United States: Fifth Circuit Upholds Lower Court’s Economic Substance And Negligence Penalty Holdings In FOCus Tax Shelter Case

The US Court of Appeals for the Fifth Circuit affirmed in part and vacated in part a decision by the US District Court for the Southern District of Mississippi in Nevada Partners Fund v. United States.1 In an appeal arising from eleven notices of final partnership administrative adjustment (FPAAs) issued with respect to three limited liability companies treated as partnerships for tax purposes, the appellate court affirmed the district court's determinations that the transactions at issue, known as "Family Office Customized" or "FOCus" transactions, lacked economic substance and should be disregarded for tax purposes. The court also affirmed the negligence penalty and rejected the partnerships' reasonable cause defense, but did not apply the valuation misstatement penalty.


James Kelley Williams expected to realize $18 million in capital gains in 2001. After conferring with his accountant and his attorney, an accounting firm gave a presentation to him and his attorneys on Bricolage Capital LLC's "FOCus" program, which was expected to yield a tax benefit with zero net capital gains and losses. According to the presentation, a second law firm would provide a "more likely than not" tax opinion with regard to the structure.

As part of the FOCus program, Bricolage set up three tiers of LLCs, with the first-tier LLC being 99 percent owned by a subchapter S corporation called Pensacola PFI Corp. ("Pensacola"). The third-tier LLC engaged in foreign currency straddle transactions that resulted in 80 closely offsetting loss and gain legs, resulting in $18 million in gains and $18 million in losses. Then Pensacola began the process of separating gains and losses through the partnership to two shareholders who were investors connected to Bricolage. More than 50 percent of the interest in one of the partnerships was sold or exchanged, resulting in the termination of the tax year, so one of the partnerships was required to declare certain gains and losses on the straddle trades, resulting in the gains flowing up the partnership to Pensacola. Because the parties were related parties, they could only claim the gains from the straddle trades, not the losses, so the gain legs were reported on the owners' tax returns and Bricolage "achieved its first goal of creating an embedded loss that one of its investor-clients could later claim for tax purposes".2

In December 2001, Williams purchased a 99 percent interest in the first-tier partnership for $883,000. Bricolage kept a one-percent interest. Williams' Trust, which held most of his wealth, purchased the first-tier partnerships' interest in the second-tier partnership for $523,000 and then increased its basis in one of the partnerships by transferring equity interests and cash into the partnership, giving Williams a tax basis in the partnership of approximately $9.7 million. Later that month, the third-tier partnership settled five remaining open loss legs, producing $1 million in ordinary losses, that flowed up the partnership chain to Williams, who reported them as ordinary losses. The second-tier partnership sold its interest in the third-tier partnership to another Bricolage corporation for $168,000, triggering a $17 million capital loss for the second-level partnership. Williams had a 99 percent share of that loss but could not yet take advantage of the losses because he did not have enough basis in the second-tier partnership. To increase his basis, Williams signed a personal guarantee of a $9 million loan for the second level partnership to participate in a carry trade involving Japanese Yen. The second-level partnership and the lending institution limited their exposure to rate fluctuations with a narrow risk collar that set the partnership's maximum gain at $77,000 and maximum loss at $90,000. The partnership gained $51,000 on the transactions.

Williams paid Bricolage $845,000, or seven percent of the $18 million desired loss.

IRS Notice 2000-44

The IRS published Notice 2000-44 "Tax Avoidance Using Artificially High Basis" in September 2000 to combat abusive tax shelters known as Son of BOSS schemes. In April 2002, the IRS compelled the accounting firm that presented the FOCus transaction to Williams to disclose information about participants in the FOCus programs. The IRS issued Notice 2002-50, "Partnership Straddle Tax Shelter" on June 27, 2002, which designated partnership straddle tax shelters as "listed transactions."

Two months after straddle transactions became designated listed transactions, Williams received the "more likely than not" opinion from the law firm. The opinion stated that the FOCus transaction was, in the firm's opinion, "more likely than not" "the same as, or substantially similar to, the listed transaction described in Notice 2002-50." The tax opinion did not distinguish the FOCus transactions from those described in the notice but still recommended that the transactions more likely than not had economic substance.

Parties' Positions and Court's Analysis

The IRS issued FPAAs challenging the transactions and disallowing the losses claimed by the partnerships under the economic substance doctrine. The FPAAs also assessed three alternative penalties under section 6662: the substantial understatement penalty (twenty percent), the negligence penalty (twenty percent), and the gross valuation misstatement penalty (forty percent).

The partnerships challenged the FPAAs in Mississippi district court, which held, inter alia, that the FOCus program lacked economic substance. The appellate court upheld the district court's holding that the transactions lacked economic substance under its test derived from Frank Lyon, which examines whether the transaction: (1) has economic substance compelled by business or regulatory realities, (2) is imbued with tax-independent considerations, and (3) is not shaped totally by tax-avoidance features. After reviewing the question of economic substance de novo and the facts for clear error, the appellate court saw no clear error in the district court's decision regarding economic substance. The court stated: "In sum, the transactions that created [the] $18 million embedded loss had no economic substance and Williams obtained the benefit of an $18 million deduction on his 2001 personal income tax return without suffering any real economic loss."3

The court affirmed the district court's imposition of a negligence penalty (and vacated its approval of the substantial understatement penalty because the two are alternatives). The court stated that the district court "was justified in concluding as a matter of fact that the partnerships were negligent and exposed themselves to liability for the section 6662 accuracy-related penalties because they did not meet their burden of proving due care and the absence of negligence."4 The court further stated that the partnerships were negligent in participating in the FOCus program after the IRS issued Notice 2002-50. The court rejected the parties' reasonable cause and good faith defense. The parties stated that Williams had relied on the tax advice of two law firms and an accounting firm, but the court found this unpersuasive—Williams did not become a controlling member until late 2001, and the partnership's negligence related to the FOCus program began before that: "Williams' subsequent reliance on tax law advice by counsel cannot serve retroactively to shield the partnerships from liability for their prior negligence and disregard of rules and regulations in formulating, promoting, and beginning to carry out the unlawful FOCus tax avoidance scheme."5 According to the court, the law firm's opinion "clearly reflect[ed]" that the partnership did not provide the facts and circumstances surrounding the transaction to the law firms and that Williams and the partnerships knew that the tax opinions did not contain key information. Accordingly, the court held that the tax opinions could not be relied upon in good faith. Because Williams' other counsel had relied upon these tax opinions, and the partnerships knew this, the partnerships also did not reasonably rely upon the advice of Williams' second law firm.


1 No. 10 60559 (5th Cir. June 24, 2013).

2 Slip. op. at 9.

3 Slip op. at 26 27.

4 Id. at 32.

5 Id. at 36.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

In association with
Related Topics
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions