Free Response to Motion - District Court of Federal Claims - federal

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IN TliE UNITED STATES COURT OF FEDERAL CLAIMS

No. 07-209 T

(Judge Marian Blank Horn)

If\lI'RIMIS INVESTORS LLC WFXFORD SPECIAL SITUATIONS 1997 INSTITUTIONAL. 1.1'. lAX MATTFRS PARTNER,
PlaintI ff

v.

TlIF L INIIED STATES OF AMERICA,
Defendant.

RESPONSE BY THE UNITED STATES TO MOTIONS FOR SUMMARY ./lJDGMENT BY PLAINTIFF AND I'ARTICII'ATING PARTNER ADDRESSING INTERPRETATION OF TIn: PARTNERSHIP AGREEMENT
NATHAN .I. 1I0ClIMAN Assistant Attorney General
DA VID GUSTAfSON STEVEN r. FRAHM JENNIFER 1'. WILSON Attorneys
.I ustice Depai1ment (Tax)

Court of federal Claims Section P.O. Box 26 Ben Franklin Post Offce Washington, D.C. 20044 (202) 307-6495
(202) 5 I 4-9440 (facsimile)

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INDEX

Page
Statement offacts:
A. Formation of

the Imprimis Partnership .................................2

B. Parnership Agreement Proyides for Allocations of Parnership Income ....... 3

C. Parnership Reported Income and Allocations for Tax Year 2000 ............ 5

D. Insight Notified the IRS that it Reported Net Short Term Capital
Gain on its 2000 Return Inconsistently with the Schedule K-l Issued by Imprimis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
E. The Internal Revenue Service Examined the Partnership's Reporting .........7

F. New York State Court Litigation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

G. Imprimis Commenced This Parnership Proceeding and Insight
Elected to Participate .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

H. The Dispute At Issue in the Pending Motions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Argument:

1. THE PLAIN LANGUAGE OF THE INSIGHT ALLOCA nON is LIMITED TO ITEMS OF ORDINARY INCOME, WHICH DOES NOT INCLUDE SHORT-TERM CAPITAL GAIN. . . .. .. . . . . . . . . . i i
A. Relevant Principles of

Contract Interpretation.. .................. 12

B. Thc Plain Language orthe Insight Allocation .. .................. 13

C. Insight's Interpretation of

Ordinary Income Is Reasonable. . . . . . . . .. .14

D. Imprimis' Interpretation of

Ordinary Income Is Not Rcasonab Ie . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

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Page

If. THE SFI'ILEMENT AGREEMENT DOES NOT IIA VI'

ANY EFFECT ON TIlE INTERPRElA llON OF THE PARTNJ'RSHIP AGREEMENT FOR PURPOSES OF TI liS TAX DISl'lJTI; . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
III. THE DETERMINATION OF TI IE TIIRESI 10LD INTERPRETATION

ISSL!L; WILL NARROW AND FRAME THE REMAINING ISSUES
IN Tl LIS CASE .................................................. 21

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

CITATIONS
Cases:
Crisl' v. Uniled SloLes. 34 Fed. CI. 112 (1995) ................................ 16

i,'d Finc OIdlmohile. Inc 1'. Diamond :'ì/aLe Telegral'h ('0" 494 A.2d 636
(DeL. 1985) . , . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . , . .

.......16

Gcorge Hyman ('ol1llmcLion ('0. 1'. Uniled Slales, 832 F.2d 574 (Fed. Cir.
1987) .......................................................... 16, 18

I-ane BryanL. Inc v. UniLed SIoLes. 35 F.3d 1570 (Fed. Cir. 1994) . . . . . . . . . . . . . . . . . 18
I.aurilzen v. I.orscn, 345 U.S. 571 (1953) .................................... 12

Majkowski 1'. American Imaging ManagemenL Services. I-U', 913 A.2d

572 (DeL. Ch. 2006) .... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16, 19
Melric ConsLmcLors, Inc. v. NASA, 169 F.3d 747 (Fed. Cir. 1999).................14

M.G. ('onslrue/iol1 Inc 1'. UniLed SIaLes, 67 Fed. CJ. 176 (2005) . . . . . . . . . . . . . . . . . . 13
Namo floldings, I..C v. World ivfarkeL CenLer VenLure. l..c. 2007 WI. 20X8851 (DeL. Ch. 2(07) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
NVT Technologies v. UniLed SIale.l. 370 F.3d 1153 (Fed. Cir. 2(04) ............ 13, 14

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Page

Cases (continued):

Shell Oil Co. v. Uniled States, 80 Fcd. CI. 411 (2008) .......................16

Specialiy Trans., Inc. v. United SIales, 57 Fed. Cl. 1 (2003) . . . . . . . . . . . . . . . . 13, 19
Thoughiworks, Inc. v. SV Investment Partners, LLC, 902 A.2d 745 (DeL.

Ch.2006) ....................... . . . . . . . . . . . . . . . . . . . . . .. 12, 13,14, 18, 19

Statutes:
Internal Rcvcnue Code of 1986 (26 U.sc.):
§ 1 . . . . . . . . . . . . . . . . . . . . . . . .. . . .. . . . . . . . . . . . . . . . . . . . . . .. . . . . . .. 15

§ 64. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . .. 15
§ 703 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 5 § 704 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 11,21 § 761 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 12,20 § 1222 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 15 § 6222 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 6 § 6226 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 8, 20

Miscellaneous:
B. Bittker & L. Lokken, Federal Taxation ofIncome, Estates and Gifts '146.2.1 (2008)
(2000 WI. 485606 (W.G.&.L.)) .................................... 15

Tax Reform Act of 1986, Pub. L. No. 99-514, §§ 301,311,
100 Stat. 2216, 2219 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

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IN THE UNITED STATES COURT OF FEDERAL CLAIMS (Judgc Marian Blank Horn)
No. 07-209 T

IMPRIis INVESTORS LLC, WEXFORD SPECIAL SITUATIONS 1997 INSTITUTIONAL,

LP, TAX MATTERS PARTNER,
Plaintiff,
Y.

THE UNITED STATES OF AMERICA,
Defendant.

RESPONSE BY THE UNITED STATES TO MOTIONS FOR SUMMARY JUDGMENT BY PLAINTIFF AND PARTICIPATING PARTNER ADDRESSING INTERPRETATION OF THE PARTNERSHIP AGREEMENT

Pursuant to the Court's instructions, the plaintiff, Imprimis Invcstors LLC (through its tax
matters parner) and the participating partner, Insight Vcntures Associates II, LLC, have filed
motions for summary judgment addrcssing the interpretation of

the Imprimis partncrship

agreemcnt. The United States agrees with the arguments in thc motion filed by Insight and
disagrccs with the arguments in the motion fiIcd by Imprimis. The meaning of

the term "itcms of

ordinary income," which is the critical term in the provision at issue in the Imprimis partncrship

agrcement, is unambiguous and docs not include capital gain. In addition, the scttlcment of a
separatc, state court action in which the United States was not a party, does not have any effect
on the interprctation of

the Imprimis partnership agreement. The Unitcd States asks the Court to

make thesc dctcrminations, which will narrow and frame the rcmaining issues in this case.
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STATEMENT OF FACTS'
Á. Formation of

the Imprimis Partnership

Imprimis Investors LLC C'lmprimis"). the partncrship at issue in this procecding, is an

inyestment vehicle which makes, holds, and manages investments on behalf of investment funds

for Wexli,rd Capital LLC. (Revised Joint Stip. ~ 1.) During the tax year endcd Deccmbcr 31,
2000, tbe tax year at issue in this proceeding. Imprimis' membership consisted of: Wexliird
Special Situations i 997 Institutional. 1..1.: Wexford Spcctrum Inyestors U.C Wexford Partners

Investment Company (collectively, the "Wexford Members"); and Insight Venturcs Associates II.

LL.C C'lnsight"). (id' 4.) Wexford Capital i.i.c is an invcstment advisor registered with thc
Securities and Exchangc Commission. (/d. ~ 2.) Insight is a limited liability company that is in
thc business ofinvcstments, and is atfliated with a vcnturc capital firm, Insight Venture Partners.

(/J. '1'1 6.7.) Thc Wcxford Members and Insight entered into a limited liability company

agreement (referred to hercin as thc "Imprimis partnership agreement"), effective as of

September 30, 1998. (/d. ~ 9 and Ex. I.) The stated purposc of the company is to make
investments. (/J. '12.3.)
The partnership agreement provides that Imprimis was form

cd under the law of

Delaware, and that the agreemcnt is governed by, interpreted, and enforced in accordance with

Delaware law. (Ex. I '1'12.1, i 2.1.) The partnership agreement constituted the complete
agreement among the mcmbers with regard to the subject matter addressed in the agrecment. and

'This factual statement is based entirely on the stipulated facts and the exhibits included with that stipulation contained in the revised joint stipulation of facts and exhibits, filed on December 6. 2007. under seaL. Because we do not discuss in detail any of the facts or exhibits that raise confidentiality concerns or bear a notation "under seal" in the factual stipulation, we
have not filed this brief under seaL.

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superscdcd all prior written and oral statements, discussions, and agrcemcnts relating to thc same
subject matter. (Ex. 1 i¡ 12.8.)
R. Partnership Agreement Provides for AIIoeations of Partnership Ineome

Article VII of

the partnership agreement goyerns distributions, allocations, and expenses

gcnerally, othcr than as specifically provided in thc exhibits and schedules attached to the

3greement. (Ex. 1 at CTC00003 I.) The partnership agreement provides that distributions to
Insight shall be nwdc only as providcd by Exhibits B or C:

Except as otherwise provided on Exhibit B or C with rcspect to the investments identified on Schedule I and Schedule 2 of Exhibit A, the Company shall make distributions to Wexj(ird Members pro rata in accordance with thc Distribution Share of each Wexl()rd Membcr with respect to the applicable Class. Dislrihiiiiof/s 10 Il1sighi"r10 any oiher Non-l'orlicil'Oling Memher shall he made only as sellÒrih in E,hihii B or Hxhihil (',

(Lx. 1 ~ 7.1, emphasis added.) Exhibit A to the partnership agreement identities the members
with interests in Class A and Class B, and has attached Schedules 1 and 2. listing particular
investmcnts. (Ex. i at CFC000043-47.) The Wextèird Membcrs had intcrcsts and distribution

shares in Class A and B. (lJ. at CFC000043-44.) Insight had an interest in Class A, but had a
0':-0 distribution sharc. and did not have an intercst in Class B. (ld. at CFC000043.) The
partnership agreement provides, with respcct to investments listed on Schedule i, '"Insight shall

receive allocations and distributions as provided in Exhibit B," and with respect to investments
listed on Schedule 2, "Insight shall rcceive allocations and distributions as provided in Exhibit

c." (lJ. at CFC000043 n.l: see also Schedules I and 2 at CFC000045-47.) In addition, the
partnClship agreement proyides that "¡ w Jith respect to inyestmcnfs that arc not listed on either

Schedule i or Schedule 2, Insight shall not receIYc any allocation or distribution." (lJ.)

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According to these provisions, allocations and distributions to Insight are governed exclusively

by the terms set forth in Exhibits Band C of the partnership agreement.
Exhibit B provides for the allocation of "Net Profits and Net Losses" with respect to the
inyestments identified on Schedule 1. (Ex. i, Exhibit B ~ 3.) The allocation of

"Net Profits" to
Exhibit B (referred to

Insight that is at issue in this procecding is reflected in Section 3(1) of

herein as the "Insight Allocation" or "special allocation") and provides a supervening rule when
Net Profits consist of

items of ordinary income:

(I) thereafter, 80% to the Wexford Members and 20% to Insight; provided,

however, ihal in ihe evenl any Nel Profiis consist of I/ems of ordinary income, ihen, in liea of ihe ahove allocaiions (i) a special gross income allocalion shall be made to Insighi of such items or ordinary income (to
the exieniihereof) equal 10 the Tenlaiive Insight Allocalion (as defined

below) and (ii) the resulting Net Profits, computed without regard to the items of gross income allocated under the preceding clause (i), shall be allocated:
(i) if

the initial allocation made in clause (I)(i) above (the "Initial Insight Allocation") equals the Tentative Insight Allocation, to the Wexford members, or

(ii) if

the Initial Insight Allocation is less than the Tentatiye Insight Allocation, an amount equal to such shortfall to Insight and the remainder to the Wexford Mcmbers.

For purposes of

the preceding sentence the "Tentative Insight Allocation" shall Net Profits that would otherwise have been allocated to mean the amount of Insight under this Agrecment absent the proviso of such preceding sentence.
"Net Profits

(Ex. 1, Exhibit B '13(1), emphasis added.) Exhibit C providcs for thc allocation of

and Net Losses" with respect to the invcstmcnts idcntificd on Schedule 2, and includes the samc
Insight Allocation. (Ex. 1, Exhibit C ~ 3(d).)

The term "Net Profits and Net Losses" is dcfined for purposes of

the parnership

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agreement and the attached exhibits as "the net income or loss of

the Company allocable to a

Class, determined in accordance with Section 703 of the Code. . . . (subject to certain
adjustments).'" (Ex. 1 iI7.3(a).) The term "items of ordinary income" - which is the critical

term at issue in this proceeding - is not defined in the partnership agreement or the attached
exhibits.
C. Partnership Reported Income and Allocations for Tax Year 2000

For the tax year ended December 3 1,2000, Imprimis reported income in the following
amounts on its Form 1065 U.S. Return of

Partnership Income:'
Ordinarv Dividends Net Short Term

Interest Income

Capital Gain
$ 1 ,882,005

Net Long Term Capital Gain
$73,444,348

$21,678 $99,821,405

(Ex. 3, Schedule K, p. 5, lines 4(a), (b), (d), and (c).) Imprimis issued Schedules K-I reflecting
the following distributive share ofthe above items of

income to the members:

'The parnership agreement defines "Code" to mean "the Internal Reyenue Code of 1986, as amended from time to timc." (Ex. 1 ii 1.6.)
3The partnership also reportcd "other portfolio income" in the amount of $8,607. (Ex. 3,
Schedule K, p. 5, line 4(1).)
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Intcrest Income

Ord. Div.

Net Short Term Capital Gain
$49,384,376
$ i 3,792,529

Net Long Term Capital Gain
$57,410,272

Wexford l
Wexford 25 Wexford 36

$806,388 $225,216
$53,036 $797,243
$122

$16,945
$4,733
$0 $0 $0

$16,034,076
$0 $0 $0

$21,412

Insight'
Wexford 48

$36,623,088
$0

The amounts of distributive shares reportcd on the Schedules K-l reflcct the total amount of each
category of income reported by the partnership on Schedule K.

The parncrship return was due to be filed on April 15,2001, and appears to have been

fied on or about March 30, 2001. (See Ex. 3.)

D. Insight Notifed the IRS that it Reported Net Short Term Capital Gain on its
2000 Return Inconsistently with the Schedule K-I Issued by Imprimis
For thc 2000 tax ycar, Insight filed a Form 8082 Notice ofInconsistent Treatment with
the Internal Revenue Service pursuant to Internal Rcvcnuc Code § 6222(b). Insight reported

inconsistent rcporting ofnct short tcrm capital gain. (Ex. 35, item 10, at CFC000772.) In the

4"Wexford I" is identified on the Schedule K-l as "Wcxford Spccial Situations 1997
L.P." (Ex. 3, Schedule K-l, pp. 18-21.)

'''Wexford 2" is identified on the Schedule K-l as "Wcxford Spccia1 Situations 1997 Institutional." (Ex. 3, Schedule K-I, pp. 22-25.)

'''Wexford 3" is identificd on thc Schedule K-I as "Wexford Spectrum Investors LLC." (Ex. 3, Schedule K-1, pp. 26-28.)
'''Insight'' is identified on thc Schcdule K-l as "Insight Vcnturc Associatcs Il, LLC." (Ex. 3, Schedule K-1, pp. 29-31.)

g"Wcxford 4" is identified on the Schedule K-I as "Wexford Partners Investment Company." (Ex. 3, Schedule K-I, pp. 32-33.)
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attached statemcnt, Insight statcd, in pertinent par:

the Schedule K-l received by the taxpayer from Imprimis Investors, LLC ("Imprimis") was not properly reported. This amount reflects an allocation of entirely short-term capital gain that is an improper allocation under the terms of the operating agreement for Imprimis. . . . . It would appear that Imprimis, which generated approximately $189,450,006 which $97,991,181 was short-term and S91,458,825 was capital gains (of of long-term) has included "short-term"capital gain in ordinary income. . . . .
The $36,623,088 reported on Line 4d of

In accordance with both the Code, and the operating agreement ofImprimis, the the $36,623,088 of capital gain allocated to the taxpayer correct allocation of
would be as follows:
$18,942,926 short-term capital gain SI 7,680,162 long-term capital gain

(M. at CFC000773)
E. The Internal Revenue Service Examined the Partnership's Reporting

The Internal Revenue Service began a parnership-level examination of Imprimis for its

2000 tax year in July, 2004. (Revised Joint Stip. ~ 28.) On January 2,2007, the Service issued a

Final Partnership Administrative Adjustment ("FPAA"). (ld. ~ 32, Ex. 39.) In the Schedule of
Adjustments, thc Service determined that it would accept the amounts reported on the partnership

return as fied, but made two alternative determinations with respect to the partnership's
allocation of

short-term capital gain9 (Ex. 39 at CFC000008-12.) In "Inconsistent Position A,"

the Service determined that the revised allocation of short-term capital gain claimed by Insight in

the Form 8082 is disallowed, and the original Schedule K-l issued by Imprimis to Insight for the
2000 tax year is "deemed to be correct." (ld. at CFCOOOOI 0.) In "Inconsistent Position B," the

'On line 2, the Service appears to correct the amount of dividends reported by the partnership from 521,678 to $24,678, but the corrected number is erroneous, as reflected by the
$0 adjustment. (Ex. 39 at CFC000008.) In addition, the corrected amount of

net long-term

capital gain of $73,488,348 is erroneous, as reflected by the SO adjustment. (Id.) The United
States has admitted that these entries in the FP AA were erroneous. (See Answer ~~ 1 4.e- f. 7

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Service reached the opposite conclusion, determining that Imprimis incorrectly allocated short-

term capital gain to Insight in the amount of $36,623,088, and re-allocating the short-term capital

gain between Insight, Wexford Special Situations 1997 L.P., and Wexford Special Situations
1997 Institutional (ie. Wexford i and Wexford 2 on the char on page 6 of

this brief). (Id.)

F. New York State Court Litigation
On October 12,2000, the first of

several lawsuits involving Wexford (and affiliated

entities) and Insight (and affliated entities and members) was filed in New York state court.
(Revised Joint Stip. iiii 15-21.) The state court lawsuits, which were consolidated into one action
on July 9,2002 (zd. '122), were resolved in July 2003 by

a settlement agreement executed by all

of

the parties to thc consolidated action ("Settlement Agreement"). (Id. ii 25; Ex. 31.) Ncither

the United States, nor the Internal Revenue Service was a party to or had any involyement in the
actions filed in New York state court.

G. Imprimis Commenced This Partnership Proceeding and Insight Elected to Participate
On March 29,2007, the tax matters parner for Imprimis, Wexford Special Situations
1997 Institutional, LP, filed a petition for readjustment of

parnership items in this Court,

pursuant to Internal Revenue Code § 6226(a). Imprimis contests the determinations made thc
Service in "Inconsistent Position B" of the FP AA, and agrees with the determination made in

"Inconsistent Position A." (Complaint'17.) Imprimis asscrts that Insight was corrcctly allocated
$36,623,088 of short-term capital gain pursuant to the tcrms of

the parncrship agrcemcnt. (Id.

ili¡15(h)-U).)

On May 9,2007, Insight filed a notice of election to participate and an amendment to the
complaint, pursuant to Code § 6226( e )(2) and Rule 4(b) of Appendix F of the Rules of the
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United States Court of Federal Claims. Insight contcsts the Service's conclusions set forth in the
Schcdule of Adjustments in the FP AA, and in "Inconsistent Position A." (Amendment to
Complaint ~17.) Insight contends that although Scction 3(f) of

Exhibit B to the Imprimis

partnership agreement purports to specially allocate ordinary income to Insight, but it does not
purport to provide for a disproportionatc allocation of

short-term capital gain. (Id. ~I'I 1 1,26,27.)

Insight thus contends that the disproportionate allocation of short-term capital gain is contrar to
the partnership agreement. (Id. 'I 28.)

H. The Dispute At Issue in the Pending Motions
Following a conference on April 11,2008, the Court instructed the parties to complete
briefing on the two issues idcntificd in thc joint statemcnt of issues of law that involve the
interpretation of

the partnership agrcement. Thc two issues were stated by the parties as follows:

I. Whether the Amendcd and Restated Limited Liability Company

Agreement of Imprimis Inyestors LLC, dated September 30, 1998 ("Imprimis LLC Agreement"), as applicable to the Imprimis 2000 tax year, provided a special allocation to Insight of items of short term
capital gain.

2. What is the effect, if any, of

the executed settlement of the claims by Insight and Imprimis in a lawsuit filcd in the Ncw York Supreme Court (the "Settlement Agreement") on the tax dispute at issue in this TEFRA proceeding, which arose from thc allocation ofpartncrship incomc to Insight as reflected in this Imprimis partnership tax return for the 2000

tax year and thc rclatcd Schedule K- 1 issucd to Insight.

(Joint Statement ofIssues of Law, Docket Entry No, 17.)
Imprimis had previously filed a brief addressing both of

these issues, in addition to other

issues, pursuant to the Court's order dated December 11, 200710 With respect to issue 1,

Plaintiffs Motion for Summary Judgment, fied by Imprimis on Februar 21,2008 (Docket Entry No. 30-3.), as the "Imprimis Motion."
IOFor convenience, we refer herein to the Corrected Brief in Support of

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Imprimis contends that it is entitled to summar judgment based on: "(1) a plain and fair reading
of the opcrative provision of

the Imprimis LLC Agrccment (i.e. thc Insight Allocation); and (2)

the extrinsic evidence supporting Wexford's understanding of

what that provision meant."

(Imprimis Motion, p. 44.) With respect to issue 2, lmprimis contends that the Settlement
A~,'Teement resolved the interpretation issue of the term "items of ordinary income" in Section

3(f) of

Exhibit B of

the partnership agreement. (Id., p. 50.)

On May 7,2008, Insight filed a motion for summary judgment addressing issues 1 and 2. With respect to issue i, Insight contends that the partnership agreement unambiguously provides

for a special allocation of only ordinar income to Insight, and not a special allocation of short-

term capital gain. (Insight Motion, pp. 10-22.) With respect to issue 2, Insight contends that thc
Settlement Agreement has no effect on the tax allocations currently in dispute. (Id., pp. 23-25.)

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ARGUMENT
The threshold tax issue in this case is whcther the Imprimis partnership agreement
provided for the special allocation of short-tcrm capital gain to Insight that the partnership madc
in the year 2000. As bctwccn Imprimis and Insight, the Court's resolution of

the issue will

determine their relative tax burdens.
The paries agree that the operative provision of

the Imprimis parnership agreement is

Section 3( f) of Exhibit B. Specifically, the analysis hinges on the meaning of the term within
that provision "items of ordinary income." As explained in Section I, the goyernent agrees
with Insight that the meaning of this term is unambiguous, and does not include items of

short-

term capital gain." In addition, as explained in Section II, the Settlement Agreement has no
effect on the interpretation of

the Imprimis partnership agreement.
I.

THE PLAIN LANGUAGE OF THE INSIGHT ALLOCATION IS LIMITED TO ITEMS OF ORDINARY INCOME, WHICH DOES NOT INCLUDE SHORT-TERM CAPITAL GAIN
The starting point for thc analysis of

the tax issue in this case is the language ofthc

partnership agreement. See § 704(a) (providing that a partner's distributive share ofincomc, gain,

ctc. shall be determined by thc partncrship agreement, except as otherwise provided). A
parnership agreement includes "any modifications of thc partnership agreement made prior to, or
at, the time prescribed by law for thc filing of

the partnership return for the taxable year (not

including extensions) which arc agrccd to by all the partners, or which are adopted in such othcr

11 In the interest of cfficiency, in instances where the government agrees with the analysis

and conclusions proyided by Insight in its motion, we reference the pages of Insight's motion and state the basis for our agreement, rather than re-stating Insight's analysis in its cntircty.
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maner as may be provided by the partnership agreement. § 761 (c).

The parnership agreement in this casc is the Amended and Restated Limited Liability

Company Agrecmcnt ofImprimis Investors LLC, effective as of Scptember 30, i 998. (Ex. 1.)
The agreement exprcssIy states that it constituted the complete agreemcnt among the members

with regard to the subject matter addrcssed in the agreement, and superseded all prior written and
oral statements, discussions, and agreements rclating to the same subject matter. (Ex. 1 '1 12.8.)

Because there is no evidence that thc September 30, 1998, parncrship agreement was modified
prior to or at the time for filing the year 2000 tax return, April

15, 2001, it constitutes the

complete and operative partnership agreement.

It is undisputed that Imprimis allocated $36,623,088 of short-tcrm capital gain, and no
long-tcrm capital gain to Insight, purportedly pursuant to Section 3( f) of Exhibit B to the
partnership agreement. The question is whether the partncrship agreement actually proyides for
that. This is an issuc of contract interpretation.12

A. Relevant Principles of Contract Interpretation
"It is well settled that if

the terms of a contract are clear, the court must accord the

language its ordinary meaning." Thoughtworks, Inc. v. SV Inveslmenl Parlners, LLe, 902 A.2d
745, 752 (DeL. Ch. 20(6). If, however, a contract tcrm is ambiguous on its face, a court may

consider extrinsic or parol evidence to determine thc partics' intcnt in entering into the contract. I'The partnership agreement provides that Imprimis was formed undcr the law of
Dclaware, and that thc af,'Tcemcnt is governcd by, interpreted, and enforced in accordance with

Delaware law. (Ex. i i¡i¡ 2.1,12.1.) Accordingly, we refer primarily to Dclaware state law. See
l-aurZlzen v. Larsen, 345 U.S. 571, 588-89 (1953) ("Except as forbidden by some public policy,

the tcndency of the law is to apply in contract matters the law which the parties intended to apply."). However, to the extent that thc FcdcraI Circuit and this Court have employcd idcntical (and well settled) contract interpretation principles in deciding cases involving interpretation of a contract term, we refer to those decisions as well.
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ld. In ordcr to demonstrate ambiguity, "a party must show that thc instruments in question can

bc reasonably read to have two or morc mcanings." ld.; see also Nama Holdings, LLC v. World
Market Cenler Venlure, LLC, 2007 WI. 2088851 at *6 (DeL. Ch. 2007) ("a contract is only

ambiguous when a disputed provision is susceptible to two reasonable interpretations) (internal

quotation and citation omitted)), aff'd, 2008 WI. 571543 (Table) (DeI.Supr. 2(08). Extrinsic
evidence should not be considered in determining whether a contract is ambiguous. Specialty
Transp.lnc. v. Uniled SIales, 57 Fed. Cl. 1,9 (2003). The interpretation ofa contract term, and

the determination of ambiguity, are questions of law. NVT Technologies, lnc. v. Uniled Stales,

370 F.3d 1153,1159 (Fed. Cir. 2004); MG. Const., Inc. v. United SIales, 67 Fed. CI. 176, 181
(2005), aff'd, 253 Fed.Appx. 935 (Fed. Cir. 2007).
B. The Plain Language of the Insight Allocation

Contract interpretation begins with the plain language of

the written agreement. NVT

Technologies, 370 F.3d at 1159; MG. Consl., Inc., 67 Fed. Cl. at 182. The contract at issue here
provides that "Net Profits" will be allocated: "80% to the Wexford Members and 20% to Insight;
provided. however, that in the event any Net Profits consist of ilems of ordinary income, then, in
lieu of

the abovc allocations (i) a spccial gross income allocation shall bc made to Insight of such

ilems or ordinary income (to the extent thercof) equal to the Tentative Insight Allocation.
(Ex. 1, Exhibit B, ii 3(1).)
Within this structure, there is a general allocation of

"Net Profits", as between Insight
ordinary

and the Wexford Members. But under the special allocation, relatively more items of

income arc allocated to Insight. Thus, the pivotal term, determining the character of income

allocated among the partners, is "items of ordinary income." The partnership agreement does not
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dcfinc this term.

The partics to the agreement, Imprimis and Insight, both view the term "items of ordinary

income" as unambiguous, but disagree regarding its meaning. Imprimis contcnds that the tcrm
refers to "allocations of

income or gain taxable at the rates applicable to ordinary income."

(Imprimis Motion, p. 47.) In 2000, the tax rate applicable to short-term capital gain was thc tax
rate on ordinary income. On that basis, Imprimis concludes that itcms of ordinary income under

the parnership agreement includes short-term capital gain. (Id.) Imprimis argues further that its
interpretation is supported by the definition of ordinary income in the Fifth Edition of

Black's

Law Dictionary, which was published in 1979. (Id.)
Insight, on the other hand, contends that thc Insight Allocation operates according to thc
definition of ordinary income in the Internal Revenue Code, which definition does not include

short-term capital gain. (Insight Motion, pp. 12-16.) This disagreement between Imprimis and
Insight with respect to the interprctation of "items of ordinary incomc" does not necessarily mean

that the term is ambiguous. Thoughtworks, 902 A.2d at 752. The term is ambiguous only ifboth
parties' interpretations fall within a "zone ofreasonabIcncss." NVT Technologies, 370 F.3d at
1159 (quoting Melric Conslruclon;, Inc. v. NASA, 169 F.3d 747, 751 (Fed. Cir. 1999)).
C. Insight's Interpretation of Ordinary Income Is Reasonable

We agrec with the analysis in Insight's motion (at pp. 12-16), leading to the conclusion

that ordinar income is defined by reference to the Internal Revenue Code. In particular, we
agree with Insight's observation that it is significant that the Insight Allocation addresses thc
allocation of

"Net Profits," which term is defined in the parnership agreement by reference to the

Internal Revenue Codc. (Ex. 1 ~ 7.3(a).) It is reasonable to conclude that ordinary income,
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another term within the same provision, should also be dcfined by reference to the Internal

Revenue Code. This conclusion is reasonable for the additional reason that the Internal Revenue
Code is the most logical source for a definition of ordinary income, a term that has obvious tax

effects, but (at least in this context), does not purport to affect the amount of dollars distributed to
Insight or the Wexford Members.
We also ab'Tee with Insight that the Internal Revenuc Code provides mutually exclusivc

definitions of ordinary income and capital gain. (Insight Motion at pp. 13-15.) Internal Revenue

Code Section 64 defines ordinar income as income deriyed from the sale or exchange of
property that is not a capital asset. Capital gain, howevcr, is defined by Internal Reyenue Code
Section 1222 as gain realized from the sale or exchange of a capital asset1J Plainly, the terms

ordinary income and capital gain reflect two different classifications of sources of income. In
addition to being separately defined, ordinary income and capital gain are treated differently in
other Code sections (some of which are identified at pp. 14-15 of

Insight's motion). Thus,

"items of ordinar income" are distinct from items of capital gain, notwithstanding that one
category of capital gain - short term capital gain - is taxed at the same ratcs as ordinary income.14

13A capital gain is short-term if

§ 1222(1), whcrcas a capital gain is long-term if

the capital asset was held for not more than one ycar, the capital asset was held for more than onc year.

§ 1222(3). Long term capital gains are currently given a prcferential tax rate. § 1 (h).

"Congrcss can, and often does, ehangc the tax ratcs applicable to capital gains (as wcll as the ratcs on ordinary income). For cxample, during the pcriod 1982 through 1986, thcre was a special tax rate for capital gains of 40 percent of the rate that would othcrwise apply to the gain. Income, Estatcs and Gifts'l 46.2.1 (2008) (2000 See B. Bittker & I. Lokken, Federal Taxation of WL 485606 (W.G.&.I.)). However, thc Tax Reform Act of 1986, Pub.I. 99-514, §§ 301, 31 i, 100 Stat. 2216, 2219, eliminatcd the differential tax rates for capital gains and ordinary incomc, and during thc period 1987 through 1990, therc was no prcfcrential ratc for capital gains. !d. It would be incongruous to conclude, as Imprimis' position dcmands, that short term capital gains arc items of ordinary income in years in which thc tax rates on both are thc same, but not when the tax rates differ.
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Finally, we agree with Insight's analysis and conclusion that cven if ordinary income is

not defined by refcrcnce to the Internal Revenue Code (which it should be), the plain meaning of

the term does not include short-term capital gain. (Insight's Motion, pp. 16-19.) As indicated by
the definition in thc edition of

Black's Law Dictionary that was in effect when the partnership

agrccment was drafted in 1998 (the 6th edition, publishcd in 1990), "ordinary income" is a "tax

term" that docs not include gain from the sale of a capital asset. See, e.g., Shell Oil Co. v. United
SIales, 80 Fed. CI. 4 11, 415- i 6 (2008) CIt has been repeatedly held that a court may rcly on thc

dictionar definition of a contract term to identify that term's plain meaning."); Crisp v, United
Stales, 34 Fed. CI. 112, 118 (1995) (referring to contemporaneous law dictionary to determine
plain meaning ortcrm not defined in agreement); Majkowski v. American Imaging Managemenl

Services, LLC, 913 A.2d 572, 589 (DeL. Ch. 2006) (same).
D. Imprimis' Interpretation of Ordinary Income Is Not Reasonable

Unlike thc Insight interpretation, the Imprimis interpretation of "items of ordinary
income" as meaning "items of

income or gain taxable at the rates applicable to ordinary income,"
interpretation

is not reasonable. First, that's not what the partnership agrcement says. Imprimis'

would require the insertion of additional words into the Insight Allocation, which would contrayene well-settled contract interpretation principles. See, e.g., George Hyman Cons/. Co. v.

Uniled States, 832 F.2d 574, 581 (Fed. Cir. 1987) CIfwc accepted this argument, we would havc
to rewrite thc contract, and inscrt words the parties never agrecd to, which we do not have thc
authority to do."); Ed Fine Oldsmobile, Inc. v. Diamond SIole TeL. Co., 494 A.2d 636, 638 (Dcl.

1985) (not the function of a court to rewrite the plain language of an otherwisc valid contractual

provision); Majkowski, 913 A.2d at 588 ("courts will not bcnd contract language to read
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meanings into the words that the parties obviously did not intend."). Second, Imprimis'
interpretation flows from its crroneous assertion that the term ordinary income is defined by
reference to the rale of

taxation, rather than the source. As explained above (and by Insight in its

motion at p. 15), the Internal Revenue Code defines ordinary income (and capital gain) by
reference to the source of the income, and not the rate of

taxation. Imprimis' attempt to bolster

its reasoning by reference to one of thc dcfinitions of ordinary income in the Fifth Edition of
Black's Law Dictionary, published in 1979, is unayailing for all of

the reasons detailed by Insight

(motion at pp. 19-20).

In addition to being unreasonable, the interpretation offered by Imprimis is also
implausible. The Wcxford Members and Insight are in the busincss of

making investments.

(Revised Joint Stip. '1'1 2, 6, 7.) Moreover, the stated purposc of

the Imprimis partnership is to
the

makc investments. (Id. ii,i 2, 3.) Based on the two schedules attached to Exhibit A of

parnership agreement, the partnership investcd in capital assets. (Ex. 1 at CFC000045-47.) 1t is

reasonable to assume that parties who work in the field of investments and who entered into an

investment partnership anticipated that at least some ofthc partnership's income would include

capital gain. It is also rcasonabIe to assume that these paricular parties, given the naturc of thc
business they wcre in, had the sophistication to understand that the terms ordinary income and

capital gain had diffcrcnt meanings under the Internal Rcvcnue Code (and in ordinary usage). In
such circumstances, thcrc is no rcason to conclude that thc plain language of

the contract tcrm is

ambiguous. Indeed, if the parties to the partnership agreement had intended the term ordinary
income to mean "income taxed at ordinary tax rates" (i e. to have a definition different than that
provided by the 1ntcrnal Revenuc Code), they could have included such definition in the

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agreement.
Imprimis attcmpts to validate its interpretation of

the term ordinary income by stating that

such interprclation reflecled the parties' understanding that Insight would receive performanee-

based fees, which would be subjcct to ordinary tax rates. (Imprimis Motion, pp. 45-46.)
Imprimis states that this kind of fee arrangcment is referred to in the privatc cquity business as a
"carr" or "carred interest." (Id., p. 46.) Regardless whether Imprimis has accurately

charactcrized the paries' intent,15 such evidence has no bearing on the interprctation of

the plain

language of

the agreement. Lane Bryant, Inc. v. UnZled Slates, 35 F.3d 1570, 1576 (Fed. Cir.

1994) (court required to "take the allocation madc by the paries at face value for tax purposes,
regardless of what (courtj might think of

the 'economic realities' which drove the deal"); George
trade usage and

llyman Canst. Co., 832 F.2d at 581 ("(Ijt is well established that evidence of

custom canot be used to var or contradict the tcrms of a contract."). Where, as here, the plain

language ofa contract term is unambiguous, there is no reason to examine the parties' reasoning
or intent in drafting the language, or any other extrinsic evidence. Thoughtworks, Inc., 902 A.2d
at 752.

its factual assertion is the Declaration of Arhur H. Amron (Ex. 40). (Imprimis Motion, pp. 45-46.) Becausc no discovery has been conducted, the United States is not in a position to determine whether Mr. Amron has accurately related the understanding of all of the parties to thc partnership agreement, or whcthcr contemporaneous documents or testimony from members of Insight would shed a different light
ISThc only eyidence cited by Imprimis in support of

on this factual issue. However, there is no reason to conduct discovcry on this issue if thc Court
concludes that the plain language of

the contract is unambiguous.
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II.

THE SETTLEMENT AGREEMENT DOES NOT HAVE ANY EFFECT ON THE INTERPRETATION OF THE PARTNERSHIP AGREEMENT FOR PURPOSES OF THIS TAX DISPUTE
Imprimis contends that the interpretive question of

what "items of ordinary income"

means was "resolved" by the Settlement Agreement that concluded thc New York state

consolidatcd action involving Imprimis and Insight (and thcir members and affiliates). (Imprimis

Motion, pp. 50-52.) Imprimis cxplains that the Settlement Agreement resolved the interpretation
issue by resolving thc claims, counterclaims, and dcfcnses in the New York state consolidated

action that related to the Insight Allocation in thc partnership agreement. (Jd., p. 50.)
Contrary to Imprimis' argument, the Settlement Agreement does not have any effect on

the intcrpretation of the parnership agreement for several reasons. First, thc Settlement
Agreement is extrinsic eyidence. Since the language in the allocation proyision, "items of
ordinary income," is unambiguous (see Section i), extrinsic evidence can not be considered to
give that language somc other meaning. See Thoughtworks, Inc., 902 A.2d at 752; Majkowski,

913 A.2d at 581; Specialty Trans., Inc., 57 Fed. CI. at 9.

Eyen if the term "items of ordinary ineomc" was ambiguous, the Settlement Agrcement

would not be relevant to detcrmine its meaning. The Settlement Agrccment was cxccuted by thc
membcrs of Imprimis (and thcir members and affiliated parties), and is a contract between those

parties. Accordingly, evcn assuming that the Settlemcnt Agreement "resolved" the meaning of
thc term ordinary income, the Settlement Agreemcnt amounts to an attempt by the partics to the
partncrship agreement to modify a term of thcir agreement that they later found to bc either

ambiguous or undesirable. The settlcment agreement was executcd in 2003, well after the time
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permitted for modification of

the parnership agreement for the 2000 tax ycar. See § 761(c)

(partnership agreemcnt includes any modifications of

the partnership agreement made prior to, or
the partnership rcturn for thc taxable year, not

at, the time prescribed by law for the filing of

including extcnsions). While the Sctt1emcnt Agrecmcnt might have the cffect of prospectively

modifying the Imprimis partnership agreement for some tax period, it cannot have the effect of

reiroactively modifying the parnership agreement for the parnership's 2000 tax year.
Thc Settlement Agreement can not affect the interpretation of the Imprimis partnership agreement, and modify thc tax conscquences of the agreement, for the additional reason that the
United States was not a pary to the Scttlement Agreement (and did not have any involvement in

the New York state consolidatcd action). Whilc thc paries to the Settlement Agreement may
have resolved certain disputes and/or created enforceable rights and obligations against each other, thcir agreement does not bind the United States or dctcrmine tax consequences under the

Internal Revenuc Code. Unlike the New York state consolidated action, this proceeding does

include the United States as a party. Also unlike thc Ncw York state consolidated action, this
procccding involves a determination of all of

the partnership items for the partnership's 2000 tax

year to which thc FP AA relates (ie. whether to respect the parnership's allocations), and the

propcr allocation of such items among thc partncrs. See § 6226(f). While the parties may havc
made claims with respect to the allocation of

partnership income in the New York statc

consolidatcd action, their claims wcrc for moncy damages against each other, and not against thc
United States for readjustment of

partnership itcms for tax purposes. Accordingly, the
this proceeding, which involves a

Settlement Agreemcnt has no effect on the outcome of

differcnt party (the United States) and a different legal issue (the proper allocation of partnership
income for federal tax purposes).
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II.
THE DETERMINATION OF THE THRESHOLD INTERPRETATION ISSUE WILL NARROW AND FRAME THE REMAINING ISSUES IN THIS CASE
Thc plain language of the Insight Allocation unambiguously providcs a gcncral allocation
of

"Net Profits" to Insight, and a special allocation of ordinary income, which does not include

capital gain. In the year 2000, the partnership reported interest income of$I,882,005, ordinary
dividends of$21,678, net short-term capital gain of$99,821,405, and net long-term capital gain
ofS73,444,348. (Ex. 3, Schedule K, p. 5.) According to the plain languagc of

the parnership

agreement, both short and long-term capital gain should have been allocatcd pursuant to the

general allocation provision. Thc erroneous special allocation of short-term capital gain to
Insight should be re-allocated in accordance with the gcneral allocation provision. See
§ 704(a)16

After thc partnership's capital gain is re-allocated, the only remaining partnership item to

be dctermined is whcther the allocation of ordinary incomc (i e. interest income and ordinary dividends) made pursuant to the special allocation proyision in the partnership agreement has

"substantial economic effect" under § 704(b). Insight suggcsts that because of the relatively
small amount of income involvcd, the issue "can likely be agrecd to among the parties without

the need for further intervention by the Court." (Insight Motion, p. 25.) The United Statcs
agrees, and is interested in pursuing an efficicnt rcsoIution. However, no ncgotiations have
occurred to datc and it would bc premature to engage in such ncgotiations prior to thc Court
deciding the threshold issue of

how to intcrpret the partnership agreement.

160nce the Court rcaches the conclusion that "items of ordinary income" does not includc

short term capital gain, the paries should be able to agree to computations and stipulatc to the
amounts to be adjustcd.
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CONCLUSION
For the forcgoing reasons, the United States rcquests that the Court determine that the

plain language of the partnership agreement is unambiguous, and that the term "items of ordinar
income" does not includc itcms of capital gain. In addition, the United States requests that thc
Court determine that the Settlement Agreement does not have any effect on the interpretation of
the partnership agreement.

Respectfully submittcd,

s/Jennifcr P. Wilson JENNIFER P. WILSON Attorncy of Rccord U.S. Department of Justice - Tax Division Court of Federal Claims Section Post Offce Box 26 Ben Franklin Station Washington, D.C. 20044 (202) 307-6495 (202) 540-9440 (facsimile)
i ennifer.p. wilson(ausdoi. gOY

NATHAN J. HOCHMAN Assistant Attorncy GcncraI DAVID GUSTAFSON Chief, Court of Federal Claims STEVEN i. FRAHM Assistant Chief, Court of Federal Claims
s/Steven i. Frahm Of Counscl
Attorneys for Defendant
May 14, 2008

22