Kenna Trading, LLC v. Comm'r, 143 T.C. No. 18

• Decision Date: 16 October 2014
• Docket Number: Docket No. 9040-08,Docket No. 9128-08,Docket No. 9042-08,Docket No. 16796-08,Docket No. 9037-08,Docket No. 9036-08,Docket No. 9041-08,Docket No. 7625-08,Docket No. 9035-08,Docket No. 13981-09,Docket No. 9122-08,Docket No. 7555-08,Docket No. 9038-08,Docket No. 13982-09,Docket No. 7552-08,143 T.C. No. 18,Docket No. 9021-08,Docket No. 27636-09,Docket No. 7551-08,Docket No. 13983-09,Docket No. 19925-08,Docket No. 9126-08,Docket No. 7618-08,Docket No. 30586-09,Docket No. 7556-08,Docket No. 9123-08,Docket No. 9039-08,Docket No. 13980-09,Docket No. 9124-08,Docket No. 7553-08,Docket No. 9121-08,Docket No. 14094-08,Docket No. 671-10,Docket No. 19924-08,Docket No. 9127-08,Docket No. 7554-08,Docket No. 9125-08
• Parties: KENNA TRADING, LLC, JETSTREAM BUSINESS LIMITED, TAX MATTERS PARTNER, ET AL., Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

KENNA TRADING, LLC, JETSTREAM BUSINESS LIMITED,
TAX MATTERS PARTNER, ET AL., Petitioners¹
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

143 T.C. No. 18
Docket No. 7551-08
Docket No. 7552-08
Docket No. 7553-08
Docket No. 7554-08
Docket No. 7555-08
Docket No. 7556-08
Docket No. 7618-08
Docket No. 7625-08
Docket No. 9021-08
Docket No. 9035-08
Docket No. 9036-08
Docket No. 9037-08
Docket No. 9038-08
Docket No. 9039-08
Docket No. 9040-08
Docket No. 9041-08
Docket No. 9042-08
Docket No. 9121-08
Docket No. 9122-08
Docket No. 9123-08
Docket No. 9124-08
Docket No. 9125-08
Docket No. 9126-08
Docket No. 9127-08
Docket No. 9128-08
Docket No. 14094-08
Docket No. 16796-08
Docket No. 19924-08
Docket No. 19925-08
Docket No. 13980-09
Docket No. 13981-09
Docket No. 13982-09
Docket No. 13983-09
Docket No. 27636-09
Docket No. 30586-09
Docket No. 671-10

UNITED STATES TAX COURT

October 16, 2014

Brazilian retailers purportedly contributed distressed consumer receivables to a limited liability company, S, treated as a partnership for Federal income tax purposes. S claims carryover bases in these receivables under I.R.C. sec. 723. In 2004 S in turn contributed some of these Brazilian receivables to trading companies and contributed its interest in each trading company to a holding company. S claimed a cost of goods sold for each holding company equal to the basis of the receivables contributed. S then sold an interest in each holding company to an investor. The trading companies claimed bad debt deductions. In 2005 S allegedly contributed more of the Brazilian receivables to main trusts. Each main trust then assigned the receivables to a newly created subtrust. Investors allegedly contributed cash to the main trust in exchange for the beneficial interest in the subtrust. The subtrust claimed a bad debt deduction. Asserting that the subtrusts were, for Federal income tax purposes, grantor trusts, the investors claimed deductions on their tax returns. Mr. Rogers, the creator of the investment program, also invested in such a trust.

R disallowed the bad debt deductions, adjusted S' income for 2004 alleging that S inflated its cost of goods sold, determined that S failed to include all items of income in its gross receipts for 2004 and 2005, and disallowed S' business expense deductions. R also determined I.R.C. sec. 6662(h) gross valuation misstatement penalties against S, the trading companies, and Mr. and Mrs. Rogers, I.R.C. sec. 6662(a) accuracy-related penalties on the amounts of S' underpayments due to increased gross receipts for unreported income and the disallowed deductions, and an I.R.C. sec. 6662A listed transaction understatement penalty against S for the 2005 taxable year.

Held: The Brazilian retailers did not intend to enter into a partnership for Federal income tax purposes.

Held, further, S had a cost basis, not a carryover basis, in the receivables.

Page 2

Held, further, the transactions in issue lacked economic substance.

Held, further, the trading companies are not entitled to I.R.C. sec. 166 deductions.

Held, further, Mr. and Mrs. Rogers purchased their beneficial interest in the subtrust and are not entitled to a carryover basis.

Held, further, R properly disallowed the Rogerses' claimed I.R.C. sec. 166 deduction.

Held, further, S overstated its cost of goods sold.

Held, further, R correctly adjusted S' income to reflect certain unreported deposits.

Held, further, S is not entitled to the disallowed deductions.

Held, further, S and the trading companies are liable for the I.R.C. sec. 6662(h) gross valuation misstatement penalty.

Held, further, S is liable for an I.R.C. sec. 6662(a) and (b) accuracy-related penalty on the underpayments attributable to the omitted items of income and the disallowed deductions.

Held, further, R's I.R.C. sec. 6662A listed transaction understatement penalty against S is sustained insofar as related to the income from the trust transactions.

John E. Rogers (an officer), for petitioner Jetstream Business Limited.

John E. Rogers, for petitioners John E. and Frances L. Rogers.

Page 3

Ronald S. Collins, Jr., Laurie A. Nasky, and Bernard J. Audet, Jr. for respondent.

Michael D. Hartigan (an officer), for participating partners in docket Nos. 7552-08, 9039-08, 9121-08, and 13982-09.

WHERRY, Judge: In 2003 John Rogers developed, marketed, and sold investments, which also allegedly provided potential tax shelter, whereby investors in a partnership structure could claim partially worthless bad debt deductions under section 166² on certain distressed assets formerly owned by a Brazilian retailer. Those transactions did not produce the hoped-for tax benefits for the myriad of reasons outlined in our prior opinions and by the Court of Appeals for the Seventh Circuit. See Superior Trading, LLC v. Commissioner, 137 T.C. 70 (2011), supplemented by T.C. Memo. 2012-110, aff'd, 728 F.3d 676 (7th Cir. 2013). In 2004 Mr. Rogers sold the same shelter, this time using additional distressed assets of other Brazilian retailers. That same year, Congress modified the rules governing the allocation of built-in loss property contributed to a partnership, rendering the partnership flow-through loss-shifting shelter

Page 4

impotent.³ Undeterred, for various transactions entered into after October 22, 2004, Mr. Rogers selected and used a trust structure to attempt to gain the same tax benefits for himself and various investor-clients.

Respondent has challenged all of the partially worthless bad debt deductions under section 166, for the partnerships⁴ involved in the 2004 tax year⁵ as well as for Mr. Rogers and his wife, Frances Rogers, who claimed a section 166 deduction on their individual tax return for 2005 using the trust variant. We consolidated the Rogerses' case with the partnership cases for the purpose of resolving only the section 166 deduction issue in that case.⁶

Page 5

Respondent also challenged certain aspects of the 2004 and 2005 partnership returns of Sugarloaf Fund, LLC (Sugarloaf), the common ancestor in the many-branched family tree of partnerships and trusts through which investors in Mr. Rogers' shelters claimed tax losses. First, respondent alleges that Sugarloaf overstated its cost of goods sold for 2004 and 2005 on account of inflated tax bases of sold partnership interests. In addition, after concessions, respondent

Page 6

alleges adjustments to Sugarloaf's partnership income due to alleged underreported income of $299,996 and $925,467 for the 2004 and 2005 taxable years, respectively.⁷ Respondent also disallowed a number of Sugarloaf's claimed deductions, amounting to $747,069 for the 2004 tax year and $982,436 for the 2005 tax year, as unsubstantiated.

Respondent determined against Sugarloaf for each tax year a section 6662(a) and (h) penalty for a gross valuation misstatement, a section 6662(a) penalty on the amount of the underpayment attributable to each year's disallowed deductions, and a section 6662A penalty for understatements attributable to undisclosed reportable or listed transactions. Against the lower tier partnerships whose cases were tried with Sugarloaf's, respondent determined penalties under section 6662(a) and (h) due to gross valuation misstatements and section 6662(a) and (b)(1), (2), and (3) penalties due to negligence, substantial understatements of income tax, and substantial valuation misstatements.

Page 7

Jetstream, as tax matters partner for Sugarloaf and each of the other partnerships whose cases we consolidated with Sugarloaf's for trial, petitioned this Court for readjustment of partnership items and redetermination of penalties.⁸

In this Opinion, we resolve: (1) whether Jetstream and the Brazilian retailers formed a bona fide partnership for Federal income tax purposes for purposes of servicing and collecting distressed consumer receivables owed to the retailers; (2) whether the Brazilian retailers made valid contributions of the receivables to the purported partnership under section 721; (3) whether the retailers' claimed contributions to and subsequent redemptions from Sugarloaf should be collapsed into a single transaction and treated as a sale of the receivables, such that the receivables had a cost basis under section 1012 rather than a carryover basis under section 723; (4) whether the 2004 partnership transactions had economic substance; (5) whether the 2004 partnership transactions satisfied the statutory prerequisites for a section 166 deduction; (6) whether the 2005 trust transactions should be collapsed into sales or lacked economic substance, such that Mr. and Mrs. Rogers' trust investment would not

Page 8

entitle them to a section 166 deduction for 2005; (7) whether Sugarloaf understated gross income for the 2004 and 2005 tax years; (8) whether Sugarloaf is entitled to various deductions for the 2004 and 2005 tax years; (9) whether Sugarloaf and the other partnerships are liable for section 6662(a) penalties; and (10) whether Sugarloaf is liable for the section 6662A penalty.

We hold for respondent on all issues.⁹

FINDINGS OF FACT

The parties' stipulation of facts, supplemental stipulation of facts, and second supplemental stipulation of facts, all with the facts found from the accompanying exhibits, are incorporated herein by this reference, as are all stipulations of settled issues filed in various of these consolidated cases.¹⁰ The parties have...