Response Brief Filed in Castle Harbour Redux

On September 14, 2010, the tax matters partner (“TMP”) for Castle Harbour LLC filed its response brief in TIFD III-E Inc. v. United States, No. 10-70 (2nd Cir.) (brief linked below).  For our prior coverage of this case, see here.  As many readers are no doubt aware, this is the second time this case is before the Second Circuit.

In the response brief , the TMP frames the issues as: (1) whether the district court, upon remand, correctly determined the investment banks were partners under I.R.C. section 704(e)(1), (2) whether the IRS can reallocate income under I.R.C. section 704(b) despite the section 704(c) “ceiling rule,” and (3) whether the district court correctly decided that I.R.C. section 6662 accuracy-related penalties were not applicable.

First, the TMP argues that section 704(e)(1) creates an independent, objective alternative to the Culbertson test, with the critical issue being whether the purported partner holds a “capital interest.”  The TMP contends that, because the banks’ interests were economically and legally equivalent to preferred stock, and because preferred stock is treated as equity for tax purposes even though it possesses many characteristics of debt, the banks held “capital interests” under section 704(e)(1).  Accordingly, the TMP argues that the banks were bona fide partners in Castle Harbour, the Second Circuit’s application of Culbertson notwithstanding.

Second, the TMP contests the IRS’s ability to reallocate income under I.R.C. section 704(b) in spite of application of the section 704(c) ceiling rule (assuming the banks were bona fide partners).  The regulations under section 704(c) were amended to allow such a reallocation for property contributions occurring after December 20, 1993, which is after the contributions at issue in the case.  Accordingly, the TMP takes the position that the IRS is attempting an end-run around the effective date of the amended regulations.

Finally, the TMP also argues that victory at trial, based on the careful findings of fact by the district court, demonstrates that the transactions were primarily business-motivated, and furthermore, that substantial authority existed for the TMP’s return position.  Accordingly, the TMP contends that accuracy-related penalties should not apply, even if the IRS’s adjustment is ultimately upheld.

Taxpayer Response Brief in Castle Harbour II