Salty Brine 1, Limited v. United States

Case: 13-10799 Document: 00512718607 Page: 1 Date Filed: 07/31/2014

IN THE UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

United States Court of Appeals

Fifth Circuit

FILED

No. 13-10799 July 31, 2014

Lyle W. Cayce

Clerk

SALTY BRINE I, LIMITED,

Plaintiff,

v.

UNITED STATES OF AMERICA,

Defendant.

_________________________

THOMAS & KIDD OIL PRODUCTION, LIMITED, By and

Through Thomas/Kidd – Texas Operating Co., Incorporated,

Tax Matters Partner,

Plaintiff-Appellant,

v.

UNITED STATES OF AMERICA,

Defendant-Appellee.

Appeal from the United States District Court

for the Northern District of Texas

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Before DAVIS, ELROD, and COSTA, Circuit Judges. 1

W. EUGENE DAVIS, Circuit Judge:

Plaintiff Thomas & Kidd Oil Production, Ltd. (“TKOP”) appeals from the

district court’s determination, after a nine-day bench trial, that the transfer of

certain overriding royalty interests through a complicated transaction was an

invalid attempt to assign income. The record amply supports this finding and

supports the district court’s conclusion that the income was taxable to TKOP

for the 2006 tax year. We affirm.

I. Introduction

On April 5, 2010, The Commissioner of Internal Revenue issued a Notice

of Final Partnership Administrative Adjustment to TKOP for the tax year

ending December 31, 2006, establishing what the IRS believes to be TKOP’s

total tax liability. TKOP deposited the amount required by 26 U.S.C. § 6226(e)

with the IRS, then commenced this action seeking readjustment of partnership

items, which was consolidated with seven lawsuits under the Salty Brine I

caption. The district court had jurisdiction under 26 U.S.C. § 6226(a) and 28

U.S.C. § 1346(e), and we have jurisdiction over this timely appeal under 26

U.S.C. § 6226(g) and 28 U.S.C. § 1291.

TKOP disputed the determination of several partnership items before

the district court, including whether TKOP’s purchase of so-called Business

Protection Policies (“BPPs”) resulted in deductible business expenses, and

whether the transfer of certain overriding royalty interests by TKOP was an

invalid attempt to assign income that should have been taxed to it.

The district court ultimately concluded that the purchase of the BPPs

did not result in deductions and that the transfer of the overriding royalties

should be disregarded and the royalty income assigned to TKOP instead.

1 Judge Elrod concurs in all parts of this opinion except Part III.B.

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TKOP has appealed only the overriding royalty determination, but it is

necessary to discuss the BPP scheme because both the BPP scheme and the

royalty transaction concerned some of the same business entities and methods.

II. Factual Background

This case largely turns on the complicated facts surrounding the

overriding royalty interest transaction, which the district court addressed in a

detailed order.

In an appeal from a bench trial, we review the district

court’s findings of fact for clear error and its

conclusions of law de novo. “Specifically, a district

court’s characterization of a transaction for tax

purposes is a question of law subject to de novo review,

but the particular facts from which that

characterization is made are reviewed for clear error.” 2

We take our facts from the district court’s findings, which are not clearly

erroneous.

A. TKOP’s Ownership

The district court found that the ultimate taxpayers, John Thomas and

Lee Kidd, own and operate a group of oil and gas related businesses based in

West Texas, including TKOP. The district court noted that Thomas and Kidd

did not own their businesses directly, but rather owned them through the

trusts and investment partnerships that were involved in the BPP and royalty

interest transaction. Thomas and Kidd owned TKOP through two grantor

trusts, the Kidd Living Trust and Thomas Living Trust; and two additional

investment partnerships, Kiddel II, Ltd. and JTOM II, Ltd. The ownership

structure is unquestionably complex, but the essential finding is that all of the

related entities were owned and controlled by Thomas and Kidd.

2Southgate Master Fund, L.L.C. ex rel. Montgomery Capital Advisors, LLC v. United States,

659 F.3d 466, 480 (5th Cir. 2011) (footnote omitted).

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B. The BPP Scheme

The district court found that Thomas and Kidd’s accountant, H. Glenn

Henderson, introduced them to the concept of BPPs, which were issued by

Fidelity Insurance Company and Citadel Insurance Company, both based

offshore in the British West Indies. Fidelity and Citadel were associated with

several other companies under the umbrella of the Alliance Holding Company,

Ltd., including a trust company, an administrative services company, and a

marketing firm, Foster & Dunhill. Fidelity and Citadel were not owned by

Thomas and Kidd.

The idea behind the BPPs was to set up an offshore “asset protection

trust” then purchase cash-value life insurance policies, whose cash values

would be invested with the principal and interest allocated to “separate asset”

accounts (or “segregated accounts”). The goal was to set aside the assets of

these accounts and account for them separately from other insurance policies,

shielding them from the owners of other insurance policies and from the

creditors of the insurance companies. One of the district court’s key findings

is that the accounts were invested in accordance with the client’s instructions.

Thomas and Kidd purchased cash-value life insurance policies, through

their various companies, from Fidelity and/or Citadel beginning in 2002, and

in the relevant tax year, 2006, they had policies in place from both Fidelity and

Citadel.

The final step was the purchase of a BPP, which ostensibly insured a

given business against risks. At the end of the policy year, the profit

(approximately 85% of the premium from the BPP, less a management fee)

would be placed into the already established separate asset accounts. The

district court found that, under the arrangement, each client’s account was

responsible only for BPP claims filed by that client’s business, and no third

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party could access the account. Tellingly, each BPP provided coverage only

against remote and implausible risks, virtually guaranteeing that no claim

could be made under the policy.

Assuming no claim was made under the BPP (nearly guaranteed by the

terms of the policy), approximately 85% of the premium was deposited into the

segregated accounts as profit, including the cash value of the policy. The life

insurance policy holder could then withdraw those funds as a tax-free policy

loan. If successful, this plan would allow TKOP to deduct 100% of the

insurance premiums from taxable income as reasonable and necessary

business expenses, then the life insurance policy holder (ultimately a co-owner

of TKOP) could withdraw approximately 85% of that amount as a tax-free loan

from the life insurance policy account. The district court found that although

the BPPs were apparently set up to protect Thomas and Kidd’s businesses, in

reality the policies were merely a conduit used to funnel income from the

businesses to offshore entities in a scheme to avoid paying taxes due on that

income. The policy only protected against claims made by one of the closely

held entities controlled by Thomas and Kidd.

The district court found that Thomas and Kidd issued investment

instructions for the segregated accounts, which were in fact followed. For the

year 2006, Thomas and Kidd’s businesses paid $4.5 million in premiums on

various BPPs, which they deducted as ordinary and necessary business

expenses. At the conclusion of the one-year policies, Fidelity and Citadel

deducted $730,000 from that total in fees, then transferred the profits of $3.86

million into the various segregated accounts in accordance with Thomas and

Kidd’s instructions. In this way, the district court found, “$730,000 was spent

to acquire a $4.5 million reduction in otherwise taxable income in the United

States and to funnel the remaining $3.86 million . . . into offshore life insurance

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policies.” 3

Thomas and Kidd withdrew all $3.86 million within one day of the

transfer as policy loans.

TKOP does not appeal the findings or conclusion regarding the BPP

scheme, and the BPPs are not directly at issue in this appeal. Nevertheless,

the segregated accounts and the method of withdrawing the funds as policy

loans are central to the royalty interest transaction at issue in this appeal.

C. Royalty Interest Transaction

The district court found that the BPP scheme was not the only method

Thomas and Kidd used to avoid paying taxes. In brief, TKOP carved out

royalty interests from its working interests in a number of oil and gas

properties and then transferred these royalty interests, through intermediate

entities controlled by Thomas and Kidd, into the segregated accounts

associated with the Thomas and Kidd life insurance policies. A small portion

of the income was intended to flow back as annuity payments purchased with

the royalty interests, which payments were deferred for three years and thus

not taxable in 2006. The larger portion was held in the segregated accounts

and was available at any time for tax-free policy loans.

There were four steps involved in the royalty transaction.

(1) In early 2006, Thomas and Kidd created two limited liability

companies, one in Nevis which was owned by the same entities that own

TKOP; and one in Nevada which was soon owned 100% by the Nevis LLC. The

Nevis LLC’s role was to act as foreign intermediary.

(2) TKOP assigned royalty interests representing approximately 31% of

TKOP’s total royalty income to the Nevada entity.

(3) The Nevada LLC was transferred to the Nevis LLC, giving the Nevis

3 See District Court’s May 16, 2013 Order Nunc Pro Tunc (“Order”), p. 9.

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LLC indirect control of the royalty interests.

(4) The Nevis LLC was transferred to the life insurance segregated

accounts in exchange for two annuities, one of which would pay $192,810 per

year for the remainder of Kidd’s life, and the other of which would pay $178,579

per year for the remainder of Thomas’s life. These payments were deferred

and would not begin until January 2009. Following this exchange, the royalty

interests, which represented a future income stream, were held in the life

insurance segregated accounts.

The value of the exchanged royalty interest is not clear, though estimates

for a one-half interest (for Thomas or Kidd individually) range from $1,001,000

to $1,261,500. Thomas and Kidd’s accountant, H. Glenn Henderson, used the

higher valuation in the 2006 transaction. He sat on both sides of the

transaction, on the one side as Thomas and Kidd’s accountant, and on the other

side as a manager for the LLCs that owned the life insurance policies. The

district court also noted that there was evidence that he was also the

investment manager for the segregated accounts which ultimately held the

royalty interests.

This complicated transaction did not change anything about TKOP’s

operation of the underlying oil and gas interests. Following the transfer,

approximately 31% of the royalty income which would have been taxable to

TKOP before the transfer instead accrued to the life insurance segregated

accounts and could be withdrawn as tax-free policy loans. The district court

concluded:

The BPP transaction and the royalty transaction bear

similarities. Both transactions accomplish a transfer

of assets into cash-value life insurance policies. Both

transactions represent an internal shifting of assets

from one set of entities owned and controlled by

Thomas and Kidd to another set of entities owned and

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controlled by Thomas and Kidd. The tax benefits

sought in this case require arm's-length transfers to

third parties, but no third parties exist on either end

of the BPP or royalty transactions. 4

The district court also devoted more than five pages of its Order to

setting out the numerous problems with the legal and accounting advice TKOP

purportedly relied on for the transactions in question, including serious

conflicts of interest for Thomas and Kidd’s lawyer, Theodore Lustig, and their

accountant, H. Glenn Henderson; and several instances of other advisors

backing out of their opinions, refusing to issue a subsequent opinion, noting

that Thomas and Kidd had misrepresented facts, and similar issues.

As the district court moved on to its conclusions of law, it emphasized

what it considered the most essential fact:

The legal conclusions in this case turn on one fact:

John Thomas and Lee Kidd owned and controlled the

assets at issue before the transactions and after the

transactions. In substance, the BPP premium

payments and royalty transfers were distributions

from the Thomas and Kidd businesses to Thomas and

Kidd and their families. These distributions to

themselves do not qualify as tax deductible business

expenses or valid transfers of income to third parties. 5

III. Law and Analysis

A. TEFRA Framework and TKOP’s Jurisdictional Challenge

This case under 26 U.S.C. § 6226 is governed by the Tax Equity and

Fiscal Responsibility Act of 1982 (“TEFRA”), 26 U.S.C. §§ 6221–6233.

Under TEFRA, “the tax treatment of any partnership

item (and the applicability of any penalty, addition to

tax, or additional amount which relates to an

4 Id. at p. 12.

5 Id. at p. 18.

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adjustment to a partnership item) shall be determined

at the partnership level.” 26 U.S.C. § 6221. TEFRA

specifically sets forth the scope of judicial review:

A court with which a petition is filed in

accordance with this section shall have

jurisdiction to determine all partnership items

of the partnership for the partnership taxable

year to which the notice of final partnership

administrative adjustment relates; the proper

allocation of such items among the partners, and

the applicability of any penalty, addition to tax,

or additional amount which relates to an

adjustment to a partnership item.

26 U.S.C. § 6226(f) . . . . 6

Treasury Regulation section 301.6231(a)(3)–1, 26 C.F.R. §

301.6231(a)(3)–1, provides, “Where the determination of an item has no effect

on the partnership, the item is not a partnership item and cannot be decided

in a TEFRA proceeding.” TKOP argues for the first time on appeal that the

district court only had jurisdiction under TEFRA to address the initial

distribution of the mineral royalties from TKOP but did not have jurisdiction

to address the eventual purchase of the annuities which were used to flow the

smaller portion of the money back to Thomas and Kidd because (a) the

agreement was irrelevant to all TKOP’s partners, and (b) TKOP itself did not

participate in those annuities contracts.

TKOP cites Roberts v. Commissioner, 94 T.C. 853, 861 (1990), for the

proposition that the court has no jurisdiction under TEFRA to address an issue

that “would have no effect on any item that would affect all of the partners’

respective returns and would have no effect on any item on the

6 Klamath Strategic Inv. Fund ex rel. St. Croix Ventures v. United States, 568 F.3d 537, 547

(5th Cir. 2009) (emphasis removed).

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partnership return or the partnership’s books and records.” That begs the

question. The whole point of the district court’s determination was that the

private annuity sale was an essential part of the transaction as a whole, in that

it was the final step that returned the smaller portion of the money, after a

delay, to TKOP’s partners after sidestepping TKOP’s reported income. The

transaction unquestionably affected TKOP’s global income and, by extension,

the returns of all TKOP’s partners.

Determining “partnership items” under TEFRA necessarily requires a

holistic approach to examining the classification of potential income items.

TKOP cannot isolate just the first part of the transaction—the transfer of the

overriding royalties out of TKOP—and ignore the rest of the scheme, all of

which was essential to accomplish the goal of reducing or avoiding taxes for

TKOP, as the district court found. Thus, we conclude that the district court

had jurisdiction under TEFRA to address every part of the royalty interest

transaction, and ultimately to disregard the entire transaction, including the

annuity sale, for tax purposes. 7

B. Assignment of Income Doctrine

This case turns on the application of the assignment of income doctrine

and the economic substance doctrine. A classic explanation of the assignment

of income doctrine is found in Caruth Corp. v. United States, 865 F.2d 644 (5th

Cir. 1989):

7TKOP argued at length on appeal that the annuities were legitimate and should not have

been disregarded by the district court. What TKOP ignores is that the district court’s

determination concerned whether the transaction as a whole represented an improper

assignment of income and lacked economic substance, not whether each particular part might

be construed as proper outside of the context of the larger transaction. We agree with the

district court that the entire transaction, necessarily including the tax-free annuity

purchases, constituted an improper assignment of income and lacked economic substance

and therefore should be disregarded for tax purposes.

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The assignment of income doctrine holds that one who

earns income cannot escape tax upon the income by

assigning it to another. “[I]f one, entitled to receive at

a future date interest on a bond or compensation for

services, makes a grant of it by anticipatory

assignment, he realizes taxable income as if he had

collected the interest or received the salary and then

paid it over.” Commissioner v. P.G. Lake, Inc., 356 U.S.

260, 267, 78 S. Ct. 691, 695, 2 L. Ed.2d 743 (1958); see

also Lucas v. Earl, 281 U.S. 111, 115, 50 S. Ct. 241,

241, 74 L. Ed. 731 (1930); Helvering v. Horst, 311 U.S.

112, 120, 61 S. Ct. 144, 148, 85 L. Ed. 75 (1940). Justice

Holmes announced the doctrine by a now-famous

metaphor: income tax may not be avoided through an

“arrangement by which the fruits are attributed to a

different tree from that on which they grew.” Lucas v.

Earl, 281 U.S. at 115, 50 S. Ct. at 241.

When a taxpayer gives away earnings derived from an

income-producing asset, the crucial question is

whether the asset itself, or merely the income from it,

has been transferred. If the taxpayer gives away the

entire asset, with accrued earnings, the assignment of

income doctrine does not apply. Blair v. Commissioner,

300 U.S. 5, 14, 57 S. Ct. 330, 334, 81 L. Ed. 465 (1937)

(taxpayer’s gift conveyed entire interest in income

stream, and so did not fall under assignment of income

doctrine); United States v. Georgia R.R. & Banking

Co., 348 F.2d 278, 285 (5th Cir.1965), cert. denied, 382

U.S. 973, 86 S. Ct. 538, 15 L. Ed. 465 (1966). If the

taxpayer carves income or a partial interest out of the

asset, and retains something for himself, the doctrine

applies. P & G Lake, 356 U.S. at 265 & n. 5, 78 S. Ct.

at 694 & n. 5 (assignment of income doctrine applied

because the taxpayer transferred a “short-lived . . .

payment right carved out of” a larger interest; “[o]nly

a fraction of the oil and sulphur rights were

transferred, the balance being retained”). Ultimately,

the question is whether the taxpayer himself ever

earned income, or whether it was earned instead by

the assignee. In terms of Justice Holmes’ metaphor,

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the question is whether the fruit has been attributed

to a different tree, or whether instead the entire tree

has been transplanted. 8

A major question is whether TKOP (or its ultimate owners, Thomas and

Kidd) retained beneficial ownership of the overriding royalty interests. For tax

purposes, “[t]he true owner of income-producing property . . . is the one with

beneficial ownership, rather than mere legal title. It is the ability to command

the property, or enjoy its economic benefits, that marks a true owner.” 9 “Even

assuming their validity under State law, contractual arrangements designed

to circumvent this rule, by attempting to deflect income away from the one who

earns it, will not be recognized for Federal income tax purposes. Determining

who earns the income depends upon which person or entity in fact controls the

earning of the income, not who ultimately receives the income.” 10

As the Supreme Court noted in Commissioner v. Sunnen, 333 U.S. 591,

604 (1948), the “crucial question [is] whether the assignor retains sufficient

power and control over the assigned property or over receipt of the income to

make it reasonable to treat him as the recipient of the income for tax purposes.”

In C.M. Thibodaux Co., Ltd. v. United States, 915 F.2d 992, 995-96 (5th Cir.

1990), we applied Sunnen in holding that a corporate taxpayer had made an

anticipatory assignment of income when it transferred the right to receive

bonuses, delay rentals, and royalties under mineral leases but retained the

right to manage the leases. We reasoned that although the transfer qualified

as a property transfer under Louisiana law, in substance it was an anticipatory

assignment of income under federal income tax law which must be taxed to the

corporation.

8 865 F.2d at 648-49.

9 Chu v. Comm’r., 72 T.C.M. (CCH) 1519, at *3 (T.C. 1996) (citation omitted).

10 Benningfield v. Comm’r., 81 T.C. 408, 418-19 (1983).

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Here, the district court concluded that the royalty interest transfer was

an anticipatory assignment of income under these legal principles based on its

primary finding of fact, that Thomas and Kidd owned and controlled the assets

at issue before and after the transaction. The district court elaborated:

The economic relationship between Plaintiffs and

Thomas and Kidd was identical at the beginning and

the end of the transaction. JTOM II and Kiddel II

owned the working interests from which the

overriding royalty interests were created. After the

transfers from Thomas & Kidd Oil Production through

all of the entities, the private annuities were payable

to the same entities that owned Thomas & Kidd Oil

Production, JTOM II and Kiddel II. The transfer

merely removes income from one pocket and puts it

into another. The economic benefits of the royalty

interests did not change with the alleged assignment,

and the transaction should not be allowed to transfer

taxable income away from Plaintiffs. . . .

The income from the allegedly transferred royalty

interests should be assigned to Thomas & Kidd Oil

Production. The transaction involved a variety of

alleged transfers among entities owned and controlled

by Thomas and Kidd, ending with cash-value life

insurance policies also under their control. Once the

income was in those life polices, they continued to

control how the royalty income was used and invested

through the letters of wishes. Thomas admitted that

the royalty transaction was done for estate planning

purposes and that operation of the properties did not

change after assignment of the royalty interests.

The income from the royalty interests should remain

with Thomas & Kidd Oil Production and not the

alleged transferees, who neither received the benefits

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of the income nor exercised control over its

production. 11

On appeal, TKOP’s primary argument with respect to the assignment of

income doctrine is that the district court improperly conflated TKOP and the

various other entities in finding that TKOP retained control or benefit from

the royalty monies. TKOP argues that it was actually hurt by the overriding

royalty interest transfer because it lost that royalty income, which only flowed

to other entities controlled by Thomas and Kidd.

While it is true that TKOP lost the royalty income on paper, the district

court found that the money ended up with TKOP’s owners, bypassing income

tax in the process. TKOP cannot slice up the scheme into a series of small

parts; the thrust of the applicable law set out above is to look at the big picture.

Under the district court’s findings of fact, Thomas and Kidd controlled TKOP

and every part of the scheme, which is a hallmark of unlawful assignment of

income. Thus, this argument is without merit.

Next, TKOP argues that the district court focused on irrelevant

information, such as the fact that Thomas and Kidd entered into the

transaction for estate planning purposes, that the sale was not arm’s length,

and that TKOP’s operations did not change after the sale. Even if this

information is irrelevant, it demonstrates the true character of the transaction.

Next, TKOP argues that the royalty interest transfer was a property

transfer under IRS regulations and thus could not be an assignment of income.

TKOP ignores C.M. Thibodaux Co., Ltd. v. United States, supra, in which we

held that a purported transfer of a royalty interest may still qualify as an

assignment of income when the transferor retains control. The transfer in this

case was not a true transfer because the district court found that TKOP (or

11 See Order, pp. 26-28.

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more precisely, its ultimate owners) retained beneficial ownership of the

mineral interests and ultimately received the proceeds after a circuitous route

through several intermediaries.

Finally, TKOP argues that the district court clearly erred in finding that

Thomas and Kidd retained control of the overriding royalty interests after

TKOP’s initial transfer to the Nevada LLC. TKOP points to evidence from

which the district court could have concluded that the third party insurance

companies actually owned and controlled the royalty interests held in the

segregated accounts. TKOP has failed to show clear error. The question is not

whether the district court could have reached the findings asserted by TKOP

(i.e., that the insurance company actually controlled the segregated accounts)

but whether the district court erred in finding the opposite. The district court

rejected TKOP’s evidence and gave credence to the Government’s evidence

when it found that Thomas and Kidd actually controlled the accounts

(individually or through their businesses) through letters of wishes regarding

how the funds were to be invested and how they were to be distributed as loans.

This means that the risk-shifting normally associated with an annuity, in

which the annuitant gives up the potential of higher returns in exchange for a

guaranteed income stream, did not exist. Thomas and Kidd retained the

ability use the funds for high-risk investments and at any time could have

withdrawn the entire balance.

In short, the district court issued numerous specific findings of fact set

out above in addition to its primary finding that Thomas and Kidd were in

control of the entire transaction. We cannot say that the district court clearly

erred in making any of its findings. From these facts it follows that the royalty

interest transaction is an unlawful assignment of income for the reasons

assigned by the district court.

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C. Economic Substance

The district court also concluded that it lacked economic substance. We

explained in Klamath Strategic Inv. Fund ex rel. St. Croix Ventures v. United

States, 568 F.3d 537 (5th Cir. 2009):

The economic substance doctrine allows courts to

enforce the legislative purpose of the Code by

preventing taxpayers from reaping tax benefits from

transactions lacking in economic reality. As the

Supreme Court has recognized, taxpayers have the

right to decrease or avoid taxes by legally permissible

means. However, “transactions[] which do not vary

control or change the flow of economic benefits[] are to

be dismissed from consideration.” 12

Relying on Frank Lyon Co. v. United States, 435 U.S. 561, 583-84 (1978),

Klamath set out for the first time in this Circuit a “multi-factor test for when

a transaction must be honored as legitimate for tax purposes,” including

whether the transaction (1) has economic substance

compelled by business or regulatory realities, (2) is

imbued with tax-independent considerations, and (3)

is not shaped totally by tax-avoidance features.

Importantly, these factors are phrased in the

conjunctive, meaning that the absence of any one of

them will render the transaction void for tax purposes.

Thus, if a transaction lacks economic substance

compelled by business or regulatory realities, the

transaction must be disregarded even if the taxpayers

profess a genuine business purpose without tax-

avoidance motivations. 13

In Southgate Master Fund, L.L.C. ex rel. Montgomery Capital Advisors,

LLC v. United States, 659 F.3d 466 (5th Cir. 2011), we elaborated:

12 568 F.3d at 543 (citations omitted).

13 Id. at 544 (citation omitted).

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As to the first Klamath factor, transactions lack

objective economic reality if they “‘do not vary[,]

control[,] or change the flow of economic benefits.’”

This is an objective inquiry into whether the

transaction either caused real dollars to meaningfully

change hands or created a realistic possibility that

they would do so. That inquiry must be “conducted

from the vantage point of the taxpayer at the time the

transactions occurred, rather than with the benefit of

hindsight.” . . .

The latter two Klamath factors ask whether the

transaction was motivated solely by tax-avoidance

considerations or was imbued with some genuine

business purpose. These factors undertake a

subjective inquiry into “‘whether the taxpayer was

motivated by profit to participate in the transaction.’”

Tax-avoidance considerations are not wholly

prohibited; taxpayers who act with mixed motives,

seeking both tax benefits and profits for their

businesses, can satisfy the business-purpose test. 14

Under the district court’s findings of fact, the flow of money from TKOP’s

mineral interests to TKOP’s owners did not change in a meaningful way after

the transaction. The money merely took a more circuitous route and bypassed

income taxes in the process. The first Klamath factor fails because the royalty

interest transfer did not effect a change in control, did not ultimately change

the flow of economic benefits, and did not cause “real dollars to meaningfully

change hands.” The failure of that factor alone is sufficient to reach the

conclusion that the transaction lacked economic substance. Additionally,

based on the district court’s findings of fact, the transaction also fails the

second and third factors because the transaction had no profit motive, only a

tax avoidance motive in connection with estate planning. That would not be

14 659 F.3d at 481-82 (footnotes omitted).

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an improper motive in itself, but it cannot be the sole purpose under Klamath.

Thus, the district court correctly concluded that the transaction lacked

economic substance.

TKOP argues that the district court improperly focused on the

transaction as a whole (including the ultimate flowback to the Thomas and

Kidd-controlled entities) and instead should have focused on the initial

transfer of the overriding royalty interests from TKOP. As already noted

above, a court must look at the transaction as a whole to determine the

economic substance. TKOP’s attempt to isolate only the first transaction does

not tell the whole story.

TKOP’s argument rests on its assumption that the transfers were to

independent entities, but the district court found that Thomas and Kidd

ultimately controlled every step in the scheme, and the money ended up with

Thomas and Kidd and their families. Based on the district court’s findings of

fact, there appears to be no real profit motive at any stage of the transaction;

rather, the transaction overwhelmingly appears to have been entered into for

tax avoidance. Thus, for the reasons set out above, we conclude that the

district court did not err in concluding that the transaction lacked economic

substance.

IV. Conclusion

For the foregoing reasons, we AFFIRM. The district court properly

concluded that the entire royalty interest transaction should be disregarded

for tax purposes.

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