Tax shelter transactions disregarded.

• Author: Beavers, James

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The Fifth Circuit joined the majority of circuits and held that a lack of economic substance will invalidate the results of a transaction even if a taxpayer had a genuine motive other than tax avoidance for entering into the transaction.

Background

Cary Patterson and Harold Nix represented the state of Texas in litigation against the tobacco industry, and each man earned around $30 million from the litigation between 1998 and 2000. Patterson and Nix invested the earnings from the case in an investment strategy known as a Bond Linked Issue Premium Structure (BLIPS) marketed by Presidio Advisory Services (Presidio) and facilitated by large loans from National Westminster Bank (NatWest). The shelter was ostensibly a three-stage series of foreign currency investment transactions, with most of the risk and the potential for gains or losses coming in the second and third stages. Patterson and Nix believed the purpose of the strategy was to profit from the devaluation of certain foreign currencies. However, as they would later learn, Presidio and NatWest instead intended the strategy solely as a vehicle to secure large tax losses for investors and never intended that the strategy be continued after the first stage.

To implement the strategy for Patterson and Nix, Presidio formed Klamath and Kinabalu as limited liability companies (LLCs) taxed as partnerships. Patterson owned 90% of Klamath through a disregarded entity; Nix owned 90% of Kinabalu, also through a disregarded entity. The other 10% partners of Klamath and Kinabalu were Presidio Resources LLC and Presidio Growth LLC. Presidio Growth was the managing partner of both LLCs.

To fund Klamath and Kinabalu, Patterson and Nix (acting through the disregarded entities) made two distinct contributions. First, they each contributed $1.5 million to their respective LLCs. Second, they entered into loan transactions with NatWest, in which the bank loaned each man $66.7 million (which they also contributed to the LLCs). These loans consisted of $41.7 million denominated as the "stated principal amount" and $25 million as a "loan premium."

Klamath and Kinabalu deposited the funds into accounts controlled by NatWest. Presidio directed the LLCs to use these funds to purchase very low risk contracts on U.S. dollars and euros. They also made small, 60- to 90-day forward contract trades in foreign currencies. These were the only investments the partnerships ever made, and Patterson and...