U.S. District Court Disallows $82 Million Refund Claim as Transaction was Tax Shelter

In WFC Holdings Corp. v. U.S., No. 0:07-cv-03320 (D. Minn. 9/30/11) a refund claim based on capital loss deduction was disallowed because the underlying transaction was a tax shelter with no business purpose other than tax avoidance.

In the matter before the District Court, the taxpayer was the parent corporation of an affiliated group of corporations.   After a series of acquisitions, the taxpayer was left with a large quantity of excess leased space that it no longer needed, but which it was liable for (“underwater”).

KPMG marketed a tax product to clients called an “economic liability transaction.” The “economic liability transaction” involved a transfer of the “underwater” leases and a related stock sale to an investment bank. The taxpayer agreed to pay for KPMGs work on the “economic liability transaction.”  KPMGs employees developed the “economic liability transaction” with the understanding that a taxpayer needs a non-tax business purpose to justify the transaction.

The district court held that the transfer of “underwater” leases to a subsidiary and a related sale of stock was a sham tax shelter that the taxpayer had purchased from KPMG.  The court considered the lease restructuring transaction and, viewing the transaction as a whole, determined that the taxpayer had failed to establish a legitimate business purpose for the transaction other than tax benefits. The court concluded that the stock sale lacked economic substance and, moreover, did not accomplish the stated goal. The court stated that the lease restructuring transaction was designed, marketed, and implemented as a tax shelter, and the taxpayers actions indicated an absence of any real potential.

A full version of the opinion is available here.

The attorneys at Fuerst Ittleman, PL have extensive experience litigating against the IRS and the Department of Justice “ Tax Division regarding tax shelters and transactions the IRS considers to lack business purpose. You can contact an attorney by emailing us at: contact@fidjlaw.com.

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

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.

Second DCA Asks Florida Supreme Court To Rule On Drug Statute’s Constitutionality

On September 28, 2011, Floridas Second District Court of Appeal (“2nd DCA”) asked the Florida Supreme Court to rule on the constitutionality of Floridas Drug Abuse Prevention and Control law, § 893.13 Fla. Stat. in the case of State v. Adkins. A copy of the 2nd DCAs opinion can be read here. As we previously reported, on July 27, 2011, Judge Mary Scriven of the United States District Court for the Middle District of Florida declared the law unconstitutional under the United States Constitution as a violation of due process because it eliminated mens rea as an element of felony delivery of a controlled substance thus making the law a strict liability offense.

The federal courts decision has opened the floodgates to litigation in pending drug cases in Florida and has led to uncertainty for criminal defendants for two main reasons. First, because the United States and Florida are separate sovereigns, the rulings of federal courts other than the U.S. Supreme Court are generally not binding on state courts. Second, because neither the Florida Supreme Court nor any District Court of Appeal has ruled on the constitutionality of § 893.13, the Circuit Courts of Florida (the tribunals responsible for adjudicating felony criminal cases) have no binding precedent to rely upon in determining whether § 893.13 is constitutional.

As a result, the Circuit Courts have split on the issue as to whether § 893.13 violates the 14th Amendment. In fact, as noted in the 2nd DCAs Certification Order, in certain circuits, such as the Eleventh Judicial Circuit in Miami-Dade County, conflict exists within the different felony divisions with some judges adopting Judge Scrivens opinion and declaring the statute unconstitutional while others finding the Middle District of Floridas rationale unpersuasive because the precedent relied upon by that court was distinguishable.

In certifying the question of whether § 893.13 is constitutional, the 2nd DCA stated that because it would be the only district court of appeals to have ruled on the constitutionality of the drug law, its “decision would be binding statewide and could affect literally thousands of past and present prosecutions throughout the state.” The 2nd DCA noted that while the Florida Supreme Court prefers to resolve cases after multiple district courts have issued opinions, given the volume of the cases involved and the fact that the issue has been “fully briefed and thoroughly discussed” in trial court proceedings, it would be appropriate for the Supreme Court to decide this issue.

Although the 2nd DCA certified the question to the Supreme Court as one of “great public importance” pursuant to Fla. R. App. P. 9.125, it should be noted that because the Florida Supreme Court is a court of limited jurisdiction, the Court can choose not to decide the issue under  Article V § 3 of the Florida Constitution as jurisdiction over such certified questions is not mandatory.

Fuerst Ittleman will continue to track the progress of this matter with a keen eye as its final resolution could affect all strict liability offenses. The white collar criminal defense lawyers at Fuerst Ittleman are experienced in handling even the most complex cases where clients are facing allegations of criminal actions. The attorneys of Fuerst Ittleman have defended clients in cases involving numerous general intent and strict liability offenses including money laundering violations found at 18 U.S.C. § 1957, the operation of unlicensed money transmitting businesses found at 18 U.S.C. § 1960, and violations of the FDCA under 21 U.S.C. §§ 331 and 333 as well as prosecutions of corporate officials for FDCA violations under the Park Doctrine. For more information regarding Fuerst Ittlemans white collar criminal defense practice, contact an attorney today at contact@fidjlaw.com.

Recent Crackdown On “Commercial Marijuana Industry” A Concerted Effort By DOJ And IRS

On October 7, 2011, federal prosecutors announced that California-based medical marijuana dispensaries cannot shelter themselves from criminal prosecutions under federal law by claiming they are compliant with the states Compassionate Use Act. As we previously reported, over the past several months federal authorities have increased their efforts at prohibiting a growing medical marijuana industry because, although 15 states currently allow for the use of medical marijuana, marijuana remains prohibited under federal law. Additionally, prosecutors are now alleging that medical marijuana dispensaries violate the California Compassionate Use Act: "It is important to note that for-profit, commercial marijuana operations are illegal not only under federal law, but also under California law. While California law permits collective cultivation of marijuana in limited circumstances, it does not allow commercial distribution through the store-front model we see across California."

The announcement comes as 38 medical marijuana dispensaries were sent letters by the DOJ explaining that the operation of medical marijuana store-fronts violates the federal Controlled Substances Act. The AP reported that the letters advised the business owners, and their landlords, that the businesses have 45 days to cease operations or they will be subject to federal criminal prosecution and civil penalties. By focusing their efforts on store owners and their landlords, federal prosecutors are taking aim at the “sale, distribution, and cultivation” of medical marijuana and not the individual consumers.

The DOJ letters were issued only days after the IRS ruled that Harborside Health Center, the largest dispensary in California, owed $2.5 million in back taxes. In finding that Harborside owed back taxes, the IRS ruled that medical marijuana dispensaries are not allowed to deduct normal business expenses, such as payroll and rent. The IRS based its decision on § 280E of the Internal Revenue Code which disallows deductions in the trade or business of trafficking controlled substances. As explained by the IRS in a series of letters to Congress in December 2010:

Section 280E of the Code disallows deductions incurred in the trade or business of trafficking in controlled substances that federal law or the law of any state in which the taxpayer conducts the business prohibits. For this purpose, the term “controlled substances” has the meaning provided in the Controlled Substances Act. Marijuana falls within the Controlled Substances Act. See Californians Helping to Alleviate Medical Problems, Inc. v. C.I.R., 128 T.C. No. 14 (2007). The United States Supreme Court has concluded that no exception in the Controlled Substances Act exists for marijuana that is medically necessary. U.S. v. Oakland Cannabis Buyers Co-op., 532 U.S. 483 (2001).

While the threat of criminal prosecution and asset seizure for marijuana distribution are severe, the IRS ruling could have an equally devastating impact on the industry.

The attorneys at Fuerst Ittleman, PL have extensive experience dealing with administrative law, regulatory compliance, and white collar criminal defense. You can reach an attorney by emailing us at contact@fidjlaw.com.

Patent Reform Bill Restricts Patents on Tax Strategies

On September 16, 2011, President Obama signed into law the Leahy-Smith America Invents Act (the “Act”) (H.R. 1249) which drastically reforms the U.S. patent system. Among other effects that the Act will have on the patent system, the Act prevents the granting of “tax strategy“ patents. Since 1998, the U.S. Patent and Trademark Office (USPTO) has granted more than 160 tax strategy patents in the areas of real estate, charitable giving, retirement planning, and stock options.

Pursuant to the Act, “strateg[ies] for reducing, avoiding, or deferring tax liability” are considered to be a “prior art” and are thus not patentable. Applicants can no longer rely on the novelty or non-obviousness of a tax strategy to distinguish their claims over prior art pursuant to 35 U.S.C. § 101. The Act defines “tax liability” as any liability for a tax under any Federal, State, or local law imposed by statute, rule, regulation, or ordinance. However, the Act excludes methods, apparatus, technology, and computer programs that are used solely for tax preparation. The Act further states that existing tax strategy patents will not be affected yet, pending applications will be deemed prior art.

Proponents of the Act claim that it will bring fairness to the patent system and deter the use of tax shelters. Opponents, however, state that the ability to patent tax strategies creates an incentive to interpret existing tax law and disseminate it among the government and taxpayers as public knowledge. Opponents further say that the Act will force developers to keep new tax strategies as trade secrets.

If you have any questions or concerns related to this or any other tax issue, feel free to email an attorney at Fuerst Ittleman at contact@fidjlaw.com.

US Supreme Court to Rule on 6 Year IRS Audit for Tax Shelter

On September 27, 2011, the U.S. Supreme Court granted certiorari to determine whether an understatement of gross income attributable to an overstatement of basis in property is an "omi[ssion] from gross income" that can trigger the Internal Revenue Services (IRS) six-year statute of limitations.

Generally, the IRS has three years to assess additional tax if the Agency believes that the taxpayer’s return has understated the amount of tax owed. I.R.C. § 6501(a). However, the assessment period is extended to six years if the taxpayer "omits from gross income an amount properly includible therein . . . in excess of 25 percent of the amount of gross income stated in the [taxpayer’s] return." I.R.C. § 6501(e)(1)(A).

The case currently before the Supreme Court, U.S. v. Home Concrete & Supply, LLC, will hopefully clear up inconsistent lower court rulings regarding the amount of time the IRS has to challenge a tax shelter technique known as “Son-of-BOSS” (Bonds and Options Sales Strategy). The IRS argues that it should have six years to challenge Son-of-BOSS shelters. The Seventh, Federal, Tenth, and D.C. Circuits held that the six year statute of limitation applies, while the Fourth, Fifth, and Ninth Circuits have held that the three year statute of limitations applies.

The disputed Son-of-BOSS shelter was designed to artificially inflate the cost basis of an asset when sold, often through partnerships, allowing taxpayers to claim little to no capital gains. According to IRS estimates, this technique was used by more than 1,900 taxpayers leading to more than $6 billion in unpaid taxes.

In U.S. v. Home Concrete & Supply, LLC, a group of North Carolina taxpayers entered into a short sale of U.S. Treasury bonds and moved the transaction into a partnership which they subsequently sold.  In 2006, the IRS issued a Notice of Final Partnership Administrative Adjustment (FPAA) concluding that the taxpayers had improperly used a pass-through company to increase their cost basis, leaving them with a $69,000 gain on a sale of more than $10 million and requiring the taxpayers to pay $1.4 million. The taxpayers brought suit alleging the FPAA was barred by the general three-year limitations period in I.R.C. § 6501(a) and are seeking a refund.

Fuerst Ittleman will continue to monitor the progress of the abovementioned case along with new developments in tax law.  See our previous blogs on Son-of-BOSS tax shelters posted on February 21, 2011 and February 28, 2011. For more information, please contact us at contact@fidjlaw.com.

The IRS Requires Tax Preparer Fingerprinting

On September 21, 2011, the Internal Revenue Service (IRS) announced that starting 2012, it will require certain tax preparers to undergo fingerprinting as part of the Return Preparer Initiative.  For more information regarding the Return Preparer Initiative please see our previous posting here. 

Pursuant to Notice 2011-08, registered tax return preparers will be required submit their fingerprints when renewing their Preparer Tax Identification Numbers (PTIN) annually as part of a suitability check.  The IRS also published proposed regulations (REG-116284-11) pertinent to fingerprinting user fees.

Additionally, prior to issuing PTINs to new applicants, the IRS intends to conduct suitability checks requiring applicants to submit fingerprints to the Federal Bureau of Investigation (FBI).  With these fingerprints, the FBI will conduct a database search as part of the applicants suitability review.

At this time, the IRS does not require attorneys, certified public accountants, enrolled agents, enrolled retirement plan agents, and enrolled actuaries to be fingerprinted.  These individuals, however, must meet all other suitability requirements set forth by the IRS. Additional requirements for those who are currently exempt will be set forth in future guidance. 

If you have any questions regarding the Return Preparer Initiative or any other tax provision, please contact Fuerst Ittleman, PL at contact@fidjlaw.com.

FDA Announces Enforcement Priorities

On September 19, 2011, the U.S. Food and Drug Administration (FDA) published its Guidance document entitled “Marketed Unapproved Drugs “ Compliance Policy Guide.” Found here, the document details the widespread availability of unapproved drugs on the market and explains the Agencys priorities with respect to enforcement. Because of the large volume of these drugs on the market and the FDAs limited resources, the Agency is forced to prioritize how it will exercise its enforcement discretion. Setting forth its highest priorities, the FDA intends to continue targeting unapproved drugs that pose significant health risks to consumers.

However, the Agency notes that it will also focus its enforcement efforts on those companies marketing unapproved drugs that are reformulated in an effort to evade FDA enforcement. As discussed in the Guidance, the FDA will consider “the timing of the change, the addition of an ingredient without adequate scientific justification (see, for example, 21 CFR 300.50 and 330.10(a)(4)(iv)), the creation of a new combination that has not previously been marketed, and the claims made,” when deciding whether to bring an enforcement action against those marketing reformulated products. While there are often legitimate reasons for a manufacturer to reformulate its product, it remains to be seen how FDA will focus its enforcement actions on only those that are reformulated in an effort to evade FDA enforcement.

For more information on FDA enforcement measures or compliance, please contact us at contact@fidjlaw.com.

Del Monte Drops Suit Against FDA After FDA Lifts Import Alert

On September 27, 2011, Del Monte Fresh Produce N.A., Inc. (Del Monte) voluntarily dismissed its suit against the U.S. Food and Drug Administration (FDA) which alleged that the Agency had no basis to suggest its cantaloupes were the source of a salmonella panama contamination. The Notice of Dismissal cites the lifting of the import alert that formed the basis of the suit as its reason for seeking dismissal. The Import Alert, which prevented cantaloupes from Guatemala from being imported into the United States, was lifted the same day.

As we previously reported, companies sometimes forced to challenge importation restrictions imposed by the FDA. In Del Montes case, the Company filed suit on August 22, 2011, and was able to obtain the relief it sought in only one months time. Similarly, we previously reported on the Seagate case, where we successfully challenged the FDAs detention of Seagates shipments, and secured the release of the goods soon after bringing suit against the Agency. While companies are often reluctant to bring suit against the FDA, these cases show that litigation may be a companys only means of successfully challenging unlawful regulation.

For more information on FDA enforcement measures or import compliance, please contact us at contact@fidjlaw.com.

FDA Moves to Streamline De Novo Process

On September 30, 2011, the U.S. Food and Drug Administration (FDA) announced the release of its draft guidance, entitled “De Novo Classification Process (Evaluation of Automatic Class III Designation).” The Guidance comes as a part of the FDAs overhaul of its medical device review scheme, as the FDA intends to implement to streamline the way medical devices are reviewed and cleared. As previously reported, the FDA announced its plans to overhaul its entire system for reviewing and clearing medical devices earlier in 2011 and highlighted its intentions to target the “de novo” review process as a means to lessen the burden for manufacturers, while continuing its mission of public safety.

Unlike the de novo review process, the 510(k) program requires a new device to demonstrate substantial equivalence to a previously cleared device in order to obtain clearance from the FDA. The de novo process is different, as it is a means to obtain clearance for medical devices that have no clear predicates. While the de novo process currently is only open to medical device manufacturers that have submitted a 510(k) and have received a “not substantially equivalent” (NSE) determination, the FDA proposes changes to this requirement in its draft guidance.

Found here, the Guidance discusses FDAs additions to the de novo process, allowing for de novo petitions where no 510(k) has previously been submitted. The FDA proposes to institute a new pathway for de novo submissions initiated by a “pre de novo submission” (PDS). A PDS, the Agency explains, is a means for a submitter to show the FDA why its device would be suitable for the de novo process. If the FDA determines that the device would be appropriate for the de novo process, a suitability letter will be issued and the next step will be for the device sponsor to submit both a 510(k) and de novo petition concurrently with the FDA. Because the Agency would have already determined that the device is appropriate for de novo review, the idea is that the device sponsor will not have to wait for a NSE letter because the Agency will already have all the documentation it needs to clear the device through the de novo process.

While the FDA expresses optimism for the new additions to the de novo process, it remains to be seen whether the changes will bring the streamlined change that all have hoped for. Although FDA has attempted to simplify the de novo process, its proposed changes do little to combat key flaws, like the lack of transparency, that have caused so much criticism of the review of medical devices. The FDA has only published five of its de novo approval decisions to date, all of which have been published within the last year as part of FDAs Transparency Initiative.

Further, it appears that the FDAs new approach may actually complicate matters, as the Agency seeks to review two distinct submission types at once, the 510(k) and de novo petition. Because each of these submissions center largely on mutually excusive stances, with the 510(k) submission arguing that the device is substantially equivalent to a cleared device and the de novo petition asserting that the device has no clear predicates, it is unclear how the Agency will actually review the submissions.

The FDAs review of medical devices through the PMA, 510(k), and de novo processes are complex. Fuerst Ittleman has extensive experience successfully navigating medical devices through FDA review. For more information on FDAs review of medical devices, please contact us at contact@fidjlaw.com.