The Adventures of Don Dubious in Fantasy-land

[Famspear]

Don Dubious is a go-getter. He is a Texas oil and gas man, and he knows his stuff.

A limited partnership is formed, whereby the limited partners are numerous individuals and the general partner is an LLC with five owners. Both the limited partnership (the “LP”) and the LLC file Form 1065 federal partnership tax returns. Don is a managing member of the LLC. He is not a partner in the LP.

The LP invests in oil and gas mineral interests. Under the agreement creating the LP, the LLC has no right to a distributive share of the profits of the LP. The LLC does not share in the distributive losses of the LP. Instead, the LLC receives an acquisition fee, reportable as ordinary income by the LLC and deductible as an ordinary expense by the LP. The acquisition fee consists of a share of the mineral interests acquired by the LP (the LLC owners are the experts in oil and gas, and they find the mineral interests for the LP, which justifies the acquisition fee paid by the LP to the LLC).

Under the acquisition agreement, the LP transfers mineral interests having a fair market value -- and a cost basis to the LP -- of $1,000,000.

The members of the LLC go to find someone to have the Form 1065 partnership return prepared. For the first time, they explain the above scenario to someone (a CPA firm) who actually pays attention to federal income tax implications. The CPA firm informs the members of the LLC that the LLC is going to have to report the $1,000,000 acquisition fee as income in the year in which the deeds to the mineral interests are delivered to the LLC. No cash has been transferred from the LP to the LLC, and no cash has been transferred from the LLC to its members. The LLC has received “in kind” income.

For the year in which the mineral interests were transferred to the LLC, the LLC has no deductions. (Assume for purposes of this scenario that no royalty revenues or other income items were realized for the year, and no expenses were incurred.)

The members of the LLC panic. They have received no cash with which to cover their pro-rata shares of the income of the LLC. The deeds have already been delivered and recorded in the real property records.

Don Dubious, the manager of the LLC, gets a bright idea: “I know!” he says. “Maybe the transfer of the mineral interests from the LP to the LLC wasn’t really an acquisition fee after all! Maybe it was a purchase! Maybe the credit entry is not to ‘acquisition fee revenue’, but is instead to “note payable to LP.”

Don Dubious hastily drafts a promissory note for $1,000,000, payable by the LLC to the LP. He signs the note as the agent for the LLC, the “obligor”, and he also signs the note “on behalf of the LLC as the general partner on behalf of the LP” (with the LP as “obligee”). Hey, the LLC is the general partner of the LP, right? This should work!

Don explains what he has done to the CPA firm, but the aforementioned CPA firm has become unexpectedly too busy to take on the LLC as a client. So, Don prepares the Form 1065 return for the LLC himself, showing the $1,000,000 as a debt, and signs the return and files it with the IRS.

Later, the LLC receives a notice that the IRS has selected the return for examination.

You are advising Don Dubious. What do you tell him?

[Famspear]

Oh, I forgot to mention that the profit/loss ratio in the LLC for Don Dubious is 45%.

[LaVidaRoja]

Didn't the Tax Court decision on this case come out yesterday?

[Famspear]

Didn't the Tax Court decision on this case come out yesterday?

Nope.

But, you've whetted my curiosity. Should I be checking today's decisions at the U.S. Tax Court?

edit: I mean "yesterday's".....

[Famspear]

And, to clarify to all readers: this is a summary of an actual situation (facts changed and simplified of course), but the potential tax liabilities are not the subject of a court proceeding. It's an impending IRS audit at this point. And, no, I'm not the CPA firm in the scenario.

Ummm... I'm not "Don Dubious", either.....

[LaVidaRoja]

No. Yesterday's partnership dealt with partnership basis.

[BBFlatt]

Did Don backdate the notes to coincide with the mineral rights transfer?

Are his communications with his putative tax adviser covered by attorney-client privilege?

[Famspear]

Did Don backdate the notes to coincide with the mineral rights transfer?

No. At least he didn't backdate the notes.

Are his communications with his putative tax adviser covered by attorney-client privilege?

I guess the status of communication with the CPA firm that ended up not preparing the return is a bit open to discussion. No attorney-client privilege, but maybe the federally authorized tax practitioner (FATP) privilege could apply. If the purpose of the communication was to have a tax return prepared, then neither privilege would apply (probably). If somehow Don could argue that he hadn't yet decided whether to have the CPA actually prepare the return, then maybe the FATP privilege would apply. But even then, it would not apply in a criminal case where Don is charged with some sort of tax crime.

With respect to the advice Don might be soliciting NOW -- after having been notified that the IRS will be auditing and asking questions -- he (in my view) should talk with an attorney who does criminal tax defense and, if needed, let the attorney handle the IRS audit or have the attorney hire a Kovel accountant to handle the audit.

[LaVidaRoja]

He (clearly) has the money to do the proper audit preparation. Does he have the brains to do so?

[notorial dissent]

I seem to remember reading a case like this when I was doing real estate law, and I don't remember it ending well for the LLC, although I don't remember that was what they were using at the time, this was a long time ago. I would still say that the LLC is probably in a deep dark pit at this point.

[wserra]

You are advising Don Dubious. What do you tell him?

To carry his toothbrush.

[notorial dissent]

No long term subscriptions, warranties, or phone contracts????

[Famspear]

No long term subscriptions, warranties, or phone contracts????

Yeah, Don probably shouldn't be getting into any of that kind of stuff for now. And, he should avoid entering any long-term apartment leases, if he needs a place to live. His residential situation might be changing.

[notorial dissent]

Rather long term, and not of the quality he is currently used to I am certain.

[Famspear]

Over six months have passed since the Internal Revenue Service notified Don Dubious that the LLC's Form 1065 return was selected for examination.

Don retained a representative to deal with the IRS. The representative has admitted to the IRS revenue agent that the promissory note is "a way of deferring income."

Interestingly, although the LLC and the LP are in the high-risk oil and gas business, the "debt" evidenced by the note is just a general unsecured debt. The interest rate is 2% per year. Neither the LLC nor any of its owners have provided any personal guarantee for the "debt." The "debt" is payable annually, over a period of 18 years, with less than $100,000 of principal and interest due at the end of each year -- and with a huge balloon payment of over $600,000 due at the end of year twenty-one. To put the icing on the cake, the note contains a provision that says that the "debt" disappears if the LLC ceases to be the general partner in the LP.

I'm thinking about going to a bank down the street and asking for a 2% unsecured loan. I'll tell the bank that I want to invest the loan proceeds in oil and gas mineral interests. I wonder what the bank would say to me. I do know that if I want to buy, let's say, a $200,000 home in a nice neighborhood, the bank ain't gonna give me a 2% loan, and the bank definitely ain't gonna give me the loan on an unsecured basis.

In the case of Don Dubious and his LLC, can we think of any tax law doctrines that might be implicated by the terms and circumstances of the $1,000,000 promissory note? How about a specific Internal Revenue Code provision?

Regarding the IRS examination of the LLC's return, the LLC's representative has heard nothing from the IRS revenue agent for the past couple of months. I wonder what that could mean......

[LaVidaRoja]

I do hope Don is also retaining high-quality criminal tax representation.

[Famspear]

I do hope Don is also retaining high-quality criminal tax representation.

Absolutely. And, he might be doing so, with his criminal defense attorney monitoring the progress of the IRS audit in the background, receiving confidential reports from the representative who might be handling all communications with the IRS.

The long period of silence from the IRS is troubling. However, if I had to bet, I would say that the probability of a criminal prosecution is still somewhat low. The dollar amount of tax is significant, but I suspect that before going for a prosecution, the government would also like to see evidence of multiple years of violations.

If (again) I had to bet, I would suspect that the IRS revenue agent and his manager have been conferring with an IRS Fraud Technical Adviser (FTA) off and on for the past few months, but that the most that would come of this for Don Dubious (aside from a big tax bill on his personal return) will be a 75% civil fraud penalty, plus a 40% penalty for a Nondisclosed Noneconomic Substance Transaction, plus the standard section 6651(a)(2) penalty for failure to timely pay, plus interest.

It's possible that the IRS agent, his manager, and the FTA have agreed to make what is called a 2797 criminal referral -- which would mean that the IRS Criminal Investigation (CI) unit would become involved. CI would study the case for a while and, ultimately, it would be CI's decision on whether to go further: to make a section 6103(h) criminal referral to the Department of Justice. Then, the Department of Justice Tax Division in Washington would make a decision as to whether to prosecute.

EDIT (correction): I believe that under the next-to-last sentence of section 6662(b), the 40% non-disclosure penalty would not apply to any portion of an understatement to the extent that the 75% civil fraud penalty were to be imposed.

[LaVidaRoja]

And, the agent and manager could be conferring with National Office regarding how the case should be handled. Significant tax, admission of economic substance avoidance, etc. It's perfectly possible that there is a national program for handling this type of case.

[Famspear]

And, the agent and manager could be conferring with National Office regarding how the case should be handled. Significant tax, admission of economic substance avoidance, etc. It's perfectly possible that there is a national program for handling this type of case.

Yes, there is this: "Guidance for Examiners and Managers on the Codified Economic Substance Doctrine and Related Penalties," LB&I Control No. LB&I-4-0711-015, July 15, 2011, Heather C. Maloy, Commissioner, Large Business & International Division, Internal Revenue Service, U.S. Department of the Treasury.

The Don Dubious case (the LLC) is not in the Large Business & International Division; it's in the Small Business-Self Employed division of the IRS. But I assume that this material would be useful to the IRS revenue agent.

And, of course, you have identified the legal doctrine: the common law Economic Substance Doctrine (including but not limited to the Business Purpose Doctrine) which has been codified in Internal Revenue Code section 7701(o), which provides (in part):

(o) CLARIFICATION OF ECONOMIC SUBSTANCE DOCTRINE.—

(1) APPLICATION OF DOCTRINE.—In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if—

(A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and

(B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.

[ . . . ]

(5) DEFINITIONS AND SPECIAL RULES.—For purposes of this subsection—

(A) ECONOMIC SUBSTANCE DOCTRINE.—The term ‘economic substance doctrine’ means the common law doctrine under which tax benefits under subtitle A with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.

[ . . . ]

(D) TRANSACTION.—The term ‘transaction’ includes a series of transactions.

Paragraph (5), subparagraph (D) seems to incorporate the Step Transaction Doctrine as well.

Essentially, Congress has clarified that the Economic Position Test and the Substantial Purpose Test constitute a conjunctive hurdle that the taxpayer must clear if the Economic Substance Doctrine is "relevant." Prior to the enactment of this provision, I believe some courts had indicated that the taxpayer could succeed by satisfying just one of these tests.

The statutory term "Economic Substance Doctrine" seems to incorporate, in my mind, the Substance-Over-Form Doctrine, the Business Purpose Doctrine, the Step Transaction Doctrine, and perhaps other related common law tax doctrines.

[Famspear]

Regarding the 40% penalty for the Nondisclosed Noneconomic Substance Transaction: that's covered by Internal Revenue Code section 6662(b)(6) (which cross-references section 7701(o)) and section 6662(i).

And, according to the IRS, merely attaching the relevant source documents to the return will not avoid the 40% penalty. The taxpayer must instead use Form 8275, and must adequately disclose the transaction. It's apparently a strict liability penalty; no "reasonable cause" exception.