Kenna Trading, LLC, Jetstream Business Limited, Tax Matters Partner v. Commissioner

KENNA TRADING, LLC, JETSTREAM BUSINESS LIMITED,

TAX MATTERS PARTNER, ET AL., PETITIONERS 1 v.

COMMISSIONER OF INTERNAL REVENUE,

RESPONDENT

Docket Nos. 7551–08, 7552–08, Filed October 16, 2014.

7553–08, 7554–08,

7555–08, 7556–08,

7618–08, 7625–08,

9021–08, 9035–08,

9036–08, 9037–08,

9038–08, 9039–08,

9040–08, 9041–08,

9042–08, 9121–08,

9122–08, 9123–08,

9124–08, 9125–08,

9126–08, 9127–08,

9128–08, 14094–08,

16796–08, 19924–08,

19925–08, 13980–09,

13981–09, 13982–09,

13983–09, 27636–09,

30586–09, 671–10.

Brazilian retailers purportedly contributed distressed con-

sumer receivables to a limited liability company, S, treated as

1 Cases of petitioners listed in the appendix remain consolidated here-

with. Other petitioners have settled their cases with respondent, and

therefore their cases have been severed since the trial of these cases

322

(322) KENNA TRADING, LLC v. COMMISSIONER 323

a partnership for Federal income tax purposes. S claims

carryover bases in these receivables under I.R.C. sec. 723. In

2004 S in turn contributed some of these Brazilian receivables

to trading companies and contributed its interest in each

trading company to a holding company. S claimed a cost of

goods sold for each holding company equal to the basis of the

receivables contributed. S then sold an interest in each

holding company to an investor. The trading companies

claimed bad debt deductions. In 2005 S allegedly contributed

more of the Brazilian receivables to main trusts. Each main

trust then assigned the receivables to a newly created

subtrust. Investors allegedly contributed cash to the main

trust in exchange for the beneficial interest in the subtrust.

The subtrust claimed a bad debt deduction. Asserting that the

subtrusts were, for Federal income tax purposes, grantor

trusts, the investors claimed deductions on their tax returns.

Mr. Rogers, the creator of the investment program, also

invested in such a trust. R disallowed the bad debt deduc-

tions, adjusted S’ income for 2004 alleging that S inflated its

cost of goods sold, determined that S failed to include all

items of income in its gross receipts for 2004 and 2005, and

disallowed S’ business expense deductions. R also determined

I.R.C. sec. 6662(h) gross valuation misstatement penalties

against S, the trading companies, and Mr. and Mrs. Rogers,

I.R.C. sec. 6662(a) accuracy-related penalties on the amounts

of S’ underpayments due to increased gross receipts for unre-

ported income and the disallowed deductions, and an I.R.C.

sec. 6662A listed transaction understatement penalty against

S for the 2005 taxable year. Held: The Brazilian retailers did

not intend to enter into a partnership for Federal income tax

purposes. Held, further, S had a cost basis, not a carryover

basis, in the receivables. Held, further, the transactions in

issue lacked economic substance. Held, further, the trading

companies are not entitled to I.R.C. sec. 166 deductions. Held,

further, Mr. and Mrs. Rogers purchased their beneficial

interest in the subtrust and are not entitled to a carryover

basis. Held, further, R properly disallowed the Rogerses’

claimed I.R.C. sec. 166 deduction. Held, further, S overstated

its cost of goods sold. Held, further, R correctly adjusted S’

income to reflect certain unreported deposits. Held, further,

S is not entitled to the disallowed deductions. Held, fur-

ther, S and the trading companies are liable for the I.R.C. sec.

6662(h) gross valuation misstatement penalty. Held, further,

S is liable for an I.R.C. sec. 6662(a) and (b) accuracy-related

penalty on the underpayments attributable to the omitted

items of income and the disallowed deductions. Held, further,

R’s I.R.C. sec. 6662A listed transaction understatement pen-

took place.

324 143 UNITED STATES TAX COURT REPORTS (322)

alty against S is sustained insofar as related to the income

from the trust transactions.

John E. Rogers (an officer), for petitioner Jetstream Busi-

ness Limited.

John E. Rogers, for petitioners John E. and Frances L.

Rogers.

Ronald S. Collins, Jr., Laurie A. Nasky, and Bernard J.

Audet, Jr., for respondent.

Michael D. Hartigan (an officer), for participating partners

in docket Nos. 7552–08, 9039–08, 9121–08, and 13982–09.

WHERRY, Judge: In 2003 John Rogers developed, marketed,

and sold investments, which also allegedly provided potential

tax shelter, whereby investors in a partnership structure

could claim partially worthless bad debt deductions under

section 166 2 on certain distressed assets formerly owned by

a Brazilian retailer. Those transactions did not produce the

hoped-for tax benefits for the myriad of reasons outlined in

our prior opinions and by the Court of Appeals for the Sev-

enth Circuit. See Superior Trading, LLC v. Commissioner,

137 T.C. 70 (2011), supplemented by T.C. Memo. 2012–110,

aff ’d, 728 F.3d 676 (7th Cir. 2013). In 2004 Mr. Rogers sold

the same shelter, this time using additional distressed assets

of other Brazilian retailers. That same year, Congress modi-

fied the rules governing the allocation of built-in loss prop-

erty contributed to a partnership, rendering the partnership

flow-through loss-shifting shelter impotent. 3 Undeterred, for

various transactions entered into after October 22, 2004, Mr.

Rogers selected and used a trust structure to attempt to gain

the same tax benefits for himself and various investor-cli-

ents.

Respondent has challenged all of the partially worthless

bad debt deductions under section 166, for the partnerships 4

2 All section references are to the Internal Revenue Code of 1986 (Code),

as amended and in effect for the tax years at issue, and all Rule references

are to the U.S. Tax Court Rules of Practice and Procedure.

3 The American Jobs Creation Act of 2004 (AJCA), Pub. L. No. 108–357,

sec. 833, 118 Stat. at 1589, amended secs. 704, 734, and 743 effective for

transactions entered into after October 22, 2004. Sec. 704 as amended pro-

vides that in the case of contributions of built-in loss property to a partner-

ship, the built-in loss may be taken into account only by the contributing

partner and may not be allocated to a different partner.

4 Mr. Rogers used limited liability companies in these transactions. In

(322) KENNA TRADING, LLC v. COMMISSIONER 325

involved in the 2004 tax year 5 as well as for Mr. Rogers and

his wife, Frances Rogers, who claimed a section 166 deduc-

tion on their individual tax return for 2005 using the trust

variant. We consolidated the Rogerses’ case with the partner-

ship cases for the purpose of resolving only the section 166

deduction issue in that case. 6

Respondent also challenged certain aspects of the 2004 and

2005 partnership returns of Sugarloaf Fund, LLC

(Sugarloaf ), the common ancestor in the many-branched

family tree of partnerships and trusts through which inves-

part because they are treated as partnerships for Federal income tax pur-

poses, see sec. 301.7701–3(a), Proced. & Admin. Regs., we refer to them as

such.

5 One partnership, Zurichsee Trading, LLC, docket No. 13980–09,

claimed a sec. 166 deduction on its 2005 Federal income tax return, and

respondent issued a notice of final partnership administrative adjustment

(FPAA) for this year.

6 Mr. Rogers on brief asserts that his wife is entitled to innocent spouse

relief. We did not try this issue and do not decide it here. We likewise do

not decide whether respondent properly determined penalties against the

Rogerses.

Along with Mr. Rogers, Gary R. Fears, petitioner in docket No. 27636–

09, invested in the trust structure in 2005. As with the Rogerses’ case, we

consolidated Mr. Fears’ case solely for the purpose of resolving the sec. 166

deduction at issue there. Although Mr. Fears and respondent have entered

into a stipulation of settled issues concerning the deficiencies in his case,

the secs. 6662(a) and (h) and 6662A penalties allegedly flowing from those

deficiencies, which themselves stem from the sec. 166 deduction’s disallow-

ance, remain in dispute. Mr. Fears’ case remains consolidated for purposes

of this Opinion because our redetermination in this partnership-level pro-

ceeding of penalties determined against Sugarloaf could potentially affect

Mr. Fears, notwithstanding that he held an interest in a lower tier entity.

See sec. 6226(f); United States v. Woods, 571 U.S. ll, ll, 134 S. Ct.

557, 564 (2013) (holding ‘‘that TEFRA gives courts in partnership-level

proceedings jurisdiction to determine the applicability of any penalty that

could result from an adjustment to a partnership item, even if imposing

the penalty would also require determining affected or nonpartnership

items such as outside basis’’). Mr. Fears resides in St. Louis, Missouri,

which lies within the jurisdiction of the U.S. Court of Appeals for the

Eighth Circuit. Before Woods, that Court of Appeals held, in the context

of a gross valuation misstatement penalty determined against a sham

partnership, that ‘‘outside basis is an affected item that must be deter-

mined at the partner level’’ before a penalty determined at the partnership

level may be imposed. See Thompson v. Commissioner, 729 F.3d 869, 873

(2013), rev’g and remanding 137 T.C. 220 (2011). Thus, as stated in our

order of May 3, 2013, we intend to return Mr. Fears’ case to the general

docket after issuance of this Opinion.

326 143 UNITED STATES TAX COURT REPORTS (322)

tors in Mr. Rogers’ shelters claimed tax losses. First,

respondent alleges that Sugarloaf overstated its cost of goods

sold for 2004 and 2005 on account of inflated tax bases of

sold partnership interests. In addition, after concessions,

respondent alleges adjustments to Sugarloaf ’s partnership

income due to alleged underreported income of $299,996 and

$925,467 for the 2004 and 2005 taxable years, respectively. 7

Respondent also disallowed a number of Sugarloaf ’s claimed

deductions, amounting to $747,069 for the 2004 tax year and

$982,436 for the 2005 tax year, as unsubstantiated.

Respondent determined against Sugarloaf for each tax year

a section 6662(a) and (h) penalty for a gross valuation

misstatement, a section 6662(a) penalty on the amount of the

underpayment attributable to each year’s disallowed deduc-

tions, and a section 6662A penalty for understatements

attributable to undisclosed reportable or listed transactions.

Against the lower tier partnerships whose cases were tried

with Sugarloaf ’s, respondent determined penalties under sec-

tion 6662(a) and (h) due to gross valuation misstatements

and section 6662(a) and (b)(1), (2), and (3) penalties due to

negligence, substantial understatements of income tax, and

substantial valuation misstatements.

Jetstream, as tax matters partner for Sugarloaf and each

of the other partnerships whose cases we consolidated with

Sugarloaf ’s for trial, petitioned this Court for readjustment

of partnership items and redetermination of penalties. 8

In this Opinion, we resolve: (1) whether Jetstream and the

Brazilian retailers formed a bona fide partnership for Fed-

eral income tax purposes for purposes of servicing and col-

lecting distressed consumer receivables owed to the retailers;

(2) whether the Brazilian retailers made valid contributions

of the receivables to the purported partnership under section

721; (3) whether the retailers’ claimed contributions to and

subsequent redemptions from Sugarloaf should be collapsed

7 Respondent and Jetstream Business Limited (Jetstream), Sugarloaf ’s

tax matters partner, entered into a stipulation of settled issues reducing

the unreported income from $1,549,692 for 2004 and $1,227,467 for 2005

to the amounts stated above.

8 Jetstream was represented in this litigation by its officer, Mr. Rogers,

who also represented himself and his wife in their consolidated individual

tax case. Throughout this Opinion, we frequently refer to petitioners,

whether jointly or individually, simply as Mr. Rogers.

(322) KENNA TRADING, LLC v. COMMISSIONER 327

into a single transaction and treated as a sale of the receiv-

ables, such that the receivables had a cost basis under sec-

tion 1012 rather than a carryover basis under section 723; (4)

whether the 2004 partnership transactions had economic

substance; (5) whether the 2004 partnership transactions

satisfied the statutory prerequisites for a section 166 deduc-

tion; (6) whether the 2005 trust transactions should be col-

lapsed into sales or lacked economic substance, such that Mr.

and Mrs. Rogers’ trust investment would not entitle them to

a section 166 deduction for 2005; (7) whether Sugarloaf

understated gross income for the 2004 and 2005 tax years;

(8) whether Sugarloaf is entitled to various deductions for

the 2004 and 2005 tax years; (9) whether Sugarloaf and the

other partnerships are liable for section 6662(a) penalties;

and (10) whether Sugarloaf is liable for the section 6662A

penalty.

We hold for respondent on all issues. 9

FINDINGS OF FACT

The parties’ stipulation of facts, supplemental stipulation

of facts, and second supplemental stipulation of facts, all

with the facts found from the accompanying exhibits, are

incorporated herein by this reference, as are all stipulations

of settled issues filed in various of these consolidated cases. 10

The parties have stipulated that venue for appeal would be

the Court of Appeals for the Seventh Circuit.

I. The Mastermind: John E. Rogers

The central individual in these cases is John Rogers.

During the years at issue Mr. Rogers was a partner at the

Chicago-based law firm Seyfarth Shaw. As we have pre-

viously found, Mr. Rogers

9 With regard to Sugarloaf, our analyses and holdings as to questions

(1)–(5) represent alternative reasons, all of which, when applied, result in

the same ultimate tax result. Similarly, with regard to the trust shelter,

we offer alternative analyses and holdings on question (6).

10 Petitioners objected to a number of the stipulations and stipulated ex-

hibits on the grounds of relevance. According to Fed. R. Evid. R. 401: ‘‘Evi-

dence is relevant if: (a) it has any tendency to make a fact more or less

probable than it would be without the evidence; and (b) the fact is of con-

sequence in determining the action.’’ We find the stipulations and stipu-

lated exhibits relevant and consequently overrule petitioners’ objections.

328 143 UNITED STATES TAX COURT REPORTS (322)

started his professional career in 1969 at the now-dissolved accounting

firm Arthur Andersen, where he rose through the ranks to eventually

become an equity partner. [Mr.] Rogers left Arthur Andersen in 1991

and went to work for a startup medical device company called Reddy

Laboratories. The venture failed after the Food and Drug Administration

denied the company’s application for a license. In 1992 [Mr.] Rogers

joined FMC Corp., a $5 billion company with operations in over 100

countries. [Mr.] Rogers served as FMC Corp.’s director of taxes and

assistant treasurer through 1997.

In 1998 [Mr.] Rogers became an equity partner in Altheimer & Gray,

a full-service law firm headquartered in Chicago, Illinois, with offices in

Eastern Europe. Altheimer & Gray dissolved in 2003, and [Mr.] Rogers

joined the Seyfarth Shaw, LLP (Seyfarth Shaw), law firm in July of that

year. * * * [Mr.] Rogers left Seyfarth at the end of May 2008, when he

opened his own firm, Rogers & Associates.

[Superior Trading, LLC v. Commissioner, 137 T.C. at 75.]

Mr. Rogers during or before 2003 conceived a plan that he

contended would successfully invest in and manage dis-

tressed retail consumer receivables overseas and remit the

proceeds to the United States. He used a tiered partnership

structure in 2003 and most of 2004 and a tiered trust struc-

ture in 2005, 2006, and 2007 to sell interests to individual

investors. Mr. Rogers contended the business would profit

through aggressive collection efforts, translation gain from

currency speculation, and a planned initial public offering.

The first step under this plan was for Brazilian retailers to

‘‘contribute’’ receivables to a limited liability entity controlled

by Mr. Rogers, which, for U.S. tax purposes, would accede to

the tax basis of the retailers in the consumer debt.

In 2003 he used a limited liability company called Warwick

Trading, LLC, to purchase receivables from Lojas Arapua,

S.A. (Arapua), a Brazilian retailer of household appliances

and consumer electronics. In 2004 he used a different limited

liability company, Sugarloaf, to which two other Brazilian

retailers, Globex Utilidades, S.A. (Globex), and Companhia

Brasileira de Distribuic¸a˜o (CBD), also ‘‘contributed’’ dis-

tressed accounts receivable for interests in that company. In

2004 Sugarloaf contributed a tranche of those assets to other

limited liability companies (trading companies). Sugarloaf

then contributed most or all of its interest in the trading

companies to yet other limited liability companies (holding

companies). In 2005 Sugarloaf ‘‘contributed’’ assets to trusts

(main trusts), which each created another trust (subtrust).

The main trust assigned the beneficial interests of the receiv-

(322) KENNA TRADING, LLC v. COMMISSIONER 329

ables in the subtrust to an investor who contributed money

to the main trust. In both years Sugarloaf and the trading

companies entered loan management and servicing agree-

ments with a British Virgin Islands company called

Multicred Investments Limited and/or a Brazilian company

called Multicred Investimentos Limitada. Renato

Mazzucchelli and Jennifer Dowek were both intimately

involved in the management and operation if not also the

ownership of these companies. While the parties dispute the

significance of these two companies and Mr. Rogers alleges

that the British Virgin Islands company engaged in some

sort of scheme to defraud, such a dispute is irrelevant to

these cases, and we find that for practical purposes the

companies are the same and refer to them interchangeably

as Multicred.

Mr. Rogers formed Sugarloaf through entities he owned

and controlled. He was the sole owner of an S corporation,

Portfolio Properties, Inc. (PPI), which owned Jetstream, at

that time a British Virgin Islands company. On April 17,

2003, Mr. Rogers, through Jetstream, formed Sugarloaf, a

Delaware limited liability company. According to the oper-

ating agreement, Jetstream was the initial manager. On July

23, 2003, Mr. Rogers sent an engagement letter to Mr.

Mazzucchelli as ‘‘Managing Member’’ of Sugarloaf by which

Sugarloaf agreed to retain Seyfarth Shaw as its legal

counsel. In August Mr. Rogers represented to Seyfarth Shaw

that the owners of Sugarloaf were Mr. Mazzucchelli and Ms.

Dowek. He never disclosed Jetstream’s ownership, which was

100% at that time.

II. The Receivables: The Brazilian Connection

A. Arapua

On July 1, 2004, Sugarloaf and Arapua entered into a con-

tribution agreement by which Arapua agreed to ‘‘contribute’’

distressed consumer receivables with an outstanding balance

of R$37,765,501 to Sugarloaf in exchange for a 99% member-

ship interest. 11 Sugarloaf later disposed of these receivables

11 When we refer to receivables of the three Brazilian retailers, we refer

to checks written by consumers for products. Brazilian companies at the

time generally lacked sufficient purchase-with-financing installment sales

Continued

330 143 UNITED STATES TAX COURT REPORTS (322)

in a transaction not necessarily at issue in these cases. Mr.

Rogers signed this contribution agreement as manager of

Sugarloaf.

B. Globex

In July 2004 Sugarloaf entered into a contribution agree-

ment with Globex, a consumer-goods retailer doing business

under the name Ponto Frio. According to the contribution

agreement, Globex contributed receivables with an out-

standing balance of R$219,087,756.03 in exchange for a 99%

membership interest in Sugarloaf. Mr. Rogers signed this

agreement as manager of Sugarloaf. 12

The parties provided three versions of the contribution

agreement: a Portuguese version, a certified English trans-

lation of that version, and the English version provided by

Mr. Rogers. A cursory comparison of the certified English

translation and Mr. Rogers’ version reveals that Mr. Rogers’

and the Portuguese versions are not reliable translations of

one another. One difference is that, according to the certified

English translation, Sugarloaf represented that it ‘‘is aware

that, for purposes of Brazilian law, taxes were lowered for

accounting and tax purposes for the majority of the tax

credits of most objects of this instrument, although it had not

been lowered for the purpose of American law.’’ The version

facilities and in lieu thereof had the practice of extending credit to con-

sumers whereby the consumer would write a series of postdated checks

and the retailer would deposit those checks on the appropriate day. The

receivables in these cases are distressed, meaning that they are past due.

The average age of the sampled receivables as of the date of contribution

to Sugarloaf was 5.2 years in the case of CBD and 6.6 years in the case

of Globex. The contributed receivables’ value in Brazilian reais was not

stated in the CBD contribution agreement but was to be provided in a

schedule I to the agreement. However, no schedule I was attached to the

translated version of the agreement Mr. Rogers placed in evidence and

submitted to the Court. The same was true of the translated Globex con-

tribution agreement offered by Mr. Rogers, discussed infra p. 331.

12 According to the Arapua contribution agreement, Arapua already

owned 99% of Sugarloaf. The transfer of a 99% interest to Globex is a

mathematical impossibility. And, as discussed infra pp. 332–334, CBD en-

tered a contribution agreement whereby it ostensibly received a 17% mem-

bership interest. Mr. Rogers contends that the subsequent contribution

agreements merely diluted the previous ownership. But these numbers

cannot be reconciled, and they support our finding, see infra pp. 351–353,

that the parties did not intend to form a partnership.

(322) KENNA TRADING, LLC v. COMMISSIONER 331

provided by Mr. Rogers lacks identical or even analogous lan-

guage.

Mr. Rogers’ version of the contribution agreement pur-

ported to have attached an exhibit A which set forth all of

the receivables contributed. The certified English translation

included an annex I, which stated in part: ‘‘The data related

to the Credits are recorded on a CD–Rom delivered in this

act by GLOBEX to the Fund [Sugarloaf]’’. The parties stipu-

lated that neither exhibit A nor the media referenced in

annex I were attached to the agreements.

One of the individuals promoting the shelter for Mr.

Rogers, Michael Hartigan, sent money in 2004 to Multicred,

which passed on a portion of that money to Globex as

indicated in a January 5, 2005, email from Ms. Dowek to Mr.

Rogers. These payments were, in Mr. Rogers’ own words,

‘‘constructive distributions from Warwick or Sugarloaf.’’ In

2005 Mr. Hartigan sent money received from the investors,

less his fees, directly to the credit of the trusts. 13

At some point, Globex requested a partial redemption of its

membership interest. Initially Globex requested a 13.24%

partial redemption and apparently later requested a larger or

complete redemption. In the spring of 2006 Ms. Dowek sent

two emails to Mr. Rogers telling him that Globex needed

documentation showing the sale of its interest in Sugarloaf.

On December 15, 2006, Mr. Rogers wired $300,000 to a bank

account in the name of Globalstores, S.A. A week or so later,

Ms. Dowek wrote the following to Mr. Rogers: ‘‘Bought more

from Globex . . . Global Store . . . so please send $650K

instead of $350K.’’ Mr. Rogers agreed and on December 28,

2006, wired an additional $650,000 to the account of

Globalstores, S.A. Further correspondence between Mr.

Rogers and the various parties involved in these transactions

demonstrates an intent to redeem Globex out of Sugarloaf.

In April 2007 Mr. Rogers expressed concerns to Multicred

that Globex never transferred the distressed assets to

Sugarloaf. He asked Multicred for proof of a transfer before

2006, which was when collections on the Globex receivables

began. The parties stipulated that Globex retained custody of

the receivables until at least March 28, 2007.

13 See infra pp. 342–344.

332 143 UNITED STATES TAX COURT REPORTS (322)

C. CBD

In the fall of 2004 Sugarloaf and Multicred were negoti-

ating the acquisition of receivables from another Brazilian

retailer, CBD, a large supermarket chain in Brazil which

operated some stores under the brand name Pa˜o de

Ac¸u´car. 14 Early drafts of agreements from Multicred indicate

that as of August 3, 2004, Sugarloaf and CBD intended to

enter into a purchase-sale agreement. On October 1, 2004,

Sugarloaf and Multicred entered into a contribution agree-

ment with CBD. Once again, there are several versions of

this contribution agreement: one copy in Portuguese, a cer-

tified English translation of the Portuguese version, and an

English-language version provided by Mr. Rogers. While,

from their cover pages, the Portuguese version and Mr.

Rogers’ version appear to be translations of one another, a

cursory examination of the format of the body of the agree-

ment in each version quickly reveals that they are not

accurate translations.

The certified English translation only confirms that Mr.

Rogers’ version and the Portuguese version are different

documents. The certified translation and Mr. Rogers’ version

both state that CBD received a 17% membership interest in

Sugarloaf in exchange for a contribution of receivables con-

tracts. Mr. Rogers’ version indicates that the subject receiv-

ables contracts are listed in schedule I, which itself refers to

an attached ‘‘diskette’’ (although apparently Mr. Rogers

never received a copy), while the certified translation

includes an annex I which references a contemporaneously

delivered CD–ROM and provides a detailed key to the data

supposedly contained thereon. Mr. Rogers’ version and the

certified translation both state that the receivables had an

outstanding balance of R$154,630,651.15. Only the certified

translation, however, discloses that the value of these receiv-

ables was R$1,855,568. Further, according to the certified

translation, the Portuguese document is an agreement

between CBD, Sugarloaf (with Mr. Rogers signing as man-

ager), and Multicred (with Mr. Mazzucchelli signing on its

behalf ). Mr. Rogers’ version, however, is an agreement

between only CBD and Sugarloaf, with Mr. Rogers again

14 The parties often refer to CBD as CBD/PDA or PDA. For convenience,

we use CBD.

(322) KENNA TRADING, LLC v. COMMISSIONER 333

signing as manager. Finally, Mr. Rogers’ version contains a

representation by CBD that it had not taken action with

respect to the receivables that would constitute a charge-off

under section 166. The certified translation contains no such

representation.

Sugarloaf, CBD, and Multicred entered the contribution

agreement with the understanding that CBD would be

redeemed out for cash shortly. On December 22, 2004,

Sugarloaf loaned Multicred $800,000 pursuant to a promis-

sory note. According to an October 21, 2007, email from Mr.

Rogers: ‘‘The $800,000 was used to redeem out PDA.’’ 15

Multicred then purchased CBD’s 17% interest in Sugarloaf

for R$1,855,568 on December 29, 2004. On October 14, 2005,

Multicred assigned its interest in Sugarloaf to an entity

called Sugarloaf Investimentos Limitada (Sugarloaf

Limitada), which was owned by Sugarloaf and controlled by

Mr. Rogers, in exchange for Sugarloaf Limitada’s assumption

of the obligations to Sugarloaf under the $800,000 promis-

sory note. Sugarloaf, through Mr. Rogers, was a party to this

agreement. On September 22, 2006, Sugarloaf Limitada sold

the 17% interest in Sugarloaf back to Sugarloaf, and it paid

off three-quarters of the promissory note. Mr. Rogers signed

this agreement on behalf of both Sugarloaf and Sugarloaf

Limitada. Sugarloaf Limitada paid the remaining balance

due on the note in 2007. The Sugarloaf purchase agreement

refers to these transactions as ‘‘stage’’ or ‘‘stages’’.

In addition, the record contains hints that a shadow invest-

ment group may have been involved in the purchase of the

CBD receivables. An email from Ms. Dowek says: ‘‘[W]e will

have four or five investors purchasing their [CBD’s] interest

and * * * Multicred will act as agent for them.’’ Additional

documents implicate an entity named Sugarloaf Overseas,

Ltd. (Sugarloaf Overseas), in this shadow investment group;

it received $1 million from Sugarloaf as payment for assets

on or about February 26, 2006. Mr. Rogers repeatedly denied

knowing Sugarloaf Overseas and claimed that he could

remember no reason why Sugarloaf would have made the $1

million transfer. We do not credit his testimony and believe

that Mr. Rogers knew, at the time, what Sugarloaf Overseas

15 PDA and CBD are one and the same. See supra note 14.

334 143 UNITED STATES TAX COURT REPORTS (322)

was and also what its role was, however murky to us, in the

CBD buyout.

D. Collections

As mentioned, collections on the Globex receivables did not

begin until 2006 at the earliest. As for the other receivables,

Multicred did not have collection data available for 2004. Mr.

Rogers therefore used R$2,656, or about USD$1,000, as the

collections reported for each investor in 2004.

E. Valuation and Performance

Sugarloaf received valuations for the CBD and the Globex

receivables from Financial Management Control, Ltda.

(FMC). Both these letters were dated October 1, 2004, but

the parties stipulated that Sugarloaf did not receive the let-

ters until 2007. The letters are almost identical. The FMC

letter for Globex opined that the fair market value of the

receivables, which had an average age of six to seven years

and average balance of R$500, was 6% of the notional face

value amount. FMC concluded that the CBD receivables had

an average age of three years and average balance of R$300

and were also worth 6% of the notional face value amount.

These appraisal letters bear a remarkable similarity to an

appraisal letter written by a company called Lourenc¸o

Assessoria e Recuperadora de Cre´dito Ltda. (LARC) for War-

wick. The LARC appraisal letter purported to appraise

Arapua receivables at, again, 6% of the notional face value

amount.

At the trial and without objection, respondent offered John

D. Finnerty as an expert in valuation of fixed income invest-

ments. The Court accepted Dr. Finnerty as such an expert

and received his report into evidence. Dr. Finnerty used a

discounted cashflow method which took into account similar

assets, expected net cashflow, and the collection expenses at

the time of acquisition. He concluded that the Globex receiv-

ables had a fair market value of at most 0.5% of the notional

face value amount and that the CBD receivables had a fair

market value of at most 0.8% of the notional face value

amount.

Dr. Finnerty also dismissed the FMC valuations as being

internally inconsistent and containing flawed reasoning. For

example, the FMC valuations purport to use the comparables

(322) KENNA TRADING, LLC v. COMMISSIONER 335

method, the replacement method, and the discounted

cashflow method to arrive at the 6% figure. But the letters

state that the comparables method yields a 2% to 4% valu-

ation and the replacement method yields a 2% valuation for

the CBD receivables and a 3% valuation for the Globex

receivables. The letters do not discuss a specific value deter-

mined using the discounted cashflow method and why such

a method would result in higher valuations. So, it is not clear

how FMC arrived at the 6% valuations. Furthermore, the

FMC letters purport to affirm the discounted cashflow anal-

ysis provided by Multicred without mentioning what valu-

ation that method yields. Finally, FMC fails to explain why

it gave identical valuations to two sets of receivables despite

significantly different characteristics, such as the age and

average balance per account of the receivables. The Court is

left to assume that the $200 higher average balance of the

Globex receivables exactly balanced out the fact that their

average age was three to four years older than the CBD

receivables so that each group was worth 6% of face.

At trial and without objection, the Court accepted respond-

ent’s witness Martin D. Hanan as an expert in business valu-

ation and received his report into evidence. Mr. Hanan’s

extensive report opined as to the expected and actual pretax

and after-tax rates of return from the investments at issue

in these cases. He reviewed the amounts paid by investors,

the collections allegedly made, and other data. He concluded

that an after-tax rate of return was positive only because of

the tax benefit afforded by the section 166 deduction. Mr.

Hanan concluded that the exorbitant fees and the exchange

rate at the time of the origination of the receivables contrib-

uted heavily to the negative pretax rates of return. Only Mr.

Hartigan’s investment, on his own behalf, stood a chance of

realizing a profit because Mr. Hartigan waived his own fee.

Mr. Hannan concluded that a reasonable investor would not

have invested in this transaction but for the tax benefit. The

Court does note that Mr. Hannan’s analysis assumes a con-

stant exchange rate of 2.00 Brazilian reais to the U.S. dollar.

Mr. Rogers with some reasonable basis for his conclusions

believed the Brazilian real was undervalued and would

appreciate vis-a-vis the dollar within a reasonable invest-

ment period. Investors may have thought likewise.

336 143 UNITED STATES TAX COURT REPORTS (322)

F. Other Problems With the Receivables

At trial and without objection, the Court accepted respond-

ent’s witness Sergio Tostes as an expert in Brazilian

commercial taxation law. Mr. Tostes reported that the con-

tribution agreement between Globex and Sugarloaf was illicit

under Brazilian law because it purported to assign a 99%

interest in Sugarloaf to Globex. According to Mr. Tostes,

because Arapua already owned a 99% interest, the Globex

contribution agreement was legally impossible. Mr. Tostes

opined that the CBD agreement is similarly invalid under

Brazilian law.

III. The 2004 Partnership Structure: Your DAD’s Tax Shelter

The 2004 partnership shelters essentially mirror the Dis-

tressed Asset/Debt or ‘‘DAD’’ shelter structure we described

in Superior Trading, LLC v. Commissioner, 137 T.C. at 71–

73.

A. The Typical Structure

Mr. Rogers typically structured the 2004 shelters as fol-

lows. Jetstream and Sugarloaf would create a trading com-

pany, an Illinois limited liability company, with Jetstream

contributing a nominal amount of cash (e.g., $1,500) for a 1%

membership interest and Sugarloaf contributing distressed

assets. The contribution agreement between Sugarloaf and

the trading company would state that Sugarloaf was contrib-

uting a portfolio of notes. The contribution agreement would

also state that exhibit A would set forth the notes contrib-

uted, but this exhibit was never prepared for any of the 2004

transactions. 16

Jetstream and Sugarloaf would then form a holding com-

pany, also an Illinois limited liability company, with Jet-

stream contributing a nominal amount of cash for a 1%

interest and Sugarloaf contributing a 99% interest in a

trading company in exchange for a 99% interest. Next,

16 In its reply brief at 114, Jetstream states: ‘‘The schedules were pre-

pared and were provided to IRS [Internal Revenue Service] auditors.

Mazzucchelli retained the original version.’’ This contention directly con-

tradicts paragraph 147 of the parties’ trial stipulation, which states in

part: ‘‘Exhibit A to the Contribution Agreements between Sugarloaf and

each trading company was never prepared.’’ To the extent that Jetstream’s

objection requests to be relieved of the stipulation, we reject that request.

(322) KENNA TRADING, LLC v. COMMISSIONER 337

Sugarloaf would sell its 99% interest or, in some cases, a 98%

interest, in the holding company to an investor. 17 Two

individuals marketed the Sugarloaf transactions for Mr.

Rogers, Mr. Thomas Agresti and Mr. Hartigan. The investor

would pay a percentage of the U.S. dollar notional amount of

the receivables, and the size of that percentage depended on

whether the investor purchased the interest through Mr.

Hartigan or Mr. Agresti. Jetstream would retain a 1%

interest in each trading company and each holding company

and would act as tax matters partner for both companies.

Sugarloaf would retain a 1% interest in each trading com-

pany and for the most part in each holding company.

Numerous iterations of this sequence took place.

The investors’ contribution agreements incorrectly stated

the value of the outstanding balance of the receivables

contributed. For instance, the Bielersee contribution agree-

ment states that Sugarloaf contributed assets with an out-

standing balance of R$2,500,000. But, on its Form 1065, U.S.

Return of Partnership Income, Bielersee reported a section

166 loss of $2,425,000, or 97% of $2,500,000. That amount,

in Brazilian currency, would be greater than R$2,500,000. In

any event, the amount contributed to the partnership

depended on the size of the tax deduction the investor

sought.

Generally, Mr. Agresti’s clients paid 8% of the U.S. dollar

notional amount, while Mr. Hartigan’s clients paid 15%. Of

those amounts, between 4% and 5% went to Sugarloaf or PPI

as the purchase price of the receivables. Another 2% to 3%

represented an amount retained by Sugarloaf for professional

and operating expenses. Mr. Rogers gave discounts to his two

promoters. Mr. Hartigan paid only 1.75% to Sugarloaf to buy

into the shelter, and Mr. Agresti paid 4%. Like the percent-

age paid, the source of the receivables also depended on

17 It is not always clear how much of an interest Sugarloaf retained in

a particular holding company. The parties stipulated that Sugarloaf re-

tained ‘‘for the most part, a 1% interest in each holding company.’’ Jet-

stream, on brief, contends that ‘‘Sugarloaf retained no interest in a holding

company.’’ The documentary evidence is similarly contradictory. For exam-

ple, in the case of Bielersee Trading, LLC (Bielersee), Sugarloaf purported

to contribute a 98% interest in Bielersee to Alber Fund, LLC (Alber), in

exchange for a 99% membership interest in Alber. Sugarloaf then pur-

ported to sell its entire 99% interest in Alber to the investor, RD3J, Ltd.

338 143 UNITED STATES TAX COURT REPORTS (322)

whose client the investor was. For Mr. Agresti’s clients,

Sugarloaf contributed CBD receivables. For Mr. Hartigan’s

clients, Sugarloaf used Globex receivables.

The formation of R B Taylor Trading, LLC (R B Taylor),

is an exception from the general pattern. The documents

indicate that Warwick, on July 17, 2004, contributed the

receivables to R B Taylor in exchange for membership

interests; that Warwick, on July 18, 2004, contributed 98%

of R B Taylor to a holding company, Chipping Wood Fund,

LLC; and that Warwick then sold 99% of the holding com-

pany on July 26, 2004, to the investors, Russell and Betsy

Taylor. R B Taylor claimed a section 166 bad debt loss of

$11,640,000 in 2004. A document purporting to be an inven-

tory of receivables transferred to and owned by R B Taylor

lists Globex receivables, which Warwick did not have. The

investor was a client of Mr. Hartigan’s. We find that, to the

extent there was a partnership formed, Sugarloaf, not War-

wick, was the initial contributing entity. 18

In addition to a contribution agreement, each investor also

had to enter into a subscription agreement. This agreement

allowed the investor to establish sufficient tax basis in the

partnership interest to claim the deduction flowing from the

anticipated section 166 bad debt charge-off. The amounts of

the subscription agreements were generally the same as the

U.S. dollar notional amounts of the receivables less any pur-

chase price paid. Some investors used promissory notes in

favor of Sugarloaf to obtain the necessary tax basis in their

partnership interests.

B. The Music Stops

In October 2004 Congress passed the American Jobs Cre-

ation Act of 2004 (AJCA), Pub. L. No. 108–357 sec. 833, 118

Stat. at 1589, which sharply curtailed the tax benefits of the

partnership structure used by Mr. Rogers and Sugarloaf in

2004 by amending sections 704, 734, and 743. The relevant

provisions had an effective date of October 20, 2004. Mr.

Rogers determined that if an investor signed a letter of

intent to purchase a partnership interest before that date,

18 We are disappointed that the parties did not provide the Court with

a complete rather than a partial copy of R B Taylor’s 2004 partnership re-

turn, which could have assisted the Court with this finding of fact.

(322) KENNA TRADING, LLC v. COMMISSIONER 339

the partner would still be entitled to deduct the built-in

losses from subsequently contributed receivables. In addition,

if a potential investor signed a letter of intent but then

backed out of the deal, Mr. Rogers determined that a new

investor could be substituted for the original investor despite

not having signed a letter of intent before the effective date

of the AJCA.

C. The Underlying Investors

Most of the individual investors in these partnerships have

settled the underlying tax liability issues. In some cases the

investors filed notices of election to participate under section

6226(c) and Rule 245(b) in the Tax Court cases for the

trading companies in which they indirectly invested. Most of

these investors have settled and have entered into stipula-

tions of settlement with respondent. 19 But these stipulations

settle these trading company cases only as to the distributive

shares of the settling partners. Furthermore, Mr. Hartigan

remains an officer for participating partners in four cases. At

trial, Mr. Rogers, Mr. Hartigan, and respondent disagreed as

to the proper tax matters partner of Knight Trading, LLC,

docket No. 9121–08. We asked the parties to submit status

reports on this subject, and only respondent submitted the

requested report. Mr. Hartigan did not produce any docu-

mentation showing that Paragon Fund, LLC, replaced Jet-

stream as the tax matters partner of Knight Trading, and in

the absence of other evidence, Jetstream is the proper tax

matters partner.

In addition, Windmere Fund, LLC, as tax matters partner

for Ironwood Trading, LLC, docket No. 19925–08, and

respondent have entered into a stipulation of settled issues

as to Windmere Fund’s partnership items. Jetstream initially

filed the petition on behalf of Ironwood Trading. Windmere

19 Respondent and the following participating partners entered into stip-

ulations of settled issues: Robert Greer, participating partner in docket No.

7555–08; Joel R. Baker, participating partner in docket No. 7625–08; Rus-

sell C. Taylor, participating partner in docket No. 9038–08; Mark Herbert,

participating partner in docket No. 9124–08; Michael Koretsky, partici-

pating partner in docket No. 19924–08; and Thomas Turner, participating

partner in docket No. 13980–09.

340 143 UNITED STATES TAX COURT REPORTS (322)

was subsequently substituted as the tax matters partner. 20

Because Jetstream initially filed the petition and retains a

1% interest in Ironwood, we treat Jetstream as a partici-

pating partner in these cases. Likewise, respondent and

Arrowhead Fund, LLC, as tax matters partner for Murtensee

Trading, LLC, docket No. 9040–08, 21 entered a stipulation of

settled issues as to Arrowhead Fund’s partnership items.

Again, Jetstream was the tax matters partner at the time

the petition was filed, and we treat Jetstream as a partici-

pating partner in these cases.

Finally, two participating investors have not yet settled:

Jonathan Greer, participating as the ultimate investor in

Grey Stone Trading, LLC, docket No. 7556–08, and Scott

Ray, participating as the ultimate investor in Thornhill

Trading, LLC, docket No. 9021–08. They did not appear at

trial and have waived any right to participate therein.

D. Returns and Adjustments

In 2004, Sugarloaf entered into at least 30 investment

deals using the tiered partnership structure described above

and distressed assets from Globex and CBD. The trading

companies in these deals all filed Forms 1065, which were

prepared by an employee of Mr. Rogers, Jonathan Gabel, and

signed by Mr. Rogers, and all claimed section 166 deductions.

Respondent issued FPAAs in these cases denying the fol-

lowing deductions:

Bad debt deduction

Partnership name sec. 166

Bielersee Trading, LLC ............................... $2,425,000

Bodensee Fund, LLC ................................... 4,850,000

Connemara Trading Group, LLC ............... 485,000

Cumnor Group, LLC ................................... 1,940,000

Davis Fund, LLC ......................................... 1,660,000

Dent-Blanche Fund, LLC ............................ 1,067,000

Essex Fund, LLC ......................................... 1,940,000

Grey Stone Trading, LLC ........................... 485,000

20 Participating partner Lancer A. Barton represents that he is Ironwood

Trading’s majority member through one or more pass-through entities, in-

cluding Windmere, in which he holds at least a majority interest.

21 Participating partner Christopher H. Brown represents that he is

Murtensee Trading’s majority member through one or more pass-through

entities, including Arrowhead, in which he holds at least a majority inter-

est.

(322) KENNA TRADING, LLC v. COMMISSIONER 341

Bad debt deduction

Partnership name sec. 166

Grand-Combin Fund, LLC .......................... 1,455,000

Harlan Fund, LLC ....................................... 1,455,000

Ironwood Trading, LLC ............................... 970,000

Kenna Trading, LLC ................................... 970,000

Knight Trading, LLC .................................. 4,365,000

Lakeview Trading, LLC .............................. 1,670,000

Larkspur Trading, LLC .............................. 970,000

Lyman Trading, LLC .................................. 4,850,000

Monte Rosa Trading, LLC .......................... 1,940,000

Murtensee Trading, LLC ............................ 3,977,000

Northgate Trading, LLC ............................. 970,000

Ofenpass Fund, LLC ................................... 2,910,000

Remington Trading, LLC ............................ 7,275,000

Ridgeway Trading, LLC .............................. 485,000

Riversedge Fund, LLC ................................ 2,910,000

Saddlebrook Trading, LLC ......................... 4,850,000

Suten Fund, LLC ......................................... 2,910,000

R B Taylor Trading, LLC ............................ 11,640,000

Thornhill Trading LLC ............................... 485,000

Turnberry Trading LLC .............................. 824,500

Warner Fund, LLC ...................................... 2,260,000

Zugersee Trading, LLC ............................... 3,880,000

Zurichsee Trading, LLC .............................. 2,538,000

Total .......................................................... 81,411,500

Most trading companies claimed the deduction for 2004.

Riversedge Fund, LLC (Riversedge), claimed a $450,000

deduction for 2004 and a $2,460,000 deduction for 2005. 22

Zurichsee Trading, LLC, claimed the deduction for 2005.

Zugersee Trading, LLC, claimed a $3,200,000 deduction for

2004 and a $680,000 deduction for 2005. Warner Fund, LLC,

claimed a $2,260,000 deduction for 2005. 23

In most cases, the trading company claimed a deduction

equal to 97% of the U.S. dollar notional value of the receiv-

ables. In other cases, the investor requested that a smaller

deduction be used for that tax year. Respondent timely

issued notices of final partnership administrative adjustment

(FPAA) to all trading companies disallowing their claimed

section 166 losses. Respondent also adjusted to zero deduc-

22 We note that Riversedge’s 2005 tax return is not in the record. We in-

stead rely on the FPAA issued for that year.

23 Warner Fund, LLC, also claimed a $650,000 deduction on its 2004 tax

return. Jetstream’s petition for that year, docket No. 19542–08, was dis-

missed as untimely.

342 143 UNITED STATES TAX COURT REPORTS (322)

tions claimed for amortization expenses and collection

expenses. Petitioners in these partnership cases timely filed

petitions for review of the partnership adjustments. 24

IV. The 2005 Trust Structure: DAD 2.0

Because Congress in late 2004 essentially eviscerated Mr.

Rogers’ 2004 shelter structure, Mr. Rogers moved toward a

similar structure that purported to use trusts to reach the

same end result. In this structure, two Illinois common law

business trusts, a main trust and a subtrust, replaced the

holding company and the trading company.

A. The Typical Structure

When an investor agreed to purchase the shelter,

Sugarloaf would form a main trust with Mr. Rogers as

trustee and Sugarloaf as the initial grantor and beneficiary.

Each trust would have its own bank account controlled by

Mr. Rogers. Sugarloaf would then contribute receivables

through a contribution agreement between Mr. Rogers, as

trustee of the main trust, and Sugarloaf. The contribution

agreement would include a schedule A stating: ‘‘See CD Rom

disk attached hereto describing the issuer name, date of

issuance, outstanding amount and other relevant data.’’ No

such media would be attached.

The investor would purchase a beneficial interest in the

main trust. Sugarloaf and Mr. Rogers would then create a

subtrust, allocate the receivables to the subtrust, and des-

ignate the investor as the beneficiary. The investor would

also receive a Series 2005–A Beneficial Interest Certificate

granting a 100% interest in the rights to the receivables in

the trust.

Investors in the trust structure usually paid between 5%

and 6% of the notional value of the receivables, which was

also the tax basis eventually claimed, plus fees charged by

the promoters to obtain their subtrust interests. 25 The pur-

chase money went into the main trust’s bank account, but

24 Jetstream, through its ‘‘Director’’, Mr. Rogers, filed petitions for them

as their tax matters partner.

25 For the 2005 transactions, the investors appear to have paid approxi-

mately 5% of the notional value of the receivables plus other fees. Other

evidence in the record suggests that for transactions in subsequent tax

years, the purchase price was 6%.

(322) KENNA TRADING, LLC v. COMMISSIONER 343

over the course of 2005, 2006, and 2007, these amounts were

essentially transferred to Sugarloaf. Even though the pur-

chase money went into the bank account Mr. Rogers estab-

lished for the main trust, the parties to the transaction

viewed the transaction as a purchase and not a contribution

of money to a trust account. For example, most investors

signed an Agreement for Purchase of Trust Beneficial

Interest. The compliance booklets, which investors received

and signed, cast the transaction as a purchase of a beneficial

interest in the main trust.

The investors, pursuant to the agreements creating the

subtrusts, had the power to transfer the certificates of bene-

ficial ownership. The only apparent restriction was that an

investor had to give notice to the trustee. Furthermore, an

investor could at any time choose to revoke and terminate

the subtrust in which that investor had acquired an interest.

During the revocation and termination, the investor was

entitled to direct the disposition of the subtrust assets.

Mr. Rogers prepared and filed for each main trust and

each subtrust a Form 1041, U.S. Income Tax Return for

Estates and Trusts. The returns indicated that each subtrust

was a grantor trust and attached Grantor Information State-

ments. These statements indicated that the investors were

the grantors and listed amounts for collection income, collec-

tion expenses, fiduciary expenses, legal expenses, and section

166 deductions. The main trusts’ returns indicated that the

investors were the beneficiaries and reported no gains or

losses.

Respondent issued notices of deficiency to the subtrust

investors. Some of these investors petitioned the Court for

redetermination. We consolidated some of those cases for

trial at the same time as the partnership and Sugarloaf

cases. All but Mr. and Mrs. Rogers and Gary R. Fears 26 have

settled with respondent, and we have since severed those

other individual tax cases from this group.

B. Sterling Ridge Trust

Mr. and Mrs. Rogers invested in the Sterling Ridge 2005–

A Subtrust through an S corporation wholly owned by Mrs.

Rogers, Sterling Ridge, Inc. Mr. Rogers was president of

26 See supra note 6.

344 143 UNITED STATES TAX COURT REPORTS (322)

Sterling Ridge. Sugarloaf contributed receivables to Sterling

Ridge 2005 Trust with a claimed tax basis of $5 million.

Sterling Ridge 2005 Trust allocated these receivables to the

Sterling Ridge 2005–A Subtrust. Sterling Ridge, Inc., pur-

chased the beneficial interest in Sterling Ridge 2005–A

Subtrust for $150,000. Sterling Ridge, Inc., sent the purchase

money to the Heritage Bank account of the Sterling Ridge

2005 Trust. Over the course of December 2005 $95,500 was

withdrawn from this bank account.

Mr. Rogers filed Forms 1041 for the main trust and the

subtrust for the tax years 2005 and 2006. On the subtrust’s

2005 Form 1041, he attached a Grantor Information State-

ment stating that Sterling Ridge, Inc., was the grantor. This

statement also listed collection income of $1,518, collection

expenses of $304, a fiduciary expense of $1,000, a legal

expense of $1,000, and a section 166 expense of $4,850,000.

On its 2006 Form 1041, the subtrust reported collecting

$39,232 of income and a collection expense of $19,616.

Sterling Ridge, Inc., on its 2005 Form 1120S, U.S. Income

Tax Return for an S Corporation, prepared by Mr. Rogers,

reported a loss of $3,282,119 almost entirely attributable to

the $4,850,000 section 166 deduction. 27 Mr. and Mrs. Rogers

reported this loss on their 2005 tax return, which they both

signed. Respondent timely issued a notice of deficiency for

2005 disallowing, among other determinations, the section

166 deduction that flowed through from Sterling Ridge. Mr.

and Mrs. Rogers timely petitioned this Court for redeter-

mination.

V. The Section 166 Deduction: Aggregate and Arbitrary

At no point did the participants in these transactions con-

duct any kind of study as to which of the receivables should

be written down. The individual receivables were not charged

off individually. Mr. Gabel’s handwritten notes after a 2005

meeting in Brazil reflect the reality that Multicred lacked the

resources to conduct a writeoff study. At one point, statistical

27 Sterling Ridge did not report the collection expense or the fiduciary ex-

pense from the 2005 Grantor Information Statement, and it is not clear

whether the legal expense and the collection income were included on its

return.

(322) KENNA TRADING, LLC v. COMMISSIONER 345

sampling was discussed, but such a sampling was never

done.

VI. The Hub: Searching for Sugarloaf

A. Uncertain Ownership

Evidence as to the purported owners of Sugarloaf is con-

tradictory. The three principal sources all provide conflicting

information. First, contribution agreements suggest that Jet-

stream owns a 1% interest in Sugarloaf, Arapua owns a 99%

interest in Sugarloaf, Globex owns a 99% interest in

Sugarloaf, and CBD owns a 17% interest in Sugarloaf.

Second, Sugarloaf ’s Quickbooks balance sheet for 2003 lists

Barnard, CITCO NV, Mr. Rogers, and Teviot as having

equity interests in Sugarloaf. 28 The 2004 yearend balance

sheet shows the same equity owners. The 2005 yearend bal-

ance sheet reflects that the following entities and persons

owned equity in Sugarloaf: Barnard, CITCO NV, Mr. Rogers,

Multicred, Sugarloaf Overseas, and Teviot. Mr. Rogers testi-

fied that Barnard, CITCO NV, and Teviot all made equity

investments in Sugarloaf. He also stated that the balance

sheets, with the 2005 yearend balance sheet time-stamped

October 2006, reflected only equity deposits that had been

recorded up to that point and that the equity portion of the

balance sheets was irrelevant. Third and finally, Schedules

K–1, Partner’s Share of Income, Deductions, Credits, etc.,

filed with Sugarloaf ’s 2004 and 2005 tax returns claimed

that Jetstream was a 1% capital and 0.1% profit and loss

owner, Warwick a 1% capital and 0.1% profit and loss owner,

CBD a 49% capital and 49.9% profit and loss owner, and

Globex a 49% capital and 49.9% profit and loss owner.

Additional evidence provides no clarity. With respect to

Teviot and Barnard, a May 3, 2005, email from Mr.

Mazzucchelli to Mr. Rogers lists investors in Sugarloaf.

These investors were Andrew Barnard for $100,000, Teviot

Investments, Ltd., for $100,000, and Warwick for $100,000.

Sugarloaf ’s bank accounts show wire transfer deposits in

28 According to Mr. Rogers, Teviot is Teviot Investments, Ltd., a com-

pany related to Mr. Mazzuchelli, and Barnard is Mr. Mazzuchelli’s father-

in-law. Somewhat surprisingly, the voluminous record in these cases af-

fords no meaningful information about CITCO NV.

346 143 UNITED STATES TAX COURT REPORTS (322)

December 2004 from Teviot and Barnard in the amounts of

$200,000 and $99,995, respectively.

A fax from Ms. Dowek to Mr. Rogers suggests that

Sugarloaf Overseas was due $950,000 on behalf of a PDA

Investor Group for acquisition of notes. Emails among the

parties suggest that Teviot and Barnard were involved, along

with Multicred and Mr. Rogers, in the purchase of the CBD

assets. Mr. Rogers also states that Sugarloaf Overseas

received a $1 million payment for the sale of CBD receivables

having a $47,500,000 notional face value.

B. Adjustments to Income

Respondent used the specific item method to reconstruct

Sugarloaf ’s income for the 2004 and 2005 tax years through

a bank deposits analysis. The only deposits remaining in dis-

pute for the 2004 tax year are:

Date Source Amount

12/1/2004 Teviot Investments Ltd. $200,000

12/20/2004 Andrew A. Barnard 99,995

Total 299,995

Mr. Rogers testified that these amounts represented equity

investments. He also testified that Mr. Mazzucchelli

approached him in 2010 demanding repayment of money Mr.

Barnard sent to Sugarloaf.

Respondent also alleges that the following deposits in 2005

constitute gross income to Sugarloaf:

Date Description1 Amount

7/28/05 Unknown—deposit from PPI $72,000

9/28/05 Multicred 49,982

11/10/05 Unknown—deposit from PPI 60,000

11/29/05 Kevin Walzter 100,000

11/30/05 Unknown—Sterling Ridge 87,500

12/7/05 M–D Medical Services 24,000

12/14/05 Betacom Inc. 180,000

12/19/05 Sugarloaf Overseas 249,985

12/23/05 Orchard Financial Group, LLC 60,000

12/29/05 Capital Preservation Services 12,000

12/30/05 CO Trust 30,000

(322) KENNA TRADING, LLC v. COMMISSIONER 347

Date Description1 Amount

Total 925,467

1 The Description column is gleaned from the bank state-

ments. Where the bank statements are missing or not

helpful, we use ‘‘unknown’’ followed by, for demonstrative

purposes, the description or source as listed in Sugarloaf ’s

Quickbooks reconciliation. This is not a finding that these

are necessarily the sources of the deposits because we do

not believe the Quickbooks data alone is a sufficiently reli-

able indicator of Sugarloaf ’s items of income and loss.

With respect to the July 28, 2005, $72,000 deposit, the par-

ties provided a customer receipt evidencing a deposit in that

amount, but it does not otherwise identify a source. Also in

the record are handwritten notes stating that the July

Sugarloaf bank statement is missing and purporting to show

that the $72,000 deposit was from ‘‘JER’’. The Sugarloaf

Quickbooks bank account reconciliation records the deposit

as a deposit from ‘‘PPI a/c’’.

The September 28, 2005, $49,982 deposit is reflected on

Sugarloaf ’s bank statement as a wire transfer from

Multicred. The Quickbooks reconciliation also records this

amount as a deposit from Multicred.

The bank account statement for Sugarloaf does not list any

detail beyond ‘‘deposit’’ for the $60,000 November 10, 2005,

deposit. The Quickbooks reconciliation describes this deposit

as a deposit from PPI and/or Mr. Rogers.

The bank account statement describes the $100,000

November 29, 2005, deposit as a wire transfer from Kevin

Waltzer. The Quickbooks reconciliation describes this deposit

as ‘‘Customer Deposits/Retainers’’.

The bank account statement lists no detail beyond

‘‘deposit’’ for the $87,500 November 30, 2005, deposit. The

Quickbooks reconciliation describes the deposit as a deposit

from Sterling Ridge.

The bank account statement describes the December 7,

2005, $24,000 deposit as a wire transfer from ‘‘M–D Medical

Services’’. The Quickbooks reconciliation describes this

deposit as ‘‘Customer Deposits/Retainers’’.

The bank account statement describes the December 14,

2005, $180,000 deposit as a wire transfer from ‘‘Betacom

Incorporated’’. The wire transfer information sheet lists a ref-

erence of ‘‘Betacom 2005 Trust’’. The Quickbooks reconcili-

348 143 UNITED STATES TAX COURT REPORTS (322)

ation describes this deposit as ‘‘Customer Deposits/

Retainers’’.

The bank account statement describes the December 19,

2005, $249,985 deposit as a wire transfer from Sugarloaf

Overseas. The Quickbooks reconciliation does not describe

this deposit in any meaningful way but does indicate it is a

deposit from Sugarloaf Overseas.

The bank account statement describes the December 23,

2005, $60,000 deposit as a wire transfer from Orchard Finan-

cial Group LLC. The wire transfer information sheet lists a

reference of ‘‘30000 - Lance Barton 2005 Fund 30000 - Brad

Black 2005 Fund’’. The Quickbooks reconciliation describes

this deposit as ‘‘Deposits from Barton (30,000) and Black

(30,000)’’.

The bank account statement describes the December 29,

2005, $12,000 deposit as a wire transfer from Capital

Preservation Services. The wire transfer information sheet

lists the same as well as a reference to ‘‘CPS 2005 Trust’’.

The Quickbooks reconciliation describes this deposit as ‘‘Cus-

tomer Deposits/ Retainers’’.

The bank account statement describes the December 30,

2005, $30,000 deposit as a wire transfer from CO Trust. The

Quickbooks reconciliation describes this deposit as from CO

Trust and contains Mr. Rogers’ initials.

C. Adjustments to COGS

In the FPAA respondent also adjusted Sugarloaf ’s reported

cost of goods sold. On its 2004 tax return, Sugarloaf reported

a cost of goods sold of $122,950,000. Sugarloaf claimed a cost

of goods sold for each holding company it sold to an investor

and took the position that the cost of goods sold was equal

to the claimed adjusted basis in the contributed receiv-

ables. 29

D. Disallowed Deductions

Sugarloaf claimed on its 2004 and 2005 tax returns the fol-

lowing miscellaneous deductions:

29 The total of the claimed adjusted bases of the receivables in the com-

panies at issue in these cases is $102,950,000. This amount does not in-

clude three transactions which are not part of these cases, for which the

total claimed adjusted basis is $20 million.

(322) KENNA TRADING, LLC v. COMMISSIONER 349

Deduction 2004 2005

Legal & professional fees $218,530 $345,743

Management fees 80,000 290,000

Consulting fees 430,000 78,312

Amortization 86 400

Meals & entertainment 280 ---

Accounting 18,120 27,229

Bank charges 53 73

Computer services --- 2,000

Office expense --- 2,679

Trust expense --- 236,000

Total 747,069 982,436

Respondent disallowed all deductions. Petitioner provided

Quickbooks account records and canceled checks purporting

to substantiate the expenses.

OPINION

Because this Opinion disposes of 10 discrete issues, see

supra pp. 326–327, we first offer a road map for the reader.

We begin with the big picture. In Part I we focus on

Sugarloaf, analyzing (1) whether it constitutes a bona fide

partnership for Federal income tax purposes, (2) whether the

Brazilian retailers made valid contributions to it under sec-

tion 721, (3) whether the step transaction doctrine should be

applied to collapse those claimed contributions and the

retailers’ subsequent redemptions into sales, such that the

receivables had a cost basis under section 1012 rather than

a carryover basis under section 723, (4) whether the 2004

partnership transactions had economic substance, and (5)

whether the statutory prerequisites for a section 166 deduc-

tion were satisfied. We then turn in Part II to (6) whether

Mr. and Mrs. Rogers’ trust investment entitles them to a sec-

tion 166 deduction for 2005, applying the analysis of Part I

to the trust structure in which the Rogerses invested. With

respect to Sugarloaf and the trust structure, we present our

analyses and holdings in the alternative.

We then turn to the details. In Part III we consider (7)

whether Sugarloaf understated gross income and/or (8) is

entitled to various deductions for the 2004 and 2005 tax

years. In Part IV, we resolve (9) whether Sugarloaf and the

other partnerships are liable for the section 6662(a) pen-

350 143 UNITED STATES TAX COURT REPORTS (322)

alties, and (10) whether Sugarloaf is liable for the section

6662A penalty.

I. Superior Trading Revisited

Section 723 states the general rule that the basis of prop-

erty a partner contributes to a partnership is a carryover tax

basis, which is the same adjusted basis as it had in the

hands of the contributing partner, increased by any gain rec-

ognized by the contributing partner under section 721(b).

Petitioners contend that the distressed, unpaid Brazilian

receivables contributed to Sugarloaf had the same tax basis

in the United States as they had in the hands of the Bra-

zilian retailers and that section 723 preserved the built-in

losses inherent in those receivables. Under their theory, sec-

tion 723 continued to operate upon and governed the subse-

quent contribution of the receivables to the trading compa-

nies. Petitioners allege that under section 722, Sugarloaf had

a basis in each trading company equal to the basis it had in

the receivables. When Sugarloaf contributed the trading com-

pany to the holding company, petitioners contend that

Sugarloaf again, under section 722, obtained a tax basis in

its interest in the holding company equal to its tax basis in

the trading company. Here petitioners contend that tax basis

was equal to the tax basis in the underlying receivables. And

when Sugarloaf sold the holding company, it sold it for a

fraction of its adjusted tax basis, resulting in a cost of goods

sold much higher than the purchase price.

The investors, when they bought their interests in the

holding companies, each took a cost basis. But they then

inflated their bases in their partnership interests through

contributions of cash, notes, or other property to the holding

companies. Thus, when a trading company claimed the sec-

tion 166 deduction, the investor could claim a corresponding

flowthrough deduction up to the full amount of his or her

basis in the holding company partnership.

As this recounting of petitioners’ theory illustrates, the

whole shelter revolves around the initial contribution of the

receivables and the shifting of the built-in loss from the tax-

indifferent Brazilian retailer to the tax-sensitive United

States taxpayer/investor. Up until October 22, 2004, such

shifting was theoretically possible because the inside basis

(322) KENNA TRADING, LLC v. COMMISSIONER 351

adjustment of section 743(b) was required only if the partner-

ship filed an election under section 754. Section 704(c)(1)(C)

now requires allocation of built-in losses to the partner

contributing the built-in loss property, and only to that

partner. A section 743(b) basis adjustment is now mandatory

upon any transfer of a partnership interest in a partnership

with a substantial built-in loss. In short, the partnership

version of the transaction as originally structured by Mr.

Rogers clearly no longer worked after October 22, 2004, even

according to Mr. Rogers’ interpretation of the law; thus, Mr.

Rogers substituted his trust structure. We add the caveat

concerning Mr. Rogers’ interpretation of the law because, for

all of the reasons we articulated in Superior Trading, his

structures were conceptually flawed, very clearly never

worked, and in any event were never fully implemented in

accordance with Mr. Rogers’ design.

Respondent attacks the 2004 partnership transactions

using a variety of analytical tools. He unscrews the partner-

ship itself, taking the position that Sugarloaf was not a valid

partnership because the parties did not intend to enter into

a partnership nor did the alleged ‘‘contributions’’ of receiv-

ables ever properly occur. He next saws through all the steps

undertaken by the parties and collapses them into simple

sales and purchases of receivables. Using the heaviest

hammer in the toolbox, he then smashes the entire trans-

action as lacking economic substance. Finally, large-scale

demolition completed, he pries apart the section 166 deduc-

tion piece by piece, contending that petitioners failed to prove

they satisfied the requisite statutory elements.

A. Still Not a Valid Partnership

As an initial matter, we ask whether the retailers and Jet-

stream formed a partnership. ‘‘Whether a valid partnership

exists for purposes of Federal tax law is governed by Federal

law. See Commissioner v. Culbertson, 337 U.S. 733, 737

(1949).’’ Superior Trading, LLC v. Commissioner, 137 T.C. at

81. The Supreme Court directs us to ask ‘‘ ‘whether the part-

ners really and truly intended to join together for the pur-

pose of carrying on the business and sharing in the profits

and losses or both.’ ’’ Commissioner v. Culbertson, 337 U.S. at

741 (quoting Commissioner v. Tower, 327 U.S. 280, 287

(1946)). The question is one of fact. Id. at 742.

352 143 UNITED STATES TAX COURT REPORTS (322)

Section 301.7701–3(a), Proced. & Admin. Regs., allows

‘‘[a]n eligible entity with at least two members * * * [to]

elect to be classified as * * * an association * * * or a part-

nership’’. If no election is made, the regulations by default

treat an eligible two-or-more-member entity as a partnership.

Sec. 301.7701–3(b)(i), Proced. & Admin. Regs. These so-called

check-the-box regulations do not supersede Culbertson

insofar as the putative members must still come together to

form an entity. See, e.g., Superior Trading, LLC v. Commis-

sioner, 728 F.3d at 680 (applying the tests of Culbertson and

Tower). And we do not believe or find that Jetstream, Globex,

Arapua, and/or CBD came together to form a partnership.

Nothing in the record convinces us that Jetstream, Globex,

and CBD intended to join together for the purposes of car-

rying on a debt collection business. Everything in the record

convinces us that Globex and CBD had every intention of

dumping their distressed receivables and that Jetstream

intended to sell a tax shelter.

Among many other indicators, the math in the contribution

agreements between Sugarloaf and Arapua, CBD, and

Globex just does not add up. According to these agreements,

the three Brazilian retailers own a collective 215% interest

in Sugarloaf. Mr. Rogers would have us believe that with

every new contribution agreement, the membership interests

of the current members were diluted to make room for the

new member. But he provides no contemporaneous acknowl-

edgment or assent from the members of such dilution of their

membership interests nor other corroborating evidence.

Their arithmetical flaws aside, the contribution agree-

ments highlight a second indicator that no partnership was

formed: They directly conflict with other evidence in the

record as to who Sugarloaf ’s purported partners even were.

Arapua, CBD, and Globex executed contribution agreements

suggesting that Jetstream was Sugarloaf ’s only other

partner. Sugarloaf ’s 2004 and 2005 tax returns identify Jet-

stream, CBD, and Globex as partners but exclude Arapua

and include Warwick. And Mr. Rogers testified that there are

at least three other equity partners in Sugarloaf whose cap-

ital interests do not appear on Sugarloaf ’s tax returns. There

is not a scrap of documentation of these supposed capital

interests outside of Quickbooks balance sheets, corroborated

only by Mr. Rogers’ self-serving testimony.

(322) KENNA TRADING, LLC v. COMMISSIONER 353

Parties genuinely embarking on a joint business endeavor

with the intent of sharing in its profits and losses would not

accept such ambiguity regarding their respective proportions

and with whom they would be sharing those profits and

losses. These issues in Sugarloaf ’s formation are alone

enough for us to conclude that, as a factual matter—and as

was true in Superior Trading—the parties never intended to

join together in the conduct of a business. But we need not

and do not stop there.

B. Poorly Disguised Sales

Like the transactions with the partnerships, the trans-

actions with the Brazilian retailers in these cases suffer the

same infirmity as the transactions in Superior Trading;

namely, Mr. Rogers has once again failed to adequately and

convincingly rebut persuasive evidence of redemptions. 30

Both Globex and CBD received cash distributions in redemp-

tion of their interests within two years of their alleged con-

tributions of property to Sugarloaf.

Generally contributions of property by partners to a part-

nership do not trigger gain or loss recognition. Sec. 721(a).

But in some situations the direct or indirect transfer of

money or other property to a partner that is related to a

direct or indirect transfer of money to the partnership can be

recharacterized as a sale or exchange of property. Sec.

707(a)(2)(B). The basic test to determine whether the trans-

fers constitute a sale of property is whether, considering all

the facts and circumstances, ‘‘(i) [t]he transfer of money or

other consideration would not have been made but for the

transfer of property; and (ii) [i]n cases in which the transfers

are not made simultaneously, the subsequent transfer is not

dependent on the entrepreneurial risks of partnership oper-

ations.’’ Sec. 1.707–3(b)(1), Income Tax Regs. The regulations

instruct us to consider a number of facts and circumstances

in determining whether the transaction constitutes a sale. Id.

subpara. (2).

30 There is also a significant question whether the purported trans-

actions ever occurred given the apparent failure to properly identify the re-

ceivables being transferred, to notify the makers, and to otherwise comply

with Brazilian law.

354 143 UNITED STATES TAX COURT REPORTS (322)

The regulations governing disguised sales also contain a

two-year presumption. Id. para. (c). Distributions within two

years of a contribution give rise to a presumption that the

transaction is a disguised sale. Id. Distributions more than

two years after the contribution give rise to a presumption

that the transaction is not a disguised sale. Id. Petitioners

here bear the burden of rebutting the former presumption.

See Superior Trading, LLC v. Commissioner, 738 F.3d at

681.

With respect to Globex, as Mr. Hartigan signed up inves-

tors and received the purchase price, he forwarded some of

the money to Multicred. Multicred used a portion of this

money to redeem Globex. These initial payments took place

in 2004 and thus trigger the two-year presumption in favor

of a sale. 31 Petitioners did nothing to rebut this presump-

tion, and it is only strengthened by the undated letter in

which Globex requests a redemption.

Furthermore, Mr. Rogers sent additional money to the

account of Globalstores, which we believe to be related to

Globex, in 2006. The evidence surrounding these 2006 pay-

ments shows that Mr. Rogers believed that he had already

paid Globex. It is possible that these 2006 payments were for

the purchase of additional receivables. Either way, peti-

tioners introduced no evidence sufficient to rebut the dis-

guised-sale presumption raised by Mr. Hartigan’s payments

to Globex via Multicred in 2004. Therefore, Sugarloaf, to the

extent it was a partnership, had only a cost basis in the

Globex receivables. Because of the opaque manner of the

redemption, Sugarloaf lacks clear records of what it paid for

31 Mr. Rogers and Mr. Hartigan spent a significant portion of the trial

disputing who paid what, when, and why. Mr. Rogers evidently believes,

or at least would have us believe, that Mr. Hartigan embezzled the money

paid by the investors and due to Sugarloaf. Mr. Hartigan says that, pursu-

ant to Mr. Rogers’ instructions, he sent the money to Multicred. Respond-

ent, to the extent he wanted to get embroiled in this dispute, states these

disagreements amount to finger-pointing possibly stemming from Mr.

Hartigan’s 10% fees. Ultimately, the evidence shows that Mr. Rogers in-

structed Mr. Hartigan to send portions of the payments Mr. Hartigan col-

lected from investors and owed to Sugarloaf, to Multicred, as constructive

distributions from Sugarloaf. To us, the intent to distribute the cash in

2004 is sufficient to invoke the disguised-sale rule. At the very least, it is

near-conclusive proof that the transfer of the receivables would not have

been made but for the promise of near-contemporaneous cash payments.

(322) KENNA TRADING, LLC v. COMMISSIONER 355

the receivables and so has not established that its basis was

greater than zero.

With respect to CBD, we also find that the two-year

presumption in favor of a disguised sale applies. While the

transactions here were slightly more complex, the weight of

the evidence reflects an indirect transfer of money to CBD in

exchange for a direct transfer of assets. The purported

transfer of assets took place as early as the date of the con-

tribution agreement, October 1, 2004. CBD received money

for its partnership interest by the end of December 2004. As

with the Globex receivables, petitioners have not presented

evidence sufficient to overcome the presumption under the

disguised-sale regulations that the transaction should be

treated as a sale. Therefore, in Sugarloaf ’s hands, the CBD

receivables, like the Globex receivables, had only a cost basis.

C. Retracing Our Steps

Once again echoing Superior Trading, we also believe that

the transactions at issue here should be collapsed to reflect

their true economic substance: a sale of receivables from the

retailers to Sugarloaf. The true substance of a transaction

rather than its nominal form governs its Federal tax treat-

ment. Superior Trading, LLC v. Commissioner, 137 T.C. at

88; see also Commissioner v. Court Holding Co., 324 U.S.

331, 334 (1945). One tool that this Court, like others, uses

to drill down to the substance of a transaction is the step

transaction doctrine. See Gordon v. Commissioner, 85 T.C.

309, 324 (1985) (‘‘[F]ormally separate steps in an integrated

and interdependent series that is focused on a particular end

result will not be afforded independent significance in situa-

tions in which an isolated examination of the steps will not

lead to a determination reflecting the actual overall result of

the series of steps.’’). In deciding whether to invoke this doc-

trine, courts generally look to one of three alternative tests:

the binding commitment test, the end result test, or the

interdependence test. Superior Trading, LLC v. Commis-

sioner, 137 T.C. at 88.

The binding commitment test is the most restrictive and

asks whether there was a binding commitment at the time

of the first step to take the subsequent steps. Commissioner

v. Gordon, 391 U.S. 83, 96 (1968). This test ‘‘is seldom used

and is applicable only where a substantial period of time has

356 143 UNITED STATES TAX COURT REPORTS (322)

passed between the steps that are subject to scrutiny.’’

Andantech LLC v. Commissioner, T.C. Memo. 2002–97, slip

op. at 70, aff ’d in part, remanded in part, 331 F.3d 972 (D.C.

Cir. 2003); see also McDonald’s Rests. of Ill., Inc. v. Commis-

sioner, 688 F.2d 520, 525 (7th Cir. 1982) (stating that the

test ‘‘was formulated to deal with the characterization of a

transaction that in fact spanned several tax years’’), rev’g 76

T.C. 972 (1981). The transactions in question took place

within two months at the shortest and, if we look only at Mr.

Rogers’ 2006 payment to Globex and disregard the contem-

poraneous payments by Mr. Hartigan, two years at the

longest. This is not a situation where the transactions

spanned several years, and it is unclear whether the binding

commitment test should apply. See Superior Trading, LLC v.

Commissioner, 137 T.C. at 89 (citing Associated Wholesale

Grocers, Inc. v. United States, 927 F.2d 1517, 1522 n.6 (10th

Cir. 1991), for the same proposition).

The end result test looks to the subjective intent of the

parties and asks ‘‘whether the formally separate steps are

prearranged components of a composite transaction intended

from the outset to arrive at a specific end result.’’ Id.; see also

McDonald’s Rests. of Ill., Inc. v. Commissioner, 688 F.2d at

524. In these cases, Mr. Rogers intended from the outset to

import the foreign losses into the United States to obtain tax

benefits. He could not have done so without the alleged part-

nership contributions and subsequent distributions—other-

wise he would lose the tax basis and would be unable to allo-

cate the built-in losses to the investors.

While no one from Globex or CBD testified as to the intent

of the Brazilian retailers, our disguised-sale analysis above

supports the conclusion that they intended from day one to

obtain cash for their assets independent of any entrepre-

neurial risk of a debt collection business. In fact, the parties

underwent transactional contortions to avoid the appearance

of a redemption. In the case of CBD, the parties used a series

of middlemen and loan documents. In the case of Globex, Mr.

Rogers and Mr. Hartigan sent the money to Globex through

Multicred. In both cases the end result is the same: The Bra-

zilian retailers received cash, and Sugarloaf acquired receiv-

ables with, in its view, built-in tax losses. The end result test

allows and encourages us to collapse the contribution of

(322) KENNA TRADING, LLC v. COMMISSIONER 357

receivables to Sugarloaf and its subsequent distributions of

money and to treat the transactions as sales.

The same holds true when we apply the interdependence

test, which asks ‘‘whether ‘the steps are so interdependent

that the legal relations created by one transaction would

have been fruitless without a completion of the series.’ ’’

Penrod v. Commissioner, 88 T.C. 1415, 1430 (1987) (quoting

Redding v. Commissioner, 630 F.2d 1169, 1177 (7th Cir.

1980), rev’g on other grounds 71 T.C. 597 (1979)). The steps

in the transactions among Sugarloaf, the retailers, and the

intermediaries who funneled cash to the retailers wholly lack

valid and independent economic or business purposes, which

represents the heart of the inquiry under the interdepend-

ence test. Superior Trading, LLC v. Commissioner, 137 T.C.

at 90. Petitioners cannot explain the redemption of the Bra-

zilian retailers except to claim any payments were participa-

tion payments due to Sugarloaf ’s securitization of the receiv-

ables. This feeble explanation—much like Mr. Rogers’ claims

that when he used the word ‘‘redeemed’’ in contemporaneous

documents he was using the term loosely, and that he used

the term ‘‘purchase’’ as a term of art—do not persuade us

that the cash payments to the retailers served any purpose

other than redeeming their purported partnership interests.

We find no economic or business purpose for the Brazilian

retailers’ entry into and exit from Sugarloaf. These trans-

actions’ only purpose was to facilitate the always-intended

writeoff of the receivables’ built-in losses and their allocation

to the United States tax shelter investors.

Thus, we collapse the steps undertaken by Mr. Rogers, the

retailers, and the intermediaries. The proper characterization

of the ‘‘stepped’’ transaction is as a sale of the receivables

from the retailers to Sugarloaf. Hence, Sugarloaf ’s basis in

the receivables would be a cost basis. With respect to CBD,

the evidence shows that the money sent to CBD through

middlemen was $800,000. Thus, Sugarloaf took a basis in the

CBD receivables of $800,000. As discussed infra pp. 359–360,

this finding does not allow the trading company petitioners

a section 166 deduction because they failed to prove that

they meet the requirements of section 166.

The evidence with respect to Globex is less clear. Globex

clearly received money from both Mr. Hartigan, via

Multicred, in 2004 and again from Mr. Rogers in 2006, but

358 143 UNITED STATES TAX COURT REPORTS (322)

petitioners were unable to substantiate these payments in

any meaningful manner. Evidence suggests that Mr. Rogers

sent Globex $950,000 in 2006, but its not clear whether this

payment was solely duplicative of payments by Mr. Hartigan

or whether a portion of it was for a new batch of receivables.

Either way, it is not enough for us to accurately determine

Sugarloaf ’s cost basis. Consequently, petitioners having

failed to carry their burden of establishing basis, Sugarloaf

had a zero basis in the Globex receivables.

D. Sham on You

A general principle of Federal income taxation is that

while a taxpayer has a right to conduct transactions in a

manner that minimizes or outright avoids Federal income

tax, Gregory v. Helvering, 293 U.S. 465, 469 (1935), the tax-

payer does not have a right to use forms or structures

lacking economic substance to avoid taxation, Zmuda v.

Commissioner, 79 T.C. 714, 719, aff ’d, 731 F.2d 1417 (9th

Cir. 1984). In such a case, ‘‘[s]ubstance prevails over form.’’

Superior Trading, LLC v. Commissioner, 728 F.3d at 680.

This doctrine is as applicable in the trust context, Paulson v.

Commissioner, 992 F.2d 789, 790 (8th Cir. 1993), aff ’g T.C.

Memo. 1991–508, as it is in the partnership context, Superior

Trading, LLC v. Commissioner, 728 F.3d at 680.

The Court of Appeals for the Seventh Circuit, addressing

a transaction almost identical to the 2004 partnership trans-

actions in these cases, said: ‘‘There is not even a colorable

basis for the tax shelter that * * * [Mr. Rogers] created and

the * * * [parties] implemented.’’ Id. at 682. Affirming this

Court’s decision for the Commissioner, the Court of Appeals

held that the Sugarloaf-type entity in that case was a sham

partnership and ‘‘entitled to none of the benefits that the

Internal Revenue Code bestows on partnerships.’’ Id. at 681.

The Court of Appeals concluded that ‘‘[n]o joint business goal

motivated the creation of Warwick’’, the Sugarloaf-type

entity, and that a redemption by Warwick of the Brazilian

retailer created the presumption of a sale, which the tax-

payers did not rebut. Id. at 680–681. The only differences in

these cases are that two different Brazilian retailers were

used, and the redemption of these retailers occurred in a

slightly different manner. But for all practical purposes, the

transactions are the same. Consequently, under the Court of

(322) KENNA TRADING, LLC v. COMMISSIONER 359

Appeals for the Seventh Circuit’s logic and ours, Sugarloaf

must also be a sham partnership not entitled to the benefits

of the Federal income tax laws.

E. Statutory Noncompliance

The loss deductions ultimately claimed by the partnerships

and by Mr. and Mrs. Rogers rested on the claim that the

receivables were bad debts. Section 166(a) provides:

SEC. 166(a). GENERAL RULE.—

(1) WHOLLY WORTHLESS DEBTS.—There shall be allowed as a deduc-

tion any debt which becomes worthless within the taxable year.

(2) PARTIALLY WORTHLESS DEBTS.—When satisfied that a debt is

recoverable only in part, the Secretary may allow such debt, in an

amount not in excess of the part charged off within the taxable year,

as a deduction.

The amount of the deduction is limited to the taxpayer’s

adjusted basis. Sec. 166(b). The Code does not permit noncor-

porate taxpayers to take ordinary income deductions under

section 166 for wholly or partially worthless nonbusiness

debt, requiring that they instead treat such worthlessness as

a capital loss. Sec. 166(d)(1). Nonbusiness debt is ‘‘debt other

than—(A) a debt created or acquired (as the case may be) in

connection with a trade or business of the taxpayer; or (B)

a debt the loss from the worthlessness of which is incurred

in the taxpayer’s trade or business.’’ Sec. 166(d)(2). The tax-

payer must establish the amount of the debt that is worth-

less. Sec. 1.166–3(a)(2)(ii), Income Tax Regs.

Respondent distills the above requirements into four ele-

ments: (1) a charge-off for a partially worthless debt, (2)

proof of a trade or business, (3) proof of worthlessness, and

(4) proof of basis in the debt. We agree with this character-

ization and also agree with respondent that petitioners have

not carried their burden of proof with respect to any of these

elements.

First, the partnerships and the trusts, as far as we can

tell, did not keep reliable, if any, financial books or records,

particularly as to the specific receivables purchased and

which ones should be charged off. Instead a blanket 97% of

all receivables was used for charge-off purposes. Thus, peti-

tioners failed to properly show that they charged off the por-

tion of the debt claimed as a deduction.

360 143 UNITED STATES TAX COURT REPORTS (322)

Second, petitioners failed to show that they acquired the

receivables in connection with a trade or business. The

trading companies and the trusts did not operate as trades

or businesses. They merely operated as conduits for losses

imported into the U.S. tax system. With one exception, there

is no evidence that any of the investors entered into these

relationships with the expectation of economic profit inde-

pendent of the tax results. 32 In addition, in the case of the

Globex receivables, it is likely that the collection efforts (the

only purported business activity with which Sugarloaf and

the other partnerships were connected) did not even begin

until a considerable time after the receivables were acquired.

Third, petitioners failed to prove worthlessness. Evidence

in the record reflects that petitioners and Multicred could not

conduct an analysis of the individual debts. And petitioners

provided no statistical study or other analysis of which debts

or types of debts were worthless. The fact that every trading

company and trust claimed a deduction of 97% across the

board undercuts any claim that the companies truly analyzed

the assets’ value. 33

Fourth, petitioners failed to prove they ever had bases in

the receivables equal to the deductions claimed. For the rea-

sons discussed above, petitioners had at most cost bases.

In summary, petitioners have not carried their burden of

proving their entitlement to the claimed section 166 deduc-

tions. Respondent correctly disallowed these deductions in

full.

II. Superior Trading With a Twist of Trust

The substantive analysis above applies equally to the 2004

and 2005 tax year transactions, in particular the trans-

32 The one exception is Christopher Heath Brown, an investor who ques-

tioned Mr. Rogers as to when he would see results. Mr. Rogers essentially

rebuffed Dr. Brown, saying that he should be happy with the tax losses,

and Dr. Brown did not complain again.

33 Petitioners’ only argument on the worthlessness issue, presented in

their answering brief, is: ‘‘97% built-in loss was chosen as that was the

rate of bad debt reserve provided by Arapua against the balance sheet

gross historic cost of the receivables. A partial worthlessness percentage

against CBD and Globex receivables could have been less [or more] than

the 97% used in the case of Arapua.’’ Far from carrying petitioners’ burden

of proof, this argument amounts to additional evidence that the 97%

worthlessness claim was an arbitrary number.

(322) KENNA TRADING, LLC v. COMMISSIONER 361

actions involving Sterling Ridge that underlay the Rogerses’

claimed section 166 deduction for 2005. The Brazilian

retailers’ ‘‘contributions’’ to Sugarloaf failed to preserve the

retailers’ built-in losses in the receivables because no valid

partnership was formed, or alternatively because the ‘‘con-

tributions’’ were in fact disguised sales. Accordingly, there

was no, or next to no, section 166 deduction for the subtrusts

formed in 2005 to claim.

Yet even leaving aside the fundamental flaws in the

transfer of assets at the Sugarloaf level, which necessarily

limit built-in losses in the assets of the trusts, the step trans-

action doctrine discussed supra pp. 355–358 applies to col-

lapse the steps in the trust transactions into sales of receiv-

ables from Sugarloaf to the main trusts.

The steps of the 2005 transactions can be summarized as

follows. Mr. Rogers formed a main trust in the name of an

investor. He then caused Sugarloaf to ‘‘contribute’’ receiv-

ables to the main trust, formed a subtrust under that main

trust, and assigned the receivables to the subtrust. The

investor ‘‘contributed’’ cash (and/or promissory notes) to the

main trust’s bank account, which was controlled by Mr.

Rogers, and received in exchange a beneficial interest in the

receivables in the subtrust. The investor, by the terms of the

various documents, was entitled to take direct ownership of

those receivables. Sugarloaf, over the course of months,

drained the main trust bank account under the guise of

maintenance payments or other payments.

Applying the end result test, the overall objective of these

transactions was for Mr. Rogers to sell, and for the investors

to purchase, tax losses. Achieving this objective entailed

transferring the receivables to the investor in a manner that

would preserve the receivables’ tax bases in the hands of the

Brazilian retailers while obtaining cash from the investors.

Because of the AJCA, the partnership structure was no

longer viable, so Mr. Rogers employed a trust structure

instead. The parties clearly intended that the transaction

generate tax losses well in excess of the investors’ economic

outlays. Applying the interdependence test, no independent

business or economic purpose existed for the convoluted trust

structure. The creation of the main and subtrusts would be

fruitless without the eventual flowthrough of the section 166

deductions. Thus, we have no qualms about collapsing the

362 143 UNITED STATES TAX COURT REPORTS (322)

steps of the trust transactions. Sterling Ridge’s investment in

the 2005 trust transaction was no more than a purchase of

receivables from Sugarloaf. Thus, Sterling Ridge was entitled

to only a cost basis.

Our foregoing conclusions regarding the collapse of the

trust transactions into sales of receivables and the basis

problems at the Sugarloaf level would each alone suffice to

disallow the Rogerses’ claimed section 166 deduction for

2005. But the 2005 trust structure fails at a more funda-

mental level, and lest Mr. Rogers’ faulty template persist as

a trap for the unwary, we proceed to explain why.

The 2005 trust transactions were close cousins of the 2004

partnership transactions. Because built-in losses could no

longer be shifted within a partnership, while the Code con-

tained no analogous limitation for trusts, Mr. Rogers hoped

that the receivables would have a carryover basis upon con-

tribution to a trust without the relationship between the

investor and Sugarloaf turning into a partnership. See sec.

1015. After those receivables had been allocated to a subtrust

and an investor designated as its beneficiary, the investor

would be the subtrust’s beneficiary and grantor, by virtue of

the investor’s cash ‘‘contribution’’ to the main trust. Because

the terms of the various trust documents entitled the

investor to take direct ownership of the subtrust assets, Mr.

Rogers reasoned that the subtrust would be a grantor trust.

In a grantor trust, the person treated as the grantor includes

in his or her Federal taxable income, as computed on the tax

return, the trust’s items of income, deduction, and credits

against tax. See sec. 671. Hence, the investor could partake

in the receivables’ built-in losses.

Mr. Rogers also hoped that the main and subtrusts would

qualify as trusts under the check-the-box regulations. See

sec. 301.7701–4, Proced. & Admin. Regs. But Federal law

determines how an entity organized under State law is

taxed. Moline Props., Inc. v. Commissioner, 319 U.S. 436,

438–439 (1943). Whether an arrangement is a trust generally

depends on whether ‘‘the purpose of the arrangement is to

vest in trustees responsibility for the protection and con-

servation of property for beneficiaries who cannot share in

the discharge of this responsibility and, therefore, are not

associates in a joint enterprise for the conduct of business for

profit.’’ Sec. 301.7701–4(a), Proced. & Admin. Regs.; see also

(322) KENNA TRADING, LLC v. COMMISSIONER 363

Morrissey v. Commissioner, 296 U.S. 344, 357, 359–360

(1935) (discussing the difference between an ordinary trust

and a business trust). The ‘‘business trust’’ label ‘‘will not

change the real character of the organization if the organiza-

tion is more properly classified as a business entity under

§ 301.7701–2.’’ Sec. 301.7701–4(b), Proced. & Admin. Regs. 34

As a purely factual matter, the purpose of the trust

arrangements was not ‘‘to vest in trustees responsibility for

the protection and conservation of property for beneficiaries

who cannot share in the discharge of this responsibility’’. See

sec. 301.7701–4(a), Proced. & Admin. Regs. The purpose of

the main trust and the subtrust was merely to transfer tax

losses from one party to another party. The parties did not

intend to protect and conserve the receivables, as the absence

of assignment and collection documentation demonstrates.

That the trusts wrote off most of the receivables within

weeks or months of their formation reveals for the fiction

that it is the proposition that the trustee here protected and

conserved the trusts’ assets. Therefore, neither the main

trusts nor the subtrusts appear to be trusts for Federal

income tax purposes. Nor can we properly classify them as

‘‘business trusts’’, given that they did not operate ‘‘to provide

a medium for the conduct of a business and sharing its

gains.’’ See Morrissey v. Commissioner, 296 U.S. at 357.

Because these entities were not trusts for the purposes of

Federal income tax law, we are left to determine what hap-

34 Mr. Rogers calls his trusts Illinois business trusts. Such entities,

under State law, are not partnerships. Schumann-Heink v. Folsom, 159

N.E. 250, 252 (Ill. 1927) (discussing a Massachusetts business trust). A

business trust can be a trust ‘‘ ‘where the owners of a business, or of shares

in a business corporation, transfer the property of the business, or all or

a large part of the stock, to trustees for themselves.’ ’’ Hanley v. Kusper,

337 N.E.2d 1, 6 (Ill. 1975) (quoting G. Bogert, The Law of Trusts and

Trustees, sec. 270.40, at 347 (2d ed. 1964)).

Sec. 301.7701–4(b), Proced. & Admin. Regs., merely restates the general

principle that labels used by taxpayers are not conclusive. See Frank Lyon

Co. v. United States, 435 U.S. 561, 583–584 (1978); see also Hutchinson v.

Commissioner, 47 T.C. 680, 686 (1967) (‘‘ ‘Mere forms of instruments, of

course, and the use of words ‘trust’ and ‘trustee’ cannot be depended upon

in determining whether or not a trust is in reality created. The transaction

itself must be scrutinized.’ ’’ (quoting Morsman v. Commissioner, 90 F.2d

18, 23 (8th Cir. 1937), aff ’g 33 B.T.A. 800 (1935))). We look beyond Mr.

Rogers’ labels.

364 143 UNITED STATES TAX COURT REPORTS (322)

pened. Usually, such an entity with two or more members

would, by default, be considered a partnership. Sec.

301.7701–2, Proced. & Admin. Regs. But there was no more

intent for the investor and Sugarloaf to join together to con-

duct a debt-collection business than there was for Sugarloaf

and the Brazilian retailers to join together in such a busi-

ness. See Commissioner v. Culbertson, 337 U.S. at 742; supra

pp. 351–353. Therefore, we are left in a situation analogous

to that with the Brazilian retailers and Sugarloaf. The

investor exchanged cash for receivables, which were intended

to generate tax losses. We note that even if we were to find

that the trust investor and Sugarloaf entered into a partner-

ship, the AJCA would prevent the shifting of losses away

from a contributing partner, and the disguised sales rules of

section 707 would also come into play.

Under both the step transaction doctrine and the rules

governing trusts, neither the Sterling Ridge Trust nor its

subtrust was a trust for Federal income tax purposes.

Rather, Sterling Ridge as a stand-alone entity purchased the

receivables from Sugarloaf.

Finally, as we concluded with Sugarloaf, we find that the

Sterling Ridge Trust and subtrust lacked economic substance

and were shams. Sterling Ridge Trust and subtrust were not

trusts for the purposes of Federal income tax law. The par-

ties did not intend for the trustee to preserve and conserve

the assets for the beneficiaries. Consequently, Mr. and Mrs.

Rogers were entitled to none of the Federal income tax bene-

fits of the trust structure. See Superior Trading, LLC v.

Commissioner, 728 F.3d at 681 (‘‘ ‘An entity without economic

substance, whether a sham partnership or a sham trust, is

a sham either way and hence is not recognized for federal tax

law purposes.’ ’’ (quoting Sparkman v. Commissioner, 509

F.3d 1149, 1156 n.6 (9th Cir. 2007), aff ’g T.C. Memo. 2005–

136)).

For the foregoing reasons, we conclude that respondent

properly disallowed the Rogerses’ claimed section 166 deduc-

tion for 2005.

III. The Devil’s in the Details

Respondent determined that Sugarloaf greatly overstated

its cost of goods sold on its partnership return by taking the

(322) KENNA TRADING, LLC v. COMMISSIONER 365

position that its cost of goods sold was equal to its claimed

carryover basis in the ‘‘contributed’’ receivables. We agree.

For the reasons stated above, Sugarloaf failed to prove that

it had a basis in the Globex receivables and failed to prove

it had a basis greater than $800,000 in the CBD receivables.

At most, therefore, Sugarloaf proved a basis of $800,000 in

the partnership interests it sold. Sugarloaf is entitled to a

cost of goods sold of only $800,000. 35

With respect to the deductions respondent disallowed,

Sugarloaf is not entitled to them. Deductions are ‘‘a matter

of legislative grace’’, and taxpayers bear the burden of

proving that they are entitled to any deduction. Rule 142(a);

INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992).

Taxpayers must identify each deduction, show they meet all

requirements, and substantiate all items underlying claimed

deductions. Sec. 6001; Roberts v. Commissioner, 62 T.C. 834,

836–837 (1974). Section 162(a) allows a deduction for all

ordinary and necessary business expenses paid or incurred in

connection with a trade or business. But ‘‘expenditures made

in an attempt to obtain abusive tax shelter benefits are not

ordinary and necessary business expenses or otherwise

deductible under section 162(a).’’ Gerdau Macsteel, Inc. v.

Commissioner, 139 T.C. 67, 182 (2012). The transactions in

question were tax shelters, and Sugarloaf ’s claimed expendi-

tures were made in an attempt to obtain abusive tax shelter

benefits. 36

35 We note that while ‘‘economic substance is a prerequisite to the appli-

cation of any Code provision allowing deductions,’’ Lerman v. Commis-

sioner, 939 F.2d 44, 52 (3d Cir. 1991), aff ’g T.C. Memo. 1988–570, cost of

goods sold is not a deduction, see Azimzadeh v. Commissioner, T.C. Memo.

2013–169, at *12-*13 (citing Metra Chem. Corp. v. Commissioner, 88 T.C.

654, 661 (1987)).

36 Furthermore, Jetstream, through Mr. Rogers, failed to substantiate

items underlying Sugarloaf ’s deductions. The record includes only a

Quickbooks transaction record for most expenses and canceled checks

drawn on Sugarloaf ’s bank account to Mr. Gabel and to Seyfarth Shaw.

Sugarloaf ’s records are generally unreliable, and we do not accept the

Quickbooks records as sufficient substantiation. While Mr. Gabel testified

that he provided services to Sugarloaf during the years at issue, we have

no invoices or other proof, including testimony, of the extent of his serv-

ices. Mr. Rogers failed to provide evidence as to the nature and extent of

the services provided by Seyfarth Shaw. Because of the confusing flows of

money among the investors, Seyfarth Shaw, Sugarloaf, and various other

Continued

366 143 UNITED STATES TAX COURT REPORTS (322)

Respondent also determined that Sugarloaf understated its

gross income based upon a bank deposits analysis. Petitioner

Jetstream disputes certain deposits for both 2004 and 2005

and accordingly bears the burden of proving that respond-

ent’s inclusion of these deposits in Sugarloaf ’s income is

incorrect. See DiLeo v. Commissioner, 96 T.C. 858, 869

(1991), aff ’d, 959 F.2d 16 (2d Cir. 1992).

With respect to the two disputed deposits in 2004, Mr.

Rogers claims that both were equity contributions to

Sugarloaf. Unfortunately, Mr. Rogers provides no evidence

other than his self-serving testimony and a balance sheet.

Mr. Rogers disavows the accuracy of the balance sheet with

respect to some entries, but expects us to accept it as

accurate with respect to others. 37 We decline to do so. In

addition, his testimony conflicts with the tax returns filed by

Sugarloaf. He did not provide contribution agreements or

other indicia of an equity investment by the depositing

individuals. Thus, we cannot conclude that these payments

were equity contributions. Mr. Rogers did not provide any

other explanation for these deposits, and he did not carry

Jetstream’s burden of proof that these deposits were other

than income to Sugarloaf.

With respect to the disputed 2005 deposits, Mr. Rogers

claims these deposits are either capital contributions (equity

deposits) or amounts transferred to Sugarloaf that should

have been deposited directly into trust accounts (trust

deposits). As with the 2004 deposits, we reject Mr. Rogers’

position. He introduced no evidence, other than self-serving

testimony and Quickbooks records, that the equity deposits

were in fact equity contributions. As to the July 28,

November 10, and November 30, 2005, deposits, Sugarloaf ’s

Quickbooks entries indicate these deposits were from PPI

funds or, in the case of the November 30 deposit, Sterling

Ridge. But, there is no corroborating evidence that these

entities, and in light of the lack of a factual basis on which to make esti-

mates, we decline to estimate the extent of services, and hence we bear

heavily on Sugarloaf ’s inexactitude. See Williams v. United States, 245

F.2d 559, 560 (5th Cir. 1957); Cohan v. Commissioner, 39 F.2d 540, 543–

544 (2d Cir. 1930); Vanicek v. Commissioner, 85 T.C. 731, 742–743 (1985).

37 On brief, Mr. Rogers contends that the amounts shown as equity inter-

ests for Multicred and Sugarloaf Overseas are loans, not equity invest-

ments.

(322) KENNA TRADING, LLC v. COMMISSIONER 367

deposits actually came from PPI, and frankly, we do not find

Mr. Rogers’ testimony or the Quickbooks entries credible.

With respect to the alleged Sterling Ridge deposit, we have

no way of knowing whether the deposit came from Sterling

Ridge, Inc., or the Sterling Ridge Trust, if it even came from

either of these sources.

With respect to the alleged Multicred equity deposit, we

have rejected petitioner’s contention that Multicred was a

partner in Sugarloaf and likewise reject its contention that

this deposit was an equity contribution. The Quickbooks

entries alone are insufficient to prove these deposits were

equity investments. Cf. Olive v. Commissioner, 139 T.C. 19,

32–33 (2012) (holding that general ledgers by themselves are

insufficient to substantiate items underlying a taxpayer’s

claimed deductions); Ohana v. Commissioner, T.C. Memo.

2014–83, at *21 (finding Quickbooks records of expenses a

summary of the taxpayer’s assertions, which, when

uncorroborated, are not enough to substantiate items under-

lying the taxpayer’s claimed deductions).

While the names of the transferors are consistent with

those of trust investors, Mr. Rogers has nonetheless failed to

convince us that the trust deposits are anything but income

to Sugarloaf. First, we have no evidence that these amounts

were ever transferred to the trust bank accounts. Second,

and conclusively here, we found that in these 2005 trans-

actions, the investors each purchased a tranche of receivables

from Sugarloaf, making the money paid into the trust

accounts income to Sugarloaf under section 1001. So, regard-

less of whether the 2005 investors’ payments went into the

trust accounts or directly to Sugarloaf, those amounts were

still income to Sugarloaf. 38

38 We note that respondent has determined only that the six trust depos-

its actually deposited into Sugarloaf ’s bank account constitute income.

Under our findings, all payments by the trust investors would constitute

income to Sugarloaf, less fees retained by the promoters. We will not ques-

tion respondent’s magnanimity.

368 143 UNITED STATES TAX COURT REPORTS (322)

IV. In the Penalty Box 39

A. Section 6662

Respondent determined penalties against all of the part-

nerships in these consolidated cases—that is, for Sugarloaf

and for each of the trading companies. He determined that

the partnerships were liable for the gross valuation

misstatement penalty under section 6662(h) on portions of

their underpayments attributable to misstatements of their

respective bases in the receivables. Respondent also deter-

mined that Sugarloaf is liable for the accuracy-related pen-

alty for negligence or, in the alternative, substantial under-

statements of income tax on portions of its underpayments

attributable to its additional income and the disallowed

deductions. He bears the burden of production with respect

to these accuracy-related penalties, but petitioners bear the

burden of proof if respondent meets his burden of production.

See Higbee v. Commissioner, 116 T.C. 438, 446–447 (2001).

Section 6662(a) and (b)(3) provides for a 20% penalty to be

imposed on the portion of an underpayment of tax required

to be shown on a return that is attributable to a substantial

valuation misstatement. As relevant here, for returns filed

after August 17, 2006, a substantial valuation misstatement

occurs when ‘‘the value of any property (or the adjusted basis

of any property) claimed on any return of tax imposed by

chapter 1 is 150 percent or more of the amount determined

to be the correct amount of such valuation or adjusted basis

(as the case may be)’’. Sec. 6662(e)(1)(A). For returns filed on

or before August 16, 2006, the percentage was 200% instead

of 150%. Pension Protection Act of 2006, Pub. L. No. 109–

280, sec. 1219(a)(1)(A), (e), 120 Stat. at 1083, 1085. Section

6662(h) increases this penalty to 40% if the value or adjusted

basis claimed on the return is 200% or more of the actual

value or adjusted basis. For returns filed on or before August

16, 2006, the 40% penalty applies if the value or adjusted

basis is 400% or more of the actual basis or value. Id. sec.

1219(a)(2)(A). A regulation clarifies that, when the actual

value or basis is zero, that value is considered 400% or more

39 We do not here redetermine the penalties determined against Mr. and

Mrs. Rogers and Mr. Fears with respect to their Forms 1040, U.S. Indi-

vidual Income Tax Return. See supra note 6.

(322) KENNA TRADING, LLC v. COMMISSIONER 369

of the correct amount. Sec. 1.6662–5(g), Income Tax Regs.

Petitioners do not challenge application of this regulation.

See United States v. Woods, 571 U.S. ll, ll, 134 S. Ct.

557, 566 n.4 (2013) (noting the inherent mathematical

problem of dividing a number by zero).

In these cases, respondent has met his burden of produc-

tion. The Globex receivables had a zero basis, and the part-

nerships with those receivables grossly overstated their bases

in those receivables. For the CBD receivables, which had a

total combined basis of $800,000, the partnerships (including

two not at issue here) reported a total adjusted basis of

$48,600,000. Assuming that each partnership received a

tranche of receivables with a basis equal to its pro rata share

of the $800,000 aggregate basis, each partnership overstated

its basis by far more than 400%. Furthermore, Sugarloaf ’s

aggregate claimed adjusted basis in the partnership interests

it sold was far more than 400% of the actual adjusted basis,

which we found to be, in total, $800,000.

An accuracy-related penalty will not be imposed ‘‘with

respect to any portion of an underpayment if it is shown that

there was a reasonable cause for such portion and that the

taxpayer acted in good faith’’. Sec. 6664(c)(1). When deter-

mining whether a partnership had reasonable cause and

acted in good faith, we look to the general partner. Superior

Trading, LLC v. Commissioner, 137 T.C. at 91. During the

years at issue Jetstream was the managing member of

Sugarloaf and each of the trading companies. We do not

believe Mr. Rogers when he claims that Mr. Mazzucchelli

was the manager of Sugarloaf. We think that claim, along

with the engagement letter between Sugarloaf and Seyfarth

Shaw, a poorly veiled attempt to get around the conflict of

interest inherent in having Mr. Rogers’ law firm represent a

limited liability company controlled, through its tax matters

partner, Jetstream, by Mr. Rogers. Mr. Rogers, through Jet-

stream, was the only individual with the authority to act on

behalf of Sugarloaf and the trading companies, and it is his

conduct that is relevant for determining whether we should

sustain the determined accuracy-related penalties.

As was the case in Superior Trading, Mr. ‘‘Rogers’ knowl-

edge and experience should have put him on notice that the

tax benefits sought by the form of the transactions would not

be forthcoming and that these transactions would be re-

370 143 UNITED STATES TAX COURT REPORTS (322)

characterized and stepped together to reveal their true sub-

stance.’’ Id. at 92. We reject his contention that he reason-

ably relied on the advice of tax professionals. See

Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99

(2000) (establishing a three-factor test for determining

whether reliance on tax professionals may be reasonable

cause), aff ’d, 299 F.3d 221 (3d Cir. 2002). Mr. Rogers’ asser-

tions on brief that he relied upon outside professionals lack

even a smidgen of evidentiary foundation other than his own

testimony.

Petitioners have not borne their burden of proof under sec-

tion 6664(c) with respect to any of the partnerships, and we

therefore hold that the section 6662(a) and (h) penalty

applies. To be clear, this penalty applies against the trading

companies, for overstating their bases in the receivables, as

well as to Sugarloaf. In Sugarloaf ’s case, it not only over-

stated its basis in the receivables but also overstated its

basis in the trading companies that it subsequently sold,

resulting in a grossly overstated cost of goods sold.

Further, we find that an accuracy-related penalty of 20%

applies to the portions of the undepayments attributable to

Sugarloaf ’s omissions from gross income and disallowed

deductions. A section 6662(a) penalty applies to portions of

an underpayment of tax due to negligence or disregard of

rules and regulations or to a substantial understatement of

income tax if the amount of the understatement exceeds the

greater of $5,000, $10,000 in the case of a corporation, or

10% of the tax required to be shown on the return. Sec.

6662(b)(1) and (2).

We conclude that respondent has met his burden of

production with respect to the penalty for negligence or dis-

regard of rules and regulations. Petitioners failed to substan-

tiate the items underlying their deductions and provide a

reasoned and convincing explanation for the deposits. Their

recordkeeping appears to have been scanty to nonexistent,

and noncontemporaneous beyond a Quickbooks log, which we

did not find credible and will not rely on. The cashflows

to and from Sugarloaf are confusing, and Mr. Rogers’

failure to keep records of the alleged contributions to capital

and to explain contemporaneous document equity ownership

totaling up to 215% is negligent at best. Furthermore, for the

same reasons discussed above, Mr. Rogers has fallen well

(322) KENNA TRADING, LLC v. COMMISSIONER 371

short of his burden of proving reasonable cause and good

faith.

B. Section 6662A

Respondent also seeks to impose a section 6662A penalty

on Sugarloaf for its 2004 and 2005 tax years. Section 6662A

imposes a 20% penalty on understatements due to reportable

transactions or listed transactions. Sec. 6662A(a), (b)(2). This

penalty increases to 30% if the taxpayer does not adequately

disclose the transaction. Sec. 6662A(c).

For the same reasons discussed below with respect to the

2005 tax year, we find that respondent has satisfied his bur-

den of production as to this penalty for 2004. However, the

section 6662A penalty does not apply with respect to the por-

tion of an understatement on which a gross valuation

misstatement penalty is imposed. Sec. 6662A(e)(2)(B). We

have imposed the gross valuation misstatement penalty on

the portions of the 2004 understatement of Sugarloaf that

would be subject to the section 6662A penalty, so that pen-

alty does not apply to any amount for Sugarloaf ’s 2004 tax

year.

As for Sugarloaf ’s 2005 tax year, respondent wants us to

apply the section 6662A penalty to ‘‘any understatement

attributable to adjustments to Sugarloaf ’s tax characteriza-

tion of the DAT [distressed asset trust] transaction in 2005’’.

Respondent contends that the DAT transaction is a listed

transaction, and Sugarloaf did not disclose it.

Section 6662A(d) refers us to section 6707A(c)(2) for the

definition of a listed transaction. The Code defines a listed

transaction as a tax avoidance transaction identified by the

Internal Revenue Service (IRS) and points us to the regula-

tions under section 6011. Sec. 6707A(c)(2). The regulations

define a listed transaction as the same as or substantially

similar to any transaction identified by the IRS as such in

a ‘‘notice, regulation, or other form of published guidance’’.

Sec. 1.6011–4(b)(2), Income Tax Regs. A substantially similar

transaction is ‘‘either factually similar or based on the same

or similar tax strategy.’’ Sec. 1.6011–4(c)(4), Income Tax

Regs.

In these cases, no one disputes that the trust transactions

are substantially similar to the transaction identified in

372 143 UNITED STATES TAX COURT REPORTS (322)

Notice 2008–34, 2008–1 C.B. 645. 40 Generally, the IRS

requires a taxpayer to disclose listed transactions on a state-

ment attached to the taxpayer’s return. Sec. 1.6011–4(e)(1),

Income Tax Regs. In these cases, the IRS issued the notice

on March 24, 2008, well after Sugarloaf filed its 2005 tax

return on October 14, 2006. The regulations in effect for the

tax years at issue covered just such a situation, requiring the

taxpayer to file a disclosure statement ‘‘as an attachment to

the taxpayer’s tax return next filed after the date the trans-

action is listed’’. Sec. 1.6011–4(e)(2)(i), Income Tax Regs. Nei-

ther Sugarloaf nor its tax matters partner filed such a disclo-

sure statement. Section 6664(d)(1) provides a reasonable

cause and good faith defense to the section 6662A penalty,

but only if the transaction is disclosed. Thus, the 30% pen-

alty applies to the portion of Sugarloaf ’s 2005 understate-

ment that stems from the trust transactions to the extent the

understatement is not already subject to the 40% section

6662(h) gross valuation misstatement penalty. See sec.

6662A(e)(2)(B).

V. Conclusion

Contrary to Mr. Rogers’ contentions throughout these

cases, the 2004 partnership structures did not materially

40 Mr. Rogers, on Sugarloaf ’s behalf, contends that Notice 2008–34,

2008–1 C.B. 645, is invalid as a violation of Executive Order 12866, 3

C.F.R. 638 (1994). He believes that Notice 2008–34, supra, is a significant

regulatory action, and that under Executive Order 12866 the Office of

Management and Budget (OMB) must review proposed significant regu-

latory action. Because OMB did not do so, Mr. Rogers argues the notice

is invalid. In so arguing, he ignores section 10 of the executive order,

which states:

Nothing in this Executive order shall affect any otherwise available judi-

cial review of agency action. This Executive order is intended only to im-

prove the internal management of the Federal Government and does not

create any right or benefit, substantive or procedural, enforceable at law

or equity by a party against the United States, its agencies or instru-

mentalities, its officers or employees, or any other person. [Exec. Order

No. 12866, 3 C.F.R. at 649.]

Mr. Rogers cannot challenge Notice 2008–34, supra, as not in compliance

with the executive order. See Blak Invs. v. Commissioner, 133 T.C. 431,

447 (2009) (rejecting for the same reason a taxpayer’s challenge to tem-

porary regulations under Executive Order 12866), supplemented by T.C.

Memo. 2012–273.

(322) KENNA TRADING, LLC v. COMMISSIONER 373

differ from the 2003 structures at issue in Superior Trading,

LLC. Like Arapua in Superior Trading, LLC, the Brazilian

retailers in these cases were also redeemed out of the parent

partnership (in that case, Warwick), resulting in a deemed

sale of the receivables to Sugarloaf. And Mr. Rogers provided

no convincing evidence that the structure in these cases had

any objective independent of the shifting of losses from a tax-

indifferent party to a tax-motivated party.

The 2005 trust transactions differed little from the 2004

transactions. They suffer from the same fatal flaws as the

2004 transactions—namely, the planned and near-contem-

poraneous redemption of the Brazilian retailers. Further, the

form of the transaction, when appropriately stepped together,

consists of a sale of receivables to the investors. We treat it

as such. In addition, the 2005 trust transaction was devoid

of economic substance, and we will therefore issue an order

stating that Mr. and Mrs. Rogers are not entitled to the sec-

tion 166 deduction they claimed on their 2005 tax return.

This Opinion makes abundantly clear that neither the

2004 partnership transaction nor the 2005 trust transaction

works, and we have discussed myriad reasons why not.

These reasons constitute ‘‘alternative holdings, each by itself

sufficient to sustain respondent’s adjustments’’. Superior

Trading, LLC v. Commissioner, T.C. Memo. 2012–110, slip

op. at 7.

Moreover, Jetstream, through Mr. Rogers, failed to

successfully carry its burden of proof with respect to any of

Sugarloaf ’s claimed deductions on its 2004 and 2005 tax

returns. Mr. Rogers similarly failed to provide convincing

explanations for the challenged gross receipts in Sugarloaf ’s

2004 and 2005 tax years.

Sugarloaf is liable for the 40% gross valuation

misstatement penalty for the 2004 tax year for overstating

the bases of its interests in the holding companies sold to

investors. The remaining partnerships in these cases are

likewise liable for the 40% gross valuation misstatement pen-

alty for overstating their bases in the receivables. Sugarloaf

is further liable for a 20% accuracy-related penalty under

section 6662(a) and (b)(1) for the portions of the underpay-

ments due to the disallowed deductions for the 2004 and

2005 tax years and the amounts of income omitted from its

2004 and 2005 tax returns. Sugarloaf is also liable for a 30%

374 143 UNITED STATES TAX COURT REPORTS (322)

penalty under section 6662A for the reportable transaction

understatement attributable to the 2005 trust structure.

The Court has considered all of the parties’ contentions,

arguments, requests, and statements. To the extent not dis-

cussed herein, the Court concludes that they are moot, irrele-

vant, or without merit. 41

Appropriate orders will be issued at docket

Nos. 27636–09 and 30586–09, decision will

be entered under Rule 155 in docket No. 671–

10, and decisions will be entered for

respondent in all other cases.

APPENDIX

Kenna Trading, LLC, Jetstream Business Limited, Tax Mat-

ters Partner, docket No. 7551–08; Connemara Trading

Group, LLC, Jetstream Business Limited, Tax Matters

Partner, docket No. 7552–08; Zugersee Trading, LLC, Jet-

stream Business Limited, Tax Matters Partner, docket No.

7553–08; Bielersee Trading, LLC, Jetstream Business Lim-

ited, Tax Matters Partner, docket No. 7554–08; Ridgeway

Fund, LLC, Jetstream Business Limited, Tax Matters

Partner, docket No. 7555–08; Grey Stone Trading, LLC, Jet-

stream Business Limited, Tax Matters Partner, docket No.

7556–08; Turnberry Trading, LLC, Jetstream Business Lim-

ited, Tax Matters Partner, docket No. 7618–08; Northgate

Trading, LLC, Jetstream Business Limited, Tax Matters

Partner, docket No. 7625–08; Thornhill Trading, LLC, Jet-

stream Business Limited, Tax Matters Partner, docket No.

9021–08; Saddlebrook Trading, LLC, Jetstream Business

Limited, Tax Matters Partner, docket No. 9035–08; Suten

Fund, LLC, Jetstream Business Limited, Tax Matters

Partner, docket No. 9036–08; Remington Trading, LLC, Jet-

stream Business Limited, Tax Matters Partner, docket No.

41 For instance, we find Mr. Rogers’ contention that respondent’s failure

to audit the subtrusts’ returns is fatal to be without merit. Likewise, re-

spondent’s statement in his answer in docket No. 671–10 that he prepared

the answer without benefit of the administrative file does not render the

determined deficiency arbitrary and capricious. Finally, we reject Mr. Rog-

ers’ claim to a deduction for Sugarloaf for income reported by Warwick on

its 2003 tax return but purportedly never received.

(322) KENNA TRADING, LLC v. COMMISSIONER 375

9037–08; R B Taylor Trading, LLC, Jetstream Business Lim-

ited, Tax Matters Partner, docket No. 9038–08; Riversedge

Fund, LLC, Jetstream Business Limited, Tax Matters

Partner, docket No. 9039–08; Murtensee Trading, LLC,

Arrowhead Fund, LLC, Tax Matters Partner, docket No.

9040–08; Monte Rosa Fund, LLC, Jetstream Business Lim-

ited, Tax Matters Partner, docket No. 9041–08; Ofenpass

Fund, LLC, Jetstream Business Limited, Tax Matters

Partner, docket No. 9042–08; Knight Trading, LLC, Jet-

stream Business Limited, Tax Matters Partner, docket No.

9121–08; Essex Fund, LLC, Jetstream Business Limited, Tax

Matters Partner, docket No. 9122–08; Lyman Trading, LLC,

Jetstream Business Limited, Tax Matters Partner, docket

No. 9123–08; Dent-Blanche Fund, LLC, Jetstream Business

Limited, Tax Matters Partner, docket No. 9124–08; Harlan

Fund, LLC, Jetstream Business Limited, Tax Matters

Partner, docket No. 9125–08; Grand-Combin Fund, LLC, Jet-

stream Business Limited, Tax Matters Partner, docket No.

9126–08; Larkspur Trading, LLC, Jetstream Business Lim-

ited, Tax Matters Partner, docket No. 9127–08; Lakeview

Trading, LLC, Jetstream Business Limited, Tax Matters

Partner, docket No. 9128–08; Davis Fund, LLC, Jetstream

Business Limited, Tax Matters Partner, docket No. 14094–

08; Cumnor Trading, LLC, Jetstream Business Limited, Tax

Matters Partner, docket No. 16796–08; Bodensee Fund, LLC,

Jetstream Business Limited, Tax Matters Partner, docket

No. 19924–08; Ironwood Trading, LLC, Windmere Fund,

LLC, Tax Matters Partner, docket No. 19925–08; Zurichsee

Trading, LLC, Jetstream Business Limited, Tax Matters

Partner, docket No. 13980–09; Zugersee Trading, LLC, Jet-

stream Business Limited, Tax Matters Partner, docket No.

13981–09; Warner Fund, LLC, Jetstream Business Limited,

Tax Matters Partner, docket No. 13982–09; Riversedge Fund,

LLC, Jetstream Business Limited, Tax Matters Partner,

docket No. 13983–09; Gary R. Fears, docket No. 27636–09;

John E. Rogers & Frances L. Rogers, docket No. 30586–09;

Sugarloaf Fund, LLC, Jetstream Business Limited, Tax Mat-

ters Partner, docket No. 671–10.

f