Sugarloaf Fund, LLC v. CIR , 911 F.3d 854 ( 2018 )

In the
United States Court of Appeals
For the Seventh Circuit
____________________
No. 18-1046
SUGARLOAF FUND, LLC,
Petitioner-Appellant,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellee.
____________________
Appeal from the United States Tax Court.
No. 671-10 — Robert A. Wherry, Judge.
____________________
ARGUED SEPTEMBER 28, 2018 — DECIDED DECEMBER 21, 2018
____________________
Before RIPPLE, SYKES, and SCUDDER, Circuit Judges.
SCUDDER, Circuit Judge. Before us in this appeal is a tax
shelter almost identical to the one we agreed reflected an abu-
sive sham in Superior Trading, LLC v. Commissioner, 728 F.3d
676 (7th Cir. 2013). We reach the same conclusion here and
affirm the Tax Court’s judgment and imposition of penalties.
2 No. 18-1046
I
A
John Rogers is an experienced tax lawyer and the architect
of a tax structure that the Commissioner of Internal Revenue
has found to be an abusive tax-avoidance scheme. In Superior
Trading, we considered the legitimacy of the scheme Rogers
designed and implemented for the 2003 tax year. Here we
consider a similar scheme he implemented for tax years 2004
and 2005.
Despite some minor changes that Rogers made over time,
the gist of the scheme has remained the same: Rogers forms a
partnership that he uses to acquire severely-distressed or
uncollectible accounts receivables from retailers located in
Brazil. A distressed or uncollectible receivable is exactly what
it sounds like—an amount owed to a retailer for which there
is no prospect of meaningful collection. For tax purposes the
partnership carries the receivables at their face amount, not at
the amount (often zero or something close to zero) any retailer
or debt collector would estimate collecting. The partnership
then conveys the receivables to U.S. taxpayers, who deem
them uncollectible and deduct from their income the
associated “loss.” The upshot is reduced U.S. tax liability.
Against this general overview, we turn in more detail to
the scheme at issue here. In April 2003 Rogers formed
Sugarloaf Fund, LLC, effectively a partnership. Several
Brazilian retailers then contributed accounts receivables to
Sugarloaf in exchange for interests in the partnership.
Sugarloaf structured the retailers’ contributions in such a way
to purportedly allow the partnership to assume the retailers’
original basis in the receivables. Think of this as the
No. 18-1046 3
partnership acquiring a $100 receivable that nobody in good
faith believed was worth more than $1 with the partnership
nonetheless recording the receivable as a $100 asset. In this
way, Sugarloaf assumed ownership of the receivables with a
built-in loss ($99 in our example) that, through the scheme,
would then be passed to U.S. taxpayers to reduce their income
tax liability.
All of that happened this way: not long after making con-
tributions to the Sugarloaf partnership, each of the Brazilian
retailers redeemed their interests in the partnership, effec-
tively cashing out the partnership interest they had received
in exchange for their contribution of receivables.
Once Sugarloaf owned the uncollectible accounts receiva-
bles, the next part of the scheme required transferring them to
U.S. taxpayers. Rogers did so by forming several limited lia-
bility companies in which Sugarloaf became a member and
contributed the distressed or uncollectible receivables. In a
complex series of transactions, the LLCs were, for all intents
and purposes, then sold to various U.S. taxpayers. For tax
purposes, whenever Sugarloaf sold an entity (and with it, the
associated uncollectible receivables), it recognized an expense
in an amount roughly equivalent to the face value of the re-
ceivables ($100 in our prior example). Sugarloaf characterized
this expense as a cost-of-goods-sold expense. The U.S. tax-
payer who acquired ownership of the uncollectible receiva-
bles also wrote them off and likewise claimed a bad-debt ex-
pense, typically for the same amount as the expense claimed
by Sugarloaf. In this way, and consistent with the principles
of partnership taxation, the “losses” on the receivables flowed
through to the U.S. taxpayer who had invested in the LLC.
4 No. 18-1046
The IRS caught on to structures like this and encouraged
legislation to prevent them. In October 2004, Congress ac-
cepted the invitation and amended the Tax Code to prohibit
partnerships like Sugarloaf from transferring built-in-losses
on uncollectible receivables to U.S. taxpayers in this manner.
See American Jobs Creation Act of 2004, Pub. L. No. 108-357,
§ 833, 118 Stat. 1589.
Undeterred, Rogers modified the scheme. In the new
structure, the Sugarloaf partnership contributed the uncol-
lectible receivables not in the first instance to an LLC, but in-
stead to a trust in which Sugarloaf was both the grantor and
beneficiary. Some additional maneuvering then ensued: a
U.S. taxpayer would contribute cash in exchange for a benefi-
cial interest in the trust; the trust would assign the receivables
to a sub-trust; and the U.S. taxpayer would be designated as
the beneficiary of the sub-trust. The U.S. taxpayer then
claimed ownership of the accounts receivables, wrote them
off, and deducted the associated bad-debt expense from their
net income. The end result was the same under this modified
structure—a reduced tax liability for the U.S. taxpayer.
B
The Commissioner determined that the Sugarloaf partner-
ship was a sham formed solely to evade taxes. This determi-
nation had a consequence: the Brazilian retailers’ purported
contribution of receivables to Sugarloaf was recharacterized
as a sale of assets from the Brazilian retailers to Sugarloaf.
Treating the contribution as a sale had the effect of depriving
Sugarloaf of the built-in-loss on the uncollectible receivables
that it tried to pass along to U.S. taxpayers. Or, to put the point
more technically, with the Brazilian retailers’ contributions
recharacterized as a sale, Sugarloaf’s original basis in the
No. 18-1046 5
receivables was reduced to the fair value of the receivables—
nearly nothing.
Upon receiving notice of the Commissioner’s
determination, Sugarloaf appealed in Tax Court. The parties
went to trial to resolve the dispute, and the Tax Court issued
an opinion in October 2014 affirming the Commissioner’s
determination that Sugarloaf was a sham partnership. In the
alternative, the Tax Court determined that, even if Sugarloaf
had been a legitimate or bona fide partnership, the Brazilian
retailers’ redemptions of their interest in the Sugarloaf
partnership was, in substance, a sale of receivables from the
retailers to Sugarloaf. This, too, had a consequence: pursuant
to the step-transaction doctrine, the Commissioner was
permitted to collapse the different steps of the scheme into
one and thereby recharacterize the transaction as a sale of the
Brazilian retailers’ accounts receivables to Sugarloaf. See
Atchison, Topeka and Santa Fe R.R. Co. v. United States, 443 F.2d
147, 151 (10th Cir. 1971) (explaining that under the step-
transaction doctrine, a series of formally separate steps that
are in substance “integrated, interdependent, and focused
toward a particular end result” may be combined and treated
as a single transaction”); McDonald’s Restaurants of Ill., Inc. v.
Commissioner, 688 F.2d 520, 524 (7th Cir. 1982) (describing
different approaches to analysis under the step-transaction
doctrine).
Based on these determinations, the Tax Court affirmed the
Commissioner’s adjustments to Sugarloaf’s income. Those
adjustments disallowed the cost-of-goods-sold expense the
partnership reported for 2004 when it sold its interest in the
LLCs and associated uncollectible receivables to various U.S.
taxpayers. Additional adjustments reflected Sugarloaf’s
6 No. 18-1046
failure to include certain income when reporting its 2004 and
2005 tax liabilities, and certain business expense deductions it
reported but were not permitted.
The Tax Court also upheld penalties the Commissioner
imposed on Sugarloaf, finding that a 40% penalty applied
(pursuant to 26 U.S.C. § 6662(h)(1) & (2)(A)(1) (2000 & Supp.
IV 2004)) to Sugarloaf’s tax underpayment resulting from its
gross misstatement of the 2004 cost-of-goods-sold expense,
and a 20% penalty applied (pursuant to 26 U.S.C. § 6662(a),
(b)(1) & (2)) to Sugarloaf’s underpayments attributable to its
negligence when failing to include certain income and taking
disallowed business expense deductions on its 2004 and 2005
tax returns.
Sugarloaf now seeks relief in our court.
II
A
A preliminary matter warrants our consideration before
turning to the merits. At oral argument, we raised a question
of professional responsibility, asking whether John Rogers
had a conflict of interest that prevented him from represent-
ing Sugarloaf in this appeal. We raised this concern because
Rogers, in addition to serving as Sugarloaf’s counsel, is the
beneficial owner of Jetstream Business Limited, an entity that
in turn owns an interest in Sugarloaf, and, as a result, has a
personal financial interest in the outcome of the appeal. At
oral argument Rogers responded by positing that there was
no conflict of interest in part because he had obtained conflict-
of-interest waivers from the U.S. taxpayers affected by the
Commissioner’s determinations at issue in this appeal.
No. 18-1046 7
We requested supplemental briefing on the conflict issue,
and Rogers responded by maintaining that no conflict existed.
He also submitted 35 conflict-of-interest waivers, only 12 of
which were signed by the associated U.S. taxpayer. Rogers’s
supplemental brief provided little comfort that he was not la-
boring under an impermissible conflict.
At our request the Commissioner also submitted a brief on
the conflict question. The Commissioner informed us that “all
of the U.S. taxpayers whose tax liabilities were ultimately at
issue in [the proceedings below] have entered into settlement
agreements with the Commissioner or otherwise resolved
their liabilities.” The Commissioner added that a decision by
our court affirming the Tax Court’s judgment will result in no
person other than Rogers being affected because the conse-
quences of the Commissioner’s adjustments to Sugarloaf’s
2004 and 2005 partnership tax returns will all flow to Rogers.
We have no reason not to credit the Commissioner’s rep-
resentations. That the other U.S. taxpayers who invested in
Rogers’s scheme will not be affected by our decision is funda-
mental to our analysis. See Illinois Rules of Professional Con-
duct, Rule 1.7 (2010). Based on this representation, we con-
clude that any conflict of interest that otherwise may have ex-
isted does not prevent us from allowing Rogers to continue to
represent Sugarloaf in this appeal.
All of this takes us to the merits.
B
Our review of the record before us leads us to renew what
we underscored in Superior Trading: “the absence of a nontax
business purpose is fatal,” and “[i]f the only aim and effect are
to beat taxes, the partnership is disregarded for tax purposes.”
8 No. 18-1046
728 F.3d at 680 (citing ASA Investerings Partnership v.
Commissioner, 201 F.3d 505, 512 (D.C. Cir. 2000)). “A
transaction that would make no commercial sense were it not
for the opportunity it created to beat taxes doesn’t beat them.”
Id.
Despite Rogers’s contention at oral argument that Superior
Trading was “almost irrelevant” to the outcome in this appeal,
the scheme at issue here is identical in all material respects to
the one we considered in Superior Trading. Indeed, our obser-
vation in Superior Trading that the partnership at issue there
was a sham applies with full force here. Id. (explaining that
the partnership “was really just a conduit from the original
owner of the receivables [the Brazilian retailers] to the U.S.
taxpayers who wanted a deduction equal to the difference be-
tween the face amount of the receivables (the promissors’
debt) and the receivables’ current, greatly depressed market
value”).
The only difference here is that, for parts of 2004 and all of
2005, Rogers used trusts to transfer the tax losses to U.S. tax-
payers. (He had not yet implemented this aspect of the
scheme in Superior Trading.) But this difference has no effect
on our analysis because it has no effect on the purpose of
Sugarloaf’s partnership—the modified scheme’s use of trusts
was nothing more than window dressing for Sugarloaf’s
method of transferring the uncollectible receivables and re-
lated “losses” to U.S. taxpayers.
The Sugarloaf partnership was a sham, and this conclu-
sion is underscored by the record here in much the say way it
was in Superior Trading. For example, in exchange for their
contributions, two different Brazilian retailers were each
granted separate 99% interests in Sugarloaf, a mathematical
No. 18-1046 9
impossibility that suggests the same blatant disregard for
partnership formalities we observed in Superior Trading. See
id. (explaining that the “reason for Rogers’ insouciance re-
garding formalities was that the aim of the partnership was
not to make money” but instead “to sell interests in the part-
nership to U.S. taxpayers seeking tax savings”).
Take another example. The record indicates that the
Brazilian retailers’ contribution agreements did not identify
the specific accounts receivables being transferred to
Sugarloaf, nor were the agreements ever registered in Brazil,
making their assignment to Sugarloaf invalid under Brazilian
law. This fact alone, we observed in Superior Trading,
undercuts any argument that Sugarloaf intended to engage in
any good-faith effort to attempt to collect on the receivables.
See id. (emphasizing that “there is considerable doubt
whether the receivables, which could be transferred only
pursuant to Brazilian law, were ever actually transferred to
[the partnership]”).
Even if we assumed that Sugarloaf was a bona fide
partnership, the Tax Court properly determined that the step-
transaction doctrine permitted the Commissioner to treat the
Brazilian retailers’ contributions and subsequent
redemptions as a sale of assets. And with the transaction
properly recharacterized as a sale, Sugarloaf’s basis in the
uncollectible receivables is reduced from their face value to
what it paid for them, thereby voiding the bad-debt expenses
Sugarloaf tried to pass along to U.S. taxpayers. The scheme
collapses and is revealed for what it truly is—an abusive
sham.
10 No. 18-1046
C
Finally, we review the penalties imposed by the
Commissioner. As a threshold matter, Sugarloaf argues that
the imposition of penalties was procedurally improper
because the Commissioner has not shown that the approval
requirements under 26 U.S.C. §§ 6751 and 7491 were
obtained, and further, that these requirements are
jurisdictional in nature and cannot be waived. This contention
ignores what happened in the Tax Court.
Sugarloaf stipulated in the Tax Court that the
Commissioner had properly obtained approval for the
penalties. The partnership cannot now be heard on appeal to
contend that any procedural requirements imposed by
§§ 6751 and 7491 are jurisdictional and incapable of being
waived, and we see nothing in these statutes precluding
waiver. See Chai v. Commissioner, 851 F.3d 190, 222 (2d Cir.
2017) (holding that the written-approval requirement is
appropriately viewed as an element of a penalty claim, but
not a component of subject matter jurisdiction); accord
Kaufman v. Commissioner, 784 F.3d 56, 71 (1st Cir. 2015)
(similarly treating as waived a taxpayer’s argument that the
Commissioner failed to comply with the procedural
requirements of § 6751). On this record, there was no
procedural flaw in the Commissioner’s imposition of
penalties.
Turning to the merits of the penalties, under the standard
that existed in 2004, a 40% gross-valuation misstatement pen-
alty like the one the Commissioner imposed on Sugarloaf was
permitted if the partnership’s claimed basis in the uncollecti-
ble receivables was 400% percent or more of the actual basis.
See 26 U.S.C. § 6662(h)(1) & (2)(A)(i) (2000 & Supp. IV 2004).
No. 18-1046 11
Sugarloaf claimed a basis in the uncollectible receivables that
was roughly equal to their face value, and as a result, reported
a cost-of-goods-sold expense of $122,950,000 after transfer-
ring the receivables to U.S. taxpayers. In reality, however, its
actual basis in the receivables (as a matter of economic sub-
stance) was a small fraction of what it claimed—clearly satis-
fying the gross-valuation standard.
And a 20% penalty like the one the Commissioner im-
posed on Sugarloaf was permitted if the partnership was neg-
ligent or disregarded rules and regulations when it failed to
include certain income and took impermissible deductions.
See 26 U.S.C. § 6662(a), (b)(1) & (2). This standard, too, is
clearly satisfied given Sugarloaf’s failure to reasonably ex-
plain why certain income was omitted or to substantiate the
disallowed deductions, as well as its, in the Tax Court’s
words, “scanty to nonexistent, and noncontemporaneous”
recordkeeping.
If Sugarloaf could establish that it had “reasonable cause”
and “acted in good faith” when reporting its income, it could
have avoided these penalties. 26 U.S.C. § 6664(c)(1); see United
States v. Boyle, 469 U.S. 241, 250–51 (1986). In Superior Trading
we observed that “there is not even a colorable basis for the
tax shelter that [Rogers] created.” Just as there was no
colorable basis then, there certainly is no colorable basis now,
such that the Tax Court did not clearly error when it found
Sugarloaf could not avail itself of the reasonable-cause
defense. The assessed penalties were proper.
For these reasons, we AFFIRM.