Call it the Government just being obstinate or worse call it for what it is - just plain dumb idea - Klamath Strategic Investment Fund, LLC v. United States, --- F.Supp.2d ----, 2007 TNT 66-9 (E.D.Tex.. 2007). (Part II).

Well the Government asked the Court to reconsider its opinion. Let’s just say for the Government that said motion was not a wise choice but for taxpayers in the Fifth (and maybe the Eleventh) they say “Thank You”!!!

Not only did the Court not reconsider its opinion but it further elaborated as to why the plaintiff’s were entitled to deduct operational and interest expenses. Bottom line – It looks like the taxpayers did a lot better than they would have if they had agreed to the settlement initiative offered by the IRS.

The Court in two paragraphs dismissed the Government’s motion to reconsider and focused on the Government’s argument as to disallowing the operational expenses claimed by the plaintiffs.

The government had two arguments -- 1) No deduction can be taken for expenses related to a sham transaction, and 2) Presidio, as the managing partner, did not have the requisite profit motive. As to the first argument the Government stated that expenses incurred in connection with a transaction that lacks economic substance are not deductible and that the fees associated with a loan can only be deducted if the underlying debt is determined to be genuine. The plaintiffs disagreed and the Court agreed with the plaintiffs.

The Court looked at the cases cited by the Government and politely accused the government of misrepresenting what the cases actually held. The Court found that the cases cited by the Government were not as broad as the Government contended but limited to disallow only the losses generated as part of the sham transactions. The Court found that in contrast “The operating expenses were real economic losses and were never going to be recovered as a part of the loan transactions that lacked economic substance. When the taxpayers executed these loan transactions, they expected to repay them in full and the taxpayers planned to use those loan proceeds for the purpose of making a profit.”

“Furthermore, a court "may not ignore transactions that have economic substance even if the motive for the transaction is to avoid taxes.". "Even where a transaction is not intended to serve business purposes, it may give rise to a deduction to the extent that it has objective economic substance apart from tax benefits." The plaintiffs in this case incurred actual economic losses which are separable from the tax benefits of the premium loan transactions. Some of these economic losses involve the fees paid to Presidio as part of the investment plan, the losses from the foreign currency transactions, and the interest expenses from the loan. Although these losses relate to the premium loan transactions, they were real and are separable from the tax benefits associated with those loans.”  (citations Omitted).

Now that analysis really hurts. In the shelters I have seen this language from the Court will come into play – it’s called cash out of pocket and the Court determined that  cash out of pocket losses can be deducted. This Court’s position clearly goes against the IRS’s announcements of no cash out pocket for those that did not partake in the IRS's settlement initiatives.

As to the second argument the government argued that it is the partnership's primary motive, rather than the individual partners' profit motives, that governs the deductibility of expenses. The Plaintiffs argued that it was the individual taxpayers that paid and claimed the expenses.

The Court agreed with the Plaintiffs. The Court found that the plaintiffs had entered into these transactions for the purposes of making a profit. So even though the partnership arguably did not have a profit motive, the Court applied an aggregate not an entity theory and allowed the expenses to be claimed by the individual taxpayers. Call this a major ouch!

There was no analysis conducted by the Court - No Tefra, No aggregate/entity. If I were the Government I would leave this case alone and not appeal but it is the Government and this is a major loss.

So when the Government trumpets its victory in Jade Trading (I know I am jumping the gun) just remember what Lee Corso says – “Not so fast my friend” because in Klamath you got hammered!! The taxpayer for all practical purposes won – No penalties and deductibility of cash out of pocket.

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