Judge Holmes Weighs (At Length) Against Taxpayers Involved in Complex Bullshit Tax Shelters; Fraud Penalties Approved (7/14/21; 7/15/21)

Back in my younger years in the practice of tax law, I heard something like an aphorism or at least a pithy statement meant to suggest some truth that the difference between a doctor and a lawyer cheating on their taxes is that the doctor will file a false return underreporting tax liability (a felony) whereas the lawyer will file no return (generally a misdemeanor).  While there may be some truth in the statement, there is probably not as much truth as those acting on it by failing to file would like to hope.

I was reminded of that statement in today’s opinion in Ernest S. Ryder & Associates, Inc., APLC. v. Commissioner, T.C. Memo. 2021-88, here.  The opinion. 191 pages long and with a table of contents to help one navigate the opinion, is written by Judge Holmes who weighs in with his usual gusto in writing.

Here is the opening (Slip Op. pp.  4-5,  footnotes omitted):

Ryder & Associates, Inc., APLC (R&A), marketed six tax-reduction strategies that produced over $31 million in revenue between 2003 and 2011. The firm’s fixed costs were low, and its out-of-pocket expenses not very large. Yet year after year it paid no income tax. Its revenue flowed instead into 560 accounts and into Ryder Law Corporation, a related S corporation.  It flowed into more than 1,100 ESOPs,  other S corporations, LLCs, and other passthroughs. It flowed into ranches in Arizona, and it flowed into other ranches in New Mexico. And then it mostly seemed to pool in places where it would benefit Ernest S. Ryder and his wife Patricia, who received more than $15 million in distributions between 2002 and 2011 but paid only $31,000 in income tax during the years at issue.

The lead petitioner is a corporation, but the case is consolidated with other cases.  The principal actor in the drama, Ryder, was an accomplished tax lawyer, with an LLM from NYU Law School.  His entry into the law practice in the 1970s was particularly auspicious as noted by Judge Holmes (Slip Op. pp. 6-7): 

His timing was fortunate--he was at the stem-cell stage of his career the year that Congress enacted the Employee Retirement Income Security Act of 1974 (ERISA). When there’s an avulsive change in the law like ERISA, young lawyers can develop valuable expertise in an environment uncluttered with more senior competitors.

Knowledgeable associates in a fast-growing field are a hot commodity, and in 1975 Ryder was hired away by Harrigan, Ruff & Osborne to help that firm’s clients get their retirement plans qualified under the new law. “[T]hat’s when my career really took a turn,” Ryder explained, and he was well on his way to becoming an expert in qualified retirement plans.

Judge Holmes recounts Ryder's trajectory thereafter to include (Split Op. 8 & 9, footnotes omitted):

The aggressiveness of Ryder’s tax-reduction strategies seems to have caused some tension with his partners at Ruff Ryder, and he was asked to leave the firm sometime in 1995. Ruff Ryder’s entire pension department and its profit-sharing clients left with him. With ample experience and a fully staffed pension practice, Ryder decided to open up his own firm in early 1996. And here begins the Ryders’ tax problems. R&A is a professional law corporation and has always been taxed as a C corporation. Ryder has owned 100%, and has acted as president, of R&A since its creation. We find that Ryder also provided 100% of his legal services to clients through R&A during the years at issue. 

Despite its success and longevity, R&A reported zero taxable income from 2002 through 2011. The Ryders also reported minimal taxable income on their individual returns for those years.

I can't help but point out the catchy firm name "Ruff Ryder."

At this point, I am sure you intuit where this opinion is going.  Not surprisingly, the bullshit tax shelter “Son-of-Boss” is implicated.  (See Slip Op. pp. 11, 26, 39 & 67, 69 n. 32, 112, 117 & 187.)  And IRS listed transactions also make an appearance.  (Slip Op. 24 at n. 17, footnotes omitted.)

The facts are long with a large number of entities floating in and out for tax purposes.  I won’t get into those details and complex factual development based on bank deposit analysis.

Then audit the started as described (pp. 46-49):

The IRS began a section 6700 investigation into R&A’s use of ESOPs on August 26, 2003, after someone noticed that the firm had applied to have more than 800 ESOPs qualified at the same time. Then, like antibodies swarming to an infection, two more investigations latched onto the promotional activities of Robert Pancheri and Karen Baker--former R&A employees whom Ryder had used to “manage” many of the different entities. These converged into a full-blown audit of the Ryders and his law firm. This überaudit spanned nearly a decade and expanded backward and forward to the Ryders’ 2002-11 and R&A’s 2005-09 tax years.

When questioned by IRS agents, Ryder pleaded the Fifth and refused to answer any questions regarding the tax structures sold by his law firm. Ryder’s silence left the Commissioner with no choice but to use subpoenas and third-party interviews. Revenue Agent Huong Phan--the first revenue agent on this case-- issued over 30 summonses to various financial institutions and third parties--essentially any party that he was able to recognize.

More investigations broke out. The California Franchise Tax Board executed a search warrant of R&A’s office in April 2010. The IRS then expanded its audit team to add Revenue Agent Joseph Haynes. He focused on identifying what payments and deposits had moved through all these entities and accounts. It was a staggering job--RA Haynes himself issued over 300 summonses to financial institutions and other third parties during the course of his investigation. He even had a summons served on the Franchise Tax Board to get access to the records that it had seized in its investigation. The Commissioner found a tangle of 560 financial accounts used by hundreds of entities created by Ryder through R&A. Ryder himself had signature authority over approximately two-thirds of these accounts; the fraction rises to nearly 95% if one includes accounts where Ryder’s employees had signature authority. RA Haynes also traced the flow of funds through R&A’s accounts to identify which were for the Ryders’ benefit. After this work was completed, RAs Haynes and Phan both analyzed the items going through the accounts to identify which accounts were used to collect R&A’s fees. And, finally, Revenue Agent Nistha Boyer--who took over the work of RA Phan after RA Phan changed roles within the IRS--completed a bank-deposit analysis  (BDA) to identify R&A’s gross receipts. RA Boyer also determined that the Ryders were taking funds out of these accounts to pay personal expenses and linked these funds to R&A’s gross receipts.

B. Cashflow

1. Following the Money

We can begin with a general explanation of this complex analysis by the Commissioner’s revenue agents. Their work uncovered 41 of R&A’s financial accounts and 10 of the Ryders’. They identified and sorted the specific items of income deposited into these accounts, and then sorted the accounts into two “boxes”.

The first contained the 41 R&A accounts. This is the law-firm box, and the agents   determined that any money coming into that box was income of R&A. But if money just sloshed around from one account to another inside this box the agents didn’t count it as R&A income. We find that this is a generally reasonable way for us to identify R&A’s income.

The second box held the Ryders’ personal accounts. When money came into this “personal box” from the law-firm box, or left the law-firm box to go to a third party for the benefit of Ryder or his family, the agents treated it as a distribution to Ryder, unless the money was already included in their reported  income. Just as with the law-firm box, the Commissioner did not add to the Ryders’ income any deposits and withdrawals between accounts within the personal box. We also find this to be a generally reasonable way for us to identify the Ryders’ possibly taxable distributions

2. Gross Income

This bank-deposit analysis is the heart of these cases. And given the astonishing complexity of the cashflows in and out of the accounts, we next describe in some detail the links between R&A’s tax products and these accounts. 

I’ll stop there with the facts because the details are granular indeed.

Judge Holmes then in the Opinion section starts as many Tax Court opinions do with Burden of Proof. Here’s how he handles that in short order (p. 84-85):

I. Burden of Proof

The parties bicker about the burden of proof, but with more than 8 million pages of evidence and 2,300 pages of transcript we can decide almost all the issues on the preponderance of the evidence. One exception is the issue of fraud—section 7454 and Rule 142(b) require the Commissioner to prove fraud by clear and convincing evidence.

We note Ryder’s attacks on the presumption of correctness that we’ve said attaches to the Commissioner’s notices of deficiency and bank-deposit analyses. We don’t need to rule on these objections--the profusion of evidence, which for the BDAs includes credible testimony from the revenue agents who compiled those analyses together with their source material--makes them moot. We do note that these cases pose questions of unreported income, and the Ninth Circuit has held that in such cases the Commissioner must establish some connection between a taxpayer and income-producing activities. See Weimerskirch v. Commissioner, 596 F.2d 358, 362 (9th Cir. 1979), rev’g 67 T.C. 672 (1977). A “minimal evidentiary foundation” is all that is required. See id. at 361. The Commissioner’s introduction of volumes of evidence--which he aptly referred to as “buckets”—and the extensive backup to his BDAs show much more than a minimal evidentiary foundation to link Ryder and R&A to this income.

We also note our ever more elaborate rules on the burden of production for penalties. Section 7491(c) places this burden on the Commissioner for penalties that he asserts against individuals. We held in Graev v. Commissioner (Graev III), 149 T.C. 485 (2017), supplementing and overruling in part 147 T.C. 460 (2016), that this means the Commissioner has to produce evidence that “the initial determination of such assessment [i.e., of the penalties] [wa]s personally  approved (in writing) by the immediate supervisor of the individual making such determination.” See id. at 492-93. Section 6751(b)(2) excepts certain penalties from this written supervisory approval requirement--including those under sections 6651, 6654, and 6655.

 Continuing with some other interesting parts of the opinion:

 Judge Holmes has an excellent discussion of assignment of income (could be useful for a class)  (Slip Op. 86-129)  Some interesting excerpts (Slip Op. 118-119, cleaned up):

Summary. All of these fees paid by the clients of the different tax products were compensation to R&A for its services in spinning webs of entities and squirting barrels of ink to hide the connection between itself and the fees it charged. We of course recognize that Ryder diverted these payments through contracts and entities, and the accounts and divisions within entities. We also recognize the invocation of Moline Properties that corporate forms must be respected. But the assignment-of-income doctrine does not immunize assignments of income to corporations or other entities. The income that R&A produced from sales of these deals to its clients was income to R&A because it was R&A itself that did the work. Ryder also cited a number of cases, including [cases omitted] where the  Commissioner attempted to attribute income reported by legitimate corporations to other persons or entities. But in each of the cases cited by Ryder, there were questions about who was the true earner of the income in question.  Here there is no reasonable dispute about who earned what--it was R&A’s  income, and hiding it in otherwise nonfunctioning entities doesn’t make it any less an assignment of income.

Our finding here does not even rely on attributing to R&A income that was reported by different businesses--or determining the “true earner,” as in the cases that Ryder cites. Rather, we are actually attributing to R&A deposits into bank accounts--deposits that were funneled through tax schemes but that were always payments for the services provided through R&A. The question of whether these structures were separate from R&A or were actually conducting legitimate business activities is irrelevant to this determination. All that matters is that the fees that went into these accounts were fees for services that R&A provided. 

 As to penalties, some were conceded.  The Court addressed some of the penalties.  The Court held (Slip Op. pp. 183-184) that Mrs. Ryder was not subject to the § 6663 fraud penalty, holding that, despite being “a sophisticated business” woman, the IRS did not show by clear and convincing proof that she had the requisite intent (even with willful blindness) to be liable for the penalty.

 Moving to Mr. Ryder and R&A, the court starts pithily (Slip Op. 185):

As for R&A and Ryder himself, things are rather different.

Ryder is about as well-educated as one can be in tax law. It was his tax expertise that brought clients into R&A, and it was his use of that expertise that made the money that we’ve found taxable, first to R&A and then to him. We acknowledge his position that he did not intend to evade tax, but only to seek shelter in the gray areas in the Code. We agree that there are gray areas in tax law. But one area that no one should consider gray is misrepresenting facts. Especially material facts.

For those taxpayers, it goes down from there.  

I’ll end this journey by getting back to the theme I introduced at the start and that Judge Holmes discusses at the end of the penalties discussion (Slip Op. pp. 190-191):

Not only did Ryder fail to show reasonable cause; he testified that he made the choice not to file. Ryder claims that he learned during his time in NYU’s LL.M. program that “where you’re uncertain as to how you should respond or report, you’re better off not filing than filing at all.” And when discussing why he had filed other returns late in the past, Ryder stated: “[I]t’s better to have a misdemeanor  than a felony.” It’s hard to believe that Ryder’s decision not to file was done with any other purpose than to evade tax.

The Commissioner wins on this one.

JAT Comments:

1. Whew!

2.  I presume that civil fraud would have been required for some of the older years, although failure to file may have left the statute open in some cases.  § 6501(c)(1)-(3).  

3.  (Added 7/15/21 11:00 am)  The audit of Ryder's activities was started with a § 6700 penalty investigation "after someone noticed that the firm had applied to have more than 800 ESOPs qualified at the same time."  (Slip Op. p. 46.)  The opinion discussed above involves a Tax Court proceeding to redetermine income tax deficiencies.  The opinion, while mentioning the § 6700 investigation starting in August of 2003, does not say what happened to that investigation.  The § 6700 penalties could be enormous since the penalty is 50% of the gross income derived or to be derived from the penalized conduct.  Given the specifics and tenor of Judge Holmes' opinion, it is hard to imagine that the IRS did not assert the § 6700 penalty.  Of course, the IRS could still assert the § 6700 penalty since there is no statute of limitations. E.g.,  Lamb v. United States, 977 F.2d 1296 (8th Cir. 1992); and Capozzi v. United States, 980 F.2d 872 (2d Cir. 1992).  The § 6700 penalty can apply to any of the actors involved in the misstatements, so there can be multiple actors subject to the penalty for the same underlying false or fraudulent statements.  In the Ryder cases, Ryder himself seems to have been at the center of the action but some others may have played a role.  For those craving more on the § 6700 penalty, I link here the discussion in my Federal Tax Procedure 2021 edition working draft (due for publication in August 2021).  Note that, since this is from the working draft, the page numbers and footnote numbers will almost certainly be different in the published version.

3.  I have to give kudos to the IRS agents and their leadership for devoting the resources and creativity to getting through the fog created by Ryder to prevent transparency to the IRS.  

4. The opinion is a multi-taxpayer consolidated case opinion.  The opinion is one opinion and applies to all of the cases.  This single opinion accounted for all of today's opinions at the Tax Court.  Here is the snapshot of today's opinions.