Filed: Jan. 23, 2014
Latest Update: Mar. 02, 2020
Summary: Case: 10-41219 Document: 00512510322 Page: 1 Date Filed: 01/23/2014 IN THE UNITED STATES COURT OF APPEALS FOR THE FIFTH CIRCUIT United States Court of Appeals Fifth Circuit FILED January 23, 2014 No. 10-41219 Lyle W. Cayce Clerk NPR INVESTMENTS, L.L.C., by and through Nelson Roach, a Partner other than the Tax Matters Partner, Plaintiff–Appellee Cross–Appellant, HAROLD W. NIX; CHARLES C. PATTERSON, Intervenor Plaintiffs–Appellees, v. UNITED STATES OF AMERICA, Defendant–Appellant Cross–Appellee.
Summary: Case: 10-41219 Document: 00512510322 Page: 1 Date Filed: 01/23/2014 IN THE UNITED STATES COURT OF APPEALS FOR THE FIFTH CIRCUIT United States Court of Appeals Fifth Circuit FILED January 23, 2014 No. 10-41219 Lyle W. Cayce Clerk NPR INVESTMENTS, L.L.C., by and through Nelson Roach, a Partner other than the Tax Matters Partner, Plaintiff–Appellee Cross–Appellant, HAROLD W. NIX; CHARLES C. PATTERSON, Intervenor Plaintiffs–Appellees, v. UNITED STATES OF AMERICA, Defendant–Appellant Cross–Appellee. A..
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Case: 10-41219 Document: 00512510322 Page: 1 Date Filed: 01/23/2014
IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT United States Court of Appeals
Fifth Circuit
FILED
January 23, 2014
No. 10-41219 Lyle W. Cayce
Clerk
NPR INVESTMENTS, L.L.C., by and through Nelson Roach, a Partner other
than the Tax Matters Partner,
Plaintiff–Appellee
Cross–Appellant,
HAROLD W. NIX; CHARLES C. PATTERSON,
Intervenor Plaintiffs–Appellees,
v.
UNITED STATES OF AMERICA,
Defendant–Appellant
Cross–Appellee.
Appeals from the United States District Court
for the Eastern District of Texas
Before DENNIS, CLEMENT, and OWEN, Circuit Judges.
PRISCILLA R. OWEN, Circuit Judge:
In a Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”)1
partnership proceeding, the district court held that valuation misstatement and
substantial understatement tax penalties were inapplicable to NPR
1
Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. 97-248, 96 Stat. 324 (codified
as amended at 26 U.S.C. §§ 6221-6234 (2012)).
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No. 10-41219
Investments, LLC (NPR). The United States appeals those determinations. The
district court also held that a notice of a Final Partnership Administrative
Adjustment (FPAA) issued by the Internal Revenue Service (IRS) to NPR, which
made adjustments to NPR’s tax return and could result in additional tax
liabilities to some of the partners, was valid. NPR, by and through one of its
partners, Nelson J. Roach, and two of NPR’s other partners, Harold W. Nix and
Charles C. Patterson, cross-appeal that holding. We will refer to Nix, Patterson,
and Roach, collectively, as the Taxpayers.
We conclude that, in this partnership-level proceeding, (1) valuation
misstatement penalties under 26 U.S.C. § 6662(e) and (h) are applicable; (2) a
substantial underpayment penalty under 26 U.S.C. § 6662(d) is applicable
because there was no substantial authority for the tax treatment of the
transactions at issue; (3) NPR failed to carry its burden of establishing a
reasonable-cause defense under 26 U.S.C. § 6664; and (4) the Taxpayers’
respective, individual reasonable-cause defenses under 26 U.S.C. § 6664 are
partner-level defenses that the district court did not have jurisdiction to
consider. We accordingly affirm the district court’s judgment regarding the
finality of the FPAA, reverse the district court’s judgment regarding the
valuation misstatement and substantial underpayment penalties, reverse the
district court’s judgment regarding NPR’s reasonable-cause defense, and vacate
the district court’s judgment regarding the Taxpayers’ reasonable-cause
defenses.
I
Harold Nix, Charles Patterson, and Nelson Roach are partners in the law
firm of Nix, Patterson & Roach, LLP. They represented the State of Texas in
litigation against the tobacco industry and in 1998 were awarded a fee of
approximately $600 million that is to be paid over a period of time. They also
received fees totaling approximately $68 million in connection with tobacco
2
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No. 10-41219
litigation in Florida and Mississippi. Nix, Patterson, and Roach share the fees
40%, 40%, and 20%, respectively.
Nix and Patterson have participated in at least two “Son-of-BOSS” tax
shelters. BOSS stands for “Bond and Options Sales Strategy.”2 Courts,
including our court and the district court in this case,3 have described a Son-of-
BOSS transaction as “a well-recognized ‘abusive’ tax shelter.”4 Artificial losses
are generated for tax deduction purposes.
Before creating NPR and engaging in the transactions at issue in this
appeal, Nix and Patterson invested in another Son-of-BOSS tax shelter, known
as BLIPS. It involved sham bank loans, and our court considered various tax
issues related to Nix’s and Patterson’s transactions with regard to that shelter
in Klamath Strategic Investment Fund ex rel. St. Croix Ventures v. United
States.5
In August 2000, after the investment in BLIPS but before NPR was
formed, the IRS issued a notice that it considered Son-of-BOSS transactions,
including BLIPS, abusive and that deductions for artificial losses generated from
such transactions would not be permitted. The Notice, IRS Notice 2000-44,
states:
In another variation [of transactions generating losses
through artificially high bases], a taxpayer purchases and writes
options and purports to create substantial positive basis in a
2
Am. Boat Co. v. United States, 583 F.3d 471, 474 (7th Cir. 2009); Kligfeld Holdings
v. Comm’r,
128 T.C. 192, 194 (2007).
3
NPR Invs., LLC, ex rel. Roach v. United States, 732 F. Supp. 2d 676, 679 n.3 (E.D. Tex.
2010).
4
Nev. Partners Fund, L.L.C. ex rel. Sapphire II, Inc. v. United States, 720 F.3d 594, 605
(5th Cir. 2013) (citing Bemont Invs., L.L.C. ex rel. Tax Matters Partner v. United States,
679
F.3d 339, 342, 344 (5th Cir. 2012)); see also 106 Ltd. v. Comm’r,
684 F.3d 84, 86 (D.C. Cir.
2012); Desmet v. Comm’r,
581 F.3d 297, 299 (6th Cir. 2009).
5
568 F.3d 537 (5th Cir. 2009).
3
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No. 10-41219
partnership interest by transferring those option positions to a
partnership. For example, a taxpayer might purchase call options
for a cost of $1,000X and simultaneously write offsetting call
options, with a slightly higher strike price but the same expiration
date, for a premium of slightly less than $1,000X. Those option
positions are then transferred to a partnership which, using
additional amounts contributed to the partnership, may engage in
investment activities.
Under the position advanced by the promoters of this
arrangement, the taxpayer claims that the basis in the taxpayer’s
partnership interest is increased by the cost of the purchased call
options but is not reduced under § 752 as a result of the
partnership’s assumption of the taxpayer’s obligation with respect
to the written call options. Therefore, disregarding additional
amounts contributed to the partnership, transaction costs, and any
income realized and expenses incurred at the partnership level, the
taxpayer purports to have a basis in the partnership interest equal
to the cost of the purchased call options ($1,000X in this example),
even though the taxpayer’s net economic outlay to acquire the
partnership interest and the value of the partnership interest are
nominal or zero. On the disposition of the partnership interest, the
taxpayer claims a tax loss ($1,000X in this example), even though
the taxpayer has incurred no corresponding economic loss.
The purported losses resulting from the transactions
described above do not represent bona fide losses reflecting actual
economic consequences as required for purposes of § 165. The
purported losses from these transactions (and from any similar
arrangements designed to produce noneconomic tax losses by
artificially overstating basis in partnership interests) are not
allowable as deductions for federal income tax purposes.6
In 2001, the Taxpayers consulted with their CPA, Sid Cohen, with whom
they had a longstanding professional relationship, about investing in foreign
currency. Cohen introduced the Taxpayers to Diversified Group, Inc. (DGI) in
the summer of 2001. Cohen arranged and attended a meeting with DGI in
October 2001 at which Patterson was also present. DGI explained its
6
I.R.S. Notice 2000-44, 2000-2 C.B. 255.
4
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investment opportunity, which involved the purchase, and contribution to a
partnership, of offsetting foreign, European-style currency options.7 This
offsetting-option shelter was called “OPS” (Option Partnership Strategy). The
structure of the investment was similar to that described in and prohibited by
Notice 2000-44. Cohen characterized the options as high-risk from the
standpoint of an investment for profit, but said that Patterson and his partners
had the “potential to make a lot of money on it” if the options “hit the sweet
spot.” “Hitting the sweet spot” could only occur if, on the expiration date of the
options, the exchange rate was at or above the strike price of the long option but
below the strike price of the short option. If that occurred, there would be no
payment obligation under the short option to offset the payout received under
the long option. However, the difference between the strike price of the long
option and that of the short option was negligible, only three pips. A pip is the
smallest unit quoted for the price of any currency. The district court noted that
in any given fifteen-minute period, the prices that banks quote for foreign
currencies can vary by more than three pips.8 Cohen and Patterson were
advised that unless the “sweet spot” was attained, there would be tax losses.
They never inquired about and were never told the odds of “hitting the sweet
spot.” Neither NPR nor the Taxpayers presented evidence in the district court
of the likelihood of hitting the sweet spot, though a Government witness testified
that there was no real probability of hitting the sweet spot.
On the same day that Cohen and Patterson met with DGI, they met with
R.J. Ruble, who was then an attorney with Sidley, Austin, Brown & Wood LLP
(Sidley Austin), at DGI’s offices. Ruble provided Patterson and Cohen with a
draft, template tax opinion letter describing a transaction similar to the one
7
European-style means that the options could only be exercised on their expiration
dates.
8
NPR Invs., 732 F. Supp. 2d at 680 n.6.
5
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No. 10-41219
proposed by DGI. At this meeting, Ruble explained the potential tax benefits of
the transaction. He told Patterson and Cohen that hitting the sweet spot was
unlikely.
Nix and Patterson decided to enter into the investment scheme, and
subsequently, Roach did as well. Each Taxpayer formed a single member
limited liability company (SMLLC), managed by DGI. Nix and Patterson each
funded their respective SMLLC’s by contributing $625,000, and Roach
contributed $375,000 to his. DGI and Alpha Consultants, Inc. (Alpha) formed
NPR, a partnership, each contributing $50,000, and became its exclusive co-
managers. Patterson, Nix, and Roach each purchased two pairs of offsetting
foreign currency options, through their SMLLCs, with each paired option having
the same expiration dates and near-identical strike prices. The Taxpayers
contributed their SMLLCs to NPR, receiving partnership interests in NPR.
Patterson and Nix each paid DGI an “advisory fee” of $750,000, and Roach paid
DGI $450,000. Patterson and Nix each paid Cohen $250,000, and Nix paid him
$150,000. All of these fees were based on a percentage of the tax losses that the
investment strategy was expected to generate, which was $25,000,000 for Nix,
$25,000,000 for Patterson, and $15,000,000 for Roach. DGI paid Cohen a
referral fee of $325,000, although the Taxpayers were unaware of this until after
the IRS had completed its audit of NPR.
The Government argues in its brief that the fees paid by the Taxpayers,
and the contribution of the options to NPR, made it impossible for Roach to make
a profit and made it extremely unlikely for Patterson and Nix to make a profit.
The district court found that the NPR “investment strategy could be profitable,
excluding any advisement fees,”9 indicating that the strategy could not be
profitable if the fees were considered.
9
Id. at 680.
6
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No. 10-41219
Forty days after becoming partners in NPR, the Taxpayers withdrew,
receiving cash and foreign currencies, although the expiration dates of the
options were months in the future. Each of the Taxpayers knew that
withdrawing from NPR eliminated any possibility of “hitting the sweet spot” and
therefore that a profit was impossible. They each contributed the foreign
currencies to the Nix, Patterson & Roach, LLP law firm. All gains or losses from
the foreign currencies were specially allocated to the respective contributing
partner on the law firm’s books and on the tax returns, although only the dollar
amounts of losses, not the currencies or the currency transactions, were
identified. On the law firm’s tax returns, the losses were identified under a
heading “Business Risk Division.” Foreign currencies were sold in 2001, 2002,
and 2003, and the law firm offset the losses against income allocated to each
Taxpayer to reduce the earned income shown on Schedules K-1 issued to the
Taxpayers.
After resigning from NPR, each Taxpayer obtained a written opinion from
Sidley Austin on the proper tax treatment of their investments. The Taxpayers
reviewed the opinions with Cohen, who concluded that they “had cited the
important areas where there might be potential controversy and had adequately
dealt with them to [his] satisfaction and that [the Taxpayers] would be ok.”
Cohen advised them that they could rely on the opinions because Sidley Austin
was a “very well known firm,” the opinions were “very, very well reasoned,” and
Ruble was an “acknowledged partnership tax expert.”
In accordance with the tax opinions, the Taxpayers treated their bases in
NPR as the premiums on the long options, ignoring the amount they might have
to pay on the short options. These bases were carried over to the foreign
currency after distribution, which was used by the Taxpayers to calculate
approximately $65,000,000 in tax losses once the foreign currencies were sold.
Nix’s and Patterson’s actual “investment” in NPR was $625,000, and Roach’s
7
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No. 10-41219
was $375,000, but Nix and Patterson each claimed an outside basis in the long
options of almost $25,000,000, and Roach claimed an outside basis of almost
$15,000,000.
The IRS ultimately concluded, in the FPAA issued in 2005, that NPR
lacked economic substance, was a sham, and must be disregarded. This resulted
in zeroing out all of the tax losses the Taxpayers had claimed on their individual
returns. The FPAA also imposed accuracy-related and other penalties as a
result of the partnership-level TEFRA audit.
The Taxpayers revived NPR in 2005. Patterson became its managing
partner and Roach became a notice partner. In district court, Roach filed a
petition for readjustment of partnership items on behalf of NPR. Nix intervened
pursuant to § 6226(c)(2), and Patterson intervened pursuant to both §§
6226(b)(6) and (c)(2).10 The joint pre-trial order in the district court reflects that
NPR, Nix, Patterson, and Roach conceded that NPR lacked a profit motive
during 2001. Accordingly, the district court found that “the actual adjustments
made by the IRS to the tax returns and whether NPR had [a] profit motive are
not materially disputed. Rather, the dispute is whether the penalties applied by
the IRS are applicable.”11
The district court ruled on summary judgment that penalties for gross and
substantial valuation misstatement did not apply as a matter of law. It also
ruled, on the United States’ motion to dismiss for lack of jurisdiction or
alternatively for summary judgment, that it had jurisdiction over the Taxpayers’
reasonable-cause and good-faith defenses to the asserted penalties. After a
10
26 U.S.C. § 6226(b)(6) (“The tax matters partner may intervene in any action brought
under this subsection.”); id. § 6226(c)(2) (“If an action is brought . . . with respect to a
partnership for any partnership taxable year[,] . . . the court having jurisdiction of such action
shall allow each such person to participate in the action.”).
11
NPR Invs., 732 F. Supp. 2d at 684.
8
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No. 10-41219
bench trial, the district court concluded that the August 15, 2005 FPAA was
validly issued, and therefore the adjustments were proper. However, the court
also held that the penalty for negligence was inapplicable because there was a
reasonable basis for the Taxpayers’ positions and that the penalty for substantial
understatement of income tax was inapplicable because the Taxpayers had
substantial authority for their tax positions. In the alternative, the district court
held that none of the penalties was applicable because the Taxpayers met the
requirements for the reasonable-cause and good-faith defense.
The Government appeals the district court’s decision that the valuation
misstatement and substantial understatement penalties are applicable. The
Government has not appealed the district court’s holding regarding the
negligence penalty. NPR cross-appeals the district court’s decision that the
August 2005 FPAA was validly issued. Accordingly, we must resolve whether
the FPAA imposing penalties was valid. If it was, we must determine whether
the various penalties at issue are applicable to NPR, and whether NPR and the
Taxpayers have defenses that may be considered in this partnership-level
proceeding, rather than a partner-level proceeding.
II
A brief overview of tax law in this area, and TEFRA in particular, is
helpful in analyzing the questions before us. The Supreme Court has explained
the statutory scheme applicable to partnership-related tax matters in its recent
decision in United States v. Woods.12 We quote that discussion:
A partnership does not pay federal income taxes; instead, its taxable
income and losses pass through to the partners. 26 U.S.C. § 701. A
partnership must report its tax items on an information return,
§ 6031(a), and the partners must report their distributive shares of
the partnership’s tax items on their own individual returns, §§ 702,
704.
12
134 S. Ct. 557 (2013).
9
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Before 1982, the IRS had no way of correcting errors on a
partnership’s return in a single, unified proceeding. Instead, tax
matters pertaining to all the members of a partnership were dealt
with just like tax matters pertaining only to a single taxpayer:
through deficiency proceedings at the individual-taxpayer level. See
generally §§ 6211–6216 (2006 ed. and Supp. V). Deficiency
proceedings require the IRS to issue a separate notice of deficiency
to each taxpayer, § 6212(a) (2006 ed.), who can file a petition in the
Tax Court disputing the alleged deficiency before paying it,
§ 6213(a). Having to use deficiency proceedings for
partnership-related tax matters led to duplicative proceedings and
the potential for inconsistent treatment of partners in the same
partnership. Congress addressed those difficulties by enacting the
Tax Treatment of Partnership Items Act of 1982, as Title IV of the
Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). 96 Stat.
648 (codified as amended at 26 U.S.C. §§ 6221–6232 (2006 ed. and
Supp. V)).
Under TEFRA, partnership-related tax matters are addressed
in two stages. First, the IRS must initiate proceedings at the
partnership level to adjust “partnership items,” those relevant to the
partnership as a whole. §§ 6221, 6231(a)(3). It must issue an FPAA
notifying the partners of any adjustments to partnership items,
§ 6223(a)(2), and the partners may seek judicial review of those
adjustments, § 6226(a)–(b). Once the adjustments to partnership
items have become final, the IRS may undertake further
proceedings at the partner level to make any resulting
“computational adjustments” in the tax liability of the individual
partners. § 6231(a)(6). Most computational adjustments may be
directly assessed against the partners, bypassing deficiency
proceedings and permitting the partners to challenge the
assessments only in post-payment refund actions. § 6230(a)(1), (c).
Deficiency proceedings are still required, however, for certain
computational adjustments that are attributable to “affected items,”
that is, items that are affected by (but are not themselves)
partnership items. §§ 6230(a)(2)(A)(i), 6231(a)(5).13
This is an appeal from determinations the district court made in a partner-
level TEFRA proceeding.
13
Woods, 134 S. Ct. at 562-63.
10
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III
A dispositive issue in this appeal is the validity of the August 15, 2005
FPAA that notified NPR of adjustments to the partnership tax return and
imposed the penalties that are contested by NPR and the Taxpayers. The
Taxpayers contend that this FPAA was a second notice, in violation of 26 U.S.C.
§ 6223(f), and therefore none of the penalties imposed in that FPAA can be
applied. The district court disagreed and we affirm the district court in this
regard.
TEFRA requires that partnerships, while not taxable entities, “file
informational returns reflecting the distributive shares of income, gains,
deductions, and credits attributable to its partners.”14 The IRS is required to
notify certain partners of both the beginning and the end of a partnership-level
proceeding.15 An FPAA signifies the end of partnership-level proceedings.16 The
IRS may only mail one FPAA for a taxable year with respect to a partner unless
there has been “a showing of fraud, malfeasance, or misrepresentation of a
material fact.”17 The district court found there was a material misrepresentation
of fact by NPR that permitted the IRS to issue a second notice under § 6223(f),
if the FPAA at issue was in fact a second notice.18 We find no error in the
district court’s findings of fact and conclusion of law in this regard.
NPR filed its 2001 partnership tax return in April 2002. The return
answered “No” to the question, “Is this partnership subject to the consolidated
14
Weiner v. United States, 389 F.3d 152, 154 (5th Cir. 2004).
15
26 U.S.C. § 6223(a).
16
See id. § 6223(a)(2).
17
Id. § 6223(f).
18
NPR Invs., LLC, ex rel. Roach v. United States, 732 F. Supp. 2d 676, 687-88 (E.D.
Tex. 2010).
11
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audit procedures of Sections 6221 to 6223 [TEFRA]?” It is undisputed that
because one of NPR’s partners was a partnership, the answer should have been
“Yes.”19 However, the return did designate a Tax Matters Partner, which is only
required if the answer to the question of whether TEFRA procedures apply is
“Yes.”
By late 2002, the IRS had begun auditing Nix’s and Patterson’s respective
individual tax returns in connection with their participation in the BLIPS tax
shelter, the subject of a prior, separate appeal to this court. Paul Doerr, an IRS
Agent, initially examined NPR’s tax return in 2005. He did not use TEFRA
procedures, but instead applied deficiency procedures because of his belief that
NPR was not subject to TEFRA procedures. On March 25, 2005, Doerr sent a
no-change letter to NPR indicating that the IRS had completed its audit of
NPR’s 2001 return and determined that no adjustments should be made to
NPR’s tax return. Doerr signed the notification on behalf of the IRS. Doerr and
his managers decided to issue the no-change letter because they intended to
deny the losses from the digital currency OPS investment scheme by issuing
notices of deficiency directly to NPR’s partners.
The March 25, 2005 deficiency notices denying losses on Patterson’s
personal tax returns (both for this OPS transaction and for his previous
participation in BLIPS) were reviewed by an IRS manager, Robert Gee, and Gee
concluded that NPR actually was subject to the TEFRA audit procedures. Gee
determined that it would be necessary to issue an FPAA adjusting several
partnership items on NPR’s return rather than pursuing only deficiency
proceedings. The IRS accordingly issued FPAAs to NPR’s partners on August
15, 2005. The FPAA made several adjustments to NPR’s partnership tax return,
19
See 26 U.S.C. § 6231(a)(1)(B)(i)–(ii) (excluding small partnerships from the definition
of “partnership” as long as each partner is an individual, a C corporation, or an estate of a
deceased partner).
12
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No. 10-41219
providing various explanations and imposing the penalties at issue in this
appeal.
If the March 2005 no-change letter was an FPAA, then the August 2005
FPAA was only validly issued if there was “fraud, malfeasance, or
misrepresentation of a material fact.”20 If the August 2005 FPAA was not validly
issued, then none of the partnership adjustments are valid, and none of the
penalties contained therein are applicable.
The Government contends that the March 2005 no-change letter was not
an FPAA because the IRS did not intend it to be an FPAA. Therefore, the
Government argues, § 6223(f) did not bar it from mailing the August 2005 FPAA.
We find it unnecessary to address this contention, however, because we agree
with the district court that NPR made a “misrepresentation of a material fact”
on its partnership return, and therefore the August 2005 FPAA is valid.
The language of the statute is our guidepost in determining whether there
was a material misrepresentation.21 “We follow the ‘plain and unambiguous
meaning of the statutory language,’ interpreting undefined terms according to
their ordinary and natural meaning and the overall policies and objectives of the
statute.”22 In determining the ordinary meaning of terms, dictionaries are often
a principal source.23 “If the statute is ambiguous, we may look to the legislative
20
26 U.S.C. § 6223(f).
21
United States v. Rains, 615 F.3d 589, 596 (5th Cir. 2010) (citing Watt v. Alaska,
451
U.S. 259, 265 (1981)) (“As in any case involving statutory interpretation, we begin by
examining the text of the relevant statutes.”).
22
United States v. Orellana, 405 F.3d 360, 365 (5th Cir. 2005) (quoting United States
v. Kay,
359 F.3d 738, 742 (5th Cir. 2004)).
23
Id. (quoting Thompson v. Goetzmann,
337 F.3d 489, 497 n.20 (5th Cir. 2003)).
13
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history or agency interpretations for guidance.”24 We must strive to give
meaning to every term.25
Because “misrepresentation” is not defined by TEFRA, we consider
dictionaries for a definition. Black’s Law Dictionary defines “misrepresentation”
as “[t]he act of making a false or misleading assertion about something, usu[ally]
with the intent to deceive.”26 However, as the district court observed,27 that
same dictionary granulates the broad term “misrepresentation” into more
specific categories, including “fraudulent misrepresentation,” “innocent
misrepresentation,” “material misrepresentation,” and “negligent
misrepresentation.”28 The commonly understood term “misrepresentation” can
encompass a fraudulent, negligent, or an innocent misrepresentation. In
construing § 6223(f), intent to deceive does not appear to be required to establish
a “misrepresentation.” A successive notice may be mailed when there has been
“a showing of fraud, malfeasance, or misrepresentation of a material fact.”29
“Malfeasance” does not necessarily involve intent to deceive.30 We will not read
an intent to deceive into “misrepresentation” when another standard of conduct
set forth in the statute does not require intent to deceive.
24
Id. (citing Kay, 359 F.3d at 742).
25
See United States v. Rayo-Valdez, 302 F.3d 314, 318 (5th Cir. 2002) (citing TRW, Inc.
v. Andrews,
534 U.S. 19, 31 (2001); United States v. Vickers,
891 F.2d 86, 88 (5th Cir. 1989))
(“[W]hen interpreting a statute, it is necessary to give meaning to all its words and to render
none superfluous.”).
26
BLACK’S LAW DICTIONARY 1091 (9th ed. 2009).
27
NPR Invs., LLC, ex rel. Roach v. United States, 732 F. Supp. 2d 676, 687 (E.D. Tex.
2010).
28
BLACK’S LAW DICTIONARY 1091-92 (9th ed. 2009).
29
26 U.S.C. § 6223(f).
30
BLACK’S LAW DICTIONARY 1042 (9th ed. 2009) (defining “malfeasance” as “[a] wrongful
or unlawful act; esp[ecially] wrongdoing or misconduct by a public official”).
14
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No. 10-41219
NPR cites several decisions that interpret “misrepresentation” as requiring
some sort of culpability. These decisions are inapposite. One Supreme Court
case cited by NPR interprets a different statute, and in any event, concludes that
negligent misrepresentation is encompassed by the term “misrepresentation.”31
In two other decisions, one by a district court and one by a sister circuit court,
“misrepresentation” is used in a different, albeit similar, context, but the list of
conduct in which the term “misrepresentation” appears does not include
“malfeasance.”32 A fourth decision, which interprets “misrepresentation” in a
statute with nearly identical wording, follows a 1935 Board of Tax Appeals
decision that concerned setting aside closing agreements, a situation quite
different from the case at hand.33
NPR argues that if we hold that “misrepresentation” encompasses
innocent misrepresentations, then we should also hold that the IRS must
justifiably rely on that misrepresentation for the exception to apply. We decline
to do so because there is no basis in the statute for such a requirement. NPR
derives its argument from principles of tort law. This is not a tort case, however,
and tort principles are inapposite.
NPR also cites to 26 U.S.C. § 6231(g)(2), which provides,
31
United States v. Neustadt, 366 U.S. 696, 702, 706-07 (1961) (construing
“misrepresentation” as used in the Federal Tort Claims Act, 28 U.S.C. § 2680(h), to include
negligent misrepresentations when accompanied by the terms “assault, battery, false
imprisonment, false arrest, malicious prosecution, abuse of process, libel, slander, . . . deceit,
or interference with contract rights”).
32
Lane v. United States, 286 F.3d 723, 731-32 (4th Cir. 2002) (construing
“misrepresentation” when accompanied by “fraud,” but not “malfeasance,” to require more
than an innocent misrepresentation); United States v. N. Trust Co.,
93 F. Supp. 2d 903, 908-09
(N.D. Ill. 2000) (construing “misrepresentation” when accompanied by “fraud,” but not
“malfeasance,” to require an intentional or knowing misrepresentation), rev’d on other
grounds,
372 F.3d 886 (7th Cir. 2004).
33
Halpern v. Comm’r, 79 T.C.M. 1976,
2000 WL 502842, at *4 (2000); see also
Ingram v. Comm’r,
32 B.T.A. 1063 (1935).
15
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[i]f, on the basis of a partnership return for a taxable year, the
Secretary reasonably determines that this subchapter does not
apply to such partnership for such year but such determination is
erroneous, then the provisions of this subchapter shall not apply to
such partnership (and its items) for such taxable year.
This provision does not, however, override § 6223(f), which expressly permits the
IRS to mail a second notice of final partnership administrative adjustment for
a partnership taxable year if there is “a showing of fraud, malfeasance, or
misrepresentation of a material fact.” NPR’s construction of § 6231(b)(2) would
excise § 6223(f) from the Code.
IV
The district court correctly held that the August 2005 FPAA was valid, but
concluded that none of the penalties imposed by the FPAA could be applied. We
first consider the 20% substantial valuation misstatement under 26 U.S.C.
§ 6662(e) and the 40% gross valuation misstatement under § 6662(h). These
penalties are not cumulative. If there was a gross valuation misstatement, only
the 40% penalty applies.34
A
A threshold question is whether the district court had jurisdiction to
address the applicability of the valuation misstatement penalties in this
partnership-level TEFRA proceeding. Two decisions from our sister circuits had
held that district courts do not,35 and we asked for further briefing from the
parties on this question, particularly in light of the fact that the Supreme Court
had called for briefing on the jurisdictional issue before deciding United States
34
26 U.S.C. § 6662(h)(1) (“To the extent that a portion of the underpayment to which
this section applies is attributable to one or more gross valuation misstatements, subsection
(a) shall be applied with respect to such portion by substituting ‘40 percent’ for ‘20 percent’.”).
35
See Jade Trading, LLC ex rel. Ervin v. United States, 598 F.3d 1372, 1379-80 (Fed.
Cir. 2010); Petaluma FX Partners LLC v. Comm’r,
591 F.3d 649, 655-56 (D.C. Cir. 2010).
16
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v. Woods.36 We now have a definitive answer from the Supreme Court in Woods,
which is that the district court did have jurisdiction to determine the
applicability of the misstatement penalties, even if only provisionally.37
In the interest of accuracy and the conservation of judicial resources, we
again quote at length from the Woods decision:
Under TEFRA's two-stage structure, penalties for tax
underpayment must be imposed at the partner level, because
partnerships themselves pay no taxes. And imposing a penalty
always requires some determinations that can be made only at the
partner level. Even where a partnership's return contains
significant errors, a partner may not have carried over those errors
to his own return; or if he did, the errors may not have caused him
to underpay his taxes by a large enough amount to trigger the
penalty; or if they did, the partner may nonetheless have acted in
good faith with reasonable cause, which is a bar to the imposition of
many penalties, see § 6664(c)(1). None of those issues can be
conclusively determined at the partnership level. Yet
notwithstanding that every penalty must be imposed in
partner-level proceedings after partner-level determinations,
TEFRA provides that the applicability of some penalties must be
determined at the partnership level. The applicability
determination is therefore inherently provisional; it is always
contingent upon determinations that the court in a
partnership-level proceeding does not have jurisdiction to make.
Barring partnership-level courts from considering the applicability
of penalties that cannot be imposed without partner-level inquiries
would render TEFRA's authorization to consider some penalties at
the partnership level meaningless.
Other provisions of TEFRA confirm that conclusion. One
requires the IRS to use deficiency proceedings for computational
adjustments that rest on “affected items which require partner level
determinations (other than penalties . . . that relate to adjustments
to partnership items).” § 6230(a)(2)(A)(i). Another states that while
a partnership-level determination “concerning the applicability of
36
134 S. Ct. 557 (2013).
37
Woods, 134 S. Ct. at 564.
17
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any penalty . . . which relates to an adjustment to a partnership
item” is “conclusive” in a subsequent refund action, that does not
prevent the partner from “assert[ing] any partner level defenses
that may apply.” § 6230(c)(4). Both these provisions assume that
a penalty can relate to a partnership-item adjustment even if the
penalty cannot be imposed without additional, partner-level
determinations.
These considerations lead us to reject Woods’ interpretation
of § 6226(f). We hold that TEFRA gives courts in partnership-level
proceedings jurisdiction to determine the applicability of any
penalty that could result from an adjustment to a partnership item,
even if imposing the penalty would also require determining
affected or non-partnership items such as outside basis. The
partnership-level applicability determination, we stress, is
provisional: the court may decide only whether adjustments
properly made at the partnership level have the potential to trigger
the penalty. Each partner remains free to raise, in subsequent,
partner-level proceedings, any reasons why the penalty may not be
imposed on him specifically.
Applying the foregoing principles to this case, we conclude
that the District Court had jurisdiction to determine the
applicability of the valuation-misstatement penalty—to determine,
that is, whether the partnerships’ lack of economic substance (which
all agree was properly decided at the partnership level) could justify
imposing a valuation-misstatement penalty on the partners. When
making that determination, the District Court was obliged to
consider Woods’ arguments that the economic-substance
determination was categorically incapable of triggering the penalty.
Deferring consideration of those arguments until partner-level
proceedings would replicate the precise evil that TEFRA sets out to
remedy: duplicative proceedings, potentially leading to inconsistent
results, on a question that applies equally to all of the partners.
To be sure, the District Court could not make a formal
adjustment of any partner’s outside basis in this partnership-level
proceeding. See Petaluma, 591 F.3d, at 655. But it nonetheless
could determine whether the adjustments it did make, including the
economic-substance determination, had the potential to trigger a
penalty; and in doing so, it was not required to shut its eyes to the
legal impossibility of any partner’s possessing an outside basis
18
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greater than zero in a partnership that, for tax purposes, did not
exist. Each partner’s outside basis still must be adjusted at the
partner level before the penalty can be imposed, but that poses no
obstacle to a partnership-level court’s provisional consideration of
whether the economic-substance determination is legally capable of
triggering the penalty.38
The district court had jurisdiction to adjudicate the applicability of the
valuation misstatement penalties in a case, such as this, in which the
partnership is disregarded in its entirety as a sham and the outside basis of its
partners is reduced to zero.
B
The district court held on summary judgment that no penalty for valuation
misstatement applied. This court reviews the district court’s grant of summary
judgment de novo.39 “Summary judgment is appropriate [when] there is no
genuine issue of material fact and the moving party is entitled to judgment as
a matter of law.”40
The Supreme Court’s decision in Woods also resolves the applicability of
the valuation misstatement penalties.41 We accordingly reverse the district
court as to the applicability of these penalties.
Under 26 U.S.C. § 6662(a) and (b)(3), a 20% penalty applies to “the portion
of any underpayment which is attributable to . . . [a]ny substantial valuation
misstatement under chapter 1.”42 Under the version of the tax code applicable
38
Id. at 564-65.
39
Conway v. United States, 647 F.3d 228, 232 (5th Cir. 2011) (citing Staff IT, Inc. v.
United States,
482 F.3d 792, 797 (5th Cir. 2007)).
40
Id. (citing Staff IT, 647 F.3d at 797-98); see also FED. R. CIV. P. 56(a).
41
Woods, 134 S. Ct. at 565-68.
42
26 U.S.C. § 6662(a), (b)(3).
19
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to the transactions at issue, a “substantial understatement” occurs if “the value
of any property (or the adjusted basis of any property) claimed on any return of
tax imposed by chapter 1 is 200 percent or more of the amount determined to be
the correct amount of such valuation or adjusted basis (as the case may be).”43
The penalty increases to 40% under § 6662(h) for a “gross” valuation
misstatement if the value or adjusted basis exceeds the correct amount by at
least 400%.44
The foreign currency OPS transactions in which NPR and the Taxpayers
engaged were used to generate tax losses by enabling the partners in NPR to
claim a high outside basis in the partnership. The FPAA deemed the NPR
partnership to no longer exist, and accordingly, no partner could legitimately
claim an outside basis greater than zero. If the Taxpayers used an outside basis
figure greater than zero to claim losses on their respective tax returns, which
they did in this case, “then the resulting underpayment would be ‘attributable
to’ the partner[s’] having claimed an ‘adjusted basis’ in the partnership that
exceeded the ‘correct amount of such . . . adjusted basis’” within the meaning of
§ 6662(e)(1)(A).45 Treasury regulations provide that when an asset’s true value
or adjusted basis is zero, then the value or adjusted basis claimed is considered
to be 400% or more of the correct amount, and the valuation misstatement is
deemed gross and subject to the 40% penalty.46
In holding that the valuation misstatement penalties did not apply as a
matter of law, the district court relied on authorities from our court that have
been overruled or abrogated by Woods. The district court erred in its holding.
43
26 U.S.C. § 6662(e)(1)(A) (2000) (amended 2006).
44
Id. § 6662(h) (2000) (amended 2006).
45
See Woods, 134 S. Ct. at 566.
46
See id. (quoting Treas. Reg. § 1.6662-5(g), 26 C.F.R. § 1.6662-5(g) (2013)).
20
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The 40% valuation misstatement penalty applies, at least provisionally, as
explained in Woods.
V
The Internal Revenue Code provides for a 20% penalty for the portion of
underpayment of tax that is attributable to any substantial understatement of
income tax.47 The amount of an understatement is reduced by any portion of the
understatement that is attributable to “the tax treatment of any item by the
taxpayer if there is or was substantial authority for such treatment.”48 In cases
in which the facts are essentially undisputed, whether substantial authority
exists for a tax treatment is a legal question that this court reviews de novo.49
In a case involving a tax shelter, prior to the 2004 amendments to the Tax Code,
the substantial authority exception did not apply unless the “taxpayer
reasonably believed that the tax treatment of such item by the taxpayer was
more likely than not the proper treatment.”50
The FPAA imposed a substantial understatement penalty of 20% (in
addition to a valuation misstatement penalty) under 26 U.S.C. § 6662(d). The
Taxpayers contended, and the district court held at the conclusion of a bench
trial, that there was “substantial authority” for the Taxpayers’ tax treatment of
their investments, within the meaning of § 6662(d)(2)(B)(i). The district court
further held that assuming, without deciding, that NPR was a tax shelter, the
Taxpayers reasonably believed that the tax treatment applied to the
47
26 U.S.C. § 6662(a), (b)(2).
48
26 U.S.C. § 6662(d)(2)(B)(i).
49
Stanford v. Comm’r, 152 F.3d 450, 455 (5th Cir. 1998).
50
26 U.S.C. § 6662(d)(2)(C)(i)(II) (2000) (amended 2004).
21
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transactions was “more likely than not” the proper tax treatment.51 Whether the
Taxpayers reasonably believed that the tax treatment of their respective
investments was more likely than not the proper treatment would appear to be
a partner-level matter that should not be resolved in a partnership-level
proceeding. But we do not reach the issue because there was no substantial
authority for the tax treatment. That is a question common to all NPR partners
and does not depend on an individual taxpayer’s circumstances. A partnership
item is “any item required to be taken into account for the partnership’s taxable
year under any provision of Subtitle A [income tax] to the extent regulations
prescribed by the Secretary provide that, for purposes of this subtitle, such item
is more appropriately determined at the partnership level than at the partner
level.”52 IRS regulations provide that partnership items include, among other
items, “[i]tems of income, gain, loss, deduction, or credit of the partnership,” and
“partnership liabilities,” as well as “the accounting practices and the legal and
factual determinations that underlie the determination of the amount, timing,
and characterization of items of income, credit, gain, loss, deduction, etc.”53 The
parties to this appeal agree, and we concur, that whether there was substantial
authority for the tax treatment given to the NPR assets that were distributed to
the Taxpayers is “more appropriately determined at the partnership level than
at the partner level.”54
51
NPR Invs., LLC, ex rel. Roach v. United States, 732 F. Supp. 2d 676, 689-90 (E.D.
Tex. 2010).
52
26 U.S.C. § 6231(a)(3).
53
Treas. Reg. § 301.6231(a)(3)-1.
54
26 U.S.C. § 6231(a)(3).
22
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“The substantial authority standard is an objective standard involving an
analysis of the law and application of the law to relevant facts.”55 Substantial
authority exists “if the weight of the authorities supporting the treatment is
substantial in relation to the weight of authorities supporting contrary
treatment.”56 The substantial authority standard is lower than the more-likely-
than-not standard, but greater than the reasonable-basis standard.57 Treasury
regulations provide a lengthy list of what constitutes authority for purposes of
the substantial authority exception.58 Notably, “[t]reatises, legal periodicals,
legal opinions or opinions rendered by tax professionals are not authority.”59
However, the authorities underlying those opinions may give rise to substantial
authority.60 Whether substantial authority exists is determined as of “the time
the return containing the item is filed or . . . on the last day of the taxable year
to which the return relates.”61
The district court’s opinion correctly stated the applicable legal principles,
but it then partially based its holding that the Taxpayers had substantial
authority on the existence of a tax opinion from the law firm of Sidley, Austin,
Brown & Wood LLP and the fact that the Taxpayers received legal advice from
tax counsel.62 The district court’s opinion does not cite or discuss the authorities
55
Treas. Reg. § 1.6662-4(d)(2).
56
Id. § 1.6662-4(d)(3)(i).
57
Id. § 1.6662-4(d)(2).
58
See id. § 1.6662-4(d)(3)(iii).
59
Id.
60
Id.
61
Treas. Reg. § 1.6662-4(d)(3)(v).
62
NPR Invs., LLC, ex rel. Roach v. United States, 732 F. Supp. 2d 676, 689 (E.D. Tex.
2010).
23
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analyzed in the tax opinion. To the extent that the district court concluded that
the opinion itself provided substantial authority, the court erred as a matter of
law. The tax opinion itself cannot provide substantial authority.63
To the extent that the district court’s opinion holds that the authorities
contained in the Sidley Austin tax opinion provide substantial authority for the
Taxpayers’ position, the district court also erred. NPR relies principally on the
Helmer64 line of cases for substantial authority. Helmer, a Tax Court opinion,
established the proposition that contingent obligations are not liabilities under
26 U.S.C. § 752 and thus do not effect a change in a partner’s basis.65 The
Helmer rule was authoritative at the time that the tax returns were filed. It was
not changed by IRS regulation until 2003, after the relevant time period here.66
However, other courts have held that reliance on Helmer alone cannot
support substantial authority in circumstances similar to those before us.67
These cases generally reason that Helmer does not address the situation in
which the transactions lack economic substance. According to IRS regulations,
“[t]he weight accorded an authority depends on its relevance and
persuasiveness.”68 When the underlying transactions lack economic substance,
Helmer cannot provide substantial authority. In a similar vein, Helmer does not
address the situation in which the partnership lacked a profit motive. NPR has
63
Treas. Reg. § 1.6662-4(d)(3)(iii).
64
Helmer v. Comm’r, 34 T.C.M. 727,
1975 WL 2787 (1975).
65
Id.
66
Treas. Reg. § 1.752-1(a)(4)(ii), (iv).
67
See, e.g., New Phoenix Sunrise Corp. v. Comm’r, 132 T.C. 161, 191-92 (2009), aff’d,
408 F. App’x 908 (6th Cir. 2010) (unpublished); Stobie Creek Invs., LLC v. United States,
82
Fed. Cl. 636, 706 (2008), aff’d,
608 F.3d 1366 (Fed. Cir. 2010); Palm Canyon X Invs., LLC v.
Comm’r,
98 T.C.M. 574,
2009 WL 4824326, at *35-*36 (2009).
68
Treas. Reg. § 1.6662-4(d)(3)(ii).
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not cited, nor have we found, any cases that stand for the proposition that the
Taxpayers could deduct these losses when NPR lacks a profit motive. The
authorities appear to support the opposite proposition.69 NPR and the Taxpayers
have conceded that NPR lacked a profit motive and that this precludes the
Taxpayers from deducting the losses.
An IRS notice, Notice 2000-44, that was issued before the Taxpayers
invested in the OPS shelter is another authority supporting nondeductibility.70
Notice 2000-44 warns that the IRS is of the opinion that transactions such as
those at issue here are abusive tax practices and that it will not allow deductions
from such artificial losses. NPR argues that the Notice is only the IRS’s
litigating position and cannot be authority. However, NPR’s argument is
directly contrary to IRS regulations, which list such notices as authority for
purposes of the substantial authority analysis.71 The Notice may have less
weight than a statute or regulation, but it is authority nonetheless. The only
authorities concerning deductions when the partnership did not have a profit
motive point to nondeductibility. We therefore reverse the district court’s
judgment that there was substantial authority for the tax treatment of the OPS
transactions. The substantial understatement of income tax penalty applies.
69
Marinovich v. Comm’r, 77 T.C.M. 2075,
1999 WL 339316, at *3 (1999); see
also, e.g., Copeland v. Comm’r,
290 F.3d 326, 330 (5th Cir. 2002); Fidelity Int’l Currency
Advisor A Fund, LLC v. United States,
747 F. Supp. 2d 49, 236 (D. Mass. 2010) (citing pre-
2000 cases for the proposition that “[e]ven if taxpayers invest in a partnership with the
individual objective of making a profit, they are not entitled to deduct any amounts invested
in the partnership as losses under Section 165(c)(2) if the partnership transactions are not
entered into for profit”); Farmer v. Comm’r,
68 T.C.M. 178,
1994 WL 386167, at *3
(1994).
70
Notice 2000-44, 2002-2 C.B. 255.
71
Treas. Reg. § 1.6662-4(d)(3)(iii).
25
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VI
Even if penalties are properly imposed and would otherwise be applicable,
the Internal Revenue Code provides a defense “if it is shown that there was a
reasonable cause for” the underpayment of tax.72 The district court held that the
Taxpayers demonstrated reasonable cause. Because the district court did not
have jurisdiction to adjudicate the individual partners’ defenses in a
partnership-level proceeding, we vacate this part of the district court’s judgment.
To the extent that the district court’s judgment can be construed as concluding
that NPR demonstrated reasonable cause, we reverse the district court’s
judgment in this regard. There was no evidence presented that would support
a finding of reasonable cause as to NPR. To the contrary, the evidence is
conclusive that NPR did not have reasonable cause.
It is well-settled that a district “court does not have jurisdiction to consider
a partner-level defense in a partnership-level proceeding.”73 Our court has held,
however, in connection with Nix’s and Patterson’s BLIPS transactions, that
“when considering the determination of penalties at the partnership level the
court may consider the defenses of the partnership.”74 Other circuit courts have
similarly concluded that partnership defenses can be adjudicated in partner-
level proceedings.75
72
26 U.S.C. § 6664(c)(1) (“No penalty shall be imposed under section 6662 or 6663 with
respect to any portion of an underpayment if it is shown that there was a reasonable cause for
such portion and that the taxpayer acted in good faith with respect to such portion.”).
73
See, e.g., Am. Boat Co. v. United States, 583 F.3d 471, 478 (7th Cir. 2009).
74
Klamath Strategic Inv. Fund ex rel. St. Croix Ventures v. United States, 568 F.3d 537,
548 (5th Cir. 2009).
75
See Stobie Creek Invs. LLC v. United States, 608 F.3d 1366, 1380-81 (Fed. Cir. 2010);
Am.
Boat, 583 F.3d at 479-80. But see Clearmeadow Invs., LLC v. United States,
87 Fed. Cl.
509, 520-21 (2009) (criticizing Klamath and Stobie Creek and concluding that these decisions
“are in error”).
26
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In Klamath, “reasonable cause and good faith were asserted on behalf of
Klamath and Kinabalu, by the current managing partners.”76 In the present
case, the district court’s decision reflects that it focused entirely on the
reasonable belief and good faith of each of the individual Taxpayers, not NPR’s
reasonable belief and good faith.77 No mention is made by the district court of
NPR’s or its managing partner’s reasonable belief or good faith. The district
court lacked jurisdiction to make any determinations with regard to the
reasonable belief or good faith of the individual Taxpayers.
NPR asks that we affirm the district court’s holdings as to it. However, at
the time that the Taxpayers made their respective decisions as to how to treat
the NPR transactions, they had withdrawn from NPR and were no longer
partners. When NPR was created, through the time that the Taxpayers
withdrew from NPR, its managing partners were exclusively DGI and Alpha
Consultants LLC. Patterson did not become the managing partner of NPR until
2005, when the partnership was reformed to pursue this litigation. NPR has
conceded that it never had a profit motive. The managing partners of NPR at
the relevant time periods did not claim a reasonable belief regarding the tax
treatment of the NPR investments. Those partners are not parties to this
litigation and have refused to testify, asserting their Fifth Amendment privilege.
NPR had the burden to prove a reasonable belief and good faith.78 It failed to
carry that burden. NPR is not entitled to the reasonable-cause and good-faith
defense.
* * *
76
Klamath, 568 F.3d at 548.
77
NPR Invs., LLC, ex rel. Roach v. United States, 732 F. Supp. 2d 676, 692-93 (E.D.
Tex. 2010).
78
Klamath, 568 F.3d at 548 (“The plaintiff bears the burden of proof on a reasonable
cause defense.”).
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For the foregoing reasons, we AFFIRM the district court’s judgment
regarding the finality of the FPAA; REVERSE the district court’s judgment
regarding the valuation misstatement and substantial underpayment penalties
as well as its judgment regarding NPR’s reasonable-cause defense; and VACATE
the district court’s judgment regarding the Taxpayers’ reasonable-cause
defenses.
28
