Sunday, May 4, 2014

The Role and Culpability of the Taxpayers Participating in Bullshit Tax Shelters (5/4/14)

I write today to collect and update some thoughts I have expressed before on this blog.  The background is the bullshit tax shelters on which I have written and even fulminated, if not eloquently, at least often.  I start with my own definition from my Tax Procedure Book (footnotes omitted).
  Abusive tax shelters are many and varied.  Some are outright fraudulent, usually wrapped in a shroud of paper work designed to present the shelter as a real deal.  The more sophisticated are often without substance but do have some at least attenuated, if superficial, claim to legality.  Some of the characteristics that I have observed for tax shelters that the Government might perceive as abusive are that (i) the transaction is outside the mainstream activity of the taxpayer, (i) the transaction is incredibly complex in its structure and steps so that not many (including specifically IRS auditors) will have the ability, tenacity, time and resources to trace it out to its illogical conclusion (this feature is often included to increase the taxpayer’s odds of winning the audit lottery); (iii) the transaction costs of the arrangement and risks involved, even where large relative to the deal, still have a favorable cost benefit/ratio only because of the tax benefits to be offered by the audit lottery, (iv) the promoters of the adventure make a lot more than even an hourly rate even at the high end for professionals (the so-called value added fee, which is often insurance type compensation to mediate shift potential penalty risks to the tax professional or the netherworld between the taxpayer and the tax professional) and (v) the objective indications as to the taxpayer's purpose for entering the transaction are a tax savings motive rather than any type of purposive business or investment motive.  More succinctly, Michael Graetz, a Yale Law Professor, has described an abusive tax shelter as “[a] deal done by very smart people that, absent tax considerations, would be very stupid.”  Other thoughtful observers vary the theme, e.g. a tax shelter “is a deal done by very smart people who are pretending to be rather stupid themselves for financial gain.”
The bullshit tax shelter with which I am most familiar is the Son-of-Boss shelter.  That shelter purported to generate offsets to taxable income.  The offsets were wrapped in commotion but ultimately simply created from thin air -- very thin, indeed a perfect vacuum.  Bullshit shelters appear in many guises other than Son-of-Boss.  The commotion they are wrapped in serve two purposes:  (i) creating the illusion of some basis for the magical tax benefits and (ii) hiding the fact that the illusion is an illusion.  Bottom-line, several courts have characterized the imagined benefits as "too good to be true" and indeed recognizably "too good to be true."

As readers of this blog know, many bullshit tax shelter promoters have been convicted for their participation in the bullshit tax shelters.  Taxpayers themselves have not been prosecuted or convicted.  I do understand that some taxpayers have been named targets or subjects of grand jury investigations for their participation but those investigations ended in only promoter prosecutions.

Since one of the principal reasons these taxpayers paid excessive fees and costs for the shelters was that the commotion (including the complexity and hokey opinion letters) would insulate them from penalties, the Government's inability or unwillingness to prosecute them means that they got this benefit for which they paid handsomely.  Many even got civil penalty relief and indeed avoidance of tax altogether if the Government did not get to them until it thought the statute of limitations had expired.  Other taxpayers unlucky enough to get caught within an applicable statute of limitations, did pay the tax and a civil penalty (perhaps mitigated in part by variations on amnesty).  As I will point out later in this blog, those taxpayers who thought the statute of limitations had run may be in for a rude awakening as the Government can move at any time to collect the taxes, penalties and interest due -- amounts that would be staggering in many cases at this time.

With that background, let's look at DDRA Capital, Inc. v. KPMG LLP, 2014 U.s. Dist. LEXIS 59177 (D VI 4/29/14), here.  In that case, one John K. Baldwin, was a very wealthy man had a large amount of gain in 2001.  Shawn Scott, also a very wealthy person, was involved as well.  (Scott's relationship is not clear to me, but he was involved as a person who would benefit and involved in the consideration of the shelter.)  Not appreciating the joy or civic duty of paying taxes on income, Baldwin and Scott looked at some bullshit tax shelters.  He chose one of KPMG's promoted versions of Son-of-Boss, a so-called short option strategy, acronymed to SOS.  The shelter did not work.  The IRS spotted it in time and collected taxes, penalties and interest from Baldwin (or related entities).

As often happens when people suffer loss, financial or otherwise, from their own misconduct, they look for a scapegoat.  Baldwin thought KPMG an easy scapegoat because it has deep pockets and KPMG had entered a deferred prosecution agreement with respect to this genre of shelter and, like a man, KPMG fessed up when it was brought to its knees.  (That was obviously not a voluntary confession, but it was a confession.)  Baldwin makes no such confession in that form, but his words (quoted below) are a confession, although he has no sense of culpability.  Baldwin imagines in this litigation that he can shift the financial cost of his dilly-dallying in a bullshit tax shelter to KPMG.  My understanding is that many bullshit tax shelter taxpayers have succeed in milking something from KPMG.  But all haven't.  Baldwin hasn't -- at least not yet.

Baldwin imagined that, after KPMG refused to settled on Baldwin's terms, he could sue and get a judge or jury to mitigate the damages he incurred in paying taxes, penalties and interest.  Indeed, he appears to have been so confident that he could prevail, that he filed a suit and then, after discovery, filed a motion for summary judgement.  The cited DDRA Capital opinion is the denial of the motion.  That means that, barring some other disposition, the case will go to trial.  (It is unclear whether bullshit tax shelter cases -- whether tax cases or civil damage cases -- are best tried before a judge or a jury, but that is not the issue I address here.)  However, given what the judge says in her opinion, it could well be that the judge would entertain a KPMG motion for summary judgent.

The Judge, Anne E. Thompson (Wikipedia here), is a senior federal judge in New Jersey overseeing DDRA Capital.  Just judging by the Judge's opinion, she can get past the bullshit.  Let's see her take on things.

In terms of methodology in reviewing her opinion, readers should keep in mind that this is an action on a motion for summary judgment. So, I think readers have to be careful in trying to separate those facts which are "established" at least for the motion (usually but not necessarily those facts tend to be established for the rest of the case) and those facts which are not established and thus cannot just a motion for summary judgment.  Since she was denying the plaintiff's motion, she could have just said more summarily that facts justifying summary judgment are just not established and must be tried.  The wording of the opinion, however, indicates that she is more firm in the facts she found and those facts will influence her views in later proceedings and the trial.  So, let's look at the facts that she stated in her words (Note I omit citations to the underlying record in all quotes in this blog).
Defendant [KPMG] knew when it presented SOS to Plaintiffs that if the IRS learned of Defendant's SOS clients it would disallow all associated losses claimed by the clients on their tax returns. 
During Plaintiffs' initial meeting with Defendant, Plaintiffs were accompanied by Jerry Mottern (Plaintiffs' CPA), Dave Jensen (Plaintiffs' CPA), and Phil Murphy (Plaintiffs' attorney). Plaintiffs' accountants and lawyers researched and considered Defendant's SOS product. 
The key point that these facts make, I think, is that Baldwin can recover from KPMG only if he relied and reasonably relied upon KPMG's actions and, as a result of that reliance, suffered financial damage that he would not have otherwise suffered.  In almost all of these cases, wealthy taxpayers were involved and had counseling from competent tax professionals -- well, at least experienced (competence can be questioned if they blessed these shelters for their clients).  I will let that speak for itself right now.

Reflecting on his decision to purchase SOS, Scott stated that he “thought the government would have no problem with [SOS] if KPMG was recommending it.” Scott further stated that he thought “KPMG wouldn't recommend something the government didn't like or was against.”

That's an interesting concept worthy of serious cross-examination -- that anyone – particularly a sophisticated businessman – could believe much less testify credibly that he believed a shelter promoter, whether KPMG or otherwise, would only hawk tax shelters that the IRS would accept.  Or, by inference, if it was hawked by KPMG, the IRS would accept it.  I doubt that Judge Thompson believes the statement.  I also question whether even Scott believes the statement.  I don’t think any of my sophisticated clients over the years would have believed it.

Each of Baldwin and Scott signed KPMG engagement letters.  The letters recognized that there could be a challenge to the SOS structure and then made the critical factual representation as follows:
You may realize either profits or losses based upon the price movement of the investments. You have informed us that no one has provided you with any assurances or guarantees that you will make money in any of these transactions on a pre-tax or after-tax basis. You acknowledge that you are at all times subject to market risks for both reward and loss. We recommend that you seek independent advice concerning the investment aspects of the proposed transaction before agreeing to participate in the transactions. You have independently determined that there is a reasonable opportunity for you to earn a reasonable pre-tax profit from the investments in excess of all associated fees and costs, and this determination has been confirmed by Gramercy.
This is the key point.  All of the bullshit tax shelters with which I am familiar required that the taxpayer represent that he or she had a profit motive independent of the tax consequences. Yet, Baldwin admitted on deposition that this was his lie.  His personal representation to KPMG was a lie.  Here is Judge Thompson's discussion of the problem.
During depositions, Plaintiff Baldwin acknowledged that part of the KPMG engagement letter was not true. Specifically, at the time Plaintiff Baldwin signed the KPMG engagement letter, Plaintiff Baldwin had not independently determined that there was a reasonable opportunity to earn a “reasonable pre-tax profit from the investments in excess of all associated fees and costs” and Plaintiff Baldwin had not confirmed the opportunity to earn a reasonable profit with Gramercy. [Record citations omitted]
In addition, Hasting [the KPMG promoter] stated to Plaintiffs that the SOS transaction needed to have a legitimate business purpose. During depositions, Plaintiffs agreed that their primary motivation for purchasing SOS was to minimize their taxes.
In support of the foregoing, Judge Thompson offers the following in footnotes:
  n4 Plaintiff Baldwin stated the following during his deposition:
Carl [Hasting] did say that a transaction, you know, the kind of business — the kind of thing that he was proposing needed to have a business purpose. It needed to be something that had — that made money or more likely than not would make money just like any business. He likened it to saying okay, if you go - you know, you go open a 7-Eleven, you don't know that it's going to make money, but you open it with the anticipation that it's going to make money, and these investments had to have that element as well.
  n5 Plaintiff Baldwin stated the following during his deposition:
Defense Counsel: Was it your desire to take advantage of one of those programs that enabled rich people to not pay taxes?
Baldwin: Yes
Defense Counsel: Okay. And was it your desire to be in a posture where, like, you know, other wealthy people you wouldn't have to pay taxes?
Baldwin: Yes, as long as it was legal and there was [sic] no problems with it, I wanted to do the same.
Scott stated the following during his deposition:
Defense Counsel: Okay. At the time you understood that there was going to be a sale of the Delta Downs Racetrack, did you undertake some tax planning?
Scott: Yes.
Defense Counsel: And the end result of that tax planning was the transaction that's the issue in this case; correct?
Scott: Yes
Defense Counsel: And explain for me what was the reason or what motivated you to do that transaction.
Scott: Largely my — my faith that Carl Hasting and KPMG would look out for our interests.
Defense Counsel: But what were you trying to accomplish through the transaction?
Scott: Well, we wanted to minimize our tax that we would have to pay to the extent the law allowed us to do so.
Defense Counsel: So tax minimization is what you were looking to accomplish; correct?
Scott: Yes.
Then, Judge Thompson says:
Plaintiff Baldwin listed a loss of $21,999,107.00 on the 2001 tax returns for Sunset Management. In his deposition, Plaintiff Baldwin acknowledged that Sunset Management did not actually experience a loss of $21,999,107.00 in 2001 as a result of the transactions related to SOS. 
Then:
Defense Counsel deposed Plaintiffs' expert witness in this case, Brant Hellwig, and asked questions about SOS. In response to a question about whether SOS was too good to be true, Hellwig stated the following:
To me, it seems like this transaction would strike anybody as producing a result that would be too good to be true. And I'll qualify that by saying that there is also a view out there that these too good to be true transactions are available if you have the right sophisticated advisors.
That's it for a defense -- some "view out there that these too good to be true transactions are available if you have the right sophisticated advisors."  Stated otherwise, there is a view that rich people – those that can afford sophisticated advisors – can choose not to pay tax simply by having those well paid/sophisticated chant magic words in an opaque opinion letters and rafts of documents for equally opaque structures.

Yet, based on this, the plaintiffs sued KPMG for:
(1) Breach of Fiduciary Duty;
(2) Fraud;
(3) Negligent Misrepresentation;
(4) Negligence;
(5) Violation of 18 U.S.C. § 1962 (c);
(6) Violation of 18 U.S.C. § 1962 (d);
(7) Restitution;
(8) Federal Securities Fraud; and
(9) Securities Fraud in Violation of the Nevada Statute.
In the opinion, Judge Thompson polishes off the fraud claim first, finding that the record on summary judgement did not require a finding of "justifiable reliance."  Basically, the Court said all the warning signals were there:  qualifications in the opinion letter, warning that the IRS may contest, etc.  Then she says:
In addition, under Nevada law, reliance is not justifiable if the plaintiff has “information which would serve as a danger signal … to any normal person of his intelligence and experience.” Collins v. Burns, 103 Nev. 394, 397, 741 P.2d 819 (1987). Here, there were danger signals suggesting the potential illegality of SOS
First, Plaintiffs' engagement letter with KPMG contained a false statement. Plaintiffs' engagement letters with KPMG contained the following language: “You have independently determined that there is a reasonable opportunity for you to earn a reasonable pre-tax profit from the investments in excess of all associated fees and costs, and this determination has been confirmed by Gramercy.” During deposition, Plaintiff Baldwin acknowledged that this part of the KPMG engagement letter was not true. At the time Plaintiff Baldwin signed the KPMG engagement letter, Plaintiff Baldwin had not independently determined that there was a reasonable opportunity to earn a “reasonable pre-tax profit from the investments in excess of all associated fees and costs” and Plaintiff Baldwin had not confirmed the opportunity to earn a reasonable profit with Gramercy. n8
   n8 Plaintiff Baldwin stated the following during his deposition:
Defense Counsel: Now, if you can turn to page 2 for a second, it then says in the next sentence, you have independently determined that there is a reasonable opportunity for you to earn a reasonable pretax profit from the investments in excess of all associated fees and costs and this determination has been confirmed by Gramercy. Had you at the time you signed this letter independently determined that there was a reasonable opportunity for you to earn a reasonable pretax profit from the investment in excess of all associated fees and costs?
Baldwin: No.
Defense Counsel: And had you had that determination confirmed by Gramercy?
Baldwin: No.
[Record citation omitted] 
Second, the amount of money Plaintiffs paid to execute SOS and the resulting figures Plaintiffs listed on their tax returns could have signaled the potential illegality of SOS. Plaintiff Baldwin paid Defendant $1,540,000.00 to execute SOS. After Defendant executed SOS for Plaintiff Baldwin, Plaintiff Baldwin listed a loss of $21,999,107.00 on the 2001 tax returns for Sunset Management. Plaintiff DDRA paid Defendant $3,360,000.00 to execute SOS. After Defendant utilized SOS for Plaintiff DDRA, Plaintiff DDRA listed a loss of $47,907,020.00 on its 2001 tax returns. Plaintiffs' own expert stated “it seems like this transaction would strike anybody as producing a result that would be too good to be true.”  
Third, after Hasting executed SOS for Plaintiff Baldwin, Plaintiff Baldwin listed a loss of $21,999,107.00 on the 2001 tax returns for Sunset Management. In his deposition, Plaintiff Baldwin acknowledged that Sunset Management did not actually experience a loss of $21,999,107.00 in 2001 as a result of the transactions related to SOS.  
Given the danger signals suggesting the potential illegality of SOS and the documents suggesting the IRS might challenge the SOS transaction, Plaintiffs have not met their burden on a motion for summary judgment with respect to the fourth element of fraud: justifiable reliance. Therefore, Plaintiffs' motion for summary judgment, with respect to their claim of fraud by affirmative misrepresentation, will be denied.
And so goes the rest of the opinion.  Taxpayer’s Motion for Summary Judgment denied.

You get the flavor here.  The taxpayers lied in the representation.  Without that lie, voluntarily and intentionally made by the taxpayers, KPMG would not have participated in the transaction.  Without that lie, the shelter would have never been implemented.  Without that lie, the taxpayers could not hope the avoid the audit lottery by not paying the tax, without major risk of criminal prosecution.  And, as I have noted they did get the benefit of that part of the bargain.  KPMG did, as it has admitted, commit criminal misconduct in these shelters.  But, because of the critical role of this lie, both KPMG and the taxpayers involved were what the law would call co-conspirators for at least a Klein / defraud conspiracy and probably also an offense conspiracy.

The question is whether one co-conspirator is entitled to recover from another co-conspirator, particularly where the co-conspirator seeking to recover was the one who would benefit most had the crime worked.  It just seems to me a bit excessive to have any sympathy from a legal or moral perspective for these taxpayers.  I think that is probably Judge Thompson's view as well, so that taxpayers better hope that they have a jury sympathetic to rich people and unable to call a lie a lie.

Now, I noted, the taxpayers and others similar situated taxpayers engaging in bullshit taxpayers did get the benefit of at least the major part of what they were seeking – no criminal prosecution for their intentional misbehavior.  Focus on the lie.  As the prosecution said in Enron case, “This is a simple case. It is not about accounting [substitute tax]. 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).  For my blogs on the Big Lie, see here.

And, not only did they avoid criminal prosecution, some took amnesty so that they did not pay as much in civil penalties as they otherwise would have.

And some won the audit lottery altogether by the closure of the statute of limitations.  I am not sure that the fat lady has sung the finale on that one, though.

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  2. ChiTownTaxAttorneyMay 5, 2014 at 11:50 AM

    This is an excellent summary of the garbage jurisprudential acrobatics appellate courts employ to achieve their desired results. Fed. R. App. 3 states what "must" be contained in a notice of appeal. The failure to comply with the notice of filing requirements often "denies" the appellate court jurisdiction. The definition of "must" includes "[to] be commanded OR REQUESTED TO DO". Synonyms of must include "have (to), need, OUGHT (TO), shall, SHOULD". Please, anyone with a sincere belief "shall" or "must" really means anything other than a mandatory act or prohibition, or with no consequences for failure of compliance, post a $50 million bond. I will then intentionally file a notice of appeal one-billionth of a second late before the 7th Circuit and tell Judge Easterbrook (or even worse, Judge Posner) the following:

    "The rule for timely filing a notice of appeal 'must' have been simply advisory or even a mere suggestion, because its definition and synonyms include a request, and what I ought to or should have done.. 'Must' is a very slippery word, just like shall, and could not possibly mean I was obligated to file, particularly because filing one billionth of a second late doesn't in any way prejudice the court or the government."

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