Economic Substance in Tax Crimes (10/14/09)

In American Boat LLC v. United States, ___ F.3d ___ (7th Cir. 2009), here, the Seventh Circuit affirmed a district court's holding that a taxpayer in a Son of Boss transaction was not liable for civil penalties for claiming the tax shelter on his return (I need not differentiate the civil penalties for present purposes). The essence of the relief granted was that the taxpayer had reasonable cause because of the tax lawyer's involvement and opinion (essentially like the other opinions for Son of Boss). The shelter was Jenkens & Gilchrist shelter of the type for which the lawyers promoting it have been indicted. (See discussion of indictment here.)

Echoing the mantra in the Nixon Watergate debacle, the Court said that "Again, the focus is on what Jump [the taxpayer] knew or should have known at the time he obtained the opinion letter." Focusing on the issuer of the opinion in a criminal context, it seems to me that the issue is the same -- to paraphrase, the focus is on what the lawyer knew or should have known at the time he issued the opinion letter. I don't think my paraphrasing is particularly insightful, but I do think it is helpful to state the truism from time to time, for I think it will help focus on the issue I raised in my earlier blog yesterday (see here). Keep in mind that the lawyer is guilty of a tax crime only if he knew the law (i.e., the crime was both knowable and he knew it) and he intended to violate the law.

Let's just take a simple example. Assume that there is a tax benefit that some courts say requires the presence elements A and B (the conjunctive), but other courts say that the benefit requires only the presence of element A or B (the disjunctive). A person promoting the tax benefit could be guilty of a tax crime under the conjunctive interpretation if he or she knew that only one element was present, but would not be guilty of a crime under the disjunctive interpretation if he or she knew that only one element was present. The Government is aware of the split and has made no attempt to resolve it by regulation or by petition for certiorari. The Government is content to let the issue rattle around in the courts for a while, with the corresponding uncertainty to the practitioner community which knows about the split.

Let's say that the Government then prosecutes a gaggle of defendants who promoted a shelter the Government thinks is abusive. The Government is concerned that the disjunctive A or B interpretation is more likely to produce an acquittal. Most of the defendants' home districts are in areas covered by courts of appeals that hold that the disjunctive A or B applies. Using the liberal venue notions for conspiracy, the Government prosecutes in a district where the court of appeals has held that the conjunctive interpretation A and B is the law. Is the Government entitled to prosecute on the conjunctive interpretation, and is the trial court required to submit to the jury on that interpretation?

I suppose that the tolerance our system has for allowing different interpretations of the law among the various circuits until resolved by the Supreme Court would be tested in a case like this. On the one hand, the argument might be that persons undertaking potentially criminal conduct take our system as they find it and thus assume the risk that they will be prosecuted in a location imposing a less lenient interpretation of the law. On the other hand, the argument might be -- I think should be -- that in the criminal arena involving multi-district activity we should have less tolerance for differing interpretations. After all, the Supreme Court has said in the tax arena that prosecutions are permissible only if the legal duty is clear, and how can the legal duty be clear if the lower courts are still fighting about what the legal duty is. So, in this case, I would think that the proper standard for imposing a criminal penalty would be the disjunctive, and the jury should be instructed accordingly even when, on the civil side of the equation, the court would apply the conjunctive test.

Of course, the differing interpretations are rarely this crisply presented. But, I think they can be in the economic substance context. At least in civil tax cases, the courts do differ as to whether the test is conjunctive or disjunctive. E.g., Shannon Weeks McCormack, Tax Shelters and Statutory Interpretation: A Much Needed Purposive Approach, 2009 U .Ill. L. Rev. 697, 709 n. 51 (2009). In the instructions in United States v. Larson (presented in yesterday's blog here), Judge Kaplan stated the test in the obverse of the example I gave. Judge Kaplan said that the Government must prove both (1) that "the relevant taxpayer had no business purpose for engaging in the transaction apart from creating the tax deduction" and (2) "that there was no reasonable possibility that the transaction would result in a profit." In other words, he was addressing the disjunctive A or B I discuss above, because the inability of the Government to prove either would mean that the prosecution failed.

The devil, of course, is in the details. In Larson, the enablers and not the taxpayers were being prosecuted. The test should not be any different if the taxpayers were in the dock. But, at least in the situations in which I was involved, most of the taxpayers had independent counsel advising them of the tax consequences and many had independent financial advisers reviewing the investment program. Hence, when they "represented" that they had the required profit motive or business purpose (in the various formulations appearing among the various shelters), unless they lied, they were stating their belief that they indeed had the required profit motive. Of course, if they were lying in making that representation (i.e., they knew that they did not have the stated business or profit purpose and said it anyway), they would be guilty of a crime for lying about their purpose. (For more on the lie in tax prosecutions.) But if they indeed were not lying and really had the belief (however unreasonable it might be), then the Government cannot prove the first prong of Judge Kaplan's formulation of the test. (Note that Judge Kaplan did not formulate the test to be that the taxpayer had no reasonable business purpose; just that the taxpayer had no business purpose.)

So, let's take this analysis back to the conviction of the enablers in Larson. In order to convict, the jury was required for each count of evasion involving an absent taxpayer to assess the absent taxpayer's motivations on the first element and determine whether that absent taxpayer lied about his business purpose in the written representations he or she made to the enablers in getting into the shelter ab initio. How can the Government prove that element the only evidence is the taxpayer's contemporaneous written representation and some objective evidence that the possibility of profit was a long shot, but nothing else bearing upon the taxpayer's individualized motivation upon which the test on its face turns?