Nev. Partners Fund, L.L.C. v. United States

720 F.3d 594

NEVADA PARTNERS FUND, L.L.C., by and through SAPPHIRE II, INCORPORATED, Tax Matters Partner, Plaintiff–Appellant Cross–Appellee

v.UNITED STATES of America, by and through its agent, the INTERNAL REVENUE SERVICE, Defendant–Appellee Cross–Appellant

Carson Partners Fund, L.L.C., by and through Sapphire II, Incorporated, Tax Matters Partner, Plaintiff–Appellant Cross–Appellee

v.United States of America, by and through its agent, the Internal Revenue Service, Defendant–Appellee Cross–Appellant

Reno Partners Fund, L.L.C., by and through Carson Partners Fund, L.L.C., Tax Matters Partner, Plaintiff–Appellant Cross–Appellee

v.United States of America, by and through its agent, the Internal Revenue Service, Defendant–Appellee Cross–Appellant

Carson Partners Fund, L.L.C., by and through Nevada Partners Fund, L.L.C., Tax Matters Partner, Plaintiff–Appellant Cross–Appellee

v.United States of America, by and through its agent, the Internal Revenue Service, Defendant–Appellee Cross–Appellant

Reno Partners Fund, L.L.C., by and through Delta Currency Management Company, Tax Matters Partner, Plaintiff–Appellant Cross–Appellee

v.United States of America, by and through its agent, the Internal Revenue Service, Defendant–Appellee Cross–Appellant

Carson Partners Fund, L.L.C., by and through Bricolage Capital Management Company, Tax Matters Partner, Plaintiff–Appellant Cross–Appellee

v.United States of America, by and through its agent, the Internal Revenue Service, Defendant–Appellee Cross–Appellant

Nevada Partners Fund, L.L.C., by and through Bricolage Capital Management Company, Tax Matter Partner, Plaintiff–Appellant Cross–Appellee

v.United States of America, by and through its agent, the Internal Revenue Service, Defendant–Appellee Cross–Appellant.

No. 10–60559.

United States Court of Appeals, Fifth Circuit.

June 24, 2013.

David Decoursey Aughtry, Esq., Chamberlain, Hrdlicka, White, Williams & Aughtry, Charles E. Hodges, II, Esq., Attorney, Kilpatrick, Townsend & Stockton, L.L.P., Atlanta, GA, Alveno N. Castilla, Kaytie Michelle Pickett, Esq., Walter Whitaker Rayner, Esq., Jones Walker LLP, Jackson, MS, for Plaintiff–Appellant Cross–Appellees.

Arthur Thomas Catterall, Tamara W. Ashford, Esq., Deputy Assistant Attorney, Kenneth L. Greene, Esq., Supervisory Attorney, Gilbert Steven Rothenberg, Esq., Deputy Assistant Attorney, Michael N. Wilcove, U.S. Department of Justice, Washington, DC, for Defendant–Appellee Cross–Appellant.

Appeals from the United States District Court for the Southern District of Mississippi.

Before KING, BENAVIDES, and DENNIS, Circuit Judges.

JAMES L. DENNIS, Circuit Judge:

This appeal arises from eleven notices of final partnership administrative adjustment (FPAAs) issued by the IRS with respect to three Limited Liability Companies (LLCs) treated as partnerships for tax purposes: ¹ Nevada Partners Fund, LLC (“Nevada”), Carson Partners Fund (“Carson”), and Reno Partners Fund, LLC (“Reno”) (collectively, the “plaintiffs” or “partnerships”). See26 U.S.C. §§ 6223, 6226(a). The FPAAs eliminated approximately $18 million of claimed tax losses and determined that penalties were applicable. According to the IRS, the partnerships' transactions provide one partner, James Kelley Williams, with an illegal tax shelter to avoid taxes on his unrelated personal capital gain of the same approximate amount. The partnerships challenged the FPAAs by timely filing eleven suits consolidated in the district court pursuant to 26 U.S.C. § 6226(b)(1). After a bench trial, the district court entered final judgment and a memorandum opinion upholding the IRS's disallowance of the claimed loss and upholding two of the three asserted penalties. Nevada Partners Fund, LLC ex rel. Sapphire II, Inc. v. United States, 714 F.Supp.2d 598 (S.D.Miss.2010). The partnerships timely appealed and the government cross-appealed. We affirm in part and vacate in part.

I.

A. The FOCus Program²

James Kelley Williams, an experienced and highly successful Mississippi businessman, expected to realize a large capital gain in the 2001 tax year—$18 million from the cancellation of Williams' liability on a loan he had guaranteed.³ Because of this expected gain, Williams conferred with his accountant and tax advisor, KPMG, LLP, and his attorneys at Baker Donelson, PC. At a meeting with them on October 2, 2001, KPMG agents gave a PowerPoint presentation to Williams and his attorneys that described a long-term investment program offered by Bricolage Capital, LLC (“Bricolage”), called the Family Office Customized or “FOCus” program. According to the PowerPoint presentation, the FOCus program had a “structure [that] may result in favorable income tax consequences [ ] to the investor” and explained that the program was expected to yield a tax benefit with zero net capital gains and losses. ⁴ The PowerPoint indicated that the favorable income tax consequences would be approved in a “ ‘more likely than not’ tax opinion from Arnold & Porter LLP.” In an internal memorandum, KPMG referred to this program as an “investment vehicle with a tax loss-generator possibility for th[at] year.”

The history of the FOCus program can be traced to earlier in 2001. Bricolage formulated the program for its clients who wished to obtain favorable tax treatment of certain assets. Bricolage enlisted Credit Suisse–First Boston (“Credit Suisse”) as the bank that would be essential to the program, which would involve using LLCs or partnerships in “execut[ing] foreign exchangetransactions in conjunction with a larger tax-motivated transaction ... that generates tax losses for clients of Bricolage.” An internal Credit Suisse memorandum ⁵ concisely set forth how these trades would produce a tax benefit for the investor:

Clients of Bricolage will invest in an investment partnership that has embedded losses that have not yet been realized for tax purposes. The clients will guarantee liabilities of the investment partnership to create sufficient tax basis to recognize such losses without any limit, and the losses will be triggered and allocated to the clients. The Transaction results in the allocation of an ordinary tax loss to an investor that economically did not suffer the loss.

As described to Williams in the KPMG PowerPoint, Bricolage's FOCus program entailed a three-tiered investment strategy that would produce the desired deductible tax loss. The first tier of this strategy involved the investment manager establishing an LLC with a transitory partner to act as a holding company for other funds (known as a “fund of funds”). The first-tier LLC would own 99% of a second LLC, which in turn would own 99% of a third LLC. Initially, the transitory partner would own a 99% interest in the first-tier LLC, with 1% interest in each LLC held by Bricolage. The two lower-tiered LLCs would engage in the transactions that would produce the desired tax loss. The third-tier LLC would enter into sets of currency forward contracts, or “straddle” trades, that would produce offsetting gains and losses. In the “gain” legs of the straddle trades, the gains would be realized and reported as income by the 99% transitory partner; while the losses in the other legs would be suspended in the books of the third-tier LLC. At that point, the investor-client would purchase the transitory partner's interest in the LLCs. The second-tier LLC would then obtain a Credit Suisse loan guaranteed by the investor that would be used to engage in a limited-risk foreign currency trade. The investor's guarantee of the loan would give him enough basis ⁶ in the LLCs to take advantage of the embedded loss they had generated.⁷ Finally, after the investor had offset the large tax gain with the embedded loss, the FOCus program called for the investor to conduct more traditional investments with Bricolage. In addition to the foregoing benefits, Bricolage would furnish a legal opinion letter from the law firm of Arnold & Porter, LLP, approving of the tax treatment of this investment structure.⁸

Following Williams' October 2, 2001, meeting, Bricolage began to carry out the FOCus strategy described in the PowerPoint presentation. Bricolage utilized three LLCs in which it already owned interests, Nevada Partners, Carson Partners, and Reno Partners. They became, respectively, the first-, second-, and third-tier LLCs in the FOCus Program. The initial transitory 99% owner of Nevada was Pensacola PFI Corp. (“Pensacola”), an S-corporation whose directors were two Bricolage principals, Andrew Beer and Samyak Veera. The two shareholders of Pensacola were two LLCs wholly owned, respectively, by Andrew Ahn and Jason Chai, two investors with connections to Bricolage. Bricolage Capital Management Company retained a 1% ownership interest in Nevada and Carson, and the 1% owner of Reno was Delta Currency Management Co., another Bricolage-affiliated company owned by Beer and Veera.⁹

Pursuant to the FOCus plan, between October and December of 2001, Reno engaged in foreign currency straddle transactions, which resulted in approximately eighty closely offsetting loss and gain “legs,” as described in the FOCus program documents. These trades were conducted through Credit Suisse and resulted in approximately $18 million in gains and $18 million in losses. ¹⁰ In order to begin the process of separating the corresponding gains and losses, Pensacola distributed its 99% ownership interest in Nevada to the two LLCs owned by Ahn and Chai. As more than fifty percent of the interest in Nevada was sold or exchanged in this transaction, it resulted in the “technical termination” of Nevada and the lower-tier LLCs for that tax year,¹¹ meaning that Reno closed its books for tax purposes and reopened them the next day. Because Reno's tax year had closed, it was required to declare, or “mark to market,” certain of the gains and losses on its straddle trades.¹² Reno did so, and the gains flowed up the partnership chain to Ahn and Chai's LLCs. Ahn and Chai ultimately...