The Economic Rational Actor Model (4/22/15)

I offer today a good, succinct explanation of what is commonly called the standard deterrence model for the economically rational actor for tax obligations.  Kathleen DeLaney Thomas, The Psychic Cost of Tax Evasion, 56 B.C. L. Rev, 618 (2015), here.  I quote her brief explanation (pp. 623-626), omitting all except two footnotes:

A. Standard Deterrence Theory: The Rational Actor Model 

Standard deterrence theory, as applied to tax compliance, assumes that taxpayers are rational actors seeking to maximize their expected utility. Accordingly, a taxpayer who is deciding whether to comply with the tax law will weigh the expected cost of tax evasion against the cost of complying and choose the cheaper option. The cost of complying is simply the amount of tax owed. The cost of evasion, however, is somewhat more complex. If a taxpayer evades and is caught, she will have to pay the tax owed and will also have to pay a penalty, which is usually some fraction of the tax owed (e.g., twenty percent). Together, this penalty added to the tax owed can be thought of as the total fine for evasion (F). There is a chance, however, that the IRS will not detect the taxpayer’s evasion, in which case the taxpayer incurs no cost. Thus, the expected cost of tax evasion is the total fine for evasion discounted by the probability of detection (P): 

Cost of Compliance = Tax Owed
v.
Expected Cost of Evasion = P x F19 

For example, if the probability of detection were one percent (which is the current overall audit rate) and the penalty for evasion were twenty percent of the tax due, the expected cost of evading $100 of tax would be the $100 of tax due plus a $20 penalty (F = $120), discounted by one percent chance of being detected (P). The resulting $1.20 expected cost would be substantially cheaper than the cost of complying (i.e., the $100 of tax owed). In that case, a rational taxpayer would cheat. 

A policymaker seeking to deter a rational taxpayer from evading tax can do so by raising the expected cost of evasion, with the goal of making it more expensive than the cost of compliance. It follows from the model that raising either the probability of detection or the penalty for evasion, or some combination of the two, can increase the expected cost of evasion. In the context of tax compliance, this means higher tax penalties, raising the audit rate, or finding some other method to increase the rate of detection. 

At first glance, raising tax penalties appears to be a simple and potentially cost-effective solution for increasing tax compliance. Current civil tax penalties in the United States range from just twenty percent to seventy-five percent of the tax due, resulting in sub-optimal expected penalties if the risk of detection is small. n22 If Congress increased nominal penalties significantly, it could potentially deter tax evasion without investing more re-sources in ferreting out noncompliant taxpayers.
   n22 In the example in the text above, the expected penalty for evading $100 of tax was just $1.20 when the risk of detection was one percent and the penalty was twenty percent.

Two Courts' Approaches to Taxpayer Culpability in the Son-of-Boss Bullshit Tax Shelter (3/26/15)

I write today on two recent cases that evidence different approaches to taxpayer culpability for tax underpayment from "investing" in bullshit tax shelters.  These cases are CNT Investors LLC et al. v. Commissioner, 144 T.C. No. 11 (2015), here, and Kerman v. Chenery Associates, Inc. (WD Ky NO. 3:06-CV-00338-CRS 3/23/15), here.

For context, readers will recall that the Son-of-Boss ("SOB") tax shelter and the Custom Adjustable Rate Debt Structure ("CARDS") tax shelter are variations on the theme of no-cost (except promoter fees and reams of paper and commotion) tax benefits from thin air.  They have been the basis for several  prominent criminal prosecutions.  Courts have routinely called them too good to be true.  Most courts have reached that conclusion with respect to the type of sophisticated taxpayers who entered these shelters.  All of these shelters not only involved sophisticated taxpayers but required that those sophisticated taxpayers represent to the promoter and the issuers of the legal opinions that they had a profit motive independent of the tax motive.  In the context of the tax adventure in which that representation was made (tax benefits created from nothing except paper shuffling and payment of large fees to the promoters), that representation was bullshit.  That's my opinion and probably the opinion of most courts that have dealt with the issue.  I am some readers will disagree and I welcome their comments/corrections.

So, let's turn to the cases.  First, I will discuss the Kerman case.

Kerman was a suit by a taxpayer - "investor" against promoters of the adventure.  The originally named defendants were prominent players in the bullshit shelter industry:  Chenery Associates, Inc., Chenery Management, Inc., Sussex Financial Enterprises, Inc, Sidley Austin Brown & Wood, LLP, R. J. Ruble, Roy Hahn, Bayerische Hypo-Und Vereinsbank, HVB U.S. Finance, Inc.   The HVB defendants moved for dismissal of the remaining claims against it.

The IRS had prevailed in the Kerman's Tax Court case. here, and appeal, here, which had, successively, imposed the tax and the 40% accuracy related penalty.  (I will discuss this in more detail in discussing CNT Investors.)  For my blog discussion of the appellate case, see A Self-Proclaimed "Simple Man," "Utterly Uneducated" in Tax and Finance, but Still a Self-Made Multi-Millionaire Loses his Bullshit Tax Shelter Case (Federal Tax Crimes Blog 4/13/13), here. As a result, the Kermans conceded in their suit against the HVB defendants that:  "[i]ndisputably, the[y] participated in the abusive tax-shelter in conjunction with HVB."  Seizing on that concession, "HVB now contends that this admission is fatal to the Kermans' remaining claims against it under the theory of in pari delicto."

The Kerman court opened its discussion as follows:

The common law docntrine in pari delicto is a phrase that is short for the maxim in pari delicto potior est condition defendent is, which means: "In a case of equal or mutual fault . . . the position of the [defending] party . . . is the better one." Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 306, 105 S. Ct. 2622, 2626, 86 L. Ed. 2d 215 (1985) (quoting Black's Law Dictionary 711 (5th ed. 1979) (alternation in original)). When applied, it serves as a defense that prevents two parties whose wrongdoing are found to be in pari delicto from recovering from one another for any damages that arose from that joint wrongdoing. Bateman Eichler, 472 U.S. at 306, 105 S.Ct. 2622 (footnotes omitted). Courts apply the doctrine based on "two premises: first, that courts should not lend their good offices to mediating disputes among wrongdoers; and second, that denying judicial relief to an admitted wrongdoer is an effective means of deterring illegality." See id.; see also In re Dublin Securities, Inc., 133 F.3d 377, 380 (6th Cir.1997) ("'No Court will lend its aid to a man who founds his cause of action upon an immoral or illegal act.'"). 

In one germane application of the doctrine, a Kentucky court found that when two parties participate in a tax evasion transaction, they are deemed to be in pari delicto. Eline Realty Co. v. Foeman, 252 S.W.2d 15, 19 (Ky. 1952)(citing Stacy v. Williams, 253 Ky. 353, 69 S.W.2d 697; Middlesboro Home Telephone Co., v. Louisville & N. R. Co., 214 Ky. 822, 284 S.W. 104). This is true even if the plaintiff was induced to enter the transaction. Id. Here, the Kermans' admit that "[i]ndisputably, [they] participated in the abusive CARDS tax-shelter with HVB and the other Defendants." DN 227, p. 5. Moreover, they do not even dispute that, as a result, they are in pari delicto with HVB. Id. Instead, they argue that, regardless of whether they are in pari delicto with the Defendants, the defense does not bar their claims for rescission or under KRS §446.070 in this instance. We address these arguments in turn.

Another Bullshit Tax Shelter Bites the Dust on Appeal Also (9/12/14; 9/20/14)

In Chemtech Royalty Associates v. United States, 766 F.3d 453 (5th Cir. 2014), here, the Fifth Circuit rejected another audit lottery attempt in the guise of a bullshit tax shelter of the smoke and mirrors variety.  For my blog entry on the district court opinion, see Yet Another Bullshit Tax Shelter Bites the Dust (Federal Tax Crimes Blog 2/27/13), here.  This shelter was was hawked to Dow Chemical by the venerable financial wizardry firm of Goldman Sachs, here.  As with bullshit tax shelters generally, it was know by an acronym -- SLIPs for Special Limited Investment Partnerships.  And as with many bullshit tax shelters it needed one or more tax indifferent parties to appear to earn the taxable income that offset of the tax benefits the taxpayer claims.  The tax indifferent parties for many of the bullshit tax shelters are foreign banks some of whom appear more than willing, for a fee, to assist U.S. taxpayers raid the federal fisc.  (I am not sure how these banks can be distinguished from the Swiss banks that the U.S. DOJ has hammered.)  At any rate, the case was about the U.S. taxpayer at the center of this scam -- called by the courts a sham.  The U.S. taxpayer lost.

An issue ever present when taxpayers do such scams is the penalty exposure.  As readers of this blog know, when such sophisticated taxpayers enter such scams, they look to minimize their penalty exposure with tax opinions from tax professionals upon which they claim to have "relied."  If they can convince a court that they relied, then the cost of playing the audit lottery via the scam is just paying the taxes they owed anyway, interest during the period they used the fisc's money, and the exorbitant fees they paid to implement the scam.  So, as is typical,. this taxpayer got an opinion letter from a prominent law firm, Andrews & Kurth, here, which had helped Goldman Sachs conceptualize the scam.  By the time of trial, for some unexplained reason, the taxpayer did not rely upon the opinion for penalty relief.  The district court in its opinion (fn. 4) said:  "Dow does not rely on the opinion of Andrews & Kurth in this case, and the Court does not take it into consideration in this opinion."

So, after rejecting the scam, the Fifth Circuit turned to the issue of whether the taxpayer could avoid the penalties that come along with bullshit tax shelters.  Excepting civil fraud penalties that perhaps ought to come along with such scams, the penalties at play in these well-papered and well-lawyered scams are the accuracy related penalties of 20% or in particularly egregious cases 40%.  The district court imposed the 20% penalty for (i) negligence and (ii) substantial understatement.  The district court declined to assert the gross valuation misstatement penalty based upon outlier Fifth Circuit authority that suggested that, when the shelter was so stinky as a matter of law that it had no substance whatever, any gross misvaluation or basis overstatement can be ignored so the grosss valuation misstatement did not apply.  After the district court so held, the Supreme Court decided United States v. Woods, ___ U.S. ___, 134 S. Ct. 557 (2013), here, which rejected that notion.  For my blog entry on Woods, see Supreme Court Applies 40% Penalty to Bullshit Basis Enhancement Shelters (Federal Tax Crimes Blog 12/3/13), here. Accordingly, the Fifth Circuit remanded to the district court to reconsider its penalty conclusions in light of Woods.

Addendum 9/20/14 3:00 pm:

As in many bullshit tax shelters, the phantom income that is the consequence of phantom tax benefits need to be deflected, otherwise if that income were left with the taxpayer playing the game, the benefits would be reversed.  So, as is typical, the hunt is on in these deals for a tax indifferent party who can "suffer" the phantom income with no tax cost.  Foreign banks are real accommodating in that respect.  They were ubiquitous in the tax shelter shenanigans of the 1990s and early 2000s, both the individual mass (somewhat) marked individual shelters and the corporate shelters that I have discussed in this blog.  Needless to say they were prominent in Chemtech.  From the Fifth Circuit opinion:

This appeal concerns the tax consequences of two transactions undertaken by Dow Chemical Company  ("Dow") and a number of foreign banks n1 from 1993 through 2006. During those years, Dow and the foreign banks purported to operate two partnerships that generated over one billion dollars in tax deductions for Dow.  * * * *
   n1 Bank of Brussels Lambert, Dresdner Bank A.G., Kredietbank N.V., National West-minster Bank plc, and Rabo Mercent Bank N.V. (collectively, "the foreign banks"). 

Third, the corporation had to entice foreign entities to participate in the transaction. The tax benefits generated by the partnership could be attained only if the partnership's income could be assigned to a tax-indifferent party.

The foreign banks were the tax indifferent parties.  Hence, they entered fake transactions to assist the taxpayer in raiding the fisc.  Shame on them.  Why not more consequences than shame?  At least in the individual tax shelter cases, major penalties were imposed on some of the banks for facilitating the bullshit tax shelters other than the taxpayers suffered any costs for enabling the bullshit tax shelters, except perhaps reputational when called out by name in cases such as Chemtech.  And the corporate tax shelter taxpayers only paid the tax, often a 20% penalty and sometimes a 40% penalty, and interest on the tax and penalty, costs hardly sufficient on a cost benefit basis to really discourage the benefits of winning the audit lottery.  How many of these deals and at what cost to the fisc that were never discovered or if discovered to complex to understand in the blizzard of contrivances in which they were packaged?

Another Bullshit Shelter Bites the Dust Even with Variations (5/14/14)

I write today on the defeat of another bullshit tax shelter of the Son-of-Boss ("SOB") variety.  The Markell Company, Inc. v. Commissioner, T.C. Memo. 2014-86, here, decided yesterday.  If it were just another ho-hum SOB, it would be worth noting only in passing.  But, it has a twist -- both the twist and the outcome is projected in the opening two short paragraphs:

This case began when the Commissioner found the remains of a corporation on an Indian reservation in an extremely remote corner of Utah. The tribe claimed not to know how the corporation's stock had ended up in its hands. And there was little or no money or valuable property left inside the corporate shell. 

All signs pointed to the corporation's manager, a sophisticated East Coast moneyman, as the key person of interest. And his method was a series of complex transactions that bore a striking resemblance to Son-of-BOSS deals already examined many times before by this Court -- but with a corporate-partner twist.

The last sentence of the first paragraph resonates with the equally bullshit intermediary transactions.  One of the strategies in shelters is to push tax consequences to an empty shell of a company, so that the IRS is left without anyone to collect tax clearly due.

The Son-of-Boss transactions in their pure bullshit form seemed to promise to the gullible or complicit that the taxable income disappearing from the taxpayer's tax ledger would just go away.  But, every one I know that gave a hard and knowledgeable look knew that, even if the imagined scheme worked to push the income from the original taxpayer (always a doubtful proposition), some taxpayer down the line would be liable for the tax.  Enter the intermediary gambit to make sure that taxpayer down the line had no assets to pay the tax because the taxpayer and the promoters would have sucked all the value out of the company.  Thus, this intermediary was designed to deal with an inherent and blatant flaw in the SOB transactions.  (Of course, SOB transactions had flaws in them before reaching this stage, but the intermediary was a fine artistic touch to put on the bullshit.)

The Merits

Another Bullshit Shelter Bites the Dust (12/19/13)

We have yet another of the genre out of the Tenth Circuit, this time proving Michael Graetz's famous observation that an abusive tax shelter is “[a] deal done by very smart people that, absent tax considerations, would be very stupid.”  The new case is Blum v. Commissioner, 737 F.3d 1303 (10th Cir. 2013), here.

Before discussing the case, I offer this description of tax shelters from my Federal 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, (ii) 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.”

Blum fits the pattern.

Mr. Blum was a very successful businessman.  He was apparently very capable in assessing risks and rewards of financial ventures.  Mr. Blum retained KPMG who sold him one of its tax shelter products which it marketed in the 1990s and early 2000s.  This particular product was OPIS, a basis enhancement strategy. The abusive basis enhancement strategies claimed to create large amounts of basis without the taxpayer having to incur a cost for the basis.  The taxpayer would then use the artificial basis to offset otherwise taxable gain, thereby artificially reducing the tax liability.  Mr. Blum got into the deal when he had a large gain that would otherwise be taxed.

When KPMG's representative made the pitch, Mr. Blum "claims he saw an investment opportunity; the Commissioner claims Mr. Blum saw a tax evasion opportunity."  (Emphasis supplied.) Mr. Blum bought the pitch and made a representation to KPMG that he was doing the deal for a legitimate nontax business or investment purpose.  (That representation was essential to KPMG's participation in implementing the transaction.)  Bottom-line, the Tax Court concluded and the Tenth Circuit concluded that the representation was false.

Supreme Court Applies 40% Penalty to Bullshit Basis Enhancement Shelters (12/3/13)

In United States v. Woods, ___ U.S. ___, 134 S. Ct. 557 (2013), here, the Court rejected procedural arguments and applied the special 40% accuracy related penalty for valuation and basis overstatements.  §§6662(a), (b)(3), (e)(1)(A), (h).  The unanimous opinion is written  by Justice Scalia, the plain language justice, who not surprisingly concludes:  "The penalty’s plain language makes it applicable here."

I am sure others and even I will have a lot to say about the opinion and its ramifications later. For now, this caught my eye as Justice Scalia jabs at the use of the Blue Book:

Woods contends, however, that a document known as the “Blue Book” compels a different result. See General Explanation of the Economic Recovery Tax Act of 1981 (Pub. L. 97–34), 97 Cong., 1st Sess., 333, and n. 2 (Jt.Comm. Print 1980). Blue Books are prepared by the staff of the Joint Committee on Taxation as commentaries on recently passed tax laws. They are “written after passage of the legislation and therefore d[o] not inform the decisions of the members of Congress who vot[e] in favor of the [law].” Flood v. United States, 33 F. 3d 1174, 1178 (CA9 1994). We have held that such “[p]ost-enactment legislative history (a contradiction in terms) is not a legitimatetool of statutory interpretation.” Bruesewitz v. Wyeth LLC, 562 U. S. ___, ___ (2011) (slip op., at 17–18); accord, Federal Nat. Mortgage Assn. v. United States, 379 F. 3d 1303, 1309 (CA Fed. 2004) (dismissing Blue Book as “a post-enactment explanation”). While we have relied on similar documents in the past, see FPC v. Memphis Light, Gas & Water Div., 411 U. S. 458, 471–472 (1973), our more recent precedents disapprove of that practice. Of course the Blue Book, like a law review article, may be relevant to the extent it is persuasive. But the passage at issue here does not persuade. It concerns a situation quite different from the one we confront: two separate, non­overlapping underpayments, only one of which is attributable to a valuation misstatement. 

Addendum 12/4/13 10:32am:

I have posted the foregoing, along with more discussion on the Blue Book on my Federal Tax Procedure Blog:   Supreme Court Applies 40% Penalty to Bullshit Basis Enhancement Shelters (Federal Tax Procedure Blog 12/3/13), here.

Also, I have extended and updated those comments on the following:  More on the Supreme Court's Opinion in Woods on TEFRA and the 40% Basis Overstatement Penalty (Federal Tax Procedure Blog 12/4/13), here.

Addendum 12/10/13 8:45 am:

For a good crisp discussion of the holdings, see Alan Horowitz, Supreme Court Rules for Government on Both Issues in Woods (Tax Appellate Blog 12/3/13), here.

A Self-Proclaimed "Simple Man," "Utterly Uneducated" in Tax and Finance, but Still a Self-Made Multi-Millionaire Loses his Bullshit Tax Shelter Case (4/13/13)

In Kerman v. Commissioner, ___ F.3d ___, 2013 U.S. App. LEXIS 7032 (6th Cir. 2013), here, the Sixth Circuit rejected the Kerman's claim for tax benefits or, at least, relief from penalties from a bullshit tax shelter, this one of the Cards variety that has met with uniform rejection from the courts.  I just gave you the final result.  But the opinion starts this way (usually you can tell the result from the opening):

A tax shelter can be legitimate — if the reported transaction has economic substance. But the shelter Mark Kerman participated in lacked such substance. The transaction had no purpose other than the creation of an income tax benefit. After Kerman claimed the benefit on his tax return, the IRS disallowed the deduction and imposed a valuation misstatement penalty pursuant to 26 U.S.C. § 6662(e), which was increased to 40 percent of the unpaid tax pursuant to § 6662(h). The tax court affirmed the IRS's decision. Kerman appeals, contending that the shelter was legitimate and that, even if it was not, the penalty should not be imposed. Because the transaction lacked economic substance and Kerman lacked reasonable cause or good faith to believe that it did, we AFFIRM.
I
A
Mark Kerman is a college-educated multi-millionaire.

Toward the end of the opinion another key signal dot is connected as follows:

Finally, Kerman argues, the tax court gave him too much credit. He's just a simple man, "utterly uneducated in the complex tax arena — let alone the more byzantine tax-shelter realm." Appellant's Br. 48. Consequently, he was forced to rely on personal advisors. And, he argues, his reliance was reasonable even if his advisors had conflicts of interest.

So, what should I say about the opinion?  Prudence and respect for my readers time counsels that I should not say anything except the bullet points from the case.  So, I won't.

Supreme Court Will Decide Whether Bullshit Tax Shelters with Basis Overstatements Draw the 40% Penalty (3/25/13)

The Supreme Court has decided to accept cert on the split in the circuits on the issue of whether the 40% valuation / basis overstatement applies to bullshit tax shelters that fail in a number of ways other than just valuation / basis overstatement.  The Supreme Court docket page in the case, United States v. Woods, No. 12-562. is here.  The entry granting cert adds the following TEFRA partnership procedure issue:

In addition to the question presented by the petition, the parties are directed to brief and argue the following question: Whether the district court had jurisdiction in this case under 26 U. S. C. 6226 to consider the substantial valuation misstatement penalty.

I can't get excited about the TEFRA issue.  It is important, to be sure.  But, the principal issue is foisted on the Supreme Court by the Fifth and Ninth Circuits' stubborn insistence to grant relief to bullshit tax shelters with basis overstatements despite their own expressed doubts and the critical mass of circuit court opinions denying that relief. I guess, though, that the TEFRA jurisdictional issue could perhaps give the Court an opportunity to duck the merits issue, thus not resolving the conflict.  (I would think, however, that, if the Supreme Court ducked the issue, the Fifth and Ninth Circuits could still resolve the issue by moving to the majority view in the next cases presenting the issue; alternatively, the Supreme Court might resolve the split in some case that does not present a jurisdictional impediment (such as the case for which petition for certiorari was filed from a majority view case in Alpha I L.P. v. United States, No. 12-550, here.)

For good discussions of the split, see Gustashaw v. Commissioner, 696 F.3d 1124, 1136 (11th Cir. 2012), here; Crispin v. Commissioner, ___ F.3d ___, ___ n. 18 2013 U.S. App. LEXIS 3852 (3d Cir. 2013), here; ; AHG Investments LLC et al. v. Commissioner, 140 T.C. ___, No. 7 (2013), here (adopting this majority rule for the Tax Court in cases where the Circuit Court to which an appeal would be taken has not spoken); and  Jeremiah Coder, Self-Serving Concessions and Penalty Avoidance, 134 Tax Notes 1583 (Mar. 26, 2012).

Yet Another Bullshit Tax Shelter Bites the Dust (2/27/13)

We have yet another court rejection of a bullshit tax shelter.  Chemtech Royalty Associates LP et al. v. United States, 2013 U.S. Dist. 26329 (MD LA 2013), here  This time it is Dow Chemical who tried unsuccessfully to underpay its taxes and thus shift its share of the burden of Government to the citizens of this country.  This bullshit tax shelter was cooked up by Goldman Sachs in league with lawyers at King & Spalding.

The trial judge says:  "Both arrangements are enormously complicated in their construction and operation."  Which brings me to the features of a tax shelter.  I address this in my Federal Tax Procedure Book and this is a portion of that discussion (footnotes omitted):

Tax shelters are many and varied.  Some are outright fraudulent wrapped in what is disguised as a real deal.  The more sophisticated, however, are often without substance but do have some at least tenuous 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, (ii) 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 in the final analysis is simply a premium for putting the reputations and perhaps their freedom at risk to give a comfort opinion that the deal which will not work if discovered, 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, 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.”

Yet Another Bullshit Tax Shelter Bites the Dust (2/26/13)

In Crispin v. Commissioner, 708 F.3d 507 (3d Cir. 2013), here, as had the Tax Court, the Third Circuit smacked down yet another Bullshit tax shelter, this one of the CARDS variety.  Also, as had the Tax Court, the Third Circuit addressed the credibility of the taxpayer's representations of profit motive.

The CARDS Shelter.  Although the patched together CARDS transactions have nuances, here is the broad overview by the Third Circuit:

      A CARDS transaction is a tax-avoidance scheme that was widely marketed to wealthy individuals during the 1990's and early 2000's. It purports to generate, through a series of pre-arranged steps, large "paper" losses deductible from ordinary income. First, a tax-indifferent party, such as a foreign entity not subject to United States taxation, borrows foreign currency from a foreign bank (a "CARDS Loan"). Then, a United States taxpayer purchases a small amount, such as 15 percent, of the borrowed foreign currency by assuming liability for a an equal amount of the CARDS Loan. The taxpayer also agrees to be jointly liable with the foreign borrower for the remainder of the CARDS Loan and so the taxpayer purports to establish a basis equal to the entire borrowed amount. n3 Finally, the taxpayer exchanges the foreign currency he purchased for United States dollars. That exchange is a taxable event, and the taxpayer claims a loss equal to the full amount of his supposed basis in the CARDS Loan, less the proceeds of the relatively small amount of currency actually exchanged. The taxpayer uses that loss to shelter unrelated income. n4
   n3
The Commissioner contends that that step in the CARDS transaction "is predicated on an invalid application of the ... basis provisions of the Internal Revenue Code." (Appellee's Br. at 4.) Specifically, I.R.C. § 1012 provides that a taxpayer's basis in property is generally equal to the purchase price paid by the taxpayer. That purchase price includes the amount of the seller's liabilities assumed by the taxpayer as part of the purchase, on the assumption that the taxpayer will eventually repay those liabilities. See Comm'r v. Tufts, 461 U.S. 300, 308-09, 103 S. Ct. 1826, 75 L. Ed. 2d 863 (1983). But in a CARDS transaction, the Commissioner argues, the  taxpayer and the foreign borrower agree that the taxpayer will repay only the portion of the loan equal to the amount of currency the taxpayer actually purchases.  [JAT NOTE:  This footnote 3 is as revised by subsequent order, Crispin v. Commissioner, 2013 U.S. App. LEXIS 5341 (3d Cir. Mar. 19, 2013).]   n4 The general structure of a CARDS transaction is well and thoroughly set forth in Gustashaw v. Commissioner, 696 F.3d 1124, 1127-28, 1130-31 (11th Cir. 2012).

The following is the gravamen of the smack down on the merits -- actually lack of merits (footnote omitted):