ORDER ON SUPPLEMENTAL MOTIONS FOR SUMMARY JUDGMENT
I. INTRODUCTION
Pursuаnt to the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”), petitioners initiated these proceedings to challenge the government’s treatment of partnership items in their 1999 and 2000 tax returns. In Final Partnership Administrative Adjustments (“FPAAs”) issued by the government, petitioners were denied
The government now moves a second time for summary judgment as to the provisional applicability of the substantial understatement penalty. Petitioners have filed their own motion for summary judgment seeking findings that discrete losses and expenses incurred in connection with the BLIPS transactions have independent economic substance аnd are therefore properly deductible. For the reasons stated below, petitioners’ motion for summary judgment is granted in part and denied in part. To the extent not previously granted by the July Order, the government is entitled to summary judgment on the non-deductibility of the three categories of losses and expenses identified in petitioners’ motion. In addition, the government’s motion for summary judgment for a finding that the substantial understatement penalty is provisionally applicable at the partnership level is granted.
II. BACKGROUND
The partiеs’ motions implicate a number of issues previously addressed by the July Order. After considering the facts of the case
Turning to the next prong of the government’s motion, the July Order found that genuine issues of material fact precluded a determination that the negligence penalty provisionally applied at the partnership level. The Order determined, however, that the valuation misstatement penalty was provisionally applicable. Finally, the government prevailed on its argument that the LLC-2 components of the BLIPS products were “tax shelters” as defined by Treasury Regulation § 1.6662 — 4(g).
III. LEGAL STANDARD
Summary judgment is appropriate “if the movant shows that there is no genuine
IV. DISCUSSION
A. Petitioners’ Motion for Summary Judgment
1. Taxability of Interest Income
Petitioners first contend that interest income derived from the proceeds of loans underlying the BLIPS transactions should be exempt from taxation. There is no dispute that this treatment would be consistent with case law. See Alessandra v. C.I.R.,
2. Deductibility of Certain Losses and Expenses
Petitioners next move for summary judgment on the deductibility of two categories of losses and expenses incurred by the partnerships in connection with the BLIPS transactions: (1) losses from foreign currenсy trading activity; and (2) management fees and guaranteed payments. According to petitioners, these losses and expenses are separable from the loans (which, they argue, formed the foundation of the July Order’s economic substance finding) and were sustained in the primary pursuit of genuine profit.
“It is a basic premise of tax law that a transaction devoid of economic substance, or a sham transaction, simply is not recognized for federal taxation purposes, for better or worse.” Alessandra,
Notwithstanding Rice’s Toyota and its progeny, the government contends there is no need to evaluate the individual deductions sought by petitioners because the July Order forecloses characterization of any element of the BLIPS transactions, including the currency investments, as having economic substance. Indeed, the July Order made several determinations specific to the purpose and substance of the currency forward contracts, including findings that the investments had only a “remote likelihood of any profit during” the brief 60-day window during which they were held and were purchased “for the purpose of maintaining the fagade of economic activity.”
Nevertheless, petitioners argue the July Order did not expressly find that the currency investments, independently considered in a vacuum, were a sham. In support of the argument that such individualized, component-level analysis is warranted, petitioners urge reliance on ACM Partnership v. Commisioner,
Under the circumstances of this case and in light of findings already made, the currency investments cannot be recognized for tax purposes. The July Order determined that the BLIPS transactions were interlinked financial products formulated to produce artificial tax losses for participants.
ACM does not change this conclusion. In a parallel strand of authority, other courts hаve held that the “overall transaction ... must have economic substance before” subcomponents may be deducted.
In passing, petitioners point out that the government conceded the deductibility of the BLIPS currency trading losses in the related Klamath litigation. They make little of this argument, though, perhaps because it demonstrates key distinctions between that case and this one. In Kla-math, the district court .was asked to determine only whether the loans central to the BLIPS transactions lacked economic substance. Klamath Strategic Inv. Fund, LLC v. United States (Klamath II),
Moreover, the Klamath district court found that the individual BLIPS investors in that case had specifically sought out the forward contracts with the primary motive of making a profit; in fact, the currency investments were the animating purpose
These proceedings, in contrast, are focused only on objective and subjective indicia of economic substance at the Presi-dio principal-level. Such indicia were considered at length in the July Order, which found that the BLIPS transactions — not merely the underlying loans — were shams and should be disregarded for tax purposes. Petitioners have failed to demonstrate that the July Order leaves any room for the relief they request. Flowing from this determination, petitioners have not shown that management fees and guaranteed payments remitted in connection with the BLIPS products are separable from the overall sham transaction. Because they were paid as transaction costs incident to an integrated scheme that lacked economic substance, the expenses and taxes identified by petitioners cannot be deducted. Klamath Strategic Inv. Fund ex rel. St. Croix Ventures v. United States,
For the foregoing reasons, petitioners’ motion for summary judgment is granted in part as to the non-taxability of the loan income and is otherwise denied. To the extent the July Order did not explicitly so find, the government is entitled to summary judgment on the non-deductibility of those losses and expenses specified in the FPAAs.
B. Government’s Motion for Summary Judgment
In its motion, the government seeks summary judgment on the provisional applicability of the substantial understatement penalty. To obtain summary judgment, the government .must clear two hurdles. First, it must demonstrate that a partnership-level finding on substantial understatement is authorized because the penalty “relates to an adjustment to a partnership item.” 26 U.S.C. § 6226(f). If jurisdiction exists and the penalty provisionally applies, the government must
1. Provisional Applicability of Substantial Understatement Penalty
The Supreme Court’s recent opinion in United States v. Woods defines the contours of a district court’s authority to make penalty findings at the partnership level.—U.S.-,
The FPAAs have the potential to trigger the substantial understatement penalty. As described in the July Order, the net result of BLIPS was to create a tax loss for the client through an artificially inflated outside basis in the LLC-2.
Petitioners contend that, unlike the negligence and valuation misstatement penalties, the substantial understatement penalty is not susceptible to provisional application because it does not flow inevitably from the partnership adjustments. This is not the relevant test; the government must merely demonstrate that the adjustments at issue might potentially trigger the penalty. Woods,
Engaging in an item-by-item analysis of the Belford partnership return, petitioners further attempt to demonstrаte that myriad unknown variables might impact whether BLIPS partners have indeed substantially understated their tax liability. Again, such uncertainty is immaterial. See Woods,
2. Reasonable Cause
Although it has already been determined that they lack a partnership-level reasonable cause defense to accuracy penalties, petitioners seek to revive this defense as it relates to the loss and expense deductions addressed in their motion for summary judgment. It would make little sense, however, to hold that petitioners have a reasonable cause defense for sоme partnership items and not others where the entire BLIPS scheme has been determined to lack economic substance. Consistent with this order’s determination that the deductibility of the losses and expenses identified in petitioners’ motion has been settled by the July Order, there is no basis to reconsider petitioners’ entitlement to the reasonable cause defense.
3. Substantial Authority
In addition to finding the substantial and gross valuation misstatement penalties provisionally applicable and denying summary judgment on the negligence рenalty, the July Order determined that the LLC-2s qualified as “tax shelters” under the Treasury Regulations. As a consequence of this finding, to prevent provisional application of the substantial understatement penalty petitioners must show that: (1) there was substantial authority for the tax treatment of the partnership item; and (2) they reasonably believed the tax treatment of that item was more likely than not the proper treatment. Treas. Reg. § 1.6662-4(g)(l)(i)(A)-(B). The substantial authority standard is objective, and will be met where the “weight of the authorities suрporting the treatment is substantial in relation to the weight of the authorities supporting contrary treatment.” Id. at § 1.6662-4(d)(3).
The question of substantial authority was addressed by the July Order in connection with its finding that the LLC-2s were tax shelters. In relevant part, the Order reasoned that substantial authority did not support petitioners’ treatment of the BLIPS loan premiums as contingent.
As they have done throughout this round оf briefing, petitioners attempt to reframe the issue. They contend that the question is not whether treatment of the loan premiums as contingent was justified. Instead, petitioners argue, the relevant inquiry at this stage is whether other collateral deductions were supported by substantial authority. This argument dovetails with the central premise of petitioners’ motion — that “a sham transaction may contain elements whose form reflects economic substance and whose normal tax consequences may not therefore be disregarded.” Rice’s Toyota World v. Comm’r, 752 F.2d 89, 96 (4th Cir.1985). As noted above, however, the Rice’s Toyota principle is inapplicable here; it does not mandate that the BLIPS transactions be disaggregated into their component parts for purposes of determining wheth
Turning to the question of whether substantial authority supported the BLIPS transactions generally, the July Order determined that the two primary authorities cited in KPMG’s opinion letter were inap-posite and did not justify the tax positions taken by the partnerships.
Petitioners do not seriously contest that the primary purpose and outcome of the BLIPS products — the creation of large tax losses through the artificial inflation of partners’ outside basis in the LLC-2s— was unsupported by substantial authority. Accordingly, that defense is inapplicable here and cannot be relied upon to support the validity of other related tax deductions stemming from the transactions. Because petitioners have not demonstrated that substantial authority supported the BLIPS transactions, there is no need to address the question of whether they had a reasonable belief in the propriety of the tax treatment they claimed.
V. CONCLUSION
In some cases, courts have found discrete, economically substantive components of sham transactions to be separable from the larger scheme and thus potentially deductible. This is not such a case. In evaluating the prepackaged tax shelter product at issue here, it would be misguided to discriminate among the various transactional elements and find that some were instilled with economic substance while others were not.
As a result, petitioners’ motion for summary judgment is granted in part as to the non-taxability of the loan income and is otherwise denied. The government is entitled to summary judgment finding that losses and expenses stemming from the BLIPS transactions, as specified in the FPAAs, will be disregarded for tax purposes and cannot be deducted. The government’s separate motion is granted: the substantial understatement penalty provisionally applies at the partnership level. No later than three weeks from the date of this order, the parties shall each submit a letter to the court clarifying their respective positions on what partnership-level issues, if any, remain in these related cases.
IT IS SO ORDERED.
Notes
. A detailed summary of the history and contours of the BLIPS transactions, based on undisputed facts derived from discovery materials and the parties’ first round of summary judgment briefs, can be found in the July Order. Shasta Strategic Invest. Fund LLC, et al. v. United States, No. C-04-04264-RS,
. As a consequence of the government’s non-opposition to their argument regarding interest income, petitioners have abandoned the prong of their motion seeking summary judgment on the deductibility of certain state taxes paid in connection with the BLIPS transactions. Consistent with the July Order, these expenses will be disregarded for tax purposes as provided in the FPAAs.
. More broadly, the Ninth Circuit has declined to adopt the economic substance test articulated by the Fourth Circuit in Rice’s Toyota. Casebeer v. Comm’r,
. As petitioners themselves argued in their oppоsition to the government's first motion for summary judgment, “the premium loan and foreign currency transactions went hand-in-hand.” Dkt. 233 at 21.
. At issue in both Lee and Winn-Dixie was the deductibility of interest expenses arising from genuine indebtedness incurred in connection with sham transactions. Lee,
.’ In a similar but distinct argument, petitioners claim that even if a transaction has been held to lack economic substance, the deducti-bility of individual losses and expenses must still be evaluated under 26 U.S.C. § 165(c). Petitioners' own authorities demonstrate otherwise. Keeler v. Comm’r,
. Although the two partnerships at issue in Klamath withdrew from the investments early like other investors, the district court found that they "did not have an understanding of the significant tax loss that would be generated by withdrawing at the end of the 60 day period.”