Case Information
*1 Before E ASTERBROOK Chief Judge , P OSNER W ILLIAMS Circuit Judges .
P OSNER Circuit Judge
. These appeals are multiple LLCs (limited liability companies) involved creation administration shelter. For sake simplicity we’ll treat appeals one appeal, Warwick Trading, LLC. other appellants are subsidiaries used attract needn’t discussed separately. appeal challenges decision Tax Court uphold *2 2 12 3367 12 3371 ing disallowance by Internal Revenue Service loss ‐ es claimed by Warwick (ultimately for benefit in ‐ vestors in tax shelter) and also upholding percent penalty for “gross valuation misstatement.” U.S.C. §§ 6662(a), (h); T.C. 70, 87, 91–92 (2011); see also T.C. Memo T.C.M. (CCH) (opinion denying reconsid ‐ eration). dollar amount penalty, which depends tax improperly taken shelter, yet determined.
An LLC, such as Warwick, generally treated as part nership purposes, 301.7701–3(a), and like other partnerships income and are deemed flow through partners are taxed them rather partnership. U.S.C. §§ 701–04, Until “all items determined individual taxpayer level.” But “often required duplicative pro ceedings different partners sometimes resulted inconsistent treatment items partner partner.” Petaluma FX Partners, LLC v. (D.C. Cir. 2010); see also Southgate Master L.L.C. n. So law changed, now how much income loss should given recognition purposes when partners file their returns determined audit §§ 6221–6232. lawyer named John Rog
ers, petitioner companion case Rogers Commis sioner No. also decided today. (We note dis approval loquacity of, lame attempts humor in, Tax Court’s opinion, include making fun Rog ers’ name, section title “Mr. Rogers’ Neighbor *3 ‐ ‐ hood.”) purpose of creating was beat taxes transferring a bankrupt Brazilian retailer consumer electronics named Lojas Arapuã S.A. U.S. ‐ payers who would from their taxable ‐ come. Arapuã had with a face U.S. $30 million. Because they were a great extent uncollectible (they were owed consumers, very small balances, very old), a negligible market value. Rog ‐ ers used a company owned, Jetstream Business Lim ited, join with forming Warwick. Jetstream designated managing (that is, active) partner, charged with trying collect receivables. net re ceipts Jetstream’s activity would be Warwick’s partner ship income eventually divided between Jetstream (meaning Rogers) Arapuã.
Rogers’ aim create what called a distressed set/debt (“DAD”) shelter. See IRS, “Coordinated Issue Paper—Distressed Asset/Debt Tax Shelters,” LMSB ‐ ‐ 031, Apr. 18, 2007, www.irs.gov/Businesses/Partnerships/ Coordinated Issue Paper C Distressed Asset Debt Tax Shelters (visited Aug. 26, DAD based loophole closed American Jobs Creation Act Pub. L. No. Stat. 1589, amending §§ 704(c), year after Rogers Warwick. To spare reader headache, we’ll provide simplified explanation Rogers’ DAD.
When asset contributed partnership, con tributor receives exchange interest. formally owns asset, but contributor owns slice recognition his contribution, so hasn’t really parted asset. *4 ‐ ‐ In the hands the partnership the asset’s basis is the con tributor’s original basis, (with adjustments we can ignore) is the asset’s original cost. U.S.C. §§ Recognition purposes gain or loss attributable any change in the asset’s value before the asset contrib uted the partnership deferred until the partnership sells the asset. See U.S.C. § 721(a). So if the asset worth less the contributor paid it, loss in (what termed “built in loss”) will recognized, thus usable reduce taxable income, only when the partnership sells the asset. See U.S.C. § 704(c)(1)(A); Laura E. Cunningham & Noël B. Cunningham, Logic Subchapter K ed. If contributing partner sells his partnership inter est before partnership sells asset, buyer partnership interest steps into his shoes so recognizes built in loss gain if when sells asset. 3(a)(7).
Rogers’ DAD involved Arapuã’s contributing receiva bles built in Warwick, followed sale Arapuã’s interest (acquired contributing those receivables partnership) investors—the seekers. Because shelterers bought Arapuã’s interest in partnership, partnership’s when sold flowed through Arapuã’s successors in investor partners’ purpose in buying Arapuã’s inter est (and thus becoming Jetstream’s part ners—for remember Jetstream original partners Warwick) built loss. But partner can claim loss up amount his partnership, §§ 704(d); 705(a)(2)(A); *5 ‐ to ‐ Mertens Law of Federal Income Taxation § 35C:1 (2013), the basis of the partnership interest that an investor acquired (thereby becoming a partner) was the price which Arapuã had sold the interest to him. § ‐ 1. That price would have very low, since the buyers—the shelter in vestors—were just buying tax savings based on built ‐ in loss. In fact each dollar of that loss could be worth no than cents in savings, because the top income tax bracket in percent. So the most a top ‐ bracket shelter inves tor would pay partnership interest that would give investor right to built ‐ in loss would be sliv er less percent loss, otherwise he’d obtain no savings. In fact shelter investors paid only to percent value they obtained buying into shelter.
But investor had to contribute additional property to in order inflate his basis in his interest level he could deduct entire built in loss. If he paid $100 asset once worth $1000, could not claim loss $900—the full built in loss—but $100; other $800 be wasted avoidance standpoint. assets that shelter investors in order raise their basis built in loss promissory notes made out *6 to permitted any part of it, because the partner ‐ ship was a sham. It was really just a conduit origi nal owner receivables (Arapuã) U.S. taxpayers who wanted a deduction equal difference between face amount receivables (the promissors’ debt) receivables’ current, greatly depressed market value. genuine is business jointly owned two persons (or firms) for purpose earning money through business activities. If only aim effect are beat taxes, disregarded for purposes. “[T]ax considerations cannot be only reason partnership’s formation.” Southgate Master L.L.C. supra (emphasis original). There must be “profit motivated reason oper ate partnership.” Id . “[T]he absence nontax business purpose fatal.” ASA Investerings Partnership Commission er (D.C.
Jetstream, supposedly active partner Warwick, made few, feeble attempts collecting receivables attempts were window dressing. Collection gov erned Brazilian law, which required contract transfer Arapuã’s be translat ed into Portuguese filed Brazilian government. Neither these things was done. Indeed there considera ble doubt whether receivables, could trans ferred pursuant Brazilian law, ever actually transferred Warwick. reason Rogers’ insouciance regarding formalities aim make money collecting Arapuã’s receivables—which apparently *7 3371 7
would have Quixotic undertaking, for collection ef forts were perfunctory and yielded little revenue—but sell interests U.S. taxpayers seeking sav ings. revenue from sale these interests was partnership’s revenue. transaction that make commercial sense it for opportunity it created beat taxes
doesn’t beat them. Substance prevails over form. See Gregory v. Helvering , U.S. 465, (1935), and Moline Properties, Inc. v. Commissioner , U.S. (1943), applica tion sham Southgate Master Fund, L.L.C. v. United States , supra . question “whether partners really truly intended join together purpose carrying business sharing profits or both.” Commissioner v. Tower , U.S. (1946); see al so v. Culbertson , U.S. (1949); Southgate Master L.L.C. v. United States , supra , F.3d at 483–91; TIFD III E, Inc. , 231– (2d 2006); ASA Investerings Partnership Commission er supra 511–13; Cunningham & Cunningham, supra No joint business goal motivated creation Warwick. Arapuã’s aim was extract some otherwise worthless receivables, Jetstream’s aim make those bonanza. appellants argue that these cases super seded. They point out that under Illi nois law, it valid LLC under law, that 3(b)(1) defines LLC one member (as did Warwick) as unless organizers choose designate purposes corporation. But purpose regulation merely *8 determine whether default tax treatment of entity shall be under corporate or partnership provisions of federal tax law, not whether shall be entitled bene fits (such as deferral property) creat ed those provisions should be found inapplicable for other reasons. As a sham partnership Warwick entitled none benefits that Internal Revenue Code stows partnerships. See § 1(a)(1); Southgate Master L.L.C. supra n. 53. “An entity without economic substance, wheth er sham partnership sham trust, is sham either way hence is recognized federal law purposes.” Sparkman n.
With Warwick out picture, shelter collaps es, because all that is left is sale Arapuã receiva bles shelter investors. built loss is recognized purposes when property loss sold. U.S.C. §§ 1001(a) (c). buyer’s what pays, equal case very low market Arapuã’s receivables. buyer therefore built loss; loss recognized Arapuã, once Arapuã’s “contribution” Warwick recharacterized as sale investors.
Even if Warwick actual rather than fake between Arapuã Jetstream, cash transfer within two years company’s contribution assets presumption company sold assets (Arapuã’s receivables) received cash distribution delayed payment them, rather *9 to having them partnership. 3(c); see also § 707(a)(2)(B). Arapuã re ‐ ceived substantial distribution Warwick months after contributing receivables, thus triggering pre sumption. presumption been rebutted. Since sold receivables Warwick rather than contrib uting them, it had recognize any at time sale, leaving claim when entered judge decided impose penalty sham. Should have? Section 6662(h)(1) Internal Revenue Code, read conjunction with subsections (a) (b)(3), imposes percent penalty so much underpay ment is attributable any “gross valuation mis statement.” Under subsection (h)(2)(A)(i) (2000 & Supp. IV 2004) which time defined “gross valuation misstate ment” cover any deduction involving property whose claimed price (basis) four times correct value, valuation misstatement case had “gross.” aggregate transferred close zero, but Warwick, say Rogers, valued them roughly $30 million.
There disagreement among courts appeals con cerning applicability penalties misstating valu ation when transaction involving overvalued asset itself disregarded because lacks economic substance. Compare, e.g., Crispin v. Commissioner , F.3d n. (3d Cir. 2013); Gustashaw v. Commissioner F.3d 1136–37 (11th Cir. 2012), Fidelity Int’l Currency Advisor LLC (1st Cir. 2011), Keller 1059–61 *10 3371 2009), Heasley v. Commissioner , F.2d (5th Cir. 1990). The majority view, we now join, that tax payer who overstates basis participates sham transac tions, as case, should punished least as severely as one who does former. Supreme Court granted certiorari resolve circuit conflict. United States v. Woods S. Ct. (2013). appellants have avoided penalty had they
proved had “reasonable cause” built losses. 6664(c)(1); see United States v. Boyle, U.S. 250–51 (1985); University Chicago (7th Cir. 2008); Richardson They didn’t prove that. They all just tools—extensions, really—of Rogers, experienced lawyer who more than years expe rience taxation international business transactions. tools no more autonomy than his fingers. There even colorable that he appellants implemented. There are we’ve seen multiple grounds disallowing Rogers engineered (in fact grounds we’ve both ered discuss), all are grounds he either knew about should, given neophyte, known about. FFIRMED . notes had because Rogers had no intention causing collect them. inten tion simply create appearance investors’ interest high enough enable entire built loss investors acquired offset against their taxable income. But all means should have permitted their entire built loss—yet fact shouldn’t