As tax professionals, understanding the nuances of partnership taxation, particularly in distressed asset transactions, is crucial. The recent affirmations in PICCIRC, LLC and PIMLICO, LLC v. Commissioner provide critical insights into how courts scrutinize structured transactions and apply anti-abuse doctrines. This article will dissect the United States Tax Court’s original holding[^1] and the subsequent affirmance by the Second Circuit Court of Appeals[^2], highlighting key legal interpretations and their practical implications.

Factual Background of the Transaction

The case revolves around a structured distressed debt investment transaction marketed by BDO Seidman, LLP (BDO), involving Mr. John D. Howard as the investor, and Gramercy Advisors, LLC, which implemented the transaction. The core assets were distressed Brazilian trade receivables, specifically "duplicatas," originally issued by Santa Bárbara Indústria e Comércio de Ferro Ltda. (Santa Barbara) to Encol S/A Engenharia Comércio e Indústria (Encol), a company that later filed for bankruptcy.

In 2002, Santa Barbara contributed these Encol receivables into a tiered partnership structure. First, Santa Barbara and Gramercy Advisors formed XBOXT, LLC, with Santa Barbara holding a 99% interest in exchange for the receivables. Second, XBOXT and Tall Ships Capital Management, LLC (an affiliate of Gramercy Advisors) formed PIMLICO, LLC, with XBOXT contributing the majority of the Encol receivables for a 99% interest. Finally, PIMLICO and Tall Ships formed PICCIRC, LLC, where PIMLICO contributed 104 Encol receivables for a 99% ownership interest.

Mr. Howard, with extensive experience in distressed assets, was pitched the transaction by BDO, with specific discussions concerning potential tax benefits and losses. He entered into a consulting agreement with BDO for $865,000, receiving an opinion letter on federal income tax consequences, and also paid a $59,836 fee to Mead Point Capital Management LLC, an affiliate of Gramercy Advisors.

A critical sequence of events unfolded in December 2002:

On December 11, 2002, Mr. Howard acquired an 89.10% membership interest in PIMLICO from XBOXT for $300,164.
On December 26, 2002, PICCIRC sold all its Encol receivables to Gramercy Financial Services, LLC, an affiliate of Gramercy Advisors, for $357,144. Mr. Howard was unaware of this sale.
On January 16, 2003, Gramercy Advisors received a fax of a letter, dated December 16, 2002, from Santa Barbara requesting a withdrawal of $300,164 of its membership interest in XBOXT.
An XBOXT account at Boston Trust, which received an internal transfer of $300,164 on December 23, 2002 (matching Mr. Howard’s payment for his PIMLICO interest), had a closing balance of only $79 by January 30, 2003. This activity strongly suggested the withdrawal was paid from these funds.

PICCIRC reported an ordinary loss of $22,718,351 from the transaction on its 2002 Form 1065, which was allocated to PIMLICO, resulting in Mr. Howard claiming flow-through ordinary loss deductions of over $20 million across 2002 and 2004. Tax opinion letters were later issued by BDO and Proskauer Rose, LLP, supporting the transaction’s economic substance and disclaiming penalties.

Taxpayer’s Request for Relief

PIMLICO, as a partner in PICCIRC, filed a Petition for review under section 6226 after the Commissioner of Internal Revenue (Respondent) issued a notice of final partnership administrative adjustment (FPAA) disallowing the $22,718,351 ordinary loss deduction claimed by PICCIRC on its 2002 return. PIMLICO contended that the transaction was not a disguised sale and that it was in compliance with the Internal Revenue Code.

The Tax Court’s Analysis and Holdings

The Tax Court, under Judge Gale, sustained the Commissioner’s determinations, including the disallowance of the loss deduction and the imposition of accuracy-related penalties.

Burden of Proof

The Tax Court first established that the Commissioner’s determinations in an FPAA are presumed correct, placing the burden on the taxpayer to prove they are erroneous. In TEFRA partnership cases, Section 7491(c), which typically places the burden of production for penalties on the Commissioner, does not apply. Therefore, PIMLICO carried the burden to show the penalty determination was incorrect.

Disguised Sale Analysis

The Tax Court applied the disguised sale rules of Section 707(a)(2)(B) and Treasury Regulation § 1.707-3. Generally, contributions to a partnership and distributions are tax-free under Sections 721 and 731, but these rules do not apply if the transaction is, in substance, a disguised sale. A disguised sale occurs if a partner contributes property and receives a related distribution that serves as consideration for the property, and the transfer of consideration would not have occurred "but for" the property transfer, and if not simultaneous, was not dependent on entrepreneurial risks.

A key aspect is the presumption of a disguised sale if transfers between a partnership and a partner occur within a two-year period, unless facts and circumstances "clearly establish" otherwise. This presumption places a "high burden" on the partnership to validate such transfers.

The Tax Court found the two-year presumption applicable:

Santa Barbara contributed receivables to XBOXT on August 1, 2002.
Santa Barbara requested a $300,164 withdrawal from XBOXT on December 16, 2002.
This $300,164 matched the amount Mr. Howard paid for his PIMLICO interest from XBOXT on December 11, 2002.
The funds transferred into XBOXT’s account on December 23, 2002, were nearly depleted by January 30, 2003, strongly indicating the payment to Santa Barbara.

The court concluded that these facts were not coincidental and that the circumstances suggested a preconceived step to shift basis to Mr. Howard. The payment to Santa Barbara was sourced from Mr. Howard’s acquisition proceeds, not operational profits, and was for the same amount as his acquisition. The court found that XBOXT was formed solely as a conduit to execute a disguised sale of the Encol receivables, and PIMLICO failed to rebut the presumption. Accordingly, the transaction was deemed a disguised sale, and the claimed loss deduction was disallowed to the extent it exceeded the correct transferred basis.

Basis in Encol Receivables

Under Section 723, the basis of contributed property to a partnership is the contributing partner’s adjusted basis at the time of contribution. The only evidence provided regarding basis was 125 duplicatas and a spreadsheet, which the court found insufficient to determine the value of the duplicatas immediately before Santa Barbara’s contribution. Consequently, the Tax Court could not determine the basis in the Encol receivables.

Validity of Partnerships

The Tax Court evaluated whether the partnerships were valid for federal income tax purposes. A partnership generally exists when parties intend to join in a trade or business and share in profits or losses, acting in good faith with a business purpose. While LLCs can be classified as partnerships by default under "check-the-box" regulations (Treasury Regulation § 301.7701-3(b)(1)), this does not automatically entitle them to Code benefits.

The court noted the stringent scrutiny applied to "abusive tax-avoidance schemes" designed to exploit partnership provisions. A partnership must display "good ’common sense from an economic standpoint’" and have a "legitimate, profit-motivated reason," with the absence of a nontax business purpose being fatal. The court found no evidence that Santa Barbara and Gramercy Advisors, or PICCIRC, PIMLICO, and Tall Ships, engaged in a common enterprise with a community of interest in profits and losses.

The Tax Court also applied the partnership antiabuse rules under Treasury Regulation § 1.701-2. These rules require partnership provisions to be applied consistently with the intent of Subchapter K, meaning the partnership must be bona fide, each transaction must have a substantial business purpose, respect substance over form, and accurately reflect partners’ economic agreement. The Commissioner has broad authority to disregard partnerships formed with a principal purpose of inconsistent tax consequences.

Relevant factors indicating disregard included:

The present value of aggregate federal tax liability for partners being substantially less than if assets were owned and activities conducted directly.
Aggregate tax liability being substantially less than if purportedly separate transactions were integrated into a single transaction.
One or more necessary partners having a nominal interest and being protected from loss.

The court found that if the transaction were integrated as a direct sale from Santa Barbara to Mr. Howard, his cost basis under Section 1012 would be significantly lower than the claimed transferred basis, leading to much smaller losses and substantially higher aggregate tax liability. Furthermore, Santa Barbara had no risk of loss, and XBOXT and PICCIRC had no activities beyond facilitating tax shelters, with Santa Barbara having only a nominal interest in XBOXT. Consequently, the Tax Court concluded that the partnerships should be disregarded for violating the partnership antiabuse rules, and that the partnerships were shams.

Accuracy-Related Penalties

The Tax Court sustained accuracy-related penalties under Section 6662, which imposes a 20% penalty for underpayments attributable to negligence, substantial understatement, or substantial valuation misstatement. A gross valuation misstatement, triggering a 40% penalty, occurs if the claimed value or adjusted basis is 400% or more of the correct amount. If the correct basis is zero, the gross valuation misstatement penalty applies.

The Tax Court determined that PICCIRC’s reported basis of $23,075,495 greatly exceeded 400% of the correct basis (which was, at most, $300,164 under the disguised sale analysis). Since PIMLICO failed to produce evidence to refute the penalty and did not address it in its post-trial briefs, the court deemed the issue conceded and sustained the penalty at the heightened rate.

Second Circuit Court of Appeals Affirmation

PIMLICO, LLC appealed the Tax Court’s final decision to the United States Court of Appeals for the Second Circuit, arguing primarily that the Tax Court erred in applying the presumption of a disguised sale and in concluding that PIMLICO did not present facts to rebut it.

The Second Circuit affirmed the judgment of the Tax Court. The appellate court reviews legal conclusions de novo and factual findings for clear error.

Disguised Sale on Appeal

The Second Circuit concurred with the Tax Court’s determination that the presumption of a disguised sale was applicable. It reiterated the factual timeline: Santa Barbara contributed duplicatas to XBOXT in August 2002; Mr. Howard purchased a part of XBOXT’s interest in PIMLICO for $300,164, reflected in XBOXT’s bank records; Santa Barbara requested a $300,164 withdrawal from XBOXT on December 16, 2002; and XBOXT’s account no longer contained those funds by January 31, 2003. The court found the natural inference was that XBOXT transferred the $300,164 received from Mr. Howard to Santa Barbara, thus confirming the contribution and distribution occurred within two years.

Regarding the rebuttal of the presumption, the Second Circuit agreed with the Tax Court that the facts and circumstances did not rebut the presumption. The court cited several factors supporting the disguised sale conclusion:

Mr. Howard’s contribution of $300,164 to XBOXT permitted the transfer of money to Santa Barbara.
Santa Barbara’s partial withdrawal was disproportionate to its continuing interests in the partnership.
The close timing and identical sums involved in the creation of the partnership, Mr. Howard’s purchase, and Santa Barbara’s partial sale were not coincidental.
The appellate court explicitly noted that these actions had the effect of engineering a tax windfall for Mr. Howard. It explained that, prior to 2004, Treasury regulations (under former Section 704(c)(1)(B) and Treasury Regulation § 1.704-3(a)(7)) allowed a new partner to buy an existing partner’s interest and claim the built-in loss from the asset contributed by the existing partner. Mr. Howard, by purchasing XBOXT’s interest, became entitled to the tax loss that XBOXT would have claimed from PICCIRC’s sale of the duplicatas.
The court stated that the circumstances surrounding Santa Barbara’s partial redemption were a "preconceived step" to shift the benefits of ownership (the tax loss) to Mr. Howard.

PIMLICO’s arguments that Santa Barbara’s contribution agreement evinced no right to distributions or that no debt was taken on were found to be not inconsistent with a disguised sale, as the regulations provide guiding inquiries rather than a mechanical checklist. The Second Circuit ultimately found no clear error in the Tax Court’s conclusion that the "distribution" to Santa Barbara would not have occurred but for the transfer of the duplicatas and was independent of the entrepreneurial risks of the partnership.

Conclusion

The PICCIRC and PIMLICO cases serve as a stark reminder of the judiciary’s rigorous scrutiny of structured transactions, particularly those involving partnership provisions designed to achieve significant tax losses. The courts’ detailed analysis and application of disguised sale rules under Section 707 and the partnership antiabuse rules under Treasury Regulation § 1.701-2 underscore the importance of genuine business purpose and economic substance.

For tax professionals, this case reinforces several key takeaways:

Transactions structured to shift basis or losses through tiered partnerships will face intense scrutiny, especially if distributions are funded by new partner contributions rather than entrepreneurial risk.
The two-year presumption for disguised sales is a significant hurdle, requiring clear evidence to rebut. The timing and matching of cash flows are critical indicators of prearranged sales.
The "check-the-box" election for LLCs does not automatically validate a partnership for tax purposes; a bona fide partnership must still satisfy the Tower-Culbertson tests of intent to conduct a business and share profits/losses.
The partnership antiabuse rules provide broad authority for the Commissioner to disregard partnerships or recast transactions if a principal purpose is to produce tax consequences inconsistent with Subchapter K’s intent. This includes situations where aggregate tax liability is substantially reduced or partners have nominal interests with no real risk.
Accuracy-related penalties, particularly gross valuation misstatements, are a high risk in these types of transactions, and the burden to disprove them in TEFRA cases rests firmly with the taxpayer.

The Second Circuit’s affirmation solidifies the Tax Court’s stance, providing further judicial precedent on how these complex tax avoidance schemes are analyzed and ultimately dismantled. Professionals advising on distressed asset investments or complex partnership structures must ensure that transactions possess true economic substance and a legitimate business purpose beyond tax benefits to withstand judicial review.

Prepared with assistance from NotebookLM.

[^1]: PICCIRC LLC et al. v. Commissioner, TC Memo 2024-50, April 22, 2024

[^2]: PIMLICO LLC v. Commissioner, CA2 Case No. 23-1982, August 11, 2025