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D.C. Circuit Affirms Tax Court's Ruling That Investment Partnership Was a Sham

(Parker Tax Publishing April 2021)

The D.C. Circuit affirmed the Tax Court's ruling that the extensions on the three-year statute of limitations agreed to by the partners and the tax matters partner of a partnership were not voidable due to misrepresentation or undue influence. The D.C. Circuit also held that the Tax Court did not err in holding that the partnership was created to carry out a tax avoidance scheme and should therefore be disregarded for tax purposes. BCP Trading and Investments, LLC v. Comm'r, 2021 PTC 73 (D.C. Cir. 2021).


BCP Trading & Investments, LLC (BCP) was a 39-member partnership whose managing member was Bolton Capital Planning, LLC (Bolton Capital). Charles Bolton owned and operated Bolton Capital. Belle Six worked for Bolton Capital and was a former employee of Ernst & Young (E&Y). BCP's 38 other members (i.e., client members) were limited liability companies and limited partnerships, and all were clients of E&Y. Two groups of client members, all limited partnerships, were relevant to this case: (1) KP1, KP2, and PCMG XII, and (2) WTETP and PCMG VI. Kevin Kalkhoven and Dan Pettit were limited partners in the KP1, KP2 and PCMG XII limited partnerships. Jim Cox of E&Y managed both Kalkhoven's and Pettit's business matters. William Esrey was a limited partner in WTETP and Ronald LeMay was a limited partner in PCMG VI. E&Y prepared their tax returns beginning in the 1980s. Over the years both Esrey's and LeMay's relationship with E&Y evolved from tax preparation to estate, financial and tax planning - Mike Carr of E&Y served as Esrey's and LeMay's point of contact.

In 1999, Six left E&Y to join The Private Capital Management Group (TPCMG) to help TPCMG market an E&Y-promoted financial transaction called a Contingent Deferred Swap (CDS). CDS transactions defer taxes on ordinary income by one year and transform the ordinary income into capital gains. Through their respective limited partnerships, Kalkhoven, Pettit, Esrey and LeMay (i.e., the taxpayers) engaged in CDS transactions with TPCMG in 1999. In late 1999 or early 2000, TPCMG transferred the CDS business to Bolton. Six joined Bolton to continue to market the CDS transactions and act as liaison between Bolton and E&Y.

To offset the capital gains taxes generated from the CDS transactions, E&Y created a new transaction - the transaction at issue in this case - known as the CDS Add-On or CDS Plus (i.e., the Add-On). E&Y and Six described the Add-On to Esrey, LeMay, Kalkhoven and Pettit and they all decided to participate. In May 2000, on E&Y's advice, Bolton Capital formed BCP to execute the Add-On. Between 2000 and 2001 BCP client membersincluding the taxpayers' limited partnershipsengaged in the E&Y-designed Add-On.

In 2004, the IRS obtained an extension of the three-year statute of limitations for adjustments for tax year 2000 from Bolton as BCP's tax matters partner (i.e., the partnership extension). Bolton subsequently executed eight more partnership extensions extending the audit period for tax years 2000 and 2001 through June 30, 2008. The IRS also obtained timely individual extensions from Kalkhoven, Pettit, Esrey and LeMay. Pettit and Kalkhoven signed individual extensions for tax year 2000 in 2003 and 2004. Esrey and LeMay also signed individual extensions for tax year 2000. The taxpayers continued to sign individual extensions, extending the assessment of their tax liability for tax years 2000 and 2001 through at least December 31, 2008.

While the IRS sought the partnership and individual extensions, E&Y was actively advising BCP and the taxpayers and representing the taxpayers before the IRS. E&Y's Cox advised Kalkhoven and Pettit to consent to the individual extensions and did not discuss any extension downside with them. Similarly, E&Y's Carr advised Esrey and LeMay to authorize individual extensions. E&Y also advised BCP to sign the partnership extension. Six wrote to the taxpayers, informing them that Bolton Capital planned to sign the partnership extension based on E&Y's recommendation. Around the same time, E&Y was the subject of several civil and criminal investigations. By 2002, E&Y knew the IRS was auditing CDS transactions. In March 2002, E&Y became the subject of an IRS "civil promoter" audit to determine if E&Y had failed to disclose tax shelters. That audit was settled in 2003. In 2004, a grand jury investigation began to examine E&Y's tax shelters.

In 2008, the IRS issued final partnership administrative adjustments (FPAAs) against BCP for tax years 2000 and 2001. In the FPAAs, the IRS determined BCP was a sham and should be disregarded for tax purposes. The taxpayers, through their partnerships, challenged the FPAAs in the Tax Court, arguing that the extensions were voidable under agency and contract law and that BCP was a bona fide partnership with a valid business purpose. The Tax Court upheld the IRS's adjustments after finding that the extensions were valid and that BCP was created to carry out a tax avoidance scheme and should therefore be disregarded for tax purposes.

BCP and the partners appealed to the D.C. Circuit. They argued that their agreements to extend the limitations period were tainted because they could not have made an informed decision without knowing of E&Y's conflict. They further argued that the extensions were invalid under the contract principles of misrepresentation and undue influence. The taxpayers also contended that BCP was not a sham because it had a business purpose and that the Tax Court erred in applying the factors set forth in Luna v. Comm'r, 42 T.C. 1067 (1964), to evaluate whether BCP was a sham because Luna is separate from the business purpose doctrine.


The D.C. Circuit affirmed the Tax Court's decision after finding that the Tax Court applied the correct legal precedent in reaching its decision and committed no clear error in its findings upholding the IRS's adjustments. The D.C. Circuit found that, although the Tax Court opinion was at times unclear or its reasoning cursory, such flaws did not per se establish clear error.

Addressing the issue of whether the extensions were voidable, the court noted that Six informed the taxpayers that Bolton planned to sign the partnership extension based on E&Y's advice and that it would be signed unless Bolton Capital heard from them. In addition, the court found that E&Y advised each taxpayer to sign his individual extension. Accordingly, the court said that if the taxpayers' assent to any extension was due to E&Y's misrepresentation or undue influence, the extension could be voidable. However, the court found that for the taxpayers to void the extensions, they had to have justifiably relied on E&Y. In the court's view, various events occurred before the taxpayers' individual extensions or the partnership extension were signed, all of which should have put the taxpayers on notice that they should not rely on E&Y's advice any longer. For instance, as early as 2000, Esrey and LeMay were aware that E&Y's tax strategies were being investigated and in 2003, they learned of the civil promoter audit. In addition, Kalkhoven and Pettit learned in 2004 of the IRS's position that E&Y was a tax shelter promoter of the Add-On and other transactions. The court also noted that the taxpayers were sophisticated businessmen who should not have relied unquestioningly on E&Y after gaining direct knowledge of the IRS's scrutiny of its tax strategies.

Regarding the Tax Court's determination that BCP was a sham, the D.C. Circuit found that although the Luna intent inquiry is distinct from the business purpose doctrine, the two analyses are not mutually exclusive. The court agreed with the Tax Court that the agreement of the parties and their conduct in executing its terms, and the fact that the business was not conducted in the joint names of the parties, weighed against finding BCP was a partnership for tax purposes. The court further observed that BCP's "business" was limited to one type of transaction, the Add-On, and that Bolton Capital's level of control over BCP was particularly unusual. Accordingly, the court held that the Tax Court was correct in concluding that BCP failed the Luna analysis. In addition, BCP and the Add-On had no practical economic effect other than the creation of tax losses, in the court's view, considering that the client members invested only $16.5 million and claimed $3.1 billion in tax losses. The court found that the Tax Court correctly recognized that those losses were artificial.

For a discussion of the Luna factors for determining the existence of a partnership, see Parker Tax ¶20,105. For a discussion of TEFRA audit procedures, see Parker Tax ¶28,505. For a discussion of the economic substance, sham transaction doctrines, and business purpose doctrines, see Parker Tax ¶110,130.

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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