LNV vs. Gebhardt: Request for Investigation into Attorney Charles King

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Denise Subramaniam 13865 SW Walker Rd. Beaverton OR 97005

Attorney Registration & Disciplinary Commission Of the Supreme Court of Illinois One Prudential Plaza 130 East Randolph Drive, Suite 1500 Chicago, IL 60601-6219 June 17, 2014 RE: Request for an investigation of attorney Charles Elliott King and his participation in a conspiracy to defraud and to launder money in behalf of renown gambler D. Andrew Beal To Whom It Concerns;

Charles Elliott King was admitted to the Illinois Bar on January 29, 2013. He works for Dovenmuehle Mortgage, Inc., 1 Corporate Drive Suite 360, Lake Zurich, IL 60047-8944.

I am a member of a group of victims of mortgage fraud committed by LNV Corporation (LNV), MGC Mortgage Inc. (MGC) and Dovenmuehle Mortgage, Inc. (DMI) in collusion with each other. Most of these victims were put into a fabricated default by MGC; i.e. the homeowners did not miss payments but MGC intentionally misappropriated their payments then claimed they were in default so that MGC could initiate a foreclosure in behalf of LNV. LNV claims to be the holder in due course of the homeowners note when in fact they are not. (A few of these homeowners were not put into a fabricated default by MGC but stopped making payments to MGC on the advice of their attorneys.)

LNV and MGC are owned by D. Andrew Beal; sole owner of Beal Bank and Beal Financial Inc. Beal is a multi-billionaire gambler located in Plano Texas. Beal has a history of creating sham companies to use as fraudulent tax shelters. Beals MGC and LNV are such sham companies. In addition to being used as fraudulent tax shelters they are used to defraud homeowners of their property; to defraud courts and then to ultimately launder proceeds from their fraudulent activities overseas. (See Southgate Master Fund, LLC v. US, 659 F. 3d 466 - Court of Appeals, - 5th Circuit 2011 and Bemont Investments, L.L.C. v. United States, 679 F.3d 339 - 5th Cir. 2012 attached to this request for investigation in the form of a motion for judicial notice in the case of LNV vs. Catherine Gebhardt in the Tennessee Middle District in Knoxville. These cases are available in Pacer.)

The 7195 Dallas Parkway, Plano TX address for the corporate headquarters of MGC and LNV is an empty lot. This is shown by a Google map search. Another of the victims in our group, JoAnn Breitling, visited this location and took photos of the empty lot. (See attached Google map screen shots and photos taken by JoAnn.) Mail sent to this address is force delivered to 6000 Legacy Drive, Plano TX, the address for Beal Bank headquarters.

Evidence indicates that MGC does not have a federal tax ID or EIN number; yet it claims to be a mortgage servicer for LNV. It appears from our research that MGC is not licensed as mortgage servicer in any state. Checks written to MGC by consumers were deposited into bank accounts belonging to other entities. (See attached canceled check this is only one of many such checks.)

Most of the victims received payoff letters from MGC with a Fedwire account number where they were told to wire funds. I recognized the routing number as being for Bank of America and phoned my business banker there to inquire about the account. I was told it was not a valid account, although

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it had a valid Bank of America routing number. Collectively we made a series of phone calls to Bank of America to verify this information. Each call was recorded and witnessed; i.e one victim spoke on the phone with the Bank of America representative and another listened in silence so they could be a witness to the conversations in court. This information was thus validated.

Fraud victim, Cathy Gebhardt, wanted written proof that the account wasnt valid and asked for advice from her bank manager who suggested she wire a small amount of funds to the account as this would generate a wire transfer rejection receipt showing it was an invalid account. Cathy did this, but the funds were not rejected as expected. We spoke with authorities about how an account that numerous Bank of America employees told us was invalid could actually receive funds. A former Tennessee Bureau of Investigations agent suggested that someone inside Bank of America had created a special account that was flying under the radar so most Bank of America employees would not find it. Cathy decided to make another wire transfer, this time omitting CHICAGO as per the payoff instructions. This time the wire transfer was rejected. Then what happened shows evidence of foul play beyond anything we ever imagined.

Sherry R. Cole, customer service representative for Tennessee State Bank, received a phone call from a man who identified himself as Charles King with Mortgage Relief Aid. The caller ID showed U.S. Government. Charles King asked Sherry questions she thought were bizarre about whether Tennessee State Bank accepted ACH deposits for customers. He then told her Bank of America did not. (See attached written confirmation of this phone call dated September 19, 2013 by Sherry R. Cole.)

I have a business account at Bank of America and know this is not true. I phoned my business banker and he confirmed that Bank of America most certainly does accept ACH deposits for customers. Next I phoned Oregon Congresswoman Bonamicis office and asked about the government agency Mortgage Relief Aid and was told no such government agency existed. I asked about how U.S. Government could show up on the caller ID and was told this is unfortunately all too easy to do and even though it is illegal under the Truth in Caller ID Act it is still a serious problem as it is used in scams to deceive Americans into believing they are speaking with someone from the government.

Charles King had no legitimate reason to hide his caller ID and spoof it so it looked like he was calling from the U.S. Government. Nor did he have any legitimate reason to misrepresent himself as a government employee with the Mortgage Relief Aid a government agency that does not exist.

We then made a series of additional phone calls to Bank of America (all taped and witnessed.) We were ultimately told that this Fedwire account was a global account with DMI as the domestic intermediary; i.e. our mortgage payoffs were being laundered through DMI to an overseas account. Ive attached copies of the Fedwire receipts. A letter from Bank of America (attached) points to Charles King with Dovenmuehle as the party who made the phone call.

D. Andrew Beal is known as a staunch supporter of online gambling and high stakes poker games. He has been reported to have lost as much as $16 Million in a single poker game. D. Andrew Beal is also known to have frequented a gambling establishment in New York operated by art dealer and collector Hillel (Helly) Nahmad, who runs the Helly Nahmad Gallery inside the Carlyle Hotel on Madison Avenue, that was named in a sweeping federal criminal indictment in which it is alleged that the 34-year-old Mr. Nahmad joined with Russians named Alimzhan Tokhtakhounov and Vadim Trincher to launder millions of dollars.

The Nahmad-Trincher Organization laundered the proceeds of the gambling operation through a host of American bank accounts and Titan P & H LLC (Titan), a plumbing company in the Bronx that the Nahmad-Trincher organization acquired a fifty percent interest in as repayment of a gambling debt. The organization laundered tens of millions of dollars through various companies and bank accounts. It was assisted in its money laundering by Ronald Uy, a branch manager at a bank in New

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York City. Uy advised Illya Trincher on how to structure financial transactions so as to avoid bank reporting requirements.

NYPD Commissioner Raymond W. Kelly said, The subjects in this case ran high-stakes illegal poker games and online gambling, proceeds from which are alleged to have been funneled to organized crime overseas. IRS-CI Special Agent in Charge Toni Weirauch said, International money laundering is not a victimless crime. Rather, it is a national and global threat that can provide criminal enterprises with resources to conduct further illegal activity. The laundering of illegal gambling proceeds, in particular, facilitates the underground, untaxed economy which, in turn, harms our nations economic strength. (See attached screen shots from the FBI website and other reputable sources.)

The Bank of America global account where MGC instructs consumers to wire their mortgage payoffs to DMI as a domestic intermediary for some unknown overseas party appears to have been similarly set up so as to avoid bank reporting requirements. (Consumers mortgage payoffs are being illegally laundered overseas.) Cathys transfers into this account caused DMI attorney Charles King to phone her bank; perhaps to determine whether the FBI was investigating their money laundering scheme.

Attached is a copy of a 1098 tax form sent to one of the victims in our group, Stuart Hamm, showing DMI as the servicer for MGC. DMIs federal tax ID number is shown as 36-2435132. This EIN number is for a DMI retirement fund. (See attached 1098 and screen shot.) Why are consumers mortgage payments going directly into a retirement fund? One possible answer is tax evasion. (We have additional evidence that shows DMI and MGC are falsely reporting income derived from their illegal mortgage servicing activities to the IRS.)

Consumers are routinely lied to and shuffled around whenever they call DMI or MGC. It is impossible to reach anyone who is employed by LNV. Even attorneys representing LNV claim they cannot contact their client. These companies routinely refuse to provide consumers with an accounting history of their payments and how they have been applied to their loans.

DMI claims its address is 1 Corporate Drive Suite 360, Lake Zurich, IL 60047-8944, but JoAnn Breitling, and her husband visited this address to speak with someone from DMI only to discover DMI is not located at this address. The postmaster for Lake Zurich told her that DMI picks up its mail at the post office.

Charles King most certainly is knowingly participating in this fraud and overseas money laundering scheme in violation of the professional code of conduct for attorneys and in violation of a host of federal and state laws. We demand an investigation into his illegal activities and that of his employer Dovenmuehle Mortgage Inc., and its clients LNV Corporation and MGC Mortgage Inc. and the illegal activities of the ultimate owner of these two companies D. Andrew Beal.

Sincerely, Denise Subramaniam

503-764-5300 ext # 1

Cc: Congresswoman Bonamici; U.S. Justice Department, FBI, IRS and others

On 8/29/2013 Catherine Gebhardt phoned Bank of America, Cammy Depew was listening in on the call and the call was recorded.

Case # 3:12 CV 1681 MO

Subramaniam vs Beal, Chase, GMAC et al Exhibit J Page 3 of 9

An MGC victim who lives in Texas drove to Plano and took these photos.

This is a sign on the Beal Bank property located at 6000 Legacy Drive, Plano Texas address.

Both MGC and LNV use the 7195 Dallas Parkway address.

In this photo the MGC customer/victim is standing at the location of the 7195 Dallas Parkway address and looking towards the Beal Bank complex. This image is consistent with the Google Map information.

Case # 3:12 CV 1681 MO

Subramaniam vs Beal, Chase, GMAC et al Exhibit J Page 4 of 9

Form 1098 (Keep for your records) D CORRECTED (if Department of the Treasurychecked) Internal Revenue Service'CluUon:The amount shown may not be fully OMB No. 1545-0901 Mortgagedeductible by you. Umits based on the loanamount and the cost and value of the secured ~ @11property may apply. Also, you may only deduct Interestinterest to the extent it was incurred by you,actually paid by you, and not reimbursed by Statementanother person. Form 10981 $Mortgageinterest received from payer(s)tborrower(s)$"9,861 .12 CopyB

1----RF'r.ii:>iF'Nl:;;;;!~i,;~~;t;fi;;;t~-;:;;;~PAYFm:;;;~i;;I;;;;;::;;;;;;;_;;;;;;:;h.;;_----i_::!kc=__::_:c7JC:_::_:::_::_::_;:_:_::_::_::7":"=:_::_:cc_:_:_:c_:;_:------:---::-::-JForPayer/BorrowerI RECIPIENT'S Federal identification no. PAYER'S social security number P'd The information in boxes2 oints pal on purchase of principal residence $ 00 1,2, 3, and 4 is importanttax information and isbeing furnished to the

Internal RevenueService. If you are

required to file fl return,a negligence penalty orother sanction may beimposed on you if theIRS determines that

an underpayment of taxresults because you

overstated a deductionor this mortgage interest

or for these pointsor because you did not

report fhis refund ofinterest on your return.1424099578

RECIPIENT'S I LENDER'S name, address, and telephone numberDOVENMUEHLE MORTGAGE, INC., SERVICER FORMGC MORTGAGE, INC.1 CORPORATE DRIVE, SUITE 360LAKE ZURICH, IL 60047-89451-877-471-7888

36-2435132 ***-**-3568PAYER'S I BORROWER'S name, street address, city, state, and ZIP code

4522

STUART HAMM5160 COUNTY ROAD 405FLORESVILLE TX 78114-4740

1'1111'111'1111111'1.1'1.1111.1"11111111.1"'1'11.1111'11111'1.1

13564Account number (see instruotions)

$3 Refund of overpaid interest $.00$

4 Mortgage insurance premiums

$ $.005PROPERTY TAXESPRINCIPAL PAIDENDING PRIN BAL

$10,144.48$1,558.68$153,234.73

This information is provided for your use in preparing your 2011 tax returns. You are responsible for providing us with your correct SSN/TIN. Please contact ourCustomer Service Department at the above phone number if this number is wrong. Please review the reverse side for important Internal Revenue Service /

_i_n_fo_r_m_a_t_io_n_. -!\

DeniseText BoxNotice the EIN or Tax ID number supplied on this 1098 for Dovenmuehle Mortgage Inc. is 36-2435132. On the next page you will see that this EIN number is for a Dovenmuehle Savings and Retirement Plan. Why are payments for individual mortgages going into a retirement fund?

DeniseText BoxVictims of fraud committed by MGC, LNV and Dovenmuehle have continually been denied requested accounting histories for their mortgages. This evidence is only the tip of the iceberg. We can collectively show evidence of fraud that reaches the level of racketeering.

http://www.brightscope.com/form-5500/basic-info/165973/Dovenmuehle-Mortgage-Inc/168562/Dovenmuehle-Mortgage-Inc-Savings-Retirement-Plan/2012/

Evidence suggests Dovenmuehle Mortgage Inc. attorney Charles Elliot King is involved in illegal money laundering on behalf of Daniel Andrew Beal through a global Bank of America wire account referenced in this request for investigation. http://www.fbi.gov/newyork/press-releases/2013/manhattan-u.s.-attorney-charges-34-members-and-associates-of-two-russian-american-organized-crime-enterprises-with-operating-international-sportsbooks-that-laundered-more-than-100-million

RELAVANT EXCERPTS FROM FBI WEBSITE ARTICLE ON PREVIOUS PAGE:

IRS-CI Special Agent in Charge Toni Weirauch said, International money laundering is not a victimless crime. Rather, it is a national and global threat that can provide criminal enterprises with resources to conduct further illegal activity. The laundering of illegal gambling proceeds, in particular, facilitates the underground, untaxed economy which, in turn, harms our nations economic strength.

NYPD Commissioner Raymond W. Kelly said, The subjects in this case ran high-stakes illegal poker games and online gambling, proceeds from which are alleged to have been funneled to organized crime overseas. The one thing they didnt bet on was the New York City police and federal investigators attention. I commend the NYPD Organized Crime Investigations Division and their partners in the FBI and U.S. Attorney Bhararas office for identifying and bringing the members of this organization to justice.

The organization laundered tens of millions of dollars through various companies and bank accounts. It was assisted in its money laundering by RONALD UY, a branch manager at a bank in New York City. UY advised ILLYA TRINCHER on how to structure financial transactions so as to avoid bank reporting requirements.

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Online source showing D. Andrew Beal the renowned gambler in Russia.

http://table-tango.pokerworks.com/2012/05/07/andy-beal-is-in-russia-omg/

http://observer.com/2013/04/pocket-aces-tycoons-celebrities-oligarchs-and-algorithms/

Several sources with firsthand knowledge of the games named some of the players, including household names in the world of finance such as Daniel Andrew Andy Beal, chairman of Beal Bank, who makes no secret of his enjoyment of and expertise in poker

UNITED STATES DISTRICT COURT EASTERN DISTRICT OF TENNESSEE

AT KNOXVILLE

LNV CORPORATION, ) )

Plaintiff, ) )

v. ) No.: 3:12-CV-468-TAV-HBG )

CATHERINE GEBHARDT ) )

Defendant. )

INTERVENERS MOTION FOR JUDICIAL NOTICE OF THE SOUTHGATE AND BEMONT CASES

Comes Now the Interveners, representing themselves, pursuant to Rule 201 Judicial Notice of

Adjudicative Facts hereby requests this Court take Judicial Notice of the documents described

herein and in support states as follows:

1. THE INTERVENERS move this Court to take judicial notice of:

Southgate Master Fund, LLC v. US, 659 F. 3d 466 - Court of Appeals, 5th Circuit 2011

This case involves tax shelters created for D. Andrew Beal by Tom Montgomery, CPA,

through the creation of several on paper companies as vehicles for sham tax shelters

including: Southgate Master Fund, LLC; Eastgate LLC; Montgomery Capital Advisers,

LLC; and Martell LLC. The appellate court in this case affirmed the district courts

findings: "Discerning none, we affirm the district courts holding that Southgate was a

sham partnership that must be disregarded for federal-income-tax purposes." (Attached

hereto as Exhibit A.)

Bemont Investments, L.L.C. v. United States, 679 F.3d 339 (5th Cir. 2012) This case

involves tax shelters created for D. Andrew Beal by Tom Montgomery, CPA, through the

creation of several on paper companies as vehicles for bogus tax shelters including:

BM Investments LC (Bemont); BPB Investments; and BFC Capital Inc. Montgomery

was a managing partner of Baggett, Drews, LLP and sold all its assets to Solution 6

Holding Ltd, an Australian software and sales firm. Montgomery began working for Beal

in 2001 and became the head of BFC with an objective to explore new investment

opportunities for Beal and his banks. As with the Southgate case they cooked up a hedge

scheme that would give Beal significant tax benefits for paper only losses. Here the court

concluded that the partnership item adjustments made by the IRS are correct In

summary, the Court concludes that the proposed tender offer in this case was just a

smokescreen for tax avoidance... The Court finds that the swap transaction was

substantially similar to those transactions noted in Notice 2000-44. The notice also

covers those transactions lacking in any real economic substance. Here, the tax losses

claimed do not correspond to any actual economic losses; nor do they constitute the type

of bona fide losses that are allowable deductions under the IRS Code and regulations;

and, in any event, they are not actual and real. (Attached hereto as Exhibit B.)

2. These cases are relevant to the Gebhardt case because, first they establish that D. Andrew

Beal is the founder and sole owner of the Beal Financial Corporation and its subsidiary,

Beal Bank, and that Beal and the Banks core business involves identifying and

purchasing assets that are undervalued because the market has mispriced their level of

risk. Second, they establish a modus operandi used by Beal and his associates specific

to debt acquisition and debt collection that are consistent with the facts in the Gebhardt

case. This modus operandi substantiates Gebhardts assertions that LNV Corporation

(LNV) and MGC Mortgage Inc. (MGC) are sham companies created for D.

Andrew Beal in the same manner using the same means as the companies identified as

being shams by the appellate justices in the Southgate and Bemont cases. These cases

establish that Beal has a documented history of creating shell companies to give the

appearance that they are something that they are not.

3. From the courts finding of fact in Southgate: Montgomery anticipated that most of the

portfolios actual value would come from the discovery of a few nuggets within the

pool, loans whose values would prove to be many multiples of their acquisition prices.

A reasonable person would conclude that such nuggets might be over collateralized

loans; (the property is worth considerably more than the loans out-standing balance.)

Several of the Interveners have or had significant equity in their homes. Beal may have

other motivation for considering specific loans nuggets. Perhaps criteria for the

determining a nugget is whether the homes location is in a judicial district known to

be friendly to banks and financial institutions.

4. In Bemont the court found that: Although, at some point in time, Andrew Beal and Tom

Montgomery focused on a possible tender offer, the structuring of the swaps to claim

considerable losses was the primary objective of the parties. This shows that Beal has a

propensity for intentionally structuring business entities to meet specific business

objectives; that may not be considered legal or valid business objectives by a reasonable

and impartial observer.

5. Also from the courts finding of fact in Bemont: Pocsik [the IRS auditor assigned to

examine Beals 2002 tax return] specifically examined whether Beal had sufficient basis

to absorb the losses, however, he was not furnished any information concerning the short

swaps by Beth Montgomery, Beals personal accountant, and Ms. Montgomery never

furnished information as to the short swaps in the audit; thus, the IRS did not have all

information available to it. These findings of fact show that Beal has the propensity for

intentionally withholding evidence from the government, regulators, investigators, and

the courts.

6. Additionally from the courts finding of fact in Bemont: The Court believes that Coscia

was no more than a puppet for Plaintiffs and rendered no real independent or

objective advice. Coscia said what he was paid to say. These findings of fact show that

Beal has a propensity to pay witnesses well so they will say what he wants them to say in

a court. Gebhardt and many of the other Interveners can provide evidence that would

cause a reasonable person to conclude that Beal paid not just witnesses, but attorneys to

sabotage their own clients cases in favor of Beals companies to meet his business and

profit objectives.

7. Under Federal Rule of Evidence 201 the court may judicially notice a fact that is not

subject to reasonable dispute because it: (1) is generally known within the trial courts

territorial jurisdiction; or (2) can be accurately and readily determined from sources

whose accuracy cannot reasonably be questioned. The Court may take judicial notice of

records of any court of record of the United States.

8. THE INTERVENERS move this Court to take Judicial Notice of the judicially

discovered facts in these cases as it shows that D. Andrew Beal has a demonstrated

propensity to misrepresent and falsify facts pertaining to the genuine nature of business

entities he has structured to achieve his personal business and profit objectives; and that

these business objectives include tax evasion; and possibly money laundering.

9. The documents attached hereto as Exhibit A may be accessed online from PACER or

through the King County Superior Court electronic filing system.

10. Timely written notice of this request is hereby given by email and postal mail service

upon Plaintiffs counsel as required by law.

WHEREFORE, pursuant to Federal Rule of Evidence 201 THE INTERVENERS move

this Court to take Judicial Notice without hearing of judicially determined facts

pertaining to the business practices of D. Andrew Beal, his Beal Bank and his other

business entities, including LNV Corporation and MGC Mortgage Inc.; specific to their

propensity to misrepresent and falsify facts pertaining to mortgage related documents,

and for such other and further relief as this Court deems just and proper under the

circumstances.

RESPECTFULLY SUBMITTED on this _____ day of May, 2014

_________________________________ DENISE SUBRAMANIAM as Representative for THE INTERVENERS

EXHIBIT A

IN THE UNITED STATES COURT OF APPEALSFOR THE FIFTH CIRCUIT

No. 09-11166

SOUTHGATE MASTER FUND, L.L.C., by and through Montgomery CapitalAdvisors, LLC its Tax Matters Partner,

PlaintiffAppellantCross-Appellee

v.

UNITED STATES OF AMERICA,

DefendantAppelleeCross-Appellant

Appeals from the United States District Courtfor the Northern District of Texas

Before JOLLY, HIGGINBOTHAM, and SMITH, Circuit Judges.PATRICK E. HIGGINBOTHAM, Circuit Judge:

We affirm in all respects the district courts judgment disposing of thispetition for a readjustment of partnership tax items under 26 U.S.C. 6226. Theplaintiff, Southgate Master Fund, L.L.C., was formed for the purpose offacilitating the acquisition of a portfolio of Chinese nonperforming loans(NPLs). A partnership for tax purposes, Southgates disposition of its portfolioof NPLs generated more than $1 billion in paper losses, about $200 million ofwhich were claimed as a deduction by one of its partners in tax year 2002. TheInternal Revenue Service determined that Southgate was a sham partnershipthat need not be respected for tax purposes and that Southgates allocation of the$200 million loss to the deducting partner should be disallowed. The district

United States Court of AppealsFifth Circuit

F I L E DSeptember 30, 2011

Lyle W. CayceClerk

Case: 09-11166 Document: 00511618581 Page: 1 Date Filed: 09/30/2011

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No. 09-11166

court upheld these determinations. After laying out the pertinent factualbackground in Part I, we explain in Part II why the district court was correct todo so. The Service further determined that the accuracy-related penalties in 26U.S.C. 6662(b)(1)(3) applied to the underpayments of tax resulting fromSouthgates treatment of its losses. On this point, the district court disagreed,disallowing the accuracy-related penalties on the ground that Southgate hadreasonable cause for, and acted in good faith with respect to, the tax positionsthat resulted in the underpayments of tax. Although this issue is a close one, weaffirm the district courts decision to disallow the penalties.

I. FACTUAL BACKGROUNDAt issue on this appeal are the income-tax consequences of three

interrelated transactions entered into by Southgate and its three members, D.Andrew Beal, Thomas Montgomery, and China Cinda. As a limited liabilitycompany (LLC), Southgate is treated as a partnership for federal-income-taxpurposes. The Internal Revenue Code subjects partnerships to pass-through1

tax treatment. Partnerships do not pay income tax; instead, a partnershipsincome and losses flow through to its partners. The Southgate partner whose2 3

individual income-tax liability will ultimately be affected by this action is Beal. 4

See 26 U.S.C. 761(a).1

Id. 701.2

Although the co-owners of a limited liability company technically are known as3members, this opinion tracks the language of the Code and refers to Southgates membersas partners.

A petition for review under 6226 is a partnership-level proceeding. See 26 U.S.C.4 6221. Accordingly, our jurisdiction is limited to determining Southgates legitimacy as apartnership, whether its claimed losses should be allowed, how those losses (if allowed) shouldbe allocated among its partners, and whether penalties should be imposed. See id. 6226(f);Petaluma FX Partners, LLC v. Commr, 591 F.3d 694, 65354 (D.C. Cir. 2010); KlamathStrategic Inv. Fund v. United States, 568 F.3d 537, 54748 (5th Cir. 2009). Although thesedeterminations likely will affect the tax liability of one or more of the partners, determiningthe specific tax consequences to an individual partner is beyond the scope of this proceeding. See generally Jade Trading, LLC ex rel. Ervin v. United States, 598 F.3d 1372, 137980 (Fed.

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No. 09-11166Beal is a billionaire Dallas banker who has made a name and a fortune forhimself as an investor in stressed and distressed debt. Montgomery is a certifiedpublic accountant and an associate of Beals who specializes in locating stressed-and distressed-debt investment opportunities in foreign markets. Cinda is aChinese-government-owned financial institution. The three transactions inquestion are the formation of Southgate itself, Southgates acquisition fromCinda of a portfolio of Chinese NPLs with a face value of about $1.1 billion, andBeals contribution to Southgate of approximately $180 million worth ofGovernment National Mortgage Association (GNMA) securities. Summarizedhere are the relevant facts as found by the district court following a fifteen-daybench trial.

A. The business planBeal is the founder and sole owner of the Beal Financial Corporation and

its subsidiary, Beal Bank (collectively, the Bank). Beal and the Banks corebusiness involves identifying and purchasing assets that are undervaluedbecause the market has mispriced their level of risk. Included within thiscategory are NPLs, which are loans as to which the borrowers are in default, arein arrears, or have otherwise failed to perform under the terms of the loanagreement. For years the Bank focused primarily on domestic investmentopportunities. But as the domestic market began to price risk more efficiently,Beal and the Bank began to focus on identifying inefficiencies and investmentopportunities in foreign markets. In 2001, Beal hired Montgomery to help himidentify opportunities to invest in foreign NPLs. Over the next year,Montgomery identified NPL investment opportunities in half a dozen foreigncountries. Most notably, in early 2002 Montgomery advised Beal on a purchaseof a package of NPLs that were originated in Jamaica. The Bank paid $23million for the NPLs (approximately five percent of their face value) and

Cir. 2010); Nehrlich v. Commr, 93 T.C.M. (CCH) 1105, at *2 (2007).

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No. 09-11166ultimately doubled its money on the investment. As the Jamaican NPLtransaction was drawing to a close, Montgomery realized that if the transactionhad been structured differently, it could have provided substantial income-taxbenefits for Beal.

Around the same time that Beal and Montgomery were beginning to lookfor opportunities to invest in foreign NPLs, a robust market for NPLs wasemerging in China. By the late 1990s, Chinas big four state-ownedcommercial banks had become saddled with huge numbers of NPLs. In an effortto reform and modernize its banks, the Chinese government created four newstate-owned asset-management companies to assume and resolve the banksNPLs. Cinda was one of these four new asset-management companies. TheChinese government required the asset-management companies to purchase thebanks NPLs at face value (that is, outstanding principal plus unpaid accruedinterest), notwithstanding the fact that, because the loans were nonperforming,they were worth far less than their face values. From the Chinese governmentsperspective, the full-value-purchase requirement had the dual benefits ofcleaning up the banks balance sheets and providing the banks with an infusionof capital. In 2000 and 2001, Chinas big four banks sold approximately $169billion worth of NPLs to the four asset-management companies. Cindapurchased loans with face values of approximately $45 billion.

The asset-management companies were charged with resolving the loansthey had assumed. To that end, the statute that created these companies vestedthem with a series of so-called super powers that were designed to facilitatethe companies ability to resolve and collect on the NPLs. These super powersincluded the authority to restructure and compromise the loans, the right topursue litigation against debtors, and the ability to toll the running of thestatute of limitations.

As the size of the Chinese asset-management companies NPL portfoliosgrew, investment banks and other sophisticated international investors began

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No. 09-11166to enter the Chinese NPL market. Foreign investors believed that theavailability of these new super powers increased the likelihood that value couldbe realized from Chinese NPLs. In November 2001, China Huarong, another ofChinas four new asset-management companies, auctioned off some of its NPLs. Goldman Sachs and Morgan Stanley both acquired portfolios of NPLs. Eachretained Huarong to service its loans, and the market intelligence was thatcollections were strong and that the investment banks had enjoyed sizeablereturns on their investments.

By early 2002 Montgomery was aware of this market intelligence and hadidentified the Chinese NPL market as a potential investment opportunity forBeal and the Bank. Over the next several months, Montgomeryacting in hiscapacity as an employee of the Bankresearched the emerging market inChinese NPLs. Like many other sophisticated investors, Montgomery quicklybecame convinced that the market held significant potential for profit. Montgomery had a contact at Deutsche Bank, which had signed a brokerage dealwith Cinda that made it Cindas sourcing agent on all NPL deals. In July 2002,Montgomerys contact put him in touch with a representative from Cinda. Montgomery then began to conduct due diligence on acquiring a portfolio ofNPLs from Cinda. Montgomery made several trips to China, where he met withrepresentatives from Cinda and reviewed various NPL portfolios. Montgomeryeventually determined that the pricing structure would be more favorable on aninvestment in unsecured NPLs rather than secured NPLs.

B. The tax planAt the same time he was researching the profit potential of an investment

in Chinese NPLs, Montgomery also began researching the potential tax benefitsthat could be created by such an investment. In May of 2002, Deutsche Bankintroduced Montgomery to the law firm of De Castro, West, Chodorow, Glickfeld& Nass, Inc. (De Castro). Montgomery sought De Castros advice on how tostructure an acquisition of Chinese NPLs so that it would create tax benefits for

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No. 09-11166Beal. In a series of memoranda that it sent to Montgomery in June and July of2002, De Castro laid out its plan for such a transaction structure. In short, DeCastro proposed to Montgomery that, once he had identified the portfolio ofNPLs he was going to recommend that Beal acquire, he form a partnership withCinda and have Cinda contribute the NPLs to the partnership. By purchasinga portion of Cindas interest in the partnership to which it had contributed theNPLs instead of purchasing the NPLs directly from Cinda, Beal would be ableto generate a paper loss that he could claim as a deduction on his individual taxreturn.

Understanding why De Castro proposed this structure requires a briefreview of the relevant provisions of the Internal Revenue Code and itsimplementing regulations. The Code treats a taxpayers sale or other dispositionof a piece of property in the ordinary course of his business as a taxabletransaction. If the amount realized on the sale is less than the taxpayersadjusted basis in the property, then the taxpayer is entitled to deduct that lossfrom his taxable income. Basis is the amount that the seller has invested in5

the property; ordinarily, the taxpayer takes a cost basis in a piece of propertyequal to the propertys purchase price. The amount of the loss is determined by6

subtracting the taxpayers adjusted basis in the property from the amountrealized on the sale. For example, assume a taxpayer purchases a piece of7

property for $60 and later sells it for $20. The taxpayers cost basis is $60, andhe has suffered a loss of $40 on the sale; that loss, when incurred in the ordinarycourse of the taxpayers business, is deductible against the taxpayers income. By contrast, if a taxpayer purchases a piece of property for $60 and later sellsit for $100, he has realized a gain of $40. He would be required to pay tax on

26 U.S.C. 165(a), (c)(1). 5

See 26 U.S.C. 1012(a). See generally 26 U.S.C. 10111016. 6

26 U.S.C. 1001(a). If the amount realized on the sale exceeds the taxpayers7adjusted basis in the property, then the taxpayer realizes a taxable gain.

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No. 09-11166that gain. This latter example describes, in the most simplified terms, thestructure and tax consequences of the Banks early 2002 purchase of a portfolioof Jamaican NPLs.

These rules apply to purchases of property. De Castros plan for theChinese NPL transaction was designed to take advantage of the fact thatdifferent rules apply to sales of partnership interests, with the result thatpurchasing an interest in a partnership that owns property can offer big taxadvantages compared to purchasing the property directly. When a partneracquires an interest in a partnership by contributing property to thepartnership, the contribution is generally not a taxable disposition of theproperty. Instead, the partners basis in the property transfers, or carries over,8

to the partnership. The partnerships basis in the transferred property is often9

referred to as inside basis, and the partnership has the same inside basis inthe property that the partner had before the contribution. If, at the time of the10

transfer, the propertys fair market value is lower than the partners adjustedbasis in the property, the property has a built-in loss. Ordinarily, if a partner11

transfers property with a built-in loss to the partnership, any loss thepartnership incurs when it sells that property must be allocated back to thecontributing partner; the other partners cannot share in the loss. 12

26 U.S.C. 721(a)(b).8

26 U.S.C. 723.9

See 26 C.F.R. 1.723-1 (The basis to the partnership of property contributed to it10by a partner is the adjusted basis of such property to the contributing partner at the time ofthe contribution. . . . [S]uch property has the same basis in the hands of the partnership as ithad in the hands of the contributing partner . . . .).

See 26 U.S.C. 704(c)(1)(C) ([T]he term built-in loss means the excess of the11adjusted basis of the property . . . over its fair market value at the time of contribution.).

See id. 704(c)(1)(C)(I); see also 26 C.F.R. 1.704-3(a)(1) (The purpose of section12704(c) is to prevent the shifting of tax consequences among partners with respect toprecontribution gain or loss.).

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For example, suppose that A and B form a partnership, agreeing to a5050 split of profits. B contributes $10 in cash to the partnership, and Acontributes built-in-loss property with a fair market value of $10 and in whichAs basis is $100. A and B each receive a capital-account credit of $10, and the13

partnership takes a carryover inside basis in the property of $100. If thepartnership later sells the property for $10, the partnership has realized a $90loss on the sale. Under 704(c)(1)(C)(ii) of the Internal Revenue Code, theentirety of that $90 loss must be allocated to A. 14

In this way, the normal operation of 704(c) ensures that tax value followsbook value. In other words, when property is sold for a loss, the sale creates atax benefit in the form of a deduction. The purpose of 704(c) is to allocate thatbenefit to the person who has actually suffered a real economic loss due to thepropertys diminution in value: the partner who paid $100 for property that isnow only worth $10.

A wrinkle arises when the contributing partner sells his partnershipinterest to a new partner before the partnership sells the property with the built-in loss. In that circumstance, Treasury Regulation 1.704-3(a)(7) requires thebuilt-in loss to be allocated to the partner who purchased the partnershipinterest in the same manner that it would have been allocated to thecontributing partner. This rule enables the benefit of claiming the loss as a tax15

Capital accounts, which generally reflect a partners percentage ownership interest13in the partnership, are calculated based on the fair market value of the property at the timeof the contribution. See generally LAURA E. CUNNINGHAM & NOL B. CUNNINGHAM, THE LOGICOF SUBCHAPTER K: A CONCEPTUAL GUIDE TO THE TAXATION OF PARTNERSHIPS ch. 4 (4th ed.2011).

By contrast, if B contributed $100 in cash to the partnership, A contributed property14with a fair market value of $100, the propertys value declined to $10 post-contribution, andthe partnership sold the property for $10, then A and B each would be allocated a distributiveshare of that $90 loss (here, $45 each). See 26 U.S.C. 704(a)(b).

26 C.F.R. 1.704-3(a)(7).15

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deduction to be separated and transferred away from the person who sufferedthe real, economic loss of the propertys diminution of value. 16

To continue with the prior example, suppose that after A and B formedtheir partnership, A sold her partnership interest to C for $10. If thepartnership later sold the property contributed by A for $10, thepartnershipwhose inside basis in the property is $100would suffer a loss of$90. Regulation 1.704-3(a)(7) would require that $90 loss to be allocated to C. 17

Thus, even though the transaction was revenue-neutral for C in real economicterms (the partnership sold the property for the same amount of money that Cspent to purchase his partnership interest), for tax purposes C has suffered a$90 loss, which C is then eligible to deduct against his other income. By18

contrast, if C had simply purchased the property directly from A, C would havetaken a cost basis of $10, and his later resale of the property for $10 would havebeen income-tax neutral. The real economic consequences to C of the twotransactions are identical. But by running the acquisition through thepartnership structure instead of consummating a direct purchase, C receives anincome-tax windfall despite not being the party who suffered real economic lossas a result of the propertys diminution in value.

This example describesagain in highly simplified termsthe transactionstructure that De Castro proposed to Montgomery for Beals acquisition of aportfolio of Chinese NPLs. Cinda was an ideal partner for such a transaction.

At the time that Montgomery was researching an investment in Chinese NPLs, there16was no cap on the amount of built-in loss that could be transferred this way. Congress hassubsequently amended the Code to impose a $250,000 ceiling on the amount of built-in lossthat can be transferred among partners. See 26 U.S.C. 743(d)(1).

Cf. 26 C.F.R. 1.704-3(b)(2) ex. 1(iii) (describing the proper allocation of gain upon17a partnerships sale of property with a built-in gain).

The portion of this $90 loss that C would be able to claim as a deduction in any given18tax year would be capped at the amount of Cs outside basis in the partnership. See infranotes 2122 and accompanying text.

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Because the Chinese government had required Cinda to purchase its NPLs atface value, Cinda had a cost basis in its NPLs that far exceeded the loans fairmarket value; the NPLs had a huge built-in loss. As a foreign corporation notsubject to U.S. income taxation, Cinda was a tax-indifferent party, unable toobtain any economic benefit from claiming the built-in loss as a deduction on anAmerican tax return. If Beal were to purchase the NPLs directly from Cinda,that built-in loss would evaporate, and Beal would take a cost basis in the NPLsequal to their purchase price. If Cinda instead contributed to the NPLs to apartnership and Beal then purchased Cindas interest in the partnership, thebuilt-in loss would be preserved and transferred to Beal. Any loss realized onthe partnerships sale of the NPLs would be allocated to Beal for tax purposes.

C. The dealOn July 18, 2002, Montgomery, Beal, and attorneys from De Castro

participated in a conference call in which Montgomery presented the results ofhis due diligence and recommended that Beal invest in a portfolio of unsecuredChinese NPLs. The parties also discussed the potential tax benefits to Beal thatwould result from the partnership-based transaction structure proposed by DeCastro. Beal explained on the call that the Bank was not in a position to investin the NPLs. Montgomerywho up until this time had been acting in hiscapacity as an employee of the Bankasked Beal to release him from hisobligation to the Bank so that he could continue to pursue the deal in anindividual capacity. Beal agreed. He also told Montgomery that he might beinterested in pursuing the investment personally, outside of the Bank, and askedMontgomery to come back to him once Montgomery had finalized a deal. Thatsame day, Montgomery formed Montgomery Capital Advisers, LLC (MCA), asingle-member limited liability company through which Montgomery couldcontinue to pursue an investment in Chinese NPLs.

By late July, Montgomery had settled on a particular portfolio ofapproximately 24,000 of Cindas most severely distressed unsecured NPLs. The

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loans had a face value of approximately $1.145 billion. Montgomery anticipatedthat most of the portfolios actual value would come from the discovery of a fewnuggets within the pool, loans whose values would prove to be many multiplesof their acquisition prices. Based on his experience investing in severelydistressed unsecured NPLs in the United States, Montgomery believed that thenuggets would make the portfolio of Chinese NPLs worth, at a minimum, 13percent of its face value. To confirm this belief, Montgomery commissionedZhongyu, a Chinese valuation firm, to provide a valuation analysis of the NPLs. Zhonguyu was tasked with estimating the total value of the portfolio based ona statistically valid sample of about 35 percent of the loans in the portfolio. Zhongyu was to report its findings to Montgomery by mid-August. MCA alsoretained the services of Haiwen, a Chinese law firm, to perform legal duediligencethat is, to confirm that the loans were legally valid and enforceable,that Cinda owned the loans, and that Cinda had the ability to transfer the loansto an American entity. This due-diligence report was due by the end of August.

Eager to close the deal, Montgomery decided to move forward with Cindabefore he received the results of the two due-diligence reports he hadcommissioned. On July 31 and August 1, 2002, Montgomery and Cindaconsummated a series of five transactions. First, Cinda formed Eastgate, asingle-member limited liability company organized under Delaware law. As awholly owned subsidiary of Cinda, Eastgate was created for the purpose of actingas Cindas United States investment vehicle for NPL transactions.

Second, Cinda contributed to Eastgate the portfolio of NPLs selected byMontgomery. Cinda contributed the NPLs to Eastgate pursuant to acontribution agreement in which it made a series of warranties andrepresentations stating that Cinda had not written off, compromised, or madea determination of worthlessness as to any of the NPLs.

Third, MCA (Montgomerys single-member LLC) and Eastgate formed andorganized Southgate as a limited liability company under Delaware law. Upon

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formation, Eastgate contributed the NPLs to Southgate pursuant to a virtuallyidentical contribution agreement. In exchange, Eastgate received a 99 percentownership interest in Southgate and an initial capital account balance of$19,420,000 (an amount roughly equal to 1.7 percent of the NPLs face value,which reflected the parties negotiated determination of the loans fair marketvalue). Montgomery contributed cash and a promissory note worth $196,162 inexchange for a 1 percent ownership interest in Southgate. Montgomery wasappointed as Southgates sole manager.

Fourth, Montgomery entered into a brokerage agreement with DeutscheBank. Montgomery agreed to pay Deutsche Bank $50,000 for its services as theexclusive placement agent for Cindas NPLs. In addition, Montgomery agreedthat he would pay an additional fee to Deutsche Bank if and when an investorpurchased Cindas interest in Southgate. The fee, which was tied to thepercentage of the face value of the loans in Southgates portfolio, came to about$8.5 million. Montgomery anticipated that Beal (or some other investor) wouldsatisfy this obligation.

Finally, Southgate and Cinda signed a loan-servicing agreement (LSA)in which Southgate agreed to pay Cinda 25 percent of net collections in exchangefor servicing the NPLs. The LSA was critical to the investment strategy in tworespects. First, it reduced the up-front purchase cost of the NPLs. Cinda hadinitially proposed an acquisition price of between $34.36 million and $40.08million (that is, between 3 and 3.5 percent of the portfolios face value). However, Montgomerys due diligence had revealed that Cinda was required touse 99 percent of the acquisition price it received for the NPLs to service thebonds it had used to purchase the loans. But any fees it earned as a loanservicer it was free to retain for its own operations. Montgomery thus was ableto negotiate the acquisition price of the NPLs from 3-to-3.5 percent down to 1.7percent by agreeing to have Southgate enter into an LSA that paid Cinda a moregenerous fee than it otherwise would have been willing to pay. The second

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reason the LSA was critical to Montgomerys business plan was that it increasedthe likelihood of realizing value on the loan portfolio. By retaining Cinda as itsloan servicer, Southgate was able to take advantage of Cindas statutory superpowers, which increased the likelihood of successful collections. And by shiftingsome of the total value that Cinda would receive in the transaction out of thepurchase price and into the LSAs fee structure, Montgomery hoped toincentivize Cindas efforts to service and collect on the loans.

These transactions positioned Southgate as a tax-friendly investmentvehicle. Southgate was holding NPLs with a built-in loss of more than $1.3billion, all of which was allocable to Cinda. An investor who purchased Cindas19

interest in Southgate would step into Cindas shoes and be positioned to claimthe tax losses that Southgate generated as it disposed of the loans in its portfoliofor pennies on the dollar. Southgate thus stood to generate more than $1 billiondollars in paper losses, losses that would arguably be of ordinary-incomecharacter. To a high-net-worth individual paying a marginal tax rate of 3520

percent, the ability to deduct these losses would be of tremendous value. The final pieces of the deal fell into place over the next month. In mid-

August, Zhongyu reported the findings of its valuation analysis to Montgomery. Zhongyu estimated that Southgates portfolio of NPLs was worth between $44.67million (3.90 percent of face value) and $111.8 million (9.76 percent of facevalue). Around the same time, Montgomery traveled to China and got apreliminary report from Haiwen that the NPLs were valid loans. On August 25,

The district court found that when Cinda contributed the NPLs to Eastgate, Cindas19basis in the NPLs was equal to their purchase price of $1.380 billion, which included $1.145billion of unpaid principal and $235 million of accrued but unpaid interest. On appeal, neitherparty challenges this basis calculation. Southgates basis in the NPLs was the same asEastgates, see sources cited supra notes 910, and Eastgates basis was the same as Cindas,see generally 26 C.F.R. 301.7701-3 (providing that certain single-member entities are to bedisregarded for tax purposes).

See generally 26 U.S.C. 742(b); id. 751(d); id. 1221(a)(4). We stress that these20losses are arguably ordinary; we do not judge their proper characterization in this appeal.

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2002, Montgomery sent a memo to Beal summarizing the results of his duediligence and enthusiastically recommending that Beal purchase a portion ofCinda/Eastgates interest in the Southgate partnership. Beal readily agreed todo so. He formed a single-member Delaware LLC, Martel Associates, throughwhich he would invest in Southgate. By the end of the week, Haiwens finallegal due-diligence report came through and confirmed that all but a tiny sliverof the loans in the portfolio were legally enforceable and had not beencompromised, written off, or discharged in bankruptcy. On August 30, 2002,Beal paid Cinda $19,407,000 in exchange for 90 percent of Eastgates interest inSouthgate. Beal thus wound up with an 89.1 percent ownership interest, leavingCinda with a 9.9 percent interest and Montgomerys 1.0 percent shareunchanged. Beal also assumed Montgomerys obligations under the brokerageagreement with Deutsche Bank and paid the $8.5 million placement fee.

With the deal papered, the parties turned to developing a collectionstrategy that would be responsive to both profit- and tax-driven concerns. Onthe business side, Montgomery and Cinda decided to focus on identifying a smallnumber of loans (between 15 and 25 percent of the portfolio) that held enoughprofit potential to merit further review. The goal was to focus collection effortson nuggets that would eventually be identified within this smaller pool. Thebalance of the portfolio would be packaged into smaller groups and sold off tosmall Chinese collection firms; the proceeds of the sales would provide Southgatewith working capital. Consistent with the three-year term of the LSA betweenSouthgate and Cinda, Montgomery and Cinda decided to aim for resolving about25 percent of the NPLs in 2002, 50 percent in 2003, and 25 percent in 2004. Itjust so happened that this collection strategy would create losses in amountstailored to the amounts of personal income against which Beal sought to claimdeductions.

Ultimately, Southgate proved to be a failure as an investment venture. The primary cause of Southgates poor performance was Cindas disappointing

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performance as a loan servicer. The value of many of the loans that Southgateidentified as nuggets derived from the fact that they were backed by a Chinese-government guarantee. Cindas initial efforts to collect on these loans andenforce the guarantees generated push-back and fallout in China. Politicalpressure from the Chinese government led to Cindas repeatedly selling off NPLsthat Southgate had identified as high-value nuggets. These sales were in directbreach of both the Southgate Operating Agreement and the LSA and cut the legsfrom Southgates business plan. The total net collections on Southgates NPLportfolio were approximately $10.69 million, far less than Zhongyus valuationreport had projected.

D. The basis-buildConsistent with the collection strategy developed by Cinda and

Montgomery, in late 2002 Southgate sold off approximately 22 percent of theloans in its portfolio. The net recovery on the sales was approximately $2.2million. Southgate suffered a loss on the sales of approximately $294.9 million,of which $292.8 million was pre-contribution, built-in loss. Since Beal hadpurchased 90 percent of Cindas interest in Southgate, 90 percent of that built-inloss was allocable to Beal and available for him to take as a deduction on his2002 individual tax return.

One final step remained in the tax plan: Beal needed to build his outsidebasis in Southgate. A partners outside basis is his adjusted basis in hisownership interest in the partnership. When a partner purchases a partnershipinterest, he generally takes a cost basis in his partnership interest. In other21

words, his outside basis is equal to the amount he paid to acquire thepartnership interest. And while partnership losses are deductible by theindividual partners, the amount of allocated partnership loss that a partner canclaim as a deduction on his individual tax return is capped at the amount of his

See 26 C.F.R. 1.742-1.21

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outside basis. If the amount of a partnership loss that is allocable to the22

partner exceeds his outside basis, the overage remains suspended inside thepartnership and can only be claimed if the partner builds his outside basisduring a future tax year. Thus, the fact that some $263.5 million of Southgatesbuilt-in losses were allocable to Beal was not enough to make the full value ofthose losses deductible by Beal on his 2002 tax return. Up until the very end of2002, Beals outside basis in Southgate was only about $29.9 million (the roughly$19.4 million he paid for his partnership interest plus about $10.5 million intransaction and operating costs). To be able to deduct most of the built-in lossthat was allocable to him, Beal needed to build his outside basis in Southgate.

This was the purpose of what the parties have dubbed the GNMA basis-build. In late 2002, Beal owned some GNMAs with a fair market value of23

approximately $180.6 million. GNMAs are fixed-rate, mortgage-backedsecurities. The GNMAs that Beal owned were platinum securities backed by thefull faith and credit of the United States, which guaranteed timely payment ofprincipal and interest. In late December 2002, Beal nominally contributed theGNMAs to Southgate in an effort to build his outside basis in the partnership.

As relevant here, the GNMA basis-build took place in three steps. First,Beal contributed the GNMAs to Martel (the single-member LLC through whichhe had purchased his interest in Southgate). Second, Martel distributed its24

See 26 U.S.C. 704(d) (A partners distributive share of partnership loss . . . shall22be allowed only to the extent of the adjusted basis of such partners interest in the partnershipat the end of the partnership year in which such loss occurred.); see also Klamath StrategicInv. Fund v. United States, 568 F.3d 537, 542 (5th Cir. 2009) (Generally, a partners basis ina partnership is determined by the amount of capital he contributes to the partnership, andwhen a partnership loses money the partners can only deduct the losses from their taxableincome to the extent of their basis in the partnership.).

At oral argument, Southgate readily conceded that Beals contribution of the GNMAs23was primarily a tax-motivated transaction.

Soon thereafter, Martel entered into a repo transaction with UBS PaineWebber Inc.,24in which Martel, in substance, pledged the GNMAs as collateral for a $162 million securedloan. Martel transferred the proceeds of this loan to the Bank. Thus, when the GNMAs were

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interest in Southgate to Beal. Beal thereby became an 89.1 percent owner ofSouthgate. Instead of owning an interest in Southgate through Martel, Bealnow owned his interest in Southgate directly. Third, Beal contributed Martelto Southgate. Both Southgates and Martels operating agreements wereamended to irrevocably appoint Beal as the sole manager of Martel and to reflectBeals admission as a partner in Southgate, Beals contribution of Martel toSouthgate, and Southgates admission as a partner in Martel. At the time of itscontribution to Southgate, Martel still owned the $180.6 million worth ofGNMAs. A partners contribution of property to a partnership generallyincreases the partners outside basis in his partnership interest. As a result,25

Beal took the position that his contribution of the GNMAs to Southgate hadincreased his outside basis in Southgate by $180.6 million.

Beals contribution of the GNMAs to Southgate came with numerousstrings attached. Four terms of the amendments to the operating agreementsare particularly important for our later analysis of this putative contribution. Three of these terms expressly ensured that the vast majority of the GNMAsvalue would be reserved to Beal. First, all of the interest that accrued on theGNMAs after their contribution to Southgate was allocated to Beal. Second, inhis capacity as Martels sole manager, Beal had the absolute right in his solediscretion to cause Martel to distribute to him the GNMAs and/or all paymentsreceived with respect to the GNMAs. Beals exercise of this right would not giverise to an obligation on Southgates part to make proportionate distributions to

contributed to Southgate, Southgate assumed Martels liability on the loan that the GNMAssecured. Ordinarily a partnerships assumption of a partners liability causes the partnersoutside basis to be reduced by the amount of the liability. See 26 U.S.C. 752(b). However,Martel had distributed the proceeds of the loan to Beal in exchange for Beals agreeing topersonally and unconditionally guarantee the loan, and the district court found that Beal wasat risk on the guarantee, see generally 26 C.F.R. 1.752-1(a)(1), 1.752-2(b)(1). Beal thusassumed Southgates liability on the loan, and his outside basis was increased concomitantly. See 26 U.S.C. 752(a).

See 26 U.S.C. 722.25

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the other two partners. Third, Beal had unconditional rights to direct the useand application of all proceeds from the GNMAs and to direct any and all othermatters pertaining to the GNMAs. There was a single provision that, at leasttheoretically, created a possibility that the other partners might profit from thecontribution of the GNMAs. If the GNMAs appreciated in value during the timethey were held in Southgate, the gain was to be allocated among Southgatespartners in accordance with their percentage interest in the partnership.

The contribution of the GNMAs, at least in form, brought Beals outsidebasis in Southgate up to a total of about $210.5 million. When Southgate filedits 2002 partnership return, it allocated to Beal a loss of approximately $263.5million. The GNMA basis-build enabled Beal to claim $210.5 million of that lossas a deduction on his 2002 individual tax return.

E. Procedural historyThe Service issued a final partnership administrative adjustment

(FPAA) to Southgate pertaining to its 2002 partnership return. The FPAAconcluded that Southgate was a sham partnership that had been formed solelyfor the purposes of tax avoidance, determined that Southgate would not berecognized as a partnership for federal-income-tax purposes, disallowedSouthgates claimed losses arising out of its 2002 dispositions of Chinese NPLs,and imposed substantial penalties. Southgate filed a petition for review infederal district court under 26 U.S.C. 6226(a)(2). The district court issuedfindings of fact and conclusions of law after presiding over a fifteen-day benchtrial. The court upheld the FPAAs disallowance of Southgates claimed losseson the ground that the Southgate partnership was a sham for tax purposes. However, the court disallowed the imposition of penalties on the ground thatSouthgate had established reasonable cause and good faith and thus had acomplete defense to any accuracy-related penalties. Southgate appeals theformer determination; the Government appeals the latter.

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II. TAX CONSEQUENCES This appeal requires us to determine the tax consequences of Southgates

formation, Southgates acquisition of its portfolio of Chinese NPLs, and theGNMA basis-build. The starting point for our analysis is the cardinal principleof income taxation: a transactions tax consequences depend on its substance, notits form. This principle is no schoolboys rule; it is the cornerstone of sound26

taxation . . . . Tax law deals in economic realities, not legal abstractions. 27

This foundational principle finds its voice in the judicial anti-abuse doctrines,which prevent taxpayers from subverting the legislative purpose of the tax codeby engaging in transactions that are fictitious or lack economic reality simply toreap a tax benefit. The judicial doctrines empower the federal courts to28

disregard the claimed tax benefits of a transactioneven a transaction thatformally complies with the black-letter provisions of the Code and itsimplementing regulationsif the taxpayer cannot establish that what wasdone, apart from the tax motive, was the thing which the statute intended. 29

Our disposition of this appeal requires us to make use of three of thejudicial doctrines. The first is the economic-substance doctrine. [T]he law doesnot permit the taxpayer to reap tax benefits from a transaction that lacks

See, e.g., Freytag v. Commr, 904 F.2d 1011, 1015 (5th Cir. 1990) (The fundamental26premise underlying the Internal Revenue Code is that taxation is based upon a transactionssubstance rather than its form.), affd, 501 U.S. 868 (1991); see also Arevalo v. Commr, 469F.3d 436, 439 (5th Cir. 2006) (The Supreme Court has repeatedly stressed that, in examiningtransactions for the purpose of determining their tax consequences, substance governs overform. (citing Frank Lyon Co. v. United States, 435 U.S. 561, 57273 (1978))).

Estate of Weinert v. Commr, 294 F.2d 750, 755 (5th Cir. 1961) (quoting Commr v.27Sw. Exploration Co., 350 U.S. 308, 315 (1956) (internal ellipsis omitted)); see also Frank LyonCo., 435 U.S. at 573 (In the field of taxation, administrators of the laws and the courts areconcerned with substance and realities, and formal written documents are not rigidlybinding. (quoting Helvering v. Lazarus & Co., 308 U.S. 252, 255 (1939))).

Coltec Indus., Inc. v. United States, 454 F.3d 1340, 135354 (Fed. Cir. 2006).28

Gregory v. Helvering, 293 U.S. 465, 469 (1935).29

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economic reality. Thus, [t]ransactions that have no economic effect other30

than the creation of income tax losses are shams for tax purposes and will notbe recognized. The second is the sham-partnership doctrine. A partnership31

may be disregarded where it is a sham or unreal . . . [,] a bald and mischievousfiction. A taxpayer must be able to demonstrate that there was some nontax32

business purpose for his use of the partnership form. Finally, the doctrine of33

substance over form provides that the tax consequences of a transaction aredetermined based on the underlying substance of the transaction rather than itslegal form. The substance-over-form doctrine allows a transaction to be34

recharacterized so that its taxable form corresponds to its economic substance.35

In an appeal from a bench trial, we review the district courts findings offact for clear error and its conclusions of law de novo. Specifically, a district36

courts characterization of a transaction for tax purposes is a question of lawsubject to de novo review, but the particular facts from which thatcharacterization is made are reviewed for clear error. Our de novo application37

Coltec, 454 F.3d at 1355.30

Boynton v. Commr, 649 F.2d 1168, 1172 (5th Cir. Unit B July 1981).31

Moline Props., Inc. v. Commr, 319 U.S. 436, 439 (1943).32

See, e.g., Estate of Strangi v. Commr, 293 F.3d 279, 28182 (5th Cir. 2002); ASA33Investerings Pship v. Commr, 201 F.3d 505, 51213 (D.C. Cir. 2000).

Wells Fargo & Co. v. United States, 641 F.3d 1319, 1325 (Fed. Cir. 2011) (citing34Griffiths v. Helvering, 308 U.S. 355, 357 (1939)).

See Blueberry Land Co. v. Commr, 361 F.2d 93, 101 (5th Cir. 1966) ([C]ourts will,35and do, look beyond the superficial formalities of a transaction to determine the proper taxtreatment.).

Klamath Strategic Inv. Fund v. United States, 568 F.3d 537, 543 (5th Cir. 2009).36

Duffie v. United States, 600 F.3d 362, 364 (5th Cir.), cert. denied, 131 S. Ct. 35537(2010); see also Frank Lyon Co. v. United States, 435 U.S. 561, 581 n.16 (1978) (The generalcharacterization of a transaction for tax purposes is a question of law subject to review.). TheGovernment incorrectly contends that Merryman v. Commr, 873 F.2d 879 (5th Cir. 1989),establishes that sham-partnership determinations are reviewed only for clear error.

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of the judicial doctrines to the facts as found by the district court leads us tothree conclusions. First, Southgates acquisition of its portfolio of Chinese NPLshad economic substance. Second, Southgate itself was a sham partnership. Thissecond conclusion finds substantial support in our determination that theGNMA basis-build lacked economic substance. Third, Southgates acquisitionof the NPLs should be recharacterized under the substance-over-form doctrineas a direct sale from Cinda to Beal and Montgomery.

A. The acquisition of the NPLs had economic substance.With little difficulty, we affirm the district courts conclusion that

Southgates acquisition of the portfolio of NPLs had economic substance. InKlamath, we derived a three-part test for determining whether a transaction hassufficient economic substance to be respected for tax purposes: whether thetransaction (1) has economic substance compelled by business or regulatoryrealities, (2) is imbued with tax-independent considerations, and (3) is notshaped totally by tax-avoidance features. In other words, the transaction38

must exhibit objective economic reality, a subjectively genuine business purpose,and some motivation other than tax avoidance. While these factors are phrasedin the conjunctive, meaning that the absence of any one of them will render thetransaction void for tax purposes, there is near-total overlap between the39

Merrymans application of the clearly-erroneous standard of review to the Tax Courts decisionin a sham-partnership case was the result of the unusual fact that the petitioning taxpayersagreed with the law applied by the Tax Court and challenged only the underlying factualfindings. Id. at 881. Merryman did not unseat the well-established rule in this Circuit thatlegal conclusion[s] that transactions are shams in substance are reviewed de novo. CompaqComputer Corp. v. Commr, 277 F.3d 778, 780-81 (5th Cir. 2001) (alteration in original)(quoting Killingsworth v. Commr, 864 F.2d 1214, 1217 (5th Cir. 1989)); see also id. at 781 n.1(considering and rejecting the argument that this Court should review the legal conclusionthat a transaction is a sham only for clear error).

Klamath, 568 F.3d at 544. 38

Id.; accord Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1355 (Fed. Cir. 2006)39([A] lack of economic substance is sufficient to disqualify the transaction without proof thatthe taxpayers sole motive is tax avoidance.).

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latter two factors. The district courts findings of fact strongly support its40

conclusion that Southgates acquisition of the NPLs satisfies the standardannounced in Klamath.

As to the first Klamath factor, transactions lack objective economic realityif they do not vary[,] control[,] or change the flow of economic benefits. This41

is an objective inquiry into whether the transaction either caused real dollars tomeaningfully change hands or created a realistic possibility that they would do42

so. That inquiry must be conducted from the vantage point of the taxpayer at43

the time the transactions occurred, rather than with the benefit of hindsight. 44

Southgates acquisition of the NPLs readily satisfies the first Klamathfactor. The district court found that Southgate and its members entered into theNPL investment with a reasonable possibility of making a profit. That the NPLinvestment ultimately turned out not to be profitable does not call this findinginto question. The investment failed largely because of Cindas shortcomings asa loan servicer and interference from the Chinese government. The districtcourt found that these shortcomings were not foreseeable to Beal and

To say that a transaction is shaped totally by tax-avoidance features is, in essence,40to say that the transaction is imbued solely with tax-dependent considerations.

Klamath, 568 F.3d at 543 (quoting Higgins v. Smith, 308 U.S. 473, 476 (1940)); see41also Coltec, 454 F.3d at1355 ([T]he objective economic substance inquiry [asks] whether thetransaction affected the taxpayers financial position in any way. (quoting Adver & GrapevineRecords & Tapes, Inc. v. IRS (In re CM Holdings, Inc.), 301 F.3d 96, 103 (3d Cir. 2002))).

[A] circular flow of funds among related entities does not indicate a substantive42economic transaction for tax purposes. Merryman, 873 F.2d at 882.

Portland Golf Club v. Commr, 497 U.S. 154, 170 n.19 (1990) (A transaction has43economic substance and will be recognized for tax purposes if the transaction offers areasonable opportunity for economic profit, that is, profit exclusive of tax benefits. (quotingGefen v. Commr, 87 T.C. 1471, 1490 (1986))); accord Coltec, 454 F.3d at 1356; Rices ToyotaWorld, Inc. v. Commr, 752 F.2d 89, 94 (4th Cir. 1985) (explaining that the inquiry intoobjective economic substance requires an objective determination of whether a reasonablepossibility of profit from the transaction existed apart from tax benefits).

Smith v. Commr, 937 F.2d 1089, 1096 (6th Cir. 1991).44

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Montgomery at the time they decided to undertake the investment. In thesummer of 2002, the available market intelligence and valuation data stronglyindicated that the emerging market in Chinese NPLs held significant profitpotential. If Zhongyus upper-end valuation estimate had proven to be accurate,Beal and Montgomery stood to net upwards of $50 million on theirinvestments. The district court was correct to conclude that Southgates45

acquisition of the NPLs had objective economic reality. The latter two Klamath factors ask whether the transaction was motivated

solely by tax-avoidance considerations or was imbued with some genuinebusiness purpose. These factors undertake a subjective inquiry into whetherthe taxpayer was motivated by profit to participate in the transaction. Tax-46

avoidance considerations are not wholly prohibited; taxpayers who act withmixed motives, seeking both tax benefits and profits for their businesses, cansatisfy the business-purpose test. 47

Here, too, Southgates acquisition of the NPLs easily passes muster. Thedistrict court found that Southgate and its members acquired the NPLs forlegitimate purposes and that they believed they could earn a profit from theNPLs. This is not an instance of a taxpayers engaging in an exotic, one-offtransaction that bears no resemblance to its ordinary business activities. Bealand Montgomery specialize in buying stressed debt. They had previouslyidentified a growth opportunity in foreign NPL markets. As the district court

Of course, it turned out that Zhongyus valuation report had substantially45overestimated the NPLs value, but the district court found that it was reasonable forSouthgate to rely on Zhongyus analysis, and the Government does not contend that thisfinding was clearly erroneous.

Dow Chem. Co. v. United States, 435 F.3d 594, 599 (6th Cir. 2006) (quoting Illes v.46Commr, 982 F.2d 163, 165 (6th Cir. 1992)); see also In re CM Holdings, 301 F.3d at 102 n.4(explaining that the subjective inquiry plays the basic role of evaluating whether thetaxpayer had a business reason, apart from tax avoidance, for engaging in the transaction).

See Compaq Computer Corp. v. Commr, 277 F.3d 778, 786 (5th Cir. 2001) (collecting47cases).

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found, the acquisition of the NPLs fit squarely within Beal and Montgomeryscore business. The district court also found that Beal and Montgomery wouldhave done the deal regardless of whether it had any tax benefits. As toMontgomery specifically, the court found that he was not in a position to receivetax benefits from the NPLs. His motives were exclusively profit- and business-driven: to earn money on the deal and develop a marketable expertise in ChineseNPLs that he could use in similar transactions in the future. As to Beal, thecourt found he acted with mixed motives, investing in Southgate both becauseit posed profit potential and because it offered potential tax benefits. Under ourdecision in Compaq Computer Corp., that finding is sufficient for economic-48

substance purposes.The Government urges us to conclude that the acquisition of the NPLs

lacked economic substance because the district court found only that thetransaction had some profit potential and such a finding is not sufficient foreconomic-substance purposes if a transactions profit potential is insubstantialrelative to its expected tax benefits. This argument misfires factually andlegally. Factually, the district court made three separate findings that theacquisition of the NPLs had not just a de minimis profit potential but areasonable profit potential. Under Klamath, those findings support theconclusion that the acquisition had economic substance. The cases that the49

Government cites in support of its contrary position present readilydistinguishable facts. Legally, the Government would have us conflate our50

Id.48

See Klamath Strategic Inv. Fund v. United States, 568 F.3d 537, 545 (5th Cir. 2009)49(emphasizing that the proper focus is on whether the loan transactions presented areasonable possibility of profit and concluding that the transaction in question lackedeconomic substance because no reasonable possibility of profit existed).

See Rogers v. United States, 281 F.3d 1108, 111718 (10th Cir. 2002) (distinguishing50between the economic-substance doctrine and the substance-over-form doctrine beforeapplying the latter); Keeler v. Commr, 243 F.3d 1212, 1220 (10th Cir. 2001) (rejecting a

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analysis of the acquisition of the NPLs under the economic-substance doctrinewith our analysis of the formation of Southgate under the sham-partnershipdoctrine. The acquisition of the NPLs did not, by itself, generate any taxbenefits. It was the funneling of that acquisition through the partnershipstructure that generated massive deductions for Beal. The fact that aneconomically substantial transaction comes wrapped in a dubious form is not areason to disregard the transaction; it is a reason to disregard the form. Once theacquisition of the NPLs is recharacterized as a direct sale, it becomes apparent51

that the tax benefits it created were not disproportionate to its expectedprofitability. As a result, we affirm the district courts conclusion that52

Southgates acquisition of a portfolio of Chinese NPLs was an economicallysubstantial transaction motived by a genuine business purpose.

B. Southgate was a sham partnership. We are also persuaded that the district court was correct to determine that

Southgate was a sham partnership that must be disregarded for federal-income-tax purposes. As the Supreme Court explained in Commr v. Culbertson,53

taxpayers argument that a complicated derivative-trading scheme, which as a whole providednothing but an illusory opportunity for economic profit, nonetheless had economic substancebecause individual trades within the scheme sometimes generated profits); ACM Pship v.Commr, 157 F.3d 231, 258 & n.52 (3d Cir. 1998) (explaining that the prospect of a nominal,incidental pre-tax profit is not enough to support a finding of economic substance where noneof the partners reasonably expected to gain any pretax profit from the transaction); Kuperv. Commr, 533 F.2d 152, 159 (5th Cir. 1976) (holding that the form assigned to a set ofeconomically substantial transactions need not be respected wherelarger tax objectives . . . ultimately controlled [the] specific form of the transactions).

See infra Section II.C. 51

Indeed, the only reason the sale created any tax benefits at all is that Beal suffered52real, out-of-pocket losses because of his participation in the transaction.

Southgate engages in question-begging when it contends that 26 U.S.C. 704(c)53mandated the tax treatment at issue in this appeal. Section 704(c) governs the allocation oflosses among partners in a valid partnership. It is silent on the question of when a putativepartnership is in fact valid. Here the judicial doctrines step into the breach. Sham-partnership analysis makes it plain that Southgate was not a valid partnership for taxpurposes. Neither the text of the statute nor Congresss intent in enacting it compels the

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whether a partnership will be respected for tax purposes depends on whetherthe parties in good faith and acting with a business purpose genuinelyintended to join together for the purpose of carrying on the business andsharing in the profits and losses. This determination is made in light of all54

the relevant facts and circumstances, including the agreement, the conduct ofthe parties in execution of its provisions, their statements, the testimony ofdisinterested persons, the relationship of the parties, their respective abilitiesand capital contributions, the actual control of income and the purposes forwhich it is used, and any other facts throwing light on their true intent.55

Because so many abusive tax-avoidance schemes are designed to exploitthe Codes partnership provisions, our scrutiny of a taxpayers choice to use the56

partnership form is especially stringent. We are not compelled to conclude that57

a partnership must be respected for tax purposes merely because the taxpayercan point to the existence of some business purpose or objective reality inaddition to [the partnerships] tax-avoidance objective. Rather, a taxpayers58

application of partnership tax treatment to an entity that was not a true partnership. Section704(c) does not control.

Commr v. Culbertson, 337 U.S. 733, 74142 (1949) (quoting Commr v. Tower, 32754U.S. 280, 287 (1946)); see also ASA Investerings Pship v. Commr, 201 F.3d 505, 513 (D.C. Cir.2000) (describing the basic inquiry as whether, all facts considered, the parties intended tojoin together as partners to conduct business activity for a purpose other than tax avoidance);Scofield v. Davant, 218 F.2d 486, 489 (5th Cir. 1955) ([T]he reality vel non of the partnershipfor tax purposes . . . depends upon whether the partners really and truly intended to jointogether for the purpose of carrying on a business and sharing in the profits or losses orboth.).

Culbertson, 337 U.S. at 742.55

See BORIS I. BITTKER & LAWRENCE LOKKEN, FEDERAL TAXATION OF INCOME, ESTATES56AND GIFTS 86.1.2 (2011); Bradley T. Borden, The Federal Definition of Tax Partnership, 43HOUS. L. REV. 925, 92829 (2006); Karen C. Burke, Repairing Inside Basis Adjustments, 58TAX LAW. 639, 639 & n.1 (2005).

See TIFD III-E, Inc. v. United States, 459 F.3d 220, 232 n.13 (2d Cir. 2006); ASA57Investerings, 201 F.3d at 513.

See TIFD III-E, 459 F.3d at 232.58

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formation of a partnership must, on balance, display good common sense froman economic standpoint.59

The fact that a partnerships underlying business activities had economicsubstance does not, standing alone, immunize the partnership from judicialscrutiny. The parties selection of the partnership form must have been driven60

by a genuine business purpose. This is not to say that tax considerations61

cannot play any role in the decision to operate as a partnership. It is only to62

say that tax considerations cannot be the only reason for a partnershipsformation. If there was not a legitimate, profit-motivated reason to operate as63

a partnership, then the partnership will be disregarded for tax purposes even ifit engaged in transactions that had economic substance.64

Boca Investerings Pship v. United States, 314 F.3d 625, 631 (D.C. Cir. 2003). 59

See TIFD-IIIE, 459 F.3d at 231 (The IRS . . . is entitled in rejecting a taxpayers60characterization of an interest to rely on a test less favorable to the taxpayer, even whe

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