Tax Shelter Transactions Disregarded

By James Beavers, J.D., LL.M., CPA

The Fifth Circuit joined the majority of circuits and held that a lack of economic substance will invalidate the results of a transaction even if a taxpayer had a genuine motive other than tax avoidance for entering into the transaction.


Cary Patterson and Harold Nix represented the state of Texas in litigation against the tobacco industry, and each man earned around $30 million from the litigation between 1998 and 2000. Patterson and Nix invested the earnings from the case in an investment strategy known as a Bond Linked Issue Premium Structure (BLIPS) marketed by Presidio Advisory Services (Presidio) and facilitated by large loans from National Westminster Bank (NatWest). The shelter was ostensibly a three-stage series of foreign currency investment transactions, with most of the risk and the potential for gains or losses coming in the second and third stages. Patterson and Nix believed the purpose of the strategy was to profit from the devaluation of certain foreign currencies. However, as they would later learn, Presidio and NatWest instead intended the strategy solely as a vehicle to secure large tax losses for investors and never intended that the strategy be continued after the first stage.

To implement the strategy for Patterson and Nix, Presidio formed Klamath and Kinabalu as limited liability companies (LLCs) taxed as partnerships. Patterson owned 90% of Klamath through a disregarded entity; Nix owned 90% of Kinabalu, also through a disregarded entity. The other 10% partners of Klamath and Kinabalu were Presidio Resources LLC and Presidio Growth LLC. Presidio Growth was the managing partner of both LLCs.

To fund Klamath and Kinabalu, Patterson and Nix (acting through the disregarded entities) made two distinct contributions. First, they each contributed $1.5 million to their respective LLCs. Second, they entered into loan transactions with NatWest, in which the bank loaned each man $66.7 million (which they also contributed to the LLCs). These loans consisted of $41.7 million denominated as the “stated principal amount” and $25 million as a “loan premium.”

Klamath and Kinabalu deposited the funds into accounts controlled by Nat- West. Presidio directed the LLCs to use these funds to purchase very low risk contracts on U.S. dollars and euros. They also made small, 60- to 90-day forward contract trades in foreign currencies. These were the only investments the partnerships ever made, and Patterson and Nix elected to withdraw from Klamath and Kinabalu (for reasons unrelated to the investment strategy) before the end of the first stage. They received cash and euros on liquidation, and they sold the euros in 2000, 2001, and 2002.

Upon liquidation of the partnerships, Patterson and Nix claimed that their basis in the partnerships (and, by extension, the property distributed to them in their liquidation) was $26.5 million, the total amount contributed to the partnerships (the $1.5 million of their own money plus the $66.7 million loaned by NatWest) less the amount of the liabilities the partnerships assumed, which they limited to the $41.7 million stated principal amount portion of the NatWest loan. They did not reduce the basis amount by the loan premium portion of the NatWest loan because they contended it was not a liability for purposes of Sec. 752 (dealing with treatment of partners’ liabilities). This meant that when Patterson and Nix sold the euros they received when the partnerships liquidated, the sales resulted in losses of over $25 million, which they deducted from their taxable income in 2000, 2001, and 2002.

The IRS disagreed with Patterson’s and Nix’s calculation of their losses from the euro sales. The Service claimed that under Sec. 752, the taxpayers should have treated the full amount of the $66.7 million loans from NatWest as liabilities in calculating the basis of Klamath and Kinabalu and that the basis in the euros should have been reduced by $25 million, thus eliminating most of the loss Patterson and Nix claimed on their eventual sale. In the alternative, the IRS argued that the transactions should be disregarded because they were sham transactions or lacked economic substance.

The IRS issued final partnership administrative adjustments (FPAAs) disallowing the losses. The FPAAs also made adjustments to the expenses claimed by the partnerships and asserted accuracy penalties against the partnerships. Patterson and Nix paid the taxes owed based on the FPAAs and then challenged the IRS’s adjustments in district court.

District Court’s Decision

The district court initially granted summary judgment for the taxpayers on the basis issue, holding that under the law in effect at the time the transactions occurred, the loan premium portion of each of the NatWest loans was a contingent liability that was not treated as a liability for purposes of Sec. 752. However, in a bench trial, the court held that the transactions lacked economic substance and must be disregarded (Klamath Strategic Investment Fund, LLC, No. 5:04-CV-278 (E.D. Tex. 1/31/07)).

In determining whether the transactions had economic substance, the court followed the decision in Compaq Computer Corp., 277 F.3d 778 (5th Cir. 2001), in which the Fifth Circuit held that there must be a reasonable possibility of profit from a transaction for it to have economic substance. The court also stated that it must judge the economic substance of the transactions based on all the evidence, as opposed to only the terms of the written agreements. Despite the literal terms of the documents, the court found that Presidio, as the agent of and on behalf of Klamath and Kinabalu, entered into additional understandings and agreements with NatWest concerning the expected duration of NatWest’s lending relationship with individual investors, including Nix and Patterson. In addition, Presidio and NatWest understood that none of the $66.7 million contributed to the partnerships would be used to provide leverage for foreign currency transactions.

Finally, the court found that Presidio’s fee structure strongly suggested that Presidio’s goal was not to earn a profit but rather to secure large tax losses for its investors. Therefore, although Nix and Patterson intended to make a profit through trading in foreign currencies, Presidio and NatWest did not intend that the LLCs would use the NatWest loans for foreign currency trades that had a profit objective. Consequently, the court held the loan transactions lacked economic substance.

Fifth Circuit’s Decision

The Fifth Circuit affirmed the district court’s holding that the transactions must be disregarded but followed a slightly different path than the district court in making its decision. According to the Fifth Circuit, “[t]he economic substance doctrine allows courts to enforce the legislative purpose of the Code by preventing taxpayers from reaping tax benefits from transactions lacking in economic reality.” To determine whether a transaction lacks economic reality, the court applied the test from Frank Lyon Co., 435 U.S. 561 (1978). In that case, the Supreme Court held that a transaction lacks economic reality if it does not have three characteristics. The transaction must (1) have economic substance compelled by business or regulatory realities, (2) be imbued with tax-independent considerations, and (3) not be shaped totally by tax-avoidance features. Thus, a transaction that lacks economic substance will fail the test, even if the taxpayer had a genuine nontax business purpose for entering into the transaction.

Analyzing the strategy that Presidio implemented through Klamath and Kinabalu, the Fifth Circuit found that it did not pass the economic reality test. It found that the Presidio and NatWest had specifically designed the loan transactions and the investment strategy not to make a profit but to generate a large tax loss for the investors with little or no risk to the investors or Presidio or NatWest. Although Patterson and Nix had a genuine profit motive for engaging in the transactions, Presidio and NatWest controlled the transactions, and they had not structured or implemented the transactions to make a profit. Therefore, the transactions lacked economic substance. Because they lacked economic substance, the court held that the transactions failed the economic reality test and must be disregarded.


In a side issue, the Fifth Circuit reversed the district court on whether Patterson and Nix could deduct the operating expenses and fees of Klamath and Kinabalu. Under Sec. 212, a business must have a profit motive to deduct operating expenses. The district court held that Klamath and Kinabalu had a profit motive because Patterson and Nix had a profit motive with respect to the LLCs. Thus, the expenses were deductible to Patterson and Nix as members.

The Fifth Circuit disagreed, stating that while the district court had correctly held that the deductibility of the expenses of an LLC taxed as a partnership was determined at the LLC level, it had not correctly identified how to determine if the LLC had a profit motive. According to the Fifth Circuit, whether an LLC had a profit motive depended on whether the controlling members of the LLC had a profit motive with respect to it, not the members who ultimately paid and deducted the expenses. The court found that Presidio Growth controlled both Klamath and Kinabalu under the terms of their LLC agreements and it did not have a profit motive with respect to the LLCs. Therefore, the court held that the operating expenses and fees of the LLCs were not deductible to any of their members.

Klamath Strategic Investment Fund, No. 07-40861 (5th Cir. 5/21/09)

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