Klamath Strategic Investment Fund v. United States , 557 F. App'x 368 ( 2014 )

Case: 12-41286 Document: 00512549032 Page: 1 Date Filed: 03/03/2014
IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT United States Court of Appeals
Fifth Circuit
FILED
March 3, 2014
No. 12-41286
Lyle W. Cayce
Clerk
KLAMATH STRATEGIC INVESTMENT FUND, by and through St Croix
Ventures (Managing member),
Plaintiff–Appellee
v.
UNITED STATES OF AMERICA,
Defendant–Appellant
Appeal from the United States District Court
for the Eastern District of Texas
USDC No. 5:04-CV-278
Before BARKSDALE, PRADO, and HAYNES, Circuit Judges.
PER CURIAM:*
This is the second time this case has appeared before this Court. In the
first appeal, we held that the district court had erred in failing to consider
which partner—Charles “Cary” Patterson (“Patterson”) and Harold Nix (“Nix”)
or Presidio Advisory Services (“Presidio”)—effectively controlled Klamath
Strategic Investment Fund, LLC (“Klamath”) and Kinabalu Strategic
Investment Fund, LLC (“Kinabalu”) (collectively, the “Partnerships”) at the
* Pursuant to 5TH CIR. R. 47.5, the court has determined that this opinion should not
be published and is not precedent except under the limited circumstances set forth in 5TH
CIR. R. 47.5.4.
Case: 12-41286 Document: 00512549032 Page: 2 Date Filed: 03/03/2014
No. 12-41286
time certain expenses were incurred. Klamath Strategic Inv. Fund ex rel St.
Croix Ventures v. United States (Klamath IV), 568 F.3d 537, 551 (5th Cir.
2009). On remand, the district court held that, because Nix and Patterson
controlled the Partnerships at the time the operating expenses were incurred,
the expenses were tax deductible. The United States makes two arguments on
appeal. First, it argues that Presidio, not Nix and Patterson, effectively
controlled the Partnerships at the time the transactions occurred. Second, the
United States claims that the district court exceeded its jurisdiction in holding
that Nix and Patterson are entitled to personal deductions for certain fees paid
in exchange for investment advice. We AFFIRM.
I. BACKGROUND
A. Factual Background
Nix and Patterson are partners in the law firm Nix, Patterson & Roach,
LLP. Their law firm represented the state of Texas in tobacco litigation, and
when the case settled, Nix and Patterson expected to receive significant
attorneys’ fees, approximately $30 million per partner from 1998 to 2000. Nix
and Patterson asked Pollans & Cohen, their accounting firm, to help them
investigate investment opportunities. Pollans & Cohen identified Presidio, a
firm that claimed to specialize in foreign currency trading, as a firm that could
provide Nix and Patterson with opportunities to invest in foreign currency.
After Pollans & Cohen conducted due diligence and Nix and Patterson met
with representatives of Presidio a few times, Nix and Patterson decided to
invest in foreign currencies through Presidio. Nix and Patterson each paid Sid
Cohen (“Cohen”), a partner at Pollans & Cohen, $250,000 for his help in
identifying Presidio. Nix and Patterson each reported Cohen’s $250,000
advisory fee on their individual tax returns.
Presidio executed its investment strategy through a series of LLCs. First
Presidio formed Klamath and Kinabalu as LLCs, which elected to be taxed as
2
Case: 12-41286 Document: 00512549032 Page: 3 Date Filed: 03/03/2014
No. 12-41286
partnerships for federal tax purposes. Presidio also formed two single-member
LLCs—St. Croix for Patterson and Rogue for Nix—which are disregarded for
tax purposes (their activities are reported directly on Patterson’s and Nix’s tax
returns). Patterson owned 100% of St. Croix, and St. Croix became a 90%
partner of Klamath. The remaining 10% membership of Klamath consists of
Presidio Resources LLC (9% ownership of Klamath) and Presidio Growth LLC
(1% ownership of Klamath). The set-up for Nix/Rogue/Kinabalu was nearly
identical: Nix owned 100% of Rogue; Rogue owned 90% of Kinabalu; Presidio
Resources LLC owned 9% of Kinabalu; and Presidio Growth LLC owned 1% of
Kinabalu.
Presidio’s strategy was structured to take place in three stages over a
seven-year period, but Nix and Patterson retained the ability to withdraw from
the plan. Nix and Patterson ultimately decided to withdraw before the end of
the first stage.
B. Procedural Background
This litigation initially arose from Final Partnership Administrative
Adjustments (“FPAAs”) that the IRS issued in 2004 to Klamath and Kinabalu.
The IRS disagreed with the Partnerships’ calculation of their tax basis.
Specifically, the IRS argued that “the transactions were shams or lacked
economic substance and should be disregarded for tax purposes[,] . . . made
adjustments to operational expenses reported by the Partnerships[,] and
asserted accuracy-related penalties.” In response, the Partnerships filed suit
seeking readjustment of the partnership items pursuant to 26 U.S.C. § 6226.
The district court first granted partial summary judgment for Nix and
Patterson, holding that the Partnerships’ tax treatment of the amounts
borrowed to fund the Partnerships was proper. Klamath Strategic Inv. Fund,
LLC, ex rel St. Croix Ventures, LLC v. United States (Klamath I), 440 F. Supp.
2d 608, 614, 625–26 (E.D. Tex. 2006). Following a bench trial, the district court
3
Case: 12-41286 Document: 00512549032 Page: 4 Date Filed: 03/03/2014
No. 12-41286
found that, while Nix’s and Patterson’s primary motivation in entering these
foreign investments was to make a profit, the loan transactions lacked
economic substance and should be disregarded. Klamath Strategic Inv. Fund,
LLC v. United States (Klamath II), 472 F. Supp. 2d 885, 896 (E.D. Tex. 2007).
The court found that Presidio and National Westminster Bank (“NatWest”),
the bank that had loaned money to Patterson and Nix to fund the Partnerships,
had a private agreement that the investment transactions were only to be used
to generate tax losses, and so Presidio and NatWest lacked a true profit motive.
Id. at 896–98. But, because Nix and Patterson acted in good faith, they were
not subject to tax penalties for Presidio’s and NatWest’s actions. Id. at 905.
The issues relevant to this appeal stem from Klamath Strategic
Investment Fund v. United States (Klamath III), Nos. 5:04-CV-278, 5:04-CV-
279, 2007 WL 1051766 (E.D. Tex. Apr. 3, 2007). In Klamath III, the district
court held that Nix and Patterson were entitled “to deduct the operational and
interest expenses associated with the loan and foreign currency exchange
transactions.” Id. at *3. The district court reasoned that, because Nix and
Patterson paid these expenses and entered into the transactions to make a
profit, the expenses were deductible. Id.On appeal, this Court vacated the portion of the district court’s decision
regarding the deduction of the operating expenses. Klamath IV, 568 F.3d at
553. We acknowledged that the district court had “concluded that the partners
had different motivations: Nix and Patterson at all times pursued the
investment strategy with a genuine profit motive, while Presidio’s primary
intent was to achieve a tax benefit.” Id. at 551. Thus, as we explained, “[t]he
crucial inquiry, then [was] which partner’s intentions should be attributed to
the Partnership.” Id. In Klamath III, the district court had determined that
Nix and Patterson’s motives should be attributed to the Partnerships “with
little explanation,” reaching that conclusion because Nix and Patterson paid
4
Case: 12-41286 Document: 00512549032 Page: 5 Date Filed: 03/03/2014
No. 12-41286
the operational expenses. Id. This Court concluded that the district court had
erred in failing to determine who effectively controlled the Partnerships at the
time the expenses were incurred and remanded the case for the district court
to answer that question. Id.On remand, the district court concluded that Nix and Patterson
effectively controlled the Partnerships at the time the operating expenses were
incurred. Klamath Strategic Inv. Fund, LLC v. United States (Klamath V),
Nos. 5:04-CV-278, 5:04-CV-279, 2012 WL 4889805, at *7 (E.D. Tex. Sept. 24,
2012). Considering the facts as a whole, the district court made several
findings of fact that led it to conclude that Nix and Patterson had effective
control of the Partnership at the time in question:
[Nix and Patterson] set the parameters within which Presido could
operate by means of the partnership agreements. These
partnerships were formed and existed for a single purpose—to
affect an investment strategy selected by Nix and Patterson.
Presidio was the managing partner only because Nix and
Patterson made it so. Not only did the partnership agreements
define Nix and Patterson’s investment strategy, they confined
Presidio to that strategy in express and unequivocal terms; and if
all else failed, Nix and Patterson could shut down the whole
process by withdrawing from the partnerships they had created.
Id. at *5. While acknowledging that Presidio played a role, the district court
concluded it was “managerial only” and “not the true determining influence,
i.e.: control.” Id.The district court, on remand, also determined that it had jurisdiction to
determine whether Nix and Patterson were entitled to a personal deduction on
their individual tax returns for the $250,000 fee paid to Cohen. Id. at *6. The
district court concluded that this Court had “remand[ed] the specific question
of the Pollans & Cohen fees (as operating expenses)” and that “[t]he Fifth
Circuit certainly would not have expressly directed [the district court], through
5
Case: 12-41286 Document: 00512549032 Page: 6 Date Filed: 03/03/2014
No. 12-41286
its remand, to take up a matter (the fees paid to Pollans & Cohen) that it had
no authority to address.” Id. The district court ultimately found that Nix and
Patterson were entitled to a personal deduction for Cohen’s fees. Id. at *7.
The United States timely appealed.
II. JURISDICTION
The district court had jurisdiction pursuant to 28 U.S.C. § 1346(e). 1
Because this is an appeal of a final judgment of a district court, this Court has
jurisdiction pursuant to 28 U.S.C. § 1291.
III. DISCUSSION
A. Standard of Review
The question of who has effective control over an entity is a question of
fact, which we review for clear error. See Gustin v. United States, I.R.S. 876
F.2d 485, 491 (5th Cir. 1989) (reviewing whether an individual was a
“responsible person” under a tax statute for clear error); see also Coltharp v.
Goodwill Indus. of El Paso Inc., No. 98-50252, 232 F.3d 210, *4 (5th Cir. 2000)
(unpublished) (“[T]he question of whether the United States retained sufficient
control over its independent contractor within the meaning of Texas law so as
to be liable thereunder on the basis asserted is a question of fact, and we review
the district court’s finding that the United States did not retain sufficient such
control under the clearly erroneous standard.”). The question of what factors
are legally relevant in determining effective control is a question of law, which
we review de novo. See Whitehouse Hotel Ltd. P’ship v. Comm’r, 615 F.3d 321,
341 (5th Cir. 2010) (reviewing the tax court’s determination of whether the
elements for “reasonable cause” were proven and reviewing de novo the
1 We address the United States’ argument concerning jurisdiction—that the district
court exceeded its jurisdiction in finding that Nix and Patterson are entitled to personal
deductions for the fees they paid Cohen—in greater detail in Part III(B).
6
Case: 12-41286 Document: 00512549032 Page: 7 Date Filed: 03/03/2014
No. 12-41286
“determination of what elements must be present to constitute reasonable
cause” (citations and internal quotation marks omitted)).
This Court reviews questions of the district court’s jurisdiction de novo.
MSOF Corp. v. Exxon Corp., 295 F.3d 485, 489 (5th Cir. 2002). The Court also
reviews a district court’s interpretation of a remand order, including whether
the law-of-the-case doctrine or the mandate rule applies, de novo. Gene &
Gene, L.L.C. v. BioPay, L.L.C., 624 F.3d 698, 702 (5th Cir. 2010) (citation
omitted).
B. Analysis
1. Whether the district court erred in determining that Nix and
Patterson effectively controlled the Partnerships
The United States makes three arguments to support its claim that the
district court erred in finding that Nix and Patterson effectively controlled the
Partnerships at the time the operating expenses were incurred. First, the
United States argues that the district court based its finding on factors that
the Fifth Circuit had already held were insufficient to show Nix and Patterson
exercised effective control. Second, it argues that the factors the district court
relied on are legally irrelevant to the issue of effective control. Finally, the
United States claims that, even assuming the factors the district court relied
upon are correct factors, the record does not support the district court’s
findings. We address each of these arguments in turn.
i. Whether the district court relied on factors that this Court has
already held are insufficient to establish effective control
The United States argues that “[t]he district court’s analysis of the
‘effective control’ issue is flawed on its face” in light of the earlier appeal in this
case. In the first appeal, this Court held that “[n]one of the arguments
articulated by the Partnerships or the district court persuade us that the
motives of Patterson and Nix, to whom the overall control and management of
7
Case: 12-41286 Document: 00512549032 Page: 8 Date Filed: 03/03/2014
No. 12-41286
the Partnerships was expressly denied under the LLC agreements, should be
attributed to the Partnerships.” Klamath IV, 568 F.3d at 551. According to
the United States, on remand, the Partnerships simply repeated—and the
district court simply adopted—those previously rejected arguments, but this
Court’s prior ruling forecloses reliance on those factors.
After comparing the district court’s initial opinion (Klamath III), our
opinion in the first appeal (Klamath IV), and the district court’s opinion on
remand, it is clear that the United States is incorrect. On remand, the district
court relied on factors different from those this Court rejected in the first
appeal. In the first appeal, we noted that “[t]he district court appears to have
concluded, with little explanation, that Patterson and Nix’s motives must be
attributed to the Partnerships because they paid the expenses at issue here
and reported them on their individual tax returns.” Klamath IV, 568 F.3d at
551. And the district court’s initial opinion supports that characterization of
the order: in Klamath III, the district court did very little analysis and appears
to have found that Nix and Patterson had effective control solely because they
actually paid the operating expenses and included them on their personal tax
returns. See Klamath III, 2007 WL 1051766 at *3. By contrast, on remand,
the district court did not focus on the fact that Nix and Patterson paid the
operating expenses, relying instead on several different factual findings to
conclude that Nix and Patterson had effective control of the Partnerships. See
Klamath V, 2012 WL 4889804 at *4–5. Thus, we conclude that the district
court did not rely on factors we have previously held were insufficient to
establish effective control.
ii. Whether the district court relied on legally irrelevant factors in
finding that Nix and Patterson had effective control
The United States next argues that the factors the district court used to
determine effective control are legally irrelevant. The United States claims:
8
Case: 12-41286 Document: 00512549032 Page: 9 Date Filed: 03/03/2014
No. 12-41286
(1) even if a member of the LLC sets the scope of the managing-member’s
authority, the managing member still controls the LLC; (2) the fact that an
LLC was set up to achieve the investment strategy of the loan investor–
member does not mean that the investor–member controls the LLC; (3) if a
non-managing member of the LLC selects the managing member, that does not
necessarily mean that the non-managing member controls the LLC; and (4) a
member’s right to withdraw from an LLC does not indicate effective control of
the LLC.
We disagree and hold that the district court relied on legally relevant
factors to determine who effectively controlled the Partnerships. The primary
difficulty with the United States’ argument is that the United States never
identifies what factors should be considered legally relevant, and it cites no
law explaining what the correct and legally relevant factors are. 2 Further, we
have found no case law to support the United States’ argument that the factors
the district court relied on are incorrect.
The two cases that the Government cites to show that the district court
relied on legally irrelevant factors——Redlands Surgical Services v.
Commissioner, 113 T.C. 47 (1999) and Zink v. United States, 929 F.2d 1015(5th Cir. 1991)—do not advance its argument. In Redlands, the tax court
considered whether the petitioner had formal control over a surgery center and
found that, although the petitioner could veto expansion of the center, that fact
did “not establish that [the] petitioner [had] effective control” over the way the
2 In addressing this point in its brief, the United States argues that Delaware law
shows that the district court considered legally irrelevant factors in deciding the question of
effective control. The Partnerships counter that Delaware law actually supports the district
court’s reliance on those factors. These arguments about Delaware law, however, are not
germane to the question of what factors are legally relevant to the question of effective
control. In other words, the parties are actually using Delaware law to bolster their
arguments about the accuracy of the district court’s factual findings—not to argue that the
district court’s factors were legally irrelevant.
9
Case: 12-41286 Document: 00512549032 Page: 10 Date Filed: 03/03/2014
No. 12-41286
center conducted activities. 113 T.C. at 80. In Zink, this Court considered
whether the Zinks’ activities were sufficient to establish that that they were in
trade or business, ultimately concluding that, although the Zinks could “yank
their investment,” the United States did not establish that they had control
over the activities of the business. 929 F.2d at 1022–23.
The United States uses these cases to argue that a member’s ability to
withdraw from an LLC and a member’s ability to limit the control of a
managing member are not legally relevant factors. That argument, however,
does not follow from either Redlands or Zink. The question of whether the
findings are sufficient to show effective control—what Redlands and Zink
discuss—is a fact-based question and different from the threshold question of
whether the factors are relevant. Neither case holds that veto power over the
operations of a business or ability to withdraw funding are legally irrelevant
factors; in fact, the opinions consider those factors when determining whether
the individuals in question had control. While the facts in Redlands and Zink
may have been insufficient to demonstrate effective control, those cases do not
show that the factors the district court considered are legally irrelevant. Thus,
we hold that the district court did not rely on legally irrelevant factors in
answering the question of who effectively controlled the Partnerships.
iii. Whether the record supports the district court’s factual findings
The United States also argues that, even if the factors the district court
used are legally relevant, the record does not support the district court’s factual
findings. Specifically, the United States alleges: (1) the district court
“inaccurately suggest[ed] that Patterson and Nix played an active role in
delineating the confines of Presidio’s managerial authority”; (2) the
Partnership was not created to “implement an investment strategy determined
by Patterson and Nix”; (3) Presidio made itself managing member (i.e., Nix and
Patterson did not select Presidio); (4) Nix and Patterson could not terminate
10
Case: 12-41286 Document: 00512549032 Page: 11 Date Filed: 03/03/2014
No. 12-41286
the Partnership by withdrawing; (5) Nix and Patterson never acted “in
derogation of Presidio’s exclusive management authority”; and (6) the district
court improperly analogized to investor–money-manager relationships in
making its findings.
After reviewing the record, we hold that the district court did not clearly
err in finding that Nix and Patterson effectively controlled the Partnerships.
In arguing that the district court clearly erred, the Government essentially
advances one argument: to support a finding that Nix and Patterson effectively
controlled the Partnerships—notwithstanding Presidio’s role as managing
member—“the record would have to contain evidence of managerial actions by
Nix and Patterson inconsistent with Presidio’s exclusive management rights
under the terms of the LLC agreements.” But, this Court has previously held
that courts should take a holistic view in determining who controls a
partnership. See Agro Sci. Co. v. Comm’r, 934 F.2d 573, 576–77 (5th Cir. 1991)
(weighing multiple characteristics). Here the district court took that holistic
view, making several findings of fact in reaching its conclusion that Nix and
Patterson effectively controlled the Partnerships:
[Nix and Patterson] set the parameters within which Presido could
operate by means of the partnership agreements. These
partnerships were formed and existed for a single purpose—to
affect an investment strategy selected by Nix and Patterson.
Presidio was the managing partner only because Nix and
Patterson made it so. Not only did the partnership agreements
define Nix and Patterson’s investment strategy, they confined
Presidio to that strategy in express and unequivocal terms; and if
all else failed, Nix and Patterson could shut down the whole
process by withdrawing from the partnerships they had created.
Klamath V, 2012 WL 4889805 at *5.
The United States takes issue with specific factual findings. For
example, the United States argues that “Patterson and Nix could not terminate
11
Case: 12-41286 Document: 00512549032 Page: 12 Date Filed: 03/03/2014
No. 12-41286
[the Partnerships] by withdrawing from them.” But, the record shows that Nix
and Patterson were 90% owners of the Partnerships, retained the right to
withdraw at the end of each investment stage, and when Nix and Patterson
withdrew, the practical result was the end of the Partnerships. Even if Nix
and Patterson’s withdrawal did not legally necessitate the dissolution of the
partnership, their decision to withdraw had that practical effect. Thus, the
United States’ arguments do not leave a “definite and firm conviction” that the
district court made a mistake. See Payne v. United States, 289 F.3d 377, 381
(5th Cir. 2002) (“In reviewing factual findings for clear error, [this Court]
defer[s] to the findings of the district court unless we are left with a definite
and firm conviction that a mistake has been committed.”).
Moreover, the record affirmatively supports the district court’s factual
finding that Nix and Patterson had effective control. The district court
correctly found that the agreement defined the investment strategy and
confined Presidio to that investment strategy. The district court was also
correct that the Partnerships were formed for a single purpose—for Nix and
Patterson to engage in foreign currency investments. Finally, as the
Partnerships point out, Nix and Patterson had a 90% ownership interest in the
Partnerships, a factor that in other tax contexts suggests effective control. See,
e.g., Treas. Reg. §§ 1.52-1(d)(3)(i), 1.414(c)-2(c)(2)(i)–(iii).
Thus, we hold that the district court did not clearly err in finding that
Nix and Patterson effectively controlled the Partnerships.
2. Whether the district court exceeded its jurisdiction in finding that Nix
and Patterson were entitled to personal deductions for the $250,000
payments to Pollans & Cohen
The United States also claims that the district court lacked jurisdiction
to determine whether Nix and Patterson were entitled to a personal deduction
for the $250,000 fee each paid to Pollans & Cohen. Because this is a
12
Case: 12-41286 Document: 00512549032 Page: 13 Date Filed: 03/03/2014
No. 12-41286
partnership-level proceeding, the United States argues, the district court
exceeded its jurisdiction in considering personal tax questions. While
acknowledging that, in the first appeal, the Fifth Circuit included the $250,000
fee in a list of operational expenses to be addressed on remand, the United
States claims that the law-of-the-case doctrine does not apply here because
finding the district court had jurisdiction would constitute manifest error.
The Partnerships, however, respond that the law-of-the-case doctrine
means the district court had jurisdiction to address the $250,000 fee. They
also claim that, even assuming the Fifth Circuit erred in remanding for
consideration of the $250,000 fee, the error was not so manifest as to invoke
the exception to the law-of-the-case doctrine.
We hold that the law-of-the-case doctrine applies here. “Where the
question of jurisdiction was actually raised and argued before the prior panel
and the panel subsequently exercised jurisdiction without explanation in its
opinion, it is clear enough that the necessary assumption is that the prior panel
found subject matter jurisdiction present, and the ruling constitutes law of the
case.” USPPS, Ltd. v. Avery Dennison Corp., 647 F.3d 274, 283 (5th Cir. 2011)
(citation and internal quotation marks omitted). Here, the question of
jurisdiction was raised and argued in the first appeal. Specifically, the United
States disputed the district court’s authority to determine whether Nix and
Patterson were entitled to this personal deduction, Klamath IV, 568 F.3d at
543, yet the Court nevertheless included the $250,000 on the list of operating
expenses and then remanded to the district court a question involving the
operating expenses, id. at 548–49 (“These operational expenses include
interest on the loans, a breakage fee, a management fee paid to Presidio, and
a $250,000 fee paid to Pollans & Cohen.”). Further, this Court has previously
held that there is no jurisdiction exception to the law-of-the-case doctrine. Free
v. Abbott Labs., Inc., 164 F.3d 270, 273 (5th Cir. 1999) (citing Ferreira v. Borja,
13
Case: 12-41286 Document: 00512549032 Page: 14 Date Filed: 03/03/2014
No. 12-41286
93 F.3d 671, 674 (9th Cir. 1996) (“Surely a court that has decided that it has
jurisdiction is not duty-bound to entertain thereafter a series of repetitive
motions to dismiss for lack of jurisdiction.”)). We therefore hold that the law-
of-the-case doctrine applies and the district court did not exceed its
jurisdiction.
IV. CONCLUSION
For the foregoing reasons, we AFFIRM.
14