Third Circuit Court of Appeals Affirms Tax Court Decision on CARDS Tax Shelter

Mar 13, 2013   

On February 25, 2013, the United States Court of Appeals for the Third Circuit in the case of Crispin v. Commissioner, ___ F.3d ___, 2013 U.S. App. LEXIS 3852 (3d Cir. 2013), available here, affirmed the decision of the Tax Court (Crispin v. Comm’r, T.C. Memo 2012-70, available here) which held, among other things, that the CARDS tax shelter did not result in an ordinary loss deduction for the taxpayer. The Third Circuit described the CARDS transaction as follows:

A CARDS transaction is a tax-avoidance scheme that was widely marketed to wealthy individuals during the 1990’s and early 2000’s. It purports to generate, through a series of pre-arranged steps, large “paper” losses deductible from ordinary income. First, a tax-indifferent party, such as a foreign entity not subject to United States taxation, borrows foreign currency from a foreign bank (a “CARDS Loan”). Then, a United States taxpayer purchases a small amount, such as 15 percent, of the borrowed foreign currency by assuming liability for a an equal amount of the CARDS Loan. The taxpayer also agrees to be jointly liable with the foreign borrower for the remainder of the CARDS Loan and so the taxpayer purports to establish a basis equal to the entire borrowed amount.

The Commissioner contends that that step in the CARDS transaction “is predicated on an invalid application of the … basis provisions of the Internal Revenue Code.” (Appellee’s Br. at 4.) Specifically, I.R.C. § 1012 (available here) provides that a taxpayer’s basis in property is generally equal to the purchase price paid by the taxpayer. That purchase price includes the amount of the seller’s liabilities assumed by the taxpayer as part of the purchase, on the assumption that the taxpayer will eventually repay those liabilities. See Comm’r v. Tufts, 461 U.S. 300, 308-09 (1983) (available here) (noting that a loan must be recourse to the taxpayer to be included in basis). But in a CARDS transaction, the Commissioner argues, the taxpayer and the foreign borrower agree that the taxpayer will repay only the portion of the loan equal to the amount of currency the taxpayer actually purchases.

Finally, the taxpayer exchanges the foreign currency he purchased for United States dollars. That exchange is a taxable event, and the taxpayer claims a loss equal to the full amount of his supposed basis in the CARDS Loan, less the proceeds of the relatively small amount of currency actually exchanged. The taxpayer uses that loss to shelter unrelated income. The general structure of a CARDS transaction is well and thoroughly set forth in Gustashaw v. Commissioner, 696 F.3d 1124, 1127-28, 1130-31 (11th Cir. 2012), (available here)

We have previously blogged about the Gustashaw case, available here. Ultimately, the Third Circuit held in that case as follows: “In this case, there was ample documentary and testimonial evidence that contradicted Crispin’s account of the business purpose of his CARDS transaction, and the Tax Court did not abuse its discretion in deciding  not to credit Crispin’s evidence”¦” Consequently, the taxpayer was not entitled to the ordinary loss deduction.

Interestingly, the Third Circuit noted a circuit split regarding the imposition of the gross valuation misstatement penalty in § 6662(h), available here. A the Third Circuit described:

Our sister circuits are divided as to whether the valuation misstatement penalty applies to tax deductions that have been totally disallowed under the economic substance doctrine. Compare Fidelity Int’l Currency Advisor A Fund, LLC v. United States, 661 F.3d 667, 671-75 (1st Cir. 2011) (holding that the penalty is applicable), Zfass v. Comm’r, 118 F.3d 184, 190 (4th Cir. 1997) (same), Gilman v. Comm’r, 933 F.2d 143, 151 (2d Cir. 1991) (same), and Massengill v. Comm’r, 876 F.2d 616, 619-20 (8th Cir. 1989) (same), with Heasley v. Comm’r, 902 F.2d 380, 383 (5th Cir. 1990) (holding that when the IRS totally disallows a deduction, the underpayment is “not attributable to a valuation overstatement” but rather to claiming an improper deduction), Gainer v. Comm’r, 893 F.2d 225, 228 (9th Cir. 1990) (same), and Todd v. Comm’r, 862 F.2d 540, 543 (5th Cir. 1988) (holding that the penalty was inapplicable when the deficiency was not due to overstated basis but to a failure to place property into service). However, Crispin’s reliance on Todd and Gainer is misplaced because they do not state the law of this Circuit. See Merino v. Comm’r, 196 F.3d 147, 157-159 (3d Cir. 1999) (holding that the valuation misstatement penalty applies to property acquired in a transaction found to lack economic substance and expressly declining to follow Todd and Heasley).

Our reasoning as to the applicability of the valuation misstatement penalty finds support in the recent decision of the United States Court of Appeals for the Eleventh Circuit in Gustashaw, supra. In that case, the taxpayer conceded the tax deficiency that the Commissioner had assessed as a result of the disallowance of a CARDS Loan loss, so the economic substance issue was not before the Court, but the taxpayer contested the penalties. Applying the “majority rule,” the Eleventh Circuit held that the 40 percent penalty applies “even if the deduction is totally disallowed because the underlying transaction, which is intertwined with the overvaluation misstatement, lacked economic substance.” 696 F.3d at 1136. Also, the Fifth and Ninth Circuits “have questioned the wisdom of their positions” in Todd, Heasley, and Gainer because those positions create the “anomalous result” of relieving a taxpayer of the penalty when a deduction is disallowed because it is so egregious that it is improper for a reason other than valuation, such as a lack of economic substance, See Bemont Investments, L.L.C. ex rel. Tax Matters Partner v. United States, 679 F.3d 339, 355 (5th Cir. 2012) (Prado, J., concurring) (noting that the “Todd/Heasley rule,” by “[a]mplifying the egregiousness of the scheme ”” to the point where the transaction is an utter sham ”” could … , perversely, shield the taxpayer from liability for overvaluation”); Keller v. Comm’r., 556 F.3d 1056, 1061 (9th Cir. 2009) (recognizing that the rule as expressed in most Circuits, including Merino, is a “sensible method of resolving overvaluation cases” because it “cuts off at the pass what might seem to be an anomalous result ”” allowing a party to avoid tax penalties by engaging in behavior one might suppose would implicate more tax penalties, not fewer[,]” but acknowledging that, “[n]onetheless, in this circuit we are constrained by Gainer“).

The Crispin case, on its face, looks like a total loss for the taxpayer. However, given that in the Fifth and Ninth Circuits taxpayers can successfully attack the valuation misstatement penalty when the underlying deduction has been totally disallowed by the IRS, the Circuit divide on this issue could provide fertile ground to push back on the IRS in tax shelter litigation. The attorneys at Fuerst Ittleman David & Joseph, PL have extensive experience litigating against the IRS and the U.S. Department of Justice in the U.S. Tax Court, the U.S. Court of Federal Claims, the various U.S. District Courts and Courts of Appeals in both civil and criminal tax cases. You can contact us by emailing us at: or by telephone at 305.350.5690.