Opinion
Civil Action No. 4:19-cv-00755-O
2021-03-15
Marc W. WALRAVEN and Elizabeth I. Walraven, Plaintiffs, v. UNITED STATES of America, Defendant.
George William Connelly, Chamberlain Hrdlicka White Williams & Aughtry, Houston, TX, Randal L. Dean, Brown Pruitt Wambsganss Ferrill & Dean PC, Fort Worth, TX, for Plaintiffs. Curtis C. Smith, US Department of Justice - Tax Division, Dallas, TX, for Defendant.
George William Connelly, Chamberlain Hrdlicka White Williams & Aughtry, Houston, TX, Randal L. Dean, Brown Pruitt Wambsganss Ferrill & Dean PC, Fort Worth, TX, for Plaintiffs.
Curtis C. Smith, US Department of Justice - Tax Division, Dallas, TX, for Defendant.
ORDER
Reed O'Connor, UNITED STATES DISTRICT JUDGE
Before the Court are the Government's Motion for Summary Judgment and Brief and Appendix in Support (ECF Nos. 23–25) (collectively, the "Motion"), filed December 7, 2020; Plaintiffs’ Response and Brief and Appendix in Support (ECF Nos. 28–30) (collectively, the "Response"), filed January 11, 2021; the Government's Reply and Appendix in Support (collectively, the "Reply") (ECF No. 31), filed January 25, 2021; and Plaintiffs’ Sur-Reply and Appendix in Support (collectively, the "Sur-Reply") (ECF No. 35), filed February 19, 2021. Having considered the briefing, the relevant facts, and the applicable law, the Court finds that the Motion for Summary Judgment (ECF No. 23) should be and is hereby GRANTED .
I. BACKGROUND
This case arises out of an income tax dispute involving a complex arrangement of business and estate-planning entities created by Plaintiff Marc Walraven ("Walraven") that resulted in his reporting a loss of almost $8 million on his 2008 tax return from the liquidation of one of those entities. After an audit, the IRS rejected the claimed loss, leading the Walravens to file this lawsuit.
Marc Walraven is an attorney and businessman in North Texas. Mot. App. 278–92, ECF No. 25. In October 2008, Walraven had his tax attorney, Richard Shanks, establish three entities: Walraven Family Investments, Ltd. ("WFI"), Walraven Management Trust ("WMT"), and Pribilof Holdings, Inc. See id. at 13. WFI was created as a limited partnership composed of WMT and Pribilof. See id. Pribilof was the limited partner and owned 99% of the capital, profits, and loss of the partnership at formation. See id. Walraven and his father, Joe, each owned approximately 50% of Pribilof. Defs.’ Resp. App. 7, ECF No. 30-4. WMT was the general partner and owned the remaining 1%. See Mot. App. 13, ECF No. 25. Walraven was the grantor, the trustee, and, initially, the sole beneficiary of WMT, and possessed total discretion and control of the trust. See id. at 13, 267–68. As trustee of WMT, Walraven was also managing partner of WFI and had "full, complete and exclusive power to manage and control" WFI. See id. at 84–85, 268.
Pribilof similarly served as the limited partner in a partnership created by Joe Walraven: Joe L. Walraven Family Partnership, Ltd. See Mot. App. 14, ECF No. 25. According to Walraven, both "partnerships were used to protect assets from lawsuits in case [Pribilof] got sued." Id.
At the time those entities were formed, Walraven and his father owned Eagle Construction, an environmental cleanup business. See id. at 280–81. On November 5, 2008, they sold Eagle Construction to Progressive Environmental for a substantial sum of cash and stock in Progressive. See id. at 15, 282–87. The following day, Walraven contributed a combined $19,605,235 in cash and stock proceeds from the sale of Eagle Construction to Pribilof. See id. at 136–60, 286–87. Walraven and his father formed Pribilof as an equipment dealing business, with the goal of buying and selling heavy equipment, such as bulldozers, forklifts, and tractors. See id. at 10–11. Their stated intent was to hire Ron Jacobson to run the business. See id. When that did not materialize, they liquidated the business on December 29, 2008, a little over two months after its formation. See id. During its short existence, Pribilof bought and sold eight pieces of heavy equipment. See id. at 10, 134, 290. At liquidation, Pribilof's 99% interest in the WFI partnership—the $19,605,235 originally contributed by Walraven to fund Pribilof—was transferred back to Walraven individually. See id. at 134. At that point, Walraven's trust, WMT maintained its 1% interest in WFI, with Walraven owning the remaining 99% as limited partner. See id. at 13, 134. Shortly thereafter, Walraven took that 99% limited partnership interest in WFI and transferred 1% of it to each of his four children. See id. at 127–33.
On its corporate income tax return, Pribilof claimed an income loss of over $16.5 million for discounts applied to Pribilof's limited partnership interests in WFI and the Joe L. Walraven Family Partnership, Ltd. See id. at 246–48. This figure was calculated by applying discounts to the fair market value of Pribilof based on a lack of marketability and control as a limited partner in the two-family partnerships. See id. at 261–62. On their personal income tax return for 2008, Plaintiffs reported Walraven's portion of Pribilof's loss, which amounted to $7,997,997. See id. at 169. After an audit, the IRS rejected the claimed loss, determined that the Walravens owed additional taxes in the amount of $990,993.00, and assessed an underpayment penalty of $198,198.60. See id. at 241. The penalty was approved by the auditing revenue agent's supervisor on October 18, 2012. See id. at 245. The Walravens paid the additional taxes and penalty assessed and subsequently filed this suit to obtain a refund. See Compl., ECF No. 1. The Government moved for summary judgment, and the Motion is ripe for the Court's review. See Mot., ECF Nos. 23–25; Resp., ECF Nos. 28–30; Reply, ECF No. 31; Sur-Reply, ECF No. 35. II. LEGAL STANDARD
A corporation formed under subchapter S of the Internal Revenue Code ("S Corp"), like Pribilof, is not a taxable entity for purposes of income taxes. See 26 U.S.C. § 1366. Its income, losses, deductions, and credits generally flow through pro rata to its shareholders. See id.
In their briefs, the parties raise a number of other facts, including past cases involving the Walravens’ tax attorney, Richard Shanks, Joe Walraven's 2008 tax return, and the deposition testimony of Ron Jacobson concerning the alleged offer for him to manage Pribilof in 2008. See Mot., ECF Nos. 23–25; Resp., ECF Nos. 28–30; Reply, ECF No. 31; Sur-Reply, ECF No. 35. As always, the Court includes and bases its ruling on only those relevant facts necessary to inform the Court's resolution of the pending motion. See Murungi v. Xavier Univ. , 313 F. App'x 686, 688 (5th Cir. 2008) ("only disputes over outcome-determinative facts properly preclude summary judgment") (citing Anderson v. Liberty Lobby, Inc. , 477 U.S. 242, 248, 106 S.Ct. 2505, 91 L.Ed.2d 202 (1986) ).
Summary judgment is appropriate only where the pleadings and evidence show "that there is no genuine dispute as to any material fact and the movant is entitled to judgment as a matter of law." Fed. R. Civ. P. 56(a). Summary judgment is not "a disfavored procedural shortcut," but rather an "integral part of the Federal Rules as a whole, ‘which are designed to secure the just, speedy and inexpensive determination of every action.’ " Celotex Corp. v. Catrett , 477 U.S. 317, 327, 106 S.Ct. 2548, 91 L.Ed.2d 265 (1986) (quoting Fed. R. Civ. P. 1 ). A genuine dispute of material fact exists "if the evidence is such that a reasonable jury could return a verdict for the nonmoving party." Anderson v. Liberty Lobby, Inc. , 477 U.S. 242, 248, 106 S.Ct. 2505, 91 L.Ed.2d 202 (1986). "[T]he substantive law will identify which facts are material." Id. The movant makes a showing that there is no genuine dispute of material fact by informing the court of the basis of its motion and by identifying the portions of the record that reveal there are no genuine, material fact disputes. See Celotex , 477 U.S. at 323, 106 S.Ct. 2548.
On a motion for summary judgment, the evidence must be viewed in the light most favorable to the nonmovant. Ion v. Chevron USA, Inc. , 731 F.3d 379, 389 (5th Cir. 2013). "Moreover, a court must draw all reasonable inferences in favor of the nonmoving party and may not make credibility determinations or weigh the evidence." Id. And if there appears to be some support for disputed allegations, such that "reasonable minds could differ as to the import of the evidence," the court must deny the motion for summary judgment. Anderson , 477 U.S. at 250, 106 S.Ct. 2505.
"The party opposing summary judgment is required to identify specific evidence in the record and to articulate the precise manner in which that evidence supports his or her claim." Ragas v. Tenn. Gas Pipeline Co. , 136 F.3d 455, 458 (5th Cir. 1998). If a party "fails to make a showing sufficient to establish the existence of an element essential to that party's case, and on which that party will bear the burden of proof at trial," summary judgment must be entered. Celotex , 477 U.S. at 322, 106 S.Ct. 2548. In such a situation, no genuine dispute of material fact can exist, as the failure to establish an essential element of the claim "necessarily renders all other facts immaterial." Id. at 323, 106 S.Ct. 2548.
III. ANALYSIS
In its Motion for Summary Judgment, the Government raises two issues. See Mot. 13–25, ECF No. 24. First, it argues the Walravens’ claimed loss related to Pribilof's liquidation, while in conformity with the letter of the tax code, violates anti-abuse doctrines of tax law. See id. at 15. Second, and necessarily dependent on its success on the first issue, the Government contends the underpayment penalty assessed on the Walravens was appropriate under the code. See id. at 24–25. The Court takes each issue in turn.
A. Walraven's Claimed Loss
1. Valuation Discounts and the Anti-Abuse Tax Doctrines Generally
The Walravens’ claim for refund centers on section 336 of the Internal Revenue Code. See Compl. 2, ECF No. 1. That section provides that, "[e]xcept as otherwise provided in this section or section 337, gain or loss shall be recognized to a liquidating corporation on the distribution of property in complete liquidation as if such property were sold to the distributee at its fair market value." 26 U.S.C. § 336(a). Fair market value is "the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts." 26 C.F.R. § 20.2031-1(b) ; accord United States v. Cartwright , 411 U.S. 546, 551, 93 S.Ct. 1713, 36 L.Ed.2d 528 (1973).
"When applying the willing buyer-willing seller test, ‘the potential transaction is to be analyzed from the viewpoint of a hypothetical buyer whose only goal is to maximize his advantage.’ " Adams v. United States , 218 F.3d 383, 386 (5th Cir. 2000) (quoting Estate of Smith v. Comm'r of Internal Revenue , 198 F.3d 515, 529 (5th Cir. 1999) ). In evaluating the fair market value based on what a hypothetical buyer would pay, the IRS permits discounts in the taxable value of property based on any lack of marketability or control. See, e.g., Strangi v. Comm'r , 417 F.3d 468, 474 n.2 (5th Cir. 2005) ; Robertson v. United States , No. 03-cv-2113, 2006 WL 302302, at *6 (N.D. Tex. Jan. 13, 2006) ; Peracchio v. Comm'r , 86 T.C.M. (CCH) 412. The rationale for this is clear, as a hypothetical buyer "is a rational economic actor ... seek[ing] to maximize his advantage" in the market and would pay less for a company he cannot control. Estate of Jameson v. Comm'r of Internal Revenue , 267 F.3d 366 (5th Cir. 2001).
At the same time, "tax law deals in economic realities, not legal abstractions." Comm'r v. Southwest Exploration Co. , 350 U.S. 308, 315, 76 S.Ct. 395, 100 L.Ed. 347 (1956). "It is a long-settled rule of law that transactions which have no economic purpose or substance other than the creation of income tax losses or credits are to be disregarded for tax purposes." Merryman v. Comm'r , 873 F.2d 879, 881 (5th Cir. 1989). For this reason, discounts for marketability and control are subject to anti-abuse doctrines of tax law. These are equitable doctrines created by the courts to "prevent taxpayers from ... engaging in transactions that are fictitious or lack economic reality simply to reap a tax benefit." Coltec Indus., Inc. v. United States , 454 F.3d 1340, 1353–54 (Fed. Cir. 2006). These "judicial doctrines empower the federal courts to disregard the claimed tax benefits of a transaction—even a transaction that formally complies with the black-letter provisions of the Code and its implementing regulations—if the taxpayer cannot establish that ‘what was done, apart from the tax motive,’ " was proper under the code. Southgate Master Fund, L.L.C. v. United States , 659 F.3d 466, 479 (5th Cir. 2011).
Some of these common law doctrines, including the economic substance doctrine and substance-over-form doctrine at issue in this motion, have since been codified. Congress incorporated the economic substance doctrine into the Internal Revenue Code in 2010, two years after the tax year in question here. See Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152, 124 Stat. 1029 (2010) (codified at 26 U.S.C. § 7701(o) ). Likewise, the substance-over-form doctrine can be found at 26 C.F.R. § 1.165-1(b).
Neither party here disputes that the Walravens complied with the letter of the law in section 336 by claiming their portion of marketability and control discounts for the liquidation of Pribilof. See Mot., ECF Nos. 23–25; Resp., ECF Nos. 28–30; Reply, ECF No. 31; Sur-Reply, ECF No. 35. Rather, the parties’ entire dispute centers on two of these anti-abuse tax doctrines the Government argues apply here. See id. The Court analyzes both doctrines against the facts of this case.
2. Economic Substance Doctrine
The Government first argues that the economic substance doctrine prevents the Walravens from claiming the Pribilof loss. See Mot. 16–21, ECF No. 24. It insists that, even though the Pribilof loss may formally comply with the code, the Court should disregard this transaction for federal income tax purposes because the transaction has no effect other than generating an income tax loss. See id. at 17. The Government contends that the question of whether a transaction has economic substance is a factual determination for which the Walravens bear the burden of proof. See id. It argues that, under the Fifth Circuit's two-prong test for economic substance, Pribilof's purported loss has no economic substance compelled by legitimate business realities, as the Pribilof transaction was nothing more than a circular flow of funds back to Walraven. See id. at 18–19 (citing Klamath Strategic Inv. Fund v. United States , 568 F.3d 537, 543 (5th Cir. 2009) ). And because Walraven controlled every aspect of WFI as grantor, trustee, and beneficiary of the revocable WMT, the discounts for lack of control and marketability of Pribilof should not apply. See Mot. 19–20, ECF No. 24. The Government also addresses the Walravens’ reliance on experts’ valuation of Pribilof that found the discounts appropriate. See Reply 8–9, ECF No. 31. In response, the Government indicates that all of these experts assumed a hypothetical, third-party buyer, and none found that the discounts were appropriate with knowledge that Walraven was grantor, trustee, and beneficiary of the general partner, WMT. See id.
The Walravens respond that neither the dissolution of the business nor the liquidation of Pribilof were anticipated when it was created. See Resp. 17, ECF No. 29. Contrary to the Government's arguments, the Walravens claim their economic position changed both as a factual and a legal matter when they created Pribilof. See id. Instead of owning cash and securities outright, after Pribilof's formation and liquidation, they owned a limited partnership interest in WFI. See id. They contend that, as a legal matter, these are simply not treated the same, as even the Government's witness, Mr. Burns, acknowledged in valuing Pribilof. See id. at 18. The Walravens also argue that the decision to utilize a limited partnership to shelter Pribilof's assets from potential creditors was a tax-independent consideration. See id. at 19. For this reason, the Government fails to meet the tax-avoidance prong of the Klamath test. See id. Likewise, the Walravens argue that the creation of Pribilof had no income tax impact and was created to function as a legitimate business for profit. See id. at 20–21. Because Walraven lacked any tax-avoidance intent in forming Pribilof, the economic substance doctrine is not applicable. See id. Finally, the Walravens indicate that three experts analyzed the transaction, conducted a valuation of Pribilof, and independently came to the conclusion that a loss should be recognized after applying discounts for lack of marketability and control. See Sur-Reply 5, ECF No. 35.
The Court concludes that the economic substance doctrine precludes the Walravens’ claim for a refund here. While taxpayers are generally free to take advantage of every legally permissible route to decrease their tax liability, "transactions[ ] which do not vary control or change the flow of economic benefits[ ] are to be dismissed from consideration." Higgins v. Smith , 308 U.S. 473, 476, 60 S.Ct. 355, 84 L.Ed. 406 (1940). In Klamath , the Fifth Circuit adopted a multi-factor test for analyzing whether a transaction has economic substance. 568 F.3d at 544 (citing Frank Lyon Co. v. United States , 435 U.S. 561, 583–84, 98 S.Ct. 1291, 55 L.Ed.2d 550 (1978) ). To determine whether a transaction must be honored as legitimate for tax purposes, the Court looks to whether the transaction (1) has economic substance compelled by business or regulatory realities; (2) is imbued with tax-independent considerations; and (3) is not shaped totally by tax-avoidance features. Klamath , 568 F.3d at 544. "While ‘these factors are phrased in the conjunctive, meaning that the absence of any one of them will render the transaction void for tax purposes,’ there is near-total overlap between the latter two factors." Southgate Master Fund, L.L.C. v. United States , 659 F.3d 466, 480 (5th Cir. 2011) (quoting Klamath , 568 F.3d at 544 ). "Accordingly, the economic substance doctrine effectively has two prongs: an objective economic prong and a subjective business purpose prong." Tucker v. Comm'r , 766 F. App'x 132, 139 (5th Cir. 2019). Both must be met for the transaction to be legitimate for tax purposes. Southgate , 659 F.3d at 480.
a. First Prong – Economic Reality
"[T]ransactions lack objective economic reality if they ‘do not vary, control, or change the flow of economic benefits.’ " Southgate , 659 F.3d at 481 (quoting Klamath , 568 F.3d at 543 ). "This is an objective inquiry into whether the transaction either caused real dollars to meaningfully change hands or created a realistic possibility that they would do so." Id. "[A] circular flow of funds among related entities does not indicate a substantive economic transaction for tax purposes." Merryman v. Comm'r , 873 F.2d 879, 882 (5th Cir. 1989). The transaction here lacks economic reality to justify the claimed discounts, as there was no change in economic benefit or actual diminution in the value of the limited partnership interests transferred to Walraven at the time of Pribilof's liquidation. The facts are that Walraven funded Pribilof with his proceeds from the sale of Eagle Construction. Two months later, he transferred those same funds back to himself individually in the form of Pribilof's 99% limited partnership interests while already holding the other 1% interest owned by his trust, WMT, as general partner of WFI. To the extent any dollars "changed hands," it was from Walraven's left hand to his right. As trustee of WMT and thus managing partner of WFI, at all times Walraven maintained 100% ownership and control of the partnership and, by extension, the assets of all of the partners. Simply put, Walraven was made no worse off in this exchange.
Plaintiffs do not dispute that Walraven maintained control of WFI as trustee of WMT, the general partner in the partnership. See Resp., ECF No. 29; Sur-Reply, ECF No. 35. Instead, they indicate that Walraven had fiduciary obligations as trustee of WMT and focus in the abstract on the fact that ownership of a limited partnership interest is not the same as outright ownership of underlying assets. See id. at 18. As a practical matter, any fiduciary obligations Walraven had as trustee were to himself as the sole beneficiary of the trust at the time of Pribilof's liquidation. And the Walravens’ contention that "the assets were [ ] another step away from them" is precisely the type of economic fiction the economic substance doctrine exists to eliminate in consideration of tax liability.
Indeed, in advising Walraven to transfer the 1% limited partnership interests to an investment trust established for his children, Walraven's tax attorney told him this would "keep the partnership valid for IRS reasons" but still allow Walraven to "maintain[ ] control" of WFI. Mot. App. 226, ECF No. 25.
It is also not enough for this prong that Walraven intended the business to be operational or that actual pieces of equipment were bought and sold. "[W]hen applying the economic substance doctrine, the proper focus is on the particular transaction that gives rise to the tax benefit, not collateral transactions that do not produce tax benefits." Here, that is the liquidation of Pribilof and transfer of its interests to Walraven. If the "transaction lacks economic substance compelled by business or regulatory realities, the transaction must be disregarded even if the taxpayers profess a genuine business purpose without tax-avoidance motivations." Klamath , 568 F.3d at 544. Viewed objectively, the transaction is the type of circular flow of funds that has no legitimate economic reality for purposes of the claimed tax benefit. It thus fails the first prong.
Because the absence of either prong renders the transaction void for tax purposes, the Pribilof transaction lacks economic substance. See Southgate , 659 F.3d at 480. Nevertheless, the Court addresses the second prong below.
b. Second Prong – Tax Avoidance
The second prong of the economic substance test is "a subjective inquiry into whether the taxpayer was motivated by profit to participate in the transaction. Tax-avoidance considerations are not wholly prohibited; taxpayers who act with mixed motives, seeking both tax benefits and profits for their businesses, can satisfy the business-purpose test." Southgate , 659 F.3d at 481–82 (citation and quotation marks omitted). "[T]he absence of a nontax business purpose is fatal to the argument that the Commissioner should respect an entity for federal tax purposes." Saba P'ship v. Comm'r , 273 F.3d 1135, 1141 (D.C. Cir. 2001). Put another way, the presence of any legitimate business purpose to a taxable event is enough to satisfy the tax-avoidance prong of the Klamath test.
In consideration of this prong, there is at least some evidence that Walraven had a legitimate business motivation in forming Pribilof with his father and subsequently dissolving it when the business prospects fizzled out. Evidence in the record indicates that two reasons for structuring the entities as they did were to shelter Pribilof from the claims of potential creditors and for estate planning purposes. See Resp. App. 19–20, ECF No. 30-5. During its time in operation, Pribilof bought and sold pieces of heavy equipment, the stated purpose in starting the company. See id. at 19, 34–35. Walraven also stated that he and his father attempted to hire a manager, Rob Jacobson, to run Pribilof. See id. at 26. When Jacobson did not end up coming on, they no longer viewed their business model as viable. See id. at 34. While other facts cited by the Government point to tax-avoidance motivations by Walraven and his tax attorney, viewing all of the evidence in the light most favorable to the Walravens, as the Court must, the presence of at least some evidence tending to show legitimate profit motive satisfies the business-purpose prong of the test. See Southgate , 659 F.3d at 481–82.
3. Substance-Over-Form Doctrine
The Government devotes a separate section of its brief on the Motion to argue that the Walravens’ claimed loss is not a bona fide loss under Treasury Regulation section 1.165-1(b). See Mot. 21–22, ECF No. 24. At least as applied to these facts, that argument is part and parcel of the Government's substance-over-form-doctrine argument. For that reason, the Court addresses both arguments here.
The Government also bases its summary judgment motion on the substance-over-form doctrine, urging the Court to reject the Walravens’ formal characterization of the transaction and, instead, look at its underlying substance. See Mot. App. 22, ECF No. 24. Given the use of intermediaries for the purpose of decreasing his tax burden, the Government insists the Court should disregard the form and disallow this end run around the provisions of the tax code. See id. In this same vein, the Government argues that the claimed "loss" itself is not a bona fide loss under the Treasury Regulations. See id. at 21. "If a loss is merely a ‘tax loss,’ but does not correspond to an actual economic loss, it is not deductible under the Internal Revenue Code." See id. Because the transaction here was not arms-length and Walraven maintained the benefit of the assets the entire time, the Government submits that this does not qualify as a bona fide loss under the code. See id. at 21–22.
In response, the Walravens contend that the transaction here involved several closed and completed transactions fixed by identifiable events. See Resp. 18, ECF No. 29. The final event of liquidation produced a loss under section 336, and that section's operation to this taxable event is mandatory. See id. at 16. Because the fair market value of the partnership was in fact less than its tax basis, this is a bona fide loss under the code. See id. According to the Walravens, the fact that the Government disapproves of this result does not allow it to ignore the plain language and meaning of the statutes. See id.
The Court holds that the claimed loss by Pribilof also violates the substance-over-form doctrine. "A fundamental principle of our income tax structure is the basic rubric that economic substance prevails over form." Sandvall v. Comm'r , 898 F.2d 455, 458 (5th Cir. 1990) (citations and internal quotations omitted). Closely related and often overlapping with the economic substance doctrine, the substance-over-form doctrine is integral to tax law and has been called "the cornerstone of sound taxation." Estate of Weinert v. Comm'r , 294 F.2d 750, 755 (5th Cir. 1961). "The substance over form doctrine permits a court to determine a transaction's characterization according to its ‘underlying substance of the transaction rather than its legal form.’ " Estate of Streightoff v. Comm'r , 954 F.3d 713, 719 (5th Cir. 2020) (quoting Southgate , 659 F.3d at 480 ). "[E]ven if a transaction falls within the literal requirements of the tax statute, the transaction will be disregarded ... if it has no business purpose or economic effect other than the creation of tax deductions, or if its only purpose is tax avoidance." Griffin v. United States , 42 F. Supp. 2d 700, 703 (W.D. Tex. 1998). "To permit the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress." Comm'r v. Court Holding Co. , 324 U.S. 331, 334, 65 S.Ct. 707, 89 L.Ed. 981 (1945), superseded by statute as stated in Eckerd Corp. v. United States , 37 Fed. Cl. 713, 720 (1997).
Here, looking beyond the formal nature of the liquidation and transfer, the transaction lacks economic substance beyond its effect on the Walravens’ tax liability. Unlike other cases conducted at arms-length, Marc Walraven's presence on all sides of this transaction confirms that there was never any actual or potential lack of control or marketability of Pribilof's limited partnership interests in WFI. As such, there was also no bona fide loss, which must be a loss "actually sustained" in the taxable year. 26 C.F.R. § 1.165-1(b) ; see also ACM P'ship. v. Comm'r , 157 F.3d 231, 252 (3d Cir. 1998) ("Tax losses such as these ... which do not correspond to any actual economic losses, do not constitute the type of ‘bona fide’ losses that are deductible under the Internal Revenue Code and regulations."). Considering what actually occurred in the liquidation of the limited partnership interests here reveals the substance of the Walravens’ claimed loss to be illusory. Applying the substance-over-form doctrine to these facts, the Pribilof transaction and claimed discounts resulting in a loss need not be respected for tax purposes.
* * *
Because the Court holds that both the economic substance doctrine and the substance-over-form doctrine independently preclude the Walravens’ refund claim as a matter of law, no rational jury could find to the contrary. Accordingly, the Court GRANTS the Government's Motion for Summary Judgment on the Walravens’ claim for refund of overpaid income taxes.
B. Underpayment Penalty
The Government also moves for summary judgment on the Walravens’ challenge to the underpayment penalty assessed under section 6662(a) of the Internal Revenue Code. See Mot. 24, ECF No. 24. The Government submits that the Walravens underpaid their 2008 taxes by $990,993. See id. Applying the standard for assessing when an understatement of tax is "substantial" under the code, the Government argues that the twenty percent penalty assessed, or $198,198.60, was correct under the law and must be upheld. See id. at 24–25. The Walravens do not dispute the accuracy of the calculation. Instead, they raise three arguments they say preclude summary judgment on this issue: (1) pleading deficiency by the Government; (2) timeliness of the approval of penalty; and (3) the presence of reasonable cause by the Walravens. See Resp. 23–27, ECF No. 29; Sur-Reply 7–8, ECF No. 35.
1. Pleading Deficiency
Section 6751(b) of the Internal Revenue Code provides that "[n]o penalty under this title shall be assessed unless the initial determination of such assessment is personally approved (in writing) by the immediate supervisor of the individual making such determination." 26 U.S.C. § 6751(b). The Walravens argue that compliance with that statute was an affirmative defense the Government was required to plead in its Answer under Federal Rules of Civil Procedure 8 and 12. See Resp. 23–24, ECF No. 29. The Walravens contend that it was not enough for the Government to simply deny the allegation that the penalty is inapplicable due to section 6751(b) —it needed to affirmatively plead how it had complied with that provision. See id. The Government responds that, under the Rules of Civil Procedure, it was not required to affirmatively plead compliance with the penalty approval in more particularity than it did in its response to the Complaint. See Reply 14–15, ECF No. 31. The Court agrees.
First, assuming this was an affirmative defense that needed to be pleaded, the Court holds that the Government's Answer was sufficient. "Central to requiring the pleading of affirmative defenses is the prevention of unfair surprise. A defendant should not be permitted to ‘lie behind a log’ and ambush a plaintiff with an unexpected defense." Ingraham v. United States , 808 F.2d 1075, 1079 (5th Cir. 1987). There can be no surprise here. The Walravens were the ones who raised the timeliness issue in their Complaint. See Compl., ECF No. 1. In submitting Certificates of Assessment for the Walravens’ 2008 income taxes, the Government had already effectively indicated its compliance with that provision. See United States v. Fior D'Italia Inc. , 536 U.S. 238, 242, 122 S.Ct. 2117, 153 L.Ed.2d 280 (2002) ("It is well established in the tax law that an assessment is entitled to a legal presumption of correctness—a presumption that can help the Government prove its case against a taxpayer in court.").
Additionally, in its Answer, the Government stated that it did not know whether the IRS had previously demonstrated to the Plaintiffs that the auditing agent's penalty assessment had been timely approved by the supervisor. See Answer 3, ECF No. 11. This is not the same as pleading a lack of knowledge that the auditing agent's penalty assessment had, in fact, been timely approved by the supervisor. In response to that allegation in the Complaint, the Government denied that was the case. See id. ("The United States denies the third sentence of paragraph 17."). The Government's denial of the section 6751(b) allegation was sufficient for purposes of Rule 8, which requires only short, plain statements of substance in defense to claims asserted against it. See Fed. R. Civ. P. 8(b). For that reason, the Government also complied with Rule 12, which requires that "[e]very defense to a claim for relief in any pleading [ ] be asserted in the responsive pleading if one is required." Fed. R. Civ. P. 12(a). Notably, neither the Federal Rules nor section 6751(b) requires the Government "to demonstrate" compliance with the provision to the taxpayer on the front end, as Plaintiffs suggest. See Resp. 24, ECF No. 29. The statute merely requires that an auditing agent obtain approval from the immediate supervisor prior to assessing a penalty under that section. See 26 U.S.C. § 6751(b). The Walravens point the Court to no caselaw or interpretation of the rules that applies that in a way to require the more onerous pleading standard they seek here.
Second, to the extent the Government should have pleaded compliance with section 6751(b) with greater specificity, the Court holds that there was no waiver here. The Government raised that defense in a sufficient amount of time as part of the current Motion for Summary Judgment, the Walravens had sufficient time to respond to it, and because there was no surprise, as explained above, there was no prejudice in it being raised at this stage. See Simon v. United States , 891 F.2d 1154, 1157 (5th Cir. 1990) (noting that if a party raises an issue at a "pragmatically sufficient time," and the opposing party is not prejudiced in its ability to respond, there is no waiver of the claim or defense) (citation omitted). As such, the Walravens’ argument on this point fails.
2. Timeliness of Supervisor Approval
The Walravens also argue that there is a dispute of material fact concerning whether the Government actually complied with section 6751(b). See Resp. 24–25, ECF No. 29. They contend that there has been no proof of when an initial determination was made; therefore, there is no way to know if the proferred approval was timely. See id. at 25. In support of this, the Walravens appear to point to notes made by the auditing agent on the case that predate the Penalty Approval Form signed by the agent's supervisor. See Resp. App. 1–8, ECF No. 30-4. The Government responds that the Civil Penalty Approval Form was timely completed by the supervisor on October 18, 2012 and that the initial determination was made no earlier than October 24, 2021. See Mot. 24, ECF No. 24. Although section 6751(b) does not define "initial determination," some courts have held that supervisor approval is necessary even before "proposed adjustments are communicated to the taxpayer formally as part of a communication that advises the taxpayer that penalties will be proposed...." Clay v. Comm'r , 152 T.C. 223, 249 (2019). Even under this standard, the evidence conclusively shows that the auditing agent here obtained supervisor approval prior to proposed adjustments being communicated for the first time to the Walravens on October 24, 2021. See Resp. App. 9, ECF No. 30-4; Reply App. 20–21, ECF No. 31-1. In its Sur-Reply, the Walravens point to no evidence to refute this. See Sur-Reply, ECF No. 35. As such, this argument fails to raise a genuine dispute of material fact on this issue.
3. Reasonable Cause
Finally, the Walravens argue that the Internal Revenue Code imposes a 20% penalty for substantial underpayment like the one assessed here, unless "it is shown that there was a reasonable cause for such portion [of an underpayment] and that the taxpayer acted in good faith with respect to such portion." 26 U.S.C. § 6664(c). They suggest that the Walravens reliance on their tax attorney, Richard Shanks, in claiming the 2008 loss demonstrates reasonable cause. See Resp. 26, ECF No. 29. There are several facts they argue support this determination. See id. Mr. Shanks is an experienced tax attorney and licensed CPA. See id. He had been handling estate planning and tax issues for the Walravens for at least ten years. See id. Given this, they argue it would be unfair and unreasonable to have expected them to question his expertise or seek out a second opinion on the matter of the claimed discounts and loss. See id. Because the Government cannot demonstrate a lack of reasonable cause on the part of the Walravens and there are factual disputes on this issue, summary judgment cannot be granted to the Government on the penalty claim. See id. at 27; Sur-Reply 8, ECF No. 35.
In response, the Government argues that the Walravens bear the burden of showing this defense applies, and they have not done so. See Reply 16, ECF No. 31. The Government submits first that, as an attorney and experienced businessman, Walraven knew or should have known that a paper loss of over $7 million for a business that was in operation only two months was too good to be true. See id. at 17. Next, the Government argues that Shanks was a promoter of the deal and had a conflict of interest, so reliance on him by the Walravens was per se unreasonable. See id. at 18. Because Shanks charged the Walravens one fee for the creation of the tax structure at issue and then opined on the validity of the discounts after dissolution, he was conflicted, and any advice was given in defense of the structure he had created. See id. at 18–19. Finally, the Government contends that the Walravens cannot establish reliance on Shanks's advice, as they have not provided the Court with the necessary facts upon which to evaluate the reasonableness of any such reliance. See id. at 19.
The Court holds that the Walravens did not have reasonable cause for their underpayment here. "The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts and circumstances." 26 C.F.R. § 1.6664-4(b). "Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of all of the facts and circumstances...." Id. "The most important factor is the extent of the taxpayer's effort to assess his proper liability in light of all of the circumstances." Id. Reliance on the advice of a professional tax advisor may but does not necessarily constitute reasonable cause. See id. Generally speaking, "when an accountant or attorney advises a taxpayer on a matter of tax law, such as whether liability exists, it is reasonable for the taxpayer to rely on that advice." Chamberlain v. Comm'r , 66 F.3d 729, 732–33 (5th Cir. 1995). However, "[r]eliance is not reasonable if the advisor has ‘an inherent conflict of interest’ about which the taxpayer knew or should have known; nor is it reasonable if the taxpayer knew or should have known that the transaction was ‘too good to be true.’ " Salem Fin., Inc. v. United States , 786 F.3d 932, 958 (Fed Cir. 2015). "[T]he taxpayer's education, sophistication and business experience will be relevant in determining whether the taxpayer's reliance on tax advice was reasonable and made in good faith." 26 C.F.R. § 1.6664-4(c)(1).
While reliance on the advice of a tax advisor might demonstrate reasonable cause in many instances, the Court holds that it was not reasonable under these facts. Walraven, himself an attorney, approached Shanks about the sale of Eagle Construction in 2008 prior to the sale taking place. See Mot. App. 293, ECF No. 25. In those conversations, Shanks informed Walraven of the tax implications of liquidating Pribilof in the future and that it would be more likely to recognize a loss if Pribilof was liquidated relatively quickly after its formation. See id. at 260–61.
Walraven then paid Shanks a flat fee of $195,000 to (1) review the sale of Eagle Construction; (2) prepare formation documents for the S-Corp, Pribilof, including a certificate of formation, written consent, and bylaws; (3) prepare formation documents for the limited partnership, WFI, including a certificate of formation, partnership agreement, transfer and assignments, written consent, and bylaws; (4) prepare formation documents for the family trust, WMT; and (5) complete the partnership, funding, and closing documents. See id. at 6–9, 279. After Walraven's decision to liquidate Pribilof after only two months, Shanks also (1) prepared the certificate of termination, completed the final franchise tax return, and obtained the certificate of dissolution for Pribilof; (2) prepared ten promissory notes and transfer and assignment documents; and (3) revised four of the promissory notes. See id. at 8–10. When the Walravens’ 2008 tax return was later audited, Shanks also represented them in that audit. See id. at 257. He did not charge the Walravens any additional fees for any of these follow-on legal services that would not have been anticipated given the stated intent for Pribilof to be a viable business under the management of Ron Jacobson. See id. at 8–10, 294.
When deposed, Walraven stated that he was aware that a general partner controls a limited partnership. See id. at 289. As WMT was the general partner of WFI and Walraven trustee of WMT, he was managing partner of WFI and acknowledged his full control of WFI both before and after the dissolution of Pribilof in 2008. See id. at 289, 291. In other words, he was aware that, in reality, he was the only party to the transaction when he transferred the limited partnership interests of Pribilof to himself when Pribilof dissolved. Because he controlled every aspect of WFI as the trustee of WMT, it was unreasonable for him to accept the notion that there was any lack of control or marketability of Pribilof's limited partnership interests to justify discounts for these factors. Furthermore, when they transferred those interests back to Walraven, Shanks advised Walraven to make 1% transfers to each of his children to "keep the partnership valid for IRS reasons." See id. at 226. Despite knowing Shanks’ own concerns of the validity of the partnership moving forward, Walraven claimed a paper loss of almost $8 million for the return of his initial $19.6 million capital contribution to Pribilof. See id. at 169, 134. The Court holds that, considering all of the pertinent facts, it was not reasonable for Walraven, a legally educated and savvy businessman, to rely on the advice of Shanks in claiming that loss on his 2008 tax return. The Court would be hard-pressed to find a case that better fits the "too good to be true" scenario than the present one. See Salem Fin. , 786 F.3d at 958. Given this, there is no genuine dispute of material fact on the issue of the Walravens’ reasonable cause.
* * *
Because each of the Walravens’ objections to the underpayment penalty fails as a matter of law, the Court GRANTS the Government's Motion for Summary Judgment on the Walravens’ claim for refund of the penalty.
IV. CONCLUSION
For the foregoing reasons, the Government's Motion for Summary Judgment (ECF No. 23) is GRANTED .
SO ORDERED on this 15th day of March 2021 .