“You got to put a splash of diesel fuel in it . . . so we can generate tax credits.” Alternative Carbon Res., LLC v. United States, No. 2018-1948, 2019 U.S. App. LEXIS 29043, *6 (Fed. Cir. Sept. 25, 2019).
A quote like that spells trouble, especially if the taxpayer claimed $19,773,393 in tax credits based on that logic. And the Federal Circuit’s opinion lives up to that expectation.
A little background is in order: Section 6426(e) of the Internal Revenue Code provides for tax credits for “alternative fuel used by the taxpayer in producing any alternative fuel mixture for sale or use in a trade or business of the taxpayer.” I.R.C. § 6426(e)(1). An “alternative fuel mixture” is “a mixture of alternative fuel and taxable fuel,” I.R.C. § 6426(e)(2), hence the “splash of diesel fuel.” 1
But it takes more than just a splash of diesel: To qualify for the credit, the alternative fuel mixture must either be “sold by the taxpayer producing such mixture to any person for use as fuel,” or else “used as a fuel by the taxpayer producing such mixture.” I.R.C. § 6426(e)(2)(A), (B). And this taxpayer could not show that because its business was essentially a sham designed to generate tax credits.
The taxpayer’s operations followed a basic model:
- First, it bought feedstock from ethanol producers, which consisted of organic matter left over from ethanol production, known as “thin stillage.”
- Second, it paid trucking companies to transport the feedstock; along the way, the trucking company would add the “splash of diesel fuel.”
- Third, the trucking company delivered the mix of diesel and feedstock to digester operators, which were companies that operated anaerobic digestion tanks. The digester operators then fed the mixture to microorganisms in the tanks that would produce methane by digesting it.
Alternative Carbon Resources, 2019 U.S. App. LEXIS 29043 at *5-*6.
There were some problems with this business model. The “splash of diesel fuel” was added solely for tax purposes; the taxpayer’s expert acknowledged at trial that the diesel didn’t change the methane production and admitted that he would not recommend adding diesel to one of the digestion tanks. Id. at *6.
Then there was what happened when the trucking companies delivered the “alternative fuel mixture”: The digester operators didn’t pay for it; instead Alternative Carbon paid the digester operators a disposal fee to take the mixture off its hands. The taxpayer did collect an annual fee from the digester operators, but it was modest; the fees generated just under $9,000 in income for 2011, while the disposal fees exceeded $1.5 million. Id. at *7. For good measure, there was nothing to show the fee had any relationship to the value of the mixture.
Once the mixture was delivered, it was fed into tanks and helped generate methane; some of the methane was “flared off,” and some was used to produce electricity. Id.
While the business plan looked a little shaky, the taxpayer did consult with counsel, who advised that the case for claiming the credit would be stronger “if you charge the user of the mixture for the fuel value, and they charge you a disposal fee.” Id. at *9. But the lawyer really did not understand the client’s business and asked some pointed questions: “[h]ow do you make money from this business if you pay the digester company to take the liquid” and “[d]oes this business cash flow without the 50 cent per gallon credit?” Id.
Then in July 2011, the IRS issued an advisory letter which indicated when an alternative fuel mixture was used by a digester operator, it was not “used as a fuel” within the meaning of section 6426. Despite this, the lawyer told his client to proceed as planned after a conversation with an IRS agent who reportedly indicated that it could claim the credits so long as its alternative fuel registration with the IRS was not revoked. Id. at *10-*11.
After the taxpayer claimed $19,773,393 in credits on its 2011 return, the IRS immediately audited, disallowing all of the credits and imposing penalties for good measure. Id. at *11.
The dispute wound up in the Court of Federal Claims, where the taxpayer lost. On appeal, it fared no better.
The Federal Circuit first examined the taxpayer’s claim that it was entitled to the credits because it sold an alternative fuel mixture. The linchpin of its argument was the fee it collected from the digester operators. The Court of Appeals was unimpressed: “Even if this fee might be technically characterized as a price, or as meaningful consideration, it lacked economic substance and should be disregarded.” Id. at *20 (citations omitted). The taxpayer’s argument was rejected, because it “offered no evidence suggesting the annual fee meaningfully changed its economic position or had any non-tax purpose whatsoever.” Id. at *21 (citations omitted). The court reviewed the background to the various contracts; the fee that the taxpayer received from the digester operators was offset by a corresponding administrative fee that Alternate Carbon paid the digester operators. As one witness testified, the fee charged to the digester operators was “for [Alternative Carbon’s] tax stuff.” Id. at *23.
While the taxpayer had a plethora of additional arguments, the Federal Circuit readily disposed of them.
Then the Court of Appeals turned to the penalty. Alternative Carbon was penalized under section 6675 of the Code, which packs a wallop. While most accuracy-related penalties are less than the amount of the improper deduction or credit, a bogus claim for alternative fuel credits is subject to a penalty of “[t]wo times the excessive amount.” I.R.C. § 6675(a)(1). That meant that Alternative Carbon’s tax case was not a $19,773,393 problem; instead, it was a $59,320,179 problem.
The penalty under section 6675 is subject to a reasonable cause exception but does not incorporate a definition. The taxpayer argued that the general standards developed under section 6664 should apply. The Court of Appeals agreed. Alternative Carbon Resources, 2019 U.S. App. LEXIS 29043 at *30-*31.
The victory was short-lived, as the Federal Circuit proceeded to bury the taxpayer on the penalty. While Alternative Carbon invoked the advice it had received from its lawyer, the fact that he hedged his advice and did not understand the economics of the business counted against it. The court concluded that the taxpayer could not show that its reliance on the lawyer’s advice was reasonable. Id. at *32. To make matters worse, the taxpayer had not actually followed the lawyer’s advice, which had been to charge based on the value of the fuel mixture. Id. at *33.
And there was a bigger problem: “Alternative Carbon’s partners should have recognized that receiving millions of dollars in tax credits for transferring feedstock from one entity to another—while mixing in a meaningless amount of diesel along the way—was ‘too good to be true.’” Id. at *34 (citation omitted).
It is hard to quarrel with the result here. The taxpayer’s “business” was an exercise in window dressing. When the Federal Circuit looked at the facts, it readily recognized a methane-producing biomass.
1 Diesel is one of three “taxable fuels” that would qualify; the others are gasoline and kerosene. See I.R.C. § 4083(a)(1).