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.

Background

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.

Footnotes

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.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
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
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration
Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:
  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.
  • Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.
    If you do not want us to provide your name and email address you may opt out by clicking here
    If you do not wish to receive any future announcements of products and services offered by Mondaq you may opt out by clicking here

    Terms & Conditions and Privacy Statement

    Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

    Use of www.mondaq.com

    You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). 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 & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

    Disclaimer

    Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd 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 or performance of information available from this server.

    The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

    Registration

    Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

    • To allow you to personalize the Mondaq websites you are visiting.
    • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
    • To produce demographic feedback for our information providers who provide information free for your use.

    Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

    Information Collection and Use

    We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

    We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

    Mondaq News Alerts

    In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

    Cookies

    A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

    Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

    Log Files

    We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

    Links

    This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

    Surveys & Contests

    From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

    Mail-A-Friend

    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

    Emails

    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

    Security

    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at enquiries@mondaq.com.

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.

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