Fifth Circuit Court of Appeals affirms District Court’s determination that Partnership Was a Sham

Oct 11, 2011   

Fifth Circuit Court of Appeals affirms District Courts determination that Partnership Was a Sham

In Southgate Master Fund LLC v. U.S., No. 09-11166 (5th Cir. 9/30/11), the Court held that the loss claimed by the deducting partner was properly disallowed because the partnership was a sham.

The facts of the case are complex.  A Chinese-government-owned financial institution formed a single-member limited liability company (SMLLC).   As a wholly owned subsidiary, the SMLLC was created for the purpose of acting as its parents U.S. investment vehicle for nonperforming loans (NPLs) transactions. The parent company contributed to the SMLLC  a portfolio of NPLs.  The parent company contributed the NPLs to the SMLLC pursuant to a contribution which contained a series of warranties and representations stating that the parent company had not written off, compromised, or made a determination of worthlessness as to any of the NPLs.

The SMLLC and a related party formed and organized an S-corp.  Upon formation, the SMLLC contributed the NPLs to the S-corp. pursuant to a virtually identical contribution agreement. In exchange, the SMLLC received a 99% ownership interest in the S-corp.  The related party contributed cash and a promissory note in exchange for a 1% ownership interest in the S-corp. The related party was appointed as the S-corp.s sole manager.

After receiving due diligence reports that the loans were valid and worth between $44.67 million (3.9% of face value) and $111.8 million (9.76% of face value), the taxpayer agreed to purchase a portion of the Chinese parent company and the SMLLCs interest in the S-corp.

The taxpayer formed its own single-member LLC, (TSMLLC), through which he would invest in the S-corp. The taxpayer executed a series of transactions which resulted in the taxpayer becoming a direct 89.1% owner of the S-corp. The taxpayer then took the position that the series of transactions had increased his outside basis in the S-corp. by $180.6 million. The taxpayer ultimately took a $210.5 million deduction on his tax return because of losses from the NPLs.

The IRS issued a final partnership administrative adjustment (FPAA) pertaining to its partnership return. The partnership filed a petition for review in federal district court. The district court upheld the FPAA’s disallowance of the claimed losses on the ground that the partnership was a sham for tax purposes. However, the district court disallowed the imposition of penalties on the ground that the partnership had established reasonable cause and good faith and thus had a complete defense to any accuracy-related penalties. Both parties appealed the adverse determinations.

The Fifth Circuit held that the partnership was a sham, the deduction should be disallowed, and disallowed the accuracy-related penalties.  The Fifth Circuit applied a totality-of-the-facts-and-circumstances test to determine whether the partnership was a sham. Ultimately the Court determined that the partnership was “a meaningless and unnecessary incident” inserted into the chain of entities, transactions, and agreements through which the NPL acquisition took place. The partnership served no legitimate purpose whose accomplishment was not already assured by other means or could not have been equally well assured by alternative, less tax-beneficial means.  The full text of the opinion can be found here.