Superior Trading, LLC v. Comm'r of Internal Revenue

• Decision Date: 01 September 2011
• Docket Number: 20652–07,20653–07,20338–07,20232–07,20936–07,20867–07,20230–07,20337–07,20654–07,20870–07,19543–08.,20243–07,Nos. 20171–07,20655–07,20871–07,s. 20171–07
• Citation: 137 T.C. No. 6,137 T.C. 70
• Parties: SUPERIOR TRADING, LLC, Jetstream Business Limited, Tax Matters Partner, et al., 1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
• Court: U.S. Tax Court

137 T.C. 70
137 T.C. No. 6

SUPERIOR TRADING, LLC, Jetstream Business Limited, Tax Matters Partner, et al., 1 Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

Nos. 20171–07

20230–07

20232–07

20243–07

20337–07

20338–07

20652–07

20653–07

20654–07

20655–07

20867–07

20870–07

20871–07

20936–07

19543–08.

United States Tax Court.

Sept. 1, 2011.

[137 T.C. 70]

R denied losses claimed by Ps, tax matters or other participating partners on behalf of purported partnerships, relating to distressed consumer receivables acquired from a Brazilian retailer in bankruptcy reorganization. R adjusted partnership items, attributing a zero basis to the receivables in lieu of the claimed carryover basis in the full face amount of the receivables. R determined accuracy-related penalties under sec. 6662(h), I.R.C., for gross valuation misstatements of inside bases.

Held: Ps failed to establish that the distressed consumer receivables had any tax basis upon transfer from the Brazilian company.

Held, further, the purported contribution of the receivables by the Brazilian company to a nominal partnership and the subsequent redemption of the Brazilian company's

[137 T.C. 71]

partnership interest are properly treated as a single transaction and recharacterized as a sale of the receivables.

Held, further, Ps did not substantiate the amount paid for the receivables, and therefore the receivables have a zero basis for Federal tax purposes following their transfer.

Held, further, Ps were unable to demonstrate good faith and reasonable cause, and therefore the accuracy-related penalties are sustained.

Paul J. Kozacky, John N. Rapp, Jeffrey G. Brooks, John A. Cochran, and Ralph Minto, Jr., for petitioners.

Lawrence C. Letkewicz and Laurie A. Nasky, for respondent.

WHERRY, Judge:

Each of these consolidated cases constitutes a partnership-level proceeding under the unified audit and litigation provisions of the Tax Equity and Fiscal Responsibility Act of 1982, Pub.L. 97–248, sec. 402(a), 96 Stat. 648, commonly referred to as TEFRA. The issues for decision are: (1) Whether a bona fide partnership was formed for Federal tax purposes between a Brazilian retailer and a British Virgin Islands company for purposes of servicing and collecting distressed consumer receivables owed to the retailer; (2) whether this Brazilian retailer made a valid contribution of the consumer receivables to the purported partnership under section 721; ² (3) whether these receivables should receive carryover basis treatment under section 723; (4) whether the Brazilian retailer's claimed contribution and subsequent redemption from the purported partnership should be collapsed into a single transaction and recharacterized as a sale of the receivables; and (5) whether the section 6662 accuracy-related penalties apply.

Background

The alphabet soup of tax-motivated structured transactions has acquired yet another flavor—“DAD”. DAD is an acronym for distressed asset/debt, the essential transaction at the core of these consolidated partnership-level proceedings. See the Commissioner's “Distressed Asset/Debt Tax Shelters/Coordinated Issue Paper”, LMSB–04–0407–031 (Apr. 18, 2007). It

[137 T.C. 72]

seems only fitting that after devoting countless hours in the last decade to adjudicating Son–of–BOSS transactions, we have now progressed to deciding the fate of DAD deals. And true to the poet's sentiment that “The Child is father of the Man”, the DAD deal seems to be considerably more attenuated in its scope, and far less brazen in its reach, than the Son–of–BOSS transaction.

A Son–of–BOSS transaction seeks to exploit the narrow definition of a partnership liability under section 752 to conjure up a tax loss. For a detailed description of the contours of a prototypical Son–of–BOSS transaction, see Kligfeld Holdings v. Commissioner, 128 T.C. 192, 2007 WL 1556083 (2007). In a nutshell, the Son–of–BOSS stratagem pairs a contingent liability that evades the reach of section 752 with an asset and contemplates a contribution of the liability-ridden asset to a purported partnership. The euphemistically termed “taxpayer” then claims an artificially inflated basis as a consequence of the contribution. Upon subsequently unwinding the contribution and settling the matching liability, the alleged partner contends that he has suffered a loss recognizable for tax purposes. See id.

By contrast, a DAD deal is more subtle. 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.

Because of a DAD deal's comparatively modest grab and highly stylized garb, we can safely address its sought-after tax characterization without resorting to sweeping economic substance arguments. Those arguments have underpinned the judicial resolution of statutory provisions that have protected the public fisc against the attacks of Son–of–BOSS opportunists. See, e.g., Cemco Investors LLC v. United States, 515 F.3d 749, 752 (7th Cir.2008); New Phoenix Sunrise Corp. & Subs. v. Commissioner, 132 T.C. 161, 185, 2009 WL 960213 (2009), affd. 408 Fed. Appx. 908 (6th Cir.2010);

[137 T.C. 73]

Jade Trading, LLC v. United States, 80 Fed. Cl. 11 (2007), revd. on other grounds 598 F.3d 1372, 1376 (Fed.Cir.2010). Unlike the stilted single-entity Son–of–BOSS transaction, a DAD deal requires a minimum of two parties, with one willing to give up something of substantive value. In an arm's-length world, this would happen only if adequate compensation changed hands. Consequently, we need only look at the substance lurking behind the posited form, and where appropriate, step together artificially separated transactions, to get to the proper tax characterization. But we are getting ahead of ourselves.

FINDINGS OF FACT I. Introduction

All of the consolidated cases involve, directly or indirectly, Warwick Trading, LLC (Warwick), an Illinois limited liability company. Our narrative begins on May 7, 2003, when Warwick entered into a Contribution Agreement (contribution agreement) with Lojas Arapua, S.A. (Arapua), a Brazilian retailer in bankruptcy reorganization.³

Arapua, a public company headquartered in Sao Paulo, Brazil, was at one time the largest retailer of household appliances and consumer electronics in Brazil.⁴ Arapua's growth had been driven, in large part, by its consumer credit program. Arapua had been the first company in Brazil to grant credit directly to its retail customers in order to increase sales.

Many of Arapua's credit customers had become delinquent in their payments, and some of these delinquent accounts, constituting Arapua's past due receivables, were the subject of the contribution agreement. Pursuant to this agreement, Arapua purported to contribute to Warwick certain past due consumer receivables in exchange for 99 percent of the membership interests in Warwick. At different times during the latter half of 2003, Warwick, in turn, claims to have contributed varying portions of the Brazilian consumer receivables acquired from Arapua in exchange for a 99–percent membership

[137 T.C. 74]

interest in each of 14 different limited liability companies (trading companies).⁵

Individual U.S. investors acquired membership interests in the various trading companies through yet another set of limited liability companies (holding companies). To accomplish this, Warwick contributed virtually all of its membership interests in each given trading company to the corresponding holding company. During the years at issue, Jetstream Business Limited (Jetstream), then a British Virgin Islands company, was the managing member of Warwick and of each of the trading companies and holding companies. The tax matters or other participating partners of Warwick and the trading companies have brought these consolidated actions on behalf of their respective entities.

All of these entities elected to be treated as partnerships for Federal income tax purposes and claimed a carryover basis in the Brazilian consumer receivables that were the subject of the contribution agreement. During 2003 and 2004, each of the trading companies wrote off almost the entire basis in its share of the Brazilian consumer receivables ostensibly resulting in business bad debt deductions and, in one instance, a capital loss.

Individual U.S. investors holding membership interests in a given trading company, through the corresponding holding company, claimed the benefits of these deductions on their respective Federal income tax returns. Warwick also claimed losses on the sale of membership interests in the holding companies to the individual U.S. investors. Pursuant to TEFRA's unified partnership-level audit provisions, respondent issued notices of final partnership administrative adjustment (FPAAs) denying these deductions and attacking the characterization of the transactions engaged in by Warwick and the trading companies on several grounds including lack of economic substance, the partnership antiabuse rules of section 1.701–2, Income Tax Regs., the disguised sale rules of section 707(a)(2)(B), and the transfer pricing rules of section 482.⁶ Further, the FPAAs adjusted the partnerships'

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bases in the receivables to zero and determined accuracy-related penalties for gross valuation misstatements under section 6662(h).

Petitioners timely petitioned the Court challenging the FPAAs. A trial was conducted the week of October 5, 2009, in Chicago, Illinois.

II. Mr. Rogers'...