The Second Circuit had already approved the application of the 20% substantial understatement penalty, but, as it turns out, when pushed to the taxpayer, the tax involved, though large, would not meet the threshold requirement that the understatement be "substantial" -- defined as exceeding "(i) 10 percent of the tax required to be shown on the return for the taxable year." Section 6662(d)(1)(A)(i), here.
Readers will recall that the 20% accuracy related penalty has another basis -- if the position is due to negligence, which has no threshold limitation. Section 6662(c), here. So, the Government made another run to extract from GE some penalty for having played the audit lottery and lost for its bullshit tax shelter. Again, this time, the district court tilted for GE, thus insulating GE from any cost or penalty for playing the audit lottery. Why?
The Court opens its opinion as follows:
Defendant, the United States, moves for an order imposing a negligence penalty on plaintiff TIFD III-E Inc. ("TIFD") for tax years 1997 and 1998. During the 1990s, TIFD's parent company, General Electric Capital Corporation ("GECC"), joined with a pair of Dutch banks ("the Dutch Banks" or "the Banks") to form an aircraft leasing company. TIFD considered the Dutch Banks to be its partners in the venture, and did not report any income allocated to the Banks on its own tax returns. During the course of this litigation, I twice found that decision to be more than reasonable; indeed, I found that the company correctly deemed the Banks to be equity stakeholders rather than lenders. TIFD III-E v. United States, 342 F. Supp. 2d 94 (D. Conn. 2004) [*4] ("Castle Harbour I"); TIFD III-E v. United States, 660 F. Supp. 2d 367 (D. Conn. 2009) ("Castle Harbour III"). The Second Circuit twice disagreed. TIFD III-E v. United States, 459 F.3d 220 (2d Cir. 2006) ("Castle Harbour II"); TIFD III-E v. United States, 666 F.3d 836 (2d Cir. 2012) ("Castle Harbour IV"). So, after more than a decade of litigation, TIFD ultimately lost this case. In addition, the Second Circuit held that the IRS could impose a 20% accuracy penalty against TIFD for substantial understatement of its income taxes in 1997 and 1998.Despite having "twice found that [GE's] decision to be more than reasonable," the judge candidly acknowledges that the Second Circuit disagreed. The court then proceeds to find GE reasonable again.
I won't review the facts, for the court itself that "I assume the parties' familiarity with the facts underlying this case." I will note that, as is common in these bullshit corporate tax shelters, a foreign bank was the linchpin to make it have the superficial appearance of working. (Foreign banks also played an essential role in the bullshit individual Son-of-Boss tax shelters; in this regard, see my postings Credit Suisse DOJ Investigation Status and New NY Investigation (Federal Tax Crimes Blog 4/7/14), here; and NY State Agency Makes New Moves in Investigation of Credit Suisse (Federal Tax Crimes Blog 4/17/14), here.)
Now, here is the Court's reasoning for again trying to hand the victory to GE by, not surprisingly, finding GE's conduct reasonable:
I have little trouble finding that TIFD had a "reasonable basis" for treating the Dutch Banks' stake in Castle Harbor as an equity interest rather than debt. GECC never intended to indebt itself to the Dutch Banks. The evidence at trial demonstrated just the opposite: in 1993, it was contractually barred from leveraging its assets to borrow money, and it solicited proposals from financial professionals with the explicit instruction that the plans raise capital, not incur debt. As TIFD has always maintained, GECC believed that it was offering the Banks a partnership stake akin to "non-participating preferred equity," a class of financial interest that pays holders dividends at a fixed rate following a pre-determined formula. Pl.'s Mem. Opp. N. Penalty 5 (doc. # 167); Pl.'s Post Hr'g Mem. 4 (doc. # 176).
In Castle Harbour III, I accepted this analogy, and cited Jewel Tea as providing substantial authority for TIFD's position. 660 F. Supp. 2d at 399. The Second Circuit disagreed:
In Jewel Tea, we ruled that purported preferred shares, unlike the debentures in O.P.P., were properly treated as equity for tax purposes because at no time could the holders demand their money; "they were at the mercy of the company's fortunes and payment was merely a way of distributing profits." In contrast to the holders of the preferred shares in Jewel Tea, the banks in the instant case were effectively promised recovery of their principal investment at a set rate of return, payable on a set schedule. Of course, the banks' return was not completely divorced from Castle Harbour's performance. But, as we have explained, because those aspects of the banks' promised return that depended on Castle Harbour's performance were so unlikely to result in the banks' receipt of a return that meaningfully deviated from the Applicable Rate, the banks were in no real sense co-venturers in the partnership's fortunes.
Castle Harbour IV, 666 F.3d at 849. In other words, because the Dutch Banks likely would receive a sum certain within a fixed time period, they were effectively creditors. In the Second Circuit's estimation, the Dutch Banks simply accepted too little risk in the venture to be treated as equity holders.
But GECC reasonably could have believed that, to borrow the Second Circuit's term, the Dutch Bank's "narrowly circumscribed risk" would not transform equity into debt. TIFD points to a mountain of authority – all decided or promulgated before TIFD filed its returns – that classified preferred stock as equity even though holders were guaranteed a result and their profits did not depend on corporate growth. Indeed, courts have long treated preferred stock as equity. See, e.g., Staked Plains Trust v. Comm'r, 143 F.2d 421 (5th Cir. 1944) (holding that certificates were equity not debt even though holders were entitled to a sum certain plus fixed interest); Dorsey v. United States, 311 F. Supp. 625, 628 (S.D. Fla. 1969). In Dorsey, for example, a mortgage company's principal contributed $100,000 to the company, because it needed capital to meet federal capitalization requirements. In exchange, the company created a class of stock that paid the investor a fixed 4% return, but the company retained the power to call the stock as soon as it had enough money to meet the capitalization requirement on its own. When the company tried to deduct the 4% payment as loan interest, the government objected and the district court agreed. Id. at 629.
Provisions of the Internal Revenue Code also classify preferred stock as equity for tax purposes, even when the stock's value does not depend on corporate growth, is redeemable at the holder's discretion, and is callable by a corporation at a fixed price. For example, under I.R.C. § 351, a party who controls a company may exchange property for stock in the entity without reporting a gain on his tax return. But the stock cannot be a scrim for a loan; subsection (d) excludes unsecured "indebtedness" from the exemption. The provision then clarifies that preferred stock should not be considered debt, even though it "is limited and preferred as to dividends and does not participate in corporate growth to any significant extent." I.R.C. § 351(g); see also I.R.C. §1504(a)(4) (respecting as equity nonvoting stock that "does not participate in corporate growth to any significant extent"). The IRS has echoed this principle in rulings that distinguish preferred stock from bonds. In 1994, just after GECC and the Dutch Banks struck the Castle Harbour deal, the agency ruled that preferred stock was equity for tax purposes even though it resembled debt in almost every respect: the interest was debt for corporate law purposes, the stock matured and paid-out a fixed amount on a specific date, and its holders retained the rights of creditors. Rev. Rul. 94-28, 1994-1 C.B. 86.
Preferred stock differs from the Castle Harbour deal in some respects, and the Second Circuit discarded the comparison in favor of an analogy to a "secured lender." But a reasonable person might not have known that it had chosen the wrong comparator – indeed as a government expert testified at trial:
[T]he accounting standards in debt versus equity are complicated. There is no standard that relates to any instrument exactly like this. One has to draw [analogies] to other instruments and as we've seen there are many analogies that can be drawn.
Pl.'s Mem. Opp. N. Penalty 9. Given this murkiness, it was entirely reasonable for TIFD to rely upon decisions in which an investor made a capital contribution and was compensated with a low-risk payout over a fixed period of time. TIFD did so and reasonably concluded that the Dutch Banks' stake in Castle Harbour was the partnership equivalent of corporate preferred stock, an interest in a company that guarantees a return, limits the extent of profits, and allows a company to repurchase the stock at its own discretion.
TIFD's view looks especially reasonable in light of this litigation. If it had been clear that the Dutch Banks were lenders, there would have been no need for a two-week trial, two district court opinions, and two appeals. Having presided at the trial of this matter, I twice found not merely that TIFD was reasonable in its tax position, but that it was correct. Although the Second Circuit ultimately disagreed with my interpretation of the law, it did not indicate that my conclusions were "unreasonable." The Court openly acknowledged that the case was not a slam-dunk for the government, because the relevant statute and regulations are ambiguous and "subject to multiple interpretations." Castle Harbour IV, 666 F.3d at 843. Moreover, academic experts have cited the split between the district court and the Second Circuit in this case as evidence that "corporate tax abuse is an uncertain area of the law." E.g., Joshua Blank and Nancy Staudt, Corporate Shams, 87 N.Y.U. L. Rev. 1641, 1643 (2012).
Simply put, the objective reasonableness of a tax position becomes virtually unassailable when the taxpayer actually prevails at trial before a district judge who was not compromised by conflict, substance abuse, or senility. The reasonableness of the tax position on which TIFD sustained its burden of proof of correctness after a lengthy bench trial – even if both taxpayer and judge ultimately were mistaken – scarcely can be questioned. Indeed, I am aware of no case in which a negligence penalty has been applied following reversal of a taxpayer's district court victory.4 To the contrary, the Second Circuit has admonished the government for attempting to impose a negligence penalty in a case where it found that the district court had misinterpreted the law. Holmes v. United States, 85 F.3d 956, 963 n.7 (2d Cir. 1996) ("One may disagree, as we did, with the taxpayer [and the district court] on whether or not § 280A applies to cooperative stock, but the government's bald claim that the taxpayer did not exercise due care in making his argument is little short of reprehensible. And its persistence in asserting the negligence claim even after it lost below is mind boggling. . . . We therefore not only reject the claim of negligence in this case, but caution the government against making like claims in similar situations where the law is, at best, unclear.").
The government's position in this case can fairly be described as "mind boggling." See Holmes, 85 F.3d at 963 n.7. It does not seriously argue that no authorities supported TIFD's tax position. At oral argument, the government declined to respond to TIFD's many proffered authorities because "it's too late, and it doesn't matter." Mot. Hr'g Tr. 32-33, Dec. 3, 2012 (doc. # 168). According to the government, TIFD must present evidence that it actually, subjectively relied on those precedents when it determined its tax liability. The government essentially asks me to draw an adverse inference from the fact that TIFD did not waive the attorney-client privilege with respect to the tax advice it received, but instead attempted to win based on the state of the law alone. But that interpretation defies both common sense and the larger structure of the regulations governing penalties. In general, a review for reasonableness is an objective assessment, one that does not consider an individual's actual state of mind. Section 1.6662-3 reflects this accepted standard, ascribing "reasonable basis" to the tax position, not the taxpayer. Treas. Reg. § 1.6662-3(b)(1) ("A return position that has a reasonable basis . . . is not attributable to negligence."); see also Didonato v. C.I.R., 105 T.C.M. (CCH) 1067 (T.C. 2013) (noting that "petitioners could not avail themselves of the defense under section 6662(d)(2)(B)(ii) because they have failed to provide authority that could provide a reasonable basis for their return position" (emphasis added)); I.R.S. Chief Couns. Mem. at 3 (Feb. 26, 2010) (looking to the section 6662 accuracy-related penalty for guidance and finding that "[a] taxpayer's state of mind has no bearing on meeting the reasonable basis standard" contained in I.R.C. § 6676).
The IRS regulations do contain a safe harbor provision that examines a taxpayer's conduct and its subjective belief, allowing the taxpayer to avoid a penalty if it had "reasonable cause . . . and acted in good faith." Treas Reg. § 1.6664-4. In determining whether the reasonable cause and good faith defense applies, the most important factor generally is "the extent of the taxpayer's effort to assess the taxpayer's proper tax liability." Id. Under section 1.6664-4, "[r]eliance on an information return, professional advice, or other facts . . . constitutes reasonable cause and good faith if, under all the circumstances, such reliance was reasonable and the taxpayer acted in good faith." Id. (emphasis added). But section 1.6664-4 is not the provision upon which TIFD relies. The IRS included no such language in section 1.6662-3, and there is no reason to believe that it intended the "reasonable basis" standard to include a similar subjective component.
Of course, one way to bolster a case for a reasonable basis could be to show that a taxpayer relied on the independent advice of counsel. Such was the strategy in the case cited by the government, Stobie Creek Investments, LLC v. United States, 82 Fed. Cl. 636 (Fed. Cl. 2008), aff'd, 608 F.3d 1366 (Fed. Cir. 2010). Factual differences aside (Stobie Creek involved an opinion issued by a conflicted attorney and a transaction that lacked economic substance), that case does not support the proposition that there must be actual, subjective reliance by a taxpayer hoping to avoid a negligence penalty. Whether a taxpayer's subjective reliance on certain authorities or on the advice of counsel was reasonable need not enter the equation until its position appears unreasonable to the objective observer. Here, the taxpayer's conduct appeared more than reasonable to me, it appeared correct. In such a case, the taxpayer's subjective belief simply is not relevant.
Finally, even if TIFD's conduct or state of mind were at issue here, the record reflects a cautious effort to create equity, not debt, and the company cannot be faulted for failing to correctly predict the ultimate outcome of this case. Corporate representatives reviewed proposals from seven respected investment firms before deciding on a plan. They evaluated those proposals based on one central criterion – that GECC amass no additional debt, for doing so would trigger a financial catastrophe for the company. After a series of revisions, vetted by Babcock & Brown and at the very least GECC's inside legal team, the company offered the Dutch Banks an ownership stake in the partnership. In short, there was nothing negligent or haphazard about the decision to enter into the Castle Harbour transaction or to treat the Banks' participation as a partnership interest rather than a loan. Accordingly, the negligence penalty is not applicable in this case.Note the bold face text immediately above. I don't think that the Second Circuit viewed GE as having offered the Dutch banks an ownership stake in the partnership. Here is the Second Circuit's conclusion on that issue from the second opinion:
The banks’ interest was therefore necessarily not a “capital interest,” which is “an interest in the assets of the partnership . . . distributable to the owner . . . upon withdrawal . . . or liquidation.” Treas. Reg. § 1.704-1(e)(1)(v) (emphasis added). Because the banks’ interest was for all practical purposes a fixed obligation, requiring reimbursement of their investment at a set rate of return in all but the most unlikely of scenarios, their interest rather represented a liability of the partnership. Moreover, in our prior opinion, we specifically distinguished the banks’ right to force repayment of their investment at the Applicable Rate upon their withdrawal from Castle Harbour from a partner’s typical right to force a buyout of her share, giving account to the profits gained and losses suffered during her participation, noting that the banks’ right was characteristic of debt, not equity. See 459 F.3d at 238 (“The position of the Dutch banks was thus very different from an ordinary equity partner’s ability to force liquidation of a partnership.”) Accordingly, for the same reasons that the evidence compels the conclusion that the banks’ interest was not bona fide equity participation, it also compels the conclusion that their interest was not a capital interest within the meaning of § 704(e)(1)Note that GE did not try to buttress its "reasonableness" by relying upon advice of counsel. Indeed, it chose not to disclose the opinions. In this regard, the Tax Court just yesterday entered a decision requiring production of the opinion when the taxpayer sought to avoid the accuracy related penalty based on reasonable cause -- there's that pesky word reasonable again -- and good faith. AD Investment 2000 Fund LLC et al. v. Commissioner, 142 T.C. No. 13 (4/16/14), here. Here is the syllabus of the opinion:
In anticipation of Ps' affirmative defenses to accuracy-related penalties (e.g., reasonable cause and good faith), R moves (1) to compel production of letters expressing attorneys' opinions as to whether it was more likely than not that anticipated tax benefits from transactions in question would be upheld and (2) to sanction Ps for noncompliance with any order directing production. Ps object on grounds that the letters are privileged attorney-client communications. R argues that Ps impliedly waived any privilege by putting into issue the LLCs' beliefs and state of mind. Ps deny that the LLCs relied on the letters.
Held: By putting the LLCs' legal knowledge and understanding into contention in order to establish a good-faith and state-of-mind defenses, Ps forfeit the LLCs' privilege protecting attorney-client communications relevant to the content and the formation of their legal knowledge, understanding, and beliefs; an order directing production will be issued.
Held, further, if Ps fail to comply with the order directing production, the Court will consider the sanction of preventing Ps, in support of affirmative defenses, from introducing evidence of the LLCs' reasonable beliefs and state of mind.I probably will write something on AD Investment 2000 Fund LLC on this blog or my Federal Tax Procedure Blog soon.
Addendum 4/19/14 4:30pm:
Note that the TIFD court studiously avoids the defense of reasonable cause and good faith belief. However, the negligence inquiry blends into reasonable cause and good faith. A taxpayer acting with reasonable cause and good faith is not negligent. This blending is seen in Streber v. Commissioner, 138 F.3d 216 (1998), here. Here is my discussion of this aspect of Streber from my Tax Procedure Book (footnotes omitted):
You are assigned Streber v. Commissioner, 138 F.3d 216 (1998) (in the materials), a Fifth Circuit case involving the application of the negligence penalty. There, the Fifth Circuit said that “the relevant inquiry for the imposition of a negligence penalty is whether the taxpayer acted reasonably” and that good faith reliance on a tax professional is reasonable. (A watershed on this issue was the Fifth Circuit decision in the Heasley case, a case which has been cited with favor by many courts, and is cited by the Fifth Circuit in Streber.) The Streber Court did not distinguish carefully between the elements of the conduct penalized under § 6662(c) and the reasonable cause exception under § 6664(c) which it did not even mention. In other words, a taxpayer can avoid the penalty if the return position is not negligent or, even if negligent, he had reasonable cause under that standard (discussed in more detail below). The Court held that “Due care does not require young, unsophisticated individuals to independently examine their tax liabilities after taking the reasonably prudent step of securing advice from a tax attorney,” apparently referring to the conduct penalized in § 6662(c) itself.It is also telling that GE did not assert the defense in Section 6664(c), here, that it acted with reasonable cause and with good faith. See the Regs. § 1.6664-4, here. There is no question that the GE planners wanted to have the bank treated as a partner rather than a lender, but the issue is what GE did in a non-negligent way in so nominating the bank as a partner. If they had done no diligence whatever, they still could have nominated the bank as a partner because that is what they wanted, but that would be negligence. So what diligence did they do and was that diligence negligent or not. Why would not GE assert the defense, either for its affect on the initial negligence determination or as a defense? Consider the following from my Tax Procedure Book:
b. Reasonable Reliance on Tax Advisor.
Reasonable reliance on a qualified tax professional should permit this defense. Reasonable reliance is not determined in a vacuum – i.e., it does not apply simply because a qualified tax professional was involved. Rather, it applies only if, under all the circumstances, reliance upon the qualified tax professional was reasonable. The Regulations thus caution:
All facts and circumstances must be taken into account in determining whether a taxpayer has reasonably relied in good faith on advice (including the opinion of a professional tax advisor) as to the treatment of the taxpayer (or any entity, plan, or arrangement) under Federal tax law. For example, the taxpayer's education, sophistication and business experience will be relevant in determining whether the taxpayer's reliance on tax advice was reasonable and made in good faith. In no event will a taxpayer be considered to have reasonably relied in good faith on advice (including an opinion) unless the requirements of this paragraph (c)(1) are satisfied. The fact that these requirements are satisfied, however, will not necessarily establish that the taxpayer reasonably relied on the advice (including the opinion of a tax advisor) in good faith. For example, reliance may not be reasonable or in good faith if the taxpayer knew, or reasonably should have known, that the advisor lacked knowledge in the relevant aspects of Federal tax law.
The reliance on the advisor must be objectively reasonable. You should now read Addington v. Commissioner, 205 F.3d 54 (2d. Cir. 2000), which is in the materials. By way of background, the taxpayers were lawyers who invested in a hokey tax shelter. They sought to rely upon their hire tax specialists, “Guy Maxfield, a professor of tax law at New York University School of Law,” and conferred with “John Y. Taggart,” also at one time a professor of tax law at NYU Law who had helped prepare the offering documents for the shelter. Well, you can read the opinion as to whether that worked.
The Tax Court has held that this relief requires reliance on an independent tax advisor. In the context of that holding, the independent element precluded reliance on an in-house advisor. There are, of course, myriad of possibilities as to independence. The case held that during the period the tax advisor was not in-house but was an independent consultant, the taxpayer could rely and qualify for penalty relief. But there are many less obvious situations – perhaps the worst cases typified by taxpayers claiming reliance on an ostensibly independent tax advisor but known to be affiliated with the promoter of the tax scheme for which the taxpayer desires penalty relief. The fact that the such an affiliated tax advisor is not really independent bears on the reasonableness of the taxpayer’s reliance on the tax advisor.
Finally, one of the dangers in a taxpayer asserting this defense is that the taxpayer thereby waives the attorney-client privilege or the new Federally Authorized Tax Practitioner privilege which parallels the attorney-client privilege for non-lawyer practitioners. Since many counsel realizing the dangers lurking in high risk planning tend to hedge their opinions, the actual underlying opinion may do more harm than good for the defense.In the final analysis, a penalty to GE for this misbehavior will be a pittance relative to its financial position. It was not a pittance to the Streber sisters, and I am sure that contributed in part to the Fifth Circuit's decision. In my mind, the circumstances are vastly different. GE just made a conscious choice to treat a lender as a partner and got caught. Are there any costs to playing the audit lottery?