I discussed United States v. Daugerdas, ___ F.3d ___, 2016 U.S. App. LEXIS 17219 (2d Cir. 2016), here, recently, Daugerdas Conviction and Sentencing Affirmed by Second Circuit Court of Appeals (Federal Tax Crimes Blog 9/21/16), here. I quoted the part of the opinion relevant to today's discussion, but will present the quote again here:
As an essential part of the marketing of all the tax shelters, Daugerdas and his colleagues issued "more-likely-than-not" opinion letters to clients who purchased the shelters. Such letters state that "under current U.S. federal income tax law it is more likely than not that" the transactions comprising the shelters are legal and will have the effect sought by the clients. They protect clients from the IRS's imposition of a financial penalty in the event that the IRS  does not permit the losses generated by the shelter to reduce the client's tax liability. Paralegals or attorneys who worked for Daugerdas generated these letters and Daugerdas often reviewed and signed them himself. The letters stated that the clients had knowledge of the particular transactions underlying the shelter and that the clients were entering into the shelter for non-tax business reasons. Multiple clients testified that they never made representations of knowledge to Daugerdas or his associates and that, in any event, these representations were false because the clients knew little or nothing about the underlying transactions and entered into the shelters only to reduce their tax liability.Daugerdas' shelters were clearly of the abusive -- aka bullshit -- variety. In essence, for the tax shelters Daugerdaus and his partners in crime hawked, the play in the shelter gave the taxpayer a shot at the audit lottery and some way potentially to mitigate the penalty damage if he did not win the audit lottery. But, as it turns out, these shelters were so bad, that they did not really offer much in the way of penalty mitigation except, sometimes, through IRS amnesty programs. In essence, most of the taxpayers -- certainly the more sophisticated taxpayers who had millions and millions of income to shelter -- got into the shelter on a wink and a nod, hoping for the best with some downside protection.
In Exelon Corp. v. Commissioner, 147 T.C. ___, No. 9 (2016), here, the taxpayer had $1.6 billion in gain that it perceived a need to shelter -- i.e., avoid paying tax on. The transactions are convoluted (as in the case of many tax shelters where the convolutions masks lack of substance). (The complexity of the opinion is suggested by the fact that the substantive discussion concludes on p. 161 of the slip opinion.) The details of the transactions are not important for purposes of this blog, but they are variations on leveraged leases with their own acronym that is familiar to affionados of bullshit tax shelters -- SILOs (to be contrasted from related tax shelters called LILOs). In the opinion, Judge Laro offers the following "Primer on Leveraged Leases, LILOs, and SILOs:"
We have discussed in detail the seminal cases and regulations related to leveraged leases, LILOs, and SILOs in this Court's opinion in John Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. 1, 15-16, 54-77 (2013). We briefly reiterate some of that analysis here to provide the reader with sufficient details relevant to the cases [*105] at hand.
Frank Lyon Co. v. United States, 435 U.S. 561 (1978), is the seminal Supreme Court case discussing leveraged lease transactions. The taxpayer in Frank Lyon engaged in a sale-leaseback transaction to finance the construction of a new building. Out of the required $7.64 million, Frank Lyon invested $500,000 of its own money and financed the remainder with a third-party lender through a secured mortgage with the building serving as a collateral. In addition, Frank Lyon made a promise to assume personal responsibility for the loan's repayment and an assignment to the lender of the rental payments under the lease. Id. at 566-568.
The lease in Frank Lyon was a net lease requiring lessee to pay taxes, insurance, and utilities. Lessee had an option to purchase the building at certain times during the lease and at the end of the 25-year lease term. Lessee also had an option to renew the lease for additional periods of time. Frank Lyon claimed depreciation deductions and interest expense deductions related to the building. Id. at 567-569.
After considering the transaction, the Supreme Court held that the form of a sale-leaseback transaction will be respected for Federal tax purposes as long as the lessor retains significant and genuine attributes of a traditional lessor. Id. at 584. The Supreme Court recognized that these attributes necessarily depend on the facts of a particular case. Id. According to the Supreme Court, several factors weighed in favor of the taxpayer in Frank Lyon. Frank Lyon bore the financial risks of the transaction by assuming responsibility for loan repayment and investing its own money in the transaction. Id. at 581. The Supreme Court concluded that there was a real possibility that the lessor could walk away from the transaction at the end of the initial lease. The parties negotiated the deal in good faith and were independent of each other. The parties paid the same tax rates, making the transaction tax neutral. The rent and purchase option prices were reasonable, and Frank Lyon assumed the credit risk of the lessee's defaulting on its rent payments. Id. at 575-584.
Around the time the Supreme Court issued its ruling in Frank Lyon, the Government was working on developing a set of rules to determine whether a leveraged lease transaction is a true lease or something else. In 1975 the Commissioner issued guidelines for advance ruling purposes on whether a leveraged lease will be respected for Federal tax purposes as a lease. Rev. Proc. 75-21, 1975-1 C.B. 715. In 1984 Congress enacted what has become known as the "Pickle rule", which subjected property leased to a tax-exempt entity to unfavorable depreciation rules. Deficit Reduction Act of 1984, Pub. L. No. 98-369, sec. 31, 98 Stat. at 509.
The unintended consequence of the Pickle rule was the proliferation of LILO transactions with tax-exempt entities. LILO transactions were designed to work around the Pickle rule because the taxable party leased the property from the tax-exempt counterparty instead of buying it, and then immediately subleased it back to the tax-exempt entity. To fund the transaction, the taxable party typically took out a nonrecourse loan covering 80%-90% of the initial lease. See John Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. at 11.
The sublease to a tax-exempt entity would typically be shorter than the initial lease term. At the end of the sublease, the tax-exempt entity usually has the option to purchase the remainder of the leasehold interest in the initial lease. Even if the tax-exempt entity decides not to exercise its purchase option, the taxable party could still compel the tax-exempt entity to renew the sublease, take possession of the asset, or procure the replacement sublease. To return the asset to the taxable party, the tax-exempt entity would typically need to meet certain conditions, including refinancing the nonrecourse loan involved in the transactions. Failure to meet the return conditions meant that the tax-exempt entity had to exercise the purchase option. See Id.
In 1999 LILO transactions became less popular because of a change in the regulations under section 467, which required that prepayment of the initial lease rent be treated as a loan for tax purposes. Id. at 16; see also sec. 1.467-4, Income Tax Regs. After that, investors started using SILOs to obtain similar results. See John Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. at 16.
A typical SILO transaction would be similar to a LILO except that the term of the initial lease extends beyond the remaining useful life of the asset, as is the case with the Spruce, Scherer, and Wansley test transactions here. Thus, the initial lease is treated as a sale for Federal tax purposes. The end-of-sublease options for the taxable entity usually include either compelling the lessee to arrange a service contract for the asset for a predetermined term or to take possession of the asset. Id.
The payments in SILO and LILO transactions are typically secured by the various defeasance instruments. Although the form of such instruments differs from one transaction to another, typically they entail setting aside several deposits with third-party financial institutions--payment undertakers--for various payments due under the transaction documents, including purchase options. Id. at 12. As a result of defeasance, the parties to the transaction do not have to come up with any out-of-pocket payments during the initial lease term. Id.
In 2002 the Commissioner issued Rev. Rul. 2002-69, 2002-2 C.B. 760, which explained that LILO transactions should be properly characterized as a future interest in property. Consequently, a taxpayer may not deduct rent or interest paid or incurred in connection with such a transaction. In the ruling the Commissioner stated that he would challenge tax benefit claims based on LILO transactions under the substance over form and economic substance doctrines. Id.
Congress eliminated the benefits associated with LILO and SILO transactions in the American Jobs Creation Act of 2004, Pub. L. No. 108-357, secs. 847-849, 118 Stat. at 1601. John Hancock Life Ins. Co. (U.S.A.) v. Commissioner, 141 T.C. at 16. That law was prospective in effect and did not apply to transactions entered by taxpayers before its effective date. Id.Well, these SILOs in Exelon did not work because the appraisals that supported the legal opinions were faulty. As the court said, the lawyers serving up the legal opinions for very hefty fees had "interfered" with the appraisal by telling the appraisers the details of the bottom line conclusions the law firm needed from the appraisers to render the legal opinions the clients then needed for penalty protection (all in opinions over 300 pages long). As a result, the appraisals did not support the legal opinions and for that, and other reasons, the client could not claim the "reasonable cause" and "good faith defense" for penalty protection By the way, the 20% accuracy related penalties were over $87 million.
So, how did the Court get there. First, § 6662 imposes two potentially applicable accuracy related penalties for this type of transaction -- the negligence penalty, § 6662(c), and the substantial understatement penalty, § 6662(d). The IRS had initially imposed both in the notice of deficiency but conceded the substantial understatement penalty. The opinion does not state why the IRS conceded, but it is likely the reduction in § 6662(d)(2)(B)(ii) since the "shelter" was registered and thus likely disclosed and, since it all turned on appraisals, the taxpayer may have had some type of "reasonable basis." But that is my speculation and need not further detain us. I quote the portion of the penalty discussion related to the negligence penalty:
Section 6662(a) and (b)(1) imposes a 20% penalty on any portion of an underpayment of tax attributable to negligence or disregard of rules or regulations. Negligence includes "any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws or to exercise ordinary and reasonable care in the preparation of a tax return." Sec. 1.6662-3(b)(1), Income Tax Regs. Negligence is "strongly indicated" when the taxpayer fails to make a reasonable inquiry into correctness of an item that appears "too good to be true." Id. subpara. (1)(ii).
Disregard includes "any careless, reckless or intentional disregard of rules or regulations," which includes "the provisions of the Internal Revenue Code, temporary or final Treasury regulations * * * and revenue rulings or notices (other than notices of proposed rulemaking) issued by the Internal Revenue Service and published in the Internal Revenue Bulletin." Id. subpara. (2). Disregard is "careless" if the taxpayer does not use "reasonable diligence to determine the correctness of a [tax] return position that is contrary to the rule or regulation." Id. Disregard is "reckless" if the taxpayer "makes little or no effort to determine whether a rule or regulation exists under circumstances which demonstrate a substantial deviation from the standard of conduct that a reasonable person would observe." Id. Finally, disregard is "intentional" if a taxpayer knows of the disregarded rule or regulation. Id.
However, the penalty does not apply to any portion of an underpayment for which a taxpayer had reasonable cause and acted in good faith. See sec. 6664(c)(1). This defense can be established through reasonable and good-faith reliance on advice received from a competent tax professional. See United States v. Boyle, 469 U.S. 241, 250-251 (1985); sec. 1.6664-4(b)(1), Income Tax Regs.
Respondent argues that petitioner failed to make a reasonable attempt to comply with the existing tax laws and failed to exercise ordinary and reasonable care in the preparation of the tax returns for the years at issue. Respondent asserts that Exelon should have known that the like-kind exchange and the test transactions provided it with a result "too good to be true" and should have evaluated the transactions more carefully. Respondent also asserts that Exelon was aware that LILO transactions were already under scrutiny from the IRS and did not sufficiently closely review the tax opinions provided by Winston & Strawn at the time of entering into the transactions.
Petitioner, in turn, argues that it conducted a thorough due diligence of all aspects of the like-kind exchange and test transactions before deciding to engage in them. Petitioner also argues that it reasonably relied in good faith on the advice it received from its advisers on the various aspects of the transactions, including tax treatment. Because the issue of whether petitioner under section 6662(a) was negligent or disregarded rules or regulations is so closely intertwined in these cases with whether petitioner under section 6664(c) reasonably and in good faith relied on advice it received from tax professionals, we consider the two issues together.
It is well recognized that taxpayers may establish that they should not be liable for a section 6662 penalty if they acted in good faith and reasonably relied on advice of a tax professional. Reliance on a professional tax adviser, however, does not automatically establish reasonable cause and good faith. Sec. 1.6664-4(b)(1), Income Tax Regs. Instead, all facts and circumstances must be taken into account, including the taxpayer's knowledge and experience and the reliance on the advice of a professional. Id. In the case of reliance on an opinion or advice, the facts and circumstances inquiry should account for "the taxpayer's education, sophistication and business experience," as well as whether "the taxpayer knew, or reasonably should have known, that the advisor lacked knowledge in the relevant aspects of Federal tax law." Id. para. (c)(1).
To show that reliance on advice of a tax professional constitutes reasonable cause, the taxpayer must prove by a preponderance of the evidence the following three requirements: (1) the adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on adviser's judgment. Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff'd, 299 F.3d 221 (3d Cir. 2002). Reliance may be unreasonable when it is placed upon insiders, promoters, or their offering materials, or when the person relied upon has an inherent conflict of interest that the taxpayer knew or should have known about. Id. at 98. In addition, the advice must not be based on unreasonable factual or legal assumptions and must not unreasonably rely on representations, statements, findings, or agreements of the taxpayer or any other person. Sec. 1.6664-4(c)(1)(ii), Income Tax Regs.
Petitioner claims it reasonably relied in good faith on Winston & Strawn's tax advice and therefore no accuracy-related penalty should be imposed. Respondent contends that petitioner's reliance on Winston & Strawn was unreasonable and not in good faith because Winston & Strawn was too involved in the structuring of the transactions to provide a reliable tax opinion.
First, we will analyze the factors outlined in Neonatology. The record in these cases and the testimony of the parties establishes that petitioner carefully considered various factors, including necessary expertise in tax, in selecting its tax adviser. Winston & Strawn, in petitioner's opinion, was a strong firm possessing the necessary qualifications and expertise in handling similar deals.
We do not find that Winston & Strawn was so involved in structuring the transaction that reliance on its tax opinions was per se unreasonable. Petitioner contacted Winston & Strawn to provide advice on the transaction, and there is no evidence that Winston & Strawn had a conflict of interest in rendering its advice. Winston & Strawn billed its normal hourly rates, and its fee did not depend on the closing of the test transactions. Cf. Kerman v. Commissioner, T.C. Memo. 2011-54, slip op. at 43 (finding that a tax opinion was burdened with an inherent conflict of interest where the fee for it was based on the amount of loss generated for the taxpayers in a CARDS transaction), aff'd, 713 F.3d 849 (6th Cir. 2013). Thus, petitioner met the first prong of the Neonatology test.
As to the second prong of the Neonatology test, the parties do not dispute that Winston & Strawn was closely involved in the transactions and knew all the relevant facts to render a tax opinion. Respondent does not allege that petitioner misrepresented any material facts to Winston & Strawn, and the record does not contain any indicia that this was the case.
However, as we discussed above, Winston & Strawn's tax opinions were based in large part on the appraisals prepared by Deloitte. We found that Winston & Strawn interfered with the integrity and the independence of the appraisal process by providing Deloitte with a list of conclusions it expected to see in the appraisals to be able to issue tax opinions at the "will" and "should" level. Such interference improperly tainted the Deloitte appraisal, rendering it useless. Further, because Winston & Strawn directed the conclusions that Deloitte had to arrive at, we are highly suspicious that the tax opinions are similarly tainted.
We also concluded that the technical and engineering assumptions used in the Deloitte appraisals were inconsistent with the return conditions specified in the test transaction documents, which made the exercise of the purchase/cancellation options considerably more likely. Winston & Strawn, as the firm that drafted the transaction documents and was closely involved in all stages of the test transactions, knew or should have known of this defect and that its tax opinions were therefore based on unreasonable assumptions and arrived at unreasonable conclusions in the light of how the transactions were actually structured. See sec. 1.6664-4(c)(1)(ii), Income Tax Regs.
The third prong of the Neonatology test requires the taxpayer to show that it relied in good faith on the adviser's judgment. There is a longstanding policy of not requiring taxpayers to second-guess the work of a tax professional providing the advice. As the Supreme Court has stated, "[t]o require the taxpayer to challenge the attorney, to seek a 'second opinion,' or to try to monitor counsel on the provisions of the Code himself would nullify the very purpose of seeking the advice of a presumed expert in the first place." Boyle, 469 U.S. at 251; see also Bruce v. Commissioner, T.C. Memo. 2014-178, at *56-*57 (finding it was objectively reasonable for the taxpayer to rely on the advice of his longtime tax adviser, even though the Court concluded that the advice was incorrect), aff'd, 608 F. App'x 268 (5th Cir. 2015); Estate of Giovacchini v. Commissioner, T.C. Memo. 2013-27, at *113-*114 (finding reasonable cause and good faith where there was no requirement under the circumstances to second-guess the advice of a CPA).
Sophistication and expertise of a taxpayer are important when it comes to determining whether a taxpayer relied on a tax professional in good faith, or simply attempted to purchase an expensive insurance policy for potential future litigation. Petitioner had been involved in the power industry since 1913 and described itself as "an electric utility company with experience in all phases of that industry; from generation, transmission, and distribution to wholesale and retail sales of power." Although petitioner did not have experience with section 1031 transactions, it certainly had experience in operating power plants and must have understood the concept of obsolescence.
Petitioner indeed engaged many advisers to assist with the due diligence and documenting the transactions at issue. Petitioner's employees recognized that they did not have expertise in like-kind exchanges and thus sought help from outside lawyers, accountants, and other consultants to guide them in the transactions. Petitioner formed an internal project team that was responsible for investigating and evaluating the like-kind exchange opportunity. The team included high-level employees with experience in tax, finance, and engineering. The team reported its findings to petitioner's board of directors, and the board approved the transactions. Although the board did not have the benefit of reviewing the final versions of the tax opinions, it did have a chance to ask questions of the Winston & Strawn team as well as the PwC team.
Petitioner's employees and the board, however, had other considerations in mind as well: They were under pressure to find a reasonable solution to the problem of higher-than-anticipated revenue from the sale of its fossil fuel power plants. The clock on the section 1031 transaction was ticking, and the amount at stake--over $1.6 billion of potentially taxable sale proceeds--was too significant to let the like-kind exchange plan fall apart. Our analysis of the test transactions shows that petitioner knew or should have known that CPS and MEAG were reasonably likely to exercise their respective cancellation/purchase options because they would not be able to return the Spruce, Scherer, and Wansley power plants to petitioner without incurring significant expenses to meet the return requirements.
It is true that Winston & Strawn provided a very favorable tax opinion on the test transactions, notwithstanding the obvious inconsistency of the return provisions and the projected plant capacity factor at the end of the respective subleases. Yet we are not persuaded that Winston & Strawn's tax opinion can serve as a shield for petitioner under the circumstances. We believe that petitioner fully recognized that a plant with a capacity factor of 82%--the minimum rate at which the Spruce station had to be running when returned by CPS upon expiration of the sublease--would be worth significantly more than the same plant with a capacity factor of 58%--the capacity factor used in the Deloitte appraisals. Petitioner, as a sophisticated power plant operator, must have appreciated that it would be very expensive for CPS to sufficiently upgrade the plant to meet the capacity requirements. Thus, petitioner must have understood that Winston & Strawn's tax opinions, based on the Deloitte appraisals, were flawed.
This brings us to two conclusions: first, petitioner could not have relied on the Winston & Strawn tax opinions in good faith because petitioner, with its expertise and sophistication, knew or should have known that the conclusions in the tax opinions were inconsistent with the terms of the deal. Second, in the light of the previous conclusion, petitioner's alleged reliance on Winston & Strawn's tax advice fails the Neonatology test. n35
n35 Petitioner also alleges that it relied on its auditor, Arthur Andersen, to raise red flags about the transactions. According to petitioner, Arthur Andersen had no objections or challenges to petitioner's reporting of the like-kind exchange. Unlike petitioner, Arthur Andersen did not have the benefit of vast experience in operating power plants and may have overlooked the issue of return conditions. The record is also silent as to what documents related to the transactions were actually reviewed by Arthur Andersen and to what extent. We are thus not persuaded by petitioner's argument.
We note that petitioner expended significant resources on due diligence and consulting fees related to the like-kind exchange and the test transactions. However, we find troubling petitioner's cavalier disregard of the risks connected with the test transactions and the underlying facts. Mr. Berdelle, petitioner's controller and a senior employee with substantial discretionary and strategic authority, testified that he had read the Winston & Strawn tax opinions and was otherwise intimately involved in the decisionmaking process behind the proposed transaction. In addition, Winston & Strawn had advised petitioner of certain tax risks that could accompany the proposed transactions, and indeed petitioner registered the test transactions as a confidential corporate tax shelter around the same time it entered into the transactions.
It is true that Mr. Roling and other employees of petitioner besides Mr. Berdelle had only cursorily read the opinion package prepared by Winston & Strawn. This fact on its own might be sufficient to demonstrate a failure by petitioner to exercise ordinary and reasonable care in entering into the transaction and preparing the related tax returns. However, considering that petitioner (1) was a sophisticated taxpayer, (2) claims to have read the Winston & Strawn tax opinions in their entirety, (3) knew or should have known that Winston & Strawn's tax opinions based on the Deloitte appraisal reports were flawed, (4) was apprised of the risk that the proposed transactions might be classified as corporate tax shelters and registered them as such with the IRS around the same time it entered into the test transactions, and (5) proceeded with the transactions anyway, we find that petitioner disregarded the applicable rules and regulations. At a minimum, petitioner carelessly disregarded the rules and regulations by failing to "exercise reasonable diligence to determine the correctness of a return position." See sec. 1.6662-3(b)(2), Income Tax Regs. Moreover, petitioner's use of Winston & Strawn's tax opinions--flawed as the opinions were because of Winston & Strawn's interference with the independence of the appraisal reports that undergirded them--was misguided. We cannot condone the procuring of a tax opinion as an insurance policy against penalties where the taxpayer knew or should have known that the opinion was flawed. A wink-and-a-smile is no replacement for independence when it comes to professional tax opinions.
We conclude that petitioner evinced disregard of rules and regulations within the meaning of section 6662 with respect to ascertaining the tax consequences of the test transactions. We further conclude that petitioner did not have reasonable cause and act in good faith within the meaning of section 6664(c). Accordingly, we uphold the accuracy-related penalties as determined by respondent for tax years 1999 and 2001. Because we have sustained the accuracy-related penalties on the ground of disregard of rules or regulations, we do not address the parties' arguments on a substantial understatement of income tax for the 1999 tax year.Given the amounts involved, Exelon has disclosed the consequences of the decision on its SEC Form 8-K, here. In relevant part, that report says:
The September 19, 2016 Tax Court Ruling
On September 19, 2016, the Tax Court rejected Exelon's position in the case and ruled that Exelon was not entitled to defer tax on the transaction. In addition, contrary to Exelon's evaluation that penalties were unwarranted, the Tax Court ruled that Exelon is liable for accuracy-related penalties.
In order to appeal the adverse decision, Exelon would be required to either post a bond or pay the tax, penalties and interest for the tax years before the Court. Consistent with previous disclosure, Exelon estimates that the potential tax and after-tax interest, exclusive of penalties, that could become payable may be as much as $870 million, of which approximately $300 million would be attributable to ComEd after consideration of Exelon's agreement to hold ComEd harmless from any unfavorable impacts of the after-tax interest amounts on ComEd's equity, and the balance to Exelon. The $870 million above comprises $1,190 million of tax and interest that could become payable in 2016, reduced by $320 million of interest benefit that will be realized in subsequent taxable years.
In addition, if the penalty ruling stands, the amount of penalties and after-tax interest that would be due is approximately $190 million. The $190 million comprises $260 million of penalties and interest reduced by $70 million of tax benefit from interest expense that will be realized in subsequent taxable years. It is expected that Exelon's remaining tax years affected by the litigation will be settled following a final appellate decision.
Exelon has not yet determined whether a charge to earnings for the penalties assessed is appropriate at this time. In any event, Exelon will not seek recovery from ComEd ratepayers for the effect of the penalties assessed. Exelon is still evaluating the Tax Court's decision and considering next steps.JAT Comments: I suppose It is possible that Exelon might have a claim against Winston & Strawn or possibly the appraisers. But, I do think Judge Laro lays responsibility on Exelon's personnel who knew or should have known and procured the opinion as an insurance policy against "penalty insurance" with a "wink-and-a-smile."