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The Tax Court has held that two S corporation owners who entered into a Custom Adjustable Rate Debt Structure (CARDS) transaction in 2000 weren’t entitled to deduct losses and costs associated with the transaction because it lacked economic substance. The Court determined that use of the transaction’s proceeds in the taxpayers’ business didn’t mean that the transaction itself had economic substance.

Background. The economic substance doctrine provides that (1) a transaction ceases to merit tax respect when it has no economic effects other than the creation of tax benefits (the objective test), and (2) even if the transaction has economic effects, it must be disregarded if it has no business purpose and its motive is tax avoidance (the subjective test). In the Eleventh Circuit, the relevant Court of Appeal in this case, a transaction must satisfy both the objective and subjective tests to enable a taxpayer to claim a loss.

Facts. Donald Kipnis and Lawrence Kibler each graduated first in his class from the University of Florida’s building construction programs in ’82 and ’75, respectively, and each was highly regarded in the construction business. They were employees at Miller & Solomon General Contractors, Inc. (M&S) for several years before purchasing it in ’85. M&S was an S corporation in 2000.

M&S incurred a loss of over $3 million in connection with its construction of a 26-story building in ’99. Because of the anticipated construction boom, Kipnis and Kibler wanted to increase M&S’s bonding capacity. They didn’t want to put in their own money, and they unsuccessfully attempted to get funds from other sources.

In 2000, Kipnis and Kibler learned about CARDS transactions from their accountant, who explained it as a source of financing with tax benefits. Kibler analyzed the transaction and projected that M&S could achieve gross profits of $28,714,471 and after-tax net income of $17,343,541 by 2006. Kibler did not examine the numerous steps of the CARDS transaction or whether it would be profitable per se, and neither he nor the accountant fully understood the transaction. They also didn’t examine the books of the other parties to the transactions or review the rights and obligations of the parties involved. But they did know that the transaction guaranteed them a tax loss.

When they decided to enter the transaction (in 2000), M&S had a profitable year and did not at any time have to forgo construction of a project because it could not get bonding.

The complicated, multi-step CARDS transaction at issue in this case involved a 30-year credit facility (i.e., access to capital) from a bank to a newly formed LLC; a series of agreements under which Kipnis and Kibler purportedly purchased a portion of, and assumed liability for the remainder of, the credit facility, despite the LLC’s significant control over the proceeds; foreign currency conversions; and a forward exchange contract that essentially prevented Kipnis and Kibler from realizing any profit. Then, there was a “collateral swap,” and on Jan. 11, 2001, they began using the proceeds from the credit facility.

After the transaction was complete, M&S had an additional $423,000 of “net quick” (a figure based on a contractor’s working capital that is used to determine bonding capacity), and the CARDS promoters received over $500,000 in fees. The transaction was unwound in 2001.

M&S claimed an ordinary loss deduction from trade or business activities of $1,540,819 for 2000 as a result of the CARDS transaction. A statement was attached to the return explaining that the high basis was claimed on account of the assumed liability on the loan. It also disclosed the fees associated with the transaction and stated that the reason for entering the transaction was to secure funding for M&S. For 2001, M&S’s claimed loss deduction from the CARDS transaction was $243,259. Kipnis and Kibler each claimed half of these losses, as well as half of the expenses associated with the transaction, as deductions on their own returns.

Parties’ positions. IRS disallowed the deductions, claiming that the transaction lacked economic substance. Kipnis and Kibler argued that the transaction should be viewed as part of their overall business strategy, and distinguished the facts of their case from other CARDS cases based on the fact that they actually used the proceeds from the transaction to increase M&S’s net quick. IRS responded that “to look to the use of the proceeds from the CARDS transaction would permit taxpayers to legitimize sham transactions by grafting them onto legitimate business transactions.”

Court agrees with IRS. The Tax Court agreed with IRS that the CARDS transaction lacked economic substance and upheld its denial of Kipnis’ and Kibler’s claimed deductions.

The Court rejected the taxpayers’ arguments to consider the transaction as part of their overall business strategy and take into account the use of the funds in evaluating the transaction. In an earlier CARDS case, the Court noted that it looks only “at the transaction that gave rise to the tax loss.” Accordingly, it analyzed the transaction separately from the transfer of proceeds to M&S.

Under the objective portion of the economic substance test, the Tax Court found that the transaction lacked substance. Notably, it was structured in such a way to minimize profit, and the taxpayers testified that there was no real profit potential beyond currency fluctuation (and they admitted that they didn’t perform any research as to the profitability of currency trading before entering the transaction). Further, the amounts paid to participate in the transaction, and claimed as a deduction, significantly outweighed the profits therefrom.

The Court then noted that, once it determines that the objective test has not been met, the taxpayers’ subjective intent is irrelevant. Nonetheless, the Court analyzed the taxpayers’ purported business purpose and found it ultimately inconsistent with their actions.

The taxpayers’ deductions for the fees paid to participate in the CARDS transaction were also denied. The Tax Court noted that “[f]ees incurred in connection with a sham transaction are generally not deductible.” And, while courts have upheld certain deductions based on bona fide debts where the debts were elements of a transaction lacking in economic substance, no genuine indebtedness existed in this case.