Thursday, February 18, 2010

More on Economic Substance in Criminal Tax Cases (2/18/10)

I have previously blogged here on the stunning not guilty verdict in the Virgin Island’s residency issue. I thought I would share excerpts from the jury instructions in the case. (Thanks to Chuck Meadows, a lead defense lawyer in the case, for provising them.)  The portion related to the tax crimes allegations may be viewed here. I provide below a subset of those excerpts dealing with the economic substance / sham transaction issue. My question to readers is whether these instructions give a jury meaningful guidance on the economic substance issue? The court equates lack of economic substance and sham transaction which I think is defendant friendly because, I believe, lack of economic substance as the Government imagines it in criminal cases is a broader concept than sham transaction.

Sham Transactions

101. The third way in which the government seeks to satisfy the first element of income tax evasion, that is, that Mr. Auffenberg claimed false deductions against his income, is based on the legal principle that for transactions to be recognized for tax purposes, they must have economic substance. In other words, even if a transaction complies precisely with all requirements of the Internal Revenue Code for obtaining a deduction, if it lacks economic substance it simply is not recognized for federal taxation purposes.

102. The taxpayer has a legal right to decrease the amount of what otherwise would be his taxes or altogether to avoid them, by means which the law permits. However, the first of two critical questions is whether what was done, apart from the tax benefits, was the thing which the law intended. If it was not, you must then answer the second question, which is whether the defendant willfully engaged in such conduct for the purposes of evading taxes. I will explain the concept of "willfulness" to you momentarily.

103. In determining whether a particular transaction is a "sham," that is, whether it lacked economic substance, you are instructed to consider the overall circumstances surrounding the asserted transaction. Furthermore, when presented with a series of related transactions, the income tax effect of these [*42] transactions can only be evaluated by viewing the series of related transactions in their totality. It is the economic reality behind a series of interrelated steps viewed as a whole that matters.

* * * *

" Willfully"

108. For the counts of income tax evasion, conspiracy to defraud the United States, and other specific counts set forth in these instructions, the government must prove beyond a reasonable doubt that each defendant acted willfully. For you to find that a defendant acted "willfully, you must find that he voluntarily and intentionally violated a known legal duty under the tax laws.


"Good Faith

109. The defendant's conduct was not willful if he acted through negligence, mistake, accident, or due to a good faith misunderstanding of the requirements of the law. A person acts in "good faith" when he or she has an honestly held belief, opinion, or understanding regarding the law, even though the belief, opinion, or understanding turns out to be inaccurate or incorrect. Thus, in this case if a defendant made an honest mistake or had an honest misunderstanding about the law, he did not act willfully.
Note that this instruction does not include the broader spin on economic substance given by Judge Kaplan in the Larson case involving the KPMG tax shelters. That spin was:
In order to establish that a transaction lacks economic substance, the government must prove beyond a reasonable doubt both of two factors. The first factor is that the relevant taxpayer had no business purpose for engaging in the transaction apart from creating the tax deduction.

The second factor is that there was no reasonable possibility that the transaction would result in a profit.
For Judge Kaplan's further elaboration on what this means, see his excerpted jury instructions here.

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