Fifth Circuit Decides Klamath on Economic Substance for Tax Shelters

The Fifth Circuit has rendered its long-awaited decision in Klamath Strategic Investment Fund v. United States, ___ F.3d ___ (5th Cir. 2009). By way of background, Klamath involved the BLIPS tax shelter that was involved in the star-crossed KPMG individual defendants criminal indictment way back in 2004 (as well as the related KPMG deferred prosecution agreement). After slapping the Government for prosecutorial abuse in that case and dismissing most of the defendants (dismissal sustained in United States v. Stein, 541 F.3d 130 (2d Cir. 2008)), the Government finally took four of the defendants to trial and obtained a conviction on the BLIPS shelters in December 2008. During the winding journey that started at least by 2004 and ended in those convictions in December 2008, the Government had pulled out all the stops to prevent the issue of viability of the BLIPS shelter from being decided in a civil case. Obviously, the reason was that, if a taxpayer prevailed in a civil case or even avoided penalties in a civil case, the Government's charges in the criminal case might not pass the requirement that the legal duty be certain in order to support criminal charges (as established by the Supreme Court in James and in a number of cases from the courts of appeals, including Garber (5th Circuit), Dahlstrom (9th Circuit) and Pirro (2d Circuit).

Notwithstanding the Government's determined attempt to avoid a civil test of its claims about BLIPS, the district court in Klamath refused to stay the case and took it to resolution, hence the court of appeals case. In the district court, the court made a critical pre-trial ruling sustaining the legal superstructure employed in BLIPS (and many other tax shelters) which centered on an application of the Helmer case to allow, in effect, a cost-free basis in a partnership interest from a conditional obligation. At trial, however, the court held that (1) notwithstanding its previous holding that Helmer works (or at least worked at the time the shelter was implemented), the BLIPS transaction in the case failed the economic substance test and thus the IRS adjustments at the partnership level were correct but (2) (a) the accuracy related penalty did not apply and (b) in any event, partnership established the defense of reasonable cause and good faith defense precluded the IRS's claim for the accuracy related penalties. The partnership appealed the first holding (on the economic substance test), and the Government appealed the holdings on (1) that the penalty did not apply and (2) the predicate holding that the Helmer gambit in the case worked.

The key Fifth Circuit holdings are:

1. The economic substance test requires that the taxpayer establish both independent objective economic substance and a taxpayer motive independent of tax savings. In determining whether there was independent economic substance, the Court disregarded the relatively small, high risk investment play independent of the loan transaction that gave rise to the application of Helmer cost-free basis that was the tax play in the case. The court said (slip op. pp. 10 & 11, citations omitted):

The Partnerships further argue that the loan transactions had a reasonable possibility of profit, as evidenced by the fact that two small, low-risk investments were actually made in foreign currencies. However, these investments were made using the $1.5 million that Patterson and Nix contributed to the partnerships, not the funding amounts of the loans. Various courts have held that when applying the economic substance doctrine, the proper focus is on the particular transaction that gives rise to the tax benefit, not collateral transactions that do not produce tax benefits. Therefore, the proper focus is on whether the loan transactions presented a reasonable possibility of profit, not whether the capital contributions from Patterson and Nix could have produced a profit. The loan transactions could never have been profitable because the funding amount could not actually be used for investments, and the high-risk investments for which the funding amount might have provided security were never intended to occur.

The evidence clearly shows that Presidio and NatWest designed the loan transactions and the investment strategy so that no reasonable possibility of profit existed and so that the funding amount would create massive tax benefits but would never actually be at risk. Regardless of Patterson and Nix’s desire to make money, they entered into transactions controlled by Presidio and NatWest that were not structured or implemented to make a profit. This particular situation highlights the logic of following the majority approach to the economic substance doctrine, because the minority approach would allow tax benefits to flow from transactions totally lacking in economic substance as long as the taxpayers offered some conceivable profit motive. In cases such as the instant one, this approach would essentially reward a “head in the sand” defense where taxpayers can profess a profit motive but agree to a scheme structured and controlled by parties with the sole purpose of achieving tax benefits for them. We therefore agree with the district court that since the loan transactions lacked economic substance, they must be disregarded for tax purposes.

2. The Fifth Circuit then moved to the Government's appeal.

a. The Fifth Circuit declined to accept the Government's invitation to reverse the district court's acceptance of the Helmer gambit in its predicate holding in the case. The Fifth Circuit reasoned that the Government prevailed in the case on the basis of the application of the economic substance test and thus the district court's Helmer holding was moot. For that reason, the district court's Helmer holding was nonprecedential and inappropriate for consideration on appeal. [It seems obvious to me that the Government's angst about that holding was not really about the precedential effect in other civil cases, but the persuasive effect it might have in a criminal case where the defendants will assert the viability of the Helmer gambit in the defense case or, more likely, that, even if not ultimately viable, it did not create a Cheek / James-type known and knowable legal duty.]

b. The Fifth Circuit sustained the district court's holding that the reasonable cause and good faith defense to the penalties could be applied at the partnership level. Since this holding meant that, even if the penalties were otherwise applicable, the defense eliminates the penalties, the Fifth Circuit declined to consider whether the penalties were otherwise applicable. Since this particular issue requires analysis of the TEFRA unified partnership audit and litigation procedures and involves some degree of procedural esoterica not particularly important to most readers of the blog, I forego further discussion of this issue. I do note, however, that the Fifth Circuit's avoidance of the issue of whether the penalties were otherwise applicable permitted it to duck the Government's attack on the Fifth Circuit's prior holding in Heasley.

In summary, both parties got a share of the big pie. The Government got the principal tax dollars involved and the taxpayers avoided the penalty bullet which could have cost an additional 40%.

I decline at this point to speculate what effect this holding will have in subsequent Helmer related criminal proceedings, including the pending appeal in the KPMG individual defense case. I am sure the parties will address that issue in the briefs. I will keep the readers advised.