Partners entitled to deductions for investment partnerships they controlled

Partners entitled to deductions for investment partnerships they controlled

Klamath Strategic Investment Fund, LLC, (DC TX 09/21/2012) 110 AFTR 2d ¶ 2012-5299

On remand from the Fifth Circuit, a district court has found that the 90% owners of two partnerships, which were formed to facilitate the partners' investment in foreign currency transactions found to be tax shelters, controlled the partnerships when various operating costs were incurred and thus were entitled to deduct them. Although an entity that served as the managing partner was in charge of the partnerships' day-to-day operations, the entity's actions were limited by the partnership agreement and it merely implemented the investment decisions made by the partners.

Background. Individuals can deduct ordinary and necessary expenses paid or incurred during the tax year for: (1) the collection or production of income, (2) the management, conservation or maintenance of property held for the production of income, or (3) the determination, collection or refund of any tax. (Code Sec. 212) To be deductible under Code Sec. 212, the taxpayer must have a profit motive. (Agro Science, (CA 5 1991) 67 AFTR 2d 91-700)

The profit motive of a partnership is determined at the partnership level. (Simon v. Comm., (CA 3 1987) 60 AFTR 2d 87-5741) In determining whether a partnership has a profit motive, the testimony of general partners and promoters is relevant since they often control the partnership's activities. (Agro Science) Where different partners have different motivations (e.g., profit motive and tax benefit), the court must determine which partner's intentions should be attributed to the partnership, which in turn depends on which partner effectively controlled the partnership's activities. (Simon)

Facts. During '99, two law partners, Charles Patterson and Harold Nix, discussed the possibility of investing in foreign currencies to diversify their investments and earn profits. They retained a partner at another firm (Sid Cohen) who found and vetted Presidio, an investment advisory firm that specialized in foreign currency trading. Cohen also faciliated several meetings between Patterson and Nix and Presidio representatives who explained its overall investment strategy including the potential to make a profit through the devaluation of pegged currencies. Nix and Patterson each paid Cohen $250,000 for his services, which they reported on their individual income tax returns.

Presidio advocated, and Patterson and Nix ultimately agreed to invest in, a complex plan involving strategic investments in foreign currencies pegged to the U.S. dollar. In 2000, Presidio formed Klamath Strategic Investment Fund, LLC (Klamath) and Kinabalu Strategic Investment Fund, LLC (Kinabalu; collectively, the partnerships), which were 90% owned by Patterson and Nix (with Presidio entities holding the remainder and acting as Managing Partner of each), in order to make these investments. Patterson and Nix each contributed $1.5 million to their respective partnership, then each company borrowed $66.7 million from National Westminster Bank (NatWest) to faciliate and provide leverage for the partnerships' investments. The loans carried an above-market interest rate of 17.97%, a $25 million “loan premium,” and provisions to protect NatWest from the possibility of early repayment.

Patterson and Nix each contributed the $66.7 million, and assigned the corresponding loan obligations, to the partnerships. The funds were ultimately used to purchase contracts on U.S. dollars and Euros, and to make small, short-term forward contract trades in foreign currencies. The partnerships also incurred other operating expenses, such as various fees and taxes. When Nix and Patterson exercised their right to withdraw from the investments and the partnerships, they received a liquidating distribution of $359,635 and approximately $63,726 worth of Euros. (For more details about the transactions, which were characterized in earlier proceedings as a tax shelter known as “Bond Linked Issue Premium Structure” (or BLIPS).

On their income tax returns for 2000, 2001, and 2002, Patterson and Nix each claimed over $25 million in losses from their respective partnerships. Patterson and Nix were able to report such high losses because when they each calculated their basis in the partnership, they did not reduce it by the $25 million loan premium amount. In other words, they computed basis equal to the $1.5 million that was individually contributed and the $66.7 million in loan proceeds, but they did not consider the loan premiums to be liabilities and thus only subtracted the remaining $41.7 million principal amount—leaving each with over $25 million in basis to support the claimed losses.

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