Kerman v. Comm'r

• Citation: 713 F.3d 849
• Decision Date: 27 June 2013
• Docket Number: No. 11–1822.,11–1822.
• Parties: Mark L. KERMAN and Lucy M. Kerman, Petitioners–Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (6th Circuit)

713 F.3d 849

Mark L. KERMAN and Lucy M. Kerman, Petitioners–Appellants,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellee.

No. 11–1822.

United States Court of Appeals, Sixth Circuit.

Argued: Dec. 6, 2012.

Decided and Filed: April 8, 2013.

Rehearing and Rehearing En Banc Denied June 27, 2013.

ARGUED:Donald L. Cox, Lynch, Cox, Gilman & Goodman, PSC, Louisville, Kentucky, for Appellants. Judith A. Hagley, United States Department of Justice, Washington, D.C., for Appellee. ON BRIEF:Donald L. Cox, Clare Feler Cox, Matthew D. Watkins, Lynch, Cox, Gilman & Goodman, PSC, Louisville, Kentucky, for Appellants. Judith A. Hagley, Tamara W. Ashford, Gilbert S. Rothenberg, Richard Farber, United States Department of Justice, Washington, D.C., for Appellee.

Before: KETHLEDGE and WHITE, Circuit Judges; LUDINGTON, District Judge.^*

OPINION

LUDINGTON, District Judge.

A tax shelter can be legitimate—if the reported transaction has economic substance. But the shelter Mark Kerman participated in lacked such substance. The transaction had no purpose other than the creation of an income tax benefit. After Kerman claimed the benefit on his tax return, the IRS disallowed the deduction and imposed a valuation misstatement penalty pursuant to 26 U.S.C. § 6662(e), which was increased to 40 percent of the unpaid tax pursuant to § 6662(h). The tax court affirmed the IRS's decision. Kerman appeals, contending that the shelter was legitimate and that, even if it was not, the penalty should not be imposed. Because the transaction lacked economic substance and Kerman lacked reasonable cause or good faith to believe that it did, we AFFIRM.

I

A

Mark Kerman is a college-educated multi-millionaire.¹ After earning a bachelor's degree in business administration from the University of Louisville, Kerman founded Kenmark Optical, Inc., a wholesale distributor of eyeglass frames. Headquartered in Kentucky, Kenmark imports frames from around the world and sells them to optical retailers, opticians, and optometrists under both its own brand and other licensed brands (such as Hush Puppies®).

Founded in 1972, Kenmark initially had annual sales of about $2 million. By 1990, annual sales had grown to $20 million. By 2000—the tax year at issue in this case—annual sales approached $35 million. Kerman's wealth grew with his company's successes. In 2000, his personal net worth topped $12.5 million.

Kenmark finances its operations in part through a credit line with National City Bank. In 2000, Kenmark's credit line was $12 million, with an interest rate of prime minus one-half percent (8.5 percent).

From its founding until 2000, Kerman was the sole owner of Kenmark. This changed in May 2000, however, when Kerman sold an ownership interest to Kenmark's employee stock ownership plan. Specifically, he sold 27 percent of his stock for $6.1 million, realizing a taxable gain of $5.4 million.

Looking to shelter the gain, Kerman consulted his long-time friend and personal financial advisor, Bruce Cohen. The two men discussed two tax-savings strategies. One was a “basis boost” transaction, which Kerman decided not to pursue. The other was a “CARDS” transaction, which he did pursue.

B

CARDS, short for “Custom Adjustable Rate Debt Structure,” was a tax-saving strategy introduced in the 1990s. Developed and promoted by Chenery Associates, Inc., the strategy centered on a “high basis, low value” foreign currency loan designed to create a tax benefit by offsetting real taxable income against an artificial tax loss.

Briefly, CARDS was designed to proceed in three stages: origination, assumption, and operation. It would start when a British company (not subject to U.S. tax law) borrowed a large amount of foreign currency from a foreign bank. A U.S. taxpayer (for whom the CARDS transaction was organized) would then receive a small amount of the borrowed currency from the British company. And the taxpayer would agree to be jointly liable for the full amount of the loan. The taxpayer would then exchange his portion of the foreign currency for dollars. A currency exchange is a taxable event. The taxpayer would claim that the currency's basis (the initial cost of the assets acquired) was the full amount of the loan, not simply the small amount of the currency actually purchased from the British company. Because of the currency's inflated basis, the taxpayer would claim that the exchange generated a large taxable loss. The dollars would be deposited in the same foreign bank with the balance of the foreign currency. One year later, the funds would be used to pay off the loan. Because the loan would be repaid rather than forgiven, the taxpayer would not recognize discharge of indebtedness income.

To illustrate the model with monetary values: A British company borrows $5 million worth of euros from a foreign bank. A U.S. taxpayer then purchases $750,000 worth of the euros from the British company and agrees to be jointly liable for the entire loan—the full $5 million. The taxpayer exchanges the euros he actually purchased for dollars. For economic purposes, the currency exchange is a wash—$750,000 worth of euros for $750,000. For tax purposes, however, the taxpayer claims a $4.25 million loss, on the theory that his basis in the exchanged euros was $5 million. All of the currency—dollars and euros—remains at the bank as collateral, where they are used to unwind the loan one year later. Thus, the taxpayer is able to report a large tax loss without an economic loss.

In a nutshell that's the CARDS strategy. But the substance of the strategy (more precisely, the lack thereof), is in the details.

To set the strategy in motion, Chenery needed not only a client—a U.S. taxpayer seeking shelter for a taxable gain—but the cooperation of three other parties as well. First, it needed a foreign bank to make the loan. It found a willing partner in German bank Bayerische Hypo-und Vereinsbank AG (“HVB”). ² Next, Chenery obtained the cooperation of a partner at a prominent law firm, Raymond Ruble of Brown & Wood, LLP,³ who prepared a sample tax opinion concluding that the CARDS strategy is a legitimate type of tax shelter. And it needed a few Brits.

That is, each particular CARDS transaction begins with British citizens creating a limited liability company for the sole purpose of facilitating the particular transaction for a U.S. taxpayer. Registered in Delaware, the LLC is capitalized according to the size of the tax loss that the U.S. taxpayer wishes to generate (specifically, the cooperating bank requires the LLC to be capitalized at 3 percent of the face value of the foreign currency loan). While a separate LLC is created for each CARDS transaction, the members are always British citizens, so that the LLC is a tax resident of Great Britain. This is important for tax purposes because under the US–Great Britain tax treaty, the LLC will not be subject to U.S. income tax.

Shortly after its creation, the LLC enters into a credit agreement for a loan denominated in foreign currency with one of the foreign banks privy to the CARDS strategy, such as HVB. The loan is denominated in foreign currency because a loss realized on the disposition of foreign currency is an “ordinary” loss under U.S. tax law, which may be used to offset both ordinary income and capital gains.

The loss that the taxpayer wants to recognize through the CARDS transaction determines the amount of the loan. The loan has a 30–year term, with interest payments due annually and the principal due after 30 years. Under the credit agreement, however, the loan may be unwound by either party without penalty after the first year (and, moreover, the parties informally agree that the loan will in fact be unwound after the first year). The interestrate on the loan floats with the LIBOR plus a credit spread.

Importantly, the bank retains the proceeds of the loan as the “collateral” for the loan. This ensures that the loan may be repaid from the liquid collateral at any time. And it ensures that the LLC cannot default on its obligations to make interest payments on the loan.

After executing the credit agreement with the bank, the LLC executes a purchase agreement with the particular U.S. taxpayer who has initiated the CARDS transaction.

Under the purchase agreement, the LLC transfers the present value of the principal repayment—15 percent of the loan proceeds denominated in euros—to the taxpayer in exchange for the taxpayer's commitment to repay the principal when the loan matures. (The LLC is also compensated by Chenery for its troubles, which, in turn, is compensated by the taxpayer.)

The purchase agreement provides that the LLC will make the annual interest payment and the taxpayer will repay the principal. It further provides that the taxpayer will sign the LLC's credit agreement with the bank as a co-obligor and assume joint and several liability for the full amount of the loan. This is important for tax purposes because under assumption of liability principles the taxpayer claims that his basis is not the 15 percent of the loan proceeds that he actually received, but the 100 percent of the loan that he agreed to be jointly and severally liable for.

The taxpayer then exchanges his 15–percent share of the loan (received in euros) for U.S. dollars—a taxable event. Claiming a basis in the full amount of the loan, the taxpayer realizes a tax loss of 85 percent of the face value of the loan. (On a $5 million loan, for example, the taxpayer's “loss” would be $4.25 million.)

The U.S. currency is deposited with the bank, where it earns interest (at a lower rate than the interest charged on the loan). Then, one year after it began, the transaction is unwound. The “collateral” held by the bank (the money loaned) is used to pay off the loan. But because the loan is repaid rather than forgiven the taxpayer does not recognize a “discharge of indebtedness” gain.

For setting up the structure, Chenery charges a fee of 10 percent of the total...