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Contributions of Distressed Brazilian Receivables Generate Massive Penalties.
(Parker Tax Publishing November 4, 2014)

Taxpayers were not entitled to deduct losses associated with an investment program involving Brazilian retailers that purportedly contributed distressed consumer receivables to several partnerships; instead, the taxpayers were subject to multiple penalties because the transactions lacked economic substance. Kenna Trading, LLC v. Comm'r, 143 T.C. No. 18 (2014).

In 2003, John Rogers developed, marketed, and sold investments whereby investors in a partnership structure could claim partially worthless bad debt deductions under Code Sec. 166 on certain distressed assets. The investment program involved Brazilian retailers purportedly contributing distressed consumer receivables to partnerships. The partnerships claimed carryover basis in these receivables under Code Sec. 723, contributed some of these Brazilian receivables to trading companies, and then contributed its interest in each trading company to a holding company. The partnerships claimed a cost of goods sold deduction for each holding company equal to the basis of the receivables contributed. The partnerships then sold an interest in each holding company to an investor. The trading companies claimed bad debt deductions.

In 2005, the partnerships allegedly contributed more of the Brazilian receivables to certain trusts. Each main trust then assigned the receivables to a newly created subtrust. Investors allegedly contributed cash to the trusts in exchange for a beneficial interest in the subtrusts. The subtrusts claimed bad debt deductions. Asserting that the subtrusts were, for federal income tax purposes, grantor trusts, the investors claimed deductions on their tax returns.

The IRS disallowed the bad debt deductions, adjusted the partnership's income for 2004 alleging that the partnership inflated its cost of goods sold, determined that the partnership failed to include all items of income in its gross receipts for 2004 and 2005, and disallowed the partnership's business expense deductions. According to the IRS, the entire transaction lacked economic substance, and John and the partnerships failed to prove they satisfied the requisite elements for a bad debt deduction.

The IRS also asserted gross valuation misstatement penalties against the partnerships, the trading companies, and John and his wife. Accuracy-related penalties were also applied on the amounts of the partnerships' underpayments due to increased gross receipts for unreported income and the disallowed deductions, as well as a listed transaction understatement penalty against the partnerships for the 2005 tax year.

The Tax Court held that the Brazilian retailers did not intend to enter into a partnership for federal income tax purposes. With respect to the distressed receivables contributed to the partnerships, the court said that the partnerships took a cost basis, not a carryover basis, in those receivables. The court agreed with the IRS that the transactions lacked economic substance and that the trading companies were not entitled to Code Sec. 166 deductions.

The Tax Court also concluded that the partnerships overstated their cost of goods sold and that the IRS correctly adjusted the partnerships' income to reflect certain unreported deposits. With respect to the penalties, the court found that the partnerships and the trading companies were liable for the gross valuation misstatement penalty, and that the partnerships were liable for the accuracy-related penalty on the underpayments attributable to the omitted items of income and the disallowed deductions. The court also sustained the IRS's listed transaction understatement penalties against the partnerships.

For a discussion of the economic substance doctrine, see Parker Tax ¶99,700. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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