Kearney Partners Fund, LLC v. United States

KEARNEY PARTNERS FUND, LLC; NEBRASKA PARTNERS FUND, LLC;and LINCOLN PARTNERS FUND, LLC, Plaintiffs, v. UNITED STATES OF AMERICA, Defendant.

Case No. 2:10-cv-153-FtM-37CM

UNITED STATES DISTRICT COURT MIDDLE DISTRICT OF FLORIDA FT. MYERS DIVISION

Dated: March 6, 2014

MEMORANDUM OPINION AND ORDER

This cause is before the Court following an eight-day bench trial that concluded on September 25, 2013. (Docs. 246-52, 255.)¹ Having considered the pleadings, evidence, argument, and relevant legal authority, and having made determinations on the credibility of the witnesses, the Court hereby renders its decision on the merits of this case, pursuant to Federal Rule of Civil Procedure 52.

BACKGROUND

These consolidated cases arise out of a tax dispute between the Internal Revenue Service ("IRS") and Plaintiffs, which are a three-tiered set of LLCs treated as partnerships for tax purposes (and which the Court will refer to herein as "partnerships"). (See Doc. 173-6, ¶ 1.) The IRS contends that the creation and operation of the partnerships constituted an illegal tax shelter. (Doc. 173, p. 9.)

Thus, the IRS issued Notices of Final Partnership Administrative Adjustments("FPAA"), which adjusted the partnerships' tax returns to eliminate the tax consequences of the alleged shelter. (J-1 to J-11.)² The IRS' contention is that the partnerships' transactions lacked economic substance. (Doc. 173, pp. 10-11.) The IRS also determined that accuracy-related penalties should be imposed due to the alleged misstatements on the tax returns. (Id. at 10.)

Plaintiffs then filed these consolidated suits challenging the FPAAs. (Id.) Case Nos. 2:10-cv-154, -158, and -159 were brought for tax periods before December 4, 2001; at that time, the partnerships were formally owned by entities affiliated with a company called Bricolage. (See id. at 7-8.) Case Nos. 2:10-cv-153 and -157 were brought for tax periods after that date; at that time, Mr. Pat Sarma formally purchased the core partnership (Nebraska) and indirectly owned the other partnerships (Lincoln and Kearney). (Id.)

At trial, the facts revealed a complex series of transactions and interactions between Mr. Sarma, Bricolage, the partnerships, and other entities advising them. Based on the findings of fact explicitly laid out below and the record as a whole, the Court finds that Mr. Sarma and Bricolage, in conjunction with their advisors, schemed to create and operate the partnerships (even before Mr. Sarma formally purchased them) to serve as an abusive tax shelter; this allowed Mr. Sarma to avoid paying taxes on a large capital gain that he had incurred, in exchange for significant fees to Bricolage and the other advisors.

Though the facts are complicated, the law is less so: transactions are not entitled to tax respect if they lack any economic substance—either objective economic effects ora subjective business purpose. The Court therefore concludes that the IRS was correct to eliminate the tax consequences of the shelter's transactions, which had no economic substance whatsoever. However, the Court finds that the penalties are inapplicable due to an amnesty program propagated by the IRS in which Mr. Sarma participated on behalf of the partnerships.

FINDINGS OF FACT³

I. Mr. Sarma

1. Mr. Sarma is a well-educated, intelligent, and successful individual: He has an undergraduate degree in mechanical engineering and a graduate degree in operations research. (Tr. II, 187:11-25.) He is a sophisticated investor who has personally conducted some foreign exchange trading. (Tr. I, 89:5-7, 105:7-10.) In 2001, the time relevant to this case, his net worth was about $134 million. (J-110.)

2. In the 1980s, Mr. Sarma, along with his business partner Mr. Shankar, founded a computer company called American Megatrends. (Tr. II, 190:18-191:10.)

3. American Megatrends eventually became very well-known, and Mr. Shankar and Mr. Sarma sold one of its popular divisions in early 2001. (Id. at 193:5-194:13; Tr. III, 5:7-10.)

4. An entity called KPMG was American Megatrends' accountant and advised the company on the accounting aspects of the division sale. (Tr. II, 203:3-6; Tr. III, 41:15-17.)

5. Mr. Sarma was expected to receive a capital gain of approximately $80.9 million from the division sale, which would result in a tax obligation of about $16 million. (Tr. III, 5:7-10, 40:25-41:5; see also D-124.) Mr. Sarma received his first payment from the sale on September 1, 2001. (Tr. III, 5:7-10, 40:25-41:5.)

6. Later that month, Mr. Sarma was hospitalized and underwent surgery. (Tr. II, 196:11-16.) He remained in the hospital until September 25, 2001. (Id. at 196:18-24; Tr. III, 42:12.)

7. Around that time, Mr. Sarma decided to part ways with Mr. Shankar and to sell his American Megatrends stock. (Tr. II, 194:14-23, 200:18-201:2; Tr. III, 5:11-18.) He received a payment from that sale on December 1, 2001. (Tr. III, 6:22-25.)

II. Bricolage & KPMG

8. Bricolage was created in 1999 to manage alternative investment strategies, such as hedge funds and funds-of-funds, for high net-worth individuals. (Tr. I, 73:2-7, 74:3-17, 85:19-22; J-97.) Bricolage worked with accounting firms, specifically KPMG, to get referrals to these individuals. (Tr. II, 92:1-5.)

9. In September 2001, KPMG began identifying individuals who had recently had a "large liquidity event" as prospective Bricolage referrals. (Id. at 24:14-17, 92:24-93:1, 94:1-5, 95:22-24.) KPMG and Bricolage then marketed to its clients an investment vehicle known as a "Family Office Customized Partnership," or "FOCus." (Id.)

10. KPMG was aware of Mr. Sarma's large capital gain due to its involvementwith the American Megatrends sale. (Id. at 203:3-6; Tr. III, 41:15-17.) Further, Mr. Sarma's banker First Union—which was also involved in FOCus—introduced him to Bricolage.⁴ (Tr. II, 201:19-22; D-114; D-123.)

11. Bricolage and KPMG structured the FOCus investment vehicle as a three-tiered set of partnerships akin to a "customized family fund of funds." (Tr. II, 47:2-6.)

12. Through a complicated series of pre-planned steps, Bricolage and KPMG explicitly intended for FOCus to generate artificial tax losses for their high net-worth clients. (Id. at 94:13-17; D-26.) Those steps, encapsulated in Bricolage and KPMG PowerPoint presentations, match up almost perfectly with the facts as they unfolded in this case. (See D-26; D-124.) The following is a paraphrase of the steps (see D-124), which the Court will reference periodically throughout:

(1) A corporation and a third party create an LLC to serve as a holding company.

(2) They create a second LLC subsidiary to the first LLC.

(3) They create a third LLC subsidiary to the second LLC which invests in hedging instruments. The third LLC recognizes gains and holds unrealized losses in equal amounts.

(4) The investor buys the first LLC from the third party.

(5) The investor agrees to contribute additional capital to the second LLC.

(6) The investor buys the second LLC, yielding a suspended capital loss.

(7) The second LLC borrows money to engage in currency option trading. The investor guarantees the loan.

(8) The investor fulfills his agreement to contribute additional capital, increasing his tax basis in the second LLC.

(9) The third LLC recognizes its previously unrealized losses from Step (3), which are passed through to the investor.

(10) The second LLC terminates its currency option trading and the loanguarantee. This results in a capital gain, which is offset by the suspended capital loss in Step (6).

(11) The investor continues the investment program through the first and second LLCs for at least three years.

III. Creation of NLK

13. In September 2001, Bricolage created ten FOCus investment vehicles based on the three-tiered structure described in Steps (1) through (3) above. See supra ¶ 12(1)-(3). Each FOCus vehicle had the name of a state as the core partnership with the name of two cities in the state as the lower-tier partnerships. (See Tr. II, 55:12-24, 63:9-23, 75:20.) One of those vehicles was the Nebraska/Lincoln/Kearney ("NLK") set of partnerships which are Plaintiffs in this case.⁵ The structure of that three-tiered vehicle as a whole, referred to as the "NLK FOCus" or the "NLK partnerships," is described in detail below and then depicted in a graph.

14. Nebraska Partners Fund was the top tier of the NLK partnerships, called the "core fund." (Id. at 48:11-16.) It functioned as a holding company. (Id. at 49:17-18.) Nebraska was capitalized and 99% owned by Pensacola PFI Corp., which was affiliated with Bricolage.⁶ (Id. at 80:21-23.) AnotherBricolage entity called Bricolage Capital Management Company ("BCMC") owned the other 1% as the fund administrator. (Id. at 48:11-20, 52:6-16.) The creation of this partnership fulfilled Step (1) of Bricolage and KPMG's pre-planned steps. See supra ¶ 12(1).

15. Lincoln Partners Fund was the middle tier of the NLK partnerships. (Tr. II, 49:1-4.) Nebraska owned 99% of Lincoln, and BCMC owned the other 1%. (Id.) The creation of this partnership fulfilled Step (2) of the preplanned steps. See supra ¶ 12(2).

16. Kearney Partners Fund was the bottom tier of the NLK partnerships. (Tr. II, 49:5-9.) Lincoln owned 99% of Kearney, while another Bricolage entity, Delta Currency Management Company ("DCMC"), owned the other 1%.⁷ (Id.) Kearney's primary function was to conduct foreign exchange ("FX") trading. (Id. at 49:24-50:5.) The creation of this partnership fulfilled the first part of Step (3) of the pre-planned steps. See supra ¶ 12(3). Thus, the NLK partnerships at their creation were structured as follows:

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IV. Mr. Sarma Decides to Purchase NLK

17. Once Bricolage created the NLK FOCus, the vehicle needed an investor; therefore, on behalf of its client Mr. Sarma, First Union set up a meeting for September 20, 2001, with KPMG, Bricolage, and Mr. Sarma's attorney.⁸ (D-58.)

18. At the meeting, KPMG presented all of the FOCus steps, see supra ¶ 12(1)-(11), which demonstrated that Mr.

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