Judge Wherry Tells it Like It Is
No, not a law firm, but a summary of Judge Wherry’s unwhimsical, but very illuminating, exegesis of the 6SOL, the sham-transaction-economic-substance-step-transaction thicket that courts have encountered since the days of Gregory v. Helvering, 293 U.S. 465 (1935), and the interplay of United States v. Woods, 571 U.S. ___, 134 S. Ct. 557 (2013) with United States v. Home Concrete Supply, LLC, 566 U.S. ___, 132 S. Ct. 1836 (2012).
All this is yours to enjoy (if you’re unusually warped mentally) in CNT Investors, LLC, Charles C. Carroll, Tax Matters Partner, 144 T. C. 11, filed 3/23/15.
Don’t panic, I won’t give a detailed recital of the 119 pages of Judge Wherry’s prose. I will only hit a few high points.
The deal was a backhand son-of-BOSS, concocted by Jenkins & Gilchrest, hawkers of dubious basis-builders. The aim was to separate land from buildings and business operations of Charlie’s funeral parlor empire, in order to sell the business to a big operator who didn’t want to buy the land. By keeping and net-leasing the land, Charlie could get continuing income.
The land was put into a phony partnership, the counterparty to Charlie teaming up with Deutsche Bank (well-known facilitator of tax dodges for a fee) to run a no-real-loss T-note short sale, with an immediate repo.
Land has basis of bupkis, FMV in seven figures, so short-sale generates huge paper loss because repo is not recognized as offsetting.
Everyone agrees this is a sham, but does the 6SOL apply? Charlie says no, because he’s Californian and the Keller case applies. You can’t have a substantial understatement of value in a sham transaction.
But Woods, supra, put paid to that argument.
What about Home Concrete? Overstated basis is not an omission of income, said the Supremes.
No good, says Judge Wherry, because Charlie’s unwinding of the phony partnership didn’t even mention the miniscule Section 311(b) pick-up from Charlie’s Sub S, created to hold the land and later dump it off to Charlie and kids, which is an omission of income entirely separate from the phony partnership.
“Under section 311(b), if a corporation distributes appreciated property to a shareholder, the corporation must recognize gain as if it had sold the property for fair market value. Where the corporation is an S corporation, that gain passes through and is taxable to the corporation’s shareholders pursuant to section 1366(a)(1). Yet neither [Charlie’s Sub S] nor its shareholders reported any of this gain. Hence, an item of gross income was omitted from … Form 1120S and from its three shareholders’ …Forms 1040. By respondent’s computations, because this omission amounted to more than 25% of gross income for each partner, section 6501(e)(1)(A) applies.” 144 T. C., 11, at p. 43.
That’s the 6SOL 25% omission test, except on the math it doesn’t as to two of the three [Charlie’s kids], but Charlie gets nailed.
Charlie objects that the FPAA that triggers this fight has to do with an entity other than the one from which Charlie got the gain, but that doesn’t matter. The issue here is that Charlie didn’t report what he got.
But Charlie says he really got nothing, because the whole transaction was a sham, and that he really has what he started with, namely the land, buildings and business. No, say IRS and Judge Wherry, the last step wasn’t a sham: you wanted to separate land from buildings and business, and you did. That you couldn‘t do it tax-free is your problem.
Now sham, economic substance and step transaction are all in play here. But what do those terms mean?
“The doctrines’ substantive similarities would not, alone, generate uncertainty for taxpayers (or tenure opportunities for tax academics) if courts applying the doctrines did so using consistent terminology. We have not.” 144 T. C. 11, at p. 51 (Footnote omitted).
There are two goals in play here. “On one hand, having clear, concrete rules embodied in a written Code and regulations that exclusively define a taxpayer’s obligations (1) facilitates smooth operation of our voluntary compliance system, (2) helps to render that system transparent and administrable, and (3) furthers the free market economy by permitting taxpayers to know in advance the tax consequences of their transactions. On the other side of the scales, the Code’s and the regulations’ fiendish complexity necessarily creates space for attempts to achieve tax results that Congress and the Treasury plainly never contemplated, while nevertheless complying strictly with the letter of the rules, at the expense of the fisc (and other taxpayers).” 144 T. C. 11, at pp. 58-59.
But all attempts to reduce the tax dodges to formulae will fail.
“Attempts to parse and define the doctrines merely intellectualize what is, ultimately, an equitable exercise. Those who favor transparency might prefer a strictly circumscribed taxonomy of judicial doctrines, to include exclusive definitions of the circumstances in which they should be applied. Those who favor administrability, protection of the fisc, and respect for congressional purpose might prefer that courts exercise carte blanche in disallowing results of transactions perceived as abusive.” 144 T. C. 11, at p 59.
Finally, Judge Wherry eschews academic sesquipedelianisms, and lays it on the line: “Litigants and courts employ specialized terminology to make this effort appear more rigorous, but candidly, underneath, we are simply engaged in the difficult, commonsense task of judging.” 144 T. C. 11, at pp. 59-60.
But some good news for Charlie. Though he is in the zone for the 40% chop, he wasn’t particularly hip, his G. I. Bill advanced degree was in mortuary science, he never owned stock or bonds, traded anything, and relied on his attorney of thirty years (who had some vague tax credentials). So Charlie escapes the chop.
But this is a T. C. well worth reading. Much good stuff here.