Daugerdas Retrial Jury Instructions - Part 07 Tax Evasion Instructions Part 3 Economic Substance (11/27/13; 11/29/13)

I address in this blog the relationship to the defendants served as enablers and the taxpayers whose taxes were allegedly evaded.  In the prior cases, as I recall it, the Government conceded that the taxpayers themselves were innocent.  That would mean that the enabler defendants could not have aided and abetted the taxpayers' tax evasion.  It is not clear to me that the Government made that concession in this Daugerdas retrial.  So, I suppose, the jury could have applied an aiding and abetting construct to say that the enabler defendants aided and abetted some or all guilty taxpayers, but I think on the instructions given which did not develop the aiding and abetting concept, they would have had to find the defendants directly guilty of the crime of tax evasion which they could do because tax evasion can apply to enablers directly without the help of derivative liability provisions.

But, I want to focus on the taxpayers because it was their taxes that had to be evaded in all events for the crime of tax evasion as charged in Daugerdas.  What would it require for their taxes to have been evaded via the tax shelters promoted by the enabler defendants?  In the Tax Due and Owing instruction, Judge Pauley explained that the critical issue as to whether there was a tax due and owing was whether the shelters lacked economic substance.  (I have previously written on what I perceive as major difficulties in presenting the concept of economic substance to juries; they can be reviewed via the "Economic Substance" link.)  One uncertainty is whether the two component tests commonly applied to determine economic substance are in the disjunctive or the conjunctive.  That uncertainty has existed for a long time.  So, Judge Pauley asked the jury to apply the test in the conjunctive -- the most defendant-friendly application of the economic substance test.

Judge Pauley explained in explaining Tax Due and Owing:

The Government claims that the reason the taxpayers * * * * owed more taxes than they reported is that the losses they claimed on their tax returns as a result of the Short Sale, SOS, Swap, or HOMER tax shelters were not allowable. The Government contends that these losses were not allowable because they stemmed from transactions that lacked “economic substance.” 

A transaction that lacks economic substance cannot enter into tax computations. Any deduction claimed for a tax loss allegedly sustained in such a transaction is not properly claimed on a tax return. 

In order to establish that a transaction lacks economic substance, the Government must prove, beyond a reasonable doubt, two components. 

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

The second component is that there was no reasonable possibility that the transaction would result in a profit.

Now, let me provide an explanation of the first component—namely, whether the taxpayer had a business purpose, that is, any non-tax reason for entering into the tax shelter. In deciding that question, you may consider any direct evidence of the taxpayer’s motive. But you are not limited to direct evidence in deciding why a taxpayer did the transaction. You may consider circumstantial evidence as well.  

For example, you may consider the manner in which the tax shelter was sold to the taxpayer—in other words, whether and to what extent it was sold to the taxpayer as a way to create a tax deduction to offset other taxable income and/or as a way to generate a return, exclusive of tax benefits, on an investment.  

You may consider also whether a reasonable taxpayer would have paid the fees necessary to do the transaction in order to gain the chance of whatever profit potential existed if the transaction had not also resulted in tax benefits.  

You may also consider the evidence of whether a taxpayer had developed a genuine secondary motive to enter in to the transaction for profit after being told of its associated tax benefits.
Ultimately, if you find that the Government has proved beyond a reasonable doubt that the taxpayer had no genuine business purpose for entering into the tax shelter in any particular count, you will go on to consider the second part of the economic substance test. If you find, however, that the Government has not proved that tax benefits were the sole reason for entering into the tax shelter, you must reject the Government’s economic substance argument and, therefore, reject its contention that there was additional tax due and owing. That would require you to find the defendant you are considering not guilty on the particular tax evasion count that you are considering. 

Now, as I mentioned, the second component of the economic substance test that the Government must prove beyond a reasonable doubt is that there was no reasonable possibility that the tax shelter in question would result in a profit. The word “profit” in this context means a return in excess of all of the costs and fees incurred by the taxpayer in connection with entering into the tax shelter, disregarding entirely any tax benefits. 

I want to emphasize to you that this component requires you to reach an objective judgment about whether the Government has proved that there was no reasonable possibility that the strategy 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. In doing this, you will have to consider the evidence concerning the investment aspects of each of the four tax shelters at issue in this case—for example, the digital options trades involved in the SOS tax shelter and the German bonds transactions involved in the HOMER transactions. 

In considering whether the Government has met its burden of proof on this second factor, you should take into account whether the taxpayer, considering all of the aspects of the strategy, had any reasonable chance of making a profit, as I defined it a moment ago. 

If you unanimously find that the Government has proved beyond a reasonable doubt both components of the economic substance test—in other words, that the taxpayer had no genuine business purpose for entering into the tax shelter and that there was no reasonable possibility of making a profit—you may find that the requirement of additional tax due and owing has been satisfied. At that point, you will go on to consider whether the Government has proven that the additional tax due and owing was substantial. If you do not find that both components of the economic substance test have been proved beyond a reasonable doubt, then the Government will not have proved that additional tax was due and owing and you must find the defendant you are considering not guilty. 

I want to focus on the instructions about the first of the two component tests.  In order to do that, I want to repeat the entirety of the instructions regarding that first component test:
The first component is that the relevant taxpayer had no genuine business purpose for engaging in the transaction in question apart from the creation of the tax deduction.  

* * * * 

Now, let me provide an explanation of the first component—namely, whether the taxpayer had a business purpose, that is, any non-tax reason for entering into the tax shelter. In deciding that question, you may consider any direct evidence of the taxpayer’s motive. But you are not limited to direct evidence in deciding why a taxpayer did the transaction. You may consider circumstantial evidence as well.  

For example, you may consider the manner in which the tax shelter was sold to the taxpayer—in other words, whether and to what extent it was sold to the taxpayer as a way to create a tax deduction to offset other taxable income and/or as a way to generate a return, exclusive of tax benefits, on an investment.  

You may consider also whether a reasonable taxpayer would have paid the fees necessary to do the transaction in order to gain the chance of whatever profit potential existed if the transaction had not also resulted in tax benefits.  

You may also consider the evidence of whether a taxpayer had developed a genuine secondary motive to enter in to the transaction for profit after being told of its associated tax benefits.
Ultimately, if you find that the Government has proved beyond a reasonable doubt that the taxpayer had no genuine business purpose for entering into the tax shelter in any particular count, you will go on to consider the second part of the economic substance test. If you find, however, that the Government has not proved that tax benefits were the sole reason for entering into the tax shelter, you must reject the Government’s economic substance argument and, therefore, reject its contention that there was additional tax due and owing. That would require you to find the defendant you are considering not guilty on the particular tax evasion count that you are considering. 

In other words, Judge Pauley states the test succinctly in terms of the "relevant taxpayer's" having or not having a "genuine business purpose."  After crisply stating that, Judge Pauley goes on to consider the types of circumstantial evidence that might bear on that determination.

What does he mean by "relevant taxpayer."  That simply is each taxpayer whose return(s) were the subject of the various tax evasion counts for the enablers defendant.  These were Counts 2 through 11.

Now, I would like to parse the succinct statement of this first component.  As stated, the Government could meet this required component by showing beyond a reasonable doubt that the "relevant taxpayer" for each count either had no business purpose at all (other than tax savings) or his or her business purpose was not genuine.  Perhaps that is the same thing, but perhaps not.  In any event, this seems to be a subjective test.

My concern is how the jury could have made a determination beyond a reasonable doubt that each "relevant taxpayer" had no genuine business purpose.  In this regard, only some of the taxpayers testified.  What was the basis for the determination, at least for those who did not testify?  It would have to be circumstantial evidence.

Note that the Judge instructs them first to determine the subjective test before determining the objective test, but surely their belief that the shelters objectively lacked business purpose or profit motive drove them to determine that the relevant taxpayers lacked a genuine business purpose.  And the jury did that despite the fact that each of the taxpayers had represented in the original engagement documents that he or she did have such a purpose and had nothing to show the intent or purpose of the taxpayer other than certain objective indicia that those taxpayers might not have such  a purpose and might have been lying in saying they did.  And, they accepted that evidence as proof beyond a reasonable doubt that those relevant taxpayers did not have a genuine business purpose without hearing their testimony or gauging their real credibility.

And, even if they heard from some of the taxpayers who may have now stated that they had no genuine business purpose, how is that proof that the other nontestifying taxpayers did not have such a purpose.

It just seems to me that, even setting aside the ability of a jury to understand holistically what the hell economic substance is all about, this is just not stuff of which proof beyond a reasonable doubt it made.

There are some issues here.  Readers may recall that I posted a blog on the use of statistics -- a small sample used to project inferences over a population.  That was in a sentencing context where the proof was merely preponderance of the evidence.  I and readers questioned the validity of the inference of tax loss on which sentencing was based.  Here, the proof required is beyond a reasonable doubt and the juries are projecting from a sample set of taxpayers who did testify as to the mental mindset of other taxpayers who did not testify, with the only common point that they invested in the same shelter and heard the same pitch (or close variations) from the enabler defendants.

Furthermore, since the jury would have to find that none of the taxpayers involved had a genuine business purposes, they necessarily made the key factual finding beyond a reasonable doubt that those taxpayers committed tax evasion because they did not have the required business purpose and that they lied in so stating in the engagement documents (think tax obstruction, including joining the conspiracy).  That is an inescapable conclusion.  The IRS should be able now to easily open up all statutes of limitations and get the fraud penalties for all of these taxpayers and those similarly situated -- being those that got into the shelters and heard the same pitch.  And, here's the real kicker, the IRS can do that even if those years are otherwise closed by a court decision or some type of settlement with the IRS (including closing agreement or Form 870-AD.

Finally, here are excerpts from the charge conference related to this issue:

First, I identify the cast of characters:

The Court:  Judge Pauley.
Mr. Mazurek - counsel for Mr. Daugerdas.
Ms. McCarthy, counsel for Mr. Field
Mr. Okula - the prosecutor, counsel for the Government

I have bold-faced some portions to call readers attention to that text.

MR. MAZUREK:  Judge, I would also ask and make an application that with respect to the tax evasion counts, Counts Three and Four, for similar reasons that Ms. McCarthy made with respect to the allegations in the indictment, be dismissed and not go back to the jury.
I think as a matter of law it is very clear that clients Shackleton and Harter, who the government declined to call as witnesses at this trial, there is absolutely no evidence on the record with respect to the subjective prong to either of these taxpayer clients.
As the instruction makes clear, in order for the government to prove tax evasion with respect to these clients, there has to be proof beyond a reasonable doubt as to both the subjective and objective prongs.  I would say that there is wholly lacking any evidence with respect to clients Shackleton and Harter charged in Counts Three and Four and ask that they be dismissed and not go back to the jury. 

MS. McCARTHY:  We join.
That was my next application, your Honor. 

MR. MAZUREK:  Sorry. 

MS. McCARTHY:  No problem. 

MR. OKULA:  Your Honor, with respect to Mr. Shackleton, Erwin Mayer testified, and I asked him specific questions about whether Woody Shackleton ever articulated to him any nontax business reasons for pursuing his transaction. He said no.
We know that his transaction could not make a profit, so there is a foundation for the inclusion of Mr. Shackleton's transaction.  Mr. Greisman testified about his participation in some manner of Mr. Harter's tax reporting in his transaction.
Viewed as a whole, your Honor, the defendants' argument is premised on the notion that you have to have one of the taxpayers actually get on the stand to say I had no business motive in order to support that going to the jury.
We couldn't disagree more with that.  I think, viewed as a whole with respect to how these transactions were sold, that the Court can infer that the same pattern that followed with respect to those clients -- who testified consistent with the manner in which Mr. Mayer testified, that his clients had no genuine purpose -- allows the Court to infer that Mr. Harter as well lacked any genuine business purpose for pursuing the transaction.
So we would submit you don't have to have the clients testify.
Suzette Ducote didn't testify.  Her brother testified about him being the point person, and there was no genuine purpose, but it's hardly necessary to have the taxpayer to get on the stand to say that is so.
Indeed that was the case with respect to the Larson and Pfaff prosecution ]see * below], where Judge Kaplan noted at sort of Rule 29 time that only four or five of the 20 some odd substantive tax evasion counts had been supported by direct testimony of the taxpayers, but he found in rejecting Rule 29 arguments -- and all those convictions were affirmed, some of the tax evasion convictions were affirmed on appeal -- that the Court could infer and the jury could find beyond a reasonable doubt that, viewed as a whole, the conspiracy supported the notion that even a taxpayer who didn't testify lacked the subjective business purpose for pursuing the transaction. 

MS. McCARTHY:  Your Honor, I don't know the proof in Larson.  I know the proof here.  I know that in this case there was no testimony about the state of mind of the taxpayers. Mr. Shackleton is not at issue for Mr. Field, but he didn't testify.  I don't recall anybody testifying about making a presentation to him, talking to him, or anything about Mr. Shackleton's business or his investing history.
Also, there is no evidence about Mr. Harter.  At the last trial, we had both Mr. Harter and Mr. Shanbrom.  We could have just had Mr. Shanbrom or just Mr. Harter.  We had nobody. In the Ducote example, that is an example where the jury does have something to hang its hat on if it wants to with the testimony of her brother where he is the point person, and he can testify about whether or not any of them discussed having a business purpose.
There is zero evidence in this record on a substantive tax count as to which Mr. Field could go to jail for five years.  It is inappropriate for this jury to consider this substantive tax count against him, and we ask that it not be sent to the jury. 

MR. MAZUREK:  Judge, the reference that Mr. Okula madewith respect to the testimony of Erwin Mayer regarding Mr. Shackleton, is all of this.
It is on page 2531 of the record starting with line 10:
"Q. Did you ever meet with Mr. Shackleton?
"A. Not personally.  I had spoken with him on the phone.
"Q. When you spoke to Mr. Shackleton on the phone, did he articulate any nontax business reason for pursuing this tax shelter?
"A. No, sir."
That is the extent of the testimony on the subjective prong of the tax evasion count with respect to Mr. Shackleton. I guess it's based, again, on a coconspirator's statement where there is no evidence whatsoever that Mr. Shackleton was involved with this conspiracy except for Mr. Mayer's testimony.
So basically we are down to the fact that if Mr. Mayer testifies as an alleged coconspirator to another tax client who the government claims is a coconspirator, that that should be sufficient proof beyond a reasonable doubt.  I suggest that the law is much more stringent than that. 

MR. OKULA:  Just finishing out the point, your Honor, your Honor's proposed charge on page 50 notes that, under the theory of causing, the taxpayer's intent is irrelevant.  It does not matter whether the taxpayer lacked the intent to evade the taxes.
I would also note that with respect to the first trial, in addition to the Risches and the others, there were HOMER clients, there was a HOMER client named John Kerner who was named in Count Eighteen of the indictment.
But, viewed as a whole, given the way that the transactions were sold and the lack of any business purpose from virtually any client who we heard evidence about, that the Court concluded and denied Rule 29 motions and any motions after trial with respect to that substantive tax evasion charge.
The bottom line is this, Judge.  We don't have to call every single taxpayer in order to establish that there's this pervasive conspiracy to market these things as tax loss generators without any client intent being admitted. 

MR. MAZUREK:  The apropos words that Mr. Okula just left us with, we don't have to prove it for a conspiracy.  This is not a conspiracy.  These are substantive counts that are charged in the indictment, Counts Three and Four. So when he's talking about conspiracy, I understand. Conspiracy is different from substantive counts.  These are substantive counts that have been charged against these defendants. 

THE COURT:  The defendants' motions to dismiss Counts Three and Four are denied.

* The Larson and Pfaff case referred to above is the first in the big tax shelter prosecutions in SDNY, which was tried by Judge Lewis Kaplan.  Their convictions were affirmed.  See Larson, Pfaff, Ruble Convictions In KPMG Tax Shelters Case Affirmed (Federal Tax Crimes Blog 8/27/10), here.

The full set of Judge Pauley's instructions on retrial in Daugerdas is linked here.  I have bookmarked the instructions for easier navigation, but the bookmarks are apparently viewable only if you download the pdf file.

Addendum 11/29/13 8:30 am:

I pull together my more relevant earlier blogs.  In thinking further about the question, it seems to me that the problem is that people will exploit uncertainty in the law and the potential difficulty of successfully prosecuting a criminal case.  Of course, taxpayers and their enablers who prosecute bullshit tax shelters do that with the hope of avoiding civil and criminal penalties for their exploits.  The prize is, of course, to avoid those civil and criminal penalties for aggressive behavior that exploits uncertainty (or even perceived uncertainty).  So, all practitioners know that there is a substantial reward to playing in the ground between a certain proper tax position and a tax position that is a certain improper tax position (i.e., criminally improper).  Exploiting uncertainty is worth a lot to clients willing to play that game.  The problem is in discerning the line between a clearly improper position and one that is really uncertain (which may be wrong but not criminally wrong).

How then should the Government prosecute this behavior.  It seems to me that the key is in the lie.  In the SDNY trilogy of cases, there was more than one big lie.  The big lie was the representation by the taxpayers of nontax profit motives which, of course, neither the taxpayers nor the enablers believed to be true.  Without that lie, those tax shelters would not have been done.  More broadly, lying is at the heart of all tax crimes -- evasion, tax perjury, aiding and assisting, tax obstructions, Klein conspiracy, etc.  Maybe that issue is buried in the economic substance issue as presented to the juries in the trilogy.  But it seems to me it should be made a direct issue for the jury to address.  I develop this in more detail in my early blog, Economic Substance in Criminal Cases - Is It About the Lie? (Federal Tax Crimes Blog 5/19/09), here,

For my earlier blogs fleshing out my thoughts on economic substance in criminal tax cases and dealing with the earlier prosecutions and some that were not prosecuted:

• Coplan # 6 - Court Approves the Economic Substance Instruction (Federal Tax Crimes Blog 12/5/12), here.
• Economic Substance Doctrine Tax Felonies (6/1/11), here.
• Another Set Back for the Remaining Daugerdas Defendants - Economic Substance is Sufficiently Malleable to Establish a Line a Citizen Could Know (Federal Tax Crimes Blog 10/29/10), here.
• Economic Substance Jury Instruction in Larson/Pfaff/Ruble (Federal Tax Crimes Blog 3/22/10), here.
• More on Economic Substance in Criminal Tax Cases - the Coplan Instructions.(Federal Tax Crimes Blog 3/17/10), here.
• More on Economic Substance in Criminal Tax Cases (Federal Tax Crimes Blog 2/18/10), here.
• The KPMG Enabler Convictions -- The Role of the Absent Taxpayers (Federal Tax Crimes Blog 1/26/10), here.
• More on Legal Uncertainty and, More Importantly, the Subjective Prong of the Economic Substance Test (Federal Tax Crimes Blog 1/19/10), here.
• Tax Shelters, Economic Substance and Tax Crimes (Federal Tax Crimes Blog 11/13/09), here.
• Economic Substance in Tax Crimes (Federal Tax Crimes Blog 10/14/09), here.
• Economic Substance in Criminal Cases - Is It About the Lie? (Federal Tax Crimes Blog 5/19/09), here.

General on Importance of Jury Instructions

• Article on Importance of Jury Instructions in White Collar, including Tax, Crime Cases (Federal Tax Crimes Blog 1/29/13), here.

On economic substance in civil jury trials

• Altria # 1 - Frank Lyon and tax shelters (Federal Tax Crimes Blog 3/20/10), here.
• Altria #2 - Economic Substance and Juries (Federal Tax Crimes Blog 3/22/10), here.