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NPR Investments, L.L.C. ex rel. Roach v. United States

United States Court of Appeals, Fifth Circuit

January 23, 2014

NPR INVESTMENTS, L.L.C., by and through Nelson Roach, a Partner other than the Tax Matters Partner, Plaintiff-Appellee Cross-Appellant,
United States of America, Defendant-Appellant Cross-Appellee. Harold W. Nix; Charles C. Patterson, Intervenor Plaintiffs-Appellees,

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Thomas A. Cullinan (argued), Sutherland Asbill & Brennan, L.L.P., Atlanta, GA, J. Hoke Peacock, II, Esq., Orgain, Bell & Tucker, L.L.P., Beaumont, TX, for Plaintiff-Appellee Cross-Appellant, Intervenor Plaintiffs-Appellees.

Arthur Thomas Catterall (argued), Richard Bradshaw Farber, Esq., Supervisory Attorney, Gilbert Steven Rothenberg, Esq., Deputy Assistant Attorney General, U.S. Department of Justice, Washington, DC, Andrew L. Sobotka, U.S. Department of Justice, Dallas, TX, for Defendant-Appellant Cross-Appellee.

Appeals from the United States District Court for the Eastern District of Texas.

Before DENNIS, CLEMENT, and OWEN, Circuit Judges.

PRISCILLA R. OWEN, Circuit Judge:

In a Tax Equity and Fiscal Responsibility Act of 1982 (" TEFRA" ) [1] partnership proceeding, the district court held that valuation misstatement and substantial understatement tax penalties were inapplicable to NPR Investments, LLC (NPR). The United States appeals those determinations. The district court also held that a notice of a Final Partnership Administrative Adjustment (FPAA) issued by the Internal Revenue Service (IRS) to NPR, which made adjustments to NPR's tax return and could result in additional tax liabilities to some of the partners, was valid. NPR, by and through one of its partners, Nelson J. Roach, and two of NPR's other partners, Harold W. Nix and Charles C. Patterson, cross-appeal that holding. We will refer to Nix, Patterson, and Roach, collectively, as the Taxpayers.

We conclude that, in this partnership-level proceeding, (1) valuation misstatement penalties under 26 U.S.C. § 6662(e) and (h) are applicable; (2) a substantial underpayment penalty under 26 U.S.C. § 6662(d) is applicable because there was no substantial authority for the tax treatment of the transactions at issue; (3) NPR failed to carry its burden of establishing a reasonable-cause defense under 26 U.S.C. § 6664; and (4) the Taxpayers' respective, individual reasonable-cause defenses under 26 U.S.C. § 6664 are partner-level defenses that the district court did not have jurisdiction to consider. We accordingly affirm the district court's judgment regarding the finality of the FPAA, reverse the district court's judgment regarding the valuation misstatement and substantial underpayment penalties, reverse the district court's judgment regarding NPR's reasonable-cause defense, and vacate the district court's judgment regarding the Taxpayers' reasonable-cause defenses.


Harold Nix, Charles Patterson, and Nelson Roach are partners in the law firm of Nix, Patterson & Roach, LLP. They represented the State of Texas in litigation against the tobacco industry and in 1998 were awarded a fee of approximately $600 million that is to be paid over a period of time. They also received fees totaling approximately $68 million in connection with tobacco litigation in Florida and Mississippi. Nix, Patterson, and Roach share the fees 40%, 40%, and 20%, respectively.

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Nix and Patterson have participated in at least two " Son-of-BOSS" tax shelters. BOSS stands for " Bond and Options Sales Strategy." [2] Courts, including our court and the district court in this case,[3] have described a Son-of-BOSS transaction as " a well-recognized ‘ abusive’ tax shelter." [4] Artificial losses are generated for tax deduction purposes.

Before creating NPR and engaging in the transactions at issue in this appeal, Nix and Patterson invested in another Son-of-BOSS tax shelter, known as BLIPS. It involved sham bank loans, and our court considered various tax issues related to Nix's and Patterson's transactions with regard to that shelter in Klamath Strategic Investment Fund ex rel. St. Croix Ventures v. United States. [5]

In August 2000, after the investment in BLIPS but before NPR was formed, the IRS issued a notice that it considered Son-of-BOSS transactions, including BLIPS, abusive and that deductions for artificial losses generated from such transactions would not be permitted. The Notice, IRS Notice 2000-44, states:

In another variation [of transactions generating losses through artificially high bases], a taxpayer purchases and writes options and purports to create substantial positive basis in a partnership interest by transferring those option positions to a partnership. For example, a taxpayer might purchase call options for a cost of $1,000X and simultaneously write offsetting call options, with a slightly higher strike price but the same expiration date, for a premium of slightly less than $1,000X. Those option positions are then transferred to a partnership which, using additional amounts contributed to the partnership, may engage in investment activities.
Under the position advanced by the promoters of this arrangement, the taxpayer claims that the basis in the taxpayer's partnership interest is increased by the cost of the purchased call options but is not reduced under § 752 as a result of the partnership's assumption of the taxpayer's obligation with respect to the written call options. Therefore, disregarding additional amounts contributed to the partnership, transaction costs, and any income realized and expenses incurred at the partnership level, the taxpayer purports to have a basis in the partnership interest equal to the cost of the purchased call options ($1,000X in this example), even though the taxpayer's net economic outlay to acquire the partnership interest and the value of the partnership interest are nominal or zero. On the disposition of the partnership interest, the taxpayer claims a tax loss ($1,000X in this example), even though the taxpayer has incurred no corresponding economic loss.
The purported losses resulting from the transactions described above do not represent bona fide losses reflecting actual economic consequences as required for purposes of § 165. The purported losses from these transactions (and from

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any similar arrangements designed to produce noneconomic tax losses by artificially overstating basis in partnership interests) are not allowable as deductions for federal income tax purposes.[6]

In 2001, the Taxpayers consulted with their CPA, Sid Cohen, with whom they had a longstanding professional relationship, about investing in foreign currency. Cohen introduced the Taxpayers to Diversified Group, Inc. (DGI) in the summer of 2001. Cohen arranged and attended a meeting with DGI in October 2001 at which Patterson was also present. DGI explained its investment opportunity, which involved the purchase, and contribution to a partnership, of offsetting foreign, European-style currency options.[7] This offsetting-option shelter was called " OPS" (Option Partnership Strategy). The structure of the investment was similar to that described in and prohibited by Notice 2000-44. Cohen characterized the options as high-risk from the standpoint of an investment for profit, but said that Patterson and his partners had the " potential to make a lot of money on it" if the options " hit the sweet spot." " Hitting the sweet spot" could only occur if, on the expiration date of the options, the exchange rate was at or above the strike price of the long option but below the strike price of the short option. If that occurred, there would be no payment obligation under the short option to offset the payout received under the long option. However, the difference between the strike price of the long option and that of the short option was negligible, only three pips. A pip is the smallest unit quoted for the price of any currency. The district court noted that in any given fifteen-minute period, the prices that banks quote for foreign currencies can vary by more than three pips.[8] Cohen and Patterson were advised that unless the " sweet spot" was attained, there would be tax losses. They never inquired about and were never told the odds of " hitting the sweet spot." Neither NPR nor the Taxpayers presented evidence in the district court of the likelihood of hitting the sweet spot, though a Government witness testified that there was no real probability of hitting the sweet spot.

On the same day that Cohen and Patterson met with DGI, they met with R.J. Ruble, who was then an attorney with Sidley, Austin, Brown & Wood LLP (Sidley Austin), at DGI's offices. Ruble provided Patterson and Cohen with a draft, template tax opinion letter describing a transaction similar to the one proposed by DGI. At this meeting, Ruble explained the potential tax benefits of the transaction. He told Patterson and Cohen that hitting the sweet spot was unlikely.

Nix and Patterson decided to enter into the investment scheme, and subsequently, Roach did as well. Each Taxpayer formed a single member limited liability company (SMLLC), managed by DGI. Nix and Patterson each funded their respective SMLLC's by contributing $625,000, and Roach contributed $375,000 to his. DGI and Alpha Consultants, Inc. (Alpha) formed NPR, a partnership, each contributing $50,000, and became its exclusive co-managers. Patterson, Nix, and Roach each purchased two pairs of offsetting foreign currency options, through their SMLLCs, with each paired option having the same expiration dates and near-identical strike prices. The Taxpayers contributed

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their SMLLCs to NPR, receiving partnership interests in NPR. Patterson and Nix each paid DGI an " advisory fee" of $750,000, and Roach paid DGI $450,000. Patterson and Nix each paid Cohen $250,000, and Nix paid him $150,000. All of these fees were based on a percentage of the tax losses that the investment strategy was expected to generate, which was $25,000,000 for Nix, $25,000,000 for Patterson, and $15,000,000 for Roach. DGI paid Cohen a referral fee of $325,000, although the Taxpayers were unaware of this until after the IRS had completed its audit of NPR.

The Government argues in its brief that the fees paid by the Taxpayers, and the contribution of the options to NPR, made it impossible for Roach to make a profit and made it extremely unlikely for Patterson and Nix to make a profit. The district court found that the NPR " investment strategy could be profitable, excluding any advisement fees," [9] indicating that the strategy could not be profitable if the fees were considered.

Forty days after becoming partners in NPR, the Taxpayers withdrew, receiving cash and foreign currencies, although the expiration dates of the options were months in the future. Each of the Taxpayers knew that withdrawing from NPR eliminated any possibility of " hitting the sweet spot" and therefore that a profit was impossible. They each contributed the foreign currencies to the Nix, Patterson & Roach, LLP law firm. All gains or losses from the foreign currencies were specially allocated to the respective contributing partner on the law firm's books and on the tax returns, although only the dollar amounts of losses, not the currencies or the currency transactions, were identified. On the law firm's tax returns, the losses were identified under a heading " Business Risk Division." Foreign currencies were sold in 2001, 2002, and 2003, and the law firm offset the losses against income allocated to each Taxpayer to reduce the earned income shown on Schedules K-1 issued to the Taxpayers.

After resigning from NPR, each Taxpayer obtained a written opinion from Sidley Austin on the proper tax treatment of their investments. The Taxpayers reviewed the opinions with Cohen, who concluded that they " had cited the important areas where there might be potential controversy and had adequately dealt with them to [his] satisfaction and that [the Taxpayers] would be ok." Cohen advised them that they could rely on the opinions because Sidley Austin was a " very well known firm," the opinions were " very, very well reasoned," and Ruble was an " acknowledged partnership tax expert."

In accordance with the tax opinions, the Taxpayers treated their bases in NPR as the premiums on the long options, ignoring the amount they might have to pay on the short options. These bases were carried over to the foreign currency after distribution, which was used by the Taxpayers to calculate approximately $65,000,000 in tax losses once the foreign currencies were sold. Nix's and Patterson's actual " investment" in NPR was $625,000, and Roach's was $375,000, but Nix and Patterson each claimed an outside basis in the long options of almost $25,000,000, and Roach claimed an outside basis of almost $15,000,000.

The IRS ultimately concluded, in the FPAA issued in 2005, that NPR lacked economic substance, was a sham, and must be disregarded. This resulted in zeroing out all of the tax losses the Taxpayers had claimed on their individual returns. The

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FPAA also imposed accuracy-related and other penalties as a result of the ...

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