Kornman & Associates, Inc. v. U.S.

Decision Date12 May 2008
Docket NumberNo. 06-11422.,06-11422.
Citation527 F.3d 443
PartiesKORNMAN & ASSOCIATES, INC., as tax matters partner for Valiant Investments 99-100, LP, a TEFRA Partnership, Plaintiff-Appellant, v. UNITED STATES of America, Defendant-Appellee. Colm Producer, Inc., as tax matters partner for GMK-GMK II, LP, a TEFRA Partnership, Plaintiff-Appellant, v. United States of America, Defendant-Appellee. Ettman Family Trust I, a 5-percent group of Valiant Investments 99-100, LP, a TEFRA Partnership, Plaintiff-Appellant, v. United States of America, Defendant-Appellee. Ettman Family Trust I, a partner of GMK-GMK II, LP, a TEFRA Partnership, Plaintiff-Appellant, v. United States of America, Defendant-Appellee.
CourtU.S. Court of Appeals — Fifth Circuit

Cole B. Ramey, Crouch & Inabnett, Jeffrey Mark Tillotson (argued), Lynn, Tillotson & Pinker, Dallas, TX, for Plaintiffs-Appellants.

Joan I. Oppenheimer (argued), Richard Bradshaw Farber, Gilbert S. Rothenberg, U.S. Dept. of Justice, Tax Div. App. Section, Washington, DC, Michelle C. Johns, U.S. Dept. of Justice, Tax Div., Dallas, TX, for U.S.

Appeal from the United States District Court for the Northern District of Texas.

Before KING, DeMOSS and SOUTHWICK, Circuit Judges.

DeMOSS, Circuit Judge:

In these consolidated TEFRA partnership proceedings,1 the Government argues that the Appellants attempted to create an enormous, artificial tax loss that is devoid of any economic content by using the short sale variant of the "Son of BOSS" tax shelter.2 Through a pre-arranged series of transactions involving the short sale of Treasury Notes (T-Notes) and subsequent transfers between a trust, two limited partnerships (LPs), and an individual, the Ettman Family Trust (the Trust) reported a short-term capital loss of approximately $102.6 Million on its 1999 tax return despite the fact that it only suffered an economic loss of approximately $200,000 in connection with those transactions.3 Because non-corporate taxpayers can carry an unused capital loss forward to succeeding taxable years until it is exhausted, the trust used this artificial capital loss in 1999 to offset its legitimate income and capital gains in 2000 and 2001.

On September 25, 2003, the Internal Revenue Service (IRS) mailed notices of final partnership administrative adjustment (FPAA) to Kornman & Associates, Inc. (K&A), the tax matters partner of Valiant Investments 99-100, L.P. (Valiant), and to Colm Producer, Inc. (Colm), the tax matters partner of GMK-GMK II, L.P. (GMK). On December 23, 2003, K&A and Colm filed timely petitions for readjustment of partnership items in the district court. See I.R.C. § 6226(a)(2). On February 19, 2004, the Trust filed a timely petition for readjustment of partnership items of both LPs. The district court granted the Government's motion for summary judgment and dismissed the actions with prejudice on December 1, 2006. The Appellants filed a timely notice of appeal.

Because we conclude that the obligation to close a short sale is a liability for purposes of I.R.C. § 752, we affirm the judgment of the district court.

I. Facts
A. The Participants

All of the participants in this pre-arranged series of transactions were connected to Gary Kornman, an attorney who marketed tax shelters to wealthy individuals. The Trust was organized for the benefit of Kornman and his descendants, and Kornman was its sole trustee in 1999. Valiant's general partner was K&A, and GMK's general partner was Colm. Kornman was the sole shareholder of both K&A and Colm. Brian Czerwinski, who ultimately purchased GMK's interest in Valiant, worked for the Heritage Organization, L.L.C. (Heritage), of which Kornman was the sole shareholder. Heritage filed for Chapter 11 bankruptcy in the United States Bankruptcy Court for the Northern District of Texas on May 17, 2004.

B. The Transactions

"Like many tax shelters it was complex in detail but simple in principle . . . ." Cemco Investors, L.L.C. v. United States, 515 F.3d 749, 750 (7th Cir.2008). On December 23, 1999, the Trust opened a brokerage account at Donaldson, Lufkin & Jenrette (DLJ) with a cash deposit of $2 Million. On December 27, 1999, the Trust used this deposit as margin and executed a short sale of $100 Million (face value) of T-Notes. This meant that the Trust borrowed the T-Notes from DLJ and then sold them on the open market. This short sale generated cash proceeds of approximately $102.5 Million, which was deposited in the Trust's brokerage account. After the completion of the short sale, the Trust's brokerage account consisted of approximately $104.5 Million in cash, comprised of the $2 Million initial deposit and the $102.5 Million short sale proceeds, plus an obligation to replace the borrowed property (i.e. return in-kind T-Notes to DLJ). The money in the brokerage account could not be withdrawn until the Trust returned the borrowed T-Notes to DLJ.

On the same day that it executed the short sale, December 27, 1999, the Trust transferred the brokerage account to Valiant in return for a 99.99% limited partnership interest in Valiant. By acquiring the brokerage account, Valiant assumed the obligation to replace the borrowed T-Notes. On December 28, 1999, the Trust transferred its interest in Valiant to GMK in return for a 99.99% limited partnership interest in GMK. The Trust then owned a 99.99% limited partnership interest in GMK, which owned a 99.99% limited partnership interest in Valiant, which owned the brokerage account consisting of $104.5 Million in cash and the obligation to replace the borrowed T-Notes.

On December 30, 1999, GMK sold its interest in Valiant to Czerwinski for a promissory note in the amount of $1.8 Million. Czerwinski assumed the obligation to close the short sale. The price that Czerwinski paid for Valiant reflected the reality that most of the cash in the brokerage account would be used to close the short sale. On that same day, December 30, 1999, the short sale was closed through the acquisition of T-Notes in three separate transactions at a total cost of approximately $102.7 Million, including accrued interest. These transactions were reported on the Trust's brokerage account statement. According to the Government, Czerwinski did not have any authority over this account; Kornman always remained the signatory.

C. The Tax Treatment of the Transactions

Although partnerships do not pay federal income tax, see I.R.C. § 701, they are required to file annual information returns reporting the partners' distributive share of income, gain, deductions or credits. Weiner v. United States, 389 F.3d 152, 154 (5th Cir.2004). The individual partners then report their distributive share on their federal income tax returns. Id.; see also I.R.C. § 702.

On its partnership return for 1999, GMK reported a short-term capital loss of $102.7 Million from the sale of its partnership interest in Valiant. It computed this loss by subtracting its purported outside basis in Valiant of $104.5 Million from the purported sales price of $1.8 Million. GMK did not treat Czerwinski's assumption of Valiant's obligation to replace the borrowed T-Notes as part of the amount realized on the sale of its partnership interest, and GMK's outside basis in the partnership interest was not adjusted or reduced based on the obligation to replace the shorted T-Notes.

GMK's reported loss of $102.7 Million enabled the Trust, a 99.99% partner in GMK, to offset its future capital gains. On Schedule D (Capital Gains and Losses) of its 1999 tax return (Form 1041), the Trust reported a short-term capital loss of $102.6 Million as its pro rata share of GMK's loss. I.R.C. § 1211(b) limited the deduction of capital losses to the lower of $3,000 or the excess of capital losses over capital gains. Having no capital gains in 1999, the Trust deducted $3,000 of its loss. It then carried over the remaining loss to 2000. See I.R.C. § 1212(b).

On its 2000 tax return, the Trust used the capital loss carryover to offset $562,000 in short-term capital gains and $123,000 in long-term capital gains. This offset reduced the Trust's net capital loss to $101.9 Million. The Trust then claimed a capital loss deduction of $3,000 on its 2000 tax return and carried forward the remaining loss to 2001. On its 2001 tax return, the Trust used this capital loss carryover to offset short-term capital gains of $1.1 Million and long-term capital gains of $585,000.

D. The Cross-Motions for Summary Judgment

In their motion for summary judgment, the Appellants relied upon I.R.C. § 1233 in arguing that the obligation to close a short sale is a "contingent liability," which does not constitute a liability for purposes of I.R.C. § 752. Second, the Appellants argued that the transaction was valid under the economic substance doctrine. Third, the Appellants argued that Treasury Regulation § 1.701-2(b), which was relied upon by the IRS to recharacterize the transaction, was invalid and unconstitutional. Fourth, the Appellants argued that Treasury Regulation § 1.752-6 does not apply to this case, is invalid because it exceeded the scope of the Congressional grant of authority, is invalid because it is impermissibly retroactive, and is unconstitutional under the Due Process Clause of the Fifth Amendment.

In response, the Government argued that the obligation to close a short sale is a liability for purposes of I.R.C. § 752. Second, the Government argued that Treasury Regulation § 1.752-6 requires that the obligation to close a short sale must be treated as a liability that reduces the Trust's outside basis in Valiant. Third, the Government argued that Treasury Regulation § 1.701-2, the Partnership Anti-Abuse Rule, was valid and allowed the IRS to recast the transaction as a sale of the brokerage account by the Trust, rather than a sale by GMK of its interest in Valiant, which purportedly owned the brokerage account. This recharacterization would result in a disallowance of the non-economic portion of GMK's loss....

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