Tuesday, January 24, 2012

Second Circuit Strikes Down Another BS Tax Shelter (1/24/12)

I post another decision in a BS  Tax Shelter, this time involving none other that GE.  Tax Notes has just posted the Second Circuit's slam-down on the shelter.  The opinion is here; the Tax Prof blog is here.  (By the way, the Tax Prof Blog is highly recommended as daily reading.)

The case is TIFD III-E Inc. v. United States, 666 F.3d 836 (2d Cir. 2012).  The case has some history.  The district court seems to have been smoking from the same exotica plant that the taxpayer was.  The district court sustained the shelter the first time.  The Second Circuit graciously gave the district court another chance at it.  The district court, having not given up its sense of rightness, sustained the shelter again.  In this new opinion, the Second Circuit shuts it down, handily rejecting the shelter and imposing the 20% accuracy related penalty.  (The Second Circuit did throw a words only consolation to the district court by calling his opinion "thorough and thoughtful" albeit wrong.  The Second Circuit offered no consolation to the taxpayer.)

For those who are procedure fans, you will recall that the 20% accuracy related penalty generally has an out if the taxpayer either had substantial authority or disclosed and had at least a reasonable basis.  But there is no such out if the tax in issue relates to a tax shelter (defined very broadly).  The district could held that the transaction was not a tax shelter and that the penalty did not apply because the taxpayer had substantial authority.   The Second Circuit rejected the second basis (finding that substantial authority did not exist) and thus did not have to reverse the district court on its holding that the transaction was not a tax shelter.  The Court said (p. 25 fn 10):
  n10 Our conclusion that a substantial understatement penalty is properly imposed on the taxpayer makes it unnecessary for us to consider whether the district court correctly determined that (1) Castle Harbour was not a tax shelter, see § 6662(d)(2)(C) (1993) (providing that the substantial authority defense is unavailable with respect to items attributable to a tax shelter); and (2) that the taxpayer is not subject to a negligence penalty, see Treas. Reg. § 1.6662-2(c) (barring imposition of a negligence penalty in addition to a substantial understatement penalty for the same understatement of tax)
I speculate that the Second Circuit might have been given the district judge another consolation by not reversing him on everything, although it seems likely that had the court reached this issue, it would have reversed.

Now, why do I write about BS tax shelters on a federal tax crimes blog?  Well, I am still struggling for some meaningful way to distinguish between those tax shelters that are just BS and those BS shelters that are criminal. Maybe readers can weigh in on this issue, but I am no opining either way on this one (besides, my opinion is not important any way).  I would be interested in readers opinion of the dividing line (other than you'll know it when you see it).

And, a related observation.  Was GE's conduct in this case any more morally upright or commendable than most of the persons who have been herded into OVDP 2009 and OVDI 2011 with far more draconian penalties?  Yet, GE drew a relatively light 20% penalty.  Is that fair (to play a theme from President Obama)?

Indeed, the slap on the wrist 20% penalty raises serious questions about the civil penalty regime.  One could argue that a 20% penalty is too light a punishment for GE's conduct.  Surely GE, which  reputedly has the the "world's best tax law firm." (David Kocienewski, G.E.'s Strategies Let It Avoid Taxes Altogether (NYT 3/24/11), here,)) realized that the deal it cobbled together at great expense would be challenged on audit if it were discovered and understood and, I suspect, fully realized that it was not likely to prevail in in litigation.  (Maybe GE had some type of MLTN opinioin, but the quality of the opinion might have been suspect which may be why GE apparently did not assert reliance on professional advice as an out for the penalty.) 

The Briefs in the Second Circuit are:
Government's Opening Brief, here.
Taxpayer's Answering Brief, here.
Government's Reply Brief, here.


  1. "I am still struggling for some meaningful way to distinguish between those tax shelters that are just BS and those BS shelters that are criminal."

    As a defense lawyer, I have argued that a shelter is criminal if it is based on fraudulent factual statements (a coal mining shelter where the promoter doesn't actually own the coal mine and forges a deed; an equipment leasing shelter where the same piece of equipment is simultaneously leased to multiple investors), and not criminal if all of the factual representations are true and the shelter is merely based on colorable, but ultimately unsuccesful, legal arguments. The so-called "Son of BOSS" prosecutions were wrong, according to this view.

  2. "And, a related observation. Was GE's conduct in this case any more morally upright or commendable than most of the persons who have been herded into OVDP 2009 and OVDI 2011 with far more draconian penalties? Yet, GE drew a relatively light 20% penalty. Is that fair (to play a theme from President Obama)?"

    GE did not lie on its return in order to avoid an audit. GE, which is in the "automatic audit" category of corporations, took an aggressive tax position and fully disclosed it on its tax return. Taxpayers have a right to take a tax position which differs from the IRS's view and to submit the dispute to the courts.

  3. Hi, Elliott,

    Thanks for your views. You are an excellent lawyer. I and the readers appreciate your views.

    I do, however, differ. Let me state at the outset that nothing I reviewed suggests that GE "lied" on its return. But GE did take a position on the return signed which was signed with the following jurat: "Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct, and complete." And it submitted that return with a position that lacked substantial authority. Now, one can infer from the penalty structure that the jurat is not violated with a substantial authority position or with a reasonable basis position (at least if there is disclosure). And I think that is what most tax practitioners think. So, I will assume the truth of that and assume that GE did not violate the jurat and therefore did not lie in that sense.

    Now, you say that GE fully disclosed the position on the return. Given the preceding part of your sentence, I think you may be assuming that, because GE was under ongoing audits, the position was disclosed. I don't think the opinions indicate that GE affirmatively disclosed the position. If not, even with ongoing audits, GE could have been playing the audit lottery. Keep in mind that this was not like many abusive shelters that, with a thorough audit, would stick out as outside the main stream. This shelter was related to the taxpayer's business but essentially inserted straw parties to defer income. So, it is at least conceivable that, prospectively, it was by no means certain that the IRS would discover the abuse.

    Now, let me say why I infer -- perhaps speculate -- that GE did not disclose. Remember that the trial judge tried to let GE off the penalty by finding (i) that the transaction was not a tax shelter and (ii) that GE had substantial authority. The trial judge would not have had to find substantial authority if GE had disclosed, for the penalty is avoided in nontax shelter transactions with a mere reasonable basis (significantly less than substantial authority). And, had GE disclosed, the Second Circuit to sustain the penalty would have had to conclude that there was no reasonable basis or that the transaction was a tax shelter. The Second Circuit did neither and, without directly questioning the trial judge's holding that the transaction was not a tax shelter, imposed the penalty because there was no substantial authority.

    In short, it seems to me that unless GE disclosed and failed to argue that it should prevail even without substantial authority, then one can reasonably infer that GE failed to disclose. And, if one can infer that GE failed to disclose an aggressive position that it certainly knew about, one might also infer that GE was playing the audit lottery.

    I could be wrong but those are inferences that are consistent with what I know about the cases.



  4. Elliot,

    Also on your point that colorable arguments without express lies should draw no criminal penalties, I am not sure that the Government takes that view. I think, perhaps, my concern depends upon what colorable is. I think that one can infer from the penalty provisions that reasonable basis positions should draw no criminal penalty. But what about positions that do not even rise to reasonable basis? Is "colorable" something less than reasonable basis or is less than reasonable basis in criminal territory?



  5. Further to Elliott's comments, I provide the following from a Tax Notes Today article (Jeremiah Coder, Repeat After Me: The Second Circuit Does Not Like Castle Harbour, 2012 TNT 16-5 (1/25/12))

    Lawrence M. Hill, a partner with Dewey & LeBoeuf LLP, said, "It strikes me that the application of substantial understatement penalties in this instance was unduly harsh -- particularly when it is clear that the district court itself struggled with the debt versus equity issue."

    * * * *

    Matthew D. Lerner of Steptoe & Johnson LLP said the court's outcome on penalties was troubling. "I recognize that substantial authority is in some senses a factual test, where a court must decide whether there is or is not authority for a position, but the notion that a circuit court can uphold the government's imposition of such a tax penalty when a lower court has twice said that the taxpayer's position should prevail is surprising to me," he said. While the circuit court took a dim view of the judicial authorities relied on by the taxpayer and the district court, "the lower court clearly thought that there was a reasonable foundation for the taxpayer's position," he said.


    By presenting these quotes here, I am not saying that I agree with them. I just present them because they are in line with Elliott's analysis. I think readers should consider them.

  6. It is interesting to contrast the approaches of two judges from the same district -- the district of Connecticut. The district courts in that district have considered two prominent BS tax shelters -- the GE tax shelter which is the subject of this blog and the Long Term Capital tax shelter. See Long Term Capital Holdings, Inc. v. United States, 338 F.Supp.2d 122 (D. Conn. 2004), aff’d by unpublished order (2nd Cir. 9/27/05). Somehow, it is hard to imagine that Judge Aterton -- the author of LTCH -- would have reached the same conclusions as did Judge Underhill -- the author of TIFD.

    Indeed, it is hard to imagine that Judge Underhill was not fully aware of the LTCH trial and appellate results and that his approach was at some level seriously inconsistent with LTCH.

    I would appreciate other readers views on this.

    Jack Townsend

    Jack Townsend

  7. Of course, if Judge Underhill did not get the point of the Second Circuit's first reversal in TIFD, I suspect he may not have gotten the point of LTCH.

    Jack Townsend


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