Sarma v. Comm'r of Internal Revenue

• Citation: 45 F.4th 1312
• Decision Date: 19 August 2022
• Docket Number: 21-12303
• Parties: Raghunathan SARMA & Gaile Sarma, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (11th Circuit)

45 F.4th 1312

Raghunathan SARMA & Gaile Sarma, Petitioners-Appellants,

v.COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 21-12303

United States Court of Appeals, Eleventh Circuit.

Filed: August 19, 2022

Charles E. Hodges, II, Aditya Shrivastava, Attorney, Jones Day, Atlanta, GA, for Petitioners-Appellants.

Douglas Campbell Rennie, Arthur Thomas Catterall, Jacob Earl Christensen, Francesca Ugolini, U.S. Department of Justice, Appellate Section Tax Division, Michael J. Desmond, Chief Counsel-IRS, Washington, DC, for Respondent-Appellee.

Before Newsom, Marcus, Circuit Judges, and Middlebrooks,^* District Judge.

Middlebrooks, District Judge:

This appeal involves the tax consequences of Raghunathan Sarma's participation in a complex tax avoidance scheme. In 2001, Sarma expected to realize an $80.9 million capital gain as a result of selling a portion of his company. The scheme, which involved a set of tiered partnerships, allowed Sarma to claim a $77.6 million artificial loss to offset his legitimate capital gains. A federal District Court found the scheme to be an abusive tax shelter and upheld the IRS's disallowance of the benefits of the shelter in a partnership-level proceeding, and a prior panel of this Court affirmed. Kearney Partners Fund LLC v. United States , 803 F.3d 1280 (11th Cir. 2015) (per curiam).

As a result of the partnership-level proceeding, the IRS issued a notice of deficiency to Petitioners disallowing the $77.6 million loss deduction they reported on their joint tax return. Petitioners sought review in the U.S. Tax Court, which rejected their various challenges. After careful review and with the benefit of oral argument, we affirm.

I

A

Partnerships are not taxpayers; taxable income and losses of a partnership are passed through to its partners. 26 U.S.C. § 701. Partnerships do, however, file annual information returns reporting their tax items, such as gains, losses, deductions and credits. Id. § 6031(a). Partners are responsible for reporting their distributive share of the partnership's tax items on their individual federal income tax returns. Id. §§ 702, 704.

The Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA"), the governing scheme in effect during the relevant period, established uniform audit and litigation procedures for the resolution of partnership tax items. Pub. L. No. 97-248, 96 Stat. 648.¹ Prior to TEFRA, the IRS could not audit items that were attributable to the partnership in a single unified proceeding. United States v. Woods , 571 U.S. 31, 38, 134 S.Ct. 557, 187 L.Ed.2d 472 (2013). Instead, the IRS had to adjust partnership-level items individually with each partner through the normal deficiency proceedings. Id. (citing 26 U.S.C. §§ 6211 – 6216 (2006 ed. and Supp. V)). This led to duplicative proceedings involving the same tax items and inconsistent results among partners of a given partnership. Id. By enacting TEFRA, Congress sought to alleviate those problems. Id.

TEFRA provides a two-step process for resolving partnership tax matters. First, "partnership item[s]" are adjusted "at the partnership level" in a single partnership-level proceeding. 26 U.S.C. § 6221(a), 6231(a)(3). A "partnership item" is "any item required to be taken into account for the partnership's taxable year" if "such item is more appropriately determined at the partnership level than at the partner level." Id. § 6231(a)(3). Conversely, a "nonpartnership item" is "an item which is (or is treated as) not a partnership item." Id. § 6231(a)(4). To challenge a partnership item, the IRS initiates an administrative proceeding against the partnership. Id. § 6223(a)(1). The IRS then issues a notice of final partnership administrative adjustment ("FPAA") to the partners informing them of the adjustments to partnership items. Id. § 6223(a)(2). Partners can seek judicial review of the adjustments to partnership items in a partnership-level proceeding. Id. § 6226(a), (b)(1).

Then, once partnership-level adjustments are final, the IRS determines whether the partnership-level adjustments necessitate any partner-level changes, including to "affected items." Id. §§ 6225, 6231(a)(5). An "affected item" is "any item to the extent such item is affected by a partnership item." Id. § 6231(a)(5). If an adjustment is merely computational and does not require partner-level factual determinations, the IRS may directly assess the computational adjustment without issuing a notice of deficiency, i.e. , there is no prepayment right to judicial review. See id. §§ 6230(a)(1), (c), 6231(a)(6); Treas. Reg. § 301.6231(a)(6)-1(a)(2). If an adjustment attributable to an affected item requires partner-level determinations, the IRS must issue an affected item notice of deficiency to the partner and the normal deficiency procedures apply, i.e. , there is a prepayment right to judicial review. 26 U.S.C. § 6230(a)(2)(A)(i) ; Treas. Reg. § 301.6231(a)(6)-1(a)(3).

Any partnership that filed partnership return during the relevant time period was subject to TEFRA, unless it qualified as a "small partnership." 26 U.S.C. § 6231(a)(1)(A), (B)(i). A small partnership is a "partnership having 10 or fewer partners each of whom is an individual ..., a C corporation, or an estate of a deceased partner." Id. § 6231(a)(1)(B)(i). A partnership cannot be a small partnership if any partner is a "pass-thru partner," Treas Reg. § 301.6231(a)(1)-1(a)(2), which is an entity through which "other persons hold an interest," 26 U.S.C. § 6231(a)(9). The determination that a partnership is a small partnership is made "with respect to each partnership taxable year." Treas. Reg. § 301.6231(a)(1)-1(a)(3). Small partnerships are exempt from the definition of "partnership." 26 U.S.C. § 6231(a)(1)(B)(i). Meaning, small partnerships are not subject to TEFRA's audit and litigation procedures unless they elect to have TEFRA apply. See id. § 6231(a)(1)(A)–(B). Tax items of small partnerships must be challenged at the partner level in deficiency proceedings. See Arenjay Corp. v. Comm'r , 920 F.2d 269, 270 (5th Cir. 1991).

B

Sarma² participated in a tax avoidance scheme called "Family Office Customized partnership" or "FOCus." Kearney Partners Fund, LLC v. United States , 803 F.3d 1280, 1283 (11th Cir. 2015) (per curiam). An investment firm called Bricolage Capital, LLC ("Bricolage") and the accounting firm KPMG marketed FOCus to wealthy individuals with recent "large liquidity event[s]." See id. at 1283. Sarma was one such individual. In 2001, Sarma expected to realize an $80.9 million capital gain as a result of selling a division of his company, American Megatrends. Id. at 1282. Sarma participated in the FOCus scheme to avoid paying the resulting taxes.

Each FOCus vehicle required the creation of a set of three tiered partnerships: an upper tier, middle tier and lower tier. Id. at 1283. The partnerships owned a 99% interest in the partnership in the tier below it, with Bricolage-affiliated entities owning the remaining 1% of each entity. Id. at 1284. Sarma invested in the FOCus vehicle comprised of the following partnerships:³ (1) Nebraska Partners Fund, LLC ("Nebraska"), the upper tier, (2) Lincoln Partners Fund, LLC ("Lincoln"), the middle tier, and (3) Kearney Partners Fund, LLC ("Kearney"), the lower tier.

FOCus was designed to generate significant artificial losses to offset legitimate taxable income. An essential component was a series of offsetting foreign currency exchange forward contracts, referred to as straddles ("FX straddles"), executed by Kearney through Credit Suisse First Boston ("Credit Suisse").⁴ The proceeds from the gain legs of the FX straddles were placed into certificates of deposit ("CDs") at Credit Suisse. Kearney reported and realized a $79.1 million gain from the gain legs.⁵ The loss legs had not been closed out and remained unrealized. However, the amounts of those losses were locked in.

The scheme also required several ownership changes in the partnerships, which resulted in the partnerships having several short tax periods within the 2001 calendar year.⁶ On December 4, 2001, Sarma acquired a 99% interest in Nebraska. Nebraska already owned a 99% interest in Lincoln, and Lincoln owned a 99% interest in Kearney. All three partnerships terminated their tax periods. See Treas. Reg. § 1.708-1(b)(2). The three partnerships each filed partnership returns for their respective December 4, 2001 short tax years, and new partnerships were deemed formed on December 5, 2001. See id. § 1.708-1(b)(4). On December 14, 2001, Sarma acquired a 99% interest in Lincoln from Nebraska. At this point, Lincoln became a small partnership. See 26 U.S.C. § 6231(a)(1)(B)(i). Lincoln and Kearney terminated their tax periods and filed partnership returns for their respective short tax years ending December 14, 2001.

On December 19, 2001, Lincoln (a small partnership) sold its 99% interest in Kearney (a TEFRA partnership) for $737,118 to a Bricolage-affiliated entity. On the date of the sale, Lincoln claimed an outside basis in Kearney of $79,110,062. "Tax basis is the amount used as the cost of an asset when computing how much its owner gained or lost for tax purposes when disposing of it." Woods , 571 U.S. at 35, 134 S.Ct. 557. Outside basis is "[a] partner's tax basis in a partnership interest." Id. at 35–36, 134 S.Ct. 557. Outside basis increases when the partnership has a gain and decreases when the partnership has a loss. 26 U.S.C. § 705(a). In computing its outside basis in Kearney, Lincoln increased its outside basis to account for the gain legs from the FX straddles, but it did not decrease its basis to account for the unrealized losses from the loss legs. Lincoln reported a $78,392,194 short term capital loss on its partnership return for its December 31, 2001 short tax period. Lincoln allocated $77,608,272 of the Lincoln loss to Sarma in accordance with his 99% partnership interest. Sarma, in turn, claimed a deduction for this loss on his 2001 joint tax...