Eleventh Circuit Affirms Tax Court's Disallowance of $78 Million Tax Shelter Loss

(Parker Tax Publishing September 2022)

The Eleventh Circuit affirmed a ruling of the Tax Court disallowing a taxpayer's $77.6 million deduction for a loss resulting from a complex tax avoidance scheme involving tiered partnerships and foreign currency transactions which was found to be an abusive tax shelter in a partnership-level court proceeding. The court rejected the taxpayer's argument that a notice of deficiency was untimely after finding that, because the notice adjusted an affected item (one partnership's outside basis in a lower-tier partnership), the statute of limitations was held open until one year after the partnership-level proceeding became final. Sarma v. Comm'r, 2022 PTC 241 (11th Cir. 2022).

Background

Raghunathan Sarma participated in a tax avoidance scheme called "Family Office Customized partnership" or "FOCus." An investment firm called Bricolage Capital, LLC (Bricolage) and the accounting firm KPMG marketed FOCus to wealthy individuals with recent "large liquidity events." Sarma was one such individual. In 2001, Sarma expected to realize an $80.9 million capital gain as a result of selling a division of his company, American Megatrends. Sarma participated in the FOCus scheme to avoid paying the resulting taxes.

Each FOCus vehicle required the creation of a set of three tiered partnerships: an upper tier, a middle tier, and a lower tier. The partnerships owned a 99 percent interest in the partnership in the tier below it, with Bricolage-affiliated entities owning the remaining 1 percent of each entity. Sarma invested in the FOCus vehicle comprised of the following partnerships: (1) Nebraska Partners Fund, LLC (Nebraska), the upper tier, (2) Lincoln Partners Fund, LLC (Lincoln), the middle tier, and (3) Kearney Partners Fund, LLC (Kearney), the lower tier. FOCus was designed to generate significant artificial losses to offset legitimate taxable income. An essential component was a series of offsetting foreign currency exchange forward contracts, referred to as FX straddles, executed by Kearney through Credit Suisse First Boston (Credit Suisse). The proceeds from the gain legs of the FX straddles were placed into certificates of deposit (CDs) at Credit Suisse. Kearney reported and realized a $79.1 million gain from the gain legs. The loss legs had not been closed out and remained unrealized. However, the amounts of those losses were locked in.

In 2001, Lincoln sold its 99 percent interest in Kearney for $737,118 to a Bricolage-affiliated entity. On the date of the sale, Lincoln claimed an outside basis in Kearney of $79,110,062. Lincoln increased its outside basis in Kearney to account for the gain legs from the FX straddles, but it did not decrease its basis to account for the unrealized losses from the loss legs. Lincoln reported a $78,392,194 short term capital loss and allocated $77,608,272 of it to Sarma in accordance with his 99 percent partnership interest. Sarma, in turn, claimed a deduction for this loss on his 2001 tax return, and carried over the remaining portions to his 2002, 2003 and 2004 returns.

For the years at issue, the partnership audit procedures under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) were in effect. The IRS issued nine final partnership administrative adjustments (FPAAs) to the partnerships for several tax years, including Kearney's 2001 tax year. In the FPAAs, the IRS determined that the partnerships were an abusive tax shelter and adjusted partnership items to eliminate the benefits of the shelter. The partnerships sought judicial review of the adjustments in the FPAAs in a district court. The district court sustained the adjustments that reduced Kearney's gains and losses from the FX straddles to zero, and a panel of the Eleventh Circuit affirmed. The partnership-level proceeding became final on January 11, 2016.

On September 9, 2016, the IRS issued an affected item notice of deficiency to Sarma, asserting deficiencies for 2001 through 2004 arising out of his involvement in the FOCus shelter (2016 notice). Because Kearney was a sham, the IRS determined that Lincoln had no basis in Kearney. The IRS therefore disallowed Sarma's $77.6 million loss deduction and asserted tax deficiencies. Previously, in 2009 and 2010, the IRS had also issued notices of deficiency to Sarma for his 2001 through 2004 tax years. Sarma challenged the 2016 notice in the Tax Court. The Tax Court held that Lincoln's outside basis in Kearney was zero and that Lincoln had no gain or loss on the Kearney sale. Thus, because Lincoln was not entitled to deduct the loss, Sarma was not entitled to deduct the $77.6 million passthrough loss.

Sarma appealed to the Eleventh Circuit. He argued that the 2016 notice was untimely because the three-year statute of limitations under Code Sec. 6501(a) had expired prior to its issuance. He also contended that the 2016 notice was an invalid multiple notice under Code Sec. 6212(c)(1), which generally bars the issuance of multiple notices of deficiency to the same taxpayer for the same tax year. In addition, Sarma argued that because Kearney was a sham partnership, Lincoln's sale of its interest in Kearney should be treated as a sale of Kearney's assets. According to Sarma, Lincoln took a cost basis of $81.8 million in the Kearney's assets (namely, the CDs) and thus realized an $81 million loss on the deemed asset sale.

Analysis

The Eleventh Circuit affirmed the Tax Court and rejected Sarma's arguments. The court found that the 2016 notice was not untimely because under Code Sec. 6229, the filing of the FPAA suspended the limitations period for assessment of tax attributable to affected items until the conclusion of the partnership-level proceeding and for one year thereafter, i.e., January 11, 2017. According to the court, the 2016 notice asserted a deficiency that was attributable to an affected item and therefore, the statute of limitations had not expired when the IRS issued the September 9, 2016, notice of deficiency.

The court explained that the timeliness of the 2016 notice depended on whether Lincoln's outside basis in its Kearney interest was an affected item, and the court determined that it was. Under Code Sec. 6231(a)(5), an affected item is any item to the extent such item is affected by a partnership item. The court found that a determination that a partnership lacks economic substance and is a sham is a partnership item. Since Lincoln's outside basis in Kearney was clearly an "item," the court said that the operative question was whether Lincoln's outside basis in Kearney was "affected by" the district court's determination that Kearney was a sham. The court concluded that, because the determination that Kearney was a sham factored into Lincoln's computation of its gain or loss on the sale of its Kearney interest, Lincoln's outside basis in Kearney was an item affected by a partnership item. Further, because the 2016 notice adjusted an affected item, the court found that it was not subject to the general rule barring the issuance of multiple notices under the exception for affected item notices of deficiency provided in Code Sec. 6230(a)(2)(C).

The court also rejected Sarma's argument that Lincoln's sale of its Kearney interest should be deemed an asset sale. The court noted that under Code Sec. 6233 and Reg. Sec. 301.6233-1, when a sham partnership files a return (which Kearney did), the return is treated as though it were filed by a partnership subject to TEFRA. Meaning, TEFRA applied to Kearney, its items and any person holding an interest in Kearney for that tax year. Thus, under Code Sec. 6226(f), the partnership-level court had jurisdiction to determine the entity's items that would have been partnership items, as well as to determine the proper allocation of any items to the purported partners. Basis in the CDs, the court noted, would be a partnership item of Kearney. The court found that Kearney did not distribute the CDs to Lincoln, nor did the district court treat Kearney as having distributed the CDs to Lincoln or treat Lincoln as the owner of the CDs. The court further reasoned that recharacterizing Lincoln's sale of its Kearney interest as an asset sale would run afoul of the principle that a taxpayer is generally bound to the form of the transaction he or she chose. This was especially true, the court added, considering that the form of this transaction - the sale of an interest in a partnership, albeit one later determined to be a sham - was an integral and pre-planned part of an abusive tax shelter.

For a discussion of TEFRA audit procedures, see Parker Tax ¶28,505.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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