Argued April 19, 2013
Appeals from the United States Tax Court. Nos. 20171-07, 20230-07, 20243-07, 20655-07, 19543-08 — Robert A. Wherry, Jr., Judge.
Before Easterbrook, Chief Judge, and Posner and Williams, Circuit Judges.
Posner, Circuit Judge.
These appeals are by multiple LLCs (limited-liability companies) involved in the creation and administration of a tax shelter. For the sake of simplicity we'll treat the appeals as one appeal, by Warwick Trading, LLC. The other appellants are subsidiaries of Warwick used to attract investors in it and needn't be discussed separately. The appeal challenges a decision by the Tax Court upholding the disallowance by the Internal Revenue Service of losses claimed by Warwick (ultimately for the benefit of the investors in the tax shelter) and also upholding a 40 percent penalty for a "gross valuation misstatement." 26 U.S.C. §§ 6662(a), (h); 137 T.C. 70, 87, 91–92 (2011); see also T.C. Memo 2012-110, 103 T.C.M. (CCH) 1604 (opinion denying reconsideration). The dollar amount of the penalty, which depends on the tax losses improperly taken by the investors in the shelter, has not yet been determined.
An LLC, such as Warwick, is generally treated as a partnership for tax purposes, Treas. Reg. § 301.7701–3(a), and like other partnerships its income and losses are deemed to flow through to the partners and are taxed to them rather than to the partnership. 26 U.S.C. §§ 701–04, 6031. Until 1982 "all partnership items were determined at the individual taxpayer level." But this "often required duplicative proceedings for different partners and sometimes resulted in inconsistent treatment of partnership items from partner to partner." Petaluma FX Partners, LLC v. Commissioner, 591 F.3d 649, 651 (D.C. Cir. 2010); see also Southgate Master Fund, L.L.C. v. United States, 659 F.3d 466, 469 n. 4 (5th Cir. 2011). So the law was changed, and now how much partnership income or loss should be given recognition for tax purposes when the partners file their tax returns is determined by an audit of the partnership. 26 U.S.C. §§ 6221–6232.
Warwick had been created by a lawyer named John Rogers, the petitioner in the companion case of Rogers v. Commissioner, No. 12-2652, also decided today. (We note with disapproval the loquacity of, and lame attempts at humor in, the Tax Court's opinion, which include making fun of Rogers' name, as in the section title "Mr. Rogers' Neighbor- hood.") The purpose of creating Warwick was to beat taxes by transferring the losses of a bankrupt Brazilian retailer of consumer electronics named Lojas Arapuã S.A. to U.S. tax- payers who would deduct the losses from their taxable in- come. Arapuã had receivables with a face value of U.S. $30 million. Because they were to a great extent uncollectible (they were owed by consumers, had very small balances, and were very old), they had a negligible market value. Rogers used a company that he owned, Jetstream Business Limited, to join with Arapuã in forming Warwick. Jetstream was designated the managing (that is, the active) partner, charged with trying to collect the receivables. The net receipts from Jetstream's activity would be Warwick's partner- ship income and would eventually be divided between Jetstream (meaning Rogers) and Arapuã.
Rogers' aim was to create what is called a distressed as- set/debt ("DAD") tax shelter. See IRS, "Coordinated Issue Paper—Distressed Asset/Debt Tax Shelters, " LMSB-04-0407- 031, Apr. 18, 2007, www.irs.gov/Businesses/Partnerships/ Coordinated-Issue-Paper-Distressed-Asset-Debt-Tax- Shelters (visited Aug. 26, 2013). A DAD shelter is based on a tax loophole closed by the American Jobs Creation Act of 2004, Pub. L. No. 108-357, § 833, 118 Stat. 1589, amending 26 U.S.C. §§ 704(c), 743, the year after Rogers created Warwick. To spare the reader a headache, we'll provide a simplified explanation of Rogers' DAD.
When an asset is contributed to a partnership, the contributor receives in exchange a partnership interest. The partnership formally owns the contributed asset, but the contributor owns a slice of the partnership in recognition of his contribution, and so hasn't really parted with the asset. In the hands of the partnership the asset's basis is the contributor's original basis, which (with adjustments that we can ignore) is the asset's original cost. 26 U.S.C. §§ 723, 1012. Recognition for tax purposes of gain or loss attributable to any change in the asset's value before the asset was contributed to the partnership is deferred until the partnership sells the asset. See 26 U.S.C. § 721(a). So if the asset is worth less than the contributor paid for it, that loss in value (what is termed "built-in loss") will be recognized, and thus usable to reduce taxable income, only when the partnership sells the asset. See 26 U.S.C. § 704(c)(1)(A); Laura E. Cunningham & Noël B. Cunningham, The Logic of Subchapter K 10 (4th ed. 2011). If the contributing partner sells his partnership interest before the partnership sells the contributed asset, the buyer of the partnership interest steps into his shoes and so recognizes built-in loss or gain if and when the partnership sells the asset. Treas. Reg. § 1.704-3(a)(7).
Rogers' DAD involved Arapuã's contributing its receivables with built-in losses to Warwick, followed by the sale of Arapuã's partnership interest (acquired by contributing those receivables to the partnership) to investors—the tax- shelter seekers. Because the tax shelterers bought Arapuã's interest in the partnership, the partnership's losses when it sold the receivables flowed through to the investors as Arapuã's successors in the partnership.
The investor-partners' purpose in buying Arapuã's inter- est in the partnership (and thus becoming Jetstream's partners—for remember that Arapuã and Jetstream were the original partners in Warwick) was to deduct the built-in loss. But a partner can claim a loss only up to the amount of his basis in the partnership, 26 U.S.C. §§ 704(d); 705(a)(2)(A); 9 Mertens Law of Federal Income Taxation § 35C:1 (2013), and the basis of the partnership interest that an investor acquired (thereby becoming a partner) was the price at which Arapuã had sold the interest to him. Treas. Reg. § 1.742-1. That price would have been very low, since the buyers—the shelter investors—were just buying tax savings based on built-in loss. In fact each dollar of that loss could be worth no more than 35 cents in tax savings, because the top income tax bracket in 2004 was 35 percent. So the most a top-bracket shelter investor would pay Arapuã for a partnership interest that would give the investor the right to its built-in loss would be a sliver less than 35 percent of the loss, for otherwise he'd obtain no tax savings. In fact the shelter investors paid only 3 to 6 percent of the value of the losses they obtained by buying into the shelter.
But the investor had to contribute additional property to the partnership in order to inflate his basis in his partnership interest to a level at which he could deduct the entire built-in loss. 26 U.S.C. § 722. If he paid $100 for an asset once worth $1000, he could not claim a loss of $900—the full built-in loss—but only of $100; the other $800 of losses would be wasted from a tax-avoidance standpoint. The assets that the shelter investors contributed in order to raise their basis to the built-in loss were promissory notes made out to the partnership. The notes had no value because Rogers had no intention of causing Warwick to collect on them. The intention was simply to create the appearance that the investors' interest in the partnership had a high enough basis to enable the entire built-in loss that the shelter investors had acquired to be offset against their taxable income. But all this means is that the investors should not have been permitted to deduct their entire built-in loss—yet in fact they shouldn't have been permitted to deduct any part of it, because the partner- ship was a sham. It was really just a conduit from the original owner of the receivables (Arapuã) to the U.S. taxpayers who wanted a deduction equal to the difference between the face amount of the receivables (the promissors' debt) and the receivables' current, greatly depressed market value.
A genuine partnership is a business jointly owned by two or more persons (or firms) and created for the purpose of earning money through business activities. If the only aim and effect are to beat taxes, the partnership is disregarded for tax purposes. "[T]ax considerations cannot be the only reason for a partnership's formation." Southgate Master Fund, L.L.C. v. United States, supra, 659 F.3d at 484 (emphasis in original). There must be a "profit-motivated reason to operate as a partnership." Id. "[T]he absence of a nontax business purpose is fatal." ASA Investerings Partnership v. Commissioner, 201 F.3d 505, 512 (D.C. Cir. 2000).
Jetstream, supposedly the active partner in Warwick, made a few, feeble attempts at collecting the receivables that Arapuã had contributed to the partnership. The attempts were window dressing. Collection would have been governed by Brazilian law, which required that the contract for the transfer of Arapuã's receivables to Warwick be translated into Portuguese and filed with the Brazilian government. Neither of these things was done. Indeed there is considerable doubt ...