Rovakat, LLC v. Comm'r of Internal Revenue, T.C. Memo. 2011-225

• Decision Date: 20 September 2011
• Docket Number: Docket No. 3251-09.,T.C. Memo. 2011-225
• Parties: ROVAKAT, LLC, A PARTNERSHIP, SHANT S. HOVNANIAN, TAX MATTERS PARTNER, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

ROVAKAT, LLC, A PARTNERSHIP, SHANT S. HOVNANIAN, TAX MATTERS PARTNER, Petitioner
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

T.C. Memo. 2011-225
Docket No. 3251-09.

UNITED STATES TAX COURT

Filed: September 20, 2011

William R. Rankin, for petitioner.

Laurie A. Nasky and Justin D. Scheid, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

LARO, Judge: This case is a partnership-level proceeding subject to the unified audit and litigation procedures of the Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. 97-248, sec. 402, 96 Stat. 648. Shant S. Hovnanian (Mr. Hovnanian), as the tax matters partner of Rovakat, LLC (Rovakat), petitioned the

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Court to readjust partnership items that respondent adjusted for Rovakat's 2002 through 2004 taxable years. See sec. 6226(a).¹ Respondent's principal adjustment was to disallow Rovakat's claim to section 988 ordinary losses of $130,766 for 2002, $890,485 for 2003, and $2,479,991 for 2004. These losses stem from Rovakat's receipt of $34,185 in Swiss francs (francs) that, Mr. Hovnanian claimed, carried with them a $5,805,000 tax basis. Respondent determined that the claimed losses are not allowed because Mr. Hovnanian failed to establish Rovakat's basis in the francs. Respondent determined alternatively that the claimed losses are not allowed because the transaction underlying Rovakat's receipt of the francs (francs transaction) lacked economic substance. We agree with respondent on both points.²

We also decide the following secondary issues: (1) Whether Rovakat omitted income of $650,000 and $90,443 for 2002 and 2003, respectively. We hold it omitted income of $593,125 for 2002; (2) whether the period of limitations for assessment has expired as to Rovakat's 2002 taxable year. We hold it has not; (3) whether $593,125 and $943,192 of Rovakat's income for 2002 and 2003, respectively, is self-employment income. We hold it

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is; (4) whether Rovakat may deduct "other expenses" of $63,964 and $352,663 for 2003 and 2004, respectively. We hold it may not; (5) whether the 40-percent accuracy-related penalty under section 6662(a) and (h) for gross valuation misstatement applies to any underpayment of tax attributable to the reporting of the losses of $130,766 for 2002, $890,485 for 2003, and $2,479,991 for 2004. We hold it does; and (6) whether a 20-percent accuracy-related penalty under section 6662(a) and (b)(1), (2), or (3) for negligence or disregard of rules or regulations, substantial understatement of income tax, or substantial valuation misstatement, respectively, applies to any underpayment of tax attributable to the omitted income for 2002 and the disallowed deductions for 2003 and 2004. We hold it does.

FINDINGS OF FACT

I. Preliminaries

The parties filed with the Court numerous stipulations of fact and accompanying exhibits. The Court also deemed some facts and accompanying exhibits stipulated pursuant to Rule 91(f).³The stipulated facts, including those deemed established, and the accompanying exhibits are incorporated herein by this reference. We find the stipulated facts accordingly.

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II. Mr. Valdez

A. Background

Lance O. Valdez (Mr. Valdez) is a tax attorney who practiced law through his wholly owned professional corporation, Lance O. Valdez & Associates, P.C. (LOVA). He also is a financial adviser who provided investment advisory services primarily through two other entities that he controlled, LVCM, Ltd. (Limited), and Lance Valdez Tax Management.

As part of his investment advisory services, Mr. Valdez structured and marketed tax-shelter transactions which generated for U.S. taxpayers superficial Federal income tax losses greatly disproportionate to economic outlay in the activities underlying those losses. For the most part, Mr. Valdez designed and implemented these transactions, and he created the transaction documents effecting their implementation. The documents were generally the same as to each transaction, except for the names of the parties to the transaction and the amounts involved.

B. Transactions Promoted

Mr. Valdez promoted his transactions as "investments". While the transactions varied according to the entities, taxpayers, and assets involved, the transactions generally involved foreign property with significant built-in losses incurred by a foreign person not subject to U.S. tax, and used the same three steps.

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As the first step in the transaction, a foreign entity, pursuant to an agreement with Mr. Valdez in which he agreed to pay the foreign entity a fee, transferred the built-in loss property with its purportedly high basis and a low fair market value (distressed assets) to a domestic partnership in exchange for an interest in the partnership. Second, the foreign entity sold a significant portion of its interest in the partnership to a U.S. taxpayer who was one of Mr. Valdez's "investors". Third, the partnership disposed of the distressed assets to formally trigger the built-in losses claimed to continue to inhere in the distressed assets, with those "losses" allocated to the U.S. taxpayer to offset the taxpayer's unrelated income otherwise subject to Federal income tax.

In total, Mr. Valdez's transactions caused over $147 million in "losses" to be allocated among his "investors" who did not actually realize economic losses of anywhere near the amounts allocated and who had minimal economic outlays in relation to the allocated "losses".

C. IRS Investigates Mr. Valdez

The Internal Revenue Service (IRS) investigated Mr. Valdez, LOVA, and Lance Valdez Tax Management as organizers, sellers, or promoters of potentially abusive tax shelters. That investigation led the IRS to examine Rovakat's 2002 through 2004

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Forms 1065, U.S. Return of Partnership Income (2002 return, 2003 return, and 2004 return, respectively).

III. Rovakat

A. Formation of Rovakat

International Capital Partners, LP (ICP), and International Strategic Partners, LLC (ISP), formed Rovakat on June 6, 2002, as a Delaware limited liability company.⁴ Rovakat uses the cash receipts and disbursements method of accounting for Federal tax purposes, and Rovakat reports its income and expenses on the basis of the calendar year. Rovakat's mailing address and registered office were in the third judicial circuit of the United States when the petition was filed.

B. ICP

1. Overview

Mosafa, Ltd. (Mosafa), and Credicom N.V. (CNV) formed ICP as a Cayman Islands limited partnership on May 7, 2001. ICP conducted its activities and maintained its books and records in U.S. dollars. Mr. Valdez controlled ICP at all relevant times.

2. Mosafa

Mosafa is a Cayman Islands company. As part of ICP's formation, Mosafa transferred $1,000 to ICP in exchange for a 2-percent general partnership interest.

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3. CNV

CNV is a Belgian company that is a subsidiary of Immobilière Hoteliere, S.A. (Immobiliere), a French real estate and hotel conglomerate. CNV conducted its activities and maintained its books and records on the basis of the Belgian franc (Belgian franc). CNV's managing director was Henri Van Zeveren (Mr. Van Zeveren), a Belgian citizen and resident. As part of ICP's formation, CNV contributed $49,000 to ICP in exchange for a 98-percent limited partnership interest.

4. Investment Advisory Agreement

LVCM, LLC (LVCM), is a Delaware limited liability company whose managing member was Mr. Valdez. LVCM and ICP entered into an investment advisory agreement under which LVCM agreed to provide investment advisory and management services to ICP from May 10, 2001, through December 31, 2015, in exchange for a management fee and an allocation of ICP's profits. The agreement appointed LVCM as ICP's manager, agent, and attorney-in-fact, and the agreement authorized LVCM to bind ICP with respect to, among other things, asset transfers, bank accounts, and transactions.

C. ISP

Limited formed ISP on January 23, 2001, as a Delaware limited liability company. During March 2002, Mr. Hovnanian purchased a 93.9-percent interest in ISP; he did not conduct any due diligence regarding that purchase. ISP's remaining 6.1-

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percent interest was owned by ICP and by Mr. Valdez's wholly owned corporation Horizon Capital Holdings Corp. Mr. Valdez controlled ISP at all relevant times.

IV. Mr. Hovnanian and Related Entities

A. Mr. Hovnanian

Mr. Hovnanian is the managing member of Rovakat and its tax matters partner. He earned a bachelor of science degree in economics from the University of Pennsylvania, and he has over 20 years of experience in the computer, software, and wireless telecommunications industries. He has invested in real estate, startup companies, and financial instruments such as foreign currency contracts, hedging contracts, and the buying and selling of stock (including short selling). He is a wealthy individual, and he is a high-income taxpayer.

B. VSHG

Mr. Hovnanian was the executive vice president of V.S. Hovnanian Group (VSHG) from June 1980 until January 1991. VSHG was a holding company, and its subsidiaries engaged in construction, development, and utilities. At all relevant times, Mr. Hovnanian owned 25 percent of VSHG, and three members of his family equally owned the remaining 75 percent.

Hovbilt, Inc. (Hovbilt), a C corporation, was one of VSHG's subsidiaries. VSHG owned 99 percent of Hovbilt, and...