Filed: Jul. 31, 2014
Latest Update: Mar. 02, 2020
Summary: Case: 13-10799 Document: 00512718607 Page: 1 Date Filed: 07/31/2014 IN THE UNITED STATES COURT OF APPEALS FOR THE FIFTH CIRCUIT United States Court of Appeals Fifth Circuit FILED No. 13-10799 July 31, 2014 Lyle W. Cayce Clerk SALTY BRINE I, LIMITED, Plaintiff, v. UNITED STATES OF AMERICA, Defendant. _ THOMAS & KIDD OIL PRODUCTION, LIMITED, By and Through Thomas/Kidd – Texas Operating Co., Incorporated, Tax Matters Partner, Plaintiff-Appellant, v. UNITED STATES OF AMERICA, Defendant-Appellee. App
Summary: Case: 13-10799 Document: 00512718607 Page: 1 Date Filed: 07/31/2014 IN THE UNITED STATES COURT OF APPEALS FOR THE FIFTH CIRCUIT United States Court of Appeals Fifth Circuit FILED No. 13-10799 July 31, 2014 Lyle W. Cayce Clerk SALTY BRINE I, LIMITED, Plaintiff, v. UNITED STATES OF AMERICA, Defendant. _ THOMAS & KIDD OIL PRODUCTION, LIMITED, By and Through Thomas/Kidd – Texas Operating Co., Incorporated, Tax Matters Partner, Plaintiff-Appellant, v. UNITED STATES OF AMERICA, Defendant-Appellee. Appe..
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Case: 13-10799 Document: 00512718607 Page: 1 Date Filed: 07/31/2014
IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT
United States Court of Appeals
Fifth Circuit
FILED
No. 13-10799 July 31, 2014
Lyle W. Cayce
Clerk
SALTY BRINE I, LIMITED,
Plaintiff,
v.
UNITED STATES OF AMERICA,
Defendant.
_________________________
THOMAS & KIDD OIL PRODUCTION, LIMITED, By and
Through Thomas/Kidd – Texas Operating Co., Incorporated,
Tax Matters Partner,
Plaintiff-Appellant,
v.
UNITED STATES OF AMERICA,
Defendant-Appellee.
Appeal from the United States District Court
for the Northern District of Texas
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No. 13-10799
Before DAVIS, ELROD, and COSTA, Circuit Judges. 1
W. EUGENE DAVIS, Circuit Judge:
Plaintiff Thomas & Kidd Oil Production, Ltd. (“TKOP”) appeals from the
district court’s determination, after a nine-day bench trial, that the transfer of
certain overriding royalty interests through a complicated transaction was an
invalid attempt to assign income. The record amply supports this finding and
supports the district court’s conclusion that the income was taxable to TKOP
for the 2006 tax year. We affirm.
I. Introduction
On April 5, 2010, The Commissioner of Internal Revenue issued a Notice
of Final Partnership Administrative Adjustment to TKOP for the tax year
ending December 31, 2006, establishing what the IRS believes to be TKOP’s
total tax liability. TKOP deposited the amount required by 26 U.S.C. § 6226(e)
with the IRS, then commenced this action seeking readjustment of partnership
items, which was consolidated with seven lawsuits under the Salty Brine I
caption. The district court had jurisdiction under 26 U.S.C. § 6226(a) and 28
U.S.C. § 1346(e), and we have jurisdiction over this timely appeal under 26
U.S.C. § 6226(g) and 28 U.S.C. § 1291.
TKOP disputed the determination of several partnership items before
the district court, including whether TKOP’s purchase of so-called Business
Protection Policies (“BPPs”) resulted in deductible business expenses, and
whether the transfer of certain overriding royalty interests by TKOP was an
invalid attempt to assign income that should have been taxed to it.
The district court ultimately concluded that the purchase of the BPPs
did not result in deductions and that the transfer of the overriding royalties
should be disregarded and the royalty income assigned to TKOP instead.
1 Judge Elrod concurs in all parts of this opinion except Part III.B.
2
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TKOP has appealed only the overriding royalty determination, but it is
necessary to discuss the BPP scheme because both the BPP scheme and the
royalty transaction concerned some of the same business entities and methods.
II. Factual Background
This case largely turns on the complicated facts surrounding the
overriding royalty interest transaction, which the district court addressed in a
detailed order.
In an appeal from a bench trial, we review the district
court’s findings of fact for clear error and its
conclusions of law de novo. “Specifically, a district
court’s characterization of a transaction for tax
purposes is a question of law subject to de novo review,
but the particular facts from which that
characterization is made are reviewed for clear error.” 2
We take our facts from the district court’s findings, which are not clearly
erroneous.
A. TKOP’s Ownership
The district court found that the ultimate taxpayers, John Thomas and
Lee Kidd, own and operate a group of oil and gas related businesses based in
West Texas, including TKOP. The district court noted that Thomas and Kidd
did not own their businesses directly, but rather owned them through the
trusts and investment partnerships that were involved in the BPP and royalty
interest transaction. Thomas and Kidd owned TKOP through two grantor
trusts, the Kidd Living Trust and Thomas Living Trust; and two additional
investment partnerships, Kiddel II, Ltd. and JTOM II, Ltd. The ownership
structure is unquestionably complex, but the essential finding is that all of the
related entities were owned and controlled by Thomas and Kidd.
2Southgate Master Fund, L.L.C. ex rel. Montgomery Capital Advisors, LLC v. United States,
659 F.3d 466, 480 (5th Cir. 2011) (footnote omitted).
3
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B. The BPP Scheme
The district court found that Thomas and Kidd’s accountant, H. Glenn
Henderson, introduced them to the concept of BPPs, which were issued by
Fidelity Insurance Company and Citadel Insurance Company, both based
offshore in the British West Indies. Fidelity and Citadel were associated with
several other companies under the umbrella of the Alliance Holding Company,
Ltd., including a trust company, an administrative services company, and a
marketing firm, Foster & Dunhill. Fidelity and Citadel were not owned by
Thomas and Kidd.
The idea behind the BPPs was to set up an offshore “asset protection
trust” then purchase cash-value life insurance policies, whose cash values
would be invested with the principal and interest allocated to “separate asset”
accounts (or “segregated accounts”). The goal was to set aside the assets of
these accounts and account for them separately from other insurance policies,
shielding them from the owners of other insurance policies and from the
creditors of the insurance companies. One of the district court’s key findings
is that the accounts were invested in accordance with the client’s instructions.
Thomas and Kidd purchased cash-value life insurance policies, through
their various companies, from Fidelity and/or Citadel beginning in 2002, and
in the relevant tax year, 2006, they had policies in place from both Fidelity and
Citadel.
The final step was the purchase of a BPP, which ostensibly insured a
given business against risks. At the end of the policy year, the profit
(approximately 85% of the premium from the BPP, less a management fee)
would be placed into the already established separate asset accounts. The
district court found that, under the arrangement, each client’s account was
responsible only for BPP claims filed by that client’s business, and no third
4
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party could access the account. Tellingly, each BPP provided coverage only
against remote and implausible risks, virtually guaranteeing that no claim
could be made under the policy.
Assuming no claim was made under the BPP (nearly guaranteed by the
terms of the policy), approximately 85% of the premium was deposited into the
segregated accounts as profit, including the cash value of the policy. The life
insurance policy holder could then withdraw those funds as a tax-free policy
loan. If successful, this plan would allow TKOP to deduct 100% of the
insurance premiums from taxable income as reasonable and necessary
business expenses, then the life insurance policy holder (ultimately a co-owner
of TKOP) could withdraw approximately 85% of that amount as a tax-free loan
from the life insurance policy account. The district court found that although
the BPPs were apparently set up to protect Thomas and Kidd’s businesses, in
reality the policies were merely a conduit used to funnel income from the
businesses to offshore entities in a scheme to avoid paying taxes due on that
income. The policy only protected against claims made by one of the closely
held entities controlled by Thomas and Kidd.
The district court found that Thomas and Kidd issued investment
instructions for the segregated accounts, which were in fact followed. For the
year 2006, Thomas and Kidd’s businesses paid $4.5 million in premiums on
various BPPs, which they deducted as ordinary and necessary business
expenses. At the conclusion of the one-year policies, Fidelity and Citadel
deducted $730,000 from that total in fees, then transferred the profits of $3.86
million into the various segregated accounts in accordance with Thomas and
Kidd’s instructions. In this way, the district court found, “$730,000 was spent
to acquire a $4.5 million reduction in otherwise taxable income in the United
States and to funnel the remaining $3.86 million . . . into offshore life insurance
5
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policies.” 3
Thomas and Kidd withdrew all $3.86 million within one day of the
transfer as policy loans.
TKOP does not appeal the findings or conclusion regarding the BPP
scheme, and the BPPs are not directly at issue in this appeal. Nevertheless,
the segregated accounts and the method of withdrawing the funds as policy
loans are central to the royalty interest transaction at issue in this appeal.
C. Royalty Interest Transaction
The district court found that the BPP scheme was not the only method
Thomas and Kidd used to avoid paying taxes. In brief, TKOP carved out
royalty interests from its working interests in a number of oil and gas
properties and then transferred these royalty interests, through intermediate
entities controlled by Thomas and Kidd, into the segregated accounts
associated with the Thomas and Kidd life insurance policies. A small portion
of the income was intended to flow back as annuity payments purchased with
the royalty interests, which payments were deferred for three years and thus
not taxable in 2006. The larger portion was held in the segregated accounts
and was available at any time for tax-free policy loans.
There were four steps involved in the royalty transaction.
(1) In early 2006, Thomas and Kidd created two limited liability
companies, one in Nevis which was owned by the same entities that own
TKOP; and one in Nevada which was soon owned 100% by the Nevis LLC. The
Nevis LLC’s role was to act as foreign intermediary.
(2) TKOP assigned royalty interests representing approximately 31% of
TKOP’s total royalty income to the Nevada entity.
(3) The Nevada LLC was transferred to the Nevis LLC, giving the Nevis
3 See District Court’s May 16, 2013 Order Nunc Pro Tunc (“Order”), p. 9.
6
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LLC indirect control of the royalty interests.
(4) The Nevis LLC was transferred to the life insurance segregated
accounts in exchange for two annuities, one of which would pay $192,810 per
year for the remainder of Kidd’s life, and the other of which would pay $178,579
per year for the remainder of Thomas’s life. These payments were deferred
and would not begin until January 2009. Following this exchange, the royalty
interests, which represented a future income stream, were held in the life
insurance segregated accounts.
The value of the exchanged royalty interest is not clear, though estimates
for a one-half interest (for Thomas or Kidd individually) range from $1,001,000
to $1,261,500. Thomas and Kidd’s accountant, H. Glenn Henderson, used the
higher valuation in the 2006 transaction. He sat on both sides of the
transaction, on the one side as Thomas and Kidd’s accountant, and on the other
side as a manager for the LLCs that owned the life insurance policies. The
district court also noted that there was evidence that he was also the
investment manager for the segregated accounts which ultimately held the
royalty interests.
This complicated transaction did not change anything about TKOP’s
operation of the underlying oil and gas interests. Following the transfer,
approximately 31% of the royalty income which would have been taxable to
TKOP before the transfer instead accrued to the life insurance segregated
accounts and could be withdrawn as tax-free policy loans. The district court
concluded:
The BPP transaction and the royalty transaction bear
similarities. Both transactions accomplish a transfer
of assets into cash-value life insurance policies. Both
transactions represent an internal shifting of assets
from one set of entities owned and controlled by
Thomas and Kidd to another set of entities owned and
7
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No. 13-10799
controlled by Thomas and Kidd. The tax benefits
sought in this case require arm's-length transfers to
third parties, but no third parties exist on either end
of the BPP or royalty transactions. 4
The district court also devoted more than five pages of its Order to
setting out the numerous problems with the legal and accounting advice TKOP
purportedly relied on for the transactions in question, including serious
conflicts of interest for Thomas and Kidd’s lawyer, Theodore Lustig, and their
accountant, H. Glenn Henderson; and several instances of other advisors
backing out of their opinions, refusing to issue a subsequent opinion, noting
that Thomas and Kidd had misrepresented facts, and similar issues.
As the district court moved on to its conclusions of law, it emphasized
what it considered the most essential fact:
The legal conclusions in this case turn on one fact:
John Thomas and Lee Kidd owned and controlled the
assets at issue before the transactions and after the
transactions. In substance, the BPP premium
payments and royalty transfers were distributions
from the Thomas and Kidd businesses to Thomas and
Kidd and their families. These distributions to
themselves do not qualify as tax deductible business
expenses or valid transfers of income to third parties. 5
III. Law and Analysis
A. TEFRA Framework and TKOP’s Jurisdictional Challenge
This case under 26 U.S.C. § 6226 is governed by the Tax Equity and
Fiscal Responsibility Act of 1982 (“TEFRA”), 26 U.S.C. §§ 6221–6233.
Under TEFRA, “the tax treatment of any partnership
item (and the applicability of any penalty, addition to
tax, or additional amount which relates to an
4 Id. at p. 12.
5
Id. at p. 18.
8
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adjustment to a partnership item) shall be determined
at the partnership level.” 26 U.S.C. § 6221. TEFRA
specifically sets forth the scope of judicial review:
A court with which a petition is filed in
accordance with this section shall have
jurisdiction to determine all partnership items
of the partnership for the partnership taxable
year to which the notice of final partnership
administrative adjustment 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) . . . . 6
Treasury Regulation section 301.6231(a)(3)–1, 26 C.F.R. §
301.6231(a)(3)–1, provides, “Where the determination of an item has no effect
on the partnership, the item is not a partnership item and cannot be decided
in a TEFRA proceeding.” TKOP argues for the first time on appeal that the
district court only had jurisdiction under TEFRA to address the initial
distribution of the mineral royalties from TKOP but did not have jurisdiction
to address the eventual purchase of the annuities which were used to flow the
smaller portion of the money back to Thomas and Kidd because (a) the
agreement was irrelevant to all TKOP’s partners, and (b) TKOP itself did not
participate in those annuities contracts.
TKOP cites Roberts v. Commissioner, 94 T.C. 853, 861 (1990), for the
proposition that the court has no jurisdiction under TEFRA to address an issue
that “would have no effect on any item that would affect all of the partners’
respective returns and would have no effect on any item on the
6 Klamath Strategic Inv. Fund ex rel. St. Croix Ventures v. United States,
568 F.3d 537, 547
(5th Cir. 2009) (emphasis removed).
9
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partnership return or the partnership’s books and records.” That begs the
question. The whole point of the district court’s determination was that the
private annuity sale was an essential part of the transaction as a whole, in that
it was the final step that returned the smaller portion of the money, after a
delay, to TKOP’s partners after sidestepping TKOP’s reported income. The
transaction unquestionably affected TKOP’s global income and, by extension,
the returns of all TKOP’s partners.
Determining “partnership items” under TEFRA necessarily requires a
holistic approach to examining the classification of potential income items.
TKOP cannot isolate just the first part of the transaction—the transfer of the
overriding royalties out of TKOP—and ignore the rest of the scheme, all of
which was essential to accomplish the goal of reducing or avoiding taxes for
TKOP, as the district court found. Thus, we conclude that the district court
had jurisdiction under TEFRA to address every part of the royalty interest
transaction, and ultimately to disregard the entire transaction, including the
annuity sale, for tax purposes. 7
B. Assignment of Income Doctrine
This case turns on the application of the assignment of income doctrine
and the economic substance doctrine. A classic explanation of the assignment
of income doctrine is found in Caruth Corp. v. United States, 865 F.2d 644 (5th
Cir. 1989):
7TKOP argued at length on appeal that the annuities were legitimate and should not have
been disregarded by the district court. What TKOP ignores is that the district court’s
determination concerned whether the transaction as a whole represented an improper
assignment of income and lacked economic substance, not whether each particular part might
be construed as proper outside of the context of the larger transaction. We agree with the
district court that the entire transaction, necessarily including the tax-free annuity
purchases, constituted an improper assignment of income and lacked economic substance
and therefore should be disregarded for tax purposes.
10
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The assignment of income doctrine holds that one who
earns income cannot escape tax upon the income by
assigning it to another. “[I]f one, entitled to receive at
a future date interest on a bond or compensation for
services, makes a grant of it by anticipatory
assignment, he realizes taxable income as if he had
collected the interest or received the salary and then
paid it over.” Commissioner v. P.G. Lake, Inc., 356 U.S.
260, 267,
78 S. Ct. 691, 695,
2 L. Ed. 2d 743 (1958); see
also Lucas v. Earl, 281 U.S. 111, 115,
50 S. Ct. 241,
241, 74 L. Ed. 731 (1930); Helvering v. Horst,
311 U.S.
112, 120,
61 S. Ct. 144, 148,
85 L. Ed. 75 (1940). Justice
Holmes announced the doctrine by a now-famous
metaphor: income tax may not be avoided through an
“arrangement by which the fruits are attributed to a
different tree from that on which they grew.” Lucas v.
Earl, 281 U.S. at 115, 50 S. Ct. at 241.
When a taxpayer gives away earnings derived from an
income-producing asset, the crucial question is
whether the asset itself, or merely the income from it,
has been transferred. If the taxpayer gives away the
entire asset, with accrued earnings, the assignment of
income doctrine does not apply. Blair v. Commissioner,
300 U.S. 5, 14,
57 S. Ct. 330, 334,
81 L. Ed. 465 (1937)
(taxpayer’s gift conveyed entire interest in income
stream, and so did not fall under assignment of income
doctrine); United States v. Georgia R.R. & Banking
Co., 348 F.2d 278, 285 (5th Cir.1965), cert. denied,
382
U.S. 973,
86 S. Ct. 538,
15 L. Ed. 465 (1966). If the
taxpayer carves income or a partial interest out of the
asset, and retains something for himself, the doctrine
applies. P & G Lake, 356 U.S. at 265 & n.
5, 78 S. Ct.
at 694 & n. 5 (assignment of income doctrine applied
because the taxpayer transferred a “short-lived . . .
payment right carved out of” a larger interest; “[o]nly
a fraction of the oil and sulphur rights were
transferred, the balance being retained”). Ultimately,
the question is whether the taxpayer himself ever
earned income, or whether it was earned instead by
the assignee. In terms of Justice Holmes’ metaphor,
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the question is whether the fruit has been attributed
to a different tree, or whether instead the entire tree
has been transplanted. 8
A major question is whether TKOP (or its ultimate owners, Thomas and
Kidd) retained beneficial ownership of the overriding royalty interests. For tax
purposes, “[t]he true owner of income-producing property . . . is the one with
beneficial ownership, rather than mere legal title. It is the ability to command
the property, or enjoy its economic benefits, that marks a true owner.” 9 “Even
assuming their validity under State law, contractual arrangements designed
to circumvent this rule, by attempting to deflect income away from the one who
earns it, will not be recognized for Federal income tax purposes. Determining
who earns the income depends upon which person or entity in fact controls the
earning of the income, not who ultimately receives the income.” 10
As the Supreme Court noted in Commissioner v. Sunnen, 333 U.S. 591,
604 (1948), the “crucial question [is] whether the assignor retains sufficient
power and control over the assigned property or over receipt of the income to
make it reasonable to treat him as the recipient of the income for tax purposes.”
In C.M. Thibodaux Co., Ltd. v. United States,
915 F.2d 992, 995-96 (5th Cir.
1990), we applied Sunnen in holding that a corporate taxpayer had made an
anticipatory assignment of income when it transferred the right to receive
bonuses, delay rentals, and royalties under mineral leases but retained the
right to manage the leases. We reasoned that although the transfer qualified
as a property transfer under Louisiana law, in substance it was an anticipatory
assignment of income under federal income tax law which must be taxed to the
corporation.
8 865 F.2d at 648-49.
9 Chu v. Comm’r.,
72 T.C.M. 1519, at *3 (T.C. 1996) (citation omitted).
10 Benningfield v. Comm’r.,
81 T.C. 408, 418-19 (1983).
12
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Here, the district court concluded that the royalty interest transfer was
an anticipatory assignment of income under these legal principles based on its
primary finding of fact, that Thomas and Kidd owned and controlled the assets
at issue before and after the transaction. The district court elaborated:
The economic relationship between Plaintiffs and
Thomas and Kidd was identical at the beginning and
the end of the transaction. JTOM II and Kiddel II
owned the working interests from which the
overriding royalty interests were created. After the
transfers from Thomas & Kidd Oil Production through
all of the entities, the private annuities were payable
to the same entities that owned Thomas & Kidd Oil
Production, JTOM II and Kiddel II. The transfer
merely removes income from one pocket and puts it
into another. The economic benefits of the royalty
interests did not change with the alleged assignment,
and the transaction should not be allowed to transfer
taxable income away from Plaintiffs. . . .
The income from the allegedly transferred royalty
interests should be assigned to Thomas & Kidd Oil
Production. The transaction involved a variety of
alleged transfers among entities owned and controlled
by Thomas and Kidd, ending with cash-value life
insurance policies also under their control. Once the
income was in those life polices, they continued to
control how the royalty income was used and invested
through the letters of wishes. Thomas admitted that
the royalty transaction was done for estate planning
purposes and that operation of the properties did not
change after assignment of the royalty interests.
The income from the royalty interests should remain
with Thomas & Kidd Oil Production and not the
alleged transferees, who neither received the benefits
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of the income nor exercised control over its
production. 11
On appeal, TKOP’s primary argument with respect to the assignment of
income doctrine is that the district court improperly conflated TKOP and the
various other entities in finding that TKOP retained control or benefit from
the royalty monies. TKOP argues that it was actually hurt by the overriding
royalty interest transfer because it lost that royalty income, which only flowed
to other entities controlled by Thomas and Kidd.
While it is true that TKOP lost the royalty income on paper, the district
court found that the money ended up with TKOP’s owners, bypassing income
tax in the process. TKOP cannot slice up the scheme into a series of small
parts; the thrust of the applicable law set out above is to look at the big picture.
Under the district court’s findings of fact, Thomas and Kidd controlled TKOP
and every part of the scheme, which is a hallmark of unlawful assignment of
income. Thus, this argument is without merit.
Next, TKOP argues that the district court focused on irrelevant
information, such as the fact that Thomas and Kidd entered into the
transaction for estate planning purposes, that the sale was not arm’s length,
and that TKOP’s operations did not change after the sale. Even if this
information is irrelevant, it demonstrates the true character of the transaction.
Next, TKOP argues that the royalty interest transfer was a property
transfer under IRS regulations and thus could not be an assignment of income.
TKOP ignores C.M. Thibodaux Co., Ltd. v. United States, supra, in which we
held that a purported transfer of a royalty interest may still qualify as an
assignment of income when the transferor retains control. The transfer in this
case was not a true transfer because the district court found that TKOP (or
11 See Order, pp. 26-28.
14
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more precisely, its ultimate owners) retained beneficial ownership of the
mineral interests and ultimately received the proceeds after a circuitous route
through several intermediaries.
Finally, TKOP argues that the district court clearly erred in finding that
Thomas and Kidd retained control of the overriding royalty interests after
TKOP’s initial transfer to the Nevada LLC. TKOP points to evidence from
which the district court could have concluded that the third party insurance
companies actually owned and controlled the royalty interests held in the
segregated accounts. TKOP has failed to show clear error. The question is not
whether the district court could have reached the findings asserted by TKOP
(i.e., that the insurance company actually controlled the segregated accounts)
but whether the district court erred in finding the opposite. The district court
rejected TKOP’s evidence and gave credence to the Government’s evidence
when it found that Thomas and Kidd actually controlled the accounts
(individually or through their businesses) through letters of wishes regarding
how the funds were to be invested and how they were to be distributed as loans.
This means that the risk-shifting normally associated with an annuity, in
which the annuitant gives up the potential of higher returns in exchange for a
guaranteed income stream, did not exist. Thomas and Kidd retained the
ability use the funds for high-risk investments and at any time could have
withdrawn the entire balance.
In short, the district court issued numerous specific findings of fact set
out above in addition to its primary finding that Thomas and Kidd were in
control of the entire transaction. We cannot say that the district court clearly
erred in making any of its findings. From these facts it follows that the royalty
interest transaction is an unlawful assignment of income for the reasons
assigned by the district court.
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C. Economic Substance
The district court also concluded that it lacked economic substance. We
explained in Klamath Strategic Inv. Fund ex rel. St. Croix Ventures v. United
States, 568 F.3d 537 (5th Cir. 2009):
The economic substance doctrine allows courts to
enforce the legislative purpose of the Code by
preventing taxpayers from reaping tax benefits from
transactions lacking in economic reality. As the
Supreme Court has recognized, taxpayers have the
right to decrease or avoid taxes by legally permissible
means. However, “transactions[] which do not vary
control or change the flow of economic benefits[] are to
be dismissed from consideration.” 12
Relying on Frank Lyon Co. v. United States, 435 U.S. 561, 583-84 (1978),
Klamath set out for the first time in this Circuit a “multi-factor test for when
a transaction must be honored as legitimate for tax purposes,” including
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.
Importantly, these factors are phrased in the
conjunctive, meaning that the absence of any one of
them will render the transaction void for tax purposes.
Thus, if a transaction lacks economic substance
compelled by business or regulatory realities, the
transaction must be disregarded even if the taxpayers
profess a genuine business purpose without tax-
avoidance motivations. 13
In Southgate Master Fund, L.L.C. ex rel. Montgomery Capital Advisors,
LLC v. United States, 659 F.3d 466 (5th Cir. 2011), we elaborated:
12 568 F.3d at 543 (citations omitted).
13
Id. at 544 (citation omitted).
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As to the first Klamath factor, transactions lack
objective economic reality if they “‘do not vary[,]
control[,] or change the flow of economic benefits.’”
This is an objective inquiry into whether the
transaction either caused real dollars to meaningfully
change hands or created a realistic possibility that
they would do so. That inquiry must be “conducted
from the vantage point of the taxpayer at the time the
transactions occurred, rather than with the benefit of
hindsight.” . . .
The latter two Klamath factors ask whether the
transaction was motivated solely by tax-avoidance
considerations or was imbued with some genuine
business purpose. These factors undertake a
subjective inquiry into “‘whether the taxpayer was
motivated by profit to participate in the transaction.’”
Tax-avoidance considerations are not wholly
prohibited; taxpayers who act with mixed motives,
seeking both tax benefits and profits for their
businesses, can satisfy the business-purpose test. 14
Under the district court’s findings of fact, the flow of money from TKOP’s
mineral interests to TKOP’s owners did not change in a meaningful way after
the transaction. The money merely took a more circuitous route and bypassed
income taxes in the process. The first Klamath factor fails because the royalty
interest transfer did not effect a change in control, did not ultimately change
the flow of economic benefits, and did not cause “real dollars to meaningfully
change hands.” The failure of that factor alone is sufficient to reach the
conclusion that the transaction lacked economic substance. Additionally,
based on the district court’s findings of fact, the transaction also fails the
second and third factors because the transaction had no profit motive, only a
tax avoidance motive in connection with estate planning. That would not be
14 659 F.3d at 481-82 (footnotes omitted).
17
Case: 13-10799 Document: 00512718607 Page: 18 Date Filed: 07/31/2014
No. 13-10799
an improper motive in itself, but it cannot be the sole purpose under Klamath.
Thus, the district court correctly concluded that the transaction lacked
economic substance.
TKOP argues that the district court improperly focused on the
transaction as a whole (including the ultimate flowback to the Thomas and
Kidd-controlled entities) and instead should have focused on the initial
transfer of the overriding royalty interests from TKOP. As already noted
above, a court must look at the transaction as a whole to determine the
economic substance. TKOP’s attempt to isolate only the first transaction does
not tell the whole story.
TKOP’s argument rests on its assumption that the transfers were to
independent entities, but the district court found that Thomas and Kidd
ultimately controlled every step in the scheme, and the money ended up with
Thomas and Kidd and their families. Based on the district court’s findings of
fact, there appears to be no real profit motive at any stage of the transaction;
rather, the transaction overwhelmingly appears to have been entered into for
tax avoidance. Thus, for the reasons set out above, we conclude that the
district court did not err in concluding that the transaction lacked economic
substance.
IV. Conclusion
For the foregoing reasons, we AFFIRM. The district court properly
concluded that the entire royalty interest transaction should be disregarded
for tax purposes.
18
