economic substance

Sixth Circuit affirms that CARDS transaction lacked economic substance Kerman, (CA 6 4/08/2013) 111 AFTR 2d ¶ 2013-619 The Court of Appeals for the Sixth Circuit has affirmed a Tax Court decision that held that a taxpayer who entered into a Custom Adjustable Rate Debt Structure (CARDS) transaction in 2000 wasn't entitled to a $4.25 million loss deduction because the transaction lacked economic substance. The Sixth Circuit further held that the taxpayer was liable for a gross valuation misstatement penalty under Code Sec. 6662(h). 

Background.  A taxpayer may deduct “any loss sustained during the taxable year and not compensated by insurance or otherwise.” (Code Sec. 165(a)) However, “only a bona fide loss is allowable,” and the taxpayer has the burden of showing that he is entitled to the claimed loss. (Reg. § 1.165-1(b)) When deciding whether a deduction is valid, the Sixth Circuit considers whether the transaction had economic substance, and if so, whether the taxpayer was motivated by profit to participate in the transaction. Thus, the test has both an objective and a subjective component. A transaction that lacks economic substance is a sham. In determining whether a transaction is a sham, the main consideration is whether is has any practicable economic effects other than the creation of tax losses. RIA observation: For transactions entered into after Mar. 30, 2010—i.e., after the time period involved in this case—the Health Care and Education Reconciliation Act (P.L. 111-152, 3/30/2010) added Code Sec. 7701(o). It provides that a transaction is treated as having economic substance under a conjunctive two-prong test only if—apart from Federal income tax effects—both: (1) the transaction changes the taxpayer's economic position in a meaningful way; and (2) the taxpayer has a substantial (non-tax) purpose for entering into the transaction. Under Code Sec. 6662, a 20% penalty is imposed with respect to underpayment that results from a substantial valuation misstatement. The penalty is increased to 40% if the taxpayer claims an adjusted basis in the property that is 400% or more of the correct amount (i.e., for a “gross valuation misstatement”). (Code Sec. 6662(h)) There is currently a circuit split over whether a transaction disallowed for lack of economic substance is subject to Code Sec. 6662's penalty provisions. The Sixth Circuit, with the majority of the Courts of Appeal, has held that it is. Facts.  Mark Kerman founded Kenmark Optical, Inc. (Kenmark) in '72 and was its sole owner until 2000 (the year at issue). By 2000, Kenmark had annual sales of near $35 million, and Kerman's personal net worth was over $12.5 million. In May of 2000, Kerman sold 27% of his stock in Kenmark to its employee stock ownership plan for $6.1 million, resulting in a taxable gain of $5.4 million. Kenmark discussed tax-savings strategies with his long-time friend and personal financial advisor and ultimately pursued a “CARDS” transaction—essentially, a transaction structured to create artificial losses and reduce taxable income. CARDS transactions were developed and promoted by Chenery Associates, Inc. (Chenery). The CARDS strategy was targeted by IRS in August of 2000 (Notice 2000-44, 2000-2 CB 255, which warned taxpayers that noneconomic losses produced by certain basis-inflating transactions aren't allowable as tax deductions), but Chenery continued to market the CARDS strategy. To reassure potential clients that they wouldn't be subject to penalties, Chenery provided clients with a sample tax opinion that questioned whether Notice 2000-44 was validly issued and ultimately concluded that a CARDS transaction was a legitimate tax avoidance strategy. Kerman wanted to generate a $4.25 million tax loss for 2000, so he decided to implement a CARDS transaction with a $5 million loan. The essential steps were as follows: ... a British limited liability company (LLC) was created; ... the LLC entered into a master pledge security agreement and a credit agreement for a loan denominated in foreign currency (because a loss realized on the disposition of foreign currency is an ordinary loss under U.S. tax law); ... the LLC executed a purchase agreement and assumption agreement with Kerman and transferred to him the present value of the principal payment (approximately 15% of the total amount) in exchange for his commitment to repay the principal when the loan matures (by assuming this liability, the taxpayer claims basis in the full amount of the loan); ... Kerman exchanged his 15% share of the loan for U.S. dollars; and ... Kerman claimed a loss using as basis the full amount of the loan. On his 2000 return, Kerman claimed that his sale of the foreign currency resulted in a $4,251,389 loss. The loan was eventually repaid in full in December of 2001. In the end, Kerman earned $63,194 in interest on the CARDS loan, but incurred borrowing costs of over $600,000. On Mar. 14, 2002, Kerman was encouraged by the successor to the law firm that issued CARDS opinion letter to participate in IRS's voluntary disclosure program, noting that the liberality of the program “makes it worthy of serious consideration by any taxpayer that may have a questionable item on his return.” Days later, IRS issued Notice 2002-21, 2002-1 CB 730, in which it described a CARDS transaction, warned of potential penalties, and advised taxpayers to file amended returns. Kerman, however, didn't disclose the transaction or amend his returns. Kerman's 2000 return was audited in June of 2003. In 2006, IRS issued a notice of deficiency to Kerman disallowing the $4.25 million loss and imposing an accuracy-related penalty. This resulted in a determined tax deficiency of $1,248,876 and penalty of $499,550. Kerman petitioned the Tax Court for a redetermination. Tax Court decision.  The Court agreed with IRS that the claimed loss should be disallowed, based on its conclusion that the CARDS transaction lacked economic substance. The Court found that, aside from the tax benefits, that the transaction “makes no economic sense as a source of financing. Kerman testified at his trial that he entered the CARDS transaction to provide working capital to Kenmark and to reduce his personal tax burden. However, his testimony was undercut by that of Kenmark's CFO during the year at issue, who acknowledged on cross-examination that Kenmark did not in fact borrow or receive any funds from the transaction. Kerman's former personal financial advisor also stated that Kerman's interest in the transaction was purely tax-motivated. The government expert also testified, and although Kerman's counsel initially had no objection to his being admitted as an expert in the case, they later objected to the admission of his report. The objection was overruled. The Tax Court also upheld IRS's imposition of a Code Sec. 6662 penalty. It found that Kerman didn't reasonably rely on expert advice or act in good faith and that, given his business experience, he knew or should have known that the transaction was too good to be true. Also, because he overstated his basis in the foreign currency obtained in the transaction by more than 400%, the Court upheld the gross valuation misstatement penalty under Code Sec. 6662(h). Kerman appealed the Tax Court's decision. Sixth Circuit affirms.  The Sixth Circuit described the “hallmarks” of a sham transaction—negative-pre-deduction cash flows and a claimed tax benefit that is seemingly created “from thin air”—and easily concluded that Kerman's CARDS transaction was a sham. The transaction cost over $600,000 and returned just over $60,000, and absent the claimed tax benefits, it was a “losing proposition.” However, it generated a tax benefit of $1,248,876, and also allowed Kerman to claim a tax loss without any corresponding economic loss. Kerman's argument that he had legitimate reasons for entering the transaction was belied by the fact that the transaction had no economic effects other than the creation of tax losses, and his claim that the transaction generated a profit in 2001 was unsupported. His argument that the Tax Court erred in admitting the government expert's report was also rejected. The Sixth Circuit also upheld the gross valuation misstatement penalty. Quoting the First Circuit, the Court stated that “it would be perverse to allow the taxpayer to avoid a penalty otherwise applicable to his conduct on the ground that the taxpayer had also engaged in additional violations that would support disallowance of the claimed losses.” Looking to the language of the statute, the Court found that the gross valuation misstatement penalty presumptively applied, given Kerman's 530% basis overstatement. It further concluded that he was unable to establish reasonable cause for same, noting that his claimed business reasons for entering the transaction weren't credible, that he knew or should have known that the tax benefits of the transaction were too good to be true, and that he didn't reasonably investigate the transaction or its participants. 


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