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IRS Files Answer to 5-Hour Energy Company’s Tax Court Petition

MAY 28, 2019

Innovation Ventures LLC et al. v. Commissioner

DATED MAY 28, 2019
DOCUMENT ATTRIBUTES

Innovation Ventures LLC et al. v. Commissioner

INNOVATION VENTURES, LLC, MANOJ BHARGAVA, TAX MATTERS PARTNER,
Petitioners,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent

RESPONDENT'S ANSWER

UNITED STATES TAX COURT

ANSWER

RESPONDENT, in answer to the petition filed in the above-entitled case, admits, denies and alleges as follows:

1. Admits.

2. Admits.

3. Admits.

4. Admits only that Manoj Bhargava ("Bhargava") is a notice partner within the meaning of section 6231(a)(8).

5. Admits.

6. Admits.

7. Admits.

8. Admits.

9.

a. through i. Denies the Respondent erred as alleged.

10.

a. First underlined sentence: Denies Bhargava made a gift to Rural India Supporting Trust. Second and third sentences: Admits. Fourth and fifth sentences: Denies for lack of sufficient knowledge or information.

1. Denies for lack of sufficient knowledge or information.

2. Denies for lack of sufficient knowledge or information.

3. - 4. Admits only that prior to the transaction described in Paragraph 10.a.7, Bhargava directly and indirectly owned  805,656 Class A Units in Innovation Ventures, LLC ("Innovation Ventures"), that Innovation Ventures Acquisition Co., LLC ("Acquisition Co.") is wholly-owned by Bhargava, and that Bhargava elected for Acquisition Co. to be disregarded as an entity separate from Bhargava. Denies the remainder for lack of sufficient knowledge or information.

5. Admits only that Acquisition Co. issued documents styled as promissory notes and pledge agreements in connection with its acquisition of 305,656 Class A Units. Denies the remainder for lack of sufficient knowledge or information.

6. Admits only that Bhargava directly and indirectly owned an approximate 80% interest in Innovation Ventures represented by 805,656 Class A Units. Denies the remainder for lack of sufficient knowledge or information.

7. Admits only that in form Bhargava transferred 454,545 Class A Units in 2009 to Rural India Supporting Trust ("RIST") and that these units represented an approximate 45% interest in Innovation Ventures; denies the remainder.

8. Admits only that in 2009, respondent issued a determination letter stating that RIST is exempt from federal income tax under section 501 (c) (3) and 'qualifies as a Type 1 Supporting Organization under section 509(a) (3); denies the remainder.

9. - 10. Denies for lack of sufficient knowledge or information.

11. Admits; alleges that after examination of Bhargava's Form 1040, Bhargava and respondent agreed that no part of his purported $623.4 million contribution to RIST was a deductible charitable contribution under section 170.

12. Denies for lack of sufficient knowledge or information.

13. Denies.

14. Admits only that in 2009, 454,545 Class A Units represented an approximate 45% interest in Innovation Ventures; denies the remainder.

15. First underlined sentence: Denies on the ground that there are no material allegations of fact that require an answer pursuant to Tax Court Rule 36(b). Second sentence: Admits only that a document styled as a Membership Interest Purchase Agreement between RIST and Nevada 5, Inc. ("Nevada 5") exists with respect to the sale of 454,545 Class A Units of Innovation Ventures; denies the remainder.

16. Denies.

17. Admits only that Nevada 5 is a Nevada corporation; denies the remainder.

18. First sentence: Admits only that in form, Knowledge Medical Research Charitable Trust ("KMRCT") is a shareholder of Nevada 5, denies the remainder. Second sentence: denies. Third sentence: Admits only that the trust agreement includes the alleged purpose; denies the remainder.

19. Admits only that Bhargava was the president of Nevada 5 from its organization in 2009 and at all relevant times thereafter; denies the remainder.

20. Admits only that Bhargava signed a document on behalf of Nevada 5 styled as a secured promissory note in favor of RIST in the amount of $623,640,000; denies the remainder.

21. - 22. Admits only that the referenced agreement includes a section with the heading "Earnout" (5.1), and that Innovation Ventures reported the purported increases in purchase price in the amounts of $364,184,104 and $394,491,091 on its Forms 1065 in connection with the Section 754 Amortization Deductions; denies the remainder for lack of sufficient knowledge or information.

23. Denies for lack of sufficient knowledge or information.

24. Admits only that Innovation Ventures Reported that Nevada 5's cost basis in 454,545 Class A units of Innovation Ventures was $1,382,315,195; denies the remainder.

25. Admits.

26. - 27. Denies.

28. Admits only that Innovation Ventures reported the basis adjustments described in paragraphs 10.a.26 and 10. a.27; and that none of these adjustments were allowed in the FPAAs attached to the petition; denies the remainder.

29. Admits only that the FPAAs decrease the Section 754 Amortization Deductions for each of the years at issue; denies the remainder.

30. Denies.

b. Denies on the ground that there are no material allegations of fact that require an answer pursuant to Tax Court Rule 36(b).

1. Admits only that Bhargava's acquisition of Class A units upon the formation of Innovation Ventures did not give rise to a section 743(b) adjustment; denies the remainder for lack of sufficient knowledge or information.

2. Admits only that prior to the transaction described in Paragraph 10.a.7, Bhargava indirectly owned Class A units through Acquisition Co. Denies the remainder for lack of sufficient knowledge or information.

3. Admits only that in form Bhargava acquired 295,000 Class A units through Acquisition Co., that the stated consideration was a promissory note in the amount of $438,075,000, and that Bhargava executed a document styled as a pledge agreement in connection with the purported sale. Denies the remainder for lack of sufficient knowledge or information.

4. Admits only that in form Bhargava acquired 10,656 Class A units through Acquisition Co., which units were eventually held by him indirectly through MIR Acquisition Co., LLC ("MIR"), that MIR is wholly-owned by Bhargava, that Bhargava elected for MIR to be disregarded as an entity separate from Bhargava, that the stated consideration for the transfers of 10,656 Class A units was three promissory notes in the collective amount of $13,170,000, that Bhargava executed documents styled as pledge agreements in connection with the transfers, and that for federal tax purposes, Bhargava is deemed to own all the units held by MIR and Acquisition Co. Denies the remainder for lack of sufficient knowledge or information.

5. Admits only that Innovation Ventures reported section 743(b) basis adjustments attributable to Bhargava's purported purchase of the 295,000 Class A units in 2008 and 2009 in the amounts of $430,851,704 and $2,426,427, respectively; denies the remainder.

6. First and second sentences: Denies. Third sentence: Denies for lack of sufficient knowledge or information.

7. Admits only that Innovation Ventures did not report any reductions in section 743(b) adjustments to reflect Bhargava's transfer of 454,545 Class A units; denies the remainder.

c. Denies.

11. Denies generally each and every allegation of the petition not herein specifically admitted, qualified or denied.

12. FURTHER ANSWERING THE PETITION, respondent claims that none of the section 754 amortization claimed by Innovation Ventures for 2009, 2010, 2011, 2012, and 2013 should be allowed, that the section 6662 (h) penalty for gross valuation misstatements is applicable to any underpayment in tax resulting from the amortization disallowed in the FPAAs or in this paragraph, and that in the alternative, the section 6662 (e) penalty for substantial valuation misstatements is applicable to any underpayment in tax resulting from the amortization disallowed in the FPAAs or in this paragraph, and in support thereof, respondent alleges as follows:

a. In 2007, Bhargava purportedly sold Indu Rawat ("Rawat") 200,000 Class A units of Innovation Ventures for $1.

b. Rawat is a Canadian citizen and a non-resident alien for U.S. federal tax purposes.

c. In documents with an effective date of December 28, 2007, Rawat purportedly transferred 5,000 Class A units of Innovation Ventures to RIST.

d. Pursuant to documents with an effective date of January 4, 2008, Bhargava purports to have purchased 5, 000.Class A units of Innovation Ventures from RIST in exchange for a promissory note in the amount of $7,425,000, and 295,000 Class A units of Innovation Ventures from Rawat in exchange for a promissory note in the amount of $438,075,000. Bhargava, through Acquisition Co., issued the aforementioned promissory notes: to RIST in the amount of $7,425,000, and to Rawat in the amount of $438,075,000.

e. Rawat did not file a U.S. income return for 2008 or report any gain in connection with her sale of the Class A units to Bhargava. The amount and extent of Rawat's ordinary income and capital gain to be recognized in connection with the sale is the subject of a pending case in this Court, Indu Rawat v. Commissioner, Dkt. No. 15340-16.

f. In documents with an effective date of December 29, 2008, Edward Snyder ("Snyder") purportedly transferred 5,050 Class A units of Innovation Ventures to RIST, and Savindar Sajwan ("Sajwan") purportedly transferred 606 class A units of Innovation Ventures to RIST.

g. Pursuant to documents with an effective date of January 5, 2009, Bhargava purports to have purchased from RIST the Class A units purportedly donated by Snyder and Sajwan for promissory notes in the collective amount of $5,745,000.

h. Rawat and RIST are tax-indifferent parties (nonresident aliens and tax-exempt organizations), and neither reported any gain on their purported sales of interests in Innovation Ventures.

i. Bhargava continued to exercise total control over Innovation Ventures despite purporting to possess only a minority interest. The financial statements for Innovation Ventures for 2012 and 2013 report the interests titled in the name of Nevada 5, MIR, and Acquisition Co. as owned and controlled by Bhargava.

j. All consideration for the transfers of membership interests in Innovation Ventures is in the form of interest-only promissory notes. The terms of the notes limit interest payment obligations to distributions from Innovation Ventures. The operating agreement, and Bhargava's control over membership units nominally owned by other entities, provide Bhargava with total control over whether Innovation Ventures will make distributions.

k. The valuations obtained by Innovation Ventures and Bhargava for the membership interests were inflated in order to provide artificial deductions for interest and amortization to shelter Bhargava's net income. Innovation Ventures' income and cash flow are dependent upon its continued access to intellectual property owned by Bhargava — the formula for 5-Hour Energy.

l. The valuations were based upon the past and projected financial performance of Innovation Ventures. The company's continued success was dependent upon Bhargava's willingness to license his formula to it. No independent investor would purchase membership interests at the indicated valuations without assurance that the company's access to Bhargava's intellectual property would continue.

m. The transactions giving rise to the Section 754 Amortization Deductions are artificial and should not be respected. RIST could not be a partner without violating its representations to respondent and jeopardizing its tax-exempt status. RIST's "ownership" of the Class A units was so transitory it was never allocated even one dollar of income or loss.

n. Nevada 5 is completely under Bhargava's dominion and control. He is the only officer and the only director. Bhargava is effectively its only shareholder, through KMCRT. KMCRT is not recognized as a charity or foundation by any state or federal authority.

o. KMCRT's purported trustee, David Lieberman ("Lieberman")r asserted in 2014 that KMCRT could not and would not qualify as a charity or foundation. Lieberman also executed a KMCRT trust amendment effective as of March 31, 2009, KMCRT's purported date of formation, that removed all directors except Bhargava and eliminated the trustee's ability to remove Bhargava as a director or appoint any other directors without Bhargava's consent. There is no evidence that any person has claimed a charitable contribution deduction for any contribution to KMCRT or that the Attorney General for the State of Michigan was ever aware of its existence as a purported charitable trust.

p. The FPAAs allowed and disallowed Section 754 Amortization Deductions as follows:

Year

Amount Reported

Amount of Adjustment

Amount Allowed

2009

60,570,917

43,166,039

17,404,878

2010

88,271,269

75,065,401

13,205,868

2011

117,533,657

104,327,789

13,205,868

2012

125,120,025

111,914,157

13,205,868

2013

125,120,025

111,914,157

13,205,868

q. As of March 31, 2009 Bhargava purportedly transferred his interest in MIR to Nevada 5. For 2009, Innovation Ventures pro-rated the amortization 25% to Bhargava and 75% to MIR.

r. Innovation Ventures did not issue any Forms K-1 to Acquisition Co.

s. The amounts allowed in the FPAAs as Section 754 Amortization Deductions are attributable to the optional basis adjustments under section 743(b) for the purported purchase of the Class A units by Bhargava in 2008 through Acquisition Co., other than units held by MIR after its transfer to Nevada 5, reduced pro-rata by the roughly 57.18 percent of Bhargava's membership interests that were purportedly transferred by Bhargava through RIST to Nevada 5.

t. Bhargava is not entitled to any optional basis adjustments under section 743 (b) for the purported purchase of the Class A units by Bhargava in 2008 through Acquisition Co. for the years 2009-2013. The proper amount of Section 754 Amortization Deductions for Innovation Ventures in each of the years 2009-2013, inclusive, is zero.

u. Innovation Ventures is not entitled to increase the inside basis of its assets on account of Bhargava's purported purchases of membership interests in 2008 because:

1. RIST never became, or intended to become, a member of Innovation Ventures nor did Bhargava intend for RIST to become a bona fide partner in Innovation Ventures. Measured by or in terms of economic reality, these transactions did not include a transfer to either RIST or Rawat, nor was there a bona fide sale or exchange of the interest to Bhargava or Nevada 5 that would give rise to a basis adjustment under section 743(b).

2. Alternatively, the transactions at issue in this case meet all the requirements for invocation of the anti-abuse provisions under Treasury Regulation section 1.701-2, under which provisions the Commissioner may recast a transaction for federal tax purposes where a partnership has engaged in a transaction a principal purpose of which is to reduce substantially the present value of the partners' aggregate federal tax liability in a manner that is inconsistent with the intent of subchapter K.

3. Alternatively, the increased basis of the goodwill should be disregarded for Federal tax purposes under judicial doctrines, including the economic substance doctrine and the step transaction doctrine.

Gross Valuation Misstatement Penalty

v. The adjusted basis in goodwill claimed by Innovation Ventures on each of its returns for the taxable years 2009 through 2013 exceeded 200% of the allowable basis set forth in the FPAA and/or in this answer. The 40% penalty of section 6662 (h) is applicable to any underpayment in tax due from any partner of Innovation Ventures for each of the taxable years 2009 through 2013 attributable to the disallowed basis and resulting disallowed amortization deductions determined in the FPAA and/or claimed in this answer.

w. In the alternative, the adjusted basis in goodwill claimed by Innovation Ventures on each of its returns for the taxable years 2009 through 2013 exceeded 150% of the allowable basis set for in the FPAA and/or in this answer. The 20% penalty of Section 6662 (e) is applicable to any underpayment in tax due from any partner of Innovation Ventures for each of the taxable years 2009 through 2013 attributable to the disallowed basis and resulting disallowed amortization deductions determined in the FPAA and/or claimed in this answer.

x. Respondent has complied with section 6751 (b) with respect to the gross and substantial valuation misstatement penalties asserted in this answer. James M. Cascino ("Cascino") is the immediate supervisor of H. Barton Thomas, and Cascino has countersigned the answer to evidence his written approval for the penalties.

WHEREFORE, respondent requests that:

The relief sought in the petition be denied; and that respondent's determinations, as set forth in the notices of final partnership administrative adjustment and respondent's claims as set forth in this answer, be in all respects approved.

MICHAEL J. DESMOND
Chief Counsel
Internal Revenue Service

Date: May 28, 2019

By: H. BARTON THOMAS
Special Trial Attorney
(Large Business & International)
Tax Court Bar No. TH0204
200 West Adams St., #2400
Chicago, IL 60606
Telephone: (312) 368-8155
barton.thomas@irscounsel.treas.gov

Date: May 28, 2019

JAMES M. CASCINO
Deputy Area Counsel (Strategic Litigation)
Tax Court Bar No. CJ0276
200 West Adams St., #2400
Chicago, IL 60606
Telephone: (312) 368-8654
james.m.cascino@irscounsel.treas.gov

OF COUNSEL:
ROBIN GREENHOUSE
Division Counsel
(Large Business & International)
WILLIAM G. MERKLE
Area Counsel
(Large Business & International)

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