Tuesday, July 27, 2010
SALA v. U.S., Cite as 106 AFTR 2d 2010-XXXX, 07/23/2010 ________________________________________ CARLOS E. SALA; TINA ZANOLINI-SALA, Plaintiffs - Appellees, v. UNITED STATES OF AMERICA, Defendant - Appellant. Case Information: Code Sec(s): Court Name: UNITED STATES COURT OF APPEALS TENTH CIRCUIT, Docket No.: No. 08-1333, Date Decided: 07/23/2010. Disposition: UNITED STATES COURT OF APPEALS TENTH CIRCUIT, APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF COLORADO (D.C. NO. 1:05-cv-00636-LTB-KLM) DISCUSSION The Government's primary argument is that the transaction giving rise to Sala's claimed tax loss had no economic substance. When considering a district court's economic substance determination, this court reviews findings of fact for clear error and any legal determinations de novo. See Keeler v. Comm'r, 243 F.3d 1212, 1217 [87 AFTR 2d 2001-1224] (10th Cir. 2001). The ultimate determination of whether a transaction lacks economic substance is a question of law. James v. Comm'r, 899 F.2d 905, 909 [65 AFTR 2d 90-1045] (10th Cir. 1990) (“[W]e review de novo the ultimate characterization of the transactions as shams.”);see also Frank Lyon Co. v. United States , 435 U.S. 561, 581 [41 AFTR 2d 78-1142] n.16 (1978) (“The general characterization of a transaction for tax purposes is a question of law ....”).But see Nicole Rose Corp. v. Comm'r , 320 F.3d 282, 284 [90 AFTR 2d 2002-7702] (2d Cir. 2003) (treating the ultimate determination of whether a transaction lacks economic substance as a question of fact). * ``````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````````` “we consider both the taxpayers' subjective business motivation and the objective economic substance of the transactions.” Jackson v. Comm'r, 966 F.2d 598, 601 [70 AFTR 2d 92-5024] (10th Cir. 1992) (quotation and alteration omitted). A taxpayer is not permitted to deduct losses resulting from a transaction that lacks economic substance. Keeler, 243 F.3d at 1217. “[T]ransactions lacking an appreciable effect, other than tax reduction, on a taxpayer's beneficial interest will not be recognized for tax purposes.”James , 899 F.2d at 908. That a transaction has some profit potential does not necessarily compel the conclusion the transaction has economic substance. Keeler, 243 F.3d at 1219. Rather, “tax advantages must be linked to actual losses.” Id. at 1218; Coltec Indus., Inc., 454 F.3d at 1352 (explaining the economic substance doctrine requires “disregarding, for tax purposes, transactions that comply with the literal terms of the tax code but lack economic reality”); Rogers v. United States, 281 F.3d 1108, 1116 [89 AFTR 2d 2002-1115] (10th Cir. 2002) (explaining the economic substance doctrine applies where “the transaction lacks economic reality”). We have also recognized “correlation of losses to tax needs coupled with a general indifference to, or absence of, economic profits may reflect a lack of economic substance.” Keeler, 243 F.3d at 1218. In light of these well-established standards, this court concludes Sala's participation in Deerhurst GP lacked economic substance. Most compelling is that the claimed loss generated by the program was structured from the outset to be a complete fiction. It is clear the transaction was designed primarily to create a reportable tax loss that would almost entirely offset Sala's 2000 income with little actual economic risk. By acquiring a series of long and short options that largely offset one another, contributing them to Deerhurst GP in exchange for a partnership interest, and then almost immediately liquidating the partnership, Krieger was able to ensure that a tax loss nearly equivalent to Sala's income would be achieved in just a few weeks. This is because, if the rule in Helmer controlled, the short options would not be treated as liabilities when calculating Solid's partnership basis. 34 T.C.M. (CCH) 727 [¶75,160 PH Memo TC] (1975). Through this mechanism, the generated loss was designed to be entirely artificial. Indeed, rather than suffering any actual financial loss through Deerhurst GP, Sala actually profited from the transaction. Sala does not contest that the loss is fictional, but rather protests that the rule fromHelmer should control. This argument does not, however, address the claimed loss's absence of economic reality. The absence of economic reality is the hallmark of a transaction lacking economic substance. See Keeler, 243 F.3d at 1218–19; Coltec Indus., Inc., 454 F.3d at 1352; Rogers, 281 F.3d at 1116. The pre-determined nature of the Deerhurst GP stage further highlights the transaction was structured mainly to create a tax loss. The district court noted Sala's participation in Deerhurst GP involved a $728,000 investment, which it found had the potential to produce a 45% profit, net of fees, over the course of the year. Before Sala invested, however, he was aware Deerhurst GP would exist for only a short time and would have to be liquidated before the end of the 2000 tax year in order to generate a tax loss large enough to offset his income. Consequently, liquidation was set to occur irrespective of any profits or losses, and would have happened even if market conditions indicated it would be more profitable not to dispose of the long and short options at that point. Though a taxpayer is permitted to structure a transaction in a way that minimizes his tax liability, the transaction must nevertheless have economic substance. Keeler, 243 F.3d at 1218. The pre-determined nature of the liquidation indicates a lack of economic substance. Additionally, while the district court found the long and short options had a potential to earn profits of $550,000 over the course of one year, 3 the expected tax benefit was nearly $24 million. That expected tax benefit dwarfs any potential gain from his participation in Deerhurst GP such that “the economic realties of [the] transaction are insignificant in relation to the tax benefits of the transaction.” Rogers, 281 F.3d at 1116. The existence of some potential profit is “insufficient to impute substance into an otherwise sham transaction” where a “common-sense examination of the evidence as a whole” indicates the transaction lacked economic substance.Keeler , 243 F.3d at 1219 (quotation omitted). The district court also found Sala provided plausible business explanations for various components of the Deerhurst GP stage, including his use of an S Corporation, the creation and almost immediate liquidation of the Deerhurst GP partnership, and the selection of the particular foreign currency options he acquired. Any anticipated economic benefit from participating in Deerhurst GP for a few weeks, and then quickly liquidating the partnership before year's end, however, is negligible in comparison to the $24 million tax benefit which would not have been achieved but for this pre-determined course of action. Likewise, the district court's finding that Sala entered into the Deerhurst Program primarily for profit does not alter our conclusion. “[W]e have never held that the mere presence of an individual's profit objective will require us to recognize for tax purposes a transaction which lacks economic substance.”Jackson , 966 F.2d at 601 (quotation omitted). More importantly, the district court's findings on this issue were based on its consideration of the five-year Deerhurst Program as a whole. As noted above, only the Deerhurst GP phase is relevant to the economic substance analysis. 4 Presented with a transaction specifically designed to produce a massive tax loss devoid of economic reality, we hold Sala's participation in Deerhurst GP lacks objective economic substance. As a result, the district court's decision must be reversed. As this conclusion resolves the Government's appeal, we need not reach any of the other issues it presented. IV. CONCLUSION For the foregoing reasons, this court REVERSES and REMANDS to the district court with instructions to vacate its judgment and enter judgment in favor of the United States. ________________________________________ * Honorable M. Christina Armijo, U.S. District Judge, District of New Mexico, sitting by designation. ________________________________________ 1 Because Carlos Sala and his wife, Tina Zanolini-Sala, jointly filed their tax return and refund claims, Zanolini-Sala is also a party to this lawsuit. For ease of reference, this opinion refers only to Carlos Sala. ________________________________________ 2 In Helmer v. Comm'r, the Tax Court ruled that a contingent obligation should not be treated as a liability when calculating a partner's basis in his partnership interest. 34 T.C.M. (CCH) 727 [¶75,160 PH Memo TC] (1975). This is because no liability arises until the obligation becomes fixed, which might never occur. Id. The short options purchased by Sala and contributed to Deerhurst GP are contingent obligations. Though Sala argues the Helmer rule should control the tax treatment of the Deerhurst GP transaction, it should be noted that prior to Sala's participation in the Deerhurst Program, the IRS challenged the sort of offsetting-options structure employed by Deerhurst GP. On August 13, 2000, the IRS released Notice 2000-44 explaining its position that transactions involving the transfer of property and offsetting contingent liabilities to a partnership, followed by the taxpayer's exit from the partnership to achieve a non-economic loss, do not give rise to an allowable tax deduction. I.R.S. Notice 2000-44, 2000-2 C.B. 255. The Notice states that “purported losses resulting from ... [such] transactions ... do not represent bona fide losses reflecting actual economic consequences as required for purposes of [26 U.S.C. § 165].”Id. It also informed taxpayers that the IRS would challenge such transactions and seek penalties.Id. ________________________________________ 3 The district court found the transaction had a $550,000 profit potential over one year. As noted, however, it was pre-determined that Deerhurst GP would only exist for approximately one month. ________________________________________ 4 It should also be noted the district court's finding that Sala entered into the Deerhurst Program primarily for profit was not part of its economic substance analysis. Rather, this finding was made in the district court's analysis of whether the claimed tax loss was deductible under 26 U.S.C. § 165(c)(2), which limits deductibility of an individual's losses to those “incurred in any transaction entered into for profit.” © 2010 Thomson Reuters/RIA. All rights reserved.