RICHARD K. EATON, Judge.
This is a consolidated action brought by three related limited liability companies, AD Global FX Fund, LLC ("AD FX"), AD Equity Investment Fund LLC ("AD Equity"), and AD Global 2001 Fund LLC ("AD 2001"), formed by Alpha Consultants Inc. ("Alpha") and The Diversified Group Inc. ("Diversified") (the source of the "AD" in the name of each fund) (collectively, "plaintiffs"), challenging the Internal Revenue Service's ("IRS" or "defendant") Notice of Final Partnership Administrative Adjustments ("FPAA") issued to each plaintiff. In each company's respective FPAA, the IRS determined that the entities were formed as tax shelters intended to create artificial tax losses to offset the individual fund's corporate partners' unrelated taxable gains and, thus, the entities were to be disregarded as shams for tax purposes. These consolidated actions were commenced by plaintiffs pursuant to 26 U.S.C. § 6226(a) (2000), which allows a partnership to seek a readjustment of determinations made in a FPAA. Plaintiffs have moved for partial summary judgment. For the reasons stated below, the motion is granted in part.
This case involves the alleged organization of limited liability companies as tax shelters in order to produce large, artificial tax losses for the companies' corporate partners.
For example, Moxon Corp. ("Moxon"), a partner in AD FX, simultaneously purchased a long option on the Canadian Dollar for $40 million USD, and sold a short option on the Canadian Dollar to Lehman for $39.8 million USD. Pls.' 56.1 ¶ 3. "The net result was that Moxon paid Lehman $200,000." Pls.' 56.1 ¶ 3.
Second, each partner contributed the option pairs in exchange for partnership interests in their respective limited liability companies. Pls.' 56.1 ¶¶ 4, 20, 33. The percentage interest received by the contributing partner was determined by the partnership based on the value of the long options, without consideration of the partner's obligation under the short option. Pls.' 56.1 ¶¶ 4, 20, 33. Presumably, this was because the value of the short option was sufficiently speculative that it might be ignored when computing basis. Accordingly, each partner's capital account reflected an initial contribution of property valued at the gross purchase price of the long option, without netting the offsetting liability incurred under the paired short option. Thus, each partner's capital account valued the contributed long option at an amount far in excess of the amount actually expended to acquire that option. For example, Moxon's capital account in AD FX reflected an initial contribution of approximately $40 million, the purchase price of the long option. This was notwithstanding that Moxon only paid approximately $200,000 to acquire the option because of the contemporaneous sale of the short option to Lehman for approximately $39.8 million. Pls.' 56.1 ¶¶ 3, 4.
Third, the partnership liquidated its assets and each partner withdrew from the partnership. Pls.' 56.1 ¶¶ 9, 23, 36. Upon withdrawal, each partner received the value of its share of the partnership's assets, which was a relatively small amount, especially when compared to the value of the partner's initial contribution, as reflected in the partnership's capital account. See Pls.' 56.1 ¶¶ 9, 12, 23, 25, 36, 39.
Finally, on its federal income tax return, each plaintiff partnership took the position that it had received the options from its partners as contributions to a partnership within the meaning of 26 U.S.C. § 721, with a carryover basis determined under 26 U.S.C. § 723. Pls.' 56.1 ¶¶ 10, 24, 37. In each case, the partnership claimed that each partner's initial contribution was equal to the value of the long option, without considering the partnership's assumption of the partner's offsetting liability under the short option.
For example, upon withdrawal, Moxon received approximately $60,000 as the value of its investment in AD FX. When subtracted from the $40 million value of the long option contributed as its initial capital investment in AD FX, this resulted in a claimed tax loss in excess of $39 million. Pls.' 56.1 ¶ 12. In other words, Moxon's claimed basis in its partnership interest was approximately $40 million, and its claimed partnership interest upon withdrawal was approximately $60,000. Moxon then claimed a tax loss equal to the difference in its alleged basis ($40 million) and its alleged share of assets on liquidation ($60,000). Pls.' 56.1 ¶ 12.
For each partnership, the IRS issued an FPAA challenging these reported losses.
The FPAA issued for AD 2001 ("AD 2001 FPAA"), which was virtually identical in substance to the FPAAs for AD FX and AD Equity, made the following findings:
Plaintiffs have moved for partial summary judgment
The FPAAs determined that the plaintiff partnerships should be disregarded because they were "formed and availed of solely for purposes of tax avoidance," and because their "formation. . . had no business purpose other than tax avoidance, lacked economic substance, and, in fact and substance, constitute[d] an economic sham for federal income tax purposes." AD 2001 FPAA. Plaintiffs argue, however, that they are partnerships for tax purposes as a matter of law because they met the formal requirements of a partnership under the tax code. "Partnership" is defined by the Tax Code as any "unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a corporation or a trust or estate." 26 U.S.C. § 761(a). Limited liability companies, like plaintiffs, with more than one member are classified as partnerships for tax purposes. 26 C.F.R. § 301.7701-2(c)(i) (1999).
Plaintiff insists that the standard for determining whether an entity constitutes a partnership for tax purposes is the "totality-of-the-circumstances" test set forth by the Supreme Court in Commissioner v. Culbertson. In Culbertson, the Court found that a partnership exists when,
Comm'r v. Culbertson, 337 U.S. 733, 742 (1949) (emphasis added). Plaintiffs argue that this test is "easily met in this case," asserting that their principal purpose being to evade taxes is irrelevant. In other words, plaintiffs claim that because they were partnerships in form, they are partnerships for tax purposes as a matter of law, notwithstanding their tax evasion motives, because "a purpose to reduce taxes has not, to date, been considered relevant in determining whether a partnership is bona fide."
Plaintiffs' argument cannot be accepted. Courts "`look to the objective economic realities of a transaction rather than to the particular form the parties have employed.'" Altria Grp. Inc. v. United States, 658 F.3d 276, 284 (2d Cir. 2011) (quoting Frank Lyon Co. v. United States, 435 U.S. 561, 573 (1978)). "`To permit the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress.'" Id. (quoting Comm'r v. Ct. Holding Co., 324 U.S. 331, 334 (1945)). Under various form over substance principles, including the sham entity and step transaction doctrines, courts routinely refuse to recognize a partnership or other organization for tax purposes "if it is fictitious or if it has no business purpose . . . other than the creation of tax deductions." Ferguson v. Comm'r, 29 F.3d 98, 101 (2d Cir. 1994) (citation and internal quotation marks omitted). Thus, where the validity of a partnership for tax purposes is called into question, in addition to meeting the formal requirements set forth in Culbertson, the partnership must also pass muster under sham entity and related doctrines.
In determining whether a putative partnership constitutes a sham entity, the "basic inquiry [is] . . . whether, all facts considered, the parties intended to join together as partners to conduct business activity for a purpose other than tax avoidance," ASA Investerings, P'ship v. Comm'r, 201 F.3d 505, 513 (D.C. Cir. 2000), and "`the absence of a nontax business purpose is fatal' to the validity of a partnership," Andantech LLC v. Comm'r, 331 F.3d 972, 978 (D.C. Cir. 2003) (quoting ASA Investerings, 201 F.3d at 512-13). Indeed, in Culbertson itself, the Supreme Court observed that not all partnerships meeting the formal requirements are partnerships for tax purposes. The mutual, "good faith" intention of the partners "to conduct a business" is an essential element of partnership status for income tax purposes under Culbertson. Culbertson, 337 U.S. at 744-45. Because there are genuine factual disputes concerning whether the plaintiff entities were shams created for the primary purpose of tax evasion, the court cannot find, on this record, that these entities were bona fide partnerships for tax purposes as a matter of law. Thus, plaintiff's motion is denied.
Plaintiffs argue that because two items are not "partnership items," those items were improperly adjusted in the FPAAs and that the court lacks jurisdiction to review the adjustments. First, plaintiffs contend that each partner's outside basis
Pursuant to the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA"), 26 U.S.C. §§ 6221 et seq., although partners individually pay taxes, the tax treatment of "any partnership item" is determined at the partnership level. 26 U.S.C. § 6221. TEFRA was enacted to "establish a single unified procedure for determining the tax treatment of all partnership items at the partnership level, rather than separately at the partner level," thus avoiding the inconsistent treatment that was prevalent when the IRS was required to audit each partner individually. Callaway v. Comm'r, 231 F.3d 106, 108 (2d Cir. 2000) (citation omitted). "Individual taxpayers still pay the relevant taxes, but the determination as to the amount of tax attributable to partnership items [are now] made at the partnership level." Madison Recycling Assocs. v. Comm'r, 295 F.3d 280, 281 n.1 (2d Cir. 2002) (citation omitted).
Under TEFRA, the partnership, usually through its tax matters partner, files its tax positions with the IRS. If the IRS disagrees with the partnership's positions, it issues a FPAA making the adjustments it deems appropriate. The partnership may challenge any determinations in the FPAA by commencing an action in the U.S. Tax Court, the Court of Federal Claims, or a U.S. District Court. 26 U.S.C. § 6226(a). The determination in that proceeding is binding on all partners. See Callaway, 231 F.3d at 109. Pursuant to the statute, "[a] court with which a petition is filed . . . shall have jurisdiction to determine all partnership items of the partnership for the partnership taxable year to which the [FPAA] relates, the proper allocation of such items among the partners, and the applicability of any penalty, addition to tax, or additional amount which relates to an adjustment to a partnership item." 26 U.S.C. § 6226(f). Under the statute, the court's jurisdiction only extends to "partnership items" addressed in a FPAA. See Petaluma, 591 F.3d at 654-55.
"A partnership item is an item that is (1) required to be taken into account under any provision of subtitle A, governing income taxes, and (2) identified by the Secretary in the regulations as `more appropriately determined at the partnership level.'" Tigers Eye Trading LLC v. Comm'r, 138 T.C. 67, 98 (2012) (quoting 26 U.S.C. 6231(a)(3)). Partnership items include, among other things, "the partnership aggregate and each partner's share of . . . items of income, gain, loss, deduction, or credit of the partnership." 26 C.F.R. § 301.6501(b)(1)(i)-(vi). Other items, affected by partnership level determinations, but properly handled at the partner level, are merely "affected items," which are not properly determined in a FPAA. See 26 U.S.C. § 6231(a)(5) ("The term `affected item' means any item to the extent such item is affected by a partnership item.").
Plaintiffs argue that, under TEFRA, an FPAA cannot properly adjust a partner's outside basis because outside basis is not a partnership item. Pls.' Br. 10. Defendant concedes that the partners' outside bases are not partnership items and that the FPAAs are "erroneous to the extent that they purport to" directly adjust the partners' outside bases. Def.'s Br. 14. This view was recently affirmed by the United States Supreme Court's decision in United States v. Woods which places the conclusion that the plaintiffs' outside bases could not be conclusively determined in the FPAAs beyond doubt. United States v. Woods, 134 S.Ct. 557 (2013). In Woods, the Court reviewed a case decided on strikingly similar facts,
The FPAAs contain findings that the "the amount treated as contributed by the partners . .. is reduced by the amounts received by the contributing partners from the contemporaneous sales of the [short] option(s) to the same counter-party. Thus, the basis of the contributed option(s) is reduced, both in the hands of the contributing partners and [the partnership]." AD 2001 FPAA. In other words, the FPAAs found that the value of the long options to the partnership was reduced by the obligations assumed under the short options.
Plaintiff claims this netting of the options is not a partnership item because "whether the options should be netted at the partner level has no possible effect on the items of income, gain, loss, deduction, or credit of the partnerships." Pls.' Br. 11. Plaintiffs' insist, therefore, that the "only possible impact [of netting the options] is on the partners' outside bases in the partnerships, which, for the reasons discussed above, is not a partnership item." Pls.' Br. 11. In other words, plaintiffs argue that because the netting only affects non-partnership items (i.e., calculating gain or loss on the individual partners' returns), and the FPAAs can only adjust partnership items, the FPAAs were not permitted to net the value of the options. This matters because, if the FPAAs were not permitted to do so, they would lack evidence that the partnerships are shams.
The government counters that
Def.'s Br. 16. In other words, the defendant argues that netting is required to compute the value of each partnership's own inside basis in the options. Inside basis is "the partnership's basis in its own assets." Woods, 134 S. Ct. at 561 (citation omitted). Thus, according the defendant, netting is a partnership item because it is required to calculate the value of the contributed assets to the partnership itself.
The court finds that the netting of the options insofar as necessary to calculate the partnership's inside basis is a "partnership item." First, the FPAAs make it clear that the netting of the option premiums is necessary to determine the "basis of the contributed option(s) . . . in the hands of" each of the partnerships. AD 2001 FPAA. The value of the options to the partnership determines the partnership's basis therein, and "[t]he partnership's basis in contributed property is a partnership item." Murfam Farms, LLC v. United States, 94 Fed. Cl. 235, 241 (2010).
Second, the characterization of the short option received by the partnership is as a "partnership item" pursuant to 26 C.F.R. § 301.6231(a)(3)-1(c)(2), which defines "[t]he character of the amount received from a partner" and "[t]he basis to the partnership of contributed property (including necessary preliminary determinations, such as the partners' basis in the contributed property)" as "partnership items." 26 C.F.R. § 301.6231(a)(3)-1(c)(2).
Finally, each of these determinations is relevant to the factual issue of whether these partnerships lacked economic substance and were, therefore, sham entities, which is, itself, a partnership item. Woods, 134 S. Ct. at 563 ("[A] determination that a partnership lacks economic substance is an adjustment to a partnership item."); Petaluma, 531 F.3d at 653 ("[T]he determination that a partnership is a sham and lacks economic substance is a partnership item because it is a legal determination that underlies the amount and characterization of other partnership items." (citations omitted)).
As noted above, the FPAAs could not adjust the outside bases of the individual partners. To the extent that the FPAAs claimed to do so using netting, they exceeded their authority. However, the Department was permitted to determine the inside basis of contributed property and to observe, provisionally, that the calculation of the partnership's inside basis in the option pairs would be an identical calculation to that subsequently undertaken at the individual partner level to determine that partner's outside basis in the partnership assets. Accordingly, plaintiff's motion for summary judgment on this issue is denied.
Next, plaintiffs contend that the determinations in the FPAAs to characterize the short options as liabilities are incorrect as a matter of law because, under the rule stated in Helmer v. Comm'r, 34 T.C.M. (CCH) 727 (1975), contingent liabilities are not liabilities for purposes of calculating the basis of partnership property, and the liabilities created under the short options were contingent. In the FPAAs, the IRS relied upon Treasury Regulation § 1.752-6T, which superseded Helmer by requiring that contingent liabilities, such as variable payout required under the short options, be treated as liabilities for purposes of computing basis. Plaintiff argues that this regulation, which was promulgated after the transactions at issue in this case, cannot lawfully be applied to plaintiffs retroactively. See 26 U.S.C. § 7805.
Defendant, on the other hand, argues that the court need not address the retroactivity of Treasury Regulation § 1.752-6T at this juncture, because whether the short options should be treated as a liability for tax purposes presumes that the plaintiff entities were bona fide partnerships. For defendant, since there will be a trial in this case to determine whether the partnerships were sham entities that should be disregarded entirely for tax purposes, deciding whether the regulation can lawfully be applied retroactively at this stage would be premature. The court agrees.
The plaintiff concedes that issues of fact remain as to whether the partnerships should be disregarded under the sham entity doctrine or similar legal theories. Were the court to find that the partnerships were to be disregarded on such grounds, deciding whether to treat the short options as liabilities under Treasury Regulation § 1.752-6T would be unnecessary. See Stobie Creek Invs. LLC v. United States, 608 F.3d 1366, 1374 n.4 (Fed. Cir. 2010). Accordingly, the court finds that this issue is not ripe for summary adjudication and plaintiffs' motion with respect to this issue is denied.
Finally, plaintiff argues that the determination in the FPAAs that plaintiffs did not "enter[] into to the option(s) positions or purchase the foreign currency or stock with a profit motive for purposes of [26 U.S.C.] § 165(c)" was invalid. AD 2001 FPAA. Section 165(c) permits a deduction for "any loss sustained during the taxable year and not compensated for by insurance or otherwise," but "in the case of an individual, the deduction . . . shall be limited to . .. losses [that are] incurred in any transaction entered into for profit." Plaintiff insists that this section is inapplicable because plaintiffs are partnerships, and these limitations only apply in "the case of an individual." Put another way, for plaintiffs the requirement that losses be incurred in connection with transactions entered into for profit before they can be deducted does not apply to juridical entities such as partnerships and corporations.
The defendant responds that section 703(a) of the Internal Revenue Code prescribes that "[t]he taxable income of a partnership shall be computed in the same manner as in the case of an individual." Def.'s Br. 32. Accordingly, defendant argues, courts have treated partnerships as individuals for purposes of the profit motive requirement in section 165. Def.'s Br. 32-33.
The court finds that this issue is also not ripe for summary adjudication. If, following trial, it is found that the plaintiff partnerships were sham entities to be disregarded for tax purposes, the losses created by the liquidation of these entities would not be deductible, regardless of whether section 165 is applicable to partnerships. Thus, it would be inappropriate for the court to determine this issue at this stage. See Jade Trading, LLC, 598 F.3d at 1381.
Accordingly, plaintiffs' motion for partial summary judgment is granted in part. The parties are directed to confer and file a joint status report within 30 days of service of this opinion.
It is SO ORDERED.
