SCOTUS Reports

Tag: Tax Shelters

  • Bank of N.Y. Mellon Corp. v. Comm’r, 140 T.C. 15 (2013): Application of the Economic Substance Doctrine to Tax Shelters

    Bank of N. Y. Mellon Corp. v. Comm’r, 140 T. C. 15 (U. S. Tax Ct. 2013)

    In Bank of N. Y. Mellon Corp. v. Comm’r, the U. S. Tax Court ruled that the Bank of New York Mellon’s participation in a Structured Trust Advantaged Repackaged Securities (STARS) transaction with Barclays lacked economic substance and was thus invalid for federal tax purposes. The court disallowed foreign tax credits and deductions claimed by the bank, holding that the transaction was designed solely to generate tax benefits without any legitimate business purpose or economic effect. This decision underscores the IRS’s efforts to combat tax shelters and reaffirms the application of the economic substance doctrine in evaluating complex tax arrangements.

    Parties

    The petitioner, Bank of New York Mellon Corporation (BNY Mellon), as successor in interest to The Bank of New York Company, Inc. , sought review of a deficiency notice issued by the respondent, the Commissioner of Internal Revenue. BNY Mellon was the plaintiff at the trial level, appealing the Commissioner’s determination of tax deficiencies for the tax years 2001 and 2002.

    Facts

    BNY Mellon, through its subsidiary The Bank of New York (BNY), entered into a Structured Trust Advantaged Repackaged Securities (STARS) transaction with Barclays Bank, PLC (Barclays) in November 2001. The STARS transaction involved the creation of a complex structure to shift income and generate foreign tax credits. BNY contributed approximately $6. 46 billion in assets to a trust managed by a U. K. trustee, which was subject to U. K. taxation. The transaction included a $1. 5 billion loan from Barclays to BNY, with the interest rate adjusted by a spread contingent on the U. K. tax benefits. BNY claimed foreign tax credits of $98. 6 million and $100. 3 million for 2001 and 2002, respectively, and sought to deduct related expenses and interest. The Commissioner determined that the STARS transaction lacked economic substance and disallowed the claimed tax benefits.

    Procedural History

    The Commissioner of Internal Revenue issued a notice of deficiency to BNY Mellon, asserting deficiencies of $100 million and $115 million for the tax years 2001 and 2002, respectively. BNY Mellon filed a petition with the U. S. Tax Court to challenge these determinations. The court’s standard of review was de novo, with the burden of proof on BNY Mellon to show that the STARS transaction had economic substance and was entitled to the claimed tax benefits.

    Issue(s)

    Whether the STARS transaction had economic substance such that BNY Mellon was entitled to foreign tax credits under 26 U. S. C. § 901 and deductions for expenses incurred in furtherance of the transaction?

    Whether the income attributed to the trust with a U. K. trustee was U. S. source income rather than foreign source income?

    Rule(s) of Law

    The economic substance doctrine, as articulated in cases such as Frank Lyon Co. v. United States, 435 U. S. 561 (1978), and codified in 26 U. S. C. § 7701(o), requires a transaction to have both objective economic substance and a subjective non-tax business purpose to be respected for tax purposes. The doctrine allows the IRS to disregard transactions that are designed solely to generate tax benefits without any legitimate business purpose or economic effect.

    Holding

    The U. S. Tax Court held that the STARS transaction lacked economic substance and was therefore disregarded for federal tax purposes. Consequently, BNY Mellon was not entitled to the foreign tax credits under 26 U. S. C. § 901, nor could it deduct the expenses incurred in furtherance of the transaction. Additionally, the court held that the income attributed to the trust was U. S. source income, not foreign source income.

    Reasoning

    The court applied the economic substance doctrine, evaluating both the objective and subjective prongs. Objectively, the STARS transaction did not increase the profitability of the assets involved and was characterized by circular cashflows, indicating a lack of economic substance. The court found that the transaction’s primary purpose was to generate foreign tax credits without any incremental economic benefit. Subjectively, BNY Mellon’s claimed business purpose of obtaining low-cost financing was rejected, as the transaction was not economically rational without the tax benefits. The court also found that the spread, which was used to reduce the loan’s cost, was contingent on the tax benefits and not a legitimate component of interest. The court concluded that the transaction was designed solely for tax avoidance and did not align with Congressional intent for the foreign tax credit.

    The court further reasoned that expenses incurred in furtherance of a transaction lacking economic substance are not deductible. The STARS transaction’s lack of economic substance meant that BNY Mellon could not deduct the claimed transactional expenses, interest, or U. K. taxes paid on trust income. Finally, the court held that because the transaction was disregarded, the income from the trust assets was treated as U. S. source income, and the U. S. -U. K. tax treaty did not apply.

    Disposition

    The U. S. Tax Court entered a decision for the Commissioner of Internal Revenue, disallowing the foreign tax credits and deductions claimed by BNY Mellon in connection with the STARS transaction.

    Significance/Impact

    The decision in Bank of N. Y. Mellon Corp. v. Comm’r is significant for its reaffirmation of the economic substance doctrine as a tool to combat tax shelters. It underscores the IRS’s and courts’ willingness to scrutinize complex tax arrangements and disregard those that lack economic substance. The case has implications for the structuring of international tax transactions and the application of the foreign tax credit, emphasizing that tax benefits must be derived from transactions with genuine economic substance and business purpose. Subsequent courts have relied on this decision in similar cases involving tax shelters and the economic substance doctrine.

  • New Phoenix Sunrise Corp. v. Commissioner, 132 T.C. 161 (2009): Economic Substance Doctrine in Tax Shelters

    New Phoenix Sunrise Corp. & Subsidiaries v. Commissioner of Internal Revenue, 132 T. C. 161 (U. S. Tax Ct. 2009)

    In New Phoenix Sunrise Corp. v. Commissioner, the U. S. Tax Court ruled that a complex tax shelter known as the BLISS transaction lacked economic substance and was designed solely for tax avoidance. The court disallowed a claimed $10 million loss, upheld the disallowance of legal fees, and imposed accuracy-related penalties on the taxpayer, New Phoenix Sunrise Corp. , emphasizing the importance of the economic substance doctrine in evaluating tax shelters.

    Parties

    New Phoenix Sunrise Corporation and its subsidiaries (Petitioner) v. Commissioner of Internal Revenue (Respondent). New Phoenix was the petitioner at the trial level before the U. S. Tax Court.

    Facts

    New Phoenix Sunrise Corporation, a parent company of a consolidated group, sold substantially all of the assets of its wholly owned subsidiary, Capital Poly Bag, Inc. , in 2001, realizing a gain of about $10 million. Concurrently, Capital engaged in a transaction called the “Basis Leveraged Investment Swap Spread” (BLISS), involving the purchase and sale of digital options on foreign currency with Deutsche Bank AG. Capital contributed these options to a newly formed partnership, Olentangy Partners, in which it held a 99% interest and its president, Timothy Wray, held a 1%. The options expired worthless, and Olentangy Partners dissolved shortly thereafter, distributing shares of Cisco Systems, Inc. , to Capital, which Capital sold at a nominal economic loss but claimed a $10 million tax loss. New Phoenix reported this loss on its consolidated tax return to offset the $10 million gain from the asset sale. The IRS issued a notice of deficiency disallowing the claimed loss and imposing penalties under section 6662 of the Internal Revenue Code.

    Procedural History

    The Commissioner of Internal Revenue issued a notice of deficiency to New Phoenix on September 14, 2005, determining a deficiency of $3,355,906 and penalties of $1,298,284 for the tax year 2001. New Phoenix filed a timely petition with the U. S. Tax Court on December 8, 2005. The case was tried in the Tax Court’s Atlanta, Georgia session on January 22 and 23, 2008. The parties stipulated that any appeal would lie in the U. S. Court of Appeals for the Sixth Circuit.

    Issue(s)

    Whether the BLISS transaction entered into by Capital Poly Bag, Inc. , lacked economic substance and should be disregarded for federal tax purposes?

    Whether the legal fees paid to Jenkens & Gilchrist in connection with the BLISS transaction are deductible by New Phoenix?

    Whether New Phoenix is liable for accuracy-related penalties under section 6662 of the Internal Revenue Code?

    Rule(s) of Law

    The economic substance doctrine requires that a transaction have a practical economic effect other than the creation of income tax losses. Dow Chem. Co. v. United States, 435 F. 3d 594 (6th Cir. 2006).

    Under section 6662 of the Internal Revenue Code, accuracy-related penalties may be imposed for underpayments due to negligence, substantial understatements of income tax, or valuation misstatements.

    Holding

    The U. S. Tax Court held that the BLISS transaction lacked economic substance and was therefore disregarded for federal tax purposes. Consequently, the court disallowed the $10 million loss claimed by New Phoenix. Additionally, the court held that the legal fees paid to Jenkens & Gilchrist were not deductible because they were related to a transaction lacking economic substance. Finally, the court imposed accuracy-related penalties on New Phoenix under section 6662 for a gross valuation misstatement, substantial understatement of tax, and negligence.

    Reasoning

    The court analyzed the economic substance of the BLISS transaction, finding that it lacked any practical economic effect. The transaction involved a digital option spread with Deutsche Bank, where Capital purchased a long option and sold a short option, contributing both to Olentangy Partners. The court found that the design of the transaction, including Deutsche Bank’s role as the calculation agent, ensured that Capital could not realize any economic profit beyond the return of its initial investment. The court also noted that the transaction was structured solely to generate a tax loss to offset the gain from the asset sale, without any genuine business purpose or profit potential.

    The court rejected New Phoenix’s arguments that the transaction had economic substance based on the testimony of its expert witness, who argued that similar trades were done for purely economic reasons. The court found the expert’s testimony unpersuasive in light of the transaction’s structure and the lack of any realistic chance of economic profit.

    Regarding the legal fees, the court applied the principle that expenses related to transactions lacking economic substance are not deductible. The court found that the fees paid to Jenkens & Gilchrist, which were involved in promoting and implementing the BLISS transaction, were not deductible under section 6662.

    The court imposed accuracy-related penalties under section 6662, finding that New Phoenix had made a gross valuation misstatement by overstating its basis in the Cisco stock, substantially understated its income tax, and acted negligently by relying on the advice of Jenkens & Gilchrist, which had a conflict of interest as a promoter of the transaction. The court rejected New Phoenix’s argument that it had reasonable cause and acted in good faith, finding that reliance on Jenkens & Gilchrist’s opinion was unreasonable given the firm’s conflict of interest and the taxpayer’s awareness of IRS scrutiny of similar transactions.

    Disposition

    The U. S. Tax Court upheld the Commissioner’s determinations in the notice of deficiency and found New Phoenix liable for the section 6662 accuracy-related penalties.

    Significance/Impact

    New Phoenix Sunrise Corp. v. Commissioner is significant for its application of the economic substance doctrine to a complex tax shelter. The decision reinforces the principle that transactions lacking economic substance cannot be used to generate tax losses. It also highlights the importance of independent tax advice and the potential consequences of relying on the opinions of transaction promoters. The case has been cited in subsequent tax shelter litigation and serves as a reminder to taxpayers of the IRS’s focus on economic substance in evaluating tax transactions. The ruling underscores the need for careful scrutiny of transactions designed primarily for tax avoidance, emphasizing that such transactions may be disregarded and penalties imposed under section 6662.

  • Estate of Campion v. Commissioner, 110 T.C. 165 (1998): The Non-Applicability of TEFRA Settlement Procedures to Pre-TEFRA Years

    Estate of James T. Campion, Deceased, Leona Campion, Executrix, et al. v. Commissioner of Internal Revenue, 110 T. C. 165 (1998)

    The Tax Equity and Fiscal Responsibility Act (TEFRA) settlement procedures do not apply to partnership taxable years before September 4, 1982.

    Summary

    In Estate of Campion v. Commissioner, investors in the Elektra Hemisphere tax shelters sought to vacate final decisions and obtain revised settlements based on more favorable terms offered earlier. The Tax Court denied their motions, ruling that TEFRA settlement procedures did not apply to pre-TEFRA years (1979-1982). The court found no obligation for the IRS to extend earlier settlement terms to later settling taxpayers, rejecting claims of fraud and emphasizing that all taxpayers were treated consistently based on the litigation timeline.

    Facts

    Investors in the Elektra Hemisphere tax shelters, including the Estate of James T. Campion, had settled their cases with the IRS based on the no-cash settlement terms available after the Krause test case decision in 1992. They later sought to vacate these settlements and obtain revised agreements reflecting the cash settlement terms offered in 1986-1988. The IRS had progressively offered less favorable settlements as the litigation progressed, with deadlines for each offer. The taxpayers alleged that the IRS failed to disclose the earlier, more favorable settlements, constituting a fraud on the court.

    Procedural History

    The taxpayers filed motions in the Tax Court to vacate the final decisions entered in their cases and to compel the IRS to enter into new settlement agreements. The Tax Court consolidated these motions with similar motions from other taxpayers involved in the Elektra Hemisphere tax shelters.

    Issue(s)

    1. Whether the TEFRA settlement procedures apply to partnership taxable years before September 4, 1982.
    2. Whether the IRS had a duty to offer all taxpayers the most favorable settlement terms ever offered to any taxpayer in the Elektra Hemisphere tax shelters.
    3. Whether the IRS’s failure to disclose prior settlement offers constituted a fraud on the court.

    Holding

    1. No, because the TEFRA provisions, including the settlement procedures, expressly apply only to partnership taxable years beginning after September 3, 1982.
    2. No, because absent a contractual agreement or impermissible discrimination, the IRS is not required to offer the same settlement terms to similarly situated taxpayers.
    3. No, because the taxpayers failed to provide clear, unequivocal, and convincing evidence of fraud on the court.

    Court’s Reasoning

    The court applied the plain language of TEFRA, which limits its application to partnership taxable years beginning after September 3, 1982. The court rejected the taxpayers’ interpretation of section 6224(c)(2), which they argued required consistent settlement terms across all years once a partnership became subject to TEFRA for any year. The court cited prior cases like Consolidated Cable and Ackerman to support its view that TEFRA settlement procedures do not apply to pre-TEFRA years. The court also found no evidence of fraud, noting that the taxpayers’ counsel likely knew of all settlement offers and that the IRS treated all taxpayers consistently based on the litigation timeline. The court emphasized that the IRS’s settlement positions changed over time based on the “hazards of litigation” and that the taxpayers chose to settle based on the terms available at the time of their settlement.

    Practical Implications

    This decision clarifies that TEFRA settlement procedures do not apply to pre-TEFRA years, limiting the ability of taxpayers to challenge settled cases based on more favorable terms offered earlier. Practitioners should be aware that the IRS is not obligated to offer the same settlement terms to all taxpayers unless there is a contractual agreement or evidence of impermissible discrimination. The case also underscores the importance of timely settlement, as the IRS may offer less favorable terms as litigation progresses. This ruling has been applied in subsequent cases involving similar tax shelter disputes, reinforcing the principle that taxpayers must accept the settlement terms available at the time they choose to settle.

  • Estate of Campion v. Commissioner, 110 T.C. 165 (1998): Timeliness of Requests for Consistent Settlements Under TEFRA

    Estate of Campion v. Commissioner, 110 T. C. 165 (1998)

    Under the TEFRA partnership provisions, requests for consistent settlements must be made within specific statutory time limits, and the IRS has no obligation to notify all partners of settlements entered into by others.

    Summary

    In Estate of Campion, investors in the Elektra Hemisphere tax shelters sought to set aside no-cash settlement agreements and enter into more favorable cash settlements previously offered to other investors. The Tax Court denied their motions, ruling that their requests for consistent settlements were untimely under TEFRA provisions. The court clarified that the IRS had no duty to notify all partners of settlements, and that responsibility fell to the tax matters partner (TMP). This decision underscores the importance of adhering to statutory deadlines for requesting consistent settlements and the limited notification obligations of the IRS in TEFRA partnership proceedings.

    Facts

    Investors in the Elektra Hemisphere tax shelters had entered into no-cash settlements with the IRS in 1994 and later years, which disallowed deductions related to their investments but did not impose penalties beyond increased interest. These investors later sought to set aside these settlements and enter into cash settlements offered to other investors in 1986-1988, which allowed deductions for cash invested. They claimed that they were unaware of these prior, more favorable settlements and argued that the IRS had a continuing duty to offer consistent settlements to all investors.

    Procedural History

    The investors filed motions in the Tax Court to file untimely notices of election to participate in TEFRA partnership proceedings and to set aside existing settlement agreements. The court held an evidentiary hearing on these motions on May 21, 1997, and subsequently issued its opinion denying the investors’ motions.

    Issue(s)

    1. Whether the investors’ requests for consistent settlements were timely under the TEFRA partnership provisions?
    2. Whether the IRS had an obligation to notify the investors of cash settlements entered into by other investors?

    Holding

    1. No, because the requests were not made within the statutory time limits specified in section 6224(c)(2) and related regulations, which require requests to be made within 150 days after the FPAA is mailed to the TMP or within 60 days after a settlement is entered into, whichever is later.
    2. No, because the responsibility to notify other partners of settlements rested with the TMP, not the IRS, as per section 6223(g) and related regulations.

    Court’s Reasoning

    The court applied the TEFRA provisions, specifically section 6224(c)(2) and the regulations under section 301. 6224(c)-3T, which set strict time limits for requesting consistent settlements. The court found that the investors’ requests were made years after the statutory deadlines, rendering them untimely. The court also emphasized that the IRS had no affirmative duty to notify all partners of settlements entered into by others, as this responsibility was placed on the TMP by section 6223(g). The court rejected the investors’ arguments of fraud or malfeasance by the IRS, finding no credible evidence to support these claims. The court also noted that consistent settlement rules do not apply across different partnerships or tax years within a tax shelter project.

    Practical Implications

    This decision reinforces the importance of adhering to the statutory deadlines under TEFRA for requesting consistent settlements. Legal practitioners must advise clients to monitor partnership proceedings closely and act promptly to request consistent settlements when applicable. The ruling clarifies that the IRS is not responsible for notifying all partners of settlements, shifting this burden to the TMP. This may lead to increased diligence by TMPs in communicating with partners. The decision also highlights the limited scope of consistent settlement rules, applying only to the same partnership and tax year, which may affect how tax shelters are structured and managed. Subsequent cases have cited Estate of Campion to uphold the strict application of TEFRA’s timeliness requirements.

  • Vulcan Oil Technology Partners v. Commissioner, 110 T.C. 153 (1998): Strict Deadlines for TEFRA Consistent Settlement Elections

    Vulcan Oil Technology Partners v. Commissioner, 110 T.C. 153 (1998)

    Under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), partners seeking consistent settlement terms in partnership-level tax proceedings must strictly adhere to statutory and regulatory deadlines, and the IRS has no obligation to offer settlements beyond those deadlines or across different partnerships.

    Summary

    Investors in Elektra Hemisphere tax shelters sought to set aside previously agreed-upon settlements with the IRS or compel the IRS to offer them more favorable settlement terms that were available to other investors in earlier years. The investors argued they were unaware of these earlier, more favorable “cash settlements” when they agreed to “no-cash settlements” and that the IRS had a continuing duty to offer consistent settlements. The Tax Court denied the investors’ motions, holding that their requests for consistent settlements were untimely under TEFRA regulations and that the IRS had no obligation to offer settlements beyond established deadlines or across different partnerships. The court also found no evidence of fraud or misrepresentation by the IRS.

    Facts

    The case involved investors in Denver-based limited partnerships related to the Elektra Hemisphere tax shelters. The IRS conducted TEFRA partnership proceedings for the 1983, 1984, and 1985 tax years. Initially, in 1986-1988, the IRS offered “cash settlements” allowing deductions for cash invested. Later, after adverse court decisions in test cases like Krause v. Commissioner, the IRS offered less favorable “no-cash settlements” (no deductions allowed). Most investors in this case entered into no-cash settlements in 1994 and later. Some investors who had settled and others who had not, moved to participate late in the TEFRA proceedings, set aside their settlements, and compel “cash settlements.” They argued they were unaware of the earlier cash settlements and should be offered consistent terms.

    Procedural History

    The investors filed motions in the consolidated TEFRA partnership proceedings before the United States Tax Court. These motions sought leave to file untimely notices of election to participate, to set aside existing settlement agreements, and to compel the IRS to offer settlement terms consistent with earlier, more favorable settlements.

    Issue(s)

    1. Whether the Tax Court should grant movants leave to file untimely notices of election to participate in the consolidated TEFRA partnership proceedings.
    2. Whether the Tax Court should set aside settlement agreements entered into by most movants.
    3. Whether the Tax Court should require the IRS to enter into settlement agreements with movants consistent with settlement terms offered to other investors in earlier years.

    Holding

    1. No, because the movants failed to comply with the statutory and regulatory deadlines for electing to participate in consistent settlements under TEFRA.
    2. No, because the movants failed to demonstrate fraud, malfeasance, or misrepresentation by the IRS that would justify setting aside valid settlement agreements.
    3. No, because the IRS has no continuing duty under TEFRA to offer the most favorable settlement terms indefinitely or to offer consistent settlements across different partnerships or tax years.

    Court’s Reasoning

    The court emphasized the statutory and regulatory framework of TEFRA, particularly 26 U.S.C. § 6224(c)(2) and Treas. Reg. § 301.6224(c)-3T, which establish strict deadlines for requesting consistent settlements. The court found that the movants’ requests were significantly untimely, years after both the issuance of Final Partnership Administrative Adjustments (FPAAs) and the finalization of earlier cash settlements. The court stated, “Since movants’ requests for consistent settlements pertaining to 1983 and 1984 were made by movants in 1995, they are untimely by approximately 6 years.”

    The court rejected the argument that the IRS had a duty to notify each partner of settlement terms, clarifying that under TEFRA, this responsibility rests with the Tax Matters Partner (TMP). Quoting 26 U.S.C. § 6230(f), the court noted, “failure of the TMP to provide notice… would not affect the applicability of any partnership proceeding or adjustment to such partner.”

    Regarding the claim of fraud or misrepresentation, the court found no credible evidence to support the allegations that the IRS intentionally misled investors or concealed the availability of earlier cash settlements. The court stated, “There is no evidence herein that would support a finding of fraud, malfeasance, or misrepresentations of fact on respondent’s behalf…”.

    The court also clarified that the consistent settlement rules under 26 U.S.C. § 6224(c)(2) apply to partners within the same partnership and for the same tax year, not across different partnerships or years. Quoting Boyd v. Commissioner, the court affirmed that “There is no provision in the Code requiring… respondent to settle the… B partnership under the same settlement terms that were negotiated for the… A partnership, a separate and distinct partnership.”

    Practical Implications

    Vulcan Oil Technology Partners reinforces the critical importance of adhering to TEFRA’s strict deadlines for electing consistent settlements in partnership tax proceedings. It clarifies that the IRS is not obligated to offer consistent settlements indefinitely or across different partnerships, even within related tax shelter projects. Legal practitioners must advise partners in TEFRA proceedings to be vigilant about deadlines and to actively seek information about settlement opportunities, as the onus is not on the IRS to provide individualized notice. This case highlights that investors who delay seeking consistent settlements or who misjudge litigation strategy bear the risk of less favorable outcomes and cannot retroactively claim parity with earlier settlement terms once deadlines have passed and adverse legal precedents emerge.

  • Schaefer v. Commissioner, T.C. Memo. 1996-483: When Income from a Covenant Not to Compete is Not Passive Income

    Schaefer v. Commissioner, T. C. Memo. 1996-483

    Income from a covenant not to compete is not considered passive income under section 469 of the Internal Revenue Code.

    Summary

    In Schaefer v. Commissioner, the Tax Court upheld the validity of a temporary regulation under section 469, ruling that income from a covenant not to compete does not constitute passive income. William Schaefer, who sold his Toyota dealership and received payments from a covenant not to compete, argued that these payments should be treated as passive income to offset his passive activity losses. The court, however, found that such income is more akin to earned or portfolio income, which Congress intended to exclude from being sheltered by passive losses, and thus upheld the regulation.

    Facts

    William H. Schaefer, Jr. , the petitioner, was the sole shareholder of Toyota City, which he sold on November 7, 1984. The sale agreement included a covenant not to compete within a 5-mile radius of the buyer’s business for 3 years. Schaefer received monthly payments under this covenant, starting 6 months after the sale and continuing for 13 years. He reported these payments as passive income on his 1988, 1989, and 1990 tax returns, claiming they should be offset by his passive activity losses. The Commissioner of Internal Revenue disagreed, asserting that income from a covenant not to compete is not passive income under the applicable regulation.

    Procedural History

    The Commissioner determined deficiencies in Schaefer’s income taxes for the years 1988, 1989, and 1990. After Schaefer’s concessions, the sole issue remaining was the characterization of the covenant not to compete income. The case was brought before the United States Tax Court, where Schaefer challenged the validity of the temporary regulation under section 469 that classified such income as non-passive.

    Issue(s)

    1. Whether income received pursuant to a covenant not to compete is passive income for purposes of section 469 of the Internal Revenue Code?

    Holding

    1. No, because the court found that the temporary regulation excluding income from a covenant not to compete from passive income was valid and consistent with the legislative intent behind section 469.

    Court’s Reasoning

    The court upheld the validity of the temporary regulation under section 1. 469-2T(c)(7)(iv), which excludes income from a covenant not to compete from passive income. The court reasoned that temporary regulations are entitled to the same deference as final regulations and must be upheld if they reasonably implement the congressional mandate. The court found that the regulation was consistent with the purpose of section 469, which was to prevent taxpayers from using passive losses to shelter income that does not bear similar risks, such as portfolio or earned income. The court cited historical cases equating covenant not to compete income with earned income, emphasizing that such income is positive and does not bear deductible expenses, aligning it more closely with non-passive income sources. Schaefer’s arguments that the income was different from earned or portfolio income were rejected, as the court found that the regulation’s classification was reasonable and within the Secretary’s authority granted by Congress.

    Practical Implications

    This decision impacts how income from covenants not to compete is treated for tax purposes. Taxpayers cannot use such income to offset passive activity losses under section 469. Legal practitioners must advise clients accordingly when structuring sales agreements involving non-compete clauses, ensuring that the tax implications of such income are clearly understood. The ruling reinforces the IRS’s ability to issue regulations that clarify and interpret tax laws, even on a temporary basis. Future cases involving similar issues will likely follow this precedent, and taxpayers may need to adjust their tax planning strategies to account for this classification of income.

  • Krause v. Commissioner, 99 T.C. 132 (1992): Profit Objective Requirement for Deductibility of Partnership Losses in Tax Shelters

    Krause v. Commissioner, 99 T.C. 132 (1992)

    To deduct losses from partnership activities, the partnership must demonstrate an actual and honest profit objective; tax benefits alone are insufficient.

    Summary

    Taxpayers invested in limited partnerships designed as tax shelters focused on enhanced oil recovery (EOR) technology. The partnerships claimed substantial losses based on license fees for EOR technology and minimum royalties for tar sands properties. The Tax Court disallowed these losses, finding that the partnerships lacked an actual and honest profit objective. The court reasoned that the transactions were structured primarily for tax benefits, with excessive fees and royalties that bore no relation to the technology’s value or industry norms, precluding any realistic profit potential. The court also found the debt obligations to be shams lacking economic substance.

    Facts

    Petitioners invested in limited partnerships, Technology-1980 and Barton Enhanced Oil Production Income Fund, marketed as tax shelters focused on EOR technology and oil and gas drilling. Technology-1980 acquired rights to EOR technology from Elektra and leases for tar sands properties from TexOil, agreeing to pay substantial license fees and royalties, largely through long-term promissory notes. Barton obtained similar EOR technology licenses from Hemisphere, Elektra’s successor, also with significant fees and royalties. Offering memoranda emphasized tax benefits, projecting large losses for investors. The EOR technology was largely untested and of speculative value. Partnership expenses, particularly license fees and royalties, were disproportionately high compared to potential revenues. A significant portion of investor cash went to promoters and fees rather than technology development.

    Procedural History

    The Commissioner of Internal Revenue determined deficiencies against individual partners (Hildebrand and Wahl) for disallowed losses from Technology-1980 for 1980-1982. The Commissioner also issued a Notice of Final Partnership Administrative Adjustment (FPAA) disallowing losses claimed by Barton for 1982 and 1983. The cases were consolidated in the United States Tax Court.

    Issue(s)

    1. Whether the activities of the partnerships, Technology-1980 and Barton, were engaged in with actual and honest profit objectives.
    2. Whether the stated debt obligations of the partnerships constituted genuine debt obligations or were contingent, sham obligations lacking economic substance.

    Holding

    1. No, because the partnerships’ activities were not primarily engaged in for profit; they were tax-motivated transactions lacking a genuine business purpose.
    2. No, because the debt obligations, particularly related to license fees and royalties, were not genuine, reflecting inflated and non-arm’s-length amounts that did not represent true economic obligations.

    Court’s Reasoning

    The court applied the principle that to deduct partnership losses, activities must be engaged in with an actual and honest profit objective, not primarily for tax benefits. The court considered factors from Treasury regulations under section 183 and other relevant circumstances, emphasizing that tax benefits were heavily promoted, and information about EOR technology was inaccurate. The financial structure of fees and royalties was deemed critical. The court found the license fees and royalties were excessive, bore no relation to the EOR technology’s value, and were not established through arm’s-length bargaining. The fees precluded any realistic profit opportunity and did not conform to industry norms, which typically involve running royalties based on actual production. The court noted the offering memoranda were misleading, exaggerating the EOR technology’s development and potential while downplaying risks. Expert testimony supporting profit objectives was deemed unpersuasive, relying on unreasonable assumptions and projections. The court concluded the transactions were structured to generate tax deductions, not genuine profit, and the debt obligations were shams.

    Practical Implications

    Krause v. Commissioner reinforces the importance of profit motive in tax shelter investments, particularly those involving novel or speculative technologies. Legal professionals should advise clients that tax benefits cannot be the primary driver of an investment; a genuine profit objective must be demonstrable. When evaluating similar cases, courts will scrutinize the economic substance of transactions, focusing on whether fees and obligations are reasonable, arm’s-length, and aligned with industry standards. The case serves as a cautionary tale against investments with disproportionately high expenses, especially license fees or royalties, relative to realistic revenue projections and where promotional materials heavily emphasize tax advantages over economic viability. It highlights the need for thorough due diligence, independent valuations, and realistic business plans when structuring and analyzing investments, particularly in emerging technology sectors.

  • Marine v. Commissioner, 93 T.C. 265 (1989): When Tax Shelter Investments Lack Economic Substance

    Marine v. Commissioner, 93 T. C. 265 (1989)

    A taxpayer cannot deduct losses from tax shelter investments lacking economic substance, even if the investments were promoted as offering tax benefits.

    Summary

    In Marine v. Commissioner, the Tax Court disallowed deductions claimed by taxpayers who invested in limited partnerships promoted by Gerald L. Schulman. The partnerships purportedly purchased post offices to generate tax deductions, but the transactions were shams with no economic substance. The court held that the partnerships’ activities were not engaged in for profit, and thus the taxpayers could not deduct losses. The decision underscores that for tax deductions to be valid, the underlying transactions must have economic reality and be entered into with a profit motive, not merely for tax avoidance.

    Facts

    James B. Marine and his wife invested in two limited partnerships, Clark, Ltd. and Trout, Ltd. , promoted by Gerald L. Schulman. The partnerships claimed to acquire post offices leased to the U. S. Government, with the investment structured to provide tax deductions equal to the investors’ cash contributions through purported interest expenses. However, the partnerships engaged in circular financing schemes and purchased the properties at inflated prices using nonrecourse notes. The transactions lacked economic substance, and Schulman was later convicted of tax fraud related to these schemes.

    Procedural History

    The Commissioner of Internal Revenue disallowed the Marines’ claimed deductions and assessed deficiencies. The taxpayers petitioned the Tax Court, which held a trial in July 1988. The court issued its opinion in 1989, disallowing the deductions and upholding the Commissioner’s determinations.

    Issue(s)

    1. Whether the taxpayers are entitled to deduct theft losses on their initial cash contributions to the limited partnerships.
    2. Whether the taxpayers can claim losses in connection with the real estate activities of the limited partnerships.
    3. Whether the taxpayers are liable for additions to tax under sections 6653(a) and 6661, and additional interest under section 6621(c).

    Holding

    1. No, because the taxpayers did not discover the alleged theft loss during the taxable years in issue and the transactions were not thefts but rather tax shelters lacking economic substance.
    2. No, because the partnerships’ activities were not engaged in for profit, and the transactions lacked economic substance, making the claimed deductions invalid.
    3. Yes, because the taxpayers were negligent in claiming the deductions and the understatements were substantial and attributable to tax-motivated transactions.

    Court’s Reasoning

    The court applied the economic substance doctrine, holding that the partnerships’ transactions were shams designed solely for tax avoidance. The court found that the purchase prices of the post offices were grossly inflated, the nonrecourse notes had no economic significance, and the partnerships had no realistic chance of generating a profit. The court rejected the taxpayers’ theft loss argument, stating that they received what they bargained for – tax deductions – and did not discover the loss until years later. The court also found the taxpayers negligent for failing to conduct due diligence before investing and claiming the deductions. The court’s decision was influenced by policy considerations favoring the integrity of the tax system over allowing deductions from transactions lacking economic reality.

    Practical Implications

    This case reinforces the importance of the economic substance doctrine in tax law. Taxpayers and practitioners must ensure that transactions have a legitimate business purpose beyond tax avoidance. The decision impacts how tax shelters and similar investments should be analyzed, emphasizing the need for a profit motive and economic reality to support deductions. It also underscores the importance of due diligence before investing in tax-driven schemes. Subsequent cases, such as ACM Partnership v. Commissioner, have further developed the economic substance doctrine, solidifying its role in determining the validity of tax transactions.

  • Marine v. Commissioner, 92 T.C. 958 (1989): When Tax Deductions from Sham Transactions Are Disallowed

    Marine v. Commissioner, 92 T. C. 958 (1989)

    Tax deductions claimed from sham transactions and transactions not engaged in for profit are disallowed.

    Summary

    James and Vera Marine invested in limited partnerships promoted by Gerald Schulman, who promised tax deductions equal to the investors’ cash contributions through circular financing schemes. The Tax Court held that the partnerships’ transactions, including the claimed first-year interest deductions, lacked economic substance and were shams, disallowing the deductions. The court also ruled that the partnerships were not engaged in for profit, and upheld additions to tax and additional interest due to the taxpayers’ negligence and the tax-motivated nature of the transactions.

    Facts

    James and Vera Marine invested in Clark, Ltd. in 1979 and Trout, Ltd. in 1980, both limited partnerships organized by Gerald Schulman. Schulman promoted these partnerships as tax shelters, promising first-year interest deductions equal to the limited partners’ cash contributions. The partnerships allegedly purchased post offices at inflated prices using nonrecourse financing, with no actual loans or interest payments. Schulman was later convicted of tax fraud related to these schemes. The Marines claimed substantial tax deductions based on the partnerships’ reported losses, which were disallowed by the IRS.

    Procedural History

    The IRS issued a notice of deficiency to the Marines, disallowing their claimed partnership losses and asserting additions to tax and additional interest. The case proceeded to the U. S. Tax Court, where the Marines argued for theft loss deductions and the validity of their partnership losses. The court ruled against the Marines, upholding the IRS’s determinations.

    Issue(s)

    1. Whether the Marines are entitled to theft loss deductions on their cash contributions to the partnerships.
    2. Whether the partnerships’ transactions had economic substance and were entered into for profit, entitling the Marines to deduct their distributive shares of the partnerships’ losses.
    3. Whether the Marines are liable for additions to tax under sections 6653(a) and 6661, and additional interest under section 6621(c).

    Holding

    1. No, because the Marines did not discover the alleged theft loss during the years in issue and the transactions did not constitute theft.
    2. No, because the partnerships’ transactions lacked economic substance and were not engaged in for profit, rendering the claimed deductions invalid.
    3. Yes, because the Marines were negligent in claiming the deductions, and the transactions were tax-motivated, justifying the additions to tax and additional interest.

    Court’s Reasoning

    The court applied the economic substance doctrine, finding that the partnerships’ purchase prices for the post offices were grossly inflated and the financing arrangements were shams. The court referenced Estate of Franklin v. Commissioner to determine that the transactions lacked economic substance due to the disparity between the purchase price and the fair market value of the properties. The court also considered the absence of a profit motive under section 183, concluding that the partnerships’ primary purpose was tax avoidance. The court rejected the Marines’ arguments for theft loss deductions, noting that they received what they bargained for and did not discover any theft during the years in issue. The court upheld the additions to tax and additional interest, citing the Marines’ negligence and the tax-motivated nature of the transactions.

    Practical Implications

    This decision underscores the importance of economic substance in tax transactions and the disallowance of deductions from sham transactions. It impacts how tax professionals should advise clients on investments promising large tax deductions, emphasizing the need for due diligence on the economic viability of the underlying transactions. The ruling also serves as a warning to investors to thoroughly investigate the legitimacy of tax shelters and the credibility of promoters. Subsequent cases involving similar tax shelter schemes have referenced Marine in disallowing deductions based on transactions lacking economic substance.

  • Structured Shelters, Inc. v. Commissioner, T.C. Memo. 1988-533: When Tax Shelters Lack Economic Substance

    Structured Shelters, Inc. v. Commissioner, T. C. Memo. 1988-533

    Investments lacking economic substance cannot be used to claim tax deductions or credits.

    Summary

    In Structured Shelters, Inc. v. Commissioner, the Tax Court denied tax deductions and credits for investments in various programs marketed by Structured Shelters, Inc. (SSI). The court found that the investments in master recordings, cocoa processing, agricultural preservation research, computer software, and leasing of storage containers were devoid of economic substance and designed solely to generate tax benefits. The court applied the Rose v. Commissioner framework, focusing on the absence of arm’s-length dealings, lack of investor due diligence, and overvaluation of assets. As a result, the investors were denied deductions and credits, and were subject to additional penalties for negligence and valuation overstatements.

    Facts

    Structured Shelters, Inc. (SSI) marketed various investment programs to its clients, including master recordings, cocoa processing, agricultural preservation research, computer software, and leasing of storage containers. Investors entered these programs based on SSI’s recommendations without conducting independent due diligence. SSI structured these investments to provide significant tax benefits, including deductions and credits. The transactions involved overvalued assets and deferred payment through promissory notes, with investors often unaware of the specifics of their investments until after investing.

    Procedural History

    The case was assigned to a Special Trial Judge and consolidated with other related cases. The Tax Court adopted the Special Trial Judge’s opinion, which found that the investments lacked economic substance and were designed solely for tax benefits. The court denied the investors’ claims for deductions and credits, and imposed additional penalties for negligence and valuation overstatements.

    Issue(s)

    1. Whether the investments in the various programs marketed by SSI had economic substance sufficient to allow the investors to claim deductions and credits?
    2. Whether the investors were liable for additions to tax under sections 6653(a) and 6659 for negligence and valuation overstatements?
    3. Whether the investors were liable for additional interest under section 6621(c) for tax-motivated transactions?

    Holding

    1. No, because the investments lacked economic substance and were designed solely to generate tax benefits.
    2. Yes, because the investors were negligent in relying on SSI without conducting independent due diligence, and they overstated the value of their investments.
    3. Yes, because the transactions were tax-motivated shams, warranting the imposition of additional interest.

    Court’s Reasoning

    The court applied the Rose v. Commissioner framework to determine the economic substance of the investments. Key factors included the lack of arm’s-length dealings, the absence of investor due diligence, the structure of the financing, and the relationship between the fair market value and the price of the investments. The court found that the transactions were designed to artificially inflate tax benefits, with little to no genuine economic activity. The court also noted the absence of negotiations, the use of overvalued assets, and the reliance on promissory notes that were unlikely to be paid. The court rejected the investors’ arguments that they relied on competent advice, finding that the chartered representatives had a financial stake in promoting the investments. The court’s decision was supported by expert testimony and evidence of the poor quality and marketability of the assets involved.

    Practical Implications

    This decision underscores the importance of economic substance in tax-related investments. Practitioners should advise clients to conduct thorough due diligence and ensure that investments have a genuine profit motive beyond tax benefits. The case highlights the risks of relying on promoters’ representations without independent verification. Future cases involving similar tax shelters will likely be analyzed under the Rose framework, focusing on objective factors such as arm’s-length dealings and asset valuation. Businesses offering tax-advantaged investments must be cautious about structuring transactions that lack economic substance, as they may face significant penalties and disallowance of tax benefits. This decision also serves as a reminder that the IRS and courts will scrutinize investments that appear designed primarily to generate tax benefits, potentially leading to increased enforcement actions against such schemes.