A. The formation and operation of the partnerships

From about 1971 through 1998, Hoyt organized, promoted to thousands of investors, and operated more than 100 cattle- and sheep breeding partnerships.² (ER 916; SER 4.) Hoyt began with cattle partnerships, and in the late 1970s, became interested in sheep as well. (ER 916.) Hoyt discussed his interest with David Barnes — a childhood friend, a longtime and well-regarded sheep breeder, and the owner of Barnes Ranches (a sheep-breeding sole proprietorship). (ER 916–917.)

From 1981 through 1990, Hoyt organized nine sheep-breeding partnerships. (ER 914.) Hoyt did not issue a separate prospectus for each sheep partnership, but instead used the same promotional literature that he had developed for the cattle partnerships. (ER 913–914; see, e.g., ER 942–960; SER 106–138.) For each partnership, Hoyt was both a managing general partner and the tax matters partner (TMP). (ER 915.) Hoyt, an IRS enrolled agent, was responsible for and directed the preparation of each partnership’s income tax return for the periods at issue, although he may not have personally prepared each return. (ER 915, 1064, 1071.)

Each of the sheep partnerships was operated in a substantially identical manner. (ER 915.) In theory, the partnerships would

² The opinions in the Supplemental Excerpts contain a detailed history of the Hoyt organization. See also, e.g., Durham Farms #1 v. Commissioner,

T.C. Memo. 2000-159, 79 T.C.M. (CCH) 2009, aff’d, 59 Fed. Appx. 952 (9th Cir. 2003); Bales v. Commissioner, T.C. Memo. 1989-568, 58 T.C.M. (CCH) 431. 3093738.3

purchase purebred, registered breeding ewes (mostly yearlings) from Barnes Ranches. (ER 917; SER 60 n.28.) The main sales documents (all signed only by Hoyt for both the partnerships and their partners) (ER 917–919, 921) were: a bill of sale listing the sheep sold (ER 979–992), a promissory note obligating the partnership to pay Barnes Ranches over a fifteen-year period, a security agreement covering the sheep, a sharecrop operating agreement (ER 993–999), and a certificate of assumption of liability obligating the partners to pay their partnership’s debts. Under the sharecrop agreement Barnes Ranches received all lambs and culled sheep in exchange for sheep care and recordkeeping, payment of all sheep expenses, a 5% annual net flock increase guarantee, and a fertility warranty under which Barnes Ranches would replace ewes that could not breed. (ER 920–921.)

In reality, there were serious problems with the Hoyt organization that prevented the partnerships from acquiring the benefits and burdens of sheep ownership.³ Hoyt and Barnes were not independent parties acting at arm’s length. (ER 917.) Some of the partnerships lack some or all of the sales documents. (ER 917,

³ For that reason, we use terms like “purchased” and “owned” for convenience only. Our use of such terms should not be treated as a concession that the partnerships actually acquired any sheep. 3093738.3 925–939.) The promissory notes and assumption agreements were not bona fide recourse debt, and the security agreements were invalid. (ER 918– 919.) The bills of sale contained numerous errors, including listing large numbers of sheep that did not, in fact, exist. (ER 921–923, 925.) The sheep purportedly sold to the partnerships were not of the quality represented on the bills of sale, and nowhere near the quality of the sheep commanding top dollar at auctions. (ER 923.)

Barnes Ranches did not provide any sheep-management services as it was supposed to under the sharecrop agreements. (ER 920.) It commingled partnership sheep with its own sheep, and failed to keep records adequate to identify each partnership’s sheep. (ER 920–921.) It is impossible to determine the specific sheep owned by each partnership or their value. (ER 923, 940.) Barnes Ranches neither provided lambs under the 5%, flock-increase guarantee, nor replaced ewes under the fertility warranty. (ER 921.) Despite the sharecrop agreement, under which Barnes Ranches was to pay all sheep expenses, Hoyt would periodically bill the partners for sheep feed and other services. (ER 920, 940.)

Other than tax returns, Hoyt failed to maintain separate books and records for each partnership. (ER 916, 940.) In many years, Hoyt kept no records, and the existing records (including the tax returns and flock recap sheets prepared by Hoyt) were inadequate, unreliable, and often falsified. (ER 923, 940, SER 6.) Hoyt did not maintain a separate bank account for each partnership, but instead commingled funds in “pooling” accounts in the names of various Hoyt entities. (ER 940., 1377; SER 82a–82b, 90.) Hoyt used money paid by the sheep partners for purposes and entities other than the sheep partnerships. (ER 941.)

B. The Commissioner’s enforcement efforts

Around 1980, the Commissioner began auditing the tax returns filed by the partnerships and the partners. (SER 7.) Because Hoyt failed to maintain accurate records and separate accounts, the Commissioner audited the returns as a group. (ER 940.) The audits convinced the Commissioner that the partnerships were abusive tax shelters, and they led to extensive civil litigation and to four criminal investigations of Hoyt for tax crimes. (SER 7–10.) None of the tax investigations resulted in prosecution, and Hoyt remained as TMP of each partnership. (ER 940; SER 9–10.)

In 1989, the Tax Court held in a case involving tax years from the late 1970s that the Hoyt cattle partnerships were not shams and that their transactions had economic substance. Bales v. Commissioner, T.C. Memo. 1989-568, 58 T.C.M. (CCH) 431. Bales “set back considerably” the IRS’s tax enforcement efforts against Hoyt and his partnerships. (SER 7.) In response to Bales, the IRS decided to count and inspect the Hoyt livestock to confirm its suspicions that Hoyt had greatly overstated the number and the value of the animals. (SER 8.) Hoyt did not cooperate, forcing the IRS to bring a summons-enforcement action that delayed the count until late 1992. (Ibid.) From February 1991 through March 1993, Hoyt executed extensions of the limitations period for assessments for the 1987 to 1989 tax years of four of the partnerships. (SER 10–11.)

By February 1993, the Commissioner concluded that Hoyt had greatly overstated the number and the value of the animals. (SER 8.) The IRS sent the partners prefiling notices telling them that, starting with tax year 1992, it would disallow their partnership deductions and credits and not issue tax refunds attributable to those items. (SER 8, 159.) The Hoyt organization began to experience financial difficulties because the freezing of the partners’ refunds greatly reduced its cash flow. (SER 8.) Moreover (and partly due to the Commissioner’s tax enforcement), an increasing number of partners became disgruntled with Hoyt, stopped making their partnership payments, and withdrew from their partnerships. (Ibid.)

From 1993 through 1998, the Hoyt organization declined further. It was subject to investigations by other federal agencies, and it was forced into an involuntary liquidating bankruptcy by a group of partners who had secured an $11 million default judgment for fraud. (SER 8–10.) The IRS also disbarred Hoyt as an enrolled agent for improprieties relating to his individual tax returns. (ER 939; SER 5.) By the end of 1998, the Hoyt organization was effectively finished. All of its entities were consolidated in the bankruptcy, and Hoyt had been indicted on multiple counts of conspiracy, fraud, and money laundering (but no tax crimes). (SER 8–10.)

In June 1999, the Tax Court issued an opinion in River City Ranches #4 (RCR#4), a test case sustaining the Commissioner’s disallowance of all tax benefits claimed by RCR#4 for 1987–1991, RCR#6 for 1987–1991, and OGT90 for 1991. (ER 915; SER 44–66.) See also Durham Farms, T.C. Memo. 2000-159, 79 T.C.M. (CCH) 2009 (test case sustaining disallowance of tax benefits claimed by several Hoyt cattle partnerships for tax years after 1986). The Tax Court in this case incorporated by reference its findings in RCR#4. (ER 6.)

- 13 In 2001, Hoyt was convicted, sentenced to almost 20 years in prison, and ordered to pay over $102 million in restitution. United States v. Hoyt, No. 98cr529 (D. Or. 2001), aff’d, 47 Fed. Appx. 834 (9th Cir. 2002), cert. denied, 537 U.S. 1212 (2003). Hoyt died in prison on September 6, 2007. Jeremiah Coder, Shelter Promoter Hoyt Dies in Prison, 2007 Tax Notes Today 185-4 (Sept. 21, 2007).

SUMMARY OF ARGUMENT

1. For many of the years at issue, I.R.C. § 6621(c) imposed interest at 120% of the normal rate on underpayments exceeding $1,000 attributable to tax-motivated transactions including, inter alia, valuation overstatements of 150% or more of the correct amount and sham or fraudulent transactions.

The partnerships claimed deductions based on average sheep values from $1,135 to $2,126 each. In reality, the sheep were worth less than $400 each. This large valuation overstatement makes tax-motivated interest applicable to partner underpayments in excess of $1,000 attributable to the overvaluation.

The partnerships and their transactions were also shams lacking in economic substance. The partnerships did not acquire the benefits and burdens of sheep ownership, and Barnes Ranches did not render the services that it was contractually required to provide. Without sheep or services, the partnerships could not fulfill their sole legitimate business purpose, sheep-breeding. Instead, the partnerships provided only tax benefits. Hoyt inserted bogus partnership deductions into the partners’ returns to zero out the taxes that they would otherwise owe, and then he required the partners to send him 75% of the tax savings that he generated. When the IRS began freezing partner refunds in 1993, the Hoyt organization began to experience financial difficulties because of its greatly reduced cash flow. The motives of the individual partners in joining Hoyt partnerships are irrelevant to the correct characterization of the partnerships and their transactions.

1. The Commissioner timely issued FPAAs within the six-year limitations period for assessing tax under I.R.C. § 6229(c)(1) when a partner, with an intent to evade tax, participates in the preparation of a partnership tax return that includes false or fraudulent items. It is beyond dispute that Hoyt was a partner who participated in the preparation of partnership returns

2. containing false or fraudulent items. The partnerships’ argument that Hoyt did not intend to evade tax ignores Hoyt’s role as the controlling mastermind of a massive, fraudulent scheme designed to fund itself using false and fraudulent
1. tax-reduction items inserted into the partners’ returns (which were prepared in advance of, and without any data from, the partnership returns on which they were supposedly based).

2. In the alternative, the FPAAs were issued while the limitations period for assessments was still open because in March 1993, Hoyt (as TMP) signed consents to extend that limitations period. The Tax Court erred in invalidating these consents on a theory that the IRS knew or had reason to know that Hoyt’s interest in extending the time for the FPAAs was in conflict with the partners’ interest receiving the FPAAs promptly. The Tax Court’s ruling is contrary to the TEFRA partnership provisions in the Code and the Treasury regulations designed to facilitate the efficient resolution of partnership tax disputes, neither of which provide for removal of a TMP for conflicts of interest between the TMP and the other partners. This reflects an IRS determination, entitled to Chevron deference, that it is not necessary for the efficient administration of the tax laws for the IRS to police conflicts of interest.

In any event, this Court should, at a minimum, vacate as unnecessary that portion of the Tax Court’s opinion.

ARGUMENT

I

The Tax Court’s findings that the Hoyt sheep partnerships engaged in tax-motivated transactions for purposes of imposing interest at an increased rate under former I.R.C. § 6621(c) are not clearly erroneous

Standard of review

This Court reviews the imposition of tax-motivated interest and findings regarding valuation under the clearly erroneous standard. Hill v. Commissioner, 204 F.3d 1214, 1217, 1220–21 (9th Cir. 2000); Wolf v. Commissioner, 4 F.3d 709, 715 (9th Cir. 1993). If the Tax Court correctly applied the proper legal standard (issues reviewed de novo), its findings regarding the sham nature of a partnership and its transactions are reviewed for clear error. Sacks v. Commissioner, 69 F.3d 982, 986 (9th Cir. 1995); Sochin v. Commissioner, 843 F.2d 351, 353 (9th Cir. 1988). The partnerships had the burden of proof on all of these issues. Hill, 204 F.3d at 1220.

A. An overview of the TEFRA partnership procedures

The issues presented by this appeal arise out of the TEFRA partnership procedures. See Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Pub. L. No. 97-248, §§ 402–406, 96 Stat. 324, 648–71.

TEFRA makes the determination of income taxes based on partnership items more efficient, while ensuring that the partners can participate meaningfully in partnership audits and litigation.

Partnerships are not taxable entities for purposes of federal income taxation. I.R.C. § 701. Instead, partnerships file annual information returns, and each partner must report on his individual return his distributive share of the partnership’s tax items, treating the items consistently with the partnership’s return. I.R.C. §§ 701–704, 6031, 6221– 6222. “Partnership items” are tax items that the IRS has decided are “more appropriately determined at the partnership level.”

I.R.C. § 6231(a)(3); Treas. Reg. § 301.6231(a)(3)-1(a).

To treat all partners in a partnership consistently and to remove the substantial burden occasioned by duplicative audits and litigation, Subchapter C of Chapter 63 of the Code (currently I.R.C. §§ 6221–6234) contains comprehensive procedures for determining all partnership items uniformly at the partnership level in a single, unified audit and judicial proceeding. See H.R. Conf. Rep. No. 97-760, at 599–600 (1982), reprinted in 1982-2 C.B. 600, 662–63. Under TEFRA, each partnership must designate a general partner as the “tax matters partner” (TMP). See I.R.C. § 6231(a)(7). Although the TMP receives notices before the other partners and can take actions on their behalf in tax disputes, TEFRA also requires that the other partners be given notice of, and be allowed to participate in, partnership audits and litigation. I.R.C. §§ 6223–6224, 6226–6228.

Once a final, partnership-level adjustment has been made to a partnership item, corresponding “computational adjustments” are made to the tax returns of the partners. I.R.C. §§ 6221, 6230(a)(1). The adjustments will sometimes affect other items on the partners’ returns. See I.R.C. § 6231(a)(5) (defining “affected items” as partner-level items affected by partnership items). If the proper treatment of an affected item flows strictly from the partnership item, the partner can only challenge the computational adjustment in a refund suit. See I.R.C. § 6230(c)(3). If factual determinations need to be made at the partner level, however, the normal deficiency procedures apply. I.R.C. § 6230(a)(2)(A)(i). Any tax deficiency attributable to partnership items is then assessed at the partner level. See I.R.C. § 701.

B. The partnerships at issue here engaged in tax-motivated transactions

The Hoyt sheep partnerships reported on their tax returns deductions and credits based on the ownership of sheep and the operation of a sheep-breeding activity. (ER 14–16.) Some of those items (e.g., depreciation and interest deductions) are directly tied to the reported value and basis of the sheep, and none of the tax-reduction items are allowable if the partnerships or their transactions were shams lacking in economic substance. For the 1984 through 1988 tax years of the partners in seven partnerships (see the table at page 6, supra), an additional consequence of a disallowance for overvaluation or sham is the imposition of interest at 120% of the normal rate under former I.R.C. § 6621(c), often referred to as “tax-motivated interest.”⁴

Tax-motivated interest is applicable to underpayments in excess of $1,000 attributable to tax-motivated transactions including, inter alia, valuation overstatements and sham or fraudulent transactions.

I.R.C. § 6621(c)(2), (3). Tax-motivated interest is an affected item. The character of a partnership’s transactions is determined at the partnership level, but the issue whether any individual partner is liable

⁴ In 1984, Congress enacted I.R.C. § 6621(d) applicable to interest accruing after December 31, 1984, even on pre-enactment transactions. In 1986, Congress amended § 6621(d) and redesignated it as § 6621(c).In 1989, Congress repealed § 6621(c). Because Congress decided to make the repeal effective only for returns due after December 31, 1989, interest at the increased rate continues to accrue on earlier liabilities. The partnerships thus err in arguing (Br. 56–58) that the repeal should somehow relieve their partners of liability. See Deficit Reduction Act of 1984, Pub. L. No. 98-369, § 144, 98 Stat. 494, 682–684; Tax Reform Act of 1986, Pub. L. No. 99-514, §§ 1511(c)(1), 1535, 100 Stat. 2085, 2744,2750; Omnibus Budget Reconciliation Act of 1989, Pub. L. No. 101-239,§ 7721(b), (d), 103 Stat. 2106, 2399–2400. 3093738.3

for the interest requires the determination at the partner level whether there is an underpayment exceeding $1,000 attributable to tax-motivated partnership transactions. (SER 41–42.)

In its first opinion in this case, the Tax Court held that it lacked jurisdiction in partnership-level cases to rule on an affected item like tax-motivated interest. (SER 30–32.) This Court reversed and remanded, holding that the Tax Court had jurisdiction in a partnership-level proceeding to rule on the partnership-item components of affected items, such as the nature of the partnerships’ transactions for purposes of § 6621(c) interest. (SER 41–42.) On remand, the Tax Court made partnership-level findings, determining that the sheep partnerships had overvalued their sheep and that the partnerships and their transactions were shams lacking in economic substance. (ER 26–30.) Those findings are not clearly erroneous and should be affirmed.

1. The partnerships overvalued the sheep

Tax-motivated transactions include “any valuation overstatement (within the meaning of section 6659(c)).” I.R.C. § 6621(c)(3)(A)(i). Former § 6659(c) provided that there was a valuation overstatement if the value or basis claimed for an item on any return was 150% or more of the correct amount. Here, the Tax Court correctly found that, to the extent that the partnerships acquired any sheep, they overvalued the animals and overstated their bases.⁵ (ER 30.)

The partnerships reported the following purchase prices for the sheep, and they used the prices to establish their bases for their depreciation and other valuation-dependent deductions (ER 922):

Partnership Sheep Number Total Price Average Price

In reality, any sheep that the partnerships acquired were worth only a small fraction of those prices. Barnes Ranches annually entered only twenty to twenty-five of their best yearling sheep in national

⁵ As noted by the Tax Court (ER 30) and as discussed in our briefs in the pending Hoyt overvaluation-penalty appeals (Keller v. Commissioner (9th Cir. – No. 06-75441) and McDonough v. Commissioner (9th Cir. – No. 0773610)), an overvaluation also exists when an asset-acquisition transaction is an economic sham. Economic sham is an independent ground for asserting § 6621(c) interest, as we discuss in section I.B.2., infra. 3093738.3

shows, and those sheep often won awards. (ER 917.) In arms-length transactions at auctions, Barnes Ranch’s best, purebred, registered sheep sold at prices ranging from $175 to $1,100, with prices of $400 or more going to sheep that had won championships or other awards at those shows. (ER 12, 923; SER 60.) Barnes testified that registered ewes were worth $350–$600, and that common, unregistered, ewe lambs sold for $200. (SER 92, 97.) Around the same time, lower quality commercial sheep could be purchased for $75–$100. (SER 51.) The parties stipulated that each of the sheep partnerships was operated in a substantially identical manner, that the sheep were not of the quality represented on the bills of sale, and that the partnerships’ sheep “were nowhere near the quality of breeding sheep selling for $400 or more.” (ER 12, 915, 923.) The bills of sale listed substantial numbers of sheep of unknown or dubious ancestry that were not (and could not) be registered. (ER 924; SER 48, 59–60.)

The prices paid by the partnerships, however, start at the highest prices paid in arms-length transactions and go up from there. And the partnerships (who bear the burden of proof) have not pointed to any evidence that any partnership received better sheep than the other partnerships. Therefore, contrary to partnerships’ argument (Br.

51–52), the stipulated facts adopted by the Tax Court are more than sufficient to support a finding that the partnerships’ sheep were grossly overvalued. (ER 11–12, 30; SER 51, 59–60, 92, 97.)

The partnerships further argue (Br. 32–33, 52–53) that the sheep were not overvalued because the purchase price purportedly included such items as the sheep’s breeding value certificates, the 5% annual flock-increase guarantee, and the fertility warranty (see ER 13). There is no indication, however, that arms-length, auction purchasers did not also purchase a sheep’s breeding value along with the rest of the animal. Moreover, the flock-increase and fertility warranties were not

part of the purchase transaction, but instead were covered by the sharecrop agreement and purportedly paid for under that agreement with lambs and culls. (ER 920–921, 993–999.) Despite that sharecrop arrangement, Hoyt periodically billed the partners for feed and services for the sheep. (ER 940.) In any event, the warranties were worthless because Barnes Ranch neither grew the partnerships’ flocks nor replaced any of their breeding ewes. (ER 13, 921.)

⁶ Had the warranties been part of the purchase transaction, they would have been grossly overpriced. When the prices paid by the partnerships are compared to the fair market value of the sheep (a figure well below $400 per head), it is apparent that the partnerships would have paid not only for the sheep, but also for the replacement of each sheep many times over. 3093738.3

- 24 To the extent that the partnerships acquired any sheep, they overvalued them by more than 150%. Therefore, § 6621(c) interest is (at a minimum) applicable to any partner underpayments in excess of $1,000 attributable to the overvaluations.

2. The partnerships and their transactions lacked economic substance

Tax-motivated transactions also include “any sham or fraudulent transaction.” I.R.C. § 6621(c)(3)(A)(v); Erhard v. Commissioner, 46 F.3d 1470, 1479 (9th Cir. 1995). “It has long been the law that a transaction with no economic effects, in which the underlying documents are a device to conceal its true purpose, does not control the incidence of taxes.” Sacks, 69 F.3d at 986. A transaction or entity is an economic sham if it subjectively lacks a non-tax business purpose and objectively lacks economic substance beyond the generation of tax benefits. Sochin, 843 F.2d at 354. The two-part analysis is not rigid, but instead is a more precise way of stating the traditional sham question whether there is a lack of “any practical economic effects other than the creation of income tax losses.” Sochin, 843 F.2d at 354; see also Sacks, 69 F.3d at 987–88; Erhard, 46 F.3d at 1476–77; Casebeer v. Commissioner, 909 F.2d 1360, 1363 (9th Cir. 1990). Because shams are not recognized for tax purposes, the issue of sham is considered before the issue of profit motive, and it is not necessary to consider profit motive if a transaction or entity is found to lack economic substance. Cook v. Commissioner, 941 F.2d 734, 736, 738 (9th Cir. 1991); Sochin, 843 F.2d at 353 n.6.

The partnerships argue that in previous Hoyt cases (see SER 52–64) the Tax Court found a lack of economic substance but not a sham (Br. 47.) That “magic words” argument is unavailing. “The terms used in dealing with tax-avoidance cases are often confusing.” Rogers v. United States, 281 F.3d 1108, 1113 n.2 (10th Cir. 2002). A “factual sham” is a transaction that did not occur, did not occur as reported, or violated some background assumption of commercial dealing, whereas an “economic” or “substantive” sham is a transaction that occurred but that lacked economic substance. Rogers, 281 F.3d at 1113 n.2; Horn v. Commissioner, 968 F.2d 1229, 1236 n.8 (D.C. Cir. 1992); see also Cook, 941 F.2d at 735. Moreover, “[a]n entity without economic substance, whether a sham partnership or a sham trust, is a sham either way and hence is not recognized for federal tax law purposes.” Sparkman v. Commissioner, 509 F.3d 1149, 1156 n.6 (9th Cir. 2007). Thus, a finding a that a transaction or entity lacks economic substance is equivalent to finding that it is an “economic” or “substantive” sham.

In this case, the Tax Court found that the partnerships and their sheep-purchase transactions were shams lacking in economic substance with no business purpose beyond the generation of tax benefits.⁷ (ER 13, 26–30.) See also Hansen v. Commissioner, 471 F.3d 1021, 1025 n.4 (9th Cir. 2006) (Hoyt “sheep- and cattle-breeding tax shelters were, in reality, largely economic shams”). This finding is well supported by the record here. “The high stakes in tax cases, and the high intelligence of tax lawyers, makes it impossible to have a simple checklist or rigid formula for determining whether a transaction is a sham.” Sacks, 69 F.3d at 988. Nevertheless, the determination of the existence of an economic sham generally includes the questions whether: (1) the parties dealt at arms length; (2) an interest in property was actually transferred; (3) the price paid reflected the fair market value of the asset; (4) any debt used to finance the transaction created a genuine liability; (5) the parties fulfilled their obligations arising out of the transaction; and (6) business purposes beyond tax avoidance and economic benefits beyond tax reduction can be identified. See

⁷ The Commissioner does not argue that the partnership entities did not exist as such, as they erroneously assume (see Br. 39–41), only that they lacked substance.

3093738.3

Sparkman, 509 F.3d at 1155; Sacks, 69 F.3d at 988–92; Erhard, 46 F.3d at 1477–79; Casebeer, 909 F.2d at 1363–65.

As indicated by the Tax Court (ER 26–27), its findings in RCR#4 (SER 44– 66) and the parties’ stipulations support the conclusion that the partnerships and their transactions were shams.⁸ The purported business purpose of each partnership was sheep breeding, and all of the partnerships were operated in the same manner. (ER 914–915; SER 48 n.11.) Hoyt and Barnes were the principal individuals involved in the sheep-purchase transactions, and Hoyt and Barnes Ranches did not deal at arms length regarding the partnerships’ activities. (ER 917; SER 63.) Some of the partnerships lack some or all of the sales documents. (ER 917, 925–939; SER 47 n.9.) The bills of sale contained numerous errors, did not reflect the sheep bought by the partnerships,

⁸ In RCR#4, the Tax Court considered evidence pertaining to all of the sheep partnerships, and it incorporated by reference its RCR#4 findings in this case. (ER 6, 26–27). The partnerships argue (Br.46–47) that reliance on the factual findings in RCR#4 is improper because Hoyt and Barnes controlled the evidence in that case and were attempting to cover up their fraud. In RCR#4, however, Hoyt and Barnes lost while attempting to defend the partnerships on the merits. (SER 44–66.) The partnerships’ later appeal argued that Hoyt had committed fraud on the court by not revealing his theft, not that the Tax Court had erred on the merits. (SER 67–68.) There is no basis for disregarding the Tax Court’s factual findings on the merits of the partnerships and their transactions. 3093738.3 and listed large numbers of sheep that did not even exist.⁹ (ER 921–923, 925; SER 47, 51–59.) It was not possible to match a significant number of the sheep listed on the bills of sale to registration certificates,¹⁰ some ewes were reported as having impossibly high numbers of lambs, and the bill of sale for RCR#4 was prepared years after its alleged purchase and backdated. (SER 48–59.) The sheep purportedly sold to the partnerships were not of the quality stated on the bills of sale, and were grossly overvalued. (ER 922–924; SER 59–60.) No sheep were transferred to the partnerships from Barnes Ranches, and the partnerships did not acquire the benefits and burdens of ownership of any sheep. (ER 925.)

The promissory notes and assumption agreements were not bona fide recourse debt that the partnerships or their partners were obligated to pay, and the security agreements were invalid. (ER 918–919; SER 60–63.) The parties stipulated that Barnes Ranches

⁹ To the extent that the sheep did not exist, the purchase transaction was a factual sham. Thus, the lack of sheep can support not only a limited finding of factual sham, but also a general finding of economic sham. It is impossible to determine from the record the specific sheep purportedly acquired by each partnership or their value. (ER 923, 925.)

¹⁰ Because the sheep associations lack the resources to verify the existence of a sheep, the issuance of a registration certificate does not necessarily indicate the existence of a sheep. (SER 48, 57.) 3093738.3

never requested note payments from the partnerships or the partners, that the debt documents did not create any legally enforceable obligations, and that the notes were illusory with no practical economic effect on the partnerships. (ER 918–919.) The Tax Court found in RCR#4 that Hoyt permitted defaulting partners to withdraw from their partnerships, that he tried to treat the withdrawals as not affecting the tax benefits claimed by the remaining partners, and that no enforcement actions were taken. (SER 50, 61–62. But see ER 1385–1386; SER 8; Br. 22–23.) Hoyt also arranged circular transactions under which the Barnes family purchased the partnerships’ “breeding value certificates” at grossly inflated prices, with the proceeds being used to pay down the balances due on the notes (held by the sole-proprietorship Barnes Ranches), which balances reflected the grossly inflated sheep prices. (ER 916; SER 46, 62–63.) The partnerships conceded that they were not entitled to deductions for depreciation or interest during the years at issue. (ER 920, 925.)

Barnes Ranches did not provide any sheep-management services under the sharecrop agreements. (ER 920.) It neither provided lambs under the flock-increase guarantee, nor replaced ewes under the fertility warranty. (ER 921.) Barnes Ranches commingled the partnerships’ sheep with its own sheep, and it failed to maintain records sufficient to identify each partnership’s sheep as required by the sharecrop agreements. (ER 920– 921; SER 55.) Hoyt failed to maintain separate books and records for each partnership (other than tax returns). (ER 916, 940.) Hoyt’s flock recap sheets were inconsistent with the bills of sale, were false, and did not represent the sheep purportedly owned by each partnership. (ER 922, 940; SER 47 n.10, 51, 55–56.) The Tax Court in RCR#4 opined that the flock recap sheets were deficient because “the requisite number of specific breeding sheep did not exist and could not, in fact, be assigned to each partnership.” (SER 56.) There are no accurate records identifying the breeding sheep owned by each partnership, and the partnerships cannot identify either the specific sheep they purchased or the sheep they owned at any point in time.¹¹ (ER 925; SER 53, 55.) Hoyt did not maintain a separate bank account for each partnership, commingled funds in various “pooling” accounts, and used money paid by the sheep

¹¹ The partnerships argue (Br. 33–34, 36) that the Hoyt organization had extensive records. Those records, however, were mostly “irrelevant window dressing” presented to confuse the IRS and others. (SER 99.) The partnerships’ decision to concede their Hoyt items on the merits (SER 4, 9) is a telling indication that the extant records cannot be tied to the tax returns or to the facts on the ground. 3093738.3 partners for purposes and entities other than the sheep partnerships. (ER 940–941, 1377; SER 82a–82b, 90.)

As the Tax Court observed, the only alleged business purpose of the partnerships was sheep breeding. (ER 29, 914.) But without the benefits and burdens of sheep ownership, and without performance by Barnes Ranches under the sharecrop agreement, the partnerships did not (indeed, could not) conduct any economic activities in fulfillment of their stated business purpose. (ER 29.) Instead, as the Tax Court stated in its first opinion, Hoyt made false representations to obtain cash from the partners (SER 16), and a primary source of that cash was the tax reductions that Hoyt had secured for them.

In other words, Hoyt sold tax benefits. His promotional literature (used for both the cattle and the sheep partnerships (ER 914)) had titles like The 1,000 lb. Tax Shelter (ER 942–959 (1982 ed.))¹² and Harvesting Tax Savings by Farming the Tax Code (SER 106–138). Harvesting Tax Savings told potential partners that “[y]ou only considered making an investment in the cattle business AFTER you heard about the tax benefits. Tax benefits were your incentive. They encouraged you to make a high risk and financially questionable

¹² The much longer, 1984 edition of The 1,000 lb. Tax Shelter is also in the record at pages 488–572 of Exhibit 620-P.

3093738.3 investment.” (SER 114 (emphasis in original).) Both brochures compared a tax shelter to a roller coaster in that prospective tax-shelter investor “is excited about the potential tax savings, is ready to put his money down and experience the ‘thrill’ of big tax savings.” (SER 126; see also ER 950–952; SER 126–128.) The brochures projected a 6%–8% pre-tax return on investment from cattle operations, but a 27%–30% after-tax return. (ER 947–948; SER 114–115.) Inasmuch as Hoyt’s own offering material explicitly described a Hoyt investment as a tax shelter and touted the tax savings to be realized, the partnerships’ argument (Br. 35–38, 40, 43) that their partners invested primarily for non-tax reasons is questionable, at best.

The 1,000 lb. Tax Shelter urged the partners to have the Hoyt organization to prepare their individual returns, purportedly because Hoyt and his staff understood the Hoyt program, how to report it, and how to defend it against the IRS at audit. (ER 953–958.) According to the brochure, Hoyt could call for a “Circle of the Wagons” (illustrated by a cartoon of a Native American labeled “IRS” about to ambush the Hoyt & Sons “Circle of Wagons”) so that no partner could be picked off to the detriment of the overall shelter. (ER 953–955.) But another reason was to make it easier for Hoyt to generate the tax reductions out of which he got paid.

Upon joining a Hoyt partnership, a new partner provided his tax materials to the Hoyt organization, which would assign to the partner sufficient Hoyt deductions and credits to eliminate the partner’s taxes for the current year and for the previous three years through carryback deductions. (ER 361– 365; SER 114–115.) The partner would then pay Hoyt 75% of the resulting tax savings as his “capital contribution” to his partnership. (ER 362–365; SER 114–115.) For future years, Hoyt claimed that “[i]f a Partner needs more or less Partnership loss any year, it is arranged quickly within the office without the Partner having to pay a higher fee while an outside preparer spends more time to make the arrangements.”¹³ (ER 955.) The partner would then send Hoyt 75% of the tax savings that Hoyt claimed to have generated, keeping the remaining 25% as a return on investment. (ER 362–365, 944; SER 88–89, 115, 133–134.) And, as this Court stated in holding that a non-Hoyt partnership lacked a profit motive, “the tax losses occurred almost exactly as predicted in the offering memorandum.” Hill, 204 F.3d at 1218.

¹³ The Hoyt partners in Bales conceded that Hoyt’s after-the-fact reallocations were impermissible. Bales, 58 T.C.M. at 435, 449. 3093738.3

- 34 The importance of tax-funded partner payments to the Hoyt organization is demonstrated by the fact that, when the IRS began freezing the partners’ Hoyt refunds in 1993, the Hoyt organization began to experience financial difficulties because “[f]reezing the tax refunds greatly diminished the amount of money the Hoyt organization obtained from new and existing partners.” (SER 8.) Partners were even instructed to adjust their income-tax withholding so that they could kept all of their wages and the IRS could not intercept their refunds. (ER 837–838; SER 90–95, 139– 142, 151, 160–163.) The partnerships argue that the transactions were valid but for Hoyt’s fraud. (Br. 26, 32, 36–37, 41, 47, 55.) But the partnerships and their sheep-purchase transactions cannot be separated from the fraud; they lacked economic substance and were shams precisely because of Hoyt’s fraud. It is well established that “a transaction is to be given its tax effect in accord with what actually occurred and not in accord with what might have occurred” had the transaction been executed differently. Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 148–49 (1974); Founders Gen. Corp. v. Hoey, 300 U.S. 268, 275 (1937) (“To make the taxability of the transaction depend upon the determination whether there existed an alternative form which the statute did not tax would create burden and uncertainty”).

The Tax Court correctly found that the partnerships had no purpose beyond the generating the tax benefits promised by Hoyt in his promotional materials, and that they were shams lacking in economic substance. (ER 28.) Tax-motivated interest is therefore applicable to any partner underpayments in excess of $1,000 attributable to the sham nature of the partnerships and their transactions.

3. The partnerships’ arguments about their individual partners are irrelevant and, ultimately, meritless

The partnerships argue (Br. 6–22, 26, 35–46, 54–56) that the motives and actions of their individual partners are relevant to the Tax Court’s partnership-level determinations regarding the nature of the partnerships and their sheep-purchase transactions. That partner-level argument has no place in this partnership-level proceeding where the only issue is the nature of the partnerships’ transactions. It seeks consideration of matters beyond the Tax Court’s jurisdiction, is not supported by the text of I.R.C. § 6621(c), and is contrary to precedent.

The Tax Court’s jurisdiction in this partnership-level proceeding was limited to ruling on partnership items like the nature of the partnerships’ transactions. (See SER 42.) The Tax Court made those findings, which will be relevant to the later resolution at the partner level of the issue whether each individual partner is liable for § 6621(c) interest. See Nault v. United States, 517 F.3d 2, 5, 8 (1st Cir. 2008) (no jurisdiction in partner-level case to revisit decision that partnership transactions lacked economic substance). But the Tax Court did not determine — and indeed lacked jurisdiction to determine — the interest liability of the individual partners. If a partner believes that his motive is a defense to § 6621(c) interest, he must make that argument in a later, partner-level proceeding.

In any event, I.R.C. § 6621(c) contains no reference to an individual taxpayer’s motives. Tax-motivated interest applies when there is an underpayment in excess of $1,000 attributable to tax-motivated transactions. Section 6621(c)(3) defines “tax motivated transactions” as including “any valuation overstatement (within the meaning of section 6659(c))” and “any sham or fraudulent transaction,” a definition that focuses on the transaction, not the taxpayer. Here, the partnerships’ sheep-related deductions and credits are not allowable because the sheep-purchase transactions orchestrated by Hoyt and Barnes overvalued the sheep and lacked economic substance. The disallowances of those passthrough items on the individual partners’ returns (and any resulting underpayments) are attributable to the sham nature of Hoyt’s transactions, not to the partners’ motives in joining the partnerships.

This Court and other courts of appeals have likewise held that the relevant inquiry focuses on the nature of a partnership’s transactions, not on the individual partners’ motivations for investing. “[B]y its plain language

I.R.C. § 6621(c) imposes no inquiry into the taxpayer’s investment motive when the transaction is found to be a sham.” Thomas v. United States, 166 F.3d 825, 832, 834 (6th Cir. 1999). See also Hill, 204 F.3d at 1220; Thompson v. United States, 223 F.3d 1206, 1212–13 (10th Cir. 2000); Chakales v. Commissioner, 79 F.3d 726, 727–28 (8th Cir. 1996). And if the inquiry progresses beyond the sham nature of a transaction to the question of profit motive, “it is well established that the determination of an existing profit motive is made at the partnership level and does not address the subjective intent of the particular partner in question.” ¹⁴ Hill, 204 F.3d at 1218; Wolf, 4

¹⁴ The cases that the partnerships rely on (Br. 55–56) are not to the contrary. In both Casebeer, 909 F.2d at 1361–64, and Rice’s Toyota World, Inc. v. Commissioner, 752 F.2d 89, 90–92 (4th Cir. 1985), the taxpayers did not invest in a partnership but instead personally engaged in the tax-shelter transaction at issue. 3093738.3

F.3d at 713 (same); Polakof v. Commissioner, 820 F.2d 321, 323 & n.3 (9th Cir. 1987) (same).

II

The Commissioner issued FPAAs within the six-year limitations period for assessments applicable when a partner, with an intent to evade tax, participates in the preparation of a partnership tax return that includes a false or fraudulent item

Standard of review

This Court reviews the Tax Court’s factual determinations, including its determinations regarding intent to evade taxes, under the clearly erroneous standard. Maciel v. Commissioner, 489 F.3d 1018, 1027 (9th Cir. 2007); Estate of Trompeter v. Commissioner, 279 F.3d 767, 770 (9th Cir. 2002).

A. The limitations period for assessments is extended when partnership returns contain false or fraudulent items

Section 6229 of the Code extends the usual limitations period for assessments (I.R.C. § 6501) to provide a minimum period for making assessments against partners for income taxes and related liabilities attributable to partnership and affected items. AD Global Fund v. United States, 481 F.3d 1351, 1352, 1354 (Fed. Cir. 2007). Section 6229 states that the period for partnership-related assessments shall not expire before three years after the filing of a partnership return (or its original due date if the return is filed early). I.R.C. § 6229(a).

The remaining subsections of § 6229 address circumstances under which that minimum period can be extended, suspended, or adjusted. If the Commissioner timely issues an FPAA, the running of the remainder of the limitations period for assessments is suspended during the period within which a Tax Court petition can be filed, during the pendency of any ensuing litigation, and for one year thereafter.

I.R.C. § 6229(d). At issue here is I.R.C. § 6229(c)(1), which establishes at least a six-year limitations period for all partners “[i]f any partner has, with the intent to evade tax, signed or participated directly or indirectly in the preparation of a partnership return which includes a false or fraudulent item.” For the 1987 through 1989 years of four partnerships, the Commissioner sent the FPAAs more than three but less than six years after the filing of the partnerships’ returns.¹⁵ (ER 5.) The Tax Court correctly held that the FPAAs were timely because Hoyt’s fraud in the preparation of the partnerships’ tax returns triggered the six-year limitations period for assessments. (ER 37–48.)

¹⁵ The Tax Court upheld an unlimited extension signed by Hoyt in 1987 for RCR#4’s 1984 tax year. (ER 37.) The partnerships do not challenge that holding on appeal. (Br. 3 n.5.) 3093738.3

B. Hoyt, the TMP of each partnership, with an intent to evade tax, participated in the preparation of partnership tax returns that included false or fraudulent items

As the Tax Court explained, the six-year limitations period for assessments of I.R.C. § 6229(c) applies if four requirements are met: (1) the entity is a partnership; (2) the partnership’s return includes a false or fraudulent item; (3) a partner signed or participated directly or indirectly in the preparation of the return; and (4) the partner signed or participated with the intent to evade tax. (ER 38–39.) Transpac Drilling Venture 1983-2 v. United States, 83 F.3d 1410, 1414 (Fed. Cir. 1996), aff’g, 32 Fed. Cl. 810 (1995) (Transpac83-2).

There can be no dispute here that the first three requirements of I.R.C. § 6229(c) have been satisfied. (ER 39–40.) The parties stipulated that “[p]etitioners are partnerships,” that “Hoyt was the tax matters partner (TMP) of each of the Sheep Partnerships from the time of their formation through the taxable periods at issue,” that during the same time “Hoyt was a general partner responsible for the management and operations of each of the Sheep Partnerships,” and that “Hoyt was responsible for and directed the preparation of each of the Sheep Partnerships’ U.S. Partnership Return of Income, Form 1065, for the periods at issue, although he may not personally have prepared each return.” (ER 913–915.) The partnerships have also acknowledged by their stipulated admissions that all of the partnership returns contained false or fraudulent items, including interest and depreciation deductions claimed for overvalued and nonexistent sheep. (ER 39, 915, 918–925.) Their unexplained suggestion that the returns could somehow be accurate even though the underlying documents were false is absurd. (Br. 25, 28, 31–32, 34, 36.)

The only issue remaining is whether Hoyt signed or participated in preparing the returns with the intent to evade tax. There is no requirement that the signer of a partnership return intend to evade his own taxes, or that the other partners know of the false or fraudulent nature of the items claimed on the partnership return. Transpac83-2, 83 F.3d at 1414–15. Because of the flow-through nature of partnership tax items, the individual Hoyt partners received the benefits of the partnerships’ false or fraudulent deductions and credits. I.R.C. §§ 701, 6031; Treas. Reg. §§ 1.701-1, 1.702

1. In other words, the intent of the signer to evade the taxes of the other partners satisfies the intent element. Transpac83-2, 83 F.3d at 1414–15; cf. Allen v. Commissioner, 128 T.C. 37, 40, 42 (2007) (fraudulent nature of the return itself extends the limitations period).

Although the Commissioner must prove intent to evade by clear and convincing evidence, he can do so by indirect or circumstantial evidence because intent to evade is rarely established by direct evidence. (See Br.

28–30.) Maciel, 489 F.3d at 1026; Laurins v. Commissioner, 889 F.2d 910, 913 (9th Cir. 1989); Bradford v. Commissioner, 796 F.2d 303, 307 (9th Cir. 1986). Examples of the “badges of fraud” include sophistication in tax and business matters, inadequate records, consistent and substantial understatement of tax liability, failure to cooperate with tax authorities, and implausible or inconsistent explanations of behavior. Estate of Trompeter, 279 F.3d at 773; Laurins, 889 F.2d at 913; Bradford, 796 F.2d at 307; Bahoric v. Commissioner, 363 F.2d 151, 153–54 (9th Cir. 1966). Ample evidence supports the Tax Court’s finding of intent here.

Hoyt was sophisticated in tax and business matters. He had studied agricultural economics and beef cattle management for two years at the University of California at Davis, and he was an IRS enrolled agent who understood the Code and its requirements. (ER 1064, 1071.) He ran a large and complex ranching operation. (ER 415, 579–581, 597–599, 611–621, 664–665, 739–741, 1405–1406.) He drafted the marketing material for the partnerships, was “well versed in tax law and procedures,” and had a “fine command of many technical issues” as demonstrated by his correspondence with the IRS. (ER 1064, 1071.) When sentencing Hoyt, the district court stated that he had “engaged in about every form of deceit that was conceivable,” that he was “the craftiest criminal that I’ve ever sentenced, ever, in 38 years on the bench with 10,000 criminals I’ve sentenced,” and that he had “the most brains” and had “used the most manipulation that I’ve ever experienced.” (ER 1356–1357.)

Hoyt had total control over the partnerships. (See ER 913–915.) The district court stated at sentencing that “[t]here was no one else in this organization that knew what was going on except” Hoyt. (ER 1357.) An IRS memorandum similarly concluded that Hoyt had complete control over the ranching, financial, and tax aspects of the partnerships. (ER 1070–1071.) Those findings are reinforced by the testimony of David Barnes. According to Barnes, Hoyt approached him with the idea of sheep partnerships, and Hoyt formed the partnerships. (ER 1365; SER 69–70.) Barnes stated that the cattle and sheep partnerships were operated the same way out of the Hoyt offices in Burns, Oregon. (SER 89–90, 97; Br. 6.) Partner payments were processed in Burns under Hoyt’s control, and only after processing did

Barnes Ranches receive checks from Hoyt entities. (ER 1366, 1385–1387; SER 72–73, 77–87, 90.) Barnes Ranches did not track and had no way of knowing whether it was getting its fair share of the money.

(Ibid.) Barnes testified that Hoyt was responsible for preparing the bills of sale from lists of ewes sent by Barnes Ranches, determining when there were a sufficient number of partners for each partnership, doing the paperwork, monitoring the partnerships’ notes, and assigning partnership losses to the partners. (ER 1364; SER 74–76, 82.) Barnes relied on Hoyt, and he followed instructions received from Hoyt. (ER 1387–1388; SER 78, 83–85.) Finally, Barnes stated that Hoyt never told him the number of partners, only wanted to know the number of sheep available, and assured Barnes that there were enough sheep. (ER 1366, 1386–1387; SER 82.)

Hoyt’s intent to evade taxes is further demonstrated by the nature of his scheme, discussed in the previous section (see pp. 24–35, supra). The Hoyt sheep partnerships and their transactions were shams lacking in economic substance designed to claim false and fraudulent tax-reduction items attributable to nonexistent and overvalued sheep and to funnel the resulting tax savings into the Hoyt organization’s coffers. See Transpac832, 32 Fed. Cl. at 821 (sham nature of shelter supports finding of intent to evade). As this Court stated in the first appeal, Hoyt claimed “phony tax benefits for the partnerships, on which his partners relied for purposes of their individual tax returns.” (SER 38.)

The Hoyt organization’s records were aptly described by the Tax Court as “inaccurate, unreliable, and in many instances falsified.” (ER 9.) Hoyt’s computerized data systems and his enrolled-agent status showed that he knew what records to keep and how, and Hoyt’s excuse of poor bookkeeping practices was untenable because “his so called ‘errors’ are performed with such consistency, that they represent deliberate attempts to avoid taxes and to defraud investors.” (ER 1070.) The Tax Court in RCR#4 echoed that sentiment when it found “incredible” and “unworthy of belief” the partnerships’ argument that Hoyt and Barnes (both experienced businessmen and longtime breeders) “had unknowingly participated in the issuance of unreliable sales documents” or had remained unaware over the years of the problems with those documents. (SER 55, 59.) The court further stated that there was no reason for Hoyt’s flock recap sheets to be prepared in such a “highly deficient” manner, and that “the Court believes that the flock recap sheets were prepared in this manner because the requisite number of specific breeding sheep did not exist and could not, in fact, be assigned to each partnership.” (SER 56.) Had the sheep existed, Barnes Ranches would not have kept inadequate records, and Hoyt would not have accepted such deficient recordkeeping regarding the sheep owned by his partnerships. (SER 59.)

Finally, Hoyt was in charge of his organization’s tax office, and he directed the preparation of the partnerships’ returns. (ER 356–357, 915; SER 55.) Because partnerships are pass-through entities, their returns (Form 1065) must be prepared first, before preparing the Schedules K-1 sent to the partners to inform them of the partnership items being passed through for inclusion on their own returns (Form 1040). See Internal Revenue Service, Instructions for Form 1065 at 21 (2007). Hoyt did the opposite. Henry Nathaniel (who prepared partner returns for Hoyt from 1984–1994 and then partnership returns until 1996) testified that the partner returns were prepared before the partnership returns and without the benefit of Schedules K-1 or other specific information regarding partnership expenses. (ER 356–360, 363, 365; see also ER 846, 848, 1067, 1070.) Instead, the partners’ returns were prepared using their non-Hoyt information, and then sufficient Hoyt items were “special allocated” (i.e., plugged in) to the returns to eliminate or to reduce greatly the partners’ liabilities. (ER 361–365, 1067–1070.) See also Hansen, 471 F.3d at 1025 n.4 (Hoyt reported “grossly exaggerated” depreciation expenses on partner returns, and would “‘plug in’ fake interest expenses, which expenses were conveniently sufficient to reduce to zero partners’ tax liability”). The fictitious Hoyt items allowed the partners to secure promptly the refunds out of which they funded their 75%-of-tax-savings payments to Hoyt. (ER 1067–1070.) Hoyt would then seek extensions for the partnership returns, falsely claiming that he needed third-party information to complete the returns. (ER 1070.)

The combination of the Hoyt organization’s bad records and its backward method of preparing tax returns was virtually guaranteed to result in the placement of false and fraudulent items on the partnership returns and in the evasion of the partners’ taxes. An April 26, 1989 IRS memorandum explains that a computer analysis of partnership returns “demonstrated that the returns on their face were fabricated.” (SER 99.) Hoyt invented income and expenses that cancelled each other out, leaving only depreciation and interest deductions. (Ibid.) When shown this analysis, an accountant representing Hoyt “admitted that they had fabricated the expenses to hide the flimsy nature of the shelter.” (Ibid.) An IRS agent testified about, and the partnerships have admitted to, instances in which Hoyt would first report a large deduction on a loyal partner’s return, and then (after the partner had left the partnership) file a partnership return with a Schedule K-1 reporting substantial income for the partner. (ER 846–847; Br. 22–23.) The Tax Court in RCR#4 reported that Hoyt had delayed for several years reporting income that two partnerships had purportedly received from selling breeding value certificates. (SER 62–63.) It also found that RCR#3 had claimed farming-expense deductions in 1987, 1988, and 1989, even though its Hoyt-prepared flock recap sheet indicated that it had no breeding sheep by 1987. (SER 56; see also ER 54, 57, 940.)

The partnerships argue that Hoyt was convicted of fraud other than tax fraud, that Hoyt was at most negligent in preparing the partnership returns, that he possibly was a victim of fraudulent misrepresentations by Barnes, and that the record lacks specific, return-by-return evidence of Hoyt’s intent. (Br. 5, 23–25, 28–33, 35–36, 47–53.) But these arguments erroneously disregard the overwhelming evidence that Hoyt was the controlling mastermind behind one of the largest tax shelters in the country and “the most egregious white collar crime committed in the history of the State of Oregon,” and that an integral part of his scheme was to game the tax system, year after year, to obtain the refunds necessary to fund it. (ER 1350, 1357; SER 99.) If a partnership is a continuing enterprise operated the same way over time, and if fraudulent tax items are an integral part of the same scheme for creating fictitious losses for the partners, then the partnership must point to some evidence indicating that the relevant partner was honest for the year at issue to avoid the six-year limitations period. Transpac83-2, 83 F.3d at 1415. As this Court explained, “a pattern of conduct over a course can be applied to its segments,” and although the partnerships might try to prevail “by compartmentalizing the elements and going to work on each singly,” “in the end, they must all be brought together.” Bahoric, 363 F.2d at 154.

Given the record as a whole, the partnerships’ argument that the partnership returns were somehow a small island of honesty in the ocean of Hoyt’s deceit is untenable. The Tax Court correctly found that the record established by clear and convincing evidence that Hoyt knew that the partnership returns contained false and fraudulent deductions and that he intended income tax to be evaded at the partner level. Accordingly, under I.R.C. § 6229(c)(1), the six-year limitations period for assessments applies and the FPAAs at issue were timely issued within that period.

III

In the alternative, Hoyt executed valid consents to extend the limitations period for assessments, and the FPAAs were timely issued within that period

Standard of review

This Court reviews de novo the Tax Court’s interpretation of the Internal Revenue Code and the Treasury regulations. Metro Leasing & Dev. Corp. v. Commissioner, 376 F.3d 1015, 1021 (9th Cir. 2004). The issue whether Hoyt had a conflict of interest sufficient to invalidate his consents to extend the limitations period for assessments presents a mixed question of fact and law that is also reviewed de novo. See Earp v. Ornoski, 431 F.3d 1158, 1182 (9th Cir. 2005).

A.

If this Court affirms the Tax Court’s decision regarding the six-year limitations period for assessments, it should vacate as unnecessary the Tax Court’s alternative holding that extensions signed by Hoyt were invalid

In its first opinion in this case, the Tax Court upheld Hoyt’s consents to extend the limitations period for assessments against a claim that Hoyt had a disabling conflict. (SER 25–30.) The court stated, inter alia, that Hoyt was not under investigation for tax crimes when he executed the extensions, and that any violations by Hoyt of his general partnership duties had only “a remote and highly attenuated connection, at best, to his execution as TMP of the extensions in dispute.” (SER 29.) This Court vacated and remanded for further discovery, positing a potential conflict between Hoyt’s desire to delay “as long as possible any threat to the house of cards he had constructed,” and the partners’ interest in learning as soon as possible about Hoyt’s fraud. (SER 39–41.) In its opinion on remand, the Tax Court treated that hypothetical conjecture as fact, and it invalidated the extensions executed by Hoyt in March 1993 because the IRS by then “knew or had reason to know” of such a conflict. (ER 33–37.)

We respectfully submit that the Tax Court erred and that this Court should address this issue regardless of its decision on the six-year limitations period for assessments under I.R.C. § 6229(c). As we argue below, if the Court determines that the Tax Court erred in applying the six-year limitations period of I.R.C. § 6229(c), it should nevertheless affirm on the alternative ground that Hoyt’s consents to extend the limitations period for assessments were valid and the FPAAs were issued within the extended period.¹⁶ Furthermore, even if ¹⁶ The partnerships argue (Br. 58) that this Court cannot consider (continued...) 3093738.3 this Court affirms (as it should) the Tax Court’s decisions based on the six-year period, it should vacate the Tax Court’s other ruling. See Cardinal Chem. Co. v. Morton Int’l, Inc., 508 U.S. 83, 95–98 (1993) (affirmance on one ground does not render moot other grounds for affirmance). The Tax Court’s conclusion on the conflict-of-interest issue was unnecessary to its ultimate holding that the FPAAs were issued while the period for assessment was still open. But the Tax Court or other courts might treat the ruling as having precedential or persuasive effect in future litigation. Indeed, this has already happened in another Hoyt case. See In re Martinez, 366 B.R. 604 (Bankr. E.D. La. 2007), aff’d, 382 B.R. 285 (E.D. La. 2007), appeal pnd’g, 5th Cir. Nos. 07-31163 & 08-30136. Therefore, this Court should vacate the conflict of-interest ruling as unnecessary to the ultimate decisions.

¹⁶ (...continued)this issue in the absence of a cross appeal, but an appellee can seek affirmance on any ground supported by the record so long as it does not enlarge its own rights or lessen those of the appellant. El Paso Natural Gas Co. v. Neztsosie, 526 U.S. 473, 479 (1999).

3093738.3

B. If this Court rejects the Tax Court’s holding regarding the six-year limitations period for assessments under I.R.C. § 6229(c), it should affirm on the alternative ground that Hoyt validly consented to extend the limitations period

1. The Tax Court’s ruling is contrary to the detailed Treasury regulations promulgated to facilitate the resolution of partnership tax disputes

In our tax system, issues are normally raised, investigated, and resolved in audits and, if necessary, litigation. See Abelein v. United States, 323 F.3d 1210, 1214 (9th Cir. 2003); Delpit v. Commissioner, 18 F.3d 768, 770, 772 &

n.3 (9th Cir. 1994). The ultimate purpose of an audit and any resulting litigation is to determine the truth about the tax items at issue. See United States v. Bisceglia, 420 U.S. 141, 145–46 (1975); Lopez v. United States, 373 U.S. 427, 440 (1963). As explained in section I.A., supra, Congress enacted the TEFRA partnership provisions to make partnership audits and litigation more efficient and to secure the consistent resolutions of issues among the partners.

The tax matters partner (TMP) is the central figure of the TEFRA partnership proceedings. (SER 26.) Although a partnership usually designates its own TMP, the Code also contains a default selection rule, and it allows the IRS to choose a TMP as a last resort. I.R.C.

§ 6231(a)(7); Temp. Treas. Reg. § 301.6231(a)(7)-1T.¹⁷ The powers granted to the TMP by TEFRA include the ability to extend the limitations period for tax assessments with respect to all partners by an agreement with the IRS. I.R.C. § 6229(b)(1)(B). The removal of a TMP does not affect the validity of any of his actions before the removal, including (by specific example) his extensions under I.R.C. § 6229(b)(1). Treas. Reg. § 301.6231(a)(7)-1T(l) (flush text).

A TMP for a tax year remains TMP until one or more specified events occur. A partnership may terminate a TMP and select a new one. Treas. Reg. § 301.6231(a)(7)-1T(j). A TMP is also removed if “[t]he partnership items of the tax matters partner become nonpartnership items under section 6231(c) (relating to special enforcement areas).” Treas. Reg. § 301.6231(a)(7)-1T(l)(4). In turn, I.R.C. § 6231(c)(1) contains a list of “special enforcement areas” pursuant to which the IRS can remove a partner (including a TMP) from a unified TEFRA proceeding by treating his partnership items as nonpartnership items. The statute also allows the IRS to designate other special enforcement areas by regulation.

¹⁷ The final regulation (effective December 26, 1996 (see T.D. 8698, 61 Fed. Reg. 67,459 (Dec. 23, 1996))) preserved subsections (a)through (m) of the temporary regulation with minor stylistic changes. See Treas. Reg. § 301.6231(a)(7)-1. 3093738.3

None of the listed items triggers an automatic removal. Instead, the IRS must “determine[] and provide[] by regulations that to treat items as partnership items will interfere with the effective and efficient enforcement” of the tax laws, and the IRS can “prescribe by regulation such special rules as the Secretary determines to be necessary to achieve the purposes of [TEFRA] in any case described in [§ 6231(c)(1)].” I.R.C. § 6231(c)(2), (3). In other words, the IRS can remove a partner from a TEFRA proceeding, but only when necessary to allow the proceeding to move forward.

Thus, Congress expressly delegated to the IRS the authority not only to determine the manner in which TMPs are selected, but also to issue regulations identifying “special enforcement considerations” and formulating “special rules” governing those areas. I.R.C. § 6231(a)(7)(A) & (c)(1)(E), (3). The regulations at issue here are therefore specific-authority regulations and should be given controlling weight unless they are arbitrary, capricious, or manifestly contrary to the statue. Chevron USA, Inc. v. Natural Res. Def. Council, Inc., 467

U.S. 837, 843–44 (1984). The scope of review under that standard is narrow: the agency can use its experience and expertise to choose among reasonable policy alternative, and courts should not substitute their judgment for the agency’s. Federal Express Corp. v. Holowecki, 128 S. Ct. 1147, 1158 (2008); National Cable & Telecomm. Ass’n v. Brand X Internet Servs., 545 U.S. 967, 980 (2005); Motor Vehicle Mfrs. Ass’n v. State Farm Mut. Auto Ins. Co., 463 U.S. 29, 43 (1983).

The Code, the temporary regulation in effect at the time relevant to this case, and the final regulation in effect today neither identify potential “conflicts of interest” between the TMP and the other partners as a special enforcement area nor provide a mechanism for the IRS to remove a TMP on the basis of real or suspected conflicts of interest. ¹⁸ See I.R.C. § 6231(c); Temp. Treas. Reg. §§ 301.6231(c)-4T to 301.6231(c)-8T; Treas. Reg. §§ 301.6231(c)-4 to 301.6231(c)-8. This reflects a determination by the IRS, based on the criteria established by the statute authorizing the regulation

(I.R.C. § 6231(c)), that it is not necessary for the effective and efficient enforcement of the internal revenue laws for the IRS to police conflicts of interest. That decision is reasonable, inasmuch as a primary purpose of TEFRA is to streamline

¹⁸ The only special enforcement area implicated here is the IRS’s criminal investigations of Hoyt. Hoyt, however, was not under investigation when he signed the consents to extend invalidated by the Tax Court, and the court did not invalidate the consents because of the investigations. (ER 37; SER 29.) Moreover, it has been held in Hoyt cases that criminal investigations do not require automatic removal. Phillips v. Commissioner, 272 F.3d 1172, 1175–76 (9th Cir. 2002);Mekulsia v. Commissioner, 389 F.3d 601, 603–06 (6th Cir. 2004).

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and centralize partnership proceedings for practical convenience. The Tax Court erred in not giving it the Chevron deference to which it is entitled.

This Court has recognized that the TMP is a statutory creation, but it has also stated that he owes a fiduciary duty to his partners and that his actions in breach of that duty can be invalidated. (SER 39.) Phillips, 272 F.3d at 1175. The dilemma is that the IRS often has to deal directly with a TMP, and there is no practical difference between a ruling that the IRS must remove a TMP and a ruling that the IRS must treat a TMP as removed by disregarding his actions. Perhaps the best way to reconcile the seeming conflict between the regulation and the precedent is to view the TMP as having a mostly administrative, rather than a fiduciary, role. Thus, an action by a TMP should not be invalidated unless it is part of an effort to disrupt or delay inordinately the TEFRA procedures for arriving at the truth in partnership cases. As we will show, the extensions to which Hoyt consented pass that test.

2. The conflict-of-interest standard employed by the Tax Court is unjustified

As noted above, the Tax Court invalidated the extensions that Hoyt signed in March 1993 because it believed that the IRS “knew or had reason to know that Hoyt’s interest in extending the period within which [the Commissioner] could issue the FPAAs was in conflict with the investor-partners’ interest in not delaying the issuance of the FPAAs.” (ER 36–37.) The Tax Court assumed that a short audit resulting an early FPAA would benefit the partners because such an FPAA would be harder for the IRS to defend in court, and that a long audit would be in Hoyt’s interest because it would delay discovery of his fraud. (See SER 41.) This is not necessarily so.

One need look no further than the 1989 Bales opinion to see the dangers arising from the IRS’s losing a tax-shelter case. In Bales (involving tax years mostly from the late 1970s), the Tax Court declined to disregard the Hoyt partnerships and their transactions for lack of economic substance. Bales v. Commissioner, T.C. Memo. 1989-568, 58 T.C.M. (CCH) 431. As recognized by the Tax Court and by this Court, Bales was a “major setback” for the IRS’s enforcement efforts against Hoyt. (SER 7, 40.) It was not until after the completion of the livestock count in 1993, and further trials in 1996 and 1997, that the IRS in 1999 won its first victory on the merits of the Hoyt program. (SER 44–66.) An IRS victory in Bales could have accelerated the end of Hoyt’s scheme by a decade. Instead, Hoyt used the Bales opinion as part of his marketing and partner-retention efforts. (E.g., Br. 17; ER 1412–1414; SER 95, 98, 143– 150, 152–158.) As IRS officials stated, “[e]ach time we attempt to provide meaningful information to the investors in an attempt to discredit Hoyt, he promptly begins to wave the Bales decision around and tells the investors that we’re not being entirely truthful.” (ER 1059.) Thus, contrary to the Tax Court’s unfounded assumption, an IRS loss because of a premature FPAA can benefit a shelter promoter while actually postponing the day that the investors finally learn the truth.

There is also no indication that the delay in issuing the instant FPAAs from March to December 1993 affected the decisions of the investor partners. Hoyt’s own promotional materials warned that the IRS would brand the Hoyt shelter as an “abuse,” subject it to “automatic” and “constant” audit, and even ambush it in such a way that the partners needed the security of the Hoyt & Sons “Circle of Wagons.” (ER 953–958.) Hoyt’s brochure also warned that the partners might be required to pay back their tax savings plus penalties and interest, and it used the phrase “head torn off” to describe “the prospect of having to pay the taxes back when you have put the tax money into a tax shelter, and its gone.” (ER 948, 950.) The partnerships thus err when they argue (Br. 13–15) that the partners were not warned of the tax risks of a Hoyt investment. The IRS began auditing the Hoyt partnerships in approximately 1980, and began issuing notices of deficiency, FPAAs, and other warnings as early as 1982. (SER 7–8, 100–105.) See Bales, 58 T.C.M. at 431 (listing docket numbers beginning with 12479-82). The IRS also sent the partners prefiling notices and began freezing their Hoyt tax refunds in early 1993. (SER 8.) There is no basis for assuming that issuance of another round of FPAAs would have suddenly enlightened the partners who were otherwise inclined to remain loyal to Hoyt. (See SER 21–22.)

This case also stands in sharp contrast to the only appellate case setting aside extensions based on a disqualifying conflict — Transpac Drilling Venture 1982-12 v. Commissioner, 147 F.3d 221 (2d Cir. 1998) In that extreme case, the TMPs came under criminal investigation, became cooperating witnesses, were granted immunity from prosecution, were ordered by the IRS not to reveal the existence of the criminal investigation (the IRS responded to questions from the limited partners by telling them to talk to the TMPs), and consented to extensions that most of the individual limited partners had refused to grant when asked by the IRS. Id. at 223–24, 227. The Second Circuit invalidated the extensions, stating that the TMPs had “a powerful incentive to ingratiate themselves to the government” and finding it “especially disquieting” that “the Commissioner knew that the extensions were unwanted by the limited partners for whom the TMPs were purporting to act.” Id. at 227. In other words, the IRS created an actual and severe conflict of interest, disrupted the truth-discovery purpose of the audit by keeping the limited partners in the dark, and then sought to profit from its own actions to the detriment of the limited partners. The Second Circuit essentially held that the IRS was estopped from relying on consents obtained under such circumstances. Cf. Phillips, 272 F.3d at 1175; Madison Recycling Assocs. v. Commissioner, 295 F.3d 280, 282–83, 289 (2d Cir. 2002).

In sum, the premise of the Tax Court’s finding of a conflict of interest is erroneous. It can be in the best interests of the partners to tolerate the delays needed for the IRS to uncover the truth in a proper audit, and the three years allowed for assessments in ordinary cases might not be sufficient in a case involving fraud. Badaracco v. Commissioner, 464 U.S. 386, 399 (1984). The invalidated extensions did not disrupt the audits or inordinately delay the issuance of the FPAAs, which the IRS issued within the six years allowed by Congress in cases involving partnership returns containing false or fraudulent items. I.R.C. § 6229(c).

The conflict-of-interest standard employed by the Tax Court creates other practical difficulties for the IRS in partnership audits. Tax-shelter schemes often use partnerships or other pass-through entities, and the shelter promoter (often the only general, active partner) routinely acts as TMP. But when the promoter is the TMP, there is always a potential conflict of interest with the other investors. The promoter wants to sell his scheme and get paid; the investors want their deductions upheld in the long run.

Because the promoter-investor conflict is inherent in tax-shelter schemes, the IRS would always be at risk of having its dealings with the TMP invalidated under the “reason to know” aspect of the Tax Court’s standard because it would always suspect a conflict. (ER 37.) As illustrated by this case involving tax years from the 1980s and extensions signed in 1993, TEFRA proceedings can take a long time. See also Fargo v. Commissioner, 447 F.3d 706, 708 (9th Cir. 2006). Under the Tax Court’s standard, tax-shelter partners could make after-the-fact, “heads I win, tails you lose” arguments. They would not object to extensions so long as their tax benefits appeared secure, but they could make eleventh-hour, conflict-of-interest arguments when their case starts to go sour. The IRS could take various steps to protect itself from the risk of losing a case many years down the road over a “routine accommodation” (Phillips, 272 F.3d at 1175), but all of those options are troublesome.

Currently, the IRS’s primary mission is to enforce the tax laws, not to protect consumers or to insure taxpayers against losses from their tax-shelter investments. See Phillips, 272 F.3d at 1174; Ertz v. Commissioner,

T.C. Memo. 2007-15, 93 T.C.M. (CCH) 696, 703. The idea of converting the IRS into a consumer watchdog might have surface appeal, but the IRS’s fulfillment of such a mission “could well involve far less agreeable invasions of house, business, and records” than exist under the current system. Bisceglia, 420 U.S. at 146. The IRS would need to obtain not only the records relevant to a partnerships’ tax items, but also records necessary police the partners’ dealings with each other. And if an apparent shelter turns out to be legitimate, the IRS might face accusations of unwarranted meddling in private business affairs.¹⁹

¹⁹ Moreover, the partners are not necessarily without a remedy and may have state-law causes of action against a dishonest TMP. Indeed, a group of former Hoyt partners won a default judgment

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- 64 The IRS could amend the Treasury regulations to allow for the routine removal of promoter TMPs, but that would mean removing the one person who presumably understands the shelter, has its records, and is best-situated to be the main point-of-contact in a unified partnership proceeding. If it cannot deal with the promoter, IRS could face the difficulty and delay inherent in dealing with countless individual partners spread across the nation who lack access to the records and who cannot act on behalf of the partnership. The IRS could also face accusations that it removed the one person who understood the transaction and could defeat the IRS. Moreover, any replacement TMP could be vulnerable to the charge that he was an IRS-approved “patsy” who did not represent the partnership vigorously, thereby setting up a conflict-of-interest claims of a different sort. In this case, there is no dispute that Hoyt was the TMP of the sheep partnerships, that he extended the limitations period for assessments, and that the extensions did not suffer from technical deficiencies. There is no evidence that the extensions were part of an effort to disrupt or inordinately delay the partnership audits. The Tax Court erred in invalidating those extensions.

¹⁹ (...continued) against Hoyt in Louisiana state court. (SER 8–9.)

CONCLUSION

The decisions of the Tax Court are correct and should be affirmed.