Stein - The Court got it right! The Government and the Wall Street Journal Editorial just don't get it.

Judge Kaplan dismissed the indictment against 13 of the former KPMG employees who were charged in the largest criminal tax case in the history of the United States. The Court correctly found that the government violated their constitutional rights when it coerced KPMG to stop paying their legal fees. See United States of America v. Stein, -- F.Supp. 2d – (SD. N.Y. 2007).

The Government filed its appeal claiming there was no constitutional violation. This past Thursday, the editorial page the Wall Street Journal blasted the government for attempting to proceed with the case. The Government and the Wall Street Journal just don’t get it.
As stated in the blog Posted on February 11, 2007 “KPMG and the Government's "Prosecution of KPMG" - Can we learn any lessons from this investigation with the approach of FIN 48?”, the Government violated the defendants’ constitutional rights. The troubling part was the Government did not need to pursue said actions in order to prevail in this case. The cold hard facts were that the transactions being investigated by the government were aggressive tax shelters being promoted by KPMG. Moreover, KPMG knew that these transactions had no economic substance and violated title 26.

Simply stated, I challenge anyone to tell me that a taxpayer can have million + dollar transaction magically disappear by a transaction that is marketed to high wealth individuals and corporations and with an argument “that this is what the code permits.”

Bottom line not even KPMG believed in these transactions – look at the e-mails and the records submitted by KPMG in response to the summons action initiated by the Government and finally look at the guilty plea that is not actually a guilty plea which the Government claims is a victory. Translation of the plea: Not much of a victory. Reason the government realized that it could not afford to lose another major accounting firm and thus the Government, with the assistance of the law firm representing KPMG, focused on the individual partners and managers of KPMG who were involved in the transactions.

So the Government will seek its appeal and one can hope that the Second circuit will follow the lead of Judge Kaplan. Based on its prior review of the case one can conclude that the Second Circuit will allow the dismissal to stand as a lesson to an overzealous prosecution and a reminder the government wears the white hats - if the hat gets the slightest tinge of gray in it the government, as the representative of the people, needs to be reminded that it cannot cross the line.

At the same time that the government failed to understand the significance of its actions in Stein, the editorial page in this past Thursday’s Wall Street Journal failed to understand the essential fact in the Stein case. In the editorial it alleged that the transactions at issue were legal. Oh really?

Justice Holmes once observed “Taxes are what we pay for civilized society.” Compania General de Tabacos de Filipinas v. Collector of Internal Revenue, 275 U.S. 87 (1927). The internal revenue code and judicial doctrines are the mechanisms that ensure that proper planning is undertaken to ensure that the least amount of tax is properly reported and paid.

As a mentor of mine has said tax law allows for “deferral but not evasion” of taxes. The code and the judicial doctrines allow for proper planning mechanisms to be employed. See United Parcel Service of America v. Commissioner, 254 F. 3d 1014 (11th Cir. 2001). There is no need for planners to ignore their fiduciary obligations to their clients and expose the clients to planning solutions that are nothing more than glorified mechanisms for tax evasion. The accountants and lawyers were in a position of trust and they marketed the tax shelters which we all became aware of.

Those planners were engaged in the practice of tax law and they knowingly ignored the law. When someone willfully violates the law, said individual is normally subject to criminal prosecution. So am I missing something?

What the Wall Street Journal fails or does not want to recognize is that the practice of tax is the practice of law. Sadly, I guess the Government agrees but the last time I looked the tax code is in Title 26 and if one violates Title 26 U.S.C. Section 7201 et. al. then one will face a criminal trial. If the individual is found guilty then that individual will face a criminal sentence under the guidelines. Simply stated, a criminal violation of the code is not just reserved for Al Capone. Sadly it was alleged and KPMG “kind a of agreed” that a violation of the code occurred here. Unfortunately, the Government crossed the line and just as unfortunate, if we are to believe the editorial section of the Wall Street Journal, corporate America did not learn the lesson because it just didn’t get it.

Bakersfield Energy Partners, LP v. Commissioner, 128 T.C. No. 17 (2007). The IRS goes for the trifecta and loses.

The IRS had some “notable” wins in Kligfeld Holdings et al. v. Commissioner; 128 T.C. No. 16 (2007) and G-5 Investment Partnership v. Commissioner, 128 T.C. No. 15 (2007) but a win in Bakersfield would have made every partner in a partnership potentially subject to a six year statute. Yes, the IRS was focused on tax shelters but its argument had applications far greater than those partners involved in tax shelters. Thus, Bakersfield was the crown jewel in the battle as to the statue of limitations and the IRS lost.

In Kligfeld Holdings, the IRS was able to secure an extension to the statute of limitations as to a TEFRA partnership due to a John Doe summons at the partner level. In G-5, the Tax Court agreed with the Court of Claims and found that the carryover deductions from a TEFRA partnership were similar to NOL carryovers and thus allowed the Service to investigate the carryover amount attributable to the TEFRA partnership.

Needless to say, both opinions have limited application to most legitimate TEFRA partnerships. After all how often will a partner be the subject of a John Doe summons? The answer is not very often.

As to the NOL argument in G-5, most tax shelters have a huge permanent impact in the first year and the remaining years are usually either timing issues or the permanent deductions are not nearly as great as the first year. Thus, the IRS was looking for a bigger stick – a six year statute and in Bakersfield the IRS lost that pivotal argument.

The relevant facts in Bakersfield are as follows: the IRS issued a Notice of Final Partnership Administrative Adjustment (FPAA) on October 4, 2005 to the TEFRA partnership. The FPAA alleged that the TEFRA partnership had overstated its basis in certain gas reserves sold during the taxable year 1998. According the IRS the TEFRA partnership had a $0 basis in the gas reserves it sold during the taxable year 1998 and any optional basis adjustment under section 743(b) was the result of a sham transaction, a transaction lacking economic substance that had no business purpose and no economic effect and/or was availed for tax avoidance purpose and should not be respected for tax purposes. Thus, the inflated basis caused an understatement of the partnership’s income by more than 25 percent of the amount stated in the return.

The Tax Court disagreed with the IRS. The Court commenced its opinion by reminding the IRS that § 6229 did not create a completely separate statute of limitations for assessments attributable to partnership items, instead, § 6229 supplements § 6501. Thus, for the Statute of Limitations to be open, the IRS had to convince the Court that Colony, Inc. v. Commissioner, 357 U.S. 28 (1958) did not apply.

The Tax Court cited to Colony, Inc. v. Commissioner, 357 U.S. at 37 as follows:


We think that in enacting section 275(c) Congress manifested no broader purpose than to give the Commissioner an additional two years [now three] to investigate tax returns in cases where, because of a taxpayer's omission to report some taxable item, the Commissioner is at a special disadvantage in detecting errors. In such instances the return on its face provides no clue to the existence of the omitted item. On the other hand, when, as here, the understatement of a tax arises from an error in reporting an item disclosed on the face of the return the Commissioner is at no such disadvantage. * * * [ Id. at 36.]


This language led the Tax Court to hold that “The precise holding of the Supreme Court in Colony, Inc. v. Commissioner, supra, was that the extended period of limitations applies to situations where specific income receipts have been “left out” in the computation of gross income and not when an understatement of gross income resulted from an overstatement of basis.”

To the Tax Court the Supreme Court was clear in Colony, Inc. “omits” means something “left out” and not something put in and overstated. How he IRS will react to this major loss remains to be seen but there is only one conclusion: The loss in Bakersfield is a major blow for the IRS and I would expect it will seek legislative relief in this area.

Call it the Government just being obstinate or worse call it for what it is - just plain dumb idea - Klamath Strategic Investment Fund, LLC v. United States, --- F.Supp.2d ----, 2007 TNT 66-9 (E.D.Tex.. 2007). (Part II).

Well the Government asked the Court to reconsider its opinion. Let’s just say for the Government that said motion was not a wise choice but for taxpayers in the Fifth (and maybe the Eleventh) they say “Thank You”!!!

Not only did the Court not reconsider its opinion but it further elaborated as to why the plaintiff’s were entitled to deduct operational and interest expenses. Bottom line – It looks like the taxpayers did a lot better than they would have if they had agreed to the settlement initiative offered by the IRS.

The Court in two paragraphs dismissed the Government’s motion to reconsider and focused on the Government’s argument as to disallowing the operational expenses claimed by the plaintiffs.

The government had two arguments -- 1) No deduction can be taken for expenses related to a sham transaction, and 2) Presidio, as the managing partner, did not have the requisite profit motive. As to the first argument the Government stated that expenses incurred in connection with a transaction that lacks economic substance are not deductible and that the fees associated with a loan can only be deducted if the underlying debt is determined to be genuine. The plaintiffs disagreed and the Court agreed with the plaintiffs.

The Court looked at the cases cited by the Government and politely accused the government of misrepresenting what the cases actually held. The Court found that the cases cited by the Government were not as broad as the Government contended but limited to disallow only the losses generated as part of the sham transactions. The Court found that in contrast “The operating expenses were real economic losses and were never going to be recovered as a part of the loan transactions that lacked economic substance. When the taxpayers executed these loan transactions, they expected to repay them in full and the taxpayers planned to use those loan proceeds for the purpose of making a profit.”


“Furthermore, a court "may not ignore transactions that have economic substance even if the motive for the transaction is to avoid taxes.". "Even where a transaction is not intended to serve business purposes, it may give rise to a deduction to the extent that it has objective economic substance apart from tax benefits." The plaintiffs in this case incurred actual economic losses which are separable from the tax benefits of the premium loan transactions. Some of these economic losses involve the fees paid to Presidio as part of the investment plan, the losses from the foreign currency transactions, and the interest expenses from the loan. Although these losses relate to the premium loan transactions, they were real and are separable from the tax benefits associated with those loans.”  (citations Omitted).

Now that analysis really hurts. In the shelters I have seen this language from the Court will come into play – it’s called cash out of pocket and the Court determined that  cash out of pocket losses can be deducted. This Court’s position clearly goes against the IRS’s announcements of no cash out pocket for those that did not partake in the IRS's settlement initiatives.

As to the second argument the government argued that it is the partnership's primary motive, rather than the individual partners' profit motives, that governs the deductibility of expenses. The Plaintiffs argued that it was the individual taxpayers that paid and claimed the expenses.

The Court agreed with the Plaintiffs. The Court found that the plaintiffs had entered into these transactions for the purposes of making a profit. So even though the partnership arguably did not have a profit motive, the Court applied an aggregate not an entity theory and allowed the expenses to be claimed by the individual taxpayers. Call this a major ouch!

There was no analysis conducted by the Court - No Tefra, No aggregate/entity. If I were the Government I would leave this case alone and not appeal but it is the Government and this is a major loss.


So when the Government trumpets its victory in Jade Trading (I know I am jumping the gun) just remember what Lee Corso says – “Not so fast my friend” because in Klamath you got hammered!! The taxpayer for all practical purposes won – No penalties and deductibility of cash out of pocket.

Celebration time at the IRS!

Did you hear that champagne cork pop from Washington, D.C.? I think we all did as this past week the Supreme Court denied certiorari in Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006). The obvious question becomes - Now What?

Well first the obvious – The opinion as to Jade Trading should be coming out shortly and it should be in the favor of the government. This is not a difficult conclusion to make after all the Court of Claims is bound by the Federal Circuit and the parties had agreed to postpone the Court’s ruling until Coltec’s appeal. It appears that the Court just wanted to see the appeal run its course. Thus, for all those pending cases in the Court of Claims the outcome is pretty well settled and the only remaining question will be one of penalties.

The interesting question is what will the IRS do with it new toy? Well with the Son of Boss cases pending in the United States Tax Court, we can and should expect the IRS to seek to have the Coltec standard applied in these cases. That is, the worst kept secret is that the IRS was disappointed with the result in Salina v. Commissioner, T.C. Memo 2000-352. Yes, the the IRS did win its section 752 argument but Judge Jacob’s refused to accept the Coltec argument as submitted by the IRS. Rather, Judge Jacobs looked at the entire transaction for purposes of applying the economic substance doctrine. As stated in the opinion:

"Contrary to respondent's position, we decline to analyze the economic substance of the disputed transaction by focusing solely on events occurring during the period December 28 through 31, 1992. Segregating FPL's investment in Salina into two parts, as respondent suggests, would violate the principle that the economic substance of a transaction turns on a review of the entire transaction. See Kirchman v. Commissioner, supra at 1493-1494; Winn-Dixie Stores, Inc. v. Commissioner, supra at 280. Although we agree with respondent that Goldman Sachs structured FPL's purchase of the Salina partnership interest to provide FPL with a perceived tax benefit, this factor, standing alone, is insufficient to render the transaction a sham in substance. "

With Coltec out there, one should expect the IRS to try again and persuade the United States Tax Court to reconsider its position. Personally, I hope the entire Court visits the economic substance doctrine.  Even though I question various aspects of the Tax Court’s opinion in Estate of Bongard v. Commissioner, 124 T.C. 95 (2005), Bongard gave tax litigators and planners an opportunity to examine/reexamine the merits of family limited partnerships. I believe most tax litigators/tax planners would likewise want to hear the full court's views on economic substance.  Stated bluntly, the Court is a national forum and there is too much intellectual and judicial talent to have it spent on due process hearing cases and I want to hear, for better or for worse, what the full Court has to say on this important judical doctrine.

But if I were the IRS I would be very careful as to which cases I would seek to apply the Coltec standard. After all not all tax deferral mechanisms are tax shelters. For example, the IRS might be emboldened to bring out the Coltec standard in a LILO case. Yes, I am familiar with the case in North Carolina but that LILO case was the exception not the general rule. Most LILO cases involve legitimate factual issues. The IRS’s pointing to interest earning financial instruments while interest deductions are being claimed may not be sufficient - After all can we say UPS.

In United Parcel Service of America v. Commissioner, 254 F. 3d 1014 (11th Cir. 2001), the Eleventh Circuit in an eight page opinion disposed of the one hundred plus page opinion of the Tax Court. In the Eleventh Circuit’s opinion at page 1019, the Court stated:

“A “business purpose” does not mean a reason for a transaction that is free of tax considerations. Rather, a transaction has a “business purpose,” when we are talking about a going concern like UPS, as long as it figures in a bona fide, profit-seeking business. See ACM P'ship v. Comm'r, 157 F.3d 231, 251 (3d Cir.1998). This concept of “business purpose” is a necessary corollary to the venerable axiom that tax-planning is permissible. See Gregory v. Helvering, 293 U.S. 465, 469, 55 S.Ct. 266, 267, 79 L.Ed. 596 (1935) (“The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits, cannot be doubted.”).”

Thus, I would humbly submit that not even the Coltec standard could withstand the UPS standard if the facts involved an aggressive but legitimate LILO. As they say we shall see.

Ramblings: So what was argued in Klamath Strategic Investment Fund, LLC v. United States, --- F.Supp.2d ----, 2007 WL 283790 (E.D.Tex.. 2007)?

I will “blame” the severe weather conditions in the Northeast for the lack of cases reported this week. But thanks to Tax Notes Today, tax practitioners were able to see what the Government argued in Klamath and taxpayer’s response.

Before I get to those arguments, if you like this kind of transparency then take notice that the United States Tax Court is accepting comments as to the amendments to its proposed rules. Under the proposed rules, only if you live in the Washington DC area will you have access to its electronic filings. Otherwise, you will still have to contact the Docket room and obtain a hard copy.

Simply stated, I don’t like it. Two points, the IRS gets full access as should all private practitioners not just those private practitioners that live in the DC area and can go by the Court house and review the case of interest. Second, the United States Tax Court must strive to be fully transparent. See Estate of Kanter v. Commissioner, T.C. Memo. 2007-21 and it looks like they have not learned that lesson. I mean wouldn’t you just love to see what exactly the Special Trial Judge’s report actually said, compare it to the IRS’s brief and then compare to the opinion. I bet, without seeing that STJ report, the IRS’s brief equals the final opinion. Oh well, just a guess but I digress. To Klamath, I go.

As stated in the blog of two weeks ago, the Government’s “victory” was to ask the Court to accept its argument raised in Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1356-57 (Fed.Cir.2006), i.e. the transaction to be analyzed is the particular transaction that gives rise to the tax benefit. In its brief the Government argued:

"When applying the economic substance doctrine, courts have taken pains to emphasize that the transaction to be analyzed is the particular transaction that gave rise to the tax benefit, and not collateral transactions which do not produce tax benefits. Coltec Indus., Inc. v. United States, 454 F.3d 1340, 1356-57 (Fed. Cir. 2006); Nicole Rose Corp. v. Comm'r., 320 F.3d 282, 283-84 (2d Cir. 2002); ACM P'ship v. Comm'r., 157 F.3d 231, 260 (3d Cir. 1998); Long-Term Capital Holdings v. United States, 330 F. Supp 2d 122, 171 (D. Conn. 2004).

For example, in the recent Coltec decision, the Federal Circuit explained that the taxpayer had missed the point when it attempted to prove that the creation of a subsidiary, and the transfer of certain management activities of its business to that subsidiary, had a business purpose (454 F.3d at 1358): "Here . . . we must focus on the transaction that gave the taxpayer a high basis in the stock and thus gave rise to the alleged benefit upon sale. That transaction is Garrison's assumption of Garlock's asbestos liabilities in exchange for the $375 million note. . . . It is this exchange that provided Garlock with the high basis in the Garrison stock, this exchange whose tax consequence is in dispute, and therefore it is this exchange on which we must focus."

The Government then focused solely on the transaction that gave rise to the tax benefit - the premium loan and argued that the leg had no economic substance. Question: Is the line becoming a little blurry as to the economic substance doctrine and the step-transaction doctrine? Most private practitioners recognize that there is a distinction between the two doctrines even thought the doctrines are kissing cousins. Yet, it appears that the two doctrines are morphing into one.

After all if one compares Klamath, Coltec with True v. United States, 190 F.3d 1165, 1177 (10th Cir.1999) what do we get? [ As stated in True at 1177:  “To ratify a step transaction that exalts form over substance merely because the taxpayer can either (1) articulate some business purpose allegedly motivating the indirect nature of the transaction or (2) point to an economic effect resulting from the series of steps, would frequently defeat the purpose of the substance over form principle.”]. I would respectfully submit that the judicial doctrines are being morphed together and we are moving farther away from a clearly defined test and are being left with a glorified smell test. Thus, it will be interesting to see what the United States Supreme Court does with Coltec. For if Coltec is reversed then it appears that the Government’s one pony ride on the back of Cotlec will cause Klamath to be overturned assuming it is appealed.

Klamath was also note worthy as to the taxpayer’s victory as to the penalties. Surprisingly the Government’s brief gave little argument as to the 40% penalty – no case law analysis, no argument other than a “one paragraph argument “which submitted that the 40% penalty was applicable. Then the Government attacked the reasonable cause defense based on the following arguments:

  • “In the first place, plaintiffs' due diligence was a sham itself. They failed to even inquire as to the profit performance of the 75 prior BLIPS deals in 1999 and 2000 (prior to their transactions); not one of which made a profit.” Needles to say, it is apparent that the Government is really insisting on the use of pattern evidence as to the penalty phase of the case. 
  • “Furthermore, their claim that they only belatedly learned of BLIPS' enormous tax benefits defies common sense.” The old common sense argument. This is usually an argument of last resort when the testimony is not to one’s liking or the trial attorney forgot to have his/her expert testify as to a point – such emphasizing after tax rate of return vs. economic rate of return.
  • “Plaintiffs' argue that they are not tax lawyers and relied upon professional advisors for tax advice. Here, the authors of these legal opinions had a conflict of interest. Lemons had discussed the design of the BLIPS tax shelter with Presidio before it was ever sold to Nix and Patterson, and both Holland & Hart and Olson Lemons had both represented Presidio and its principals on numerous corporate and tax matters concerning BLIPS in general -- including the question of whether or not to register BLIPS as a tax shelter.” Looks like the Government did bring out the 500lb monster (the attorneys work with the promoters argument) and lost big time. The fact is the code is complex and the law firms that were engaged in these transactions were highly reputable firms. What is a taxpayer to do? It appears that the Government is arguing that the taxpayer should disagree with a prestigious tax firm when they tell the taxpayer – “Yes, even though it looks to be good to be true, this really does comply with the tax code.”
  • “Moreover, these so-called legal opinions were worthless since their ultimate conclusion as to the allowance of the BLIPS tax benefits was based on the accuracy and correctness of information allegedly provided by the plaintiffs themselves.” The Government trotted out Long Term Capital and it came right back at them. End result - it left the Government feeling like Darius III at the Battle at Issus.

Not surprisingly, the taxpayers in Klamath argued that penalties were not warranted based on the following:

  • The Government had admitted that the transactions "complied with the literal provisions of the Internal Revenue Code.” As such there was substantial authority for the positions taken on the returns. 
  • The 40% penalty did not apply due to Weiner v. United States, 389 F.3d 152 (5th Cir. 2004); Heasley v. Comm'r, 902 F.2d 380, 383 (5th Cir. 1990).
  • Taxpayers relied on and in good faith on the advice of several qualified tax professionals.The taxpayers also obtained detailed opinions from prominent tax counsel. 
  • As to the theory that there was no due diligence as to the facts, the taxpayers submitted that the lawyers prepared the statement of facts from the underlying transactional documents and that they had Presidio review the fact statement to confirm its accuracy. In addition, the lawyers sent the opinions under cover letters that instructed the taxpayers to review the fact statements for accuracy and, had the taxpayers been silent, they would have taken that as an affirmative representation that the facts were accurate. The lawyers testified that it was common for a practitioner to prepare fact statements for opinions since the practitioner knows what representations are important to the issues at hand -- and to then have the taxpayers review and approve those representations. This argument was accepted by the Court when it stated “ That Holland & Hart and Olson Lemons (the attorneys) had access to all relevant transactional documents which were reviewed by Presidio for accuracy.” This is the part of the opinion that hurts the Government more than any other part of the opinion. Reason:  It puts Long Term Capital on its head.

In conclusion: With Long Term Capital, the Government had the perfect storm (Noble Prize winner who knew a little bit about economics, an oral tax opinion, etc.) but in these other shelters both sides have litigation risks. Once the Government understands that  the concept of hazards of litigation does apply to these cases then more cases will be settled in terms that are more likely than not favorable to the Government. What is that saying about pigs? Well government keep trying cases in circuits that are not favorable and you will end up just like that poor old hog.

2007 Midyear meeting of the ABA Tax Section

This past week the Tax Section of the American Bar Association held its midyear meeting in Hollywood, Florida. I was able to attend two break-out sessions of interest – Tax Shelters and Court Procedure and Practice.

Caveat: As stated by the Government attorneys at these sessions: Their comments do not necessarily represent the views of the Government but are their respective individual views on the subject matter. Therefore, out of respect I will not associate any of the statement with the individual who made the statement.

Tax Shelters – The first topic of interest was whether the doctrine of economic substance was going to be codified. The government officials recognize that our tax system is based on a code and taxpayers are entitled to certainty based on those rules. However, the tax system is also based on a series of principles that guide taxpayers and their planners. These principles underlie the code and must be accounted for when considering various the planning opportunities that exist. These principles are flexible and therefore to “codify” these doctrines would enable a certain segment of “tax planners” to plan around the definition. Thus, whereby previously the flexible and evolving doctrine would have voided the doctrine, the plan may be structured to avoid the literal terms of the definition of economic substance. Compare Coltec with UPS. Thus understandably, the government officials were not enthusiastic about seeking a codification of the economic substance doctrine. As will be discussed later, the IRS and Treasury Department are already concerned about the next generation of tax shelters and want a system which is flexible enough to combat the new generation of “tax shelters”, without resorting to another series of code changes that we saw in the 1980’s such as the passive activity loss rules.

Observation: Although I tend to agree and sympathize with the government, the one problem that I see is that the doctrine of economic substance depends on which circuit the individual resides and which forum the taxpayer elects to enter into. For example a taxpayer who resides in the Fifth Circuit has a better opportunity to prevail on the same transaction without incurring a 40% penalty than a taxpayer that resides in the Fourth and Third circuits. (Compare Compaq and Todd with ACM, Long Term Capital, and Rice's Toyota World, Inc.). Let alone the lack of uniform definition will cause forum shopping to arise based on the definition of economic substance. Compare Coltec with Salina. Thus, the doctrine of consistency is being violated. Therefore, I recommend that we all stay tuned to see whether the Supreme Court grants Coltec’s Writ of Certiorari.

Another topic was the tax shelter regulations and Circular 230. As stated before the Government is concerned about the next generation of tax shelters. With that said, it was stated that the “new” provisions of Circular 230 are too weak. In their opinion, Circular 230 has been reduced to a disclaimer statement on letters, e-mails, etc. Thus, expect new guidance shortly. Along those reins, the Government is looking forward to receiving comments as to the tax shelter regulations concerning “Transaction of Interest” (aka Listed Light). The concern is that if taxpayers do not report these transactions then the IRS may view the transaction as a deadly sin, even though the transaction was not designed to avoid taxes. On the other extreme to much information will cause the IRS to be overwhelmed. Members of the ABA’s Tax Shelter sub-committee will submit their respective views on the matter so stay tuned.

Court Procedure and Practice – The topics of interest that were discussed was Dual Prosecution and Textron. To say that at times it was contentious is an understatement. As most readers are aware the Service’s policy has changed concerning Dual Prosecutions. In summary, the prior policy was once criminal prosecution was over then civil action commenced. The reason for the policy is the limited discovery in criminal proceedings in contrast to the open discovery rules of civil litigation. Fast forward, the IRS wants those that promote the new generation of tax shelters to understand that they face criminal and civil sanctions for these shelters. Thus, the policy was revisited due to the tax shelter that we have seen. See KPMG trial in New York.

As pointed out by the audiences’ questions, the problem lies in preparing the civil cases. Needless to say a deposition and a trial proceeding were the Fifth is asserted carries presumptions against the taxpayer. Just as important is the government’s use of “pattern evidence” wherein a taxpayer is subpoenaed to testify as to a transaction that he/she was involved with. Needless to say, the testimony of the witness will be used against the witness when the investors’ transaction is at issue and may be used against the witness if a criminal proceeding is sought. Needless to say this raises a concern for both the investor and his counsel, as in criminal cases there is that old presumption of innocence.

The next issue involved U.S. v. Textron. Textron is a summons case concerning “tax accrual workpapers”. The facts are straightforward: Textron’s in-house counsel provided the accountants for purposes of certifying the financial statements a spreadsheet that lists the issues identified by the tax advisors and, for each issue, the hazards of litigation percentage determined by the tax advisors. Needless to say the government wants this document and is claiming under Powell that it is entitled to these documents. Textron is asserting three privileges: Attorney-client, Section 7525 and work-product. The case has been fully briefed and closing arguments were heard just last week.

The issue is not one of discovery as that standard is relatively light and favorable for the government. But rather this is a battle as to the work-product doctrine and what the government intends to do not with the worksheet but with the attorneys. After all the premise of the Governments’ position is clear: there was subject matter waiver and therefore the attorneys and the documents they relied to form their opinions are now fair game. Compare Arthur Young with Roxworthy and Adlman. With FIN 48 Disclosures on IRS Examinations and Administrative Practice being unanimously passed, it would be wise to monitor Textron as it proceeds up the judicial chain.

Finally, I attended the Court Procedure and Practice Officers and Committee meeting. The Committee will be submitting our views to the Court’s new rules. The IRS is concerned about premature assessments due to the new rules concerning the social security numbers. The ABA is concerned about greater access to on-line documents as currently only those practitioners in Washington, D.C. will have access to the on-line documents.

The topics for the Washington meeting in May were discussed. Of interest will be FIN 48, TEFRA settlements, the importance if any of burden of proof (see McCord) and a workshop for young lawyers as to responding to the government’s request for information.

Year in Review - Tax shelters and the economic substance doctrine

The Court of Appeals overturned various lower court opinions and the Federal Circuit created yet another legal standard as to the economic substance. In Black & Decker Corp. v. United States, 436 F.3d 431 (4th Cir. 2006), which involved a transfer of stock in exchange, in part, for contingent liabilities, the Fourth Circuit remanded the case back to the lower court for consideration of the economic doctrine test under Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89, 91 (4th Cir. 1985). In TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006), overturned the lower court decision based on “the totality-of-the-circumstances”. The 2d circuit cited as authority Commissioner v. Culbertson, 337 U.S. 733, 742 (1949), which is an assignment of income case. But by far the most important case was Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006). In Coltec Industries, the Federal Circuit Court created a new standard for economic substance.

The Court of Appeals overturned various lower court opinions and the Federal Circuit created yet another legal standard as to the economic substance. In Black & Decker Corp. v. United States, 436 F.3d 431 (4th Cir. 2006), which involved a transfer of stock in exchange, in part, for contingent liabilities, the Fourth Circuit remanded the case back to the lower court for consideration of the economic doctrine test under Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89, 91 (4th Cir. 1985). In TIFD III-E, Inc. v. United States, 459 F.3d 220 (2d Cir. 2006), overturned the lower court decision based on “the totality-of-the-circumstances”. The 2d circuit cited as authority Commissioner v. Culbertson, 337 U.S. 733, 742 (1949), which is an assignment of income case. But by far the most important case was Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006). In Coltec Industries, the Federal Circuit Court created a new standard for economic substance. 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.  
      1. Arrangements with subsidiaries, i.e. related parties, that do not affect the economic interest of independent third parties deserve particularly close scrutiny.

For a thorough analysis of Coltec, see Dawson, COLTEC: A New Standard for Economic Substance, Business Entities (WG&L) (Nov./Dec. 2006)

On November 8, 2006, Coltec filed a Writ of Certiorari citing to the fact that there is a split amongst the Circuits as to proper applicable standard for the economic substance test and that the Coltec test is in conflict with those judicial standards.

Whether the Supreme Court accepts the case for review will be worth following, after all Congress has continuously been considering whether to adopt a uniform definition for economic substance and has postponed making a decision. The Supreme Court may view the definition of economic substance as a matter for Congress and therefore not accept the case.