Coplan # 6 - Court Approves the Economic Substance Instruction (12/5/12)

I continue discussion of the issues in United States v. Coplan, et al., 703 F.3d 46 (2d Cir. 11/29/12), here and here.

The Court affirmed the economic substance instruction.  Economic substance is not a clearly defined concept in the tax law, and there are various interpretations of it.  Hence, in my view, it is a difficult concept to convey to a jury.  [Remember the black box nature of the jury I discussed in an earlier blog on Coplan, Coplan #2 - The Sufficiency Challenge for the Conspiracy Counts (Federal Tax Crimes Blog 12/2/12), here. Nevertheless, in a criminal tax case, the courts seem to adopt the most taxpayer friendly version of the economic substance concept (except to the extent they are bound by Circuit precedent) and instruct the jury accordingly.  I think that is what happened in Coplan (subject to Circuit precedent) and the other principal tax shelter criminal tax cases.  I am not saying that is right, because even as thus interpreted, the concept is a difficult one for a lay jury to understand.

Let's see what the Court said about the instruction.  I enclose at the end of this blog the complete economic substance instruction that was given.  The portion that the Court deemed relevant is included in a footnote to the opinion, so I cut and paste here the entire discussion on economic substance (including the footnote with the relevant excerpts from the instructions but excluding another footnote dealing with the codified economic substance doctrine in 26 USC § 7701(o), here):  I present first the excerpted portion of the Economic Substance instruction and then include the text of the discussion without footnotes:

THE EXCERPTED INSTRUCTION (from footnote 40):

   fn40 With respect to the economic substance test, the District Court instructed the jury as follows:
In order to establish that a transaction lacks economic substance, the government must prove two elements beyond a reasonable doubt: The first element is that there was no reasonable possibility that the transaction would result in a profit. The second element is that the relevant taxpayer had no business purpose for engaging in the transaction in question apart from the creation of the tax deduction.
. . . .
Now, let me say a few words about your determination as to whether or not there was a reasonable possibility that the shelter would result in a profit. This element requires you to reach an objective judgment about whether the government has proved that there was no reasonable possibility that the shelter would result in a profit. In other words, this does not depend upon what the taxpayer believed about the profit potential. It requires you to consider all of the evidence and reach a conclusion about whether the government has proved beyond a reasonable doubt that there was no reasonable possibility of a profit on the tax shelter after the fees and other costs were paid. If you find that the government has proved beyond a reasonable doubt that there was no reasonable possibility of a profit, then you move on to the second element, whether the relevant taxpayer had no business purpose for engaging in the tax shelter. If you find that the government has not proved the lack of a reasonable possibility of a profit, then you must reject the government's theory and find the defendants not guilty.
A VI: 424/6176-77 (paragraph breaks omitted).

THE COURT'S DISCUSSION (footnotes omitted)

C. Economic Substance Instruction 

Finally, the defendants also argue that the instructions on Counts Two and Three contained an improper definition of "economic substance." The District Court instructed the jury that the Add-On transaction lacked "economic substance" if (1) the transaction offered "no reasonable possibility that the transaction would result in a profit," and (2) the relevant taxpayer had "no business purpose" for engaging in the transaction. fnn40 The defendants challenge the "no reasonable possibility that the transaction would result in a profit" language in the first element of the instruction, arguing instead a transaction lacks economic substance only where there is "no market risk." 

As a general matter, a transaction that lacks economic substance will not provide the basis for a tax deduction. Ferguson v. Comm'r, 29 F.3d 98, 101 (2d Cir. 1994). A transaction lacks economic substance if it "can not [sic] with reason be said to have purpose, substance, or utility apart from [its] anticipated tax consequences." Lee v. Comm'r, 155 F.3d 584, 586 (2d Cir. 1998) (quotation mark omitted); see also Jacobson v. Comm'r, 915 F.2d 832, 837 (2d Cir. 1990) ("A sham transaction analysis requires a determination whether the transaction has any practicable economic effects other than the creation of income tax losses." (internal quotation marks omitted)). 

The law of economic substance, it must be said, is not a model of clarity. The economic substance doctrine was, "if not formulated, then at least popularized" by Judge Learned Hand's opinion in Helvering v. Gregory, 69 F.2d 809 (2d Cir. 1934), aff'd, Gregory v. Helvering, 293 U.S. 465 (1935). David P. Hariton, Sorting Out the Tangle of Economic Substance, 52 Tax Law. 235, 241 (1999). Since Gregory, the economic substance doctrine "has been applied differently from circuit to circuit and sometimes inconsistently within circuits." Modern Tax Controversies, 957 Practicing Law Inst. at 478-35 (summarizing the "disjunctive, conjunctive, and unitary formulations" of the economic substance doctrine). 

Our Circuit is no exception. In United States v. Atkins, we approved an instruction that a transaction lacks economic substance if it was subject to "no market risk." 869 F.2d 135, 140 (2d Cir. 1989) (upholding a charge that the transaction at issue lacked economic substance if (1) it was "not intended either to make or preserve any profit or to limit a loss in any way," and (2) it was subject to no market risk in that "changes in market prices cannot have any effect" (quotation marks omitted)). In United States v. Regan, 937 F.2d 823, 827 (2d Cir. 1991), we suggested, without expressly ruling, that a "no market risk" instruction was erroneous on the particular facts of that case. Most recently, in a nonprecedential disposition, we approved an instruction that a transaction lacks economic substance when there is "no reasonable possibility that the transaction would result in a profit." United States v. Pfaff, 407 F. App'x 506, 508 (2d Cir. 2010) (quotation marks omitted). In so holding, we noted that the "narrower definition" we previously approved did not "state the outer limits of the economic substance doctrine." Id. 

Despite these inconsistencies, we return to the premise that a transaction lacks economic substance if it "can not [sic] with reason be said to have purpose, substance, or utility apart from [its] anticipated tax consequences." Lee, 155 F.3d at 586 (emphasis added). Given the presence of the reasonableness standard in our early formulations of the economic substance doctrine, we now hold that the District Court's "no reasonable possibility that the transaction would result in a profit" instruction, see note 40, ante, accurately stated the law.

The dispute thus was over whether the jury needed to find whether there was no possibility of profit  or no reasonable possibility of profit.  Even if the jury understood that nuance, I still think it is difficult for a lay jury to deal with this issue.  Of course, most hokey tax shelter have some infirmity other than a lack of economic substance.   And usually that will offer a relative clear black or white choice for a jury in a way that does not require the jury to grapple with amorphous tax concepts.  As the prosecutors told the jury in the Enron prosecution, "This is a simple case. It is not about accounting. It is about lies and choices." John C. Hueston, Behind the Scenes of the Enron Trial: Creating Decisive Moments, 44 Am. Crim. L. Rev. 197, 207 (2007).  Juries understand lies and choices.  I am not sure they understand economic substance.

But, of course, the Second Circuit is boxed in by its precedent.  Precedent can be wrong.  I won't even bother to cite cases where we know that is true; you all know examples of that.

ENTIRE ECONOMIC SUBSTANCE INSTRUCTION (from another source)

23. ECONOMIC SUBSTANCE 

The government contends with respect to Counts Two and Three that there was a tax due and owing because losses claimed as a result of the CDS Add-On tax shelter were not properly deductible under the tax laws, and thus that the clients understated the taxes they owed when those losses were reported on their tax returns as deductions that offset taxable income or gains. The government’s position is that the CDS Add-On shelter lacked economic substance.
This means that you must decide whether or not the CDS Add-On tax shelters implemented in Counts Two and Three lacked economic substance, and thus whether any of the relevant taxpayers claiming deductions from the shelter owed more federal income tax than was reflected on their individual tax returns. 

As I mentioned earlier, the Indictment alleges that tax evasion was one of the objects of the conspiracy charged in Count One. Specifically, paragraph 37 of the Indictment, in Count One, alleges generally that the defendants agreed to attempt to evade taxes owed by clients of the CDS Add-On tax shelter. Thus, the tax evasion object relates to CDS Add-On clients in general. 

However, Counts Two and Three allege that the defendants committed tax evasion with respect to specific CDS Add-On clients. Count Two, which is alleged in paragraphs 41 through 48 of the Indictment, alleges that the defendants committed tax evasion with respect to taxes owed on income offset by approximately $30 million in losses reported on the 2000 individual income tax returns for two members of the LaRocque Trading Group LLC. Count Three, which is alleged in paragraphs 49 through 56 of the Indictment, alleges that the defendants committed tax evasion with respect to  taxes owed on income offset by approximately $20 million in losses reported on the calendar year 2000 individual income tax returns for seven individual partners of Cornerstone Partners GP. 

Therefore, with respect to Count Two, you may find a tax due and owing if the shelter lacked economic substance with respect to the losses claimed on the individual returns of either of the two members of LaRocque Trading Group. In other words, a tax is due and owing under Count Two if the shelter lacked economic substance with respect to losses reported by at least one of the relevant taxpayers. However, if you find a lack of economic substance as to only one of the two relevant taxpayers in Count Two, you must agree as to which taxpayer the government has proved a lack of economic substance. Similarly, with respect to Count Three, you may find a tax due and owing if you agree that the CDS Add-On shelter lacked economic substance as to any one of the partners of Cornerstone Partners who reported losses on their individual tax returns, provided you agree that the government has proved a lack of economic substance as to at least one relevant taxpayer. 

On the other hand, if do not agree that the CDS Add-On shelter lacked economic substance as to at least one relevant taxpayer, then you must conclude that there is no additional tax due and owing with respect to the relevant count and find the defendants not guilty on that count.
I will now instruct you on how to determine whether economic substance exists with respect to each relevant taxpayer. 

Under our system of tax laws, a loss produced through a financial transaction that lacks economic substance cannot enter into a taxpayer’s tax computations. Any deduction claimed for a tax loss sustained in such a transaction cannot properly be claimed on a tax return. Thus, if you find that the tax losses from the CDS Add-On shelter were not properly deducted, you may conclude that the taxpayers owed more in taxes than was reported on their income tax returns, and proceed to decide whether that amount was substantial. 

In order to establish that a transaction lacks economic substance, the government must prove two elements beyond a reasonable doubt: 

The first element is that there was no reasonable possibility that the transaction would result in a “profit.” 

The second element is that the relevant taxpayer had no business purpose for engaging in the transaction in question apart from the creation of the tax deduction. 

Now, let me define a term and then say a few things about each of these elements. 

First the definition. The word “profit” in this context means a return in excess of all the fees and costs incurred by the client in connection with entering into the tax shelter, disregarding entirely the value of any tax benefits. 

Now let me say a few words about your determination whether there was a reasonable possibility that the shelter would result in a profit. This element requires you to reach an objective judgment about whether the government has proved that there was no reasonable possibility that the shelter would result in a profit. In other words, this does not depend upon what the taxpayer believed about the profit potential. It requires you to consider all of the evidence and reach a conclusion about whether the government has proved beyond a reasonable doubt that there was no reasonable possibility of a profit on the tax shelter after the fees and other costs were paid. If you find that the government has proved beyond a reasonable doubt that there was no reasonable possibility of a profit, then you move on to the second element, whether the relevant taxpayer had no business purpose for engaging in the tax shelter. If you find that the government has not proved the lack of a reasonable possibility of a profit, then you must reject the government’s theory and find the defendants not guilty.
Now let me discuss the second element that I mentioned—whether the taxpayer had any business purpose, that is, a non-tax reason, for participating in the shelter. In deciding that question, you may consider any direct evidence of the taxpayer’s motive. For instance, you may consider testimony or other statements by the taxpayer as to his or her reason or reasons for participating in the shelter. 

But you are not limited to direct evidence in deciding why a taxpayer participated in the shelter. You may consider circumstantial evidence as well. For example, you may consider the manner in which the shelter was marketed or sold to the taxpayer. Thus, for instance, you are entitled to consider whether and to what it extent the shelter was advertised as a tax savings device, a means of obtaining a profit, and so forth. You may also consider the likelihood of a significant profit in relation to the amount of fees that clients were required to pay to participate in the tax shelter. Common sense tells you that if the client pays large fees to enter into a transaction with a large intended tax benefit and a very small likelihood of profit, that fact might tend to show that the client did not have a non-tax reason for doing the shelter. Conversely, if there is a significant possibility that the transaction will return a profit greater than all fees and costs, such a fact might tend to show that the client did have a non-tax reason for doing the transaction.
Taking into account both direct and circumstantial evidence of the relevant taxpayer’s intent, you must determine whether the government has proved beyond a reasonable doubt that the relevant taxpayer had no business or non-tax reason for doing the tax shelter in order to conclude that it lacked economic substance. 

If you unanimously find with respect to at least one relevant taxpayer in each of Counts Two and Three that the government has proved beyond a reasonable doubt both prongs of the economic substance test—that is, losses were claimed on an individual tax return as a result of a tax shelter for which there was no reasonable possibility of making a profit and where the relevant taxpayer had no business purpose for engaging in the shelter—you may find that the requirement of additional tax due and owing is satisfied with respect to the count you are considering. As I said earlier, however, you do not need to find that the CDS Add-On lacked economic substance as to all of the relevant taxpayers in Counts Two and Three; if it lacked economic substance as to losses claimed by a single relevant taxpayer, then there is an additional tax due and owing. If you conclude that an additional tax is due and owing, you then will go on to consider whether the government has proven that the additional tax due and owing was substantial. 

However, if you do not find that both elements of the economic substance test have been proven beyond a reasonable doubt as to losses claimed by any relevant taxpayer in a given count, then the government will not have proved that additional tax was due and owing as to that count, and you must find the defendants not guilty of the tax evasion count you are considering.

Question for those readers who took the trouble to read the entire instruction through.  Imagine yourself a lay person.  Would you find it helpful? Would you as a juror want to send someone to jail if you did not understand it fairly, if not completely?  Now, as a lawyer, assume you were on the panel, would you assume that the jury understood the instruction and properly applied it.  Maybe, but we are back to the black box.  Which is why instructions and the legal duty need to be crystal clear before we can indulge the assumption that the jury properly applied the instructions.

And, if you were a defendant, would you want to trust your fate to a jury properly understanding the instruction?  Well, I suppose that would depend upon whether the evidence with the instruction properly applied (if that is possible) would indicate guilt or innocence.