On May 17, 2016, the US Court of Appeals for the Fifth Circuit affirmed a decision by the district court for the Middle District of Louisiana in Chemtech Royalty Associates v. United States and upheld accuracy-related penalties imposed on Chemtech under Section 6662.5 The district court held that the substantial-understatement and negligence penalties applied against Chemtech I for tax years 1997 through 1998, which subjected Chemtech I to a 20 percent penalty.

Background

Dow Chemical Company (“Dow”) created Chemtech I (“Chemtech”), a limited partnership, and contributed 73 patents to the partnership, which Dow later leased back in return for royalty payments. Dow deducted its royalty payments to Chemtech. In 1998, Dow terminated Chemtech in response to a change in the US tax law. The Service conducted a partnershiplevel audit for Chemtech, disregarded the partnership form of Chemtech for tax purposes, reasoning that Chemtech was a sham transaction. The Service asserted adjustments, resulting in the disallowance of $1 billion of tax deductions to Dow, and asserted accuracy-related penalties pursuant to Section 6662. Dow contested the substantial-understatement and negligence penalty award as to Chemtech. Dow argued that it had reasonable cause and substantial authority for its position that Chemtech was a valid partnership. The district court held that the penalties properly applied to Chemtech. On appeal, the Circuit Court concluded that “[t]he district court did not err in failing to justify the negligence and substantial understatement penalties on the basis of our sham-partnership holding, but it could have done so.”6

Analysis

On the merits, the Circuit Court recognized that in order for there to be substantial authority “the weight of the authorities supporting treatment of an item must be substantial in relation to the weight of those supporting contrary treatment.”7 Substantial authority is more stringent then the reasonable-basis standard but less stringent than the more-likely than-not standard.8 Dow argued that it had substantial authority for its position that Chemtech was a valid partnership, relying on Hunt v. Commissioner9 and Morris v. Commissioner. 10

In Hunt, the Tax Court held that a partnership was not a sham when a partner was entitled to a cumulative return of 18 percent, followed by a return of its capital contribution, before any other partners received returns of capital. In Morris the Tax Court held that despite receiving only a fixed 6 percent return plus 2 percent of profits, the petitioner’s wife was a true limited partner in her husband’s brokerage partnership. Dow argued that both decisions treated an interest with minimal sharing of profits and losses as a partnership interest. But the Circuit Court distinguished both Hunt and Morris and rejected Dow’s interpretation, which the court found would eliminate any intent element from the sham-partnership doctrine. The Circuit Court also cited the totality of circumstances test in Culbertson, 11 which holds that a partnership is a sham if the partners do not intend to share profits and losses. The court added that Hunt and Morris fail to constitute substantial authority when taking into account the court’s prior decision in Merryman v. Commissioner. 12 That decision affirmed a finding that a partnership with similar features as Chemtech (partner control of property contributed, minority partners lack of risk, circular flow of funds), was a sham. The court held that “[b]ecause Merryman is more apposite than are Morris and Hunt, and because Merryman is published circuit authority, whereas Morris and Hunt are Tax Court cases, Dow lacked substantial authority for its position that [Chemtech] was a valid partnership.”13