Another Bullshit Tax Shelter Bites the Dust (11/14/17)

In Smith v. Commissioner, T.C. Memo. 2017-218, here, the taxpayers implemented and claimed the tax benefits of a tax shelter concocted by a Houston lawyer to shelter their income upon retirement.  Professor Bryan Camp has a nice discussion of the gambit and the result in Lesson From The Tax Court: The Power Of Fact-Finding (TaxProf Blog 11/13/17), here, who described it as a "Rube Goldberg scheme," which, he confessed, "I don’t understand how this works even as I am writing it!"

While I, like Professor Bryan Camp, don't profess to understand all the machinations, I think the core idea was for the taxpayers to create a limited partnership in which they directly or indirectly owned all the partnership interests - 98% LP interests and 2% GP interests.  They contributed significant cash and marketable securities to the partnership through an interim entity, an S Corporation.  The limited partnership was allegedly created for estate planning and preservation reasons.  Without the intervention of the S Corporation, that would not be particularly noteworthy.  The S Corporation first received the assets and then contributed them to the limited partnership.  (I haven't focused on the precise order of those steps, but it is not important.)  The S corporation then, in the same year, liquidated.

The machinations resulted in the following:

• At the beginning of the process, the taxpayers had the cash and assets.
• At the end of the process, the taxpayers had the LP interests and, indirectly, the GP interests.
• Between the beginning and the end the Subchapter S corporation was created and liquidated. 

The taxpayers then claimed ordinary loss deductions based on the purported tax results of the S corporation.  I confess that I did not spend the time to fully understand exactly how those results worked.  Normally, the liquidation of an S corporation generates a capital loss to the extent that the value of the assets distributed is less than the shareholders' basis in the stock.  I think, however, that the lawyer pulled of some other sleight of hand to create the appearance of an ordinary loss in the S Corporation that flowed through to the shareholders via the K-1.  The ordinary loss was needed to shelter the ordinary income that caused the taxpayers to adopt the "Rube Goldberg scheme" in the first instance.  I may not have that right, because, in my mind, it is not critical to the result in the case.

The linchpin to the planning was that the S corporation be recognized for tax purposes.  This presented the issue that bedeviled true Bullshit tax shelters -- economic substance.  The taxpayers had to convince the court that they had some real reason to create and then liquidate the S corporation in the same year without any material activity other than routing assets from the taxpayer into the limited partnership.  The taxpayers failed in that burden.  The Tax Court Judge found that their testimony as to some legitimate nontax purpose for the S corporation was not credible.  Stated otherwise, the Tax Court found that they lied about the claimed nontax business purpose.

In this sense, the shelter is like the Bullshit tax shelters that have been featured prominently in this blog over the years.  A key element of the Bullshit tax shelters was some key "not credible" factual statement that the taxpayers would have to make in order to at least keep their feet in the door to establish the basis for claiming the tax benefits.  In the Bullshit tax shelters, the taxpayers had to claim that they had a true nontax purpose for entering the shelters (which often deployed similar short-term arrangements analogous to the S Corporation in Smith).  That proved to be too heavy a lift for most of the taxpayers and even a heavier lift for the professionals concocting the schemes (some were prosecuted and convicted).  The machinations creating a gerrymandered tax superstructure were not credible once the onion was peeled back.  And, even if they could clear that hurdle, the legal analyses often did not stand scrutiny.

The Smiths failed this threshold inquiry -- they could and did not establish the required nontax business purpose.

Now, I will say that Smith may vary from the other Bullshit tax shelters I have featured on this blog which have usually featured marketed tax shelters where the promoter of the shelter was financially rewarded handsomely (at least until the IRS and the courts called out the tax shelter).  According to the opinion:\

Mr. Shanks [the lawyer] generally charged a flat fee for his legal services. He charged petitioners a flat fee of $23,200 for services relating to their will and relevant estate planning documents and the RACR structure. 

The lawyer concocting the scheme thus was not rewarded in the Smith case as handsomely relative to the tax benefits as did the promoters in the other Bullshit tax shelters.  The opinion states that the lawyer "had implemented similar structures for 10 to 15 other clients between 1999 and 2009."  There is no indication of his fees for doing so in the other cases.