Attorney-at-Law

MORE SHELL GAMES

In Uncategorized on 09/02/2011 at 17:31

I said often enough that this blog is for the in-the trenches practitioner, not the writer of law review articles or newsletters for the two-yacht preparer. But Tax Court has an interesting take that has a good deal of general application.

This was Superior Trading, LLC, Jetstream Business Limited, Tax Matters Partner, et al., 137 T.C. 6, filed 9/1/11.

Judge Wherry was tasked with unraveling this son-of-DAD deal, where, like so many similar schemes, a pseudo but recognized loss is married to a real gain, and immediately afterward the parties unwind the deal, right after the real gain is shielded from tax. Like the currency trade shenanigans (see my blogpost of 4/14/11, “An Option Isn’t a Contract”), the DADs (distressed asset/debt) take distressed debt, which supposedly generates a massive loss, and ties it in to a real gain (the packager of the deal making a fee from selling the scam to the gainer, which is split with the distressed assetholder/debtor).

Take it away, Judge Wherry! “Instead of a claimed permanent tax loss manufactured out of whole cloth, a DAD deal synthesizes an evanescent one. The loss is proclaimed under authority of sections 723 and 704(c) from an alleged contribution of a built-in loss asset by a ‘tax indifferent’ party to a purported partnership with a ‘tax sensitive’ one. However, this loss is preordained to be nullified by a matching gain upon the dissolution of the venture. Consequently, the tax benefits sought by the tax sensitive party are, absent other factors, confined to timing gains. Moreover, claiming these benefits requires sufficient “outside basis”, which, in turn, entails an investment of real assets.” 137 T.C. 6, at pp. 4-5.

So here, a bankrupt Brazilian equivalent of Circuit City, which provided purchase-money financing to its customers who promptly defaulted, contributes all its allegedly worthless consumer paper to a partnership. The Brazilian partner, of course, has no effective connection with, substantial presence in, ever done business of any kind in or with, or even can find the USA on a map. Various characters sell partnership interests to US parties who need a quick write-off. The Brazilians claim their customers’ paper is worthless and take a huge write-off.

This loss winds up on the 1040s of the US investors who bought these partnership interests. Of course, TEFRA administrative partnership adjustments rain down on the heads of the US investors, who Judge Wherry styles as inhabitants of “Mr. Rogers’ Neighborhood.” Only this Mr. Rogers is not a Presbyterian minister, like the eponymous television personality; rather, this dude is Mr. John E. Rogers, who  “has a B.A. in mathematics and physics from the University of Notre Dame, a J.D. from Harvard Law School, and an M.B.A. from the University of Chicago, with a concentration in international finance and econometrics.” 137 T.C. 6, at p. 9. Clearly, Mr. Rogers’ credentials wow even the unflappable Judge Wherry, as he devoted a three-quarter-page footnote to Mr. Rogers’ glowing resume.

But Mr. Rogers’ tiered partnerships and swapping around of distressed debt was only a timing gain. Eventually, the gains would overtake the losses, but the timing benefit could be substantial, resulting in deferral of gain. In any event, Congress slammed the door on such shell games by the American Jobs Creation Act of 2004; distressed debt cannot be allocated among partners–the contributing partner keeps it all.

Ultimately, these pre-Act deals fall apart because the Brazilians and Americans never intended to go into business together. There was no real partnership; the Brazilians carried on their collection activities independently from the Americans, who played their own games on their own playgrounds. There was no common business. Tax Court concludes that the Brazilians sold their distressed assets to the partnership, and bought them back, a process known to some by the arcane technical term as “selling the chumetz”. And it doesn’t fly.

While it’s true that tax benefits can exceed true economic gain without denuding a transaction of economic substance, here there was no substantial business purpose to these partnerships. IRS wins.

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