Cemco Investors v. United States ( 2008 )

In the
United States Court of Appeals
For the Seventh Circuit
____________
No. 07-2220
CEMCO INVESTORS, LLC, and
FOREST CHARTERED HOLDINGS, LTD.,
Plaintiffs-Appellants,
v.
UNITED STATES OF AMERICA,
Defendant-Appellee.
____________
Appeal from the United States District Court for the
Northern District of Illinois, Eastern Division.
No. 04 C 8211—Joan B. Gottschall, Judge.
____________
ARGUED DECEMBER 7, 2007—DECIDED FEBRUARY 7, 2008
____________
Before EASTERBROOK, Chief Judge, and MANION and
KANNE, Circuit Judges.
EASTERBROOK, Chief Judge. Paul M. Daugerdas, a tax
lawyer whose opinion letters while at Jenkins & Gilchrist
led to the firm’s demise (it had to pay more than
$75 million in penalties on account of his work), designed
a tax shelter for himself, with one client owning a
37% share. Like many tax shelters it was complex in
detail but simple in principle, and to facilitate exposition
we cover only its basics, rounding all figures.
Four entities played a role: Cemco Investors, a limited
liability company that for tax purposes is treated as a
2 No. 07-2220
partnership (so that its profits and losses are passed
through to its owners); Cemco Investment Partners (the
Partnership), Cemco Investors Trust (the Trust), and
Deutsche Bank. (Forest Chartered Holdings, which
Daugerdas controls, is Cemco’s tax-matters partner. It
handles Cemco’s tax paperwork and has managed this
litigation but did not participate in the underlying trans-
actions. We do not mention it again.)
In December 2000 the Trust purchased from Deutsche
Bank two options in euros, one long and one short. The
long position had a premium of $3.6 million (nominally
paid to Deutsche Bank) and entitled the Trust to
$7.2 million if, two weeks in the future, the euro was
trading at $.8652 or lower. (Back in 2000 the dollar was
worth more than the euro.) The short position had roughly
the same premium (nominally paid by Deutsche Bank
to the Trust) and required the Trust to pay Deutsche
Bank $7.2 million if, on the same date, the euro ex-
change rate was $.8650 or lower. In other words, if on
the exercise date the euro was worth $.8652 or more, or
$.8650 or less, the long and short positions would cancel
out; but if the euro was trading for $.8651 on December 19,
2000, then Deutsche Bank would pay $7.2 million to the
Trust. Like the options, the premiums matched almost
exactly. The only money that changed hands was $36,000,
which the Trust paid Deutsche Bank as the difference
between the long and short premiums. And Deutsche
Bank promised to refund $30,000 of this $36,000 if the
options offset on the exercise date.
The Trust assigned its rights in these options to the
Partnership, contributing some cash as well. The partner-
ship spent about $50,000 to buy euros at an exchange
rate of .89 dollars per euro. The next day Deutsche Bank
remitted $30,000, because the options had offset. Soon the
Partnership liquidated and distributed its assets (both
dollars and euros) to the Trust. Next the Trust transferred
No. 07-2220 3
to Cemco the i56,000 it had received from the Partner-
ship. Finally, on the year’s last business day, Cemco sold
the euros for $50,000.
One would think from this description that the Trust
(and the Partnership as its assignee) suffered a loss of
$6,000—the net premium paid for options that cancelled
each other out and hence lacked value on the exercise
date—while Cemco had neither profit nor loss. Yet Cemco
filed a tax return for 2000 showing a loss of $3.6 million!
Its theory was that the Partnership’s euros (later contrib-
uted to Cemco) had the same $3.6 million basis as the
long option, and that a loss could be recognized once the
euros had been sold. Cemco passed the loss to Daugerdas
and his client, who reported it on their tax returns. What
of the $3.6 million that Deutsche Bank “paid” the Trust
for the short option, which almost exactly offset the
long option? Well, Cemco took the view that this stayed
with the Trust—and would never be taxed to the Trust,
which, after all, had a net loss of $6,000—or if assumed
by Cemco may be ignored because the options offset in
the end. The purchase and sale of euros was the device
used to transfer the basis of one option to Cemco while
consigning the other option to oblivion.
A transaction with an out-of-pocket cost of $6,000 and
no risk beyond that expense, while generating a tax loss
of $3.6 million, is the sort of thing that the Internal
Revenue Service frowns on. The deal as a whole seems to
lack economic substance; if it has any substance (a few
thousand dollars paid to purchase a slight chance of a big
payoff) then the $3.6 million “gain” on one premium should
be paired with the $3.6 million “loss” on the other; and
at all events the deal’s nature ($36,000 paid for a slim
chance to receive $7.2 million) is not accurately reflected
by treating i56,000 as having a basis of $3.6 million. The
IRS sent Cemco a Notice of Final Partnership Administra-
tive Adjustment disallowing the loss and assessing a
4 No. 07-2220
40% penalty for Cemco’s grossly incorrect return. In the
ensuing litigation, the district court sided with the IRS.
2007 U.S. Dist. LEXIS 22246 (N.D. Ill. Mar. 27, 2007).
Cemco says that in treating $50,000 of euros as having
a $3.6 million basis, which turned into a loss when the
euros were sold for exactly what they had been worth all
along, it was just relying on Helmer v. CIR, 34 T.C.M. 727(1975), and a few similar decisions. That may or may not
be the right way to understand Helmer; we need not
decide, for it is not controlling in this court—or any-
where else. The Commissioner has a statutory power to
disregard transactions that lack economic substance.
Compare Gregory v. Helvering, 293 U.S. 465 (1935), with
Frank Lyon Co. v. United States, 435 U.S. 561 (1978). And
the IRS has considerable latitude in issuing regulations
that specify sorts of transactions that may be looked
through. (These regulations avoid the need to litigate, one
tax shelter at a time, whether any real economic trans-
action is inside the box.) A few months before Daugerdas
set up this tax shelter, the IRS had issued Notice 2000–44,
2000–2 C.B. 255, alerting taxpayers to its view that
Helmer could not be relied on, that purported losses
from transactions that assigned artificially high basis
to partnership assets would be disallowed, and that
formal regulations to this effect were on their way. One
of the transactions covered in Notice 2000–44 is the
offsetting-option device.
Getting from a warning to a regulation often takes years,
however, and did so here. Treasury Regulation §1.752–6,
26 C.F.R. §1.752–6, was issued in temporary form in 2003.
T.D. 9062, 2003–2 C.B. 46. Two more years passed
before the temporary regulation was made permanent.
T.D. 9207, 2005–1 C.B. 1344, 70 Fed. Reg. 30334 (May 26,
2005). This sets the stage for Cemco’s principal argument.
It concedes that Notice 2000–44 and Treas. Reg. 1.752–6
scupper the entire class of offsetting-option tax shelters.
No. 07-2220 5
The regulation does this by subtracting, from the partner-
ship’s basis in an asset, the value of any corresponding
liability. Thus if Cemco’s basis in the euros comes from
the premium for one option, then the premium for the
offsetting option must be subtracted. That gets the basis
back to roughly $50,000 (the value of the euros) + $6,000
(the difference in the premiums). But as Cemco sees
things the notice lacks legal effect, while the regulation
cannot be applied retroactively. One district court has
held that Treas. Reg. §1.752–6 does not affect transac-
tions that predate it. Klamath Strategic Investment Fund,
LLC v. United States, 440 F. Supp. 2d 608 (E.D. Tex.
2006). We disagree with that conclusion.
The regulation could not be more explicit: “This section
applies to assumptions of liabilities occurring after
October 18, 1999, and before June 24, 2003.” Treas. Reg.
§1.752–6(d)(1). (Transactions after June 23, 2003, are
governed by the more elaborate 26 C.F.R. §1.752–7.) Why
October 18, 1999? Because, although regulations gen-
erally do not apply to transactions that occur before
the initial publication date of a draft regulation, see 26
U.S.C. §7805(b)(1)(C), the norm of prospective application
“may be superseded by a legislative grant from Congress
authorizing the Secretary to prescribe the effective date
with respect to any regulation.” 26 U.S.C. §7805(b)(6).
Section 309 of the Community Renewal Tax Relief Act
of 2000, Pub. L. 106–554, 114 Stat. 2763A–587, 638 (2000),
enacts basis-reduction rules for many transactions and
authorizes the IRS to adopt regulations prescribing sim-
ilar rules for partnerships and S corporations. Section
309(d)(2) of the 2000 Act adds that these regulations
may be retroactive to October 18, 1999. That’s the power
the Commissioner used when promulgating Treas. Reg.
§1.752–6.
The district court in Klamath did not doubt that retroac-
tivity could rest on the 2000 Act; Treas. Reg. §1.752–6
6 No. 07-2220
applies to partnerships (and LLCs treated as partner-
ships) a rule “similar” to the approach that Congress
adopted for other business entities. Klamath held, how-
ever, that when promulgating Treas. Reg. §1.752–6 the
IRS had not availed itself of that power. But if the IRS was
not using that authority, why in the world does the
regulation reach back to October 18, 1999? Retroactivity
requires justification; to make a rule retroactive is to
invoke one of the available justifications; and the choice
of date tells us that the justification is the one supplied
by the 2000 Act (in conjunction with §7805(b)(6)). A reg-
ulation’s legal effect does not depend on reiterating the
obvious. So Treas. Reg. §1.752–6 applies to this deal and
prevents Cemco’s investors from claiming a loss. Cemco
is scarcely in a position to complain—not only because
this tax shelter was constructed after the warning in
Notice 2000–44, but also because all the regulation does
is instantiate the pre-existing norm that transactions
with no economic substance don’t reduce people’s taxes.
See Coltec Industries, Inc. v. United States, 454 F.3d 1340(Fed. Cir. 2006).
Cemco offers several other arguments, only one of
which requires discussion. Sections 6221 to 6234 of the
Internal Revenue Code link the tax treatment of partners
to that of their partnerships. Disputes are resolved in a
single proceeding at the partnership level, and each
partner then must treat all partnership items on his
own return the same way they were treated in that
proceeding. 26 U.S.C. §6222(a). That’s why the Commis-
sioner issued the Notice of Final Partnership Administra-
tive Adjustment to Cemco and why it rather than
Daugerdas or his client is the plaintiff. Under Treas. Reg.
§301.6231(a)(3)–1, 26 C.F.R. §301.6231(a)(3)–1, both assets
and liabilities can be “partnership items,” and this is
Cemco’s opening. It asks us to treat the euros as a “part-
nership item” of the Partnership. When the Trust contrib-
No. 07-2220 7
uted this “partnership item” to Cemco, it had the same
basis as in the Partnership’s (and later the Trust’s) hands.
To ensure consistent treatment, Cemco maintains, the
IRS should have issued the Notice of Final Partnership
Administrative Adjustment to the Partnership instead
of Cemco. As long as the euros have a basis of $3.6 million
for the Partnership and Trust, they must have the same
basis for Cemco, the argument concludes.
Cemco’s approach misstates the scope of §§ 6221–34.
They concern the treatment of “partnership items” by the
partners of a partnership. Cemco has never been a partner
of the Partnership or the Trust. These sections of the
Code therefore do not link the tax treatment of the euros
in Cemco’s hands to their tax treatment in anyone else’s.
Cemco is effectively contending that §§ 6221–34 should
be extended to create a general requirement of consistency
in tax treatment. That sort of argument has been made
before—and has been rejected by the Supreme Court.
Restaurants must withhold taxes on tips paid to their
employees. One restaurant, which had been dunned for
underpayment of the withholding tax, insisted that it
need not pay until income taxes had been assessed against
the employees; otherwise the employees’ taxable tip
income might be calculated differently for the restaurant
and the workers, though the actual level of tips must
be the same from either perspective. United States v. Fior
D’Italia, Inc., 536 U.S. 238 (2002), held, however, that
the IRS need not ensure consistent tax treatment unless
a statute so requires. Sections 6221 to 6234 don’t re-
quire this, because Cemco is not an investor in the Part-
nership.
True enough, 26 U.S.C. §723 provides that Cemco’s
basis in the euros must equal the basis the asset had for
its last owner. But this means the actual basis, not
whatever number the prior owner chooses to report. The
IRS is free to determine assets’ correct basis, under
8 No. 07-2220
governing law, whether or not a former owner has filed a
creative tax return full of fanciful numbers. The Partner-
ship did not claim a $3.6 million tax shield, so there was
no reason for the IRS to spend time or money pinning
down the correct tax on its slight income. Cemco’s re-
turn is what matters to what real taxpayers owe, so it
was both sensible and lawful for the Commissioner to
issue the Notice of Final Partnership Administrative
Adjustment to Cemco alone. To the extent that Roberts v.
CIR, 94 T.C. 853 (1990), combines §723 with §6222 to
produce a requirement that the IRS first recalculate the
taxes of whoever contributes an asset to a partnership,
the better to ensure consistency, it misreads the Code.
Section 6222 requires partnerships and their partners to
treat consistently the “partnership items” of that partner-
ship. No statute requires the IRS to treat identically two
or more entities just because they have some partners
in common (Daugerdas has interests in Cemco, the Trust,
and the Partnership).
AFFIRMED
A true Copy:
Teste:
________________________________
Clerk of the United States Court of
Appeals for the Seventh Circuit
USCA-02-C-0072—2-7-08