More on Legal Uncertainty and, More Importantly, the Subjective Prong of the Economic Substance Test (1/19/10)

I have previously discussed here the economic substance instruction that Judge Kaplan gave in the skinnied down KPMG trial that resulted convicted three defendants of multiple tax evasion crimes and is currently on appeal to the Second Circuit. I blogged about the Government’s outsized brief filed last Friday (see the brief here). My topic of focus was the effect of legal uncertainty in the law.

Today, I carry that discussion further in the context of the Government’s claims about the role of the economic substance doctrine in a criminal tax case. To set the stage, there clearly is some uncertainty in the civil cases about the economic substance doctrine. Two tests have been developed, which the Government calls (Br. 55) and most practitioners call a subjective prong and an objective prong. The subjective prong is whether the taxpayer engaging in the transaction had a nontax profit or business objective. Under this test, tax can be a consideration but the taxpayer must have an actual business or profit object or intent; further, there is no requirement that the taxpayer's objective be reasonable. The objective prong is whether the transaction has some – perhaps limited to some reasonable – possibility of profit. The major uncertainty from the civil cases is whether the tests are in the conjunctive or disjunctive. That is, whether a taxpayer desiring to sustain his claim of tax benefits must prove (i) both that he had the profit objective (however unreasonable) and that it was a reasonable profit or business objective or (ii) either of those prongs. (For tax coneheads (among whom I number myself), this objective / subjective inquiry, if indeed conjunctive, may be analogized to the relief from the substantial understatement penalty for tax shelter transactions if the taxpayer had a belief that the transaction will more likely prevail and the belief is objectively reasonable.) The courts in the civil cases are split on that conjunctive / disjunctive issue for the economic substance test.

To state the obvious, criminal cases are not civil cases and different policies are implicated that requires some role reversal. The criminal case asks whether the Government has proved beyond a reasonable doubt that the civil tax result is certain and was willfully violated. Accordingly, in instructing the jury, as he should in a criminal case, Judge Kaplan adopted the most defendant friendly version of the split – that is, he advised the jury that the Government had to both that there was no taxpayer profit or business objective and no reasonable profit or business objective. I have doubts about turning over the economic substance test under either formulation to a jury in a criminal case, but if it must be turned over (and Second Circuit authority says it must), I think Judge Kaplan made the right choice by requiring the conjunctive application of the test. (It is important at this stage to note that the Government argued to Judge Kaplan that the jury should be instructed in the disjunctive – i.e., the jury can convict if either (i) under the subjective prong, the Government proved beyond a reasonable doubt that the taxpayers involved had no profit or business motive, or (ii) under the objective prong, the Government proved beyond a reasonable doubt that there was no possibility – or, in the Government’s mind reasonable possibility -- of profit; that notion is just goofy in a criminal case, but I won't digress further here.)

I want to return shortly to the subjective prong that, in my view, was transformed in this case to an objective inquiry (although I will continue to call it the subjective prong in order to differentiate it from the subpart of the economic substance test that really is supposed to be objective). As to the objective prong, the parties dispute at length in their brief as to whether the possibility of profit is limited by the adjective “reasonable.” I think much of this discussion is semantics echoing Bill Clinton’s famous line – “It depends on what the meaning of the word 'is' is.” (In this semantical game, the Government easily sets up a strawman only to knock it down.) I don’t want to enter that fray right now, but I want to return and address the so-called subjective prong of the economic substance test as it played out in the case.

Let’s go back to the test. It is supposedly an inquiry into the subjective thinking of the taxpayer(s) involved. And, the test as formulated is not an objective test; so long as the taxpayer(s) involved had a subjective profit motive, regardless of how unreasonable it may have been, the tax shelter passes this leg of the economic substance test in a civil case.  Transforming this test to a criminal setting, the Government would have to prove that the taxpayer(s) involved in the counts of conviction had no actual intent -- even if the intent were unreasonable.

As I shall note, at best at least for the absent, nontestifying taxpayers in the counts of conviction, all the Government may have proved beyond a reasonable doubt was that it may have been unreasonable for them to have a profit or business motive, but that is not the same as prove beyond a reasonable doubt that they did not have the motive.

I have asked before how the Government can make that stringent level of proof, at least as to taxpayers as to whom there was no evidence other than the fact that they claimed benefits alleged in the counts of convictions. These taxpayers did not testify and the Government introduced no evidence going to their actual intent. Judge Kaplan and the jury were left to infer that the taxpayers had no such intent solely from the objective evidence of their involvement and the further proof that Government had proved objectively that the shelters could not produce a profit (or at least a reasonable prospect of producing a reasonable profit). The net result is that, in my mind, the court and the jury just conflated two separate tests and turned them into a single objective test -- if the shelter transaction is objectively unreasonable, the presumption is that the taxpayers acted as reasonable persons and thus did not have the intent. This was virtually an irrebutable presumption becuase the taxpayers had no practical ability to prove what the taxpayers might have intended or to otherwise attack the presumption thus raised by the Government in meeting the objective prong of the test.

I ask this simple question: would the proof adduced at trial as to the absent taxpayers have alone sufficed in criminal prosecution of those taxpayers to prove beyond a reasonable doubt that they had no profit or business motive? Does that evidence prove beyond a doubt that the taxpayers could not have been mistaken? In a criminal prosecution of the taxpayers themselves, the Government would have proved a host of facts about the individual taxpayers (education, business savvy, etc.) that would have offered some basis to reasonably infer whether the taxpayers had the actual intent, however unreasonable, or not. At best, all the evidence proves -- perhaps even proves beyond a reasonable doubt -- is that a reasonable taxpayer would have had no such subjective profit motive. The test, however, is not a reasonable one but a subjective one testing whether the taxpayer actually had such intent regardless of whether it was reasonable or not.  (Certainly a diversion to my main point, but the even more startling thing here is that a necesssary conclusion from the Government's arguments is that it in fact proved beyond a reasonable doubt that they taxpayers themselves committed tax evasion, even though they were given no opportunity to defend themselves.)

Sure, Judge Kaplan mouthed the right words – the test is the intent of the taxpayers without qualifying whether it should be reasonable intent, but in the final analysis the jury had no specific evidence of the taxpayers’ intent and were left to conclude only that the taxpayers must not have had the intent because no reasonable taxpayer could have had such an intent. That is an objective test in the guise of a subjective one.

And, of course, the Government knows that it skirted the subjective nature of the subjective prong (that second subjective is not redundant here). I won’t pull out all the points in the brief where the Government fudges on this issue. But you can clearly see the bootstrap with reference to the Gibson Dunn memo. Gibson Dunn, a law firm, was engaged or more taxpayers to opine about the transaction. Gibson Dunn had some doubts and evidenced those doubts in a memo that the defendants were aware of contemporaneously. Notwithstanding Gibson Dunn’s concerns in the memo, some of the Gibson Dunn clients allegedly invested. The Government cites (br. 41-42) that memo as proof that the taxpayers’ “lack of a nontax motive was unquestionable.” I fail to see the logical connection there. I don’t think that the Government ever proved that each of the absent taxpayers in the counts of conviction ever read the memo. But even more breathtaking in its gall, is the Government’s claim that it is entitled to send people to jail on the assumption that the clients have to subjectively believe the same thing as a lawyer whose advice they did not follow. That is not the stuff, in my mind, of criminal tax cases.

The tragedy of all this, in my mind, is that, if these defendants were guilty of some conduct for which criminal penalties are appropriate, the Government had plenty of tools to do it. Tax perjury, aiding and assisting, tax obstruction and even the Klein defraud conspiracy (oops, that's right the jury acquitted on that charge). According to the Government's claims in the briefs, the transactions were laced with lies and pretenses which could have easily been the proper fulcrum into one or more of the other tax crimes with penalties that would have produce ample incarceration periods for the gravity of the claimed misconduct, but the Government chose to make multiple evasion claims that, in my judgment, are seriously questionable.

That is the thread of my argument. Maybe I’ll write more on it in another forum, but it tests the limits of what I imagine is appropriate for a blog.