in resolving the case.

 

The district court below had held that in the year 2000 Fort did not actually receive the income from the Restricted Shares but was in constructive receipt of the Restricted Shares and therefore the value of such stock should be includible in gross income to the extent of the agreed value of such Shares in 2000.

The Eleventh Circuit observed that in general,, when assets are placed in escrow as security or otherwise and the taxpayer receivesno right to control or otherwise enjoy those assets, the courts and the Service have held that income is not realized until such time as the contingency is satisfied and the funds are paid over to the taxpayer. On the other hand, the courts and the Service have generally held ... that income is presently realized notwithstanding that the taxpayer lacks an absolute right to possess the escrowed assets. Consistent with the IRS's position, courts have held that a taxpayer presently realizes income when he or she possesses sufficient indicia of control over the assets held within an escrow account or escrow-type arrangement.

In a case involving the legendary comedian and actor, Charles Chaplin v. Commissioner, a company delivered shares of stock to Charlie Chaplin in 1928, who then was required to place the shares in escrow, only to be released when he delivered photoplays to the company in later years. 136 F.2d at 300. The Ninth Circuit held that the shares were income to Chaplin at the time of the initial delivery in 1928, not later, when Chaplin delivered the photoplays and the shares were released. Id. The Ninth Circuit emphasized that Chaplin possessed the following indicia of control over the shares in escrow: (1) the contract at issue vested ownership immediately in Chaplin and the shares were issued in his name; (2) Chaplin had voting rights in the shares; (3) dividends on the shares were declared and paid to an escrow agent who held them for Chaplin's benefit; and (4) Chaplin was considered the owner of the shares.

 

In Bonham v. Commissioner, also cited above, a taxpayer and a company agreed that the taxpayer would receive title in 750 shares of stock, but the shares would be deposited with the company "as a guarantee for [his] performance." The Eighth Circuit held that the taxpayer realized immediate income when he initially received the 750 shares, not when the shares were later withdrawn.

In the case at bar the Eleventh Circuit was impressed with the fact that it could look at other courts which addressed the same issue arising from the same transaction.. In each of these cases, the courts held that the receipt of the Restricted Shares constituted income in the year 2000.United States v. Bergbauer , 602 F.3d 569, 581] (4th Cir. 2010), cert. denied, 131 S. Ct. 297 (2010);Fletcher , 562 F.3d at 845; Nackel, 686 F. Supp. 2d at 1026; United States v. Berry, 2008 WL 4526178 [102 AFTR 2d 2008-6447], at 7 (D.N.H. Oct. 2, 2008);United States v. Culp , 2006 WL 4061881 [99 AFTR 2d 2007-618], at 1 (M.D. Tenn. Dec. 29, 2006).

Of those related decisions, the lower court placed emphasis on the Fletcher decision out of the Seventh Circuit. In Fletcher the court stated that "a taxpayer's willingness to defer consumption does not defer taxation." 562 F.3d at 843. The court concluded that the CGE&Y agreement was merely a deferral of consumption, not income, for three reasons: (i) the partners bore the market risk that the Restricted Shares would appreciate or depreciate from the date of the closing, because the market price of the Restricted Shares could rise or fall while the shares were in the Merrill Lynch account; (ii) Cap Gemini had already paid the Restricted Shares into the partners' Merrill Lynch accounts, the partners merely agreed to postpone unrestricted access to the stock, rather than to allow Cap Gemini to pay them later; and (iii) the partners agreed to value the Restricted Shares at a discount—95% of the market price of the underlying shares on the closing date—which reflects "not only illiquidity but also the risk that [Cap Gemini] would use its power over the account in an unauthorized way, or that Merrill Lynch might fail in its duty as a custodian." The Eleventh Circuit concurred with the lower court that the Fletcher Court’s decision and supporting analysis was persuasive and that the case involved a mere "delay in consumption" and not a "delay of income".

After weaving through the various restrictions and limitations under the master purchase agreement, the Eleventh Circuit held that the lower court’s grant of summary judgement was affirmed. In sum, Fort constructively received the Restricted Shares in 2000. The fact that Fort could not access the shares immediately was merely a postponement of consumption, not income: CGE&Y paid the full consideration of the shares into Fort's Merrill Lynch account on the closing date, and therefore, Fort bore the market risk of share appreciation or depreciation beginning on the closing date. This conclusion is buttressed by the fact that Fort possessed indicia of control over the shares: he had dividend and voting rights in the shares, and the shares were held in an individual account in Fort's name. Additionally, constructive receipt was not impossible simply because Fort was required to forfeit the shares upon the occurrence of certain conditions, because Fort had sufficient control over whether those conditions would occur. Therefore, Fort realized income at the time the Restricted Shares were transferred into his Merrill Lynch account in 2000.

Constructive Receipt Doctrine . Cap Gemini did not require Fort to forfeit any of his Restricted Shares. Shortly after his termination, Fort learned that several former E&Y consulting partners had filed amended year 2000 tax returns, claiming that they did not realize income from the Restricted Shares in that year. Fort followed suit, filing his own year 2000 amended return, asserting that he did not realize income in 2000 from the then-value of the Restricted Shares. The IRS initially accepted Fort's amended return and granted him a refund for his 2000 tax return. Subsequently, however, the IRS determined that the refund to Fort was in error, and the government filed this suit to recover the refund.

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In Historic Boardwall Hall, LLC. V. Commissioner, 136 T.C. No. (2011) the Tax Court ruled that a LLC which was formed to facilitate a corporation's, i.e, Pitney Bowes, investment in the rehabilitation of an historic government building, East Hall, a National Historic Landmark property in Atlantic City, New Jersey had business purpose and was not a sham.The investment was designed to earn the controlled entity of Pitney Bowes, Historic Boardwalk Hall, LLC, rehabilitation credits under section 47. The Tax Court ruled, therefore, that the corporate partner was entitled to its distributive share of the claimed rehabilitation tax credits.

 

The Tax Court determined that the LLC that was formed by New Jersey Sports and Exposition Authority (NJSEA) and investment corp. (corp. partner), to allow corp. partner investment in rehabilitation of historic hall/governmentally-owned building and obtain §47 rehabilitation tax credits, had objective economic substance based on fact that corporate partner did not enter into transaction solely for tax credits but also to invest with a realistic possibility of realizing economic gain or profit and that corporate partner’s investment provided NJSEA  with more money than it otherwise would have had, that development fee involved was legitimate expense, and that there were real risks involved. Court also viewed the legislative purpose to the rehabilitation credit provision and found that the evidence in the case was not inconsistent with such purpose.  The Court rejected arguments lobbied by the government that the corporate partner never obtained partner status, the benefits and burdens of the hall’s ownership were never transferred in a sale to the partnership, and that the purchase option, under which NJSEA could buy back the hall did not cause the taxpayer’s reporting of the rehabilitation credits to be erroneous. The Tax Court further rejected the IRS’s determination under the anti-abuse regulation, Treas. Reg. §1.701-2(b), to recast the transaction so as to deny the corporate partner its desired allocation of the §47 rehabilitation credits.

 

Economic Substance of Transaction Upheld.

 

The Court found that there was both an objective profit motive and subject business purpose present under the facts. See CM Holdings, Inc., 90 AFTR 2d 2002-5850 , 301 F3d 96 ,  2002-2 USTC ¶50596 (CA-3, 2002)(conjunctive two part test applied by 3rd Circuit). The IRS argued that Boardwalk Hall had no possibility of earning a profit apart from a 3% fixed return and the benefits related to the rehabilitation credits. For the subjective test, the IRS argued that Boardwalk Hall had no business purpose because it was intended solely to facilitate NJSEA's sale of rehabilitation tax credits to Pitney Bowes.

 

The Tax Court dismissed the arguments by noting that section 47 is intended to encourage taxpayers to participate in what would otherwise be an unprofitable activity. The court added that when the rehabilitation tax credits were taken into account, the objective profit test was adequately satisfied. Further, because Boardwalk Hall pursued the risk-laden objective of rehabilitating a landmark convention center for use as a special events center, the court found that the subjective business purpose requirement was also met. In sum, the Tax Court concluded that Boardwalk Hall had economic substance and was not a sham.

 

Partnership Status

 

The IRS also argued that Pitney Bowes was not a partner in Boardwalk Hall because it had no meaningful stake in its success or failure and its interest in Boardwalk Hall was more like debt than equity. The Tax Court dismissed these arguments, stating that Pitney Bowes and NJSEA joined together in a transaction with economic substance to allow Pitney Bowes to invest in the East Hall rehabilitation. Further, the court noted that the decision to invest provided a net economic benefit to Pitney Bowes through its 3% preferred return and rehabilitation tax credits.

 

Rejection of Application of Partnership Anti-Abuse Regulation

 

Finally, the IRS argued that it was necessary to recast the transaction under Treas. Reg. §1.701-2(b), the anti-abuse transaction. Because of its finding that the transaction had economic substance, the Court held it was inappropriate to then hear the case under the filter of this GAAR rule for partnerships.  

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In Gudmundsson v. U.S., 107 AFTR 2d 107 AFTR2d ¶2011-456 (2nd Cir. 2011) the Court of Appeals for the Second Circuit has affirmed a district court decision which dismissed the taxpayers’ claim for refund in tax based on an alleged overvaluation of stock one of the spouse’s received under an incentive (employee) stock option plan where the stock subsequently precipitously fell in value. The lower court found that since the stock received had "vested" for purposes of §83, i.e., the stock was transferable and not subject to a substantial risk of forfeiture on the date of receipt, there was no rule in §83 that would permit the taxpayer to defer the recognition date or the proper time for valuing the stock until a later date.

The taxpayer was an office of a Midwest food concern and was a participant in an incentive stock plan. Under the plan he received the right to the distribution of approximately 73,000 shares of employer stock as part of an IPO of the company. The IPO was effectuated in July, 1998. Under the terms of the plan, the taxpayer was issued and received the shares of stock on July 1, 1999. The taxpayers 1999 return, consistent with the Form W-2, reported that the taxpayer, Olafur Gudmundson, received stock worth $1.3M. This is due to the rules underlying §83 that vested stock received for services is valued for federal income tax purposes on the date of receipt. re not subject to a substantial risk of forfeiture. The stock received was still subject to certain resale restrictions imposed by securities laws and internal agreements.

By the end of 1999, the value of the publicly traded shares fell by over 26%. A further drop in value to 50% of the IPO value occurred in February 2000. Claims of alleged mismanagement of the Company resulted in the filing of indictments in early 2001 against the former officers of the Company who eventually entered guilty please for securities fraud and related charges.

The taxpayers filed an amended return within the 3 year period for filing a claim for refund the taxpayer claimed was due for an alleged overpayment of tax of approximately $300,000 plus statutory interest for 1999. The argument made by the taxpayer that the stock he received on July 1, 1999 should have valued at the market price at the end of the year instead of based on the stock price on date received. The IRS rejected the claim and the taxpayers filed a refund suit in Federal District Court. 104 AFTR 2d 2009-7093.

The District Court rendered a summary judgment and stated that the taxpayer failed to show that the stock was not "vested" for §83 purposes as of July 1, 1999. The Court of Appeals for the Second Circuit examined the timing and valuation issues involved in the case. First it rejected the argument made that the risk that the taxpayer could lose his job did not defer or postpone the proper date for including the value of the stock received in gross income. Such possibility did not constitute under the facts of the case a "substantial risk of forfeiture". What the taxpayer failed to prove was that the stock would be forfeited, not simply the taxpayer’s job. The Court further held that the taxpayer’ claim that he was potentially running the risk of a fraud action filed by the SEC constituted a a substantial risk of forfeiture. However, §83(c)(3) blocked this approach since its application is limited to civil suits other than those brought under §16(b) of the 1934 Securities Act. The Court found that the stock received was transferable under §83.

On the stock value, the taxpayer was held to have failed to offer any legal basis for not valuing the stock received on July 1, 1992 and not some later date. For purposes of §83(a), property received [for services] is valued at its "fair market value (determined without regard to any restriction other than a restriction which by its terms will never lapse)". The taxpayer failed in his effort to convince the appellate court that the trial failed in determining fair market value by not reducing the IPO value by restrictions imposed on him with respect to transferring the shares and lack of marketability. Here such issues were limited in duration and thus were property rejected.

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In Canal Corp., supra, the Tax Court recently held that a corporation's 1999 transfer of a wholly owned subsidiary to a joint venture was a disguised sale that required the company to include in capital gain the amount realized in the year of sale on its consolidated federal income tax return. An accuracy related penalty under §6662 for a substantial understatement of income tax was imposed notwithstanding the fact the PricewaterhouseCoopers (PwC) had issued a favorable opinion letter on the transaction. The Court, per the majority opinion written by Judge Kroupa,  held that the “should” level of comfort  opinion was nothing more than a “quid pro quo” between the taxpayer and the accounting firm which its board of directors insisted upon in order to engage in the tax motivated transaction.

FACTS
In 1985, the taxpayer, Chesapeake Corp. (Chesapeake), the predecessor to Canal Corp. (and subsidiaries), acquired Wisconsin Tissue Mills, Inc., (WISCO) its largest subsidiary. Chesapeake restructured 12 years later focusing on specialty packaging but WISCO did not fall within the new strategy. Chesapeake’s basis in WISCO was small relative to its value and therefore Chesapeake preferred to not engage in a direct taxable sale to an interested buyer, Georgia-Pacific (GP). 
An investment banking firm selected to advise Chesapeake recommended a leveraged partnership structure. The leveraged partnership involved WISCO and Georgia-Pacific contributing their respective tissue-business assets to a joint venture. The joint venture would borrow money from a third party and distribute it to Chesapeake, which would guarantee the debt, resulting in WISCO having a minority interest in the joint venture and Georgia-Pacific having the majority interest. The intended result would be that Chesapeake would receive a large sum of cash but would not recognize gain for tax purposes under the disguised sales rules under §707(a)(2)(B). It would still book the transaction as a sale for financial accounting purposes.
PwC, the outside auditor and tax return preparer for Chesapeake, assisted in structuring the transaction and helped in the drafting of an indemnity agreement whereby WISCO served as the indemnitor of the joint venture's debt. In its opinion letter, PwC expressed its highest level of comfort that the company would succeed on the merits and would avoid gain treatment on the distribution of the cash. Chesapeake's board, in approving the transaction, made clear to PWC and its investment banker that the asset transfer and special distribution had to be nontaxable for it to approve the transaction. The planned tax deferral enabled Chesapeake to accept a lower price for WISCO.
The planned joint venture was effectuated, i.e., formation of Georgia-Pacific Tissue LLC, and a subsidiary of Georgia-Pacific loaned money to the LLC to help repay the original return. Chesapeake did not report any gain on the transaction although, as mentioned,  the transaction was treated as a sale for accounting purposes. The companies carried out the transaction, creating Georgia-Pacific/WISCO LLC. The joint venture operated for a year, with WISCO selling its minority interest to Georgia-Pacific in 2001.

Notice of Deficiency Issued by IRS
The IRS issued Chesapeake a notice of deficiency, attributing $524 million in capital gains to the company from the transaction, finding that it was a disguised sale, and imposing a $36 million accuracy-related penalty.
In its opinion, the Tax Court stressed that when a partner receives a distribution shortly after making a contribution of property, the transaction may be deemed a sale. Under Treas. Reg. §1.707-3(c)(1), “contributions and distribution transactions” within 2 years are presumed to effect a sale unless the facts and circumstances clearly establish otherwise. The court concluded that a disguised sale occurred under the rules.
The taxpayer’s reliance on Treas. Reg. §1.707-5(b), the so-called “debt-financed transfer” exception was rejected. It found instead that WISCO's indemnity agreement should be disregarded under the partnership anti-abuse regulation pertaining to the allocation of partnership debt. Treas. Reg. §1.752-2(j)(4).

Tax Court's Decision In Favor of Respondent-Commissioner
The court found that the agreement was designed to limit the risk to WISCO's assets. The court also found that an intercompany note between WISCO and Chesapeake only served the purpose of giving the appearance of economic risk, and it said the indemnity agreement lacked economic substance.
The court also rejected Chesapeake's argument that the 10% net worth requirement in Rev. Proc. 89-12 was  also inapplicable. The court found that the indemnity agreement should be disregarded and further found that WISCO sold its business assets to Georgia-Pacific in 1999 in accordance with §707(a)(2)(B), the year it contributed the assets to the LLC, not the year it liquidated its LLC interest.
Finally, the court sustained the IRS's determination that Chesapeake was liable for a §6662(a) accuracy-related penalty for 1999. It found that PwC lacked the independence necessary for Chesapeake to establish good-faith reliance and that Chesapeake did not act with reasonable cause or in good faith in relying on PwC's opinion.
The mathematics to the disguised sale resulted in a $755M recharacterization of the distribution as a receipt from the disguised sale resulting in a realized gain of approximately $524M. The deficiency in tax was approximately $183.5M and the penalty was 20% of such amount or approximately $36.7M.

 

Reliance on PwC Opinion Did Not Result in Abatement of Accuracy Related Penalty
Chesapeake’s Board not only accepted a lower price for WISCO based on the tax deferral but further conditioned entering into the transaction in exchange for PwC’s issuance of a “should” (approximately 70-75% favorable) tax opinion. The fee for the opinion was for an agreed price of $800,000.
PwC knew that the transaction’s favorable treatment depended on whether the leveraged debt would, under the indemnity agreement, be allocated solely to WISCO. While there was no direct authority on point, the PwC favorable opinion was based on the indemnification by WISCO of Georgia-Pacific’s guaranty be given substance for federal income tax purposes. PwC advised Chesapeake, therefore, that WISCO could defer gain until it sold its remaining assets, paid off the debt, or sold its partnership interest. Mr. Miller advised that WISCO maintain assets of at least 20% of its maximum exposure under the indemnity. Although there was no direct authority requiring this percentage such standard was sourced from Rev. Proc. 89-12, 1989-1 C.B. 798, obsoleted by Rev. Rul. 2003-99, 2003-2 C.B. 388. Moreover, Rev. Proc. 89-12, supra, made no reference to allocation of partnership liabilities.
The parties effected the transaction on the same day PWC issued the "should" opinion.

Termination of the Georgia-Pacific Joint Venture
One year after the establishment of the joint venture, the deal ended in 2001 when Georgia-Pacific set out to acquire the Fort James Corporation. The Department of Justice in order to approve of the acquisition, required Georgia Pacific to sell its LLC interest for antitrust purposes. As part of a sale to a Swedish concern, Georgia-Pacific  first offered to purchase and WISCO agreed to sell its minority interest in the LLC to Georgia-Pacific for $41 million, a gain of $21.2M from its initial valuation of $19.8M. Georgia-Pacific further agreed to pay Chesapeake $196M to compensate Chesapeake for any loss of tax deferral. Chesapeake reported a $524M capital gain on its consolidated Federal tax return for 2001. Chesapeake determined that the termination of the indemnity resulted in WISCO receiving a deemed distribution under §752. Chesapeake also reported the $196M tax cost make-up payment from GP as ordinary income on its consolidated Federal tax return for 2001.
Respondent issued Chesapeake a notice of deficiency for 1999 claiming that the alleged joint venture was instead a disguised sale that produced $524 million of capital gain includable in Chesapeake's consolidated income for 1999. Chesapeake timely filed a petition to the Tax Court. Respondent asserted in an amended answer a $36,691,796 accuracy-related penalty under section 6662 for substantial understatement of income tax.

Analysis of Accuracy Related Penalty

Most tax advisors are quite familiar with the particular rules surrounding the imposition of an accuracy related penalty under §6662(a) and §6662(b)(2) for a substantial understatement of income tax . The mathematical threshold was easily reached in this case, i.e., the greater of10% of the tax required to be shown on the return or $10,000. §6662(d)(1); Treas. Reg. §1.6662-4(b)(1). However the penalty does not apply with respect to any portion of an underpayment if a taxpayer shows that there was reasonable cause for, and that the taxpayer acted in good faith with respect to that portion.  §6664(c)(1); Treas. Reg. §1.6664-4(a), Income Tax Regs. Among the relevant factors are the taxpayer’s efforts to determine its proper amount of taxes owed, its knowledge and experience and the reliance on the advice of a competent tax adviser. Treas. Reg. §1.6664-4(b)(1). See §6664(c); U.S. v. Boyle, 469 U.S. 241, 250-251 (1985).

However, the Tax Court opinion warned that reliance on the advice of a tax professional is not unlimited. Neither reliance on the advice of a professional tax adviser nor reliance on facts that, unknown to the taxpayer, are incorrect the required reasonable cause or good faith needed to avoid imposition of the penalty. Long Term Capital Holdings v. U.S., 330 F. Supp. 2d 122, 205-206 (D. Conn. 2004), affd. 150 Fed. Appx. 40 (2d Cir. 2005). Moreover, it is unreasonable for a taxpayer to rely on a tax adviser actively involved in planning the transaction and tainted by an inherent conflict of interest. See e.g., Mortensen v. Commissioner, 440 F.3d 375, 387 (6th Cir. 2006), affg. T.C. Memo. 2004-279; Pasternak v. Commissioner, 990 F.2d 893 (6th Cir. 1993), affg. Donahue v. Commissioner, T.C. Memo. 1991-181; Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43 (2000), affd. 299 F.2d 221 (3d Cir. 2002). A professional tax adviser with a stake in the outcome has such a conflict of interest.

In countering the taxpayer’s arguments of proper reliance and good faith, the Service argued that the taxpayer unreasonably relied on an opinion that made improper assumptions and was written by a tax advisor which had a conflict of interest.

The Court went on to criticize the manner in which the agreed fee was determined, the sloppiness of the written opinion itself and the amount of time actually spent on it, and concluded that PwC’s time spent in analyzing and writing the opinion was not relevant to the determination of the amount of the fee which was substantial. The opinion was found to be filled with questionable conclusions and unreasonable assumptions. There was, for example, a conclusion made by PwC that WISCO’s maintaining 20% of the LLC debt was a favorable factor in reaching its “should” opinion. The Court was highly critical of the work product and effort that went into the production of the “should” tax opinion. The Court was also upset about the number of times the draft opinion used the word “it appears” in the draft opinion. This language was used to support the author’s analysis under §752 regulations adopting an “all or nothing approach” which had no basis other than the author’s interpretation. The opinion failed to consider whether the indemnity agreement had substance. Factors indicating it did not was that neither the joint venture agreement nor the indemnity agreement included provisions requiring WISCO to maintain any minimum level of capital or assets. WISCO and Chesapeake could also remove WISCO's main asset, the intercompany note, from WISCO's books at any time and for any reason. The opinion was therefore not of reasonably quality and analysis and it was unreasonable for the taxpayer to rely on such an opinion. It did not act in good faith.

Finally, the PwC opinion was inflicted or tainted with an inherent conflict of interest. The party issuing the opinion not only researched and drafted the tax opinion he also "audited" WISCO's and the LLC's assets to make the assumptions in the tax opinion. He made legal assumptions separate from the tax assumptions in the opinion. He reviewed State law to make sure the assumptions were valid regarding whether a partnership was formed. In addition, he was intricately involved in drafting the joint venture agreement, the operating agreement and the indemnity agreement. 
As the court stated: “In essence, Mr. Miller issued an opinion on a transaction he helped plan without the normal give-and-take in negotiating terms with an outside party. We are aware of no terms or conditions that GP required before it would close the transaction. We are aware only of the condition that Chesapeake's board would not close unless it received the "should" opinion. Chesapeake acted unreasonably in relying on the advice of PWC given the inherent and obvious conflict of interest. See New Phoenix Sunrise Corp. & Subs. v. Commissioner, 132 T.C. 161, 192-194 (2009) (reliance on opinion by law firm actively involved in developing, structuring and promoting transaction was unreasonable in face of conflict of interest); see also CMA Consol., Inc. v. Commissioner, T.C. Memo. 2005-16 (reliance not reasonable as advice not furnished by disinterested, objective advisers); Stobie Creek Invs., LLC v. United States, 82 Fed. Cl. 636, 714-715 (2008), affd. ___ Fed. 3d ___ (June 11, 2010).”
The Court therefore held that PWC lacked the independence necessary for Chesapeake to establish good faith reliance. It further found that the taxpayer did not act with reasonable cause or in good faith in relying on PWC's opinion.  The penalty was therefore properly imposed by the Service.
Comment
The Canal Corp., supra, case warns taxpayers that certain tax opinions and advise by tax advisers, including those who are highly compensated and work for high-powered accounting and law firms, will in various instances not avoid the imposition of an accuracy related penalty. For issues involving the alleged lack of economic substance, the presence of a favorable tax opinion is irrelevant. See §7701(o). See also, August, “Codification of Economic Substance Doctrine, Parts I and II”, Business Entities (Sept/Oct) and (Nov/Dec 2010).

 

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The Seventh Circuit has just overruled the Tax Court on whether an erroneous overstatement of basis constituted an "omission of gross income" for purposes of §6501(e)(1)(A) thereby resulting in a six year statute of limitations instead of the general or standard three year statute where the resulting omission reaches the 25% threshold.

The case involved the taxpayer’s investment in a Son-of-BOSS (bond and option sales strategy) type transaction which the government labeled as abusive. In a Son-of-BOSS transaction, an individual uses a short sale to artificially increase his basis in a partnership interest or stock in an S corporation prior to selling the interest, thereby materially reducing his capital gains tax on the sale. A short sale is a "sale in which an investor sells borrowed securities in anticipation of a price decline and is required to return an equal number of shares at some point in the future." The short sale produces proceeds from the sale of the shares as well as an outstanding liability in the amount of the number of borrowed shares multiplied by the current price per share. This liability disappears when the short is closed out, and the hope of the usual short seller is that between the time he borrows the shares and the time he closes out the short, the price per share will have dropped so that he makes more selling the borrowed shares up front than he spends later to replace them. The tax gain or loss recognition in a short sale is delayed until the seller closes the sale by replacing the borrowed property. A Son-of-BOSS transaction strategy is designed to produce a substantial capital loss which can be used to reduce the taxpayer’s long term capital gains from other sources, such as gain from the sale of a business.

In Notice 2000-444, the Service announced it would challenge Son-of-Boss type transactions. This later resulted in favorable court decisions for the Service on the finding that Son-of-Boss basis plays lacked economic substance. In 2004, the IRS offered a settlement initiative to approximately 1,200 identified taxpayers, but that left a large number of taxpayers who did not qualify or who had not yet been identified as taking part in a Son-of-BOSS transaction.

Here, in 1999, the taxpayer participated in a short sale of U.S. Treasury Notes, recognizing cash proceeds of $12,160,000. Beard then purchased more Treasury Notes in two transactions for $5,700,000 and $6,460,000. He then transferred these Treasury Notes to two Subchapter S companies in which he was majority owner, MMCD, Inc. and MMSD, Inc., respectively, along with the obligation to close out the short positions. On that same day, MMCD and MMSD sold these Treasury Notes and closed out the short positions for $7,500,000 and $8,500,000, respectively. Beard then sold his ownership interests in the two companies.

On their 1999 tax return, the Beards reported long-term capital gains of $413,588 and $992,748 from the sale of the MMCD and MMSD stock, respectively. They arrived at these numbers by subtracting bases of $6,161,351 and $6,645,463 from the sale prices of $6,574,939 and $7,638,211. The Beards also reported gross proceeds from the sale of Treasury Notes of $12,125,340, a cost basis of $12,160,000, and a resulting net loss of $34,660. The high bases in MMCD's and MMSD's stock resulted from the asymmetric treatment of the short sale transactions—Beard had increased his outside bases in the companies by the amount of the short sale proceeds contributed to each company, but had not reduced the bases by the offsetting obligation to close the short positions taken into account by the corporations. The 1999 tax returns of MMCD and MMSD did not indicate that these S corporations had assumed the liability to cover the short positions.

In 2006, the Service issued a notice of deficiency, reducing the Beards' bases in the MMCD and MMSD stock by the amount of the transferred Treasury Notes, and increased the Beards' taxable capital gains by $12,160,000.

The Beards contested this deficiency in the Tax Court, and, rather than disputing the facts, moved for summary judgment on the legal ground defense that the statute of limitations had run, and in particular, that an overstatement of basis is not an omission from gross income for the purpose of the extended six-year statute limitations per §6501(e). See Colony Inc. v. Comm’r, 357 U.S. 28 (1958). The Tax Court granted summary judgment in favor of the taxpayers and the Service appealed.

In reviewing the applicable precedent and legislative history, and the lower court’s reliance on the Colony Inc., supra, decision, the Seventh Circuit noted that the question has been addressed by multiple federal courts, with differing results. Some have found that Colony does not apply and an overstatement of basis can be an omission from gross income. See, e.g., Phinney v. Chambers, 392 F.2d 680 (5th Cir. 1968); Home Concrete & Supply, LLC v. United States, 599 F. Supp. 2d 678 (E.D. N.C. 2008), appeal docketed, No. 09-2353 (4th Cir. Dec. 9, 2009); Burks v. U.S., 2009 WL 2600358 (N.D. Tex. June 13, 2008), appeal docketed, No. 09-11061 (5th Cir. Oct. 26, 2009); Brandon Ridge Partners v. U.S., 100 A.F.T.R. 2d 2007-5347, 2007 (M.D. Fla. Jul. 30, 2007). Others have found that Colony, supra, does apply and an overstatement of basis is not an omission of gross income. See, e.g., Salman Ranch Ltd. v. U.S., 573 F.3d 1362 (Fed. Cir. 2009);Bakersfield Energy Partners LP v. Comm’r, 568 F.3d 767 (9th Cir. 2009);Grapevine Imports, Ltd. v. U.S.,77 Fed. Cl. 505 (2007), appeal docketed, No. 2008-5090 (Fed. Cir. June 27, 2008).

The Seventh Circuit reversed and despite acknowledging that the issue is a "close call" it held that the plain meaning of the Code and a close reading of Colony case supports the conclusion that Colony does not control the proper interpretation of (revised) §6501(e)(1)(A) and that an overstatement of basis can be treated as an omission from gross income under the 1954 Code. In support it cited Regions Hospital v. Shalala, 522 U.S. 448, 467 (1997); Hawkins v. U.S., 469 F.3d 993, 1000 (Fed. Cir. 2006).

The Court further alluded to Temp.Reg. §301.6501(e)-1T(a)(1)(iii) which takes the position that an overstatement in basis can lead to an omission from gross income. This regulation has now been finalized. While the Seventh Circuit decided the case without taking the regulation into account, i.e., it found that Colony, supra, was not applicable, it strongly hinted that it would have been inclined to grant the temporary regulation Chevron deference had it needed to resolve the case on this alternative theory.

 

 

 

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The Tax Court, applying the Chevron “deference” for Service issued interpretative regulations test,  held that the §6664 definition of underpayment is ambiguous but that  Treas. Reg. §1.6664-2(c)(1) is a permissible construction of the statute and therefore a valid regulation. The court also held that the tax evasion exception to the statute of limitations in §6015 applies and that the taxpayer is subject to fraud penalties based on application of the regulation in question to the facts in the case. . 

Summary of Facts
Petitioner-Feller was a CPA and a partner in his accounting firm. In Rick D. Feller was a CPA and partner in his accounting firm. In 2004 Feller and two members of his firm became 100% owners of the stock of a corporate which owned and operated two nursing homes. Feller served as president, was active in the business operations of the corporation and also prepared the corporation’s tax returns. On his income tax returns for prior periods, i.e.., 1992-1997, both actual and false W-2 reporting of his wages were attached. He also filed Schedules E claiming false losses from his CPA firm and false Schedules A claiming inflated deductions for state and local taxes based on his false W-2s. He then claimed refunds for all 7 years in issue. 
Following an audit, Feller was charged criminally with preparing and filing a false return for 1997. In 2003, he pleaded guilty to preparing and filing a false return for 1997 and admitted he intentionally filed false returns for all the years at issue and had filed false claims for refund when in fact he owed taxes. 
The Service issued notices of deficiency in 2006 but ignored prepayment tax credits in its calculation. Section 6664 requires that excess withholding tax credits be used in determining a section 6663 overpayment. The IRS  later sent Feller corrected notices shortly thereafter. Feller then sought a  redetermination by the Tax Court, arguing that the statute of limitations in section 6501 barred the assessments and that section 6664 is invalid.

Tax Court Rules in Favor of Commissioner
The Tax Court rejected Feller’s arguments.  The Tax Court, per Judge Haines, first addressed the statute of limitations argument. Petitioner argued that the statutory notice was not filed within the normal 3 year period set forth in §6501(a). The government countered that because the petitioner’s returns that were filed were “false” and with an intent to evade taxes, that the unlimited period for assessment under §6501(c)(1) was controlled.  that the issuance of the notices of deficiency was barred by section 6501(a). Section 6501(a) provides the general rule that the amount of any tax imposed must be assessed within 3 years after the return is filed. An exception to the 3-year rule is provided in section 6501(c)(1). As per §7454(a) and Tax Court Rule 142(b), the government had the burden of proof of the intent to evade to keep the statute open. See Petzoldt v. Comm’r, 92 T.C. 661, 699 (1989).

By virtue of the petitioner’s guilty plea under §7206(1) for filing a false return in 1997 and further admitted, in his plea agreement, that by attaching to his returns fictitious Forms W-2 which overstated income tax withheld, he engaged in a pattern of filing false returns and fraudulent conduct. Through his conduct he obtained $320,078 in Federal refunds to which he was not entitled over the 6-year period. Based on the record, the Tax Court held that the Service met its burden of proof by clear and convincing evidence that petitioner filed his returns for the years at issue with the intent to evade tax. See Brister v. U.S., 35 Fed. Cl. 214 (1996) (involving an accountant and bookkeeper who overstated withholding credits to obtain refunds). Thus, the unlimited period for assessment under §6501(c)(1) applied for all years in which such fraudulent conduct arose.

The next argument made by petitioner was to the imposition of the civil fraud penalty. Under §§6663 and 6664, along with Treas. Reg. §1.6664-2(c), the Service must prove respondent must also prove that the fraud resulted in underpayments of tax required to be shown on the returns. The term “underpayment” per §6664(a) is the amount of tax imposed by this title exceeds the excess of: (i) the sum of (A) the amount shown as the tax on the taxpayer’s return, plus (ii) the amounts no so shown previously assessed (or collected without assessment), less: (i) the amount of rebates, i.e., abatements, credits, refunds or other repayment.

The Court disagreed that §6664 can into play. It looked at Treas. Reg. §1.6664-2(c)(1), which interprets the definition of "underpayment" in §6664 by stating that the tax shown on the return is reduced by the excess of: (i) the amounts shown by the taxpayer on his return as credits for tax withheld under §31 (relating to tax withheld on wages) * * * over (ii) the amounts actually withheld, * * * with respect to a taxable year before the return is filed for such taxable year.
The regulation extends the meaning of "underpayment" to include a taxpayer's overstated credits for withholding. See Treas. Reg. §1.6664-2(g), Ex.(3).  Where a taxpayer overstates prepayment credits, e.g., credits for wages withheld, the overstatement decreases the amount of tax shown on the return and increases the underpayment of tax. Citing. Sadler v. Comm’r, 113 T.C. 99, 103 (1999).

In response the Petitioner contends that Treas. Regs. §1.6664-2(c)(1) and (g), Ex. (3), are invalid because the statute which it interprets,  §6664, does not refer to credits for tax withheld, and it was not Congress' intent to include withholding credits in the calculation of an underpayment. Feller’s counsel also looked at other parts of the procedural rules to argue that the legislative history to the definition of an “underpayment” in §6664(a) in effect during the years in issue supported its argument. The Serviced argued that when Congress enacted a new penalty regime and significantly reworded the definition of "underpayment" for income tax purposes, it justified the Secretary's clarification of the treatment of overstated prepayment credits.

The fraud penalty would involve a determination of whether the regulations were entitled to judicial deference. The Court of Appeals for the Sixth Circuit, which was the applicable appellate court under the Tax Court’s Golsen Rule,  held that regulations issued under the general authority of the Secretary to promulgate necessary rules, with notice and comment procedures, are entitled to judicial deference as outlined by the U.S. Supreme Court in Chevron U.S.A. Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984). See sec. 7482(b)(2); Golsen v. Comm’r, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir. 1971).

In Chevron, the Supreme Court addressed the circumstances in which the judiciary is to afford an agency discretion to interpret the statutes the agency administers. In what is commonly referred to as the two-step "Chevron analysis", the Supreme Court stated:

“When a court reviews an agency's construction of the statute which it administers, it is confronted with two questions. First, always, is the question whether Congress has directly spoken to the precise question at issue. If the intent of Congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress. If, however, the court determines Congress has not directly addressed the precise question at issue, the court does not simply impose its own construction on the statute, as would be necessary in the absence of an administrative interpretation. Rather, if the statute is silent or ambiguous with respect to the specific issue, the question for the court is whether the agency's answer is based on a permissible construction of the statute.” 467 @ 842-843.

As applied here, the question is what the term "underpayment" means in the context of a fraud statute. The examination requires us to analyze the definitions of a "deficiency" and of an "underpayment" and their interrelationship, if any, in §§6663 and 6664. The question to consider was whether an underpayment can exist without a deficiency.

In determining a deficiency under §6211(a), which has been unchanged since 1954, the term means the correct amount of tax reduced the tax reported by the taxpayer. The excess is a deficiency. Estimated tax payments and withholding credits are ignored. §6211(b)(1).

The definition of an underpayment for purposes of the civil fraud penalty remained unchanged from 1954 until 1989 when existing provisions I the Code were replaced with the accuracy-related penalties set forth in §§6662-6665. See Omnibus Budget Reconciliation Act of 1989, Pub. L. 101-239, sec. 7721(a), 103 Stat. 2395. The legislative history was cited by the Tax Court in recognizing that Congress' primary focus in enacting a new penalty regime was to alleviate taxpayer confusion and the difficulties of administration of several different penalties relating to the accuracy of a tax return. H. Rept. 101-247, supra at 1388. The House report also stated that the definition of "underpayment" in section 6664(a) was not "intended to be substantively different from * * * [previous] law."

Repealed §6653(b)(1) provided that if any part of any underpayment (as defined in subsection (c)) of tax required to be shown on a return was due to fraud, certain penalties applied. Former § 6653(c) tied the definition of an underpayment to the definition of a deficiency.  Again, this tied into the definition of a deficiency in §6211(b)(1) where estimated payments and withholding credits did not enter into the calculation.

Sections 6663 and 6664 replaced repealed  §6653. The 75% civil fraud penalty under §6663 applies “if any part of any underpayment of tax required to be shown on a return is due to fraud…” The term "underpayment" is defined in §6664(a) as the amount by which the tax imposed exceeds the excess of the amount reported on the return which is essentially the same definition as used previously.

Judge Haines opined that where a case involves a deficiency and fraud in which no excess withholding credits are claimed, the calculation of an underpayment is unchanged. In such case, “deficiency” and “underpayment” mean the same thing. However, in a fraud case where there is no deficiency but excess withholding credits have been claimed, as was present in this case, or where there is a fraud case where there is a deficiency and such credits have been claimed, the effect of the statutory changes, in relation to the amount of any underpayment, is unclear from looking at §§6663 and 6664(a) on their face. In other words, the statutory definition of an underpayment is no longer connected or directly linked to the definition of a deficiency under §6211, as it had been in former §6653(c), and the restrictions in §6211(b)(1), excluding estimated tax and withholding credits from the calculation of a deficiency, no longer apply to an underpayment by explicit cross-reference.

Therefore, under Chevron’s first step, for the determination of an underpayment, Congress apparently wanted to retain the basic formula (correct tax - reported tax = underpayment) in §6664 but deleted the express cross-reference to the definition of a deficiency in §6211. Section 6664 is silent and therefore  ambiguous with respect to the issue before the Court, i.e., Congress has not directly addressed the meaning of the term "underpayment" when a taxpayer has overstated withholding credits.

Thus, based on this open question, the Chevron doctrine requires whether the regulation that “filled in the gap” so to speak, Treas. Regs. §§ Treas. Regs. §§ 1.6664-2(c)(1) and (g), Ex.(3), is based upon a permissible construction of the statute.  Judge Haines stated that it doesn’t have to be the only permissible construction. The Court should not disturb the agency's action unless it appears from the statute or its legislative history that it is one that Congress would not have sanctioned.

On March 4, 1991, the Federal Register published a notice of proposed rulemaking regarding the accuracy-related penalty under §6662, the fraud penalty under §6663, and the definitions and rules for purposes of both penalties under  §6664. See Notice of Proposed Rulemaking, 56 Fed. Reg. 8943 (Mar. 4, 1991). The preamble to the proposed regulations stated, inter alia: (i) overstated prepayment credits increase the amount of an underpayment but have no effect on the calculation of a deficiency; (ii) whether a position with respect to an item has substantial authority or is disclosed on a return is relevant to the determination of the amount of a deficiency, but not to the determination of the amount of an underpayment; and (iii) the amount of an underpayment is reduced by amounts not shown on the return that have been previously assessed (or collected without assessment), but the amount of a deficiency is not. The proposed regulations were adopted and published as final regulations on December 31, 1991. T.D. 8381, 1992-1 C.B. 374.

Treas. Reg. §1.6664-2(c)(1), interprets the definition of "underpayment" in §6664 by stating that the tax shown on the return is reduced by the excess of: (i) the amounts shown by the taxpayer on his return as credits for tax withheld under section 31 (relating to tax withheld on wages) * * * over (ii) the amounts actually withheld, * * * with respect to a taxable year before the return is filed for such taxable year. This resulted in “underpayment” status for the year in issue for civil fraud penalty purposes.

Feller, the petitioner, argued that the regulation was inconsistent with Congress’ intent that the House Report to the 1989 legislation stated that the definition of "underpayment" in §6664(a) was not "intended to be substantively different from * * * [previous] law." H. Rept. 101-247, supra at 1394. On the basis of that statement, petitioner argues that the definition of an underpayment, as contemplated by  §6664, should not be different from what it was under §6653(c) and thus withholding credits should be excluded from the computation of an underpayment.

The Court rejected the taxpayer’s argument finding that neither §6664(a) nor the regulation in issue differs substantively from prior law. The basic formula (correct tax - reported tax = underpayment) is retained, and in cases involving a deficiency in which no excess withholding credits are claimed, the calculation of an underpayment, for purposes of  §6664 and its regulations, is no different from what it would have been under former §6653(c)(1). Indeed, Congress has amended §6664 on three occasions but has not altered the definition of the term "underpayment" in response to the regulation. (citations omitted).

The Court found the regulation was entitled to Chevron deference and upheld the validity of the regulation and civil fraud penalty in this case. As to the particular regulation in issue, Judge Haines wrote “By fleshing out the mechanics of what factors into the section 6664 underpayment calculation when a deficiency is not present, it promotes fairness in the administration of the penalties. It also facilitates the standardization of the reasonable cause/good faith exception criteria for the application of all accuracy-related penalties.”

Where the Service proves any portion of an underpayment is due to fraud, the entire underpayment will be treated as attributable to fraud for purposes of the penalty under §6663(b), except any portion of the underpayment that the taxpayer establishes by a preponderance of the evidence is not attributable to fraud. Knauss v. Comm’r, T.C. Memo. 2005-6.  Here, the government proved that the taxpayer committed fraud in filing his returns for the years at issue and the taxpayer  has not shown that any portion of the underpayment in any year at issue is not attributable to fraud. Therefore, the underpayments for the years at issue are subject in their entirety to fraud penalties. §6663(b). Ten other judges agreed with the majority opinion, one concurred and there were two dissents.

 

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So, stay tuned to see if the IRS investigates the case further and Mr. Cooper ultimately is successful in his efforts in filing his claims.

The Petitioner-Cooper in this case, filed 2 claims for a whistleblower award with the IRS pursuant to §7623(b)(4) appealing an adverse determination by the Service. Petitioner then filed with the Tax Court to which the government responded by seeking a dismissal based on lack of jurisdiction because the Service had not issued a determination notice as required under §7623(b)(3). Petitioner claimed that a letter that the Service sent to him was a valid "notice" of denial sufficient to give the Tax Court jurisdiction. The Tax Court, per Judge Diane L. Kroupa, first addressed the jurisdictional issue and found in favor of the Petitioner, i.e., the letter of denial by the IRS constitutes a "determination" for purposes of establishing jurisdiction.

Background

Petitioner, an attorney, submitted two Forms 211, Application for Award for Original Information, to the Internal Revenue Service (IRS) in 2008 concerning alleged violations of the Internal Revenue Code. He alleged in the two claims that certain parties had failed to pay millions of dollars in estate and generation- skipping transfer tax. Petitioner alleged in one claim that a trust having over $102 million in assets was improperly omitted from the gross estate of Dorothy Dillon Eweson (Eweson), resulting in a possible $75 million underpayment in Federal estate tax. He learned of the alleged omission by representing the widow of Ms. Eweson's grandson, who is also the guardian of a purported beneficiary of the trust. He verified the information by examining the public records and the records of his client.

Petitioner alleged in the other claim that Eweson impermissibly modified two trusts as part of a scheme to avoid the generation-skipping transfer tax. The trusts at issue had a combined value of over $200 million at the time of Ms. Eweson's death in 2005. Again, Petitioner learned of the alleged violation through his representation of the widow of Ms. Eweson's grandson. Petitioner submitted additional information to support the allegation several months after filing the claim. He provided newly discovered filings from a New York Surrogate Court proceeding in which a corporate trustee challenged the trust modifications as designed primarily to evade taxation. Petitioner also provided a legal memorandum and draft legal documents from Ms. Eweson's attorneys that indicated the trusts were modified as part of a scheme to avoid the generation- skipping transfer tax.

The IRS Whistleblower Office (Whistleblower Office) notified Petitioner that it had received the whistleblower claims, would investigate and then determine whether his information could meet the requirements for payment of an award. Petitioner was not contacted again until 9 months later when he received a letter denying the claims on the ground that an award was not warranted for either claim because petitioner's information did not "result in the detection of the underpayment of taxes."

Petitioner filed two separate petitions with the Tax Court to which the Service moved to dismiss for lack of jurisdiction since no determination was issued.

The Tax Court derives its jurisdiction from statute, as authorized by Congress. Judge v. Comm’r, 88 T.C. 1175, 1180-1181 (1987); Naftel v. Comm’r, 85 T.C. 527, 529 (1985). As with courts in general, the Tax Court has long held it has jurisdiction to determine whether it can hear a particular case. Hambrick v. Comm’r, 118 T.C. 348 (2002); Pyo Jurisdiction. v. Comm’r, 83 T.C. 626, 632 (1984); Kluger v. Comm’r, 83 T.C. 309, 314 (1984).

Background of Whistleblower Award Program

The Service has long held the ability, i.e., the discretion, to pay an award to a person that aids in: (i) detecting underpayments of tax and (ii) detecting and bringing to trial and punishment persons guilty of violating the internal revenue laws. §7623(a). The discretionary whistleblower awards have been arbitrary and inconsistent, however, because of a lack of standardized procedures and limited managerial oversight. Prior to recent statutory revision, the Court observed that it took an average of 7½ years for a discretionary award to be paid and a slightly shorter period for being rejected. Claims that were rejected did not have to provide a specific reason for the denial on the rationale that such would potentially involving disclosure of confidential return information.

As part of the Tax Relief and Health Care Act of 2006, P.L. 109-432, Congress amended §7623 to require the Secretary to pay nondiscretionary whistleblower awards and granted the Tax Court jurisdiction to review such rewards. Under current law, a whistleblower can receive a minimum nondiscretionary award of 15% of the collected proceeds where the Service proceeds with administrative or judicial action using information provided in a whistleblower claim. Under §7623(b)(4), the whistleblower has 30 days from the issuance of a non- discretionary award determination to file a petition in this Court. Guidance in this area was issued by the Service in Notice 2008-4, 2008-1 C.B. 253. Whistleblowers must file Form 211 which the Whistleblower Office must acknowledge its receipt. The Whistleblower Office will send correspondence to the whistleblower once a final determination regarding the claim has been made. Final Whistleblower Office determinations regarding awards may beappealed to this Court. Id. Awards will not be paid, however, until there is a final determination of the tax liability and the amounts owed are collected. The Commissioner also issued procedural guidance on how whistleblower claims will be processed. See IRM 25.2. 2 (Dec. 30, 2008). In general, whistleblower claims will be denied where the information provided does not: (i) identify a Federal tax issue upon which the IRS will act; (ii) result in the detection of an underpayment of taxes; or (iii) result in the collection of proceeds. The whistleblower will be notified by the Whistleblower Office once an award decision has been made.

The Tax Court Addresses the Jurisdictional Issue Merits of the Service’s Denial of the Two

The IRS argued that there can be a determination for jurisdictional purposes only if the Whistleblower Office undertakes an administrative or judicial action and thereafter "determines" to make an award. Respondent incorrectly interprets §7623(b)(4). The statute expressly permits an individual to seek judicial review in this Court of the amount or denial of an award determination to the United States Tax Court *** within 30 days of such determination.". Accordingly, The Tax Court held that its jurisdiction is not limited to the amount of an award but extends to any determination to deny an award.

 

The Court further rejected the government’s claim that its letter(s) were not a "determination". Craig v. Comm’r, 119 T.C. 252 (2002) (form decision letter issued after an "equivalent hearing" constituted a "determination" for conferring jurisdiction under §6330(d)(1)); Lunsford v. Comm’r, 117 T.C. 159, 164 (2001) (written notice to proceed with the collection action constitutes a "determination"); Offiler v. Comm’r, 114 T.C. 492, 498 (2000) (determination notice is the jurisdictional equivalent of a deficiency notice pursuant to §6212). Finding there is no dispute that the letter put Mr. Cooper on sufficient notice to file a petition with this Court as he did so timely. Respondent's letter is therefore a determination because it constitutes a final administrative decision regarding petitioner's whistleblower claims in accordance with the established rocedures. Accordingly, we find that we have jurisdiction to review the denial of the claims.

This issue was reported by Forbes Magazine (December 14, 2009) pertaining to several large whistleblower cases in process, including UBS informant Bradley Birkenfeld in Boston. While he may be in federal prison for some time, it is reported he could leave prison with millions in reward money having filed numerous whistleblower claims against clients of UBS he knew held accounts in Switzerland and the beneficial owners had allegedly evaded billions of dollars in US taxes. Here, as perhaps a litigation tactic, heirs of the Eweson estate were turning in other heirs. It is uncertain whether Mr. Cooper filed the claims on his own behalf or on behalf of his client, an 11 year old great grandson of Dorothy Dillon Eweson. Presumably Mr. Cooper filed the claims on behalf of his client. The Forbes article reported that Mr. Cooper hopes his Tax Court actions will prompt the IRS to take a new look at the situation and generate some money for the heirs he's helping. "This was taken as a step of last resort," he says. However, experts doubt the 2006 whistleblower law created a legal right for someone to challenge an IRS decision not to pursue a Form 211 tip.

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Factual Background

In August 2001, Calloway ("Petitioner") entered into an agreement with Derivium Capital, LLC whereby Petitioner transferred 990 shares of his IBM common stock to Derivium in exchange for the sum of $93,586.23. The agreement recited that the transaction was a loan of 90% of the value of the IBM stock pleged as collateral. The program was promoted by a company that engaged in some 1,700 similar transactions involving approximately $1 .25 billion. More on Derivium below.

The purported loan was nonrecourse and precluded Petitioner from making any payments of interest or principal during the 3 year term of the loan arrangement. Under the agreement Derivium was permitted to sell the stock, which it did as soon as the transaction was entered into. The loan's terms were as follows: nonrecourse as to borrower (recourse against collateral only); dividends to be received as cash payments against interest due, with the balance of interest owed to accrue until maturity date; noncallable before maturity; no prepayment allowed before maturity; interest at 10.5% compounded annually; balloon payment at loan maturity equal to the loan principal plus accrued interest. At maturity of the "loan", Petitioner Calloway was granted the option of: (i) paying the balance due on the note and having an equivalent amount of IBM stock returned to him; (ii) renewing the purported loan for an additional term; or (iii) satisfy the "loan" by surrendering any right to receive IBM stock. At maturity in August 2004 the balance due was $40,924.57 in excess of the then value of the IBM stock. Petitioiner elected to satisfy his purported loan by surrendering any right to receive IBM stock. P was not required to and did not make any payments toward either principal or interest on the purported loan.

Prior to entering into the loan arrangement, the Petitioner relied upon the advises of Robert Nagy, who was purportedly a certified public accountant to the president of Derivium. Nagy claimed that while there was no guaranty the transaction would be treated as a "sale", there was a "solid basis for the position that these transactions are, in fact, loans." Calloway testified that a loan versus a sale transaction made economic sense to him because the loan proceeds given to him were 90% of the value of the IBM stock whereas if he had sold the stock he would have had to pay 20% capital gains taxes under the then applicable rate. The taxpayer did not report the transaction on his 2001 return holding the belief that the transaction was a loan. The Service disagreed and asserted a failure to timely file penalty as well as an accuracy related penalty.

 

In the opinion of the Court authored by Judge Ruwe, the proposed assessment of income tax of $30,911 by the Internal Revenue Service in its notice of deficiency was upheld. The Court found that the transaction, in substance, was a sale of Petitioner’s IBM stock to Derivium in August 2001 for the "loan" amount of $93,586.23. resulting from the transfer of all of the burdens and benefits of ownership. The Court distinguished the facts at bar to the securities lending arrangement described in Rev. Rul 57-451, 1957-2 CB. 295 or otherwise equivalent to a securities lending arrangement under §1058. The Petitioner was further held liable for a late filing penalty of $6,583 under §6651(a)(1) as well as an accuracy-related penalty of $6,182 under §6662.

 

The central issue in the case was whether the Derivium "master agreement" loan was to be treated as a loan or instead as a sale for Federal income tax purposes. It is somewhat universally accepted that a "sale" for Federal income tax purposes is given its ordinary meaning as a transfer of property for money or a promise to pay money." Grodt & McKay Realty, Inc. v. Comm’r, 77 T.C. 1221, 1237 (1981) (citing Comm’r v. Brown, 380 U.S. 563, 570-571 (1965)). Since the economic substance of a transaction, rather than its form, controls for tax purposes, the question for the court to determine at bar was whether the benefits and burdens of ownership of the IBM stock passed from petitioner to Derivium. This is a question of fact for which generally the taxpayer has the burden of proving by a preponderance of the evidence. See §7491. See also Arevalo v. Comm’r, 124 T.C. 244, 251-252 (2005), affd. 469 F.3d 436 [98 AFTR 2d 2006-7676] (5th Cir. 2006). Factors the courts have considered in making this determination include: (1) whether legal title passes; (2) how the parties treat the transaction; (3) whether an equity interest in the property is acquired; (4) whether the contract creates a present obligation on the seller to execute and deliver a deed and a present obligation on the purchaser to make payments; (5) whether the right of possession is vested in the purchaser; (6) which party pays the property taxes; (7) which party bears the risk of loss or damage to the property; and (8) which party receives the profits from the operation and sale of the property.

In the majority opinion by Ruwe, in which 10 judges joined and one additional judge concurring in result only, the Tax Court was critical of the taxpayer’s "loan" position on various grounds, including:

 

1. Petitioner did not treat the transaction consistent as a loan. For example, he did not include dividends pain on the stock as income from 2001 through 2004. He failed to report the "sale" of the shares on his 2004 return and further failed to alternatively report any cancellation from indebtedness income in 2004 for the balance of the "loan" left unpaid and discharged.

    

    

2. Petitioner did not retain any property interest in the stock. He retained, in the eyes of the Court, no more than an option to purchase an equivalent number of IBM shares after 3 years at a price equivalent to $93,586 plus "interest." The effectiveness of the option depended on Derivium's ability to acquire and deliver the required number of IBM shares in 2004.

    

    

3. Derivium obtained title to, possession of, and complete control of the IBM stock from Calloway. It immediately exercised those rights and sold the stock.

    

    

4. Upon receipt of the $93,586.23 from Derivium in 2001, Calloway bore no risk of loss in the event that the value of the IBM stock decreased. He was entitled to retain all the funds transferred to him regardless of the performance of the IBM stock in the financial marketplace.

    

The Court opined that at best the agreement with Derivium provided the Petitioner with an option to repurchase IBM stock at the end of 3 years however this option depended on Derivium’s ability to acquire IBM stock at that time. The Tax Court pointed out that two other Federal courts recently considered whether the transfer of securities to Derivium under its 90%-stock-loan program was a sale for Federal tax purposes (one case, dealing with Mr. Nagy, dealt with §6700 promoter penalties; the other, dealing with Mr. Cathcart, enjoined him from marketing the 90% stock loan program). In those cases, the courts, using essentially the same facts and applying the same legal standards that are found in well established cases, found that the 90%-stock-loan-program transactions were sales of securities and not bona fide loans.

The Tax Court also held that the transaction was not analogous to the securities lending arrangement in Rev Rul 57-452, 1957-2 CB 295 , nor was it equivalent to a securities lending arrangement under Code Sec. 1058 .

Petitioner was held liable for the accuracy related penalty under §6662 because he was found not to have acted with reasonable cause and in good faith because he didn't report the transaction on his returns consistent with his characterization of it. He couldn't avoid liability for the penalty by showing reliance on a competent professional adviser (i.e., his financial adviser) because he made no effort to establish that adviser's credentials or qualifications nor did he establish whether the adviser had any relations to Derivium. Finally, Calloway admitted that he knew nothing about Mr. Nagy other than that he apparently wrote an opinion letter addressed to Mr. Cathcart concerning another 90%-stock-loan transaction. In like manner there the Petitioner failed to establish "reasonable cause" or the absence of "willful neglect" in not timely filing his 2001 return which was filed more than 21 month after its due date.

 

On November 24, 2009, Judge Phyllis J. Hamilton, for the U.S. District Court for the Northern district of California, ordered a permanent injunction against the principal of Derivium, Charles Cathcart of Tuxedo Park, N.Y., from promoting a complex tax scheme involving numerous entities located around the globe and sales of over $1.25 billion in securities, the Justice Department announced today. The record indicated that Cathcart, a Ph.D. economist, developed a scheme called the "90% Loan Program" and promoted it throughout the United States through companies he controlled-including Derivium Capital LLC and Derivium USA.The 90% Loan Program falsely claimed customers could exchange their appreciated stock for loan payments equal to 90% of the stocks’ value without paying income tax on their capital gains. It also purported to allow the tax-free return of those customers’ stocks at maturity if the customers repaid the "loans." The customers’ stocks were sold immediately, with 90% of the sale proceeds going to make the purported "loans" to the customers, and the other 10% being retained by the promoters. Customers were told the loans were made by independent third-party lenders, but in fact the supposed loans were made through sham companies that Cathcart created and controlled. The sham companies never functioned as genuine lenders, never held or maintained any assets or reserves, and were located throughout the world in such far-flung places as the Isle of Man, Ireland and Hong Kong.

 

The Federal district court record reflected that Cathcart, through the 90% Loan Program, sold more than $1.25 billion worth of customers’ stock in some 3,100 transactions, leaving more than $100 million for himself and the other promoters after payment of 90% of the sale proceeds to customers as purported loans. The government complaint in the case alleged that the scheme cost the U.S. Treasury an estimated $230 million or more. Judge Hamilton previously ruled that Cathcart’s customers were not receiving loans, because the transactions were in fact sales. Thus, Cathcart’s representations to customers that they were receiving loans were false statements about the scheme’s tax benefits. The same court earlier barred Cathcart’s son, Scott, Robert Nagy, and other members of the team from promoting the 90% Loan program. A representative of the Department of Justice stated that the government wanted to shut down complex tax schemes that falsely claim to eliminate income tax on capital gains, a scheme directed towards the more affluent.

By the time that Mr. Calloway had his 2001 case heard and decided by the Tax Court, the numerous legal proceedings and investigative efforts undertaken by the Department of Justice working with the SEC and IRS made the outcome to this civil tax case before the Tax Court forseeable as well as anticlimactic. One can't help but wonder why the Petitioner still pressed forward with his case and furthermore, why it took the full Court to decide it. Perhaps the answer to the latter question was to prevent other adventurous and predatory "lenders" from falsely promoting a bad tax scheme employing a "loan" strategy.

Promoters and Principals of Derivium Subsequently  Face SEC and IRS Charges

 Tax Court’s Underlying Analysis 

The Tax Court Finds in Favor of the Service

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In an en banc decision, the Ninth Circuit Court of Appeals, reversed its prior 2-1 panel decision, and affirmed the Tax Court's determination in Xilinx, 105 AFTR2d 2010-638 (3/22/ 2010), ruling that that under pre-2004 Regulations to section 482, employee stock options (ESOs) did not have to be included in the costs shared between related companies under a bona fide, cost-sharing arrangement (CSA).

The central issue in the case was whether, under the pre-2004 Regulations to section 482, related companies that engaged in a joint venture to develop intangible property must include the value of certain ESOs in the pool of costs to be shared under a CSA, regardless of whether companies operating at arm's length would fail to do so.

Xilinx, Inc., was engaged in researching, developing, manufacturing, marketing, and selling field programmable logic devices. During the tax years initially in issue (1996-1999) it was the parent corporation of a group of affiliated subsidiaries including Xilinx Ireland (XI). Xilinx and XI entered into a cost-sharing arrangement to develop intangibles. Each party was required to pay a percentage of the total research and development based on its respective anticipated benefits from the intangibles, and to share direct costs, which included salaries, bonuses and other payroll costs, indirect costs, and acquired intellectual property rights costs.

Under the plans, Xilinx offered incentive stock options (ISOs), nonstatutory stock options (NSOs), and employees stock purchase plans (ESPPs). All ISOs and NSOs were issued at prices that were at-the-money whereas ESPP purchase rights were issued with an exercise price equal to 85% of the stock's market price.The options generally were subject to a five-year vesting period.

In 1996, Xilinx and XI entered into an agreement permitting XI employees to acquire stock in Xilinx. The agreement required XI to pay Xilinx the cost associated with the exercise of the options. Cost equaled the stock's market price on the exercise date over the exercise price. During the years in issue, generally accepted accounting principles (Accounting Principles Board Opinion 25 (APB 25)), required that the issuing company not incur expense related to options granted at-the-money.

After auditing the group’s return, the IRS issued notices of deficiency under the cost-sharing regulations, i.e., Treas. Reg. 1.482-7(d) , that the spread (stock's market price over exercise price on exercise date), or the grant date value, relating to compensatory stock options, should have been included as a research and development cost. Under the Service’s approach, Xilinx’s taxable income was substantially increased.

           

The Tax Court Sides with the Petitioner

 

The Tax Court, 125 TC 37 (2005),  rejected the IRS’s interpretation under Treas. Reg. §1.482-7(d) by holding that such analysis violated the arm’s length standard under Treas. Reg. §1.482-1(b) where it was uncontroverted that unrelated parties would not explicity share such amounts. The IRS was attempting to circumvent the arm's length standard, arguing that Treas. Reg. §1.482-7's application automatically produced the required arm's length result was in its view disingenuous and erroneous in light of Treas. Reg. §1.482-1(b)’s explicit language and history. Thus, the IRS's reallocation was arbitrary and capricious. In contrast, taxpayers' allocation, excluding any ESO-related costs from research and development expenses, satisfied the arm's length standard and was upheld.  Accordingly, it held that IRS's allocations were arbitrary and capricious and that Xilinx's allocations met the arm's-length standard mandated by  Treas. Reg. 1.482-1(b) .

 

The Ninth Circuit’s Panel Decision Reverses

 

 

In May 2009, the Ninth Circuit reversed the Tax Court, 2-1 (Judges Fisher and Reinhardt in the majority, Judge Noonan in dissent). However, Xilinx’s requesting for rehearing en banc was granted and the panel decision was withdrawn in January, 2010.

The en banc decision reversed the panel’s conclusion . In the March 2010 decision by a three-judge panel of the Ninth Circuit, Judge Raymond Fisher, who wrote the court's 2009 opinion, changed his mind. On the second try, Judge Fisher noted that while Xilinx viewed Treas. Regs. §§1.482-1(b)(1) and 1.482-7(d)(1) as irreconcilable, the IRS interpreted Treas.Reg. §1.482-7(d)(1) 's “all costs” requirement as consistent with Treas.Reg. §1.482-7(b)(1) 's arm's-length standard. In other words, the more narrowly drawn specifics contained in the CSA regulation should be controlling.

 

The Ninth Circuit disagreed and concluded that the taxpayer’s position that Treas. Reg. §1.482-1(b) was controlling where another part the of the regulations appeared to be in conflict. This was based on analyzing the legislative history of §482, the drafting history of the regulations, and authoritative comments under various tax treaties. Judge Noonan, who wrote the new opinion, held that where the two Regulations were "hopelessly ambiguous" and that the ambiguity should be resolved in light of the commonly held understanding of the arm's-length standard prior to the case's litigation. If the standard of arm's length is trumped by [Treas. Reg. §1.482-]7(d)(1), the Ninth Circuit opined that the purpose of the statute is frustrated." "If Xilinx cannot deduct all its stock option costs, Xilinx does not have tax parity with an independent taxpayer."

 

Noonan also noted that with respect to the Ireland-U.S. income tax treaty , "[i]t is enough that our foreign treaty partners and responsible negotiators in the Treasury thought that arm's length should function as the readily understandable international measure."

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On June 11, 2010, the Federal Circuit Court affirmed the application of the judicial economic substance doctrine (as compared with newly enacted section 7701(o) version of the economic substance doctrine) to a Son of BOSS tax shelter that was marketed as the Jenkins & Gilchrist law firm strategy and affirmed the imposition of accuracy related penalties in Stobie Creek Investments LLC v. U.S., Fed. Cir., No. 2008-5190 (6/11/2010).

The Son of BOSS (Bond and Option Sales Strategy) shelter attempted to take advantage that assets and contingent liabilities were treated differently for tax purposes when contributed to a partnership, thus facilitating, it was thought or planned, to permit the investor to benefit from an artificial tax loss to offset substantial realized gains of the same taxpayer. The "artificial loss" was the tax product so to speak used to offset the large gains. The government has been highly successful in defeating the Son of BOSS strategy in various lawsuits and as part of an overall national policy for inviting taxpayer concessions.

The facts involved members of a family that had a highly successful family owned business that they were in the process of selling (assets) and realizing a substantial capital gain. They approached a lawyer with Jenkins & Gilchrist in January 200. The goal of the J & G strategy was to reduce the capital gain resulting from the sale of assets.

The strategy reduced a taxpayer's capital gain by increasing, or "stepping up," the basis in the asset the taxpayer wanted to sell. Because a partnership does not pay taxes, the resulting stepped-up basis passes through to the partners, thereby reducing the partner's capital gain and attendant capital gains tax when the asset is sold. To create a stepped-up basis in the assets, the J & G strategy required the contribution of assets to a partnership followed by the distribution of the partnership's assets to the taxpayers. The goal of realized a large capital loss was to be achieved through a six step process: (i) investment in foreign currency options through a single-member LLC; (ii) formation of a partnership with a third party or wholly-owned S corporation; (iii) contribution of the foreign currency options to the partnership; (iv) recognition of an economic gain or loss by the partnership when the options expired or were exercised; (v) termination and liquidation of the partnership through contribution of the taxpayer's partnership interest to an S corporation;  and the (vi) sale of the partnership's assets by the S corporation or taxpayer.

Among the various steps, step 3 is important for the success of the tax strategy. The idea was to make a substantial investment in foreign currency option spreads, whereby the LLC sells a short option and purchases a long option in the same currency. As contributed (i.e., the options) to the tax partnership, i.e., Stobie Creek, the partners basis in his partnership interest is increased by the cost (or adjusted basis) of the purchase made in the long option, but not decreased by the short option obligation. Under the J & G strategy, the short option's contribution has no effect on the taxpayer's basis because it is not treated as a "liability" section 752 when calculating the taxpayer's basis in his partnership interest. When the partnership is liquidated during step 5, the tax basis in the partnership's assets is "stepped up" to match the partner's outside basis. This stepped-up basis allows the taxpayer to recognize less capital gain when the asset is sold during step 6.

The family involved agreed to embark on the J&G strategy, including a fee to J&G of 2% of the gain to be sheltered or approximately $4.1M. Another promoter’s fee was $2M yielding total fees of in excess of $6M. The Welles family decided to pursue the J & G strategy. To obtain help implementing the strategy,

Then, with the formation of the LLC and execution of the plan, J & G stated it would be issuing a tax opinion for the Welleses similar to the one attached to the letter, which would opine that it was "more likely than not" that the transactions would be respected for federal income tax purposes.

The IRS issued a FPAA for Stobie Creek's 2000 tax year in March 2005. The IRS issued a FPAA for Stobie Creek's 2000 stub year in February 2007. The FPAAs disregarded Stobie Creek for tax purposes as a sham and disallowed the partnership's stated basis in the closely held stock, finding it attributable to transactions entered into for the purpose of tax avoidance. As a result, the FPAAs increased Stobie Creek's capital gain income from the sale of the closely held stock and assessed over $4.2 million in additional taxes. The FPAAs also imposed accuracy-related penalties per § 6662.

Stobie Creek and the other plaintiffs filed this action in the Court of Federal Claims in July 2005. The complaint sought readjustment of partnership items for the 2000 tax year and 2000 stub year,as well as a tax refund of the $4.2 million assessed in the FPAAs.

In this case, Stobie Creek Investments LLC, JFW Enterprises Inc., and JFW Investments LLC used the Son of BOSS strategy to inflate the basis of their stock in a family business, thereby eliminating over $200 million in capital gains realized from the sale of that stock. Upon audit, the IRS disallowed the losses in their entirety charging that the Stobie Creek Investments LLC strategy was a sham. Based on this determination, the IRS disallowed the partnership's stated basis in the stock, increased the partnership's capital gain from the sale of the stock, and assessed additional taxes.

In March, 2005 a notice of final partnership administrative adjustmentFPAA Issued a Notice of Final Partnership Administrative Adjustment (FPAA) for Stobie Creek's 2000 tax year was issued in March 2005. A second FPAA for the 2000 stub year was issued in February 2007.

The FPAAs disregarded Stobie Creek as a sham and disallowed the partnership's stated basis in the stock, finding it attributable to transactions entered into for the purpose of tax avoidance. The Service increased the entity’s capital gain from the sale of stock and assessed over $4.2M in additional taxes as well as accuracy related penalties per section 6662.

Tax Refund Suit Filed by Taxpayers in the Court of Federal Claims 

The plaintiffs filed an action in the Court of Federal Claims in July 2005, seeking a refund of the increased taxes and penalties. The trial court found that the plaintiffs failed to show the underlying foreign exchange digital options transactions,  which were the economic investments that would facilitate and leverage the amount of the loss realized to the U.S. transferors, had no business purpose beyond creating a tax advantage. It further lacked economic substance. The trial court also found that Stobie Creek was liable for the accuracy-related penalties.

[As an aside, under the entity level audit procedures, the IRS must mail an FPAA to the designated "tax matters partner", all notice partners, and representatives of notice groups. The primary mailing of the FPAA, which is used for notice of deficiency purposes, is the mailing to the TMP. The mailing to the other partners must occur within 60 days after the mailing to the TMP. An FPAA is equivalent to a notice of deficiency (90-day letter) in regular audits. A deficiency attributable to a partnership item cannot be assessed until the notice of an FPAA has been mailed and 150 days have elapsed after the mailing. Where a Tax Court petition is filed within 150 days after the FPAA notice, no deficiency attributable to a partnership item may be assessed until the Tax Court's decision on the matter becomes final.]

At the trial, the court found that Stobie Creek's basis calculations complied with the literal requirements of the tax code. It declined, therefore, to retroactively apply Treas. Reg. §1.752-6. The trial court nonetheless disregarded the transactions implementing the J & G strategy under the economic substance, step transaction, and end result doctrines. 4 Had the trial court applied Treas. Reg. § 1.752-6 retroactively, plaintiff's refund action would fail under the literal application of the tax code and treasury regulations because the short options would constitute liabilities for the purpose of § 752, reducing the LLCs’ basis in their partnership interests. The government did not appeal the trial court’s determination not to apply Treas. Reg. §1.752-6 retroactively. It simply ruled against the taxpayers under the economic substance doctrine.

The trial court further held that the accuracy penalty was appropriate and that reasonable cause was not present through the argued reliance on the opinion of the J&G law firm. See §6664(c)(1). Reliance on the law firm’s opinion was not reasonable due to their clear conflict of interest.

 

On appeal to the Federal Circuit, the Court examined the economic substance doctrine as applied by the trial court. The court of appeals noted that the purpose of this rule is to separate a transaction that should be respected as legitimate and a transaction principally designed to generate a tax benefit, which is a sham. In this case, the appellants argued that the foreign exchange digital options should not be treated as shams or lacking in economic substance since there were bona fide business transactions, designed to generate an economic profit from investing in foreign currencies. See section 988.

Such argument was rejected at the trial court and by the Federal Circuit based on the facts related to the investments and through the introduction of expert testimony.

 

The economic substance doctrine distinguishes between a real transaction in a particular way to obtain a tax benefit, which is legitimate, and creating a transaction to generate a tax benefit, which is illegitimate. A transaction could meet the literal terms of the Code but still lack "economic reality". See, e.g., Frank Lyon Co. v. U.S., 435 U.S. 561, 583-84 (1978). Such transactions include those that have no business purpose beyond reducing or avoiding taxes, regardless of whether the taxpayer's subjective motivation was tax avoidance. Transactions shaped solely by tax-avoidance are also disregarded. Under an "objective" test, the Federal Circuit stated that whether a transaction lacks "economic reality," has no bona fide "business purpose" or was shaped solely by tax-avoidance features is an objective inquiry, evaluated prospectively. Coltec Industries Inc v. U.S., 454 F3d 1340 (Fed. Cir. 2006), vacg & remg 62 Fed. Cl. 716 (Ct. Fed. Cl. 2004). The objective test of economic substance requires that the transaction be evaluated based on information available to a prudent investor at the time the taxpayer entered into the transaction, not what may (or may not) have happened later. If this test is failed, then the transaction fails as well, as to its designed tax benefits, regardless of the taxpayer’s subjective motivation was (or was not) tax avoidance.

The Appeals Court, after evaluating the transcript of the proceedings below, reached the same conclusion as the trial court that the transactions did not reflect economic reality and were not motivated by a business purpose. The Court stated that the trial court properly treated the options as part of a separate, unified transaction, that were part of determining the taxpayer’s basis in Stobie Creek LLC. The options were also found to have lacked economic substance since there was not reasonable possibility that the options would return a profit. There also was no bona fide business purpose other than to generate tax benefits. This was evidenced, in part, by the fee structure. All the fees were computed by the amount of the gain to be shelter by the tax strategy.

Reasonable Cause Defense to Accuracy Related Penalties Rejected

As to the partnership level assertion of reasonable cause, to avoid the accuracy related penalty on partnership level determinations (i.e., for stepping up the basis in the closely held stock), the Court reviewed and affirmed the lower court’s determination that the penalties were to be imposed. See §6664(c). Temp. Treas. Reg. § 301.6221-1T(d). The taxpayers claimed that the TMP, Jeffrey Welles, had reasonable cause, reliance on advice from the promoter and J&G law firm, on the merits of its reporting position. Section 6664(c)(1) provides a narrow defense to § 6662 penalties if the taxpayer proves it had (1) reasonable cause for the underpayment and (2) acted in good faith. See also Treas. Reg. § 1.6664-4(c)(1). The taxpayer bears the burden of showing this exception applies. The most important of these factors contained in the regulations is "the extent of the taxpayer's effort to assess the taxpayer's proper tax liability," judged in light of the taxpayer's "experience, knowledge, and education." Treas. Reg. § 1.6664-4(b)(1).

Reliance is not reasonable, however, where, as was the case here, the adviser has an inherent conflict of interest about which the taxpayer knew or should have known. Treas. Reg. § 1.6664-4(c). This was a finding made by the trial court and the Appeals Court affirmed.Circuit Court of Appeals Affirms

 

 

 

Evaluation on Appeal of the Economic Substance Doctrine

Taxpayers Appeal to the Federal Circuit After Losing on Economic Substance; Penalties Imposed

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In Container Corp., 134 TC No 5 , Tax Ct Rep (CCH) 58131, 2010 WL 571831 (2010), a case of first impression, the Tax Court, per the opinion of Justice Holmes, held that payments received by Vitro, S.A., a Mexican corporation, from its US subsidiary for the guarantee of the subsidiary's debt obligations was not income from sources within the U.S. under Section 861 , and, therefore, was not subject to withholding under Section 1442.

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With the repeal of the General Utilities doctrine to the taxation of corporate liquidations as part of the 1986 Tax Reform Act, Congress, in preventing avoidance of corporate level taxation for liquidations, with the exception of liquidations of controlled (and solvent) subsidiaries, block safe passage from corporate level tax for C or regular corporations converting to Subchapter S. While there are several provisions which embody this thought, the main provision is section 1374. Section 1374 imposes a tax on built-in gains, i.e., unrealized appreciation, while an asset is held by a C corporation which later makes a Subchapter S election. The tax applies generally for a period of 10 years although a recent revision to section 1374 permits it to expire at the end of 7 years.

An S corporation's gain upon disposition of an asset generally is treated as recognized built-in gain under section 1374 to the extent that the fair market value of that asset on the first day of the first taxable year for which the corporation's subchapter S election is in effect exceeds that asset's adjusted basis on such date. §1374(d)(1). If an asset with built-in gain is sold during the 10-year period beginning on such date, the S corporation will be taxed on the built-in gain. §§1374(a), 1374(d)(7). The tax is then treated as a "loss" or reduction in gain for pass through purposes. §1366(f)(2).

In Ringgold Telepone, supra, the corporation, which provided telecommunications services to customers, converted to Subchapter S status effective January 1, 2000. On such date it owned a 25% partnership interest in Cellular Radio of Chattanooga (CRC). The other 25% partners were Bell South, Trenton Telephone Co. and Beldsoe Telephone Co. CRS’s primary asset was in turn a 29.54% limited partnership interest in Chattanooga MSA limited partnership (CHAT), a wireless service provider. At all times between January 1 and November 27, 2000, petitioner indirectly owned a 7.385% interest in CHAT as a result of petitioner's 25% interest in CRC and CRC's 29.54% limited partnership interest in CHAT. The partnership interests in CHAT were not publicly traded.

The petitioner’s accounting firm valued the CRC (25%) interest based on 1998 financial data at approximately $4.6M. This report was issued on September, 1999. This valuation was updated on February 20, 2000 based on 1999 financial data to $2.6M. In March, 2000, petitioner hired an investment banking firm to sell its 25% interest at $7M which included a sales incentive to the investment banker and thus it could be inferred the asking price exceeded an objective assessment of value. Finally, on July 6, 2000, BellSouth offered to purchase the CRC interest for an amount slightly in excess of $5M subject to working capital adjustments to the date of closing. The transaction closed on November 27, 2000 for a $5.2M sales price.

On its 2000 Form 1120S, petitioner reported the amount of recognized built-in gain attributable to the CRC interest using a fair market value as of January 1, 2000 (the valuation date), of $2,600,000, the amount determined by the February 2000 report. Petitioner used the valuation of the CRC interest contained in the February 2000 report on the advice of Stephen Henley, a certified public accountant petitioner consulted to review its 2000 Federal income tax return. The IRS disagreed and contended that the corporation had a deficiency in income tax of $925,260 under section 1374 and an accuracy related penalty of 20% or $185,052. The issue was whether the FMV of the partnership interest owned by the petitioner as of the effective date of the conversion, January 1, 2000, was $2.98M as the taxpayer argued, or $5.220M as the IRS asserted was the amount paid by BellSouth. At trial the parties each submitted the report and expert testimony of valuation experts with each report supporting its respective position. In addition, the Service argued that an arms length sale reasonably close in time to the valuation event should be treated as the best evidence of value. Here the sale contract was signed 6 months after the effective date of the conversion. The taxpayer argued that the sale price should not be controlling as BellSouth paid a premium to acquire its 25% interest and should therefore not be treated as the "average hypothetical buyer" since it already owned a controlling interest in CHAT, the primary asset of CRC.

Finding the sale to be highly probative of value and negotiated at arms length, Judge Wells stated that the Court, based on special circumstances surrounding the buyer, the seller and the transaction, may have skewed the purchase price from the hypothetical fair market value of the interest. The opinion cited Epic Associates 84-III v. Commissioner, T.C. Memo. 2001-64; Hansen v. Commissioner, TCM 1952, and Treas. Reg. §20.2031-2(e). The seller-taxpayer argued that BellSouth paid a control premium for its 25% interest. The IRS argued that BellSouth already controlled CHAT prior to the acquisition of the 25% interest in CRC and did not gain any additional measure of control over CHAT by virtue of its purchase of the CRC interest. In other words, the purchase price paid by Bell South according to the IRS reflected a discount for lack of control.

After considering the sales price and terms that were close in time to the valuation date, and the expert testimony and reports submitted, the Court concluded that the fair market value of the CRC interest as of the valuation date was $3.727M. The Court used a weighted average of: (i) business enterprise analysis ($2.718M); distribution yield analysis ($3.243M) and the BellSouth sales price ($5.22M), weighted equally, in arriving at its value.

The Court rejected the government’s claim for the imposition of a 20% substantial understatement penalty finding that record reflected that the taxpayer acted in a reasonable manner and with good faith. §6664(c)(1).

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In Robinson Knife Manufacturing Company and Subsidiary v. Commissioner, __F.3d__(3/19/2010), the Second Circuit,  as set forth in the opinion of Judge Calabresi, held that the petitioner-appellant should be allowed to deduct sales-based trademark royalty payments instead of being required to capitalize such costs as was the decision of the Tax Court below, T.C. Memo 2009-9 and the government’s position throughout. See 26 USC §263A.  The taxpayer had deducted the royalties under §162(a) as ordinary and necessary business expenses.  The Second Circuit held  that where  a producer's royalty payments (1) are calculated as a percentage of sales revenue from inventory and (2) are incurred only upon the sale of that inventory, they are immediately deductible as a matter of law because they are not "properly allocable to property produced" per Treas. Reg. § 1.263A-1(e). 

 
In comments cited in the tax press, a representative of the Treasury Office of Tax Legislative Counsel, acknowledged that it has two concerns with the holding in Robinson Knife which it intends to address in regulations on pre-production period costs. The first is that even though Treasury received a number of comments requesting that sales-based costs be deductible, the final  §263A regulations only provided for the exclusion for commissions to authors. In contrast, the Second Circuit accepted the argument that sales based royalties were deductible and read into the regulations what the Treasury intentionally omitted in finalizing the regulations.  The second concern involves separating the cost from the underlying right received.  The Second Circuit merely looked at the cost, i.e., if the cost is triggered at sale, it’s not capitalizable. 
 

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In a decision deserving of Supreme Court review, the en banc decision of the First Circuit Court of Appeal in Textron, 104 AFTR 2d 2009-5719, 08/13/2009 , has vacated the district court's determination that a public corporation's tax accrual workpapers were protected from IRS summons by the work-product doctrine. Instead, the First Circuit held that the work-product privilege was not implicated with regard to the taxpayer's tax accrual workpapers, because it found that the workpapers were not prepared "for" litigation and were required to be produced pursuant to an IRS administrative summons. The First Circuit noted that the IRS's right to compel the production of these types of records was important in detecting and disallowing the benefits sought by taxpayers investing in potentially abusive tax shelters. The taxpayer had indeed invested in nine sale-in, lease-out (SILO) transactions which were "listed transactions." After experiencing recent judicial defeats, the Textron case reflects the determination of the IRS Commissioner to have the judicial system reflect the proper goals and aims involved in administering the tax laws. Effective administration requires the production of non-privileged information used in preparing returns, including underlying tax analysis that supports positions and details the anticipated risk that a deficiency in tax, penalties, and interest may follow. The need to obtain tax accrual workpapers is heightened where the returns reflect tax items attributable to tax-motivated transactions. The First Circuit essentially agrees with the IRS's efforts to obtain tax accrual workpapers during discovery in appropriate cases, such as Textron. It places corporate tax payers on notice that some courts will find that tax accrual workpapers or FIN 48 workpapers are not "work product" per se, as was the position taken by the First Circuit, while other courts may use the Fifth Circuit's standard and determine that workpapers are not primarily prepared in anticipation of litigation.

Textron recently filed a writ for certioari before the Supreme Court which the government needs to respond by on or before March 29, 2010. A number of amicus curiae filings have been submitted on behalf of Textron.

 

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 ^{Wells Fargo & Company and Subsidiaries v. United States ,105 AFTR 2d 2010 (Ct. Fed. Cl. 01/08/2010).}

 

 

 

Tax refund suit filed by WF claiming over $115M in depreciation, interest and expenses for 2002 in connection with participating in 26 leveraged lease transactions, 17 with domestic transit agencies and 9 pertaining to qualified technological equipment ("QTE") Five of the 26 were selected for trial by agreement of the parties who agreed to allow the principles from these transactions to govern the balance. Of the five trial transactions, four involved public transit agencies, and one a QTE lease involving cellular telecommunications equipment. The lessees were public authorities or governmental agencies. A sale in/lease out or SILO tax shelter is where a tax-exempt entity transfers tax benefits for a fee to a United States taxpayer, e.g., WF. The transactions involving depreciable property ranging from buses to trains to telecommunications equipment. The object for each transaction is for the purchaser-lessor to obtain substantial tax deductions from an otherwise tax-exempt entity (seller-leaseback lessee).

The government’s attacks on such arrangements generally involve: (i) applying the substance over form doctrine to determine whether WF really acquired ownership with respect to the purchased assets or whether in substance, the seller really retained ownership and all that is involved is an artificial shifting of tax benefits; (ii) does the financing aspects associated with such sale and lease back, which involves a loan to the original owner to finance the transaction should be respected and allow interest deductions on the loan repayments; and (iii) whether there is any economic substance to these transactions, other than the transfer of tax benefits, that would warrant depreciation and transaction cost deductions.

The Claims Court conducted a 20 day trial in Spring 2009 at which time 33 witnesses, including 13 experts testified. The evidentiary record was voluminous consisting of over 5,000 pages of trial transcript and over 1,100 exhibits. The Court conducted a 20-day trial in Washington, D.C. during April 6 through May 1, 2009.

Other courts have been asked to rule on SILOs or "lease in/lease out" or "LILO" transaction. With one exception, the courts have ruled against the taxpayers claiming the desired tax benefits. See AWG Leasing Trust v. United States, 592 F.Supp.2d 953 (N.D. Ohio 2008); BB&T Corp. v. United States, 2007 WL 37798 [99 AFTR 2d 2007-376], at 1 (M.D.N.C., Jan. 4, 2007), aff'd, 523 F.3d 461 (4th Cir. 2008); Altria Group, Inc. v. United States, 2009 WL 874207, at 1 (S.D.N.Y. July 9, 2009). The taxpayer was successful in Consolidated Edison Company of New York, Inc. v. United States, 2009 WL 3418533 (Fed. Cl. Oct. 21, 2009) (Horn, J.), also a Claims Court case which found that the particular LILO transaction involved had legitimate business purposes and allowed the claimed dedutions.

In Hoosier Energy Rural Electric Cooperative, Inc. v. John Hancock Life Ins. Co., 588 F. Supp. 2d 919 (S.D. Ind. 2008), aff’d 582 F.3d 721 (7^{th Cir. 2009), involved an insurance company which had its credit rating reduced as part of the economic downturn. The lessor of the property, John Hancock, exercised its right to demand that Hoosier Energy find a replacement for the tenant even though it had not missed any payments. The case involves Hoosier Energy's request for injunctive relief to maintain the status quo while Hoosier Energy seeks a replacement for the tenant. In granting injunctive relief, the district court described the SILO transaction as a "blatantly abusive tax shelter" that is "rotten to the core." The Court of Appeals affirmed the district court's grant of injunctive relief, but clarified that the agreements comprising the SILO transaction were legally enforceable under New York law, even if not an approved tax shelter under the Internal Revenue Code. The Court of Appeals gave Hoosier Energy until the end of 2009, approximately 3-1/2 months, to find a replacement user. 582 F.3d at 730.}

After reviewing the record, the Claims Court found that WF is not entitled to the claimed tax deductions on the 5 trial transactions. WF never acquired the burdens and benefits of ownership. Moreover, the transactions lack economic substance, and were intended only to reduce WF’s federal taxes by millions of dollars. Although well disguised in "a sea of paper and complexity", the SILO transactions essentially amount to WF’s purchase of tax benefits for a fee from a tax-exempt entity that cannot use the deductions. The transactions are designed to minimize risk and assure a desired outcome to WF, regardless of how the value of the property may fluctuate during the term of the transactions. Indeed, nothing of any substance changes in the tax-exempt entity's operation and ownership of the assets. The only money that changes hands is Wells Fargo's up-front fee to the tax-exempt entity, and Wells Fargo's payments to those who have participated in or created the intricate agreements. If the Court were to approve of these SILO schemes, the big losers would be the IRS through the loss of millions of taxes.

On the issue of economic substance, the Court examined if there was any likelihood of profit aside from the tax benefits. After going through the detailed paperwork the Court concluded that the end result is that the trial transactions produce an overall loss without the tax benefits, and no rational person would engage in these transactions absent the tax benefits. The Court announced that it will set a conference with counsel during the next 45 days to determine whether any further proceedings are necessary to address the remaining 21 transactions at issue in this case.

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In Menard, Inc., 560 F3d 620 (7th Cir., 2009), rev'g TC Memo 2004-207 , the Seventh Circuit Court of Appeals reversed the Tax Court and found in favor of the taxpayer that a large 5% bonus arrangement payment was in fact paid for services rendered and was deductible in computing the corporation's taxable income for 1998, the year in issue. It reversed the lower court’s (Tax Court's memorandum decision) holding that the 5% bonus compensation was a disguised dividend.

Menard, Inc, was a closely held hardware and building supply company which maintained retails stores in the Midwest. It was founded by the Taxpayer, John Menard, in 1962. The year in issue was 1998, at which time the Company had grown to 138 stores and was the third largest chain store of its type. Menard owed 100% of the voting stock and 56% of the nonvoting stock. The balance of the shares were held by family members, several of whom worked in the business. The record reflected that under his stewardship, Menard caused the Company’s reveunes to grow from $788M (1991) to $3.4B (1998) and that its taxable income grew from $59M to $315M resulting in a 18.8% return which was higher than its competitors, Home Depot or Lowes. Menard’s salary in 1998 was modest, i.e., $157,000 and he received a profit-sharing bonus under a plan of slightly over $3M. He also received a 5% bonus under a program that yielded him more than $20.6M. The 5% bonus plan, which went into effect approximately 25 years earlier, was suggested by the Company’s accounting firm. It called for a bonus in the amount of 5% of net income before taxes subject to a reimbursement agreement if part of the 5% bonus were held to be unreasonable. As a result of his salary, profit-sharing bonus, and the 5% bonus, John's total compensation for the 1998 tax year exceeded $20 million. The 5% bonus also was subject to the following reimbursement agreement: In the event that the IRS disallowed as a deduction any portion of John's compensation, he had to repay to the corporation the entire amount disallowed.

Claiming the salary, profit-split and 5% bonus as deductible compensation, the IRS challenged the corporation's deduction for the entire 5% bonus to Menard as unreasonable and excessive. In response to the taxpayer’s Petitition, the Tax Court ruled that the 5% bonus was excessive and was intended to be and "looked" more like a dividend that a salary. It started its analysis by applying the independent investor test announced by the 7th Circuit in Exacto Spring Corp., 196 F.3d 833 (7th Cir. 1999). The Tax Court and the IRS agreed that John's compensation satisfied the independent investor test, but the Tax Court found the compensation paid to Menard substantially exceeded that level of compensation paid to CEOs of comparable publicly traded corporations. The Tax Court looked at what the CEO of Home Depot was paid in 1998 and that was only $2.8 million that year, even though Home Depot was a much larger company than Menards. In addition, the CEO of Lowe's, also a larger company than Menard, was paid $6.1 million. Accordingly, the Tax Court viewed: (i) Menard’s compensation substantially succeeded that paid to CEO of comparable public companies; and (ii) such evidence was sufficient to rebut the presumption of reasonableness created by the Company’s rate of return under the "independent investor" test. Looking at financial ratios among the three companies, the Tax Court concluded that only an amount slightly in excess of $7M was reasonable and that the excess portion was not intended as compensation but instead as a dividend.

The Seventh Circuit, on appeal, reversed and registered its strong disagreement with the Tax Court. It took special note of the fact that unlike a public company, owners of a closely held business there is tax incentive to treat payments from profits to some extent as compensation and not as a non-dedeductible dividend. The Court, in general, distinguished the application of the various factors when looking at a closely held corporation. It did not view the 5% of net profits bonus looked like a concealed dividend inasmuch as dividends are generally stated as specific dollar amounts rather than a percentage of earnings. Here the 5% bonus was a clear incentive for Menard to work hard and increase profits, and had no application to a passive shareholder’s waiting to realize a satisfactory rate of return.

While the Tax Court was also critical of the "one-man" determination of compensation that Menard made, since he was the sole voting shareholder, the 7th Circuit noted that such fact could not change and rejected such idea. Still, the 7th Circuit thought it would have been a slightly better argument to say that the board of directors should have sought outside advice on appropriate compensation. The record reflected however that Menard had a strong view on what the value of his services were worth.

The Seventh Circuit also discounted the argument that since the corporation had paid no formal dividend, that some portion of the compensation was a disguised dividend.

Menard sounds a major victory for paying high levels of deductible compensation employee-shareholders of closely held corporations. Still, things are no so simple and the prudent tax advisor must address the factual and legal terrain in setting forth compensation awards and programs on a go forward basis as well as in assessing  potential IRS challenges under section 162 and related sections, including section 531 pertaining to the accumulated earnings tax.  

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In Klamath Strategic Investment Fund, 103 AFTR 2d 2009-2220 (5th Cir. 2009), the Fifth Circuit adopted the same approach used by a majority of the other circuits by concluding that a taxpayer must, in order to avoid a lack of economic substance challenge, satisfy what is referred to as both a subjective test and an objective test that the transaction was entered into for profit. Meeting both parts or standards is challenging for the typical tax shelter in which the costs of entering into the transaction are substantially greater than the true economic gain that stands to be realized. that have concluded that a transaction lacks economic substance unless the taxpayer can satisfy both a subjective test and an objective test.

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The Tax Court in Ocumulgee Fields stated it was not ruling, as a matter of law, that a finding of basis shifting precludes the absence of a principal purpose of tax avoidance, but, in the case at hand, the immediate tax consequences resulting from petitioner's deemed exchange resulted in a $1.8 million reduction in taxable gain and the substitution of a 15% tax rate for a 34% tax rate. Still, the Ocumulgee Fields and Teruya Bros. decisions make it difficult to find a more likely than not basis to qualify a related party exchange through a QI particularly in instances where the related party already owned the replacement property.

The Tax Court’s recent decision in Ocumulgee Fields v. Commissioner, places great stress on the ability of a taxpayer to successfully structure a related party exchange under §1031(f) where the related party transfers the replacement property to the taxpayer through a qualified intermediary. The hurdle is the non-tax avoidance prohibition set forth in §1031(f)(4). Ocmulgee Fields is an important development because it highlights the potential tax risk in acquiring replacement property from a related party. After the Tax Court’s prior decision to the same effect in Teruya Brothers, it was not necessarily clear that the acquisition of replacement property from a related party would, in general, be viewed as "abusive" within the meaning of section 1031(f)(4) .The judicial analysis set forth in Ocmulgee Fields confirms what some had suspected that most acquisitions of replacement property from a related party may be "bad" exchanges and will not qualify for tax free treatment.

As many tax advisors know, §1031(a)(1) provides that no gain or loss is recognized with respect to an "exchange" of property of like-kind. Certain properties described in a parenthetical clause to §1031(a), such as interests in a partnership, stocks or securities, inventory, choses in action, etc., are ineligible for tax-free exchange treatment under this provision. Frequently §1031 is used to exchange real property held for productive use in a trade or business or for investment for property of like kind, i.e., replacement property to be held either for productive use in a trade or business or for investment. The cost for avoiding gain (or loss) recognition under §1031(a) is that the owner of the relinquished property uses the same basis in the replacement property decreased by any money receive and increase by any gain recognized. §1031(d). Other special rules are set forth in the regulations, including rules pertaining to a deferred exchange of property. §1031(a)(3). A deferred exchange will that otherwise qualifies under §1031(a) will in fact qualify where the replacement property: (i) is identified within 45 days of the transfer of the relinquished property; and (ii) such replacement is received by the earlier of 180 days after the transfer of the relinquished property or the due date (including extensions) of the transferor's tax return for the taxable year in which the relinquished property is transferred.

Treas. Reg. §1.1031(k)-1(g)(4) permits a taxpayer to use a qualified intermediary (other than the taxpayer, the taxpayer’s agent or a "disqualified person"), to facilitate a like-kind exchange. Treas. Reg. §1.1031(k)-1(g)(4)(i). If the various requirements in inserting a qualified intermediary as well as the identification (45 days) and replacement period (180 days) requirements are met, etc., the taxpayer's transfer of the relinquished property to a qualified intermediary and subsequent receipt of like-kind replacement property from the qualified intermediary through a third party acquired with the sales proceeds from the relinquished property, is treated as an exchange with the qualified intermediary.

Section 1031(f) provides special rules for property exchanged between related persons intended to qualify under §1031(a). In pertinent part, it provides that if a taxpayer exchanges property with a "related person", that otherwise qualifies as a tax-free exchange under §1031(a), and within 2 years after the date of the last transfer which was part of such exchange the related person disposes or the property or the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer, the prior exchange will be fully taxable. As an exception, §1031(f)(2) provides that the related party recognition rule which overrides §1031(a) will not apply where it is established by the taxpayer (transferor of the relinquished property) to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax, and provided that the exchange was not part of a transaction or series of transactions structure to avoid the related party rule in §1031(f).

In Ocumulgee Fields, taxpayer transferred appreciated property to a qualified intermediary (QI) under an exchange agreement in conformity with the requirements under Treas. Reg. §1.1031(k)-1(g)(4), whereupon the QI sold the same property to an unrelated third party and used the sales proceeds to purchase from a "related person" like-kind property that was transferred back to taxpayer to complete the exchange.

The IRS, in assessing a deficiency for the income tax on the gain realized from the taxpayer’s receipt of the replacement property, argued that the exchange was part of a transaction structured to avoid §1031(f) and did not make the "lack of tax avoidance" exception under §1031(f)(2)(C) absent credible proof. The Service viewed the interposition of the QI was to reflect a significant basis shifting in the taxpayer’s holding and an immediate cash out that resulted in substantial tax savings.

The Tax Court agreed with the Service and found taxpayer's claim of "no tax avoidance" purpose unpersuasive and concluded that the end result of actual exchange involving QI was the same as if the taxpayer had made the exchange directly with the related person followed by the related person’s making an outside sale to a third party. In essence the taxpayer failed to carry its burden of proof of the absence of a principal purpose of tax avoidance. In Teruya Bros., Ltd.. & Subs, 124 T.C. 45 (2005), aff’d 104 AFTR 2d 2009 (9th Cir. 9/8/09)

Note: the taxpayer negotiated the sale of relatively low basis real property to an unrelated person through a QI structure, same as in the Ocumulgee Fields case. In anticipation of the sale, the taxpayer arranged to purchase relatively high basis replacement property from a related person. To carry out the transaction, the taxpayer arranged for a qualified intermediary to acquire the property the taxpayer had agreed to sell and to sell it to the unrelated person, to use the proceeds to purchase the replacement property from the related person, and then to transfer that replacement property to the taxpayer. On a related note, Teruya Bros. was just affirmed by the 9th Circuit in upholding the Tax Court’s denial of §1031(a) treatment.

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