Experienced Tax Attorney Should Have Known He Had No Basis for Losses; 40 Percent Penalty Appropriate (Parker Tax Publishing: September 22, 2013)

Losses claimed by a partnership created as a tax shelter for the benefit of its investors were disallowed because the partnership lacked economic substance; penalties for gross valuation misstatements were upheld. Superior Trading, LLC v. Comm'r, 2013 PTC 263 (7th Cir. 8/26/13).

John Rogers, a tax attorney, created a partnership, Warwick Trading, LLC, for the purpose of selling tax shelter interests to U.S. investors. The partners in Warwick were a foreign consumer electronics retailer, Lojas Arapua S.A., and Jetstream Business Limited, another company owned by John. Superior Trading, LLC, a holding company, was a subsidiary of Warwick. Arapua contributed to Warwick largely uncollectible receivables of $30 million that were worth less than their face amount. Jetstream was designated managing partner and responsible for collecting the receivables. The net receipts collected by Jetstream would be Warwick's income to be divided between Jetstream and Arapua. With this arrangement, John intended to create a distressed asset/debt (DAD) tax shelter.

In a DAD tax shelter, when an asset is contributed to a partnership, the contributor receives a partnership interest in exchange. Although the partnership formally owns the asset, the contributor owns a partnership interest in recognition of the contribution and has actually parted with the asset. John's DAD tax shelter involved Arapua's contribution of receivables with built-in loss to Warwick, followed by the sale of Arapua's partnership interest to U.S. investors. The partnership losses generated when the receivables were sold would flow through to the U.S. investors. The investors would deduct the built-in loss up to the amount of their basis in the partnership. The basis of the partnership interest that investors acquired was the price at which Arapua sold the interest to the investors. The price for the interest was approximately 3 to 6 percent of the value of the losses obtained by buying into the shelter since the investors were only buying tax savings based on built-in loss. To increase their basis in the partnership to a level where the investors could deduct the entire built-in loss, investors contributed promissory notes to Warwick. The notes had no actual value, as John did not intend to collect on them.

Warwick claimed losses of the sale of the partnership interests to the U.S. investors. The IRS issued notices of final partnership administrative adjustment (FPAAs) for 2003 and 2004, denying the deductions, adjusting the partnership basis in the receivables to zero and imposing penalties for gross valuation misstatements under Code Sec. 6662(h). The Tax Court upheld the IRS's FPAAs and imposition of the 40 percent gross valuation misstatement penalty.

Code Sec. 723 provides that when an asset is contributed to a partnership, the asset's basis is the original basis of the contributor, which is the asset's original cost with adjustments. Recognition of gain or loss attributable to a change in the asset's value before the asset was contributed to the partnership is deferred until the partnership sells the asset. Code Sec. 704 states that if an asset is worth less than the contributor paid for it, then the loss in value, or built-in loss, will be recognized and used to reduce taxable income only when the partnership sells the asset.

The Seventh Circuit affirmed the Tax Court and held that Warwick lacked economic substance because there was no genuine business goal between Arapua and Jetstream to carry on a business and share in its profits and losses. The court looked to case law in Southgate Master Fund, LLC v. U.S., 659 F.3d 466 (5th Cir. 2011), which defined a genuine partnership as a business jointly owned by two or more persons and created for the purpose of earning money through business activities, and concluded that if the only purpose was to avoid taxes, then the partnership would be disregarded for tax purposes. Jetstream did not actively attempt to collect the receivables that Arapua contributed to the partnership, and the proceeds from the sale of the partnership interests was Warwick's only revenue, the court noted. Because the transaction did not make commercial sense, the court determined that the purpose of the partnership was not to earn money by collecting Arapua's receivables, but to sell interests to U.S. investors seeking tax savings. John's claim that Warwick was a valid LLC organized under state (Illinois) law and thus entitled to the tax benefits such as the deferral of losses in contributed property was rejected. The court found that Warwick was a sham partnership without economic substance and should be disregarded for federal tax purposes. The court concluded that, since Arapua's contribution of the receivables to Warwick was recharacterized as a sale to shelter investors, Arapua had to recognize any loss at the time of the sale and left no built-in loss for investors to claim when they entered the partnership.

Finally, the court determined that the 40 percent penalty for an understatement of tax attributable to any gross valuation misstatement was properly imposed. The valuation misstatement in this case was gross since the aggregate basis of the receivables transferred to Warwick was near zero and John valued them at $30 million. John failed to show that he had reasonable cause to deduct the built-in losses since he was an experienced tax attorney and knew or should have known that he had no reasonable basis to claim the partnership losses.

For a discussion of the 40 percent gross valuation misstatement penalty, see Parker Tax ¶262,120.

Parker Tax Publishing Staff Writers

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