Settlement doesn't legitimize sham.

The U.S. District Court of New Hampshire ruled that a taxpayer couldn't claim losses stemming from partnerships' transactions that lacked economic substance, even though a settlement with the IRS had allowed some of their claims.

Richard Nault invested in several agricultural limited partnerships between 1984 and 1986 that reported significant losses the first year and small amounts of income subsequently In 1987, the IRS audited the partnerships and rejected the losses. In 2001, the partnerships and IRS settled the case, disallowing 72% of the losses as lacking economic substance but permitting the partnerships to retain investment tax credits. The IRS also adjusted Nault's returns for the three years, and he paid additional taxes. Meanwhile, the partnerships terminated as a result of the controversy.

In 2002, Nault fled amended returns for six years claiming ordinary loss deductions under section 165 by "restoring" his basis in the partnerships based on the disallowed losses and the partnership interests having become worthless. The IRS denied Nault's refund claims, saying since the partnerships' settlement had conceded that the transactions had lacked economic substance, Nault was not entitled to a loss deduction stemming from them. The taxpayer countered that since the partnerships had been allowed to keep the investment credit and he had to pay tax on some income, there was the requisite profit motive. In rejecting Nault's argument, the district court also noted that results of unified partnership audit procedures under the Tax Equity and Fiscal Responsibility Act could not be litigated at the partner level.

* Richard M. Nault v. U.S., 99 AFTR2d 2007-1027.

Prepared by Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accountancy and director, MTA Program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.