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Eleventh Circuit Rejects Penalties Relating to Voluntary Disclosure under Amnesty Program.

(Parker Tax Publishing November 2, 2015)

The Eleventh Circuit rejected accuracy related penalties, finding it was disingenuous for the IRS to apply penalties on a taxpayer who disclosed his participation in a tax shelter in response to an IRS Announcement that had said no penalties would apply to taxpayers who stepped forward. Kearney Partners Fund, LLC v. U.S., 2015 PTC 366 (11th Cir. 2015).

Pat Sarma was the founder of a large tech company, American Megatrends. After deciding to sell his company's stock in 2001, Sarma was approached by KPMG with advice on how to shield the gain from the stock sale. KPMG and a company named Bricolage structured an investment vehicle, called FOCus, which consisted of a three-tiered set of partnerships. Through a complicated series of pre-planned steps, Bricolage and KPMG explicitly intended for FOCus to generate artificial losses for their high net-worth clients such as Sarma. At a meeting with Sarma in 2001, KPMG demonstrated to Sarma that by using the FOCus vehicle, he could offset his $80 million capital gain from the sale of American Megatrends with an artificial $80 million capital loss, thereby saving $16 million in taxes. In October of 2001, Sarma decided to buy a FOCus investment vehicle, which consisted of the following three partnerships: Kearney Partners Fund, LLC, Nebraska Partners Fund, LLC, and Lincoln Partners Fund, LLC (NLK FOCus).

In early 2002, the IRS released Announcement 2002-2, an amnesty provision which provided that if a taxpayer properly disclosed his involvement in a tax shelter, the IRS would waive certain accuracy-related penalties. Sarma decided to make a disclosure of his involvement in the NLK FOCus pursuant to the Announcement.

The IRS issued Notices of Final Partnership Administrative Adjustment (FPAA) to the three partnerships in the NLK FOCus. In the FPAAs, the IRS concluded that the partnerships' transactions lacked economic substance. The IRS disallowed all items claimed on the partnership returns on the ground that the partnerships constituted an abusive tax shelter designed to generate artificial, noneconomic tax losses. The IRS also assessed accuracy-related penalties due to the alleged misstatements on the tax returns. The partnerships challenged the FPAAs in a district court.

The U.S. District Court for the Middle District of Florida held that the partnerships lacked economic substance and the FPAAs properly made adjustments accordingly. However, the court held that the imposition of penalties was improper. The purpose of Announcement 2002-2, the court said, was to call out questionable behavior for scrutiny. According to the court, it was disingenuous for the IRS to turn around and apply penalties for a shelter pursuant to an Announcement that prompted the uncovering of the shelter in the first place. The court said the IRS needed to be held to the terms of its bargain and waived the accuracy-related penalties because Sarma's disclosure, made on behalf of the partnerships, was compliant with Announcement 2002-2.

The partnerships appealed the decision, questioning whether the district court had jurisdiction to determine all partnership and nonpartnership items for the tax periods in question, and, if it had jurisdiction, whether it erred in determining that the transactions at issue lacked economic substance and therefore had to be disregarded for tax purposes.

The Eleventh Circuit affirmed the lower court's decision without comment.

For a discussion of when accuracy-related penalties apply, see Parker Tax ¶262,120. (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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