Logan Trust v. Commissioner, IRS

United States Court of Appeals
FOR THE DISTRICT OF COLUMBIA CIRCUIT
Argued November 18, 2014 Decided June 26, 2015
No. 12-1148
LOGAN TRUST,
APPELLANT
TIGERS EYE TRADING, LLC, ET AL.,
APPELLEES
v.
COMMISSIONER OF INTERNAL REVENUE SERVICE,
APPELLEE
On Appeal from the Order and Decision
of the United States Tax Court
David D. Aughtry argued the cause for appellant. With
him on the briefs was William E. Buchanan.
Andrew M. Weiner, Attorney, U.S. Department of Justice,
argued the cause for federal appellee. With him on the brief
were Tamara W. Ashford, Acting Deputy Assistant Attorney
General, and Gilbert S. Rothenberg and Joan I. Oppenheimer,
Attorneys. Ellen P. DelSole, Attorney, entered an appearance.
James P. Wehner was on the brief for appellees Tigers
Eyes Trading, LLC, et al.
2
Before: HENDERSON, GRIFFITH, and SRINIVASAN, Circuit
Judges.
Opinion for the Court filed by Circuit Judge GRIFFITH.
GRIFFITH, Circuit Judge: H.L. Mencken famously
observed, “[T]here is always an easy solution to every human
problem—neat, plausible, and wrong.” H.L. MENCKEN, A
MENCKEN CHRESTOMATHY 443 (First Vintage Books 1982)
(1949) (emphasis added). When first taken, this appeal
presented a complex problem that has vexed the courts and
for which there was no easy answer: whether and when the
Tax Court may apply a penalty to a taxpayer who underpays
his taxes by participating in a partnership that was nothing
more than an intricate tax shelter. But an intervening decision
of the Supreme Court has recently revealed a disposition for
this case that is neat, plausible, and right. By the time of oral
argument, even the parties agreed, leaving us little to do but
briefly explain why they are correct.
I
Although partnerships do not themselves pay taxes, the
partnership must still submit a yearly information return to the
Internal Revenue Service (IRS) that reports partnership items
such as the business’s income and losses. When the IRS
suspects something is amiss on a partnership’s return, the
agency conducts an audit of the return. If the IRS finds that
the partnership lacks economic substance and is in reality a
tax shelter, it will adjust the partnership’s return accordingly
and notify the partners of the changes. I.R.C. §§ 6221,
6223(a)(2), 6231(a)(3). The partners may challenge such
adjustments in court. Id. § 6226(a).
 3
After any such challenges are resolved, the IRS will
adjust each partner’s tax return to reflect any increase or
decrease in his tax liability based on changes made to the
partnership’s return. Id. § 6231(a)(6). Once those individual
adjustments are made, each partner must pay any increase in
his tax liability and any applicable penalties. If the
adjustments to the partner’s return can be made mechanically
without taking into account his unique circumstances, the IRS
will assess his new tax liability and impose any penalties
directly against the partner. The partner can only raise any
defenses in a refund action after he has paid the taxes and
penalties. Id. § 6230(a)(1), (c)(4). On the other hand, if the
partner’s liability turns on facts unique to him, the IRS must
use the deficiency process, which benefits the partner by
allowing him to challenge the IRS’s conclusions before
paying. Id. § 6230(a)(2)(A)(i).
Until 1997, the IRS was limited to using deficiency
proceedings to recover penalties against a partner. But that
year, Congress created an exception to this process that is at
the heart of this case. Taxpayer Relief Act of 1997, Pub. L.
No. 105-34, § 1238, 111 Stat. 1026-27. Now, if a penalty
“relates to an adjustment to a partnership item” and thus
applies to all partners whose individual returns contain the
same errors identified and corrected in the partnership’s
return, the reviewing court can determine the “applicability”
of the penalty when reviewing the challenge to the IRS
adjustments to the partnership’s return. I.R.C. § 6226(f). If the
court determines that the penalty does apply, the IRS may
assess the penalty against the partners directly once all
partnership matters have been resolved and require the
partners to raise any objections only after they have paid in a
refund action. Id. § 6230(a)(2), (c)(4).
4
This appeal involves a Son of BOSS tax shelter, the
direct descendant of an equally abusive tax shelter known as a
BOSS (bond option sales strategy). As we and numerous
other courts have found, the Son of BOSS abuses the
partnership form of doing business by “employ[ing] a series
of transactions to create artificial financial losses that are used
to offset real financial gains, thereby reducing tax liability.”
Petaluma FX Partners, LLC v. C.I.R., 591 F.3d 649, 650
(D.C. Cir. 2010). This tax shelter allows a partner to
artificially inflate the value of his capital contributions to the
partnership (referred to as his outside basis) and then use that
basis to generate a “loss” on his personal tax return.
II
Taxpayer A. Scott Logan inflated his basis in a
partnership that functioned as a Son of BOSS tax shelter,
Tigers Eye Trading, LLC, and as a result could claim a
substantial loss on his 1999 tax return. This paper loss of
close to $27 million offset the taxes Logan otherwise would
have owed on around $27 million he had made in capital
gains. Logan joined Tigers Eye through three trusts he had
formed. The trusts were the true partners in Tigers Eye, Logan
claimed losses based on the three trusts’ outside basis, and he
participated in this proceeding through one of the trusts. For
simplicity’s sake, however, we refer to Logan himself and not
his trust as the appellant and the partner involved in this case.
The IRS audited Tigers Eye and concluded that, like
other Son of BOSS tax shelters, it was a sham entity that
lacked economic substance and was created solely so that its
participants could avoid taxes. The IRS issued a notice that
disregarded the partnership’s existence and any contributions
made to the sham enterprise, adjusted the outside basis of
5
each of its partners, including Logan, to zero, and determined
that any partner who underpaid his taxes as a result of
reporting his outside basis in Tigers Eye faced a gross
valuation-misstatement penalty. The gross valuation-
misstatement penalty is a 40 percent penalty that applies to
any portion of taxes that a partner underpaid because he
overstated the value of his basis in property by 400 percent or
more of its true value. I.R.C. § 6662(h)(2) (2000). ∗ When, as
in a sham partnership, an asset’s true value is zero, the gross
valuation-misstatement penalty is automatically triggered if a
partner claimed on his tax return that the asset was worth
anything at all. Treas. Reg. § 1.6662-5(g). Along with the
partnership, Logan challenged the notice in the Tax Court.
After Logan’s motions for summary judgment were denied,
the partnership settled with the IRS and entered into a
stipulated decision that accepted the IRS’s findings and bound
all parties.
Shortly after the stipulated decision was entered, we held
in Petaluma that the Tax Court lacked jurisdiction to do what
it had just done in Logan’s case: determine a partner’s outside
basis in a proceeding that was adjudicating the tax treatment
of the partnership. 591 F.3d at 654-55. We remanded the case
to the Tax Court to decide if it could nonetheless determine
the applicability of penalties to be imposed on individual
partners without adjusting any partner’s outside basis. Id. at
655-56. Logan moved to revise the stipulated decision,
arguing that under Petaluma the Tax Court not only lacked
jurisdiction to adjust his outside basis to zero, but also to
∗
Congress has since amended and lowered the threshold for
the gross valuation-misstatement penalty. It is now triggered when
a taxpayer claims that his basis in an asset was 200 percent or more
of its true (adjusted) value. I.R.C. § 6662(h)(2) (2012).
6
apply the penalty to him. The Tax Court disagreed with
Logan’s reading of Petaluma and left the stipulated decision
intact. Logan appealed to this court.
While Logan’s appeal was pending, the Supreme Court
resolved the jurisdictional questions related to outside basis
and penalties once and for all. United States v. Woods, 134 S.
Ct. 557 (2013). As the parties agree, Woods makes clear that a
court adjudicating partnership matters has jurisdiction to
apply “any penalty that could result from an adjustment to a
partnership item.” Id. at 564. That authority encompasses
situations like this one where the partnership is a mere tax
shelter, which is a determination that we held in Petaluma and
the Court affirmed in Woods should be made in the course of
adjudicating partnership issues. In such a case, the partnership
never existed, and no partner could have any outside basis in
the entity. It follows, therefore, that any partner who claimed
his outside basis as a loss on his tax return faces a potential
gross valuation-misstatement penalty for doing so. That
penalty “relates to” and flows directly from an “adjustment to
a partnership item,” I.R.C. § 6226(f), that is, from the
“determination that [the] partnership lacks economic
substance,” Woods, 134 S. Ct. at 563. Thus, in the course of
adjudicating matters related to the partnership, the court can
announce that any member of the tax-shelter partnership who
the IRS later finds shirked his taxes by claiming a basis
greater than zero is subject to a gross valuation-misstatement
penalty, Woods, 134 S. Ct. at 565—a penalty that the IRS can
impose directly on the partner, requiring him to pay it before
bringing a refund action.
Woods also made clear that outside basis is not a
partnership item that a court has jurisdiction to adjust when
reviewing matters involving only the partnership. Id. at 565.
 7
That adjustment must be formally conducted in proceedings
with each partner, although the reviewing court can
“determine whether the adjustments it [does] make, including
the economic-substance determination, ha[ve] the potential to
trigger a penalty; and in doing so, it [is] not required to shut
its eyes to the legal impossibility of any partner’s possessing
an outside basis greater than zero in a partnership that, for tax
purposes, d[oes] not exist.” Id. Thus, although a court may
announce that a penalty has been triggered in a proceeding
involving the partnership based on the presumption that
outside basis in a sham partnership is zero, the court cannot
formally adjust a partner’s outside basis at that time.
Once Woods was decided, we ordered new briefing and
held oral argument. We have jurisdiction pursuant to I.R.C.
§ 7482(a)(1). We review jurisdictional and statutory
interpretation questions de novo. Munsell v. Dept. of Agric.,
509 F.3d 572, 578 (D.C. Cir. 2007); United States v. Wilson,
290 F.3d 347, 352 (D.C. Cir. 2002).
Because the parties to this case agree about how the
issues they once disputed should now be resolved, our
analysis is brief. The parties recognize that Woods answered
the questions about the Tax Court’s jurisdiction over penalties
and outside basis. Logan concedes rightly that the Tax Court
properly applied his penalty when the court conducted its
review of the partnership and its items, and we will affirm the
Tax Court on this point. In turn, the IRS acknowledges
correctly that the Tax Court lacked jurisdiction to determine
that the Tigers Eye partners had no basis in the partnership,
and we will reverse the portion of the Tax Court’s decision
that did so.
8
That leaves only two additional issues raised by Logan
that we will not consider because “at oral argument, the
dispute between the parties . . . disappeared before our eyes.”
Washington Legal Found. v. Henney, 202 F.3d 331, 335 (D.C.
Cir. 2000). Logan argued that certain language in the Tax
Court’s summary judgment ruling, and in the notice that the
Tax Court approved in its stipulated decision, is legally
erroneous and could preclude him from raising his reliance on
his law firm’s advice as a defense to penalties in a future
refund action. In its brief and at oral argument, however,
counsel for the IRS explained that the Tax Court issued no
binding ruling regarding Logan’s defense based on his firm’s
advice, leaving all issues regarding its availability and
application to be litigated in a future refund action. See Oral
Arg. Tr. 26:13-28:8. In the IRS’s view, then, nothing can
prevent Logan from asserting this defense, and Logan’s
counsel explained that the IRS’s concession at oral argument
sufficiently protects his client. Id. 32:6-17.
III
The Tax Court’s order and decision entered on February
13 and 15, 2012, is affirmed with regard to the court’s holding
that the gross valuation-misstatement penalty applies to the
Tigers Eye partners. It is reversed with regard to the court’s
holding that the Tigers Eye partners had no outside basis in
the partnership. We remand this case to the Tax Court for
further proceedings consistent with this opinion.