II. Analysis

The case, Klamath Strategic Investment Fund, LLC v. U.S., reads for the most part like your run of the mill tax shelter case.[1]  Two attorneys, faced with the receipt of some substantial income (and therefore some substantial income tax) created a Bond Linked Issue Premium Strategy Shelter (or BLIPs), which system of initially overvalued and rapidly depreciating assets generated losses as the attorneys, partners in a variety of linked entities, gradually relinquished their shares in the flailing enterprises.[2]  The court came to the (predictable) conclusion that these series of transactions lacked economic substance.  No substance was found because the facts suggested that the web of contracts/entities existed for the sole purpose of avoiding the incidence of tax, which has been squarely rejected as a business purpose having economic substance.[3]  Consequently, the court held that the taxpayers were responsible for the taxes they had failed to pay.[4] 

However, on the issue of penalties, they adopted the plaintiff's argument as to all three areas of penalties proposed by the IRS.  The first penalty offered by the IRS dealt with the overvaluation of assets by the taxpayers.[5]  On this issue the court held that "as a matter of law, an overvaluation penalty cannot apply when the IRS totally disallows a deduction or credit."[6]  In so holding, the court relied on earlier 5th Circuit decisions (in conflict with 4th Circuit holding [7]) which held that in any instance where the IRS totally disallows a deduction or credit, the IRS may not penalize the taxpayer for overvaluation.[8]  Essentially, this premise appears to disprove the age-old adage that two wrongs don't make a right.  In this case, two wrongs (one being the creation of tax shelters lacking independent economic substance, two being overvaluation of the assets in those shelters), make a right (no penalty under the overvaluation statute). 

The next penalty proposed by the IRS addressed the substantial understatement of the taxpayers' income taxes.[9]  In this instance, the court held that the taxpayers had reasonably relied on "substantial authority" as produced by their creative lawyers, which authority purportedly validated their series of entities and transactions.  This author's question is this -- how can the same court that states that a "tax shelter" possesses as a definitional element the aim of avoiding or evading Federal income tax, a court that also says that this shelter existed for no other legitimate business purpose, accept that the taxpayers reasonably relied on substantial authority in their enterprise?  Admitting that the three thoughts are not inherently inconsistent, the author questions the court's very sparse analysis of what could have constituted substantial authority authorizing the transaction relative to "the weight of authorities supporting contrary treatment."[10]

Finally, the court addresses the final proposed penalty to be exacted for the taxpayers' negligent disregard for the rules and regulations of the tax code.[11]  Similar in exception to the susbtantial understatement penalty, the court wriggles its way out of this one in finding that the taxpayers acted in good faith and with reasonable cause in underpaying.[12]  Once again, the court very generally speaks to the expertise of the counsel sought in demonstrating the necessary diligence.[13]  Given that it is not necessary, however, under this test (in contrast to the "substantial authority" test) to evaluate the quality of the opinion sought, but only the reasonableness in reliance on the opinion sought, this declination to penalize is a bit easier to swallow than the other two.

 IV. Conclusion

 What is the importance of this decision?  On its own, not a whole lot.  It isn't groundbreaking law.  What it potentially represents, however, is the success of some crafty, tax-fearing individuals in avoiding any actual repercussions for their behavior.  It gives a nation full of people already chomping at the bit for tax freedom a little more rein and breathing room to explore the world of tax evasion where the carrot is possibly huge, and at smallest, about the size of the time value of money.

[1]  Klamath Strategic Investment Fund, LLC v. U.S., 2007 WL 283790 (E.D. Tex 2007).

[2] Id.

[3] Id. at 9.

[4]  Id. at 9-12.

[5] Id. at 12, see also 26 U.S.C.A. § 6662(b)(3),(h) (West 2007).

[6]  Supra note 1 at 12.

[7]  See Zfass v. Comm., 118 F.3d 184, 190 (4th Cir. 1997).

[8]  Supra note 1 at 12-13, citing Heasley v. Comm., 902 F.2d 380, 383 (5th Cir. 1990); Weiner v. U.S., 389 F.3d 152, 161-62 (5th Cir. 2004).

[9]  Supra note 1 at 13, see also U.S.C.A. § 6662(b)(2), (d) (West 2007).

[10]  Supra note 1 at 14.

[11]  Supra note 1 at 15, see also 26 U.S.C.A. § 6662(b)(1) (West 2007).

[12]  Supra note 1 at 18-19.

[13]  See supra note 1 at 18-19.