Rigas v. U.S.

• Decision Date: 02 May 2011
• Parties: JOHN A. RIGAS, and CARRIE RIGAS, Plaintiffs, v. UNITED STATES OF AMERICA, Defendant.
• Court: U.S. District Court — Southern District of Texas

JOHN A. RIGAS, and CARRIE RIGAS, Plaintiffs,

v.UNITED STATES OF AMERICA, Defendant.

CIVIL ACTION NO. H-09-3770

UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF TEXAS HOUSTON DIVISION

Dated: May 2, 2011

MEMORANDUM AND ORDER

Pending before the Court are the cross-motions for summary judgment of Plaintiffs John A. Rigas and Carrie Rigas (collectively, the "Rigases") and Defendant United States of America (the "Government"), and Plaintiffs' Motion to Shift the Burden of Proof. Upon considering the Motions, all responses thereto, arguments of counsel, and the applicable law, the Court finds that Plaintiffs' Motion to Shift the Burden of Proof (Doc. No. 30) must be granted, Plaintiffs' Motion for Summary Judgment (Doc. No. 38) must be denied, and Defendant's Motion for Summary Judgment (Doc. No. 32) must be granted.

I. BACKGROUND

This is a tax refund case brought by the Rigases against the Government. The Rigases claim they are entitled to a refund on their 2004 personal income tax return because income that was reported and taxed as ordinary income should have been reported and taxed as capital gains. The income that is the source of the dispute are proceeds from a business relationship between Odyssey Energy Capital I, LP ("Odyssey") and Hydrocarbon Capital LLC ("Hydrocarbon").

Prior to 2003, John Rigas, David Stewart, R. Kelly Plato, Harold Abels, and Robert Loving worked for Mirant Corporation ("Mirant") and managed Mirant's oil and gasinvestments. (Stip. of Facts ¶ 2.) In March 2003, Hydrocarbon purchased from Mirant a portfolio of interests related to the oil and gas industry, including credit agreements, royalty interests, and stock warrants. (Id. ¶ 1.) Hydrocarbon asked the five former Mirant employees to manage the portfolio of assets due to their past management experience. (Id. ¶ 2.) The five men formed Odyssey to carry out the management functions. (Id.) Each man was a limited partner in Odyssey, while Odyssey's general partner was a limited liability corporation. (Doc. 32 Ex. 7.)

Odyssey and Hydrocarbon entered into a Loan Management and Servicing Agreement (the "Management Agreement"). (Doc. 32 Ex. 5.) Under the terms of the Management Agreement, Odyssey provided servicing, management, administration and disposition services with respect to the asset portfolio, including the hiring of necessary environmental and petroleum consultants and conducting physical inspection of the assets within the portfolio. (Id. Art. V.) Odyssey agreed to maintain an office, to employ adequate personnel, to collect payments on the assets, and to track overhead expenses. (Id.) Odyssey's overhead expenses, including salaries of the individual partners of Odyssey, were funded through a $6 million nonrecourse promissory note (the "Promissory Note") issued by Hydrocarbon to Odyssey. (Doc. No. 32 Exs. 3, 10.) On a semiannual basis, Odyssey would submit a budget for overhead expenses to Hydrocarbon for its review and approval. Once approved, Hydrocarbon would draw down sums from the promissory note and wire the loan funds to Odyssey. (Id.)

Odyssey possessed the authority to take actions with respect to the assets that were in the best interest of Hydrocarbon. (Id. Art. VII.) However, Odyssey was subject to certain limitations on its authority, including the inability to enter into binding commitments to dispose of assets, to incur unforeseen expenses, and to enter into transactions that were not previously approved by Hydrocarbon. (Id.) Odyssey acknowledged that Hydrocarbon retained title, ownership, andexclusive control of the assets and that Odyssey would not acquire title to, any security interest in, or rights of any kind in the assets. (Id. Art. II.) Finally, Article 18.1 of the Management Agreement provided,

No Partnership Intended. Nothing in this Agreement shall be deemed or construed to create a partnership or joint venture between or among any of the parties hereto nor shall [Odyssey] be deemed to be the general partner of [Hydrocarbon]. It is specifically acknowledged and agreed that, in performing its duties and obligations hereunder, [Odyssey] is acting solely in the capacity as an independent contractor for, and an agent of, [Hydrocarbon].

Under the Management Agreement, Odyssey would be paid a performance fee (the "Performance Fee") "[a]s full compensation for rendering services." (Doc. No. 32 Ex. 5 at 33.) The Performance Fee would be paid after disposing of income realized on the asset portfolio in the following manner. First, Hydrocarbon would recoup all third-party out-of-pocket expenses. Second, Hydrocarbon would recoup the initial value of the asset portfolio. Third, Hydrocarbon would receive a preferred return of 10% of the profits. Fourth, Hydrocarbon would use the remaining funds to pay off any amounts outstanding on the Promissory Note. Fifth and finally, Odyssey and Hydrocarbon would split the profits whereby Odyssey would take 20% of the profits and Hydrocarbon would retain 80% of the profits. (Id. at 33-34.) Odyssey's Performance Fee was subject to a "claw-back" provision that ensured Hydrocarbon would receive the amounts provided for in steps 1-4 of this calculation. (Id. at 34.)

In 2004, the capital assets in the portfolio were sold for $288,000,000. (Stip. of Facts ¶ 4.) Hydrocarbon's gain on the sale was approximately $110,000,000. (Id.) After providing for the first four steps in the Performance Fee calculation, Odyssey received approximately $20 million as its Performance Fee. (Doc. No. 32 Ex. 1 at 1.) Odyssey later paid Hydrocarbon $31,920 under the claw-back provision of the Management Agreement. (Stip. of Facts ¶ 6.)

Odyssey filed a partnership income tax return on Form 1065 for the tax year 2004 (the "Original 2004 Odyssey Return"). (Doc. No. 32 Ex. 1.) In it, Odyssey characterized the approximately $20 million it had received from Hydrocarbon as "gross profit" income. (Id. at 1.) Odyssey issued Schedules K-1 to its limited partners, including John Rigas. (Id. at 13.) The K-1 stated that Odyssey had distributed to Rigas approximately $4 million in ordinary business income. In turn, the Rigases filed a joint individual income tax return for tax year 2004 (the "Original 2004 Rigas Return"). (Doc. No. 32 Ex. 25.) In line with the K-1, the Rigases reported the approximately $4 million they received from Odyssey as ordinary income.

In April 2007, Odyssey filed an amended partnership tax return for tax year 2004 (the "Amended 2004 Odyssey Return"). (Doc. No. 32 Ex. 2.) Odyssey used the standard Form 1065 and checked the box next to "Amended Return" to indicate that it was amending its original 2004 return. In the amended return, Odyssey changed the way it characterized the $20 million it had received from Hydrocarbon. Odyssey now characterized the $20 million as "net long-term capital gain" acquired from a sale of "Hydogen Capital." (Id. at 3, 6.) Odyssey also attached amended Schedules K-1 for its limited partners, including John Rigas. Rigas's amended K-1 listed the $4 million distribution to Rigas as "net long-term capital gain" rather than ordinary business income. (Id. at 7.) The Amended 2004 Odyssey Return was accepted and processed by the Internal Revenue Service ("IRS"). IRS records show that activity on the return occurred in September 2007, November 2007, and January 2008, but without full examination by an IRS field office. (Doc. No. 42 Exs. 1, 2, 3; Swain Aff. ¶¶11-14.)

Meanwhile, the Rigases also filed an amended individual tax return for tax year 2004 (the "First Amended 2004 Rigas Return"). (Doc. No. 32 Ex. 27.) The Rigases changed the characterization of the approximately $4 million received from Odyssey in 2004 from ordinaryincome to capital gains. As the explanation for the changes made to the return, the Rigases stated: "Taxpayers received amended K-1S from Odyssey Energy Capital I LP and from Odyssey Energy Capital LLC after their original return was filed. This amended return reflects the amended information." (Id. at 2.) Based on the new characterization of the income as "capital gains," the Rigases sought a refund of approximately $800,000. (Id. at 1.)

In August 2007, the IRS sent the Rigases a request for more information, including a "completed Form 1040X to support the changes you have made" and a "completed copy of Part II, page 2, Form 1040X. We need to know what items of income, deductions, or credits you changed, the amount of each change, and the reasons for the changes. Attach supporting forms and/or schedules to the amended return." (Doc. No. 32 Ex. 47 at 1.) Specifically, the IRS noted that the amended K-1 did not explain the tax decrease or the increase to adjusted gross income and taxable income. (Id.)The Rigases' accountant responded by mailing the IRS the Original 2004 Odyssey Return, the Amended 2004 Odyssey Return, the original and amended Forms K-1, the Original 2004 Rigas Return, and the First Amended 2004 Rigas Return. (Doc. No. 32 Ex. 48.) The accountant explained in his letter that the "long-term capital gains" changed from a loss of $3,000 to a gain of $4,448,657, and that passive income and loss had changed from income of $4,222,999 to a gain of $3,394. (Id.)

In December 2007, the IRS disallowed the Rigases' refund claim. (Doc. No. 42 Ex. 13.) However, the IRS accepted the amended individual tax returns of two of Odyssey's other limited partners, which had been filed based on the Amended 2004 Odyssey Return, and issued refunds to them in February and May 2008. (Doc. No. 42 Ex. 5 ¶¶ 14-15.)

The Rigases subsequently filed another amended individual tax return in January 2008 (the "Second Amended 2004 Rigas Return"). (Doc. No. 32 Ex. 28.) The case was assigned to anIRS examining officer named Michael Glass. (Doc. No. 42 Ex. 20; Ex. 11 at 18) Glass contacted the Rigases and spoke with the Rigases' accountant over the course of 2008 and early 2009 about the return. Glass understood the main issue to be whether the income received by Odyssey from...