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.

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