Klamath Strategic Investment Fund v. U.S.

Decision Date15 May 2009
Docket NumberNo. 07-40861.,07-40861.
Citation568 F.3d 537
PartiesKLAMATH STRATEGIC INVESTMENT FUND, by and through ST. CROIX VENTURES (Managing member), Plaintiff-Appellee-Cross-Appellant, v. UNITED STATES of America, Defendant-Appellant-Cross-Appellee. Kinabalu Strategic Investment Fund, by and through Rogue Ventures LLC (Managing member), Plaintiff-Appellee-Cross-Appellant, v. United States of America, Defendant-Appellant-Cross-Appellee.
CourtU.S. Court of Appeals — Fifth Circuit

Kent Jones, Sutherland, Asbill & Brennan, Washington, DC, N. Jerold Cohen, Thomas A. Cullinan (argued), Sutherland, Asbill & Brennan, Atlanta, GA, for Plaintiffs-Appellees-Cross-Appellants.

Arthur Thomas Catterall (argued), Richard Bradshaw Farber, Gilbert S. Rothenberg, U.S. Dept. of Justice, Tax Div., App. Section, Washington, DC, for U.S.

Appeals from the United States District Court for the Eastern District of Texas.

Before GARWOOD, GARZA and OWEN, Circuit Judges.

EMILIO M. GARZA, Circuit Judge:

In this tax case, Plaintiffs Klamath Strategic Investment Fund ("Klamath") and Kinabalu Strategic Investment Fund ("Kinabalu") (collectively, the "Partnerships") filed suit against defendant the United States of America for readjustment of partnership items. Both parties appeal various aspects of the district court's readjustment determination. For the following reasons, we affirm in part, vacate in part, and remand.


This case involves a highly complex series of financial transactions, which the district court categorized as a tax shelter known as Bond Linked Issue Premium Structure ("BLIPS"). The transactions were undertaken by two law partners, Cary Patterson and Harold Nix. Patterson and Nix's law firm represented the State of Texas in litigation against the tobacco industry and each partner earned around $30 million between 1998 and 2000. Interested in managing this wealth, Patterson and Nix requested their long-time accounting firm, Pollans & Cohen, to investigate investment opportunities.

The accountants identified Presidio Advisory Services ("Presidio"), an investment advisory firm purporting to specialize in foreign currency trading. Presidio advocated a complex plan involving strategic investments in foreign currencies pegged to the U.S. dollar. Patterson and Nix agreed to invest in Presidio's plan. Generally, the Presidio strategy was structured as a three-stage, seven-year investment program. Stage I lasted 60 days and entailed relatively low risk investments. Stage II lasted from day 60 through day 180, and the risk was somewhat higher. Stage III extended from day 180 through the end of the seventh year and involved the highest risk as well as potentially the highest return. At each stage of the plan, Presidio required the investors to contribute significantly more capital. The investors retained the right to exit the plan at the end of Stage I and at each 60-day period thereafter.

To implement the strategy Presidio formed Klamath and Kinabalu as limited liability companies, taxed as partnerships. Next, Presidio formed two single-member LLCs, which are disregarded for tax purposes: St. Croix for Patterson and Rogue for Nix. Patterson owned 100% of St. Croix, and St. Croix became a 90% partner of Klamath. The other 10% partners of Klamath were Presidio Resources LLC and Presidio Growth LLC. Presidio Growth was the managing partner. Kinabalu had a similar structure. Nix owned 100% of Rogue, and Rogue was a 90% partner of Kinabalu. The other 10% partners of Kinabalu were Presidio Growth and Presidio Resources, with Presidio Growth acting as the managing partner.

To fund Klamath and Kinabalu, Patterson and Nix (acting through St. Croix and Rogue) made two distinct contributions. First, they each contributed $1.5 million to their respective partnership. Second, they entered into loan transactions with National Westminster Bank ("NatWest"), where the bank loaned each company $66.7 million. This included $41.7 million denominated as the "Stated Principal Amount" and $25 million as a "loan premium." The classification of the $25 million as something different than the principal loan amount is central to this case. The loan premium was given in exchange for Patterson and Nix paying NatWest a higher than market interest rate on the principal: 17.97%. To protect NatWest from the possibility that the loans would be repaid early and the benefit of the higher interest rate would not be realized, the credit agreements required that a prepayment amount be paid if the loans were paid off early. The prepayment amount would vary depending on when the loan was repaid, starting at about $25 million and decreasing over seven years. After year seven, no prepayment amount would apply.

Patterson and Nix each contributed the $66.7 million to Klamath and Kinabalu and assigned the corresponding loan obligations to the Partnerships. The Partnerships deposited the funds into accounts controlled by NatWest. Presidio directed Klamath and Kinabalu to use these funds to purchase very low risk contracts on U.S. dollars and Euros. They also made small, short 60- to 90-day term forward contract trades in foreign currencies. These were the only investments the Partnerships ever made, and Patterson and Nix elected to withdraw from Klamath and Kinabalu before the end of Stage I. They received cash and Euros on liquidation, and they sold the Euros in 2000, 2001, and 2002.

On their income tax returns for 2000, 2001, and 2002, Patterson claimed total losses of $25,277,202 arising from Klamath's activities and Nix claimed total losses of $25,272,344 arising from Kinabalu's. These massive losses occurred because each partner claimed a significant tax basis in their respective partnership. Generally, a partner's basis in a partnership is determined by the amount of capital he contributes to the partnership, and when a partnership loses money the partners can only deduct the losses from their taxable income to the extent of their basis in the partnership. When a partnership assumes a partner's individual liabilities, the liability amount is subtracted from the partner's basis.1 Patterson and Nix were able to report such high losses because when they each calculated their basis in the partnership, they did not reduce it by the $25 million loan premium amount. When Patterson and Nix contributed the $66.7 million plus the $1.5 million to Klamath and Kinabalu, they would have each had a $68.2 million basis in their partnership. However, the Partnerships also assumed the loan obligations, so Patterson and Nix's bases had to be reduced by the amount of the liabilities. Patterson and Nix did not consider the loan premiums to be liabilities, so they only subtracted the $41.7 million principal amount. Therefore, each claimed a taxable basis in the partnership in excess of $25 million. This meant that when Patterson and Nix sold the Euros, they were able to deduct over $25 million from their taxable income.2

The IRS disagreed with this basis calculation, and in 2004 issued Final Partnership Administrative Adjustments ("FPAAs") to Klamath and Kinabalu stating that under 26 U.S.C. § 752 of the Internal Revenue Code (the "Code"), the partners should have treated the entire $66.7 million as a liability. Alternatively, the IRS argued that the transactions were shams or lacked economic substance and should be disregarded for tax purposes. The FPAAs also made adjustments to operational expenses reported by the Partnerships and asserted accuracy-related penalties. Patterson and Nix paid the taxes owed based on the FPAAs, and then reformed the partnerships in order to seek readjustment in the district court.

The Partnerships filed suit against the Government under 26 U.S.C. § 6226 for readjustment of partnership items. The Partnerships moved for partial summary judgment, and the Government cross-moved for summary judgment on the issue of whether the partners' tax bases were properly calculated; specifically, whether the loan premiums constituted liabilities under § 752 of the Code. The district court granted the Partnerships' motion and denied the Government's, holding that the loan premiums were not liabilities under § 752 and therefore the partners' bases were properly calculated under the Code. However, following a bench trial the district court held that the loan transactions must nonetheless be disregarded for federal tax purposes because they lacked economic substance. The district court also concluded that the penalties asserted by the IRS did not apply and the Partnerships' operational expenses were deductible. The Government moved the court to reconsider and vacate its summary judgment decision, arguing that the decision was mooted by the bench trial judgment. The court denied this motion. Finally, the court issued an order holding that it had jurisdiction to order a refund to the Partnerships, and that Patterson and Nix could deduct the $250,000 management fee paid to their accountants.

The Government appeals the district court's partial summary judgment in favor of the Partnerships, arguing that the "loan premiums" constitute liabilities under § 752. The Government also argues that the Partnerships are liable for penalties, that operating expenses and fees may not be deducted, and that the district court lacked jurisdiction to order a refund to the Partnerships. The Partnerships cross-appeal the district court's bench trial judgment, arguing that the loan transactions had economic substance.


We review the district court's grant of summary judgment de novo, applying the same standard as the district court. Kornman & Assocs. v. United States, 527 F.3d 443, 450 (5th Cir.2008). On appeal from a bench trial, we review findings of fact for clear error and legal issues de novo. Houston Exploration Co. v. Halliburton Energy Servs., Inc., 359 F.3d 777, 779 (5th Cir.2004). Specifically, we have held that a district court's characterization of a transaction for tax purposes is a...

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