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.

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.

Klamath, Estate of Kanter, and IRS's Announces Civil/Criminal Enforcement in Foreign Transactions

Two opinions were announced this week - Klamath Strategic Investment Fund, LLC v. United States, --- F.Supp.2d ----, 2007 WL 283790, (E.D.Tex.. 2007); Estate of Kanter v. Commissioner, T.C. Memo. 2007-21. These two opinions were highly anticipated as they afforded the respective Courts an opportunity to interpret new judicial doctrines/rules and answer questions concerning the trial judge’s role in evaluating and determining witness credibility.

In addition, in three separate publications, the IRS’s criminal and civil intentions as to foreign transactions were broadcast.

The inherent facts and issues of Klamath are set forth in: Dawson, COLTEC: A New Standard for Economic Substance, Business Entities (WG&L) (Nov./Dec. 2006). As stated in the article, there were three issues worth following: 1) Whether the Court would refine its application of the economic substance test in light of Coltec? As stated in the article they might and the Court did. 2) In light of the 5th Circuit’s ruling in Todd v. I.R.S., 862 F.2d 540 (5th Cir.1988), would the Court impose a 40% penalty for gross valuation misstatement? As stated in the article the Court would not and it did not as a matter of law. 3) Would the Court impose a 20% negligence penalty? No opinion offered was in the article as it was viewed as a question of fact. Based on the Court’s determination concerning the credibility of the witnesses no penalty was asserted.

Issue #1. The Court in citing to Compaq Computer Corp. v. Comm'r, 277 F .3d 778, 781-82 (5th Cir.2001) noted that the Compaq “declined, however, to consider whether a court must invalidate a transaction that fails only one of the prongs of the test.” Noting this declination, the Court decided that indeed only one of the prongs must be found to fail the economic substance test and the appropriate prong to test is the event that creates the tax loss, i.e. did that event have independent business purpose other than the creation of a tax loss. The Court stated:

“When applying the economic substance doctrine, courts emphasize that the transaction to be analyzed is the particular transaction that gives 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).”

The Court then focused on the loan agreements and arrangements at issue and determined that the financial institutions and Presido never intended to implement the seven year plan. To the contrary, if necessary the financial institutions and Presido would have compelled the taxpayers to exit the strategy at the end of Stage I through financial pressure. In addition, Presidio’s fee arrangement as set forth in its Congressional testimony was predicated on the tax loss generated by the investment plan. Thus, taxpayer’s intent concerning the legitimate business reasons for the transaction was all for naught as Presidio and the financial institutions did not the “investment plan” in the same light.

From the Government’s perspective this could not be better news. The Court in the 5th Circuit applies Coltec and as stated in the blog of January 21, 2007 the Government’s use of pattern evidence was justified. That is, the Court stated that it can and should focus on the intent of all the parties of the transactions and not just the intent of the taxpayers. Thus, if the intent of one of the parties, i.e. a facilitator, and/or stage is dubious in terms of economic profit then the transaction will fail regardless of the taxpayer’s and the plan’s overall economic profit.

But as the saying goes the Government won the battle but lost the war. Taxpayer’s and their representatives have realized that as to the majority of these transactions it will be difficult to demonstrate that the investments have economic substance. (I still maintain that certain LILO’s may have economic substance even though RJT Investments ruling is to the contrary. See Blog dated January 14, 2007). Thus, the primary concern of many practitioners and taxpayers was/is the penalty(ies) issue.

As to the office of Chief Counsel, we have been hearing from them that the maximum amount of penalties would be sought and obtained. The IRS in various cases had done very well in obtaining the maximum amount of penalties it had sought. See Long Term Capital Holdings, Ltd. v. United States, 330 F.Supp.2d 122, 205 (D.Conn.2004); Santa Monica Pictures v. Commissioner, T.C. Memo. 2005-104. However none of the cases had been in the forum the IRS has sustained it’s more notable losses – the 5th Circuit. Well in this case the IRS not only failed to obtain the 40% penalty the IRS got zeroed out.

Issue #2 The IRS’s loss as to the 40% penalty was not surprising as it was based on a matter of law. Todd v. I.R.S., 862 F.2d 540 (5th Cir.1988); Heasley v. Commissioner, 902 F.2d 380, 383 (5th Cir.1990); Weiner v. U.S., 389 F.3d 152, 161-62 (5th Cir.2004). It is obvious that the IRS wanted to test the Court and see if they could get it to reconsider Todd as the Court in Santa Monica had done. One factor the IRS failed to consider was the forum it was in. In Santa Monica the forum was the Tax Court here it was a Federal District Court. [It should be noted that Santa Monica is currently on Appeal to the 9th Circuit]. Thus, the IRS losing on the 40% issue was not surprising.

Issue #3: However, the fact that no penalties were imposed is from the taxpayer’s perspective the victory that they have long sought. The reason is premised on how the Court arrived at its conclusion. The Court arrived at its conclusion by looking at the taxpayer’s particular facts and circumstance. The Court decision in Klamath as to the penalties focused on the primary role of the fact-finder – his assessment as to credibility of the primary witnesses. The Court found the taxpayer and their testimony to be credible. He found that they were not looking solely at the tax advantages of the transaction. To the contrary, the taxpayers had a continuous and ongoing relationship with their accountants and had asked their accountants to identify a firm that specialized in foreign currency trading.

The Court found the taxpayers to be credible when they testified that when they met with the representatives from Presido they had no discussions of tax issues surrounding the investments. Instead, the meeting was entirely devoted to the business opportunity being presented to the taxpayers. Rather, the Court found that from the time the taxpayers began considering foreign currency investments until the time they decided to invest with Presidio, their primary motives had been to make a profit. The Court found as credible their testimony that the reason for exiting the investment was due to other financial investments.

As to the tax advice received, the Court found the taxpayer’s evidence to be highly credible. The taxpayers sought the oral advice of a prominent tax lawyer who gave the transaction his blessing. (Compare with Long Term Capital). The fact that the taxpayers received a tax opinion from the law firm that represented Presidio was not troubling to the Court as the opinion was detailed, came from qualified attorneys, the taxpayer’s needed advice as to the transaction, and the taxpayers had determined for themselves that there was no conflict of interest with the opinion.

Needless to say, that part of the opinion is and will be a major blow to the IRS’s future endeavors in this area. For the Klamath Court has demonstrated a common sense resolution to the government’s argument of reliance of the “promoter’s agent” argument. The area is/was complex therefore why shouldn’t the taxpayer be entitled to rely on the opinions of reputable law firms? If the government says no, then the government needs to demonstrate that the taxpayers knew or should have known that the law firms in question were acting in a duplicitous manner. See Klamath’s opinion as to “Substantial Understatement of Income Tax”; “Disregard of Rule and Regulations” (“Contrary to the government's approach with respect to many of the other BLIPS investors, the IRS did not even bother to interview the taxpayers before it asserted the penalties. The court finds that no penalty should apply for disregard of rules or regulations.”) and “Reasonable Cause and Good Faith”.

Thus the government’s use of pattern evidence will be of limited value in the key issue in these cases – the imposition of penalties. If the question is of credibility of the witnesses, then the facts of the particular case will be of the up most relevance. Thus, the fact-finder, i.e. the particular judge’s, assessment of the witness and the evidence cannot be absconded by others. This brings me to the Estate of Kanter.

In Estate of Kanter, the key issue was the credibility of the witnesses. Tax Court Rule 183 states/stated and the Supreme Court noted that: “[d]ue regard ••• to the circumstance that the [s]pecial [t]rial [j]udge had the opportunity to evaluate the credibility of the witnesses,” must “presum[e] to be correct” fact findings contained in the report. . .” Ballard v. Commissioner, 544 U.S. 40, 45            (2005). Because of this failure to follow its own rules, the Tax Court’s decision in Kanter was overruled.

Tax Court 183 was subsequently amended and T.C. Rule 183(d) makes specific reference to the language cited by the Supreme Court. Curiously or rather enlightening,  the Kanter opinion does not highlight this language but rather highlights T.C. Rule 183(c) even though the Supreme Court and the 11th Circuit specifically brought to the attention of the United States Tax Court the above stated language of T.C. Rule 183(d).

Being that the case was one of first impression it is worth noting that the case was rendered as a T.C. Memo. opinion and not as a fully reviewed T.C. opinion. The Kanter opinion is over 450 pages long and is an attempt by the Court to explain to the 11th Circuit and the Supreme Court why the Tax Court’s original decision was correct and why the Special Trial Judge’s findings as to the witnesses and other key evidence should be given no weight at all.

The Tax Court interprets Tax Court Rule 183(c) as not providing a bar to new proposed findings of fact and leaves the matter within the discretion of the reviewing Judge. This is a rather broad read of T.C. Rule 183(c) as this interpretation gave the IRS and the Court the ability to make new findings of fact contrary to the findings of the Special Trial Judges report and contrary to the original findings proposed by the IRS awhich were objected to by petitioner’s counsel when the original trial and briefs were submitted. Simply stated we are not talking about Monday quarterbacking we are talking about Friday quarterbacking. 

Tthe Court’s docket sheet reflects a “no objection to the Special Trial Report” being filed by the Petitioners and Respondent filing an “objection to the Special Trial Report” rumored to be over a 1,000 pages long and certainly containing numerous proposed alternative findings of facts. One clear observation can be made as to Respondent’s alternative findings of fact - Petitioner was never afforded an opportunity to object to these alternative findings. Rather, according to the Court this is simply within the Court’s jurisprudence. Such an analysis by the Court’s is alarming and disturbing. This Court’s bedrock foundation is found in fairness amongst the parties and to the Court. Such fairness is found in the it’s discovery rules specifically the Branerton process, its rules as to expert testimony, and last but not least the Court rules concerning the briefing process under Tax Court 151.

Under Tax Court Rule 151, a party is afforded an opportunity to file objections to an opponent’s proposed finding of fact if said opponent has filed a brief in the case. Such position allows a party an opportunity to state for the record his/her/its objections to Respondent’s requested findings, i.e. it assures due process and does not allow Respondent or any other party an advantage in the brief processing. For this opinion to ignore such a premise/result and create a conflict as to its own rules is rather disturbing to all practitioners, i.e. is due process being ensured by this  ruling? 

Under its interpretation of new 183(c), the Court was given ample opportunity to ignore the STJ’s report and agree with Respondent and ignore the original findings as to the credibility of the witnesses. As the Court stated: “Thus, the Court does not feel constrained from correcting manifestly unreasonable findings of fact or making additional findings of fact, so long as any additional facts find direct support in the case record.”

In the ensuing opinion the Court reviewed Respondent’s requested additional findings of fact and for the majority of these new findings accepted them and rejected the STJ’s report as follows:

  • The Special Trial Judge misunderstood Respondent’s legal positions in the case. See for example the following findings made in the opinion:

o “The STJ report also incorrectly stated: "respondent's claim of fraud is not based, per se, on the payments by The Five to Kanter or any of the other entities to which such payments were directed.”
o “In addition, the statement in the STJ report limiting respondent's theory of fraud to the failure of Kanter, Ballard, and Lisle to report as income amounts "dropped down" to them in the form of loans is inaccurate and incomplete.”

  • Kanter’s testimony as well as other witnesses was in the eyes of Judge Haines unconvincing and advocacy in nature. See for example the following findings made in the opinion:

o “Errors in the STJ Report108- The STJ report was based on two fundamental misconceptions regarding respondent's position which resulted in (1) compelling evidence largely being ignored, (2) credibility determinations regarding The Five that were not relevant to a determination whether a kickback scheme existed among Kanter, Ballard, and Lisle, and (3) credibility determinations regarding Kanter, Ballard, and Lisle that were manifestly unreasonable. A detailed examination of the substantial record in these cases, along with a review of the parties' posttrial briefs, demonstrates that the ultimate holding recommended in the STJ report, i.e., that Kanter, Ballard, and Lisle did not participate in a kickback scheme, is directly contradicted by the overwhelming objective evidence in these cases and thus is manifestly unreasonable.”

In the next one hundred pages plus, the opinion details  the errors alleged to have been made by the sitting judge as to the credibility of the witnesses. Suffice it to say, that the opinion of this Judge is at odds with the opinion of the sitting judge. Suffice it to say that the observations of the Judge were made after Respondent had an opportunity to restate the record. Suffice it to say that the observations of the Judge were made over a number of years after the trial occurred and the witnesses are now deceased. Suffice it to say that it appears the instructions of the Supreme Court and the Eleventh Circuit appear to be ignored. Suffice it to say that we are looking at another Succession of McCord v. Commissioner, 461 F.3d 614 (5th Circuit 2006) or worse Dixon v. Commissioner, 316 F.3d 1041 (9th Cir. 2003) were now the Eleventh Circuit may be step in and by highly critical of the United States Tax Court..

Being that the Tax Court is an honorable institution and being that the opinion was not fully reviewed, I am forward enough to ask this honorable institution to vacate this decision on its own and determine whether Tax Court 183 was properly interpreted and applied in this proceeding.

Finally, in three different publications, (Tax Notes Today, the Wall Street Journal and BNA Daily Reports) the IRS announced that it intends to will include high-wealth individuals and tax practitioners in addition to business taxpayers under its new focus on coordinated international enforcement. See BNA Daily Tax Report for January 29, 2007. The BNA daily report stated that the “IRS will have some 500 of its 4,000 special agents trained in advanced international tax issues as part of the new strategy. Those agents will be segmented in "issue management teams" involving a number of technical issues, including foreign tax credits, hybrid arbitrage, and transfer pricing.” Call my blog of January  28th  a lucky guess.