Klamath Strategic Investment Fund v. United States

Law partners Cary Patterson and Harold Nix (the investors) arranged a tax-shelter transaction to manage their wealth. The transaction consisted of a three-stage plan involving investments in foreign currency. Stage 1 involved low risk and low returns, and stages 2–3 involved increased risk and returns. The investors both formed partnerships (plaintiffs) to which they contributed $1.5 million each. The investors also entered into a loan agreement whereby the bank issued them a $66.7 million loan, consisting of $41.7 million in loan principal and $25 million in loan premium. Certain terms allowed the bank to force the partnerships to withdraw after 60–70 days. The full $66.7 million remained in a collateral account at the bank to secure the loan and could not be used to purchase investments. Rather, the investors considered the loan necessary security for the high-risk investments. The partnerships assumed liability for the loans, and these amounts were included in the basis of the partnerships. The investors withdrew after stage 1 of the investment plan, which was their right. The investors’ basis in the partnerships was reduced by the $41.7 million loan principal. However, the investors did not consider the $25 million loan premium to be part of their liability and did not reduce the basis by that amount. The investors then sold the partnerships’ assets and claimed large losses based on the approximately $25 million in basis. The Internal Revenue Service (IRS) issued adjustments stating that the entire $66.7 million should have been treated as a liability or that the transaction lacked economic substance and should be disregarded. The IRS also adjusted certain deductions claimed for operating expenses. The partnerships filed suit, and the district court held that the loan transactions must be disregarded for tax purposes because they lacked economic substance. The partnerships appealed.