Spartanrock V. Investco, LLC: Financial Case Study

Facts: Ivanna Deduct and SpartanRock Corp formed a Florida limited liability company, Investco, LLC at 2013. Ivanna contributed $100,000 cash, and SpartanRock, the parent of Best Buy, contributed $99,900,000 Best Buy’s customer receivables. These customers’ receivables were more than 180 days old that had not been collected, with an average outstanding balance of $161.81 on each account. Ivanna sold ninety-nine interests to individual investors for $1,000,000 each in exchange for Investco’s interest. The $1,000,000 contained $100,000 in cash and a promissory note to Investco for $900,000. Later, SpartanRock received a cash distribution of $5,000,000 and withdrew from Investco. At the same time, Ivanna also received a cash distribution of $5,000,000

from Investco. There was only $99,000.000 of receivables asset left for Investco.
Issue: Each investor’s basis in Investco was $1,000,000, so the receivables were written off as worthless with the losses of $999,000 passed along to each investor. The investors deducted the loss of $999,000 as ordinary loss from Investco on their tax return. IRS disallowed the loss of $999,000, however, claiming that the entire transaction was a sham for the purpose of evading taxes. The investors would like to know if they could deduct the $999,000 loss as ordinary loss on their tax return.
Answer: The investor cannot deduct the $999,000 loss as ordinary loss on their tax return under code sec 707, §721 and §6662.
Rationale: In 2014, a federal case, Kenna Trading, LLC, et al.

v. Commissioner of Internal Revenue relating to the similar situation as Investco, LLC, was brought into U.S. Court of Appeals. Mr. Rogers was the sole owner of an S corporation, Portfolio Properties, Inc. (PPI), which owned Jetstream. He also formed Sugarloaf through entities he owned and controlled. His business would profit through aggressive receivables collection efforts and translation gain from currency speculation. He used a tiered partnership structure to sell interests to individual investors. In 2003, Mr. Rogers used a limited liability company called Warwick Trading, LLC, to purchase receivables from Lojas Arapua, S.A., a Brazilian retailer of household appliances and consumer electronics. In 2004, Globex contributed receivables with an outstanding balance of R$219,087,756.03 in exchange for a 99% membership interest in Sugarloaf, LLC. Companhia Brasileira de Distribuição (CBD) contributed distressed accounts receivable to Sugarloaf, LLC in exchange for 1% interest in that company. Both Globex and CBD received cash distributions in redemption of their interests in Sugarloaf within two years period. Sugarloaf suffered a loss after the cash distribution, so Mr. Rogers claimed an ordinary loss for Sugarloaf, LLC. However, the IRS disallowed the loss. Firstly, under code §707 and §721, the receivables contribution for Sugarloaf was not valid to the purported partnership and would be treated as a disguised sale because cash distributions within two years of a contribution give rise to a presumption that the transaction is a disguised sale. Secondly, according to the general principle of Federal income taxation, a taxpayer has a right to conduct transactions in a manner that minimizes or outright avoids Federal income tax. However, the Sugarloaf-type entity in that case was a sham partnership to avoid paying tax, so it entitled to none of the benefits of the Federal income tax laws. Lastly, §6662

imposes a 20% penalty on understatements due to reportable transactions or listed transactions, so Sugarloaf would be liable for the penalty for its 2004 and 2005 tax years.

Based on the federal case above, investors would not be able to deduct the $999,000 as ordinary loss from Investoco. Instead, Investco may be liable for a tax penalty for understating tax payments.
Authority:
Kenna Trading, LLC, et al. v. Commissioner, 143 TC 322
26 USC §707, 26 USC §721, 26 USC §6662