Klamath Strategic Investment Fund Ex Rel. St. Croix Ventures v. United States

REVISED MAY 21, 2009

IN THE UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT United States Court of Appeals

Fifth Circuit

FILED

May 15, 2009

No. 07-40861

Charles R. Fulbruge III

Clerk

KLAMATH STRATEGIC INVESTMENT FUND, by and through St Croix

Ventures (Managing member)

Plaintiff - Appellee - Cross-Appellant

v.

UNITED STATES OF AMERICA

Defendant - Appellant - Cross-Appellee

_________________________________________________

KINABALU STRATEGIC INVESTMENT FUND, by and through Rogue

Ventures LLC (Managing member)

Plaintiff - Appellee - Cross-Appellant

v.

UNITED STATES OF AMERICA

Defendant - Appellant - Cross-Appellee

Appeals from the United States District Court

for the Eastern District of Texas

Before GARWOOD, GARZA, and OWEN, Circuit Judges.

EMILIO M. GARZA, Circuit Judge:

No. 07-40861

In this tax case, Plaintiffs Klamath Strategic Investment Fund

(“Klamath”) and Kinabalu Strategic Investment Fund (“Kinabalu”) (collectively,

the “Partnerships”) filed suit against defendant the United States of America for

readjustment of partnership items. Both parties appeal various aspects of the

district court’s readjustment determination. For the following reasons, we

affirm in part, vacate in part, and remand.

I

This case involves a highly complex series of financial transactions, which

the district court categorized as a tax shelter known as Bond Linked Issue

Premium Structure (“BLIPS”). The transactions were undertaken by two law

partners, Cary Patterson and Harold Nix. Patterson and Nix’s law firm

represented the State of Texas in litigation against the tobacco industry and

each partner earned around $30 million between 1998 and 2000. Interested in

managing this wealth, Patterson and Nix requested their long-time accounting

firm, Pollans & Cohen, to investigate investment opportunities.

The accountants identified Presidio Advisory Services (“Presidio”), an

investment advisory firm purporting to specialize in foreign currency trading.

Presidio advocated a complex plan involving strategic investments in foreign

currencies pegged to the U.S. dollar. Patterson and Nix agreed to invest in

Presidio’s plan. Generally, the Presidio strategy was structured as a three-stage,

seven-year investment program. Stage I lasted 60 days and entailed relatively

low risk investments. Stage II lasted from day 60 through day 180, and the risk

was somewhat higher. Stage III extended from day 180 through the end of the

seventh year and involved the highest risk as well as potentially the highest

return. At each stage of the plan, Presidio required the investors to contribute

significantly more capital. The investors retained the right to exit the plan at

the end of Stage I and at each 60-day period thereafter.

2

No. 07-40861

To implement the strategy Presidio formed Klamath and Kinabalu as

limited liability companies, taxed as partnerships. Next, Presidio formed two

single-member LLCs, which are disregarded for tax purposes: St. Croix for

Patterson and Rogue for Nix. Patterson owned 100% of St. Croix, and St. Croix

became a 90% partner of Klamath. The other 10% partners of Klamath were

Presidio Resources LLC and Presidio Growth LLC. Presidio Growth was the

managing partner. Kinabalu had a similar structure. Nix owned 100% of

Rogue, and Rogue was a 90% partner of Kinabalu. The other 10% partners of

Kinabalu were Presidio Growth and Presidio Resources, with Presidio Growth

acting as the managing partner.

To fund Klamath and Kinabalu, Patterson and Nix (acting through St.

Croix and Rogue) made two distinct contributions. First, they each contributed

$1.5 million to their respective partnership. Second, they entered into loan

transactions with National Westminster Bank (“NatWest”), where the bank

loaned each company $66.7 million. This included $41.7 million denominated

as the “Stated Principal Amount” and $25 million as a “loan premium.” The

classification of the $25 million as something different than the principal loan

amount is central to this case. The loan premium was given in exchange for

Patterson and Nix paying NatWest a higher than market interest rate on the

principal: 17.97%. To protect NatWest from the possibility that the loans would

be repaid early and the benefit of the higher interest rate would not be realized,

the credit agreements required that a prepayment amount be paid if the loans

were paid off early. The prepayment amount would vary depending on when the

loan was repaid, starting at about $25 million and decreasing over seven years.

After year seven, no prepayment amount would apply.

Patterson and Nix each contributed the $66.7 million to Klamath and

Kinabalu and assigned the corresponding loan obligations to the Partnerships.

The Partnerships deposited the funds into accounts controlled by NatWest.

3

No. 07-40861

Presidio directed Klamath and Kinabalu to use these funds to purchase very low

risk contracts on U.S. dollars and Euros. They also made small, short 60- to 90-

day term forward contract trades in foreign currencies. These were the only

investments the Partnerships ever made, and Patterson and Nix elected to

withdraw from Klamath and Kinabalu before the end of Stage I. They received

cash and Euros on liquidation, and they sold the Euros in 2000, 2001, and 2002.

On their income tax returns for 2000, 2001, and 2002, Patterson claimed

total losses of $25,277,202 arising from Klamath’s activities and Nix claimed

total losses of $25,272,344 arising from Kinabalu’s. These massive losses

occurred because each partner claimed a significant tax basis in their respective

partnership. 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. When a partnership assumes a

partner’s individual liabilities, the liability amount is subtracted from the

partner’s basis.1 Patterson and Nix were able to report such high losses because

when they each calculated their basis in the partnership, they did not reduce it

by the $25 million loan premium amount. When Patterson and Nix contributed

the $66.7 million plus the $1.5 million to Klamath and Kinabalu, they would

have each had a $68.2 million basis in their partnership. However, the

Partnerships also assumed the loan obligations, so Patterson and Nix’s bases

had to be reduced by the amount of the liabilities. Patterson and Nix did not

consider the loan premiums to be liabilities, so they only subtracted the $41.7

million principal amount. Therefore, each claimed a taxable basis in the

partnership in excess of $25 million. This meant that when Patterson and Nix

1

These rules are defined in 26 U.S.C. § 752 et seq. of the Internal Revenue Code,

described more fully below.

4

No. 07-40861

sold the Euros, they were able to deduct over $25 million from their taxable

income.2

The IRS disagreed with this basis calculation, and in 2004 issued Final

Partnership Administrative Adjustments (“FPAAs”) to Klamath and Kinabalu

stating that under 26 U.S.C. § 752 of the Internal Revenue Code (the “Code”),

the partners should have treated the entire $66.7 million as a liability.

Alternatively, the IRS argued that the transactions were shams or lacked

economic substance and should be disregarded for tax purposes. The FPAAs also

made adjustments to operational expenses reported by the Partnerships and

asserted accuracy-related penalties. Patterson and Nix paid the taxes owed

based on the FPAAs, and then re-formed the partnerships in order to seek

readjustment in the district court.

The Partnerships filed suit against the Government under 26 U.S.C. §

6226 for readjustment of partnership items. The Partnerships moved for partial

summary judgment, and the Government cross-moved for summary judgment

on the issue of whether the partners’ tax bases were properly calculated;

specifically, whether the loan premiums constituted liabilities under § 752 of the

2

Specifically, the losses occurred from the following. Patterson received 67,341.88

Euros when Klamath liquidated. He treated these Euros as having a tax basis of $25,316,393,

calculated as:

Premium amount 25,000,000

Cash contributions 1,500,000

Interest income 91,307

Advisory fee to Pollans & Cohen 250,000

Cash distributions from Klamath (359,635)

Klamath partnership loss (1,165,279)

Basis 25,316,393

This meant that since Patterson was able to treat the loan premium as money he had put into

the partnership (i.e. not a liability that the partnership had to repay), he could claim a tax

basis of $365.94 in each Euro he received from Klamath. When he sold the Euros for much less

than this amount, large losses were created. Nix’s basis calculation was nearly identical.

5

No. 07-40861

Code. The district court granted the Partnerships’ motion and denied the

Government’s, holding that the loan premiums were not liabilities under § 752

and therefore the partners’ bases were properly calculated under the Code.

However, following a bench trial the district court held that the loan

transactions must nonetheless be disregarded for federal tax purposes because

they lacked economic substance. The district court also concluded that the

penalties asserted by the IRS did not apply and the Partnerships’ operational

expenses were deductible. The Government moved the court to reconsider and

vacate its summary judgment decision, arguing that the decision was mooted by

the bench trial judgment. The court denied this motion. Finally, the court

issued an order holding that it had jurisdiction to order a refund to the

Partnerships, and that Patterson and Nix could deduct the $250,000

management fee paid to their accountants.

The Government appeals the district court’s partial summary judgment

in favor of the Partnerships, arguing that the “loan premiums” constitute

liabilities under § 752. The Government also argues that the Partnerships are

liable for penalties, that operating expenses and fees may not be deducted, and

that the district court lacked jurisdiction to order a refund to the Partnerships.

The Partnerships cross-appeal the district court’s bench trial judgment, arguing

that the loan transactions had economic substance.

II

We review the district court’s grant of summary judgment de novo,

applying the same standard as the district court. Kornman & Assocs. v. United

States, 527 F.3d 443, 450 (5th Cir. 2008). On appeal from a bench trial, we

review findings of fact for clear error and legal issues de novo. Houston

Exploration Co. v. Halliburton Energy Servs., Inc., 359 F.3d 777, 779 (5th Cir.

2004). Specifically, we have held that a district court’s characterization of a

transaction for tax purposes is a question of law subject to de novo review, but

6

No. 07-40861

the particular facts from which that characterization is made are reviewed for

clear error. See Compaq Computer Corp. and Subsidiaries v. Comm’r, 277 F.3d

778, 780 (5th Cir. 2001) (citing Frank Lyon Co. v. United States, 435 U.S. 561,

581 n.16 (1978)).

III

We first consider the Partnerships’ cross-appeal, namely whether the

district court erred in determining that the loan transactions lacked economic

substance and must be disregarded for tax purposes.

The economic substance doctrine allows courts to enforce the legislative

purpose of the Code by preventing taxpayers from reaping tax benefits from

transactions lacking in economic reality. See Coltec Indus., Inc. v. United States,

454 F.3d 1340, 1353-54 (Fed. Cir. 2006). As the Supreme Court has recognized,

taxpayers have the right to decrease or avoid taxes by legally permissible means.

See Gregory v. Helvering, 293 U.S. 465, 469 (1935). However,“transactions[ ]

which do not vary control or change the flow of economic benefits[ ] are to be

dismissed from consideration.” See Higgins v. Smith, 308 U.S. 473, 476 (1940).

In a more recent pronouncement, the Supreme Court held that “[w]here . . .

there is a genuine multiple-party transaction with economic substance which is

compelled or encouraged by business or regulatory realities, is imbued with

tax-independent considerations, and is not shaped solely by tax-avoidance

features that have meaningless labels attached, the Government should honor

the allocation of rights and duties effectuated by the parties.” Frank Lyon, 435

U.S. at 583-84.

The law regarding whether a transaction should be disregarded as lacking

economic reality is somewhat unsettled in the Fifth Circuit, and a split exists

among other Circuits. The Fourth Circuit applies a rigid two-prong test, where

a transaction will only be invalidated if it lacks economic substance and the

taxpayer’s sole motive is tax avoidance. See Rice’s Toyota World, Inc. v. Comm’r,

7

No. 07-40861

752 F.2d 89, 91-92 (4th Cir. 1985). The majority view, however, is that a lack of

economic substance is sufficient to invalidate the transaction regardless of

whether the taxpayer has motives other than tax avoidance. See, e.g., Coltec,

454 F.3d at 1355; United Parcel Serv. of Am., Inc. v. Comm’r, 254 F.3d 1014,

1018 (11th Cir. 2001); ACM Partnership v. Comm’r, 157 F.3d 231, 247 (3d Cir.

1998); James v. Comm’r, 899 F.2d 905, 908-09 (10th Cir. 1990). We have

previously declined to explicitly adopt either approach. See Compaq, 277 F.3d

at 781-82 (finding that the transaction in question had both economic substance

and a legitimate business purpose, so it would be recognized for tax purposes

under either the minority or majority approach).

We conclude that the majority view more accurately interprets the

Supreme Court’s prescript in Frank Lyon. The Court essentially set up a multi-

factor test for when a transaction must be honored as legitimate for tax

purposes, with factors including whether the transaction (1) has economic

substance compelled by business or regulatory realities, (2) is imbued with tax-

independent considerations, and (3) is not shaped totally by tax-avoidance

features. See Frank Lyon, 435 U.S. at 583-84. Importantly, these factors are

phrased in the conjunctive, meaning that the absence of any one of them will

render the transaction void for tax purposes. Thus, if a transaction lacks

economic substance compelled by business or regulatory realities, the

transaction must be disregarded even if the taxpayers profess a genuine

business purpose without tax-avoidance motivations.

The following facts found by the district court are critical to this issue:

Presidio and NatWest understood that the transactions would not last beyond

Stage I, despite the purported seven-year term—meaning that the high risk

foreign currency transactions were never intended to occur. If the investors

failed to withdraw voluntarily, NatWest could use economic pressure to force

them out because the credit agreements required the borrowers to maintain

8

No. 07-40861

collateral on deposit at NatWest that exceeded the value of the maximum

obligations owed to the bank by some varying amount. At the time the loans

were issued, this amount was at least 101.25% of the total $66.7 million.

NatWest had the discretion to determine whether the ratio was satisfied and

could accelerate the ratio to declare a default if the bank wished to force an

investor to withdraw. This requirement also meant that none of the $66.7

million loan could ever be used for investments—it had to stay in the accounts

at NatWest. NatWest and Presidio understood that the bank would hold the

money in relatively risk-free time deposits. Presidio’s management fee was

calculated as a percentage of the tax losses generated by the investment plan.

The district court determined, however, that Patterson and Nix pursued the

transactions with a genuine profit motive and were not solely driven by the

desire to avoid taxes.

Here, the evidence supports the district court’s conclusion that the loan

transactions lacked economic substance. Numerous bank documents stated that

despite the purported seven-year term, the loans would only be outstanding for

about 70 days. NatWest’s profit in the loan transactions was calculated based

on a 72-day period. In the event that the investors wanted to remain with the

plan beyond 72 days, NatWest would force them out. The bank noted in an

internal memo that it “had no legal or moral obligation to deal [with the

investors] after Day 60.” During that 60- to 70-day window the loan funds could

not be used to facilitate the investment strategy that Presidio designed. The

requirement of keeping at least 101.25% of the $66.7 million in the NatWest

account meant, as the Government’s expert testified, that the Partnerships could

not make any investments without supplying their own funds in excess of the

loan amount.

The Partnerships contend that the loan funds were critical to the high-risk

foreign currency transactions even if the funding amount could not be spent

9

No. 07-40861

because the money provided the necessary security for the high-risk

transactions. However, the structure of the plan shows that these high-risk

transactions could not occur until Stage III, which was never intended to be

reached. As the district court found, NatWest would force the investors out long

before Stage III, so the loan transactions served no real purpose beyond creating

a massive tax benefit for Nix and Patterson.

The Partnerships further argue that the loan transactions had a

reasonable possibility of profit, as evidenced by the fact that two small, low-risk

investments were actually made in foreign currencies. However, these

investments were made using the $1.5 million that Patterson and Nix

contributed to the Partnerships, not the funding amounts of the loans. Various

courts have held that when applying the economic substance doctrine, the proper

focus is on the particular transaction that gives rise to the tax benefit, not

collateral transactions that do not produce tax benefits. See Coltec, 454 F.3d at

1356-57; Nicole Rose Corp. v. Comm’r, 320 F.3d 282, 284 (2d Cir. 2002). Here,

the transactions that provided the tax benefits at issue were the loans from

NatWest. Therefore, the proper focus is on whether the loan transactions

presented a reasonable possibility of profit, not whether the capital contributions

from Patterson and Nix could have produced a profit. The loan transactions

could never have been profitable because the funding amount could not actually

be used for investments, and the high-risk investments for which the funding

amount might have provided security were never intended to occur.

The evidence clearly shows that Presidio and NatWest designed the loan

transactions and the investment strategy so that no reasonable possibility of

profit existed and so that the funding amount would create massive tax benefits

but would never actually be at risk. Regardless of Patterson and Nix’s desire to

make money, they entered into transactions controlled by Presidio and NatWest

that were not structured or implemented to make a profit. This particular

10

No. 07-40861

situation highlights the logic of following the majority approach to the economic

substance doctrine, because the minority approach would allow tax benefits to

flow from transactions totally lacking in economic substance as long as the

taxpayers offered some conceivable profit motive. In cases such as the instant

one, this approach would essentially reward a “head in the sand” defense where

taxpayers can profess a profit motive but agree to a scheme structured and

controlled by parties with the sole purpose of achieving tax benefits for them.

We therefore agree with the district court that since the loan transactions lacked

economic substance, they must be disregarded for tax purposes.

IV

Next we consider the Government’s appeal, namely whether the district

court properly granted the Partnerships’ motion for partial summary judgment,

declined to impose various penalties on the Partnerships, allowed the

Partnerships to deduct operational expenses and fees, and ordered a refund.

A

The Government argues that the district court erred in granting the

Partnership's motion for partial summary judgment, determining that the loan

premiums were not liabilities for purposes of § 752. The Government states in

its brief that they are appealing this issue “as a protective matter, due to

possible collateral estoppel implications” in several lawsuits pending against

Presidio in California.

Despite this adverse summary judgment ruling, the Government

ultimately prevailed at trial on economic substance grounds and received the

relief it requested when the loan transactions were disregarded for tax purposes.

As a general matter, a party who is not aggrieved by a judgment does not have

standing to appeal it. See Ward v. Santa Fe Indep. Sch. Dist., 393 F.3d 599, 603

(5th Cir. 2004). In some situations, adverse collateral estoppel implications may

show that a party is aggrieved by a particular ruling. See In re DES Litig., 7

11

No. 07-40861

F.3d 20, 23 (2d Cir. 1993). However, an interlocutory ruling will only have

collateral estoppel effect in subsequent litigation if the ultimate judgment in the

case was dependent upon the interlocutory ruling. Id. (finding that a prevailing

party had no standing to appeal adverse interlocutory rulings, regarding

jurisdiction and choice of law, because the ultimate judgment in the case was not

dependent on those rulings). Accordingly, where a party who ultimately prevails

in a case attempts to show they have standing to appeal an earlier adverse

ruling by arguing that the earlier ruling could have collateral estoppel effect in

other pending cases, standing will only exist where the ultimate judgment in the

case was “dependent” on the earlier adverse ruling. Id.

Here, the district court’s summary judgment ruling has no collateral

estoppel effect. The judgment following the bench trial was entirely based on

the district court’s conclusion that the loan transactions lacked economic

substance and must be disregarded for tax purposes. This determination was

totally independent of the partial summary judgment ruling that the loan

premiums were not liabilities under § 752. Though the Government further

argues that “[i]t could be concluded that [it] is aggrieved by the [summary]

judgment [ruling] to the extent it played a part in the District Court’s rejection

of the IRS’s imposition of penalties,” we conclude that the district court’s penalty

decision was likewise not dependent on the partial summary judgment

determination. Therefore, we hold that the Government lacks standing to

appeal the district court’s partial summary judgment ruling that neither § 752

nor Treas. Reg. § 1.752-6 operates to eliminate the claimed tax benefits arising

from the Partnerships’ participation in the loan transactions.

B

12

No. 07-40861

The Government also appeals the district court’s ruling that no penalties

may be imposed on the Partnerships.3 The district court found that the

Partnerships’ actions did not meet the statutory requirements for imposition of

the penalties, and that even if they were met, none of these penalties apply

because the Partnerships acted in good faith and with reasonable cause.

Specifically, the Government argues that the district court erred in finding that

the Partnerships’ actions did not meet the statutory requirements for the

imposition of penalties, and that the district court lacked jurisdiction to consider

the reasonable cause and good faith defenses. Since the issue of whether the

Partnerships’ conduct met the requirements for the penalties is moot if the

district court had jurisdiction to consider the reasonable cause and good faith

defenses, we first consider the jurisdictional issue.

This issue is governed by the Tax Equity and Fiscal Responsibility Act of

1982 (“TEFRA”), 26 U.S.C. § § 6221-6233. Under TEFRA, “the tax treatment of

any partnership item (and the applicability of any penalty, addition to tax, or

additional amount which relates to an adjustment to a partnership item) shall

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

sets forth the scope of judicial review:

A court with which a petition is filed in accordance with this section

shall have jurisdiction to determine all partnership items of the

partnership for the partnership taxable year to which the notice of

final partnership administrative adjustment relates; the proper

allocation of such items among the partners, and the applicability

of any penalty, addition to tax, or additional amount which relates

to an adjustment to a partnership item.

3

In the FPAAs, the IRS asserted four penalties against the Partnerships, all based on

§ 6662 of the Code: (1) a 40% penalty for gross valuation misstatement; (2) a 20% penalty for

substantial valuation misstatement; (3) a 20% penalty for substantial understatement of

income tax; and (4) a 20% penalty for negligence or disregard of rules and regulations. See 26

U.S.C. § 6662(a), (b)(1), (2), (3).

13

No. 07-40861

26 U.S.C. § 6226(f) (emphasis added). This provision clearly grants the district

court jurisdiction to determine the applicability of any penalty relating to an

adjustment of a partnership item. The Code also makes clear that if a taxpayer

acts in good faith and with reasonable cause in the calculation of his or her

taxes, penalties may not be applied: “[n]o penalty shall be imposed under section

6662 or 6663 with respect to any portion of an underpayment if it is shown that

there was a reasonable cause for such portion and that the taxpayer acted in

good faith with respect to such portion.” 26 U.S.C. § 6664(c)(1).

The Government argues that the district court lacked jurisdiction to

consider the reasonable cause and good faith defense because the court’s

jurisdiction in a TEFRA proceeding is limited to assessment of partnership-level

items. Here, the Government claims, reasonable cause and good faith is a

partner-level defense that can only be asserted in separate refund proceedings.

To support this argument, the Government cites Temporary Treasury

Regulation § 301.6221-1T, which states that assessment of penalties or any

addition to tax related to partnership items is determined at the partnership

level, and “[p]artner-level defenses to any penalty, addition to tax, or additional

amount that relates to an adjustment to a partnership item may not be asserted

in the partnership-level proceeding, but may be asserted through separate

refund actions following assessment and payment.” Temp. Treas. Reg. §

301.6221-1T(c)-(d) (1999).4 The regulation defines partner-level defenses as

“those that are personal to the partner or are dependent upon the partner’s

separate return and cannot be determined at the partnership level . . .

4

This regulation was temporary for the taxable years at issue. See Temporary Proced.

& Admin. Regs., 64 Fed. Reg. 3838 (Jan. 26, 1999). However, it was made final and applicable

to partnership taxable years beginning on or after Oct. 4, 2001. See § 301.6221-1(f), Proced.

& Admin. Regs.

14

No. 07-40861

[including] . . . whether the partner has met the criteria of . . . section 6664(c)(1)

(reasonable cause exception).” Temp. Treas. Reg. § 301.6221-1T(d).

The TEFRA structure enacted by Congress does not permit a partner to

raise an individual defense during a partnership-level proceeding, but when

considering the determination of penalties at the partnership level the court may

consider the defenses of the partnership. See New Millennium Trading, LLC v.

Comm’r, 131 T.C. No. 18, 2008 WL 5330940 at * 7 (2008). Though Temp. Treas.

Reg. § 301.6221-1T(d) lists the reasonable cause exception as an example of a

partner-level defense, it does not indicate that reasonable cause and good faith

may never be considered at the partnership level. Several courts have found

that a reasonable cause and good faith defense may be considered during

partnership-level proceedings if the defense is presented on behalf of the

partnership. See Santa Monica Pictures v. Comm’r, 89 T.C.M. 1157, 1229-30

(2005) (considering the reasonable cause and good faith defense asserted by the

partnership to determine whether accuracy-related penalties should apply); See

also Stobie Creek Investments, LLC v. United States, 82 Fed. Cl. 636, 703-04,

717-21 (2008) (considering the reasonable cause defense at the partnership

level). Here, reasonable cause and good faith were asserted on behalf of

Klamath and Kinabalu, by the current managing partners. Accordingly, we hold

that the district court did not err in considering the defenses.

The plaintiff bears the burden of proof on a reasonable cause defense. See

Montgomery v. Comm’r, 127 T.C. 43, 66 (2006). The most important factor is the

extent of the taxpayer’s effort to assess his proper liability in light of all the

circumstances. Treas. Reg. § 1.6664-4(b). Reliance on the advice of a

professional tax adviser does not necessarily demonstrate reasonable cause and

good faith; rather, the validity of this reliance turns on “the quality and

objectivity of the professional advice which they obtained.” Swayze v. United

States, 785 F.2d 715, 719 (9th Cir. 1986). The district court found that Patterson

15

No. 07-40861

and Nix sought legal advice from qualified accountants and tax attorneys

concerning the legal implications of their investments and the resulting tax

deductions. They hired attorneys to write a detailed tax opinion, providing the

attorneys with access to all relevant transactional documents. This tax opinion

concluded that the tax treatment at issue complied with reasonable

interpretations of the tax laws. At trial, the Partnerships’ tax expert concluded

that the opinion complied with standards established by Treasury Circular 230,

which addresses conduct of practitioners who provide tax opinions. Overall, the

district court found that the Partnerships proved by a preponderance of the

evidence that they relied in good faith on the advice of qualified accountants and

tax lawyers.

The Government argues only that the district court lacked jurisdiction to

consider the reasonable cause and good faith defense; it has not alleged error in

the substance of the district court’s finding that Patterson and Nix acted with

reasonable cause and in good faith. Therefore, having concluded that the district

court had jurisdiction to consider this defense, we affirm the district court’s

conclusion that no penalties should apply.

C

The Government also appeals the district court’s order that the

Partnerships may deduct “operational expenses” associated with the loan and

foreign currency transactions. These operational expenses include interest on

the loans, a breakage fee, a management fee paid to Presidio, and a $250,000 fee

paid to Pollans & Cohen.5 The Government argues that the district court erred

because no deduction may be taken for expenses related to a sham transaction.

The Code governs the deductibility of actual economic expenditures.

Although the district court did not specify the provision under which the

5

The Government concedes the deductibility of the trading losses suffered by the

Partnerships in the foreign currency transactions.

16

No. 07-40861

operating expenses are deductible, the Partnerships argue that they are entitled

to the deductions under 26 U.S.C. §§ 163, 165(c)(2), and 212. Section 163

governs the deductibility of interest expenses, stating generally that “[t]here

shall be allowed as a deduction all interest paid or accrued within the taxable

year on indebtedness.” 26 U.S.C. § 163(a). Under § 165, deductions are

permitted for “any loss sustained during the taxable year and not compensated

for by insurance or otherwise.” 26 U.S.C. § 165(a). Particularly, deductions for

losses of individuals are limited to “losses incurred in any transaction entered

into for profit . . . .” 26 U.S.C. § 165(c)(2). Section 212 allows deductions for “all

the ordinary and necessary expenses paid or incurred during the taxable year

[ ] for the production or collection of income.” 26 U.S.C. § 212.

Generally, when a transaction is disregarded for lack of economic

substance, deductions for costs expended in furtherance of the transaction are

prohibited. See Winn-Dixie Stores, Inc. v. Comm’r, 113 T.C. 254, 294 (1999)

(observing that “a transaction that lacks economic substance is not recognized

for Federal tax purposes” and that “denial of recognition means that such a

transaction cannot be the basis for a deductible expense”); see also Salley v.

Comm’r, 464 F.2d 479, 483 (5th Cir. 1972); Lerman v. Comm’r, 939 F.2d 44, 45

(3d Cir. 1991); Kirchman v. Comm’r, 862 F.2d 1486, 1490 (11th Cir. 1989). This

makes sense in light of the fact that the effect of disregarding a transaction for

lack of economic substance is that, for taxation purposes, the transaction is

viewed to have never occurred at all.6 Courts have determined that they may

6

The Partnerships rely extensively on Fabreeka Prods. Co. v. Comm'r, 34 T.C. 290,

299-300 (1960), vacated on other grounds by 294 F.2d 876 (1st Cir. 1961), for the proposition

that operational expenses incurred in connection with a sham transaction may be deducted as

long as they are “separable” from the underlying transaction. To the extent that this

proposition can be supported by the since-vacated opinion in Fabreeka, we conclude that the

Tax Court has subsequently failed to follow Fabreeka’s approach to the deduction of

operational expenses, and has instead maintained that expenses incurred in connection with

a sham transaction are generally not deductible. See Winn-Dixie, 113 T.C. at 294 (finding that

administrative fees “were incurred in connection with, and were an integral part of, a sham

17

No. 07-40861

not disregard a transaction for some purposes but not for others. See ACM

P’ship, 157 F.3d at 261 (observing that “we are not aware of any cases applying

the economic substance doctrine selectively to recognize the consequences of a

taxpayer’s actions for some tax purposes but not others”). This also supports the

idea that a transaction may not be disregarded under the economic substance

doctrine for purposes of determining a partner’s tax basis in a partnership, yet

still support the deduction of operational expenses and fees. However, courts

have upheld deductions based on genuine debts, where the debts are elements

of a transaction that overall is lacking in economic substance. See Rice’s Toyota

World, Inc. v. Comm’r, 752 F.2d 89, 95-96 (4th Cir. 1985) (allowing deductions

based on recourse note debt that was an element of a sham purchase

transaction, because the notes represented actual indebtedness).

Here, the district court concluded that the interest payments were

deductible because they were real economic losses. However, § 163 does not base

the deductibility of interest on whether or not the interest paid was a real

economic loss. Rather, the test is simply whether the interest was paid or

accrued on indebtedness. See Salley, 464 F.2d at 485 (disallowing interest

deductions under § 163 because the taxpayers did not take on actual

indebtedness: “[i]n no sense can it be said that taxpayers paid any interest . . .

as compensation for the use or forbearance of money . . . which is the standard

business test of indebtedness”) (internal quotations and citation omitted).

Further, “the fact that an enforceable debt exists between the borrower and

lender is not dispositive of whether interest arising from that debt is deductible

under section 163.” Winn-Dixie Stores, 113 T.C. at 279. The overall transaction

must have economic substance in order to show genuine indebtedness, otherwise

transaction and, as a result, were not deductible”).

18

No. 07-40861

“every tax shelter . . . could qualify for an interest expense deduction as long as

there was a real creditor in the transaction that demanded repayment.” Id.

In concluding that the loan transactions in this case lacked economic

substance, the district court found that “[i]n truth, NatWest did not make any

loans” and “[t]he loans . . . were not loans at all.” These findings preclude the

conclusion that the Partnerships took on actual indebtedness. As we found

above, the loan transactions in this case lacked economic substance partly

because they were structured such that the Partnerships could never actually

spend the loaned funds—101.25% of the funding amount had to stay in the

accounts at NatWest to prevent a default. Therefore, despite the appearance of

a loan, functionally the Partnerships never took on any actual debt. Since the

loans did not constitute indebtedness, the Partnerships may not deduct the

interest paid under § 163.7

Presumably, though not specified, the district court found the remainder

of the operating expenses and fees deductible under § 212 as necessary expenses

incurred. This provision requires a profit motive. See Agro Science, 934 F.2d at

576 (noting that an expenditure is deductible under § 212 “only . . . if the facts

and circumstances indicate that the taxpayer made them primarily in

furtherance of a bona fide profit objective independent of tax consequences”).

The Government argues that the profit motive must be determined based on

Presidio’s subjective intentions because Presidio acted as managing partner

when the transactions occurred. The district court, however, determined that

the proper focus is on the motives of Patterson and Nix. Having concluded that

Patterson and Nix entered into the transactions genuinely seeking to make a

profit, the district court allowed the deductions.

7

The Partnerships may likewise not deduct interest under other provisions of the Code

as a business expense or an expense paid for the production of income. See Salley, 464 F.2d

at 483 (noting that if lack of economic substance prevents the deduction of interest under §

163, the interest is likewise not deductible under §§ 162(a) or 212).

19

No. 07-40861

The profit motive of a partnership is determined at the partnership level.

Id.; Simon v. Comm’r, 830 F.2d 499, 507 (3d Cir. 1987). We have previously

observed that the “testimony of general partners and promoters taken as a whole

is relevant in determining a partnership’s profit motive, because these

individuals control a partnership’s activities.” Agro Science, 934 F.2d at 576

(internal citations omitted). Here, the district court concluded that the partners

had different motivations: Nix and Patterson at all times pursued the

investment strategy with a genuine profit motive, while Presidio’s primary

intent was to achieve a tax benefit. The crucial inquiry, then is which partner’s

intentions should be attributed to the Partnership. Under Agro Science, this

answer depends on which partner effectively controlled the partnership’s

activities. Id.; Simon, 830 F.2d at 507 (observing that “a determination of [a

partnership’s] profit objective can only be made with reference to the actions of

those . . . who manage the partnership affairs”).

During the time of the transactions in question, Presidio acted as the

managing partner but had less than 10% ownership of Klamath and Kinabalu.

Patterson and Nix each had 90% ownership. After reforming the Partnerships

to bring this lawsuit they became managing partners. Though Patterson and

Nix were never limited partners, the LLC agreements state that “the overall

management and control of the business and affairs of the Company shall be

vested solely in the Managing Member.” The district court, however, did not

analyze which partner retained control over the partnership. The district court

appears to have concluded, with little explanation, that Patterson and Nix’s

motives must be attributed to the Partnerships because they paid the expenses

at issue here and reported them on their individual tax returns.8 However, for

8

In its brief, the Government contends that it was the Partnerships that paid the

expenses, citing to Plaintiff’s Exhibits 49, 50, 142, and 143. Since these exhibits have

apparently not made it into the record on appeal, and have not been able to be obtained from

the district court, we cannot verify the Government’s contention. Nonetheless, whether it was

20

No. 07-40861

purposes of determining the deductibility of expenses it is the motive of the

Partnership that matters, regardless of whether certain operating expenses were

borne by one partner or another. None of the arguments articulated by the

Partnerships or the district court persuade us that the motives of Patterson and

Nix, to whom the overall control and management of the Partnerships was

expressly denied under the LLC agreements, should be attributed to the

Partnerships. We therefore hold that the district court erred as a matter of law

by failing to consider which partners effectively controlled the management of

the Partnerships’ affairs, at the time the transactions occurred, in determining

whether the operating expenses and fees are deductible.

D

We turn now to the Government’s argument that the district court lacked

jurisdiction to order a refund.

The district court based its authority to order the refund on its jurisdiction

to order readjustment of partnership items, see 26 U.S.C. § 6226(f), and the Code

provision stating that a partner should not have to file a claim for a refund

following this readjustment. See 26 U.S.C. § 6230(d)(5) (“any overpayment by

a partner which is attributable to a partnership item (or an affected item) and

which may be refunded under this subchapter [26 U.S.C. §§ 6221 et seq.], to the

extent practicable credit or refund of such overpayment shall be allowed or made

without any requirement that the partner file a claim therefor”). The district

court interpreted this provision to mean that it may order a refund following a

readjustment of partnership items under § 6226, since the refund is permitted

without the taxpayers filing a claim.

an individual partner or the Partnership that paid the expenses is not dispositive of the issue

of who effectively controlled the Partnerships’ activities, and we conclude that the district court

erred in relying on this fact to allow the deductions.

21

No. 07-40861

The Government argues, however, that the Code imposes a strict

“exhaustion of administrative remedies” jurisdictional prerequisite with respect

to tax refund actions, and that nothing in the Code grants the district court the

authority to eliminate this prerequisite by ordering a refund as part of

readjustment proceedings under § 6226. As the Government contends, §

6230(d)(5) only grants the IRS the authority to provide a refund attributable to

partnership items without requiring the party to file a claim first—it does not

expand the district court’s specifically defined jurisdiction to include the

authority to order a refund.

We have not previously confronted this question, and the few cases

available reach mixed conclusions. The Government cites an unpublished

opinion from the Ninth Circuit holding that “a district court does not have

jurisdiction to order a refund in an action brought pursuant to 26 U.S.C. § 6226.”

See Gold Coast Hotel and Casino v. United States, 139 F.3d 904, 1998 WL 74991,

at *2 (9th Cir. 1998) (unpublished). Another court has ordered refunds in a §

6226 action, though it did not explain its jurisdictional basis for doing so, and the

Second Circuit reversed on appeal such that no refund was ultimately awarded.

See TIFD III-E Inc. v. United States, 342 F. Supp. 2d 94, 121-22 (D. Conn. 2004),

rev’d on other grounds, 459 F.3d 220 (2d Cir. 2006).

We conclude that the Code does not grant the district jurisdiction to order

a refund in a readjustment action brought pursuant to § 6226. This provision

specifically sets forth the scope of the district court’s jurisdiction in readjustment

proceedings. See § 6226(f). Though the provision specifies the district court’s

jurisdiction to determine partnership items, allocate those items to individual

partners, and apply penalties, taxes, or additional amounts, it does not grant

jurisdiction to order a refund.

Generally, no suit or proceeding may be maintained for the recovery of a

refund “until a claim for refund or credit has been duly filed with the Secretary

22

No. 07-40861

. . . .” See § 7422(a). Section 7422(h) provides a special rule for refund actions

with respect to partnership items: “No action may be brought for a refund

attributable to partnership items . . . except as provided in section 6228(b) or

section 6230(c).” The applicable provision here, § 6230(c), does not grant refund

authority to the district court; rather, it sets forth the grounds on which a

partner of a TEFRA partnership may file an administrative refund claim

following a final partnership administrative adjustment. Specifically, a partner

may file a claim for refund on the grounds that (1) the Secretary failed to allow

a credit or to make a refund to the partner in the amount of the overpayment

attributable to the application to the partner of a settlement, a final partnership

administrative adjustment, or the decision of a court in an action brought under

§ 6226, or (2) the Secretary erroneously imposed any penalty, addition to tax, or

additional amount which relates to an adjustment to a partnership item. See

§ 6230(c)(1)(B)-(C).

We agree with the Government that the provision upon which the district

court based its jurisdiction, § 6230(d)(5), merely contemplates that “to the extent

practicable” the IRS may grant a refund for an overpayment attributable to

partnership items without any requirement that the partner file an

administrative claim. Nothing in § 6230(d)(5) authorizes the district court to

grant a refund pursuant to readjustment proceedings under § 6226, and it would

be unreasonable to conclude that this provision—which is not referenced in

§ 6226(f) and is placed under the heading “Additional administrative

proceedings”—alters the clearly defined limits of a district court’s jurisdiction in

readjustment proceedings.

We accordingly hold that the district court was without jurisdiction to

order a refund. The Partnerships may seek a refund through administrative

proceedings, as governed by § 7422.

V

23

No. 07-40861

For the foregoing reasons, we AFFIRM the district court’s judgment that

the loan transactions lacked economic substance and must be disregarded for tax

purposes. We also AFFIRM the district court’s judgment that no penalties

apply. We VACATE the district court’s order allowing the deduction of interest

and operating expenses and REMAND for reconsideration in accordance with

this opinion. We also VACATE the district court’s order directing the IRS to

grant the Partnerships a refund.

24