United States: Seventh Circuit Affirms Tax Court In Distressed Asset/Debt Case "Superior Trading", Upholds Valuation Misstatement Penalty

On August 26, the US Court of Appeals for the Seventh Circuit joined a majority of circuits in holding that a taxpayer who overstates basis and participates in a sham transaction can be held liable for the forty-percent valuation misstatement penalty under section 6662(h).¹ In Superior Trading, LLC v. Commissioner,² the Seventh Circuit affirmed the Tax Court's decision in favor of the government after it disallowed losses claimed by "partners" in a so-called distressed asset/debt transaction.

John Rogers created a limited liability company known as Warwick LLC to transfer Brazilian company Arapuã's receivables with built in losses to US taxpayers who would then deduct the losses from their federal income tax. Arapuã and Rogers' company, Jetstream, joined to form Warwick. Jetstream was designated managing partner of Warwick. Arapuã contributed its receivables to Warwick, and Arapuã's partnership interest was sold to investors, who, as successors in the partnership, then claimed the partnership losses. To deduct the built-in losses, the investors had to contribute property. The investors contributed promissory notes made out to the partnership. The appellate court stated that the promissory notes had no value because Warwick would not collect on them—rather, they were promised only to give the appearance that the investors had enough basis to claim the built-in losses from Arapuã's receivables. The court stated that the partnership was "just a conduit from the original owner of the receivables (Arapuã) to the US taxpayers" and was a "sham." On that basis, the court affirmed the Tax Court's decision in favor of the government. It also upheld the valuation misstatement penalty, while acknowledging the circuit split on the issue and stating that the Supreme Court had granted certiorari in United States v. Woods³ to resolve the issue.

Footnotes

1 All section references are to the Internal Revenue Code and all references to regulations are to the Treasury regulations issued thereunder, unless otherwise noted.

2 Nos. 12-3367; 12-3368; 12-3369; 12-3370; and 12-3371 (7th Cir. Aug. 26, 2013).

3 133 S.Ct. 1632 (2013).

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