Stein, Coplan, and Sala - Criminal and Civil cases bang into each other. The question becomes what does this all mean?

We have heard that the Government state that the United States v. Stein, et al. is the “largest criminal tax case in American history”. United States v. Stein, 452 F. Supp. 2d 230, 237 (S.D.N.Y. 2006). Now because of the ruling in Stein v. KPMG, LLP --- F.3d ----, 2007 WL 1487822, (2d Cir. 2007), the largest criminal tax case in American history is on the verge of dismissal. Is this stopping the government from pursuing tax shelters criminally? Absolutely not just ask the defendants in United States v. Coplan, et al.

In Stein v. KPMG, LLP --- F.3d ----, 2007 WL 1487822, (2d Cir. 2007) the 2d Circuit vacated the Southern District Court’s assertion of ancillary jurisdiction over the defendant’s alleged contractual claim of attorney’s fees as to KPMG. The Second Circuit found that such proceeding to be troublesome based on the following grounds:

  1. There was no express statutory authority for such proceeding. Thus as conceded by the lower court, the district court intended to apply “ad hoc mix of the criminal and civil rules of procedure” 
  2. The ancillary proceeding’s contribution to the efficient conclusion of the criminal proceeding was entirely speculative, even if the government violated the Fifth and Sixth Amendments, which the 2d Circuit did not offer an opinion in. 
  3. The appropriate remedy for the government’s violation was dismissal of the indictment for Fifth and Sixth Amendment violations. As the Court stated:

“ If the government's coercion of KMPG to withhold the advancement of fees to its employees' counsel constitutes a substantive due process violation, or has deprived appellees of their qualified right to counsel of choice, more direct (and far less cumbersome) remedies are available. Assuming the cognizability of a substantive due process claim and its merit here, dismissal of the indictment is the proper remedy. As for the Sixth Amendment deprivation, if it turns out that the government's conduct separates appellees from their counsel of choice (an event that has not yet occurred), appellees may seek relief on appeal if they are convicted. We do not mean to exclude the possibility of other forms of relief. If, for example, a Sixth Amendment violation is the result of ongoing government conduct, the district court of course may order the cessation of such conduct. Having said that, we hold, however, that the remedies available to the district court in the circumstances presented here did not include its novel exercise of ancillary jurisdiction. The “summary advancement proceeding,” Id. at 381, it created may have been intended only as a vehicle for the government and KPMG to act on their “incentives” to somehow get appellees' counsel funded and thereby “avoid any risk of dismissal of [the indictment of the appellees] or other unpalatable relief.” Stein I at 380. Or, as Stein II suggests, it might also have been envisioned as an uncharted hybrid legal proceeding for the expeditious resolution of numerous high-dollar and potentially complex contract claims. Either way, it was not an available remedy for either constitutional violation.” See also Wall Street Journal’s article on Stein dated May 25, 2007.


On May 31, 2007 the Southern District Court quickly responded to the Second Circuit’s decision when it requested that the parties respond to three following questions:

  1. To what extent are all of the KPMG Defendants similarly situated with respect to the motion? 
  2. What if any sanctions other than dismissal of the entire indictment are available with respect to the constitutional violations found by the Court? 
  3. What if any steps are the government prepared to take voluntarily in an effort to remedy the constitutional violations found by the Court?

Clearly, the Court is asking the parties, but specifically the Government, to come up with a viable solution to what the Court rightfully perceives to be a violation of certain of the defendant’s constitutional rights. For this author’s views on those questions, see KPMG and the Government's "Prosecution of KPMG" - Can we learn any lessons from this investigation with the approach of FIN 48? Posted on February 11, 2007.

Whether the Government shares the Court’s views or accepts the Court’s invitation, will quickly be determined as the Court wants all briefing and oral arguments to be submitted by July 2, 2007. If the Government fails to provide a solution, I would expect some of the defendant’s to have their case dismissed.

What can be ascertained is that the Government’s "setback" in Stein is not stopping the Government from proceeding criminally in the tax shelter wars. Moreover, it has learned from Stein and is not repeating the same mistakes. For that we turn to the indictment filed by the United States v. Coplan, et. al.

Robert Coplan, Martin Nissenbaum, Robert Shapiro and Brian Vaughn, partners at E&Y, have been indicted on under § 7201, § 7212, Title 18 § 1000 and conspiracy charges related to the design, marketing, implementation, and defense of the following tax shelters- The Contingent Deferred Swap, COBRA, CDS Add-On shelters, PICO Shelters, and The Tradehill Shelter.

Interestingly, the indictment describes these shelters as fraudulent yet there is no decision that I could find referring to these shelters as fraudulent. Just as note worthy the shelters that I have seen, both when I worked for the Office of Chief Counsel and as a private practitioner, the IRS has not proposed any civil fraud penalty on these matters although the standard of proof is a lesser standard. See Maciel v. Commissioner, - - - F.3d - - (9th Cir. 2007). But as they say I digress.

The indictment is rather clear as to the heavy road the Government has decided to undertake. The Government will need to prove that the defendants knew, as in Cheek, that the shelters offered were not valid for tax purposes. This brings into play the doctrine of economic substance and thus brings into the foray the lawyers who rendered advice and the individual investors that the E&Y partners solicited.

Economic Substance at a glance:

When a transaction lacks economic substance, the form of the transaction is disregarded in determining the proper tax treatment of the parties to the transaction. A transaction that is entered into primarily to reduce taxes and that has no economic or commercial objective to support it, is without effect for federal income tax purposes. Gregory v. Helvering, 293 U.S. 465 (1935); Frank Lyon Co. v. United States, 435 U.S. 561 (1978); Yosha v. Commissioner, 861 F.2d 494, 498-99 (7th Cir. 1988), aff'g sub nom. Glass v. Commissioner, 87 T.C. 1087 (1986); ACM Partnership v. Commissioner, 157 F.3d 231, 246-247 (3d Cir. 1998), aff'g in part and rev'g in part, T.C. Memo. 1997-115, cert. denied, 526 U.S. 1017 (1999); United States v. Wexler, 31 F.3d 117, 122, 124 (3d Cir. 1994), cert. denied, 513 U.S. 1190 (1995); Goldstein v. Commissioner, 364 F.2d 734, 740-741 (2d Cir. 1966), aff'g 44 T.C. 284 (1965), cert. denied, 385 U.S. 1005 (1967); Saba Partnership v. Commissioner, T.C. Memo. 1999-359. That is, economic substance is a prerequisite to the application of any Code provision allowing deductions. Lerman v. Commissioner, 939 F.2d 44, 52 (3d Cir. 1991). It is the Government's trump card; even if a transaction complies precisely with all requirements for obtaining a deduction, if it lacks economic substance, it "simply is not recognized for federal taxation purposes, for better or for worse." ACM Partnership v. Commissioner, 157 F.3d 231, 261 (3d Cir.1998) (quoting Lerman, 939 F.2d at 45); see Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. 254, 278 (1999), aff'd 254 F.3d 1313 (11th Cir. 2001). The rationale behind the Gregory and Knetsch line of cases is that courts should not elevate form over substance by rewarding taxpayers who have engaged in transactions that lack any purpose save that of tax savings.


The question that I have is which economic substance test will the government seek to apply, if any, and at what level will the economic substance test be applied. During the May ABA Tax Bar meeting in Washington DC, I was surprised to here from Government officials that the applicable test of economic substance was not viewed of primary importance. Respectfully speaking I disagree. The last time I looked at Cheek v. United States, 498 U.S. 192, 199 (1991), the doctrine of economic substance will be squarely at issue. The question will be which doctrine should be applied by the Court as there is no set definition of economic substance.

Tests as to Economic Substance

Several courts have focused on two related factors, business purpose and economic substance, to determine whether a transaction is a sham. See, e.g., Bail Bonds by Marvin Nelson, Inc. v. Commissioner, 820 F.2d 1543, 1549 (9th Cir. 1987); Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89, 91 (4th Cir. 1985). The Eleventh Circuit refuses to examine subjective intent if the transaction lacks economic effects. See United Parcel Service of America, Inc. v. Commissioner, 254 F.3d 1014 (11th Cir. 2001). In ACM Partnership v. Commissioner, 157 F.3d 231, 247 (3d Cir. 1998) the Third Circuit, applying the principles of Gregory, held that a transaction's economic substance and business purpose were related factors, not a two-prong test: See also James v. Commissioner, 899 F.2d 905, 908 (10th Cir. 1990).

In Compaq Computer Corp. v. Commissioner, 277 F.3d 778, 781 (5th Cir. 2001) the Fifth Circuit declined to adopt either Rice's Toyota World' s two-prong analysis or ACM Partnership' s factors test as the appropriate standard for the economic substance doctrine. See Transcapital Leasing Associates 1990-II, L.P. v. United States, 2006 WL 897723 (W.D.Tex., 2006). The Fifth Circuit, in determining a profit motive, i.e. business purpose, will focus on the intent of the taxpayer, not that of the underlying entity or activity. Chamberlain v. Commissioner, 66 F.3d 729, 732 (5th Cir. 1995).

In Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006), The Federal Circuit created a new economic standard for the Court of Claims to apply. The standard consists of the following: 

  1. A transfer of assets will be disregard if it lacks a business purpose other than reduce taxes. A lack of economic substance is sufficient to disqualify the transaction without proof that the taxpayer’s sole motive is tax avoidance. 
  2. The taxpayer bears the burden of proving that the transaction has economic substance. 
  3. The economic substance of the transaction must be viewed objectively rather than subjectively. 
  4. The transaction to be analyzed for economic substance is the transaction that gives rise to the alleged tax benefit not the legitimate transactions at the end of the line.
    a. Arrangements with subsidiaries, i.e. related parties, which do not affect the economic interest of independent third parties, deserve particularly close scrutiny.

The next question becomes at what level is the economic test to be applied. Stated differently, whose economic substance’s governs –

  • The defendants? Without the economic substance the defendants will argue the code. Thus the government must raise the economic substance. The question that must be raised is: what is the relevance of the economic substance at the defendant’s level? They are admittedly selling a tax shelter but what if the taxpayer has the ability and the risk to absorb the loss as in Compaq and UPS
  • The investors/partnerships? At the investor/partnership level is where the economic substance doctrine typically applies. But to implicate the defendants, the Government will have to demonstrate that the defendants knew that the investors/partnership were in it solely for taxes. Question becomes why aren’t the investors also being charged criminally if that is the case.

Further complicating the matter is the factor of whether a legal opinion(s) was obtained by E&Y. In U.S. v. BDO Seidman, LLP, 2004 WL 1470034 (N.D.Ill. 2004), the Court found that BDO Seidman had obtained a valid tax opinion from outside legal counsel. Said outside legal counsel had reviewed and provided valid legal opinions as to the transactions. Thus, the role or lack thereof of the unnamed legal advisors will play a huge role in this case or is it going to be the position of the government that the advisor had no duty to inquire. If the government argues that the lawyers wre hoodwinked then the Government better look at Long Term Capital Holdings v. United States, wherein the government argued that the taxpayers were not entitled to rely on the opinion of the advisors because the law firms had not performed sufficient due diligence.

So if E&Y engaged and received legal opinions, which it appears that it did, what is the position of the United States going to be? If the government argues that the law firms were for a lack of a better term tricked then how can the government seek to collect from even less unsophisticated taxpayers the additions to tax it is currently seeking. If the government says the law firms were involved then why those aren’t lawyers being indicted or is this an issue of selective prosecution?

The issue becomes how these matters impact the average investors that participated in these shelters. For one, the Tax Court in two opinions kept the statute on these matters by tying the TEFRA partnership statutes to the individual statutes. See Kligfeld Holdings et al. v. Commissioner; 128 T.C. No. 16 (2007) - Rhone-Poulenc v. Commissioner, 114 T.C. 533 (2000) taken to the extreme. Is this really what the Commissioner wants? Posted on June 1, 2007; G-5 Investment Partnership v. Commissioner, 128 T.C. No. 15 (2007). In my opinion, the Court left the statute open as to all matters as it failed to classify were the statute was only open as to certain matters such as affected items. Thus, although the investor believed he/she had escaped the wrath of the IRS because the partnership’s statute was closed, the statute is still open on these TEFRA items if the individual investor reported a tax shelter item on his/her individual return and said statute is still open.

To make matters even more dire, the government in Sala v. United States, Slip Copy, 2007 WL 1299186, (D.Colo. 2007) made it clear that the witness in the criminal cases were essential witnesses and were hoping that those witnesses would be willing to cooperate after the criminal cases were over. It doesn’t take a rocket scientist to figure what is meant by the term “cooperation” – testify on behalf of the government at these civil trials and your sentence may be reduced. Just as scary help the government with a criminal case against the investors and your sentence may be reduced.

So what does this mean for those obvious targets - the promoters, and the not so obvious targets - the investors? I would humbly suggest that when the IRS makes contact, retain a firm that can provide representation in both forums as you made be facing prosecution in criminal court and notice of deficiency in the civil arena.

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