finding that acquisition of a portfolio of non-performing Chinese loans, though ultimately unprofitable, nonetheless possessed economic substance because at the time of purchase “the available market intelligence and valuation data strongly indicated that the emerging market in Chinese [non-performing loans] held significant profit potential”
How later courts described this case
- finding that acquisition of a portfolio of non-performing Chinese loans, though ultimately unprofitable, nonetheless possessed economic substance because at the time of purchase “the available market intelligence and valuation data strongly indicated that the emerging market in Chinese [non-performing loans] held significant profit potential”
- holding that the plaintiff had substantial authority for its position even though the court also held the partnership to be a sham
- "In this case, an application of Culbertson’s totality-of-the-facts-and-circumstances test demonstrates that the Southgate partnership was a sham that need not be respected for tax purposes.”
- "We determine whether a taxpayer acted with reasonable cause on a case-by-case basis, evaluating the totality of the facts and circumstances.’’
Written by the judges who cited it.
The opinion
Case: 09-11166 Document: 00511618581 Page: 1 Date Filed: 09/30/2011
IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT United States Court of Appeals
Fifth Circuit
FILED
September 30, 2011
No. 09-11166
Lyle W. Cayce
Clerk
SOUTHGATE MASTER FUND, L.L.C., by and through Montgomery Capital
Advisors, LLC its Tax Matters Partner,
Plaintiff–Appellant–Cross-Appellee
v.
UNITED STATES OF AMERICA,
Defendant–Appellee–Cross-Appellant
Appeals from the United States District Court
for the Northern District of Texas
Before JOLLY, HIGGINBOTHAM, and SMITH, Circuit Judges.
PATRICK E. HIGGINBOTHAM, Circuit Judge:
We affirm in all respects the district court’s judgment disposing of this
petition for a readjustment of partnership tax items under 26 U.S.C. § 6226. The
plaintiff, Southgate Master Fund, L.L.C., was formed for the purpose of
facilitating the acquisition of a portfolio of Chinese nonperforming loans
(“NPLs”). A partnership for tax purposes, Southgate’s disposition of its portfolio
of NPLs generated more than $1 billion in paper losses, about $200 million of
which were claimed as a deduction by one of its partners in tax year 2002. The
Internal Revenue Service determined that Southgate was a sham partnership
that need not be respected for tax purposes and that Southgate’s allocation of the
$200 million loss to the deducting partner should be disallowed. The district
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No. 09-11166
court upheld these determinations. After laying out the pertinent factual
background in Part I, we explain in Part II why the district court was correct to
do so. The Service further determined that the accuracy-related penalties in 26
U.S.C. §§ 6662(b)(1)–(3) applied to the underpayments of tax resulting from
Southgate’s treatment of its losses. On this point, the district court disagreed,
disallowing the accuracy-related penalties on the ground that Southgate had
reasonable cause for, and acted in good faith with respect to, the tax positions
that resulted in the underpayments of tax. Although this issue is a close one, we
affirm the district court’s decision to disallow the penalties.
I. FACTUAL BACKGROUND
At issue on this appeal are the income-tax consequences of three
interrelated transactions entered into by Southgate and its three members, D.
Andrew Beal, Thomas Montgomery, and China Cinda. As a limited liability
company (LLC), Southgate is treated as a partnership for federal-income-tax
purposes.1 The Internal Revenue Code subjects partnerships to pass-through
tax treatment. Partnerships do not pay income tax; instead, a partnership’s
income and losses flow through to its partners.2 The Southgate partner3 whose
individual income-tax liability will ultimately be affected by this action is Beal.4
1
See 26 U.S.C. § 761(a).
2
Id. § 701.
3
Although the co-owners of a limited liability company technically are known as
“members,” this opinion tracks the language of the Code and refers to Southgate’s members
as “partners.”
4
A petition for review under § 6226 is a partnership-level proceeding. See 26 U.S.C.
§ 6221. Accordingly, our jurisdiction is limited to determining Southgate’s legitimacy as a
partnership, whether its claimed losses should be allowed, how those losses (if allowed) should
be allocated among its partners, and whether penalties should be imposed. See id. § 6226(f);
Petaluma FX Partners, LLC v. Comm’r, 591 F.3d 694, 653–54 (D.C. Cir. 2010); Klamath
Strategic Inv. Fund v. United States, 568 F.3d 537, 547–48 (5th Cir. 2009). Although these
determinations likely will affect the tax liability of one or more of the partners, determining
the specific tax consequences to an individual partner is beyond the scope of this proceeding.
See generally Jade Trading, LLC ex rel. Ervin v. United States, 598 F.3d 1372, 1379–80 (Fed.
2
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Beal is a billionaire Dallas banker who has made a name and a fortune for
himself as an investor in stressed and distressed debt. Montgomery is a certified
public accountant and an associate of Beal’s who specializes in locating stressed-
and distressed-debt investment opportunities in foreign markets. Cinda is a
Chinese-government-owned financial institution. The three transactions in
question are the formation of Southgate itself, Southgate’s acquisition from
Cinda of a portfolio of Chinese NPLs with a face value of about $1.1 billion, and
Beal’s contribution to Southgate of approximately $180 million worth of
Government National Mortgage Association (“GNMA”) securities. Summarized
here are the relevant facts as found by the district court following a fifteen-day
bench trial.
A. The business plan
Beal is the founder and sole owner of the Beal Financial Corporation and
its subsidiary, Beal Bank (collectively, “the Bank”). Beal and the Bank’s core
business involves identifying and purchasing assets that are undervalued
because the market has mispriced their level of risk. Included within this
category are NPLs, which are loans as to which the borrowers are in default, are
in arrears, or have otherwise failed to perform under the terms of the loan
agreement. For years the Bank focused primarily on domestic investment
opportunities. But as the domestic market began to price risk more efficiently,
Beal and the Bank began to focus on identifying inefficiencies and investment
opportunities in foreign markets. In 2001, Beal hired Montgomery to help him
identify opportunities to invest in foreign NPLs. Over the next year,
Montgomery identified NPL investment opportunities in half a dozen foreign
countries. Most notably, in early 2002 Montgomery advised Beal on a purchase
of a package of NPLs that were originated in Jamaica. The Bank paid $23
million for the NPLs (approximately five percent of their face value) and
Cir. 2010); Nehrlich v. Comm’r, 93 T.C.M. (CCH) 1105, at *2 (2007).
3
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ultimately doubled its money on the investment. As the Jamaican NPL
transaction was drawing to a close, Montgomery realized that if the transaction
had been structured differently, it could have provided substantial income-tax
benefits for Beal.
Around the same time that Beal and Montgomery were beginning to look
for opportunities to invest in foreign NPLs, a robust market for NPLs was
emerging in China. By the late 1990s, China’s “big four” state-owned
commercial banks had become saddled with huge numbers of NPLs. In an effort
to reform and modernize its banks, the Chinese government created four new
state-owned asset-management companies to assume and resolve the banks’
NPLs. Cinda was one of these four new asset-management companies. The
Chinese government required the asset-management companies to purchase the
banks’ NPLs at face value (that is, outstanding principal plus unpaid accrued
interest), notwithstanding the fact that, because the loans were nonperforming,
they were worth far less than their face values. From the Chinese government’s
perspective, the full-value-purchase requirement had the dual benefits of
cleaning up the banks’ balance sheets and providing the banks with an infusion
of capital. In 2000 and 2001, China’s big four banks sold approximately $169
billion worth of NPLs to the four asset-management companies. Cinda
purchased loans with face values of approximately $45 billion.
The asset-management companies were charged with resolving the loans
they had assumed. To that end, the statute that created these companies vested
them with a series of so-called “super powers” that were designed to facilitate
the companies’ ability to resolve and collect on the NPLs. These super powers
included the authority to restructure and compromise the loans, the right to
pursue litigation against debtors, and the ability to toll the running of the
statute of limitations.
As the size of the Chinese asset-management companies’ NPL portfolios
grew, investment banks and other sophisticated international investors began
4
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to enter the Chinese NPL market. Foreign investors believed that the
availability of these new super powers increased the likelihood that value could
be realized from Chinese NPLs. In November 2001, China Huarong, another of
China’s four new asset-management companies, auctioned off some of its NPLs.
Goldman Sachs and Morgan Stanley both acquired portfolios of NPLs. Each
retained Huarong to service its loans, and the market intelligence was that
collections were strong and that the investment banks had enjoyed sizeable
returns on their investments.
By early 2002 Montgomery was aware of this market intelligence and had
identified the Chinese NPL market as a potential investment opportunity for
Beal and the Bank. Over the next several months, Montgomery—acting in his
capacity as an employee of the Bank—researched the emerging market in
Chinese NPLs. Like many other sophisticated investors, Montgomery quickly
became convinced that the market held significant potential for profit.
Montgomery had a contact at Deutsche Bank, which had signed a brokerage deal
with Cinda that made it Cinda’s sourcing agent on all NPL deals. In July 2002,
Montgomery’s contact put him in touch with a representative from Cinda.
Montgomery then began to conduct due diligence on acquiring a portfolio of
NPLs from Cinda. Montgomery made several trips to China, where he met with
representatives from Cinda and reviewed various NPL portfolios. Montgomery
eventually determined that the pricing structure would be more favorable on an
investment in unsecured NPLs rather than secured NPLs.
B. The tax plan
At the same time he was researching the profit potential of an investment
in Chinese NPLs, Montgomery also began researching the potential tax benefits
that could be created by such an investment. In May of 2002, Deutsche Bank
introduced Montgomery to the law firm of De Castro, West, Chodorow, Glickfeld
& Nass, Inc. (“De Castro”). Montgomery sought De Castro’s advice on how to
structure an acquisition of Chinese NPLs so that it would create tax benefits for
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Beal. In a series of memoranda that it sent to Montgomery in June and July of
2002, De Castro laid out its plan for such a transaction structure. In short, De
Castro proposed to Montgomery that, once he had identified the portfolio of
NPLs he was going to recommend that Beal acquire, he form a partnership with
Cinda and have Cinda contribute the NPLs to the partnership. By purchasing
a portion of Cinda’s interest in the partnership to which it had contributed the
NPLs instead of purchasing the NPLs directly from Cinda, Beal would be able
to generate a paper loss that he could claim as a deduction on his individual tax
return.
Understanding why De Castro proposed this structure requires a brief
review of the relevant provisions of the Internal Revenue Code and its
implementing regulations. The Code treats a taxpayer’s sale or other disposition
of a piece of property in the ordinary course of his business as a taxable
transaction. If the amount realized on the sale is less than the taxpayer’s
adjusted basis in the property, then the taxpayer is entitled to deduct that loss
from his taxable income.5 “Basis” is the amount that the seller has invested in
the property; ordinarily, the taxpayer takes a cost basis in a piece of property
equal to the property’s purchase price.6 The amount of the loss is determined by
subtracting the taxpayer’s adjusted basis in the property from the amount
realized on the sale.7 For example, assume a taxpayer purchases a piece of
property for $60 and later sells it for $20. The taxpayer’s cost basis is $60, and
he has suffered a loss of $40 on the sale; that loss, when incurred in the ordinary
course of the taxpayer’s business, is deductible against the taxpayer’s income.
By contrast, if a taxpayer purchases a piece of property for $60 and later sells
it for $100, he has realized a gain of $40. He would be required to pay tax on
5
26 U.S.C. § 165(a), (c)(1).
6
See 26 U.S.C. § 1012(a). See generally 26 U.S.C. §§ 1011–1016.
7
26 U.S.C. § 1001(a). If the amount realized on the sale exceeds the taxpayer’s
adjusted basis in the property, then the taxpayer realizes a taxable gain.
6
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that gain. This latter example describes, in the most simplified terms, the
structure and tax consequences of the Bank’s early 2002 purchase of a portfolio
of Jamaican NPLs.
These rules apply to purchases of property. De Castro’s plan for the
Chinese NPL transaction was designed to take advantage of the fact that
different rules apply to sales of partnership interests, with the result that
purchasing an interest in a partnership that owns property can offer big tax
advantages compared to purchasing the property directly. When a partner
acquires an interest in a partnership by contributing property to the
partnership, the contribution is generally not a taxable disposition of the
property.8 Instead, the partner’s basis in the property transfers, or carries over,
to the partnership.9 The partnership’s basis in the transferred property is often
referred to as “inside basis,” and the partnership has the same inside basis in
the property that the partner had before the contribution.10 If, at the time of the
transfer, the property’s fair market value is lower than the partner’s adjusted
basis in the property, the property has a built-in loss.11 Ordinarily, if a partner
transfers property with a built-in loss to the partnership, any loss the
partnership incurs when it sells that property must be allocated back to the
contributing partner; the other partners cannot share in the loss.12
8
26 U.S.C. § 721(a)–(b).
9
26 U.S.C. § 723.
10
See 26 C.F.R. § 1.723-1 (“The basis to the partnership of property contributed to it
by a partner is the adjusted basis of such property to the contributing partner at the time of
the contribution. . . . [S]uch property has the same basis in the hands of the partnership as it
had in the hands of the contributing partner . . . .”).
11
See 26 U.S.C. § 704(c)(1)(C) (“[T]he term ‘built-in loss’ means the excess of the
adjusted basis of the property . . . over its fair market value at the time of contribution.”).
12
See id. § 704(c)(1)(C)(I); see also 26 C.F.R. § 1.704-3(a)(1) (“The purpose of section
704(c) is to prevent the shifting of tax consequences among partners with respect to
precontribution gain or loss.”).
7
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For example, suppose that A and B form a partnership, agreeing to a
50–50 split of profits. B contributes $10 in cash to the partnership, and A
contributes built-in-loss property with a fair market value of $10 and in which
A’s basis is $100. A and B each receive a capital-account credit of $10,13 and the
partnership takes a carryover inside basis in the property of $100. If the
partnership later sells the property for $10, the partnership has realized a $90
loss on the sale. Under § 704(c)(1)(C)(ii) of the Internal Revenue Code, the
entirety of that $90 loss must be allocated to A.14
In this way, the normal operation of § 704(c) ensures that tax value follows
book value. In other words, when property is sold for a loss, the sale creates a
tax benefit in the form of a deduction. The purpose of § 704(c) is to allocate that
benefit to the person who has actually suffered a real economic loss due to the
property’s diminution in value: the partner who paid $100 for property that is
now only worth $10.
A wrinkle arises when the contributing partner sells his partnership
interest to a new partner before the partnership sells the property with the built-
in loss. In that circumstance, Treasury Regulation 1.704-3(a)(7) requires the
built-in loss to be allocated to the partner who purchased the partnership
interest in the same manner that it would have been allocated to the
contributing partner.15 This rule enables the benefit of claiming the loss as a tax
13
Capital accounts, which generally reflect a partner’s percentage ownership interest
in the partnership, are calculated based on the fair market value of the property at the time
of the contribution. See generally LAURA E. CUNNINGHAM & NOËL B. CUNNINGHAM, THE LOGIC
OF SUBCHAPTER K: A CONCEPTUAL GUIDE TO THE TAXATION OF PARTNERSHIPS ch. 4 (4th ed.
2011).
14
By contrast, if B contributed $100 in cash to the partnership, A contributed property
with a fair market value of $100, the property’s value declined to $10 post-contribution, and
the partnership sold the property for $10, then A and B each would be allocated a distributive
share of that $90 loss (here, $45 each). See 26 U.S.C. § 704(a)–(b).
15
26 C.F.R. § 1.704-3(a)(7).
8
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deduction to be separated and transferred away from the person who suffered
the real, economic loss of the property’s diminution of value.16
To continue with the prior example, suppose that after A and B formed
their partnership, A sold her partnership interest to C for $10. If the
partnership later sold the property contributed by A for $10, the
partnership—whose inside basis in the property is $100—would suffer a loss of
$90. Regulation 1.704-3(a)(7) would require that $90 loss to be allocated to C.17
Thus, even though the transaction was revenue-neutral for C in real economic
terms (the partnership sold the property for the same amount of money that C
spent to purchase his partnership interest), for tax purposes C has suffered a
$90 loss, which C is then eligible to deduct against his other income.18 By
contrast, if C had simply purchased the property directly from A, C would have
taken a cost basis of $10, and his later resale of the property for $10 would have
been income-tax neutral. The real economic consequences to C of the two
transactions are identical. But by running the acquisition through the
partnership structure instead of consummating a direct purchase, C receives an
income-tax windfall despite not being the party who suffered real economic loss
as a result of the property’s diminution in value.
This example describes—again in highly simplified terms—the transaction
structure that De Castro proposed to Montgomery for Beal’s acquisition of a
portfolio of Chinese NPLs. Cinda was an ideal partner for such a transaction.
16
At the time that Montgomery was researching an investment in Chinese NPLs, there
was no cap on the amount of built-in loss that could be transferred this way. Congress has
subsequently amended the Code to impose a $250,000 ceiling on the amount of built-in loss
that can be transferred among partners. See 26 U.S.C. § 743(d)(1).
17
Cf. 26 C.F.R. § 1.704-3(b)(2) ex. 1(iii) (describing the proper allocation of gain upon
a partnership’s sale of property with a built-in gain).
18
The portion of this $90 loss that C would be able to claim as a deduction in any given
tax year would be capped at the amount of C’s outside basis in the partnership. See infra
notes 21–22 and accompanying text.
9
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Because the Chinese government had required Cinda to purchase its NPLs at
face value, Cinda had a cost basis in its NPLs that far exceeded the loans’ fair
market value; the NPLs had a huge built-in loss. As a foreign corporation not
subject to U.S. income taxation, Cinda was a tax-indifferent party, unable to
obtain any economic benefit from claiming the built-in loss as a deduction on an
American tax return. If Beal were to purchase the NPLs directly from Cinda,
that built-in loss would evaporate, and Beal would take a cost basis in the NPLs
equal to their purchase price. If Cinda instead contributed to the NPLs to a
partnership and Beal then purchased Cinda’s interest in the partnership, the
built-in loss would be preserved and transferred to Beal. Any loss realized on
the partnership’s sale of the NPLs would be allocated to Beal for tax purposes.
C. The deal
On July 18, 2002, Montgomery, Beal, and attorneys from De Castro
participated in a conference call in which Montgomery presented the results of
his due diligence and recommended that Beal invest in a portfolio of unsecured
Chinese NPLs. The parties also discussed the potential tax benefits to Beal that
would result from the partnership-based transaction structure proposed by De
Castro. Beal explained on the call that the Bank was not in a position to invest
in the NPLs. Montgomery—who up until this time had been acting in his
capacity as an employee of the Bank—asked Beal to release him from his
obligation to the Bank so that he could continue to pursue the deal in an
individual capacity. Beal agreed. He also told Montgomery that he might be
interested in pursuing the investment personally, outside of the Bank, and asked
Montgomery to come back to him once Montgomery had finalized a deal. That
same day, Montgomery formed Montgomery Capital Advisers, LLC (“MCA”), a
single-member limited liability company through which Montgomery could
continue to pursue an investment in Chinese NPLs.
By late July, Montgomery had settled on a particular portfolio of
approximately 24,000 of Cinda’s most severely distressed unsecured NPLs. The
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loans had a face value of approximately $1.145 billion. Montgomery anticipated
that most of the portfolio’s actual value would come from the discovery of a few
“nuggets” within the pool, loans whose values would prove to be many multiples
of their acquisition prices. Based on his experience investing in severely
distressed unsecured NPLs in the United States, Montgomery believed that the
nuggets would make the portfolio of Chinese NPLs worth, at a minimum, 1–3
percent of its face value. To confirm this belief, Montgomery commissioned
Zhongyu, a Chinese valuation firm, to provide a valuation analysis of the NPLs.
Zhonguyu was tasked with estimating the total value of the portfolio based on
a statistically valid sample of about 35 percent of the loans in the portfolio.
Zhongyu was to report its findings to Montgomery by mid-August. MCA also
retained the services of Haiwen, a Chinese law firm, to perform legal due
diligence—that is, to confirm that the loans were legally valid and enforceable,
that Cinda owned the loans, and that Cinda had the ability to transfer the loans
to an American entity. This due-diligence report was due by the end of August.
Eager to close the deal, Montgomery decided to move forward with Cinda
before he received the results of the two due-diligence reports he had
commissioned. On July 31 and August 1, 2002, Montgomery and Cinda
consummated a series of five transactions. First, Cinda formed Eastgate, a
single-member limited liability company organized under Delaware law. As a
wholly owned subsidiary of Cinda, Eastgate was created for the purpose of acting
as Cinda’s United States investment vehicle for NPL transactions.
Second, Cinda contributed to Eastgate the portfolio of NPLs selected by
Montgomery. Cinda contributed the NPLs to Eastgate pursuant to a
contribution agreement in which it made a series of warranties and
representations stating that Cinda had not written off, compromised, or made
a determination of worthlessness as to any of the NPLs.
Third, MCA (Montgomery’s single-member LLC) and Eastgate formed and
organized Southgate as a limited liability company under Delaware law. Upon
11
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formation, Eastgate contributed the NPLs to Southgate pursuant to a virtually
identical contribution agreement. In exchange, Eastgate received a 99 percent
ownership interest in Southgate and an initial capital account balance of
$19,420,000 (an amount roughly equal to 1.7 percent of the NPLs’ face value,
which reflected the parties’ negotiated determination of the loans’ fair market
value). Montgomery contributed cash and a promissory note worth $196,162 in
exchange for a 1 percent ownership interest in Southgate. Montgomery was
appointed as Southgate’s sole manager.
Fourth, Montgomery entered into a brokerage agreement with Deutsche
Bank. Montgomery agreed to pay Deutsche Bank $50,000 for its services as the
exclusive placement agent for Cinda’s NPLs. In addition, Montgomery agreed
that he would pay an additional fee to Deutsche Bank if and when an investor
purchased Cinda’s interest in Southgate. The fee, which was tied to the
percentage of the face value of the loans in Southgate’s portfolio, came to about
$8.5 million. Montgomery anticipated that Beal (or some other investor) would
satisfy this obligation.
Finally, Southgate and Cinda signed a loan-servicing agreement (“LSA”)
in which Southgate agreed to pay Cinda 25 percent of net collections in exchange
for servicing the NPLs. The LSA was critical to the investment strategy in two
respects. First, it reduced the up-front purchase cost of the NPLs. Cinda had
initially proposed an acquisition price of between $34.36 million and $40.08
million (that is, between 3 and 3.5 percent of the portfolio’s face value).
However, Montgomery’s due diligence had revealed that Cinda was required to
use 99 percent of the acquisition price it received for the NPLs to service the
bonds it had used to purchase the loans. But any fees it earned as a loan
servicer it was free to retain for its own operations. Montgomery thus was able
to negotiate the acquisition price of the NPLs from 3-to-3.5 percent down to 1.7
percent by agreeing to have Southgate enter into an LSA that paid Cinda a more
generous fee than it otherwise would have been willing to pay. The second
12
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reason the LSA was critical to Montgomery’s business plan was that it increased
the likelihood of realizing value on the loan portfolio. By retaining Cinda as its
loan servicer, Southgate was able to take advantage of Cinda’s statutory super
powers, which increased the likelihood of successful collections. And by shifting
some of the total value that Cinda would receive in the transaction out of the
purchase price and into the LSA’s fee structure, Montgomery hoped to
incentivize Cinda’s efforts to service and collect on the loans.
These transactions positioned Southgate as a tax-friendly investment
vehicle. Southgate was holding NPLs with a built-in loss of more than $1.3
billion, all of which was allocable to Cinda.19 An investor who purchased Cinda’s
interest in Southgate would step into Cinda’s shoes and be positioned to claim
the tax losses that Southgate generated as it disposed of the loans in its portfolio
for pennies on the dollar. Southgate thus stood to generate more than $1 billion
dollars in paper losses, losses that would arguably be of ordinary-income
character.20 To a high-net-worth individual paying a marginal tax rate of 35
percent, the ability to deduct these losses would be of tremendous value.
The final pieces of the deal fell into place over the next month. In mid-
August, Zhongyu reported the findings of its valuation analysis to Montgomery.
Zhongyu estimated that Southgate’s portfolio of NPLs was worth between $44.67
million (3.90 percent of face value) and $111.8 million (9.76 percent of face
value). Around the same time, Montgomery traveled to China and got a
preliminary report from Haiwen that the NPLs were valid loans. On August 25,
19
The district court found that when Cinda contributed the NPLs to Eastgate, Cinda’s
basis in the NPLs was equal to their purchase price of $1.380 billion, which included $1.145
billion of unpaid principal and $235 million of accrued but unpaid interest. On appeal, neither
party challenges this basis calculation. Southgate’s basis in the NPLs was the same as
Eastgate’s, see sources cited supra notes 9–10, and Eastgate’s basis was the same as Cinda’s,
see generally 26 C.F.R. § 301.7701-3 (providing that certain single-member entities are to be
disregarded for tax purposes).
20
See generally 26 U.S.C. § 742(b); id. § 751(d); id. § 1221(a)(4). We stress that these
losses are arguably ordinary; we do not judge their proper characterization in this appeal.
13
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2002, Montgomery sent a memo to Beal summarizing the results of his due
diligence and enthusiastically recommending that Beal purchase a portion of
Cinda/Eastgate’s interest in the Southgate partnership. Beal readily agreed to
do so. He formed a single-member Delaware LLC, Martel Associates, through
which he would invest in Southgate. By the end of the week, Haiwen’s final
legal due-diligence report came through and confirmed that all but a tiny sliver
of the loans in the portfolio were legally enforceable and had not been
compromised, written off, or discharged in bankruptcy. On August 30, 2002,
Beal paid Cinda $19,407,000 in exchange for 90 percent of Eastgate’s interest in
Southgate. Beal thus wound up with an 89.1 percent ownership interest, leaving
Cinda with a 9.9 percent interest and Montgomery’s 1.0 percent share
unchanged. Beal also assumed Montgomery’s obligations under the brokerage
agreement with Deutsche Bank and paid the $8.5 million placement fee.
With the deal papered, the parties turned to developing a collection
strategy that would be responsive to both profit- and tax-driven concerns. On
the business side, Montgomery and Cinda decided to focus on identifying a small
number of loans (between 15 and 25 percent of the portfolio) that held enough
profit potential to merit further review. The goal was to focus collection efforts
on nuggets that would eventually be identified within this smaller pool. The
balance of the portfolio would be packaged into smaller groups and sold off to
small Chinese collection firms; the proceeds of the sales would provide Southgate
with working capital. Consistent with the three-year term of the LSA between
Southgate and Cinda, Montgomery and Cinda decided to aim for resolving about
25 percent of the NPLs in 2002, 50 percent in 2003, and 25 percent in 2004. It
just so happened that this collection strategy would create losses in amounts
tailored to the amounts of personal income against which Beal sought to claim
deductions.
Ultimately, Southgate proved to be a failure as an investment venture.
The primary cause of Southgate’s poor performance was Cinda’s disappointing
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performance as a loan servicer. The value of many of the loans that Southgate
identified as nuggets derived from the fact that they were backed by a Chinese-
government guarantee. Cinda’s initial efforts to collect on these loans and
enforce the guarantees generated push-back and fallout in China. Political
pressure from the Chinese government led to Cinda’s repeatedly selling off NPLs
that Southgate had identified as high-value nuggets. These sales were in direct
breach of both the Southgate Operating Agreement and the LSA and cut the legs
from Southgate’s business plan. The total net collections on Southgate’s NPL
portfolio were approximately $10.69 million, far less than Zhongyu’s valuation
report had projected.
D. The basis-build
Consistent with the collection strategy developed by Cinda and
Montgomery, in late 2002 Southgate sold off approximately 22 percent of the
loans in its portfolio. The net recovery on the sales was approximately $2.2
million. Southgate suffered a loss on the sales of approximately $294.9 million,
of which $292.8 million was pre-contribution, built-in loss. Since Beal had
purchased 90 percent of Cinda’s interest in Southgate, 90 percent of that built-in
loss was allocable to Beal and available for him to take as a deduction on his
2002 individual tax return.
One final step remained in the tax plan: Beal needed to build his outside
basis in Southgate. A partner’s “outside basis” is his adjusted basis in his
ownership interest in the partnership. When a partner purchases a partnership
interest, he generally takes a cost basis in his partnership interest.21 In other
words, his outside basis is equal to the amount he paid to acquire the
partnership interest. And while partnership losses are deductible by the
individual partners, the amount of allocated partnership loss that a partner can
claim as a deduction on his individual tax return is capped at the amount of his
21
See 26 C.F.R. § 1.742-1.
15
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outside basis.22 If the amount of a partnership loss that is allocable to the
partner exceeds his outside basis, the overage remains suspended inside the
partnership and can only be claimed if the partner builds his outside basis
during a future tax year. Thus, the fact that some $263.5 million of Southgate’s
built-in losses were allocable to Beal was not enough to make the full value of
those losses deductible by Beal on his 2002 tax return. Up until the very end of
2002, Beal’s outside basis in Southgate was only about $29.9 million (the roughly
$19.4 million he paid for his partnership interest plus about $10.5 million in
transaction and operating costs). To be able to deduct most of the built-in loss
that was allocable to him, Beal needed to build his outside basis in Southgate.
This was the purpose of what the parties have dubbed the GNMA basis-
build.23 In late 2002, Beal owned some GNMAs with a fair market value of
approximately $180.6 million. GNMAs are fixed-rate, mortgage-backed
securities. The GNMAs that Beal owned were platinum securities backed by the
full faith and credit of the United States, which guaranteed timely payment of
principal and interest. In late December 2002, Beal nominally contributed the
GNMAs to Southgate in an effort to build his outside basis in the partnership.
As relevant here, the GNMA basis-build took place in three steps. First,
Beal contributed the GNMAs to Martel (the single-member LLC through which
he had purchased his interest in Southgate).24 Second, Martel distributed its
22
See 26 U.S.C. § 704(d) (“A partner’s distributive share of partnership loss . . . shall
be allowed only to the extent of the adjusted basis of such partner’s interest in the partnership
at the end of the partnership year in which such loss occurred.”); see also Klamath Strategic
Inv. Fund v. United States, 568 F.3d 537, 542 (5th Cir. 2009) (“Generally, a partner’s basis in
a partnership is determined by the amount of capital he contributes to the partnership, and
when a partnership loses money the partners can only deduct the losses from their taxable
income to the extent of their basis in the partnership.”).
23
At oral argument, Southgate readily conceded that Beal’s contribution of the GNMAs
was primarily a tax-motivated transaction.
24
Soon thereafter, Martel entered into a repo transaction with UBS PaineWebber Inc.,
in which Martel, in substance, pledged the GNMAs as collateral for a $162 million secured
loan. Martel transferred the proceeds of this loan to the Bank. Thus, when the GNMAs were
16
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interest in Southgate to Beal. Beal thereby became an 89.1 percent owner of
Southgate. Instead of owning an interest in Southgate through Martel, Beal
now owned his interest in Southgate directly. Third, Beal contributed Martel
to Southgate. Both Southgate’s and Martel’s operating agreements were
amended to irrevocably appoint Beal as the sole manager of Martel and to reflect
Beal’s admission as a partner in Southgate, Beal’s contribution of Martel to
Southgate, and Southgate’s admission as a partner in Martel. At the time of its
contribution to Southgate, Martel still owned the $180.6 million worth of
GNMAs. A partner’s contribution of property to a partnership generally
increases the partner’s outside basis in his partnership interest.25 As a result,
Beal took the position that his contribution of the GNMAs to Southgate had
increased his outside basis in Southgate by $180.6 million.
Beal’s contribution of the GNMAs to Southgate came with numerous
strings attached. Four terms of the amendments to the operating agreements
are particularly important for our later analysis of this putative contribution.
Three of these terms expressly ensured that the vast majority of the GNMAs’
value would be reserved to Beal. First, all of the interest that accrued on the
GNMAs after their contribution to Southgate was allocated to Beal. Second, in
his capacity as Martel’s sole manager, Beal had the absolute right in his sole
discretion to cause Martel to distribute to him the GNMAs and/or all payments
received with respect to the GNMAs. Beal’s exercise of this right would not give
rise to an obligation on Southgate’s part to make proportionate distributions to
contributed to Southgate, Southgate assumed Martel’s liability on the loan that the GNMAs
secured. Ordinarily a partnership’s assumption of a partner’s liability causes the partner’s
outside basis to be reduced by the amount of the liability. See 26 U.S.C. § 752(b). However,
Martel had distributed the proceeds of the loan to Beal in exchange for Beal’s agreeing to
personally and unconditionally guarantee the loan, and the district court found that Beal was
at risk on the guarantee, see generally 26 C.F.R. §§ 1.752-1(a)(1), 1.752-2(b)(1). Beal thus
assumed Southgate’s liability on the loan, and his outside basis was increased concomitantly.
See 26 U.S.C. § 752(a).
25
See 26 U.S.C. § 722.
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the other two partners. Third, Beal had unconditional rights to direct the use
and application of all proceeds from the GNMAs and to direct any and all other
matters pertaining to the GNMAs. There was a single provision that, at least
theoretically, created a possibility that the other partners might profit from the
contribution of the GNMAs. If the GNMAs appreciated in value during the time
they were held in Southgate, the gain was to be allocated among Southgate’s
partners in accordance with their percentage interest in the partnership.
The contribution of the GNMAs, at least in form, brought Beal’s outside
basis in Southgate up to a total of about $210.5 million. When Southgate filed
its 2002 partnership return, it allocated to Beal a loss of approximately $263.5
million. The GNMA basis-build enabled Beal to claim $210.5 million of that loss
as a deduction on his 2002 individual tax return.
E. Procedural history
The Service issued a final partnership administrative adjustment
(“FPAA”) to Southgate pertaining to its 2002 partnership return. The FPAA
concluded that Southgate was a sham partnership that had been formed solely
for the purposes of tax avoidance, determined that Southgate would not be
recognized as a partnership for federal-income-tax purposes, disallowed
Southgate’s claimed losses arising out of its 2002 dispositions of Chinese NPLs,
and imposed substantial penalties. Southgate filed a petition for review in
federal district court under 26 U.S.C. § 6226(a)(2). The district court issued
findings of fact and conclusions of law after presiding over a fifteen-day bench
trial. The court upheld the FPAA’s disallowance of Southgate’s claimed losses
on the ground that the Southgate partnership was a sham for tax purposes.
However, the court disallowed the imposition of penalties on the ground that
Southgate had established reasonable cause and good faith and thus had a
complete defense to any accuracy-related penalties. Southgate appeals the
former determination; the Government appeals the latter.
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II. TAX CONSEQUENCES
This appeal requires us to determine the tax consequences of Southgate’s
formation, Southgate’s acquisition of its portfolio of Chinese NPLs, and the
GNMA basis-build. The starting point for our analysis is the cardinal principle
of income taxation: a transaction’s tax consequences depend on its substance, not
its form.26 This principle “is no schoolboy’s rule; it is the cornerstone of sound
taxation . . . . ‘Tax law deals in economic realities, not legal abstractions.’”27
This foundational principle finds its voice in the judicial anti-abuse doctrines,
which “‘prevent taxpayers from subverting the legislative purpose of the tax code
by engaging in transactions that are fictitious or lack economic reality simply to
reap a tax benefit.”28 The judicial doctrines empower the federal courts to
disregard the claimed tax benefits of a transaction—even a transaction that
formally complies with the black-letter provisions of the Code and its
implementing regulations—if the taxpayer cannot establish that “what was
done, apart from the tax motive, was the thing which the statute intended.”29
Our disposition of this appeal requires us to make use of three of the
judicial doctrines. The first is the economic-substance doctrine. “[T]he law does
not permit the taxpayer to reap tax benefits from a transaction that lacks
26
See, e.g., Freytag v. Comm’r, 904 F.2d 1011, 1015 (5th Cir. 1990) (“The fundamental
premise underlying the Internal Revenue Code is that taxation is based upon a transaction’s
substance rather than its form.”), aff’d, 501 U.S. 868 (1991); see also Arevalo v. Comm’r, 469
F.3d 436, 439 (5th Cir. 2006) (“The Supreme Court has repeatedly stressed that, in examining
transactions for the purpose of determining their tax consequences, substance governs over
form.” (citing Frank Lyon Co. v. United States, 435 U.S. 561, 572–73 (1978))).
27
Estate of Weinert v. Comm’r, 294 F.2d 750, 755 (5th Cir. 1961) (quoting Comm’r v.
Sw. Exploration Co., 350 U.S. 308, 315 (1956) (internal ellipsis omitted)); see also Frank Lyon
Co., 435 U.S. at 573 (“‘In the field of taxation, administrators of the laws and the courts are
concerned with substance and realities, and formal written documents are not rigidly
binding.’” (quoting Helvering v. Lazarus & Co., 308 U.S. 252, 255 (1939))).
28
Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1353–54 (Fed. Cir. 2006).
29
Gregory v. Helvering, 293 U.S. 465, 469 (1935).
19
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economic reality.”30 Thus, “[t]ransactions that have no economic effect other
than the creation of income tax losses are shams for tax purposes and will not
be recognized.”31 The second is the sham-partnership doctrine. A partnership
“may be disregarded where it is a sham or unreal . . . [,] a bald and mischievous
fiction.”32 A taxpayer must be able to demonstrate that there was some nontax
business purpose for his use of the partnership form.33 Finally, the doctrine of
substance over form “provides that the tax consequences of a transaction are
determined based on the underlying substance of the transaction rather than its
legal form.”34 The substance-over-form doctrine allows a transaction to be
recharacterized so that its taxable form corresponds to its economic substance.35
In an appeal from a bench trial, we review the district court’s findings of
fact for clear error and its conclusions of law de novo.36 “Specifically, a district
court’s characterization of a transaction for tax purposes is a question of law
subject to de novo review, but the particular facts from which that
characterization is made are reviewed for clear error.”37 Our de novo application
30
Coltec, 454 F.3d at 1355.
31
Boynton v. Comm’r, 649 F.2d 1168, 1172 (5th Cir. Unit B July 1981).
32
Moline Props., Inc. v. Comm’r, 319 U.S. 436, 439 (1943).
33
See, e.g., Estate of Strangi v. Comm’r, 293 F.3d 279, 281–82 (5th Cir. 2002); ASA
Investerings P’ship v. Comm’r, 201 F.3d 505, 512–13 (D.C. Cir. 2000).
34
Wells Fargo & Co. v. United States, 641 F.3d 1319, 1325 (Fed. Cir. 2011) (citing
Griffiths v. Helvering, 308 U.S. 355, 357 (1939)).
35
See Blueberry Land Co. v. Comm’r, 361 F.2d 93, 101 (5th Cir. 1966) (“[C]ourts will,
and do, look beyond the superficial formalities of a transaction to determine the proper tax
treatment.”).
36
Klamath Strategic Inv. Fund v. United States, 568 F.3d 537, 543 (5th Cir. 2009).
37
Duffie v. United States, 600 F.3d 362, 364 (5th Cir.), cert. denied, 131 S. Ct. 355
(2010); see also Frank Lyon Co. v. United States, 435 U.S. 561, 581 n.16 (1978) (“The general
characterization of a transaction for tax purposes is a question of law subject to review.”). The
Government incorrectly contends that Merryman v. Comm’r, 873 F.2d 879 (5th Cir. 1989),
establishes that sham-partnership determinations are reviewed only for clear error.
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of the judicial doctrines to the facts as found by the district court leads us to
three conclusions. First, Southgate’s acquisition of its portfolio of Chinese NPLs
had economic substance. Second, Southgate itself was a sham partnership. This
second conclusion finds substantial support in our determination that the
GNMA basis-build lacked economic substance. Third, Southgate’s acquisition
of the NPLs should be recharacterized under the substance-over-form doctrine
as a direct sale from Cinda to Beal and Montgomery.
A. The acquisition of the NPLs had economic substance.
With little difficulty, we affirm the district court’s conclusion that
Southgate’s acquisition of the portfolio of NPLs had economic substance. In
Klamath, we derived a three-part test for determining whether a transaction has
sufficient economic substance to be respected for tax purposes: “whether the
transaction (1) has economic substance compelled by business or regulatory
realities, (2) is imbued with tax-independent considerations, and (3) is not
shaped totally by tax-avoidance features.”38 In other words, the transaction
must exhibit objective economic reality, a subjectively genuine business purpose,
and some motivation other than tax avoidance. While “these factors are phrased
in the conjunctive, meaning that the absence of any one of them will render the
transaction void for tax purposes,”39 there is near-total overlap between the
Merryman’s application of the clearly-erroneous standard of review to the Tax Court’s decision
in a sham-partnership case was the result of the unusual fact that the petitioning taxpayers
“agreed with the law applied by the Tax Court” and challenged only the underlying factual
findings. Id. at 881. Merryman did not unseat the well-established rule in this Circuit that
“‘legal conclusion[s]’ that transactions are shams in substance are reviewed de novo.” Compaq
Computer Corp. v. Comm’r, 277 F.3d 778, 780-81 (5th Cir. 2001) (alteration in original)
(quoting Killingsworth v. Comm’r, 864 F.2d 1214, 1217 (5th Cir. 1989)); see also id. at 781 n.1
(considering and rejecting the argument that this Court should review the legal conclusion
that a transaction is a sham only for clear error).
38
Klamath, 568 F.3d at 544.
39
Id.; accord Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1355 (Fed. Cir. 2006)
(“[A] lack of economic substance is sufficient to disqualify the transaction without proof that
the taxpayer’s sole motive is tax avoidance.”).
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latter two factors.40 The district court’s findings of fact strongly support its
conclusion that Southgate’s acquisition of the NPLs satisfies the standard
announced in Klamath.
As to the first Klamath factor, transactions lack objective economic reality
if they “‘do not vary[,] control[,] or change the flow of economic benefits.’”41 This
is an objective inquiry into whether the transaction either caused real dollars to
meaningfully change hands42 or created a realistic possibility that they would do
so.43 That inquiry must be “conducted from the vantage point of the taxpayer at
the time the transactions occurred, rather than with the benefit of hindsight.”44
Southgate’s acquisition of the NPLs readily satisfies the first Klamath
factor. The district court found that Southgate and its members entered into the
NPL investment with a reasonable possibility of making a profit. That the NPL
investment ultimately turned out not to be profitable does not call this finding
into question. The investment failed largely because of Cinda’s shortcomings as
a loan servicer and interference from the Chinese government. The district
court found that these shortcomings were not foreseeable to Beal and
40
To say that a transaction is shaped totally by tax-avoidance features is, in essence,
to say that the transaction is imbued solely with tax-dependent considerations.
41
Klamath, 568 F.3d at 543 (quoting Higgins v. Smith, 308 U.S. 473, 476 (1940)); see
also Coltec, 454 F.3d at1355 (“[T]he objective economic substance inquiry [asks] ‘whether the
transaction affected the taxpayer’s financial position in any way.’” (quoting Adver & Grapevine
Records & Tapes, Inc. v. IRS (In re CM Holdings, Inc.), 301 F.3d 96, 103 (3d Cir. 2002))).
42
“[A] circular flow of funds among related entities does not indicate a substantive
economic transaction for tax purposes.” Merryman, 873 F.2d at 882.
43
Portland Golf Club v. Comm’r, 497 U.S. 154, 170 n.19 (1990) (“‘A transaction has
economic substance and will be recognized for tax purposes if the transaction offers a
reasonable opportunity for economic profit, that is, profit exclusive of tax benefits.’” (quoting
Gefen v. Comm’r, 87 T.C. 1471, 1490 (1986))); accord Coltec, 454 F.3d at 1356; Rice’s Toyota
World, Inc. v. Comm’r, 752 F.2d 89, 94 (4th Cir. 1985) (explaining that the inquiry into
objective economic substance “requires an objective determination of whether a reasonable
possibility of profit from the transaction existed apart from tax benefits”).
44
Smith v. Comm’r, 937 F.2d 1089, 1096 (6th Cir. 1991).
22
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Montgomery at the time they decided to undertake the investment. In the
summer of 2002, the available market intelligence and valuation data strongly
indicated that the emerging market in Chinese NPLs held significant profit
potential. If Zhongyu’s upper-end valuation estimate had proven to be accurate,
Beal and Montgomery stood to net upwards of $50 million on their
investments.45 The district court was correct to conclude that Southgate’s
acquisition of the NPLs had objective economic reality.
The latter two Klamath factors ask whether the transaction was motivated
solely by tax-avoidance considerations or was imbued with some genuine
business purpose. These factors undertake a subjective inquiry into “‘whether
the taxpayer was motivated by profit to participate in the transaction.’”46 Tax-
avoidance considerations are not wholly prohibited; taxpayers who act with
mixed motives, seeking both tax benefits and profits for their businesses, can
satisfy the business-purpose test.47
Here, too, Southgate’s acquisition of the NPLs easily passes muster. The
district court found that Southgate and its members acquired the NPLs for
legitimate purposes and that they believed they could earn a profit from the
NPLs. This is not an instance of a taxpayer’s engaging in an exotic, one-off
transaction that bears no resemblance to its ordinary business activities. Beal
and Montgomery specialize in buying stressed debt. They had previously
identified a growth opportunity in foreign NPL markets. As the district court
45
Of course, it turned out that Zhongyu’s valuation report had substantially
overestimated the NPLs’ value, but the district court found that it was reasonable for
Southgate to rely on Zhongyu’s analysis, and the Government does not contend that this
finding was clearly erroneous.
46
Dow Chem. Co. v. United States, 435 F.3d 594, 599 (6th Cir. 2006) (quoting Illes v.
Comm’r, 982 F.2d 163, 165 (6th Cir. 1992)); see also In re CM Holdings, 301 F.3d at 102 n.4
(explaining that the “subjective inquiry” plays the “basic role of evaluating whether the
taxpayer had a business reason, apart from tax avoidance, for engaging in the transaction”).
47
See Compaq Computer Corp. v. Comm’r, 277 F.3d 778, 786 (5th Cir. 2001) (collecting
cases).
23
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found, the acquisition of the NPLs fit squarely within Beal and Montgomery’s
core business. The district court also found that Beal and Montgomery would
have done the deal regardless of whether it had any tax benefits. As to
Montgomery specifically, the court found that he was not in a position to receive
tax benefits from the NPLs. His motives were exclusively profit- and business-
driven: to earn money on the deal and develop a marketable expertise in Chinese
NPLs that he could use in similar transactions in the future. As to Beal, the
court found he acted with mixed motives, investing in Southgate both because
it posed profit potential and because it offered potential tax benefits. Under our
decision in Compaq Computer Corp.,48 that finding is sufficient for economic-
substance purposes.
The Government urges us to conclude that the acquisition of the NPLs
lacked economic substance because the district court found only that the
transaction had “some profit potential” and such a finding is not sufficient for
economic-substance purposes if a transaction’s profit potential is insubstantial
relative to its expected tax benefits. This argument misfires factually and
legally. Factually, the district court made three separate findings that the
acquisition of the NPLs had not just a de minimis profit potential but a
reasonable profit potential. Under Klamath, those findings support the
conclusion that the acquisition had economic substance.49 The cases that the
Government cites in support of its contrary position present readily
distinguishable facts.50 Legally, the Government would have us conflate our
48
Id.
49
See Klamath Strategic Inv. Fund v. United States, 568 F.3d 537, 545 (5th Cir. 2009)
(emphasizing that “the proper focus is on whether the loan transactions presented a
reasonable possibility of profit” and concluding that the transaction in question lacked
economic substance because “no reasonable possibility of profit existed”).
50
See Rogers v. United States, 281 F.3d 1108, 1117–18 (10th Cir. 2002) (distinguishing
between the economic-substance doctrine and the substance-over-form doctrine before
applying the latter); Keeler v. Comm’r, 243 F.3d 1212, 1220 (10th Cir. 2001) (rejecting a
24
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analysis of the acquisition of the NPLs under the economic-substance doctrine
with our analysis of the formation of Southgate under the sham-partnership
doctrine. The acquisition of the NPLs did not, by itself, generate any tax
benefits. It was the funneling of that acquisition through the partnership
structure that generated massive deductions for Beal. The fact that an
economically substantial transaction comes wrapped in a dubious form is not a
reason to disregard the transaction; it is a reason to disregard the form. Once the
acquisition of the NPLs is recharacterized as a direct sale,51 it becomes apparent
that the tax benefits it created were not disproportionate to its expected
profitability.52 As a result, we affirm the district court’s conclusion that
Southgate’s acquisition of a portfolio of Chinese NPLs was an economically
substantial transaction motived by a genuine business purpose.
B. Southgate was a sham partnership.
We are also persuaded that the district court was correct to determine that
Southgate was a sham partnership that must be disregarded for federal-income-
tax purposes.53 As the Supreme Court explained in Comm’r v. Culbertson,
taxpayer’s argument that a complicated derivative-trading scheme, which as a whole provided
nothing but an illusory opportunity for economic profit, nonetheless had economic substance
because individual trades within the scheme sometimes generated profits); ACM P’ship v.
Comm’r, 157 F.3d 231, 258 & n.52 (3d Cir. 1998) (explaining that the “prospect of a nominal,
incidental pre-tax profit” is not enough to support a finding of economic substance where none
of the partners “reasonably expected to gain any pretax profit from the transaction”); Kuper
v. Comm’r, 533 F.2d 152, 159 (5th Cir. 1976) (holding that the form assigned to a set of
economically substantial transactions need not be respected where“larger tax objectives . . .
ultimately controlled [the] specific form of the transactions”).
51
See infra Section II.C.
52
Indeed, the only reason the sale created any tax benefits at all is that Beal suffered
real, out-of-pocket losses because of his participation in the transaction.
53
Southgate engages in question-begging when it contends that 26 U.S.C. § 704(c)
mandated the tax treatment at issue in this appeal. Section 704(c) governs the allocation of
losses among partners in a valid partnership. It is silent on the question of when a putative
partnership is in fact valid. Here the judicial doctrines step into the breach. Sham-
partnership analysis makes it plain that Southgate was not a valid partnership for tax
purposes. Neither the text of the statute nor Congress’s intent in enacting it compels the
25
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whether a partnership will be respected for tax purposes depends on whether
“the parties in good faith and acting with a business purpose” genuinely
“‘intended to join together for the purpose of carrying on the business and
sharing in the profits and losses.’”54 This determination is made in light of all
the relevant facts and circumstances, including “the agreement, the conduct of
the parties in execution of its provisions, their statements, the testimony of
disinterested persons, the relationship of the parties, their respective abilities
and capital contributions, the actual control of income and the purposes for
which it is used, and any other facts throwing light on their true intent.”55
Because so many abusive tax-avoidance schemes are designed to exploit
the Code’s partnership provisions,56 our scrutiny of a taxpayer’s choice to use the
partnership form is especially stringent.57 We are not compelled to conclude that
a partnership must be respected for tax purposes “merely because the taxpayer
can point to the existence of some business purpose or objective reality in
addition to [the partnership’s] tax-avoidance objective.58 Rather, a taxpayer’s
application of partnership tax treatment to an entity that was not a true partnership. Section
704(c) does not control.
54
Comm’r v. Culbertson, 337 U.S. 733, 741–42 (1949) (quoting Comm’r v. Tower, 327
U.S. 280, 287 (1946)); see also ASA Investerings P’ship v. Comm’r, 201 F.3d 505, 513 (D.C. Cir.
2000) (describing the “basic inquiry” as “whether, all facts considered, the parties intended to
join together as partners to conduct business activity for a purpose other than tax avoidance”);
Scofield v. Davant, 218 F.2d 486, 489 (5th Cir. 1955) (“[T]he reality vel non of the partnership
for tax purposes . . . depends upon whether the partners really and truly intended to join
together for the purpose of carrying on a business and sharing in the profits or losses or
both.”).
55
Culbertson, 337 U.S. at 742.
56
See BORIS I. BITTKER & LAWRENCE LOKKEN, FEDERAL TAXATION OF INCOME, ESTATES
AND GIFTS ¶ 86.1.2 (2011); Bradley T. Borden, The Federal Definition of Tax Partnership, 43
HOUS. L. REV. 925, 928–29 (2006); Karen C. Burke, Repairing Inside Basis Adjustments, 58
TAX LAW. 639, 639 & n.1 (2005).
57
See TIFD III-E, Inc. v. United States, 459 F.3d 220, 232 n.13 (2d Cir. 2006); ASA
Investerings, 201 F.3d at 513.
58
See TIFD III-E, 459 F.3d at 232.
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formation of a partnership must, on balance, display good “common sense from
an economic standpoint.”59
The fact that a partnership’s underlying business activities had economic
substance does not, standing alone, immunize the partnership from judicial
scrutiny.60 The parties’ selection of the partnership form must have been driven
by a genuine business purpose.61 This is not to say that tax considerations
cannot play any role in the decision to operate as a partnership.62 It is only to
say that tax considerations cannot be the only reason for a partnership’s
formation.63 If there was not a legitimate, profit-motivated reason to operate as
a partnership, then the partnership will be disregarded for tax purposes even if
it engaged in transactions that had economic substance.64
59
Boca Investerings P’ship v. United States, 314 F.3d 625, 631 (D.C. Cir. 2003).
60
See TIFD-IIIE, 459 F.3d at 231 (“The IRS . . . is entitled in rejecting a taxpayer’s
characterization of an interest to rely on a test less favorable to the taxpayer, even when the
interest has economic substance. This alternative test determines the nature of the interest
based on a realistic appraisal of the totality of the circumstances.”).
61
See Merryman v. Comm’r, 873 F.2d 879, 881 (5th Cir. 1989) (“The issue . . . is not
whether the operation of the oil rig had economic substance, but whether the formation of the
partnership had such substance. Courts have rejected the form of a transaction even when the
underlying activity, as in this case the operation of the oil rig, was not a sham.”); see also Saba
P’ship v. Comm’r, 273 F.3d 1135, 1141 (D.C. Cir. 2003) (“‘[T]he absence of a nontax business
purpose is fatal’ to the argument that the Commissioner should respect an entity for federal
tax purposes.” (quoting ASA Investerings, 201 F.3d at 512)); Adantech L.L.C. v. Comm’r, 331
F.3d 972, 980 (D.C. Cir. 2003) (holding that a partnership was a sham even though it was
“possible that [its] business could have been profitable”); sources cited supra note 33.
62
As Judge Learned Hand once famously said, “Any one may so arrange his affairs that
his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay
the Treasury; there is not even a patriotic duty to increase one’s taxes.” Helvering v. Gregory,
69 F.2d 809, 810 (2d Cir. 1934), aff’d, 293 U.S. 465 (1935).
63
On this score, it is telling that the great judge uttered his well-known epigram just
before disregarding the form of a transaction on the ground that it was a sham devoid of
economic substance. See id. at 811.
64
Southgate contends that the proper test of a partnership’s legitimacy is an either–or
test announced by Moline Properties v. Comm’r, 319 U.S. 436 (1943), under which a
partnership must be respected for tax purposes if it either was formed for the purpose of
carrying on business activity or in fact conducts economically substantial business activity
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In this case, an application of Culberton’s totality-of-the-facts-and-
circumstances test demonstrates that the Southgate partnership was a sham
that need not be respected for tax purposes. Montgomery, Beal, and Cinda did
not intend to come together to jointly conduct the business of collecting on the
NPLs. The structure of the GNMA basis-build underscores their lack of such an
intent. The parties also lacked any genuine business purpose for their decision
to form Southgate.
(1) The lack of an intent to join together
Culbertson directs our attention to the conduct of the parties in execution
of the partnership agreement’s provisions,65 and Beal and Montgomery’s conduct
after Southgate’s formation demonstrates that they did not truly intend to join
together with Cinda in the present conduct of a business. Concededly, Beal and
Montgomery’s intent at the time they acquired the NPLs was to conduct the
business of realizing value from the loans. But their subsequent conduct
discloses no intent to conduct that business as a partnership with Cinda.
Most damning is their response to Cinda’s shortcomings as a loan
servicer—shortcomings that, as noted above, were the primary cause of
Southgate’s failure to turn a profit on its NPL portfolio. By late 2003, with the
net collection rate on the portfolio languishing at less than 1.1 percent, these
shortcomings had become apparent, and Montgomery retained an attorney to
help him develop a strategy for improving collections. The attorney wrote a
post-formation. We disagree. Southgate’s test conflicts with our holding in Merryman. See
supra note 61. As a prior published decision of this Court, Merryman binds us, regardless of
whether its interpretation of Moline Properties was correct. See Grabowski v. Jackson Cnty.
Pub. Defenders Office, 47 F.3d 1386, 1398–1400 & n.4 (5th Cir. 1995) (Smith, J., concurring
in part and dissenting in part). That said, Merryman was correctly decided, and it is
Southgate who misreads Moline Properties. What Southgate “alleges to be a two-pronged
inquiry is in fact a unitary test,” under which “the existence of formal business activity is a
given but the inquiry turns on the existence of a nontax business motive.” ASA Investerings,
201 F.3d at 512 (citing Knetsch v. United States, 364 U.S. 361, 364–66 (1960)).
65
See also Merryman, 873 F.2d at 882–83 (relying on the parties’ post-formation
conduct as evidence of their intentions at the time they formed the partnership).
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letter to Cinda complaining about its servicing efforts. Cinda responded by
threatening to disclose the Southgate transaction to the IRS. Montgomery’s
attorney immediately apologized to Cinda, and he made no further efforts to
goad Cinda into improving its performance as the loan servicer.
This sequence of events decisively gives the lie to the notion that
Montgomery and Beal intended to jointly conduct a business with Cinda.
Without an improved collection rate, Southgate’s profit potential was doomed.
Cinda’s repeated, willful breaches of the LSA and the Southgate Operating
Agreement had put Beal and Montgomery to a decision: they could preserve the
business but risk the tax benefit, or they could sacrifice the business and
preserve the tax benefit. With no hesitation, they charted the latter course.
Their decision manifests an unmistakable intent to forgo the joint conduct of a
profit-seeking venture.66
Beal and Montgomery’s outside dealings with Cinda also shine an
illuminating light on their intentions within Southgate. In late 2003, around the
same time that Cinda’s shortcomings as a servicer became so egregious that
Montgomery began contemplating legal action, Beal and Montgomery entered
into another NPL transaction with Cinda. As the district court delicately put it,
“It is unclear why they would return to the same unprofitable NPL trough after
their difficulty with Cinda’s servicing of the Southgate portfolio, other than the
anticipated tax benefits.” Armed with first-hand information that a second
partnership with Cinda had no chance of being profitable, they nonetheless
66
While this decision is highly relevant to our sham-partnership analysis, it does not
undercut our previous conclusion that the initial acquisition of the NPLs had economic
substance. It is well settled that the parties’ post-formation conduct is a reliable gauge of
whether they intended to act as partners. See sources cited supra notes 55, 65. By contrast,
a transaction’s economic substance or lack thereof is “evaluated prospectively.” Stobie Creek
Invs. LLC v. United States, 608 F.3d 1366, 1375 (Fed. Cir. 2010). “In other words, the
transaction is evaluated based on the information available to a prudent investor at the time
the taxpayer entered into the transaction, not what may (or may not) have happened later.”
Id.
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formed such a partnership. If Beal and Montgomery’s intent in forming
Southgate had been to jointly conduct a legitimate business, they would not have
entered into a second, identically structured partnership with Cinda just as
Southgate’s legitimate business was foundering.
Cinda’s post-formation conduct is similarly incompatible with its status as
a Southgate partner. Rather than an intent to join together with Beal and
Montgomery to pursue profitable business activity, Cinda’s actions exhibit an
intent to sabotage and undermine Southgate’s efforts to make a profitable
business out of servicing and collecting on its portfolio of NPLs. Southgate’s plan
for turning a profit on the NPLs hinged on identifying a few high-value
“nuggets” within the portfolio and collecting on those loans. If Cinda had been
acting as a true partner, it would have concentrated its most aggressive
collection efforts on these loans. Instead, Cinda repeatedly sold off the NPLs
that Southgate had identified as nuggets, deliberately thwarting Southgate’s
profit potential. Cinda did not execute or abide the partnership agreement as
a true partner would have.
In addition, Cinda did not even profess to view Southgate as a true
partnership. In its public announcement of the Southgate transaction, Cinda
declared that it had completed a “package sale of bad debts.” Regulatory
approval of the transaction was predicated on Cinda’s representation that it
would retain a 10 percent interest in Southgate only “symbolically.” And from
Cinda’s perspective, its interest in Southgate was purely symbolic. Cinda had
received a $19.42 million capital-account credit when it contributed the NPLs to
Southgate. Just one month later, Beal paid Cinda $19.41 million to acquire an
interest in Southgate. Although on paper Cinda only sold 90 percent of its
interest in Southgate to Beal, in real dollars it received 99.93 percent of the
value of its loans.
Cinda also did not participate in major partnership decisions. When
Southgate was restructured and its operating agreement amended in connection
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with the GNMA basis-build, Cinda did not make an additional, matching capital
contribution, sign the restructuring agreement or the amended operating
agreement, or receive notice that its interest in Southgate had been diluted. In
short, the district court’s pertinent findings of fact establish that Cinda, Beal,
and Montgomery acted in a manner that was inconsistent with an intent to come
together in the joint conduct of business.
(2) The lack of intent to share profits and losses
In light of Culbertson’s identification of “the actual control of income and
the purposes for which it is used” as a metric of a partnership’s legitimacy, the
terms of the GNMA basis-build constitute compelling evidence that Southgate
was not a true partnership. Beal reserved for himself total control over all of the
income produced by the GNMAs. At the time of their contribution to Southgate,
the GNMAs could have provided real economic benefits to the partnership in any
of four distinct ways. But the structure of the basis-build transaction ensured
that Southgate would never receive any of those benefits.
First, the GNMAs had been used as collateral to obtain a $162 million
secured loan from UBS. The loan proceeds were derived from the value of the
GNMAs, but Beal did not distribute any of the proceeds to Southgate. Instead,
he injected the $162 million back into the Bank as capital. There was no
prospect of Southgate’s ever receiving any of the loan proceeds.
Second, the GNMAs would attract principal payments as the owners of the
mortgages backing the securities made their mortgage payments.67 These
payments, too, were diverted away from Southgate pursuant to Beal’s
unconditional right to direct the use and application of all proceeds from the
GNMAs. The principal payments were used to repay UBS for the secured loan,
67
Unlike the principal payment on a traditional bond, which is received on the bond’s
maturity date, principal payments on a mortgage-backed security are spread out over the life
of the security.
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thereby ensuring that the loan remained a self-liquidating transaction. There
was no prospect of Southgate’s ever receiving any of the principal payments.
Third, the GNMAs bore a fixed annual interest rate of 7 percent. This was
a major source of the GNMAs’ immediate present value during the time they
were held by Southgate. But Southgate’s amended operating agreement
explicitly provided that all of the interest that accrued on the GNMAs after their
contribution to Southgate was allocated to Beal. There was no prospect of
Southgate’s ever receiving any of the interest income.
Finally, the value of the GNMAs could increase in response to interest-rate
fluctuations. In other words, the market price of the GNMAs would necessarily
reflect their relative attractiveness vis-a-vis other available investment options.
If interest rates were to rise, the GNMAs—with their fixed interest rate of 7
percent—would become relatively less attractive to investors, and their market
value would go down. If interest rates were to drop, the GNMAs would become
relatively more attractive, and their value would climb. When Beal contributed
the GNMAs to Southgate, he agreed that if a drop in interest rates were to cause
the GNMAs to gain in value, any post-contribution gain was to be shared among
all three Southgate partners.
Thus, there was a prospect that Southgate might receive some economic
benefit if GNMAs appreciated in value. But that prospect existed only on paper.
In the absence of a realization event, any gain in the value of the GNMAs would
not actually redound to the benefit of the partners. As the district court found,
Southgate’s other partners could share in the gain only “in the event of a sales
transaction.” But Southgate’s amended operating agreement gave Beal the
absolute right, in his sole discretion, to determine whether, and if so when, the
GNMAs would be sold. If Beal wanted to avoid a sale, he had an absolute right
to cause Martel to distribute the GNMAs back to Beal, and such a distribution
would not create an obligation on Southgate’s part to make corresponding
distributions to Montgomery or Cinda. And the district court found that “Beal
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never intended to share any potential gains or losses from the GNMAs with the
other partners in Southgate.”68
In light of the vise grip that Beal maintained on all economic benefits
flowing from the GNMAs, the district court was correct to conclude that the
GNMA basis-build lacked objective economic reality under Klamath. Beal
reserved for himself all loan proceeds, principal payments, interest income, and
built-in gain. He contributed the right to share in any post-contribution gain in
the event the GNMAs were sold, but he retained an unconditional right to decide
whether to sell the GNMAs in the first place, and he had no intention of selling
them. Stripped to its essentials, Beal’s putative contribution of the GNMAs was
no contribution at all. When an asset is contributed to a partnership that will
only benefit the partnership in the event of a sale, on terms and under
circumstances that make it beyond unlikely that a sale will occur, with the
result that no sale ever occurs and the partnership receives no value from the
contribution, the contribution cannot be said to have economic substance.69
68
Southgate contends that this conclusion about Beal’s intent cannot be treated as a
finding of fact because it appeared in the conclusions-of-law section of the district court’s
findings and conclusions. This argument is without merit. In our review of the results of a
bench trial, we are not bound by the labels the district court attaches to its conclusions.
Instead, we make an independent determination of whether a particular conclusion is factual
or legal in nature. See, e.g., Turpen v. Mo.-Kan.-Tex. R.R. Co., 736 F.2d 1022, 1026 n.5 (5th
Cir. 1984) (“We regard this conclusion as a finding of ultimate fact, and we are not bound by
the label placed on it by the trial court.”). The district court’s conclusion that Beal had no
intention of allowing the other partners to share in the GNMAs was necessarily a finding of
fact. See, e.g., United States v. Hood, 615 F.3d 1293, 1299 (10th Cir. 2010) (describing the
question of intent as “‘the quintessential factual question’” (quoting United States v. Smith,
534 F.3d 1211, 1224 (10th Cir. 2008))), cert. denied, 131 S. Ct. 1546 (2011); Bodenheimer v.
PPG Indus., Inc., 5 F.3d 955, 956 n.3 (5th Cir. 1993) (“[I]ntent is inherently a question of fact
which turns on credibility.”); USX Corp. v. Prime Leasing Inc., 988 F.2d 433, 437 (3d Cir. 1993)
(noting “the fact questions inherent in [the] determination of the intent of the contracting
parties”).
69
Accord TIFD III-E, Inc. v. United States, 459 F.3d 220, 234–35 (2d Cir. 2006)
(disregarding as economically insubstantial a transaction that was deliberately structured to
minimize the possibility that two putative partners would earn substantial profits); Dow
Chem. Co. v. United States, 435 F.3d 594, 603 (6th Cir. 2006) (concluding that a transaction
lacked economic substance where it “contained features designed to neutralize the taxpayer’s
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For present purposes, the economically insubstantial nature of the GNMA
basis-build is important primarily because of what it reveals about the
intentions of Beal, Montgomery, and Cinda.70 The sine qua non of a partnership
is an intent to join together for the purpose of sharing in the profits and losses
of a genuine business. Because of the basis-build transaction’s structure, the
district court found, “Beal personally received all of the potential benefits, and
retained all of the risks,” associated with the GNMAs. Beal’s decision to
structure the basis-build as he did, Montgomery’s willingness to accede to such
one-sided terms, and Cinda’s total lack of participation in the transaction are
inconsistent with their professed intent to share, as partners, in Southgate’s
profits and losses.71
ability to realize . . . gains”); ASA Investerings, 201 F.3d at 513–14 (determining that a
putative partner’s “participation was formal rather than substantive” where the evidence
confirmed that it “could make no profit from the transaction”); Grant v. Comm’r, 150 F.2d 915,
917 (10th Cir. 1945) (holding that a transfer of property among partners should be disregarded
for tax purposes where the transferor partner “continues to manage and control the
partnership property and to use, enjoy, and dispose of the economic benefits derived therefrom
. . . the same as he did before . . . the formation of the partnership”).
70
Here it matters not whether the GNMA basis-build was entirely without economic
substance or actually contained some narrow sliver of economically substantial profit
potential. See TIFD III-E, 459 F.3d at 232 n.13 (holding that a transaction that passes the
economic-substance test “would not necessarily survive Culbertson”).
71
Southgate argues that the district court found as fact that the GNMA basis-build had
objective economic substance. Southgate’s argument is premised wholly on the following
statement in ¶ 235 of the district court’s findings of fact: “[The GNMA basis-build] had some
economic substance, as all of Southgate’s partners had a reasonable possibility of profit from
the GNMAs after their contribution.” This statement cannot be reconciled with the balance
of the district court’s findings on this issue, which—in addition to the three already
quoted—includes findings that Beal’s contribution of the GNMAs “was [e]ffectively [i]llusory,”
that “Beal relinquished nothing of economic value” in the basis-build transaction, that “[f]rom
Southgate’s perspective there was no economic benefit served by Beal’s alleged contribution”
of the GNMAs, that because Beal had the “option to distribute [the GNMAs] to himself, to the
exclusion of Southgate and its other members, Southgate had only a small possibility of
realizing an economic profit” from the basis-build transaction, that “Beal never exercised his
option to share any gains from the GNMAs with Southgate’s other members,” that “Southgate
allocated all income from the GNMAs to Beal” and none to Montgomery or Cinda, that “[t]he
GNMA transaction did not expand Southgate’s equity base,” and that “[t]here was no
substantive non-tax economic reason for” the basis-build, as “the proffered rationales” for the
transaction “do not amount to substantive business purposes.” In addition, the court’s
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(3) The lack of a business purpose
Finally, Culbertson instructs us to ask whether the partners were “acting
with a business purpose” when they made the decision to form the partnership.
The district court found that the formation of Southgate was important in six
separate respects. Southgate contends that these findings compel us to conclude
that Southgate was formed with a genuine business purpose and that the
partnership therefore was not a sham. Careful scrutiny of these six findings
reveals that they do not demonstrate the existence of a “non-tax need to form
[Southgate] in order to take advantage of the potential profits of the [NPL
investment].”72 Southgate was a redundancy, “a meaningless and unnecessary
incident”73 inserted into the chain of entities, transactions, and agreements
through which the NPL acquisition took place. Southgate served no function
whose accomplishment was not already assured by other means or could not
have been equally well assured by alternative, less tax-beneficial means.
First, the district court found that “the establishment of a non-Chinese
entity into which non-performing loans were transferred” both “avoided the
difficulties of getting approval for a wholly-owned foreign entity in China” and
also “allowed for easier conversion of RMB into United States dollars.” This
purpose had already been accomplished by Cinda’s formation of Eastgate, the
wholly owned subsidiary organized under Delaware law through which Cinda
became a member of Southgate.
conclusions of law unequivocally state that the GNMA basis-build “lack[ed] economic
substance” because the possibility that Beal would “allow Southgate to profit from the GNMA
transaction[,] effectively to his own economic detriment,” was simply too remote. Because it
is inconsistent with nearly a dozen other factual findings as well as the district court’s
carefully reasoned conclusions of law, we conclude that the finding contained in ¶ 235 is
clearly erroneous.
72
See Adantech L.L.C. v. Comm’r, 331 F.3d 972, 980 (D.C. Cir. 2003).
73
Minn. Tea Co. v. Helvering, 302 U.S. 609, 613 (1938).
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Second, and relatedly, the court found that “Montgomery was able to
confirm Cinda’s title to the NPLs and its authority to transfer them to a United
States-based partnership.” But Cinda confirmed its title and transfer authority
when it contributed the NPLs to Eastgate. The transfer from Eastgate to
Southgate did not further effectuate this purpose; Cinda made the same set of
representations and warranties in its contribution agreement with Eastgate that
Eastgate eventually made in its contribution agreement with Southgate.
Third, the district court found that Montgomery’s negotiation of an
acquisition price of 1.7 percent “afforded an investor an opportunity to turn a
profit,” especially when coupled with Cinda’s 25 percent collection fee, which
“aligned Cinda’s interests with Southgate’s.” But the 1.7 percent acquisition
price was not contingent on the formation of Southgate. Cinda would have
received a payment in the same amount if the transaction had instead been
structured as a direct sale. And Cinda’s 25 percent collection fee was a term of
the LSA, not a term of the Southgate Operating Agreement.
Indeed, the district court’s findings about the effects of the LSA forcefully
undercut any claim that Southgate fulfilled a genuine business purpose. The
court found that “[t]he LSA allowed Montgomery to achieve the essential
benefits of partnering with Cinda,” including “retaining Cinda’s super powers
relating to collections,” notwithstanding the fact that “[t]he LSA explicitly
disavow[ed] any partnership relationship between Cinda and Southgate arising
from that agreement.” In light of these findings, what was the purpose of
creating a formal partnership? From a tax perspective, the answer is readily at
hand. From a business perspective, none appears.
Fourth, the district court found that “Montgomery was able to ‘lock-in’ all
of the loans that met his investment criteria . . . by making the acquisition of all
such loans a condition of the transaction.” While this was formally true, as a
practical matter Southgate was inadequate for this purpose. The district court
found that Beal walked out of the August 30, 2002, closing at which he was to
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acquire an interest in Southgate and refused to go forward with the deal until
he received additional assurances about the loans. Prior to Southgate’s
formation, Montgomery had obtained a CD-ROM from Cinda that contained a
schedule of all the loans in the Southgate portfolio. Beal was concerned that
Montgomery had not done enough to ensure that the portfolio of loans Cinda
transferred to Southgate was the same portfolio of loans that Montgomery had
identified during his due diligence. Before he would go forward with the deal,
Beal demanded that the Haiwen law firm verify that the portfolio was intact and
that Deutsche Bank obtain written confirmation from Cinda that the schedule
of loans held by Southgate was identical to the schedule that had previously
been provided to Montgomery on the CD-ROM. It was only after Cinda provided
this confirmation that Beal was willing to purchase an interest in Southgate.
The fact that the loans had previously been transferred to Southgate was not
sufficient to lock in those loans for later acquisition by an investor. And even if
it had been, the confirmation from Deutsche Bank and verification from Haiwen
were equally up to the task.
Fifth, the district court found that “the formation of Southgate enabled
Cinda to remove from its books thousands of [NPLs], while retaining a profits
and servicing fee interest” and receiving immediate liquidity from an infusion
of foreign capital. Again, while the formation of Southgate was consistent with
each of these purposes, it was not necessary to the accomplishment of any of
them. The LSA was adequate to ensure that Cinda retained a servicing-fee
interest. A direct sale of the NPLs would have been just as effective at removing
the NPLs from Cinda’s books and injecting capital. And Cinda knew that its
profits interest was an empty shell. Unbeknownst to Beal and Montgomery,
Cinda had commissioned a valuation report from Zhongyu around the same time
that Zhongyu was preparing a valuation report for Montgomery. In stark
contrast to what it told Montgomery, Zhongyu reported to Cinda that the NPLs
were worth between 1.18 and 1.56 percent of face value. Given that Cinda had
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negotiated an up-front payment equal to 1.7 percent the loans’ face value, the
profits interest it retained was so slight as to be nonexistent.
Finally, the district court found that the creation of Southgate enabled
Montgomery to “obtain[] representations from Cinda that were critical to
determining . . . the NPL investment also potentially had significant United
States tax benefits.” This finding is, of course, immaterial to our analysis, which
trains exclusively on the question whether there was a nontax business purpose
that necessitated the partnership’s existence.74 Discerning none, we affirm the
district court’s holding that Southgate was a sham partnership that must be
disregarded for federal-income-tax purposes.75
C. The transaction should be recharacterized as a sale.
Where, as here, “we confront taxpayers who have taken a circuitous route
to reach an end more easily accessible by a straightforward path,” we look to
substance over form and tax the transactions “for what realistically they are.”76
74
See supra notes 61–65, 72 and accompanying text.
75
Southgate’s contention that the district court actually held that Southgate was a
valid partnership is patently untenable. Southgate’s argument rests on the fact that the
district court used the label “Southgate Itself had Economic Substance” to introduce the
subsection of its conclusions of law in which it concluded that “the Southgate transaction
regarding the Chinese NPLs” had economic substance. The wording of the label is somewhat
imprecise, but it is clear from context that the court was referring only to the acquisition of
the NPLs, not the parties’ use of the partnership form. The court addressed this latter issue
in a separate subsection of its conclusions of law (denominated, fittingly enough, “Sham
Partnership”), where it held that, “[d]espite [Southgate]’s attempts to imbue the partnership
with legitimacy, the Court must conclude it was a sham.” Indeed, Southgate elsewhere
acknowledges that the district court invalidated the partnership, primarily because of the
GNMA basis-build’s lack of economic substance. Southgate takes umbrage with this line of
reasoning, but it is well settled that if a district court arrives at a correct conclusion of law via
faulty or questionable reasoning, we can affirm its holding based on an alternative theory that
is supported by the findings of fact. See Coggin v. Longview Indep. Sch. Dist., 337 F.3d 459,
466 n.35 (5th Cir. 2003) (en banc); Hoyt R. Matise Co. v. Zurn, 754 F.2d 560, 565 & n.5 (5th
Cir. 1985); Cutliff v. Greyhound Lines, Inc., 558 F.2d 803, 807 n.12 (5th Cir. 1977). Our de
novo application of the Culbertson test moots Southgate’s objection to the district court’s
reasons for concluding that the partnership was a sham.
76
Kuper v. Comm’r, 533 F.2d 152, 153 (5th Cir. 1976); see also Minn. Tea Co., 302 U.S.
at 613 (“A given result at the end of a straight path is not made a different result because
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A court is not bound to accept a taxpayer’s formal characterization of a
transaction, even a transaction that has economic reality and substance.77 “‘The
major purpose of the substance-over-form doctrine is to recharacterize
transactions in accordance with their true nature.’”78
Because we have concluded that the acquisition of the NPLs had economic
substance but that the formal partnership structure through which that
acquisition took place was a sham, we are left to determine what transactional
form most neatly maps onto the substance of that acquisition. The outcome of
our analysis under the substance-over-form doctrine is dictated by the outcomes
of our economic-substance and sham-partnership analyses.79 Beal paid Cinda
$19.4 million in exchange for an interest in a portfolio of NPLs. That interest
was not properly classified as a partnership interest. It is most naturally
classified as an ownership interest. We hold that Southgate’s acquisition of the
portfolio of NPLs should be recharacterized as a direct sale of those NPLs by
Cinda to Beal.80
III. PENALTIES
We also affirm the district’s decision to disallow the imposition of any
accuracy-related penalties under 26 U.S.C. § 6662. Section 6662 imposes a
reached by following a devious path.”).
77
See Harris v. United States, 902 F.2d 439, 443 (5th Cir. 1990) (“The IRS . . . may
disregard form and recharacterize a transaction by looking to its substance.”); Kuper, 533 F.2d
at 155 (“[T]he incident of taxation depends on the substance rather than the form of the
transaction.”); id. (collecting cases).
78
Rogers v. United States, 281 F.3d 1108, 1115 (10th Cir. 2002) (quoting John P.
Warner, Statutory, Regulatory, and Common Law Anti-Abuse Weapons, 485 PLI/Tax 883, 889
(2000)).
79
See Fidelity Int’l Currency Advisor A Fund, LLC v. United States, 747 F. Supp. 2d 49,
233 (D. Mass. 2010) (“If a partnership is found to be a sham, the partnership should be
disregarded, and the partnership’s activities are deemed to be engaged in by one or more of
the partners.”); see also 26 C.F.R. § 1.701-2(b)(1) (same).
80
Determining the tax consequences to Beal and Montgomery of this sale is beyond the
scope of this proceeding. See supra note 4.
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penalty equal to 20 percent of the portion of any underpayment of tax that is
attributable to one or more of the following: negligence, a substantial
understatement of income tax, or a substantial valuation misstatement under
chapter 1.81 The valuation-misstatement penalty increases to 40 percent in the
case of a gross valuation misstatement.82 However, § 6664(c)(1) provides that no
penalty may be imposed under § 6662 if the taxpayer can show that there was
reasonable cause for, and that it acted in good faith with respect to, its
underpayment of tax.83 The district court held that none of the penalties in
§ 6662 were applicable and, in the alternative, that Southgate had satisfied the
requirements of § 6664(c)(1). We find no reversible error in the district court’s
conclusions that Southgate established the reasonable cause and good faith
required by § 6664(c)(1) and therefore has a complete defense to any accuracy-
related penalties.84
Southgate’s § 6664(c)(1) defense is predicated on its reliance on tax
opinions issued to it by the De Castro law firm and the accounting firm Coscia
Greilich & Company (“CGC”). Both tax opinions concluded that it was more
likely than not that the IRS would uphold the Southgate tax positions that are
the subject of this appeal. The district court found that Southgate relied on
these tax opinions in good faith, and the Government does not challenge that
finding on appeal. Therefore, the dispositive question is whether Southgate’s
reliance on the De Castro and CGC opinions constitutes reasonable cause. This
81
26 U.S.C. § 6662(b)(1)–(3). The penalties are imposed in the alternative, not
cumulatively.
82
Id. § 6662(h)(1).
83
26 U.S.C. § 6664(c)(1).
84
We do not reach the propriety of the district court’s determinations that, even in the
absence of the § 6664(c)(1) defense, none of the § 6662(b) penalties would have applied.
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is a question of fact, so we review the district court’s findings only for clear
error.85
We determine whether a taxpayer acted with reasonable cause on a
case-by-case basis, evaluating the totality of the facts and circumstances.86
“Generally, the most important factor is the extent of the taxpayer’s effort to
assess the taxpayer’s proper tax liability.”87 The Treasury Regulations clarify
that reliance on the advice of a tax professional can, but “does not necessarily[,]
demonstrate reasonable cause.”88 That advice “must be based upon all pertinent
facts and circumstances and the law as it relates to those facts and
circumstances.”89 If a tax advisor’s opinion is shown to be “based on
unreasonable factual or legal assumptions,” that is, “upon a representation or
assumption which the taxpayer knows, or has reason to know, is unlikely to be
true,” then the taxpayer’s reliance on that opinion does not constitute reasonable
cause.90 And, of course, if the taxpayer fails to actually follow the advice he
receives from a tax professional, the taxpayer cannot rely on that advice to
establish reasonable cause.91
85
See, e.g., Whitehouse Hotel Ltd. P’ship v. Comm’r, 615 F.3d 321, 341 (5th Cir. 2010);
see also United States v. Boyle, 469 U.S. 241, 249 n.8 (1985); Stobie Creek Invs. LLC v. United
States, 608 F.3d 1366, 1381 (Fed. Cir. 2010).
86
See 26 C.F.R. § 1.6664-1(b)(1). Where, as here, the reasonable-cause defense is
asserted in a partnership-level proceeding, we look to the conduct of the partnership’s
managing partners in evaluating the reasonableness of the partnership’s reporting position.
See Klamath Strategic Inv. Fund v. United States, 568 F.3d 537, 548 (5th Cir. 2009).
87
26 C.F.R. § 1.6664-1(b)(1).
88
Id. § 1.6664-4(b)(1).
89
Id. § 1.6664-4(c)(1)(i).
90
Id. § 1.6664-4(c)(1)(ii).
91
See, e.g., InterTAN, Inc. v. Comm’r, 87 T.C.M. (CCH) 767, 2004 WL 25249, at *15–17,
aff’d, 117 F. App’x 348 (5th Cir. 2004) (per curiam) (unpublished).
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The district court’s findings of fact establish that all of the elements of
reasonable cause are present in this case. Southgate received comprehensive tax
opinions from De Castro, a law firm, and CGC, an accounting firm, both of which
the district court found to be qualified tax advisors not burdened by any conflict
of interest. The district court also found that Southgate and its members
“disclosed all pertinent facts” to De Castro and CGC and that the tax opinions
“consider all facts and circumstances, analyze the relevance and persuasiveness
of authorities, [and] are not based on unreasonable assumptions.” The district
court further found that Beal and Southgate “carried out the transactions at
issue consistently with the transactional documents and descriptions in the De
Castro and CGC opinions.” Consequently, the court concluded that “the De
Castro and CGC opinions met the standards for reliance on tax advice” described
in § 6664 and its implementing regulations and that “[i]t was therefore
reasonable for Beal and Southgate to rely on the De Castro and CGC opinions.”
The Government advances two theories as to why these findings are not
sufficient to establish reasonable cause. Neither holds water. First, the
Government argues that Beal failed to follow the advice he received from De
Castro and CGC when he structured the GNMA basis-build. The record belies
this claim. Both opinions accurately describe the structure of the GNMA basis-
build; they do not assume, for example, that Beal would share the interest
proceeds with the other partners. It is true that in prior correspondence, De
Castro had laid out several alternative structures for the basis-build and
suggested that these alternatives were more likely to withstand scrutiny from
the IRS. But a taxpayer is free to select among “any of the bona fide alternatives
developed by a tax advisor acquainted with the relevant facts.”92 Both De Castro
and CGC unequivocally concluded that, even in light of the structure that Beal
had chosen, it was more likely than not that the IRS would uphold the GNMA
92
Streber v. Comm’r, 138 F.3d. 216, 221 (5th Cir. 1998).
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basis-build. In light of these facts, the district court’s finding that Beal carried
out the GNMA basis-build consistently with the advice he received from his tax
advisors is not clearly erroneous.
Next, the Government argues that the district court did not find that the
De Castro and CGC opinions were not based on any representations or
assumptions that Beal and Montgomery knew, or had reason to know, were
unlikely to be true. The Government is correct that the district court’s findings
that the tax opinions were not based on any “representations or assumptions
that [De Castro and CGC] knew or had reason to know were inaccurate” are
immaterial to our reasonable-cause determination. Our focus is on the
taxpayer’s knowledge, not the tax advisor’s. But the district court separately
found that the tax opinions were not based on any unreasonable assumptions.
That finding satisfies the requirement of Regulation 1.6664-4(c)(1)(ii).
The Government’s brief contention that this finding was clearly erroneous
finds no purchase. The opinions accurately describe the factual underpinnings
of Beal and Montgomery’s decision to invest in Chinese NPLs, their reasons for
forming Southgate, and the structure of and justifications for the GNMA basis-
build. For example, the opinions attribute several business purposes to the
decision to use the partnership structure to invest in the NPLs. These are the
same business purposes that the district court found did, in fact, motivate the
formation of Southgate.93 Our conclusion that these business purposes were not
sufficient to imbue the partnership with legitimacy for tax purposes does not call
into question the accuracy with which Beal and Montgomery reported the
relevant facts to De Castro and CGC. Regulation 1.6664-4(c) does not require
93
See supra Subsection II.B(3).
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the taxpayer to correctly anticipate the legal consequences that the IRS or the
courts will attach to the facts underlying a transaction.94
IV. CONCLUSION
The district court correctly held that, while Beal and Montgomery’s
acquisition of an interest in a portfolio of Chinese NPLs had economic substance,
the Southgate partnership was a sham that must be disregarded for federal-
income-tax purposes. As a consequence, that acquisition must be
recharacterized as a direct sale. The court was also correct to disallow all
accuracy-related penalties on the ground that Southgate had reasonable cause
for, and exhibited good faith in, reporting the positions it took on its 2002
partnership return. The judgment below is
AFFIRMED.
94
The Government correctly notes that the district court erred in its conclusions of law
by determining that penalties were not justified because Southgate’s tax advisors “relied on
a literal–if narrow–reading of the law and congressional intent” and that Southgate made
“assiduous efforts to comply with black-letter law.” If the De Castro and CGC opinions had
taken such a hypertechnical view of what a taxpayer must do to discharge its obligations
under the Code, reliance on those opinions would have been unreasonable. See supra note 89
and accompanying text. But both opinions discussed and applied the judicial doctrines and
the Treasury’s anti-abuse regulations. The court’s findings of fact amply support its
reasonable-cause determination.
44