RAGHUNATHAN SARMA & GAILE SARMA v. COMMISSIONER OF INTERNAL REVENUE
No. 21-12303
United States Court of Appeals, Eleventh Circuit
August 19, 2022
[PUBLISH]
Petition for Review of a Decision of the U.S. Tax Court
Agency No. 26318-16
Before NEWSOM, MARCUS, Circuit Judges, and MIDDLEBROOKS,* District Judge.
This appeal involves the tax consequences of Raghunathan Sarma‘s participation in a complex tax avoidance scheme. In 2001, Sarma expected to realize an $80.9 million capital gain as a result of selling a portion of his company. The scheme, which involved a set of tiered partnerships, allowed Sarma to claim a $77.6 million artificial loss to offset his legitimate capital gains. A federal District Court found the scheme to be an abusive tax shelter and upheld the IRS‘s disallowance of the benefits of the shelter in a partnership-level proceeding, and a prior panel of this Court affirmed. Kearney Partners Fund LLC v. United States, 803 F.3d 1280 (11th Cir. 2015) (per curiam).
As a result of the partnership-level proceeding, the IRS issued a notice of deficiency to Petitioners disallowing the $77.6 million loss deduction they reported on their joint tax return. Petitioners sought review in the U.S. Tax Court, which rejected their various challenges. After careful review and with the benefit of oral argument, we affirm.
I
A
Partnerships are not taxpayers; taxable income and losses of a partnership are passed through to its partners.
reporting their tax items, such as gains, losses, deductions and credits.
The Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA“), the governing scheme in effect during the relevant period, established uniform audit and litigation procedures for the resolution of partnership tax items. Pub. L. No. 97-248, 96 Stat. 648.1 Prior to TEFRA, the IRS could not
TEFRA provides a two-step process for resolving partnership tax matters. First, “partnership item[s]” are adjusted “at the partnership level” in a single partnership-level proceeding.
Conversely, a “nonpartnership item” is “an item which is (or is treated as) not a partnership item.”
Then, once partnership-level adjustments are final, the IRS determines whether the partnership-level adjustments necessitate any partner-level changes, including to “affected items.”
Any partnership that filed partnership return during the relevant time period was subject to TEFRA, unless it qualified as a “small partnership.”
small partnership if any partner is a “pass-thru partner,”
B
1282. Sarma participated in the FOCus scheme to avoid paying the resulting taxes.
Each FOCus vehicle required the creation of a set of three tiered partnerships: an upper tier, middle tier and lower tier. Id. at 1283. The partnerships owned a 99% interest in the partnership in the tier below it, with Bricolage-affiliated entities owning the remaining 1% of each entity. Id. at 1284. Sarma invested in the FOCus vehicle comprised of the following partnerships:3 (1) Nebraska Partners Fund, LLC (“Nebraska“), the upper tier, (2) Lincoln Partners Fund, LLC (“Lincoln“), the middle tier, and (3) Kearney Partners Fund, LLC (“Kearney“), the lower tier.
FOCus was designed to generate significant artificial losses to offset legitimate taxable income. An essential component was a series of offsetting foreign currency exchange forward contracts, referred to as straddles (“FX straddles“), executed by Kearney through Credit Suisse First Boston (“Credit Suisse“).4 The proceeds from the gain legs of the FX straddles were placed into certificates of deposit (“CDs“) at Credit Suisse. Kearney reported and realized
a $79.1 million gain from the gain legs.5 The loss legs had not been closed out and remained unrealized. However, the amounts of those losses were locked in.
The scheme also required several ownership changes in the partnerships, which resulted in the partnerships having several short tax periods within the 2001 calendar year.6 On December 4, 2001, Sarma acquired a 99% interest in Nebraska. Nebraska already owned a 99% interest in Lincoln, and Lincoln owned a 99% interest in Kearney. All three partnerships terminated their tax periods. See
and filed partnership returns for their respective short tax years ending December 14, 2001.
On December 19, 2001, Lincoln (a small partnership) sold its 99% interest in Kearney (a TEFRA partnership) for $737,118 to a Bricolage-affiliated entity. On the date of the sale, Lincoln claimed an outside basis in Kearney of $79,110,062. “Tax basis is the amount used as the cost of an asset when computing how much its owner gained or lost for tax purposes when disposing of it.” Woods, 571 U.S. at 35. Outside basis is “[a] partner‘s tax basis in a partnership interest.” Id. at 35-36. Outside basis increases when the partnership has a gain and decreases when the partnership has a loss.
Kearney ended its tax period and filed a partnership return for its December 19, 2001 short tax year. Lincoln‘s final short tax year in 2001 spanned from December 15, 2001 until December 31, 2001. Lincoln filed partnership returns for 2002, 2003 and 2004 with Sarma as its 99% partner.
C
The IRS issued nine FPAAs to the partnerships for several short tax years, including Kearney‘s December 19, 2001 tax year. In
the FPAAs, the IRS determined that the partnerships were an abusive tax shelter and adjusted partnership items to eliminate the benefits of the shelter. The IRS did not issue an FPAA to Lincoln for its December 31, 2001 short tax year, as Lincoln was a small partnership. However, Sarma held an indirect interest in several partnerships during the short tax years for which the FPAAs were issued. See
The District Court presided over a bench trial, at which Sarma testified. Kearney Partners Fund, LLC v. United States, 2014 WL 905459, *4, *9, *14 (M.D. Fla. March 7, 2014). Thereafter, the District Court found that “every step of the FOCus series of transactions“—including the creation of the partnerships, the purchases and sales of the various partnerships, including the sale of Kearney, and the FX straddles—was “solely motivated by tax avoidance.” Id. at *13. Sarma “schemed to create and operate the partnerships (even before [he] formally purchased them) to serve as an abusive tax shelter.” Id. at *1. The partnerships and their transactions “had no economic substance whatsoever.”7 Id. at *1, *13. The
D
The partnership-level court lacked jurisdiction to determine Lincoln‘s outside basis in Kearney, and so a partner-level proceeding was required to make that adjustment. On September 9, 2016, the IRS issued an affected item notice of deficiency to Petitioners asserting deficiencies for 2001 through 2004 arising out of Sarma‘s involvement in the FOCus shelter (“2016 notice“). Because Kearney was a sham, the IRS determined that Lincoln had no basis in Kearney. The IRS disallowed the $77.6 million loss deduction Petitioners reported and asserted resulting tax deficiencies. Previously, in 2009 and 2010, the IRS had also issued notices of deficiency to Petitioners for their 2001 through 2004 tax years. Petitioners filed a petition in the U.S. Tax Court challenging the 2016 notice.
Petitioners moved to dismiss for lack of jurisdiction. Petitioners first argued that the statute of limitations expired prior to the IRS‘s issuance of the 2016 notice. Petitioners additionally argued that the 2016 notice was an invalid third notice of deficiency. For reasons that will be more fully explained below, the resolution of both of these issues hinges on whether Lincoln‘s outside basis in Kearney is an “affected item.” The Tax Court held that it was, and thus found the notice to be both timely and valid.8
Respondent moved for summary judgment. Petitioners argued, in relevant part, that because Kearney was found to be a sham for tax purposes, Lincoln should be deemed the owner of Kearney‘s assets and Lincoln‘s sale of its Kearney interest should be deemed a sale of Kearney‘s assets. The Tax Court granted summary judgment for Respondent and rejected Petitioners’ deemed ownership theory. It held that Lincoln‘s outside basis in Kearney was zero, reasoning that a partner cannot have any basis in a sham partnership. See Woods, 571 U.S. at 41-42. Lincoln therefore had no gain or loss on the Kearney sale, Lincoln was not entitled to deduct the Lincoln loss, and Petitioners were not entitled to deduct the $77.6 million pass through loss.
Petitioners raise three issues on appeal. First, whether the Tax Court erred by finding that the statute of limitations had not expired prior to the issuance of the 2016 notice. Second, whether the Tax Court erred by finding that the 2016 notice of deficiency was a valid multiple notice. Both of these issues rise and fall with a single determination: whether Lincoln‘s outside basis in Kearney (i.e., a small partnership‘s outside basis in a TEFRA partnership) is an “affected item.” Third, whether the Tax Court erred by failing to treat Lincoln‘s sale of Kearney as a sale of Kearney‘s assets. After careful review, we affirm.
II
We review de novo the Tax Court‘s legal conclusions, including the
summary judgment de novo.9 Roberts v. Comm‘r, 329 F.3d 1224, 1227 (11th Cir. 2003) (per curiam). Summary judgment is warranted where the record establishes “that there is no genuine issue as to any material fact and that a decision may be rendered as a matter of law.” Baptiste v. Commʼr, 29 F.3d 1533, 1537 (11th Cir. 1994) (quoting Tax Ct. R. 121(b)).
A
The general limitations period for assessing tax or issuing a notice of deficiency is three years after the taxpayer files his or her individual return.
The mailing of a timely FPAA suspends the statute of limitations until the conclusion of the partnership-level proceeding and for one year thereafter.
The IRS issued the 2016 notice on September 9, 2016. If the 2016 notice adjusts an affected item, as Respondent argues, the statute of limitations did not expire until January 11, 2017—one year after the Kearney proceeding became final. Petitioners, however, contend that Lincoln‘s outside basis in Kearney is not an affected item, therefore
An affected item is “any item to the extent such item is affected by a partnership item.”
A partner‘s outside basis in a partnership interest is generally an affected item. See Woods, 571 U.S. at 41-42. Here, Lincoln claimed an inflated outside basis in Kearney based upon the artificial gains Kearney generated
is “disregarded for tax purposes, no partner could legitimately claim an outside basis greater than zero.” Woods, 571 U.S. at 44. The determination that Kearney was a sham factors into Lincoln‘s computation of its gain or loss on the sale of its Kearney interest. Thus, Lincoln‘s outside basis in Kearney is an item affected by a partnership item.
Nothing in the statutory text compels a different result when the partner is a small partnership. Small partnerships are not “partnerships” within the meaning of TEFRA, so they cannot have “partnership items.”
Petitioners’ argument to the contrary rests on an untenable analogy to TEFRA partnerships. The analogy works as follows: An upper-tier TEFRA partnership‘s outside basis in a lower-tier TEFRA partnership could not be an affected item because it would be a partnership item of the upper-tier partnership. Nonpartnership “partnership-level” items of a small partnership should receive the same treatment as partnership items of a TEFRA partnership. It follows that a small partnership‘s outside basis in a TEFRA partnership would be a “partnership-level” nonpartnership item, and the IRS should have addressed it at the “Lincoln partnership level” or the “Lincoln level.” Put simply, this analogy is contrary to the text and structure of TEFRA.
There is at least a colorable textual argument to support the proposition that an upper-tier TEFRA partnership‘s outside basis in a lower-tier partnership would be a partnership item of the upper-tier and not an affected item.10 See
Nor does TEFRA‘s structure evidence Congressional intent for “partnership level” items of small partnerships to receive like treatment as partnership items of TEFRA partnerships. TEFRA does not endeavor to treat uniformly all entities that file returns as partnerships. Rather it provides for a single unified proceeding to resolve partnership items of a given “partnership,” as that term is statutorily defined, for the purpose of uniform application of the partnership-level items among the partners. See, e.g., JT USA LP v. Comm‘r, 131 T.C. 59, 65 (2008). This concept of “levels” matters for TEFRA partnerships because separate proceedings exist and jurisdictional limits apply to the items that can be resolved at each level. See
As a final matter, the Tax Court did not “open up” Lincoln‘s December 31, 2001 “otherwise closed” tax year, as Petitioners contend. Br. of Petitioners at 36–38. “Congress anticipated that the taxable year in which an assessment is made would not always be the same as the taxable year in which the adjustments are made,” which the intersection between
of the partnership and partner‘s respective taxable years). Section 6229(a) establishes the minimum period in which the IRS must assess tax attributable to partnership items or affected items against the ultimate taxpayer, “notwithstanding the period provided for in § 6501.” Greenberg, 10 F.4th at 1164 (quoting Rhone-Poulenc, 114 T.C. at 542) (internal quotation marks omitted). Put another way, “section 6229(a) holds open the § 6501 limitations period as to all partners for a fixed period of time, thereby providing a minimum period within which to assess adjustments attributable to partnership items against all partners.” Rhone-Poulenc, 114 T.C. at 544. Here, that would be Petitioners. Lincoln is a flow-thru entity that does not itself pay taxes. TEFRA applies “to any person holding an interest” in a TEFRA partnership during the taxable year at issue.
The filing of the FPAA, the timeliness of which Petitioners do not contest, suspended the limitations period for assessment of tax attributable to affected items until January 11, 2017. The 2016 notice asserts a deficiency that is attributable to an affected item. Accordingly, the statute of limitations had not expired when the IRS issued the September 9, 2016 notice of deficiency, as the Tax Court correctly found.
Having found that Lincoln‘s outside basis in Kearney is an affected item, it then follows that the 2016 notice was valid. Section
6212(c)(1) generally bars the issuance of multiple notices of deficiency to the same taxpayer for the same tax year. Petitioners contend that the 2016 notice is invalid in light of the two prior-issued notices and, thus, that the Tax Court lacked jurisdiction. See GAP Corp. & Subsidiaries v. Comm‘r, 114 T.C. 519, 521 (2000) (“[The Tax] Court‘s jurisdiction to redetermine a deficiency in tax depends upon a valid notice of deficiency . . . .“).
However, Congress carved out an exception to this general rule in
C
We now turn to Petitioners’ deemed ownership theory. Petitioners do not challenge the Tax Court‘s finding that Lincoln had no outside basis in Kearney in light of Kearney being a sham. Rather, Petitioners argue that the Tax Court should have treated Lincoln‘s sale of its Kearney interest as something wholly
different—a sale of Kearney‘s assets.11 They argue that Kearney, as a sham partnership, must be treated as an agent or nominee of its owners. Lincoln should thus be deemed the owner of Kearney‘s assets, and Lincoln‘s sale of its Kearney interest deemed an asset sale. Petitioners contend that the Tax Court needed to resolve Lincoln‘s basis in Kearney‘s assets, namely the CDs (which Kearney purchased with the gains from the FX straddles), and determine the amount of Lincoln‘s loss on the deemed asset sale. Their position is that Lincoln took a cost basis of $81.8 million in the CDs. Were that the case, Lincoln would have sold an asset worth $81.8 million for $717,868-less than one percent of its value-yielding an $81 million loss.
When a partnership is found to be a sham for tax purposes, the rules governing the income taxation of partners (subchapter K of chapter 1) do not apply, and the activities of the purported partnership are treated as engaged in by one or more of the purported partners. 436 Ltd. v. Comm‘r, T.C. Memo 2015-28, *34-*35 (2015). A sham partnership has no identity separate from its owners and is treated as an agent or nominee. Tigers Eye Trading, LLC v. Commr, 138 T.C. 67, 96, 99 (2012), aff‘d in part, rev‘d in part sub nom. Logan Tr. v. Commʼr, 626 F. App‘x 426 (D.C. Cir. 2015). But the transactions of a disregarded partnership still need to be addressed, “to the extent [the reviewing court] ha[s] jurisdiction.” 436 Ltd., T.C. Memo 2015-28 at *35.
If a sham partnership files an informational return, which Kearney did, the return is treated as though it were filed by
entity subject to TEFRA.
To recharacterize Lincoln‘s sale of its Kearney interest as an asset sale would run afoul of the principle that “a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not, and may not enjoy the benefit of some other route he might have chosen to follow but did not.” Meruelo v. Comm‘r, 923 F.3d 938, 945 (11th Cir. 2019) (quoting Commr v. Nat. Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149 (1974)) (internal quotation marks omitted). Taxpayers generally must
accept the tax consequences flowing from “the transaction they actually execute” (meaning, they are “bound by the ‘form’ of their transaction“), and they “may not reap the benefit of some other transaction they might have made” (meaning they cannot “argue that the ‘substance’ of their transaction triggers different tax consequences“). Id. (quoting Selfe v. United States, 778 F.2d 769, 773 (11th Cir. 1985)) (internal quotation marks omitted). Lincoln reported this transaction as a sale of its interest in Kearney on its December 31, 2001 partnership return. Kearney did not distribute the CDs to Lincoln, and the District Court did not treat Lincoln as the owner of the CDs. What it did, rather, was find Kearney to be a sham and eliminate the tax consequences of the shelter at the partnership level, thereby enabling the IRS to reduce Lincoln‘s outside basis in Kearney to zero and disallow Petitioners’ $77.6 million loss deduction. That is not the tax consequence Petitioners contemplated, but it is the tax consequence to which they are bound.
Petitioners’ reliance on Gregory v. Helvering, 293 U.S. 465 (1935), and the substance over form doctrine is misplaced. Substance over form is an exception to the general rule that courts respect the form of the transaction, which allows courts “to determine the true nature of a transaction disguised by formalisms that exist solely to alter tax liabilities.” Shockley v. Comm‘r, 872 F.3d 1235, 1247 (11th Cir. 2017) (quoting John Hancock Life Ins. Co. (U.S.A.) v. Commr, 141 T.C. 1, 57 (2013)) (internal quotation marks omitted). “Taxpayer[s] can not [sic] argue substance over form, except when necessary to prevent unjust results.” Adobe Resources Corp. v. United States, 967 F.2d 152, 156 (5th Cir. 1992)
945. There is nothing unjust about holding Petitioners to the form of the transaction they chose. That is especially so considering that the form of the transaction—the sale of an interest in a partnership, albeit one later determined to be a sham—was an integral and pre-planned part of an abusive tax shelter. The Tax Court did not err in declining to recharacterize Lincoln‘s sale of its Kearney interest.
D
As a final matter, we reject Petitioners’ contention that the Tax Court failed to address due process concerns because Petitioners “were never given the opportunity to directly challenge” the disallowance of the Lincoln loss. Br. of Petitioners at 14 n.4. Lincoln and Sarma were parties to the Kearney proceeding—Lincoln as a direct partner of Kearney and Sarma as an indirect partner of Kearney through Lincoln. See
Petitioners had the opportunity to persuade the District Court that Kearney was not a sham and that its activities had economic substance. See Napoliello v. Comm‘r, T.C. Memo 2009-
104, *7 (2009), aff‘d 655 F.3d 1060 (9th Cir. 2011) (“TEFRA‘s notice provisions generally safeguard due process rights by providing partners with notice of the partnership adjustment and an opportunity to participate in the partnership-level proceeding.“). Sarma testified at the bench trial and the District Court made credibility determinations. Kearney Partners Fund, 803 F.3d at 1285. Petitioners then challenged the effects of the partnership-level adjustments on their own tax items in the instant proceeding. Petitioners received and availed themselves of notice and the opportunity to be heard, and we find no due process violations.
For the foregoing reasons, we AFFIRM.