First, Mr. Folger and the Martin family should have known that the transaction resulting in a $315.7 million tax basis for a $0.9 million offsetting options transaction was "too good to be true." Stobie Creek, 608 F.3d at 1383. Furthermore, they knew that the purpose of the transaction was to boost the basis to generate a large capital loss to offset the capital gains from the CPC sale. Finally, they proceeded with the transaction even after the issuance of Notice 2000-44, entitled "Tax Avoidance Using Artificially High Basis," which alerted them that the basis created by the options transaction would likely be disallowed. Although they were advised by Mr. Sideman that the transaction had a legitimate business purpose, Mr. Folger and the Martin family entered into this transaction with the knowledge that it would generate an artificially high capital loss. Given the level of education and business experience shared by Mr. Folger and the Martin family, they should have known that the absence of a tax liability on a sizeable capital gain did not reflect the economic reality of the transaction. The underpayment of tax was not, therefore, the result of "an honest misunderstanding of fact or law." Treas. Reg. § 1.6664-4(b)(1). Because Mr. Folger, with the consent of the Martin family, did not act in good faith, the court finds that the accuracy-related penalty was appropriately applied here.This is standard fare now. I write to develop a different angle that is demonstrated in this case -- the role of the taxpayer's own independent tax lawyer.
I originally encountered the Son-of-Boss shelters in representing one of the defendants in the massive KPMG individual defendant prosecutions. The typical pattern for these transactions is that the taxpayers considering such transactions were wealthy and engaged their own independent tax counsel with respect to the shelters rather than just rely upon the attorney tax opinions arranged or delivered by the promoters. Those independent tax counsel were often prominent and experienced tax attorneys whose sole duty of allegiance was to the taxpayer who engaged them and had no conflicts of interest such as outsized fees for promoting the abusive shelter. We never knew precisely what those engagements entailed. Did the independent tax counsel advise as to the substantive merits of the underlying shelter? Did the independent tax counsel advise and give the taxpayer some assurance with respect to at least avoiding penalties even if the substance of the tax position did not prevail? Did independent tax counsel provide any cash flow analyses with all-in costs based on claiming the benefit and later having it reversed on audit? Did independent tax counsel advise about the likelihood of audit and how to mitigate same, certainly as to penalties? How much did the independent tax counsel really know about the underlying transactions and the tax law relating to it? Did the separate tax counsel participate in the structuring of the transaction? Did independent tax counsel wordsmith the opinion letter finally rendered by the promoter arranged tax attorney, particularly the taxpayer representations upon which the opinion was putatively based. Did the independent tax counsel have reason to believe that the "representations" were not true? Were the independent tax counsel at risk of criminal prosecution depending upon what role they actually served? And, in a related matter, were the taxpayers at risk of criminal prosecution for making false representations (such as with respect to profit motive and business purpose in transactions that had neither)?
In Candyce Martin Trust, the very wealthy taxpayers expected to have a very large capital gain as a result of a sale of their interest in a corporation. This is a prototypical fact pattern -- some large taxable income transaction was on the horizon or had recently occurred and the taxpayer scrambles for shelter. The taxpayers in this case engaged Richard Sideman, a prominent San Francisco tax lawyer, and his firm (Sideman & Bancroft) to advise them with respect to consideration of tax shelters to mitigate or eliminate the very large tax expected from the sale. In this case, Sideman was instrumental in the initial consideration of shelters and extensively involved in the structuring of those shelters. The actual tax shelter opinion was rendered by the infamous R.J. Ruble who was convicted for similar behavior in the KPMG individual's criminal case. The Court noted that it is not clear precisely Sideman's advice about the tax shelter; apparently he did not render a formal written opinion. Notwithstanding that, the Court found that the taxpayers looked to Sideman to "greenlight" their undertaking the transactions. In this respect the Court said (Slip Op. 72-76):
At trial, Mr. Folger and the Martin family members testified that they did not have the expertise to fully understand how the transaction was structured and the tax ramifications and that they relied on the advice of the Sideman firm and PWC, primarily on Mr. Sideman. The evidence presented at trial tends to show that they relied on their tax attorney, Mr. Sideman, to review all the advisory opinions and analyses and to make a recommendation as to whether they should engage in the transaction. The evidence also demonstrates that Mr. Folger and the Martin family had negligible contact with either Dr. Rubinstein [an economics and financial expert engaged by Sideman] or Mr. Ruble, on whom Mr. Sideman relied for an analysis of the business purpose and legality of the transaction. Mr. Folger testified that he did not understand the Ruble opinion letter and relied on Mr. Sideman "to say this was an authentic, valid transaction, and I satisfied myself that he was answering that question." Tr. 267:3-23. While the record is clear that Mr. Folger and the Martin family relied heavily on Mr. Sideman, the record is not clear as to the extent that they relied directly on the advice of Dr. Rubinstein and Mr. Ruble, if at all. It was Mr. Sideman who appears to have relied on the advice of Dr. Rubinstein and Mr. Ruble in advising Mr. Folger and the Martin family.
With regard to Dr. Rubinstein's economic advice, the record establishes that he was given a very limited set of facts on which to conduct his analysis of whether the transaction could have a business purpose. As he testified at trial, Dr. Rubinstein limited his analysis to whether the offsetting options portfolios could make a profit but did not take into account the preexisting holdings of cash which were converted to SPDRs. Dr. Rubinstein did not know that petitioners started in a position of cash and was also instructed not to consider any tax consequences of the transaction. Thus, any reliance on Dr. Rubinstein's advice would not be reasonable because his conclusions were not based on all pertinent facts and circumstances as required for reasonable cause.
With respect to the opinion letters issued by Mr. Ruble and the Brown & Wood firm, the evidence presented at trial demonstrates that the advice was similarly not based on "all pertinent facts and circumstances" and included unreasonable factual and legal assumptions. The Brown & Wood opinion letters contained misstatements of fact and reached conclusions about the transaction that the Sideman firm and PWC, as well as the taxpayers, should have known could not be correct. For instance, in the section of each opinion letter entitled "Investor Representations," Mr. Ruble states that the investor, being each of the Martin Family Trusts, dealt with First Ship and the other members at arms length, and that the investor reviewed the description of the transactions contained in the letter and verified that the description is accurate. However, Mr. Folger testified that he had never communicated with or spoken to Mr. Ruble and that he did not remember reviewing the opinion letter or providing the investor representations, which would have been provided by the Sideman firm or PWC. For his part, Mr. Martin testified that he never read the entire Ruble opinion letter and the record reflects that at one point he was willing to proceed with the earlier Arthur Andersen shelter transaction before receiving the Ruble opinion letter. Ex. 101.
With respect to Ruble's statement that the transactions were motivated by non-tax reasons, Mr. Sideman, as well as the taxpayers, should have known that this statement was contrary to the purpose of the options transaction which was specifically to generate a large capital loss to offset the capital gains from the CPC sale. Furthermore, they should have known that Ruble's factual assumption that the series of options transactions was a viable means of reducing market risks was unfounded because the transaction actually increased the Martin Family Trusts' risk of exposure to market fluctuations and offered no reasonable expectation of profit in the face of an expected market decline, as opined by Dr. Grenadier.
There are other reasons why the Ruble opinion letter lacked "quality and objectivity," rendering reliance on his advice unreasonable. See Klamath, 568 F.3d at 548 (citing Swayze v. U.S., 785 F.2d 715, 719 (9th Cir. 1986)). After being introduced by Arthur Andersen, the Sideman firm hired Ruble in early 2000 to write an opinion letter for the shelter transaction proposed by Arthur Andersen which counsel from the Sideman firm described as one that "creates basis where there was none before." Exs. 98, 100. The evidence shows that the Ruble opinion letter that was issued to the Martin Family Trusts was based on a template opinion letter concerning foreign currency investments that had been circulated earlier in the year with respect to the Arthur Andersen proposal. In addition to the boilerplate nature of the Ruble opinion letter provided to the Martin Family Trusts, the opinion letter was rendered further unreliable after the IRS published Notice 2000-44, which put Mr. Sideman and taxpayers on notice that transactions such as the one they contemplated would be challenged as a sham transaction, particularly after PWC explained that Notice 2000-44 covered "transactions involving the same basic mechanics as the instant one." Ex. 30.
For his part, Mr. Sideman understood that Mr. Folger and the Martin family relied on him to "greenlight" or approve the transaction, but denied that he designed the transaction with PWC and JP Morgan. Tr. 149:10-20; 250:17-25. Mr. Sideman communicated primarily with Mr. Martin as the principal voice on behalf of the Martin family. Tr. 134:16-25. Mr. Sideman testified that he saw his role as that of overseeing the transaction "in a broad way [and] hiring or engaging at my recommendation the most qualified people that I knew who could provide the actual expertise about the transaction and about its financial implications." Tr. 152:19-25. Mr. Sideman characterized himself as a tax controversy lawyer, unfamiliar with economic judgments involving financial matters to advise the Martin family directly on the issue whether the tax proposal by Arthur Andersen, and the subsequent proposal by PWC, would have an economic reality or economic benefit. Mr. Sideman testified that he relied on the advice of PWC, Dr. Rubinstein and Mr. Ruble to examine the business purpose of the proposed transaction. Tr. 143:4-145:16.
While the evidence at trial establishes that Mr. Folger and the Martin family relied on Mr. Sideman's advice, the trial evidence lacks clarity as to exactly what advice Mr. Sideman gave them, other than approving or "greenlighting" the transaction based on the advice he received from the other professionals. The weaknesses noted above in the Ruble and Rubinstein opinions, as well as other aspects of the transaction, should have put at least Mr. Sideman, if not the taxpayers, on notice that the transaction was a questionable tax avoidance scheme lacking economic substance. However, the question before the court is not whether Mr. Sideman's reliance on professional advice was reasonable, but whether Mr. Folger and the Martin family's reliance on Mr. Sideman's and the other professionals' advice was reasonable. As previously noted, it is not clear to what extent the taxpayers themselves relied on any advice other than Mr. Sideman's. Nor was it established that Mr. Sideman ever specifically advised them that the transaction was bona fide or legal. All the evidence clearly establishes is that Mr. Sideman approved the transaction.
The government contends that Mr. Folger's and the Martin family's reliance on the Sideman firm and PWC was unreasonable on the ground that those firms had an inherent conflict of interest arising from their roles in promoting and implementing the transaction and receiving fees. The court is satisfied, however, that the Sideman firm and PWC did not have a profit motive or other monetary interest in the outcome of the transaction because those advisors were paid at an hourly rate to advise Mr. Folger and the Martin family, regardless of whether they ultimately engaged in the transaction. There was not, in the court's view, a conflict of interest.
The government has not provided a clear argument or any authority for whether Mr. Sideman's unreasonable reliance on the professionals he hired should be imputed to the taxpayers. This was a highly sophisticated transaction, one for which a taxpayer would reasonably be expected to hire a tax lawyer. The court is not prepared to find that having retained a tax lawyer who "greenlights" a complicated transaction as having a business purpose, a taxpayer necessarily acts unreasonably by relying on that advice. See United States v. Boyle, 469 U.S. 241, 250-51 (1985) (when an accountant or attorney advises a taxpayer on a matter of tax law, it is reasonable for the taxpayer to rely on that advice, "even when such advice turned out to have been mistaken"). Even assuming, however, that the taxpayers acted reasonably in relying on their tax lawyer's advice to proceed with the transaction, to be entitled to the reasonable cause and good faith defense, the taxpayers must also prove that they acted in good faith. Good faith is not synonymous with objective reasonableness. Even if the concept of business purpose was too complicated for the taxpayers to assess and apprehend, the court finds that Mr. Folger and the Martin family have not demonstrated good faith under the circumstances and in light of the underlying purposes of entering into the transaction.