Taxpayers’ positions exploiting the audit lottery often are criminal in nature. By criminal I mean that the taxpayer voluntarily violated a known legal duty. This is often referred to as the Cheek definition of willfulness which is the standard for most tax crimes (e.g., tax evasion in § 7201, tax perjury, in § 7206(1) and aiding and assisting in § 7206(2)). Taxpayers’ whose conduct is criminal are playing the audit lottery. Very few of them would engage in that conduct if they knew they would be detected; hence, their conduct is explainable only because the probability of detection is sufficiently low that the risk / reward ration is quite favorable. For reasons, I describe below, the audit lottery is not limited to criminal misconduct. Taxpayers merely taking super aggressive positions, positions they know are not likely to prevail but are not criminal, may also play the audit lottery. In either event, both types of taxpayers seek to exploit the IRS’s limited ability to discover, understand and correct their erroneous tax benefit claims.
In this blog, I analyze the audit lottery through the perspective of the criminal tax regime and the civil tax penalty regime. Both regimes offer penalties for misconduct with respect to claiming improper tax benefits. The criminal penalty risks can usually be practically eliminated by sophisticated, well advised taxpayers, so that the only penalty risks to playing the audit lottery are the civil penalties. Perversely, the civil penalties are too low to encourage aggressive taxpayers to forgo the audit lottery. I therefore focus here on the civil tax penalties.
The significant civil tax penalties for present purposes are:
(i) the 20% accuracy related penalty (§ 6662), consisting of (a) the negligence penalty (for negligence or intentional disregard of the rules) and (b) the substantial understatement penalty for failure to pay some threshold level of tax (fairly low) from claiming positions that do not rise to a certain level of probability of being sustained; and
(ii) the 75% civil fraud penalty (§ 6663) which is the civil counterpart to tax evasion.These rules create certain constructs about probability – sometimes called likelihood – that a taxpayer is entitled to the tax benefit the taxpayer claimed improperly.
These levels of probability are:
More likely than not to prevail if litigated (quantified as more than 50 percent likely)The last category -- frivolous -- could involve potential criminal prosecution and/or the civil fraud penalty, at least where the Government proves that, in making the frivolous claim, the taxpayer violated a known legal duty. Many taxpayers assert frivolous claims that they really believe are available, thereby not violating a known legal duty. Other taxpayers assert frivolous claims to mask that they intend to avoid paying the tax they know they owe. The thinking among the practitioner community is that frivolous claims are at high risk of criminal prosecution and assertion of the civil fraud penalty because a jury could read the taxpayers’ intent either way.
Substantial authority (quantified as perhaps 40% likely)
Reasonable basis (quantified as perhaps 20 or 25% likely)
Frivolous (less than reasonable basis)
The other categories – the nonfrivolous categories – represent some level of probability that the claim rises above being frivolous. The thinking among the practitioner community is that these taxpayers claiming tax benefits with these higher levels of probability are not committing a tax crime. These taxpayers could commit a tax crime if the tax benefit with this higher level of probability is accompanied by acts designed to impair or impede any IRS investigation, which are independent crimes regardless of the merits of the tax benefit. Assume that the taxpayer has a reasonable basis the claimed tax benefit from transaction X is would prevail. In the real world, that is not much of a probability (20 or 25%) that the taxpayer will actually sustain the position if it is discovered and contested by the IRS. But, the taxpayer claiming such a position will be subject to the civil penalty regime only, and the only civil penalty that will apply is the 20% accuracy related penalty. That taxpayer will not be subject to the civil fraud penalty or to criminal tax penalties.
Let’s assume that, based on the taxpayer’s audit profile, the taxpayer believes that IRS is 90% likely to discover and contest the claimed tax benefit that has only a 20 or 25% chances of prevailing. Is the 20% accuracy related penalty sufficient to discourage the conduct? Most likely.
Assume, however that, based on the taxpayer’s audit profile, the taxpayer believes that the IRS is only 5% likely to discover and contest the claimed tax benefit. Is the 20% accuracy related penalty sufficient to discourage the conduct? I doubt it. The rewards – 100% of the tax amount. The risks – 120% of the tax amount, but only a 5% chance of discovery. This is classic audit lottery analysis.
What is the chance of discovery is only 1%? Well, the taxpayer’s risk / benefit ratio is even more favorable. And, what if the taxpayer moves his chance of discovery from 5% to 1% by using complex documentation to disguise the nature of the transaction and thus the aggressiveness of the tax benefit claimed? Obviously, as noted above, that could move the claimed tax benefit from a civil penalty position to a criminal penalty position.
I am going to deal with a specific instance of a case implicating these issues, but first I want to address the larger issue of whether this type of conduct is a systemic problem. I am aware of no data among taxpayers generally on the underreporting potentially involved. But, there is such data for public companies who must report the potential financial impact of their risky tax positions.
Public companies do that in their Fin 48 financial statement disclosures. Those disclosures require an entity to quantify its tax positions that are not more likely than not to prevail and state the financial statement impact if those tax risks are disallowed. In an excellent analysis (Bret Wells, Adopting the More Likely Than Not Standard for Tax Returns, 127 Tax Notes 451, 454 (Apr. 26, 2010), here) Bret Wells states:
2. FIN 48 disclosures.
The new FIN 48 disclosures have revealed a substantial, even shocking, disparity between the amount of tax large firms voluntarily pay with their tax return and the amount they think they will ultimately be required to pay [if caught]. The Credit Suisse report found billions of dollars of underpayments in the sample of 362 companies. It lists, for example, a substantial difference between what the following companies reported on their tax returns and what they thought they owed.
FIN 48 Self-Disclosures of Tax Owed but Not Returned
1 Merck $7.4 billion
2 GE $6.8 billion
3 AT&T $6.3 billion
4 J.P. Morgan $4.7 billion
5 Pfizer $4.6 billion
To the extent a taxpayer makes a positive assertion in its FIN 48 workpapers that a tax position is not sustainable in full, these workpapers provide compelling evidence that the taxpayer did not in fact possess a belief in the sustainability of its tax position and thus would be subject to a substantial understatement penalty if the position were found to be wrong.In the quoted text above, I make two changes: (i) I added and bold-faced the words “if caught” in the first paragraph, because that is implicit, but I believe should be explicit; and (ii) I bold faced GE’s position because I am going to discuss a tax position that GE took that was likely a relatively small component of the quantified amount of risky positions aggregating $6.8 billion.
I wrote previously on the Second Circuit's decision in TIFD III-E, Inc. v. United States, 666 F.3d 836 (2d Cir. 2012) ("TIFD") where the real party in interest is the venerable firm of General Electric (GE) (see GE's Wikipedia entry here). The plaintiff in the refund case is the tax matters partner for a partnership named Castle Harbour LLC which undertook the transaction in question. Practitioners thus commonly refer to the case as “Castle Harbor” and I will use that convention here to refer to the transaction. The TIFD decision is here. My prior blog, titled Second Circuit Strikes Down Another BS Tax Shelter (1/24/12), is here. I revisit TIFD based on the comments to that prior blog. The gravamen of the claim by some commenters is that the 20% accuracy related penalty unfairly penalizes GE. I disagree. GE well deserved the penalty. Indeed, if anything, the penalty is too low for, in my view, the 20% penalty it does not sufficiently punish the misconduct the court found to have occurred.
As implied in Bret Wells’ article, an important component of GE's bottom-line profit is its very low effective tax rate. By claiming benefits that GE doesn’t think it is entitled to, GE’s effective tax rate is driven down. To keep its effective tax rate low, GE deploys an internal tax department that is described as the world's "best tax law firm." David Kocieniewski, G.E.’s Strategies Let It Avoid Taxes Altogether (NYT 3/24/11), here; and Mark Memott Report: General Electric Paid No Federal Taxes Last Year (NPR 3/25/11), here. GE's best tax law firm is quite good at driving down the tax costs and thus driving up after tax profit. I can't speak to how GE does that because generally GE's tax positions are secret until and unless the IRS discovers and contests the positions and GE chooses to litigate them. But, as to its tax positions generally, it appears that GE has claimed a whopping amount of tax benefits that GE itself acknowledges that GE is more than likely not entitled to. One of GE’s aggressive positions surfaced in TIFD. TIFD establishes that, at the very least, that particular tax position was not just aggressive; it was illegal.
I won't get into the technical details of the tax gambit that GE pursued through the Castle Harbour transaction. In its essence, GE documented a lending transaction to make the foreign lenders appear as partners in an entity treated as a tax partnership. In the jargon for hokey deals involving foreign parties, the foreign lenders were tax indifferent, meaning that they would not pay any U.S. tax on any income allocated to them. Through complex provisions including partnership allocations to these tax indifferent purported partners, GE diverted taxable income (but not real economic income). The intended effect, if successful, would be to defer GE’s taxable income – lots of taxable income – and perhaps convert the income into capital gain by the time the partnership was ultimately resolved years later. (I presume that this was a deferral and conversion shelter rather than one that had the opportunity to make the taxable income just go away at some future time.)
The key was to make the banks appear to be partners rather than lenders. Why would GE want to make it appear that the banks were partners when they really were not partners? Well, because GE could not allocate any taxable income to them unless they were partners sharing in the income to pass even superficial muster. There were other problems with the structure (such as substantial economic effect for the large allocations of taxable income far exceeding the banks’ economic interest in the transaction), but I focus here on just GE's representation in the documents and the tax returns that the banks were partners when we know that the banks were not partners. As the Government pointed out in its reply brief (pp.30 & 31):
As for the claim that the Code and Treasury regulations technically allowed the return position, the following illustration aptly describes how the Castle Harbour transaction exploited these provisions:
Say you have a dog, but you need to create a duck on the [tax returns]. Fortunately, there are specific [tax] rules for what constitutes a duck: yellow feet, white covering, orange beak. So you take the dog and paint its feet yellow and its fur white and you paste an orange plastic beak on its nose, and then you say to your accountants, “This is a duck! Don’t you agree that it’s a duck?” And the accountants say, “Yes, according to the rules, this is a duck.” Everybody knows that it’s a dog, not a duck, but that doesn’t matter, because you’ve met the rules for calling it a duck.
Bethany McLean & Peter Elkind, THE SMARTEST GUYS IN THE ROOM, at 142-43 (Portfolio 2004 ed.); see BB&T Corp. v. United States, 523 F.3d 461, 477 (4th Cir. 2008) (“we are reminded of Abe Lincoln’s riddle ‘How many legs does a dog have if you call a tail a leg?’ ‘The answer is four,’ because ‘calling a tail a leg does not make it one.’”) (internal citations & quotations omitted). As this Court stated, GECC’s “$60 million tax objective depended on successfully characterizing the interest of the Dutch banks as an equity partnership participation. There could be no conceivable doubt that the taxpayer had a vital interest in the acceptance by the IRS and the courts of the banks’ participation as equity, and had taken pains in the design of the partnership to promote that characterization.” (SPA70.)The Second Circuit got the point and called a duck a duck (or rather called lenders lenders). And, the Second Circuit also got the point that GE created a maze of documents and provisions designed to obscure the fact that the banks were lenders and not partners. The following are some quotes from the opinion:
The foreign banks were "ostensible partners."There is more, but to cite more would be redundant. The point is that, in structuring this transaction, GE took great pains to make the banks appear to be partners which they were not rather than lenders which they were. The economic facts -- certainly known to GE and its advisors -- were that the appearance thus created was misleading as to the banks real economic role. Why was the mischaracterization in the documents? I state the obvious – to fool the IRS. In short, GE played the audit lottery.
The parties created "[A] maze of contractual provisions" in the partnership agreement designed to insure that the banks were economically lenders rather than partners.
Some of its [the partnership agreement's] provisions, examined in isolation, were designed to give the appearance of creating the potential for a greater or lesser return in the case of unexpected profits or losses. A web of other provisions, however, together functioned to ensure that there was effectively no practical likelihood that the banks' return would deviate more than trivially from the Applicable Rate.
The "risks" [to the banks] in question were in the nature of appearance of risk, rather than real risk.
GE's best law firm would certainly have recognized that its description of the lenders as partners was thin (not to mention that the allocations of taxable income to those purported partners lacked substantial economic effect). Indeed, not only was that best law firm involved, GE had outside advice from leading partnership tax experts. The Government's opening brief says: "Moreover, GECC successfully objected to including any of the tax advice it received into the record, including a tax opinion prepared by King & Spalding" (Govt Opening Br. p. 101). King & Spalding was then the firm of the partnership tax gurus, McKee and Nelson who are principal authors of the definitive partnership tax work, Federal Taxation of Partnerships & Partners; as a side, McKee was also a principal author of the tax opinion for the infamous tax shelter that went down in flames in 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). Given this talent, GE surely must have known that its position was tenuous. Indeed, it is the lawyer’s duty to project based on their knowledge of the law and courts what a court will ultimately do with that particular case if litigated; if the lawyers fails to do that, they disserve the client. The record contains no suggestion that the lawyers did not so advise GE as to the risks of the result that the Second Circuit pronounced. The inference is that GE knew this and proceeded anyway, apparently assessing the risk – which was just an audit lottery risk, where it tried to improve its odds with a complex maze of provisions to obscure the lenders rose – as justified, given the potential benefits.
The penalty provisions and their role in TIFD case confirm this inference that GE knew its tax position on the Castle Harbour transaction was tenuous. First, as applicable at the time, tax shelters did not avoid the substantial understatement penalty unless the taxpayer reasonably believed the position would more likely than not prevail. The TIFD trial court held that the transaction was not a tax shelter, a holding the Government contested on appeal. The Court of Appeals did not reach this issue, because GE did not even have substantial authority (another disqualifier for penalty relief). But, it is interesting that GE did not urge that it reasonably believed that the position was more likely than not to prevail in the event the courts reached the issue and concluded that the transaction was a tax shelter (which it was). Had GE claimed that it reasonably believed the position would more likely than not prevail, GE would have put its tax opinions (both in-house and out–house) in issue and thus discoverable. GE studiously avoided any risk that the tax opinions would be considered. As noted, the inference that the best and brightest would have written opinions, as they are supposed to do, predicting the actual results that have now obtained.
Second, GE’s position did not even have substantial authority. GE surely also knew that going into the transaction because it was advised by the best and the brightest who certainly knew the problems with the transaction. I assume that GE thus either knew it did not have substantial authority or knew it was at high risk of not having substantial authority.
Third, on the basis of that assumption (and, of course, the fact that this was really a tax shelter in any event), GE knew that it was at high risk of being subject to the accuracy related penalty if the IRS discovered the transaction. GE did have the option of trying to mitigate the accuracy related penalty risk by making a disclosure of the transaction on its tax returns. Under the penalty provisions, if indeed the transaction were not a tax shelter and did not have substantial authority (which it did not), GE could still have avoided the penalty if it had a reasonable basis and it disclosed the reporting of the transaction. Since GE made no claim to escape the penalty by disclosure, one has to assume that GE did not disclose the transaction and the IRS had to ferret it out despite GE’s maze of paperwork.
Fourth, GE did not even try to assert a reasonable cause defense allowed under Section 6664(c). (The parties did apparently dispute whether GE could have raised the defense in the procedural posture of the case, but the Government claims correctly, I think, that GE could have.) I think a fair assumption is that GE wanted to avoid opening up the opinions it received. And, of course, GE had no hope of passing the higher hurdle with this transaction properly characterized as a tax shelter. See Section 1.6664-4(f) (minimum requirements of substantial authority and reasonable belief that the tax benefits were more likely than not to prevail, with those minimum requirements still not dispositive). GE could not have met the reasonable cause requirement whether the transaction were a tax shelter or not (it certainly was a tax shelter).
In short, GE played the audit lottery with a transaction it knew would not prevail and was unwilling to open its kimono to tell the IRS and the courts (and the world) what it knew and when it knew it. It has been my experience that taxpayers -- particularly well advised taxpayers such as GE -- assess the risks and costs should the worst happen. GE must have known that it was at high risk of at least a 20% penalty if the IRS discovered and understood the transaction. In its cost / benefit analysis of claiming the illegal benefit of the transaction, GE must have considered the 20% penalty as just a potential cost for playing the audit lottery and found that potential cost acceptable given what it stood to gain if it won the lottery.
One commenter to the original blog, thought the fact that GE (including related entities such as the partnership) was under continuous audit meant that GE in effect disclosed the transaction to the IRS. That does not follow. It is apparent that GE's structuring of the complicated arrangement without disclosure was designed for stealth even in such a continuous audit. Large taxpayers subject to continuous audits play the audit lottery if they think there is a possibility that a transaction will not be discovered or understood. What I do not know is how often such taxpayers win the audit lottery. (Perhaps the combination of the UTP reporting requirement and the whistleblower provisions will mitigate the urge to play these games in the future.) But, I infer that GE hoped to win the lottery in in reporting the Castle Harbour transaction because it did not disclose the transaction.
The unspoken issue is whether the transaction is so stinky that it could implicate potential criminal or civil fraud penalty exposure. Keep in mind that the documents clearly painted a false picture of the banks as partners when they were lenders. Should that be called fraud? I can't answer that question here because fraud requires detailed development of facts beyond what are presented in the opinions. But I do think the known facts at least fairly raise the question. What if the partnership agreement had properly identified the lenders as lenders and not partners; would an allocation of the partnership income to the lenders not have been fraudulent? How does that result change if the partnership agreement misidentifies them as partners rather than lenders? What if King & Spalding had opined in the secret opinion that the purported tax benefits of the transaction did not have substantial authority or perhaps even a reasonable basis?
Finally, we can ask the question whether this is the conduct of a good U.S. taxpayer. GE is an icon of American industry. The question here is whether it is a good taxpayer or, in a broader, since a good citizen. And, a related question is how many times has GE won this lottery with positions that should not prevail and thus forced on the citizens of this country the costs of the taxes it owed but did not pay? This is not just to pick on GE, because as suggested above, this conduct has been common among sophisticated taxpayers.
I and commenters on this blog have spent a lot of time dealing with minnows who got caught up in the Government's juggernaut on offshore accounts. By minnows, I mean those who had unreported offshore accounts but did not disguise them through mazes of foreign entities designed specifically to mislead. Those minnows who came forward took the 20% accuracy related penalty and 20% - 27.5% of their high balances (both noncompliant accounts and noncompliant foreign assets). How is GE's conduct more morally appropriate than is the conduct of those minnows? GE took much more elaborate steps the hide the conduct than did these minnows. On any fairness scale, minnows should not be penalized for their conduct greater than GE has been penalized for its conduct in reporting the Castle Harbour transaction. Or, on any fairness scale, GE should be punished more.
The answer that some argue is that the U.S. tax penalty structure permits the inference that it is OK for U.S. taxpayers to claim risky positions and play the audit lottery so long as they (i) do not cross the criminal line and (ii) pay any civil penalties for their conduct. Seen in this light, the 20% penalty would be just a cost of playing the audit lottery and, so long as there the benefits to be derived from winning that lottery exceed the cost and risk, the potential cost is not only acceptable, but playing the lottery is sanctioned by the penalty provisions. I am not sure that is a proper way to view the tax penalty structure, but it certainly is not uncommon for businesses in many legal contexts to view the risk of civil penalties as just a cost of doing business (i.e., achieving the benefits they want, in this case the financial statement benefits). I think the penalties for playing the audit lottery, particularly when the chance of avoiding detection is enhanced by complex structures involving a maze of provisions designed to obscure the nature of the transaction, should be higher than 20%. I don't know how to write such a provision so that it targets the sophisticated players most likely to be able to design transactions which might avoid the audit lottery, but I would think somebody could do it.
Here are the key links to documents:
TIFD III-E, Inc. v. United States, 2012 U.S. App. LEXIS 1268 (2d Cir. 2012), here..
United States' Appellant's Opening Brief, here
GE's Appellee's Answering Brief, here.
United States' Appellant's Reply Brief, here.
Addendum on 2/23/12
Bloomberg Business Week recounts are similar saga involving Marriott International, Inc. See Romney as Audit Chair Saw Marriott Son of BOSS Shelter Defy IRS (Bloomberg Business Week 2/23/12), here. This article describes Marriott's use of abusive tax shelters at least in the ones that were caught which failed miserably. The question I have is whether all of its abusive were caught? And the broader question of why corporations the public had imagined as industry icons engaged in such behavior. The article notes:
A version of that same strategy got others in bigger trouble. Partners at KPMG LLP counseled their clients on Son of BOSS structures, leading to a $456 million deferred prosecution agreement with the Department of Justice and causing the indictment of several former partners there, along with partners at Ernst & Young LLP. (The nickname is derived from an acronym for an earlier version of the shelter -- Bond Options Sales Strategy.)So, some people get prosecuted for the behavior; others -- particular corporate icons -- do not. To be fair, the KPMG defendants ultimately tried and convicted orchestrated the tax shelters for stealth, but I am not sure the corporations who manipulate documents to create an illusion other than reality are in a different situation. Of course, none of the taxpayers were prosecuted in the KPMG debacle and the Government even admitted for purposes of the case that the taxpayers had committed no crime.
Karen C. Burke and Grayson M.P. McCouch, "Snookered Again: Castle Harbour Revisited," 132 Tax Notes 813 (Aug. 22, 2011), here.
Monte A. Jackel, Castle Harbour Rides Again, 134 Tax Notes 1021 (Feb. 20, 2012), here.
General Electric: Not Quite a Model Citizen (Tax Justice Network 2/27/12), here.
This news item is worth quoting substantially:
Following revelations in March 2011 that GE paid no federal income taxes in 2010 and in fact enjoyed $3 billion in net tax benefits, GE told AFP (3/29/2011), "GE did not pay US federal taxes last year because we did not owe any." But don't worry, GE told Dow Jones Newswires (3/28/2011), "our 2011 tax rate is slated to return to more normal levels with GE Capital's recovery."
As it turns out, however, in 2011 GE's effective federal income tax rate was only 11.3 percent, less than a third the official 35 percent corporate tax rate.
"I don't think most Americans would consider 11.3 percent, not to mention GE's long-term effective rate of 2.3 percent, to be 'normal,' " said Bob McIntyre, director of Citizens for Tax Justice. "But for GE, taxes are something to be avoided rather than paid."
Citizens for Tax Justice's summary of GE's federal income taxes over the past decade shows that:
• From 2006 to 2011, GE's net federal income taxes have been negative $2.7 billion, despite $39.2 billion in pretax U.S. profits over the six years.
• Over the past decade, GE's effective federal income tax rate on its $81.2 billion in pretax U.S. profits has been at most 2.3 percent.
McIntyre noted that GE has yet to pay even that paltry 2.3 percent. In fact, at the end of 2011, GE reports that it has claimed $3.9 billion in cumulative income tax reductions on its tax returns over the years that it has not reported in its shareholder reports -- because it expects the IRS will not approve these "uncertain" tax breaks, and GE will have to give the money back.
GE is one of 280 profitable Fortune 500 companies profiled in "Corporate Taxpayers and Corporate Tax Dodgers, 2008-2010." The report shows GE is one of 30 major U.S. corporations that paid zero -- or less -- in federal income taxes in the last three years. The full report, a joint project of Citizens for Tax Justice and the Institute on Taxation and Economic Policy, is at http://ctj.org/corporatetaxdodgers/. Page 24 of the report explains "uncertain" tax breaks.
And, for balance, here is the corporate apologist view of GE's situation: John D. McKinnon, Spat Between Tax Group, GE Highlights Hurdles to Tax Overhaul (WSJ 9/27/12), here.
And, for counterbalance to the WSJ's apoligist view of GE's shenanigans, see Lawrence Rafferty (Guest Blogger), Corporate Tax Rate and Reality (Jonathan Turley Blog 3/4/12), here.
If I understand those numbers correctly, large corporations are paying about half of the rate that they claim is too high. Another example of how little these corporations are paying was recently discussed in a Crooks and Liars article on General Electric. “General Electric is a prime example of this trend. Despite being highly profitable and subject to a theoretical tax rate of 35 percent, GE paid only a 11.3 percent tax rate in 2011. And that number was the most they paid in more than a decade. In 2010, they actually paid no taxes and got a net tax benefit of $3 billion. For the 10 year period prior to that, their effective average tax rate was 2.3 percent.” Cooks and LiarsSo, is GE a good corporation citizen of the United States? Perhaps in a Darwinian world where not only surviving but prevailing is the only value worthy of allegiance.