12-3369, 12-3370 and 12-3371 SUPERIOR TRADING , LLC v. Commissioner of Internal Revenue

In the
United States Court of Appeals
For the Seventh Circuit
____________________
Nos. 12‐3367, 12‐3368, 12‐3369, 12‐3370 and 12‐3371
S UPERIOR T RADING , LLC, et al.,
Petitioners‐Appellants,
v.
C OMMISSIONER OF INTERNAL R EVENUE ,
Respondent‐Appellee.
____________________
Appeals from the United States Tax Court.
Nos. 20171‐07, 20230‐07, 20243‐07, 20655‐07, 19543‐08 —
Robert A. Wherry, Jr., Judge.
____________________
A RGUED A PRIL 19, 2013 — D ECIDED A UGUST 26, 2013
____________________
Before EASTERBROOK , Chief Judge, and P OSNER and
W ILLIAMS, Circuit Judges.
P OSNER , Circuit Judge. These appeals are by multiple
LLCs (limited‐liability companies) involved in the creation
and administration of a tax shelter. For the sake of simplicity
we’ll treat the appeals as one appeal, by Warwick Trading,
LLC. The other appellants are subsidiaries of Warwick used
to attract investors in it and needn’t be discussed separately.
The appeal challenges a decision by the Tax Court uphold‐

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2 Nos. 12‐3367 to 12‐3371
ing the disallowance by the Internal Revenue Service of loss‐
es claimed by Warwick (ultimately for the benefit of the in‐
vestors in the tax shelter) and also upholding a 40 percent
penalty for a “gross valuation misstatement.” 26 U.S.C. §§
6662(a), (h); 137 T.C. 70, 87, 91–92 (2011); see also T.C. Memo
2012‐110, 103 T.C.M. (CCH) 1604 (opinion denying reconsid‐
eration). The dollar amount of the penalty, which depends
on the tax losses improperly taken by the investors in the
shelter, has not yet been determined.
An LLC, such as Warwick, is generally treated as a part‐
nership for tax purposes, Treas. Reg. § 301.7701–3(a), and
like other partnerships its income and losses are deemed to
flow through to the partners and are taxed to them rather
than to the partnership. 26 U.S.C. §§ 701–04, 6031. Until 1982
“all partnership items were determined at the individual
taxpayer level.” But this “often required duplicative pro‐
ceedings for different partners and sometimes resulted in
inconsistent treatment of partnership items from partner to
partner.” Petaluma FX Partners, LLC v. Commissioner, 591 F.3d
649, 651 (D.C. Cir. 2010); see also Southgate Master Fund,
L.L.C. v. United States, 659 F.3d 466, 469 n. 4 (5th Cir. 2011).
So the law was changed, and now how much partnership
income or loss should be given recognition for tax purposes
when the partners file their tax returns is determined by an
audit of the partnership. 26 U.S.C. §§ 6221–6232.
Warwick had been created by a lawyer named John Rog‐
ers, the petitioner in the companion case of Rogers v. Commis‐
sioner, No. 12‐2652, also decided today. (We note with dis‐
approval the loquacity of, and lame attempts at humor in,
the Tax Court’s opinion, which include making fun of Rog‐
ers’ name, as in the section title “Mr. Rogers’ Neighbor‐

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Nos. 12‐3367 to 12‐3371 3
hood.”) The purpose of creating Warwick was to beat taxes
by transferring the losses of a bankrupt Brazilian retailer of
consumer electronics named Lojas Arapuã S.A. to U.S. tax‐
payers who would deduct the losses from their taxable in‐
come. Arapuã had receivables with a face value of U.S. $30
million. Because they were to a great extent uncollectible
(they were owed by consumers, had very small balances,
and were very old), they had a negligible market value. Rog‐
ers used a company that he owned, Jetstream Business Lim‐
ited, to join with Arapuã in forming Warwick. Jetstream was
designated the managing (that is, the active) partner,
charged with trying to collect the receivables. The net re‐
ceipts from Jetstream’s activity would be Warwick’s partner‐
ship income and would eventually be divided between
Jetstream (meaning Rogers) and Arapuã.
Rogers’ aim was to create what is called a distressed as‐
set/debt (“DAD”) tax shelter. See IRS, “Coordinated Issue
Paper—Distressed Asset/Debt Tax Shelters,” LMSB‐04‐0407‐
031, Apr. 18, 2007, www.irs.gov/Businesses/Partnerships/
Coordinated‐Issue‐PaperCDistressed‐Asset‐Debt‐Tax‐
Shelters (visited Aug. 26, 2013). A DAD shelter is based on a
tax loophole closed by the American Jobs Creation Act of
2004, Pub. L. No. 108‐357, § 833, 118 Stat. 1589, amending 26
U.S.C. §§ 704(c), 743, the year after Rogers created Warwick.
To spare the reader a headache, we’ll provide a simplified
explanation of Rogers’ DAD.
When an asset is contributed to a partnership, the con‐
tributor receives in exchange a partnership interest. The
partnership formally owns the contributed asset, but the
contributor owns a slice of the partnership in recognition of
his contribution, and so hasn’t really parted with the asset.

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4 Nos. 12‐3367 to 12‐3371
In the hands of the partnership the asset’s basis is the con‐
tributor’s original basis, which (with adjustments that we
can ignore) is the asset’s original cost. 26 U.S.C. §§ 723, 1012.
Recognition for tax purposes of gain or loss attributable to
any change in the asset’s value before the asset was contrib‐
uted to the partnership is deferred until the partnership sells
the asset. See 26 U.S.C. § 721(a). So if the asset is worth less
than the contributor paid for it, that loss in value (what is
termed “built‐in loss”) will be recognized, and thus usable to
reduce taxable income, only when the partnership sells the
asset. See 26 U.S.C. § 704(c)(1)(A); Laura E. Cunningham &
Noël B. Cunningham, The Logic of Subchapter K 10 (4th ed.
2011). If the contributing partner sells his partnership inter‐
est before the partnership sells the contributed asset, the
buyer of the partnership interest steps into his shoes and so
recognizes built‐in loss or gain if and when the partnership
sells the asset. Treas. Reg. § 1.704‐3(a)(7).
Rogers’ DAD involved Arapuã’s contributing its receiva‐
bles with built‐in losses to Warwick, followed by the sale of
Arapuã’s partnership interest (acquired by contributing
those receivables to the partnership) to investors—the tax‐
shelter seekers. Because the tax shelterers bought Arapuã’s
interest in the partnership, the partnership’s losses when it
sold the receivables flowed through to the investors as
Arapuã’s successors in the partnership.
The investor‐partners’ purpose in buying Arapuã’s inter‐
est in the partnership (and thus becoming Jetstream’s part‐
ners—for remember that Arapuã and Jetstream were the
original partners in Warwick) was to deduct the built‐in loss.
But a partner can claim a loss only up to the amount of his
basis in the partnership, 26 U.S.C. §§ 704(d); 705(a)(2)(A); 9

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Nos. 12‐3367 to 12‐3371 5
Mertens Law of Federal Income Taxation § 35C:1 (2013), and the
basis of the partnership interest that an investor acquired
(thereby becoming a partner) was the price at which Arapuã
had sold the interest to him. Treas. Reg. § 1.742‐1. That price
would have been very low, since the buyers—the shelter in‐
vestors—were just buying tax savings based on built‐in loss.
In fact each dollar of that loss could be worth no more than
35 cents in tax savings, because the top income tax bracket in
2004 was 35 percent. So the most a top‐bracket shelter inves‐
tor would pay Arapuã for a partnership interest that would
give the investor the right to its built‐in loss would be a sliv‐
er less than 35 percent of the loss, for otherwise he’d obtain
no tax savings. In fact the shelter investors paid only 3 to 6
percent of the value of the losses they obtained by buying
into the shelter.
But the investor had to contribute additional property to
the partnership in order to inflate his basis in his partnership
interest to a level at which he could deduct the entire built‐in
loss. 26 U.S.C. § 722. If he paid $100 for an asset once worth
$1000, he could not claim a loss of $900—the full built‐in
loss—but only of $100; the other $800 of losses would be
wasted from a tax‐avoidance standpoint. The assets that the
shelter investors contributed in order to raise their basis to
the built‐in loss were promissory notes made out to the
partnership. The notes had no value because Rogers had no
intention of causing Warwick to collect on them. The inten‐
tion was simply to create the appearance that the investors’
interest in the partnership had a high enough basis to enable
the entire built‐in loss that the shelter investors had acquired
to be offset against their taxable income. But all this means is
that the investors should not have been permitted to deduct
their entire built‐in loss—yet in fact they shouldn’t have

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6 Nos. 12‐3367 to 12‐3371
been permitted to deduct any part of it, because the partner‐
ship was a sham. It was really just a conduit from the origi‐
nal owner of the receivables (Arapuã) to the U.S. taxpayers
who wanted a deduction equal to the difference between the
face amount of the receivables (the promissors’ debt) and the
receivables’ current, greatly depressed market value.
A genuine partnership is a business jointly owned by two
or more persons (or firms) and created for the purpose of
earning money through business activities. If the only aim
and effect are to beat taxes, the partnership is disregarded
for tax purposes. “[T]ax considerations cannot be the only
reason for a partnership’s formation.” Southgate Master Fund,
L.L.C. v. United States, supra, 659 F.3d at 484 (emphasis in
original). There must be a “profit‐motivated reason to oper‐
ate as a partnership.” Id. “[T]he absence of a nontax business
purpose is fatal.” ASA Investerings Partnership v. Commission‐
er, 201 F.3d 505, 512 (D.C. Cir. 2000).
Jetstream, supposedly the active partner in Warwick,
made a few, feeble attempts at collecting the receivables that
Arapuã had contributed to the partnership. The attempts
were window dressing. Collection would have been gov‐
erned by Brazilian law, which required that the contract for
the transfer of Arapuã’s receivables to Warwick be translat‐
ed into Portuguese and filed with the Brazilian government.
Neither of these things was done. Indeed there is considera‐
ble doubt whether the receivables, which could be trans‐
ferred only pursuant to Brazilian law, were ever actually
transferred to Warwick.
The reason for Rogers’ insouciance regarding formalities
was that the aim of the partnership was not to make money
by collecting on Arapuã’s receivables—which apparently

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Nos. 12‐3367 to 12‐3371 7
would have been a Quixotic undertaking, for collection ef‐
forts were perfunctory and yielded little revenue—but to sell
interests in the partnership to U.S. taxpayers seeking tax sav‐
ings. The revenue from the sale of these interests was the
partnership’s only revenue.
A transaction that would make no commercial sense
were it not for the opportunity it created to beat taxes
doesn’t beat them. Substance prevails over form. See Gregory
v. Helvering, 293 U.S. 465, 470 (1935), and Moline Properties,
Inc. v. Commissioner, 319 U.S. 436, 439 (1943), and for applica‐
tion to a sham partnership Southgate Master Fund, L.L.C. v.
United States, supra. The question is “whether the partners
really and truly intended to join together for the purpose of
carrying on business and sharing in the profits or losses or
both.” Commissioner v. Tower, 327 U.S. 280, 287 (1946); see al‐
so Commissioner v. Culbertson, 337 U.S. 733, 742 (1949);
Southgate Master Fund, L.L.C. v. United States, supra, 659 F.3d
at 483–91; TIFD III‐E, Inc. v. United States, 459 F.3d 220, 231–
32 (2d Cir. 2006); ASA Investerings Partnership v. Commission‐
er, supra, 201 F.3d at 511–13; Cunningham & Cunningham,
supra, at 3. No joint business goal motivated the creation of
Warwick. Arapuã’s aim was to extract some value from its
otherwise worthless receivables, Jetstream’s aim to make the
losses in those receivables a tax bonanza.
The appellants argue that these cases have been super‐
seded. They point out that Warwick was created under Illi‐
nois law, that it was a valid LLC under that law, and that
Treas. Reg. § 301.7701‐3(b)(1) defines an LLC that has more
than one member (as did Warwick) as a partnership unless
the organizers choose to designate it for tax purposes as a
corporation. But the purpose of the regulation is merely to

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8 Nos. 12‐3367 to 12‐3371
determine whether the default tax treatment of the entity
shall be under the corporate or the partnership provisions of
federal tax law, not whether it shall be entitled to the bene‐
fits (such as deferral of losses in contributed property) creat‐
ed by those provisions should they be found inapplicable for
other reasons. As a sham partnership Warwick was entitled
to none of the benefits that the Internal Revenue Code be‐
stows on partnerships. See Treas. Reg. § 301.7701‐1(a)(1);
Southgate Master Fund, L.L.C. v. United States, supra, 659 F.3d
at 483 n. 53. “An entity without economic substance, wheth‐
er a sham partnership or a sham trust, is a sham either way
and hence is not recognized for federal tax law purposes.”
Sparkman v. Commissioner, 509 F.3d 1149, 1156 n. 6 (9th Cir.
2007).
With Warwick out of the picture, the tax shelter collaps‐
es, because all that is left is a sale by Arapuã of its receiva‐
bles to the shelter investors. A built‐in loss is recognized for
tax purposes when the property with the loss is sold. 26
U.S.C. §§ 1001(a)‐(c). The buyer’s basis is what he pays,
equal in this case to the very low market value of Arapuã’s
receivables. 26 U.S.C. § 1012. The buyer therefore has no
built‐in loss; that loss was recognized by Arapuã, once
Arapuã’s “contribution” to Warwick is recharacterized as a
sale to the shelter investors.
Even if Warwick had been an actual rather than fake
partnership between Arapuã and Jetstream, the cash transfer
from the partnership to Arapuã within two years of that
company’s contribution of assets to Warwick would have
created a presumption that the company had sold the assets
(Arapuã’s receivables) to the partnership and received the
cash distribution as delayed payment for them, rather than

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Nos. 12‐3367 to 12‐3371 9
having contributed them to the partnership. Treas. Reg.
§ 1.707‐3(c); see also 26 U.S.C. § 707(a)(2)(B). Arapuã re‐
ceived a substantial distribution from Warwick 10 months
after contributing the receivables, thus triggering the pre‐
sumption. The presumption has not been rebutted. Since
Arapuã sold the receivables to Warwick rather than contrib‐
uting them, it had to recognize any losses at the time of that
sale, leaving no losses for the shelter investors to claim when
they entered the partnership.
The judge decided to impose a penalty for the sham.
Should he have? Section 6662(h)(1) of the Internal Revenue
Code, read in conjunction with subsections (a) and (b)(3),
imposes a 40 percent penalty on so much of an underpay‐
ment of tax as is attributable to any “gross valuation mis‐
statement.” Under subsection (h)(2)(A)(i) (2000 & Supp. IV
2004) which at the time defined “gross valuation misstate‐
ment” to cover any tax deduction involving property whose
claimed price (basis) was more than four times its correct
value, the valuation misstatement in this case had been
“gross.” The aggregate basis of the receivables transferred to
Warwick had been close to zero, but Warwick, which is to
say Rogers, had valued them at roughly $30 million.
There is a disagreement among courts of appeals con‐
cerning the applicability of the penalties for misstating valu‐
ation when the transaction involving the overvalued asset is
itself disregarded because it lacks economic substance.
Compare, e.g., Crispin v. Commissioner, 708 F.3d 507, 516 n. 18
(3d Cir. 2013); Gustashaw v. Commissioner, 696 F.3d 1124,
1136–37 (11th Cir. 2012), and Fidelity Int’l Currency Advisor A
Fund, LLC v. United States, 661 F.3d 667, 672 (1st Cir. 2011),
with Keller v. Commissioner, 556 F.3d 1056, 1059–61 (9th Cir.

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10 Nos. 12‐3367 to 12‐3371
2009), and Heasley v. Commissioner, 902 F.2d 380, 383 (5th Cir.
1990). The majority view, which we now join, is that a tax‐
payer who overstates basis and participates in sham transac‐
tions, as in this case, should be punished at least as severely
as one who does only the former. The Supreme Court has
granted certiorari to resolve the circuit conflict. United States
v. Woods, 133 S. Ct. 1632 (2013).
The appellants would have avoided the penalty had they
proved they had “reasonable cause” to deduct the built‐in
losses. 26 U.S.C. § 6664(c)(1); see United States v. Boyle, 469
U.S. 241, 250–51 (1985); University of Chicago v. United States,
547 F.3d 773, 785 (7th Cir. 2008); Richardson v. Commissioner,
125 F.3d 551, 558 (7th Cir. 1997). They didn’t prove that.
They were all just tools—extensions, really—of Rogers, an
experienced tax lawyer who had more than 30 years of expe‐
rience in the taxation of international business transactions.
The tools had no more autonomy than his fingers. There is
not even a colorable basis for the tax shelter that he created
and the appellants implemented. There are as we’ve seen
multiple grounds for disallowing the partnership losses that
Rogers engineered (in fact more grounds than we’ve both‐
ered to discuss), and all are grounds that he either knew
about or should, given that he is no tax neophyte, have
known about.
A FFIRMED.

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