Ramblings: So what was argued in Klamath Strategic Investment Fund, LLC v. United States, --- F.Supp.2d ----, 2007 WL 283790 (E.D.Tex.. 2007)?

I will “blame” the severe weather conditions in the Northeast for the lack of cases reported this week. But thanks to Tax Notes Today, tax practitioners were able to see what the Government argued in Klamath and taxpayer’s response.

Before I get to those arguments, if you like this kind of transparency then take notice that the United States Tax Court is accepting comments as to the amendments to its proposed rules. Under the proposed rules, only if you live in the Washington DC area will you have access to its electronic filings. Otherwise, you will still have to contact the Docket room and obtain a hard copy.

Simply stated, I don’t like it. Two points, the IRS gets full access as should all private practitioners not just those private practitioners that live in the DC area and can go by the Court house and review the case of interest. Second, the United States Tax Court must strive to be fully transparent. See Estate of Kanter v. Commissioner, T.C. Memo. 2007-21 and it looks like they have not learned that lesson. I mean wouldn’t you just love to see what exactly the Special Trial Judge’s report actually said, compare it to the IRS’s brief and then compare to the opinion. I bet, without seeing that STJ report, the IRS’s brief equals the final opinion. Oh well, just a guess but I digress. To Klamath, I go.

As stated in the blog of two weeks ago, the Government’s “victory” was to ask the Court to accept its argument raised in Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1356-57 (Fed.Cir.2006), i.e. the transaction to be analyzed is the particular transaction that gives rise to the tax benefit. In its brief the Government argued:

"When applying the economic substance doctrine, courts have taken pains to emphasize that the transaction to be analyzed is the particular transaction that gave rise to the tax benefit, and not collateral transactions which do not produce tax benefits. Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1356-57 (Fed. Cir. 2006); Nicole Rose Corp. v. Comm'r., 320 F.3d 282, 283-84 (2d Cir. 2002); ACM P'ship v. Comm'r., 157 F.3d 231, 260 (3d Cir. 1998); Long-Term Capital Holdings v. United States, 330 F. Supp 2d 122, 171 (D. Conn. 2004).

For example, in the recent Coltec decision, the Federal Circuit explained that the taxpayer had missed the point when it attempted to prove that the creation of a subsidiary, and the transfer of certain management activities of its business to that subsidiary, had a business purpose (454 F.3d at 1358): "Here . . . we must focus on the transaction that gave the taxpayer a high basis in the stock and thus gave rise to the alleged benefit upon sale. That transaction is Garrison's assumption of Garlock's asbestos liabilities in exchange for the $375 million note. . . . It is this exchange that provided Garlock with the high basis in the Garrison stock, this exchange whose tax consequence is in dispute, and therefore it is this exchange on which we must focus."

The Government then focused solely on the transaction that gave rise to the tax benefit - the premium loan and argued that the leg had no economic substance. Question: Is the line becoming a little blurry as to the economic substance doctrine and the step-transaction doctrine? Most private practitioners recognize that there is a distinction between the two doctrines even thought the doctrines are kissing cousins. Yet, it appears that the two doctrines are morphing into one.

After all if one compares Klamath, Coltec with True v. United States, 190 F.3d 1165, 1177 (10th Cir.1999) what do we get? [ As stated in True at 1177:  “To ratify a step transaction that exalts form over substance merely because the taxpayer can either (1) articulate some business purpose allegedly motivating the indirect nature of the transaction or (2) point to an economic effect resulting from the series of steps, would frequently defeat the purpose of the substance over form principle.”]. I would respectfully submit that the judicial doctrines are being morphed together and we are moving farther away from a clearly defined test and are being left with a glorified smell test. Thus, it will be interesting to see what the United States Supreme Court does with Coltec. For if Coltec is reversed then it appears that the Government’s one pony ride on the back of Cotlec will cause Klamath to be overturned assuming it is appealed.

Klamath was also note worthy as to the taxpayer’s victory as to the penalties. Surprisingly the Government’s brief gave little argument as to the 40% penalty – no case law analysis, no argument other than a “one paragraph argument “which submitted that the 40% penalty was applicable. Then the Government attacked the reasonable cause defense based on the following arguments:

  • “In the first place, plaintiffs' due diligence was a sham itself. They failed to even inquire as to the profit performance of the 75 prior BLIPS deals in 1999 and 2000 (prior to their transactions); not one of which made a profit.” Needles to say, it is apparent that the Government is really insisting on the use of pattern evidence as to the penalty phase of the case. 
  • “Furthermore, their claim that they only belatedly learned of BLIPS' enormous tax benefits defies common sense.” The old common sense argument. This is usually an argument of last resort when the testimony is not to one’s liking or the trial attorney forgot to have his/her expert testify as to a point – such emphasizing after tax rate of return vs. economic rate of return.
  • “Plaintiffs' argue that they are not tax lawyers and relied upon professional advisors for tax advice. Here, the authors of these legal opinions had a conflict of interest. Lemons had discussed the design of the BLIPS tax shelter with Presidio before it was ever sold to Nix and Patterson, and both Holland & Hart and Olson Lemons had both represented Presidio and its principals on numerous corporate and tax matters concerning BLIPS in general -- including the question of whether or not to register BLIPS as a tax shelter.” Looks like the Government did bring out the 500lb monster (the attorneys work with the promoters argument) and lost big time. The fact is the code is complex and the law firms that were engaged in these transactions were highly reputable firms. What is a taxpayer to do? It appears that the Government is arguing that the taxpayer should disagree with a prestigious tax firm when they tell the taxpayer – “Yes, even though it looks to be good to be true, this really does comply with the tax code.”
  • “Moreover, these so-called legal opinions were worthless since their ultimate conclusion as to the allowance of the BLIPS tax benefits was based on the accuracy and correctness of information allegedly provided by the plaintiffs themselves.” The Government trotted out Long Term Capital and it came right back at them. End result - it left the Government feeling like Darius III at the Battle at Issus.

Not surprisingly, the taxpayers in Klamath argued that penalties were not warranted based on the following:

  • The Government had admitted that the transactions "complied with the literal provisions of the Internal Revenue Code.” As such there was substantial authority for the positions taken on the returns. 
  • The 40% penalty did not apply due to Weiner v. United States, 389 F.3d 152 (5th Cir. 2004); Heasley v. Comm'r, 902 F.2d 380, 383 (5th Cir. 1990).
  • Taxpayers relied on and in good faith on the advice of several qualified tax professionals.The taxpayers also obtained detailed opinions from prominent tax counsel. 
  • As to the theory that there was no due diligence as to the facts, the taxpayers submitted that the lawyers prepared the statement of facts from the underlying transactional documents and that they had Presidio review the fact statement to confirm its accuracy. In addition, the lawyers sent the opinions under cover letters that instructed the taxpayers to review the fact statements for accuracy and, had the taxpayers been silent, they would have taken that as an affirmative representation that the facts were accurate. The lawyers testified that it was common for a practitioner to prepare fact statements for opinions since the practitioner knows what representations are important to the issues at hand -- and to then have the taxpayers review and approve those representations. This argument was accepted by the Court when it stated “ That Holland & Hart and Olson Lemons (the attorneys) had access to all relevant transactional documents which were reviewed by Presidio for accuracy.” This is the part of the opinion that hurts the Government more than any other part of the opinion. Reason:  It puts Long Term Capital on its head.

In conclusion: With Long Term Capital, the Government had the perfect storm (Noble Prize winner who knew a little bit about economics, an oral tax opinion, etc.) but in these other shelters both sides have litigation risks. Once the Government understands that  the concept of hazards of litigation does apply to these cases then more cases will be settled in terms that are more likely than not favorable to the Government. What is that saying about pigs? Well government keep trying cases in circuits that are not favorable and you will end up just like that poor old hog.

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