Cherin v. Commissioner

CHABOT, J., concurring in part and dissenting in part: I agree with that part of the majority’s opinion holding that the purported sales of cattle were lacking in economic substance, and that the benefits and burdens of ownership were not transferred to petitioner. Furthermore, I agree with the majority that no finding regarding petitioner’s profit motive is needed to reach these conclusions, because (on the basis of the record’ in the instant case) the result would be the same as to these issues, whether or not petitioner had a predominant profit motive.

However, I dissent from that part of the majority’s holding that the transaction is a “sham”, within the meaning of section 6621(c)(3)(A)(v).

Section 6621(c) 1 provides, in general, that the interest payable on substantial underpayments attributable to certain transactions is computed at 120 percent of the otherwise applicable rate. This provision was added by section 14(a) of the Tax Reform of 1984 ( Pub. L. 98-369, 98 Stat. 494, 682), which specified four types of transactions that would trigger the increased interest rate provisions. Section 1535(a) of the Tax Reform Act of 1986 ( Pub. L. 99-514, 100 Stat. 2085, 2750) added to the list of transactions “any sham or fraudulent transaction” by adding clause (v) to section 6621(c)(3)(A).

The majority hold that “The transactions between Cherin and Southern Star are ‘shams’ for purposes of section 6621(c)(3)(A)(v), both because they lacked economic substance and because the benefits and burdens of ownership did not pass to him”. 2 (P. 1000.) I would hold that the transactions entered into by petitioner are not shams as that term is used in section 6621(c)(3)(A)(v), because respondent failed to establish 3 that petitioner lacked a profit motive in entering into the transaction.

In providing for the higher-- interest rate, the Congress chose to use the “handle” of “tax motivated transactions”. This term suggests that the taxpayer’s motive is to be critical in determining whether the higher interest rate is to apply. However, the Congress chose to provide a complete definition of this term in paragraph (3)(A) of section 6621(c). An examination of the first three clauses of this definition suggests an intention that the taxpayer’s motive ordinarily (perhaps, always) plays no part in the determination of whether a transaction is a tax-motivated transaction because it comes within one or more of these three clauses. Clause (iv), authorizing respondent to add more categories of tax-motivated transactions, is not so limited. Clause (iv) authorizes respondent to provide by regulations that certain activities constitute tax-motivated transactions. Three of the activities so specified in sec. 301.6621-2T, Proced. & Admin. Regs., depend on the taxpayer’s purposes. 4 The regulation was adopted on December 26, 1984, by T.D. 7998, 1985- 1 C.B. 368 , 49 Fed. Reg. 50390 (Dec. 28, 1984).

Thus, when the Congress added “(v) any sham or fraudulent transaction”, in the Tax Reform Act of 1986, the Congress had before it a definition of tax-motivated transaction that was mostly “no-fault” but that had some alternatives that depended on the taxpayer’s motives. The question in the instant case is whether “sham” is to be no-fault or is to be affected by petitioner’s motives.

The majority contend that “the presence of a profit motive does not preclude a «determination that a transaction lacks economic substance and thus is a sham”. (See p. 1001.) I disagree with their application of this analysis to section 6621(c)(3)(A)(v).

The intended effect of the 1986 amendment to section 6621(c) is expressed in the Statement of the Managers attached to the Conference report (H. Rept. 99-841 (Conf.) 11-796 (1986), 1986-3 C.B. (Vol. 4) 796), as follows:

The Tax Court has recently held (DeMartino v. Comm’r., T.C. Memo 1986-263 (June 30, 1986); Forseth v. Comm’r., T.C. Memo 1985-279 (June 11, 1985)) that sham transactions that would be subject to this special interest rate were they not shams are not subject to this special interest rate because they are shams. The conferees view it as anomalous that a genuine transaction (lacking the proper profit motive) would be subject to a higher interest rate, while a sham transaction, which is significantly more abusive, would escape the higher interest rate simply because it is a sham. Accordingly, the conference agreement, consistent with the legislative intent in originally enacting section 6621(d) in 1984 [redesignated as sec. 6621(c) by the Tax Reform Act of 1986], explicitly adds sham or fraudulent transactions to the list of transactions subject to this higher interest rate. The intent of the conferees is to reverse the holding of these Tax Court cases on this issue. [Emphasis added.]

In Forseth v. Commissioner, T.C. Memo. 1985-279 , the Court was faced with a motion by respondent to amend his answer to assert the applicability of section 6621(d). 5 Respondent had raised numerous alternative grounds for disallowance of the losses. One of the grounds was: “The alleged contracts were fictitious or preconceived shams lacking economic substance.” (Emphasis added.) We stated as follows in Forseth (50 T.C.M. at 113, 54 P-H Memo T.C. par. 85,279 at 85-1250):

respondent has thus raised numerous alternative grounds for disallowance, not all of which are “tax motivated transactions” as defined in section 6621(d)(3)(A). 6 [Emphasis in original.]

The opinion in Forseth dealt with “preconceived shams lacking in economic substance”, that is, those situations where, together with a fictitious transaction there is the absence of an honest profit objective. In our later opinion in the same case, Forseth v. Commissioner, 85 T.C. 127 (1985), affd. sub nom. Mahoney v. Commissioner, 808 F.2d 1219 (6th Cir. 1987), and sub nom. Enrici v. Commissioner, 813 F.2d 293 (9th Cir. 1987), and affd. per order (11th Cir., Aug. 29, 1986), and (5th Cir., Jan. 14, 1987), and on appeal (7th Cir., Feb. 4, 1986), we concluded ( 85 T.C. at 165 ):

Petitioners have failed to prove that there was any actual gold or platinum, that there was any real market or trading, or that there was any purpose, other than the avoidance of taxes, for any of the transactions in issue. [Fn. ref. omitted.]

In DeMartino v. Commissioner, T.C. Memo. 1986-263 , we concluded (51 T.C.M. at 1288, 55 P-H Memo T.C. par. 86,263 at 86-1114):

There, as here, though the taxpayers appeared to be utilizing an organized market, they were in fact creating a market for their transactions at prices they established for ulterior purposes. [Emphasis in original.]

As is indicated in the portion of the Statement of Managers quoted above, the intent of section 6621(e)(3)(A)(v) was to reverse our decisions in Forseth v. Commissioner, T.C. Memo. 1985-279 , and DeMartino v. Commissioner, T.C. Memo. 1986-263 . In these cases it was clear that the taxpayers did not have profit motives. From this, I conclude that the anomalous result that the Congress intended to avoid by enacting the “sham” clause was the avoidance of the higher interest rate where there was no substantial profit motive or there was a motive to deceive or create an appearance of economic substance, knowing that it was only a facade.

Further evidence that the^Congress meant for us to read an intent requirement intoj the word “sham” as used in section 6621(c)(3)(A)(v), is found in the fact that the term is paired with the term “fraudulent”. This appears to have been done in an effort to ensure that an abusive transaction would not escape the higher interest rates mandated by section 6621(c). That a finding of fraud requires a finding of improper intent is too well-established to require citation. The fact that “sham” was listed with “fraudulent”, absent any evidence that Congress was attempting to remedy two completely dissimilar problems by adding the one five-word clause, indicates that “sham” as well as “fraudulent” was meant to carry with it an intent requirement.

The majority’s analysis leads to harsh results in other cases.

For example, suppose that a taxpayer’s employee embezzles funds in year 1 by fictitious purchases of inventory items. The taxpayer’s tax return for year 1 reflects the fictitious transactions as increases in cost of goods sold. When the embezzlement is discovered, in year 3, it is clear that the original treatment of the matter as increased cost of goods sold for year 1 was erroneous. Instead, the embezzled amounts are deductible for year 3, the year the embezzlement was discovered. Sec. 165(e). If a notice of deficiency for year 1 were issued before the taxpayer filed an amended return'for that year, then there would be a deficiency for year 1. That deficiency would be attributable to a transaction that lacked economic substance (since the reported inventory purchases never occurred) or to a transaction in which the benefits and burdens of ownership did not pass. If the. majority follow the analysis they set forth in their opinion in the instant case, then they would hold that the transactions are shams and the taxpayer’s business and profit-seeking motives are irrelevant for purposes of section 6621(c)(3)(A)(v), and that the taxpayer would have to suffer the increased interest rate.

The majority would arrive at the same result if the embezzlement were by way of fictitious purchases of supplies and small tools. 6 Since the purchases never, in fact, occurred, the majority would treat the asserted purchases as shams, either because of the economic-substance analysis or the benefits-and-burdens analysis. The majority, under their no-fault analysis of the instant case would then impose the additional interest rate on the luckless taxpayer.

The imposition of the additibnal tax in such cases would not be commanded by the language that the Congress enacted, nor by the legislative history. Yet, this result would flow inexorably from the majority’s definition of “sham” for purposes of section 6621.(c)(3)(A)(v).

I am reluctant to believe that the Congress added the sham or fraudulent transaction clause in order to impose penalty interest on the unwitting victim in a business embezzlement or investment swindle case. Accordingly, I would hold that a transaction would not be punished under clause (v) of section 6621(c)(3)(A) if the taxpayer’s purpose in entering into the transaction would satisfy the purpose aspect of the deduction requirements of section 162(a) or 212. 7

In determining whether the exculpatory purpose exists, it may be appropriate to be guided by the following comments of Judge Simpson in Dreicer v. Commissioner, 78 T.C. 642, 645 (1982), affd. without opinion 702 F.2d 1205 (D.C. Cir. 1983):

[The taxpayer’s] motive is the ultimate question [in deciding whether to apply sec. 183]; yet, it must be determined by a careful analysis of all the surrounding objective facts, and greater weight is given to such facts than to his mere statement of intent. * * *

I would hold that, because respondent (who has the burden of proof in the instant case, see note 3, supra) did not establish that petitioner lacked a profit motive, the transaction is not a “sham” within the meaning of section 6621(c)(3)(A)(v).

This may be of small comfort to petitioner in the instant case because much of his underpayment may be attributable to a valuation overstatement (sec. 6621(c)(3)(A)(i)), in accordance with our, analyses in Rose v. Commissioner, 88 T.C. 386, 424-427 (1987), and Zirker v. Commissioner, 87 T.C. 970, 978-982 (1986). However, the rationale used by the majority in the instant case would lead to unwarranted sanctions in other cases, and so I must respectfully dissent from the majority’s analysis and conclusion regarding the section 6621(c) issue.

1 Sec. 6621(c) provides, in pertinent part, as follows:

SEC. 6621. DETERMINATION OP RATE OF INTEREST.

(c) Interest on Substantial Underpayments Attributable to Tax Motivated Transactions.—

(1) In general. — In the case of interest payable under section 6601 with respect to any substantial underpayment attributable to tax motivated transactions, the annual rate of interest established under this section shall be 120 percent of the underpayment rate established under this section.

(2) Substantial underpayment attributable to tax motivated transactions. — For purposes of this subsection, the term “substantial underpayment attributable to tax motivated transactions” means any underpayment of taxes imposed by subtitle A for any taxable year which is attributable to 1 or more tax motivated transactions if the amount of the underpayment for such year so attributable exceeds $1,000.

(3) Tax motivated transactions.—

(A) In general. — For purposes of this subsection, the term “tax motivated transaction” means—

(i) any valuation overstatement (within the meaning of section 6659(c)),

(ii) any loss disallowed by reason of section 465(a) and any credit disallowed under section 46(c)(8),

(iii) any straddle (as defined in section 1092(c) without regard to subsections (d) and (e) of section 1092), and

(iv) any use of an accounting method specified in regulations prescribed by the Secretary as a use which may result in a substantial distortion of income for any period, and

(v) any sham or fraudulent transaction.

I read this statement as indicating that either lack of economic substance or the failure of the benefit and burdens of ownership to pass will cause the transaction to be deemed a “sham”.

As the majority point out, respondent bears the burden of proof on this issue in the instant case. (P. 1000.) The majority find that “In this case petitioner’s testimony and the objective facts are not so strongly conclusive with respect to the existence of a predominant nontax motive as to mandate a finding to that effect”. (P. 992.) Since the majority do not conclude that petitioner lacked a profit motive, where the burden is on respondent we can conclude that respondent has failed to prove that petitioner did not have a profit motive for entering into the transaction. See, e.g., Anselmo v. Commissioner, 80 T.C. 872, 886 (1983), affd. 757 F.2d 1208 (11th Cir. 1985). Consequently, I would hold that the section 6621(c) increased interest rate does not apply because respondent failed in his burden of proving a necessary element, the lack of a profit motive.

A-3(9)(ii) depends on whether the taxpayer had tax-avoidance purposes and not business purposes. A-4(l) depends on whether the activity was engaged in for profit. A-4(2) depends on whether the transaction was entered into for profit.

We recognize that our holding means that a real straddle not meeting the requisite profit standard might constitute a “tax motivated transaction” under sec. 6621(d), whereas a purely fictitious “straddle” would not. While this result might seem anomalous, we believe that it is the necessary consequence of the absence, of such factual sham transactions from the statutory or regulatory definitions of tax motivated transactions, and of the explicit inclusion b)y Congress, by reference to the definition of “straddle” in sec. 1092(c), of transactions which are straddles not just in form but in substance.

The Tax Reform Act of 1984 originally enacted the provision dealing with interest on substantial underpayments attributable to tax-motivated transactions as subsec. (d) of sec. 6621. The Tax Reform Act of 1986 redesignated this provision as subsec. (c) of sec. 6621.

Since these expenditures would be deductible in arriving at adjusted gross income, as would theft, this presumably would not present the mitigation problems dealt with in the various opinions in B.C. Cook & Sons, Inc. v. Commissioner, 59 T.C. 516 (1972), and B.C. Cook & Sons, Inc. v. Commissioner, 65 T.C. 422 (1975), affd. 584 F.2d 53 (5th Cir. 1978). See especially the concurring opinion of Judge Tannenwald, 59 T.C. at 522 .

The majority refer to Patin v. Commissioner, 88 T.C. 1086 (1987). In that case, we stated that “it is abundantly clear that sufficient business activity did not exist which would support an objective finding that the transactions herein had.a business purpose". 88 T.C. at 1117. Much of the remainder of that opinion emphasizes the overwhelming focus of the taxpayers on tax benefits and the taxpayers’ indifference to rights and profits. Finally, the Patín opinion emphasizes that “we have explicitly found that the disputed transactions were not entered into for profit.” 88 T.C. at 1129. Thus, Patín is distinguishable from the instant case.