(CN) - Heirs to San Francisco's Chronicle Publishing fortune made an improper $318 million tax deduction after Hearst bought the newspaper, the 9th Circuit ruled Monday.
Conseulo Martin, granddaughter of San Francisco Chronicle co-founder M. H. de Young, along with her five children, set up a complex, tiered tax shelter during the sale of the publishing company to the Hearst Corporation in the late 1990s.
The paper reportedly sold for $660 million in 2000, and the Martins owned 16.67 percent of Chronicle Publishing's shares.
When the Martins avoided paying any taxes on the proceeds they received from the deal, the IRS commenced an audit of the family's partnerships and trusts in 2004.
The IRS audited tax returns for the years 2000 and 2001 of two family partnerships, First Ship and 2000-A, and found one rather large discrepancy. In a Notice of Final Partnership Administrative Adjustment (FPAA) issued in 2008, the IRS called the 2000-A partnership a "sham" and said it "lacked economic substance." Specifically, the agency found that short term options that the partnership had claimed as losses were actually liabilities, thus "eliminating most of the $321 million short-term capital loss reported by First Ship on its 2000 tax return," the appeals court explained.
Two of the Martin family trusts challenged the IRS's findings, arguing that the agency waited too long to make the adjustment.
U.S. District Judge Phyllis Hamilton ruled for the government in Oakland, finding that, contrary to the family's claim, the extension agreements that the IRS had executed on the limitations period covered the 2000-A because of its "direct connection" to First Ship.
A three-judge panel with the federal appeals court partially agreed on Tuesday.
"Some of the partnership items of First Ship that flow through to the Martin Family Trusts triggered some of the adjustments in the 2000-A FPAA," Judge Sidney Thomas wrote for the unanimous panel. "Specifically, in its 2000 tax return, First Ship claimed $318,018,377 in losses due to the liquidation of 2000-A. This loss is not merely First Ship's share of the losses claimed by 2000-A. Those losses, rather minor, only add up to $4,067,455. Instead, this $318 million loss originated with First Ship, due to its artificially high basis in 2000-A. This loss was a partnership flow-through item of First Ship that led to the adjustment to 2000-A. Indeed, without this large loss, which was the main target of the IRS audit and investigation, there would have been no 2000-A FPAA."
The court also found, however, that the extension agreements "do not encompass adjustments to items of 2000-A which only flow up through the minority partners and as a result have no connection to First Ship," Thomas added. "To the extent that the district court concluded otherwise, it erred."
On remand, the lower court must determine "which adjustments in the 2000-A FPAA are directly attributable to partnership flow-through items of First Ship."