The U.S. Court of Appeals for the Seventh Circuit in Chicago has affirmed the Tax Court, upholding the disallowance by the IRS of losses claimed by investors in a DAD (distressed asset/debt) tax shelter.

Warwick Trading LC was created by an attorney, John Rogers. The purpose of creating Warwick, according to the court, was “to beat taxes by transferring the losses of a bankrupt Brazilian retailer of consumer electronics, Lojas Arapua S.A., to U.S. taxpayers who would deduct the losses from their taxable income. Arapua had receivables with a face value of $30 million. Because the receivables were to a great extent uncollectible (they were owed by consumers, had very small balances, and were very old), they had a negligible market value. Rogers used a company that he owned, Jetstream Business Limited, to join with Arapua in forming Warwick.

Rogers’ DAD tax shelter involved Arapua contributing its receivables with built-in losses to Warwick, followed by the sale of Arapua’s partnership interest (which was acquired by contributing those receivables to the partnership) to the “tax-shelter seekers,” according to the court. The investor-partners’ purpose in buying Arapua’s interest in the partnership, and thus becoming Jetstream’s partners, was to deduct the built-in loss.

The investors had to contribute additional property to the partnership to bring their basis in the partnership interest to the level where they could deduct the entire built-in loss. The additional property took the form of promissory notes made out to the partnership, which had no value, said the court, because Rogers had no intention of causing Warwick to collect on them. The intention was simply to create the appearance that the investors’ interest in the partnership had a high enough basis to enable the entire built-in loss that the shelter investors had acquired to be offset against their taxable income.

“A transaction that would make no commercial sense were it not for the opportunity it created to beat taxes doesn’t beat them,” said the court, labeling the shelter a sham, entitled to “none of the benefits that the Internal Revenue Code bestows on partnerships.”

In upholding a 40 percent, rather than a 20 percent, penalty, the court joined the majority view and opted for 40 percent.

“There is a disagreement among courts of appeals concerning the applicability of the penalties for misstating valuation when the transaction involving the overvalued assets is itself disregarded because it lacks economic substance,” said the court. “The majority view, which we now join, is that a taxpayer who overstates basis and participates in sham transactions, as in this case, should be punished at least as severely as one who does only the former.”

The DAD shelter itself is based on a tax loophole closed by the American Jobs Creation Act of 2004, the year after Rogers created Warwick, the court noted.