The Supreme Court first approved an application of the doctrine of equitable recoupment in Bull v. United States, 295 U.S. 247 (1935). In a case of first impression, the Tax Court (Menard, Inc. v. Commissioner, 130 T.C. No. 4 (2008)) held that under the doctrine of equitable recoupment, it had jurisdiction to offset an income tax deficiency with a tax paid even if the court lacks subject matter jurisdiction over the tax so paid.

Section 6214(b) was amended by the Pension Protection Act of 2006 by adding the last sentence to subsection (b) authorizing the Tax Court to apply the doctrine of equitable recoupment to the same extent as it is available in the district courts and Claims Court. (This amendment confirms the jurisdiction of the court to apply equitable recoupment which had split the courts of appeal. See conflict between the Sixth and Ninth Circuits). The Commissioner had argued that the Tax Court cannot apply the doctrine unless it has jurisdiction over the tax, i.e. income, estate and gifts, and excise tax. The Commissioner argued that this group does not include the “hospital tax” imposed by sections 3101 and 31111, 

Rejecting this argument, the Tax Court stated as a matter of policy, that the 2006 Amendment should be read in such a manner so as to eliminate confusion and to provide “simplification benefits to both taxpayers and the IRS.”

Shelter + Facilitator + Rico = $6 Million Award

The IRS has rather explicitly been telling taxpayers caught in the middle of the tax shelter wars to go sue the parties that got them in the transaction. In Ducote Jax Holdings LLC et al. v. William E. Bradley, - F. Sup2d – ( E.D. La. 2007), those taxpayers that have heeded the advice of the IRS must have jumped for the heavens as the Court applied the RICO statute to what appears to be a Son-of- Boss transaction.

Let’s just say a certain Chief Counsel must have smiled when he read that decision. Question for the IRS will it seek to tax the proceeds or will they allow these taxpayers to pursue these ‘advisors” —Hell has no fury like that of a jilted “taxpayer”.

In Ducote Jax Holdings LLC et al. v. William E. Bradley, the transaction at issue was a son-of –boss transaction involving the purchase and sale of foreign exchange digital options. The advisors to the taxpayer consisted of the usual cast of characters: Paul M. Daugerdas and Jenkens & Gilchrist. According to the opinion, there was a group of advisors that induced the plaintiffs “to enter into the transactions by representing that the tax strategies had been vetted by the law firm Jenkens & Gilchrist, and that this law firm would provide legal opinions assuring the Plaintiffs that the tax strategies provided protections against penalties that the IRS could assess in the unlikely event that the IRS challenged the legitimacy of the tax strategies.”

Mr. Bradley, the Plaintiffs admit, was not even known to them. Rather, Mr. Bradley was the classic facilitator, as the term is used. His role was to allow a member of the group to wire $255,000.000 into Mr. Bradley’s trust account from the law firm of Jenkens & Gilchrist. Bradley then proceeded, on the instructions of his friend, regarding billing and the wiring of money and he disbursed all but $25,000.00, which he kept for himself. Mr. Bradley claimed that he understood very little of the basis of the financial transactions and did not know the original source of this money.

The Court found Mr. Bradley and his actions to have violated the RICO statutes. 18 U.S.C. § 1962(a). The Court found that the plaintiffs proved (1) the existence of an enterprise, (2) the defendant's derivation of income from a pattern of racketeering activity, and (3) the use of any part of that income in operating the enterprise. Thus, the Court found that Mr. Bradley violated § 1962(a).

The violation was that he billed, specifically over billed, for the alleged work he performed. Mr. Bradely fro less than 10 hours of work submitted an invoice to Jenkens & Gilchrist in the amount of $112,500.00. He further received $255,000.00 by wire from Jenkens & Gilchrist. The Court found Bradley’s actions to have caused plaintiffs injury as Bradley's wiring of money permitted the group to “fraudulently obtain funds from the Plaintiffs for work they did not do”. Ouch!!

The Court found these action to violate § 1962(c) which prohibits any person employed by or associated with any enterprise from participating in or conducting the affairs of that enterprise through a pattern of racketeering activity. The Court stated:

He was a person employed or associated with the enterprise as he was solicited by Ohle, Bank One and/or Jenkens & Gilchrist, and he faxed the opinion and billed Jenkens & Gilchrist for $112,500.00 for work on the Plaintiffs' account that he knew was fraudulent since he estimated that it took less than ten hours to complete. He participated and conducted the affairs of the enterprise through the pattern of racketeering activity when he committed predicate acts of mail and wire fraud, as listed in III(B), ¶ 3 supra. His over-billing of the hours he expended, the wiring of the money obtained through fraudulent fees, and his faxing of the fraudulent opinion caused the Plaintiffs to be charged exorbitant fees and furthered the air of legitimacy of the tax strategies. In short, Bradley's predicate acts permitted the enterprise to deceive the Plaintiffs into participating in the tax strategy. The Plaintiffs' injury from these predicate acts includes tax assessments, fees and penalties they were required to pay to the IRS and related legal fees and costs.

The Court further found that Mr. Bradley violated § 1962(d) based on the following: the generation of exorbitant fees by making misrepresentations and inducing high net-worth individuals and business entities to participate in tax strategies that he and the group knew or should have known were improper and illegal.

The Court found that Mr. Bradley’s actions constituted a Breach of Fiduciary Duty; Fraud; Negligent Misrepresentation; and Civil Conspiracy. As such, Mr. Bradley subjected the Plaintiffs into thinking that the tax strategies were legal and caused the Plaintiffs to invest in the transactions and suffer losses of tax assessments, penalties and interest and related attorneys' fees and costs. These damages totaled over $6 million. However since many of the Plaintiffs had settled their cases with the Plaintiffs, the damages were reduced to a littler over $2 million. Yet, the Court was not done as “[p]ursuant to § 1964(c), the Plaintiffs are entitled to threefold damages, the costs of bringing this suit, and reasonable attorneys' fees for Bradley's violations of § 1962's subsections”, i.e. over $ 6 million.

Needless the decision is interesting for various reasons – it found the son-of-boss transaction to be fraudulent per se because the IRS said so; the role of a facilitator was escalated to the same level as the primary group of advisors; and Mr. Bradley’s fault over billing for work that he did not perform. Like I said the IRS must be smiling as this opinion should be fear into every attorney, accountant or other advisor that has a “great tax solution” for his client. Stated differently $25,000 of fees translated to a $6 million liability and if that doesn’t scare these promoters/facilitators, in addition to Stein, then what will?

The next question for the IRS will be: Should these proceeds be taxed? On one side, the IRS will argue that these proceeds should be taxed under Old Colony Trust Co. v. Commissioner, 279 U.S. 716 (1929) and Zelenak, The taxation of Tax Indemnity Payments: Recovery of Capital and The Contours of Gross Income, 46 Tax L. Rev. 381 (1991).

In Old Colony, the president of a large corporation was paid a stated salary of approximately $1 million in 1918. In addition, the corporation agreed to pay the federal income tax on the salary, with the hoped-for result that the president would be entitled to keep the entire stated salary. The government, however, argued that payment by the corporation of the tax liability constituted additional taxable income, and the Supreme Court agreed. The Court reached this conclusion reasoning that the employer had conferred an economic benefit on its president by paying his liability, and had done so as part of his compensation.

The article written by Lawrence Zelenak – Zelenak, The taxation of Tax Indemnity Payments: Recovery of Capital and The Contours of Gross Income, 46 Tax L. Rev. 381 (1991), (hereinafter referred to as “Zelenak article”) provides that settlement/awards proceeds from tax shelter solutions should be subject to Old Colony.

The Zelenak article written in 1991 questioned the IRS’s then position in various Private Letter Rulings of treating payments made in connection with tax indemnity payments as non-taxable. The Zelenak article describes and criticizes PLR 8923052 as follows:

Stripped of legal fictions, the now-repealed safe harbor leasing rules allowed a taxpayer who could not use the tax benefits associated with ownership of an asset to sell the tax benefits to a taxpayer who could use them. In economic reality, it was a direct sale of tax benefits, rather than a sale of a tax-favored asset. Given the repeal of safe harbor leasing, the issue considered by the letter ruling may seem to be of only historical interest. In fact, however, essentially the same issue could arise today in connection with a failed nonsafe harbor sale-leaseback.

Consider the following example: L Corporation owned a building in which it operated a department store. L contracted with P Corporation for what the parties characterized as a sale of the building from L to P, followed immediately by a lease of the building from P to L, so that L's use of the building continued without interruption. Under the terms of the contract of sale, P made a down payment to L of $100, and issued a note to L for the balance of the sales price. The note provided for scheduled payments of principal and interest over a period of time which equaled the remaining useful life of the building. The term of the lease was for the same period of time as the payments on the note, and the scheduled lease payments from L to P exactly equaled the scheduled payments of principal and interest from P to L on the note. Thus, the down payment was the only net cash flow in the transaction.

P anticipated certain federal income tax benefits from the transaction, in the form of depreciation and interest deductions. These benefits depended on the transaction being characterized as a sale and leaseback for federal income tax purposes. L agreed to indemnify P for the value of those tax benefits, if it should be finally determined that the benefits were not allowable. The Service determined that the purported sale and leaseback lacked economic substance and therefore disallowed P's claimed depreciation and interest deductions. (The Service also determined, however, that P was not taxable on its supposed rental income from L.) The matter was litigated, and the court ruled in favor of the Service, holding that P did not purchase or lease a building, but rather paid a fee (the down payment) for tax benefits.

Pursuant to the contract, L then made an indemnity payment to P, measured by the value of the tax benefits P would have received if the form of the transaction had been respected for tax purposes. The payment was $150, which reflected the detriment to P of not being entitled to the depreciation and interest deductions, net of the benefit of not having taxable rental income.

The analysis of the proper tax consequences of this indemnity payment is straightforward. P has incurred no tax liability which reasonably can be characterized as a loss, so that the indemnity payment could be distinguished from Old Colony as the recovery of a loss. P has paid the correct amount of taxes. Whatever P's tax liability was for its income (all of which was, of course, unrelated to the failed sale-leaseback), it was exactly what it should have been, based on the facts of P's situation. The argument for exclusion would have to be that $150 of the taxes paid by P should be characterized as a loss, because P would not have owed those taxes if the attempted sale-leaseback had succeeded. But a sham transaction cannot turn the tax on unrelated income into a loss, so as to exempt the reimbursement of that tax from Old Colony doctrine. If it could, the integrity of Old Colony would be at the mercy of every sham transaction and every abusive tax shelter. If the payment of the taxes one properly owes can be characterized as a loss-thus making the recovery of that payment tax free-because one might have reduced one's tax liability by making a legitimate tax shelter investment, then the Supreme Court might as well overrule Old Colony.

The arguments/rationale raised in the Zelenak article were adopted by the IRS in Priv. Ltr. Rul. 9833007; Priv. Ltr. Rul. 9743035; Priv. Ltr. Rul. 9743034; Priv. Ltr. Rul. 9728052; Priv. Ltr. Rul. 9226033; Priv. Ltr. Rul 200328033.

However, the Courts have disagreed with the IRS on this matter as the Courts have, at times, treated the receipt of these awards as recoupments of capital. See Clark v. Commissioner, 40 B.T.A. 333, 334 (1939); Concord Instruments Corp. v. Commissioner, T.C. Memo. 1994-248; Centex Corp. v. United States, 55 Fed.Cl. 381 (2003), aff'd 395 F.3d 1283 (Fed. Cir. 2005).

In Clark, the taxpayers retained experienced tax counsel to prepare their individual income tax return. Tax counsel prepared a joint return and advised the taxpayers to file the return instead of separate individual income tax returns. The joint return was subsequently audited and a deficiency of $32,820.41 arose as a result of an error committed by tax counsel. Taxpayers paid the deficiency.

Recomputations were then made by the Tax counsel which disclosed that if the taxpayers had filed separate returns their combined tax liability would have been $19,941.10 less than that which was finally assessed against and paid by the taxpayers. Tax counsel tendered $19,941.10 to the taxpayers and was accepted. Subsequently, the IRS determined that the settlement proceeds should be included as income citing to Old Colony. The taxpayers disagreed and contended that the settlement payment constituted compensation for damages or loss caused by the error of tax counsel, and therefore there was no income.

The BTA agreed with the taxpayers. The BTA found that the taxpayers paid the deficiency and thereby sustained a loss caused by the negligence of his tax counsel, i.e. the resulting $19,941 was compensation to the taxpayers for the loss due to that negligence. The Court held that: “The fact that such obligation was for taxes is of no moment here. Recoupment is not income if it is not derived from capital, labor or from both combined.” The court further noted that the payments did not emanate from such rather the compensation was “for a loss which impaired petitioner’s capital.”

Concord Instruments Corp. v. Commissioner, T.C. Memo. 1994-248 arose out of Concord Control, Inc. v. Commissioner, 78 T.C. 742 (1982), wherein the Tax Court had concluded that Concord had acquired $334,985 of nondepreciable going-concern value in its purchase of K-D Lamp Company. Concord thus had to reduce both the basis of its depreciable property and the amount of depreciation it had taken. Result: Concord Instruments Corp., the successor to Concord Control, Inc., paid the IRS an income tax deficiency of $248,864 plus interest of $417,366, a total of $666,230. Concord had the right to appeal that decision. But Concord's attorneys failed to file a notice of appeal within 90 days of the entry of the Tax Court decision.

Concord then filed a $466,034. claim against their lawyers alleging negligence. After reviewing the arguments that Concord would have made if a timely appeal had been filed, the lawyers' professional liability insurance carrier paid Concord $125,000 in full settlement of the $466,034 claim. The $125,000 was not allocated to any of the claims.

The tax treatment of that $125,000 then became the subject of Concord Instruments Corp. v. Commissioner, T.C. Memo. 1994-248, hereinafter referred to as “Concord”. In Concord, the IRS contended that no portion of the $125,000 was excludable from Concord's income because the Tax Court decision had been correct and thus Concord's attorneys' conduct "did not cause petitioner to owe additional tax."

The IRS argued that the preparer's error in Clark indisputably caused Clark to pay additional tax, whereas the failure to appeal the Concord decision was harmless because an appeal would have been unavailing as petitioner’s case was correctly decided by the Tax Court. Thus, argued the IRS, the Clark case had no relevance. The Court stated the issue as follows: "[w]e must decide whether the malpractice settlement was to replace damaged capital." That, in turn, focused attention on the possible reasons the insurance company paid the damages. The Court then decreed that: "We look to petitioner's claim to decide whether the amounts are recovery of capital," i.e. the source of the claim.

The IRS and Concord agreed that the claim arose out of the law firm's handling of the tax controversy. They also agreed that Concord's payment of the income tax deficiency at issue in that controversy came from capital, in the sense that the payment was not deductible for income tax purposes. However, since the IRS did not even suggest that the $125,000 related to anything other than the law firm's handling of the tax litigation, the Tax Court concluded, except for the interest portion of the original payment, which fell under the tax benefit rule, the receipt of the $125,000 should result in no income to Concord. The Tax Court relied on Clark as being "closer to this situation than any other decided case and applying the ratio of tax to total original payment as a result of the unappealed Tax Court decision, the Tax Court found that $42,921 of the $125,000 was excludable from income. " The Court stated:

Respondent does not consider petitioner's claim from which the $125,000 was realized. Respondent does not argue that American Home paid petitioner the $125,000 for any reason other than petitioner's claim. We conclude that American Home paid the $125,000 because of petitioner's claim. Thus, petitioner's claim and American Home's payment was to compensate petitioner for a loss similar to that in Clark v. Commissioner, supra.

In Centex, a lawsuit ensued with Centex claiming that it was entitled to gross-up its award to account for the tax impact. The Court of Claims noted that the need for gross-up assumes, however, that any recovery would be taxable. The Court of Claims stated “the accuracy of that assumption to be not without doubt.”

The government objected to the gross-up in fees and cited to Clark and Rev. Rul. 57-47. The government argued that in each of those instance, the taxpayers overpaid taxes due to faulty advice from tax consultants. The taxpayers eventually were compensated by their consultants. Neither authority required the taxpayer to include the repayment as income.

The plaintiffs, however, pointed to evidence of a more recent change in IRS policy through the Private Letter Rulings it had issued. There have been at least five Private Letter Rulings which distinguished Clark and suggested that the IRS would tax an award resulting from breach of contract damages. See Priv. Ltr. Rul. 9833007; Priv. Ltr. Rul. 9743035; Priv. Ltr. Rul. 9743034; Priv. Ltr. Rul. 9728052; Priv. Ltr. Rul. 9226033. Each of the rulings included any reimbursements for tax liability as gross income so long as the taxpayer initially paid only its minimum proper federal income tax. e.g., Priv. Ltr. Rul. 9833007 (“unlike the situations in Clark and Rev. Rul. 57-47, 1957 WL 11946, you are not paying more than your minimum proper federal income tax liability •••• Therefore, ••• the indemnity payment ••• is includible in your gross income.”).

The Court noted that “the distinction between Clark and the subsequent rulings is indeed subtle” and disagreed with plaintiffs. The Court noted that it would be unfair to treat the judgment as new income as the judgment was not a replacement of lost income. Rather, the plaintiffs were receiving monies already subject to tax once before. Indeed the entire point of the breach claim was that the judgment represented tax or penalties that, but for the breach of contract, would not have been paid. The money that the plaintiffs would have saved in the absence of a breach had, by definition, already been taken into account for tax purposes. The Court then held:

It follows that an award from this court to compensate plaintiffs for the loss of that money is not subject to income tax. It represents income already taxed. If we grossed-up damages, in other words, and the judgment later was not taxed, it would result in a windfall to the plaintiffs.

Simply stated it appears that guidance needs to be issued by the IRS keeping in mind not its position but the position of the Court’s as to the underlying cause of action. If the IRS looks at the underlying cause of action(s) then the conclusion should be for non-inclusion, but, as they say that battle remains for another day.